“I know headquarters wants us to add that new product line,” said Brian Stettler

Question

“I know headquarters wants us to add that new product line,” said Brian Stettler, manager of Sparks Products’ Central Division. “But I want to see the numbers before I make a move. Our division’s return on investment (ROI) has led the company for three years, and I don’t want any letdown.” Sparks Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company’s Central Division for last year are given below: Sales $ 23,900,000 Variable expenses 15,209,091 Contribution margin 8,690,909 Fixed expenses 6,554,000 Net operating income $ 2,136,909 Divisional operating assets $ 5,975,000 The company had an overall ROI of 13% last year (considering all divisions). The company’s Central Division has an opportunity to add a new product line that would require an investment of $3,810,000. The cost and revenue characteristics of the new product line per year would be as follows: Sales $ 11,240,000 Variable expenses 65% of sales Fixed expenses $ 3,060,910 Required: 1. Compute the Central Division’s ROI for last year; also compute the ROI as it would appear if the new product line is added. (Do not round intermediate percentage values. Round your final answers to 2 decimal places (i.e., 0.1234 should be entered as 12.34).) 2. If you were in Brian Stettler’s position, would you accept or reject the new product line? Accept Reject 3. Why do you suppose headquarters is anxious for the Central Division to add the new product line? Adding the new line would decrease the company's overall ROI. Adding the new line would increase the company's overall ROI. 4. Suppose that the company’s minimum required rate of return on operating assets is 10% and that performance is evaluated using residual income. a. Compute the Central Division’s residual income for last year; also compute the residual income as it would appear if the new product line is added. b. Under these circumstances, if you were in Brian Stettler‘s position would you accept or reject the new product line? Accept Reject

Explanation / Answer

Solution:1

(3) Operating assets

Calcualtion for new product line:

Sales ............................................................................$ 11,240,000

Variable expense ........................................................... $7306000

Contribution margin(Sales - variable expense).................... $3934000

Fixed expense ................................................................$ 3,060,910

Operating income ( sales- variable expense- fixed expense) $ 873090

Solution: 2

I would have accepted the new product line because by adding the new line, the overall ROI has increased.

Solution:3

The new product line promises an ROI of 22.89% whereas the company's overall ROI last year was only 13%. Therefore, Adding the new line would increase the company's overall ROI.

Solution:4 (a)

Solution: 4 (b) I would have accepted the new product line because the overall residual income has increased with this product line.

Present New line total (1) Sales $ 23,900,000 $ 11,240,000 35140000 (2) Operating income $ 2,136,909 $ 873090 3009999

(3) Operating assets

$ 5,975,000 $3,810,000 9785000 (4) Margin (2)/(1) 8.94% 7.76% 8.56% (5) Turnover (1) / (3) 4 2.95 5.52 (6) ROI (4) * (5) 35.76% 22.89% 47.52

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