The contribution format income statement for Huerra Company for last year is giv

Question

The contribution format income statement for Huerra Company for last year is given below:

The company had average operating assets of $507,000 during the year.

Required:

1. Compute the company’s return on investment (ROI) for the period using the ROI formula stated in terms of margin and turnover.

For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described, and then compute the new ROI figure. Consider each question separately, starting in each case from the data used to compute the original ROI in (1) above.

2. Using Lean Production, the company is able to reduce the average level of inventory by $95,000. (The released funds are used to pay off short-term creditors.)

3. The company achieves a cost savings of $10,000 per year by using less costly materials.

4. The company issues bonds and uses the proceeds to purchase machinery and equipment that increases average operating assets by $125,000. Interest on the bonds is $18,000 per year. Sales remain unchanged. The new, more efficient equipment reduces production costs by $6,000 per year.

5. Sales are increased by 10%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of $17,000 is scrapped and written off as a loss.

7. At the beginning of the year, the company uses $181,000 of cash (received on accounts receivable) to repurchase and retire some of its common stock.

Total Unit Sales $ 1,000,000 $ 50.00 Variable expenses 600,000 30.00 Contribution margin 400,000 20.00 Fixed expenses 320,000 16.00 Net operating income 80,000 4.00 Income taxes @ 40% 32,000 1.60 Net income $ 48,000 $ 2.40

Explanation / Answer

Answer to Part 1.

Turnover Ratio = Sales / Average Operating Assets
Turnover Ratio = 1,000,000 / 507,000
Turnover Ratio = 1.97

Margin = Net Operating Income / Sales * 100
Margin = 80,000 / 1,000,000 * 100
Margin = 8%

ROI = Turnover Ratio * Margin
ROI = 1.97 * 8
ROI = 15.76%

Answer to Part 2.

Reduction in Average Level of Inventory will reduce the Average Operating Assets.
New Average Operating Assets = $507,000 - $95,000 = $412,000

Turnover Ratio = 1,000,000 / 412,000
Turnover Ratio = 2.43

Margin Ratio will remain Unchanged due to change in Inventory.

ROI = Turnover Ratio * Margin
ROI = 2.43 * 8
ROI = 19.44%

Answer to Part 3.

The Cost saving of $10,000 will increase the Net Operating Income by $10,000. Therefore, the New Net Operating Income will by $90,000.

Turnover Ratio will remain unchanged to 1.97.

Margin = Net Operating Income / Sales * 100
Margin = 90,000 / 1,000,000 * 100
Margin = 9%

ROI = Turnover Ratio * Margin
ROI = 1.97 * 9
ROI = 17.73%

Answer to Part 4.

The Average Operating Assets will increase by $125,000 due to Purchase of machinery and Equipment. The New Average Operating Assets will be $632,000 ($507,000 + $125,000).

The Increase expenses in Interest expense will reduce Net Operating Income by $18,000 and reduction in production cost will increase the Net Operating Income. The New Net Operating Income will be $68,000 ($80,000 - $18,000 + $6,000).

Turnover Ratio = Sales / Average Operating Assets
Turnover Ratio = 1,000,000 / 632,000
Turnover Ratio = 1.58

Margin = Net Operating Income / Sales * 100
Margin = 68,000 / 1,000,000 * 100
Margin = 6.8%

ROI = Turnover Ratio * Margin
ROI = 1.58 * 6.8
ROI = 10.74%

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