“I know headquarters wants us to add that new product line,” said Dell Havasi, m
ID: 2579042 • Letter: #
Question
“I know headquarters wants us to add that new product line,” said Dell Havasi, manager of Billings Company’s Office Products Division. “But I want to see the numbers before I make any move. Our division’s return on investment (ROI) has led the company for three years, and I don’t want any letdown.”
Billings Company is a decentralized wholesaler with five autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to the divisional managers who have the highest ROIs. Operating results for the company’s Office Products Division for this year are given below:
The company had an overall return on investment (ROI) of 17.00% this year (considering all divisions). Next year the Office Products Division has an opportunity to add a new product line that would require an additional investment that would increase average operating assets by $2,484,500. The cost and revenue characteristics of the new product line per year would be:
Required:
1. Compute the Office Products Division’s ROI for this year.
2. Compute the Office Products Division’s ROI for the new product line by itself.
3. Compute the Office Products Division’s ROI for next year assuming that it performs the same as this year and adds the new product line.
4. If you were in Dell Havasi’s position, would you accept or reject the new product line?
5. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?
6. Suppose that the company’s minimum required rate of return on operating assets is 13% and that performance is evaluated using residual income.
a. Compute the Office Products Division’s residual income for this year.
b. Compute the Office Products Division’s residual income for the new product line by itself.
c. Compute the Office Products Division’s residual income for next year assuming that it performs the same as this year and adds the new product line.
d. Using the residual income approach, if you were in Dell Havasi’s position, would you accept or reject the new product line?
Sales $ 22,900,000 Variable expenses 14,313,400 Contribution margin 8,586,600 Fixed expenses 6,205,000 Net operating income $ 2,381,600 Divisional average operating assets $ 4,580,000Explanation / Answer
Workinf Notes:
1)
Office Products Division’s ROI for this year = Net operating income / Average Operating Assets = $2381600 / $4580000 = 52%
2)
Office Products Division’s ROI for the new product line by itself = Net operating income / Average Operating Assets = $877600/$2484500 = 35.32%
3)
Net operating income / Average Operating Assets = $3259200 / $7064500 = 46.13%
4) Billings Company is a decentralized wholesaler with five autonomous divisions. The divisions are evaluated based on ROI, with year-end bonuses given to the divisional managers who have the highest ROIs. The ROI of the new product line alone is much less than the ROI that is being given by the office product's division at present. An ROI of 32% brings down the average return of the Office Product's Division to 46% from 52% because of the lower ROI of the new product line. As the divisions are being treated as responsibility centres and the managers of each division are responsible for the productivity of the corresponding divisions, and the ROI is the yardstick of the divisional performance, as a manager of this division, Dell Havasi would not like to accept the proposal.
5) The overall return on investment is 17% for the company. The ROI from the new product line itself is 32% which is much higher than the overall ROI of the company. Therefore, addition of the new product line will increase the overall ROI of the company. although it will decrease the ROI of the Office Product Division from 52% to 46%. However, from the point of view of the overall company, the addition of the new product line will improve the financial performance of the company as a whole.
6)
Workings:
a) Office Products Division’s residual income for this year = $1786200
b) Office Products Division’s residual income for the new product line by itself = $554615
c) Office Products Division’s residual income for next year assuming that it performs the same as this year and adds the new product line = $2340815
d) If the Residual Income appraoch is used as the criteria, Dell Havasi should accept the proposal as it is increasing the division's Residual Income by $554615
New Product's Line Operating Income Sales $ 99,42,400 Less: Variable expense (65% of $9942400) $ 64,62,560 Contribution $ 34,79,840 Less: Fixed expense $ 26,02,240 Net Operating Income $ 8,77,600Related Questions
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