“I know headquarterswants us to add that new product line,” said Dell Havasi, managerof Billings Company’s Office Products Division. “But I want to seethe numbers before I make any move. Our division’s return oninvestment (ROI) has led the company for three years, and I don’twant any letdown.”
Billings Company is adecentralized wholesaler with five autonomous divisions. Thedivisions are evaluated on the basis of ROI, with year-end bonusesgiven to the divisional managers who have the highest ROIs.Operating results for the company’s Office Products Division forthis year are given below:
| | |
| Sales | $ | 10,000,000 |
| Variableexpenses | | 6,000,000 |
| Contributionmargin | | 4,000,000 |
| Fixedexpenses | | 3,200,000 |
| Net operatingincome | $ | 800,000 |
| Divisionalaverage operating assets | $ | 4,000,000 |
|
The company had anoverall return on investment (ROI) of 15% this year (consideringall divisions). Next year the Office Products Division has anopportunity to add a new product line that would require anadditional investment that would increase average operating assetsby $1,000,000. The cost and revenue characteristics of the newproduct line per year would be:
| |
| Sales | $2,000,000 |
| Variableexpenses | 60% ofsales |
| Fixedexpenses | $640,000 |
|
Required:
1. Compute the OfficeProducts Division’s ROI for this year.
2. Compute the OfficeProducts Division’s ROI for the new product line by itself.
3. Compute the OfficeProducts Division’s ROI for next year assuming that it performs thesame as this year and adds the new product line.
4. If you were in DellHavasi’s position, would you accept or reject the new productline?
5. Why do you supposeheadquarters is anxious for the Office Products Division to add thenew product line?
6. Suppose that thecompany’s minimum required rate of return on operating assets is12% and that performance is evaluated using residual income.
a. Compute the OfficeProducts Division’s residual income for this year.
b. Compute the OfficeProducts Division’s residual income for the new product line byitself.
c. Compute the OfficeProducts Division’s residual income for next year assuming that itperforms the same as this year and adds the new product line.
d. Using the residualincome approach, if you were in Dell Havasi’s position, would youaccept or reject the new product line?
