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:

Sales $ 22,505,000

Variable expenses 14,105,500

Contribution margin 8,399,500

Fixed expenses 6,145,000

Net operating income $ 2,254,500

Divisional average operating assets $ 4,687,500

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 $3,261,000. The cost and revenue characteristics of the new product line per year would be:

Sales $9,750,000

Variable expenses 65% of sales

Fixed expenses $2,595,300

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 14% 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?

Answer 1

A) Answer to part 1, 2, and 3

Billing Company's Office Product Division
	Office Products Division (current Year)	New Product Line's Analysis		Office Products Division-Next Year (with new product line)
Sales	22505000	9750000		32255000
Less: Variable Cost	-14105500	-6337500		-20443000
Contribution Margin	8399500	3412500		11812000
Less: Fixed expenses	-6145000	-2595300		-8740300
Net Operating Income	2254500	817200		3071700
Average Assets	4687500	3261000		7948500
ROI	48.10	25.06		38.65

4.  

As on the Dell Havasi’s position, I would reject the new product line. The company’s divisions are evaluated on the basis of ROI and the bonus on year end is based on performance in terms of division’s ROI. The Office Products Division is leading the company with 48.10% ROI, but ROI on new product line would be 25.06% that is too low as compare the current ROI of division. If the new product line decision is accepted, It would bring the next year’s ROI of the division to 38.65%.

6. Residual Income Approach

Residual Income = Net Operating Income – (Average Operating Assets * Minimum Required Rate of Return)

a) Residual Income of Office Products Division (current year) = 2254500 - (4687500*14%)

= 2254500 - 656250 = $ 1,598,250

b) Residual Income of the new product line = 817200 - (3261000 * 14%)

= 817200 - 456540 = $ 360,660

c) Residual Income of the Office Products Division in Next Year (with new product line)

= Residual income from existing business + Residual Income from new product line

= 1598250 + 360660 = $ 1,958,910

d) As on the Dell Havasi's position, I would accept the decision to launch new product line on the basis of residual income approach. The new product line will add to shareholders worth $ 360,660 per annum which is 22.5% of the value added by existing business to shareholders net worth.

PLEASE, rate the solution, if it is helpful to you .......