Question - Return on Investment (ROI) and Residual Income
"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 the most recent year are given below:
|
Sales
|
$10,000,000
|
|
Variable expenses
|
6,000,000
|
|
Contribution margin
|
4,000,000
|
|
Fixed expenses
|
3,200,000
|
|
Net operating income
|
$800,000
|
|
Divisional operating assets
|
$4,000,000
|
The company had an overall return on investment (ROI) of 15% last year (considering all divisions).The Office Products Division has an opportunity to add a new product line that would require an additional investment in operating assets of $1,000,000. The cost and revenue characteristics of the new product line per year would be:
|
Sales
|
$2,000,000
|
|
Variable expenses
|
60% of sales
|
|
Fixed expenses
|
$640,000
|
Requirement 1: Compute the Office Products Division's ROI for the most recent year; also compute the ROI as it would appear if the new product line is added.
Requirement 2: If you were in Dell Havasi's position, would you accept or reject the new product line?
Requirement 3: Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?
Requirement 4: Suppose that the company's minimum required rate of return on operating assets is 12% and that performance is evaluated using residual income.
(a) Compute the Office Products Division's residual income for the most recent 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 Dell Havasi's position, would you accept or reject the new product line?