Thursday, 2 August 2012

“I know headquarters wants us to add that new product line,” said Fred Halloway, manager of Kirsi Products’ East Division.

Problem 11-14 Return on Investment (ROI) and Residual Income [LO1, LO2]
“I know headquarters wants us to add that new product line,” said Fred Halloway, manager of Kirsi Products’ East Division. “But I want to see the numbers before I make a move. Our division’s return on investment (ROI) has led the company for three years, and I don’t want any letdown.”
     Kirsi Products is a decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to divisional managers who have the highest ROI. Operating results for the company’s East Division for last year are given below:

     
  Sales $ 21,000,000  
  Variable expenses   13,400,000  
 

  Contribution margin   7,600,000  
  Fixed expenses   5,920,000  
 

  Net operating income $ 1,680,000  
 



  Divisional operating assets $ 5,250,000  
 





The company had an overall ROI of 18% last year (considering all divisions). The company’s East Division has an opportunity to add a new product line that would require an investment of $3,000,000. The cost and revenue characteristics of the new product line per year would be as follows:

   
  Sales $  9,000,000  
  Variable expenses   65% of sales  
  Fixed expenses $  2,520,000  

   
Required:
1.
Compute the East Division’s ROI for last year; also compute the ROI as it would appear if the new product line is added. (Do not round intermediate percentage values. Round your intermediate calculations and final answers to 2 decimal places. Omit the "%" sign in your response.)

  ROI
  Present 32 correct %  
  New product line alone 21 correct %  
  Total 28.00 correct %  


2. If you were in Fred Halloway’s position, would you accept or reject the new product line?
   
  Reject correct

3.
Why do you suppose headquarters is anxious for the East Division to add the new product line?
   
  Adding the new line would increase the company's overall ROI. correct

4.
Suppose that the company’s minimum required rate of return on operating assets is 15% and that performance is evaluated using residual income.

a.
Compute the East Division’s residual income for last year; also compute the residual income as it would appear if the new product line is added. (Omit the "$" sign in your response.)

  Residual income   
  Present $ 892,500 correct  
  New product line alone $ 180,000 correct  
  Total $ 1,072,500 correct  


b.
Under these circumstances, if you were in Fred Halloway's position would you accept or reject the new product line?
   
  Accept correct