Problem 10-18 Return on Investment (ROI) and Residual Income [LO10-1, LO10-2] "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 $ 10,000,000 Variable expenses 6,000,000 Contribution margin 4,000,000 Fixed expenses 3,200,000 Net operating income $ 800,000 Divisional average operating assets $ 4,000,000 The company had an overall return on investment (ROI) of 15% 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 $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

Solution :

Income on new line

Contribution (2,000,00 x40%)           800,000

Less fixed expense                          - 640,000

Net operating income                        160,000

Particulars                              Present            New line          Total

Sales                                 10,000,000      2,000,000    12,000,000      

Net operating income      800,000            160,000        960,000

Operating assets             4,000,000         1,000,000   5,000,000

Margin                                   8%                       8%               8%

ROI                                     20.00%                16.00%         19.20%

Residual income   = net operating income - (average assets x minimum rate or return)

Particulars                                  Present            New line          Total

Operating assets                   4,000,000         1,000,000   5,000,000      

Minimum required return          12 %                   12 %             12 %

Min net operating income     480,000             120,000      600,000

Actual net operating income  800,000            160,000      960,000

Residual income                      320,000               40,000      360,000      

month 1 start amount =$3287.90 interest=(3287.90x0.0145/12)3.97 total to pay=$3291.81 paid =$1200 balance =$2,091.87

month 2 starting amount= $2,091.87 interest =$25.28 total to pay =$2117.15 paid =$1200 balance $917.15

month 3 starting amount =$917.15 interest =$11.08 total to pay =$928.23 paid =$928.23 balance =$0 total to pay 1200+1200+928.23 = $3328.23 it will take 3 months to pay a total of $3328.23

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