Question

A condensed income statement for the Electronics Division of Gihbli Industries Inc. for the year ended December 31 is as follows:

Sales $4,080,000
Cost of goods sold 3,117,000
Gross profit $963,000
Operating expenses 555,000
Income from operations $408,000
Invested assets $3,400,000

Assume that the Electronics Division received no cost allocations from service departments.

The president of Gihbli Industries Inc. has indicated that the division’s return on a $2,900,000 investment must be increased to at least 22.5% by the end of the next year if operations are to continue. The division manager is considering the following three proposals:

Proposal 1: Transfer equipment with a book value of $580,000 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would be less than the amount of depreciation expense on the old equipment by $104,400. This decrease in expense would be included as part of the cost of goods sold. Sales would remain unchanged.

Proposal 2: Reduce invested assets by discontinuing a product line. This action would eliminate sales of $616,300, reduce cost of goods sold by $411,800, and reduce operating expenses by $181,300. Assets of $1,468,300 would be transferred to other divisions at no gain or loss.

Proposal 3: Purchase new and more efficient machinery and thereby reduce the cost of goods sold by $382,800 after considering the effects of depreciation expense on the new equipment. Sales would remain unchanged, and the old machinery, which has no remaining book value, would be scrapped at no gain or loss. The new machinery would increase invested assets by $1,450,000 for the year.

Required:

a. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and rate of return on investment for the Electronics Division for the past year.
b. Prepare condensed estimated income statements and compute the invested assets for each proposal.

Answer 1

Gihbli Industries Inc.

Electronics Division

a1. Profit margin = 10%

a2. Investment turnover = 1.2

a3. DuPont Return on Investment = 12%

b. Condensed estimated income statements:

Proposal 1 Proposal 2 Proposal 3

Sales $4,080,000 $3,463,700 $4,080,000

Cost of goods sold (3,117-104.4) 3,012,600 2,705,200 2,734,200

Gross profit $1,067,400 $758,500 $1,345,800

Operating expenses 555,000 373,700 555,000

Income from operations $512,400 $384,800 $790,800

Invested assets ($3,400-580) $2,820,000 $1,931,700 $4,850,000

Step-by-step explanation:

a) Data:

Condensed Income Statement for the year ended December 31:

Sales $4,080,000

Cost of goods sold 3,117,000

Gross profit $963,000

Operating expenses 555,000

Income from operations $408,000

Invested assets $3,400,000

Expected Return on Investment = 22.5%

b) Calculations:

Proposal 1 Proposal 2 Proposal 3

Sales $4,080,000 $3,463,700 $4,080,000

Cost of goods sold (3,117-104.4) 3,012,600 2,705,200 2,734,200

Gross profit $1,067,400 $758,500 $1,345,800

Operating expenses 555,000 373,700 555,000

Income from operations $512,400 $384,800 $790,800

Invested assets ($3,400-580) $2,820,000 $1,931,700 $4,850,000

Return on Sales = Income from operations/Sales = $408,000/$4,080,000 = 0.1 = 10%

Investment turnover = net sales/Invested assets

= $4,080,000/$3,400,000

= 1.2

Dupont rate of return = return on sales multiplied by asset turnover

= 0.1 * 1.2 = 0.12 = 12%

c) The DuPont model calculates the Electronics Division's ROI by multiplying its return on sales by its asset turnover. Investment turnover equals the net sales value divided by the sum of invested assets (shareholder equity and outstanding debt). The DuPont model enables the investor to identify strengths or weaknesses that should be addressed in an investment.