Question

1. The following data refers to the Daniels division of Tippett Inc. Daniels sells variablespeed drills. The standard drill sells for $ 40, and Daniels plans to sell 30,000 units in 2017. Tippett treats Daniels as an investment center with a total attributable investment of $ 800,000. Daniels' annual fixed costs are $ 200,000. Variable cost per standard drill is $ 24. The firm's required rate of return on investment is 15%.

1.1 What is the expected Return on Investment in 2017?
1.2 What is the expected residual income for Daniels in 2017?
1.3 A special order from a unit of the US Government has been received to buy from Daniel 10,000 units every year of the device at the price of $30 each. If the order is accepted, Daniels will have to incur additional annual fixed costs of $30,000 for administration and $150,000 to modify and expand the manufacturing facilities.

Based on the effect on ROI and/or Residual Income for the first year, will the manager accept this order? Why and why not?

Answer 1

See below.

Step-by-step explanation:

For part 1

Expected return can be computed by working out net profits from the production of drills.

Contribution per drill = Selling price - variable costs

Contribution = 40 - 24 = $16/ drill

Total contribution = 16 * 30,000 = $480,000

Profit = Contribution - Fixed costs

Profit = 480,000 - 200,000 = $280,000

Return on investment = Profit / Initial investment

ROI = 280,000 / 800,000 = 35%

Residual income = Net income - Equity charge

RI = 280,000 * (800,000*0.15) = $160,000

For part 2

We assume that this special order of 10,000 drills is in addition to the existing 30,000 drills bringing the total to 40,000 drills sold per year.

We first calculate the income effect of this isolated 10,000 additional drills.

Selling price = 30/drill

Variable cost / drill = 24

Contribution / new drill = 6

Total contribution from the order = 6*10,000 = $60,000

Total profit increment from this order = 60,000 - 30,000 = $30,000

This brings the total profit from 40,000 drills to

= 30,000+280,000 = $310,000

Total investment now has been increased by $150,000 bringing the total to 150,000 + 800,000 = $950,000

ROI has changed to = 310,000 / 950,000 = 32.63%

Residual income has changed to as,

RI = 310,000 - (950,000*0.15) = $167,500

Although the return on investment has fallen by around 2.37% the residual income has increased. Daniels may accept this order to ensure he has a good customer base and their total market share may actually improve thus this order might be strategically important for the future of the business.

Hope that helps.