Question

LaserLife Printer Company is a decentralized organization with several autonomous divisions. The division managers are evaluated, in part, on the basis of the change in their return on invested assets. Operating results for the Packer Division for 2019 are budgeted as follows:

Sale $5,000,000
Less variable costs 2,500,000
Contribution margin 2,500,000
Less fixed expenses 1,800,000
Net operating income $ 700,000
Invested capital for the division are currently $3,600,000. For 2019, the division can add a new product line for an investment of $600,000. The new product line will generate sales of $1,600,000 and will incur fixed expenses of $600,000 annually. Variable costs of the new product will average 60% of the selling price.
REQUIRED:
1. What is current ROI? Profit margin (or Return on sales)? Investment (or Capital) turnover?
2. What is the effect on ROI of accepting the new product line?
If the company's required rate of return is 6% and residual income (RI) is used to evaluate managers, would this encourage the division to accept the new product line? Explain and show computations.

Answer 1

1. The current ROI is 19.44%. The Profit margin (or Return on sales) is 14%. TheInvestment (or Capital) turnover is 1.39 times.

2. The effect on ROI of accepting the new product line is 17.62%. ROI will be decreased by 1.82%

If the company's required rate of return is 6% and residual income (RI) is used to evaluate managers the residual income amount would be of $4,000 and so Managers should accept the new product line

Step-by-step explanation:

1. To calculate the profit margin we have to use the following formula:

Profit margin= Net operating income/Sale

Hence, Profit margin = $700,000/$5,000,000 = 14%

ROI= Net operating income/Invested capital

Hence, ROI = $700,000/$3,600,000 = 19.44%

Investment (or Capital) turnover=Sale/Invested capital

Hence, Investment (or Capital) turnover = $5,000,000/$3,600,000 = 1.39 times

2. The Net operating income= ($5,000,000+$1,600,000)-($2,500,000+1,600,000*60%)-$(1,800,000+$600,000) = $740,000

Hence, ROI = $740,000/$4,200,000 = 17.62%

ROI will be decreased by (19.44-17.62) 1.82%.

In order to know if the division would accept the new product line If the company's required rate of return is 6% and residual income (RI) is used to evaluate managers, we would have to calculate the residual income as follows:

Residual income = operating income - invesed capital*required rate of return

= ($740,000-$700,000)-$600,000*6%

= $4,000

Therefore, Managers should accept the new product line.