Cost-Volume Analysis and Return on Investment

Cost-Volume Analysis and Return on Investment (ROI) (LO1)

Images.com is a small Internet retailer of high-quality posters. The company has $800,000 in operating assets and fixed expenses of $160,000 per year. With this level of operating assets and fixed expenses, the company can support sales of up to $5 million per year. The company's contribution margin ratio is 10% which means that an additional dollar of sales results in additional contribution margin, and net operating income, of 10 cents.

Required:
1. Complete the following table showing the relationship between sales and return on investments (RO1).

(see attached file for chart)

2. What happens to the company's return on investment (RO1) as the sales increase? Explain.

PROBLEM 10-13 Return on Investment (ROI) and residual Income (LO1, LO2)
"I know headquarters wants us to add that new product line," said Clem Baker, manager of Westwood Inc.'s Office Products Division. "But I want to see the numbers before I make any move. Our division has led the company for three years, and I don't want any letdown."
Westwood Inc. is a decentralized organization with five autonomous divisions. The divisions are reevaluated on the basis of the return that they are able to generate on invested assets, with year-end bonuses given to the divisional managers who have the highest ROI figures. Operating results for the company's Office Products Division for the most recent year are given below:

Sales ........................................... $9,000,000
Less variable expenses ....................... 5,400,000
Contribution margin ........................... 3,600,000
Less fixed expenses ........................... 2,520,000
Net operating income ........................ $1,080,000
Divisional operating assets ................... $4,500,000

The company had and overall ROI of 18% last year (considering all divisions). The office Products Division has an opportunity to add a new product line that would require an additional investment in operating assets of $250,000. The cost and revenue characteristics of the new product line per year would be:

Sales ........................................... $1,000,000
Variable expenses ............................. 60% of sales
Fixed expenses ................................ $350,000

Required:
1. Compute the Office Products Division's ROI for the most recent year; also compute the ROI as it will appear if the new product line is added.
2. If you were in Clem Baker's position, would you be inclined to accept or reject the new product line? Explain.
3. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?
4. Suppose that the company views a return of 15% on invested assets as being the minimum that any division should earn and that performance is evaluated by the residual income approach.
a. Compute the Office Products Division's residual income for the most recent year; also compute the residual income as it would appear if the new product line were added.
b. Under these circumstances, if you were in Clem Baker's position, would you accept or reject the new product line? Explain.

EXERCISE 11-7 Identification of Revel ant Costs (LO2)

Samantha Ringer purchased a used automobile for $10,000 at the beginning of last year and incurred the following operating costs:

Depreciation ($10,000 /10trips) ....................................... $2,000
Insurance .................................................................. $960
Garage rent ................................................................ $480
Automobile tax and license ........................................... $60
Variable operating cost ..............................................$.08 per mile

The variable operating costs of gasoline, oil, tires, maintenance, and repairs. Samantha estimates that at her current rate of usage the car will have zero resale value in five years, so the annual straight-line depreciation is $2,000. the car is kept in the garage for a monthly fee.

Required:
1. Samantha drove the car 10,000 miles last year. Compute the average cost per mile of owning and operating the car.
2. Samantha is unsure about whether she should use her own car or rent a car to go on her extended cross-country trip for two weeks during spring break. What costs above are relevant in this decision?
Explain.
3. Samantha is thinking about buying an expensive sports car to replace the car she bought last year. She would drive the same number of miles irrespective of which car she owns and would rent the same parking space. The sports car's variable operating costs would be roughly the same as the variable operating costs of her old car. However, her insurance and automobile tax and license costs would go up. What costs are relavant in estimating the incremental cost of owning the more expensive car? Explain.

PROBLEM 11-17 Dropping or retaining a Segment (LO2)
Adams County Senior Services is a nonprofit organization devoted to providing essential services to seniors who live in their own homes within the Adams County area. Three services are provided for seniors-home nursing, meals on wheels, and housekeeping. In the home nursing program, nurses visit seniors on a regular basis to check on their general health and to perform tests ordered by their physicians. The meals on wheels program delivers a hot meal once a day to each senior enrolled in the program. The housekeeping service provides weekly housekeeping and maintenance services. Data on revenue and expenses for the past year follow:

(see attached file)

The head administrator of Adams County Senior Services, Mariam Santoya, is concerned about the organizations finances and considers the net operating income of $12,000 last year to be razor thin. (Last year's results were very similar to the results for previous years and are representative of what would be expected in the future.) She feels that the organization should be building its financial reserves at a more rapid rate in order to prepare for the next inevitable recession. After seeing the above report , Ms. Santoya asked for more information about the financial advisability of perhaps discontinuing the housekeeping program.

The depreciation in housekeeping is for a small van that is used to carry the housekeepers and their equipment from job to job. If the program were discontinued, the van would be donated to a charitable organization. None of the general administrative overhead would be avoided if the housekeeping program were dropped, but the liability insurance and the salary of the program administrator would be avoided.

Required:
1. Should the housekeeping program be discontinued? Explain. Show computations to support your answer.
2. Recast the above data in a format that would be more useful to management in assessing the long run financial viability of the various services.

PROBLEM 11-20 Relevant Cast Analysis in a Variety of Situations (LO2,LO3,LO4)
Lucy 'N Pals Corporation has a single product called Pups. The company normally produces and sells 54,000 Pups each year at a selling price of $20.00 per unit. The company's unit costs at this level of activity are given below:

Direct materials ............................. $ 8.00
Direct labor ................................. 3.50
Variable manufacturing overhead ....... 1.80
Fixed manufacturing overhead .......... 2.50 ($135,000 total)
Variable selling expense ................. 1.20
Fixed selling expense ..................... 2.00 ($108,000 toal)
Total cost per unit ......................... $19.00

A number of questions relating to the production and sale of Pups and sales of Pups follow. Each question is independent.

Required:
1. Assume that Lucy 'N Pals Corporation has sufficient capacity to produce 70,000 Pups each year without any increase in fixed manufacturing overhead costs. The company could increase its sales by 20% above the present 54,000 units each year if it were willing to increase the fixed selling expenses by $40,000. Would the increase fixed expenses be justified?

2. Assume again that Lucy 'N Pals Corporation has sufficient capacity to produce 70,000 Pups each year. A customer in a foreign market wants to purchase 10,000 Pups. Import duties on the Pups would be associated with the order would be $2.60 per unit shipping cost. You have been asked by the president to compute the per unit break-even price on this order.

3. The company has 2,000 Pups on hand that have some irregularities and are therefore considered to be "seconds." Due to the irregularities, it will be impossible to sell these units at the normal price through regular distribution channels. What unit cost figure is relevant for setting a minimum selling price?

4. Due to a strike in its supplier's plant, Lucy 'N Pals Corporation is unable to purchase more material for the production of Pups. The strike is expected to last for two months. Lucy 'n Pals Corporation has enough material on hand to continue to operate at 40% of normal levels for the two month period. As an alternative, Lucy 'N Pals Corporation could close its plant down entirely for the two months. If the plant were closed, fixed overhead costs would continue at 60% of their normal level during the two-month period; the fixed selling costs would be reduced by 30% while the plant was closed. What would be the dollar advantage or disadvantage of closing the plant for the two-month period.

An outside manufacturer has offered to produce Pups for Lucy 'N Pals Corporation and to ship them directly to Lucy 'N 'Pals Corporation customers. If Lucy 'N Pals Corporation accepts this offer, the facilities that it uses to produce Pups would be idle; however, fixed overhead costs would be reduced by 70%. Since the outside manufacturer would pay for all the costs of shipping, the variable selling costs would be only two-thirds of their present amount. Compute the unit cost that is relevant for comparison to whatever quoted price is received from the outside manufacturer.