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# Return on Investment (ROI) and Residual Income

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"I know headquarters wants us to add that new product line," said Pete Johnson, manager of Sunset Products' East Division. "But I want to see the numbers before I make a move. Our division's return on investment (ROI0 has led the company for three years, and don't want any letdown."

Sunset Products is decentralized wholesaler with four autonomous divisions. The divisions are evaluated on the basis of ROI, with year end bonuses given to divisional managers who have the highest ROI. Operating results for the company's East Division for last year are given below:

Sales \$21,000,000
Variable expenses 13,400,000
Contribution margin 7,600,000
Fixed expenses 5,920,000
Net operating income \$ 1,680,000
Divisional operating assets \$5,250,000

The company had an overall ROI of 18% last year (considering all divisions). The company's East Division has an opportunity to add a new product line that would require an investment of \$3,000,000. The cost and revenue characteristics of the new product line per year would be as follows:
Sales \$9,000,000
Variable expenses 65% of sales
Fixed expenses \$2,520,000

1. Compute the East division ROI for last year; also compute the ROI as it would appear if the new product line is added.
2. Would you accept or reject the new product line and explain
3. Why do you suppose headquarters is anxious for the East Division to add the new product line?
4. Suppose that the company's minimum requires rate of return on operating assets is 15% and that performance is evaluated using residual income.
a. Compute the East Division residual income for last year , also the residual income as it would appear if the new product line is added
b. Under these circumstances would you accept or reject the new product line-explain

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#### Solution Preview

1. Compute the East division ROI for last year; also compute the ROI as it would appear if the new product line is added.

ROI of East Division = Net Operating Income/Divisional Operating Assets
=1680000/5250000
=32%

ROI of East Division (On adding new product line)
= Net Operating Income/Divisional Operating Assets
=2310000/8250000
=28%

Note:
New Net Operating Income= 1680000+ (9000000-65%*9000000-2520000)
=\$2310000
New Divisional Operating Assets= Old + ...

#### Solution Summary

Response provides guidance to compute the Return on Investment (ROI) and Residual Income

\$2.19

## Evaluating New Investment Using Return on Investment (ROI) and Residual Income.

E12-10
Evaluating New Investment Using Return on Investment and Residual Income.
Division A Division B Division C
Sales 6000000 10000000 8000000
Average operating assets 1500000 5000000 2000000
Pretax income 300000 900000 180000
Minimum required rate of return 15% 18% 12%

1. Compute the return on investment (ROI) for each division.
2. Compute the residual income for each division.
3. Assume that each division is presented with an investment opportunity that would yield a rate of return of 17%.
a. If performance is being measured by ROI, which division or division will probably accept the opportunity? Reject? Why?
b. If performance is being measured by residual income, which division or division will probably accept the opportunity? Reject? Why?

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