Return on investment (ROI) and Residual Income
Kirsi products is a 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:
Variable expenses 13,400,000
Contribution margin 7,600,000
Fixed expenses 5,920,000
Net operating income 1,680,000
Divisional opeating 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:
Variable expenses 65% of sales
Fixed expenses $2,520,000
1. Compute the East's Division's ROI for last year, also compute the ROI as it would appear if the new product line is added.
2. Why do you suppose headquarters is anxious for the East division to add the new product line?
3. Suppose the company's minimum required reate of return on operating assets is 15% and that performance is evaluated using residual income.
- 1. Compute the east division's residual income for last year, also compute the residual income as it would appear if the new product line is added
- 2. Under these circumstance, if you were in the manager's shoes would you accept or reject the new product line? Explain.
The solution explains the calculation of ROI and residual income and explains how new investment decisions would be evaluated.