Chapter 23, Problem 23.4APR

Effect of proposals on divisional performance

A condensed income Statement for the Commercial Division of Maxell Manufacturing Inc. for the year ended December 31, 2016, is as follows:

Sales	$3,500,000
Cost of goods sold	2,480,000
Gross profit	$1,020,000
Operating expenses	600,000
Income from operations	$420,000
Invested assets	$2,500,000

Assume that the Commercial Division received no charges from Service departments. The president of Maxell Manufacturing has indicated that the division’s rate of return on a $2,500,000 investment must be increased to at least 21% by the end of the next year if operations are to continue. The division manager is considering the following three proposals:

Proposal 1: Transfer equipment with a book value of $312,500 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would exceed the amount of depredation expense on the old equipment by $105,000. This increase in expense would be included as pan of the cost of goods sold. Sales would remain unchanged.

Proposal 2: Purchase new and more efficient machining equipment and thereby reduce the cost of goods sold by $560,000 after considering the effects of depredation expense on the new equipment Sales would remain unchanged, and the old equipment, which has no remaining book value, would be scrapped at no gain or loss. The new equipment would increase invested assets by an additional $1,875,000 for the year.

Proposal .3: Reduce invested assets by discontinuing a product line. This action would eliminate sales of $595,000, reduce cost of goods sold by $406,700, and reduce operating expenses by $175,000. Assets of $1,338,000 would be transferred to other divisions at no gain or loss.

Instructions

1. 1. Using the DuPont formula for rate of return on investment, determine the profit margin, investment turnover, and rate of return on investment for the Commercial Division for the past year
2. 2. Prepare condensed estimated income statements and compute the invested assets for each proposal.
3. 3. Using the DuPont formula for rate of return on investment, determine the profit margin, investment turnover, and rate of return on investment for each proposal.
4. 4. Which of the three proposals would meet the required 21% rate of return on investment?
5. 5. If the Commercial Division were in an industry where the profit margin could not be increased, how much would the investment turnover have to increase to meet the president’s required 21% rate of return on investment? Round to one decimal place.

To determine

Profit margin: This ratio gauges the operating profitability by quantifying the amount of income earned from business operations from the sales generated.

Formula of profit margin:

$\text{Profit margin}=\frac{\text{Income from operations}}{\text{Sales}}$

Investment turnover: This ratio gauges the operating efficiency by quantifying the amount of sales generated from the assets invested.

Formula of investment turnover:

$\text{Investment turnover}=\frac{\text{Sales}}{\text{Invested assets}}$

Return on investment (ROI): This financial ratio evaluates how efficiently the assets are used in earning income from operations. So, ROI is a tool used to measure and compare the performance of a units or divisions or a companies.

Formula of ROI according to Dupont formula:

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ \text{=}\frac{\text{Income from operations}}{\text{Invested assets}}\end{array}$

To determine: Profit margin, investment turnover, and return on investment of C Division

Explanation of Solution

Determine ROI of C Division, if income from operations is $420,000, sales are $3,500,000, and assets invested are $2,500,000.

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ =\frac{\$420,000}{\$3,500,000}\times \frac{\$3,500,000}{\$2,500,000}\\ \text{= }12.0\%\times 1.4\\ \text{= 16}\text{.8\%}\end{array}$

To determine

Income statement: The financial statement which reports revenues and expenses from business operations and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

To prepare: The income statements for C Division of Company M for the year ended December 31, 2016, for each of the three proposals, and compute invested assets for each proposal

Explanation of Solution

Prepare divisional income statements for C Division of Company M for the year ended December 31, 2016 for the three proposals.

Company M
Divisional Income Statements
For the Year Ended December 31, 2016
	Proposal 1	Proposal 2	Proposal 3
Sales	$3,500,000	$3,500,000	$2,905,000
Cost of goods sold	2,585,000	1,920,000	2,073,300
Gross profit	915,000	1,580,000	831,700
Operating expenses	600,000	600,000	425,000
Income from operations	$315,000	$980,000	$406,700

Table (1)

Working Notes:

Compute cost of goods sold under proposal 1.

$\begin{array}{c}\text{Revised cost of goods sold = Cost of goods sold + Depreciation}\\ \text{= \$2,480,000+\$105,000}\\ \text{= \$2,585,000}\end{array}$

Compute cost of goods sold under proposal 2.

$\begin{array}{c}\text{Revised cost of goods sold = Cost of goods sold – Depreciation}\\ \text{= \$2,480,000–\$560,000}\\ \text{= \$1,920,000}\end{array}$

Compute sales under proposal 3.

$\begin{array}{c}\text{Revised sales = Sales – Reduction}\\ \text{= \$3,500,000–\$595,000}\\ \text{= \$2,905,000}\end{array}$

Compute cost of goods sold under proposal 3.

$\begin{array}{c}\text{Revised cost of goods sold = Cost of goods sold – Depreciation}\\ \text{= \$2,480,000–\$406,700}\\ \text{= \$2,073,300}\end{array}$

Compute operating expenses under proposal 3.

$\begin{array}{c}\text{Revised operating expenses = Operating expenses – Reduction}\\ \text{= \$600,000–\$175,000}\\ \text{= \$425,000}\end{array}$

To determine

Profit margin, investment turnover, and return on investment of C Division under the three proposals.

Explanation of Solution

Determine ROI of C Division, under proposal 1, if income from operations is $315,000, sales are $3,500,000, and assets invested are $2,187,500.

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ =\frac{\$315,000}{\$3,500,000}\times \frac{\$3,500,000}{\$2,187,500}\\ \text{= }9.0\%\times 1.6\\ \text{= 14}\text{.4\%}\end{array}$

Note: Refer to part (1) for the values of income from operations and invested assets.

Determine ROI of C Division, under proposal 2, if income from operations is $980,000, sales are $3,500,000, and assets invested are $4,375,000.

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ =\frac{\$980,000}{\$3,500,000}\times \frac{\$3,500,000}{\$4,375,000}\\ \text{= }28.0\%\times 0.8\\ \text{= 22}\text{.4\%}\end{array}$

Note: Refer to part (1) for the values of income from operations and invested assets.

Determine ROI of C Division, under proposal 3, if income from operations is $406,700, sales are $2,905,000, and assets invested are $1,162,000.

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ =\frac{\$406,700}{\$2,905,000}\times \frac{\$2,905,000}{\$1,162,000}\\ \text{= }14.0\%\times 2.5\\ \text{= 35}\text{.0\%}\end{array}$

Note: Refer to part (1) for the values of income from operations and invested assets.

To determine

To indicate: The proposal which meets the desired ROI of 22.4%.

Explanation of Solution

Proposal 3 meets desired ROI of 22.4% because the proposal has 35.0% ROI.

To determine

The increase in investment turnover to meet the desired return of 21%.

Explanation of Solution

Determine increase in investment turnover of C Division, if income from operations is $406,700 and sales are $2,905,000.

Step 1: Find the required investment turnover to earn desired ROI of 21%.

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \text{Investment turnover}\\ 21\%=\frac{\$420,000}{\$3,500,000}\times \text{Investment turnover}\end{array}$

$\begin{array}{c}\text{21\% }\text{= }12.0\%\times \text{Investment turnover}\\ \text{Investment turnover}\text{= }\frac{21\%}{12\%}\\ =1.75\end{array}$

Step 2: Find the increase in investment turnover, if required investment turnover is 1.75 (From Step 1), and current investment turnover is 1.40 (From Part (1)).

$\begin{array}{c}\text{Increase in turnover = Required turnover – Current turnover}\\ \text{= 1}\text{.75–1}\text{.40}\\ \text{= 0}\text{.35}\end{array}$