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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Effect of proposals on divisional performance

 A condensed income statement for the Commercial Division of Maxell Manufacturing Inc. for the year ended December 31 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 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 tin- following three proposals:

 Proposal 1: Transfer equipment with a hook 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 depreciation expense on the old equipment by $105,000. This increase in expense would be- included as part 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 depreciation 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 the transferred to other divisions at no gain or loss.

 Instructions

  1. 1. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and 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 return on investment, determine the profit margin, investment turnover, and return on investment for each proposal. Round percentages and the investment turnover to one decimal place.
  4. 4.  Which of the three proposals would meet the required 21% return on investment?
  5. 5.  If the Commercial Division were in an industry where the profit margin could not be increases, how much would the investment turnover have to increase to meet the president's required 21% return on investment? Round to one decimal place.

(1)

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:

Profit margin=Income from operationsSales

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

Formula of investment turnover:

Investment turnover=SalesInvested 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:

Return on investment = Profit margin × Investment turnover=Income from operationsSales×SalesInvested assets=Income from operationsInvested assets

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

Explanation

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

Return on investment =          Profit margin         ×    Investment turnover=Income from operationsSales×SalesInvested assets=$420,000$3,500,000×

(2)

To determine

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

(3)

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

(4)

To determine

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

(5)

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

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