Effect of proposals on divisional performance
A condensed income statement for the Commercial Division of Maxell Manufacturing Inc. for the year ended December 31, 20Y9, 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 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
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 be transferred to other divisions at no gain or loss.
Instructions
- 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. Prepare condensed estimated income statements and compute the invested assets for each proposal.
- 3. Using the DuPont formula for return on investment, determine the profit margin, investment turnover, and return on investment for each proposal. (Round the investment turnover and return on investment to one decimal place.)
- 4. Which of the three proposals would meet the required 21% return on investment?
- 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% return on investment?
(1)
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:
Investment turnover: This ratio gauges the operating efficiency by quantifying the amount of sales generated from the assets invested.
Formula of investment turnover:
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:
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 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.
(2)
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.
Explanation of Solution
Prepare divisional income statements for C Division of Company M for the year ended December 31, for the three proposals.
Company M | |||
Divisional Income Statements | |||
For the Year Ended December 31 | |||
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.
Compute cost of goods sold under proposal 2.
Compute sales under proposal 3.
Compute cost of goods sold under proposal 3.
Compute operating expenses under proposal 3.
(3)
Explanation of Solution
1)
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.
Note: Refer to part (1) for the values of income from operations and invested assets.
2)
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.
Note: Refer to part (1) for the values of income from operations and invested assets.
3)
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.
Note: Refer to part (1) for the values of income from operations and invested assets.
(4)
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.
(5)
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%.
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)).
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