REVIEW PROBLEM: RETURN ON INVESTMENT (ROI) AND RESIDUAL INCOME

The Magnetic Imaging Division of Medical Diagnostics, Inc., has reported the following results for last year's operations:

Required:

  1. Compute the Magnetic Imaging Division's margin, turnover, and ROI.
  1. Top management of Medical Diagnostics, Inc., has set a minimum required rate of return on average operating assets of 25%. What is the Magnetic Imaging Division's residual income for the year?

Solution to Review Problem

1. The required calculations follow:

2. The Magnetic Imaging Division's residual income is computed as follows:

THE FOUNDATIONAL 15

Westerville Company reported the following results from last year's operations:

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This year the company has a $120,000 investment opportunity with the following cost and revenue characteristics:

The company's minimum required rate of return is 15%.

Required:

  1. What is last year's margin?
  2. What is last year's turnover?
  3. What is last year's return on investment (ROI)?
  4. What is the margin related to this year's investment opportunity?
  5. What is the turnover related to this year's investment opportunity?
  6. What is the ROI related to this year's investment opportunity?
  7. If the company pursues the investment opportunity and otherwise performs the same as last year, what margin will it earn this year?
  8. If the company pursues the investment opportunity and otherwise performs the same as last year, what turnover will it earn this year?
  9. If the company pursues the investment opportunity and otherwise performs the same as last year, what ROI will it earn this year?
  10. If Westerville's Chief Executive Officer will earn a bonus only if her ROI from this year exceeds her ROI from last year, would she pursue the investment opportunity? Would the owners of the company want her to pursue the investment opportunity?
  11. What is last year's residual income?
  12. What is the residual income of this year's investment opportunity?
  13. If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?
  14. If Westerville's Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?
  15. Assume that the contribution margin ratio of the investment opportunity was 50% instead of 60%. If Westerville's Chief Executive Officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity? Would the owners of the company want her to pursue the investment opportunity?

EXERCISES

EXERCISE 9–1Compute the Return on Investment (ROI)[LO1]

Tundra Services Company, a division of a major oil company, provides various services to the operators of the North Slope oil field in Alaska. Data concerning the most recent year appear below:

Required:

  1. Compute the margin for Tundra Services Company.
  1. Compute the turnover for Tundra Services Company.
  1. Compute the return on investment (ROI) for Tundra Services Company.

EXERCISE 9–2Residual Income[LO2]Midlands Design Ltd. of Manchester, England, is a company specializing in providing design services to residential developers. Last year the company had net operating income of £400,000 on sales of £2,000,000. The company's average operating assets for the year were £2,200,000 and its minimum required rate of return was 16%. (The currency in the United Kingdom is the pound, denoted by £.)

Required:

Compute the company's residual income for the year.

EXERCISE 9–3Measures of Internal Business Process Performance[LO3]

Lipex, Ltd., of Birmingham, England, is interested in cutting the amount of time between when a customer places an order and when the order is completed. For the first quarter of the year, the following data were reported:

Required:

  1. Compute the throughput time.
  1. Compute the manufacturing cycle efficiency (MCE) for the quarter.
  1. What percentage of the throughput time was spent in non–value-added activities?
  1. Compute the delivery cycle time.
  1. If by using Lean Production all queue time can be eliminated in production, what will be the new MCE?

EXERCISE 9–4Creating a Balanced Scorecard[LO4]

Mason Paper Company (MPC) manufactures commodity grade papers for use in computer printers and photocopiers. MPC has reported net operating losses for the last two years due to intense price pressure from much larger competitors. The MPC management team—including Kristen Townsend (CEO), Mike Martinez (vice president of Manufacturing), Tom Andrews (vice president of Marketing), and Wendy Chen (CFO)—is contemplating a change in strategy to save the company from impending bankruptcy. Excerpts from a recent management team meeting are shown below:

Townsend:As we all know, the commodity paper manufacturing business is all about economies of scale. The largest competitors with the lowest cost per unit win. The limited capacity of our older machines prohibits us from competing in the high-volume commodity paper grades. Furthermore, expanding our capacity by acquiring a new paper-making machine is out of the question given the extraordinarily high price tag. Therefore, I propose that we abandon cost reduction as a strategic goal and instead pursue manufacturing flexibility as the key to our future success.

Chen:Manufacturing flexibility? What does that mean?

Martinez:It means we have to abandon our “crank out as many tons of paper as possible” mentality. Instead, we need to pursue the low-volume business opportunities that exist in the nonstandard, specialized paper grades. To succeed in this regard, we'll need to improve our flexibility in three ways. First, we must improve our ability to switch between paper grades. Right now, we require an average of four hours to change over to another paper grade. Timely customer deliveries are a function of changeover performance. Second, we need to expand the range of paper grades that we can manufacture. Currently, we can only manufacture three paper grades. Our customers must perceive that we are a “one-stop shop” that can meet all of their paper grade needs. Third, we will need to improve our yields (e.g., tons of acceptable output relative to total tons processed) in the nonstandard paper grades. Our percentage of waste within these grades will be unacceptably high unless we do something to improve our processes. Our variable costs will go through the roof if we cannot increase our yields!

Chen:Wait just a minute! These changes are going to destroy our equipment utilization numbers!

Andrews:You're right Wendy; however, equipment utilization is not the name of the game when it comes to competing in terms of flexibility. Our customers don't care about our equipment utilization. Instead, as Mike just alluded to, they want just-in-time delivery of smaller quantities of a full range of paper grades. If we can shrink the elapsed time from order placement to order delivery and expand our product offerings, it will increase sales from current customers and bring in new customers. Furthermore, we will be able to charge a premium price because of the limited competition within this niche from our cost-focused larger competitors. Our contribution margin per ton should drastically improve!

Martinez:Of course, executing the change in strategy will not be easy. We'll need to make a substantial investment in training because ultimately it is our people who create our flexible manufacturing capabilities.

Chen:If we adopt this new strategy, it is definitely going to impact how we measure performance. We'll need to create measures that motivate our employees to make decisions that support our flexibility goals.

Townsend:Wendy, you hit the nail right on the head. For our next meeting, could you pull together some potential measures that support our new strategy?

Required:

  1. Contrast MPC's previous manufacturing strategy with its new manufacturing strategy.
  1. Generally speaking, why would a company that changes its strategic goals need to change its performance measurement system as well? What are some examples of measures that would have been appropriate for MPC prior to its change in strategy? Why would those measures fail to support MPC's new strategy?
  1. Construct a balanced scorecard that would support MPC's new manufacturing strategy. Use arrows to show the causal links between the performance measures and show whether the performance measure should increase or decrease over time. Feel free to create measures that may not be specifically mentioned in the chapter, but nonetheless make sense given the strategic goals of the company.
  1. What hypotheses are built into MPC's balanced scorecard? Which of these hypotheses do you believe are most questionable and why?

EXERCISE 9–5Cost-Volume-Profit Analysis and Return on Investment(ROI)[LO1]

Images.comis a small Internet retailer of high-quality posters. The company has $800,000 in operating assets and fixed expenses of $160,000 per year. With this level of operating assets and fixed expenses, the company can support sales of up to $5 million per year. The company's contribution margin ratio is 10%, which means that an additional dollar of sales results in additional contribution margin, and net operating income, of 10 cents.

Required:

  1. Complete the following table showing the relationship between sales and return on investment (ROI):

  1. What happens to the company's return on investment (ROI) as sales increase? Explain.

EXERCISE 9–6Effects of Changes in Sales, Expenses, and Assets on ROI[LO1]

BusServ.comCorporation provides business-to-business services on the Internet. Data concerning the most recent year appear below:

Required:

Consider each question below independently. Carry out all computations to two decimal places.

  1. Compute the company's return on investment (ROI).
  1. The entrepreneur who founded the company is convinced that sales will increase next year by 150% and that net operating income will increase by 400%, with no increase in average operating assets. What would be the company's ROI?
  1. The Chief Financial Officer of the company believes a more realistic scenario would be a $2 million increase in sales, requiring an $800,000 increase in average operating assets, with a resulting $250,000 increase in net operating income.
  2. What would be the company's ROI in this scenario?

EXERCISE 9–7Contrasting Return on Investment (ROI) and Residual Income[LO1, LO2]

Rains Nickless Ltd. of Australia has two divisions that operate in Perth and Darwin. Selected data on the two divisions follow:

Required:

  1. Compute the return on investment (ROI) for each division.
  1. Assume that the company evaluates performance using residual income and that the minimum required rate of return for any division is 16%. Compute the residual income for each division.
  1. Is the Darwin Division's greater residual income an indication that it is better managed? Explain.

EXERCISE 9–8Return on Investment (ROI) and Residual Income Relations[LO1, LO2]

A family friend has asked your help in analyzing the operations of three anonymous companies operating in the same service sector industry. Supply the missing data in the table below:

EXERCISE 9–9Evaluating New Investments Using Return on Investment (ROI) and Residual Income[LO1, LO2]

Selected sales and operating data for three divisions of three different companies are given below:

Required:

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

EXERCISE 9–10Computing and Interpreting Return on Investment (ROI)[LO1]

Selected operating data on the two divisions of York Company are given below:

Required:

  1. Compute the rate of return for each division using the return on investment (ROI) formula stated in terms of margin and turnover.
  1. Which divisional manager seems to be doing the better job? Why?

EXERCISE 9–11Creating a Balanced Scorecard[LO4]

Ariel Tax Services prepares tax returns for individual and corporate clients. As the company has gradually expanded to 10 offices, the founder, Max Jacobs, has begun to feel as though he is losing control of operations. In response to this concern, he has decided to implement a performance measurement system that will help control current operations and facilitate his plans of expanding to 20 offices.

Jacobs describes the keys to the success of his business as follows:

“Our only real asset is our people. We must keep our employees highly motivated and we must hire the 'cream of the crop.' Interestingly, employee morale and recruiting success are both driven by the same two factors—compensation and career advancement. In other words, providing superior compensation relative to the industry average coupled with fast-track career advancement opportunities keeps morale high and makes us a very attractive place to work. It drives a high rate of job offer acceptances relative to job offers tendered.”

“Hiring highly qualified people and keeping them energized ensures operational success, which in our business is a function of productivity, efficiency, and effectiveness. Productivity boils down to employees being billable rather than idle. Efficiency relates to the time required to complete a tax return. Finally, effectiveness is critical to our business in the sense that we cannot tolerate errors. Completing a tax return quickly is meaningless if the return contains errors.”

“Our growth depends on acquiring new customers through word-of-mouth from satisfied repeat customers. We believe that our customers come back year after year because they value error-free, timely, and courteous tax return preparation. Common courtesy is an important aspect of our business! We call it service quality, and it all ties back to employee morale in the sense that happy employees treat their clients with care and concern.”

“While sales growth is obviously important to our future plans, growth without a corresponding increase in profitability is useless. Therefore, we understand that increasing our profit margin is a function of cost-efficiency as well as sales growth. Given that payroll is our biggest expense, we must maintain an optimal balance between staffing levels and the revenue being generated. As I alluded to earlier, the key to maintaining this balance is employee productivity. If we can achieve cost-efficient sales growth, we should eventually have 20 profitable offices!”

Required:

  1. Create a balanced scorecard for Ariel Tax Services. Link your scorecard measures using the framework fromExhibit 9–5. Indicate whether each measure is expected to increase or decrease. Feel free to create measures that may not be specifically mentioned in the chapter, but make sense given the strategic goals of the company.
  1. What hypotheses are built into the balanced scorecard for Ariel Tax Services? Which of these hypotheses do you believe are most questionable and why?
  1. Discuss the potential advantages and disadvantages of implementing an internal business process measure calledtotal dollar amount of tax refunds generated. Would you recommend using this measure in Ariel's balanced scorecard?
  1. Would it be beneficial to attempt to measure each office's individual performance with respect to the scorecard measures that you created? Why or why not?

EXERCISE 9–12Effects of Changes in Profits and Assets on Return on Investment (ROI)[LO1]

The Abs Shoppe is a regional chain of health clubs. The managers of the clubs, who have authority to make investments as needed, are evaluated based largely on return on investment (ROI). The Abs Shoppe reported the following results for the past year:

Required:

The following questions are to be considered independently. Carry out all computations to two decimal places.

  1. Compute the club's return on investment (ROI).
  1. Assume that the manager of the club is able to increase sales by $80,000 and that as a result net operating income increases by $6,000. Further assume that this is possible without any increase in operating assets. What would be the club's return on investment (ROI)?
  1. Assume that the manager of the club is able to reduce expenses by $3,200 without any change in sales or operating assets. What would be the club's return on investment (ROI)?
  1. Assume that the manager of the club is able to reduce operating assets by $20,000 without any change in sales or net operating income. What would be the club's return on investment (ROI)?

EXERCISE 9–13Return on Investment (ROI) Relations[LO1]

Provide the missing data in the following table: