Question
Top management is unhappy with the investment center's return on investment (ROI). It asks the manager of the Green Division to submit plans to improve ROI in the next year. The manager believes it is feasible to consider the following independent courses of action.
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The Green Division of Frizell Company reported the following data for the current year. Sales $3,166,300 Variable costs 2,000,000 Controllable fixed costs 609,000 Average operating assets 5,219,400
Top management is unhappy with the investment center's return on investment (ROI). It asks the manager of the Green Division to submit plans to improve ROI in the next year. The manager believes it is feasible to consider the following independent courses of action.
- Increase sales by $327,000 with no change in the contribution margin percentage.
- Reduce variable costs by $106,500.
- Reduce average operating assets by 4%.
Explanation / Answer
The formula for calculating the Return on Investment is ROI = Net operating income / Value of OPerating assets First we need to calculate the Contribution margin percentage: Contribution margin = Sales - Variable costs = $3,166,300 - $2,000,000 = $1,166,300 CM ratio = (CM / Sales) * 100 = ($1,166,300 / $3,166,300) * 100 = 0.37 or 37% 1) Computing the ROI without change in the CM percentage. New sales = $3,166,300 + $327,000 = $3,493,300 CM ratio = CM / SAles 0.37 = CM / $3,493,300 CM = $3,493,300 * 0.37 = $1,292,521 Therefore, the value of Contribution margin should be $1,292,521 so that the contribution margin percentage remains constant. Variable cost = Sales - Contribution margin = $3,493,300 - $1,292,521 = $2,200,779 Computing the Net operating income: Net operating income = Contribution margin - Controllable fixed costs = $1,292,521 - $609,000 = $683,521 ROI = $683,521 / $5,219,400 = 0.13 or 13% 2) Reducing the variable costs by $106,500 New variable costs = $2,000,000 - $106,500 = $1,893,500 Contribution margin = $3,166,300 - $1,893,500 = $1,272,800 Net operating income = Contribution margin - Controllable fixed costs = $1,272,800 - $609,000 = $663,800 ROI = $663,800 / $5,219,400 = 0.127 or 12.7% 3) Reduce average operating assets by 4% Average operating assets = $5,219,400 (0.96) = $5,010,624 Net operating income = $1,166,300 - $609,000 = $557,300 ROI = $557,300 / $5,010,624 = 0.11 or 11%