The Consumer Services Division is one part of Vargas Corporation. The Consumer Services Division reported income of $112,000 on an investment in operating assets of $800,000 for Year 1. The division expects this level of performance to continue for Year 2. Senior management of Vargas Corporation has asked the Consumer Services Division to consider adding a new service line that would result in the following revenues and costs: Revenues$240,000 Variable expenses 110,000 Direct fixed expenses 70,000 Average operating assets 500,000 Required:1) Compute the ROI that would be generated by the new product line. 2) Compute the ROI for the Consumer Services Division without the new product line. 3) Compute the Consumer Services Division's residual income without the new
product line and with the new product line. The target ROI is 11%. 4) Would the new product line benefit the company as a whole? ROI for the company as a whole is 10%. Will the Consumer Services Division likely add the new product line given the company's use of ROI as a performance measure? Why or why not? Which performance evaluation measure will more likely motivate the division manager to do what is best for the company as a whole?
What will be an ideal response?
1) New product line ROI: ($240,000 - $110,000 - $70,000) ÷ $500,000 = 12%
2) Service Division ROI = $112,000 ÷ $800,000 = 14%
3) Service Division residual income:
| Without | With | ||||||
| Income | $ | 112,000 | $ | 172,000 | |||
| Less investment × Desired ROI | 88,000 | 143,000 | |||||
| Residual income | $ | 24,000 | $ | 29,000 | |||
4) The new product line will benefit the company as a whole because its ROI of 12% exceeds the company's target ROI of 11%. The Service Division will not likely add the new product line given that the product line's ROI of 12% is less than the division's current ROI of 14%. On the other hand, because the division's residual income increases with the new product line, the division would likely add the line if performance were evaluated on the basis of residual income. The use of residual income as a performance evaluation measure will more likely motivate the division manager to do what is best for the company as a whole.
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