26 PGB - Horngren'S Financial And Managerial Accounting

Question

Using ROI and RI to evaluate investment centers

Tiger Paints is a national paint manufacturer and retailer. The company is segmented into five divisions: Paint Stores (branded retail locations), Consumer (paint sold through home improvement stores), Automotive (sales to auto manufacturers), International, and Administration. The following is selected divisional information for its two largest divisions: Paint Stores and Consumer:

Net Sales Revenue Operating Income Average Total Assets

Paint Stores \( 4,000,000 \) 476,000 $ 1,420,000

Consumer 1,300,000 196,000 1,585,000

Management has specified a 19% target rate of return.

Requirements

1. Calculate each division’s ROI. Round all of your answers to four decimal places.

2. Calculate each division’s profit margin ratio. Interpret your results.

3. Calculate each division’s asset turnover ratio. Interpret your results.

4. Use the expanded ROI formula to confirm your results from Requirement 1. Interpret your results.

5. Calculate each division’s RI. Interpret your results, and offer a recommendation for any division with negative RI.

6. Describe some of the factors that management considers when setting its minimum target rate of return.

Step-by-Step Solution

Answer

1.  

	ROI
Paint Stores	33.5211%
Consumer	12.3659%

1. Consumer division is earning 0.1507 i.e.,higher profit per net sales revenue than paint store division i.e., 0.119.

	Profit margin ratio
Paint Stores	0.119
Consumer	0.1507

1. Paint store division is generating 2.8169 i.e., more sales revenue per average total assets than consumer division i.e., 0.8201.

	Asset turnover ratio
Paint Stores	2.8169
Consumer	0.8201

1. Although consumer division is earning more profit compare to paint store division, the paint store division is generating more ROI than consumer division.

	Expanded ROI
Paint Stores	33.5211%
Consumer	12.3659%

1. Paint store division is earning more than the expected income i.e., $206,200.

	RI
Paint Stores	$206,200
Consumer	($105,150)

 

1. The management should consider the following factors for setting the minimum target rate of return-

Desired residual income

Operating income

Average Investment in division

Computing ROI

Paint Stores

$\begin{array}{c}\text{ROI}=\frac{\text{Net income}}{\text{Average total asset}}\times 100\\ =\frac{\$476,000}{\$1,420,000}\times 100\\ =33.5211\%\end{array}$

Consumer

$\begin{array}{c}\text{ROI}=\frac{\text{Net income}}{\text{Average asset}}\times 100\\ =\frac{\$196,000}{\$1,585,000}\times 100\\ =12.3659\%\end{array}$

Computing profit margin ratio-

Paint Stores

$\begin{array}{c}\text{Profit margin ratio}=\frac{\text{Net income}}{\text{Net sales revenue}}\\ =\frac{\$476,000}{\$4,000.000}\\ =0.119\end{array}$

Consumer

$\begin{array}{c}\text{Profit margin ratio}=\frac{\text{Net income}}{\text{Net sales revenue}}\\ =\frac{\$196,000}{\$1,300.000}\\ =0.1507\end{array}$

Computing asset turnover ratio

Paint Stores

$\begin{array}{c}\text{Asset Turnover Ratio }= \frac{\text{Net Sales }}{\text{Average Total Assets}}\\ =\frac{\$4,000,000}{\$1,420,000}\\ =2.8169\end{array}$

Consumer

$\begin{array}{c}\text{Asset Turnover Ratio }= \frac{\text{Net Sales }}{\text{Average Total Assets}}\\ =\frac{\$1,300,000}{\$1,585,000}\\ =0.8201\end{array}$

Computing expanded ROI

Paint Stores

$\begin{array}{c}\text{ROI}=\text{Profit margin ratio}\times \text{Asset turnover ratio}\times 100\\ \text{=0.119}\times 2.8169\times \text{100}\\ \text{=33.5211\%}\end{array}$

Consumer

$\begin{array}{c}\text{ROI}=\text{Profit margin ratio}\times \text{Asset turnover ratio}\times 100\\ \text{=0.1507}\times 0.8201\times \text{100}\\ \text{=12.3659\%}\end{array}$

Computing RI

Paint Stores

$\begin{array}{c}\text{Residual Income}=\text{Operating income }-\left(\text{Minimum required rate of return}\times \text{Average operating assets}\right)\\ =\$476,000-\left(19\%\times \$1,420,000\right)\\ =\$476,000-\$269,800\\ =\$206,200\end{array}$

Consumer

$\begin{array}{c}\text{Residual Income}=\text{Operating income }-\left(\text{Minimum required rate of return}\times \text{Average operating assets}\right)\\ =\$196,000-\left(19\%\times \$1,585,000\right)\\ =\$196,000-\$301,150\\ =\left(\$105,150\right)\end{array}$

The factors that management considers when setting its minimum target rate of return

While setting the minimum target rate of return the management should consider the following factors-

Operating income

Average Investment in division 

Desired residual income