A condensed income statement for the Snowboard Division of New Wave Rides Inc. for the year ended December 31, 2010, is as follows:
Sales ......... $1,200,000
Cost of goods sold .... 826,000
Gross profit ...... $ 374,000
Operating expenses ...... 230,000
Income from operations ... $ 144,000
Invested assets ...... $1,000,000
Assume that the Snowboard Division received no charges from service departments. The president of New Wave Rides has indicated that the division’s rate of return on a $1,000,000 investment must be increased to at least 18% 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 $40,000 to other divisions at no gain or loss and lease similar equipment. The annual lease payments would exceed the amount of depreciation expense on the old equipment by $24,000. This increase in expense would be included as part of the cost of goods sold. Sales would remain unchanged.
Proposal 2: Purchase new and more efficient machining equipment and thereby reduce the cost of goods sold by $120,000. 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 $600,000 for the year.
Proposal 3: Reduce invested assets by discontinuing an engine line. This action would eliminate sales of $330,000, cost of goods sold of $286,300, and operating expenses of $65,000. Assets of $420,000 would be transferred to other divisions at no gain or loss.
Instructions
1. Using the DuPont formula for rate of return on investment, determine the profit margin, investment turnover, and rate of return on investment for the Snowboard 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 rate of return on investment, determine the profit margin, investment turnover, and rate of return on investment for each proposal.
4. Which of the three proposals would meet the required 18% rate of return on investment?
5. If the Snowboard 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 18% rate of return on investment?