Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 60

Return on Investment (ROI) Videonet Company manufactures highly specialized products for networking video-conferencing equipment. Production of specialized units are, to a large extent, performed under contract, with standard units manufactured according to marketing projections. Maintenance of customer equipment is an important area of customer satisfaction. With the recent downturn in the computer industry, the video-conferencing equipment segment has suffered, causing a slide in Videonet’s financial performance. Its income statement for the fiscal year ended October 31, 2010, follows.

VIDEONET COMPANY Income Statement For the Year Ended October 31, 2010 (000s omitted)
Net sales:
Equipment	$6,500
Maintenance contracts	1,800
Net sales	$8,300
Expenses:
Cost of goods sold	4,600
Customer maintenance	1,000
Selling expense	600
Administrative expense	900
Interest expense	150
Total expenses	$7,250
Income before tax	1,050
Income tax	420
Net income	$ 630

Videonet’s return on sales before interest and income tax was 14.5 percent in fiscal 2010 when the industry average was 18 percent. Its total asset turnover was two times, and its return on average assets before interest and income tax was 29 percent, both well below the industry average. To improve performance and raise these ratios closer to, or above, industry averages, Bill Hunt, Videonet’s president, established the following goals for fiscal 2011:

Return on sales, before interest and income tax	15%
Total asset turnover	3 times
Return on average assets, before interest and income tax	35%

To achieve Hunt’s goals, Videonet’s management team considered the growth in the international

video-conferencing market and proposed the following actions for fiscal 2011:

•         Increase equipment sales prices by 10 percent.

•         Increase the cost of each unit sold by 3 percent for needed technology, and quality improvements and for increased variable costs.

•         Increase maintenance inventory by $250,000 at the beginning of the year and add two maintenance technicians at total cost of $130,000 to cover wages and related travel expenses. These revisions are intended to improve customer service and response time. The increased inventory will be financed at an annual interest rate of 12 percent; no other borrowings or loan reductions are contemplated during fiscal 2011. All other assets will be held to fiscal 2010 levels.

•         Increase selling expenses by $250,000, but hold administrative expenses at 2010 levels.

•         The effective combined federal and state income tax rate for 2011 is expected to be 40 percent, the same as it was in 2010.

These actions were taken to increase equipment unit sales by 8 percent, with a corresponding 8 percent growth in maintenance contracts.

Required

1. Prepare a budgeted income statement for Videonet for the fiscal year ending October 31, 2011, on the assumption that the proposed actions are implemented as planned and that the increased sales objectives will be met.

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2. Calculate the following ratios for Videonet for fiscal year 2011 and determine whether Bill Hunt’s goals will be achieved:

a. Return on sales (ROS), before interest and income tax.

b. Total asset turnover.

c. Return on average assets, before interest and income tax.

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3. Discuss the limitations and difficulties that can be encountered in using the ratios in requirement 2, particularly when making comparisons to industry averages.

Step 1 of 3

1.?The pro forma income statement for Videonet Company for the fiscal year ended October 31, 2011, assuming all of management's proposed actions are implemented and the increased sales objectives are met, is presented below.

Videonet Company Income Statement For the Year Ended October 31, 2011 ($000 omitted)
Net Sales	?
Equipment ($6,500 x 1.08 x 1.10)	$7,722
Maintenance contracts ($1,800 x 1.08)	1,944
Total net sales	9,666
Expenses
Cost of goods sold ($4,600 x 1.03 x 1.08)	5,117
Customer maintenance ($1,000 + $130)	1,130
Selling expense ($600 + $250)	850
Administrative expense	900
Interest expense ($150 + ($250 x 0.12))	180
Total Expense	8,177
Income before income tax	1,489
Income tax (40%)	596
Net Income	$893