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

Exercise 41

ROI; Different Measures for Assets Ready Products, Inc., operates two divisions, each with its own manufacturing facility. The accounting system reports the following data for 2010:

HEALTH CARE PRODUCTS DIVISION Income Statement for the Year Ended December 31, 2010 (000s)
Revenues	$600
Operating costs	470
Operating income	$130

 

COSMETICS DIVISION Income Statement for the Year Ended December 31, 2010 (000s)
Revenues	$600
Operating costs	400
Operating income	$200

Ready estimates the useful life of each manufacturing facility to be 15 years. As of the end of 2010, the plant for the health-care division is four years old, while the manufacturing plant for the cosmetics division is six years old. Each plant had the same cost at the time of purchase, and both have useful lives of 15 years with no salvage value. The company uses straight-line depreciation and the depreciation charge is $70,000 per year for each division. The manufacturing facility is the only long-lived asset of either division. Current assets are $300,000 in each division.

An index of construction costs, replacement cost, and liquidation values for manufacturing facilities for the period that Ready has been operating is as follows:

			Liquidation Value
Year	Cost Index	Replacement Cost	Health-care	Cosmetics
2004	80	$1,000,000	$800,000	$ 800,000
2005	82	1,000,000	800,000	800,000
2006	84	1,100,000	700,000	700,000
2007	89	1,150,000	600,000	700,000
2008	94	1,200,000	600,000	800,000
2009	96	1,250,000	600,000	900,000
2010	100	1,300,000	500,000	1,000,000

Required

1. Compute ROI for each division using the historical cost of divisional assets (including current assets) as the investment base. Interpret the results.

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2. Compute ROI for each division, incorporating current-cost estimates as follows:

a. Gross book value (GBV) of long-lived assets, plus book value of current assets.

b. GBV of long-lived assets restated to current cost using the index of construction costs, plus book value of current assets.

c. Net book value of long-lived assets restated to current cost using the index of construction costs, plus book value of current assets.

d. Current replacement cost of long-lived assets, plus book value of current assets.

e. Current liquidation value of long-lived assets, plus book value of current assets.

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3. Which of the measures calculated in requirement 2 would you choose to (a) evaluate the performance of each division manager, and (b) decide which division is most profitable for the overall firm. What are the strategic advantages and disadvantages to the firm of each measure for both (a) and (b)?

Step 1 of 7

1.?Net book value (NBV) of fixed assets for each division (000s):

?HEALTHCARE: $70 x 11 years remaining useful life = $770

?COSMETICS:    $70 x   9 years remaining useful life = $630

ROI using historical cost of divisional assets:

?HEALTHCARE: ?$130/($770 + $300) = 12.15%

?COSMETICS:?$200/($630 + $300) =  21.51%

The COSMETICS Division is more profitable than the HEALTHCARE Division, based on ROI calculated using net book value (NBV) of divisional fixed assets (plus the current balance sheet value of current assets).