Chapter 10, Problem 3PA

(1)

To determine

Prepare the income statements for C, SC, and RB Divisions of Company CG for the year ended June 30, 20Y7

Explanation of Solution

Income statement: The financial statement which reports revenues and expenses from business operations and the result of those operations as net income or net loss for a particular time period is referred to as income statement.

Profit margin: This ratio gauges the operating profitability by quantifying the amount of income earned from business operations from the sales generated.

Formula of profit margin:

  $\text{Profit margin}=\frac{\text{Income from operations}}{\text{Sales}}$

Investment turnover: This ratio gauges the operating efficiency by quantifying the amount of sales generated from the assets invested.

Formula of investment turnover:

  $\text{Investment turnover}=\frac{\text{Sales}}{\text{Invested assets}}$

Return on investment (ROI): This financial ratio evaluates how efficiently the assets are used in earning income from operations. So, ROI is a tool used to measure and compare the performance of a units or divisions or a companies.

Formula of ROI according to DuPont formula:

$\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ \text{=}\frac{\text{Income from operations}}{\text{Invested assets}}\end{array}$

Prepare divisional income statements for C, SC, and RB Divisions of Company CG for the year ended June 30, 20Y7.

Company CG
Divisional Income Statements
For the Year Ended June 30, 20Y7
	C Division	SC Division	RB Division
Sales	$25,000,000	$8,000,000	$9,750,000
Cost of goods sold	16,670,000	5,575,000	6,795,000
Gross profit	8,330,000	2,425,000	2,955,000
Operating expenses	7,330,000	1,945,000	2,272,500
Income from operations	$1,000,000	$480,000	$682,500

Table (1)

(2)

To determine

Ascertain the Profit margin, investment turnover, and return on investment of C, SC, and RB Divisions

Explanation of Solution

a)

Determine ROI of C Division, if income from operations is $1,000,000 (From part (1)), sales are $25,000,000, and assets invested are $10,000,000.

  $\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ =\frac{\$1,000,000}{\$25,000,000}\times \frac{\$25,000,000}{\$10,000,000}\\ \text{= }4\%\times 2.5\\ \text{= 10}\text{.0\%}\end{array}$

b)

Determine ROI of SC Division, if income from operations is $480,000 (From part (1)), sales are $8,000,000, and assets invested are $4,000,000.

  $\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ =\frac{\$480,000}{\$8,000,000}\times \frac{\$8,000,000}{\$4,000,000}\\ \text{= }6\%\times 2.0\\ \text{= 12}\text{.0\%}\end{array}$

c)

Determine ROI of RB Division, if income from operations is $682,500 (From part (1)), sales are $9,750,000, and assets invested are $6,500,000.

  $\begin{array}{c}\text{Return on investment = Profit margin × Investment turnover}\\ \text{=}\frac{\text{Income from operations}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Invested assets}}\\ =\frac{\$682,500}{\$9,750,000}\times \frac{\$9,750,000}{\$6,500,000}\\ \text{= }7\%\times 1.5\\ \text{= 10}\text{.5\%}\end{array}$

(3)

To determine

Recommend the expansion of the profitable division, based on income from operations and ROI, computed in parts (1) and (2)

Explanation of Solution

The division with highest return on investment is considered as the most profitable division. Hence, SC Division is the most profitable division with highest ROI of 12.0%. Although income from operations are less than C Division, the return earned per dollar of assets invested is high for SC Division. So, it is recommended to expand the SC Division, assuming that the ROI would be standard.