Leisure World Inc. is a privately held diversified company with five separate divisions organized as investment centers. A condensed income statement for the Sporting Goods Division for the past year, assuming no service department charges, is as follows:
Leisure World Inc.—Sporting Goods Division
Income Statement
For the Year Ended December 31, 2006
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000,000
Cost of goods sold . . . . . . . . . . . . . . . . . . 10,100,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . $ 5,900,000
Operating expenses . . . . . . . . . . . . . . . . . . 1,900,000
Income from operations . . . . . . . . . . . . . . $ 4,000,000
The manager of the Sporting Goods Division was recently presented with the opportunity to add an additional product line, which would require invested assets of $12,000,000. A projected income statement for the new product line is as follows:
New Product Line
Projected Income Statement
For the Year Ended December 31, 2007
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,500,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . 4,200,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . $3,300,000
Operating expenses . . . . . . . . . . . . . . . . . . . 2,100,000
Income from operations . . . . . . . . . . . . . . . . $1,200,000
The Sporting Goods Division currently has $20,000,000 in invested assets, and Leisure World Inc.’s overall rate of return on investment, including all divisions, is 8%. Each division manager is evaluated on the basis of divisional rate of return on investment, and a bonus equal to $10,000 for each percentage point by which the division’s rate of return on investment exceeds the company average is awarded each year.
The President is concerned that the manager of the Sporting Goods Division rejected the addition of the new product line, when all estimates indicated that the product line would be profitable and would increase overall company income. You have been asked to analyze the possible reasons why the Sporting Goods Division manager rejected the new product line.
1. Determine the rate of return on investment for the Sporting Goods Division for the past year.
2. Determine the Sporting Goods Division manager’s bonus for the past year.
3. Determine the estimated rate of return on investment for the new product line.
4. Why might the manager of the Sporting Goods Division decide to reject the new product line? Support your answer by determining the projected rate of return on investment for 2007, assuming that the new product line was launched in the Sporting Goods Division, and 2007 actual operating results were similar to those of 2006.
5. Can you suggest an alternative performance measure for motivating division managers to accept new investment opportunities that would increase the overall company income and rate of return on investment?