Videonet Company manufactures highly specialized products for networking video-conferencing equipment. Productions 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.

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.

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