EXERCISE 12-17 (20 MINUTES)

2. Companies in the Same Industry

A B C

Sales ...$600,000 * $500,000 * $2,000,000

Net operating income ... $84,000 * $70,000 * $70,000

Average operating assets ...$300,000 * $1,000,000 $1,000,000 *

Margin... 14% 14% 3.5% *

Turnover... 2.0 0.5 2.0 *

Return on investment (ROI) ... 28% 7% * 7%

*Given.

Because of differences in size between Company A and the other two

companies (notice that B and C are equal in income and assets), it is

difficult to say much about comparative performance looking at net op-

erating income and operating assets alone. That is, it is impossible to

determine whether Company A’s higher ROI is a result of its lower as-

sets or its higher income. This points up the need to specifically include

sales as an element in ROI computations. By including sales, light is

shed on the comparative performance and possible problems in the

three companies.

Problem 12-19 (continued)

NAA Report No. 35 states (p. 35):

“Introducing sales to measure level of operations helps to disclose spe-

cific areas for more intensive investigation. Company B does as well as

Company A in terms of profit margin, for both companies earn 14% on

sales. But Company B has a much lower turnover of capital than does

Company A. Whereas a dollar of investment in Company A supports two

dollars in sales each period, a dollar investment in Company B supports

only fifty cents in sales each period. This suggests that the analyst

should look carefully at Company B’s investment. Is the company keep-

ing an inventory larger than necessary for its sales volume? Are receiv-

ables being collected promptly? Or did Company A acquire its fixed as-

sets at a price level which was much lower than that at which Company

B purchased its plant?”

Thus, by including sales specifically in ROI computations the manager is

able to discover possible problems, as well as reasons underlying a

strong or a weak performance. Looking at Company A compared to

Company C, notice that C’s turnover is the same as A’s, but C’s margin

on sales is much lower. Why would C have such a low margin? Is it due

to inefficiency, is it due to geographical location (requiring higher sala-

ries or transportation charges), is it due to excessive materials costs, or

is it due to other factors? ROI computations raise questions such as

these, which form the basis for managerial action.

To summarize, in order to bring B’s ROI into line with A’s, it seems obvi-

ous that B’s management will have to concentrate its efforts on increas-

ing turnover, either by increasing sales or by reducing assets. It seems

unlikely that B can appreciably increase its ROI by improving its margin

on sales. On the other hand, C’s management should concentrate its ef-

forts on the margin element by trying to pare down its operating ex-

penses.

Problem 12-20 (30 minutes)