Grate Care Company specializes in producing products for individual grooming. The company operates six divisions, adding the Hair Products Division. Each division is treated as an investment center. Managers are estimated and rewarded on the basis of ROT performance. Only those managers who produce best ROIs are selected to receive bonuses and to fill higher-level managerial positions. Fred Olsen, manager of the Hair Products Division, has forever been one of the top performers. For the past two years, Fred's division has produced the largest ROT; last year, division earned an operating income of $2.56 million and employed average operating assets valued at $16 million. Fred is satisfied with his division's performance and has been told that if division does well this year, he will be in line for a headquarters position.
For the coming year, Fred's division has been promised new capital totaling $1.5 million. Any of capital not invested by the division will be invested to earn company's required rate of return (9 percent). After some careful investigation, the marketing and engineering staff recommended that the division invest in equipment that could be used to make a crimping and waving iron, a product presently not produced by the division. The cost of the equipment was estimated at $1.2 million. The division's marketing manager estimated operating earnings from the new line to be $156,000 per year.
After receiving the proposal and reviewing the potential effects, Fred turned it down. He then prepare a memo to corporate headquarters, showing that his division would not be able to employ the capital in any new projects within the next eight to 10 months. He did note, however, that he was confident that his engineering and marketing staff would have a project ready by end of the year. At that time, he would like to have access to the capital.
Required:
1. Clarify why Fred Olsen turned down the proposal to add the capability of producing a crimping and waving iron. Give computations to support your reasoning.
2. Evaluate the effect that the new product line would have on the profitability of firm as a whole. Should division have produced crimping and waving iron?
3. Assume that the firm used residual income as a measure of divisional performance. Do you think Fred's decision might have been different and why?
4. Describe why a firm like Grate Care might decide to use both residual income and return on investment as measures of performance.
5. Did Fred present ethical behavior when he turned down the investment? In discussing issue, suppose why he refused to allow the investment.