Problem:
Cartier Custom Products has three operating divisions, which are appropriately treated as investment centers. Each of the investment centers is run by a divisional manager. The managers are evaluated on the basis of ROI performance. Those managers with the best ROI figures are most likely to be promoted to higher-level corporate positions. Jerry Jones is one of the divisional managers for Cartier. He is an ambitious person who desperately wants a promotion to headquarters. The investment center for which Jerry is responsible manufactures a line of patio furniture. This investment center has two plants, which employ over 500 workers. Operating results for each of the plants and for the division in total for the most recent year are as follows:
Total Plant A Plant B
Revenues $180,000 $120,000 $60,000
Expenses $150,000 $100,000 $50,000
Net income $25,000 $15,000 $10,000
Average operating assets $170,000 $110,000 $60,000
Cartier's cost of capital is 11%. Sales, marketing, and production managers who work for Jerry have proposed adding production capabilities for the manufacture of picnic table umbrellas. They have compiled figures that show that the estimated cost of the assets needed to produce an umbrella line is $240,000. They further estimate that the umbrella line would increase net income by $30,000 a year. After careful consideration, Jerry rejected the idea and added, "This is no time to add to our production facilities. In fact, I've been thinking of closing Plant B and moving its production to Plant A."
Required to do:
Q1. What is the most likely reason why Jerry turned down the proposal to produce umbrellas?
Q2. Would the company as a whole be better off by producing the umbrellas? Explain your answer. Using the economic value added (residual income) approach, provide computations to support your reasoning.
Q3. Why do you believe Jerry has suggested closing Plant B? How does ROI as a performance measure adversely affect the company in total?