Solution manual cost accounting by LauderbachDIVISIONAL PERFORMANCE MEASUREMENT

CHAPTER 10 DIVISIONAL PERFORMANCE MEASUREMENT 10-1 Value Menu The price reductions will probably reduce margins, but should increase turnover because of higher volume The effect on ROI depends on which change is greater It is also possible that the change could increase margins, if it results in incremental sales at value menu prices, but preserves existing sales We think this unlikely 10-2 Alternative Accounting Methods The effects of the cost flow assumptions are the same for a division of a larger company as they are for an entire company as discussed in financial accounting In the context of rising prices, a division using LIFO would show lower profits and lower inventories and hence lower book investment than if the division were using FIFO Use of weighted average would produce profits, inventories, and total investment somewhere between those resulting from LIFO and FIFO Return on book investment could appear to be lower if the division uses LIFO, though this would not necessarily be the case as the cumulative effects of LIFO on the inventory grow larger In fact, ROI would remain constant under LIFO if the division were able to price consistently at some absolute amount over current cost, while ROI would fall under FIFO if the same pricing practice were followed (This answer assumes no change in the quantity of inventory on hand and a constant investment in other assets.) If the company's practice is to set prices at a fixed percentage over replacement cost, ROI should increase under LIFO and FIFO both, though, again, the return will be lower with LIFO 10-3 Product-Line Reporting The major problem in preparing financial statements by product line, division, or principal lines of business is finding meaningful bases for allocating those balance sheet and income statement items that are not directly associated with the segments being reported upon It is highly likely that any business of sufficient size to publish public annual reports has assets, liabilities, and costs that are joint to several operating segments Segment reports could be prepared without allocations and showing unallocated balance sheet and income statement items separately, or possibly joint costs could be allocated on the basis of contribution margin minus separable costs Whether or not segment reports incorporate allocations, there may be a drawback to publishing such reports if readers of the reports fail to recognize that different types of divisions could, for reasons explained in the chapter, operate at different rates of return on sales or on investment Such understanding is, of course, a function of the sophistication of the 10-1 users On the other hand, readers of the reports would be better able to compare the performance of individual divisions with important competitors in their industries, comparisons that are not now possible for multi-industry firms As noted in Chapter 4, a company's activities can be segmented in many ways, and publishing reports on segments raises the question of what approach to use in determining which segments to use for reporting Should the reports be prepared by product line, by product, by division, by geographical area, by some common industry classification, or by some other scheme? The balance sheet and income statement items that require allocation will differ depending on the segmentation scheme Note to the Instructor: Some instructors use this opportunity to tell students the current SEC and FASB requirements for segment reporting in published reports Others try to give students an idea of the diversity that can exist in large companies by referring to the annual reports of some well-known companies Our experience has been that undergraduate students at the introductory level are seldom aware of the degree of diversification in the country's business enterprises 10-4 Performance measures and bonuses Two important aspects of the new bonus plan are the explicit identification of benchmarks and controllability Managers can now take action that will have an impact on the benchmarks and thus their bonus Under the old plan the connection between the size of the bonus and actions taken was nebulous Managers now receive feedback on a quarterly basis rather than once at the end of the year 10-5 Whirlpool's Operating Results The Sears sales should reduce margins, increase turnover, and increase ROI That answer assumes that Whirlpool does not have to add assets proportionately to the increased sales The assumption is fine for fixed assets, and we suspect that receivables from Sears would not be as high as the average, nor will the extra business require inventories in the same relative amounts as ordinary operations require A contrary answer, that turnover could ROI fall, might be made on grounds that 19% require commensurate increases in all asset 19% is significant, but doubt that it could increases 10-6 RI, ROI, and CVP Analysis (15-20 minutes) 50,000 ($600,000/$12) Required income ($1,000,000 x 20%) Fixed costs Required contribution margin 32% remain the same or decrease, and of sales is so large as to categories We acknowledge that generate so much in asset $200,000 400,000 $600,000 ($320,000/$1,000,000) Contribution margin Fixed costs (60,000 x $12) $720,000 400,000 10-2 Income $320,000 $170,000 Income (requirement 2) Required income ($1,000,000 x 15%) RI $21.00 $320,000 150,000 $170,000 $8 variable cost + $13 required contribution margin Target income ($1,000,000 x 25%) Plus fixed costs Required contribution margin Divided by 50,000 units equals required unit CM $250,000 400,000 $650,000 $13.00 55,000 units RI Minimum required income ($1,000,000 x 20%) Income Plus fixed costs Contribution margin Divided by contribution margin per unit Equals required unit volume 10-7 $ 60,000 200,000 $260,000 400,000 $660,000 $12 55,000 Comparison of ROI and RI, Investment Decisions (15-20 minutes) Schedule of projects: Project A B C D E Investment $ 600,000 700,000 1,000,000 1,100,000 1,200,000 Income $ 90,000 200,000 230,000 290,000 170,000 ROI 15% 28.6% 23% 26.4% 14.2% RI at 15% $ 95,000 80,000 125,000 (10,000) RI at 25% $(60,000) 25,000 (20,000) 15,000 (130,000) (a) The manager will select B and D, because each will increase ROI over the current 25% ($2,000,000/$8,000,000) (b) 25.41% [($2,000,000 + $200,000 + $290,000)/($8,000,000 + $700,000 + $1,100,000) = $2,490,000/$9,800,000] Note to the Instructor: It is important to point out with this early assignment that using ROI as the basic decision criterion does not mean that all projects yielding more than the current ROI would be selected For example, another project, F, yielding 25.1% would be rejected because overall ROI after adding B and D exceeds 25.1% Thus, the process of accepting specific projects must be carried out one project at a time (a) RI All except A and E, although A could be selected without reducing Income* Required return RI ($10,800,000** x 15%) * $2,000,000 + $200,000 + $230,000 + $290,000 **$8,000,000 + $700,000 + $1,000,000 + $1,100,000 10-3 $2,720,000 1,620,000 $1,100,000 (b) B and D Income* Required return RI $2,490,000 2,450,000 $ 40,000 ($9,800,000** x 25%) * $2,000,000 + $200,000 + $290,000 **$8,000,000 + $700,000 + $1,100,000 Maximizing RI is preferable because the company should invest so long as income exceeds the cost of obtaining the investment, which is the cost of capital Neither ROI nor RI is a discounted cash flow measure However, virtually any company would require a discounted cash flow analysis of a large long-lived capital investment, so division managers are not likely to accept projects with negative NPVs The problem is whether they will accept projects with positive NPVs if the book results not help their performance 10-8 Basic Transfer Pricing (20 minutes) (a) (b) (c) Increase $ 50,000 2,000 x ($150 - $125) Increase $ 50,000 2,000 x ($175 - $150) Increase $100,000 2,000 x ($175 - $125) or the sum of the increases in the incomes of the divisions ($50,000 + $50,000)} (a) (b) (c) Decrease $100,000 2,000 x ($200 - $150)] Increase $ 50,000, as in requirement (b) Decrease $ 50,000, the sum of the changes in the incomes of the divisions The answer can also be computed as follows: Lost contribution margin from outside sales, 2,000 x (200 - $125) Savings in outside purchases, 2,000 x ($175 - $125) Decrease 10-9 Product-Line Evaluation (15 minutes) Dollar amounts in the following calculation are in millions Margin Times turnover Equals ROI Investment (sales/turnover) Profit (margin x sales) $18) $150,000 100,000 $ 50,000 Cleaners Disinfectants Insect Sprays 20% 18% 25% 2.5 1.8 50% 36% 45% $12 ($30/2.5) $5 ($10/2) $10 ($18/1.8) $ (.20 x $30) $1.8 (.18 x $10) $4.5 (.25 x Dollar amounts in the following calculation are in millions Profit Required dollar profit: $12 x $ x $10 x RI Cleaners $6.0 Disinfectants $1.8 Insect Sprays $ 4.5 3.6 1.5 $2.4 $0.3 10-4 3.0 $ 1.5 Note to the Instructor: This exercise shows that the principles of evaluating divisions apply also to evaluating smaller segments The ROIs are high, as is the 30% required return You might wish to point out that the direct costs and investment associated with product lines are likely to be relatively lower than those of divisions Therefore, if the company does not allocate common costs to the lines, they should show much higher ROIs than divisions 10-10 Basic Transfer Pricing (30-35 minutes) Games gains $100,000 and Power gains $150,000 Toys-and-Stuff gains $250,000, which is also the sum of the net changes in the incomes of the individual divisions Games saves [500,000 x ($1.20 - $1.00)] Power gains the contribution margin from sales of 500,000 more units at $0.30 ($1.00 - $0.70) Toys-and-Stuff saves ($1.20 - $0.70) x 500,000 $100,000 $150,000 $250,000 Power's manager might want to keep busy, so that he avoids losing skilled workers who might leave the area because a temporary decline in demand prompted a layoff Because the order is a break-even proposition, Power's manager might accept it in a spirit of cooperation The manager might also believe that accepting the order could lead to other, profitable orders in the future Games gains $100,000 (see requirement 1); Power's income declines by $150,000 [500,000 x ($1.30 - $1.00)] because it is simply trading sales at $1.00 for sales at $1.30; and Toys-and-Stuff's income declines by $50,000 Toys-and-Stuff: Saves the $0.50 noted in requirement Loses the contribution margin on outside sales 500,000 x ($1.30 - $0.70) Net change in income (decrease) $250,000 300,000 $(50,000) In the absence of excess capacity, Power's manager is not likely to accept any price below the market price of $1.30 As in requirements and 3, Games gains $100,000 Power's income declines by $30,000 Income of Toys-and-Stuff increases by $70,000, which is also the sum of the changes in the incomes of the individual divisions 10-5 Games: Saves [500,000 x ($1.20 - $1.00)] Power: New contribution [500,000 x ($1.00 - $0.70)] Lost contribution [300,000 x ($1.30 - $0.70)] Net decrease in income Toys-and-Stuff: Saves the $0.50 noted in requirement Loses contribution margin on outside sales 300,000 x ($1.30 - $0.70) Net increase in income $1.06 The price has to bring equal the contribution margin lost Contribution margin to be lost 300,000 x ($1.30 - $0.70) $180,000 $530,000 P $100,000 $150,000 180,000 $ 30,000 $250,000 180,000 $ 70,000 contribution margin on 500,000 units to from 300,000 units sold at regular prices = Contribution margin needed on order = 500,000 x (P - $0.70) = 500,000P - $350,000 = 500,000P = $1.06 Note to the Instructor: The organization of the solutions provided for requirements 1, 2, and is designed to emphasize two points First, the effect of the transfer on the company as a whole is equal to the sum of the effects on the divisions involved in the transfer Second, the effect of the transfer on the company as a whole can be determined independently of the effects on the involved divisions 10-11 Components of ROI Return on Sales Investment Turnover ROI Return on Sales Investment Turnover ROI (15-20 minutes) Fabric and Home Care 19.1% 2.22 42.3% Food and Beverages 12.2% 1.77 21.7% Health Care 13.8% 1.75 24.2% Paper 15.1% 1.43 21.6% Fabric and Home Care 20.1% 2.22 44.6% Food and Beverages 13.2% 1.77 23.4% Health Care 14.8% 1.75 25.9% Paper 16.1% 1.43 23.0% Note to the Instructor: Some instructors might want to spend time discussing how ROI is affected by changes in its components As shown in the problem, the higher the turnover the greater increase in ROI that accompanies an increase in ROS, and vice versa (The increases in ROI are all 1% x the investment turnover; the advance in ROI was greatest for Fabric and Home Care, which had the highest turnover.) It should be pointed out that the increases here, one percentage point, are not equal percentage changes For example, the percentage increase for Fabric and Home Care is 5.2% (1%/19.1%) and for Food and Beverages is 8.2% (1%/12.2%) 10-6 10-12 ROI, RI, and CVP Analysis (15-20 minutes) 43,750 units Required profit ($900,000 x 25%) Fixed costs Contribution margin required Divided by per-unit contribution margin ($30 - $18) Equals required unit volume (a) $225,000 300,000 $525,000 $12 43,750 24% Total contribution margin ($12 x 43,000) Fixed costs Profit Divided by divisional investment Equals ROI 24% (b) $516,000 300,000 $216,000 $900,000 $22.92 Required return on additional investment (24% x $80,000) Increase in fixed costs Additional contribution margin required Additional variable costs (10,000 x $18) Additional revenues needed Divided by units in special order Equals required price for order Sales Variable costs Contribution margin Fixed costs Profit Divided by investment Equals ROI (a) Existing $1,290,000 774,000 $ 516,000 300,000 $ 216,000 $ 900,000 24% RI will increase $3,200 Additional income Required return, 20% x $80,000 Increase in RI Special Order $229,200 180,000 $ 49,200 30,000 $ 19,200 $ 80,000 24% $ 19,200 30,000 $ 49,200 180,000 $229,200 10,000 $ 22.92 Total $1,519,200 954,000 $ 565,200 330,000 $ 235,200 $ 980,000 24% $19,200 16,000 $ 3,200 A short-cut is to note that if the $22.92 price gives a 24% ROI on an $80,000 investment, then a 4% return is left after covering the 20% required return, giving 4% x $80,000 = $3,200 (b) $22.80 Additional required profit, 20% x $80,000 Additional fixed costs Required contribution margin Divided by units in special order Equals required contribution margin per unit Plus variable cost Equals required price $16,000 30,000 $48,000 10,000 $ 4.80 18.00 $ 22.80 Note to the Instructor: This exercise shows that it is possible to compute the ROI on incremental investment ($80,000 in this case), compare the 10-7 result with ROI on existing business, and thus determine whether the overall ROI will rise or fall as a result of a decision to increase (or decrease) investment 10-13 ROI, RI, and EVA for Pfizer (10 minutes) 21.4% ROI, $53.8 million RI ROI = $813/$3,796 = 21.4% Income Minimum required return, $3,796 x 20% RI $813.0 759.2 $ 53.8 Income Income tax at 35% After-tax operating income Minimum required return, $3,796 x 13% EVA $813.0 284.6 $528.4 493.5 $ 34.9 10-14 Basic RI Relationships Sales = $60 million ($40 investment x 1.5 turnovers) Profit = $12 million RI Plus required return Profit Return on sales = 20% (10-15 minutes) ($40 x 20%) ($12 profit/$60 sales) 21.7% Profit required ($5 RI + $8 minimum) Divided by sales Equals required ROS $ 4.0 8.0 $12.0 $13 $60 21.7% $65 million Profit required Divided by ROS Equals sales required, in millions 10-8 $13 20% $65 10-15 Transfer Pricing Increased Costs and Sacrificed Sales (10 minutes) Division A Gain on inside sale: Additional contribution margin, 30,000 x ($7 - $4 - $1) Less additional fixed costs Additional profit $60,000 12,000 $48,000 Loss on regular sales: Contribution margin on 10,000 units, 10,000 x ($9 - $4) Net loss on sale 50,000 $( 2,000) Division B Savings from lower price [30,000 x ($8 - $7)] $ 30,000 ABC Savings on lower price, 30,000 x ($8 - $4 - $1) $ 90,000 Less lost contriubtiion margin on outside sales, 10,000 x ($9 - $4) (50,000) Less increased fixed costs (12,000) Net gain $ 28,000 The gain to the company equals the gain and loss to the divisions, ($-2,000 + $30,000) The situation is ripe for a solution The company stands to gain $28,000, so the divisions can in effect split that amount between themselves through the transfer price Division B will certainly not pay more than $8 per unit, the price it now pays outsiders, while division A will accept no less than $7.07 (rounded), which is only $0.07 above the offer Contribution margin on lost sales Additional fixed costs Total required contribution margin on inside order Divided by units in order Equals required unit contribution margin Plus variable cost Required price $50,000 12,000 $62,000 30,000 $2.07 5.00 $7.07 Alternatively, division A faces a $2,000 loss at a $7 price, so $2,000/30,000 = $0.07 required increase in price 10-16 Transfer Prices and Decisions (25-30 minutes) Preliminary Note to the Instructor: This is one of the few early exercises where students can prepare complete income statements for the divisions and for the company as a whole By asking only for the changes in income, we tried to discourage students from preparing such statements, but many are likely to so nevertheless Solving the problem by concentrating on differences reinforces the principle, introduced in Chapter 5, that differences should be the basis for making decisions Using only the differential approach in requirements and encounters little student resistance But invariably some students insist on seeing complete income statements to clarify their understanding for requirement 3, and we believe it worthwhile to show both approaches for that requirement 10-9 Carter's income falls $30,000, Devon's income increases $30,000, and Montauk's income doesn't change Carter: Devon: Reduced contribution margin on sales to Devon because of drop in selling price 60,000 x ($4.00 - $3.50) $30,000 Increased contribution margin because of lower purchase cost [60,000 x ($4.00 - $3.50)] $30,000 Montauk: No change; the company as a whole is still paying $3.50 to make the compound $ Carter's income falls by $90,000, Devon's income increases by $30,000, and Montauk's income falls by $60,000 Carter: Devon: Loses the contribution on sales previously made to Devon [60,000 x ($4.00 - $2.50)] $(90,000) Increased contribution margin, as in requirement $ 30,000 Montauk: Loses because outsiders must be paid $3.50 for 60,000 units previously made inside for $2.50 60,000 x ($3.50 - $2.50) $(60,000) Carter should not reduce its price Refusing to reduce its price yields a $22,500 increase in income for Carter Devon's income increases $30,000 and Montauk's income rises $52,500 Carter: New contribution margin from outsiders 45,000 x ($5.00 - $2.50) Contribution margin lost from sales to Devon 60,000 x ($4.00 - $2.50) Increase in income Devon: $112,500 90,000 $22,500 Increase contribution margin, as in requirement Montauk: New revenue from outside sales by Carter 45,000 x $5 Change in costs: Costs to meet all of Devon's needs from outside (60,000 x $3.50) Savings from Carter's producing 15,000 fewer units (15,000 x $2.50) Net cost increase Net increase in income $30,000 $225,000 $210,000 37,500 172,500 $52,500 Comparing income under current conditions with revised income statements for the individual divisions and the company as a whole produces the same answer Carter Sales to outsiders: 245,000 x $5 $1,225,000 60,000 x $9 Devon $1,225,000 $540,000 10-10 Total 10-33 10-42 Transfer Pricing (CMA adapted) (30 minutes) The manager of Bradley would almost surely not accept the $5 price Because all of its output can be sold at $7.50, Bradley would lose income at the rate of $2.50 ($7.50 - $5) per unit supplied to Arjay In the short run, the company's best interests would be served if Bradley supplied the part Fill Order Revenue: Sale of assembly Sale of part outside Variable costs Contribution margin Do Not Fill Order $50.00 41.25* $ 8.75 $7.50 4.25 $3.25 * $23 + $14 + $4.25 The same conclusion results from summing the effects on the individual divisions For each unit sold, Arjay earns contribution margin of $8.00 ($50 - $23 - $14 - $5) and Bradley earns $0.75 ($5 - $4.25), for a total of $8.75 For either analysis, the $8 unit cost of the assembly for fixed overhead and administration is irrelevant One solution would be to order the Arjay Division to pay $7.50 for the part, which would satisfy Bradley and would also be in Arjay's best interest If that price were imposed, or agreed on by the managers, Arjay would show contribution of $5.50 on each assembly sold ($50 - $23 - $14 - $7.50) Instead of imposing the price, it might be better to show the manager of Arjay that offering the market price of $7.50 would be in his best interest The problem with an imposed price is that the managers would see they are not really operating decentralized units Note to the Instructor: Students often find this problem more difficult than similar ones in the chapter because of the absence of data about unit volumes Although not obviously so, the decision is essentially one of selecting the better use of a resource in limited supply The parts produced by Bradley are the resource and the supply is limited because Bradley is operating at capacity The alternative producing the higher contribution margin per unit of the resource should be chosen and the transfer price is irrelevant from the company's point of view 10-43 Budgeted and Actual Results (30-35 minutes) Without further information on the behavior of costs falling under the heading of operating expenses, we can't be sure that the entire budget variance is the result of Smith's cost-cutting decisions, but some general observations are possible Assuming that cost of sales would be essentially a variable cost, Smith's cost-cutting actions don't appear to have been applied to that major cost item The budgeted data indicate a cost of sales of about 50% of sales, but the actual data reflect a cost of sales of about 52.8% Possibly the higher cost ratio (lower margin) is the result of a difference between planned and actual product mix; about that we have no information Were it not for the favorable budget variance in operating expenses, the higher rate of cost of sales would have resulted in a lower than budgeted profit for the division 10-34 As discussed at various points in the text (including the earliest chapters), cost-cutting in discretionary areas might well have serious unfavorable effects on the future of the firm Determining whether the maintenance, employee training, and engineering costs were previously at a "good" or "proper" level is no simple matter, but at least one can argue that Smith's actions could prove detrimental in the long run Current assets for the division were over budget, suggesting that perhaps Smith authorized loosening of credit terms or allowed inventories to build up in the hope of stimulating sales (The expected relationship between sales and current assets is that the latter would be 50% of the sales, so that a sales level of $2,480,000 would suggest current assets of about $1,240,000 Actual current assets of $1,280,000 are over that expected level by $40,000, prompting the suggestion about loosened control.) As with current assets, current liabilities reflect a higher-than-budgeted relationship to the relevant base (current assets) Current liabilities are apparently budgeted at 40% of current assets, and the actual relationship at the end of last year is slightly more than 45% ($580,000/$1,280,000) Smith's statement about delaying payments to suppliers would explain the higher percentage, and the division may not have made sufficient use of trade credit in the past Nevertheless, the relationship reflected in the budget must have had some underlying explanation, and it's at least possible that Smith's actions have done some damage to the division's and possibly the company's standing with creditors Fixed assets were below the budgeted level, and Smith offers no comments that might explain this variance Smith could have postponed purchases of needed equipment or could have disposed of some existing equipment The difference is not large, however, and might simply be the result of a minor delay in the actual acquisition of approved investments The overall issue here is the conflict caused by the use of performance measures based on book returns alone and, specifically, returns for a short period Note to the Instructor: This problem provides a basis for discussing the problems associated with short-term measures of performance such as ROI and RI RI isn't mentioned in the problem, but a discussion of RI would involve points similar to those covered here in connection with ROI 10-35 10-44 Divisional Performance, Cost Allocations, and Dropping a Product Line (25-30 minutes) Sales Separable expenses: Cost of sales Selling and general Total separable expenses Joint costs, allocated on basis of sales dollars Total expenses Income Without Product A York Total Firm $200,000 $1,900,000 $100,000 50,000 $150,000 31,500* $181,500 $ 18,500 $ 990,000 421,000 $1,411,000 300,000 $1,711,000 $ 189,000 * ($200,000/$1,900,000) x $300,000 = $31,579, rounded to $31,500 York's performance looks better in terms of total profit from products that are York's responsibility If product line A is dropped, income is $18,500 compared with $16,000 ($20,000 income from Line B - $4,000 loss from Line A) when it was included The margin of revenues over separable costs has dropped from $61,000 to $50,000, so a critical question is whether York's superiors look at that margin or at income Since the income statement in the problem does not show the margin of revenues over separable costs, it may be assumed that the income figure is considered more important Despite the higher income shown for York after product line A is dropped, York's performance is not better The higher income results because the loss of margin from dropping line A is more than offset by a decrease in the allocation of common costs Unless some alternative is available to the company to compensate for the dropping of product line A, the income of the company as a whole drops $11,000 [the $11,000 of incremental profit from product line A (sales of $100,000 - $89,000 of separable costs) before it was dropped] 10-45 Developing Divisional Performance Data (30 minutes) X Division ROI computations: Current assets - current liabilities Fixed assets Totals Income ROI Rank Residual income computations: Total investment (above) Minimum required return at 15% Income (above) RI Rank 10-36 $ Y Division $ Z Division 100 2,250 $2,350 $ 600 25.5% 500 3,000 $3,500 $ 700 20% $ 500 3,750 $4,250 $ 900 21.2% $2,350.0 $352.5 600.0 $247.5 $3,500 $525 700 $175 $4,250.0 $637.5 900.0 $262.5 Income Statements Sales Cost of sales* Gross margin Selling and administrative expenses** Income X Division $2,000 640 $1,360 200 $1,160 Y Division $3,000 860 $2,140 600 $1,540 Z Division $5,000 2,400 $2,600 300 $2,300 * Data given in problem less 20%, 30%, and 50% of $1,800 **Data given less 20%, 30%, and 50% of $1,000 Balance Sheet Data X Division $ 360 300 $ 60 1,500 $1,560 Current assets* Less current liabilities Net Fixed assets (given) Net investment Y Division $ 640 200 $ 440 2,000 $2,440 Z Division $ 500 100 $ 400 2,500 $2,900 * Data given less 20%, 30%, and 50% of $200 Revised Performance Measures For convenience in making comparisons, the schedule below repeats the divisional rankings computed earlier based on data that included allocations ROI: Income Investment ROI Rank without allocations Rank with allocations X Division Y Division Z Division $1,160 $1,560 74% $1,540 $2,440 63% 3 $2,300 $2,900 79% $1,560 $ 234 1,160 $ 926 $2,440 $ 366 1,540 $1,174 $2,900 $ 435 2,300 $1,865 1 RI: Investment Minimum required return, at 15% Income RI Rank without allocations Rank with allocations Comments One aspect of the rankings stands out namely, Divisions Y and Z achieve a similar ranking under three of the four alternatives, while the position of Division X varies as much as it can with only three possible ranks and four alternatives Though some of the variation can be attributed to the nature of numbers and the fact that X is the smallest division, both in sales and in direct investment, the consistency in the rankings of the other divisions cannot be ignored As should be expected, ROI and RI produce different rankings with or without allocations, except that Y Division maintains its rank as third when allocations are included and Z Division maintains its rank as first when allocations are eliminated Given that the ROIs of all divisions exceed the required minimum using either measurement method, Division X's lower ranking when using RI is consistent with its size relative to the other divisions 10-37 Division Z's rise in the rankings when allocations are eliminated is not so easily explained Looking at the components of ROI before and after allocations can be useful here (Components were computed using data from schedules already presented.) X Division Y Division Z Division Without allocations: Return on sales 58% 51-1/3% 46% Times asset turnovers 1.28 1.23 1.72 Equals ROI 74% 63% 79% With allocations: Return on sales 30% 23-1/3% 18% Times asset turnovers 85 857 1.18 Equals ROI 25.5% 20.0% 21.2% Whether or not allocating common costs on the basis of relative sales reflects the activities that drive such costs, its effect on ROS percentages was simply to reduce each of them by 28 percentage points, the ratio of the $2,800 of allocated costs ($1,800 + $1,000) to total sales ($10,000) Hence, it is the allocation of common assets that explains the change in Division Z's ranking based solely on ROI That allocation reduced the variation in turnover rates, reducing the rate for Z Division the most in absolute terms and so reducing that Division's ROI the most given an equal percentage-point change in return on sales Without further information, it is not possible to determine whether the company has reasonable support for its method of allocating common assets (or common costs, for that matter) The ranking changes for Divisions X and Z should at least cause top managers to question the reasonableness of evaluations based on performance measures affected by allocations 10-46 Transfer Pricing (35 minutes) Whatever the transfer price, it is in the company's best interests for the transfer to take place The following schedule ignores the transfer price Contribution Margin, Outside Sales Westlake Current contribution margin: 40,000 x $24 3,500 x ($680 - $460) Total Contribution margin if action taken: 36,000 x $24* 4,500 x $212** Total Differences (decrease) Valcourt Company $960,000 $770,000 $1,730,000 864,000 954,000 $(96,000) $184,000 1,818,000 88,000 $ * Sales of speakers to outsiders will fall from 40,000 to 36,000, because of the current limitation of 45,000 units and Valcourt taking 9,000 units 10-38 **Current variable costs of $460 include $168 for two speakers purchased outside The variable cost of the Westlake speakers is $48 each, $96 for two, so that variable cost from the company's point of view becomes $388 ($460 - $168 + $96), and contribution margin becomes $212 ($600 - $388) Both divisions are better off if the transfer price is met Westlake: Additional contribution margin, sales to Valcourt ($62 - $48) x 9,000 Lost contribution margin from lost sales of 4,000 units ($24 x 4,000) Net gain to Westlake Valcourt: Current contribution margin ($3,500 x $220, which is $680 - $460) Contribution margin under proposal 4,500 x $184* Net gain to Valcourt Net gain to company $126,000 96,000 $30,000 $770,000 828,000 58,000 $88,000 * Current variable cost is $460 Valcourt would save $168 on the speakers bought outside and would pay $124 per pair for Westlake speakers ($62 x 2), giving a new variable cost of $416 ($460 - $168 + $124), which when subtracted from the $600 proposed selling price gives $184 The maximum price Valcourt would accept is about $68.45 the lowest acceptable price is about $58.67 For Westlake, Valcourt: Current selling price Current contribution margin, from requirement $770,000 Divided by expected volume, in units 4,500 Equals required contribution margin per unit Maximum variable cost that Valcourt can incur Less variable cost without speakers ($460 - $168) Maximum price for two speakers Divided by gives the maximum transfer price per speaker $68.445 Westlake: Contribution margin lost on outside sales Divided by sales to Valcourt Equals required contribution margin per unit Plus variable manufacturing cost per unit on sales to Valcourt Equals minimum acceptable price 10-47 Problems of Market-Based Transfer Prices $600.00 171.11 428.89 292.00 $136.89 $96,000 9,000 $10.667 48.000 $58.667 (40 minutes) Preliminary Note to the Instructor: This assignment treats a difficulty not covered specifically in the text namely, that market-based transfer prices can lead to unwise decisions if the market for the intermediate product is not competitive You might want to use the problem as the basis for discussing the circumstances in which market-based transfer prices not carry the advantages attributed to them under normal circumstances The problem is stated simply enough and the requirements explicitly enough that students should have little difficulty 10-39 To lay a foundation for making the point the problem was designed to make, the coverage of requirement must show clearly that it is advantageous for the manager of Lucrettia Division to buy, even at the $200 price, 5,000 units as opposed to buying none at all The review of the facts, suggested in the note with requirement 2, further facilitates students perceiving that a market-based transfer price might not be the best choice under some circumstances A critical feature of the problem is that the two available alternatives force simultaneous consideration of the transfer price and the quantity to be transferred This feature emphasizes the importance of seeking the optimal decision for the company as a whole $600 Selling Price $600 $550 $600 $550 400 400 $200 $150 x 5,000 x 6,000 $1,000,000 $ 900,000 Unit selling price Unit variable cost, given Unit contribution margin Expected volume in units Total expected contribution margin Either selling-price/volume combination increases Lucrettia's profits, even at the $200 price for the microprocessor At the $200 price, the manager of that division would prefer to buy 5,000 units but would be better off with a purchase of 5,000 or 6,000 than with no purchase at all $550 Unit selling price Variable costs to the firm: Materials Direct labor and variable overhead Variable cost of microprocessor Total variable cost to company Contribution margin to company Expected volume in units Total contribution margin expected Selling Price $600 $550 $600 $550 $ 90 110 50 250 $350 x 5,000 $1,750,000 250 $300 x 6,000 $1,800,000 Medici Division has excess capacity and presumably could make the microprocessor for $50, the listed variable cost per unit From the company's point of view, then, the better choice would be the lower selling price with its higher sales volume Note to the Instructor: situation for the students It is probably worthwhile here to summarize the * Lucrettia's manager would prefer to buy 5,000 units rather than 6,000 units, but would prefer selling either quantity to selling none * Medici's manager, with excess capacity, would prefer to sell 6,000 units rather than 5,000 units to Lucrettia, but would prefer to sell some rather than none * The company would be better off with the higher volume associated with the lower selling price and so would prefer a transfer of 6,000 units 10-40 * A $200 transfer price would prompt Lucrettia's manager to select a selling price of $600 (a volume of 5,000 units), a decision that is good for the company as well as for himself but is not the optimal decision for the company as a whole Some students will wonder why Medici does not sell more units outside, given its excess capacity The decision of Medici's manager not to so is economically sound, as shown below Selling price Variable cost Contribution margin Volume in units Total contribution margin to be expected Selling Price $200 $160 $200 $160 50 50 $150 $110 x 30,000 x 36,000 $4,500,000 $3,960,000 $175 Contribution margin from selling 5,000 units at $200 [5,000 x ($200 - $50)] Divided by Equals required contribution margin on 6,000 units Plus variable cost per unit Equals required price $750,000 6,000 units $125 50 $175 Note to the Instructor: At this point some students will ask how Medici's manager would know Lucrettia will buy 5,000 units at the $200 price If they accept that Medici's manager would know something though not necessarily everything about the potential profitability of Lucrettia's new product, there are at least two reasons to support the assertion First, Medici may be a monopolist with respect to the microprocessor, in which case Medici has no alternative supplier Second, even if alternative suppliers exist, a manager has good reason to believe the purchase will be made internally if the price from Medici and the price from an outside supplier are the same For example, without knowing the exact cost structure of Medici, Lucrettia's manager should understand enough about cost behavior to recognize that the company as a whole would benefit from an internal purchase at the same price offered by an outside supplier Too, the qualitative questions described in the discussion of make-buy decisions in Chapter could swing the decision in favor of an internal purchase Yes Lucrettia's manager would prefer a $175 transfer price for 6,000 units to a $200 price for 5,000 units because the former would produce a higher total contribution margin for the division 10-41 Selling price Variable costs: Materials Direct labor and variable overhead Cost of microprocessor Total variable cost per unit Contribution margin per unit Expected volume Expected total contribution margin Total contribution margin expected from best choice in requirement (5,000 units at transfer price of $200 and selling price of $600) Increase in contribution margin with $175 price $550 $ 90 110 175 375 $175 x 6,000 $1,050,000 1,000,000 50,000 $ The increase in contribution is relatively small ($50,000, or a 5% advantage of the larger volume over the smaller) Hence, the accuracy of the volume estimates is important, and Lucrettia's manager might perform some sensitivity analysis For example, the $50,000 advantage to the higher-volume/lower-price alternative would disappear if the 6,000-unit sales estimate were off by about 286 units ($50,000/$175 contribution margin per unit) or some 4.8% (286/6,000) By the same token, an error of smaller magnitude (but in the other direction with respect to the sales estimate associated with the higher price) would be sufficient to offset the $50,000 advantage, to the firm, of the lower price 10-48 Divisional Performance and Accounting Methods (25 minutes) Several factors besides poor performance can result in declining ROI First, the normal expectation is that ROI will decline in a period of rapidly rising capital expenditures High start-up costs, the addition of large amounts to the invested capital amounts, and lead times required for investments to bear fruit all contribute to declining ROI As the book values begin to decline (because of depreciation charges) and returns increase, the condition reverses Any method of depreciation (other than present-value methods) produces the condition of lower ROI in earlier years Accelerated depreciation methods aggravate the condition A few specific changes indicate better performance than the falling ROI seems to imply Divisional contribution margin and profit are increasing rapidly Profit is 50% higher in 20X6 than in 20X4; contribution margin doubled in the three years although sales increased by only 73% The sizable capital expenditures, along with increases in total invested capital, make it difficult to maintain the 40% ROI We might consider the results using residual income The minimum desired ROI is not given, but, at any rate below 14.3%, the additional investment has been worthwhile Change in profit ($1,200 - $800) Divided by change in investment ($4,800 - $2,000) Equals ROI on increase $ 400 $2,800 14.3% ROI is not particularly high and might well be below the minimum required The chapter mentions several possibilities The cost of new investment could be excluded from invested capital until the investment begins producing returns Start-up costs could be deferred and amortized An increasing charge depreciation method could be used Note to the Instructor: To expand the discussion of requirement 2, some 10-42 instructors might choose to introduce present-value depreciation We not discuss the method in the book, but some instructors might cover the method in association with Chapter or Chapter 10-49 Capital Budgeting and Performance Evaluation (30 minutes) General Note to the Instructor: This problem should be assigned only if the instructor plans to discuss the lease/purchase decision and is also interested in presenting or reviewing the financial accounting treatment of capitalized leases The problem can be attacked at various levels of sophistication, with the instructor choosing the depth of coverage and the side issues for discussion Two factors contribute to the complexity of this problem First, because the life of the lease is equal to the economic life of the machine, GAAP require that the lease be capitalized, which means the book investment for the Potter Division would increase if the lease alternative were accepted Subsequently, book income will be reduced by the computed interest expense and the lease amortization, rather than by the annual lease payment Second, regardless of the accounting requirement to capitalize the lease, there is no immediate cash outflow to be identified as the "required investment" for a typical capital budgeting analysis using NPVs (Indeed, the IRR would appear to be infinite, since no cash outlay is involved.) Partial explanation of the difficulties lies in the fact that the decision to enter into a capital lease rather than to purchase the asset outright is really a financing and not an investing decision, with the financing cost being the rate of return implicit in the lease agreement With tax considerations out of the way (the required ROI is before taxes and, according to the problem, approximates cost of capital which, we must assume, is also apart from tax considerations), the two alternatives offer simple cash flow differences Hence, some students are likely to compare NPVs of the alternatives in one of of the two following ways * Purchasing requires an investment of $40,000 for an annual cash savings of $10,000; leasing requires no immediate investment for an annual cash savings of $1,500 ($10,000 savings less the $8,500 lease payment) The purchase alternative would appear to be better (NPV of $16,500, computed as $10,000 times the present value factor of 5.65, less the $40,000 investment) than leasing (NPV of $8,475, computed as $1,500 times 5.65) * The $10,000 annual savings occur under either alternative and so are irrelevant Hence, some students may simply compare the present value of the lease payments ($8,500 x 5.65 = $48,025) with the purchase cost ($40,000) Again, outright purchase appears the better choice Both of these analyses are conceptually weak, however, because they treat the lease as an investment alternative rather than as one way the manager might finance the acquisition The present value calculation related to the purchase alternative (NPV of $16,500) indicates that acquisition of the machine, however that acquisition is accomplished, is wise How to finance the acquisition is decided after the wisdom of the acquisition has been determined Calculating ROI or RI requires considering the capitalization of the lease Hence, it is likely that the divisional investment, if investment is defined as total assets, would be the same under any acquisition alternative The total assets will increase by $40,000 and the asset would then be 10-43 amortized in the company's normal fashion Divisional income will be the same under any acquisition alternative as long as the divisional profit does not take into consideration financing charges (It would be inconsistent to compare the ROI of the leasing alternative to the ROI of other alternatives if the divisional income used to compute the former includes interest charges and the divisional income used to compute the former makes no provision for financing costs.) If the method of financing the acquisition is ignored, the ROI should be the same under the various acquisition alternatives In the first year, book investment will be $240,000 ($200,000 + $40,000) and book income will be $46,000 ($40,000 + $10,000 - $4,000 amortization), for ROI of 19.2% The average ROI on the investment would be 30% [($10,000 - $4,000)/ $20,000], but this will not be achieved for several years Book ROI computations are complicated further if the divisional "investment" is computed using assets minus liabilities If the leased asset is capitalized and the corresponding lease liability recorded, there is no increase in book "investment." Even if the interest expense is not charged against divisional profit, results are peculiar because the lease liability does not decline at the same rate as the asset is amortized The interest rate implicit in the lease agreement is 16.723% As the following schedule shows, the net lease liability is greater than the unamortized balance of the leased asset at the beginning of every year of the asset's life after the first Unamortized (a) (b) Balance of Book Lease Unamortized DisNet Lease Year Investment Liability count on Lease Liability $40,000 $85,000 $45,000 $40,000 36,000 76,500 38,311 38,189 32,000 68,000 31,925 36,075 28,000 59,500 25,892 33,608 24,000 51,000 20,272 30,728 20,000 42,500 15,133 27,367 16,000 34,000 10,556 23,444 12,000 25,500 6,635 18,865 8,000 17,000 3,480 13,520 10 4,000 8,500 1,219 7,281 (a) (b) The lease liability is reduced each year by the $8,500 annual lease payment Reduction of unamortized discount each year is equal to 16.723% interest on the net lease liability at the beginning of that year It is inappropriate to compute some type of ROI based on investment defined as assets minus liabilities for the lease alternative unless ROIs computed for comparison purposes also include some specific financing alternative About all that can be said is that the interest rate on this particular financing alternative is greater than the cost of capital (16.723% vs 12%) Instructors may wish to use this case to support discussion of the fact that ROI calculated without regard to financing considerations need not coincide with ROIs calculated subsequently and based on book investment amounts resulting from financing alternatives actually selected For example, if a project is financed with funds available internally and no (imputed) charge is made for such financing, divisional profit may increase with no incremental increase in divisional investment 10-44 10-50 National Automobile Company Introduction of a New Model (30 minutes) Based on the available information, the new model should be brought out Divisional RI (in thousands of dollars) will be as follows Contribution margin [80,000 x ($18,100 - $13,800)] Additional fixed costs Additional profit Required profit (18% x investment of $500 million) Additional residual income $344,000 220,000* 124,000 90,000 $ 34,000 * Total fixed costs associated with the new model are $320,000,000 (80,000 x $4,000 per unit) Of that amount, $100 million is existing fixed cost being reallocated, giving $220 million additional fixed cost to be incurred Not considered in the above analysis (or in the given facts) is the question of the longer-term outlook for the new model The $300 million investment in equipment indicates that a capital budgeting analysis is necessary Without additional information one can only suggest that the proposal warrants further consideration and study Because the company has other divisions, some possibility exists that market research on the sales effect for Yuma Division may not give a complete picture of the sales effect for the entire company (This point is brought out in the following assignment but should probably be raised even without that additional information.) 10-51 National Automobile Company Interaction Effects of Decision (Extension of 10-50) (30 minutes) The effects on profit and residual income of the Tucson Division (in thousands of dollars) are as follows Lost contribution margin [30,000 x ($16,700 - $12,900)] $114,000 Fixed cost savings 40,000* Profit reduction $ 74,000 Decline in required residual income (18% x $100 million) 18,000 Reduction in residual income $ 56,000 * Total fixed costs are currently $560 million ($3,500 x 160,000) At $4,000 per unit and 130,000 units, total fixed costs are $520 million, $40 million less than $560 million The effect on the company is that income will increase, but residual income will decrease, making the additional investment unwise The reduction in residual income can be computed directly from the changes in residual incomes of the two divisions The Tucson Division loses $56 million and the Yuma Division gains $34 million, for a net loss of $22 million A proof shows the following, again in thousands Change in profit Change in investment Required return on net added investment at 18% Actual return, above Reduction in residual income Yuma $124,000* $500,000* Tucson $(74,000) $(100,000) Company $ 50,000 $400,000 $ 72,000 50,000 $ 22,000 10-45 * See previous case A few other important points can be made besides the obvious one that Mack's action would hurt Warren's division and hurt the company as well Note that the market research group is apparently attached to the corporate offices, to be called on by divisional managers as they see fit Whether because of the personalities of the people in the group, the personalities of the divisional managers, or historical relationships between this corporate service group and operating managers, the fact remains that Gregorich didn't voluntarily give Mack the full story regarding the market research Even recognizing the autonomous nature of the divisions, it's difficult to justify Gregorich's failure to inform Mack of all of the results of the research; the organizational placement of the market research group would suggest that a "bigger picture" is exactly what the company's top management was seeking to ensure The question of what ought to be done can be debated extensively If top-level managers prevent Mack from bringing out the new model, they are admitting that the divisions are not as autonomous as is apparently believed On the other hand, if the new model is brought out, the company will suffer A major question, then, is what Mack will once he knows about the probable effects on Tucson If he insists on going ahead with the new model, the detrimental effects will probably not be limited to the loss in residual income for Tucson and the firm Warren will surely harbor ill feelings for Mack, which could make future cooperation between the two unlikely At worst, Warren might even consider the possibility of introducing a model that will compete with the Panther 10-52 ROI at Burlington Industries, Inc (20 minutes) Income statement Sales Costs and expenses: Cost of sales Selling and administrative Other expenses U.O.C.C Profit before taxes * Receivables less payables Inventories Fixed assets Totals $23,450 $16,418 1,678 1,025 1,400* 20,521 $ 2,929 $2,540 x 07 = $ 177.8 3,136 x 14 = 439.0 3,560 x 22 = 783.2 $9,236 $1,400.0 ROI for the division is 31.7% ($2,929/$9,236) minimum ROI is 15.16% ($1,400/$9,236) The weighted average Comments about the system will vary The inclusion of the U.O.C.C means that the profit before taxes figure is comparable to residual income Hence, the division with the largest profit before taxes also has the largest RI The extent to which dollar profit and ROI are weighted in the evaluating process is unknown The use of ROI based on a profit figure that already includes the U.O.C.C is an interesting variation and is not subject to any standard interpretation It's not a measure of return on equity, because U.O.C.C includes the cost of both debt and equity Note to the Instructor: Whether the system encourages managers to take desirable actions is debatable During a discussion at the symposium at 10-46 which Mr Hughes described the system, he was asked (1) whether ROI discouraged managers from accepting projects with less than but greater than the minimum required, and (2) whether managers encouraged to take a short-run view, turning down projects that profitable in the long term but unprofitable in the short run the use of average ROI were would be Mr Hughes replied only that the company did not experience dysfunctional consequences Replying to the first question, he stated that "Division management must be broad-minded in submitting needed projects that may not be equal to the current level of performance." To the second question he responded, "No, every major expansion project creates a negative impact on profit in a short run If this short-term impact dictated our actions, we would not have achieved our present status as number one in the industry." Even though the symposium was held over 30 years ago, the material has a contemporary message The issues have been around for many years and will remain with us in the future [Quotations are from Thomas J Burns, ed., The Behavioral Aspects of Accounting Data for Performance Evaluation (Columbus, Ohio: College of Administrative Science, Ohio State University, 1970), pp 76-77.] 10-47 ... for reporting Should the reports be prepared by product line, by product, by division, by geographical area, by some common industry classification, or by some other scheme? The balance sheet and... variable costs (10,000 x $18) Additional revenues needed Divided by units in special order Equals required price for order Sales Variable costs Contribution margin Fixed costs Profit Divided by investment... outside sales by Carter 45,000 x $5 Change in costs: Costs to meet all of Devon's needs from outside (60,000 x $3.50) Savings from Carter's producing 15,000 fewer units (15,000 x $2.50) Net cost increase