Professional Documents
Culture Documents
,
_
rate interest
imputed
capital invested
s center' investment
profit s center' investment income Residual
Residual income = $100,000 ($800,000) (12%) = $4,000
The imputed interest rate is used in calculating residual income, but it is not used in
computing ROI. The imputed interest rate reflects the firm's minimum required rate
of return on invested capital.
13-8 The chief disadvantage of ROI is that for an investment that earns a rate of return
greater than the company's cost of raising capital, the manager in charge of deciding
about that investment may have an incentive to reject it if the investment would
result in reducing the manager's ROI. The residual-income measure eliminates this
disadvantage by including in the residual-income calculation the imputed interest
rate, which reflects the firm's cost of capital. Any project that earns a return greater
than the imputed interest rate will show a positive residual income.
13-9 The rise in ROI or residual income across time results from the fact that periodic
depreciation charges reduce the book value of the asset, which is generally used in
determining the investment base to use in the ROI or residual-income calculation.
This phenomenon can have a serious effect on the incentives of investment-center
managers. Investment centers with old assets will show higher ROIs than investment
centers with relatively new assets. This result can discourage investment-center
managers from investing in new equipment. If this behavioral tendency persists for a
long time, a division's assets can become obsolete, making the division
uncompetitive.
13-10 The economic value added (EVA) is defined as follows:
1
1
]
1
,
_
capital
of cost
average - Weighted
s liabilitie current
s center'
Investment
assets total
s center'
Investment
income operating
tax - after
s center' Investment
added
value
Economic
,
_
rate interest
imputed
capital invested
s center' investment
profit s center' investment income Residual
Economic value added differs from residual income in its subtraction of the
investment centers current liabilities and its specific use of the weighted-average
cost of capital.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-2 Solutions Manual
13-11 a. Total assets: Includes all divisional assets. This measure of invested capital is
appropriate if the division manager has considerable authority in making
decisions about all of the division's assets, including nonproductive assets.
b. Total productive assets: Excludes assets that are not in service, such as
construction in progress. This measure is appropriate when a division manager
is directed by top management to keep nonproductive assets, such as vacant
land or construction in progress.
c. Total assets less current liabilities: All divisional assets minus current liabilities.
This measure is appropriate when the division manager is allowed to secure
short-term bank loans and other short-term credit. This approach encourages
investment-center managers to minimize resources tied up in assets and
maximize the use of short-term credit to finance operations.
13-12 The use of gross book value instead of net book value to measure a division's
invested capital eliminates the problem of an artificially increasing ROI or residual
income across time. Also, the usual methods of computing depreciation, such as
straight-line or declining-balance methods, are arbitrary. As a result, some managers
prefer not to allow these depreciation charges to affect ROI or residual-income
calculations.
13-13 It is important to make a distinction between an investment center and its manager,
because in evaluating the manager's performance, only revenues and costs that the
manager can control or significantly influence should be included in the profit
measure. The objective of the manager's performance measure is to provide an
incentive for that manager to adhere to goal-congruent behavior. In evaluating the
investment center as a viable economic investment, all revenues and costs that are
traceable to the investment center should be considered. Controllability is not an
issue in this case.
13-14 Pay for performance is a one-time cash payment to an investment-center manager as
a reward for meeting a predetermined criterion on a specified performance measure.
The objective of pay for performance is to get the manager to strive to achieve the
performance target that triggers the payment.
13-15 An alternative to using ROI or residual income to evaluate a division is to look at its
income and invested capital separately. Actual divisional profit for a period of time is
compared to a flexible budget, and variances are used to analyze performance. The
division's major investments are evaluated through a postaudit of the investment
decisions. This approach avoids the necessity of combining profit and invested
capital in a single measure, such as ROI or residual income.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 3
13-16 During periods of inflation, historical-cost asset values soon cease to reflect the cost
of replacing those assets. Therefore, some accountants argue that investment-center
performance measures based on historical-cost accounting are misleading. Most
managers, however, believe that measures based on historical-cost accounting are
adequate when used in conjunction with budgets and performance targets.
13-17 Examples of nonfinancial measures that could be used to evaluate a division of an
insurance company include the following: (1) new policies issued and insurance
claims settled in a specified period of time, (2) average time required to settle an
insurance claim, and (3) number of insurance claims settled without litigation versus
claims that require litigation.
13-18 Nonfinancial information is useful in measuring investment-center performance
because it gives top management insight into the summary financial measures such
as ROI or residual income. By keeping track of important nonfinancial data, top
managers often can see a problem developing before it becomes a serious problem.
For example, if a manufacturer's rate of defective products has been increasing over
some period of time, management can observe this phenomenon and take steps to
improve product quality before serious damage is done to customer relations.
13-19 The goal in setting transfer prices is to establish incentives for autonomous division
managers to make decisions that support the overall goals of the organization.
Transfer prices should be chosen so that each division manager, when striving to
maximize his or her own division's profit, makes the decision that maximizes the
company's profit.
13-20 Four methods by which transfer prices may be set are as follows:
(a) Transfer price = additional outlay costs incurred because goods are transferred +
opportunity costs to the organization because of the transfer.
(b) Transfer price = external market price.
(c) Transfer prices may be set on the basis of negotiations among the division
managers.
(d) Transfer prices may be based on the cost of producing the goods or services to
be transferred.
13-21 When the transferring division has excess capacity, the opportunity cost of
producing a unit for transfer is zero.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-4 Solutions Manual
13-22 The management of a multinational company has an incentive to set transfer prices
so as to minimize the income reported for divisions in countries with relatively high
income-tax rates, and to shift this income to divisions with relatively low income-tax
rates. Some countries' tax laws prohibit this practice, while other countries' laws
permit it.
13-23 Multinational firms may be charged import duties, or tariffs, on goods transferred
between divisions in different countries. These duties often are based on the
reported value of the transferred goods. Such companies may have an incentive to
set a low transfer price in order to minimize the duty charged on the transferred
goods.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 5
SOLUTIONS TO EXERCISES
EXERCISE 13-24 (10 MINUTES)
Sales margin =
revenue sales
income
=
0 $50,000,00
$4,000,000
= 8%
Capital turnover =
capital invested
revenue sales
=
0 $20,000,00
0 $50,000,00
= 2.5
Return on investment =
capital invested
income
=
0 $20,000,00
$4,000,000
= 20%
EXERCISE 13-25 (15 MINUTES)
There are an infinite number of ways to improve the division's ROI to 25 percent. Here are
two of them:
1. Improve the sales margin to 10 percent by increasing income to $5,000,000:
ROI = sales margin capital turnover
= 0 $20,000,00
0 $50,000,00
0 $50,000,00
$5,000,000
= 8% 3.125 = 25%
Since sales revenue remains unchanged, this implies that the firm can divest itself of
some productive assets without affecting sales volume.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-6 Solutions Manual
EXERCISE 13-26 (5 MINUTES)
Residual
income
= investment center income
,
_
rate interest
imputed
capital
invested
= $4,000,000 ($20,000,000 11%)
= $1,800,000
EXERCISE 13-27 (20 MINUTES)
The weighted-average cost of capital (WACC) is defined as follows:
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 7
equity of
value
Market
debt of
value
Market
equity of
value
Market
capital
equity
of Cost
debt of
value
Market
capital
debt of
cost tax - After
capital
of cost
average - Weighted
The interest rate on Golden Gate Construction Associates $60 million of debt is 10 percent,
and the companys tax rate is 40 percent. Therefore, Golden Gates after-tax cost of debt is
6 percent [10% (140%)]. The cost of Golden Gates equity capital is 15 percent.
Moreover, the market value of the companys equity is $90 million. The following
calculation shows that Golden Gates WACC is 11.4 percent.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-8 Solutions Manual
114 .
0 $90,000,00 0 $60,000,00
000,000) (.15)($90, 000,000) (.06)($60,
capital of cost
average - Weighted
+
+
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 9
EXERCISE 13-28 (20 MINUTES)
The economic value added (EVA) is defined as follows:
1
1
]
1
,
_
capital
of cost
average - Weighted
s liabilitie current
s center'
Investment
assets total
s center'
Investment
income operating
tax - after
s center' Investment
added
value
Economic
For Golden Gate Construction Associates, we have the following calculations of each
divisions EVA.
Division
After-Tax
Operating
Income
(in millions)
Total Assets
(in millions)
Current
Liabilities
(in millions) WACC
Economic
Value
Added
(in millions)
Real Estate
$20(1.40) $100 $6 .114 = $1.284
Construction $18(1.40) $ 60 $4 .114 = $4.416
EXERCISE 13-29 (30 MINUTES)
1. Average investment in productive assets:
Balance on 12/31/x1....................................................................................... $12,600,000
Balance on 1/1/x1 ($12,600,000 1.05)........................................................ 12,000,000
Beginning balance plus ending balance...................................................... $24,600,000
Average balance ($24,600,000 2)............................................................... $12,300,000
a. ROI =
assets productive average
taxes income before operations from income
=
0 $12,300,00
$2,460,000
= 20%
b. Income from operations before income taxes..................................... $ 2,460,000
Less: imputed interest charge:
Average productive assets....................................... $12,300,000
Imputed interest rate................................................. .15
Imputed interest charge.................................................................... 1,845,000
Residual income..................................................................................... $ 615,000
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-10 Solutions Manual
EXERCISE 13-29 (CONTINUED)
2. Yes, Fairmonts management probably would have accepted the investment if residual
income were used. The investment opportunity would have lowered Fairmonts 20x1
ROI because the project's expected return (18 percent) was lower than the division's
historical returns (19.3 percent to 22.1 percent) as well as its actual 20x1 ROI (20
percent). Management may have rejected the investment because bonuses are based
in part on the ROI performance measure. If residual income were used as a
performance measure (and as a basis for bonuses), management would accept any
and all investments that would increase residual income (i.e., a dollar amount rather
than a percentage) including the investment opportunity it had in 20x1.
EXERCISE 13-30 (30 MINUTES)
1. Students calculation of return on investment and residual income will depend on the
company selected and the year when the internet search is conducted. Students will
need to decide how to determine the income and the invested assets to use in both
calculations. The discussion in the text will serve as a guide in this regard.
2. Some companies annual reports include a calculation and discussion of ROI in the
management report and analysis section or the financial highlights section.
Students calculation of ROI may differ from managements due to differing assumptions
about the determination of income and invested capital.
EXERCISE 13-31 (15 MINUTES)
Memorandum
Date: Today
To: President, Sun Coast Food Centers
From: I. M. Student
Subject: Behavior of ROI over time
When ROI is calculated on the basis of net book value, it will typically increase over time.
The net book value of the bundle of assets declines over time as depreciation is recorded.
The income generated by the bundle of assets often will remain constant or increase over
time. The result is a steady increase in the ROI, as income remains constant (or increases)
and book value declines.
This effect will not exist (or at least will not be as pronounced) if the firm continues to
invest in new assets at a roughly steady rate across time.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 11
EXERCISE 13-32 (10 MINUTES)
1. The same employee is responsible for keeping the inventory records and taking the
physical inventory count. In addition, when the records and the count do not agree, the
employee changes the count, rather than investigating the reasons for the discrepancy.
This leaves open the possibility that the employee would steal inventory and conceal the
theft by altering both the records and the count. Even without any dishonesty by the
employee, this system is not designed to control inventory since it does not encourage
resolution of discrepancies between the records and the count.
2. The internal control system could be strengthened in two ways:
(a) Assign two different employees the responsibilities for the inventory records and
the physical count. With this arrangement, collusion would be required for theft to
be concealed.
(b) Require that discrepancies between the inventory records and the physical count
be investigated and resolved when possible.
EXERCISE 13-33 (15 MINUTES)
1. Sales margin =
revenue sales
income
=
2,000,000
* 100,000
= 5%
*Income = 100,000 = 2,000,000 1,100,000 800,000
Capital turnover =
capital invested
revenue sales
=
1,000,000
2,000,000
= 2
ROI =
capital invested
income
=
1,000,000
100,000
= 10%
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-12 Solutions Manual
= $380
*Outlay cost = unit variable production cost
Average
Gross
Book
Value
ROI
Based
on
Gross
Book
Value
1 $150,000 $200,000 $(50,000) $400,000 $500,000
2 150,000 120,000 30,000 240,000 12.5% 500,000 6.0%
3 150,000 72,000 78,000 144,000 54.2% 500,000 15.6%
4 150,000 54,000 96,000 81,000 118.5% 500,000 19.2%
5 150,000 54,000 96,000 27,000 355.6% 500,000 19.2%
*Average net book value is the average of the beginning and ending balances for the year in net
book value. In Year 1, for example, the average net book value is:
$400,000
2
$300,000 $500,000
Residual
Income
Average
Gross
Book
Value
Imputed
Interest
Charge
Residual
Income
1 $150,000 $100,000 $50,000 $450,000 $45,000 $ 5,000 $500,000 $50,000 0
2 150,000 100,000 50,000 350,000 35,000 15,000 500,000 50,000 0
3 150,000 100,000 50,000 250,000 25,000 25,000 500,000 50,000 0
4 150,000 100,000 50,000 150,000 15,000 35,000 500,000 50,000 0
5 150,000 100,000 50,000 50,000 5,000 45,000 500,000 50,000 0
*Average net book value is the average of the beginning and ending balances for the year in net book value.
Imputed interest charge is 10 percent of the average book value, either net or gross.
Notice in the table that residual income, computed on the basis of net book value,
increases over the life of the asset. This effect is similar to the one demonstrated for ROI.
It is not very meaningful to compute residual income on the basis of gross book
value. Notice that this asset shows a zero residual income for all five years when the
calculation is based on gross book value.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies, Inc.
13-22 Solutions Manual
PROBLEM 13-42 (35 MINUTES)
1. Current ROI of the Northeast Division:
Sales revenue $8,400,000
Less: Variable costs ($8,400,000 x 70%) $5,880,000
Fixed costs.. 2,150,000 8,030,000
Income.. $ 370,000
ROI = Income invested capital
= $370,000 $1,850,000
= 20%
Northeasts ROI if competitor is acquired:
Sales revenue ($8,400,000 + $5,200,000). $13,600,000
Less: Variable costs [$5,880,000 +
($5,200,000 x 65%)] $9,260,000
Fixed costs ($2,150,000 + $1,670,000)... 3,820,000 13,080,000
Income... $ 520,000
ROI = Income invested capital
= $520,000 [$1,850,000 + ($625,000 +
$375,000)]
= 18.25%
2. Divisional management will likely be against the acquisition because ROI will be
lowered from 20% to 18.25%. Since bonuses are awarded on the basis of ROI, the
acquisition will result in less compensation.
3. An examination of the competitors financial statistics reveals the following:
Sales revenue.. $5,200,000
Less: Variable costs ($5,200,000 x 65%).. $3,380,000
Fixed costs .. 1,670,000 5,050,000
Income... $ 150,000
ROI = Income invested capital
= $150,000 $625,000
= 24%
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 23
PROBLEM 13-42 (CONTINUED)
Corporate management would probably favor the acquisition. Megatronoics has
been earning a 13% return, and the competitors ROI of 24% will help the
organization as a whole. Even if the $375,000 upgrade is made, the competitors ROI
would be 15% if past earnings trends continue [$150,000 ($625,000 + $375,000) =
15%].
4. Yes, the divisional ROI would increase to 21.01%. However, the absence of the
upgrade could lead to long-run problems, with customers being confused (and
perhaps turned-off) by two different retail environmentsthe retail environment they
have come to expect with other Megatronics outlets and that of the newly acquired,
non-upgraded competitor.
Sales revenue ($8,400,000 + $5,200,000). $13,600,000
Less: Variable costs [$5,880,000 +
($5,200,000 x 65%)] $9,260,000
Fixed costs ($2,150,000 + $1,670,000)... 3,820,000 13,080,000
Income... $ 520,000
ROI = Income invested capital
= $520,000 ($1,850,000 + $625,000)
= 21.01%
5. Current residual income of the Northeast Division:
Divisional profit $370,000
Less: Imputed interest charge ($1,850,000 x 12%) 222,000
Residual income.. $148,000
Residual income if competitor is acquired:
Divisional profit ($370,000 + $150,000)... $520,000
Less: Imputed interest charge [($1,850,000 +
($625,000 + $375,000)) x 12%]... 342,000
Residual income... $178,000
Yes, management most likely will change its attitude. Residual income will increase
by $30,000 ($178,000 - $148,000) as a result of the acquisition.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-24 Solutions Manual
PROBLEM 13-43 (30 MINUTES)
1. Sales margin: income divided by sales revenue.
Capital turnover: sales revenue divided by invested capital
Return on investmenti: income divided by invested capital (or sales margin x capital
turnover).
Sales margin: $360,000 $4,800,000 = 7.5%
Capital turnover: $4,800,000 $6,000,000 = 80%
Return on investment: $360,000 $6,000,000 = 6%, or
7.5% x 80% = 6%
2. Strategy (a): Income will be reduced to $300,000 because of the loss, and invested
capital will fall to $5,940,000 from the disposal. ROI = $300,000 $5,940,000, or
5.05%. This strategy should be rejected, since it further hurts Washburns
performance.
Strategy (b): In terms of ROI, this strategy neither hurts nor helps. The acceleration
of overdue receivables increases cash and decreases accounts receivable,
producing no effect on invested capital. Of course, it is possible that the newly
acquired cash could be invested in something that would provide a positive return
for the firm.
3. Yes. A drastic cutback in advertising could lead to a loss of customers and a
reduced market share. This could translate into reduced profits over the long term.
With respect to repairs and maintenance, reduced outlays could prove costly by
unintentional shortening of the useful lives of plant and equipment. Such action
would likely result in an accelerated asset replacement program.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 25
PROBLEM 13-43 (CONTINUED)
4. Anderson Manufacturing ROI: ($3,000,000 - $2,400,000) $5,000,000 = 12%
Palm Beach Enterprises ROI: ($4,500,000 - $4,120,000) $4,750,000 = 8%
From the preceding calculations, both investments appear attractive given the
current state of affairs (i.e.,Reliables current 6% ROI). However, if Washburn desires
to maximize ROI, he would be advised to acquire only Anderson Manufacturing.
Current
Current +
Anderson
Current +
Anderson +
Palm Beach
Income. $ 360,000 $ 960,000* $ 1,340,000**
Invested capital 6,000,000 11,000,000 15,750,000
ROI 6% 8.73% 8.51%
* $360,000 + ($3,000,000 - $2,400,000)
** $360,000 + ($3,000,000 - $2,400,000) + ($4,500,000 - $4,120,000)
PROBLEM 13-44 (35 MINUTES)
1. The weighted-average cost of capital (WACC) is defined as follows:
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-26 Solutions Manual
equity of
value
Market
debt of
value
Market
equity of
value
Market
capital
equity
of Cost
debt of
value
Market
capital
debt of
cost tax - After
capital
of cost
average - Weighted
The interest rate on CCLSs $80 million of debt is 9 percent, and the companys tax rate is
40 percent. Therefore, the after-tax cost of debt is 5.4 percent [9% (140%)]. The cost of
CCLSs equity capital is 14 percent. Moreover, the market value of the companys equity is
$120 million. The following calculation shows that Cape Cod Lobster Shacks WACC is
10.56 percent.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 27
1056 .
00 $120,000,0 0 $80,000,00
,000,000) (.14)($120 ,000,000) (.054)($80
capital of cost
average - Weighted
+
+
,
_
capital
of cost
average - Weighted
s liabilitie current
s center'
Investment
assets total
s center'
Investment
income operating
tax - after
s center' Investment
added
value
Economic
For Cape Cod Lobster Shacks, Inc., we have the following calculations of EVA for each of
the companys divisions.
Division
After-Tax
Operating
Income
(in millions)
Total Assets
(in millions)
Current
Liabilities
(in millions) WACC
Economic
Value
Added
(in millions)
Properties
$29(1.40) $145 $3 .1056 = $2.4048
Food Service $15(1.40) $ 64 $6 .1056 = $2.8752
PROBLEM 13-45 (35 MINUTES)
1. The weighted-average cost of capital (WACC) is defined as follows:
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 29
equity of
value
Market
debt of
value
Market
equity
of value
Market
capital
equity
of Cost
debt of
value
Market
capital
debt
of cost
tax - After
capital
of cost
average
- Weighted
The following calculation shows that All-Canadians WACC is 9.72 percent.
0972 .
00 $600,000,0 00 $400,000,0
,000,000) (.12)($600 0,000,000) (.063)($40
capital of cost
average - Weighted
+
+
$ 2,600,000
Less: Imputed interest charge
(assets 15%)........................................... 1,200,000 480,000
1,680,000
Residual income............................................ $ 800,000 $ 120,000
$ 920,000
*Cost to acquire RLI.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 39
CASE 13-50 (CONTINUED)
3. a. The likely effect on the behavior of division managers whose performance is
measured by return on investment includes incentives to do the following:
Put off capital improvements or modernization to avoid capital expenditures.
Shy away from profitable opportunities or investments that would yield more
than the company's cost of capital but that could lower ROI.
b. The likely effect on the behavior of division managers whose performance is
measured by residual income includes incentives to do the following:
Seek any opportunity or investment that will increase overall residual income.
Seek to reduce the level of assets employed in the business.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-40 Solutions Manual
CASE 13-51 (45 MINUTES)
1. Yes, Air Comfort Division should institute the 5% price reduction on its air
conditioner units because net income would increase by $132,000. Supporting
calculations follow:
Before 5%
Price Reduction
After 5%
Price Reduction
Per
Unit
Total
(in thousands)
Per
Unit
Total
(in thousands)
Total
Difference
(in thousands)
Sales revenue $400 $6,000 $380 $6,612.0 $612.0
Variable costs:
Compressor $ 70 $1,050 $70 $1,218.0 $168.0
Other direct material 37 555 37 643.8 88.8
Direct labor 30 450 30 522.0 72.0
Variable overhead 45 675 45 783.0 108.0
Variable selling 18 270 18 313.2 43.2
Total variable costs $200 $3,000 $200 $3,480.0 $480.0
Contribution margin $200 $3,000 $180 $3,132.0 $132.0
Summarized presentation:
Contribution margin of sales increase ($180 2,400) $432,000
Loss in contribution margin on original volume arising from
decrease in selling price ($20 15,000) 300,000
Increase in net income before taxes $132,000
2. No, the Compressor Division should not sell all 17,400 units to the Air Comfort
Division for $50 each. If the Compressor Division does sell all 17,400 units to Air
Comfort, Compressor will only be able to sell 57,600 units to outside customers
instead of 64,000 units due to the capacity restrictions. This would decrease the
Compressor Divisions net income before taxes by $35,500. Compressor Division
would be willing to accept any orders from Air Comfort above the 64,000 unit level at
$50 per unit because there would be a positive contribution margin of $21.50 per
unit. Supporting calculations follow.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 41
CASE 13-51 (CONTINUED)
Outside
Sales
Air Comfort
Sales
Selling price ............................................................................... $100 $50.00
Variable costs:
Direct material.......................................................................... 12 $10.50
Direct labor .............................................................................. 8 8.00
Variable overhead .......................................................... 10 10.00
Variable selling expenses ...................................................... 6
Total variable costs ................................................................ $ 36 $28.50
Contribution margin .................................................................. $ 64 $21.50
Capacity calculation in units:
Total capacity ............................................................................................ 75,000
Sales to Air Comfort ................................................................................. 17,400
Balance .................................................................................................. 57,600
Projected sales to outsiders .................................................................... 64,000
Lost sales to outsiders ............................................................................. 6,400
Solution:
Contribution from sales to Air Comfort ($21.50 17,400) ...................
$374,100
Loss in contribution from loss of sales to outsiders ($64 6,400) ....
409,600
Decrease in net income before taxes ...................................................... $ 35,500
3. Yes, it would be in the best interests of InterGlobal Industries for the Compressor
Division to sell the units to the Air Comfort Division at $50 each. The net advantage
to InterGlobal Industries is $312,500 as shown in the following analysis. The net
advantage is the result of the cost savings from purchasing the compressor unit
internally and the contribution margin lost from the 6,400 units that the Compressor
Division otherwise would sell to outside customers.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-42 Solutions Manual
CASE 13-51 (CONTINUED)
Cost savings by using compressor unit from Compressor Division:
Compressor Division:
Outside purchase price .................................................................... $ 70.00
Compressor Divisions variable cost to produce (see req. 2). ...... 28.50
Savings per unit................................................................................ $ 41.50
x Number of units............................................................................. x
17,400
Total cost savings ........................................................ $722,100
Compressor Divisions loss in contribution from loss
of sales to outsiders (see req. 2): $64 6,400 ..................................
409,600
Increase in net income before taxes for InterGlobal Industries ............ $312,500
4. As the answers to requirements (2) and (3) show, $50 is not a goal-congruent
transfer price. Although a transfer is in the best interests of InterGlobal Industries as
a whole, a transfer of $50 will not be perceived by the Compressor Divisions
management as in that divisions best interests.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 43
CASE 13-52 (50 MINUTES)
1. Diagram of scenario:
2. First, compute the unit contribution margin of an LDP and an HDP as follows:
LDP HDP
Price................................................................... $28 $ 115
Less: Variable cost:
Unskilled labor........................................ $5 $ 5
Skilled labor............................................ 5 30
Raw material........................................... 3 8
Purchased components......................... 4 12
Variable overhead................................... 5 15
Total variable cost.................................. 22 70
Unit contribution margin.................................. $ 6 $ 45
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-44 Solutions Manual
GENERAL INSTRUMENTATION COMPANY
Top Management
HUDSON BAY DIVISION
Jacqueline Ducharme
VOLKMAR TACHOMETER DIVISION
Bertram Mueller
Low-Density
Panels
(LPD)
High-
Density
Panels
(HPD) Control Pack
Imported from
Japan
TCH-320
Tachometer
Outside
Market
Outside
Market
Outside
Market
Alternative 1:
Transfer the
HDP
Alternative 2:
Buy the
Control Pack
CASE 13-52 (CONTINUED)
Second, compute the unit contribution margin of Volkmar's TCH-320 under each of its
alternatives, as follows:
TCH-320
Using
Imported
Control Pack
TCH-320
Using
an
HDP
Price............................................................. $270.00 $270.00
Less: Variable cost:
Unskilled labor.................................. $ 4.50 $ 4.50
Skilled labor...................................... 51.00 85.00
Raw material...................................... 11.50 6.00
Purchased components................... 150.00 5.00
Variable overhead............................. 11.00 11.00
Variable cost of manufacturing HDP -0- 70.00
Variable cost of transporting HDP... -0- 4.50
Total variable cost............................ 228.00 186.00
Unit contribution margin............................. $ 42.00 $ 84.00
Difference
is $42.
From the perspective of the entire company, the scarce resource that will limit overall
company profit is the limited skilled labor time available in the Hudson Bay Division. The
question, then, is how can the company as a whole best use the limited skilled labor time
available at Hudson Bay? The division has two products: LDP and HDP. One can view these
as three products, though, in the sense that the HDP units can be produced either for
outside sale or for transfer to the Volkmar Tachometer Division.
Hudson Bay's "Three" Products
HDP for external sale
HDP for transfer
LDP
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 45
CASE 13-52 (CONTINUED)
What is the unit contribution to covering the overall company's fixed cost and profit from
each of these three products? The calculations above show that the unit contribution
margin of an LDP is $6, and the unit contribution of an HDP sold externally is $45.
Moreover, the unit contribution to the overall company of an HDP produced for transfer is
$42, which is the increase in the unit contribution margin of the TCH-320 when it is
manufactured with the HDP instead of the imported control pack. To summarize:
Hudson Bay's Product
Unit Contribution to
Covering the Company's
Fixed Cost and Profit
HDP sold externally $45
HDP transferred internally 42
LDP 6
The analysis of these three products' contribution margins (to General Instrumentation as a
whole) has not gone far enough, because the products do not require the same amount of
the scarce resource, skilled labor time. The important question is how much one hour of
limited skilled labor at Hudson Bay spent on each of the three products will contribute
toward the overall firm's fixed cost and profit.
Hudson Bay's Product
Unit Contribution
Margin
Skilled Labor per
Unit Required at
Hudson Bay
Contribution
Margin
per Hour
HDP sold externally $45 1.50 $30
HDP transferred internally 42 1.50 28
LDP 6 .25 24
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-46 Solutions Manual
CASE 13-52 (CONTINUED)
This analysis shows that from the perspective of the entire company, Hudson Bay's best
use of its limited skilled labor resource is to produce HDPs for external sale, up to the
maximum demand of 6,000 units per year. The second best use of Hudson Bay's limited
skilled labor is to produce HDPs for internal transfer, up to the maximum number of units
needed by the Volkmar Tachometer Division. This number is 10,000 HDPs, since that is the
demand for Volkmar's TCH-320. Hudson Bay's least profitable product is the LDP.
Therefore, from the perspective of General Instrumentation as a whole, the Hudson Bay
Division should use its limited skilled labor time as follows:
Skilled labor time available at Hudson Bay.................................... 40,000 hours
(1) Produce 6,000 HDPs for external sale
(6,000 units 1.5 hours)............................................................... 9,000 hours
Hours remaining............................................................................... 31,000 hours
(2) Produce 10,000 HDPs for internal transfer
(10,000 units 1.5 hours)............................................................. 15,000 hours
Hours remaining............................................................................... 16,000 hours
(3) Produce 64,000 LDPs (64,000 units .25 hours)........................... 16,000 hours
Hours remaining............................................................................... -0-
The final answer to requirement (2) is that all of the required 10,000 TCH-320
tachometers should be manufactured using the HDP unit from the Hudson Bay
Division.
3. Given that 10,000 HDPs are transferred, there is no effect on General Instrumentation
Company's overall income. The transfer price affects only the way the company's
overall profit is divided between the two divisions.
4. Hudson Bay's minimum acceptable transfer price is given by the general transfer-
pricing rule, as follows:
Minimum acceptable transfer price =
additional outlay
costs incurred
because goods
are transferred
+
opportunity
cost to the
organization
because of the
transfer
= $70 + $36
= $106
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 47
CASE 13-52 (CONTINUED)
Explanatory notes:
(a) The outlay cost is equal to the variable cost of manufacturing an HDP.
(b) The opportunity cost is equal to the forgone contribution margins on the LDP
units that Hudson Bay will be unable to produce because it is manufacturing an
HDP for transfer. In the 1.5 hours of skilled labor time required to produce an
HDP for transfer, Hudson Bay could manufacture six LDPs, since each LDP
requires only .25 hours. Thus, the forgone contribution margin is $36 (6 units
$6 unit contribution margin).
5. The maximum transfer price that the Volkmar Tachometer Division would find
acceptable is $112, computed as follows:
Savings if TCH-320 is produced using an HDP:
Imported control pack............................................................................ $145.00
Other raw material.................................................................................. 5.50
Total savings........................................................................................... $150.50
Less: Incremental costs if TCH-320 is produced using an HDP:
Transportation cost................................................................................ (4.50)
Skilled labor............................................................................................ (34.00)
Net savings if HDP is used.......................................................................... $112.00
If Volkmar's management must pay $112 for an HDP, it will be indifferent between using
the HDP and the imported control pack. If the transfer price is lower than $112, the
Volkmar Tachometer Division will be better off with the HDP. At a transfer price in
excess of $112, Volkmar's management will prefer the control pack.
6. The transfer is in the overall company's best interest. Thus, any transfer price in the
interior of the range $106 to $112 will provide the proper incentives to the management
of each division to agree to a transfer. For example, a transfer price of $109 would split
the range evenly, and make each division better off by making the transfer.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-48 Solutions Manual
CURRENT ISSUES IN MANAGERIAL ACCOUNTING
ISSUE 13-53
WHAT'S A NEW ECONOMY WITHOUT RESEARCH," FORTUNE, MAY 15, 2000, STEWART
ALSOP.
Money invested in R&D is tied up for the long term and cannot be turned over many
times generating more profit in the short-run. With the current pressures on CEOs to
add value to their companies, short-term investments look better on the balance sheet in
the short-run.
ISSUE 13-54
AT&T MEETS ANALYSTS, BOOSTS GOALS FOR REVENUE, BUT STOCK DOESN'T
RESPOND," THE WALL STREET JOURNAL, DECEMBER 7, 1999, REBECCA
BLUMENSTEIN AND NICOLE HARRIS.
AT&T intends to provide local phone service nationwide. The company will serve
customers it cannot reach through its cable holdings or cable joint ventures.
ISSUE 13-55
HARVARD UNIVERSITY -- SOROS SUIT BRINGS RUSSIAN BANKRUPTCY FIGHT TO U.S.
COURT," THE WALL STREET JOURNAL, NOVEMBER 23, 1999, STEVE LIESMAN.
Tyumen Oil allegedly used transfer-pricing methods to divert oil revenue from the
subsidiaries. The investors say oil was sold cheaply to buyers related to Tyumen Oil,
which then sold the crude at world prices but failed to revert the profits to the Sidanco
units.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
Managerial Accounting, 5/e 13- 49
ISSUE 13-56
COOPERATION OR COMPETITION," STRATEGIC FINANCE, FEBRUARY 2000, DAN HILL.
Three core principles:
1. Focus:
a. Employee rewards based on overall company results
b. Employee rewards not based on local merits
2. Motivation that is fair:
a. All employees share in the company's wealth creation
b. Meaningful rewards for superior company performance
3. Ability to succeed:
a. Comprehensive information feedback loop
b. Information for improvement, not measurement
c. Result is cooperation and unlocking of resources
ISSUE 13-57
EXECUTIVE PAY," BUSINESS WEEK, APRIL 21, 1997, JENNIFER REINGOLD.
1. Management performance can be linked to financial and nonfinancial measures.
Financial factors, such as earnings-per-share (EPS), profit, return on assets (ROA)
and return on sales (ROS), could be used to assess management performance.
Compensation packages could then be based on items other than share price.
2. Financial markets may decline due to general macroeconomic factors. This could
unfairly penalize an executive.
3. No. Costs associated with issuing stock options include opportunity costs and administrative
costs.
McGraw-Hill/Irwin 2002 The McGraw-Hill Companies,
Inc.
13-50 Solutions Manual