CHAPTER 11

INVESTMENT CENTER PERFORMANCE EVALUATION

Questions, Exercises, Problems, and Cases: Answers and Solutions
11.1 See text or glossary at the end of the book.
11.2 Transfer prices exist in centralized organizations to record the transfer of
goods and services from one unit to another for the same reasons such
organizations allocate costs (e.g., inventory valuation, cross- department
monitoring).
11.3 Market-based transfer pricing is considered optimal under many
circumstances, because it preserves divisional autonomy, yet encourages
division managers to make economically optimal decisions for the
company, when divisions operate at capacity.
11.4 The limitations of market-based transfer prices exist when the market
price does not reflect the opportunity cost of the goods and services, for
example if idle capacity is present. Also, temporary short-run fluctuations
in market prices could lead to suboptimal long- run decisions. But the key
limitation is that market prices are often not readily available.
11.5 The advantages of a centrally administered transfer price are that it
promotes short-run profits by ensuring proper action by divisional
managers and allows division managers to maintain their autonomy. The
disadvantages of such a transfer price are that top management will
become too involved in pricing disputes, and that division managers will
lose flexibility in their decision making. The company also loses the other
advantages of decentralization.
11.6 Companies often use prices other than market prices for interdivisional
transfers because (1) market prices may not be available, (2) market
prices can lead to suboptimal behavior when the supplier division has idle
capacity, or (3) the company is not otherwise indifferent between internal
and external buying.
11.7 The disadvantages of a negotiated transfer price system are that a great
deal of management effort may be used on the negotiating process and
that the negotiated price may be based more upon the manager's ability
to negotiate rather than other factors.
11- 1 Solutions
11.8 This occurs when the benefits of an action to one division are more than
offset by harmful effects to another division. For example, the sale of a
critical component by one division to outside customers rather than to
another division may be harmful to the company as a whole if the second
division cannot obtain the component from other sources.
11.9 Transfer prices are necessary if the profit performances of individual
divisions are to be evaluated as if the divisions were separate entities.
Without the use of transfer prices, units sold to outsiders would be
reflected in the division's revenues, but units sold to other divisions would
not be reflected. Transfer prices establish a revenue value to be
included in the evaluation of a divisions operations. They are also
necessary for tax purposes in international business.
11.10 The use of the term "price" suggests an exchange of cash or promise to
pay cash. Divisions seldom actually exchange cash.
11.11 The Internal Revenue Service (IRS) disputed the transfer price because it
was not adjusted down in the face of decreasing demand for the product.
This caused the U.S. subsidiary to report lower profits and hence pay less
taxes than they would using the market price. For this reason, the IRS
wanted the transfer price lowered to what the IRS considered to be a
market price.
11.12 In setting transfer prices between divisions in different countries, the
affects on tax liabilities, royalties, other payments required by differing
laws, and the ability to transfer profits out of a country should be
considered.
11.13 A cost- based transfer pricing method would be necessary. We
recommend using differential standard costs to the supplier plus
supplier's opportunity costs of the internal transfer, if any. If a dual
transfer pricing system is used, the supplier could be given a mark-up
without charging it to the buyer.
11.14 The economic basis for transfer pricing systems is that as long as the
transfer price is greater than the opportunity cost of the selling division
and less than the opportunity cost of the buying division, a transfer will be
encouraged.
11.15 In evaluating the division manager, top management is concerned with
those revenues and expenses over which the division manager has some
reasonable degree of control. Factors that are noncontrollable may be
deducted to compute ROI for this purpose. In evaluating the division, top
management is concerned with the division's contribution as an entity to
the profits of the company. The salary of the division manager may not
be deducted in evaluating the division but would be deducted in
calculating the ROI used to evaluate the performance of the division
manager.
Solutions 11- 2
11.16 This statement may be correct depending on how ROI is calculated. If
assets are stated at acquisition cost and depreciable assets are stated net
of accumulated depreciation, then the statement is correct. The assets of
divisions with newer assets will be stated at more recent higher costs,
assuming inflation, and at a higher proportion of their acquisition costs.
With a larger denominator, the ROI of new divisions will be lower than for
older divisions, other things being the same.
11.17 ROI measures scale the division accounting profit by the investment
required, which facilitates comparison between divisions of various sizes.
Also, managers would have incentives to maximize accounting measures
of profit without regard to the investment required. (Use of economic
profits would not have this problem, of course.)
11.18 If the return on a specific project is greater than the company's cost of
capital, but has an accounting ROI that is lower than the division's ROI, a
division manager would have an incentive to avoid that project even
though it meets the company's cost of capital requirements. This is
because it would lower the divisions ROI, which is weighted according to
investment and return.
11.19 By maximizing economic value added, managers will accept all projects
above the minimum acceptable rate of return.
11.20 According to the general rule when the selling division is below capacity
the transfer price should be set at the differential cost. The buying
division will then choose the least costly alternative between internal or
external purchasing, which will also be the least costly for the company.
Setting the transfer price higher can lead to the incorrect decisions for the
company as a whole.
11- 3 Solutions
11.21 (Transfer pricing.)
a. b.
Market- Based Negotiated
Transfer Price Transfer Price
New York New Jersey New York New Jersey
Division Division Division Division
Sales................................ $ 600,000
a
$1,500,000 $ 470,000
c
$1,500,000
Costs of Goods Sold...... (440,000 ) (840,000 )
b
(440,000 ) (710,000 )
d
Selling and Adminis-
trative Expenses ......... (120,000 ) (200,000 ) (120,000 ) (200,000 )
Operating Profit............. $ 40,000 $ 460,000 $ (90,000 ) $ 590,000
Total Company............... $500,000 $500,000
a
$600,000 = $.40 X 1,500,000 gallons.
b
$840,000 = ($.40 X 1,300,000 gallons) + $320,000.
c
$470,000 = ($.40 X 200,000 gallons) + ($.30 X 1,300,000 gallons).
d
$710,000 = ($.30 X 1,300,000 gallons) + $320,000.
c. Although the company has the same total profit, the statement is
incorrect if the type of transfer price used has an effect on the
decisions of people in either division. For example, the use of a cost-
based transfer price may provide no incentive for divisions to control
costs because they will always have zero net income. Managers may
choose not to sell to other divisions at a loss to their divisions, forcing
the buying divisions to go outside the company.
Solutions 11- 4
11.22 (Return on investment computations.)
All amounts in thousands of dollars (000 omitted).
a. Miami Division: $500/$4,000= 12.5%;
Kansas City Division: $500/$5,000= 10%;
Seattle Division: $500/$6,000= 8.33%.
b. Allocations of corporate expenses as follows:
Miami: $450 x 4/15 = $120
Kansas City: $450 x 5/15 = $150
Seattle: $450 x 6/15 = $180
Now subtract each of the above allocations from $500 and divide by
each divisions divisional investment. For Miami, for example:
Miami: ($500 - $120)/$4,000 = 9.5%
Kansas City: 7.0%
Seattle: 5.33%
c. Allocations of corporate expenses as follows:
Miami: $450 x 24/60 = $180
Kansas City: $450 x 20/60 = $150
Seattle: $450 x 16/60 = $120
Now subtract each of the above allocations from $500 and divide by
each divisions divisional investment. For Miami, for example:
Miami: ($500 - $180)/$4,000 = 8.0%
Kansas City: 7.0%
Seattle: 6.33%
d. Allocations of corporate expenses as follows:
Miami: $450 x 22.5/45 = $225
Kansas City: $450 x 12/45 = $120
Seattle: $450 x 10.5/45 = $105
Now subtract each of the above allocations from $500 and divide by
each divisions divisional investment. For Miami, for example:
Miami: ($500 - $225)/$4,000 = 6.88%
Kansas City: 7.6%
Seattle: 6.58%
:
11- 5 Solutions
11.23 (ROI computations with a capital charge.)
a. Eastern Division: $400,000/$5,000,000 = 8.0%;
Central Division: $3,000,000/$9,000,000 = 33.33%;
Western Division: $4,000,000/$18,000,000 = 22.22%.
b. Eastern Division: $400,000 - .10 x $5,000,000/$5,000,000 = -2%:
Central Division: $3,000,000 - .10 x $9,000,000/$9,000,000 =
23.33%
Western Division: $4,000,000 - .10 x $18,000,000/$18,000,000 =
12.22%
c. As the above calculations demonstrate, the ranking of the divisions
does not change. The ROI before deducting the use of capital charge
is simply reduced by the 10 percent charge. It can be argued,
therefore, that from the standpoint of top management, it does not
matter which approach is followed as long as it is used consistently.
Use of the measure in Part a., however, may lead divisions to
improper decisions. A division may be inclined to accept projects
which will increase its ROI even though the project will not return an
amount to cover the charge for the use of capital. Therefore, it is
preferable from the viewpoint of the company as a whole to allocate
the investment funds to a division that can earn at least 10 percent.
11.24 (ROI computations with replacement costs.)
Solutions 11- 6
a. Toronto Division: $800,000/$4,000,000= 20%
Phoenix Division: $1,200,000/$7,500,000 = 16%
b. Toronto Division: $800,000/$6,000,000 = 13.33%
Phoenix Division: $1,200,000/$8,000,000 = 15%
c. Analysts make two principal arguments for using acquisition cost in
the denominator as in Part a. First, it is easily obtained from the
firm's records and does not require estimates of current replacement
costs. Second, it is consistent with the measurement of net income in
the numerator (that is, depreciation expense is based on acquisition
cost and unrealized holding gains are excluded). There are also two
principal arguments for using current replacement cost in the
denominator as in Part b. First, it eliminates the effects of price
changes and permits the division which uses the depreciable assets
most efficiently to show a better ROI. Second, as discussed in the
chapter, it may lead division managers to make better equipment
replacement decisions. If acquisition cost is used as the valuation
basis in calculating ROI, divisions with older, more fully depreciated
assets may be reluctant to replace them and thereby introduce
higher, current amounts in the denominator. If current replacement
cost is used in the denominator, the asset base will be the same
regardless of whether or not the assets are replaced. Thus, the
replacement decision can be made properly (that is, based on net
present value) independent of any effects on ROI.
11.25 (ROI computations comparing net and gross book value.)
11- 7 Solutions
a. U.S. Division: $3,000,000/$20,000,000 = 15%
Australian Division: $4,000,000/$50,000,000 = 8%
b. U.S. Division: $3,000,000/$15,000,000 = 20%
Australian Division: $4,000,000/$15,000,000 = 26.67%
c. There is no universal "best" response to this question. It can be
argued that the ROI on assets net of accumulated depreciation (Part
b. ) is biased in favor of divisions with older depreciable assets. By
calculating ROI based on gross assets, the bias caused by differences
in the age of depreciable assets is removed. However, another bias is
introduced if gross assets are used. The acquisition costs of the
assets of Australian Division are more out of date than those of U.S.
Division, which were acquired more recently. Each division might
have assets of equal operating efficiency, but the amount at which
they are stated in the denominator of ROI will be different. During
periods of inflation, use of ROI based on assets gross of accumulated
depreciation also tends to be biased in favor of divisions with older
depreciable assets.
Solutions 11- 8
11.26 (Comparing profit margin and ROI as performance measures.)
The return on investment (ROI), profit margin percentage, and asset
turnover ratio of the three divisions are as follows. All amounts are in
thousands of dollars (000 omitted).
Return Profit Asset
on = Margin X Turnover
Investment Percentage Ratio
New Orleans District: $200/$2,000 = $200/$1,900 X
$1,900/$2,000
10% = 10.53% X .95
Chicago District: $500/$6,250 = $500/$8,500 X
$8,500/$6,250
8% = 5.88% X 1.36
Denver District: $1,000/$8,000 = $1,000/$10,000 X
$10,000/$8,000
12.5% = 10% X 1.25
a. Using the profit margin percentage, the ranking of the districts is New
Orleans, Denver, and then Chicago.
b. Using ROI, the ranking of districts is Denver, New Orleans, and then
Chicago.
c. The ROI is a better measure of overall performance because it relates
profits to the investment, or capital, required to generate those
profits. New Orleans had the largest profit margin percentage.
However, it required more capital to generate a dollar of sales than
did Denver. Thus, its overall profitability is less. Note that Chicago
had the largest asset turnover ratio. However, it generated the
smallest amount of operating profit per dollar of sales, resulting in the
lowest ROI of the three districts.
11- 9 Solutions
11.27 (Profit margin and investment turnover ratio computations.)
a. ROI = Profit Margin Percentage X Asset Turnover Ratio
(Amounts in thousands of dollars--000 omitted.)
= X
Year 7 $1,200/$10,000 = $1,200/$20,000 X
$20,000/$10,000
12% = 6% X 2.0
Year 8 $1,100/$11,000 = $1,100/$20,000 X
$20,000/$11,000
10% = 5.5% X 1.82
b. The cost savings programs resulted in a reduction in expenses and a
decrease in net income based on the same level of sales. Thus, the
profit margin percentage decreased from 6 percent to 5.5 percent.
The cost savings programs resulted in an increase in investment,
probably from larger amounts of inventory and fixed assets. Since
sales remained the same, the asset turnover ratio decreased.
11.28 (ROI and EVA computations.)
Annual Income = $70,000 - = $38,000
a. b.
ROI EVA
[$38, 000 X (1 .15)]
Year Investment Base $38, 000 Base [(Base $0) X .25]
1 $ 160,000 23.8% ($ 7,700 )
2 128,000
a
29.7% 300
3 96,000 39.6% 8,300
4 64,000 59.4% 16,300
5 32,000 118.8% 24,300
a
Base decreases by annual depreciation of $32,000.
Solutions 11- 10
11.29 (Transfer pricing [CPA adapted].)
It would cost the company $45,000 if Pre-Fab purchased units from the
outside supplier for $230 each. This $45,000 is the difference between
the price paid for the units from an outside supplier ($230) and the
differential cost of producing in the Hardware Division ($200) times the
1,500 units in the order. The fixed costs are sunk and, therefore, do not
enter into the decision. Both the company and Hardware would be
$45,000 worse off if Pre-Fab purchased from an outsider. Pre-Fab would
not be affected whether paying $230 per unit to hardware or to an
outsider. If management enforced the $260 transfer price and insisted
that Pre-Fab purchase the units from Hardware, then the overall company
profits would not be affected by the transfer price increase. However,
Hardware would gain $45,000 while Pre-Fab would lose $45,000
compared to the current situation.
11.30 (Transfer pricing.)
a. Total
Auditors Consultants Accounting
(Buyers) (Sellers) Firm
Buy Services Internally Pay $200 Receive $ 200 Pays $ 0
Pay 70 Pays 70
Pays $ 70
Buy Services Externally Pay $180 Receive $ 200 Receives $ 20
Pay 70 Pays 70
Pays $ 50
Hence, it is advantageous to buy consulting services externally. Note
that this result depends on whether the consulting group operates at
capacity. (See Part b. )
b. Total
Auditors Consultants Accounting
(Buyers) (Sellers) Firm
Buy Services Internally Pay $200 Receive $200 Pays $ 0
Pay 70 Pays 70
Pays $ 70
Buy Services Externally Pay $180 Receive 0 Pays $180
Pay 0 Pays 0
Pays $ 180
Hence, it is better to buy consulting services internally.
11- 11 Solutions
11.31 ( ROI and EVA using the internet.)
a. 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.
b. 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.
11.32 (Bella Vista Woodwork Company; ROI and EVA calculations.)
a. Return on Investment :
U.S. ROI = $25,500/$150,000 = 17%
Asia ROI = $28,000/$125,000 = 22.4%
Europe ROI = $29,500/$175,000 = 16.9%
b. Economic Value Added
U.S. Asia Europe
Net Operating Income after
Taxes (20%) ............................. $20,400 $22,400 $ 23,600
Cost of Capital Employed:
($150,000 $10,000) X 0.10. (14,000 )
($125,000 $5,000) X 0.10.... (12,000 )
($175,000 $15,000) X 0.10. (16,000 )
Economic Value Added............... $ 6,400 $ 10,400 $ 7,600
c. The manager of the Asia Division is doing the best job based on ROI
because it has the highest return. The Asia Division manager is also
doing best with EVA of $10,400. Although Europe has the next
highest EVA, it is earned with substantially more assets ($175,000
versus $150,000) and more capital employed ($160,000 versus
$140,000) than the U.S. Coupled with the fact that the U.S. has a
slightly higher ROI, the U.S. probably earns the overall second place
as to divisional performance.
Solutions 11- 12
11.33 (Keller Company; transfer pricing.)
a. Incremental Cash Outflow of the Computers Division
($2,000 X 400 Units)............................................................... $ 800,000
Incremental Cash Savings of the Networks Division
($1,400 X 400 Units)............................................................... (560,000 )
Net Incremental Cash Outflow.................................................. $ 240,000
The company will be worse off by $240,000 if the Computers Division
purchases the component externally.
b. Net Incremental Cash Outflow from Part a............................. $ 240,000
Incremental Cash Savings of the Networks Division.............
(150,000 )
Net Incremental Cash Outflow.................................................. $ 90,000
The company will be worse off by $90,000 if the Computers Division
purchases the component externally.
c. Incremental Cash Outflow of the Computers Division
($1,800 X 400 Units)............................................................... $ 720,000
Incremental Cash Savings of the Networks Division:
Variable Costs ($1,400 X 400) ...............................................
(560,000)
Operating Savings...................................................................
(150,000 )
Net Incremental Cash Outflow.................................................. $ 10,000
The company will be worse off by $10,000 if the Computers Division
purchases the component externally.
d. Before responding, the president should raise three questions. First,
which of the three conditions in Parts a. to c. is most likely to occur?
The president should only consider interceding if the Computers
Division's action will be detrimental to the company. Second, will the
conditions expected to occur be short-lived or continually recurring?
The president may permit the Computers Division to purchase the
component externally if it is anticipated that the outside market price
will soon increase to $2,200 or higher. In this way, divisional decision
making autonomy is maintained. If the president intercedes, division
managers may react negatively and harm the decentralized
organization structure. The third, and perhaps most critical, question
then is the effect of intercession on divisional performance.
11- 13 Solutions
11. 34. Transfer pricing, with taxes
a. Use $7 million
transfer price
Asian European
Revenue $7,000,000 $30,000,000
Third-party costs (6,000,000 ) ( 8,000,000 )
Transferred goods costs _________ ( 7,000,000 )
Taxable income $1,000,000 $15,000,000
Tax rate x 40% x 70%
Tax liability $400,000 $10,500,000
Total tax liability $10,900,000
b. Use $14 million
transfer price
Asian European
Revenue $14,000,00
0
$30,000,000
Third-party costs ( 6,000,000 ) ( 8,000,000 )
Transferred goods costs _________ (14,000,000 )
Taxable income $8,000,000 $ 8,000,000
Tax rate x 40% x 70%
Tax liability $ 3,200,000 $5,600,000
Total tax liability $8,800,000
c. The optimal price for
incentive purposes is $6
million. Using $6 million
as the transfer price:
Asian European
Revenue $6,000,000 $30,000,000
Third-party costs ( 6,000,000 ) ( 8,000,000 )
Transferred goods costs _________ (6,000,000 )
Taxable income 0 $ 16,000,000
Tax rate x 40% x 70%
Tax liability 0 $11,200,000
Total tax liability $11,200,000
Solutions 11- 14
11.35 (Biases in ROI computations.)
1. Some of the standard cost variances may be noncontrollable by the
divisional manager. For example, if the company maintains a
centralized purchasing department, the materials price variance will
not be controllable by the division's manager. A case can be made for
only attributing variances subject to some reasonable control by the
manager in determining divisional net income.
2. A question can be raised as to whether either of these divisions sells
products to other divisions in the firm. If so, the question arises as to
what transfer price is used. The manager is likely to feel the bonus
plan is unreasonable if the division is forced to sell to the other
divisions at a prescribed transfer price. In this case, perhaps the
bonus should be based only on sales to external parties.
3. Two questions can be raised regarding the allocation of central
corporate expenses. For purposes of calculating the manager's
bonus, it is questionable whether central corporate expenses should
be allocated. The manager cannot control the amount of these
expenses and may react negatively to having them affect the annual
bonus. A second question regards the equity in using sales as the
basis for the allocation. It is unlikely that the incurrence of central
corporate expenses is related to sales, unless there is centralized
advertising. In addition, there may be a tendency for divisions to
reject certain opportunities to sell products in order to hold down
sales and the amount of central corporate expenses allocated. For
example, a division may receive a special order at a price exceeding
incremental divisional expenses. However, acceptance of the offer
would mean a reduction in divisional net income after allocation of
central corporate expenses. It is in the best interest of the company
that such orders be accepted but the bonus arrangement may lead to
rejection of the order.
4. Several questions can be raised regarding the measurement of
divisional investment. First, are both of the divisions involved in
manufacturing? The Light Chocolate Division may purchase products
for resale and therefore have relatively little investment in fixed
assets while the Dark Chocolate Division may be a capital-intensive
manufacturing division. If so, the ROI measure will be biased in favor
of the Light Chocolate Division. Second, assuming both divisions are
involved in manufacturing, is one of the divisions newer with
relatively high cost fixed assets and the other division relatively old
with lower cost, more fully depreciated assets? If so, the ROI measure
will be biased in favor of the older division. To overcome these
problems, fixed assets could be stated gross, rather than net, of
11- 15 Solutions
accumulated depreciation or even stated at current replacement cost
in new condition.
5. A question can be raised as to whether the divisions' ROIs are
comparable as a base for determining bonuses. For example, one
division may be much more risky than the other. If so, a return of 15
percent in the Light Chocolate Division may be equivalent to the 10
percent return for the Dark Chocolate Division when risk is
considered.
Solutions 11- 16
11.36 (Issues in designing ROI measures.)
The following factors should be considered:
1. Should the ROI be calculated in terms of the Brazilian currency or the
U.S. dollar? Depending on the exchange rate used (for example,
current rate, historical rate when assets were acquired), the measure
of ROI could be different.
2. If ROI is to be calculated in dollars, which exchange rate (that is, the
current rate or the historical rate) will be used for each financial
statement item?
3. Will the measure of "return" in the numerator of ROI be the amount
actually received by Safety Alarm from its foreign division or will it be
the amount earned by the foreign division? Given the additional risk
involved in investing in this foreign country, it may be desirable to
base the performance measure on the amount actually received in
cash.
4. Do the domestic divisions get charged for the use of capital in
calculating their ROIs? If not, the ROI of the foreign division will not
be comparable.
5. How will "Investment" in the denominator be measured? One
question concerns whether the measure should be total assets or
stockholders' equity. An argument can be made for the latter since
this represents Safety Alarms investment in the division. Another
question concerns valuation. Should historical cost or current
replacement cost be used? Given the rates of inflation in Brazil in
recent years, a case can be made for using some type of current
value.
6. What is the basis for the transfer price set for central engineering
services? Does this represent a market price for the services in
Brazil? If not, the foreign division should probably have the flexibility
to purchase the services locally.
7. Is the ROI of the foreign divisions directly compared to those of the
domestic divisions in evaluating performance? If so, the ROIs may not
be comparable because of differences in risk.
11- 17 Solutions
11.37 (ROI and residual income.)
a. ROI before the proposed purchase of Shrimp: $800,000/$4,000,000 = 20%
ROI after the proposed purchase of Shrimp: $880,000/$4,800,000 = 18.33%
Note that the ROI will be lower after the purchase of Shrimp.
b. Residual income before proposed purchase: $800,000 (10% x $4,000,000) =
$400,000
Residual income after proposed purchase; $880,000 (10% x $4,800,000) =
$400,000
Note that residual income will be unchanged after the purchase of Shrimp.
c. If the ROI for a division decreases then the ROI for the company will also
decrease, holding everything else constant.
d. (2) and the manager might choose either (3) or (4). Using ROI to measure
performance, the manager of Shellfish has incentives not to purchase Shrimp
because that purchase will lower Shellfishs ROI. Using residual income, the
Shellfish manager would be indifferent about the purchase because the
purchase would not affect Shellfishs residual income. In our experience,
managers are risk averse. The manager of Shellfish would not purchase
Shrimp if risk averse because there is likely a 50% probability that the residual
income will be negative instead of zero.
Solutions 11- 18
11.38. (ROI and EVA)
The problem does not specify pre- tax or after-tax results. We generally
accept either, but point out that many companies use the after-tax result
for sales margin and ROI. EVA routinely uses after-tax amounts. In
addressing requirement c, one should use after-tax amounts for ROI to
make the measures comparable to EVA.
a Division A Sales margin = $60,000(1 - .30)/$230,000 = 18.26%
(or $60,000/$230,000 = 26.09% before tax)
Division B Sales margin = $90,000(1 - .30)/$520,000 = 12.12%
(or $90,000/$520,000 = 17.31% before tax)

Division A ROI = $60,000(1 - .30)/$180,000 = 23.33%
(or $60,000/$180,000 = 33.33% before tax)
Division B ROI = $90,000(1 - .30)/$380,000 = 16.58%
(or $90,000/$380,000 = 23.68% before tax)
Division A EVA = $60,000(1 - .30) - .12($180,000 - $40,000)
= $42,000 - $16,800 = $25,200

Division B EVA = $90,000(1 - .30) - .12($380,000 - $50,000)
= $63,000 - $39,600 = $23,400
b. Division A has the higher ROI, implying that it uses its assets more
efficiently. Division A is also generating more economic profit than
Division B even though it is smaller. If the ROI numbers are recomputed
using EVAs measure of investment (assets current liabilities) then the
new ROI numbers are the following: A--$42,000/$140,000 = 30%; B--
$63,000/$330,000 = 19.09%. Division As ROI is greater than Division
Bs ROI. Division A wins.
c. ROI: New Division ROI using the same approach as in requirement a.

Division A, new ROI = ($60,000 + $10,000)(1 - .30)/($180,000 +
$60,000)
= 20.42%. Compare to 23.33% in requirement a.

Division A, new EVA = ($60,000 + $10,000)(1 - .30) - .12($180,000 +
$60,000 - $40,000 -$4,000)
= $49,000 - $23,520 = $25,480. Compare to $
11- 19 Solutions
25,200 in
requirement a.
ROI would drop, while EVA would increase a little. Using the ROI
performance measure creates a conflict for the manager. Taking
the project would be good for company value because it has a
positive NPV, but the manager would look worse because divisional
ROI would decrease.
Solutions 11- 20
11.39 (ROI and EVA)
The problem does not specify pre- tax or after-tax results. We generally
accept either, but point out that many companies use the after-tax result
for sales margin and ROI. EVA routinely uses after-tax amounts. In
addressing requirement c, one should use after-tax amounts for ROI to
make the measures comparable to EVA.
a Division X Sales margin = $50,000(1 - .40)/$200,000 = 15%
(or $50,000/$200,000 = 25% before tax)
Division Z Sales margin = $90,000(1 - .40)/$500,000 = 10.08%
(or $90,000/$500,000 = 18.00% before tax)

Division X ROI = $50,000(1 - .40)/$180,000 = 16.67%
(or $50,000/$180,000 = 27.78% before tax)
Division Z ROI = $90,000(1 - .40)/$360,000 = 15%
(or $90,000/$360,000 = 25% before tax)
Division X EVA = $50,000(1 - .40) - .12($180,000 - $30,000)
= $30,000 - $18,000 = $12,000

Division Z EVA = $90,000(1 - .40) - .12($360,000 - $50,000)
= $54,000 - $37,200 = $16,800
b. Division X has the higher ROI, implying that it uses its assets more
efficiently. However, Division Z is also generating more economic profit
than Division X because it is larger. If one could invest in only one or the
other division, then the investor would choose Division Z because it
generates more economic value than Division X.
c. ROI: New Division ROI using the same approach as in requirement a.

Division X, new ROI = ($50,000 + $10,000)(1 - .40)/($180,000 +
$60,000)
= 15%. Compare to 16.67% in requirement a.

Division X, new EVA = ($50,000 + $10,000)(1 - .40) - .12($180,000 +
$60,000 - $30,000 - $4,000)
= $36,000 - $24,720 = $11,280. Compare to
$12,000 in
11- 21 Solutions
requirement a.
ROI would drop. EVA would decrease very little. Using the ROI
performance measure creates a conflict for the manager. Taking
the project would be good for company value because it has a
positive NPV, but the manager would look worse because divisional
ROI would decrease. Using EVA, the divisions performance would
look worse, but not by as much.
Solutions 11- 22
11.40 (Evaluating profit impact of alternative transfer price [CMA adapted].)
(000 omitted in all calculations)
a. (1) The bottle division profits:
Revenue .............. $10,000
Cost...................... 7,200
Profit.................. $ 2,800
(2) The cologne division profits:
Revenue .............. $63,900
Cost...................... 58,400 ($48,400 + $10,000)
Profit..................... $ 5,500
(3) The corporation profits:
Revenue .............. $63,900
Cost...................... 55,600 ($48,400 + $7,200)
$ 8,300
b.
(1) Yes. Bottle Division:
Volume
Cases ................................................ 2,000 4,000 6,000
Revenue ........................................... $ 4,000 $ 7,000 $10,000
Cost................................................... 3,200 5,200 7,200
Profit.................................................. $ 800 $ 1,800 $ 2,800
(2) No. Cologne Division:
Volume
Cases .............................................. 2,000 4,000 6,000
Revenue ......................................... $25,000 $45,600 $63,900
Cost
a
.............................................. 20,400 39,400 58,400
Profit............................................... $ 4,600 $ 6,200 $ 5,500
(3) Yes. Corporation:
Volume
Cases .............................................. 2,000 4,000 6,000
Revenue ......................................... $25,000 $45,600 $63,900
Cost
b
.............................................. 19,600 37,600 55,600
Profit............................................... $ 5,400 $ 8,000 $ 8,300
a
(In thousands) $20,400 = $16,400 Cologne Division costs plus
$4,000 paid to Bottle Division; $39,400 = $32,400 + $7,000;
11- 23 Solutions
$58,400 = $48,400 + $10,000.
b
(In thousands) $19,600 = $3,200 cost to Bottle Division +
$16,400 cost to Cologne Division; etc.
This apparent inconsistency, where the Bottle Division and the
Corporation are the most profitable at 6,000,000 volume and the Cologne
Division is most profitable at 4,000,000 volume, comes from the cost and
revenues changing differently for the Bottle Division, Cologne Division,
and the total Corporation as volume changes. Using market transfer
prices, the divisions achieve maximum profit for themselves at different
levels of sales based on the market price at the various levels relative to
the division cost at these various levels. The corporation achieves
maximum profit based on the selling price to outsiders relative to the
total cost of making the product.
Solutions 11- 24
11.41 (Impact of division performance measures on management incentives.)
Reject Accept
New Project New Project
Division A
Income from:
Existing Assets (.40 X $60,000) ............... $24,000 $24,000
New Project (.30 X $30,000) ..................... --- 9,000
(1) Net Income ....................................................... $ 24,000 $ 33,000
Assets Employed:
Existing Assets....................................... $60,000 $60,000
New Project's Assets.............................. --- 30,000
(2) Total Assets..................................................... $ 60,000 $ 90,000
Rate of Return on Investment (1)/(2) .......... 40.0% 36.7%
Net Income ....................................................... $24,000 $33,000
Less Minimum Acceptable Return on
Invested Assets [= .20 X (2)] .................... 12,000 18,000
Income in Excess of Company Minimum.... $ 12,000 $ 15,000
Division B
Income from:
Existing Assets (.25 X $60,000) ............... $15,000 $15,000
New Project (.30 X $30,000) ..................... --- 9,000
(1) Net Income ....................................................... $ 15,000 $ 24,000
Assets Employed:
Existing Assets....................................... $60,000 $60,000
New Project's Assets.............................. --- 30,000
(2) Total Assets..................................................... $ 60,000 $ 90,000
Rate of Return on Investment (1)/(2) .......... 25.0% 26.7%
Net Income ....................................................... $15,000 $24,000
Less Minimum Acceptable Return on
Invested Assets [= .20 X (2)] .................... 12,000 18,000
Income in Excess of Company Minimum.... $ 3,000 $ 6,000
11- 25 Solutions
11.41 continued.
Discussion: Management of Division A is behaving rationally given the
behavior of the home office staff. As the calculations above show, the
rate of return on investment in Division A will decline if the new project is
accepted. (Of course, one does not need to do a calculation to show that
a new project earning only 30 percent will reduce the rate of return on a
division already earning 40 percent.) If management of Division A
believes that it is being evaluated on the rate of return on investment and
on the changes in that rate, then management is correct to turn down a
project that is better than the company average but worse than its own.
Professor Robert S. Kaplan likes to point out that if one evaluates with
a ratio, then the evaluatee can increase his or her score not only by
increasing the numerator, but also by decreasing the denominator. We
have to be concerned that people may be achieving a good score by
keeping the denominator artificially small.
Our suggestion to the home office staff is that it evaluate division
management with a criterion based on a measure of income in excess of
the minimum acceptable return on investment. This calculation is also
shown for both divisions for both the "reject" and "accept" alternatives.
So long as a new investment project returns a rate larger than the
minimum acceptable rate, the income in excess of the company minimum
will increase. Evaluation of management ought, in our opinion, to be
based on this measure of excess income, rather than on an ROI
calculation.
If the home office staff will change its measurement criterion, then
management of Division A will find the new project to be worth an extra
$3,000 per year, as the management of Division B does.
Solutions 11- 26
11.42 (Diversified Electronics; capital investment analysis and decentralized
performance measurementa comprehensive case.)
a. Ralph Browning's new product proposal was rejected because its ROI
was less than 15 percent after tax.
Project ROI =
= [$230,000 (1.0.40)]/$1,000,000
= 13.8%.
The decision was not correct because it is inappropriate to use a
short-term measure like ROI to evaluate a long- term decision,
ignoring completely the project's cash flows. Also, a performance
measure that is suitable for measuring past performance should not
be used for an investment decision. (This is why accrual accounting
might be appropriate for evaluating past performance while cash
flows are used for decision making. If the company had used DCF
(Discounted Cash Flows), the results would have been as shown on
the following page.
11- 27 Solutions
11.42 a. continued.
Project Year 0 1 2 3 4 5 6 7 8
Investment
(1) Land $ (200,000 ) $400,000
(2) Plant and Equipment (800,000 )
(3) Operating Cash Flows
(10% Increase each year) $330,000
a
$363,000 $399,300 $439,230 $483,153 $531,468 $584,615 643,077
(4) Tax on Operating Cash Flows
at a 40% Rate (132,000 ) (145,200 ) (159,720 ) (175,692 ) (193,261 ) (212,587 ) (233,846 ) (257,231 )
(5) Depreciation Tax Shield
b 64,000 102,400 60,800 46,400 46,400
(6) Tax on Land Sale (80,000 )
c
Net Cash Flow $ (1,000,000 ) $ 262,000 $ 320,200 $ 300,380 $ 309,938 $ 336,292 $ 318,881 $ 350,769 $ 705,846
PV Factors (15%) 1.000 .86957 .75614 .65752 .57175 .49718 .43233 .37594 .32690
PV of Cash Flows $(1,000,000 ) $227,827 $242,116 $197,506 $177,207 $167,198 $137,862 $131,868 $230,741
Net Present Value $ 512,325
a
Net cash operating flows:
Revenue ................................................. $700,000
Variable costs ....................................... (300,000 )
Fixed costs (excluding depreciation) (70,000 )
$ 330,000
b
Depreciation tax shield:
ACRS
Depreciation Tax Tax
Year Base Rate Rate Shield
1 $800,000 X .20 X .40 = $ 64,000
2 $800,000 X .32 X .40 = $102,400
3 $800,000 X .19 X .40 = $ 60,800
4 $800,000 X .145 X .40 = $ 46,400
5 $800,000 X .145 X .40 = $ 46,400
c
$80,000 = ($400,000 $200,000) X 40%.
Solutions 11- 28
11.42 continued.
b. It appears that Diversified Electronics' management wanted the focus
of division managers to be profitability on assets rather than profits.
Hence, the choice of the investment center concept for performance
evaluation. Therefore, Diversified Electronics' choice of a measure
like ROI makes sense since it is a measure of profitability of assets
used. The possible benefits of this approach include reduction in cost
of corporate administration, improvement in operational decision
making, increased motivation at division level, and freeing corporate
management up for more effective utilization. However, some
unexpected ROI-related pitfalls that Diversified Electronics did not
anticipate are:
1. It may be inappropriate to use one ROI performance standard for
all divisions, considering differences in products, operations, risks,
and differences in measurement because of asset age. These
divisions cannot be compared with the same yardstick.
2. Diversified Electronics values its investments using net book value;
hence, there may be a disincentive to make new investments
which could, in most cases, increase the investment base more
than the net income, lowering ROI.
3. The inclusion of allocated corporate administrative expenses in the
ROI figure means that divisions and division managers are held
accountable for costs over which they have no control.
Possible Modification to the Present System
1. Within a division there could be a corporate ROI for evaluating the
division and another ROI for evaluating the manager. Each should
only include items controllable by the division and manager,
respectively.
2. There should be different ROIs for different divisions, each
reflecting the characteristics peculiar to that industry to which the
division belongs.
3. Use of gross book values and/or current values in the investment
base would standardize performance measures.
4. The residual income method may be used if managers have
incentives to reject projects having a return that is greater than
the cost of capital but less than currently earned ROI.
11- 29 Solutions
11.42 continued.
c. When a performance evaluation measure like ROI is used by divisions
at the same time as DCF models for capital budgeting, managers
often have conflicting incentives. Managers will have incentives to
reject positive NPV projects if these projects do not have a positive
impact on ROI for several years. Also, there will be a disincentive for
them to invest in any positive NPV project that may lower division ROI
by increasing the denominator by a relatively larger proportion than
the numerator.
Solutions 11- 30
11.43 (Custom Freight Systems (A); transfer pricing.)
a. The Logistics Division should accept the bid from the Forwarders
Division. Custom Freight Systems is $72 better off if the Logistics
division uses the Forwarders division for this contract.
Option I: Purchase Internally
Air
Cargo Forwarders Logistics
Division Division Division
Sales................................................
Variable Costs:
($155 X 60%) ............................
($175 $155) ...........................
(from Air Cargo Division) ........
(from Forwarders Division) ....
Operating Profit/(Cost) .................
Total Company Cost......................
$ 155

93



$ 62
-0-




210
(210)



$
$
210


20
155

35
(113)
$





$


$
Option II: Purchase Externally (United Systems)
Total Company Cost = $(185 )
b. If we assume it is optimal for the transfer to be made internally, then
the question arises as to the appropriate transfer price. The economic
transfer pricing rule for making transfers to maximize a companys
profits is to transfer at the differential outlay cost to the selling
division plus the opportunity cost to the company of making the
internal transfers.
Opportunity
Cost of
Differential + Transferring = Transfer
Outlay Cost Internally Price
If the seller (the division
supplying the goods or ser-
vices) has idle capacity.......... $175 + $ 0 = $175
If the seller has no idle
capacity..................................... $175 + $ 35 = $210
($210 sell-
ing price
$175
variable
cost)
11- 31 Solutions
11.43 continued.
c. Espinosa has many alternatives to intervention or to forcing the
manager of the Forwarders division to lower his price below $210.
Each has advantages and disadvantages.
Espinosa must trade- off the benefits of intervention on this
particular transaction against the impact of intervention on
decentralization as a policy. Too much intervention by Espinosa
will eliminate the benefits of decentralization.
Tell the Logistics and Forwarders divisions that the transfer price
will be between differential cost of $113 (which is the sum of the
Air Cargo variable cost of $93 and the added variable cost for
Forwarders of $20) and the lowest outside market price of $185
and allow them to negotiate the profit.
Espinosa could reorganize the company combining the divisions
into one operating company. However, Custom Freight Systems
would lose all of the benefits of decentralization.
Espinosa could simply do nothing and let the managers maintain
their autonomy. This would not be in the best interests of Custom
Freight Systems. However, it might be better to sub- optimize for
this transaction and obtain more general benefits from
decentralizing.
d. The reward system at Custom Freight Systems creates an
environment that encourages managers to act in the best interests of
their division rather than for the corporation. Managers are rewarded
on their return on assets and profits, which discourages discounting to
other divisions of Custom Freight Systems and ultimately costs the
corporation more.
Solutions 11- 32
11.44 (Custom Freight Systems (B); transfer pricing.)
Similar to Case A, the Logistics Division should accept the bid from the
Forwarders Division. However, if we eliminate the Forwarders Division
from the bidding process, the bid from World should be accepted.
Emphasize that even though Worlds bid is $10 per hundred higher than
Uniteds, the overall cost to Custom Freight Systems is lower because
other divisions of Custom Freight Systems are included in the bid.
Option I: Purchase Internally
Air
Cargo Forwarders Logistics
Division
Division
Division
Sales................................................
Variable Costs:
($155 X 60%) ............................
($175 $155) ...........................
(from Air Cargo Division) ........
(from Forwarders Division) ....
Operating Profit/(Cost) .................
Total Company Cost......................
$ 155

93



$ 62
-0-




210
(210)



$
$
210


20
155

35
(113)
$





$


$
Option II: Purchase Externally (United Systems)
Total Company Cost = $(185 )
Option III: Purchase Externally (World Services)
Air
Cargo Forwarders Logistics
Division
Division
Division
Sales................................................
Variable Costs:
Operating Profit/(Cost) .................
Total Company Cost......................
$ 155
93
$ 62
-0-
195
(195)
$
$
-0-

-0-
$

$


$(133)
11- 33 Solutions