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MANAGERIAL ACCOUNTING
5
MANAGERIAL ACCOUNTING
Required: (M)
a. Compute the investment turnover for each division.
b. Compute the return on sales for each division
c. Compute the return on investment for each division.
d. Which division manager is doing best? Why?
e. What other factors should be included when evaluating the managers?
For parts (b) and (c) income is defined as operating income.
Horngren
Blue Division
$?
$288,000
$1,600,000
?
0.12
1.5
10
. Basic RI relationships
L & H 10e
Hughes Division had RI of $4 million, investment of $40 million, and asset turnover of 1.5
times. The minimum required ROI was 20%.
Required:
1. Determine Hughes's sales, profit, and ROS.
2. Determine the ROS that Hughes needs to raise its RI to $5 million, holding sales and
investment constant.
3. With the ROS calculated in requirement 1, determine the sales required to earn $5 million
RI, holding investment constant.
11
13
. Sensitivity Analysis
L&H
The following information is available about the status and operations of Stills Company, which
has a minimum required ROI of 20%. ANSWER EACH ITEM INDEPENDENTLY OF THE
OTHERS.
Division A
Division B
Divisional investment
$400,000
$1,250,000
Divisional profit
$120,000
$ 580,000
Divisional sales
$800,000
$2,600,000
Required:
a. Compute ROI for Division B.
b. Compute residual income for Division A.
c. Division B could increase its profit by $80,000 by increasing its investment by $300,000.
Compute its total residual income.
d. Division A could increase its return on sales by one percentage point, while keeping the
same total sales. Compute its ROI.
e. Division A could increase its sales so that its asset turnover increased by one time, while
holding total assets constant. Compute its ROI.
Page 3 of 17
MANAGERIAL ACCOUNTING
14
16
MANAGERIAL ACCOUNTING
REQUIRED:
(A). What is the maximum price per unit that Electric Division would be willing to pay the Ball
Bearing Division for the "S" bearing?
(B). What is the minimum price that Ball Bearing Division would consider to produce the "S"
bearing?
(C). What is the minimum price that Ball Bearing Division would consider to produce the "S"
bearing if the Ball Bearing Division did not need to forfeit any of its existing sales to
produce the "S" bearing?
(D). What factors besides price would Electric Division want to consider in deciding where it
will purchase the bearing?
17
19
MANAGERIAL ACCOUNTING
Required:
a. Division A refuses to meet the $45 price, sales to outsiders cannot be increased, and
Division B buys from the outside supplier. Compute the effect on the income of Nash.
b. Division A cannot increase its sales to outsiders, does meet the $45 price, and Division B
continues to buy from A. Compute the effect on the income of Nash.
c. Suppose that Division A could sell the 5,000 units now taken by Division B to outsiders at
$57 each without disturbing sales at the regular $72 price. Division B buys outside at $45
and Division A increases its outside sales. Find the effect on the income of Nash.
20
. Comprehensive review
L & H 10e
The following information relates to the Lerner Division of Transnational Company.
Budgeted sales
80,000 units
Selling price
$32
Variable cost, per unit
$20
Annual direct fixed costs, all unavoidable
$600,000
Total divisional investment
$1,600,000
Minimum required ROI
20%
Required:
Answer each of the following questions independently.
1. What are Lerner's budgeted ROI and RI?
2. How many units must Lerner sell to earn $100,000 RI?
3. Assume that Lerner expects to produce and sell 80,000 units but has the capacity to
produce 100,000 units. The manager of Rogers Division, which is currently buying 25,000
units of a similar product from an outside supplier for $26, offers to buy the units from
Lerner only if Lerner will supply the full 25,000 units needed.
A. What is the maximum price Rogers' manager is likely to offer for the units?
B. What is the minimum price Lerner's manager is likely to accept on a sale of 25,000
units to Rogers Division?
C. If Rogers' manager offers $24 per unit and Lerner's manager accepts the offer, what
will be the amount and direction of the effect on the total income of Transnational?
Required:
1. Prepare partial income statements, down to contribution margin, for A, B, and C based on
current operations.
2. Determine whether the offer from the outside supplier should be accepted. If A meets the
outside price, C will continue to buy from A.
3. Suppose that A can sell its entire output of 10,000 units per year at $48 if it performs
additional work on the component. The additional work will add $5 to variable cost per
unit; fixed costs will be unchanged. Capacity of division A is 10,000 units. Should A meet
the outside supplier's price or allow C to buy from the outside supplier? Support with
calculations. Is A's decision good for the company?
Page 6 of 17
MANAGERIAL ACCOUNTING
SOLUTIONS
Page 7 of 17
.
Segmented Income & ROI
(a) Segment income = Profit Margin Sales
= .10 x $3,000,000 = $300,000
(b) ROI = Segment Income/Assets
Segment Income = $3,000,000 .10 = $300,000
Assets = ($300,000 - $60,000)/.15 = $1,600,000
ROI = $300,000/$1,600,000 = 18.75%
$480,000
200,000
$280,000
$ 80,000
40,000
$ 40,000
32,000
$ 8,000
3. The division should make the component. Reducing investment by $40,000 permits a cost increase (profit
decrease) of $8,000 ($40,000 x 20%) to leave residual income the same. Because the cost increase is $10,000
(see below), residual income would drop by $2,000 if the division bought the component.
Additional cost of purchasing outside [30,000 x ($5 - $4)]
$ 30,000
Less savings in fixed costs
20,000
Net increase in cost to buy component
$ 10,000
4. $200,000 ($40,000/20%)
$120,000
80,000
$ 40,000
5. 2,500 units
Total increase in income required ($400,000 x 20%)
Increase from sales of new product
Increase in contribution margin required on sales of existing products
Divided by contribution margin on 2,000 units of existing product
Equals units required
$ 80,000
40,000
$ 40,000
$
16
2,500
c. Project Ranking
ABCROI Rank3rd2nd1stRI Rank3rd1st2nd
d. A ROI = $19,500,000/$125,000,000
B ROI = $29,500,000/$150,000,000
C ROI = $15,500,000/$75,000,000
A RI
B RI
C RI
= 0.15
= 0.20
= 0.22
= 0.156
= 0.197
= 0.207
e. Everyone would be pleased if residual income was used because residual incomes increase with the expansion.
However, it would be difficult to evaluate each division on a comparative basis because each divisions investment
base is different.
Only the manager of Division A is pleased with the new investment if ROI is used because that is the only division
with an increased ROI. In the case of additional investments that are required by corporate management, residual
income may be the best to use for evaluating each manager individually, but not collectively.
RI If Minimum ROI
= 20%
= 28%
$300,000
$300,000
180,000
$120,000
252,000
$ 48,000
$300,000
$300,000
320,000
$(20,000)
448,000
$(148,000)
$240,000
336,000
$(96,000)
$280,000
224,000
$ 56,000
$260,000
280,000
$(20,000)
Though project E has a higher ROI than is currently being earned, 25% ($1,250,000/$5,000,000), it would not be
selected because its inclusion would reduce the highest possible ROI of 27.3%. Taking the projects in descending
order of ROI gives the following.
Income
Investment
ROI
Current
$1,250,000 $5,000,000
25.0%
Add D
1,530,000
5,800,000
26.4%
Add A to prior
1,830,000
6,700,000
27.3%
Project E, the next highest ROI project, earns less than 27.3%, so including it would reduce ROI below the
maximum obtainable of 27.3%. Thus, accepting a project that earns more than the current ROI will not necessarily
increase ROI. Acceptance of a project should always consider the other available opportunities.
2. (a) At a 20% minimum desired ROI, all projects except B and perhaps C
would be accepted. RI would be
$550,000 whether project C is accepted or not, because C is expected to return just 20%.
Income
Investment
RI
Current
$1,250,000 $5,000,000
$250,000
Plus A
1,550,000
5,900,000
370,000
Plus D
1,830,000
6,700,000
490,000
Plus E
2,090,000
7,700,000
550,000
RI can be calculated directly by adding the additional RI of each acceptable project to that currently being earned.
Each cumulative RI above is the prior RI plus the amount in the first schedule. Managers would be indifferent
between acceptance and rejection of project C if they consider their estimate of cost of capital to be appropriate and
are quite confident about their estimates of future returns from the investment.
(b) Only projects A and D would be selected and RI would be a negative $46,000. However, that is better than the
negative $150,000 [$1,250,000 - ($5,000,000 x 28%)] that is currently being earned. If A and D are added,
income is $1,830,000 and investment is $6,700,000 (from the answer to requirement 1). The required income
is $1,876,000 ($6,700,000 x 28%) and the result is a negative $46,000 ($1,876,000 - $1,830,000).
Note to the Instructor: Some students may wonder why the division's current RI is negative. One answer is that
investments are based on expectations and the existing investment could be earning much less, or requiring much
more investment, than had been expected when originally undertaken.
3. The policy of maximizing RI is the better one. If projects have time-adjusted rates of return in excess of cost of
capital, and therefore positive net present values, they should be accepted.
7
.
Return on Investment & Residual Income
a. Target operating income = 0.20 x $1,500,000 = $300,000
Operating income
Variable costs
Fixed costs
Target revenues
$300,000
400,000
250,000
$950,000
$1,500,000
x 0.18
$ 270,000
$ 300,000
270,000
$ 30,000
$813.0
759.2
$ 53.8
2. 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
.
Margin, Turnover & ROI
a. Investment turnover:
Plows
= $2,250,000/$1,000,000 = 2.25
Tractors
= $500,000/$400,000
= 1.25
Combines = $4,800,000/$1,750,000 = 2.74
b. Return on Sales:
Plows
= $220,000/$2,250,000
Tractors
= $60,000/$500,000
Combines = $480,000/$4,800,000
= 0.10
= 0.12
= 0.10
c. ROI:
Plows
Tractors
Combines
= 0.225
= 0.150
= 0.274
= 2.25 x 0.10
= 1.25 x 0.12
= 2.74 x 0.10
d. Combines' manager had the best performance because he had the highest investment turnover, which offset his
second-best return on sales.
e. Residual income should be considered and noncontrollable factors such as the age of the assets.
10
$ 4.0
8.0
$12.0
$13
$60
21.7%
3. $65 million
Profit required
Divided by ROS
Equals sales required, in millions
11
$13
20%
$65
Income = $60
Investment = $200
Turnover = 2 times
RI = $20
Sales = $900
Income = $72
ROI = 24%
RI = $12
Margin = 6%
Investment = $100
Turnover = 7
ROI = 42%
D Margin = 10%
Sales = $1,000
Investment = $250
RI = $50
12
13
a.
b.
c.
d.
e.
14
= 1.5 x $1,600,000
= 0.18
= $2,400,000
.
Sensitivity Analysis
ROI for B: 46.4% ($580,000/$1,250,000)
RI for A: $20,000 [$120,000 - ($400,000 x 20%)]
RI for B: $350,000 [$580,000 + $80,000 - 20% x ($1,250,000 + $300,000)]
ROI for A: 32% [$120,000/$800,000 = 15% ROS + 1% = 16%, turnover = 2 ($800,000/$400,000), so 16% x 2 =
32%]
ROI for A: 45% [$800,000/400,000 = 2 times + 1 = 3 times x ROS of 15% ($120,000/$800,000) = 45%]
.
Transfer Pricing Idle Capacity
A. The $10 per unit would equal the Division's variable costs ($5 + 2 + 3 = $10), so the contribution margin per unit is
zero. Thus, only the 8,000 units of external sales would generate a contribution margin of $80,000 (8,000 $10) to
cover fixed costs of $90,000 (10,000 $9). So the Division would show a $10,000 loss.
B.
Total fixed costs to Wire are:
Production$2 x 10,000 =$20,000
Selling$3 x 10,000 =30,000
G&A$4 x 10,000
= 40,000
Total$90,000 Less: Contrib. Margin on Regular Business [$20 - (5 + 2 + 3)] x 8,000(80,000)Unrecovered Fixed
Costs$10,000 which must be covered by CM of inside sales = Trans.Price Vol. = SP - [(5 + 2 + 3) x 2,000] SP = $15
C.
Full absorption cost:Variable Production Cost =$ 5Fixed Production Cost = 2Total full absorption cost$7Doubledx 2Transfer
price$14
D.
Proposed transfer price per unit$16Consumer's current market purchase price per unit 15Increase in cost per unit of wire to
Consumer's$ 1Times units purchasedx 2,000Decrease in profit due to increased costs$2,000
E. Wire Division must cover its out of pocket costs or the relevant variable costs; the fixed costs are irrelevant since
they will be incurred regardless of this extra inside business. Thus, the total cost to be covered is $7 (production, $5;
selling, $2).
15
.
Transfer Pricing Partial Excess Capacity
a. Washburn's income, + $25,000 [50,000 x ($4 - $3.50)]
b. Bayfield's income, + $10,000 {50,000 x ($3.50 - $2 - $0.50) - [lost contribution margin of 10,000 x ($4 - $2)] $20,000 new fixed costs}
c. Ashland's income, + $35,000 ($25,000 + $10,000)
16
.
Transfer Pricing Full Capacity
(A) Electric Division would be willing to pay no more than $100 per unit, the price offered by the external supplier.
(B) The minimum price that Ball Bearing Division would accept is the one that would leave its profits at the same level
as if it only produced "T" bearings. To produce the "S" bearing, Ball Bearing Division must give up production and
sale of 1,000 "T" bearings. These 1,000 bearings generate $20,000 of contribution margin: [1,000 ($50 - $30) ].
The sales price would have to be high enough to recoup both the variable costs of the "S" bearings and the
contribution margin that is forfeited on the 1,000 units of "T" bearings: $60 + ($20,000/600) = $93.33
(C) The minimum price would be $60, the incremental costs to produce the "S" bearing.
(D) In particular, Electric Division would want to consider the quality of both suppliers. The factors to be considered
would include: ability to meet delivery deadlines, quality of the product produced, ability to change as environmental
conditions change, willingness to work on future cost reductions/quality improvements, business reputation, stability
of the labor force, and possibility of future price increases.
17
18
$100,000
$150,000
$250,000
2. 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.
3. 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 1
$250,000
Loses the contribution margin on outside sales 500,000 x ($1.30 - $0.70)
300,000
Net change in income (decrease)
$(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.
4. As in requirements 1 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.
Games:
Saves [500,000 x ($1.20 - $1.00)]
$100,000
Power:
New contribution [500,000 x ($1.00 - $0.70)]
$150,000
Lost contribution [300,000 x ($1.30 - $0.70)]
180,000
Net decrease in income
$ 30,000
Toys-and-Stuff:
Saves the $0.50 noted in requirement 1
$250,000
Loses contribution margin on outside sales 300,000 x ($1.30 - $0.70)
180,000
Net increase in income
$ 70,000
5. $1.06. The price has to bring contribution margin on 500,000 units to equal the contribution margin lost from
300,000 units sold at regular prices.
Contribution margin to be lost = Contribution margin needed on order
300,000 x ($1.30 - $0.70) = 500,000 x (P - $0.70)
$180,000 = 500,000P - $350,000
$530,000 = 500,000P
P = $1.06
Note to the Instructor: The organization of the solutions provided for requirements 1, 2, and 3 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.
19
.
Transfer Pricing Comprehensive
a. Nash's income: Decreases $45,000 [5,000 units x ($45 outside price - $36 variable cost)]
b. Nash's income: No change
c. Nash's income: $60,000 increase ($285,000 added revenue from outsiders - $225,000 paid to the outsider by B)
20
Totals
$1,820,000
1,440,000
$ 380,000
$4
10,000
$40,000
$480,000
410,000
$ 70,000
40,000
$ 30,000
The decision is also good for the company. Division C will have the same $40 cost whether it buys from Division A
or from the outside supplier. The difference in incomes for Division A is therefore the difference for the company as
a whole because none of the other division's incomes are affected.
Note to the Instructor: You might wish to ask students what would happen if the constraint on A's capacity were
loosened so that A could make, say, 15,000 units per year. The general answer is that A should sell as many units
outside as it can at $48 and devote any leftover capacity to supplying division C.
21
$960,000
600,000
$360,000
22.5%
$360,000
320,000
$ 40,000
Target RI
Required minimum ROI ($1,600,000 x 20%)
Required divisional income
Fixed costs
Required divisional contribution margin
Divided by contribution margin per unit
Equals required sales, in units
3.
$100,000
320,000
$420,000
600,000
$1,020,000
$12
85,000
(a) $26, the price Rogers now pays to the outside supplier.
(b) $22.40
Variable costs on units supplied to Rogers, 25,000 x $20
Lost contribution margin on lost sales, 5,000 x $12
Amount to be recovered in price to Rogers
Divided by number of units to be sold to Rogers
Required price for units to be sold to Rogers
$500,000
60,000
$560,000
25,000
$ 22.40
$150,000
60,000
$90,000
$50,000
$100,000
60,000
40,000
$90,000
Note to the Instructor: Students usually find it more difficult to determine the change in the company's income
directly when the situation involves losing regular sales. Accordingly, our solutions to many of the early problems
showed both alternatives and suggested that both be presented. Our experience has been that students are more
willing to try using an approach they find more difficult if they can check their answer against one developed using
an approach that they understand better but that is more cumbersome.