CHAPTER 12

PERFORMANCE EVALUATION IN DECENTRALIZED ORGANIZATIONS

SOLUTIONS

REVIEW QUESTIONS
12.1 Firms decentralize because, as organizations grow, the number and types of decisions that
need to be made increase substantially. A single individual will not have the relevant
expertise and knowledge to make all of these decisions thus, firms delegate decision-
making responsibility.
12.2 The benefits include (1) timely decisions, (2) tailoring managerial skills and
specializations to job requirements, (3) empowering employees, and (4) training future
managers. The costs include (1) an emphasis on local versus global goals, (2) requires
coordination of decisions, and (3) can lead to improper decisions because of a divergence
between individual and organizational goals.
12.3 (1) Cost centers, (2) Profit centers, and (3) Investment centers.
12.4 Minimize the cost of producing a specified level of output or service.
12.5 Both minimize costs and maximize revenues. That is, maximize profit.
12.6 Maximize the returns from invested capital, or to put the capital invested by owners and
shareholders of the organizations to the most profitable uses.
12.7 Controllability and informativeness.
12.8 An ideal performance measure (1) aligns employee and organizational goals, (2) yields
maximum information about the decision or actions of the individual or organizational
unit, (3) is easy to measure, and (4) is easy to understand and communicate.
12.9 In the short-term, via budget variances. In the long-term, by techniques such as
benchmarking and kaizen.
12.10 Kaizen is a philosophy of continuous improvement.
12.11 By budget variances and comparing actual profit with past profit and industry profit.
Organizations also use revenue-oriented measures such as customer satisfaction and
market share. Additional cost-oriented measures might focus on employee turnover or
process improvements.
12.12 ROI = return on investment = profit divided by investment. ROI is an effective summary
of business profitability it controls for size by expressing the return per investment
dollar. Consequently, it is easy to compare the performance of investment centers of
different size. We also can decompose ROI into smaller pieces, allowing managers to see
how individual actions map into overall profitability. The major criticism of ROI is that it
can foster underinvestment. For example, if current ROI is 20%, a manager may not
invest in a project with an ROI of 18% even though the firms cost of capital is 15%. It
also favors divisions with older assets.

Balakrishnan, Managerial Accounting 1e FOR INSTRUCTOR USE ONLY

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12.13 Residual income = Profit (required return * Investment). Residual income represents
the additional profit or value generated by an investment after meeting the required rate
of return. Economic value added is a modified calculation of residual income it uses a
weighted average cost of capital and adjusts for the operating and capital costs of a
business, including taxes.
12.14 Because multiple divisions often deal with each other in the normal course of business,
diverting a portion of their resources from external business to serve internal needs.
12.15 (1) Cost-based transfer prices, (2) market-based transfer prices, and (3) negotiated
transfer prices. Market based prices do best in evaluating opportunity costs and in
preserving arms-length transactions. But, the market may not exist. Negotiated transfer
prices truly respect autonomy but might be time consuming and tedious. Cost-based
prices can be used under all situations but defining what is the right cost and the right
markup to use can lead to many disputes.
DISCUSSION QUESTIONS
12.16 The phase co-locates knowledge and decision rights means giving the decision making
authority to individuals in the organization that have the requisite knowledge and
information to make the right decision. For example, decisions regarding material
purchases in a manufacturing company such as when to purchase, how much to purchase,
which suppliers to purchase from is best left to individuals dealing with the purchase
function routinely. Similarly, sales promotion decisions are best made by marketing
personnel who have the best knowledge of market conditions and consumer behavior.
Decentralization of decision making is not always beneficial because it might to lead
decision makers at lower levels to choose actions that are in their best interests and not
necessarily in the best interests of the firm. It also requires considerable coordination
across all levels in the organization to ensure that all decisions are properly coordinated.
12.17 It might be dads responsibility to take out the garbage; mom cooks and cleans, and the
ten-year old son mows the lawn. The dad and mom may not need as much incentive to do
their tasks because it is after all their house, and it is in their best interests to keep it
clean. But mom may need a bit of an incentive to cook well because cooking takes time
away from other more fun activities such as shopping, or working out to look good.
But dad is interested in saving money and does not want to eat out routinely, and has to
provide some inducement for mom to cook (your guess is as good as ours as to what he
might do). The son likely finds lawn mowing boring, but a small monetary reward and
some monitoring (to make sure that he does not cut corners) may do the trick!
12.18 Yes. Decentralization promotes local maximization and not global maximization.
Each divisional manager is interested in casting his/her own performance in the best
possible light relative to other divisional managers. As long as divisional profit is used to
evaluate performance, each divisional manager has a natural incentive to find ways in
which to increase his/her own divisional profit even if the chosen ways might hurt other
divisions.
12.19 Both the U.S. Army and the University of Wisconsin are not-for-profit organizations.
The U.S. Armys objective is to defend the country and its borders. The University of
Wisconsins mission is to impart education. As we all know, discipline and preparedness
 12-3

are extremely important for the Army. So it has a well established chain of command and
decision structure. The Army does not use bonuses and monetary rewards to motivate its
employees. Rather, strict monitoring mechanisms are used and rules are rigidly enforced.
Any deviations are punished severely. The employees of the University are civilians.
Military regimen does not work. Rather, salary structure and monetary incentives are
very much necessary to attract good faculty. Decision making is highly decentralized.
Each branch of education is managed by a dean and his associates. The deans report to
the President/Chancellor of the University. Being a state school, its actions and decisions
have to conform to the state legislatures policies and tenets. Any deviations can affect its
access to state resources.
12.20 As we learned in the chapter, a controllable performance measure reflects the
consequences of the actions taken by the decision maker. We should hold a production
manager accountable for production delays but not for the overall volume of production,
which is driven by market demands. Marketing managers have the authority to change
prices and offer promotions that affect actual sales, which determine the required
production. Production managers, therefore, have little control over the volume of
production. It is not reasonable to hold them accountable for someone elses decisions or
random market conditions.
A performance measure is informative if it provides information about a managers effort,
even if the manager does not have control over it. Most controllable measures are
informative. For example, students control their performance on a quiz, and their score is
informative about their grasp of the subject matter. However, the student has little control
over how the rest of the class performs. Yet, the overall class performance is useful
information in evaluating each individual students performance because it tells us how
hard the quiz is.
Similarly, if a firm incurs losses when other firms in the industry are highly profitable, we
may attribute those losses to poor managerial performance. However, if other firms in the
industry are doing even worse, then the firms management may actually be doing a
terrific job of dealing with adverse business conditions. Thus, evaluating a firm relative to
other firms in the industry, or relative performance evaluation, is useful, even though the
firms managers may have little control over how other firms do.
12.21 The problem with this argument is that each manager cannot control actions of the other
managers, and the impact of their actions on the firms profit. Thus, it is possible that
even though the division is doing extremely well, its manager may not receive
commensurate reward if the firm as a whole is not doing well because of the actions of
other managers.
12.22 Variance analysis is useful for both profit centers and cost centers. As we learned in
Chapter 8, the overall variance of actual performance from budgeted performance can be
split into sales volume variance and flexible budget variance. Sales volume variances
point to the impact on profit of the difference between budgeted sales volume and actual
sales volume. It is useful in evaluating profit centers. Flexible budget variances are
useful in analyzing the reasons for deviation of actual performance from expected
performance at the actual volume. Flexible budget variances are useful for evaluating
both profit centers and cost centers.
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12.23 When the net book value is used to measure investment, the assets age becomes a
factor. As the asset becomes older, the accumulated depreciation increases and the net
book value decreases. Consequently, ROI often is higher for older assets. As a result,
managers may have less of an incentive to undertake timely asset replacement decisions.
12.24 Consider the following example. Division A has an income of $10,000 on an
investment of $100,000. Division B has an income of $100,000 on an investment of
$1,000,000. Assume that the require rate of return is 8%.
The ROI for both the divisions is 10%. But the residual income for Division A is $2,000
(=$10,000 (8% $100,000)), and the residual income for Division B is $20,000
(=$100,000 (8% $1,000,000)). Why? This is because the residual income is sensitive
to project size. All else equal, larger investments will have higher residual incomes.
12.25 Yes, both ROI and RI are short-term performance measures. ROI is widely used
because it is easy to compute and is well understood. As we learned in the chapter, ROI
can be conveniently decomposed into profitability and asset turnover ratios. By
evaluating the trends in these ratios, one can make reasonable assessments of the firms
future. Also, ROI is but one of several measures that analysts and outsiders employ to
evaluate the firms performance and its future potential.
12.26 When the supplying division is fully utilized, any transfer to the buying division is
diverting capacity away from profitable use of its capacity. Unless the firm can earn a
great profit by diverting capacity, it does not make sense to transfer. In a decentralized
environment in which both the buying and selling divisions are acting as profit centers,
the transfer price must compensate the selling division for lost profit. The buying division
will be willing to do so only if it is still able to make a profit for itself. In this case, the
company as a whole is better off because the selling divisions capacity will have been
put to the most profitable use!
12.27 In such instances, there is a natural incentive for the firms management to provide
business to its subsidiaries even if the same services can be obtained from other sources
for lower prices and at better quality.
12.28 Intellectual property is inherently difficult to price. It is very much unlike a typical
product which has a certain definite determinable life, and whose cost of production is
determinable to a fair degree of accuracy. On the other hand, the life of intellectual
property is difficult to estimate. Sometimes new technologies emerge suddenly rendering
the intellectual property totally worthless immediately. On the other hand, some
intellectual property has indefinite lives. Another problem is that the dissemination of
intellectual property is not easily controllable. The acute problem of piracy in the
software industry is a good example.
12.29 In such instances, most companies use some form of cost-based transfer prices i.e.,
variable cost plus some margin, or full cost plus some margin. However, these transfer
pricing schemes are arbitrary at best. When the supplying division has no ready market
for its product, it may be best to not view the supplying division as a profit center because
it really has no discretion over its revenue sources. Rather, it is better to structure the
division as a cost center from a performance evaluation perspective.
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12.30 It is not advisable for the head office to interfere in transfer-pricing disputes because it
would compromise the very purpose of decentralization. This said, however, if disputes
take time, then some resolution mechanism would be necessary so that the company as a
whole does not lose.
EXERCISES
12.31
a.
We believe that Karl should be evaluated as a cost center. While he provides a useful and visible
service, there is no direct impact on revenue. Further, he does not influence prices or determine
the level of output. His job is to keep up the buildings to specified quality levels within allowed
costs. This is a central characteristic of a cost center.

b.
The university should use a mix of financial and non-financial measures. Relying on financial
measures alone is not advisable because Karl can always postpone maintenance to come in
below budgeted expenditures. However, we do need to make sure that the budget is not over-
spent by a lot. Non-financial measures such as time to respond to complaints and general score
on upkeep seem useful as a way to make sure that Karl is providing the desired service quality.

12.32
a.
We believe that the branches should be evaluated as profit centers. At first blush, it appears that
the branches should be cost centers because branch managers do not decide on product choices
or prices. However, branch managers do influence volume the other determinant of revenue.
They influence volume via the general atmosphere in the cantina, speed of service, cleanliness,
and so on. Evaluation as a profit center would sensitize branch managers to the revenue
implication of their actions.

b.
From a financial perspective, Gordon should focus on budgeted and actual profit. He also
would be wise to pay attention to budget-actual comparisons of key cost items such as labor,
electricity, and so on. Unless he is using a transfer pricing scheme to charge branches for food
used, tracking spoilage seems useful. We also recommend that Gordon monitor key non-
financial metrics such as time to serve, table availability and so on. Indeed, because of the
many factors that affect success, it may be wise for Gordon to spend a day to a full day per
week at different branches just monitoring what is going on.

12.33
The following table provides the required classification, along with a brief justification.

Marketing Profit Center. It would appear that marketing should be evaluated based on
revenues alone as it does not control costs. However, the firm makes substantive
commitments based on marketing forecasts and, in this way, marketing influences
costs. Plus, few units only have revenues and no costs. Key performance measures
include budget-actual comparisons of profit, as well as non-financial measures
12-6

such as customer satisfaction and market share.

Plant Cost center. This units primary job is to respond to marketings forecasts (i.e.,
they do not control quantity or price) and to make the product at the budgeted cost
or lower (subject to quality and other standards). This is an engineered cost center
because we can reasonably relate output to expected cost. Key performance
measures include budget-actual comparisons of cost, as well as non-financial
measures such as average outgoing quality and delivery reliability.

Planning Cost center. This unit has no revenue responsibility or influence over it. Further,
there is no direct link between their output (plans) and costs. Thus, this function
would be a discretionary cost center. Key performance measures must be
subjective.

Maintenance Cost center. This unit has no revenue responsibility or influence over it. Some
portion of their operations are discretionary (e.g., general upkeep, planned
overhauls), while others relate to work done (e.g., machine hours run determine the
maintenance needed.) Overall, we believe that the engineered portion will
dominate the operations, and we lean toward evaluating the unit as an engineered
cost center. However, we need to make sure the budget has both a fixed (for
discretionary) and variable (for the output driven) portion to reflect the mixed
nature of the operations. Key performance measures include budget-actual
comparisons of cost, as well as non-financial measures such as uptime and time to
respond to complaints.

Purchasing Cost center. This unit has no revenue responsibility or influence over it. It is
difficult to determine a good measure of output because measures such as purchase
orders, purchase order lines, and number of new items are deficient in measuring
the multi-faceted nature of operations. Thus, we lean toward evaluating this unit as
a discretionary cost center. Key performance measures include purchase price
variances, as well as non-financial measures such as stock outs, new vendor
development, and so on.

12.34
The strategic performance group should be evaluated as a discretionary cost center. There is no
clear identification of their output and the relation between their output and input is unclear. This
group exists because management believes that it is worth spending money on the help regarding
strategy formulation and implementation. The groups performance has to be measured
subjectively. At a less critical level, some cost comparison relative to budget is also appropriate.

12.35
a.
There are both positive and negative aspects of performance. On the one hand, overall
volume and revenue are significantly above target. However, the average revenue per frame is
down from $120 ($9.6 million / 80,000 frames) to $110 ($11 million / 100,000 frames). This
 12-7

reduction is bothersome in light of the divisions strategy to sell high-quality products for
premium prices.

b.
Again, there are both positive and negative aspects of performance. Here, while the overall
margin is positive ($130 per frame = $9.1 million / 70,000 frames), the volume is down nearly
10%. Both situations are cause for concern. Additional data on market size and share would be
useful. It also might be prudent to revisit the forecasting process because such large swings
should be the exception and not the norm.

Note: You can also relate this analysis to the sales volume and price variances discussed in
Chapter 8. Note that we cannot compute a volume variance exactly because we do not know the
variable cost per frame.

12.36
The data pertain to an engineered cost center. That is, volume affects total cost. We need to
construct a flexible budget and perform cost variance analysis. We have:

Flexible
Budget Actual
budget*
Production volume (units) 175,000 200,000 200,000
Total variable costs $7,875,000 $9,000,000 $9,450,000
Total fixed costs 1,200,000 1,200,000 $1,350,000
* As we know from Chapter 8, the flexible budget adjusts costs for the actual volume of operations. Thus, we
have ($7,875,000/175,000) 200,000 = $9,000,000. Fixed costs do not change.

After adjusting for volume, the efficiency variance is $450,000 U and the fixed cost spending
variance is $150,000 U. While some of the cost over-runs might be legitimately attributed to the
higher volume (e.g., poorer quality materials, more supervisors hired etc), the increase is
significant and warrants investigation. Overall, the data reflect considerable cause for
concern.

12.37
a.
The data pertain to an engineered cost center. That is, volume affects total cost. That is, we need
to construct a flexible budget and perform cost variance analysis. We have:

Flexible
Budget Actual
budget
Production volume (units) 200,000 150,000 150,000
Total variable costs $9,200,000 $6,900,000 $6,875,000
Total fixed costs 1,300,000 1,300,000 $1,315,000
* As we know from Chapter 8, the flexible budget adjusts costs for the actual volume of operations. Thus, we
have ($9,200,000/200,000) 150,000 = $6,900,000. Fixed costs do not change.

After adjusting for volume, the efficiency variance is $25,000 F and the fixed cost spending
variance is $15,000 U. While we would not be concerned about either variance (i.e., the
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production department seems to have done a fine job), we would be very concerned about the
substantial reduction in volume. The lower volume would be the primary focus of our
investigation. Overall, the data reflect considerable cause for concern even though the
variances (from the production departments perspective) are negligible.

b.
The cost data, taken alone, seem to show that the production department did a very good job
during the year. After adjusting for costs associated with the breakdown, the production
department has substantially favorable ($25,000 F + $120,000 = $145,000 in variable and
$15,000 U - $75,000 = $60,000 F in fixed) variances. However, we have to ask: Why did the
machine breakdown? With proper maintenance, such a disaster should not occur. The firm must
have lost considerable money from lost sales. Unless an investigation shows that the breakdown
is due to unavoidable and unexpected causes (e.g., the machine was damaged when the plant
flooded because of torrential rains), we would be inclined to judge the production manager
harshly. Overall, the managers job is to run the plan efficiently (as per variances) and
effectively (get full use out of the resources.) At higher levels, effectiveness measures are perhaps
more informative than measures of efficiency.

12.38
a.
An alternate view of Gregs performance might be that he focuses on short-term results at the
expense of long-term performance. Examples include channel stuffing (i.e., recognizing profit
on units pushed out to dealers even if they cannot be sure of selling them), sacrificing quality,
training and maintenance, and not investing in future products. Such actions might produce
immediate gains but lead to ruin in the long run. Effective managers consider both the short- and
long-term effects of their decisions.

b.
Non-financial measures might be a good way to constrain managers who seek to short-change
the future. Periodic measurements of key process measures such as quality, machine up time, and
customer satisfaction can help ensure that managers are investing in the drivers of future value in
addition to taking care of current quarter results.
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12.39
The following table provides the required computations.

Operating Required rate

Investment ROI RI
income of return
12.5% ($27,000)
1 $225,000 $1,800,000 14%
(see 1.1) (see 1.2)
$250,000 $50,000
2 $2,500,000 10% 8%
(see 2.1) (see 2.2)
$5,000,000 7.5%
3 $500,000 10% $125,000
(see 3.1) (see 3.2)
12.5% 14.0%
4 $150,000 $1,200,000 ($18,000)
(see 4.1) (see 4.2)
Detail of computation:
1.1 $225,000/$1,800,000 = 12.5% 1.2 $225,000 - (0.14 $1,800,000) = ($27,000)
2.1 $2,500,000 0.10 = $250,000 2.2 $250,000 -($2,500,0000.08) = $50,000
3.1 $500,000/0.1 = $5,000,000 3.2 $500,000 ($5,000,000 X) = $125,000
4.1 $150,000 / 1,200,000 = 12.5% 4.2 $150,000 ($1,200,000 X) = ($18,000)

12.40
a.
We have:

Residual income (Div A): $3,750,000 (0.1 $31,250,000) = $625,000

Residual income (Div B): $1,100,000 (0.1 $5,500,000) = $550,000.

Division A is higher ranked.

b.
Repeating the exercise, we have:

Residual income (Div A): $3,750,000 (0.14 $31,250,000) = ($625,000)

Residual income (Div B): $1,100,000 (0.14 $5,500,000) = $330,000

Division B is higher ranked.

c.
This problem shows that residual income is subject to a size effect. Notice that Division As ROI
is 12% and the ROI for Division B is 20%. When we use a 10% required rate, the size for
division A propels its RI above that for division B. However, like leverage, the size also rapidly
reduces RI when we increase the rate to 14%. Thus, RI is not a good way to compare divisions
that differ greatly on size.
12-10

12.41
a.
We have:

Residual income (East): $3,000,000 0.1 $24,000,000 = $600,000

Residual income (West): $780,000 0.1 $3,900,000 = $390,000.

The Eastern division has the higher residual income.

b.
We have:

Return on Investment (East): $3,000,000 / $24,000,000 = 12.5%

Return on Investment (West): $780,000 / $3,900,000 = 20%.

The Western division has the higher ROI.

c.
This problem shows that residual income is subject to a size effect but ROI is not. In part A, the
larger size for the Eastern Division (which is more than 6 times that of the Western Division)
overcomes its lower profitability, as measured by ROI. Thus, RI is not a good way to compare
divisions that differ greatly on size.

12.42

a.
Full cost is variable cost plus allocated manufacturing cost. Thus, the full cost for this product is
$10 + $(1,500,000/250,000 units) = $16 per unit.

Thailand USA Total

Revenue $6,250,000 $6,250,000
Transfer out $4,000,000
Cost of transfer in $4,000,000
Variable cost $2,500,000 $2,500,000
Fixed cost $1,500,000 -- $1,500,000
Profit 0 $2,250,000 $2,250,000

Note that the cost of the transfers out and in cancel when we consolidate the two divisional
statements.
 12-11

b.
With the new data, we have:
Thailand USA Total
Revenue $6,250,000 $6,250,000
Transfer out $5,000,000
Cost of transfer in $5,000,000
Variable cost $2,500,000 $2,500,000
Fixed cost $1,500,000 -- $1,500,000
Profit 1,000,000 $1,250,000 $2,250,000

The change in the transfer price redistributes the profit between the two divisions.
However, it does not change total profit in any way.

c.
On a pre-tax basis, transfer prices only distribute the total profit among divisions. The transfer
price has no effect on total pre-tax profit. This conclusion is not true for after-tax profit
because the different divisions might face different tax rates. Thus, where we recognize profit
matters.

12.43
a.
The variable cost for an engine is Rs. 6,000 + 3,000 + 1,000 = Rs. 10,000. Adding the 20 % mark
up gives a price of Rs. 12,000 per engine.

b.
The full cost is variable cost plus allocated manufacturing overhead. Thus, the full cost for an
engine is Rs. 10,000 + 2,000 = Rs. 12,000. Adding the 10 % mark up gives a price of Rs. 13,200
per engine.

c.
The problem text indicates that there is a ready market for these engines. Therefore, the market
price of Rs. 18,000 per engine is the appropriate transfer price. This is the only price that
properly reflects the opportunity cost of using up the capacity in the Engines Division. A lower,
cost-based price would artificially depress profit at the Engines Division and raise the profit
reported in the Assembly Division.

12.44
a.
If division A is only making 12,000 screens, they have considerable excess capacity of 8,000
screens (=20,000 capacity 12,000 used). The opportunity cost of this excess capacity is zero.
Thus, their minimum price is just their variable cost of $105 per custom screen.

b.
If Division A is at capacity, they will have to sacrifice making standard screens to make custom
screens. Each standard screen generates a contribution margin of $210 - $90 = $120. This is the
12-12

opportunity cost of using capacity to make custom screens. Thus, the minimum transfer price is
$105 + $120 = $225 per custom screen.

c.
In this case, Division A has some (but not enough) excess capacity. Thus, it will have to sacrifice
1,000 standard screens. Thus, the lost contribution is $120 per standard screen 1,000 =
$120,000, or $120,000/5,000 screens = $24 per custom screen. Adding this opportunity cost to
the variable cost of $105 gives the minimum price of $129 per custom screen.

Note: This exercise illustrates how the opportunity cost of capacity changes as we change the
baseline situation.

PROBLEMS
12.45
a.
The CRG (Central Research Group) should be evaluated as a profit center, with a target profit
of zero. While it has clearly defined customers and products, the group is not allowed to make a
profit. Charging for the service is good because it sensitizes line managers to the idea that these
services are costly. However, pricing at cost encourages use (which might save the firm more
money in the long run). The downside to this approach is that there is no built-in incentive for the
group to save costs or become more efficient. We can easily see the groups budget growing each
year, with the result that the users wind up paying a great deal for this service (they have no other
option).

b.
In addition to financial measures, it would be worthwhile to benchmark the cost (price per
hour) with independent consultants. Further, there should be periodic surveys of customer
satisfaction and quality. Indeed, we advocate for the division managers to have complete
control over whether and how much to use the CRG. Notice that the CRG has a built-in cost
advantage both because it does not charge a profit markup and because it will always have
greater institutional knowledge relative to outside consultants. If the divisions still prefer to use
outside consultants, the corporate office would get a strong indication that something is seriously
wrong.
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12.46
a.
Let us begin by constructing a flexible budget and calculating variances.
Flexible Variance
Budget Actual
budget
Production volume (units) 40,000 45,000 45,000
Revenues $8,000,000 $9,000,000 $8,550,000 ($450,000)
Variable production costs $4,000,000 $4,500,000 $4,050,000 $450,000
Total fixed production costs 800,000 $800,000 $780,000 $20,000
Variable marketing and 400,000 $450,000 640,000 ($190,000)
customer care costs
Fixed marketing and 250,000 $250,000 450,000 ($200,000)
customer care costs
Profit before taxes $2,550,000 $3,000,000 2,630,000 ($370,000)

The variances, taken alone, show that the production manager did a very nice job. The
department saved 5% relative to the variable cost in the flexible budget and was below the
budget for fixed costs as well. The marketing department, however, seems to have dropped the
ball. They had to cut prices even though they incurred substantially more marketing costs than
budgeted. The loss from marketing more than wiped out the gain from production.

b.
It is certainly possible that marketing has a legitimate case. The lower cost for production
might have resulted for using lower quality materials or rushing the product through. These items
translate to more difficult to sell items, as well as higher warranty expenses. We would have to
look at the line item variances (i.e., variances for individual expense categories) to determine if
there was substance to the allegations.

c.
This problem might have arisen because the firm focused purely on financial measures.
Using non-financial metrics such as average outgoing quality might help prevent such problems
in the future. Some firms evaluate their production departments as profit centers (using a transfer
price to value output and passing through costs related to quality) to sensitize production
managers to the market consequences of their decisions.

12.47

This problem highlights the deficiencies in the traditional classification of cost and profit
centers. Clearly, Dan is not a cost center as he generates considerable revenues. Virtually all of
the money he expends on his labs are grant funds, and the University has only a record keeping
role. Indeed, the University collects a profit if the overhead charge is more than the direct costs
of grant administration. (Research faculty often complain such is the case.) Further, Dan
generates revenue via his clinical service. There, he does not control price, but surely influences
the quantity of patients he sees.
12-14

Dan also is not a profit center. Making profit is not the reason the University employs Dan, and it
would be sending him wrong signals (and infuriating its own donors and other constituents) if it
evaluated Dan as a profit center. Most University administrators would take offense at the notion
that their operations contain a profit component. Nevertheless, virtually all universities require
established medial researchers to support their research, and view the overhead recovery as an
important component of their inflow of funds.

In practice, Universities give considerable latitude to people such as Dan. They are allowed to
run their own show (subject to broad oversight) because they are almost entrepreneurs working
for the University. We suspect that Dan would be subject to little in the form of formal targets
(e.g., number of patients, research papers or students) but be governed via broad policies that
apply to many people. The job of his boss is to keep such a high-powered, self-motivated
individual on track with respect to the Universitys goals.

12.48
a.
ROI (travel) = $600,000 / $4,000,000 = 15%
ROI (leather) = $1,200,000 / $6,000,000 = 20%.

b.
Residual income (travel bags) = $600,000 (0.12 $4,000,000) = $120,000.
Residual income (leather) = $1,200,000 (0.12 $6,000,000) = $480,000.

c.
First, let us calculate the firms weighted average cost of capital (WACC). Referring to the
formula:

WACC = [(1 - 0.3) 0.3 0.08] + (0.7 0.12) = 10.08%.

The first term reflects the tax shield (1 - 0.3), the proportion of debt financing (30%) and the cost
of debt. The second term shows the proportion of equity financing and the cost of equity capital.

Next, we have:

EVA (travel) = ($600,000 0.7) [0.1008 ($4,000,000-$175,000)] = $34,440.

EVA (leather) = ($1,200,000 0.7) [0.1008 ($6,000,000 $800,000)] = $315,840.

Notice that we multiplied the pre-tax income by (1 - tax rate) to determine the after tax operating
income.

d.
As discussed in the text, each of the measures has costs and benefits. ROI is easy to compute and
communicate but can spur poor investment decisions. EVA is conceptually the most accurate
method but is complex to implement, particularly when we have to make substantive corrections
to GAAP statements (as is traditionally the case). Nevertheless, we lean toward using EVA
 12-15

mostly because it has stronger theoretical foundations.

12.49
a.
ROI = Operating income / Net book value of assets
= $125,000 / $350,000 = 35.71%

b.
Residual income = $125,000 (0.14 $350,000) = $76,000.

c.
First, let us calculate the firms weighted average cost of capital (WACC). Referring to the
formula:

WACC = (1- tax rate) % debt cost of debt + % of equity cost of equity

= [(1 - 0.28) (1/7) 0.12] + (6/7 0.15) = 14.09%.

The first term reflects the tax shield (1 - 0.28), the proportion of debt financing (50,000/350,000)
and the cost of debt. The second term shows the proportion of equity financing and the cost of
equity capital.

Next, we have:

EVA (leather) = ($125,000 0.72) [0.1409 ($350,000 $72,000)] = $50,829.80.

Notice that we multiplied the pre-tax income by (1 - tax rate) to determine the after tax operating
income.

d. The ROI for Hercules seems particularly high at 35.71%. We propose that a large portion of
this value might arise because of a small value for net assets the denominator in ROI. The
small value makes sense in this context because we know that Hercules relies more on
personal service and attention for its business than on modern facilities. Thus, we expect its
equipment and buildings to be somewhat dated. Naturally, the capital assets are mostly
depreciated, leading to small book value and a high ROI.

e. We believe that Tom and Lynda will accept the project. Surely, the project would lower
reported ROI. But, as owners of the business, Tom and Lynda are not as concerned about
yearly fluctuations in ROI. Their focus is to the best for Hercules, taking a long-term view.

In contrast, a division manager (such as might operate Hercules, if it were part of a large
chain) might be reluctant to take the project. The reluctance will be greater if the manager
is evaluated based on ROI, particularly year over year changes in ROI. The project puts the
manager in poor light!

The difference arises because of differences in goal congruence. There is goal congruence
12-16

in the first instance: Tom and Lynda are owner-managers of Hercules. In contrast, separating
ownership from management leads to goal incongruence. Firms use performance measures
and incentives to reduce the adverse effects due to such incongruence. However, the
correction is never perfect leading the manager not to always take actions that maximize firm
value.

12.50

a.
Mansoors performance evaluation system might be contributing to the problem. Currently,
the system rewards machine uptime, which seems to be a good thing to do. After all, if the
machine is running well, it is because it has been repaired well. However, the system does not
reward quick turnaround. Such a quick job might be the best thing to do if a major sale is on the
line. Mansoors reward system does not give him any rewards for cooperating with the
production and sales managers. Thus, his insistence on good quality, because a super repair job
(which might take a long time) ensures high run time (both because the machine has been fixed
right and because the production manager cannot afford to let it go back to the shop), which
increases his budget.

b.
It might be useful to augment Mansoors performance evaluation system either by adding
more non-financial measures (e.g., average time per repair) and by adding higher unit
performance measures (e.g., total value of goods shipped per month). Both measures,
particularly the latter, give him an incentive to cooperate with the production and marketing folks
to trade off the need for time to make good quality repairs versus the need to get the machine
back on line as quickly as possible.

12.51
The use of upper-level performance measures is one way to encourage cooperation among
lower-level managers. For instance, if two branches had many shared customers, poor customer
service by one branch could affect revenues at the other branch. Firms can sensitize managers to
the firm-wide effects of their actions by using upper level performance units. Basing bonus
payments on the profits of both branches makes the manager in either branch consider the effects
of their actions on the other branch as well. The downside is that upper level measures sever the
direct link between the managers actions and their consequences. It is easy to relate branch
profit to a branch managers actions, but is far more difficult to relate corporate profit.

The problem highlights differing tradeoffs of these costs and benefits. Firm A appears to have
considerable inter-linkages among branches. Thus, it makes sense for the firm to use upper-level
measures to induce team-based perspectives. In contrast, branches in Firm B are mostly
independent of each other. Thus, it makes sense to base performance on the directly measures at
the branch level itself.
 12-17

12.52
a.
The following is the required table:
Return on Investment Residual Income
Net book Gross Net book Gross book
value book value value
value
Houston 18.333% 17.857% $1,500,000 $1,980,000
Atlanta 16.667% 19.277% $1,400,000 $2,310,000
Seattle 14.444% 18.662% $1,200,000 $2,460,000

Consider the first column. For Houston, we have income with (Net book value) = $8.5 - $2.8 -
$2.4 = $3.3 million and net book value is $18 million. Thus, ROI is $3,300,000 / $18,000,000 =
18.33%. Considering the third column, the residual income (with net book value) is $3,300,000
(0.1 $18,000,000) = $1,500,000. Similar computations apply to the other locations.

Now, let us turn to the computations with the gross book value. First, we calculate gross book
value by adding back the annual depreciation age of assets. Then, to be consistent, we remove
depreciation from income as well. Relevant data are as follows.

GBV = Net book Adjusted income

Net book value + age * with depreciation
value Depreciation Age depreciation added back
Houston $18,000,000 $1,200,000 6 $25,200,000 $4,500,000
Atlanta $21,000,000 $1,300,000 3 $24,900,000 $4,800,000
Seattle $27,000,000 $1,400,000 1 $28,400,000 $5,300,000

Thus, for Houston, we have income with (gross book value) = $3,300,000 + 1,200,000 =
$4,500,000. Thus, ROI is $4,500,000 / $25,200,000 = 17.857%. The residual income is
$4,500,000 (0.1 $25,200,000) = $1,980,000. Similar computations apply to the other
locations.

b.
We find the Houston location to be most profitable as measured by ROI (NBV), which is the
traditional measure. However, notice that age helps this location. Older assets tend to have lower
net book value (have had greater time to depreciate), which lowers the denominator in the ROI
calculation. Further, lower depreciation (if using accelerated depreciation) also helps increase the
numerator. In general, otherwise identical operations will report different ROI solely because of
their age.

Switching measures to residual income does not solve this problem. RI has the same deficiency
with respect to age.
12-18

Changing measurements to gross book value might help us better understand these issues. With
GBV, we see that the three locations are approximately equal in terms of profitability. Indeed, the
Houston location is the least profitable. The point to note here is that we have to adjust income
and investment for depreciation to perform this computation. However, even this adjustment is
imperfect because it assumes that investment prices did not change over time. Further, it does not
reflect our net investment in the assets, which might be a better measure of remaining life. (After
all, we have 4 more years of service from Houston but 9 from Seattle, if we assume a 10-year
horizon).

The over-arching point is that variations in measurement affect the ranking of divisions. We
need to pay attention to the purpose of the ranking and use the appropriate measure for
the decision at hand. Thus, if we are deciding whether to keep or sell the asset, current market
value is the choice as it best reflects the opportunity cost of retaining the asset.

12.53
The main difficulty in this problem is calculating profit for the year 2009. We know that revenue
will be $3 million. We also know that COGS and selling expenses both are mixed costs (i.e.,
contain both fixed and variable components). We need to break these portions out to generate an
accurate profit estimate. Let us use the high-low method (see Chapter 4) to estimate the COGS
and selling expenses at the projected sales level.

We can write COGS as:

$1,800,000 = COGSfixed + Variable cost per sales $ $2,400,000

$2,010,000 = COGSfixed + Variable cost per sales $ $2,700,000

Subtracting one equation from the other, we can calculate the variable portion as:

Variable cost per sales $ = ($2,010,000 -$1,800,000)/ ($2,700,000 - $2,400,000)

= $210,000 / $300,000 = 70%.

We can then use either equation to calculate COGSfixed as $120,000 = $1,800,000 - (0.7
$2,400,000).

We can perform similar computations for selling expenses to calculate the variable selling cost at
10% of each sales $ and the fixed selling cost at $240,000.

With these data in hand, we can project the income statement for 2009.

Year 2009
Sales $3,000,000 Given
Cost of goods sold 2,220,000 $120,000 + (0.7 $3,000,000)
Gross margin 780,000
Selling expenses 540,000 $240,000 + (0.1 3,000,000)
Profit before tax $240,000
 12-19

Then, the ROI is ($240,000 / $2,275,000) = 10.55%.

The divisions residual income is $240,000 (0.1 $2,275,000) = $12,500

12.54
a.
For this problem, we have to think about the after-tax cash flows. Suppose the machine were to
be sold in Europe. Then, we would want to recognize as much of the profit as possible in the
United States because the tax rate in Europe is higher. Thus, the transfer will take place at
$750,000, meaning that the U.S. division will recognize profit of $125,000 and the European
division will recognize profit of zero. Then, Catlows total profit is:

= After-tax profit in U.S. + After-tax profit in Europe

= [(1 0.35) ($750,000 - $625,000)] + [(1- 0.45) ($750,000 - $750,000)] = $81,250.

If instead the machine were to be sold in Asia, we want the profit to be recognized in Asia. That
is, the transfer price would be $625,000, meaning that we have zero profit in the United States.
Then, Catlows profit is

= After-tax profit in U.S. + After-tax profit in Asia

= [(1 0.35) ($625,000 - $625,000)] + [(1- 0.20) ($775,000 - $625,000)] = $120,000.

Comparing the two profits, Catlow would prefer to sell the machine in Asia, set the transfer price
at $625,000, and made $120,000 in after-tax profit.

b.
The U.S. division cares more about its profit. Thus, left alone, it would prefer to take the
$700,000 bid from Europe over the $675,000 bid from Asia. Notice that the $50,000 forfeited fee
is sunk for this purpose, as is the money spent on making the machine. If this transfer were to
take place at $700,000, the net profit for Catlow is:

= After-tax profit in U.S. + After-tax profit in Europe

= [(1 0.35) ($700,000 - $625,000)] + [(1- 0.45) ($750,000 - $700,000)] = $76,250.

Notice that this amount is lower than either of the two amounts calculated in part A. Thus,
allowing the divisions to bargain and decide for themselves might lead to a sub-optimal outcome
from the corporate perspective.

c.
The benefit of allowing for decentralized operations is that division managers gain autonomy and
can be held accountable for their output. This action is most consistent with the entire philosophy
of decentralization. This might lead to profit being less than it could have been had the central
12-20

office intervened to force the right transfer. However, such intervention might prove even more
expensive in the long-run because it saps the division managers of their authority.

12.55
The division controller is in a difficult situation. While some costs are clearly fixed and others
clearly variable, many costs could be classified as mixed. There is legitimate disagreement about
what portion of the cost is fixed and what portion is variable. The transfer pricing rule provides
considerable incentives for the division to classify as many of the costs as possible as being
variable in nature. The division manager also could take actions (e.g., outsource production) that
convert fixed to variable costs. Thus, it is not clear that the division controller can outright reject
the managers request. At the same time, ethical and professional considerations bar the
controller from misrepresenting a fixed cost as being variable. Ultimately, we expect that most
people in this situation would take another hard look at fixed costs to see if any of them have a
reasonable basis (even with some stretching of definitions) to be a variable cost. However, we
also are sure that professional accountants would not cross the line and misrepresent the nature
of a cost.

Ultimately, the conflict comes about because of a flaw in the transfer pricing system. Any system
that imposes an arbitrary pricing rule creates incentives to reclassify costs, much like the
reimbursement systems provided incentives to strategically allocate costs. The central office in
Packages would be wise to revisit the transfer pricing issue and consider alternate solutions.

12.56
a.
The change might help the division by boosting the transfer price. After all, the new machines
(which make the foil printers) consume very little labor while the old machines (which make the
parts sold at full cost to other divisions) consume a great deal of labor. Thus, a labor based
system would shift the overhead to the old machines, and via the transfer price, to the other
divisions. The co-mingling of costs into a single pool aids this process by mixing the costs of the
new machines (likely a lot) with the costs of old machines.

b.
We believe that the division controller should resist this suggestion vigorously. There is little
basis (from a decision making perspective) for mingling the costs of unlike machines together
into one pool. Moreover, labor hours seem like a poor cost driver for allocating the costs of new
machines. The method seems to be designed for strategically shifting costs, and such massaging
of allocations do not appear to comply with the ethical rules promulgated by the IMA.
 12-21

12.57
a.
Full cost is variable cost plus allocated fixed cost. Thus, the full cost is $6.6 million and
the transfer price is $6.6 1.1 = $7,260,000. With this, we have:
Division A Division B Total (firm)
Revenues $12,500,000 $12,500,000
Transfer revenue $7,260,000
Total revenue $7,260,000 $12,500,000 $12,500,000
Transfer cost $7,260,000
Direct material costs $2,500,000 $1,800,000 $4,300,000
Direct labor $2,000,000 $1,500,000 $3,500,000
Variable overhead $500,000 $375,000 $875,000
Allocated fixed overhead $1,600,000 $1,200,000 $2,800,000
Total cost $6,600,000 $12,135,000 $11,475,000
Profit $660,000 $365,000 $1,025,000

Notice that the total column eliminates the transfer revenue and cost as the amounts offset each
other. In particular, the total cost $11,475,000 = $6,600,000+$12,135,000 -$7,260,000.

b.
The divisions variable cost is $5 million. The $5.0 1.2 = $6,000,000. With this, we
have:
Division A Division B Total (firm)
Revenues $12,500,000 $12,500,000
Transfer revenue $6,000,000
Total revenue $6,000,000 $12,500,000 $12,500,000
Transfer cost $6,000,000
Direct material costs $2,500,000 $1,800,000 $4,300,000
Direct labor $2,000,000 $1,500,000 $3,500,000
Variable overhead $500,000 $375,000 $875,000
Allocated fixed overhead $1,600,000 $1,200,000 $2,800,000
Total cost $6,600,000 $10,875,000 $11,475,000
Profit ($600,000) $1,625,000 $1,025,000

Again, notice that $11,475,000 = $6,600,000 + $10,875,000 - $6,000,000.

12-22

c.
Division A Division B Total (firm)
Revenues $12,500,000 $12,500,000
Transfer revenue $8,000,000
Total revenue $8,000,000 $12,500,000 $12,500,000
Transfer cost $8,000,000
Direct material costs $2,500,000 $1,800,000 $4,300,000
Direct labor $2,000,000 $1,500,000 $3,500,000
Variable overhead $500,000 $375,000 $875,000
Allocated fixed overhead $1,600,000 $1,200,000 $2,800,000
Total cost $6,600,000 $12,875,000 $11,475,000
Profit $1,400,000 (375,000) $1,025,000

d.
The comparison shows that the chosen transfer price affects divisional profit significantly.
However, the choice does not affect corporate (pre-tax) profit because the revenue and cost
cancel out when we consolidate. Note, however, that the choice would affect after-tax profit
particularly if the two divisions were in different tax jurisdictions.

We can justify each of the transfer prices. Variable cost based pricing might be appropriate when
Division A has considerable excess capacity. In this case, such a price appropriately
communicates the cost of idle capacity. A full cost based price is appropriate when the division is
operating at capacity but there is no ready market price. In this case, a full cost based price
approximates market price. Finally, a market price is the best as it clearly separates the
operations in the two divisions.

12.58
a.
We would argue that the market price is the correct transfer price that appropriately reflects the
opportunity cost of capacity in the microprocessor division. From the viewpoint of Quest, the
transfer should not happen. Notice that Quest obtains $250-$100 = $150 per micro-processor
transferred. However, it loses $70 in the PC division for a net contribution of $80 per chip
(=$1,000 -$820 - $100). It is better off if it sells the chip only and closes down the PC division.

b.
Now, the problem is a bit different because there is unused capacity in the MP division. This
capacity has an opportunity cost of zero for 12,500 chips. (No external sales would be displaced
at this level). Then, the minimum price that the MP division would accept is $100 (its variable
cost) and the maximum price that PC division would pay is $180 = $1,000 - $820 (the value at
which its contribution is zero). Any price between $100 and $180 leaves both divisions better off
relative to not transferring the chip.

The transfer also is profitable from the firms perspective. It makes $1,000 - $820 - $100 = $80
per chip if it uses the unused capacity to make chips for use by the PC division.
 12-23

c.
This new information changes the nature of the opportunity cost in the MP division. Currently,
with sales of 37,500 chips, it is making a contribution of 37,500 ($250 - $100) = $5,625,000. If
it were to lower the price, its contribution would be 50,000 ($225- $100) = $6,250,000. Thus,
from the MP divisions perspective, it needs to make $6,250,000 in contribution for it to see the
transfer as being profitable.

We can calculate the minimum transfer price acceptable to the MP division as:

12,500 (X 100) + 37,500 $(250-100) = $6,250,000

Or X = $150.

Note that if it makes the transfer, there is no need to lower the price on the 37,500 chips now
being sold. At a price of $150 per chip transferred, the MP division is indifferent to the transfer
or selling the product elsewhere. At this price, the PC division makes a contribution of $30 per
chip transferred. Thus, the transfer is worthwhile from the view point of the overall corporation
as well.

Note that the transfer is not at the market price, even though a ready market for the product
exists. Such a situation has arisen because the market for chips does not appear to be efficient. In
the long-run, such discrepancies will not persist.

12.59
Calculating the ROI is straight forward as shown below.
Basis Operating Asset ROI = profit /
Profit base investment
Net book value $125,000 $900,000 13.88%
Replacement cost $125,000 1,250,000 10.00%
Sales value 125,000 1,700,000 7.35%

The measures are all useful but in different contexts.

The ROI with net book value is useful as a way of evaluating historical trends. It is most useful
when a business is stable and the replacement of capacity is on going process and the business is
not growing or shrinking, and prices are stable.

The ROI with replacement cost is useful for evaluating whether the business is a viable long-
term entity. After all, the replacement cost ROI indicates that Tom and Lyndas profitability will
only be 10% (even assuming no further escalation in equipment prices, which might be one
reason why the replacement cost is substantially higher than book value.)

The ROI with sales value is a good way to evaluate opportunity cost. After all, one option open
to them is to sell the gym and invest the capital (earning, lets say, 12%). Then, they have to
evaluate whether the intangible benefits of operating the gym compensate for the lower
profitability. (0.12 $1,700,000 = $204,000 as compared to the $125,000 they currently make.)
12-24

As is evident, we can compute ROI using differing measures of both income and investment.
The decision context determines the relevant measure.

12.60
We have:
Proportion
Net
Cost of Cost of of debt in
operating
Invested Current debt equity total
profit after WACC EVA
capital liabilities capital capital capital
taxes
(kD) (kE) (d)
(NOPAT)
1 $200,000 $1,600,000 $150,000 8% 12% 0.75 7.50% $91,250
2 $200,000 $1,600,000 $150,000 8% 12% 0.5 9.00% $69,500
3 $200,000 $1,600,000 $350,000 8% 12% 0.5 9.00% $87,500

Detail of computation:
Row 1: ((1-0.25) * 0.75 * 0.08) + (0.25 * 0.12) = 0.075
$200,000 [0.075 ($1,600,000 - $150,000)] = $91,250
Row 2: [(1-0.25) * 0.5 * 0.08] + (0.5 * 0.12) = 0.090
$200,000 [0.090 ($1,600,000 - $150,000)] = $69,500
Row 3: $200,000 [0.09 ($1,600,000 - $350,000)] = $87,550

Comparing the rows shows the effect of financing strategies on EVA. The proportion of debt (a
lower cost, and tax advantaged instrument relative to equity) decreases from row 1 to row 2.
Thus, the cost of financing goes up, decreasing EVA. In row 3, the firm finances by relying on
current liabilities (free financing from suppliers) more so than in row 2. Naturally, EVA
increases.

Note: In general, we expect a firm moving from row 2 to row 3 to also pay higher prices, which
will depress current income and thus EVA. Likewise, it will be difficult to obtain debt at the
same rate when we increase the percent financed by debt.
 12-25

Mini-cases
12.61
a.
To evaluate the investment, let us first calculate the annual after-tax cash flow.

Pre-tax cash flows are $800,000 - $300,000 - $100,000 = $400,000.

Taxable income per year = $400,000 - $150,000 = $250,000.
Taxes paid = 0.3 $250,000 = $75,000.
Thus, after tax cash flow per year = $400,000 - $75,000 = $325,000.

The NPV of this proposal (at 12% rate) is $336,332.

We can also treat the cash inflow as an annuity. The annuity tables (see Chapter 11) for 10 years
and 12% show a factor of 5.650, meaning that the present value of the cash inflows is
$1,836,322. (Notice that this amount for the PV of the cash inflows reconciles with the Net
Present Value of $336,332 = $1,836,332 - $1,500,000.)

The payback period is just under five years.

Thus, the project meets corporate standards for funding. The project should be accepted.

b.
We know that Wendys expected ROI without the investment is:

$2,400,000 / $6,800,000 = 35.29%.

Let us now calculate her ROI with the investment/

Her new income is ($2,400,000 + $250,000) = $2,650,000

Her new asset base is (6,800,000 + $1,425,000) = $8,225,000.

Notice that the new project only adds $1,425,000, which is the average of the beginning and
ending values ($1,500,000 and $1,350,000)

Thus, her revised ROI is 32.2% (=$2,650,000 / $8,225,000). Wendy is not likely to push for
the project.

c.
The RI without the investment is $2,400,000 (0.12 $6,800,000) = $1,584,000.
The RI with the new investment is $2,650,000 (0.12 $8,225,000) = $1,663,000.
That is, the project increases the divisions residual income. Wendy is likely to favor the
project.

d.
12-26

This example illustrates the incentive to under-invest that is created when using ROI as a
performance measure. Because it is a ratio, we can think of a divisions ROI as a weighted
average of the ROI of all the projects undertaken by the division. If we add a new project that is
below the weighted average, it will drag down the divisions ROI. Thus, the division manger
would be disinclined to push for the project. The use of residual income reduces this incentive.
This simple answer is enough for the case because the annual cash flows are identical over time.

Note: A more general analysis also takes into account the pattern of cash flows and depreciation.
Generally, investments generate low income and add greatly to the asset base during the early
years. That is, the annual ROI of a project increases over its life. This feature adds to the
problem. This feature also reduces the power of residual income to alleviate the under-
investment problem. The conflict arises because accounting measures usually capture
performance over one year only, while investment decisions (by definition) span many years.

12.62
a.
Annes choice of performance measure (ROI) indicates that she views each store as an
investment center. This choice seems odd at first glance. After all, managers seem to have little
control over investments any amount over $1,000 is personally approved by Anne using
somewhat subjective criteria. Further, the manager exercises limited control over the cost of the
land and buildings, the primary fixed assets for a nursery.
However, further reflection indicates that ROI might be a good measure. After all, inventories of
plants and supplies are probably the largest item in the balance sheet for a branch. The manager
exercises considerable control over inventory values both by controlling the variety and quantity
of plants ordered. If Anne did not charge for inventory in some way, the managers have the
incentive to over-order (which is expensive) and limit the stores profitability. All in all, we
would generally agree with Annes classification of the stores as investment centers.

b.
Let us begin by verifying these estimates. The following table provides key data regarding the
investment value over time.

Investment Investment at Average Depreciati

at start of the end of investment on
year year
Current year
(year 0) $20,000 $18,000 $19,500 $2,000
Year 1 $18,000 $14,000 $16,000 $4,000
Year 2 $14,000 $10,000 $12,000 $4,000
Year 3 $10,000 $6,000 $8,000 $4,000
Year 4 $6,000 $2,000 $4,000 $4,000
Year 5 $2,000 0 $1,000 $2,000
With this data in hand, we can calculate the income from the project, each year
 12-27

Sales Contribution Depreciation Fixed Reported Cash flow

(Growth at margin costs Income from
12% (50)% operations
Current year
(year 0) $ 8,500 $4,250 $2,000 1,250 $1,000 $3,000
Year 1 $17,500 $8,750 $4,000 2,500 $2,250 $6,250
Year 2 $19,600 $9,800 $4,000 2,500 $3,300 $7,300
Year 3 $21,952 $10,976 $4,000 2,500 $4,476 $8,476
Year 4 $24,586 $12,293 $4,000 2,500 $5,793 $9,793
Year 5 $27,537 $13,768 $2,000 2,500 $7,268 $11,268

Let us now calculate the ROI for the project, year-by-year.

Average
Income investment ROI Cash flow
Current year ($20,000) + $3,000
(year 0) $1,000 $19,500 5.13% = $(17,000)
Year 1 $2,250 $16,000 14.06% $6,250
Year 2 $3,300 $12,000 27.50% $7,300
Year 3 $4,476 $8,000 55.95% $8,476
Year 4 $5,793 $4,000 144.83% $9,793
Year 5 $9,268 $1,000 926.83% $11,268
NPV (at 20%) $7,434

Thus, the project seems to meet all of the cash flow hurdles. Further, it is in line with Annes
overall strategy.

Don would be reluctant to invest in this project because of the pattern of cash flows. The project
has a negative ROI for the current year and is below 20% for the next year. Adding this project
would therefore dilute Dons ROI. With the project, Dons current year ROI would be ($92,400 +
$1,000) / ($330,000 + $19,500) = 26.7%. His bonus adjustment factor would decrease from
28/25 = 1.12 to 26.7/25 = 1.07. The project also drags his ROI (and therefore his bonus) down
for the next year. The lower ROI numbers could potentially remove Don from the running for
region chief. Deborah, who might take over, would reap the benefits of the investment.

Don might be inclined to go forward with the project if he is able to get it into next years
budget. This way, the effect of the project would show up both in the budget and actual results.
Many managers would still be reluctant because a new project tends to lower year-over-year
ROI. A new project adds immediately to investment and only slowly to income. The resulting
pattern of ROI tends to discourage new investments in firms that focus on ROI as a performance
measure.
12-28

c.

Annes way of calculating ROI is quite standard. In particular, it makes sense to average
investment over the year to get the average amount at stake. Otherwise, managers might be
induced to play games with the timing of investments.

Her use of net book value also is common. However, it is subject to the criticism that it favors
older investments. Her use of a budget as a benchmark would substantially alleviate this problem
because she can adjust the budget to reflect the differing ages.

We also agree with Annes strategy of using pre-tax income to calculate ROI. After all, the
managers have limited control over the taxes, which are computed at the corporate level in any
case.

Some might argue that Anne should leave out non-controllable investments such as land and
buildings when computing the ROI. Two factors work in favor of including these items. First,
the inclusion sensitizes managers to the value of ALL assets that they use to generate income.
Second, the inclusion would affect both the budget and the actual results in similar ways. Using
the budget as a benchmark substantially removes any negative effects from including the
amounts in the investment base.

Finally, Anne could use other measures such as residual income. We do not believe that such a
move would confer great benefits, mostly because ROI is a simple, well-understood metric.
Further, a move to RI would not eliminate the incentive to under-invest because a projects RI
would be subject to the same pattern (increasing over time) that causes the problem with ROI.

d.
The compensation plan appears to be well designed. Many plans start the payout at 90% of
the target as a way to motivate managers to set stretch targets. This feature also reduces the
incentive to play games with the target.

The cap on the payout ratio likewise reduces the incentive to manage the target. It also reduces
the payout for random events that substantially and favorably affect operations. However, the
downside of the cap is that managers lose motivation to push operations beyond the level implied
by the cap.

In general, basing at least a part of the compensation on upper-unit performance measures is

useful for inducing cooperation. This way, a branch might be inclined to help another branch out
because both contribute to regional performance. The benefit in Annes case seems small because
we cannot visualize too much interaction across branches. It is not likely that a customer at the
Columbus branch would also shop at the Cleveland branch.

We also like the idea of a formula-based plan because it increases the transparency in the system.
However, notice that the bonus pool itself is somewhat subjectively determined. Thus, Anne can adjust
the payout for factors that affected operations during the year. Overall, the system seems like it would
 12-29

work well.

12.63
a.
Let us calculate profits at the two divisions, relative to the benchmark:
$170 per unit $200 per unit $230 per unit
Seths division ($170 - $125) ($200 - $125) ($230 - $125)
20,000 = $900,000 20,000 = $1,500,000 20,000 = $2,100,000

Brendas division ($170 - $170) ($170 - $200) ($170 - $230)

20,000 = 0 20,000 = ($600,000) 20,000 = ($1,200,000)

Firm as a whole $900,000 $900,000 $900,000

For Seths division, notice that we focus only on the contribution margin. This view assumes that
the division has enough extra capacity, which makes the opportunity cost of its capacity is zero.

For Brendas division, the change in profit is directly proportional to the price differential paid.

The firms overall profit is unchanged at $900,000. If indeed, there is no other use for the
capacity in Seths division, the firm benefits to the tune of $900,000 by forcing an internal
transfer.

b.
The VP confronts a difficult problem.
One solution is to force a transfer. This solution has the benefit of increasing the firms overall
short-term profit by $900,000. This approach puts the excess capacity in Seths division to good
use. The price on the transfer is likely to be a sticking point as the price effectively apportions the
surplus between the two divisions. Brenda will push for a price close to $170 as that is her
opportunity cost. Seth would push for a price close to $230, citing the development cost and the
higher quality. No matter the final price, this solution is unlikely to be acceptable to at least one
of the two division mangers.

An alternate solution is to do nothing. This solution seems odd at first blush because it leaves
nearly a million dollars on the table. However, this might be the preferred solution. To
understand why, notice that the opportunity costs for Seth and Brenda are key for the
negotiations.

From Brendas perspective, her lowest estimate is $170 per unit. However, she is likely to
go higher because she recognizes the higher quality from Seth. She also surely recognizes
the value from nurturing a long-term relationship with a reliable and high quality
vendor. Nevertheless, she has incentives to claim a low opportunity cost purely as a
negotiating tactic. After all, every dollar she shaves off the price adds $20,000 to her
bottom line.
12-30

From Seths perspective, the opportunity cost of the excess capacity is the key
determinant of the validity of his stance. (The $240,000 in design is a sunk cost and
should not affect his decision.) If the opportunity cost is truly zero (i.e., there is no other
use for this capacity), then the computations in part (a) apply. However, only Seth is the
person best equipped to estimate this opportunity cost. He has to consider the effect of a
low price to Brenda on his other sales. Plus, he has been flogging a high quality high
price strategy and that appears to be paying off as he has received orders over the last six
months. It is possible (and we do not have the necessary information to evaluate this
outcome) that the market for Seths capacity is on an upturn and that more orders are over
the horizon. This feature would raise the opportunity cost of Seths capacity. And, Seth is
privy to this information.

From the VPs perspective, forcing a transfer generates an immediate gain of $900,000 but is
predicated on the assumption that the VP knows more than Seth about alternate opportunities for
Seths capacity! It thereby undermines the entire philosophy of decentralization. Further, if Seth
is truly wrong, he will come to his senses and re-negotiate. The $230 claim might be a
negotiating bluff, just like Brendas claim of $170.

We believe that it is worthwhile for the VP to let the division managers figure this one out
themselves. Negotiating such difficult issues is how managers distinguish themselves, and
neither Brenda nor Seth is likely to leave a million dollars on the table. One or the other will
yield (appealing to the VP might be a way to line up forces on Brendas side!) and the resolution
will likely reflect the true opportunity cost for either party, as perceived by the division mangers.