6Chapter 25

MANAGERIAL ACCOUNTINGResponsibility Accounting & Transfer Pricing

.Segment Income & ROI Barfield

Deep Sea Division is one of the operating units of Global Treasure Hunters Inc. Some of this division's 2002 operating results follow:

Sales$3,000,000

Profit margin10%

Target return15%

Residual income$60,000

REQUIRED:

(a)What was the segment income of Deep Sea Division for 2002?

(b)What was the return on investment in the Deep Sea Division for 2002?

.Segment Income & ROI BarfieldNorthern Division of Utah Chemical Co. produced the following operating results in 2002:

Sales$10,000,000

Segment income1,500,000

Assets6,000,000

Northern Division is considering a $1,000,000 investment in a new project. Northern estimates that its return on investment (for all of its operations) would be at 22 percent with the new investment.

REQUIRED:

(a)How much net segment income is the new project expected to produce?

(b)If the manager of Northern Division is evaluated on return on investment alone, will she invest in the new project? Explain.

.Return on Investment & Residual IncomeBarfieldThe manager of the Dallas Division of Walking Tours of America is preparing the budget for 2003. At this point, she has determined that average total assets for 2003 will equal $4,000,000. She is evaluated on the amount of residual income generated by her division. Assume variable costs in Dallas Division are expected to equal 60 percent of total sales and fixed costs are expected to equal $400,000 in 2003.

REQUIRED:

a.Compute the sales level that would generate a 20 percent return on investment.

b.Assuming the rate of return on investment is 15 percent, determine the level of sales that would generate $200,000 of residual income.

.RI, ROI, CVP analysis, and effect of decisions L & H 10eThe following data refer to the Pratt Division of Standard National Company.

Selling price$40

Variable costs$24

Total fixed costs$200,000

Investment$800,000

Budgeted sales in 20X430,000 units

Required:

Answer each of the following questions independently.

1.What is planned ROI for 20X4?

2.The minimum required ROI is 20% and the division manager wishes to maximize RI. A new customer wants to buy 10,000 units at $32 each. If the order is accepted, the division will incur additional fixed costs of $40,000 and will have to invest an additional $160,000 in various assets. Should Pratt accept the order?

3.The minimum desired ROI is 20% and the manager wishes to maximize RI. The division makes components for its product at a variable cost of $4. An outside supplier has offered to supply the 30,000 units needed at a cost of $5 per unit. The units that the supplier would provide are equivalent to the ones now being made and the supplier is reliable. If the component is purchased, fixed costs will decline by $20,000 and investment will drop by $40,000. Should Pratt make or buy the component?

4.Again, minimum required ROI is 20% and the goal is maximizing RI. The manager is considering a new product. It will sell for $20, variable costs are $12, fixed costs will increase by $80,000, and sales are expected to be 15,000 units. What is the most additional investment that can be made without reducing RI?

5.Assume the same facts as in requirement 4 except that investment in the new product is $400,000 and introducing the product will increase sales of the existing product by 2,000 units. What increase in unit sales of the existing product is needed to justify introducing the new product?

.Return On Investment & Residual IncomeHorngrenCapital Investments has three divisions. Each division's required rate of return is 15%. Planned operating results for 20x3 are as follows:

DivisionOperating incomeInvestment

A$15,000,000$100,000,000

B$25,000,000$125,000,000

C$11,000,000$ 50,000,000

The company is planning an expansion, which is requiring each division to increase its investments by $25,000,000 and its income by $4,500,000.

Required: (D)a.Compute the current ROI for each division.

b.Compute the current residual income for each division.

c.Rank the divisions according to their current ROIs and residual incomes.

d.Determine the effects after adding the new project to each division's ROI and residual income.

e.Assuming the managers are evaluated on either ROI or residual income, which divisions are pleased with the expansion and which ones are unhappy?

.ROI, RI, and investment decisions L & H 10eThe manager of Brandon Division of Greene Industries has been analyzing her investment opportunities. The division currently has profits of $1,250,000 and investment of $5,000,000.

Investment OpportunityAnnual ProfitAmount of Investment

A$300,000$ 900,000

B300,0001,600,000

C240,0001,200,000

D280,000800,000

E260,0001,000,000

Required:

1.The manager wants to earn the highest ROI possible. Determine which projects she will select and the ROI that she will earn.

2.The manager wants to maximize RI. Determine which projects she will select and the total RI she will earn if the minimum required return is (a) 20% and (b) 28%.

3.Assume that the ROI on each project approximates the IRR and that the minimum desired ROI approximates cost of capital. Determine which policy is better for the company: maximizing ROI or maximizing RI.

.Return On Investment & Residual IncomeHorngrenThe Coffee Division of American Products is planning the 20x3 operating budget. Average operating assets of $1,500,000 will be used during the year and unit selling prices are expected to average $100 each. Variable costs of the division are budgeted at $400,000, while fixed costs are set at $250,000. The company's required rate of return is 18%.

Required: (D)

a.Compute the sales volume necessary to achieve a 20% ROI.

b.The division manager receives a bonus of 50% of residual income. What is his anticipated bonus for 20x3, assuming he achieves the 20% ROI from part (a)?

.ROI, RI, EVA L & H 10eThe Consumer Products Segment of Pfizer had the following results, in millions of dollars.

Revenues$5,547

Profit$813

Investment$3,796

Required:

1.Determine ROI and RI if the minimum required return is 20%.

2.Pfizer faced a 35% income tax rate. Cost of capital is 13%. Determine EVA.

.Margin, Turnover & ROIHorngrenKase Tractor Company allows its divisions to operate as autonomous units. The operating data for 20x3 follow:

PlowsTractorsCombines

Revenues$2,250,000$500,000$4,800,000

Accounts receivable800,000152,5001,435,000

Operating assets1,000,000400,0001,750,000

Net operating income220,00060,000480,000

Taxable income165,00090,000385,000

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.

.Basic RI relationships L & H 10eHughes 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.

.ROI and RI relationships L & H 10eFill in the blanks in the following schedule. Each case is independent of the others. In all cases, the minimum desired ROI is 20%.

Case

ABCD

Sales$ 400$____$ 700$____

Income$____$____$ 42$ 100

Investment$____$ 300$________

Margin15%8%____%____%

Turnover____times3 times____times4 times

ROI30%____%____%40%

RI$____$____$ 22$____

.Margin, Turnover & ROI RelationshipsHorngrenProvide the missing data for the following situations: (D)

Red DivisionWhite DivisionBlue Division

Sales$?$10,000,000$?

Net operating income$200,000$400,000$288,000

Operating assets$?$?$1,600,000

Return on investment0.160.10?

Return on sales0.04?0.12

Investment turnover??1.5

.Sensitivity AnalysisL & HThe 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 ADivision 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.

.Transfer Pricing Idle CapacityBarfieldWire Division of XS Steel Corporation produces "bales" of steel wire that are used in various commercial applications. The bales sell for an average of $20 each and Wire Division has the capacity to produce 10,000 bales per month. Consumer Products Division of XS Steel uses approximately 2,000 bales of steel wire each month in its production of various appliances. The operating information for Wire Division at its present level of operations (8,000 bales per month) follows:

Sales (all external)$160,000

Variable costs per bale:

Production$5

Selling2

G&A3

Fixed costs per bale (based on a 10,000 unit capacity):

Production$2

Selling3

G&A4

Consumer Products Division currently pays $15 per bale for wire obtained from its external supplier.

REQUIRED:

(A)If 2,000 bales are transferred in one month to Consumer Products Division at $10 per bale, what would be the profit/loss of Wire Products Division?

(B)For the Wire Products Division to operate at break-even level, what would it need to charge for the production and transfer of 2,000 bales to the Consumer Products Division? Assume all variable costs indicated will be incurred by the Wire Division.

(C)If Wire Products Division transferred 2,000 wire bales to the Consumer Products Division at 200 percent of full absorption cost, what would be the transfer price?

(D)If Consumer Products Division agrees to pay Wire Products Division $16 for 2,000 bales this month, what would be Consumer's change in total profits?

(E)Assuming, for this question only, that Wire Products Division would not incur any variable G&A costs on internal sales, what is the minimum price that it would consider accepting for sales of bales to Consumer Products Division?

.Transfer Pricing Partial Excess Capacity L & HBayfield Division of Ashland Inc. has a capacity of 200,000 units and expects the following results.

Sales (160,000 units at $4) $640,000

Variable costs, at $2 (320,000)

Fixed costs (260,000)Income $ 60,000Washburn Division of Ashland Inc. currently purchases 50,000 units of a part for one of its products from an outside supplier for $4 per unit. Washburn's manager believes he could use a minor variation of Bayfield's product instead, and offers to buy the units from Bayfield at $3.50. Making the variation desired by Washburn would cost Bayfield an additional $0.50 per unit and would increase Bayfield's annual cash fixed costs by $20,000. BAYFIELD'S MANAGER AGREES TO THE DEAL OFFERED BY WASHBURN'S MANAGER.

Required:

a. Find the effect of the deal on Washburn's income and circle the correct direction. (increase decrease none)

b. Find the effect of the deal on Bayfield's income and circle the correct direction. (increase decrease none)

c. Find the effect of the deal on the income of Ashland Inc. and circle the correct direction. (increase decrease none)

.Transfer Pricing Full CapacityBarfieldElectric Division of Engineered Products Co. has developed a wind generator that requires a special "S" ball bearing. The Ball Bearing Division of Engineered Products Co. has the capability to produce such a ball bearing.

Unfortunately, the Ball Bearing Division is operating at capacity and will need to reduce production of another existing product, the "T" bearing, by 1,000 units per month to provide the 600 "S" bearings needed each month by the Electric Division. The "T" bearing currently sells for $50 per unit. Variable costs incurred to produce the "T" bearing are $30 per unit; variable costs to produce the new "S" bearing would be $60 per unit.

Electric Division has found an external supplier that would furnish the needed "S" bearings at $100 per unit. Assume that both Electric Division and Ball Bearing Division are independent, autonomous investment centers.

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?

.Range of transfer price - ComprehensiveL & H 10eAlbacor Division of Lydell Industries makes a microprocessor chip that it presently sells only to outsiders. The Consumer Products Division of Lydell is bringing out a new oven that requires a sophisticated chip and has approached Albacor for a quotation. Albacor sells the chip for $28, incurs variable costs of $9, and has excess capacity. The Consumer Products Division can acquire a suitable chip from outside the company for $22.

Required:

1.Determine the advantage to Lydell Industries as a whole for the Consumer Products Division to buy the chip from Albacor, as opposed to buying it outside.

2.Determine the minimum price that Albacor would accept for the chip.

3.Determine the maximum price that Consumer Products would pay Albacor for the chip.

4.How would your answers to each of the preceding items change if Albacor was working at capacity?

.Transfer Pricing - ComprehensiveL & H 10eThe Games Division of Toys-and-Stuff Inc. uses 500,000 batteries per year for its products. Currently, Games buys the batteries from an outside supplier for $1.20 pricing each. Power Division of Toys-and-Stuff makes batteries of the type used by Games Division and sells them at $1.30 each. Power's variable cost to produce each battery is $0.70. Power Division has ample manufacturing capacity to serve its regular customers and also meet the needs of Games Division.

Required:

Answer each of the following questions independently.

1.If Power agrees to supply the batteries at $1.00, what will be the effect on the incomes pf each of the divisions and on Toys-and-Stuff as a whole?

2.Why might Power's manager accept an offer as low as $0.70 per battery from Games?

3.Repeat requirement 1 assuming that Power has no excess capacity and so would lose outside sales if it supplies the batteries to Games, and then find the lowest per-battery price that Power's manager would accept for the 500,000 batteries.

4.Repeat requirement 1 assuming that Power has only 200,000 units of excess capacity and so would lose outside sales of 300,000 units if it supplied the 500,000 batteries needed by Games.

5.Power again has 200,000 units of excess capacity. What is the lowest price that Power can accept for 500,000 units without reducing its income?

.Transfer Pricing ComprehensiveL & HDivision A of Nash Company expects the following results. ANSWER EACH QUESTION INDEPENDENTLY.

To Division BTo Outsiders

Sales (5,000 x $60)$300,000

(25,000 x $72)$1,800,000

Variable costs at $36180,000900,000

Contribution margin$120,000$ 900,000

Fixed costs, all common, allocated on the

basis of relative units60,000300,000

Profit$ 60,000$ 600,000

Division B has the opportunity to buy its needs for 5,000 units from an outside supplier at $45 each.

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.

.Make-or-buy and transfer pricing L & H 10eBarron Enterprises, Inc. has three divisions, A, B, and C. One of the company's products uses components made by A and B, with the final assembly done by C. One unit from A and one from B are required.

Data for the product are as follows:

Selling price (C division)$110Variable costs:

A division$ 36

B division20

C division 16Total Variable costs$ 72Volume10,000 units

Divisions A and B charge division C $44 and $28, respectively, for each unit. Division C has been approached by an outside supplier who will sell the component now made by division A at $40 per unit.

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?

.Comprehensive review L & H 10eThe following information relates to the Lerner Division of Transnational Company.

Budgeted sales80,000 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 ROI20%

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?

SOLUTIONS

.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%

Segmented Income & ROI

(a)The total of the new segment income = .22($6,000,000 + $1,000,000) = .22 ($7,000,000) = $1,540,000; The portion of the total segment income that is produced by the new project = $1,540,000 - $1,500,000 = $40,000

(b)The manager would not invest in the new project because the new project would lower the Division's ROI from the current 25 percent ($1,500,000/$6,000,000) to 22 percent. The new project only generates an ROI of 4 percent ($40,000/$1,000,000).

.Return on Investment & Residual Income

(changed some numbers)

a.The required net income = 20% $4,000,000 = $800,000.

Sales = Net income + Fixed costs + Variable costs

Sales = $800,000 + $400,000 + (.60 Sales)

.40 Sales = $1,200,000

Sales = $3,000,000

b.Sales = Fixed costs + Variable costs + Required return + Residual income

Sales = $400,000 + (.60 x Sales) + (.15 x Investment) + $200,000

.25 Sales = $600,000

Sales = $3,000,000

.RI, ROI, CVP Analysis, and Effects of Decisions (35 minutes)

1.35% ($280,000/$800,000)

Contribution margin [30,000 x ($40 $24)] $480,000

Fixed costs 200,000

Income $280,000

2.Yes, because residual income would increase by $8,000.

Additional contribution margin [10,000 x ($32 - $24)] $ 80,000

Additional fixed costs 40,000

Additional profit $ 40,000

Less increase in required income ($160,000 x 20%) 32,000

Additional residual income $ 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%)

Additional contribution margin [15,000 x ($20 - $12)] $120,000

Additional fixed costs 80,000

Additional profit $ 40,000

5.2,500 units

Total increase in income required ($400,000 x 20%) $ 80,000

Increase from sales of new product 40,000

Increase in contribution margin required on sales of existing products$ 40,000

Divided by contribution margin on 2,000 units of existing product$ 16

Equals units required 2,500

.Return on Investment & Residual Income

a.A ROI= $15,000,000/$100,000,000= 0.15

B ROI= $25,000,000/$125,000,000= 0.20

C ROI= $11,000,000/$50,000,000 = 0.22

b.A RI= $15,000,000 - ($100,000,000 x 0.15)= $ 0

B RI= $25,000,000 - ($125,000,000 x 0.15)= $6,250,000

C RI= $11,000,000 - ($50,000,000 x 0.15) = $3,500,000

c.Project Ranking

ABCROI Rank3rd2nd1stRI Rank3rd1st2nd

d.A ROI= $19,500,000/$125,000,000= 0.156

B ROI= $29,500,000/$150,000,000= 0.197

C ROI= $15,500,000/$75,000,000= 0.207

A RI= $19,500,000 - ($125,000,000 x 0.15)= $ 750,000

B RI= $29,500,000 - ($150,000,000 x 0.15)= $7,000,000

C RI= $15,500,000 - ($75,000,000 x 0.15) = $4,250,000

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.

.ROI, RI, and Investment Decisions (3035 minutes)

1. Only projects A and D are acceptable.

RI If Minimum ROI

ROI = 20% = 28%

Project A (investment of $900,000):

Income $300,000$300,000 $300,000

Divided by $900,000 investment equals ROI33.33%

Required income (investment x minimum ROI) 180,000 252,000

Residual income $120,000 $ 48,000

Project B (investment of $1,600,000):

Income $300,000$300,000 $300,000

Divided by $1,600,000 investment equals ROI 18.75%

Required income (investment x minimum ROI) 320,000 448,000

Residual income $(20,000) $(148,000)

Project C (investment of $1,200,000):

Income $240,000$240,000 $240,000

Divided by $1,200,000 investment equals ROI 20.00%

Required income (investment x minimum ROI) 240,000 336,000

Residual income $ 0 $(96,000)

Project D (investment of $800,000):

Income $280,000$280,000 $280,000

Divided by $800,000 investment equals ROI 35.00%

Required income (investment x minimum ROI) 160,000 224,000

Residual income $120,000 $ 56,000

Project E (investment of $1,000,000):

Income $260,000$260,000 $260,000

Divided by $1,000,000 investment equals ROI 26.00%

Required income (investment x minimum ROI) 200,000 280,000

Residual income $ 60,000 $(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 timeadjusted rates of return in excess of cost of capital, and therefore positive net present values, they should be accepted.

.Return on Investment & Residual Income

a.Target operating income = 0.20 x $1,500,000 = $300,000

Operating income$300,000

Variable costs400,000

Fixed costs250,000

Target revenues$950,000

Sales volume = $950,000/$100 = 9,500 units

b.

Asset base$1,500,000

Minimum ratex 0.18

Required return$ 270,000

Target operating income$ 300,000

Required return 270,000

Residual income$ 30,000

Bonus = $30,000 x 0.50 = $15,000

.ROI, RI, and EVA for Pfizer (10 minutes)

1.21.4% ROI, $53.8 million RI

ROI = $813/$3,796 = 21.4%

Income $813.0

Minimum required return, $3,796 x 20% 759.2

RI $ 53.8

2. Income $813.0

Income tax at 35% 284.6

After-tax operating income $528.4

Minimum required return, $3,796 x 13% 493.5

EVA $ 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= 0.10

Tractors= $60,000/$500,000= 0.12

Combines= $480,000/$4,800,000= 0.10

c.ROI:

Plows= 2.25 x 0.10= 0.225

Tractors= 1.25 x 0.12= 0.150

Combines= 2.74 x 0.10= 0.274

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.

.Basic RI Relationships (1015 minutes)

1.Sales = $60 million ($40 investment x 1.5 turnovers)

Profit = $12 million

RI $ 4.0

Plus required return ($40 x 20%) 8.0

Profit $12.0

Return on sales = 20% ($12 profit/$60 sales)

2. 21.7%

Profit required ($5 RI + $8 minimum) $13

Divided by sales $60

Equals required ROS 21.7%

3.$65 million

Profit required $13

Divided by ROS 20%

Equals sales required, in millions $65

.ROI and RI Relationships (20 minutes)

In many cases several relationships allow you to fill in blanks.

AIncome = $60 $400 sales x 15% margin

Investment = $200 $60 income/30% ROI

Turnover = 2 times $400 sales/$200 investment, or 30% ROI/15% margin

RI = $20 $60 income (20% x $200 investment)

BSales = $900 $300 investment x 3 turnovers

Income = $72 $900 sales x 8% margin

ROI = 24% $72 income/$300 investment, or 8% margin x 3 turnovers

RI = $12 $72 income - (20% x $300 investment)

CMargin = 6% $42 income/$700 sales

Investment = $100 $42 income $22 RI = $20 income needed for 20% ROI; dividing $20 by 20% gives $100

Turnover = 7 $700 sales/$100 investment

ROI = 42% $42 income/$100 investment, or 6% margin x 7 turnovers

D Margin = 10% 40% ROI/4 times turnover

Sales = $1,000 $100 income/10% margin

Investment = $250 $1,000 sales/4 times turnover

RI = $50 $100 income (20% minimum ROI x $250 investment)

.Margin, Turnover & ROI Relationships

Red Division:

ROI= ROS x IT

0.16= 0.04 x IT

IT= 4.0

ROS= Income/Sales

0.04= $200,000/Sales

Sales = $5,000,000

IT= Sales/OA

4= $5,000,000/OA

OA = $1,250,000

White Division:

ROS = $400,000/$10,000,000= 0.04

IT = ROI/ROS= 0.10/0.04= 2.5

OA = S/IT= $10,000,000/2.5= $4,000,000

Blue Division:

Sales = IT x OA= 1.5 x $1,600,000= $2,400,000

ROI = 0.12 x 1.5= 0.18

.Sensitivity Analysis

a. ROI for B: 46.4% ($580,000/$1,250,000)

b. RI for A: $20,000 [$120,000 - ($400,000 x 20%)]

c. RI for B: $350,000 [$580,000 + $80,000 - 20% x ($1,250,000 + $300,000)]

d. ROI for A: 32% [$120,000/$800,000 = 15% ROS + 1% = 16%, turnover = 2 ($800,000/$400,000), so 16% x 2 = 32%]

e. 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$90,000Less: Contrib. Margin on Regular Business [$20 - (5 + 2 + 3)] x 8,000(80,000)Unrecovered Fixed Costs$10,000which 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).

.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)

.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.

.Range of Transfer Price (15 minutes)

1. $13 ($22 outside price $9 variable cost)

2.$9 variable cost

3.$22, the price it would have to pay on the outside

4.The company will lose $6 for each chip transferred. Albacor will lose $28 in revenue while the company saves the $22 outside price. There should be no transfer because Albacor's minimum is $28, while the Consumer Products Division is willing to pay only $22. The $6 difference is also the loss to the company.

Note to the Instructor: Some students might wonder why Albacor can sell its chip for $28 while an outside company sells one for $22. The text says that the outside company makes a "suitable chip," so that it might be of lower quality than Albacor's.

After completing requirement 3, you might also wish to point out that the range of acceptable prices, from $9 to $22, is $13, which is also the benefit to the company of making the chip. It is always true that if there is a benefit to the company in making a transfer, there is potential benefit to the divisions, as reflected in the range of acceptability of the transfer price. In this case, the divisional managers should be able to get together because the range is wide.

.Basic Transfer Pricing (3035 minutes)

1.Games gains $100,000 and Power gains $150,000. ToysandStuff gains $250,000, which is also the sum of the net changes in the incomes of the individual divisions.

Games saves [500,000 x ($1.20 - $1.00)] $100,000

Power gains the contribution margin from sales of

500,000 more units at $0.30 ($1.00 - $0.70) $150,000

Toys-and-Stuff saves ($1.20 - $0.70) x 500,000 $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 breakeven 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 ToysandStuff's income declines by $50,000.

ToysandStuff:

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 ToysandStuff 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

ToysandStuff:

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.

.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)

.MakeorBuy and Transfer Pricing (2025 minutes)

1.Partial income statements

A B C Totals

Sales $440,000 $280,000 $1,100,000 $1,820,000

Variable costs 360,000 200,000 880,000* 1,440,000

Contribution margin $ 80,000 $ 80,000 $ 220,000 $ 380,000

* Sales of A and B plus $160,000 ($16 x 10,000) variable cost incurred in C.

2.A would lose $40,000 if it failed to meet the price and the company would lose $40,000 as well. The offer should not be accepted.

Division A

Sell at $40 Do Not Sell

Sales $400,000 0

Variable costs 360,000 0

Contribution margin $ 40,000 0

Loss to company:

Difference in variable costs ($40 - $36) $4

Times volume 10,000

Equals loss $40,000

3. A should sell outside and C should buy the component outside.

Sell outside

Sales (10,000 x $48) $480,000

Variable costs [($36 + $5) x 10,000] 410,000

Contribution margin $ 70,000

Contribution margin selling inside, requirement 2 40,000

Advantage to selling outside $ 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.

.Comprehensive Review (4050 minutes)

1.(a)22.5%

Contribution margin, 80,000 x ($32 - $20) $960,000

Fixed costs 600,000

Income $360,000

Divided by investment = ROI, $360,000/$1,600,000 22.5%

(b)$40,000

Income (a) $360,000

Required minimum ROI ($1,600,000 x 20%) 320,000

RI $ 40,000

2.85,000 units

Target RI $100,000

Required minimum ROI ($1,600,000 x 20%) 320,000

Required divisional income $420,000

Fixed costs 600,000

Required divisional contribution margin $1,020,000

Divided by contribution margin per unit $12

Equals required sales, in units 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 $500,000

Lost contribution margin on lost sales, 5,000 x $12 60,000

Amount to be recovered in price to Rogers $560,000

Divided by number of units to be sold to Rogers 25,000

Required price for units to be sold to Rogers $ 22.40

(c)Income will increase by $90,000.

Transnational:

Savings from making 25,000 at $20 rather than buying at $26$150,000

Lost contribution margin ($32 - $20) x 5,000 60,000

Increase in income $90,000

Alternatively, using the changes in the incomes of the divisions.

Rogers Division:

Cost saving of $1 ($26 - $24) x 25,000 units $50,000

Lerner Division:

Contribution margin on sales to Rogers, 25,000 x $4 $100,000

Lost contribution on outside sales, 5,000 x $12 60,000

Net gain to Lerner 40,000

Increase in company income $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.

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