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13 CHAPTER Investment Centers and Transfer Pricing ANSWERS TO REVIEW QUESTIONS 13-1 The managerial accountant's primary objective in designing a responsibilityaccounting system is to provide incentives for the organization's subunit managers to strive toward achieving the organization's goals. Goal congruence means a meshing of objectives, in which the managers throughout an organization strive to achieve goals that are consistent with the goals set by top management. Goal congruence is important for organizational success because managers often are unaware of the effects of their decisions on the organization's other subunits. Also, it is natural for people to be more concerned with the performance of their own subunit than with the effectiveness of the entire organization. In order for the organization to be effective, it is important that everyone in it be striving for the same ultimate objectives. Under the management-by-objectives (MBO) philosophy, managers participate in setting goals that they then strive to achieve. These goals may be expressed in financial or other quantitative terms, and the responsibility-accounting system is used to evaluate performance in achieving them. The MBO approach is consistent with an emphasis on obtaining goal congruence throughout an organization. An investment center is a responsibility-accounting center, the manager of which is held accountable not only for the investment center's profit but also for the capital invested to earn that profit. Examples of investment centers include a division of a manufacturing company, a large geographical territory of a hotel chain, and a geographical territory consisting of several stores in a retail company. Return on investment (ROI) = income income sales revenue = invested capital sales revenue invested capital 13-2 13-3 13-4 13-5 13-6 A division's ROI can be improved by improving the sales margin, by improving the capital turnover, or by some combination of the two. The manager of the Automobile Division of an insurance company could improve the sales margin by increasing the profit margin on each insurance policy sold. As a result, every sales dollar would generate more income. The capital turnover could be improved by increasing sales of insurance policies while keeping invested capital fixed, or by decreasing the invested assets required to generate the same sales revenue. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-1 13-7 Example of the calculation of residual income: Suppose an investment center's profit is $100,000, invested capital is $800,000, and the imputed interest rate is 12 percent: imputed investment center's Residual income = investment center's profit invested capital interest rate Residual income = $100,000 ($800,000) (12%) = $4,000 The imputed interest rate is used in calculating residual income, but it is not used in computing ROI. The imputed interest rate reflects the firm's minimum required rate of return on invested capital. 13-8 The chief disadvantage of ROI is that for an investment that earns a rate of return greater than the company's cost of raising capital, the manager in charge of deciding about that investment may have an incentive to reject it if the investment would result in reducing the manager's ROI. The residual-income measure eliminates this disadvantage by including in the residual-income calculation the imputed interest rate, which reflects the firm's cost of capital. Any project that earns a return greater than the imputed interest rate will show a positive residual income. The rise in ROI or residual income across time results from the fact that periodic depreciation charges reduce the book value of the asset, which is generally used in determining the investment base to use in the ROI or residual-income calculation. This phenomenon can have a serious effect on the incentives of investment-center managers. Investment centers with old assets will show higher ROIs than investment centers with relatively new assets. This result can discourage investment-center managers from investing in new equipment. If this behavioral tendency persists for a long time, a division's assets can become obsolete, making the division uncompetitive. 13-9 13-10 The economic value added (EVA) is defined as follows: Investment Economic Investment center' s Investment Weighted - average value = after - tax center' s center' s cost of total assets added operating income current liabilities capital imputed investment center's Residual income = investment center's profit invested capital interest rate Economic value added differs from residual income in its subtraction of the investment centers current liabilities and its specific use of the weighted-average cost of capital. McGraw-Hill/Irwin 13-2 2005 The McGraw-Hill Companies, Inc. Solutions Manual 13-11 a. Total assets: Includes all divisional assets. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets, including nonproductive assets. b. Total productive assets: Excludes assets that are not in service, such as construction in progress. This measure is appropriate when a division manager is directed by top management to keep nonproductive assets, such as vacant land or construction in progress. c. Total assets less current liabilities: All divisional assets minus current liabilities. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. This approach encourages investment-center managers to minimize resources tied up in assets and maximize the use of short-term credit to finance operations. 13-12 The use of gross book value instead of net book value to measure a division's invested capital eliminates the problem of an artificially increasing ROI or residual income across time. Also, the usual methods of computing depreciation, such as straight-line or declining-balance methods, are arbitrary. As a result, some managers prefer not to allow these depreciation charges to affect ROI or residual-income calculations. 13-13 It is important to make a distinction between an investment center and its manager, because in evaluating the manager's performance, only revenues and costs that the manager can control or significantly influence should be included in the profit measure. The objective of the manager's performance measure is to provide an incentive for that manager to adhere to goal-congruent behavior. In evaluating the investment center as a viable economic investment, all revenues and costs that are traceable to the investment center should be considered. Controllability is not an issue in this case. 13-14 Pay for performance is a one-time cash payment to an investment-center manager as a reward for meeting a predetermined criterion on a specified performance measure. The objective of pay for performance is to get the manager to strive to achieve the performance target that triggers the payment. 13-15 An alternative to using ROI or residual income to evaluate a division is to look at its income and invested capital separately. Actual divisional profit for a period of time is compared to a flexible budget, and variances are used to analyze performance. The division's major investments are evaluated through a postaudit of the investment decisions. This approach avoids the necessity of combining profit and invested capital in a single measure, such as ROI or residual income. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-3 13-16 During periods of inflation, historical-cost asset values soon cease to reflect the cost of replacing those assets. Therefore, some accountants argue that investment-center performance measures based on historical-cost accounting are misleading. Most managers, however, believe that measures based on historical-cost accounting are adequate when used in conjunction with budgets and performance targets. 13-17 Examples of nonfinancial measures that could be used to evaluate a division of an insurance company include the following: (1) new policies issued and insurance claims settled in a specified period of time, (2) average time required to settle an insurance claim, and (3) number of insurance claims settled without litigation versus claims that require litigation. 13-18 Nonfinancial information is useful in measuring investment-center performance because it gives top management insight into the summary financial measures such as ROI or residual income. By keeping track of important nonfinancial data, top managers often can see a problem developing before it becomes a serious problem. For example, if a manufacturer's rate of defective products has been increasing over some period of time, management can observe this phenomenon and take steps to improve product quality before serious damage is done to customer relations. 13-19 The goal in setting transfer prices is to establish incentives for autonomous division managers to make decisions that support the overall goals of the organization. Transfer prices should be chosen so that each division manager, when striving to maximize his or her own division's profit, makes the decision that maximizes the company's profit. 13-20 Four methods by which transfer prices may be set are as follows: (a) Transfer price = additional outlay costs incurred because goods are transferred + opportunity costs to the organization because of the transfer. (b) Transfer price = external market price. (c) Transfer prices may be set on the basis of negotiations among the division managers. (d) Transfer prices may be based on the cost of producing the goods or services to be transferred. 13-21 When the transferring division has excess capacity, the opportunity cost of producing a unit for transfer is zero. McGraw-Hill/Irwin 13-4 2005 The McGraw-Hill Companies, Inc. Solutions Manual 13-22 The management of a multinational company has an incentive to set transfer prices so as to minimize the income reported for divisions in countries with relatively high income-tax rates, and to shift this income to divisions with relatively low income-tax rates. Some countries' tax laws prohibit this practice, while other countries' laws permit it. 13-23 Multinational firms may be charged import duties, or tariffs, on goods transferred between divisions in different countries. These duties often are based on the reported value of the transferred goods. Such companies may have an incentive to set a low transfer price in order to minimize the duty charged on the transferred goods. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-5 SOLUTIONS TO EXERCISES EXERCISE 13-24 (10 MINUTES) Sales margin = Capital turnover = Return on investment = income sales revenue sales revenue invested capital income invested capital = = = $10,000,000 $125,000,000 $125,000,000 $50,000,000 $10,000,000 $50,000,000 = = = 8% 2.5 20% EXERCISE 13-25 (15 MINUTES) There are an infinite number of ways to improve the division's ROI to 25 percent. Here are two of them: 1. Improve the sales margin to 10 percent by increasing income to $12,500,000: ROI = = = sales margin capital turnover $12,500,000 $125,000,000 $125,000,000 $50,000,000 10% 2.5 = 25% Since sales revenue remains unchanged, this implies a cost reduction of $2,500,000 at the same volume. 2. Improve the turnover to 3.125 by decreasing average invested capital to $40,000,000: ROI = = = sales margin capital turnover $10,000,000 $125,000,000 $125,000,000 $40,000,000 8% 3.125 = 25% Since sales revenue remains unchanged, this implies that the firm can divest itself of some productive assets without affecting sales volume. McGraw-Hill/Irwin 13-6 2005 The McGraw-Hill Companies, Inc. Solutions Manual EXERCISE 13-26 (5 MINUTES) Residual income = investment center income imputed invested capital interest rate = $10,000,000 ($50,000,000 11%) = $4,500,000 EXERCISE 13-27 (15 MINUTES) 1. Sales margin = income sales revenue = 300,000 * 6,000,000 = 5% *Income = 300,000 = 6,000,000 3,300,000 2,400,000 Capital turnover = 6,000,000 sales revenue invested capital = 3,000,000 300,000 income = 3,000,000 invested capital =2 ROI = = 10% 2. ROI = 15% = income invested capital income = 3,000,000 Income = 15% 3,000,000 = 450,000 Income = sales revenue expenses = 450,000 Income = 6,000,000 expenses = 450,000 Expenses = 5,550,000 Therefore, expenses must be reduced to 5,550,000 in order to raise the firm's ROI to 15 percent. 3. Sales margin = income sales revenue = 450,000 6,000,000 = 7.5% ROI = sales margin capital turnover = 7.5% 2 = 15% McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-7 EXERCISE 13-28 (30 MINUTES) 1. Students calculation of return on investment and residual income will depend on the company selected and the year when the internet search is conducted. Students will need to decide how to determine the income and the invested assets to use in both calculations. The discussion in the text will serve as a guide in this regard. 2. Some companies annual reports include a calculation and discussion of ROI in the management report and analysis section or the financial highlights section. Students calculation of ROI may differ from managements due to differing assumptions about the determination of income and invested capital. EXERCISE 13-29 (30 MINUTES) 1. Average investment in productive assets: Balance on 12/31/x1......................................................................................... Balance on 1/1/x1 ($25,200,000 1.05).......................................................... Beginning balance plus ending balance....................................................... Average balance ($49,200,000 2) ................................................................ a. ROI = = income from operations before income taxes average productive assets $4,920,000 $24,600,000 $25,200,000 24,000,000 $49,200,000 $24,600,000 = 20% b. Income from operations before income taxes ...................................... Less: imputed interest charge: Average productive assets ....................................... $24,600,000 Imputed interest rate.................................................. .15 Imputed interest charge ..................................................................... Residual income....................................................................................... $ 4,920,000 3,690,000 $ 1,230,000 McGraw-Hill/Irwin 13-8 2005 The McGraw-Hill Companies, Inc. Solutions Manual EXERCISE 13-29 (CONTINUED) 2. Yes, Fairmonts management probably would have accepted the investment if residual income were used. The investment opportunity would have lowered Fairmonts 20x1 ROI because the project's expected return (18 percent) was lower than the division's historical returns (19.3 percent to 22.1 percent) as well as its actual 20x1 ROI (20 percent). Management may have rejected the investment because bonuses are based in part on the ROI performance measure. If residual income were used as a performance measure (and as a basis for bonuses), management would accept any and all investments that would increase residual income (i.e., a dollar amount rather than a percentage) including the investment opportunity it had in 20x1. EXERCISE 13-30 (15 MINUTES) Date: To: From: Today Memorandum President, Sun Coast Food Centers I. M. Student Subject: Behavior of ROI over time When ROI is calculated on the basis of net book value, it will typically increase over time. The net book value of the bundle of assets declines over time as depreciation is recorded. The income generated by the bundle of assets often will remain constant or increase over time. The result is a steady increase in the ROI, as income remains constant (or increases) and book value declines. This effect will not exist (or at least will not be as pronounced) if the firm continues to invest in new assets at a roughly steady rate across time. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-9 EXERCISE 13-31 (10 MINUTES) 1. The same employee is responsible for keeping the inventory records and taking the physical inventory count. In addition, when the records and the count do not agree, the employee changes the count, rather than investigating the reasons for the discrepancy. This leaves open the possibility that the employee would steal inventory and conceal the theft by altering both the records and the count. Even without any dishonesty by the employee, this system is not designed to control inventory since it does not encourage resolution of discrepancies between the records and the count. The internal control system could be strengthened in two ways: (a) Assign two different employees the responsibilities for the inventory records and the physical count. With this arrangement, collusion would be required for theft to be concealed. Require that discrepancies between the inventory records and the physical count be investigated and resolved when possible. 2. (b) EXERCISE 13-32 (15 MINUTES) The weighted-average cost of capital (WACC) is defined as follows: Weighted - average cost of = capital After - tax cost Market Cost of Market value + equity value of debt of debt capital of equity capital Market Market value + value of debt of equity The interest rate on Golden Gate Construction Associates $90 million of debt is 10 percent, and the companys tax rate is 40 percent. Therefore, Golden Gates after-tax cost of debt is 6 percent [10% (140%)]. The cost of Golden Gates equity capital is 15 percent. Moreover, the market value of the companys equity is $135 million. The following calculation shows that Golden Gates WACC is 11.4 percent. Weighted - average = cost of capital (.06)($90,000,000) + (.15)($135,000,000) = .114 $90,000,000 + $135,000,000 McGraw-Hill/Irwin 13-10 2005 The McGraw-Hill Companies, Inc. Solutions Manual EXERCISE 13-33 (20 MINUTES) The economic value added (EVA) is defined as follows: Investment Economic Investment center' s Investment Weighted - average value = after - tax center' s center' s cost of total assets added operating income current liabilities capital For Golden Gate Construction Associates, we have the following calculations of each divisions EVA. After-Tax Operating Income (in millions) $30(1.40) $27(1.40) Current Liabilities (in millions) $9 $6 Economic Value Added (in millions) = = $1.926 $6.624 Division Real Estate Construction Total Assets (in millions) $150 $ 90 WACC .114 .114 EXERCISE 13-34 (10 MINUTES) 1. Transfer price = outlay cost + opportunity cost = $450* + $120 = $570 *Outlay cost = unit variable production cost Opportunity cost = forgone contribution margin = $570 $450 = $120 2. If the Fabrication Division has excess capacity, there is no opportunity cost associated with a transfer. Therefore: Transfer price = outlay cost + opportunity cost = $450 + 0 = $450 McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-11 EXERCISE 13-35 (25 MINUTES) 1. The Assembly Division's manager is likely to reject the special offer because the Assembly Division's incremental cost on the special order exceeds the division's incremental revenue: Incremental revenue per unit in special order........................ Incremental cost to Assembly Division per unit in special order: Transfer price ....................................................................... Additional variable cost ...................................................... Total incremental cost............................................................... Loss per unit in special order .................................................. 2. $700 $561 150 711 $ (11) The Assembly Division manager's likely decision to reject the special order is not in the best interests of the company as a whole, since the company's incremental revenue on the special order exceeds the company's incremental cost: Incremental revenue per unit in special order..................... Incremental cost to company per unit in special order: Unit variable cost incurred in Fabrication Division ........ Unit variable cost incurred in Assembly Division........... Total unit variable cost........................................................... Profit per unit in special order .............................................. $700 $450 150 600 $100 3. The transfer price could be set in accordance with the general rule, as follows: Transfer price = outlay cost + opportunity cost = $450 + 0* = $450 *Opportunity cost is zero, since the Fabrication Division has excess capacity. Now the Assembly Division manager will have an incentive to accept the special order since the Assembly Division's incremental revenue on the special order exceeds the incremental cost. The incremental revenue is still $700 per unit, but the incremental cost drops to $600 per unit ($450 transfer price + $150 variable cost incurred in the Assembly Division). McGraw-Hill/Irwin 13-12 2005 The McGraw-Hill Companies, Inc. Solutions Manual SOLUTIONS TO PROBLEMS PROBLEM 13-36 (25 MINUTES) The answer to the question as to which division is the most successful depends on the firm's cost of capital. To see this, compute the residual income for each division using various imputed interest rates. (a) Imputed interest rate of 10%: Divisional profit ..................................................................... Less: Imputed interest charge: I: $18,000,000 10%............................................... II: $ 3,000,000 10%............................................... Residual income.................................................................... (b) Imputed interest rate of 14%: Divisional profit ..................................................................... Less: Imputed interest charge: I: $18,000,000 14%............................................... II: $ 3,000,000 14%............................................... Residual income.................................................................... (c) Imputed interest rate of 15%: Divisional profit ..................................................................... Less: Imputed interest charge: I: $18,000,000 15%............................................... II: $ 3,000,000 15%............................................... Residual income.................................................................... $2,700,000 2,700,000 ________ $ 0 $600,000 450,000 $150,000 Division I $2,700,000 2,520,000 ________ $ 180,000 Division II $600,000 420,000 $180,000 Division I $2,700,000 1,800,000 ________ $ 900,000 Division II $600,000 300,000 $300,000 If the firm's cost of capital is 10 percent, then Division I has a higher residual income than Division II. With a cost of capital of 15 percent, Division II has a higher residual income. At a 14 percent cost of capital, both divisions have the same residual income. This scenario illustrates one of the advantages of residual income over ROI. Since the residual income calculation includes an imputed interest charge reflecting the firm's cost of capital, it gives a more complete picture of divisional performance. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-13 PROBLEM 13-37 (45 MINUTES) Sales revenue.......................................................... Income ..................................................................... Average investment................................................ Sales margin .......................................................... Capital turnover ...................................................... ROI............................................................................ Residual income ..................................................... Explanatory notes: a Division I $40,000,000 $ 8,000,000 $10,000,000 20%a 4b 80%c $ 7,200,000d Division II $8,000,000e $ 1,600,000 $8,000,000f 20% 1 20%g $ 960,000h Division III $3,200,000l $ 800,000k $4,000,000j 25% .8i 20% $ 480,000 Sales margin = income $8,000,000 = = 20% sales revenue $40,000,000 sales revenue $40,000,000 = =4 invested capital $10,000,000 b Capital turnover = c ROI = sales margin capital turnover = 20% 4 = 80% income = income (imputed interest rate)(invested capital) = $8,000,000 (8%)($10,000,000) = $7,200,000 income sales revenue $1,600,000 sales revenue d Residual e Sales margin = 20% = Therefore, sales revenue = $8,000,000 fCapital turnover = sales revenue invested capital $8,000,000 invested capital 1= Therefore, invested capital = $8,000,000 gROI = sales margin capital turnover = 20% 1 = 20% ROI McGraw-Hill/Irwin 13-14 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-37 (CONTINUED) hResidual income = income (imputed interest rate)(invested capital) = $1,600,000 (8%)($8,000,000) = $960,000 iROI = sales margin capital turnover = 25% capital trunover 20% Therefore, capital turnover = .8 jROI = income invested capital = 20% Therefore, income = (20%)(invested capital) Residual income = income (imputed interest rate)(invested capital) = $480,000 Substituting from above for income: (20%)(invested capital) (8%)(invested capital) = $480,000 Therefore, (12%)(invested capital) = $480,000 So, invested capital = $4,000,000 kROI = income invested capital income $4,000,000 income sales revenue 20% = Therefore, income = $800,000 lSales margin = 25% = $800,000 sales revenue Therefore, sales revenue = $3,200,000 McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-15 PROBLEM 13-38 (20 MINUTES) 1. Three ways to increase Division I's ROI: (a) Increase income, while keeping invested capital the same. Suppose income increases to $9,000,000. The new ROI is: ROI = income $9,000,000 = = 90% invested capital $10,000,000 (b) Decrease invested capital, while keeping income the same. Suppose invested capital decreases to $9,600,000. The new ROI is: ROI = income $8,000,000 = = 83.3% (rounded) invested capital $9,600,000 (c) Increase income and decrease invested capital. Suppose income increases to $8,400,000 and invested capital decreases to $9,600,000. The new ROI is: ROI = income $8,400,000 = = 87.5% invested capital $9,600,000 2. ROI = = = sales margin capital turnover 25% 1 25% McGraw-Hill/Irwin 13-16 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-39 (25 MINUTES) This problem is similar to Problem 13-36, except that here students are given a hint in answering the question about which division is the most successful by requiring the calculation of residual income for three different imputed interest rates. If the firm's cost of capital is 12 percent, then Division I has a higher residual income than Division II. With a cost of capital of 15 percent or 18 percent, Division II has a higher residual income. 1. Imputed interest rate of 12% Divisional profit..................................................................... Less: Imputed interest charge: I: $18,000,000 12% .............................................. II: $ 3,000,000 12% .............................................. Residual income ................................................................... 2. Imputed interest rate of 15% Divisional profit....................................................................... Less: Imputed interest charge: I: $18,000,000 15% ................................................ II: $ 3,000,000 15% ................................................ Residual income ..................................................................... Division I $2,700,000 2,700,000 $ 0 450,000 $150,000 Division II $600,000 Division I $2,700,000 2,160,000 $ 540,000 360,000 $240,000 Division II $600,000 McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-17 PROBLEM 13-39 (CONTINUED) 3. Imputed interest rate of 18% Divisional profit....................................................................... Less: Imputed interest charge: I: $18,000,000 18%.................................................. II: $ 3,000,000 18%.................................................. Residual income ..................................................................... Division I $2,700,000 3,240,000 $(540,000) 540,000 $ 60,000 Division II $600,000 The imputed interest rate r, at which the two divisions residual income is the same, is 14 percent, computed as follows: Division IIs residual income = Division I's residual income $600,000 (r)($3,000,000) = $2,700,000 (r)($18,000,000) (r)($15,000,000) = $2,100,000 r = $2,100,000/$15,000,000 r = 14% For any imputed interest rate less than 14 percent, Division I will have a higher residual income. For any rate over 14 percent, Division II's residual income will be higher. McGraw-Hill/Irwin 13-18 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-40 (35 MINUTES) 1. Current ROI of the Western Division: Sales revenue Less: Variable costs ($4,200,000 x 70%) Fixed costs.. Income.. ROI = Income invested capital = $185,000 $925,000 = 20% Western Divisions ROI if competitor is acquired: Sales revenue ($4,200,000 + $2,600,000). Less: Variable costs [$2,940,000 + ($2,600,000 x 65%)] $4,630,000 Fixed costs ($1,075,000 + $835,000)... 1,910,000 Income... ROI = Income invested capital = $260,000 [$925,000 + ($312,500 + $187,500)] = 18.25% 2. Divisional management will likely be against the acquisition because ROI will be lowered from 20% to 18.25%. Since bonuses are awarded on the basis of ROI, the acquisition will result in less compensation. An examination of the competitors financial statistics reveals the following: Sales revenue.. Less: Variable costs ($2,600,000 x 65%).. $1,690,000 Fixed costs .. 835,000 Income... ROI = Income invested capital = $75,000 $312,500 = 24% $2,600,000 2,525,000 $ 75,000 $6,800,000 6,540,000 $ 260,000 $2,940,000 1,075,000 $4,200,000 4,015,000 $ 185,000 3. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-19 PROBLEM 13-40 (CONTINUED) Corporate management would probably favor the acquisition. Megatronics has been earning a 13% return, and the competitors ROI of 24% will help the organization as a whole. Even if the $187,500 upgrade is made, the competitors ROI would be 15% if past earnings trends continue [$75,000 ($312,500 + $187,500) = 15%]. 4. Yes, the divisional ROI would increase to 21.01%. However, the absence of the upgrade could lead to long-run problems, with customers being confused (and perhaps turned-off) by two different retail environmentsthe retail environment they have come to expect with other Megatronics outlets and that of the newly acquired, non-upgraded competitor. Sales revenue ($4,200,000 + $2,600,000). Less: Variable costs [$2,940,000 + ($2,600,000 x 65%)] $4,630,000 Fixed costs ($1,075,000 + $835,000)... 1,910,000 Income... ROI = Income invested capital = $260,000 ($925,000 + $312,500) = 21.01% 5. Current residual income of the Western Division: Divisional profit $185,000 Less: Imputed interest charge ($925,000 x 12%) 111,000 Residual income.. $ 74,000 Residual income if competitor is acquired: Divisional profit ($185,000 + $75,000)... $260,000 Less: Imputed interest charge [($925,000 + ($312,500 + $187,500)) x 12%]... 171,000 Residual income... $ 89,000 Yes, management most likely will change its attitude. Residual income will increase by $15,000 ($89,000 - $74,000) as a result of the acquisition. $6,800,000 6,540,000 $ 260,000 McGraw-Hill/Irwin 13-20 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-41 (40 MINUTES) ROI Based on Net Book Value 12.5% 54.2% 118.5% 355.6% ROI Based on Gross Book Value 6.0% 15.6% 19.2% 19.2% Average Income Income Net of Annual Before Net Book Year Depreciation Depreciation Depreciation Value* 1 $150,000 $200,000 $(50,000) $400,000 2 150,000 120,000 30,000 240,000 3 150,000 72,000 78,000 144,000 4 150,000 54,000 96,000 81,000 5 150,000 54,000 96,000 27,000 Average Gross Book Value $500,000 500,000 500,000 500,000 500,000 *Average net book value is the average of the beginning and ending balances for the year in net book value. In Year 1, for example, the average net book value is: $500,000 + $300,000 = $400,000 2 ROI rounded to the nearest tenth of 1 percent. This table differs from Exhibit 13-3 in that ROI rises even more steeply across time than it does in Exhibit 13-3. With straight-line depreciation, ROI rises from 11.1 percent in Year 1 to 100 percent in Year 5. Under the accelerated depreciation schedule used here, we have a loss in Year 1 and then ROI rises from 12.5 percent in Year 2 to 355.6 percent in Year 5. One potential implication of such an ROI pattern is a disincentive for new investment. If a proposed capital project shows a loss or very low ROI in its early years, a manager may worry about the effect on his or her performance evaluation in the early years of the project. In an extreme case, a manager may worry that he or she will no longer have the job when the project begins to show a higher return in its later years. 1. 2. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-21 PROBLEM 13-42 (40 MINUTES) Based on Net Book Value Average Imputed Income Income Net of Annual Before Net Book Interest Residual Year Depreciation Depreciation Depreciation Value* Charge Income 1 $150,000 $100,000 $50,000 $450,000 $45,000 $ 5,000 2 150,000 100,000 50,000 350,000 35,000 15,000 3 150,000 100,000 50,000 250,000 25,000 25,000 4 150,000 100,000 50,000 150,000 15,000 35,000 5 150,000 100,000 50,000 50,000 5,000 45,000 Based on Gross Book Value Average Imputed Gross Interest Residual Book Charge Income Value $500,000 $50,000 0 500,000 50,000 0 500,000 50,000 0 500,000 50,000 0 500,000 50,000 0 *Average net book value is the average of the beginning and ending balances for the year in net book value. Imputed interest charge is 10 percent of the average book value, either net or gross. Notice in the table that residual income, computed on the basis of net book value, increases over the life of the asset. This effect is similar to the one demonstrated for ROI. It is not very meaningful to compute residual income on the basis of gross book value. Notice that this asset shows a zero residual income for all five years when the calculation is based on gross book value. McGraw-Hill/Irwin 13-22 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-43 (30 MINUTES) 1. Sales margin: income divided by sales revenue. Capital turnover: sales revenue divided by invested capital Return on investment: income divided by invested capital (or sales margin x capital turnover). Sales margin: $540,000 $7,200,000 = 7.5% Capital turnover: $7,200,000 $9,000,000 = 80% Return on investment: $540,000 $9,000,000 = 6%, or 7.5% x 80% = 6% 2. Strategy (a): Income will be reduced to $450,000 because of the loss, and invested capital will fall to $8,910,000 from the disposal. ROI = $450,000 $8,910,000, or 5.05%. This strategy should be rejected, since it further hurts Washburns performance. Strategy (b): In terms of ROI, this strategy neither hurts nor helps. The acceleration of overdue receivables increases cash decreases and accounts receivable, producing no effect on invested capital. Of course, it is possible that the newly acquired cash could be invested in something that would provide a positive return for the firm. 3. Yes. A drastic cutback in advertising could lead to a loss of customers and a reduced market share. This could translate into reduced profits over the long term. With respect to repairs and maintenance, reduced outlays could prove costly by unintentional shortening of the useful lives of plant and equipment. Such action would likely result in an accelerated asset replacement program. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-23 PROBLEM 13-43 (CONTINUED) 4. Anderson Manufacturing ROI: ($4,500,000 - $3,600,000) $7,500,000 = 12% Palm Beach Enterprises ROI: ($6,750,000 - $6,180,000) $7,125,000 = 8% From the preceding calculations, both investments appear attractive given the current state of affairs (i.e., the Hardware Divisions current ROI of 6%). However, if Washburn desires to maximize ROI, he would be advised to acquire only Anderson Manufacturing. Current + Anderson $ 1,440,000* 16,500,000 8.73% Current + Anderson + Palm Beach $ 2,010,000** 23,625,000 8.51% Current Income. $ 540,000 Invested capital 9,000,000 ROI 6% * $540,000 + ($4,500,000 - $3,600,000) ** $540,000 + ($4,500,000 - $3,600,000) + ($6,750,000 - $6,180,000) PROBLEM 13-44 (35 MINUTES) 1. The weighted-average cost of capital (WACC) is defined as follows: After - tax Market Cost of Market cost of debt value + equity value of capital of debt capital equity Market Market value + value of debt of equity Weighted average = cost of capital The following calculation shows that the companys WACC is 9.72 percent. Weighted - average = cost of capital (.063)($400,000,000) + (.12)($600,000,000) = .0972 $400,000,000 + $600,000,000 McGraw-Hill/Irwin 13-24 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-44 (CONTINUED) 2. The three divisions economic-value-added measures are calculated as follows: After-Tax Operating Income (in millions) Total Current Economic Assets Liabilities Value WACC = (in (in Added millions) millions) (in millions) [($ 70 [($300 [($480 $6) $5) $9) .0972] .0972] .0972] = $ 3,579,200 = $ 2,826,000 = $(12,181,200) Division Pacific ...... $14 (1.30) Plains ....... $45 (1.30) Atlantic .... $48 (1.30) 3. The EVA analysis reveals that the Atlantic Division is in trouble. Its substantial negative EVA merits the immediate attention of the management team. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-25 PROBLEM 13-45 (35 MINUTES) 1. The weighted-average cost of capital (WACC) is defined as follows: After - tax cost Market Cost of Market value + equity value of debt of debt capital of equity capital Market Market value + value of debt of equity Weighted - average = cost of capital The interest rate on CCLSs $120 million of debt is 9 percent, and the companys tax rate is 40 percent. Therefore, the after-tax cost of debt is 5.4 percent [9% (140%)]. The cost of CCLSs equity capital is 14 percent. Moreover, the market value of the companys equity is $180 million. The following calculation shows that Cape Cod Lobster Shacks WACC is 10.56 percent. Weighted - average = cost of capital (.054)($120,000,000) + (.14)($180,000,000) = .1056 $120,000,000 + $180,000,000 2. The economic value added (EVA) is defined as follows: Investment Economic Investment center' s Investment Weighted - average value = after - tax center' s center' s cost of total assets added operating income current liabilities capital For Cape Cod Lobster Shacks, Inc., we have the following calculations of EVA for each of the companys divisions. After-Tax Operating Income (in millions) $43.5(1.40) $22.5(1.40) Current Liabilities (in millions) $4.5 $9 Economic Value Added (in millions) = = $3.6072 $4.3128 Division Properties Food Service Total Assets (in millions) $217.5 $ 96 WACC .1056 .1056 McGraw-Hill/Irwin 13-26 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-46 (25 MINUTES) 1. The Birmingham divisional manager will likely be opposed to the transfer. Currently, the division is selling all the units it produces at $1,550 each. With transfers taking place at $1,500, Birmingham will suffer a $50 drop in sales revenue and profit on each unit it sends to Tampa. Although Tampa is receiving a $50 price break on each unit purchased from Birmingham, the $1,500 transfer price would probably be deemed too high. The reason: Tampa will lose $40 on each satellite positioning system produced and sold. Sales revenue.. Less: Variable manufacturing costs. Transfer price paid to Birmingham Income (loss) 3. $1,340 1,500 $2,800 2,840 $ (40) 2. Although top management desires to introduce the positioning system, it should not lower the price to make the transfer attractive to Tampa. MTI uses a responsibility accounting system, awarding bonuses based on divisional performance. Top managements intervention/price-lowering decision would undermine the authority and autonomy of Birminghams and Tampas divisional managers. Ideally, the two divisional managers (or their representatives) should negotiate a mutually agreeable price. MTI would benefit more if it sells the diode reducer externally. Observe that the transfer price is ignored in this evaluationone that looks at the firm as a whole. Put simply, Birmingham would record the transfer price as revenue whereas Tampa would record the transfer price as a cost, thereby creating a wash on the part of the overall entity. Produce Diode; Sell Externally Sales revenue .................... Less: Variable cost:: $1,000 ....................... $1,000 + $1,340 ........ Contribution margin.......... $1,550 1,000 $ 550 2,340 $ 460 Produce Diode; Transfer; Sell Positioning System $2,800 4. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-27 PROBLEM 13-47 (40 MINUTES) 1. a. Transfer price = outlay cost + opportunity cost = $130 + $30 = $160 b. Transfer price = standard variable cost + (10%)(standard variable cost) = $130 + (10%) ($130) = $143 Note that the Frame Division manager would refuse to transfer at this price. 2. a. Transfer price = outlay cost + opportunity cost = $130 + 0 = $130 b. When there is no excess capacity, the opportunity cost is the forgone contribution margin on an external sale when a frame is transferred to the Glass Division. The contribution margin equals $30 ($160 $130). When there is excess capacity in the Frame Division, there is no opportunity cost associated with a transfer. Fixed overhead per frame (125%)($40) = $50 Transfer price = variable cost + fixed overhead per frame + (10%)(variable cost + fixed overhead per frame) = $130 + $50 + [(10%)($130 + $50)] = $198 d. Incremental revenue per window .................................. Incremental cost per window, for Weathermaster Window Company: Direct material (Frame Division)................................ Direct labor (Frame Division)..................................... Variable overhead (Frame Division) ......................... Direct material (Glass Division)................................. Direct labor (Glass Division)...................................... Variable overhead (Glass Division) .......................... Total variable (incremental) cost............................... Incremental contribution per window in special order for Weathermaster Window Company ....................... $310 $30 40 60 60 30 60 c. 280 $ 30 The special order should be accepted because the incremental revenue exceeds the incremental cost, for Weathermaster Window Company as a whole. McGraw-Hill/Irwin 13-28 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-47 (CONTINUED) e. Incremental revenue per window .................................. Incremental cost per window, for the Glass Division: Transfer price for frame [from requirement 2(c)] .... Direct material (Glass Division)................................. Direct labor (Glass Division)...................................... Variable overhead (Glass Division) .......................... Total incremental cost................................................ Incremental loss per window in special order for Glass Division......................................................... $ 310 $198 60 30 60 348 $ (38) The Glass Division manager has an incentive to reject the special order because the Glass Division's reported net income would be reduced by $38 for every window in the order. f. One can raise an ethical issue here to the effect that a division manager should always strive to act in the best interests of the whole company, even if that action seemingly conflicts with the divisions best interests. In complex transfer pricing situations, however, it is not always as clear what the companys optimal action is as it is in this rather simple scenario. 3. The use of a transfer price based on the Frame Division's full cost has caused a cost that is a fixed cost for the entire company to be viewed as a variable cost in the Glass Division. This distortion of the firm's true cost behavior has resulted in an incentive for a dysfunctional decision by the Glass Division manager. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-29 PROBLEM 13-48 (40 MINUTES) 1. Among the reasons transfer prices based on total actual costs are not appropriate as a divisional performance measure are the following: They provide little incentive for the selling division to control manufacturing costs, because all costs incurred will be passed on to the buying division. They often lead to suboptimal decisions for the company as a whole, because they can obscure cost behavior. Costs that are fixed for the company as a whole can be made to appear variable to the division buying the transferred goods. 2. Using the market price as the transfer price, the contribution margin for both the Mining Division and the Metals Division is calculated as follows: Mining Division Selling price .............................................................................. Less: Variable costs: Direct material .............................................................. Direct labor ................................................................... Manufacturing overhead ............................................. Transfer price ............................................................... Unit contribution margin ......................................................... Volume....................................................................................... Total contribution margin........................................................ *Variable overhead = $96 x 75% = $72 Variable overhead = $75 x 40% = $30 Note: the $15 variable selling cost that the Mining Division would incur for sales on the open market should not be included, because this is an internal transfer. $ 270 $ Metals Division 450 36 48 72* 0 $ 114 x 400,000 $45,600,000 18 60 30 270 $ 72 x 400,000 $28,800,000 McGraw-Hill/Irwin 13-30 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-48 (CONTINUED) 3. If RIRC instituted the use of a negotiated transfer price that also permitted the divisions to buy and sell on the open market, the price range for toldine that would be acceptable to both divisions would be determined as follows. The Mining Division would like to sell to the Metals Division for the same price it can obtain on the outside market, $270 per unit. However, Mining would be willing to sell the toldine for $255 per unit, because the $15 variable selling cost would be avoided. The Metals Division would like to continue paying the bargain price of $198 per unit. However, if Mining does not sell to Metals, Metals would be forced to pay $270 on the open market. Therefore, Metals would be satisfied to receive a price concession from Mining equal to the costs that Mining would avoid by selling internally. Therefore, a negotiated transfer price for toldine between $255 and $270 would be acceptable to both divisions and benefits the company as a whole. 4. General transfer-pricing rule: Transfer price = outlay cost + opportunity cost = ($36 + $48 + $72)* + ($114 - $15) ** = $156 + $99 = $255 *Outlay cost = direct material + direct labor + variable overhead [see requirement (2)] **Opportunity cost = forgone contribution margin from outside sale on open market = $114 contribution margin from internal sale calculated in requirement (2), less the additional $15 variable selling cost incurred for an external sale Therefore, the general rule yields a minimum acceptable transfer price to the Mining Division of $255, which is consistent with the conclusion in requirement (3). 5. A negotiated transfer price is probably the most likely to elicit desirable management behavior, because it will do the following: Encourage the management of the Mining Division to be more conscious of cost control. Benefit the Metals Division by providing toldine at a lower cost than that of its competitors. Provide the basis for a more realistic measure of divisional performance. 2005 The McGraw-Hill Companies, Inc. 13-31 McGraw-Hill/Irwin Managerial Accounting, 6/e PROBLEM 13-49 (30 MINUTES) 1. If the transfer price is set equal to the U.S. variable manufacturing cost, Delta Telecom will make $98.40 per circuit board: U.S. operation: Sales revenue (transfer price)... Less: Variable manufacturing cost.. Contribution margin. German operation: Sales revenue Less: Transfer price. Shipping fees. Additional processing costs.. Import duties ($390.00 x 10%) Income before tax. Less: Income tax expense ($246.00 x 60%).. Income after tax 2. $ 390.00 390.00 $ -$1,080.00 $390.00 60.00 345.00 39.00 834.00 $ 246.00 147.60 $ 98.40 If the transfer price is set equal to the U.S. market price, Delta will make $117.60 per circuit board: $72.00 + $45.60 = $117.60. The U.S. market price is therefore more attractive as a transfer price than the U.S. variable manufacturing cost. U.S. operation: Sales revenue. Less: Variable manufacturing cost.. Income before tax. Less: Income tax expense ($120.00 x 40%) Income after tax. German operation: Sales revenue Less: Transfer price. Shipping fees. Additional processing costs.. Import duties ($510.00 x 10%) Income before tax. Less: Income tax expense ($114.00 x 60%).. Income after tax $ 510.00 390.00 $ 120.00 48.00 $ 72.00 $1,080.00 $510.00 60.00 345.00 51.00 966.00 $ 114.00 68.40 $ 45.60 McGraw-Hill/Irwin 13-32 2005 The McGraw-Hill Companies, Inc. Solutions Manual PROBLEM 13-49 (CONTINUED) 3. (a) The head of the German division should be a team player; however, when the circuit board can be obtained locally for $465, it is difficult to get excited about doing business with the U.S. operation. Courtesy of the shipping fee and import duty, both of which can be avoided, it is advantageous to purchase in Germany. Even if the lower of the two transfer prices is adopted, the German division would be better off to acquire the circuit board at home ($465 vs. $390 + $60 + $39 = $489). Yes. Delta will make $180.00 per circuit board ($72.00 + $108.00) if no transfer takes place and all circuit boards are sold in the U.S. U.S. operation: Sales revenue. Less: Variable manufacturing cost.. Income before tax.. Less: Income tax expense ($120.00 x 40%) Income after tax. German operation: Sales revenue.. Less: Purchase price. Additional processing costs Income before tax... Less: Income tax expense ($270.00 x 60%).. Income after tax... 4. $ 510.00 390.00 $ 120.00 48.00 $ 72.00 $1,080.00 810.00 $ 270.00 162.00 $ 108.00 (b) $465.00 345.00 When tax rates differ, companies should strive to generate less income in high taxrate countries, and vice versa. When alternatives are available, this can be accomplished by a careful determination of the transfer price. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-33 SOLUTIONS TO CASES CASE 13-50 (40 MINUTES) 1. If New Age Industries continues to use return on investment as the sole measure of division performance, Fun Times Entertainment Corporation (FTEC) would be reluctant to acquire Recreational Leasing, Inc. (RLI), because the post-acquisition combined ROI would decrease. Return on Investment FTEC RLI Combined Operating income ................................................ $1,000,000 $ 300,000 $ 1,300,000 Total assets .......................................................... 4,000,000 1,500,000 5,500,000 Return on investment (income/assets) ............. 25% 20% 23.6%* *Rounded. The result would be that FTEC's management would either lose their bonuses or have their bonuses limited to 50 percent of the eligible amounts. The assumption is that management could provide convincing explanations for the decline in return on investment. 2. Residual income is the profit earned that exceeds an amount charged for funds committed to a business unit. The amount charged for funds is equal to an imputed interest rate multiplied by the business unit's invested capital. If New Age Industries could be persuaded to use residual income to measure performance, FTEC would be more willing to acquire RLI, because the residual income of the combined operations would increase. Residual Income FTEC RLI Combined $4,000,000 $1,600,000* $5,600,000 $1,000,000 $ 300,000 $1,300,000 600,000 $ 400,000 240,000 $ 60,000 840,000 $ 460,000 Total assets ..................................................... Income ............................................................. Less: Imputed interest charge (assets 15%) ............................................ Residual income ............................................. *Cost to acquire RLI. McGraw-Hill/Irwin 13-34 2005 The McGraw-Hill Companies, Inc. Solutions Manual CASE 13-50 (CONTINUED) 3. a. The likely effect on the behavior of division managers whose performance is measured by return on investment includes incentives to do the following: Put off capital improvements or modernization to avoid capital expenditures. Shy away from profitable opportunities or investments that would yield more than the company's cost of capital but that could lower ROI. b. The likely effect on the behavior of division managers whose performance is measured by residual income includes incentives to do the following: Seek any opportunity or investment that will increase overall residual income. Seek to reduce the level of assets employed in the business. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-35 CASE 13-51 (50 MINUTES) 1. Diagram of scenario: GENERAL INSTRUMENTATION CORPORATION Top Management HUDSON BAY DIVISION Jacqueline Ducharme VOLKMAR TACHOMETER DIVISION Bertram Mueller Alternative 1: Transfer the HDP LowDensity Panels (LDP) HighDensity Panels (HDP) Alternative 2: Buy the Control Pack TCH-320 Tachometer Control Pack Imported from Japan Outside Market Outside Market Outside Market 2. First, compute the unit contribution margin of an LDP and an HDP as follows: LDP Price ...................................................................... Less: Variable cost: Unskilled labor........................................... Skilled labor ............................................... Raw material .............................................. Purchased components............................ Variable overhead ..................................... Total variable cost..................................... Unit contribution margin..................................... $28 $5 5 3 5 4 $5 30 8 15 12 HDP $ 115 22 $6 70 $ 45 McGraw-Hill/Irwin 13-36 2005 The McGraw-Hill Companies, Inc. Solutions Manual CASE 13-51 (CONTINUED) Second, compute the unit contribution margin of Volkmar's TCH-320 under each of its alternatives, as follows: TCH-320 Using Imported Control Pack $275.00 $ 4.50 51.00 10.50 150.00 12.00 -0-0TCH-320 Using an HDP $275.00 $ 4.50 85.00 5.00 5.00 12.00 70.00 4.50 Price .............................................................. Less: Variable cost: Unskilled labor .................................. Skilled labor....................................... Raw material...................................... Purchased components ................... Variable overhead ............................. Variable cost of manufacturing HDP Variable cost of transporting HDP .. Total variable cost ............................ Unit contribution margin............................. 228.00 $ 47.00 186.00 $ 89.00 Difference is $42. From the perspective of the entire company, the scarce resource that will limit overall company profit is the limited skilled labor time available in the Hudson Bay Division. The question, then, is how can the company as a whole best use the limited skilled labor time available at Hudson Bay? The division has two products: LDP and HDP. One can view these as three products, though, in the sense that the HDP units can be produced either for outside sale or for transfer to the Volkmar Tachometer Division. Hudson Bay's "Three" Products HDP for external sale HDP for transfer LDP McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-37 CASE 13-51 (CONTINUED) What is the unit contribution to covering the overall company's fixed cost and profit from each of these three products? The calculations above show that the unit contribution margin of an LDP is $6, and the unit contribution of an HDP sold externally is $45. Moreover, the unit contribution to the overall company of an HDP produced for transfer is $42, which is the increase in the unit contribution margin of the TCH-320 when it is manufactured with the HDP instead of the imported control pack. To summarize: Unit Contribution to Covering the Company's Fixed Cost and Profit $45 42 6 Hudson Bay's Product HDP sold externally HDP transferred internally LDP The analysis of these three products' contribution margins (to General Instrumentation as a whole) has not gone far enough, because the products do not require the same amount of the scarce resource, skilled labor time. The important question is how much one hour of limited skilled labor at Hudson Bay spent on each of the three products will contribute toward the overall firm's fixed cost and profit. Unit Contribution Margin $45 42 6 Skilled Labor per Unit Required at Hudson Bay 1.50 1.50 .25 Contribution Margin per Hour $30 28 24 Hudson Bay's Product HDP sold externally HDP transferred internally LDP McGraw-Hill/Irwin 13-38 2005 The McGraw-Hill Companies, Inc. Solutions Manual CASE 13-51 (CONTINUED) This analysis shows that from the perspective of the entire company, Hudson Bay's best use of its limited skilled labor resource is to produce HDPs for external sale, up to the maximum demand of 6,000 units per year. The second best use of Hudson Bay's limited skilled labor is to produce HDPs for internal transfer, up to the maximum number of units needed by the Volkmar Tachometer Division. This number is 10,000 HDPs, since that is the demand for Volkmar's TCH-320. Hudson Bay's least profitable product is the LDP. Therefore, from the perspective of General Instrumentation as a whole, the Hudson Bay Division should use its limited skilled labor time as follows: (1) (2) (3) Skilled labor time available at Hudson Bay ................................... Produce 6,000 HDPs for external sale (6,000 units 1.5 hours) ................................................................ Hours remaining ............................................................................... Produce 10,000 HDPs for internal transfer (10,000 units 1.5 hours) .............................................................. Hours remaining ............................................................................... Produce 64,000 LDPs (64,000 units .25 hours)........................... Hours remaining ............................................................................... 40,000 hours 9,000 hours 31,000 hours 15,000 hours 16,000 hours 16,000 hours -0- The final answer to requirement (2) is that all of the required 10,000 TCH-320 tachometers should be manufactured using the HDP unit from the Hudson Bay Division. 3. Given that 10,000 HDPs are transferred, there is no effect on General Instrumentation Company's overall income. The transfer price affects only the way the company's overall profit is divided between the two divisions. Hudson Bay's minimum acceptable transfer price is given by the general transferpricing rule, as follows: additional outlay costs incurred = because goods + are transferred = $70 + $36 = $106 opportunity cost to the organization because of the transfer 4. Minimum acceptable transfer price McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-39 CASE 13-51 (CONTINUED) Explanatory notes: (a) (b) The outlay cost is equal to the variable cost of manufacturing an HDP. The opportunity cost is equal to the forgone contribution margin on the LDP units that Hudson Bay will be unable to produce because it is manufacturing an HDP for transfer. In the 1.5 hours of skilled labor time required to produce an HDP for transfer, Hudson Bay could manufacture six LDPs, since each LDP requires only .25 hours. Thus, the forgone contribution margin is $36 (6 units $6 unit contribution margin). 5. The maximum transfer price that the Volkmar Tachometer Division would find acceptable is $112, computed as follows: Savings if TCH-320 is produced using an HDP: Imported control pack.............................................................................. Other raw material.................................................................................... Total savings............................................................................................. Less: Incremental costs if TCH-320 is produced using an HDP: Transportation cost.................................................................................. Skilled labor .............................................................................................. Net savings if HDP is used ........................................................................... $145.00 5.50 $150.50 (4.50) (34.00) $112.00 If Volkmar's management must pay $112 for an HDP, it will be indifferent between using the HDP and the imported control pack. If the transfer price is lower than $112, the Volkmar Tachometer Division will be better off with the HDP. At a transfer price in excess of $112, Volkmar's management will prefer the control pack. 6. The transfer is in the overall company's best interest. Thus, any transfer price in the interior of the range $106 to $112 will provide the proper incentives to the management of each division to agree to a transfer. For example, a transfer price of $109 would split the range evenly, and make each division better off by making the transfer. McGraw-Hill/Irwin 13-40 2005 The McGraw-Hill Companies, Inc. Solutions Manual CASE 13-52 (45 MINUTES) 1. Yes, Air Comfort Division should institute the 5% price reduction on its air conditioner units because net income would increase by $264,000. Supporting calculations follow: Before 5% Price Reduction After 5% Price Reduction Sales revenue Variable costs: Compressor Other direct material Direct labor Variable overhead Variable selling Total variable costs Contribution margin Total Difference Per Total Per Total Unit (in thousands) Unit (in thousands) (in thousands) $800 $12,000 $760 $13,224.0 $1,224.0 $140 74 60 90 36 $400 $400 $ 2,100 $140 1,110 74 900 60 1,350 90 540 36 $ 6,000 $400 $ 6,000 $360 $ 2,436.0 1,287.6 1,044.0 1,566.0 626.4 $ 6,960.0 $ 6,264.0 $ 336.0 177.6 144.0 216.0 86.4 $ 960.0 $ 264.0 Summarized presentation: Contribution margin of sales increase ($360 2,400) Loss in contribution margin on original volume arising from decrease in selling price ($40 15,000) Increase in net income before taxes 2. $864,000 600,000 $264,000 No, the Compressor Division should not sell all 17,400 units to the Air Comfort Division for $100 each. If the Compressor Division does sell all 17,400 units to Air Comfort, Compressor will only be able to sell 57,600 units to outside customers instead of 64,000 units due to the capacity restrictions. This would decrease the Compressor Divisions net income before taxes by $71,000. Compressor Division would be willing to accept any orders from Air Comfort above the 64,000 unit level at $100 per unit because there would be a positive contribution margin of $43 per unit. Supporting calculations follow. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-41 CASE 13-52 (CONTINUED) Outside Sales Selling price ................................................................................. $200 Variable costs: Direct material............................................................................ 24 Direct labor ................................................................................ 16 Variable overhead ............................................................. 20 Variable selling expenses ........................................................ 12 Total variable costs .................................................................. $ 72 Contribution margin .................................................................... $128 Capacity calculation in units: Total capacity .............................................................................................. Sales to Air Comfort ................................................................................... Balance .................................................................................................... Projected sales to outsiders ..................................................................... Lost sales to outsiders .............................................................................. Solution: Contribution from sales to Air Comfort ($43 17,400) .......................... Loss in contribution from loss of sales to outsiders ($128 6,400) .... Decrease in net income before taxes ....................................................... 3. $748,200 819,200 $ 71,000 75,000 17,400 57,600 64,000 6,400 Air Comfort Sales $100 $ 21 16 20 $ 57 $ 43 Yes, it would be in the best interests of Continental Industries for the Compressor Division to sell the units to the Air Comfort Division at $100 each. The net advantage to Continental Industries is $625,000 as shown in the following analysis. The net advantage is the result of the cost savings from purchasing the compressor unit internally and the contribution margin lost from the 6,400 units that the Compressor Division otherwise would sell to outside customers. McGraw-Hill/Irwin 13-42 2005 The McGraw-Hill Companies, Inc. Solutions Manual CASE 13-52 (CONTINUED) Cost savings by using compressor unit from Compressor Division: Air Comfort Divisions outside purchase price ..................................... Compressor Divisions variable cost to produce (see req. 2). ............. Savings per unit......................................................................................... x Number of units ................................................................................. Total cost savings...................................................................................... Compressor Divisions loss in contribution from loss of sales to outsiders (see req. 2): $128 6,400 .................................. Increase in net income before taxes for Continental Industries ........... 4. 140 57 $ 83 x 17,400 $1,444,200 819,200 $ 625,000 $ As the answers to requirements (2) and (3) show, $100 is not a goal-congruent transfer price. Although a transfer is in the best interests of Continental Industries as a whole, a transfer of $100 will not be perceived by the Compressor Divisions management as in that divisions best interests. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-43 CURRENT ISSUES IN MANAGERIAL ACCOUNTING ISSUE 13-53 IS WOLVERINE HUMAN? A JUDGE ANSWERS NO; FANS HOWL IN PROTEST, THE WALL STREET JOURNAL, JANUARY 20, 2003, P. A1, A5, NEIL KING JR. Toy Biz, Inc. is strongly motivated to have its products classified as toys rather than dolls, as the former attract import duties of 6.8% while the latter attract duties almost twice as high, at 12%. These duties, which are variable costs for the importer, are not controllable. However, if the firm can convince U.S. Customs to classify the products in question as toys rather than dolls, it stands to significantly lower its costs, and can thereby either improve its profit margin or lower its sales prices. ISSUE 13-54 7-ELEVEN, AMID PRESSURES, MAKES BIG BETS, THE WALL STREET JOURNAL, APRIL 25, 2002, P. B4, ANN ZIMMERMAN. ROI is an often-used indicator for how well a business uses its invested capital to earn a profit. It can be improved by increasing sales margins, and/or decreasing invested capital or increasing capital turnover. 7-Eleven is planning large increase in capital investment to fund its technology systems in order to improve supply chain management and offer new services to customers. This action will (on its own) decrease ROI. Analysts are concerned that this negative effect on ROI will outweigh the improved sales margins expected from the improved supply chain management, and the improved sales revenue expected from the added customer services. Negative ROI expectations on the part of analysts may be harmful to the firm since it would make it more expensive for the firm to raise capital to fund growth projects through the equity markets. ISSUE 13-55 WELL-HIDDEN PERK MEANS BIG MONEY FOR TOP EXECUTIVES, THE WALL STREET JOURNAL, OCTOBER 11, 2002, P. A1, A9, ELLEN E. SCHULTZ AND THEO FRANCIS. Deferred-compensation plans are effective tools for retaining top executives, but tend to be less effective for encouraging high performance from those executives. In fact, there is an inherent tension associated with these plans as they are advantageous to executives but represent a poor use of capital for shareholders. Thus, executives may be considered to be acting against the best interests of shareholders when they introduce and support such plans. McGraw-Hill/Irwin 13-44 2005 The McGraw-Hill Companies, Inc. Solutions Manual Adding to the ethical tension is inadequate reporting standards set by the SEC. Shareholders are poorly informed of the real value of capital which is associated with these long-term liabilities, with footnotes in annual reports being the only source of data. Thus, not only is there a real possibility that executives are not acting in the best interests of the shareholders, but also that shareholders will not be able to accurately estimate the value of the deferred compensation plans for a given firm. ISSUE 13-56 WHAT'S A NEW ECONOMY WITHOUT RESEARCH?, FORTUNE, MAY 15, 2000, P. 92, STEWART ALSOP. Money invested in R&D is tied up for the long term and cannot be turned over many times generating more profit in the short-run. With the current pressures on CEOs to add value to their companies, short-term investments look better on the balance sheet in the short-run. McGraw-Hill/Irwin Managerial Accounting, 6/e 2005 The McGraw-Hill Companies, Inc. 13-45 ... View Full Document

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