Div a 25 200 x 10 5000 div b 100 1085 x 10 8500 div c

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Div. A 25 - (200 x .10) = $5,000 Div. B 100 - (1,085 x .10) = –$8,500 Div. C 65 - (995 x .10) = –$34,500 Based exclusively on R.I., Div. B performed the best as it has the highest R.I. (of $5,000) c. Operating income is used as it ignores interest expense (EBIT means earnings before interest and taxes). Interest expense , being the consequence of how the operating assets are financed does not relate to the efficiency or effectiveness of how the division is run . Head office makes the decision as to how assets are to be financed. Were interest expense to be deducted in deriving the measure of income used for performance evaluation, divisions financed with equity would show higher returns (as equity financing does not cause interest/financing costs in deriving net income). Further, a fundamental principal in
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9 performance appraisal is that managers should only be held accountable for matters they have control over , as the financing decision is not make by the manager, s/he should not be held accountable for the cost of financing . d. Wealth creation means you are earning a rate of return that exceeds the risk adjusted required rate of return . Net income ignores the costs of equity financing and only deducts the cost of debt financing (interest expense). Consequently firms can have a positive net income but negative residual income (or EVA). EVA subtracts an imputed capital charge for equity financing . In the long run a firm must earn a rate of return which exceeds the required rate of return on shareholders, if it does not it will eventually go bankrupt as shareholder and creditors will not provide necessary financing to keep the firm alive . Question 3 (23 marks) Segmented Reporting a. Total Company East District West District Sales ($20 per unit) $500,000 (100%) $300,000 (100%) $200,000 (100%) Less variable expenses: Cost of good sold ($9 per unit) 225,000 (45%) 135,000 (45%) 90,000 (45%) Shipping 26,000 (5.2%) 11,000 (3.7%) 15,000 (7.5%) Sales commissions 50,000 (10%) 30,000 (10%) 20,000 (10%) Order processing (1) 17,500 (3.5%) 15,000 (5%) 2,500 (1.25%) Total variable expenses 318,500 (63.7%) 191,000 (63.7%) 127,500 (63.75%) Contribution margin 181,500 (36.3%) 109,000 (36.3%) 72,500 (36.25%) Less traceable fixed expenses: Sales salaries (2) 6,000 (1.2%) 4,000 (1.3%) 2,000 (1%) District advertising 50,000 (10%) 20,000 (6.7%) 30,000 (15%) District sales mgmt salaries 25,000 (5%) 10,000 (3.3%) 15,000 (7.5%) Total traceable fixed expenses 81,000 (16.2%) 34,000 (11.3%) 47,000 (23.5%) District segment margin 100,500 (20.1%) 75,000 (25%) 25,500 (12.75%) Less common fixed expenses: Warehouse rent (3) 40,000 (8%) Central office expenses (4) 62,500 (12.5%) Total common fixed expenses 102,500 (20.5%) Operating income (loss) $(2,000) (0.4%) NOTE: A percentage column is NOT required; however, calculation of selective ones that would be expected to go up/down (vary) with sales would be “attention-directing” for management. (1) $17,500 order processing costs / 3,500 orders = $5 per order $5 per order x 3,000 orders; and, 500 orders (2) Each salesperson earns $500 per month. 8 salespersons; and, 4 salespersons. (3) Avoid arbitrary cost allocations; thus, treat as common fixed expense. (4) $80,000 - $17,500 variable order processing costs = $32,500
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10 b. The following points can be brought to the attention of management: (i) Based on the analysis below, East District is taking many small orders, resulting in a contribution margin per order that is only one-fourth that of West District. Given the high variable cost of processing an order ($5 vs. $9 cost of goods sold), the sales staff should try to get customers to order less frequently in larger amounts.
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