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1. In a centralized operation, all major planning and operating decisions are made by top managementIn a decentralized operation, managers of separate divisions or units are delegated operating responsibility. The division (unit) managers are responsible for planning and controlling theoperations of their divisions. Divisions are often structured around products, customers, or regions.
2. The department manager of a profit center has responsibility for and authority over costs and revenues, while the manager of an investment center has responsibility for and authority over controlling investments in assets as well as costs and revenues.
3. Payroll: Number of checks issued. Accounts payable: Number of invoices paid. Accounts receivable: Number of sales invoices collected. Database administration: Number of reportsgenerated.
4. The major shortcoming of using income from operations as a measure of investment center performance is that it ignores the amount of investment committed to each center. Since investment center managers also control the amount of assets invested in their centers, they should be held accountable for the use of invested assets.
5. A division of a decentralized company could be considered the least profitable, even though it earned the largest amount of income from operations, when its rate of return on investment is the lowest. In this situation, the division would be considered the least profitable per dollar invested in the division because it generated less profit out of each dollar of assets invested.
6. By dividing income from operations by the amount of invested assets, each division is placed on a comparable basis of income from operations per dollar invested.
7. A balanced scorecard can indicate the underlying causes of financial performance from innovation and learning, customer, internal, and financial perspectives. In addition, a balanced set of measures helps managers consider trade-offs between short- and long-term financial performance and focuses on forward-looking measure as a prior performance (financial) measures.
8. The objective of transfer pricing is to encourage each division manager to work in the best interests of the company. Thus, transfer prices should encourage managers to transfer goods between divisions if the overall company income can be increased.
9. When unused capacity exists in the supplying division, the negotiated price approach is preferred over the market price approach.
10. When using the negotiated price approach to transfer pricing, the transfer price should be less than the market price but greater than the supplying division’s variable cost per unit.
Commercial Division Service Charge for Computer Technology Department:$145,200 = 1,375 billed hours × ($264,000 ÷ 2,500 hours billed)
PE 23–3A (FIN MAN); PE 8–3A (MAN)Northeast PacificDivision Division
Sales……………………………………………………… $1,155,000 $1,204,000Cost of goods sold…………………………………… 590,800 658,000Gross profit……………………………………………… $ 564,200 $ 546,000Selling expenses……………………………………… 231,000 252,000Income from operations before service
department charges………………………………… $ 333,200 $ 294,000Service department charges………………………… 195,750 239,250Income from operations……………………………… $ 137,450 $ 54,750
CHAPTER 23 Performance Evaluation for Decentralized Operations
PE 23–3B (FIN MAN); PE 8–3B (MAN)Retail Commercial
Division Division
Sales……………………………………………………… $945,000 $966,000Cost of goods sold…………………………………… 504,000 559,300Gross profit……………………………………………… $441,000 $406,700Selling expenses……………………………………… 156,800 175,000Income from operations before service
department charges………………………………… $284,200 $231,700Service department charges………………………… 118,800 145,200Income from operations……………………………… $165,400 $ 86,500
PE 23–4A (FIN MAN); PE 8–4A (MAN)a. Profit Margin = $96,000 ÷ $1,200,000 = 8.0%b. Investment Turnover = $1,200,000 ÷ $400,000 = 3.0c. Rate of Return on Investment = 8.0% × 3.0 = 24%
PE 23–4B (FIN MAN); PE 8–4B (MAN)a. Profit Margin = $36,000 ÷ $720,000 = 5.0%b. Investment Turnover = $720,000 ÷ $180,000 = 4.0c. Rate of Return on Investment = 5.0% × 4.0 = 20%
PE 23–5A (FIN MAN); PE 8–5A (MAN)Income from operations…………………………………………………………………… $90,000Less: Minimum acceptable income from operations as a
percent of assets ($450,000 × 10%)……………………………………………………… 45,000Residual income……………………………………………………………………………… $45,000
PE 23–5B (FIN MAN); PE 8–5B (MAN)Income from operations…………………………………………………………………… $420,000Less: Minimum acceptable income from operations as a
percent of assets ($910,000 × 8%)……………………………………………………… 72,800Residual income……………………………………………………………………………… $347,200
Schedules of supporting calculations (answers in italics; the solution requires working from the department level, up to the plant level, then to the vice president of production level):
UnderBudget
Mid-Atlantic Region $ 747,000 $1,800West Region 532,800 2,880South Region (g) 596,256 (h) $4,200 (i)
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–1 (FIN MAN); Ex. 8–1 (MAN) (Concluded)
UnderBudget
Factory wagesMaterials $864Power and lightMaintenance
$864
b. MEMOTo: Holly Keller, Vice President of Production
The South Region plant has experienced a budget overrun, while the Mid-Atlantic and West Region plants have experienced a budget surplus. The budget of the South Region plant reveals that the Chip Fabrication Department causes the majorityof the budget overrun. The budget for the Chip Fabrication Department indicates that the budget overrun was caused by a combination of budget overruns in wages, power and light, and maintenance that exceeded a budget surplus in materials. The supervisor of the Chip Fabrication Department should investigate the reasons for the budget overruns in wages, power and light, and maintenance. It is possible that all three of these budget overruns have the same cause, such as a need for unplanned overtime or weekend work to meet schedules.
Ex. 23–2 (FIN MAN); Ex. 8–2 (MAN)
ResidentialDivision
Net sales $595,000Cost of goods sold 338,940Gross profit $256,060Administrative expenses 102,900Income from operations before service
department charges $153,160Service department charges 54,264Income from operations $ 98,896
90,048$ 141,512
$1,083,600732,200
$ 351,400119,840
$ 231,560
For the Year Ended June 30, 2014Commercial
Division
ENDLESS RIVER CONSTRUCTION COMPANYDivisional Income Statements
a. Legal Number of hoursb. Duplication services Number of pagesc. Electronic data processing Central processing unit (CPU) time, number of
printed pages, amount of memory usaged. Central purchasing Number of requisitions, number of purchase orderse. Telecommunications Number of lines, number of minutesf. Accounts receivable Number of invoices, number of customers
Ex. 23–4 (FIN MAN); Ex. 8–4 (MAN)a. 1 e. 8b. 4 f. 5c. 6 g. 3d. 7 h. 2
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–5 (FIN MAN); Ex. 8–5 (MAN)Government
a. Residential Commercial Contract Total
Number of payroll checks:Weekly payroll × 52………… 13,000 6,500 7,800Monthly payroll × 12………… 600 1,200 720
Total……………………… 13,600 7,700 8,520 29,820Number of purchase
requisitions per year………… 3,750 3,125 2,750 9,625
Service Activity Chargeb. Dept. Cost ÷ Base = Rate
Service department charge rates:Payroll Department………………………… $119,280 ÷ 29,820 = $4.00/checkPurchasing Department…………………… $57,750 ÷ 9,625 = $6.00/req.
GovernmentResidential Commercial Contract Total
Service department charges:Payroll Department………… $54,400 $30,800 $34,080 $119,280Purchasing Department…… 22,500 18,750 16,500 57,750
Total……………………… $76,900 $49,550 $50,580
1 13,600 checks × $4.00 per check2 7,700 checks × $4.00 per check3 8,520 checks × $4.00 per check4 3,750 requisitions × $6.00 per requisition5 3,125 requisitions × $6.00 per requisition6 2,750 requisitions × $6.00 per requisition
The service department charges are determined by multiplying the servicedepartment charge rate by the activity base for each division.
c. Residential’s service department charge is higher than the other two divisions because Residential is a heavy user of service department services. Residential has many employees on a weekly payroll, which translates into a larger number of check-issuing transactions. This may be because residential jobs are less productive per labor hour, compared to larger commercial and government contract jobs. Additionally, Residential uses purchasing services more than the other two divisions. This may be because the division has many different smaller jobs requiring frequent purchase transactions.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–8 (FIN MAN); Ex. 8–8 (MAN)a. The reported income from operations does not accurately measure performance
because the service department charges are based on revenues. Revenues are not associated with the profit center manager’s use of the service department services. For example, the Reservations Department serves only the Passenger Division. Thus, by charging this cost on the basis of revenues, these costs are incorrectly charged to the Cargo Division. Additionally, the Passenger Division requires additional personnel. Since these personnel must be trained, the training costs assigned to the Passenger Division should be greater than the Cargo Division.
b.
Revenues $3,025,000 $3,025,000Operating expenses 2,450,000 2,736,000Income from operations
before service departmentcharges $ 575,000 $ 289,000
Note (2) Winter Sports Division: (20,400 bills of lading × $14.00 per bill of lading)Summer Sports Division: (22,100 bills of lading × $14.00 per bill of lading)
Note (3) Winter Sports Division: (13,120 invoices × $7.50 per invoice)Summer Sports Division: (18,880 invoices × $7.50 per invoice)
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–13 (FIN MAN); Ex. 8–13 (MAN)
SalesInvested Assets
$1,750,000 $7,000,000$7,000,000 $5,000,000
ROI = 25% × 1.40
ROI = 35%
b. The profit margin would increase from 25% to 30%, the investment turnover would remain unchanged, and the rate of return on investment would increase from 35% to 42%, as shown below.
SalesInvested Assets
$2,100,000 $7,000,000$7,000,000 $5,000,000
ROI = 30% × 1.40
ROI = 42%
a. Rate of Returnon Investment = Profit Margin × Investment Turnover
×
ROI = ×
=Rate of Returnon Investment Sales
Income from Operations
Rate of Returnon Investment = Profit Margin × Investment Turnover
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–14 (FIN MAN); Ex. 8–14 (MAN)
RevenuesInvested Assets
$6,146 $18,714$18,714 $27,244
= 32.8% × 0.69
= 22.6% (rounded)
$1,553 $11,797$11,797 $19,530
= 13.2% × 0.60
= 7.9% (rounded)
$618 $6,351$6,351 $12,221
= 9.7% × 0.52
= 5.0% (rounded)
$816 $3,049$3,049 $4,992
= 26.8% × 0.61
= 16.3% (rounded)
b. The four sectors are different from each other. Media Networks combines a good profit margin with a very low investment turnover. Media Networks is sensitive to advertising revenue, while the Studio Entertainment sector is sensitive to producingbox office hits. The Parks and Resorts sector has a good profit margin at 13.2% with a fairly low investment turnover. The combination produces a respectable ROI of 7.9%.Studio Entertainment has a weak profit margin and a weak investment turnover generating only a 5% return on investment. The Consumer Products division combinesa good profit margin with a good investment turnover. The combination produces a sound ROI of 16.3%.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–17 (FIN MAN); Ex. 8–17 (MAN)
RevenuesInvested Assets
$571 $4,383$4,383 $6,440
= 13.0% × 0.68
= 8.8% (rounded)
$105 $688$688 $2,139
= 15.3% × 0.32
= 4.9% (rounded)b. Vacation
Ownership
Income from operations…………………………… $105Less: Minimum return (5% of assets)…………… 107Residual income (loss)……………………………… $ (2)
* $6,440 × 5%
** $2,139 × 5%
c. The Vacation Ownership (VO) segment has the weakest return on investment, which is mainly the result of a weak investment turnover. The VO segment earns profit margins that are higher than the profit margins in the Hotel Ownership (HO) segment (15.3% vs. 13.0%). However, weak investment turnover is causing the ROI for the VO segment to be less than the assumed minimum acceptable return. The residual income is negative for VO, which is consistent with a ROI less than the acceptable 5% minimum return. This weak performance is due primarily to the deterioration in the real estate market that has occurred in recent years. The profit margin and investment turnover in the VO segment are closely tied to the strength of the real estate market and the overall economy, both of which deteriorated significantly in the preceding years.
The HO segment ROI is also affected by the global economy, but is still generatinga solid ROI. Stable profit margins and investment turnover generate a ROI that is above the minimum acceptable return. The residual income is positive, which is consistent with a ROI that is greater than the 5% minimum return.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–18 (FIN MAN); Ex. 8–18 (MAN)Although there is some judgment in classifying each of these measures, the following represents the author’s assessment with explanations:
Average card member spending Customer—demonstrates the usefulness of the card to the customer.
Cards in force Customer—if customers did not value thecard, they would not have one.
Earnings growth Financial
Hours of credit consultant training Internal process—advisors will do their job better if they are trained.
Investment in information technology Internal process (or innovation)—shows theinvestment in improving processes.
Number of Internet features Internal process (or innovation)—shows new process investments in a new channel.
Number of merchant signings Customer—the larger the number of merchants that honor the card, the more valuable it is to cardholders.
Number of card choices Customer—more choices are more valuable to customers.
Number of new card launches Innovation—measures the new cards (affinity, regional, etc.) being developed and marketed.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–19 (FIN MAN); Ex. 8–19 (MAN)a. UPS wanted a performance measurement system that would focus more on
the underlying drivers, or levers, of financial success. It believed that focusing on the financial numbers by themselves would not reveal how financial objectives were to be achieved, especially with new demands coming from customers in the Internet age. The balanced scorecard provides information on how the financial targets are to be achieved. Using common measures throughout the organization also aligns the organization, while simultaneously communicating priorities. Apparently, UPS determined that its future success as an organization depended on “point of arrival” measures. These measures emphasized customer performance to a much higher degree than would straight financial numbers.
b. The employee sentiment number is common in service businesses. The employees are the face of the company to the customer. If employees feel poorly about the organization, or if they feel that they don’t make a difference, then they are not likely to deliver premium service experiences to their customers. Just think of the variety of fast food experiences you may have had in the past month. Sometimes, the service is excellent with a smile; at other times, it’s poor with a scowl. Measuring the improving employee morale is critical to organizations relying on front-line employees that deliver the customer experience.
Ex. 23–20 (FIN MAN); Ex. 8–20 (MAN)a. Increase in Dart Industries’ Market Variable Cost Unit
Income from Operations = Price – per Unit × Transferred
$2,200,000 = ($180 – $125) × 40,000
b. Increase in the Instrument Division’s Market Transfer UnitIncome from Operations = Price – Price × Transferred
$1,400,000 = ($180 – $145) × 40,000
c. Increase in the Components Division’s Transfer Variable Cost UnitIncome from Operations = Price – per Unit × Transferred
CHAPTER 23 Performance Evaluation for Decentralized Operations
Ex. 23–21 (FIN MAN); Ex. 8–21 (MAN)a. Increase in Dart Industries’ Market Variable Cost Units
Income from Operations = Price – per Unit × Transferred
$2,200,000 = ($180 – $125) × 40,000
This amount is the same amount by which Dart Industries’ income from operationsincreased in Ex. 23–20 (FIN MAN); Ex 8–20 (MAN), when a transfer price of $145 was used.
b. Increase in the Instrument Division’s Market Transfer UnitsIncome from Operations = Price – Price × Transferred
$880,000 = ($180 – $158) × 40,000
This is the amount the Instrument Division saves by purchasing from the Components Division at an internal price that is lower than the market price.
c. Increase in the Components Division’s Transfer Variable Cost UnitsIncome from Operations = Price – per Unit × Transferred
$1,320,000 = ($158 – $125) × 40,000
This is the amount the Components Division earns by using available excess capacity to produce and sell products above variable cost to the Instrument Division.
d. Any transfer price will cause the total income of the company to increase, as long as the supplier division capacity is used toward making materials forproducts that are ultimately sold to the outside. However, transfer prices should be set between variable cost and selling price in order to give the division managers proper incentives. A transfer price set below variable cost would cause the supplier division to incur a loss, while a transfer price set above market price would cause the purchasing division to incur opportunity costs. Neither situation is an attractive alternative for an investment center manager. Thus, the general rule is to negotiate transfer prices between variable cost and market price when the supplier division has excess capacity. The range of acceptable transfer prices for Dart Industries would be between $180 and $125.
2. The customer service and marketing salaries are significantly over budget. The director should investigate the cause of these results. One possibility is that the company is having an increase in sales, requiring greater marketing effort and customer service. However, the warehouse and distribution costs have not shown similar increases. Thus, it’s also possible that marketing and customer service salaries are increasing because of service problems and unplanned efforts to market the company’s service.
Note: The Shareholder Relations Department and general corporate officers’ salaries are not controllable by division management and thus are not included in determining division income from operations.
TRAXONIA RAILROAD INC.Divisional Income Statements
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–2A (FIN MAN); Prob. 8–2A (MAN) (Concluded)2. The CEO evaluates the three divisions using income from operations as a
percent of revenues (profit margin). This measure is calculated for the three divisions as follows:East Division: 16% ($139,200 ÷ $870,000)West Division: 18% ($185,760 ÷ $1,032,000)Central Division: 23% ($430,560 ÷ $1,872,000)
According to the CEO’s measure, the Central Division has the highest performance.
3. To: CEOThe method used to evaluate the performance of the divisions should be reevaluated. The present method identifies the amount of income from operations per dollar of earned revenue. However, this company requires a significant investment in fixed assets, for production, and distribution facilities. The amount of assets may not be related to the revenue earned. The presentmeasure fails to incorporate these differences in asset utilization into the measure. Naturally, the amount of assets used by a division in earning a return is a very important consideration in evaluating divisional performance. Therefore, a better divisional performance measure would be either (a) rate of return on investment (income from operations divided by divisional assets) or (b) residual income (income from operations less a minimal return on divisional assets). Both measures incorporate the assets used by the divisions.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–3A (FIN MAN); Prob. 8–3A (MAN) (Concluded)3. Per dollar of invested assets, the Electronic Brokerage Division is the most
profitable of the three divisions. Assuming that the rates of return on investments do not change in the future, an expansion of the Electronic Brokerage Division will return 24 cents (24%) on each dollar of invested assets, while the Mutual Fund and Investment Banking divisions will return only 22.4 cents (22.4%) and 21.6 cents (21.6%), respectively. Thus, when faced with limited funds for expansion, management should consider an expansion of the Electronic Brokerage Division first.
Note to Instructors: The Mutual Fund Division has excellent profit margins, but the investment turnover is very low. The investment in the “bricks and mortar” of the Mutual Fund Division offices causes the rate of return on investment to be depressed. However, the Electronic Brokerage Division has very thin margins because the fees earned per trade are very small. However the assets requiredto execute trades are much less than the Mutual Fund Division because there is noneed for offices (trades are executed over the Internet). As a result of the high investment turnover in the Electronic Brokerage Division, the rate of return on investment is much better.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–5A (FIN MAN); Prob. 8–5A (MAN) (Concluded)4. On the basis of income from operations, the Consumer Division generated
$107,000 ($357,000 – $250,000) more income from operations than did the Business Division. However, income from operations does not consider the amount of invested assets in each division. On the basis of the rate of return on investment, the Business Division earned 20 cents (20.0%) on each dollar of invested assets, while the Consumer Division earned only 16.8 cents (16.8%) on each dollar of invested assets. Although the Consumer Division has a higher profit margin than the Business Division (14.0% vs. 10.0%), the Business Division has a higher investment turnover (2.0 vs. 1.2), which generated its higher rate of return on investment. Residual income can be viewed as a combination of the preceding two performance measures. Residual income considers the absolute dollar amount of income from operations generated by each division and also considers a minimum rate of return to be earned by each division. On the basis of residual income, the Business Division is the onlyprofitable division.
Sales:14,400 units × $144 per unit $2,073,600 $2,073,6002,880 units × $115 per unit 331,200 331,20021,600 units × $275 per unit $5,940,000 5,940,000
$2,404,800 $5,940,000 $8,344,800Expenses:
Variable:17,280 units × $104 per unit $1,797,120 $1,797,1202,880 units × $158* per unit 455,040 455,04018,720 units × $193** per unit 3,612,960 3,612,960
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–6A (FIN MAN); Prob. 8–6A (MAN) (Concluded)4. The Consumer Division’s income from operations would increase by $63,360:
Increase in Consumer Variable(Supplying) Division’s Transfer Cost Units
Income from Operations = Price – per Unit × Transferred
$63,360 = ($126 – $104) × 2,880
By selling to the Commercial Division, the Consumer Division earns $22 per unit on these sales.
The Commercial Division’s income from operations would increase by $69,120:
Increase in Commercial(Purchasing) Division’s Market Transfer UnitsIncome from Operations = Price – Price × Transferred
$69,120 = ($150 – $126) × 2,880
By purchasing from the Consumer Division, the Commercial Division saves $24per unit on its purchases.
Garcon Inc.’s total income from operations would increase by the same amount as in part (2), $132,480:
VariableIncrease in Garcon Market Cost Units
Income from Operations = Price – per Unit × Transferred
$132,480 = ($150 – $104) × 2,880
The increase in total company income from operations is also equal to the sum of the increases in the division incomes from operations.
5. a. Any transfer price greater than the Consumer Division’s variable expenses per unit of $104 but less than the market price of $150 would be acceptable.
b. If the division managers cannot agree on a transfer price, a price of $127 would be the best compromise. In this way, each division’s income from operations would increase by $66,240*.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–1B (FIN MAN); Prob. 8–1B (MAN)
1.
Over UnderBudget Actual Budget Budget
Sales salaries $ 819,840 $ 818,880 $ 960System administration salaries 448,152 447,720 432Customer service salaries 152,600 183,120 30,520Billing salaries 98,760 98,100 660Maintenance 271,104 273,000 1,896Depreciation of plant and
equipment 92,232 92,232Insurance and property taxes 41,280 41,400 120
Total $1,923,968 $1,954,452 $32,536 $2,052
2. The customer service salaries exceed the budget by 20% of budget ($30,520 ÷ $152,600). The manager should request additional detailed information about the customer service department. There are several possible reasons for the budget variance. The manager should determine if the cause is related to an increase in salaries or an increase in time incurred by additional employees. If the latter, the manager may wish to determine if there has been an increase in customer service problems, hence a need to hire additional people. Such information could be used by the manager to solve customer service complaints and to reduce the number of future complaints.
ADELSON INC.Budget Performance Report—Supervisor, Eastern District
Note: The Treasurer’s Department and general corporate officers’ salariesare not controllable by division management and thus are not included in determining division income from operations.
THOMAS RAILROAD COMPANYDivisional Income Statements
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–2B (FIN MAN); Prob. 8–2B (MAN) (Concluded)2. The CEO evaluates the three regions using income from operations as a percent
of revenues. This measure is calculated for the three regions as follows:North Region: 20% ($756,000 ÷ $3,780,000)South Region: 12% ($680,760 ÷ $5,673,000)West Region: 16% ($820,800 ÷ $5,130,000)
Thus, according to the CEO’s measure, the North Region has the highest performance.
3. To: CEOThe method used to evaluate the performance of the regions should be reevaluated. The present method identifies the amount of income from operations per dollar of earned revenue. However, a railroad company requires a significant investment in fixed assets, such as track, engines, and railcars. In addition, the amount of assets may not be related to the revenue earned. For example, some regions may be able to concentrate assets in a densely populated regional area and run a high amount of traffic over those assets. Other regions, however, may have widely distributed assets over sparsely populated areas that run a small amount of traffic over those assets. The present measure fails to incorporate these differences in asset utilization into the measure. Naturally, the amount of assets used by a region in earning a return is a very important consideration in evaluating regional performance. Therefore, a better regional performance measure would be either (a) rate of return on investment (income from operations divided by regional assets) or (b) residual income (income from operations less a minimal return on regional assets). Both measures incorporate the assets used by the regions.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–3B (FIN MAN); Prob. 8–3B (MAN) (Concluded)3. Per dollar of invested assets, the Retail Bakeries Division is the most profitable
of the three divisions. Assuming that the rates of return on investments do not change in the future, an expansion of the Retail Bakeries Division will return 16.8 cents (16.8%) on each dollar of invested assets, while the Cereal and Snack Cake divisions will return only 12 cents (12%) and 15 cents (15%), respectively. Thus, when faced with limited funds for expansion, management should consider an expansion of the Retail Bakeries Division first.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–5B (FIN MAN); Prob. 8–5B (MAN) (Concluded)4. On the basis of income from operations, the Road Bike Division generated
$49,600 ($172,800 – $123,200) more income from operations than did the MountainBike Division. However, income from operations does not consider the amount of invested assets in each division. On the basis of the rate of return on investment, the Road Bike Division earned 12 cents (12.0%) on each dollar of invested assets, while the Mountain Bike Division earned 15.4 cents (15.4%) on each dollar of invested assets. Although the profit margin of the Road Bike Division exceeds the Mountain Bike Division (10.0% vs. 7.0%), the investment turnover in the Road Bike Division is much less than the Mountain Bike Division (1.2 vs. 2.2). The combination of these factors caused the Mountain Bike Division to have a higher return on investment than did the Road Bike Division. Residual income can be viewed as a combination of the absolute dollar amount of income from operations generated by each division and also considers a minimum rate of return to be earned by each division. On the basis of residual income, the Mountain Bike Division is the more profitable of the two divisions.
CHAPTER 23 Performance Evaluation for Decentralized Operations
Prob. 23–6B (FIN MAN); Prob. 8–6B (MAN) (Concluded)4. The Semiconductors Division’s income from operations would increase by
$62,640:
Increase in Semiconductors Variable(Supplying) Division’s Transfer Cost Units
Income from Operations = Price – per Unit × Transferred
$62,640 = ($340 – $232) × 580
By selling to the Navigational Systems Division, the Semiconductors Division earns $108 per unit on these sales.
The Navigational Systems Division’s income from operations would increaseby $53,360:
Increase in Navigational Systems(Purchasing) Division’s Market Transfer UnitsIncome from Operations = Price – Price × Transferred
$53,360 = ($432 – $340) × 580
By purchasing from the Semiconductors Division, the Navigational SystemsDivision saves $92 per unit on its purchases.
Exoplex Industries Inc.’s total income from operations would increase by the same amount as in (2), $116,000:
VariableIncrease in Ecoplex Industries Market Cost Units
Income from Operations = Price – per Unit × Transferred
$116,000 = ($432 – $232) × 580
The increase in total company income from operations is also equal to the sum of the increases in the division incomes from operations.
5. a. Any transfer price greater than the Semiconductors Division’s variable expenses per unit of $232 but less than the market price of $432 would be acceptable.
b. If the division managers cannot agree on a transfer price, a price of $332 would be the best compromise. In this way, each division’s income from operations would increase by $58,000*.
CHAPTER 23 Performance Evaluation for Decentralized Operations
CP 23–1 (FIN MAN); CP 8–1 (MAN)This scenario is a negotiation between two divisions. Dave is not behavingunethically by attempting to get a better price from the Semiconductor Division than from the market. He is not behaving unethically because he refuses market price. This may not seem “fair,” but price negotiation is a very typical business activity and is part ofof Dave’s job. It would be unethical only if the X-ray Division refused to deal with the Semiconductor Division to purposefully hurt the Semiconductor Division’s performance, so that X-ray could look good in comparison. This claim could only be supported if the X-ray Division’s refusal to purchase from the Semiconductor Division was economically unsound. For example, maybe there are no transportation costs because the Semiconductor Division plant is on site. In this case, the total cost to the X-ray Division would be less by purchasing from the Semiconductor Division. Refusing to do so could be the basis for claiming an ethical breach.
Because the X-ray Division has overall profit responsibility and authority. This meansthat the X-ray Division has the choice of purchasing from the inside or the outside. TheX-ray Division should have incentives to purchase from the inside in order to maximize overall corporate income. This means that the transfer price should be set below market price in order to give Dave an incentive to purchase from the Semiconductor Division. Howard’s refusal to budge on market price will likely hurt the Semiconductor Division and the company as a whole. If there are no alternative buyers, the Semiconductor Division should negotiate with the X-ray Division and accept a price lower than market price. This produces a win-win for both divisions. Thus, although neither party appears to be behaving unethically, Howard’s price position appears to be the weakest.
CHAPTER 23 Performance Evaluation for Decentralized Operations
CP 23–2 (FIN MAN); CP 8–2 (MAN)The Customer Service Department head is responsible for the quantity of service, but not the source of the service (i.e., not the price). Most accountants would hold the department head responsible for the cost by transferring the cost of the brochures to the Customer Service Department, even though the price is 25% higher than could be obtained from the outside. This may not seem fair, but it does control the use of internal services to some degree. If there were no internal transfer price, departments would view the Publications Department as a “free good.” This would likely result in an over demand for the service, since there would be no pricing discipline on the user groups. This does not mean that all is well. On the contrary, the Publications Department is free to pass on its inefficiencies, since it has a captive client. A possible change in policy would be to allow internal users to go to outside vendors for printing services. This would have the effect of bringing the pressures of competition to the internal service group. It would have to offer the service competitively, or watch its demand disappear. In this way, the internal publications group would have an incentive to be as cost effective as outside printers. Another possible change in policy would be to charge Publications Department services at standard cost. In this way, inefficiencies in the Publications Department would not be transferred to user departments.
CHAPTER 23 Performance Evaluation for Decentralized Operations
CP 23–3 (FIN MAN); CP 8–3 (MAN)1. The rate of return on invested assets is computed as follows:
Snack FrozenGoods Cereal Foods
Income from operations…………………… $ 396,000 $ 554,400 $ 420,000÷ Invested assets…………………………… 2,000,000 1,680,000 1,750,000ROI……………………………………………… 19.8% 33.0% 24.0%
The Cereal Division appears to be making the best use of invested assets, since its ROI is the highest.
2. Not all projects that have greater than a 19% rate of return would be accepted. This is because all three divisions have an ROI that is greater than 19%. Thus, any project that is accepted between the 19% minimum and their existing ROI would cause their ROI to drop. This is true because of averaging. There would be little incentive to accept such projects if the divisions know they are competing against each other on the basis of ROI.
3. There are two approaches to improving ROI: (1) improving the profit margin or (2) improving the investment turnover. For all three divisions, the profit marginis excellent:
However, the investment turnover is slow in all three divisions. The company doesn’t return many sales dollars per dollar invested in assets, as shown below.
Rate of return on investment (Profit margin × Investment turnover)………………………… 30.0% 25.2% 15.4%
4. Anna is concerned about the Norsk Division because the return on investment appearsto be deteriorating over the 2012–2014 operating periods. This is happening even thoughthe profit margin is increasing over this time period. In order for this to occur, theinvestment turnover must be dropping, which is the case in part (2).
The investment turnover is dropping faster than the profit margin is increasing, causingthe rate of return on investment to drop. It appears as though the Norsk Division is makivery large investments in the business, but it is not able to reap the returns required tosupport the investment. Specifically, it appears as if the revenues are not growing fastenough to support the underlying asset investment. The invested asset base almosttripled, while the revenues less than doubled over the same time period. The improving profit margins for each revenue dollar were not enough to make up for the revenue shortfall. The division may not be able to maintain the minimum threshold rate of return investment of 15% in the future. Anna is concerned because if the trend continues it is very possible that the division’s rate of return will fall below the minimum return on investment in the future.
CHAPTER 23 Performance Evaluation for Decentralized Operations
CP 23–5 (FIN MAN); CP 8–5 (MAN)
$4,860,000$27,000,000
ROI = 18.0%
or
$4,860,000 $32,400,000$32,400,000 $27,000,000
ROI = 15.0% × 1.2
ROI = 18.0%
2. $64,000 (8.0 × $8,000 = $64,000, where 8.0 = 18.0% – 10.0%, then rounded down to the lowest whole percentage)
$2,332,800$14,400,000
ROI = 16.2%
or
$2,332,800 $12,960,000$12,960,000 $14,400,000
ROI = 18.0% × 0.90
ROI = 16.2%
4. Even though the addition of the new product line would increase the overallcompany rate of return on investment, its addition would decrease the Specialty Products Division’s rate of return on investment from 18.0% to 17.4% ($7,192,800 ÷ $41,400,000). This decrease could negatively influence management’s evaluationof the division manager. In addition, this decrease in the division’s rate of return on investment would also decrease the division manager’s bonus by approximately$8,000 (1 × $8,000, where 1 = 18% – 17%).
ROI =
ROI =
Rate of Returnon Investment =
×
SalesInvested Assets
Income from Operations × Sales
1. = Invested AssetsIncome from OperationsRate of Return
CHAPTER 23 Performance Evaluation for Decentralized Operations
CP 23–5 (FIN MAN); CP 8–5 (MAN) (Concluded)5. Use of residual income as a performance measure and as the basis for granting
bonuses would motivate division managers to accept investment opportunities that exceed a minimum rate of return. If the minimum rate of return was set at 10%, the overall company average rate of return, any investment opportunity whose rate exceeded 10% would be viewed as acceptable. If this performance measure had been used, the Specialty Products Division manager would have increased the division’s residual income by $892,800 through the addition of the new product line, as shown below.
Projected income from operations of new product line……………………… $2,332,800Less: Minimum amount of desired income from operations
($14,400,000 × 10%)………………………………………………………………… 1,440,000Residual income from new product line………………………………………… $ 892,800
The manager’s bonus could then be calculated as a percent of residual income. In this case, a bonus equal to .9% of residual income would achieve a bonus similarto the initial plan:
Income from operations…………………………………………………………… $4,860,000Less: Minimum desired income (10% × $27,000,000)………………………… 2,700,000Residual income……………………………………………………………………… $2,160,000× Bonus percentage………………………………………………………………… 3.0%
Bonus…………………………………………………………………………………… $ 64,800
The new project would add 26,784 (3% × $892,800) to the bonus.
Income from operations with new product line………………………………… $2,332,800Less: Minimum desired income (10% × $14,400,000)………………………… 1,440,000Residual income……………………………………………………………………… $ 892,800
× Bonus percentage……………………………………………………………… 3.0%
Bonus…………………………………………………………………………………… $ 26,784
In addition, nonfinancial performance indicators about product quality and customer satisfaction can be used to supplement the financial numbers.