CHAPTER 24
PERFORMANCE EVALUATION FOR
DECENTRALIZED OPERATIONS
EYE OPENERS
1. In the cost center, the department manager
is responsible for and has authority over
costs only. In a profit center, the manager’s
responsibility and authority extend to costs
and revenues.
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 investments in assets as
well as costs and revenues.
3. The difference in budget performance reports prepared for department supervisors
and plant managers is the amount of detail
provided to each. The departmental supervisors require considerable detail to control
costs. The report for the plant managers
would contain more summarized cost data
for the various departments.
4. A cost center manager is not responsible for
making decisions concerning sales or the
amount of fixed assets invested in the center.
5. Payroll: Number of checks issued. Accounts
payable: Number of invoices paid. Accounts
receivable: Number of sales invoices collected. Database administration: Number of
reports.
6. 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.
7. Revenues and expenses are considered in
computing the rate of return on investment
because they directly impact the determination of income from operations. Invested assets are considered in computing the rate of
return on investment because they are the
base by which relative profitability is measured.
8. 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.
9. 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.
10. East Division. The East Division will return
26 cents (26%) on each dollar of invested
assets, while the Central and West divisions
will return only 20 cents and 15 cents, respectively. Thus, in expanding operations,
the East Division should be given priority
over the Central and West divisions.
11. 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.
12. 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.
13. When unused capacity exists in the supplying division, the negotiated price approach is
preferred over the market price approach.
14. Standard cost prevents the transfer of seller
efficiencies or inefficiencies to the purchasing division, thus isolating cost performance
to each division.
15. The transfer price should be less than the
market price but greater than the supplying
division’s variable cost per unit.
313
PRACTICE EXERCISES
PE 24–1A
$240,000 under budget ($200,000 + $40,000)
PE 24–1B
$80,000 over budget ($63,000 + $17,000)
PE 24–2A
Norsk Division Service Charge for Travel Department:
$67,500 = 750 billed reservations × ($180,000/2,000 reservations)
West Division Service Charge for Travel Department:
$112,500 = 1,250 billed reservations × ($180,000/2,000 reservations)
PE 24–2B
Computer Division Service Charge for Help Desk:
$56,000 = 2,000 billed hours × ($140,000/5,000 hours billed)
Peripheral Division Service Charge for Help Desk:
$84,000 = 3,000 billed hours × ($140,000/5,000 hours billed)
314
PE 24–3A
Net sales .......................................................
Cost of goods sold .......................................
Gross profit...................................................
Selling expenses ..........................................
Income from operations before service
department charges ..................................
Service department charges .......................
Income from operations ..............................
Norsk
Division
West
Division
$700,000
365,000
$335,000
142,500
$770,000
462,000
$308,000
173,000
$192,500
67,500
$125,000
$135,000
112,500
$ 22,500
PE 24–3B
Net sales .......................................................
Cost of goods sold .......................................
Gross profit...................................................
Selling expenses ..........................................
Income from operations before service
department charges ..................................
Service department charges .......................
Income from operations ..............................
Computer
Division
Peripheral
Division
$ 1,200,000
610,000
$ 590,000
264,000
$ 1,305,000
764,000
$ 541,000
245,000
$
$ 296,000
84,000
$ 212,000
$
326,000
56,000
270,000
PE 24–4A
a.
Profit Margin = $50,000/$500,000 = 10%
b. Investment Turnover = $500,000/$200,000 = 2.5
c.
Rate of Return on Investment = 10% × 2.5 = 25%
315
PE 24–4B
a.
Profit Margin = $20,125/$175,000 = 11.5%
b. Investment Turnover = $175,000/$87,500 = 2.0
c.
Rate of Return on Investment = 11.5% × 2.0 = 23.0%
PE 24–5A
Income from operations .....................................................................
Minimum acceptable income from operations as a percent
of assets ($440,000 × 12%)............................................................
Residual income ..................................................................................
$ 60,000
$
(52,800)
7,200
PE 24–5B
Income from operations .....................................................................
Minimum acceptable income from operations as a percent
of assets ($650,000 × 10%)............................................................
Residual income ..................................................................................
$135,000
(65,000)
$ 70,000
PE 24–6A
Increase in Astoria (Supplying)
Division’s Income from Operations = (Transfer Price – Variable Cost per Unit) ×
Units Transferred
Increase in Astoria (Supplying)
Division’s Income from Operations = ($35 – $28) × 20,000 units = $140,000
Increase in Laramie (Purchasing)
Division’s Income from Operations = (Market Price – Transfer Price) × Units
Transferred
Increase in Laramie (Purchasing)
Division’s Income from Operations = ($40 – $35) × 20,000 units = $100,000
316
PE 24–6B
Increase in High Point (Supplying)
Division’s Income from Operations = (Transfer Price – Variable Cost per Unit) ×
Units Transferred
Increase in High Point (Supplying)
Division’s Income from Operations = ($65 – $55) × 30,000 units = $300,000
Increase in Kenosha (Purchasing)
Division’s Income from Operations = (Market Price – Transfer Price) × Units
Transferred
Increase in Kenosha (Purchasing)
Division’s Income from Operations = ($75 – $65) × 30,000 units = $300,000
317
EXERCISES
Ex. 24–1
a.
(a) $104,800
(g) $327,040
(b) $107,440
(h) $330,320
(c) $2,640
(i) $3,280
(d) $327,040
(j) $1,040,640
(e) $330,320
(k) $1,042,320
(f) $3,760
(l) $3,280
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):
ILIAD COMPANY
Budget Performance Report—Vice President, Production
For the Month Ended April 30, 2010
Plant
Budget
Mid-Atlantic Region
West Region
South Region
Actual
Over Budget
$ 416,000
$ 416,000
297,600
296,000
327,040 (g)
330,320 (h)
$1,040,640 (j) $1,042,320 (k)
Under Budget
$
0
1,600
$3,280 (i)
$3,280 (l)
$1,600
ILIAD COMPANY
Budget Performance Report—Manager, South Region Plant
For the Month Ended April 30, 2010
Department
Chip Fabrication
Electronic Assembly
Final Assembly
Budget
Actual
Over Budget Under Budget
$104,800 (a) $107,440 (b)
85,120
86,240
137,120
136,640
$327,040 (d) $330,320 (e)
318
$2,640 (c)
1,120
$3,760 (f)
$480
$480
Ex. 24–1
Concluded
ILIAD COMPANY
Budget Performance Report—Supervisor, Chip Fabrication
For the Month Ended April 30, 2010
Department
Factory wages
Materials
Power and light
Maintenance
Budget
Actual
$ 24,640
69,600
3,840
6,720
$104,800
$ 26,400
69,120
4,560
7,360
$107,440
Over Budget Under Budget
$1,760
$480
720
640
$3,120
$480
b. MEMO
To: Dana Johnson, Vice President of Production
The South Region plant has experienced a $3,280 budget overrun, while the
West Region plant has experienced a budget surplus. The budget of the
South Region plant reveals that the Chip Fabrication Department causes the
majority of 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. 24–2
DESALVO CONSTRUCTION COMPANY
Divisional Income Statements
For the Year Ended June 30, 2010
Net sales .............................................................................
Cost of goods sold .............................................................
Gross profit.........................................................................
Administrative expenses ...................................................
Income from operations before service
department charges ....................................................
Service department charges .............................................
Income from operations ....................................................
319
Residential
Division
$625,000
415,200
$209,800
74,500
Industrial
Division
$367,500
206,350
$161,150
72,400
$135,300
56,400
$ 78,900
$ 88,750
35,480
$ 53,270
Ex. 24–3
Expense
a.
Central purchasing
Activity Bases
Number of requisitions, number of purchase
orders
b. Legal
Number of hours
c.
Number of invoices, number of customers
Accounts receivable
d. Duplication services
Number of pages
e.
Electronic data processing
Central processing unit (CPU) time, number
of printed pages, amount of memory
usage
f.
Telecommunications
Number of lines, number of long-distance
minutes
Ex. 24–4
a.
4
e.
3
b. 6
f.
1
c.
8
g. 2
d. 5
h. 7
320
Ex. 24–5
a.
Residential
Commercial
Government
Contract
Total
Number of payroll checks:
Weekly payroll × 52 ....................
Monthly payroll × 12 ..................
Total .......................................
6,500
384
6,884
3,640
516
4,156
3,900
360
4,260
15,300
Number of purchase requisitions
per year .......................................
2,100
1,500
1,400
5,000
b.
Service Dept.
Activity
Cost
÷
Base
Service department charge rates:
Payroll Department ....................
Purchasing Department ............
$45,900
$22,000
Residential
Service department charges:
Payroll Department .................... $20,652
Purchasing Department ............
9,240
Total ....................................... $29,892
÷
÷
15,300
5,000
=
Charge
Rate
=
=
$3.00/check
$4.40/req.
Commercial
Government
Contract
$12,468
6,600
$19,068
$ 12,780
6,160
$ 18,940
Total
$45,900
22,000
The service department charges are determined by multiplying the service
department charge rate by the activity base for each division. For example, Residential’s service department charges are determined as follows:
Payroll:
$3.00 × 6,884 checks = $20,652
Purchasing: $4.40 × 2,100 purchase requisitions = $9,240
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
significantly more than the other two divisions. This may be because the
division has many different smaller jobs requiring frequent purchase transactions.
321
Ex. 24–6
a.
Help desk:
$88,400
= $34 per call
2,600 calls
Network center:
$609,375
= $62.50 per device monitored
9,750 devices
Electronic mail:
$67,080
= $10.40 per e-mail account
6,450 accounts
Local voice support:
$152,720
= $16.60 per phone extension
9,200 accounts
b. April charges to the COMM sector:
Help desk charge: (3,000 employees × 40% × 75% × 1.0) × $34/call = $30,600
Network center charge: [(3,000 employees × 40% × 75%) + 250] ×
$62.50/device = $71,875
Electronic mail: (3,000 employees × 40% × 75% × 95%) × $10.40/e-mail account = $8,892
Local voice support: (3,000 employees × 40%) × $16.60/phone extension =
$19,920
322
Ex. 24–7
ENCOUNTER SPORTING GOODS COMPANY
Divisional Income Statements
For the Year Ended December 31, 2010
Wholesale Division
Revenues ....................................
Cost of goods sold .....................
Gross profit.................................
Operating expenses ...................
Income from operations
before service department
charges ..................................
Less service department
charges:
Tech Support Department ....
Accounts Payable
Department.......................
Income from operations ............
$ 6,720,000
3,528,000
$ 3,192,000
1,260,000
$ 5,712,000
2,688,000
$ 3,024,000
1,176,000
$ 1,932,000
$ 1,848,000
$423,000
98,134
Retail Division
$282,000
521,134
$ 1,410,866
179,866
461,866
$ 1,386,134
Supporting calculations for controllable service department charges:
Tech Support Department:
($705,000/500) × 300 = $423,000
($705,000/500) × 200 = $282,000
Accounts Payable Department:
($278,000/20,000) × 7,060 = $98,134
($278,000/20,000) × 12,940 = $179,866
323
Ex. 24–8
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 personnel. Since these personnel must be
trained, the training costs assigned to the Passenger Division should be
greater than the Cargo Division.
b.
TRANS-CONTINENTAL AIRLINES, INC.
Divisional Income Statements
For the Year Ended June 30, 2010
Passenger Division
Revenues ....................................
Operating expenses ...................
Income from operations
before service department
charges ..................................
Less service department
charges:
Training (Note 1) ...................
Flight scheduling (Note 2) ....
Reservations (Note 3) ...........
Income from operations ............
Cargo Division
$1,400,000
950,000
$1,400,000
1,200,000
$ 450,000
$ 200,000
$128,000
62,500
210,000
$
400,500
49,500
$ 32,000
87,500
—
Note 1: Passenger Division, ($160,000/250 personnel trained) × 200
Cargo Division, ($160,000/250 personnel trained) × 50
Note 2: Passenger Division, ($150,000/600 flights) × 250
Cargo Division, ($150,000/600 flights) × 350
Note 3: Passenger Division, ($210,000/14,000 reservations) × 14,000
Cargo Division, ($210,000/14,000 reservations) × 0
324
$
119,500
80,500
Ex. 24–9
X-OUT SPORTING GOODS CO.
Divisional Income Statements
For the Year Ended June 30, 2010
Sales ............................................................................
Cost of goods sold .....................................................
Gross profit.................................................................
Divisional selling expenses.......................................
Divisional administrative expenses ..........................
Income from operations before service
department charges ............................................
Less service department charges:
Advertising expense ...........................................
Transportation expense .....................................
Accounts receivable collection expense ..........
Warehouse expense ...........................................
Total .....................................................................
Income from operations ............................................
Action
Sports
Division
Team
Sports
Division
$14,500,000
8,700,000
$ 5,800,000
$ 2,320,000
1,450,000
$ 3,770,000
$17,600,000
10,208,000
$ 7,392,000
$ 2,464,000
1,566,400
$ 4,030,400
$ 2,030,000
$ 3,361,600
$
$
256,800
148,800
93,000
960,000
$ 1,458,600
$ 571,400
385,200
166,160
108,750
640,000
$ 1,300,110
$ 2,061,490
Supporting Schedule:
Service Department Charges
Action
Sports
Division
Team
Sports
Division
Advertising expense .......................................
$ 256,800
$385,200
$642,000
Transportation rate per bill of lading .............
Number of bills of lading ................................
Transportation expense..................................
$ 12.40
× 12,000
$ 148,800
$ 12.40
× 13,400
$166,160
$314,960
Accounts receivable collection rate ..............
Number of sales invoices ...............................
Accounts receivable collection expense ......
$
7.50
× 12,400
$ 93,000
$
7.50
× 14,500
$108,750
$201,750
Warehouse rate per sq. ft.
($1,600,000/200,000 sq. ft.) .............................
Number of square feet ....................................
Warehouse expense .......................................
$
8.00
× 120,000
$ 960,000
$
8.00
× 80,000
$640,000 $1,600,000
325
Total
Ex. 24–10
a.
Sporting Goods Division:
20% ($80,000/$400,000)
Health Care Division:
16% ($41,600/$260,000)
Commercial Division:
22% ($70,400/$320,000)
b. Commercial Division
Ex. 24–11
a.
Sporting
Goods
Division
Income from operations ...........................
Minimum amount of income from
operations:
$400,000 × 10% .................................
$260,000 × 10% .................................
$320,000 × 10% .................................
$80,000
Residual income .......................................
$40,000
b. Sporting Goods Division
326
Health
Care
Commercial
Division
Division
$41,600
$70,400
40,000
26,000
32,000
$15,600
$38,400
Ex. 24–12
a.
2.20 = 22% ÷ 10%
b. 12% = 16% × 0.75
c.
12% = 18% ÷ 1.50
d. 0.70 = 14% ÷ 20%
e.
24% = 15% × 1.60
Ex. 24–13
a.
Rate of Return on
=
Investment
Profit Margin × Investment Turnover
Rate of Return on
=
Investment
Income from Operations
Sales
×
Sales
Invested Assets
ROI
=
$300,000
$1,200,000
×
$1,200,000
$2,000,000
ROI
=
25% × 0.6
ROI
=
15%
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 15% to 18%, as shown below.
Rate of Return on
=
Investment
Profit Margin × Investment Turnover
Rate of Return on
=
Investment
Income from Operations
Sales
×
Sales
Invested Assets
ROI
=
$360,000
$1,200,000
×
$1,200,000
$2,000,000
ROI
=
30% × 0.6
ROI
=
18%
327
Ex. 24–14
a.
Rate of Return on Investment =
Media Networks:
Income from Operations
Revenues
×
Revenues
Invested Assets
$4,285
$15,046
×
$15,046
$27,692
= 28.5% × 0.54
= 15.4% (rounded)
Parks and Resorts:
$1,710
$10,626
×
$10,626
$16,311
= 16.1% × 0.65
= 10.5% (rounded)
Studio Entertainment:
$1,201
$7,491
×
$7,491
$10,812
= 16.0% × 0.69
= 11.0% (rounded)
Consumer Products:
$631
$2,347
×
$2,347
$1,553
= 26.9% × 1.51
= 40.6% (rounded)
b. The four sectors are different from each other. Media Networks combines a
good profit margin with a very low investment turnover, while Consumer
Products has a good profit margin combined with an excellent investment
turnover. Media Networks is sensitive to advertising revenue, while the Studio
Entertainment sector is sensitive to producing box office hits. The Parks and
Resorts sector has a good profit margin at 16.1% with a fairly low investment
turnover. The combination produces a respectable ROI of 10.5%. The Consumer Products division combines a good profit margin with a stellar investment turnover. The combination produces an excellent ROI of 40.6%. Much of
the consumer product income is produced from licensing the Disney characters and brands, which requires very few assets.
328
Ex. 24–15
a.
25% ($210,000/$840,000)
b. $117,600 ($840,000 × 14%)
c.
$92,400 ($210,000 – $117,600)
d. $91,500 ($64,000 + $27,500)
e.
18.3% ($91,500/$500,000)
f.
12.8% ($64,000/$500,000)
g. $51,200 ($320,000 × 16%)
h. 12.5% ($40,000/$320,000)
i.
$11,200 ($51,200 – $40,000)
j.
20% ($48,000/$240,000)
k.
$28,800 ($240,000 × 12%)
l.
$19,200 ($48,000 – $28,800)
329
Ex. 24–16
a.
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
(k)
(l)
$63,000 ($525,000 × 12%)
$350,000 ($63,000/18%)
1.5 (18%/12%)
$650,000 ($65,000/10%)
$520,000 ($650,000/1.25)
12.5% (10% × 1.25)
$52,500 ($350,000 × 15%)
7.5% ($52,500/$700,000)
2.0 ($700,000/$350,000)
14.0% ($140,000/$1,000,000)
17.5% ($140,000/$800,000)
0.8 ($800,000/$1,000,000)
b. North Division: $28,000 [$63,000 – ($350,000 × 10%)]
South Division: $13,000 [$65,000 – ($520,000 × 10%)]
East Division:
$17,500 [$52,500 – ($350,000 × 10%)]
West Division: $40,000 [$140,000 – ($1,000,000 × 10%)]
c.
(1) The North Division has the highest return on investment (18%).
(2) The West Division has the largest residual income. Even though the
West Division’s rate of return is lower than the North Division’s (14% vs.
18%), the residual income is larger because the investment is large, relative to the North Division.
330
Ex. 24–17
a.
Rate of Return on Investment =
Hotel Ownership:
Income from Operations
Revenues
×
Revenues
Invested Assets
$904
$4,985
×
$4,985
$9,681
= 18.1% × 0.51
= 9.2% (rounded)
Managing and Franchising:
$600
$2,527
×
$2,527
$5,191
= 23.7% × 0.49
= 11.6% (rounded)
Timeshare:
$650
$152
×
$1,078
$650
= 23.4% × 0.60
= 14.0% (rounded)
Hotel Managing and
Ownership Franchising Timeshare
b.
Income from operations ......................
Minimum return (10% of assets) ........
Residual income ..................................
c.
$904
968
$ (64)
$600
519
$ 81
$152
108
$ 44
The Hotel Ownership segment has the weakest return on investment, which
is mainly the result of a weak investment turnover. The hotel earns good margins at above 18%, but the investment in hotel properties is significant, causing the ROI to be less than the assumed minimum acceptable
return. The residual income is negative, which is consistent with a ROI less
than the 10% minimum return. The other two segments perform very well. The
managing and franchising margins are excellent, since managing and
franchising hotels is a royalty-based business that has very few associated
costs. The asset turnover is low because Hilton is often a joint owner of the
franchised or managed hotel. As a result, the ROI for the Managing and
Franchising Division is good, and it also has the highest residual income. The
Timeshare Division has a slightly stronger asset turnover, since others own
the timeshare properties. The division combines the good investment turnover with a very good profit margin. The net result is an excellent ROI of 14%.
The residual income for the division is positive, as would be expected for a
14% ROI.
331
Ex. 24–18
Although there is some judgment in classifying each of these measures, the following represents our assessment with explanations:
Average cardmember spending
Customer—demonstrates the usefulness of the card to the customer.
Cards in force
Customer—if customers did not value
the card, 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
the investment 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.
Return on equity
Financial
Revenue growth
Financial
332
Ex. 24–19
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. 24–20
a.
Increase in Armstrong
Units
Variable
×
Manufacturing' s Income = Market –
Price
Transferre d
Cost per Unit
from Operations
$1,225,000
b.
–
$165)
×
35,000
Increase in the Engine
Units
(Purchasing) Division' s = Market – Transfer ×
Price
Price
Transferre d
Income from Operations
$700,000
c.
= ($200
=
($200 –
$180)
×
35,000
Increase in the Components
Units
(Supplying) Division' s
Variable
= Transfer –
×
Price
Transferre d
Income from Operations
Cost per Unit
$525,000
=
($180
333
–
$165)
×
35,000
Ex. 24–21
a.
Increase in Armstrong
Units
×
Variable
Manufacturing' s Income = Market –
Price
Transferre
d
Cost
per
Unit
from Operations
$1,225,000
=
($200 –
$165)
×
35,000
This amount is the same amount by which Armstrong Manufacturing’s income from operations increased in Ex. 24–20, when a transfer price of $180
was used.
b.
Increase in the Engine
(Purchasing) Division' s = Market
Price
Income from Operations
$350,000
=
($200
– Transfer
Price
×
Units
Transferre d
–
×
35,000
$190)
This is the amount the Engine Division saves by purchasing from the Components Division at an internal price that is lower than the market price.
c.
Increase in the Components
Units
= Transfer –
×
(Supplying) Division' s
Variable
Price
Transferre d
Income from Operations
Cost per Unit
$875,000
=
($190
–
$165)
×
35,000
This is the amount the Components Division earns by using available excess
capacity to produce and sell products above variable cost to the Industrial
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 for
products 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 selling price when the supplier division has excess capacity. The
range of acceptable transfer prices for Armstrong Manufacturing would be
between $165 and $200.
334
PROBLEMS
Prob. 24–1A
1.
Budget Performance Report—Director, Truck Division
For the Month Ended October 31, 2010
Budget
Actual
Customer service salaries ....... $ 260,450 $ 333,370
Insurance and property taxes
54,600
52,960
Distribution salaries .................
415,400
411,250
Marketing salaries ....................
489,700
548,460
Engineer salaries ......................
398,500
390,530
Warehouse wages ....................
279,100
267,930
Equipment depreciation ...........
87,500
87,500
Total ..................................... $1,985,250 $2,092,000
2.
Over
Budget
Under
Budget
$ 72,920 $
—
—
1,640
—
4,150
58,760
—
—
7,970
—
11,170
—
—
$131,680 $24,930
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.
335
Prob. 24–2A
1.
BROWNING TRANSORTATION CO.
Divisional Income Statements
For the Quarter Ended December 31, 2010
Revenues ............................................................
Operating expenses ...........................................
Income from operations before service
department charges......................................
Less service department charges:
Customer support ($20 × customer
contacts) ..................................................
Legal ($36 × number of hours billed) ..........
Income from operations ....................................
East
West
Metro
$600,000
362,400
$710,000
393,540
$980,000
527,760
$237,600
$316,460
$452,240
$ 75,000
30,600
$105,600
$132,000
$ 90,000
48,960
$138,960
$177,500
$135,000
42,840
$177,840
$274,400
Supporting schedules:
Service department charge rates for the two service departments, Customer
Support and Legal, are determined as follows:
Number of customer contacts ......
Number of hours billed .................
East
West
Metro
Total
3,750
850
4,500
1,360
6,750
1,190
15,000
3,400
Service
Cost
÷
Customer contact rate .................. $300,000 ÷
Legal billing rate ............................ 122,400 ÷
Output =
Rate
15,000 = $20 per contact
3,400 = 36 per hour
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.
336
Prob. 24–2A
2.
Concluded
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: 22% ($132,000/$600,000)
West Division: 25% ($177,500/$710,000)
Metro Division: 28% ($274,400/$980,000)
According to the CEO’s measure, the Metro Division has the highest performance.
3.
To: CEO
The 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 research, development, production, and
distribution facilities. In addition, the amount of assets may not be related to
the revenue earned. For example, some divisions are able to concentrate assets in a densely populated regional area and service a large population over
those assets (e.g., Metro Division). Other regions, however, have widely distributed assets over sparsely populated areas that use less services 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
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.
337
Prob. 24–3A
1.
SUNSHINE BAKING COMPANY
Divisional Income Statements
For the Year Ended June 30, 2010
Sales .....................................................
Cost of goods sold ..............................
Gross profit ..........................................
Operating expenses ............................
Income from operations ......................
2.
Bread
Division
$8,100,000
4,980,000
$3,120,000
1,662,000
$1,458,000
Snack
Cake
Division
$8,700,000
5,400,000
$3,300,000
1,995,000
$1,305,000
Retail
Bakeries
Division
$7,800,000
4,600,000
$3,200,000
1,484,000
$1,716,000
Rate of Return on
= Profit Margin × Investment Turnover
Investment
Sales
Rate of Return on Income from Operations
=
×
Investment
Sales
Invested Assets
Bread Division: ROI =
$1,458,000
$8,100,000
×
$8,100,000
$10,800,00 0
ROI = 18.0% × 0.75
ROI = 13.5%
Snack Cake Division: ROI =
$1,305,000
$8,700,000
×
$8,700,000
$10,875,00 0
ROI = 15.0% × 0.80
ROI = 12.0%
Retail Bakeries Division: ROI =
$1,716,000
$7,800,000
×
$7,800,000
$6,000,000
ROI = 22.0% × 1.3
ROI = 28.6%
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 28.6 cents (28.6%) on each dollar of invested assets, while the Bread
and Snack Cake divisions will return only 13.5 cents (13.5%) and 12.0 cents
(12.0%), respectively. Thus, when faced with limited funds for expansion,
management should consider an expansion of the Retail Bakeries Division
first.
338
Prob. 24–4A
Rate of Return on
Investment
= Profit Margin × Investment Turnover
Rate of Return on
Investment
=
Income from Operations
Sales
×
Sales
Invested Assets
Snowboard Division: ROI
=
$144,000
$1,200,000
×
$1,200,000
$1,000,000
1.
ROI
= 12.0% × 1.2
ROI
= 14.4%
2.
NEW WAVE RIDES INC.—SNOWBOARD DIVISION
Estimated Income Statements
For the Year Ended December 31, 2010
Proposal 1
Proposal 2
Proposal 3
Sales ......................................................
Cost of goods sold ...............................
Gross profit...........................................
Operating expenses .............................
Income from operations ......................
$1,200,000
850,000
$ 350,000
230,000
$ 120,000
$1,200,000
706,000
$ 494,000
230,000
$ 264,000
$ 870,000
539,700
$ 330,300
165,000
$ 165,300
Invested assets ....................................
$ 960,000
$1,600,000
$ 580,000
339
Prob. 24–4A
3.
4.
5.
Concluded
Rate of Return on
=
Investment
Profit Margin × Investment Turnover
Rate of Return on
=
Investment
Income from Operations
Sales
×
Sales
Invested Assets
Proposal 1: ROI
=
$120,000
$1,200,000
×
$1,200,000
$960,000
ROI
=
10.0% × 1.25
ROI
=
12.5%
Proposal 2: ROI
=
$264,000
$1,200,000
×
$1,200,000
$1,600,000
ROI
=
22.0% × 0.75
ROI
=
16.5%
Proposal 3: ROI
=
$165,300
$870,000
×
$870,000
$580,000
ROI
=
19.0% × 1.50
ROI
=
28.5%
Proposal 3 would yield a rate of return on investment of 28.5%.
Rate of Return on Investment
= Profit Margin × Required Investment Turnover
18% = 12% × Required Investment Turnover
Required Investment Turnover = 1.5 (18%/12%)
Current Investment Turnover = 1.2
Increase in Investment Turnover = 0.3
or
25% Increase (0.3/1.2)
340
Prob. 24–5A
1.
RUCKER-PUTNAM BIKE COMPANY
Divisional Income Statements
For the Year Ended December 31, 2010
Sales .....................................................................
Cost of goods sold ..............................................
Gross profit..........................................................
Operating expenses ............................................
Income from operations .....................................
Touring
Bike
Division
Off-Road
Bike
Division
$2,800,000
1,240,000
$1,560,000
1,168,000
$ 392,000
$2,950,000
1,375,000
$1,575,000
1,073,500
$ 501,500
Rate of Return on
Investment
=
Profit Margin × Investment Turnover
Rate of Return on
Investment
=
Income from Operations
Sales
×
Sales
Invested Assets
Touring Bike Division: ROI
=
$392,000
$2,800,000
×
$2,800,000
$1,600,000
ROI
=
14.0% × 1.75
ROI
=
24.5%
2.
3.
Off-Road Bike Division: ROI
=
$501,500
$2,950,000
×
$2,950,000
$2,950,000
ROI
=
17.0% × 1.00
ROI
=
17.0%
Touring Bike Division: $104,000 [$392,000 – ($1,600,000 × 18%)]
Off-Road Bike Division: ($29,500) [$501,500 – ($2,950,000 × 18%)]
341
Prob. 24–5A
4.
Concluded
On the basis of income from operations, the Off-Road Bike Division generated $109,500 more income from operations than did the Touring Bike 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
Touring Bike Division earned 24.5 cents (24.5%) on each dollar of invested
assets, while the Off-Road Bike Division earned only 17.0 cents (17.0%) on
each dollar. Although the profit margin of the Off-Road Bike Division exceeds
the Touring Bike Division (17.0% vs. 14.0%), the investment turnover in the
Off-Road Bike Division is much less than the Touring Bike Division (1.00 vs.
1.75). The combination of these factors caused the Touring Bike Division to
have a higher return on investment than did the Off-Road Bike Division. 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 Touring Bike Division is the more profitable of the two divisions.
342
Prob. 24–6A
1.
No. When unused capacity exists in the supplying division (the Performance
Materials Division), the use of the market price approach may not lead to the
maximization of total company income.
2.
The Performance Materials Division’s income from operations would increase
by $9,600:
Increase in Performance
= Transfer –
×
Units
Materials (Supplying)
Variable
Price
Transferre d
Division' s Income from Operations
Cost per Unit
$9,600
=
–
($64
$58)
×
1,600
By selling to the Communication Technologies Division, the Performance Materials Division earns $6 per unit on these sales.
The Communication Technologies Division’s income from operations would
increase by $22,400:
Increase in Communication
Units
= Market – Transfer ×
Technologies (Purchasing)
Price
Price
Transferre d
Division' s Income from Operations
$22,400
=
($78
–
$64)
×
1,600
By purchasing from the Performance Materials Division, the Communication
Technologies Division saves $14 per unit on its purchases.
Bay Area Scientific, Inc.’s total income from operations would increase by
$32,000:
Increase in Bay Area
Variable
Market
Units
=
–
Scientific Income from Operations
Cost per Unit × Transferre d
Price
$32,000
=
($78 –
$58)
×
1,600
The increase in total company income from operations is also equal to the
sum of the increases in the division incomes from operations.
343
Prob. 24–6A
Continued
3.
BAY AREA SCIENTIFIC, INC.
Divisional Income Statements
For the Year Ended December 31, 2010
Performance Communication
Materials Technologies
Sales:
8,000 units × $78 per unit ............
1,600 units × $64 per unit ............
12,000 units × $152 per unit ........
$624,000
102,400
$726,400
Expenses:
Variable:
9,600 units × $58 per unit ........
1,600 units × $94* per unit .......
10,400 units × $108** per unit..
Fixed ..............................................
Total expenses .........................
Income from operations ....................
Total
$
$ 1,824,000
$ 1,824,000
$556,800
624,000
102,400
1,824,000
$ 2,550,400
124,000
$680,800
150,400
1,123,200
288,000
$ 1,561,600
$
556,800
150,400
1,123,200
412,000
$ 2,242,400
$ 45,600
$
$
$
262,400
308,000
*The 1,600 units are transferred in at $64 per unit plus $30 operating expense
in the division.
**The remaining 10,400 units are purchased on the outside at a market price of
$78 per unit plus $30 operating expense in the division.
344
Prob. 24–6A
4.
Concluded
The Performance Materials Division’s income from operations would increase
by $19,200:
Increase in Performance
Units
= Transfer –
×
Materials (Supplying)
Variable
Price
Transferre
d
Division' s Income from Operations
Cost per Unit
$19,200
=
($70
–
$58)
×
1,600
By selling to the Communication Technologies Division, the Performance Materials Division earns $12 per unit on these sales.
The Communication Technologies Division’s income from operations would
increase by $12,800:
Increase in Communication
Units
= Market – Transfer ×
Technologies (Purchasing)
Price
Price
Transferre d
Division' s Income from Operations
$12,800
=
($78
–
$70)
×
1,600
By purchasing from the Performance Materials Division, the Communication
Technologies Division saves $8 per unit on its purchases.
Bay Area Scientific, Inc.’s total income from operations would increase by the
same amount as in part (2), $32,000:
Increase in Bay Area
Variable
Market
Units
=
–
Scientific Income from Operations
Cost per Unit × Transferre d
Price
$32,000
=
($78
–
$58)
×
1,600
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.
b.
Any transfer price greater than the Performance Materials Division’s variable expenses per unit of $58 but less than the market price of $78
would be acceptable.
If the division managers cannot agree on a transfer price, a price of $68
would be the best compromise. In this way, each division’s income from
operations would increase by $16,000.
345
Prob. 24–1B
1.
Budget Performance Report—Manager, Northeast District
For the Month Ended May 31, 2010
Budget
Sales salaries .......................................
System administration salaries ..........
Customer service salaries ...................
Billing salaries ......................................
Maintenance .........................................
Depreciation of plant and equipment .
Insurance and property taxes .............
Total .................................................
2.
Actual
$ 569,400 $ 568,680
311,220
310,900
106,000
125,080
68,560
68,145
188,480
189,530
64,050
64,050
28,670
28,770
$1,336,380 $1,355,155
Over
Budget
Under
Budget
—
—
19,080
—
1,050
—
100
$20,230
$ 720
320
—
415
—
—
—
$1,455
$
The customer service salaries exceed the budget by 18% of budget
($19,080/$106,000). 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 people. 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.
346
Prob. 24–2B
1.
TRI-STATE RAILROAD COMPANY
Divisional Income Statements
For the Quarter Ended December 31, 2010
Southeast
Revenues .........................................................
Operating expenses ........................................
Income from operations before service
department charges...................................
East
South
$2,100,000 $3,150,000 $2,850,000
1,367,350
2,321,870
1,963,180
$ 732,650
$ 828,130
$ 886,820
Less service department charges:
Dispatching ($92 × scheduled
trains) ....................................................
Equipment management
($62 × railroad cars) .............................
$
$
$
271,250
$ 312,650
379,750
$ 450,130
434,000
$ 487,820
Income from operations .................................
$ 420,000
$ 378,000
$ 399,000
41,400
70,380
53,820
Supporting schedules:
Service department charge rates for the two service departments, Dispatching
and Equipment Management, are determined as follows:
Southeast
Number of scheduled trains ........
Number of railroad cars in
inventory ..................................
East
South
Total
450
765
585
1,800
4,375
6,125
7,000
17,500
Service
Cost
÷ Output =
Rate
Dispatching rate ......................... $ 165,600 ÷ 1,800 = $92.00 per train
Equipment management rate .... 1,085,000 ÷ 17,500 = 62.00 per railroad
car
Note: The Treasurer’s Department and general corporate officers’ salaries are not
controllable by division management and thus are not included in determining
division income from operations.
347
Prob. 24–2B
2.
Concluded
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:
Southeast Region: 20% ($420,000/$2,100,000)
East Region: 12% ($378,000/$3,150,000)
South Region: 14% ($399,000/$2,850,000)
Thus, according to the CEO’s measure, the Southeast Region has the highest
performance.
3.
To: CEO
The 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, this 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.
348
Prob. 24–3B
1.
PERFORMANCE FINANCIAL SERVICES INC.
Divisional Income Statements
For the Year Ended June 30, 2010
Electronic
Brokerage
Division
Investment
Banking
Division
$ 2,500,000 $1,400,000
1,600,000
1,302,000
$ 900,000 $ 98,000
$ 3,250,000
2,600,000
$ 650,000
Retail
Division
Fee revenue....................................
Operating expenses ......................
Income from operations ................
2.
Rate of Return on
= Profit Margin × Investment Turnover
Investment
Rate of Return on
=
Investment
Income from Operations
Sales
×
Sales
Invested Assets
Retail Division: ROI =
$900,000
$2,500,000
×
$2,500,000
$5,000,000
ROI = 36% × 0.5
ROI = 18%
Electronic Brokerage Division: ROI =
$98,000
$1,400,000
×
$1,400,000
$350,000
ROI = 7% × 4.0
ROI = 28%
Investment Banking Division: ROI =
$650,000
$3,250,000
×
$3,250,000
$4,062,500
ROI = 20% × 0.8
ROI = 16%
349
Prob. 24–3B
3.
Concluded
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 28 cents (28%) on each dollar of invested assets, while the
Retail and Investment Banking divisions will return only 18 cents (18%) and
16 cents (16%), respectively. Thus, when faced with limited funds for
expansion, management should consider an expansion of the Electronic
Brokerage Division first.
Note to Instructors: The Retail Division has excellent profit margins, but the
investment turnover is very low. The investment in the “bricks and mortar” of
the Retail 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
required to execute trades are much less than the Retail Division because
there is no need 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.
350
Prob. 24–4B
1.
Rate of Return on
= Profit Margin × Investment Turnover
Investment
Rate of Return on
=
Investment
Water Sports Division: ROI =
Income from Operations
Sales
×
Sales
Invested Assets
$90,000
$600,000
×
$600,000
$500,000
ROI = 15% × 1.2
ROI = 18%
2.
SOUTH MOUNTAIN SPORTS INC.—WATER SPORTS DIVISION
Estimated Income Statements
For the Year Ended January 31, 2010
Proposal 1
Proposal 2
Proposal 3
Sales ................................................
Cost of goods sold .........................
Gross profit .....................................
Operating expenses .......................
Income from operations .................
$600,000
218,000
$382,000
274,000
$108,000
$525,000
209,400
$315,600
252,600
$ 63,000
$600,000
206,000
$394,000
274,000
$120,000
Invested assets ...............................
$400,000
$350,000
$750,000
351
Prob. 24–4B
3.
Concluded
Rate of Return on
=
Investment
Profit Margin × Investment Turnover
Rate of Return on
=
Investment
Income from Operations
Sales
×
Sales
Invested Assets
Proposal 1: ROI =
$108,000
$600,000
×
$600,000
$400,000
ROI =
18% × 1.5
ROI =
27%
Proposal 2: ROI =
ROI =
12% × 1.5
ROI =
18%
Proposal 3: ROI =
4.
5.
$63,000
$525,000
×
$525,000
$350,000
$120,000
$600,000
×
$600,000
$750,000
ROI =
20% × 0.8
ROI =
16%
Proposal 1 would yield a rate of return on investment of 27%.
Rate of Return on Investment
= Profit Margin × Required Investment Turnover
22% = 15% × Required Investment Turnover
Required Investment Turnover = 1.47
Current Investment Turnover = 1.20
Increase in Investment Turnover = 0.27
or
22.5% Increase (0.27/1.20)
352
(22%/15%)
Prob. 24–5B
1.
SIX LAYER COMPUTERS INC.
Divisional Income Statements
For the Year Ended December 31, 2010
Sales .....................................................................
Cost of goods sold ..............................................
Gross profit..........................................................
Operating expenses ............................................
Income from operations .....................................
2.
Personal
Computing
Division
$1,400,000
845,000
$ 555,000
345,000
$ 210,000
$ 1,120,000
690,000
$ 430,000
206,000
$ 224,000
Rate of Return on
Investment
=
Profit Margin × Investment Turnover
Rate of Return on
Investment
=
Income from Operations
Sales
×
Sales
Invested Assets
Network Equipment Division: ROI =
$210,000
$1,400,000
×
$1,400,000
$1,000,000
ROI =
15% × 1.4
ROI =
21%
Personal Computing Division: ROI =
3.
Network
Equipment
Division
$224,000
$1,120,000
×
$1,120,000
$1,400,000
ROI =
20% × 0.8
ROI =
16%
Network Equipment Division: $70,000 [$210,000 – ($1,000,000 × 14%)]
Personal Computing Division: $28,000 [$224,000 – ($1,400,000 × 14%)]
353
Prob. 24–5B
4.
Concluded
On the basis of income from operations, the Personal Computing Division
generated $14,000 more income from operations than did the Network
Equipment 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 Network Equipment Division earned 21 cents (21%) on
each dollar of invested assets, while the Personal Computing Division earned
only 16 cents (16%) on each dollar of invested assets. Although the Personal
Computing Division has a higher profit margin than the Network Equipment
Division (20% vs. 15%), the Network Equipment Division has a higher investment turnover (1.4 vs. 0.8), 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 Network Equipment Division is the more profitable of the
two divisions.
354
Prob. 24–6B
1.
No. When unused capacity exists in the supplying division (the Specialized
Semiconductors Division), the use of the market price approach may not lead
to the maximization of total company income.
2.
The Specialized Semiconductors Division’s income from operations would
increase by $56,000:
Increase in Specialized
Units
= Transfer –
×
Semiconductors (Supplying)
Variable
Price
Transferre d
Divsion' s Income from Operations
Cost per Unit
$56,000
=
($625
–
$485)
×
400
By selling to the Navigational Systems Division, the Specialized Semiconductors Division earns $140 per unit on these sales.
The Navigational Systems Division’s income from operations would increase
by $80,000:
Increase in Navigational
Units
= Market – Transfer ×
Systems (Purchasing)
Price
Price
Transferre d
Division' s Income from Operations
$80,000
=
($825 –
$625)
×
400
By purchasing from the Specialized Semiconductors Division, the Navigational Systems Division saves $200 per unit on its purchases.
Knopfler Industries, Inc.’s total income from operations would increase by
$136,000:
Variable
Increase in Knopfler
Market
Units
=
– Cost per Unit ×
Industries Income from Operations
Price
Transferre d
$136,000
= ($825 –
$485)
×
400
The increase in total company income from operations is also equal to the
sum of the increases in the division incomes from operations.
355
Prob. 24–6B
3.
Continued
KNOPFLER INDUSTRIES, INC.
Divisional Income Statements
For the Year Ended December 31, 2010
Specialized
Navigational
Semiconductors
Systems
Sales:
1,600 units × $825 per unit ..........
400 units × $625 per unit .............
2,500 units × $1,240 per unit .......
$ 1,320,000
250,000
$ 1,570,000
Expenses:
Variable:
2,000 units × $485 per unit ......
400 units × $775* per unit .......
2,100 units × $975** per unit ...
Fixed .............................................
Total expenses ........................
Income from operations ....................
$
$ 3,100,000
$ 3,100,000
970,000
Total
$ 1,320,000
250,000
3,100,000
$ 4,670,000
$
488,000
$ 1,458,000
310,000
2,047,500
636,000
$ 2,993,500
970,000
310,000
2,047,500
1,124,000
$ 4,451,500
$
$
$
$
112,000
106,500
218,500
*The 400 units are transferred in at $625 per unit plus $150 operating expenses
in the division.
**The remaining 2,100 units are purchased on the outside at a market price of
$825 per unit plus $150 operating expenses in the division.
356
Prob. 24–6B
4.
Concluded
The Specialized Semiconductors Division’s income from operations would
increase by $86,000:
Increase in Specialized
Units
= Transfer –
×
Semiconductors (Supplying)
Variable
Price
Transferre
d
Division' s Income from Operations
Cost per Unit
$86,000
=
–
($700
$485)
×
400
By selling to the Navigational Systems Division, the Specialized Semiconductors Division earns $215 per unit on these sales.
The Navigational Systems Division’s income from operations would increase
by $50,000:
Increase in Navigational
Units
= Market – Transfer ×
Systems (Purchasing)
Price
Price
Transferre d
Division' s Income from Operations
$50,000
=
($825 –
$700)
×
400
By purchasing from the Specialized Semiconductors Division, the Navigational Systems Division saves $125 per unit on its purchases.
Knopfler Industries, Inc.’s total income from operations would increase by
the same amount as in (2), $136,000:
Variable
Increase in Knopfler
Market
Units
=
–
Cost per Unit × Transferre d
Industries Income from Operations
Price
$136,000
= ($825
–
$485)
×
400
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.
b.
Any transfer price greater than the Specialized Semiconductors Division’s variable expenses per unit of $485 but less than the market price
of $825 would be acceptable.
If the division managers cannot agree on a transfer price, a price of $655
would be the best compromise. In this way, each division’s income from
operations would increase by $68,000.
357
SPECIAL ACTIVITIES
Activity 24–1
This scenario is a negotiation between two divisions. Dan is not behaving
unethically by attempting to get a good price from the Semiconductor Division.
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 of
Dan’s job. It would be unethical only if the PC Division refused to deal with the
Semiconductor Division to purposefully hurt the Semiconductor Division’s performance, so that PC could look good in comparison. This claim could only be
supported if the PC 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 PC Division would be less by purchasing from the Semiconductor
Division. Refusing to do so could be the basis for claiming an ethical breach.
The PC Division has overall profit responsibility and authority. This means that
the PC Division has the choice of purchasing from the inside or the outside. The
PC 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 Dan an incentive to purchase from the Semiconductor Division. Jamie’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 PC 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,
Jamie’s price position appears to be the weakest.
358
Activity 24–2
The 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 overdemand 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.
359
Activity 24–3
1.
The rate of return on invested assets is computed as follows:
Income from operations ......
Invested assets ....................
ROI ........................................
Snack Goods
Cereal
Frozen Foods
$
510,000
÷ $2,500,000
20.4%
$
720,000
÷ $4,800,000
15.0%
$
378,000
÷ $1,800,000
21.0%
The Frozen Foods 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 12% rate of return would be accepted. This is because all three divisions have an ROI that is greater than 12%.
Thus, any project that is accepted between the 12% 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
margin is excellent:
Snack Goods
34% ($510,000/$1,500,000)
Cereal
30% rounded ($720,000/$2,400,000)
Frozen Foods
28% ($378,000/$1,350,000)
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.
Snack Goods
0.60 ($1,500,000/$2,500,000)
Cereal
0.50 ($2,400,000/$4,800,000)
Frozen Foods
0.75 ($1,350,000/$1,800,000)
The divisions need to work on increasing revenues or reducing invested assets in order to improve ROI.
360
Activity 24–4
1.
Profit margin (Income from
operations/Sales)..................................
2008
2009
2010
15%
18%
20%
2008
2009
2010
2.0
1.5
0.8
2008
2009
2010
30%
27%
16%
2.
Investment turnover (Sales/Invested
assets) ...................................................
3.
Rate of return on investment (Profit
margin × Investment turnover) ............
4.
Kurt is concerned about the Truck Division because the return on investment
appears to be deteriorating over the 2008–2010 operating periods. This is
happening even though the profit margin is increasing over this time period.
In order for this to occur, the investment turnover must be dropping, which is
the case in part (2).
The investment turnover is dropping faster than the profit margin is increasing. Thus, the rate of return on investment is dropping. It appears as though
the Truck Division is making very large investments in the business, but it is
not able to reap the returns required to support the investment. Specifically, it
appears as if the revenues are not growing fast enough to support the underlying asset investment. The invested asset base grew by approximately six
times, 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. In addition, the division is not able to maintain the
minimum threshold rate of return on investment of 20%. Kurt is concerned
because if the trend continues, the division will be earning in the future a rate
of return less than the minimum return on investment.
361
Activity 24–5
1.
Rate of Return on Investment
=
Income from Operations
Invested Assets
ROI
=
$4,500,000
$30,000,00 0
ROI
=
15%
or
2.
3.
Rate of Return on
Investment
=
Income from Operations
Sales
×
Invested Assets
Sales
ROI
=
$4,500,000
$22,500,00 0
×
$22,500,00 0
$30,000,00 0
ROI
=
20% × 0.75
ROI
=
15%
$63,000 (7 × $9,000 = $63,000, where 7 = 15% – 8%)
Rate of Return on Investment
=
Income from Operations
Invested Assets
ROI
=
$1,350,000
$15,000,00 0
ROI
=
9%
or
4.
Rate of Return on
Investment
=
Income from Operations
Sales
×
Invested Assets
Sales
ROI
=
$1,350,000
$9,000,000
×
$9,000,000
$15,000,00 0
ROI
=
15% × 0.60
ROI
=
9%
Even though the addition of the new product line would increase the overall
company rate of return on investment, its addition would decrease the
Apparel Division’s rate of return on investment from 15% to 13%
($5,850,000/$45,000,000). This decrease could negatively influence management’s evaluation of 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 $18,000 (2 × $9,000, where 2 = 15% – 13%).
362
Activity 24–5
5.
Concluded
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 8%, the overall company average rate of return, any investment
opportunity whose rate exceeded 8% would be viewed as acceptable. If this
performance measure had been used, the Apparel Division manager would
have increased the division’s residual income by $150,000 through the addition of the new product line, as shown below.
Projected income from operations of new product line ...........
Minimum amount of desired income from operations
($15,000,000 × 8%) ..................................................................
Residual income from new product line ....................................
$1,350,000
1,200,000
$ 150,000
The manager’s bonus could then be calculated as a percent of residual income. In this case, a bonus equal to 3% of residual income would achieve a
bonus similar to the initial plan:
Income from operations ..............................................................
Minimum desired income (8% × $30,000,000) ...........................
Residual income...........................................................................
× Bonus percentage .................................................................
Bonus ............................................................................................
$4,500,000
2,400,000
$2,100,000
×
3%
$ 63,000
The new project would add $4,500 ($150,000 × 3%) to the bonus.
In addition, nonfinancial performance indicators about product quality and
customer satisfaction can be used to supplement the financial numbers.
363
Activity 24–6
This activity is designed to introduce students to two very popular divisional
performance measurement approaches, the balanced scorecard and economic
value added (EVA). Both methods are getting very strong support in corporate
America. The two consulting firms’ home pages provided in this activity have
links to brief descriptions of the two methods. Thus, the student groups should
not have trouble completing the first part of the assignment. Hopefully, the
students will see that the two methods are different in one very important
respect. The balanced scorecard uses multiple financial and nonfinancial
measures within the customer, financial, innovation, and internal process dimensions to provide a “balanced” perspective of performance. One could argue that
the balanced scorecard is probably better able to use the measurement system in
communicating strategy through the organization. EVA, in contrast, is a single
financial measure that is strongly oriented to maximizing wealth to the shareholder. Hopefully, the students will recognize EVA as a specific application of the
residual income concept. EVA’s strength is in its simplicity and its apparent
association with wealth maximization (share values). It is interesting to note that
the two methods flow from two different philosophies. The balanced scorecard
takes a multiple stakeholder perspective, while EVA is taking a stockholder
wealth maximization perspective. Both approaches have their supporters. For
example, Sears, Roebuck and Co., ExxonMobil Corporation, and FMC Corporation have had success with the balanced scorecard, while The Coca-Cola
Company is a notable success story using EVA. This activity should provide
some rich classroom discussion comparing the advantages of “balance” versus
“stockholder wealth maximization.”
364