CHAPTER 10 SEGMENTED REPORTING, INVESTMENT CENTER EVALUATION, AND TRANSFER PRICING

QUESTIONS FOR WRITING AND DISCUSSION

1. In centralized decision making, decisions are made at the very top level, and lowerlevel managers are responsible for implementing these decisions. For decentralized decision making, decisions are made and implemented by lower-level managers. 2. Decentralization is the delegation of decision-making authority to lower levels. 3. Reasons for decentralization include access to local information, cognitive limitations, more timely responses, focusing of central management, training, and motivation. 4. The only difference is the way in which fixed overhead costs are assigned. Under variable costing, fixed overhead is a period cost; under absorption costing, it is a product cost. 5. Absorption-costing income is greater because some of the periods fixed overhead is placed in inventory and not recognized on the absorption-costing income statement. 6. Absorption costing. Variable costing would recognize only the periods fixed overhead as an expense. The additional fixed overhead expense must have come from inventory. 7. Variable costing does not distort product performance by allocating common fixed costs. It allows managers to identify the contributions individual segments are making toward coverage of fixed costs. 8. Variable costing allows managers to identify what the costs ought to be for various levels of activity. By knowing what the costs ought to be for the actual level of activity, meaningful comparisons can be made to the costs that actually occurred. 9. A direct fixed cost is traceable to a particular cost object. A common fixed cost is common 11. to several cost objects. The distinction is important because direct fixed costs will vanish if the cost object is eliminated but common fixed costs will not. 10. Contribution margin is the amount available to cover fixed expenses and provide for profit. Segment margin is the amount available to cover common fixed expenses and provide for profit for a segment. Contribution margin is the difference between revenues and variable expenses. Segment margin is contribution margin less direct fixed expenses for a segment. Absorption-costing income can increase from one period to the next if more is produced than what is sold. Even though the fixed costs may not have changed, the fixed costs recognized on the income statement can change (because of inventory changes). Different customer groups cause different activities and costs. Understanding what activities are unique to the various customer groups can help the firm determine customer profitability and also help it set different prices for the customer groups.

12.

13. Margin = Operating income/Sales, and Turnover = Sales/Average operating assets. By breaking ROI into margin and turnover, more information is available to assess performance. Knowledge of margin and turnover gives more insight into why the ROI may change from one period to the next. 14. ROI (1) encourages managers to pay attention to the relationships among sales, expenses, and investment, (2) encourages cost efficiency, and (3) discourages excessive investment in operating assets. Increased profitability can be achieved (all else being equal) by increasing revenues, decreasing expenses, or lowering investment. 15. ROI may discourage managers from investing in projects that would increase the profitability of the firm but decrease the divisions

321

ROI. It also may encourage myopic behavior by encouraging managers to make decisions that are profitable in the short run but harmful in the long run (e.g., cutting research and development costs). 16. EVA is the difference between after-tax operating income and the total annual cost of capital. Owners may have difficulty developing goal congruence with managers because managers may not want to work as hard as the owner would like and because managers may wish to use the companys resources for their own benefit. Properly structured incentive pay plans may be successful in overcoming these problems. A transfer price is the price charged for goods that are transferred from one division to another. Transfer prices impact the revenues of the transferring division and the costs of the buying division and, thus, the profits of both divisions. A transfer price can affect the profits of the firm because it can affect the output decision of the buying division. If the price is set too high (low), then the output of the buying division may be too low (high). Since the transfer price can affect firmwide profitability, higher management may be tempted to interfere with the autonomy of a division and dictate the price (rather than letting the divisional manager make the pricing decision). The opportunity cost approach to transfer pricing identifies the minimum and maximum transfer prices. The minimum transfer price is the one that makes the transferring division no worse off, and the maximum transfer

price is the one that makes the buying division no worse off. 21. 22. Agree. At least one division will be made better off, and firm profits will increase. Market price. Minimum price = Maximum price = Market price. Any other price would make at least one division worse off, and firm profits may decrease if the price is not market price. Negotiated transfer prices allow both divisions to be made better off whenever opportunity costing signals that a transfer should take place. Because both can be made better off, no interference from headquarters is needed. Moreover, the price emerging is necessarily a mutually satisfactory price. In effect, negotiated prices can simultaneously satisfy the objectives of accurate performance evaluation, firmwide efficiency, and preservation of divisional autonomy. Disadvantages of negotiated transfer prices are that (1) private information can be used for exploitation, (2) performance measures are distorted by relative negotiating skills of managers, and (3) it is costly. Three cost-based transfer prices are full cost, full cost plus markup, and variable cost plus fixed fee. Disadvantages are that prices may not reflect the optimal outcome for the divisions and for the firm. Specifically, it is possible for the transfer price using one of the costing approaches to be less than the minimum price and greater than the maximum price. The prices, however, are simple to use and, in some cases, may reflect the outcome of a negotiated agreement.

17.

23.

18.

19.

24.

20.

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EXERCISES 10-1
Cost center Total cost Profit center Operating income Revenue Center - Sales Investment center - Return on Investment

102
1. Direct materials Direct labor Variable overhead Fixed overhead Total Total Cost $ 120,600 90,000 26,400 68,000 $ 305,000 Per Unit $ 6.03 4.50 1.32 3.40 $ 15.25

Cost of ending inventory = $15.25 650 = $9,912.50 2. Direct materials Direct labor Variable overhead Total Total Cost $ 120,600 90,000 26,400 $ 237,000 Per Unit $ 6.03 4.50 1.32 $ 11.85

Cost of ending inventory = $11.85 650 = $7,702.50 3. Since absorption costing is required for external reporting, the amount reported would be $9,912.50.

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103
1. Fixed overhead rate = $107,500/25,000 = $4.30 per unit The difference is computed as follows: Fixed overhead rate(Production Sales) $4.30(25,000 23,000) = $8,600 2. a. Lextel, Inc. Variable-Costing Income Statement For the Year Ended December 31, 2008 Sales (23,000 $26) ........................................ Less variable expenses: Cost of goods sold (23,000 $12.80) ...... Selling (23,000 $4) .................................. Contribution margin ....................................... Less fixed expenses: Overhead .................................................... Selling and administrative ........................ Operating income ........................................... b. $ 598,000 $ 294,400 92,000 $ 107,500 26,800 386,400 $ 211,600 134,300 $ 77,300

Lextel, Inc. Absorption-Costing Income Statement For the Year Ended December 31, 2008 Sales ..................................................................................... Less: Cost of goods sold (23,000 $17.10) ...................... Gross margin ....................................................................... Less: Selling and administrative expenses ...................... Operating income ........................................................... $ 598,000 393,300 $ 204,700 118,800 $ 85,900

104
1. Cocino Company Product-Line Income Statements Blenders Sales $ 2,200,000 Less: Variable cost of goods sold 2,000,000 Contribution margin $ 200,000 Less: Direct fixed expenses 90,000 Product margin $ 110,000 Less: Common fixed expenses Net income Coffee Makers $ 1,125,000 1,075,000 $ 50,000 45,000 $ 5,000 Total $ 3,325,000 3,075,000 $ 250,000 135,000 $ 115,000 115,000 $ 0

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2.

If the coffee-maker line is dropped, profits will decrease by $5,000, the product margin. If the blender line is dropped, profits will decrease by $110,000. Blenders Sales $ 2,405,000 Less: Variable cost of goods sold 2,200,000 Contribution margin $ 205,000 Less: Direct fixed expenses 90,000 Product margin $ 115,000 Less: Common fixed expenses Operating income Coffee Makers $ 1,125,000 1,075,000 $ 50,000 45,000 $ 5,000 Total $ 3,530,000 3,275,000 $ 255,000 135,000 $ 120,000 115,000 $ 5,000

3.

Profits increase by $5,000. Alternatively, Increased profit = ($20.50 - $20.00) 10,000 = $5,000 105
1. Absorption costing: Direct materials Direct labor Variable overhead Fixed overhead Unit cost $1.20 0.75 0.65 3.10 $5.70

Cost of ending inventory = $5.70 200 = $1,140 2. Variable costing: Direct materials Direct labor Variable overhead Unit cost

$1.20 0.75 0.65 $2.60

Cost of ending inventory = $2.60 200 = $520 3. Selling price Less: Variable cost of goods sold Commission Contribution margin per unit $ 7.50 (2.60) (0.75) $ 4.15

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4.

Sales ($7.50 17,600) ............................... Less: Variable cost of goods sold ................ Commissions ....................................... Contribution margin.................................. Less fixed expenses: Fixed overhead .................................... Fixed administrative ............................ Net income .................................................

$ 132,000 $45,760 13,200 $27,900 23,000 58,960 $ 73,040 50,900 $ 22,140

Variable costing should be used, since the fixed costs will not increase as production and sales increase.

106
1. 2. Operating income = Sales Expenses = $50,000 $48,000 = $2,000 Margin = Operating income/Sales = $2,000/$50,000 = 0.04 Turnover = Sales/Operating assets = $50,000/$10,000 = 5 3. ROI = Margin Turnover = 0.04 5 = 0.20, or 20%

107
1. 2. Average operating assets = ($78,650 + $81,350)/2 = $80,000 Margin = Operating income/Sales = $7,200/$240,000 = 0.03 Turnover = Sales/Operating assets = $240,000/$80,000 = 3.0 ROI = Margin Turnover = 0.03 3.0 = 0.09, or 9.0%

108
1. a. ROI of division without radio = $480,000/$8,000,000 = 0.06 b. ROI of the radio project = $270,000/$1,500,000 = 0.18 c. ROI of division with radio = $750,000/$9,500,000 = 0.0789 Yes, Cheryl will decide to invest in the project, since overall division ROI will increase.

2.

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109
1. 2. 3. Mortgage bonds Common stock Total After-tax cost of mortgage bonds = (1 0.3)(0.08) = 0.056 Cost of common stock = 0.06 + 0.06 = 0.12 Dollar Amount $1,300,000 700,000 $2,000,000 Percent 0.65 0.35 After-Tax Cost = 0.056 0.120 Weighted Cost 0.0364 0.0420 0.0784

Weighted average cost of capital 4. 5. Cost of capital = $1,500,000 0.0784 = $117,600 After-tax operating income Less: Cost of capital EVA $115,000 117,600 $ (2,600)

Because EVA is negative, Schipper is destroying wealth.

1010
1. 2. 3. Mortgage bonds Common stock Total After-tax cost of mortgage bonds = (1 0.4)(0.08) = 0.048 Cost of common stock = 0.06 + 0.06 = 0.12 Dollar Amount $1,300,000 700,000 $2,000,000 Percent 0.65 0.35 After-Tax Cost = 0.048 0.120 Weighted Cost 0.0312 0.0420 0.0732

Weighted average cost of capital 4. 5. Cost of capital = $1,500,000 0.0732 = $109,800 After-tax operating income Less: Cost of capital EVA $115,000 109,800 $ 5,200

EVA is now positive, and Schipper is creating wealth.

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10-11

1.

MP3 player: RI = $116,000 (0.12 $800,000) = $20,000 Voice Rec.: RI = $105,000 (0.12 $750,000) = $15,000
Add Only MP3 Player Add Only Voice Rec. Add Both Projects Maintain Status Quo

2.

Operating income $2,816,000 Minimum income* 2,256,000 Residual income $ 560,000

$2,805,000 2,250,000 $ 555,000

$2,921,000 2,346,000 $ 575,000

$2,700,000 2,160,000 $ 540,000

*Minimum income = Operating assets Minimum required rate of return The manager will invest in both the MP3 player and the voice recorder. 3. ROI MP3 player = $116,000/$800,000 = 0.145 or 14.5% ROI voice recorder = $105,000/$750,000 = 0.14 or 14.0%
4. Add Only MP3 Player Add Only Voice Rec. Add Both Projects Maintain Status Quo

Operating income Operating assets ROI

$2,816,000 18,800,000 14.98%

$2,805,000 18,750,000 14.96%

$2,921,000 19,550,000 14.94%

$2,700,000 18,000,000 15.00%

The manager will invest in neither project. 10-12

1. North Woods residual income = $140,000 (0.08)($1,000,000) = $60,000 Midwest residual income = $330,000 (0.08)($3,000,000) = $90,000 2. North Woods ROI = $140,000/$1,000,000 = 0.14 or 14% Midwest ROI = $330,000/$3,000,000 = 0.11 or 11 %

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1013
1. Maximum transfer price = $42 Minimum transfer price = $15 Only variable costs are relevant for the minimum transfer price since the Furniture Division has excess capacity. Yes, the transfer should take place. 2. Benefit to Furniture Division: Revenue ($30 10,000) Less: Variable cost ($15 10,000) Benefit Benefit to Motel Division: Outside supplier ($42 10,000) Transfer price ($30 10,000) Benefit $ 300,000 150,000 $ 150,000 $ 420,000 300,000 $ 120,000

Benefit to company = $150,000 + $120,000 = $270,000 3. Maximum transfer price = $42 Minimum transfer price = $42 It does not matter whether or not the transfer takes place because the cost to the company is the same whether the Motel Division buys from the outside supplier or from the internal supplier (the Furniture Division).

1014
1. The minimum and maximum transfer price for each division is $2.30. The company is indifferent to the transfer because it earns the same income whether or not it takes place. If the transfer takes place, the price should be $2.30. The minimum transfer price is $2.10, and the maximum price is still $2.30. The transfer should take place because the company would save $30,000 (150,000 $0.20) each year. The offer should be accepted because the Small Motor Divisions profits would increase by $15,000 (representing an even split of the savings from internal transfer).

2.

3.

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1015
1. Maximum price Minimum price* Difference Number of packages Increased profit $ 3.95 2.25 $ 1.70 150,000 $ 255,000

*Due to idle capacity of the Paper Division, the minimum price is a variable cost of $2.25 per package. Since selling costs of $0.40 are avoidable, they are not included. Yes, the transfer should take place. 2. Penelope would definitely consider the $3.20 price because her income would increase $112,500 ([$3.95 $3.20] 150,000). Tom would most likely negotiate a price less than $3.75 if he has knowledge of the excess capacity. The full-cost transfer price is $3.45 ($2.25 + $1.20). If the transfer takes place, the Paper Division will make an additional $180,000 (150,000 $1.20) and the School Photography Division will save $75,000 ([$3.95 $3.45] 150,000).

3.

1016
Revenues Expenses Operating income Assets Margin Turnover ROI A $10,000 7,800 2,200 20,000 22%1 0.502* 11%3 B $ 45,000 27,0004 18,000 144,0005 40% 0.3125 12.5%6
8 9

C $200,000 188,000 12,0007 100,000 6%8 29 12.0%10

D $19,20011 18,00012 1,20013 9,600 6.25% 2.00 12.5%14

*Indicates missing amount. 1 $2,200/$10,000 = 0.22 2 $10,000/$20,000 = 0.50 3 $2,200/$20,000 = 0.11 4 $45,000 - $18,000 = $27,000 5 $45,000 0.3125 = $144,000 6 0.4 0.3125 = 0.125 7 $200,000 - $188,000 = $12,000

$12,000/$200,000 = 0.06 $200,000/$100,000 = 2 10 $12,000/$$100,000 = 0.12 11 $9,600 2 = $19,200 12 $19,200 - $1,200 = $18,000 13 $19,200 0.0625 = 1,200 14 $1,200/$9,600 = 0.125

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10-17
1. Company A residual income = $2,200 (0.12)($20,000) = $200 Company B residual income = $18,000 (0.12)($144,000) = $720 Company C residual income = $12,000 (0.12)($100,000) = 0 Company D residual income = $1,200 (0.12)($9,600) = $48

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PROBLEMS 1018
1. Diaz Company Absorption-Costing Income Statements Sales ........................................................................... Less: Cost of goods sold* ........................................ Gross margin ............................................................. Less: Selling and administrative expenses ............ Net income ........................................................... *Beginning inventory ................................................ Cost of goods manufactured .................................. Goods available for sale ......................................... Less: Ending inventory ........................................... Cost of goods sold ............................................. Year 1 $ 572,000 299,000 $ 273,000 163,800 $ 109,200 $ 0 345,000 $ 345,000 46,000 $ 299,000 Year 2 $ 660,000 361,000 $ 299,000 163,800 $ 135,200 $ 46,000 315,000 $ 361,000 0 $ 361,000

Firm performance has improved from Year 1 to Year 2. 2. Diaz Company Variable-Costing Income Statements Sales ........................................................................... Less: Variable cost of goods sold* ......................... Contribution margin ................................................. Less fixed expenses: Overhead .............................................................. Selling and administrative .................................. Net income ................................................................. *Beginning inventory ................................................ Variable cost of goods manufactured ................... Goods available for sale ......................................... Less: Ending inventory ........................................... Cost of goods sold ............................................. Year 1 $ 572,000 195,000 $ 377,000 (120,000) (163,800) $ 93,200 $ 0 225,000 $ 225,000 30,000 $ 195,000 Year 2 $ 660,000 225,000 $ 435,000 (120,000) (163,800) $ 151,200 $ 30,000 195,000 $225,000 0 $ 225,000

Firm performance has improved from Year 1 to Year 2.

3. Year 1 fixed overhead rate = $120,000/30,000 = $4.00

4. Absorption-costing inventory = ($7.50 + $4.00) 4,000 = $46,000 Variable-costing inventory = $7.50 4,000 = $30,000

1019
332

1.

Ziemble Company Absorption-Costing Income Statement Sales ........................................................................................... Cost of goods sold* .................................................................. Gross margin ............................................................................. Selling and administrative expenses ...................................... Net income ........................................................................... *Fixed overhead rate = $300,000/75,000 = $4 per unit Applied fixed overhead = $4 74,000 = $296,000 Underapplied fixed overhead = $300,000 $296,000 = $4,000 Cost of goods sold = ($4 72,000) + $4,000 + $756,000 = $1,048,000 $ 1,512,000 1,048,000 $ 464,000 444,000 $ 20,000

2.

The difference is $8,000 ($20,000 $12,000) and is due to the fixed overhead that would be attached to the ending inventory ($4 2,000 units). IA IV = Fixed overhead rate(Production Sales) $20,000 $12,000 = $4(74,000 72,000) $8,000 = $8,000

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1020
1. Scented Sales $ 13,000 Less: Variable expenses 9,100 Contribution margin $ 3,900 Less: Direct fixed expenses 4,250 Product margin $ (350) Less: Common fixed expenses Net (loss) Musical $ 19,500 15,600 $ 3,900 5,750 $ (1,850) Regular $ 25,000 12,500 $ 12,500 3,000 $ 9,500 Total $ 57,500 37,200 $ 20,300 13,000 $ 7,300 7,500 $ (200)

Kathy should accept this proposal. The 30 percent sales increase, coupled with the increased advertising, reduces the loss from $1,000 to $200. Both scented and musical product-line profits increase. However, more must be done. If the scented and musical product margins remain negative, the two products may need to be dropped. 2. Sales Less: Variable expenses Contribution margin Less: Fixed expenses Operating income (loss) Regular $ 20,000 10,000 $ 10,000 10,500 $ (500)

Dropping the two lines would still result in a loss. Other options need to be developed. 3. Combinations would be beneficial. Dropping the musical line (which shows the greatest segment loss) and keeping the scented line while increasing advertising yields a profit (the optimal combination). Sales Less: Variable expenses Contribution margin Less: Direct fixed expenses Product margin Less: Common fixed expenses Operating income Scented $ 13,000 9,100 $ 3,900 4,250 $ (350) Regular $ 22,500 11,250 $ 11,250 3,000 $ 8,250 Total $ 35,500 20,350 $ 15,150 7,250 $ 7,900 7,500 $ 400

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1021
1. Direct materials Direct labor Variable overhead Fixed overhead ($180,000/200,000) Total $3.60 2.00 0.40 0.90 $ 6.90 $ 2,070,000 1,428,300 $ 641,700 132,100 $ 509,600

Per-unit inventory cost on the balance sheet is $6.90. Sales (207,000 $10) Less: Cost of goods sold Gross margin Less: Selling and administrative expenses Net income 2. Direct materials Direct labor Variable overhead Total $ 3.60 2.00 0.40 $ 6.00

Per-unit inventory cost under variable costing equals $6.00. This differs from the per-unit inventory cost in Requirement 1 because the balance sheet is for external use and reflects absorption costing. Variable costing does not include per-unit fixed overhead. Sales Less variable expenses: Variable cost of goods sold Variable selling and administrative Contribution margin Less fixed expenses: Fixed overhead Fixed selling and administrative Net income 3. IV IA $515,900 $509,600 $6,300 $6,300 = FOR(Sales Production) = $0.90(207,000 200,000) = $0.90(7,000) = $6,300 $ 2,070,000 1,242,000 62,100 $ 765,900 180,000 70,000 515,900

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4.

Sales (196,700 $10) Less: Cost of goods sold (196,700 $6.90) Gross margin Less: Selling and administrative expenses Absorption costing operating income Sales Less variable expenses: Variable cost of goods sold Variable selling and administrative Contribution margin Less fixed expenses: Fixed overhead Fixed selling and administrative Variable costing operating income

$ 1,967,000 1,357,230 $ 609,770 129,010 $ 480,760 $1,967,000 1,180,200 59,010 $ 727,790 180,000 70,000 477,790

5.

IA IV $480,760 $477,790 $2,970 $2,970

= FOR(Sales Production) = $0.90(200,000 196,700) = $0.90(3,300) = $2,970

1022
1. Air conditioner, ROI = $67,500/$750,000 = 9.0% Turbocharger, ROI = $89,700/$690,000 = 13.0% 2. Income Assets ROI With Air Conditioner $3,246,500 $29,650,000 10.95% With Turbocharger $3,268,700 $29,590,000 11.05% With Both Investments $3,336,200 $30,340,000 11.00% Neither Investment $3,179,000 $28,900,000 11.00%

The manager will choose the turbocharger, but not the air conditioner. 3. Cost of capital = (1 0.25)(0.12)($1,500,000) = $135,000

EVA = ($67,500 + $89,700) $135,000 = $22,200 Yes, the two investments increase the wealth of the division, since EVA is positive.

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1023
1. 2. $310,000/$3,000,000 = 10.33%* Margin: $310,000/$3,450,000 = 8.99% Turnover: $3,450,000/$3,000,000 = 1.15 ROI = 1.15 8.99% = 10.34% *Difference due to rounding. 3. ($310,000 + $57,500)/($3,000,000 + $500,000*) = 10.5% *($600,000 + $400,000)/2 The manager will approve the investment. 4. Margin: ($310,000 + $57,500)/($3,450,000 + $575,000) = 9.13% Turnover: ($3,450,000 + $575,000)/($3,000,000 + $500,000) = 1.15 The margin has increased, and the turnover ratio has stayed the same. 5. With: ($310,000 + $57,500)/($3,000,000 + $500,000 $800,000) = 13.61% Without: $310,000/($3,000,000 $800,000) = 14.09% The manager will most likely reject the investment because it lowers the divisional ROI. The investment should be accepted because it increases total profits. 6. Margin: $310,000/$3,450,000 = 8.99% Turnover: $3,450,000/$2,200,000 = 1.57

1024
1. ROI Margin Turnover 2. Year 1 8.00% 12.00% 0.67 Year 2 6.97% 11.00% 0.63 Year 3 6.30% 10.50% 0.60

ROI: $1,200,000/$15,000,000 = 8% Margin: $1,200,000/$10,000,000 = 12% Turnover: $10,000,000/$15,000,000 = 0.67 The ROI increased because expenses decreased and assets turned over at a higher rate (sales increased).

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3. Operating assets: $15,000,000 80% = $12,000,000

ROI: $945,000/$12,000,000 = 7.88% Margin: $945,000/$9,000,000 = 10.5% Turnover: $9,000,000/$12,000,000 = 0.75 The ROI increased because assets decreased. 4. ROI: $1,200,000/$12,000,000 = 10% Margin: $1,200,000/$10,000,000 = 12% Turnover: $10,000,000/$12,000,000 = 0.83 The ROI increased because expenses decreased and assets turned over at a higher rate (sales increased and the amount of assets decreased). Both margin and turnover increased.

1025
1. After-tax cost of mortgage bonds = (1 0.4)(0.06) = 0.036 Cost of common stock = 0.08 + 0.03 = 0.11 Dollar Amount Percent Mortgage bonds $ 3,000,000 0.25 Common stock 9,000,000 0.75 Total $ 12,000,000 Weighted average cost of capital Cost of capital = $4,000,000 0.0915 = $366,000 2. After-tax operating income Less: Cost of capital EVA $ 350,000 366,000 $( 16,000) After-Tax Cost = 0.036 0.110 Weighted Cost 0.0090 0.0825 0.0915

EVA is negative; Donegal is destroying wealth. 3. After-tax cost of new bonds = (1 0.4)(0.09) = 0.054 Dollar After-Tax Amount Percent Cost = Unsecured bonds $ 2,000,000 0.143 0.054 Mortgage bonds 3,000,000 0.214 0.036 0.643 0.110 Common stock 9,000,000 Total $ 14,000,000 Weighted average cost of capital Cost of capital = $5,000,000 0.0861 = $430,500

Weighted Cost 0.0077 0.0077 0.0707 0.0861

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4.

After-tax operating income Less: Cost of capital EVA

$430,000 430,500 ($ 500)

No, this is not a good idea. EVA is negative and Donegal is destroying wealth.

1026
1. Minimum: $26 Maximum: $31 ($26 + $31)/2 = $28.50. Thus, the transfer price would be expressed as full cost plus 42.5% ($20 + $8.50/$20). New minimum: $27 New maximum: $32 ($27 + $32)/2 = $29.50 or full cost plus 47.5% ($20 + $9.50/20) 4. The two divisions would renegotiate because the buying division would probably be able to buy the necessary part at a lower price from another supplier. The Auxiliary Components Division might have to reduce its price.

2.

3.

1027
1. Lorne should not reduce the price charged to Rosario if he can sell all he produces. It does not matter whether the two divisions trade internally or not. The minimum price is $53, and the maximum is $75. Yes, Lorne should consider the transfer, since his income will increase by $59,500 [3,500($70 $53)]. 3. The transfer price would be $75.60 ($63 1.2). No, the transfer would not occur, since the transfer price is higher than the outside price that Rosario could get.

2.

1028
1. Sales Variable expenses Contribution margin Component Y34 $260,000 160,000 $100,000 Model SC67 $1,680,000 920,000 $ 760,000 Company $1,940,000 1,080,000 $ 860,000

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2.

The transfer price should be the market price of $12. This is the minimum price for the Components Division and the maximum price for the PSF Division. Unless the PSF Division is able to increase the price of Model S667, the manager will discontinue production and will not purchase any of the components. (The cost of producing the scanner will increase from $38 to $43.50, a cost greater than the current selling price of $42.) All 40,000 units of Component Y34 will be sold externally at the market price of $12 per unit. Sales Variable expenses Contribution margin $480,000 160,000 $320,000

3.

4. 5.

The contribution margin decreases by $540,000. Cam made the wrong decision.

1029
1. Madengrad Company Variable-Costing Income Statement Budgeted for Next Year Sales (21,500 $900) ................................................ Less variable expenses: Cost of goods sold (21,500 $525) .................... $11,287,500 Selling (21,500 $75) .......................................... 1,612,500 Contribution margin ................................................. Less: Fixed expenses ............................................... Operating income (loss) ..................................... 2. Madengrad Company Variable-Costing Income Statement Budget Based on Technological Change Sales (21,500 $900) ................................................ Variable cost of goods sold: Direct materials (21,500 $180) ......................... Direct labor (21,500 $216) ................................ Overhead (21,500 $78.75) ................................. Variable selling (21,500 $75) ................................. Contribution margin ................................................. Less: Fixed expenses ............................................... Operating income ................................................ $ 19,350,000 $3,870,000 4,644,000 1,693,125 $ 19,350,000 12,900,000 $ 6,450,000 6,600,000 $ (150,000)

10,207,125 1,612,500 $ 7,530,375 7,260,000 $ 270,375

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1030
A. B. C. D. E. Cost; total manufacturing cost Investment; ROI Revenue; total sales revenue Profit; operating income Investment; ROI

1031
1. The profit change can be explained by the following analysis: Increase in sales revenues $20,000 Increase in variable manufacturing costs ($3.90 2,000) (7,800) Increase in variable selling costs ($0.50 2,000) (1,000) Increase in fixed overhead: Year 12,000 units $2.90 (5,800) Year 21,000 units $3.00 (3,000) Year 3 underapplied fixed OH (3,000) Net change in income $ (600) The problem is the increased fixed overhead. We expect variable costs to increase, but the increase in fixed overhead expenses is notable, because the actual fixed overhead incurred for Year 3 is the same as that of Year 2. This increase in fixed overhead recognized on the income statement is explained by the fact that in Year 3, the division sold units from prior years with fixed overhead attached to them, and by the fact that no fixed overhead was inventoried (as was the case in Year 2). 2. Year 1 Year 2 Year 3 Sales $ 80,000 $100,000 $120,000 Less variable expenses: Cost of goods sold (31,200) (40,000) (47,800) Selling expense (3,200) (5,000) (6,000) Contribution margin $ 45,600 $ 55,000 $ 66,200 Less fixed expenses: Fixed overhead (29,000) (30,000) (30,000) Other fixed costs (9,000) (10,000) (10,000) Net income $ 7,600 $ 15,000 $ 26,200 FOH, ending inventory FOH, beginning inventory Change in fixed overhead
a b

$ 5,800a 0 $ 5,800

$ $

8,800b 5,800 3,000

$ $

0 8,800 8,800

$2.90 2,000 units ($3.00 1,000 units) + $5,800

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The difference between the absorption- and variable-costing incomes is due to the change in fixed overhead in the divisions inventories. In Year 1, $5,800 of the fixed overhead went into inventory; so, absorption-costing income exceeds variable-costing income by $5,800. In Year 2, $3,000 more fixed overhead was inventoried, and absorption-costing income was $3,000 greater than variable-costing income. However, in Year 3, the inventory was sold, and absorption-costing income now recognizes that additional $8,800 of fixed overhead ($5,800 + $3,000), explaining why variable-costing income is greater by this amount. 3. Since variable-costing income provides an increase in income when sales increase and costs do not change, the company vice president would have preferred variable costing. Variable costing would have provided the expected bonus to the divisional manager and a consistent signal of improved performance.

1032
1. The transfer price based on variable manufacturing costs to produce the cushioned seat and the Office Divisions opportunity cost is $1,869 for a 100unit lot, or $18.69 per seat as summarized below: Variable cost ......................................................... Opportunity cost .................................................. Transfer price ....................................................... Variable cost: Cushioned material: Padding............................................................ Vinyl ................................................................. Total ............................................................ Cost increase 10% .......................................... Cost of cushioned seat ............................. Cushion fabrication labor ($7.50 0.5) ..................................................... Variable overhead ($5.00 0.5) ..................................................... Total variable cost per cushioned seat .............. Total variable cost per 100-unit lot ..................... $1,329 540 $1,869

$ 2.40 4.00 $ 6.40 1.10 $ 7.04 3.75 2.50 $13.29 $1,329

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1032 Continued
Overhead Analysis Variable Amount Per DLH Total $ 420,000 $1.40 375,000 1.25 180,000 0.60 140,000 200,000 1,700,000 450,000 75,000 $1,500,000 1.50 50,000 0.25 $5.00 $2,340,000 0.16* $7.80 0.47 0.67 5.67 Fixed Amount Total Per DLH $ 250,000 $0.83

Supplies Indirect labor Supervision Power Heat and light Property taxes and insurance Depreciation Employee benefits: 20% Direct labor 20% Supervision 20% Indirect labor Total

*The per DLH amount for supervision has been adjusted down to $0.16 to eliminate the rounding error between the sum of the amounts per DLH and the total divided by 300,000 DLH. Variable overhead rate = ($1,500,000/300,000) = $5.00 per DLH Fixed overhead rate = ($2,340,000/300,000) = $7.80 per DLH Opportunity cost: Labor hour constraint: DLH to make 100 deluxe office stools (1.50 100) Less: DLH to make 100 cushioned seats (0.50 100) Labor hours available for economy office stool Number of economy office stools 150 hours 50 hours 100 hours

= 100 DLH/0.8 hours per stool = 125 stools

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1032 Concluded
Opportunity cost calculation: Deluxe Office Stool $58.50 $14.55 11.25 ($7.50 1.5) 7.50 ($5.00 1.5) $33.30 $25.20 100 $2,520 Economy Office Stool $41.60 $15.76 6.00 ($7.50 0.8) 4.00 ($5.00 0.8) $25.76 $15.84 125 $1,980

Selling price Costs: Materials Labor Variable overhead Total costs CM/unit Units produced Total CM

Opportunity cost of shifting production to the economy office stool = $2,520 $1,980 = $540. 2. Variable manufacturing cost plus opportunity cost would be the best transfer pricing system to use because it would allow the supplying division to be indifferent between selling the product internally to another division or selling the product in the external market. This transfer pricing method ensures that the supplying divisions contribution to profit would be the same under either alternative. The sum of the variable manufacturing cost and the opportunity cost represents the effort put forth by the supplying division to the overall well-being of the company. An appropriate transfer price must attempt to fulfill the company objectives of autonomy, incentive, and goal congruence. While no one transfer price can necessarily satisfy each of these objectives fully in all situations, the variable manufacturing cost plus opportunity cost transfer price should be the most appropriate method for meeting these objectives in most situations.

1033
1. Many legitimate reasons support the creation of inventory (e.g., the need to avoid stockouts and the need to ensure on-time delivery). Paul Chessers reasons, however, are based on self-interest and ignore whats best for the company. Knowingly producing for inventory to obtain personal financial gain at the expense of the company certainly could be labeled as unethical behavior. Since the decision to produce for inventory was not motivated by any sound economic reasoning, and Ruth knows the real motive behind the decision, she should feel discomfort in the role she has been asked to assume. If she

2.

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decides to appeal to higher-level management, the divisional manager can counter with arguments that inventory was created because he expected the economy to turn around and did not want to be in a position of not having enough goods to meet demand. Even though Ruth may have a difficult time proving any allegation of improper conduct, if she is convinced that the behavior is truly unethical, then appeals to higher-level management with the prospect of ultimate resignation should be the route she takes. Alternatively, Ruth might decide that the use of absorption costing for internal reporting and bonus calculation has led to this situation. She could lobby higher management to begin using variable costing as a way of avoiding these dysfunctional decisions. Ruth will have a very hard time proving unethical behaviorat worst, Paul may be accused of having poor judgment regarding future economic upturns. 3. The following standards may apply: Integrity. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. (III-2) Credibility. Communicate information fairly and objectively. (IV-1) Disclose fully all relevant information that could reasonably be expected to influence an intended users understanding of the reports, comments, and recommendations. (IV-2)

1034
1. ROI based on initial estimates = $1,870,000/$15,600,000 = 11.99% ROI based on Mels estimates = $2,340,000/$15,600,000 = 15% Jason is definitely facing an ethical dilemma. While it is true that the sales and expense projections are estimates, they are the best ones available to him. If he uses a sales revenue projection from the top end of the range, he will be deliberately basing the ROI estimate on a highly unlikely sales figure. Sales and expense projections are not fantasy figures, they are supposed to be managements best estimate of what will actually happen. If Jason prepares the report in accordance with Mels desires, he will be knowingly fabricating data. One might wonder whether or not Mels offer to back up Jason is sufficient to let Jason off the hook. It is not. If Mel wants the false projections badly enough, let him sign them. Jason may have thought he had his dream job, but it is about to turn into a nightmare. Companies dont take kindly to employees who lie, and this lie is sure to come out. If the project is approved, and the sales do not approach $2.34 million, you can bet that the vice president of

2.

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sales will be quick to point out that she predicted only $1.87 million. Mel will surely pin the blame directly on Jason, the one whose name is on the report. 3. Jason should prepare the report using the figures he thinks are most descriptive of the projects potential. He should feel free to include information about the predicted range of sales, and to point out any other information that reflects favorably on the project. If Mel continues to pressure Jason, then Jason might consider looking for another job.

RESEARCH ASSIGNMENTS 1035

Answers will vary.

1036
Answers will vary.

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