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Economic
Investment center' s
value
after - tax
added
operating income
Investment
Weighted - average
Investment
center' s
center' s
cost of
total assets
current
liabilitie
s
capital
For Golden Gate Construction Associates, we have the following calculations of each
divisions EVA.
Division
Real Estate
Construction
After-Tax
Operating
Income
(in millions)
Current
Liabilities
(in millions)
Total Assets
(in millions)
Economic
Value
Added
(in millions)
WACC
$30(1.40)
$150
$9
.114
$1.926
$27(1.40)
$ 90
$6
.114
$6.624
Transfer price
outlay
cost
opportunity
cost
Opportunity cost
2.
If the Fabrication Division has excess capacity, there is no opportunity cost associated
with a transfer. Therefore:
Transfer price
outlay
cost +
opportunity
cost
= $450 + 0 = $450
McGraw-Hill/Irwin
Inc.
Managerial Accounting, 6/e
The Assembly Division's manager is likely to reject the special offer because the
Assembly Division's incremental cost on the special order exceeds the division's
incremental revenue:
Incremental revenue per unit in special order........................
Incremental cost to Assembly Division per unit
in special order:
Transfer price......................................................................
Additional variable cost......................................................
Total incremental cost..............................................................
Loss per unit in special order..................................................
2.
$561
150
711
$ (11)
The Assembly Division manager's likely decision to reject the special order is not in the
best interests of the company as a whole, since the company's incremental revenue on
the special order exceeds the company's incremental cost:
Incremental revenue per unit in special order.....................
Incremental cost to company per unit in special order:
Unit variable cost incurred in Fabrication Division.........
Unit variable cost incurred in Assembly Division...........
Total unit variable cost..........................................................
Profit per unit in special order..............................................
3.
$700
$700
$450
150
600
$100
The transfer price could be set in accordance with the general rule, as follows:
Transfer price
outlay
cost
opportunity
cost
= $450 + 0*
= $450
*Opportunity cost is zero, since the Fabrication Division has excess capacity.
Now the Assembly Division manager will have an incentive to accept the special order
since the Assembly Division's incremental revenue on the special order exceeds the
incremental cost. The incremental revenue is still $700 per unit, but the incremental
cost drops to $600 per unit ($450 transfer price + $150 variable cost incurred in the
Assembly Division).
McGraw-Hill/Irwin
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Division II
$600,000
1,800,000
________
$ 900,000
300,000
$300,000
Division I
$2,700,000
Division II
$600,000
2,520,000
________
$ 180,000
420,000
$180,000
$2,700,000
$600,000
2,700,000
________
$
0
450,000
$150,000
(c)
Division I
$2,700,000
If the firm's cost of capital is 10 percent, then Division I has a higher residual income than
Division II. With a cost of capital of 15 percent, Division II has a higher residual income. At a
14 percent cost of capital, both divisions have the same residual income. This scenario
illustrates one of the advantages of residual income over ROI. Since the residual income
calculation includes an imputed interest charge reflecting the firm's cost of capital, it gives
McGraw-Hill/Irwin
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Managerial Accounting, 6/e
McGraw-Hill/Irwin
Inc.
Managerial Accounting, 6/e
Division I
$40,000,000
$ 8,000,000
$10,000,000
20%a
4b
80%c
$ 7,200,000d
Division II
$8,000,000e
$ 1,600,000
$8,000,000f
20%
1
20%g
$ 960,000h
Division III
$3,200,000l
$ 800,000k
$4,000,000j
25%
.8i
20%
$ 480,000
Explanatory notes:
income
$8,000,000
20%
sales revenue $40,000,000
Sales margin
Capital turnover
sales revenue
$40,000,000
4
invested capital $10,000,000
income
Sales margin
= sales revenue
$1,600,000
sales revenue
invested capital
1 =
$8,000,000
invested capital
Capital turnover
ROI
= 20% 1 = 20%
McGraw-Hill/Irwin
Inc.
Managerial Accounting, 6/e
ROI
20%
ROI
income
invested capital
= 20%
ROI
20% =
income
invested capital
income
$4,000,000
income
sales revenue
25% =
$800,000
sales revenue
McGraw-Hill/Irwin
Inc.
Managerial Accounting, 6/e
Increase income, while keeping invested capital the same. Suppose income
increases to $9,000,000. The new ROI is:
ROI
(b)
Decrease invested capital, while keeping income the same. Suppose invested
capital decreases to $9,600,000. The new ROI is:
ROI
(c)
ROI
income
$8,000,000
83.3% (rounded)
invested capital $9,600,000
2.
income
$9,000,000
90%
invested capital $10,000,000
income
$8,400,000
87.5%
invested capital $9,600,000
25% 1
25%
McGraw-Hill/Irwin
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Managerial Accounting, 6/e
2.
Division I
$2,700,000
Division II
$600,000
2,160,000
$ 540,000
360,000
$240,000
Division I
$2,700,000
Division II
$600,000
2,700,000
$
0
450,000
$150,000
McGraw-Hill/Irwin
Inc.
Managerial Accounting, 6/e
Division I
$2,700,000
Division II
$600,000
3,240,000
$(540,000)
540,000
$ 60,000
The imputed interest rate r, at which the two divisions residual income is the same, is
14 percent, computed as follows:
Division IIs residual
income
McGraw-Hill/Irwin
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Managerial Accounting, 6/e
$4,200,000
$2,940,000
1,075,000
4,015,000
$ 185,000
$6,800,000
6,540,000
$ 260,000
Divisional management will likely be against the acquisition because ROI will be
lowered from 20% to 18.25%. Since bonuses are awarded on the basis of ROI, the
acquisition will result in less compensation.
3.
$2,600,000
$
2,525,000
75,000
McGraw-Hill/Irwin
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Managerial Accounting, 6/e
Yes, the divisional ROI would increase to 21.01%. However, the absence of the
upgrade could lead to long-run problems, with customers being confused (and
perhaps turned-off) by two different retail environmentsthe retail environment they
have come to expect with other Megatronics outlets and that of the newly acquired,
non-upgraded competitor.
Sales revenue ($4,200,000 + $2,600,000).
Less: Variable costs [$2,940,000 +
($2,600,000 x 65%)] $4,630,000
Fixed costs ($1,075,000 + $835,000)...
1,910,000
Income...
$6,800,000
6,540,000
$ 260,000
McGraw-Hill/Irwin
Inc.
Managerial Accounting, 6/e
Year
1
2
3
4
5
Income
Income
Average
Before
Annual
Net of
Net Book
Depreciation Depreciation Depreciation Value*
$150,000
$200,000
$(50,000) $400,000
150,000
120,000
30,000
240,000
150,000
72,000
78,000
144,000
150,000
54,000
96,000
81,000
150,000
54,000
96,000
27,000
ROI
Based
on
Net Book
Value
12.5%
54.2%
118.5%
355.6%
Average
Gross
Book
Value
$500,000
500,000
500,000
500,000
500,000
ROI
Based
on
Gross
Book
Value
6.0%
15.6%
19.2%
19.2%
*Average net book value is the average of the beginning and ending balances for the year in net
book value. In Year 1, for example, the average net book value is:
$500,000 $300,000
$400,000
2
1.
This table differs from Exhibit 13-3 in that ROI rises even more steeply across time than
it does in Exhibit 13-3. With straight-line depreciation, ROI rises from 11.1 percent in
Year 1 to 100 percent in Year 5. Under the accelerated depreciation schedule used here,
we have a loss in Year 1 and then ROI rises from 12.5 percent in Year 2 to 355.6 percent
in Year 5.
2.
One potential implication of such an ROI pattern is a disincentive for new investment. If
a proposed capital project shows a loss or very low ROI in its early years, a manager
may worry about the effect on his or her performance evaluation in the early years of
the project. In an extreme case, a manager may worry that he or she will no longer have
the job when the project begins to show a higher return in its later years.
McGraw-Hill/Irwin
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Managerial Accounting, 6/e
Year
1
2
3
4
5
Income
Income
Average Imputed
Before
Annual
Net of
Net Book Interest Residual
Depreciation Depreciation Depreciation Value*
Charge Income
$150,000
$100,000
$50,000 $450,000 $45,000
$ 5,000
150,000
100,000
50,000
350,000
35,000
15,000
150,000
100,000
50,000
250,000
25,000
25,000
150,000
100,000
50,000
150,000
15,000
35,000
150,000
100,000
50,000
50,000
5,000
45,000
*Average net book value is the average of the beginning and ending balances for the year in net book value.
Imputed interest charge is 10 percent of the average book value, either net or gross.
Notice in the table that residual income, computed on the basis of net book value,
increases over the life of the asset. This effect is similar to the one demonstrated for ROI.
It is not very meaningful to compute residual income on the basis of gross book
value. Notice that this asset shows a zero residual income for all five years when the
calculation is based on gross book value.
McGraw-Hill/Irwin
Managerial Accounting, 6/e
2.
Strategy (a): Income will be reduced to $450,000 because of the loss, and
invested capital will fall to $8,910,000 from the disposal. ROI = $450,000
$8,910,000, or 5.05%. This strategy should be rejected, since it further hurts
Washburns performance.
Strategy (b): In terms of ROI, this strategy neither hurts nor helps. The
acceleration of overdue receivables increases cash and decreases accounts
receivable, producing no effect on invested capital. Of course, it is possible
that the newly acquired cash could be invested in something that would
provide a positive return for the firm.
3.
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-14
Current
Income. $ 540,000
Invested capital
9,000,000
ROI
6%
Current +
Anderson
Current +
Anderson +
Palm Beach
$ 1,440,000*
16,500,000
8.73%
$ 2,010,000**
23,625,000
8.51%
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-15
After-axMarket CostfMarket
cost f
debt value quityvalueof
eightd-W ofdebt capitl equity
averg capitl
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-16
Weighted - average
cost of capital
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-17
(.063)($400,000,000) (.12)($600,000,000)
.0972
$400,000,000 $600,000,000
Division
3.
Total
Current
Economic
Assets
Liabilities
Value
WACC =
(in
(in
Added
millions)
millions)
(in millions)
[($ 70
[($300
[($480
.0972]
.0972]
.0972]
$6)
$5)
$9)
= $ 3,579,200
= $ 2,826,000
= $(12,181,200)
The EVA analysis reveals that the Atlantic Division is in trouble. Its
substantial negative EVA merits the immediate attention of the management
team.
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-18
a.
Transfer price
b.
Transfer price
Note that the Frame Division manager would refuse to transfer at this price.
2.
a.
Transfer price
b.
c.
d.
$310
$30
40
60
60
30
60
280
$30
The special order should be accepted because the incremental revenue exceeds
the incremental cost, for Weathermaster Window Company as a whole.
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-19
$ 310
$198
60
30
60
348
$ (38)
The Glass Division manager has an incentive to reject the special order because
the Glass Division's reported net income would be reduced by $38 for every
window in the order.
f.
3.
One can raise an ethical issue here to the effect that a division manager should
always strive to act in the best interests of the whole company, even if that action
seemingly conflicts with the divisions best interests. In complex transfer pricing
situations, however, it is not always as clear what the companys optimal action is
as it is in this rather simple scenario.
The use of a transfer price based on the Frame Division's full cost has caused a cost
that is a fixed cost for the entire company to be viewed as a variable cost in the Glass
Division. This distortion of the firm's true cost behavior has resulted in an incentive for
a dysfunctional decision by the Glass Division manager.
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-20
$ 4,350
6,000
4,500
$14,850
It is possible that closing the ice cream counter might save a portion of the
utility cost, but that is doubtful.
A better analysis follows:
Sales ....................................................................................................
Less: Cost of food ..............................................................................
Gross profit .........................................................................................
Less: Operating expenses
Wages of counter personnel ...............................................
Paper products ......................................................................
Depreciation of counter equipment and furnishings* ........
Total .......................................................................................
Profit on ice cream counter
$67,500
30,000
37,500
$18,000
6,000
3,750
27,750
$ 9,750
(a) $11,100 allocation of rent on factory building: Irrelevant, since Toon Town Toy
Company will rent the entire factory building regardless of whether it continues
to operate the Packaging Department. If the department is eliminated, the space
will be converted to storage space.
(b) $13,000 rental of storage space in warehouse: Relevant, since this cost will be
incurred only if the Packaging Department is kept in operation. If the department
is eliminated, this $13,000 rental cost will be avoided.
2.
The $13,000 warehouse rental cost is the opportunity cost associated with using
space in the companys factory building for the Packaging Department.
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-21
(b)
If Packaging
Department
is Eliminated
$51,000
____
$51,000
$66,000
2.
The owners analysis is flawed, because the book value of the old pizza oven is a sunk
cost. It should not enter into the equipment replacement decision.
3.
Correct analysis:
Savings in annual operating expenses if old pizza oven is replaced .................. $3,000
Acquisition cost of new oven, which will be operable for one year .................... (2,200)
Net benefit from replacing old pizza oven ............................................................. $ 800
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-23
The relevant cost of the theolite to be used in producing the special order is the
21,750p sales value that the company will forgo if it uses the chemical. This is an
example of an opportunity cost.
p denotes Argentinas peso.
2.
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-24
2.
(a) 97,200p book value (8,000 kilograms 12.15p per kilogram): Irrelevant, since it is
a sunk cost.
(b) 1,000 kilograms to be used in the special order: Relevant, as shown in
requirement (1).
(c) 13.05p price if next order is placed early: Relevant, since this is the cost of
replacing the used genatope.
(d) 12.45p price if next order is placed on time: Relevant, because an additional 4,000
kilograms in the next order will be purchased at a .60p per kilogram premium.
This .60p premium is the difference between the 13.05p price and the 12.45p
price.
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-25
Alpha
$9.00
3
Beta
$36.00
18
$3.00
$2.00
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-26
Decision variables:
X = number of units of Alpha to be produced
Y = number of units of Beta to be produced
2.
Objective function:
Maximize 9X + 36Y
The coefficients of X and Y are the unit contribution margins for Alpha and
Beta, respectively. Maximizing this objective function will result in the highest
possible total contribution margin.
3.
Constraints:
(a) Direct-labor time constraint: .25X + 1.5Y 11,000
The coefficients of X and Y are the number of hours of direct labor
required to produce one unit of Alpha and one unit of Beta, respectively.
For example, the direct-labor cost per unit of Beta is $18.00, so it must
require 1.5 direct-labor hours per unit of Beta.
(b) Machine time constraint: 1X + 2Y 9,000
The coefficients of X and Y are the number of hours of machine time
required to produce one unit of Alpha and one unit of Beta, respectively.
(c) Nonnegative production quantities: X, Y 0
The complete linear program is the following
Maximize 9X + 36Y
Subject to: .25X + 1.5Y
1X + 2Y
X, Y
McGraw-Hill/Irwin
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13-27
11,000
9,000
0
2.
Maximize
24X + 42Y
Subject to:
2X + 2Y
24
1X + 3Y
24
X, Y
X=0
Y=0
$ 0
X=0
Y=8
336
X=6
Y=6
396
X = 12
Y=0
288
McGraw-Hill/Irwin
Companies, Inc.
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13-28
Y
25
20
15
Machine I constraint
10
Optimal solution (X = 6, Y = 6)
Objective function
Machine II constraint
Feasible
region
5
McGraw-Hill/Irwin
Companies, Inc.
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13-29
10
15
20
25
SOLUTIONS TO PROBLEMS
PROBLEM 14-44 (25 MINUTES)
1.
Sales..
Less: Variable costs.
Contribution margin.
Paint and
Supplies
Carpeting
Wallpaper
$190,000
114,000
$ 76,000
$230,000
161,000
$ 69,000
$ 70,000
56,000
$ 14,000
This cost should be ignored. The inventory cost is sunk (i.e., a past cost that
is not relevant to the decision). Regardless of whether the department is
closed, Contemporary Trends will have a wallpaper inventory of $11,850.
3.
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13-30
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13-31
Complete sets..................................
Dress and accessory cape..............
Dress and handbag.........................
Dress only........................................
Total units if additional items are
introduced......................................
Less: Unit sales if additional items
are not introduced.........................
Incremental sales............................
Incremental contribution margin
per unit (excluding material and
cutting costs).................................
Total incremental contribution
margin.............................................
Percent
of Total Dresses
70%
1,050
6%
90
15%
225
9% 135
100%
Total Number of
Accessory
Capes
Handbags
1,050
1,050
90
225
1,500
1,140
1,275
1,250
250
-1,140
--
1,275
$192.00
$48,000
$12.80
$14,592
Additional costs:
Additional cutting cost
(1,500 $14.40)............................
Additional material cost
(250 $80.00)...............................
Lost remnant sales
(1,250 $8.00)..............................
Incremental cutting for
extra dresses (250 $32.00).......
Incremental profit............................
2.
$4.80
$6,120
$68,712
$21,600
20,000
10,000
8,000
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-32
Total
59,600
$9,112
50,000
20,000
30,000
15,000
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-33
If the companys management team is able to reduce the direct material cost
per food processor to $18 ($15 less than previously assumed), then the cost
savings from manufacturing a food processor are $33 per unit ($18 savings
computed in requirement (1) plus $15 reduction in material cost):
Food
Blender Processor
$12.00
$33.00
1 MH 2 MH
$12.00
$16.50
2.
$ 45,000
9,000
$ 54,000
$ 3,000
600
24,000
12,000
$ 39,600
$ 14,400
$144,000
75,000
$ 69,000
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-34
$156,000
144,000
$ 12,000
McGraw-Hill/Irwin
Companies, Inc.
Managerial Accounting, 6/e
13-35
Cost of
10,000 Unit
Assembly Run Per Unit
$ 180,000
$ 18
450,000
45
450,000
45
$1,080,000
$108
Enhanced
$375.00
$42.00
22.50
36.00
$495.00
$67.50
30.00
48.00
37.50
49.50
138.00
$237.00
195.00
$300.00
2.
3.
Martinez, Inc. expects to sell 10,000 Standard units (40,000 units x 25%) or
8,000 Enhanced units (40,000 units x 20%). On the basis of this sales
forecast, the company would be advised to select the Standard model.
Standard
Total contribution margin:
10,000 units x $237; 8,000 units x $300. $2,370,000
Less: Marketing and advertising
195,000
Income... $2,175,000
4.
Enhanced
$2,400,000
300,000
$2,100,000
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Managerial Accounting, 6/e
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