CHAPTER 24



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.

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)

PE 24–3A

Norsk West

Division Division

Net sales $700,000 $770,000

Cost of goods sold 365,000 462,000

Gross profit $335,000 $308,000

Selling expenses 142,500 173,000

Income from operations before service

department charges $192,500 $135,000

Service department charges 67,500 112,500

Income from operations $125,000 $ 22,500

PE 24–3B

Computer Peripheral

Division Division

Net sales $ 1,200,000 $ 1,305,000

Cost of goods sold 610,000 764,000

Gross profit $ 590,000 $ 541,000

Selling expenses 264,000 245,000

Income from operations before service

department charges $ 326,000 $ 296,000

Service department charges 56,000 84,000

Income from operations $ 270,000 $ 212,000

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%

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 $ 60,000

Minimum acceptable income from operations as a percent

of assets ($440,000 × 12%) (52,800)

Residual income $ 7,200

PE 24–5B

Income from operations $ 135,000

Minimum acceptable income from operations as a percent

of assets ($650,000 × 10%) (65,000)

Residual income $ 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

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

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 Actual Over Budget Under Budget

Mid-Atlantic Region $ 416,000 $ 416,000 $ 0

West Region 297,600 296,000 1,600

South Region 327,040 (g) 330,320 (h) $3,280 (i)

$1,040,640 (j) $1,042,320 (k) $3,280 (l) $1,600

ILIAD COMPANY

Budget Performance Report—Manager, South Region Plant

For the Month Ended April 30, 2010

Department Budget Actual Over Budget Under Budget

Chip Fabrication $ 104,800 (a) $ 107,440 (b) $2,640 (c)

Electronic Assembly 85,120 86,240 1,120

Final Assembly 137,120 136,640 $480

$327,040 (d) $330,320 (e) $3,760 (f) $480

Ex. 24–1 Concluded

ILIAD COMPANY

Budget Performance Report—Supervisor, Chip Fabrication

For the Month Ended April 30, 2010

Department Budget Actual Over Budget Under Budget

Factory wages $ 24,640 $ 26,400 $1,760

Materials 69,600 69,120 $480

Power and light 3,840 4,560 720

Maintenance 6,720 7,360 640

$ 104,800 $ 107,440 $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

Residential Industrial

Division Division

Net sales $625,000 $367,500

Cost of goods sold 415,200 206,350

Gross profit $209,800 $161,150

Administrative expenses 74,500 72,400

Income from operations before service

department charges $135,300 $ 88,750

Service department charges 56,400 35,480

Income from operations $ 78,900 $ 53,270

Ex. 24–3

Expense Activity Bases

a. Central purchasing Number of requisitions, number of purchase

orders

b. Legal Number of hours

c. Accounts receivable Number of invoices, number of customers

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

Ex. 24–5

a.

Government

Residential Commercial Contract Total

Number of payroll checks:

Weekly payroll × 52 6,500 3,640 3,900

Monthly payroll × 12 384 516 360

Total 6,884 4,156 4,260 15,300

Number of purchase requisitions

per year 2,100 1,500 1,400 5,000

b.

Service Dept. Activity Charge

Cost ÷ Base = Rate

Service department charge rates:

Payroll Department $45,900 ÷ 15,300 = $3.00/check

Purchasing Department $22,000 ÷ 5,000 = $4.40/req.

Government

Residential Commercial Contract Total

Service department charges:

Payroll Department $20,652 $ 12,468 $ 12,780 $45,900

Purchasing Department 9,240 6,600 6,160 22,000

Total $29,892 $19,068 $ 18,940

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.

Ex. 24–6

a. Help desk: [pic] = $34 per call

Network center: [pic] = $62.50 per device monitored

Electronic mail: [pic] = $10.40 per e-mail account

Local voice support: [pic] = $16.60 per phone extension

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

Ex. 24–7

ENCOUNTER SPORTING GOODS COMPANY

Divisional Income Statements

For the Year Ended December 31, 2010

Wholesale Division Retail Division

Revenues $ 6,720,000 $ 5,712,000

Cost of goods sold 3,528,000 2,688,000

Gross profit $ 3,192,000 $ 3,024,000

Operating expenses 1,260,000 1,176,000

Income from operations

before service department

charges $ 1,932,000 $ 1,848,000

Less service department

charges:

Tech Support Department $423,000 $282,000

Accounts Payable

Department 98,134 521,134 179,866 461,866

Income from operations $ 1,410,866 $ 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

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 Cargo Division

Revenues $1,400,000 $1,400,000

Operating expenses 950,000 1,200,000

Income from operations

before service department

charges $ 450,000 $ 200,000

Less service department

charges:

Training (Note 1) $ 128,000 $ 32,000

Flight scheduling (Note 2) 62,500 87,500

Reservations (Note 3) 210,000 400,500 — 119,500

Income from operations $ 49,500 $ 80,500

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

Ex. 24–9

X-OUT SPORTING GOODS CO.

Divisional Income Statements

For the Year Ended June 30, 2010

Action Team

Sports Sports

Division Division

Sales $ 14,500,000 $ 17,600,000

Cost of goods sold 8,700,000 10,208,000

Gross profit $ 5,800,000 $ 7,392,000

Divisional selling expenses $ 2,320,000 $ 2,464,000

Divisional administrative expenses 1,450,000 1,566,400

$ 3,770,000 $ 4,030,400

Income from operations before service

department charges $ 2,030,000 $ 3,361,600

Less service department charges:

Advertising expense $ 256,800 $ 385,200

Transportation expense 148,800 166,160

Accounts receivable collection expense 93,000 108,750

Warehouse expense 960,000 640,000

Total $ 1,458,600 $ 1,300,110

Income from operations $ 571,400 $ 2,061,490

Supporting Schedule:

Service Department Charges

Action Team

Sports Sports

Division Division Total

Advertising expense $ 256,800 $ 385,200 $642,000

Transportation rate per bill of lading $ 12.40 $ 12.40

Number of bills of lading × 12,000 × 13,400

Transportation expense $ 148,800 $ 166,160 $314,960

Accounts receivable collection rate $ 7.50 $ 7.50

Number of sales invoices × 12,400 × 14,500

Accounts receivable collection expense $ 93,000 $ 108,750 $201,750

Warehouse rate per sq. ft.

($1,600,000/200,000 sq. ft.) $ 8.00 $ 8.00

Number of square feet × 120,000 × 80,000

Warehouse expense $ 960,000 $ 640,000 $1,600,000

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 Health

Goods Care Commercial

Division Division Division

Income from operations $80,000 $41,600 $70,400

Minimum amount of income from

operations:

$400,000 × 10% 40,000

$260,000 × 10% 26,000

$320,000 × 10% 32,000

Residual income $40,000 $15,600 $38,400

b. Sporting Goods Division

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. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

ROI = [pic] × [pic]

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.

[pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

ROI = [pic] × [pic]

ROI = 30% × 0.6

ROI = 18%

Ex. 24–14

a. Rate of Return on Investment = [pic] × [pic]

Media Networks: [pic] × [pic]

= 28.5% × 0.54

= 15.4% (rounded)

Parks and Resorts: [pic] × [pic]

= 16.1% × 0.65

= 10.5% (rounded)

Studio Entertainment: [pic] × [pic]

= 16.0% × 0.69

= 11.0% (rounded)

Consumer Products: [pic] × [pic]

= 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.

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)

Ex. 24–16

a. (a) $63,000 ($525,000 × 12%)

(b) $350,000 ($63,000/18%)

(c) 1.5 (18%/12%)

(d) $650,000 ($65,000/10%)

(e) $520,000 ($650,000/1.25)

(f) 12.5% (10% × 1.25)

(g) $52,500 ($350,000 × 15%)

(h) 7.5% ($52,500/$700,000)

(i) 2.0 ($700,000/$350,000)

(j) 14.0% ($140,000/$1,000,000)

(k) 17.5% ($140,000/$800,000)

(l) 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.

Ex. 24–17

a. Rate of Return on Investment = [pic] × [pic]

Hotel Ownership: [pic] × [pic]

= 18.1% × 0.51

= 9.2% (rounded)

Managing and Franchising: [pic] × [pic]

= 23.7% × 0.49

= 11.6% (rounded)

Timeshare: [pic] × [pic]

= 23.4% × 0.60

= 14.0% (rounded)

Hotel Managing and

b. Ownership Franchising Timeshare

Income from operations $904 $600 $ 152

Minimum return (10% of assets) 968 519 108

Residual income $ (64) $ 81 $ 44

c. 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.

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

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. [pic] = [pic] – [pic] × [pic]

$1,225,000 = ($200 – $165) × 35,000

b. [pic] = [pic] – [pic] × [pic]

$700,000 = ($200 – $180) × 35,000

c. [pic] = [pic] – [pic] × [pic]

$525,000 = ($180 – $165) × 35,000

Ex. 24–21

a. [pic] = [pic] – [pic] × [pic]

$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. [pic] = [pic] – [pic] × [pic]

$350,000 = ($200 – $190) × 35,000

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. [pic] = [pic] – [pic] × [pic]

$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.

PROBLEMS

Prob. 24–1A

1.

Budget Performance Report—Director, Truck Division

For the Month Ended October 31, 2010

Over Under

Budget Actual Budget Budget

Customer service salaries $ 260,450 $ 333,370 $ 72,920 $ —

Insurance and property taxes 54,600 52,960 — 1,640

Distribution salaries 415,400 411,250 — 4,150

Marketing salaries 489,700 548,460 58,760 —

Engineer salaries 398,500 390,530 — 7,970

Warehouse wages 279,100 267,930 — 11,170

Equipment depreciation 87,500 87,500 — —

Total $1,985,250 $2,092,000 $131,680 $24,930

2. The customer service and marketing salaries are significantly over budget. The director should investigate the cause of these results. One possibility is that the company is having an increase in sales, requiring greater marketing effort and customer service. However, the warehouse and distribution costs have not shown similar increases. Thus, it’s also possible that marketing and customer service salaries are increasing because of service problems and unplanned efforts to market the company’s service.

Prob. 24–2A

1.

BROWNING TRANSORTATION CO.

Divisional Income Statements

For the Quarter Ended December 31, 2010

East West Metro

Revenues $600,000 $710,000 $980,000

Operating expenses 362,400 393,540 527,760

Income from operations before service

department charges $237,600 $316,460 $452,240

Less service department charges:

Customer support ($20 × customer

contacts) $ 75,000 $ 90,000 $ 135,000

Legal ($36 × number of hours billed) 30,600 48,960 42,840

$ 105,600 $ 138,960 $177,840

Income from operations $132,000 $177,500 $274,400

Supporting schedules:

Service department charge rates for the two service departments, Customer Support and Legal, are determined as follows:

East West Metro Total

Number of customer contacts 3,750 4,500 6,750 15,000

Number of hours billed 850 1,360 1,190 3,400

Service

Cost ÷ Output = Rate

Customer contact rate $300,000 ÷ 15,000 = $20 per contact

Legal billing rate 122,400 ÷ 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.

Prob. 24–2A Concluded

2. The CEO evaluates the three divisions using income from operations as a percent of revenues (profit margin). This measure is calculated for the three divisions as follows:

East Division: 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.

Prob. 24–3A

1.

SUNSHINE BAKING COMPANY

Divisional Income Statements

For the Year Ended June 30, 2010

Snack Retail

Bread Cake Bakeries

Division Division Division

Sales $8,100,000 $8,700,000 $7,800,000

Cost of goods sold 4,980,000 5,400,000 4,600,000

Gross profit $ 3,120,000 $ 3,300,000 $ 3,200,000

Operating expenses 1,662,000 1,995,000 1,484,000

Income from operations $ 1,458,000 $ 1,305,000 $ 1,716,000

2. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Bread Division: ROI = [pic] × [pic]

ROI = 18.0% × 0.75

ROI = 13.5%

Snack Cake Division: ROI = [pic] × [pic]

ROI = 15.0% × 0.80

ROI = 12.0%

Retail Bakeries Division: ROI = [pic] × [pic]

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.

Prob. 24–4A

1. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Snowboard Division: ROI = [pic] × [pic]

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 $ 1,200,000 $1,200,000 $ 870,000

Cost of goods sold 850,000 706,000 539,700

Gross profit $ 350,000 $ 494,000 $ 330,300

Operating expenses 230,000 230,000 165,000

Income from operations $ 120,000 $ 264,000 $ 165,300

Invested assets $ 960,000 $1,600,000 $ 580,000

Prob. 24–4A Concluded

3. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Proposal 1: ROI = [pic] × [pic]

ROI = 10.0% × 1.25

ROI = 12.5%

Proposal 2: ROI = [pic] × [pic]

ROI = 22.0% × 0.75

ROI = 16.5%

Proposal 3: ROI = [pic] × [pic]

ROI = 19.0% × 1.50

ROI = 28.5%

4. Proposal 3 would yield a rate of return on investment of 28.5%.

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)

Prob. 24–5A

1.

RUCKER-PUTNAM BIKE COMPANY

Divisional Income Statements

For the Year Ended December 31, 2010

Touring Off-Road

Bike Bike

Division Division

Sales $2,800,000 $2,950,000

Cost of goods sold 1,240,000 1,375,000

Gross profit $1,560,000 $1,575,000

Operating expenses 1,168,000 1,073,500

Income from operations $ 392,000 $ 501,500

2. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Touring Bike Division: ROI = [pic] × [pic]

ROI = 14.0% × 1.75

ROI = 24.5%

Off-Road Bike Division: ROI = [pic] × [pic]

ROI = 17.0% × 1.00

ROI = 17.0%

3. Touring Bike Division: $104,000 [$392,000 – ($1,600,000 × 18%)]

Off-Road Bike Division: ($29,500) [$501,500 – ($2,950,000 × 18%)]

Prob. 24–5A Concluded

4. 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.

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:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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.

Prob. 24–6A Continued

3.

BAY AREA SCIENTIFIC, INC.

Divisional Income Statements

For the Year Ended December 31, 2010

Performance Communication

Materials Technologies Total

Sales:

8,000 units × $78 per unit $624,000 $ 624,000

1,600 units × $64 per unit 102,400 102,400

12,000 units × $152 per unit $ 1,824,000 1,824,000

$726,400 $ 1,824,000 $ 2,550,400

Expenses:

Variable:

9,600 units × $58 per unit $556,800 $ 556,800

1,600 units × $94* per unit $ 150,400 150,400

10,400 units × $108** per unit 1,123,200 1,123,200

Fixed 124,000 288,000 412,000

Total expenses $680,800 $ 1,561,600 $ 2,242,400

Income from operations $ 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.

Prob. 24–6A Concluded

4. The Performance Materials Division’s income from operations would increase by $19,200:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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. 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.

b. 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.

Prob. 24–1B

1.

Budget Performance Report—Manager, Northeast District

For the Month Ended May 31, 2010

Over Under

Budget Actual Budget Budget

Sales salaries $ 569,400 $ 568,680 $ — $ 720

System administration salaries 311,220 310,900 — 320

Customer service salaries 106,000 125,080 19,080 —

Billing salaries 68,560 68,145 — 415

Maintenance 188,480 189,530 1,050 —

Depreciation of plant and equipment 64,050 64,050 — —

Insurance and property taxes 28,670 28,770 100 —

Total $1,336,380 $1,355,155 $20,230 $1,455

2. 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.

Prob. 24–2B

1.

TRI-STATE RAILROAD COMPANY

Divisional Income Statements

For the Quarter Ended December 31, 2010

Southeast East South

Revenues $2,100,000 $3,150,000 $2,850,000

Operating expenses 1,367,350 2,321,870 1,963,180

Income from operations before service

department charges $ 732,650 $ 828,130 $ 886,820

Less service department charges:

Dispatching ($92 × scheduled

trains) $ 41,400 $ 70,380 $ 53,820

Equipment management

($62 × railroad cars) 271,250 379,750 434,000

$ 312,650 $ 450,130 $ 487,820

Income from operations $ 420,000 $ 378,000 $ 399,000

Supporting schedules:

Service department charge rates for the two service departments, Dispatching and Equipment Management, are determined as follows:

Southeast East South Total

Number of scheduled trains 450 765 585 1,800

Number of railroad cars in

inventory 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.

Prob. 24–2B Concluded

2. The CEO evaluates the three regions using income from operations as a percent of revenues. This measure is calculated for the three regions as follows:

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.

Prob. 24–3B

1.

PERFORMANCE FINANCIAL SERVICES INC.

Divisional Income Statements

For the Year Ended June 30, 2010

Electronic Investment

Retail Brokerage Banking

Division Division Division

Fee revenue $ 2,500,000 $1,400,000 $ 3,250,000

Operating expenses 1,600,000 1,302,000 2,600,000

Income from operations $ 900,000 $ 98,000 $ 650,000

2. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Retail Division: ROI = [pic] × [pic]

ROI = 36% × 0.5

ROI = 18%

Electronic Brokerage Division: ROI = [pic] × [pic]

ROI = 7% × 4.0

ROI = 28%

Investment Banking Division: ROI = [pic] × [pic]

ROI = 20% × 0.8

ROI = 16%

Prob. 24–3B Concluded

3. Per dollar of invested assets, the Electronic Brokerage Division is the most profitable of the three divisions. Assuming that the rates of return on investments do not change in the future, an expansion of the Electronic Brokerage Division will return 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.

Prob. 24–4B

1. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Water Sports Division: ROI = [pic] × [pic]

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 $600,000 $525,000 $600,000

Cost of goods sold 218,000 209,400 206,000

Gross profit $382,000 $315,600 $394,000

Operating expenses 274,000 252,600 274,000

Income from operations $108,000 $ 63,000 $120,000

Invested assets $400,000 $350,000 $750,000

Prob. 24–4B Concluded

3. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Proposal 1: ROI = [pic] × [pic]

ROI = 18% × 1.5

ROI = 27%

Proposal 2: ROI = [pic] × [pic]

ROI = 12% × 1.5

ROI = 18%

Proposal 3: ROI = [pic] × [pic]

ROI = 20% × 0.8

ROI = 16%

4. Proposal 1 would yield a rate of return on investment of 27%.

5. Rate of Return on Investment = Profit Margin × Required Investment Turnover

22% = 15% × Required Investment Turnover

Required Investment Turnover = 1.47 (22%/15%)

Current Investment Turnover = 1.20

Increase in Investment Turnover = 0.27

or

22.5% Increase (0.27/1.20)

Prob. 24–5B

1.

SIX LAYER COMPUTERS INC.

Divisional Income Statements

For the Year Ended December 31, 2010

Network Personal

Equipment Computing

Division Division

Sales $1,400,000 $ 1,120,000

Cost of goods sold 845,000 690,000

Gross profit $ 555,000 $ 430,000

Operating expenses 345,000 206,000

Income from operations $ 210,000 $ 224,000

2. [pic] = Profit Margin × Investment Turnover

[pic] = [pic] × [pic]

Network Equipment Division: ROI = [pic] × [pic]

ROI = 15% × 1.4

ROI = 21%

Personal Computing Division: ROI = [pic] × [pic]

ROI = 20% × 0.8

ROI = 16%

3. Network Equipment Division: $70,000 [$210,000 – ($1,000,000 × 14%)]

Personal Computing Division: $28,000 [$224,000 – ($1,400,000 × 14%)]

Prob. 24–5B Concluded

4. 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.

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:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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.

Prob. 24–6B Continued

3. KNOPFLER INDUSTRIES, INC.

Divisional Income Statements

For the Year Ended December 31, 2010

Specialized Navigational

Semiconductors Systems Total

Sales:

1,600 units × $825 per unit $ 1,320,000 $ 1,320,000

400 units × $625 per unit 250,000 250,000

2,500 units × $1,240 per unit $ 3,100,000 3,100,000

$ 1,570,000 $ 3,100,000 $ 4,670,000

Expenses:

Variable:

2,000 units × $485 per unit $ 970,000 $ 970,000

400 units × $775* per unit $ 310,000 310,000

2,100 units × $975** per unit 2,047,500 2,047,500

Fixed 488,000 636,000 1,124,000

Total expenses $ 1,458,000 $ 2,993,500 $ 4,451,500

Income from operations $ 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.

Prob. 24–6B Concluded

4. The Specialized Semiconductors Division’s income from operations would increase by $86,000:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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:

[pic] = [pic] – [pic] × [pic]

$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. 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.

b. 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.

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.

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.

Activity 24–3

1. The rate of return on invested assets is computed as follows:

Snack Goods Cereal Frozen Foods

Income from operations $ 510,000 $ 720,000 $ 378,000

Invested assets ÷ $2,500,000 ÷ $4,800,000 ÷ $1,800,000

ROI 20.4% 15.0% 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.

Activity 24–4

1.

2008 2009 2010

Profit margin (Income from

operations/Sales) 15% 18% 20%

2.

2008 2009 2010

Investment turnover (Sales/Invested

assets) 2.0 1.5 0.8

3.

2008 2009 2010

Rate of return on investment (Profit

margin × Investment turnover) 30% 27% 16%

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.

Activity 24–5

1. Rate of Return on Investment = [pic]

ROI = [pic]

ROI = 15%

or

[pic] = [pic] × [pic]

ROI = [pic] × [pic]

ROI = 20% × 0.75

ROI = 15%

2. $63,000 (7 × $9,000 = $63,000, where 7 = 15% – 8%)

3. Rate of Return on Investment = [pic]

ROI = [pic]

ROI = 9%

or

[pic] = [pic] × [pic]

ROI = [pic] × [pic]

ROI = 15% × 0.60

ROI = 9%

4. 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%).

Activity 24–5 Concluded

5. Use of residual income as a performance measure and as the basis for granting bonuses would motivate division managers to accept investment opportunities that exceed a minimum rate of return. If the minimum rate of return was set at 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 $1,350,000

Minimum amount of desired income from operations

($15,000,000 × 8%) 1,200,000

Residual income from new product line $ 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 $4,500,000

Minimum desired income (8% × $30,000,000) 2,400,000

Residual income $2,100,000

× Bonus percentage × 3%

Bonus $ 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.

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.”

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