acct 620 chapter 11

CHAPTER 11

INVESTMENT CENTER PERFORMANCE EVALUATION

Questions, Exercises, Problems, and Cases: Answers and Solutions

11.1 See text or glossary at the end of the book.

11.2 Transfer prices exist in centralized organizations to record the transfer of goods and services from one unit to another for the same reasons such organizations allocate costs (e.g., inventory valuation, cross-department monitoring).

11.3 Market-based transfer pricing is considered optimal under many circumstances, because it preserves divisional autonomy, yet encourages division managers to make economically optimal decisions for the company, when divisions operate at capacity.

11.4 The limitations of market-based transfer prices exist when the market price does not reflect the opportunity cost of the goods and services, for example if idle capacity is present. Also, temporary short-run fluctuations in market prices could lead to suboptimal long-run decisions. But the key limitation is that market prices are often not readily available.

11.5 The advantages of a centrally administered transfer price are that it promotes short-run profits by ensuring proper action by divisional managers and allows division managers to maintain their autonomy. The disadvantages of such a transfer price are that top management will become too involved in pricing disputes, and that division managers will lose flexibility in their decision making. The company also loses the other advantages of decentralization.

11.6 Companies often use prices other than market prices for interdivisional transfers because (1) market prices may not be available, (2) market prices can lead to suboptimal behavior when the supplier division has idle capacity, or (3) the company is not otherwise indifferent between internal and external buying.

11.7 The disadvantages of a negotiated transfer price system are that a great deal of management effort may be used on the negotiating process and that the negotiated price may be based more upon the manager's ability to negotiate rather than other factors.

11-1 Solutions

11.8 This occurs when the benefits of an action to one division are more than offset by harmful effects to another division. For example, the sale of a critical component by one division to outside customers rather than to another division may be harmful to the company as a whole if the second division cannot obtain the component from other sources.

11.9 Transfer prices are necessary if the profit performances of individual divisions are to be evaluated as if the divisions were separate entities. Without the use of transfer prices, units sold to outsiders would be reflected in the division's revenues, but units sold to other divisions would not be reflected. Transfer prices establish a “revenue” value to be included in the evaluation of a division’s operations. They are also necessary for tax purposes in international business.

11.10 The use of the term "price" suggests an exchange of cash or promise to pay cash. Divisions seldom actually exchange cash.

11.11 The Internal Revenue Service (IRS) disputed the transfer price because it was not adjusted down in the face of decreasing demand for the product. This caused the U.S. subsidiary to report lower profits and hence pay less taxes than they would using the market price. For this reason, the IRS wanted the transfer price lowered to what the IRS considered to be a market price.

11.12 In setting transfer prices between divisions in different countries, the affects on tax liabilities, royalties, other payments required by differing laws, and the ability to transfer profits out of a country should be considered.

11.13 A cost-based transfer pricing method would be necessary. We recommend using differential standard costs to the supplier plus supplier's opportunity costs of the internal transfer, if any. If a dual transfer pricing system is used, the supplier could be given a mark-up without charging it to the buyer.

11.14 The economic basis for transfer pricing systems is that as long as the transfer price is greater than the opportunity cost of the selling division and less than the opportunity cost of the buying division, a transfer will be encouraged.

11.15 In evaluating the division manager, top management is concerned with those revenues and expenses over which the division manager has some reasonable degree of control. Factors that are noncontrollable may be deducted to compute ROI for this purpose. In evaluating the division, top management is concerned with the division's contribution as an entity to the profits of the company. The salary of the division manager may not be deducted in evaluating the division but would be deducted in calculating the ROI used to evaluate the performance of the division manager.

Solutions 11-2

11.16 This statement may be correct depending on how ROI is calculated. If assets are stated at acquisition cost and depreciable assets are stated net of accumulated depreciation, then the statement is correct. The assets of divisions with newer assets will be stated at more recent higher costs, assuming inflation, and at a higher proportion of their acquisition costs. With a larger denominator, the ROI of new divisions will be lower than for older divisions, other things being the same.

11.17 ROI measures scale the division accounting profit by the investment required, which facilitates comparison between divisions of various sizes. Also, managers would have incentives to maximize accounting measures of profit without regard to the investment required. (Use of economic profits would not have this problem, of course.)

11.18 If the return on a specific project is greater than the company's cost of capital, but has an accounting ROI that is lower than the division's ROI, a division manager would have an incentive to avoid that project even though it meets the company's cost of capital requirements. This is because it would lower the division’s ROI, which is weighted according to investment and return.

11.19 By maximizing economic value added, managers will accept all projects above the minimum acceptable rate of return.

11.20 According to the general rule when the selling division is below capacity the transfer price should be set at the differential cost. The buying division will then choose the least costly alternative between internal or external purchasing, which will also be the least costly for the company. Setting the transfer price higher can lead to the incorrect decisions for the company as a whole.

11-3 Solutions

11.21 (Transfer pricing.)

a. b.Market-Based NegotiatedTransfer Price Transfer Price

New York New Jersey New York New JerseyDivision Division Division Division

Sales............................ $600,000a $1,500,000 $470,000c $1,500,000

Costs of Goods Sold..... (440,000) (840,000)b (440,000) (710,000)d

Selling and Adminis-trative Expenses........ (120,000 ) (200,000 ) (120,000 ) (200,000 )

Operating Profit........... $ 40,000 $ 460,000 $ (90,000 ) $ 590,000 Total Company............. $500,000 $500,000

a$600,000 = $.40 X 1,500,000 gallons.b$840,000 = ($.40 X 1,300,000 gallons) + $320,000.c$470,000 = ($.40 X 200,000 gallons) + ($.30 X 1,300,000 gallons).d$710,000 = ($.30 X 1,300,000 gallons) + $320,000.

c. Although the company has the same total profit, the statement is incorrect if the type of transfer price used has an effect on the decisions of people in either division. For example, the use of a cost-based transfer price may provide no incentive for divisions to control costs because they will always have zero net income. Managers may choose not to sell to other divisions at a loss to their divisions, forcing the buying divisions to go outside the company.

Solutions 11-4

11.22 (Return on investment computations.)All amounts in thousands of dollars (000 omitted).a. Miami Division: $500/$4,000= 12.5%;

Kansas City Division: $500/$5,000= 10%;

Seattle Division: $500/$6,000= 8.33%.

b. Allocations of corporate expenses as follows:Miami: $450 x 4/15 = $120Kansas City: $450 x 5/15 = $150Seattle: $450 x 6/15 = $180

Now subtract each of the above allocations from $500 and divide by each division’s divisional investment. For Miami, for example:

Miami: ($500 - $120)/$4,000 = 9.5%Kansas City: 7.0%Seattle: 5.33%

c. Allocations of corporate expenses as follows:Miami: $450 x 24/60 = $180Kansas City: $450 x 20/60 = $150Seattle: $450 x 16/60 = $120



d. Allocations of corporate expenses as follows:Miami: $450 x 22.5/45 = $225Kansas City: $450 x 12/45 = $120Seattle: $450 x 10.5/45 = $105



:

11-5 Solutions

11.23 (ROI computations with a capital charge.)

a. Eastern Division: $400,000/$5,000,000 = 8.0%;

Central Division: $3,000,000/$9,000,000 = 33.33%;

Western Division: $4,000,000/$18,000,000 = 22.22%.

b. Eastern Division: $400,000 - .10 x $5,000,000/$5,000,000 = -2%:

Central Division: $3,000,000 - .10 x $9,000,000/$9,000,000 = 23.33%Western Division: $4,000,000 - .10 x $18,000,000/$18,000,000 = 12.22%

c. As the above calculations demonstrate, the ranking of the divisions does not change. The ROI before deducting the use of capital charge is simply reduced by the 10 percent charge. It can be argued, therefore, that from the standpoint of top management, it does not matter which approach is followed as long as it is used consistently. Use of the measure in Part a., however, may lead divisions to improper decisions. A division may be inclined to accept projects which will increase its ROI even though the project will not return an amount to cover the charge for the use of capital. Therefore, it is preferable from the viewpoint of the company as a whole to allocate the investment funds to a division that can earn at least 10 percent.

11.24 (ROI computations with replacement costs.)

Solutions 11-6

a. Toronto Division: $800,000/$4,000,000= 20%Phoenix Division: $1,200,000/$7,500,000 = 16%

b. Toronto Division: $800,000/$6,000,000 = 13.33% Phoenix Division: $1,200,000/$8,000,000 = 15%

c. Analysts make two principal arguments for using acquisition cost in the denominator as in Part a. First, it is easily obtained from the firm's records and does not require estimates of current replacement costs. Second, it is consistent with the measurement of net income in the numerator (that is, depreciation expense is based on acquisition cost and unrealized holding gains are excluded). There are also two principal arguments for using current replacement cost in the denominator as in Part b. First, it eliminates the effects of price changes and permits the division which uses the depreciable assets most efficiently to show a better ROI. Second, as discussed in the chapter, it may lead division managers to make better equipment replacement decisions. If acquisition cost is used as the valuation basis in calculating ROI, divisions with older, more fully depreciated assets may be reluctant to replace them and thereby introduce higher, current amounts in the denominator. If current replacement cost is used in the denominator, the asset base will be the same regardless of whether or not the assets are replaced. Thus, the replacement decision can be made properly (that is, based on net present value) independent of any effects on ROI.

11.25 (ROI computations comparing net and gross book value.)

11-7 Solutions

a. U.S. Division: $3,000,000/$20,000,000 = 15%Australian Division: $4,000,000/$50,000,000 = 8%

b. U.S. Division: $3,000,000/$15,000,000 = 20%Australian Division: $4,000,000/$15,000,000 = 26.67%

c. There is no universal "best" response to this question. It can be argued that the ROI on assets net of accumulated depreciation (Part b.) is biased in favor of divisions with older depreciable assets. By calculating ROI based on gross assets, the bias caused by differences in the age of depreciable assets is removed. However, another bias is introduced if gross assets are used. The acquisition costs of the assets of Australian Division are more out of date than those of U.S. Division, which were acquired more recently. Each division might have assets of equal operating efficiency, but the amount at which they are stated in the denominator of ROI will be different. During periods of inflation, use of ROI based on assets gross of accumulated depreciation also tends to be biased in favor of divisions with older depreciable assets.

Solutions 11-8

11.26 (Comparing profit margin and ROI as performance measures.)

The return on investment (ROI), profit margin percentage, and asset turnover ratio of the three divisions are as follows. All amounts are in thousands of dollars (000 omitted).

Return Profit Asset on = Margin X Turnover

Investment Percentage Ratio

New Orleans District: $200/$2,000 = $200/$1,900 X $1,900/$2,000

10% = 10.53% X .95

Chicago District: $500/$6,250 = $500/$8,500 X $8,500/$6,250

8% = 5.88% X 1.36

Denver District: $1,000/$8,000 = $1,000/$10,000 X $10,000/$8,000

12.5% = 10% X 1.25

a. Using the profit margin percentage, the ranking of the districts is New Orleans, Denver, and then Chicago.

b. Using ROI, the ranking of districts is Denver, New Orleans, and then Chicago.

c. The ROI is a better measure of overall performance because it relates profits to the investment, or capital, required to generate those profits. New Orleans had the largest profit margin percentage. However, it required more capital to generate a dollar of sales than did Denver. Thus, its overall profitability is less. Note that Chicago had the largest asset turnover ratio. However, it generated the smallest amount of operating profit per dollar of sales, resulting in the lowest ROI of the three districts.

11-9 Solutions

11.27 (Profit margin and investment turnover ratio computations.)

a. ROI = Profit Margin Percentage X Asset Turnover Ratio (Amounts in thousands of dollars--000 omitted.)

= X

Year 7 $1,200/$10,000 = $1,200/$20,000 X $20,000/$10,000

12% = 6% X 2.0

Year 8 $1,100/$11,000 = $1,100/$20,000 X $20,000/$11,000

10% = 5.5% X 1.82

b. The cost savings programs resulted in a reduction in expenses and a decrease in net income based on the same level of sales. Thus, the profit margin percentage decreased from 6 percent to 5.5 percent. The cost savings programs resulted in an increase in investment, probably from larger amounts of inventory and fixed assets. Since sales remained the same, the asset turnover ratio decreased.

11.28 (ROI and EVA computations.)

Annual Income = $70,000 - = $38,000

a. b.ROI EVA

[$38,000 X (1 – .15)] –Year Investment Base $38,000 ÷ Base [(Base – $0) X .25]

1 $160,000 23.8% ($ 7,700)

2 128,000a 29.7% 3003 96,000 39.6% 8,3004 64,000 59.4% 16,3005 32,000 118.8% 24,300

aBase decreases by annual depreciation of $32,000.

Solutions 11-10

11.29 (Transfer pricing [CPA adapted].)

It would cost the company $45,000 if Pre-Fab purchased units from the outside supplier for $230 each. This $45,000 is the difference between the price paid for the units from an outside supplier ($230) and the differential cost of producing in the Hardware Division ($200) times the 1,500 units in the order. The fixed costs are sunk and, therefore, do not enter into the decision. Both the company and Hardware would be $45,000 worse off if Pre-Fab purchased from an outsider. Pre-Fab would not be affected whether paying $230 per unit to hardware or to an outsider. If management enforced the $260 transfer price and insisted that Pre-Fab purchase the units from Hardware, then the overall company profits would not be affected by the transfer price increase. However, Hardware would gain $45,000 while Pre-Fab would lose $45,000 compared to the current situation.

11.30 (Transfer pricing.)

a. TotalAuditors Consultants Accounting(Buyers) (Sellers) Firm

Buy Services Internally Pay $200 Receive $ 200 Pays $ 0Pay 70 Pays 70

Pays $ 70

Buy Services Externally Pay $180 Receive $ 200 Receives $ 20Pay 70 Pays 70

Pays $ 50

Hence, it is advantageous to buy consulting services externally. Note that this result depends on whether the consulting group operates at capacity. (See Part b.)

b. TotalAuditors Consultants Accounting(Buyers) (Sellers) Firm

Buy Services Internally Pay $200 Receive $200 Pays $ 0Pay 70 Pays 70

Pays $ 70

Buy Services Externally Pay $180 Receive 0 Pays $180Pay 0 Pays 0

Pays $ 180

Hence, it is better to buy consulting services internally.

11-11 Solutions

11.31 ( ROI and EVA using the internet.)

a. Students’ calculation of return on investment and residual income will depend on the company selected and the year when the internet search is conducted. Students will need to decide how to determine the income and the invested assets to use in both calculations. The discussion in the text will serve as a guide in this regard.

b. Some companies’ annual reports include a calculation and discussion of ROI in the “management report and analysis” section or the “financial highlights” section. Students’ calculation of ROI may differ from management’s due to differing assumptions about the determination of income and invested capital.

11.32 (Bella Vista Woodwork Company; ROI and EVA calculations.)

a. Return on Investment:

U.S. ROI = $25,500/$150,000 = 17%

Asia ROI = $28,000/$125,000 = 22.4%

Europe ROI = $29,500/$175,000 = 16.9%

b. Economic Value AddedU.S. Asia Europe

Net Operating Income afterTaxes (20%)......................... $20,400 $22,400 $ 23,600

Cost of Capital Employed:($150,000 – $10,000) X 0.10. (14,000 )($125,000 – $5,000) X 0.10... (12,000 )($175,000 – $15,000) X 0.10. (16,000 )

Economic Value Added............. $ 6,400 $ 10,400 $ 7,600

c. The manager of the Asia Division is doing the best job based on ROI because it has the highest return. The Asia Division manager is also doing best with EVA of $10,400. Although Europe has the next highest EVA, it is earned with substantially more assets ($175,000 versus $150,000) and more capital employed ($160,000 versus $140,000) than the U.S. Coupled with the fact that the U.S. has a slightly higher ROI, the U.S. probably earns the overall second place as to divisional performance.

Solutions 11-12

11.33 (Keller Company; transfer pricing.)

a. Incremental Cash Outflow of the Computers Division ($2,000 X 400 Units)...................................................... $ 800,000

Incremental Cash Savings of the Networks Division ($1,400 X 400 Units)...................................................... (560,000 )

Net Incremental Cash Outflow........................................... $ 240,000

The company will be worse off by $240,000 if the Computers Division purchases the component externally.

b. Net Incremental Cash Outflow from Part a......................... $240,000Incremental Cash Savings of the Networks Division........... (150,000 )Net Incremental Cash Outflow........................................... $ 90,000


c. Incremental Cash Outflow of the Computers Division($1,800 X 400 Units)...................................................... $720,000

Incremental Cash Savings of the Networks Division:Variable Costs ($1,400 X 400)........................................(560,000)Operating Savings..........................................................

(150,000 )Net Incremental Cash Outflow........................................... $ 10,000


d. Before responding, the president should raise three questions. First, which of the three conditions in Parts a. to c. is most likely to occur? The president should only consider interceding if the Computers Division's action will be detrimental to the company. Second, will the conditions expected to occur be short-lived or continually recurring? The president may permit the Computers Division to purchase the component externally if it is anticipated that the outside market price will soon increase to $2,200 or higher. In this way, divisional decision making autonomy is maintained. If the president intercedes, division managers may react negatively and harm the decentralized organization structure. The third, and perhaps most critical, question then is the effect of intercession on divisional performance.

11-13 Solutions

11. 34. Transfer pricing, with taxes

a. Use $7 million transfer price

Asian EuropeanRevenue $7,000,000 $30,000,000Third-party costs (6,000,000) ( 8,000,000)Transferred goods costs _________ ( 7,000,000)Taxable income $1,000,000 $15,000,000Tax rate x 40% x 70%Tax liability $400,000 $10,500,000

Total tax liability $10,900,000

b. Use $14 million transfer price Asian EuropeanRevenue $14,000,00

0$30,000,000

Third-party costs ( 6,000,000) ( 8,000,000)Transferred goods costs _________ (14,000,000)Taxable income $8,000,000 $ 8,000,000Tax rate x 40% x 70%Tax liability $ 3,200,000 $5,600,000

Total tax liability $8,800,000c. The optimal price for incentive purposes is $6 million. Using $6 million as the transfer price: Asian EuropeanRevenue $6,000,000 $30,000,000Third-party costs ( 6,000,000) ( 8,000,000)Transferred goods costs _________ (6,000,000)Taxable income 0 $ 16,000,000Tax rate x 40% x 70%Tax liability 0 $11,200,000

Total tax liability $11,200,000

Solutions 11-14

11.35 (Biases in ROI computations.)

1. Some of the standard cost variances may be noncontrollable by the divisional manager. For example, if the company maintains a centralized purchasing department, the materials price variance will not be controllable by the division's manager. A case can be made for only attributing variances subject to some reasonable control by the manager in determining divisional net income.

2. A question can be raised as to whether either of these divisions sells products to other divisions in the firm. If so, the question arises as to what transfer price is used. The manager is likely to feel the bonus plan is unreasonable if the division is forced to sell to the other divisions at a prescribed transfer price. In this case, perhaps the bonus should be based only on sales to external parties.

3. Two questions can be raised regarding the allocation of central corporate expenses. For purposes of calculating the manager's bonus, it is questionable whether central corporate expenses should be allocated. The manager cannot control the amount of these expenses and may react negatively to having them affect the annual bonus. A second question regards the equity in using sales as the basis for the allocation. It is unlikely that the incurrence of central corporate expenses is related to sales, unless there is centralized advertising. In addition, there may be a tendency for divisions to reject certain opportunities to sell products in order to hold down sales and the amount of central corporate expenses allocated. For example, a division may receive a special order at a price exceeding incremental divisional expenses. However, acceptance of the offer would mean a reduction in divisional net income after allocation of central corporate expenses. It is in the best interest of the company that such orders be accepted but the bonus arrangement may lead to rejection of the order.

4. Several questions can be raised regarding the measurement of divisional investment. First, are both of the divisions involved in manufacturing? The Light Chocolate Division may purchase products for resale and therefore have relatively little investment in fixed assets while the Dark Chocolate Division may be a capital-intensive manufacturing division. If so, the ROI measure will be biased in favor of the Light Chocolate Division. Second, assuming both divisions are involved in manufacturing, is one of the divisions newer with relatively high cost fixed assets and the other division relatively old with lower cost, more fully depreciated assets? If so, the ROI measure will be biased in favor of the older division. To overcome these problems, fixed assets could be stated gross, rather than net, of

11-15 Solutions

accumulated depreciation or even stated at current replacement cost in new condition.

5. A question can be raised as to whether the divisions' ROIs are comparable as a base for determining bonuses. For example, one division may be much more risky than the other. If so, a return of 15 percent in the Light Chocolate Division may be equivalent to the 10 percent return for the Dark Chocolate Division when risk is considered.

Solutions 11-16

11.36 (Issues in designing ROI measures.)

The following factors should be considered:

1. Should the ROI be calculated in terms of the Brazilian currency or the U.S. dollar? Depending on the exchange rate used (for example, current rate, historical rate when assets were acquired), the measure of ROI could be different.

2. If ROI is to be calculated in dollars, which exchange rate (that is, the current rate or the historical rate) will be used for each financial statement item?

3. Will the measure of "return" in the numerator of ROI be the amount actually received by Safety Alarm from its foreign division or will it be the amount earned by the foreign division? Given the additional risk involved in investing in this foreign country, it may be desirable to base the performance measure on the amount actually received in cash.

4. Do the domestic divisions get charged for the use of capital in calculating their ROIs? If not, the ROI of the foreign division will not be comparable.

5. How will "Investment" in the denominator be measured? One question concerns whether the measure should be total assets or stockholders' equity. An argument can be made for the latter since this represents Safety Alarm’s investment in the division. Another question concerns valuation. Should historical cost or current replacement cost be used? Given the rates of inflation in Brazil in recent years, a case can be made for using some type of current value.

6. What is the basis for the transfer price set for central engineering services? Does this represent a market price for the services in Brazil? If not, the foreign division should probably have the flexibility to purchase the services locally.

7. Is the ROI of the foreign divisions directly compared to those of the domestic divisions in evaluating performance? If so, the ROIs may not be comparable because of differences in risk.

11-17 Solutions

11.37 (ROI and residual income.)

a. ROI before the proposed purchase of Shrimp: $800,000/$4,000,000 = 20% ROI after the proposed purchase of Shrimp: $880,000/$4,800,000 = 18.33%

Note that the ROI will be lower after the purchase of Shrimp.

b. Residual income before proposed purchase: $800,000 – (10% x $4,000,000) = $400,000

Residual income after proposed purchase; $880,000 – (10% x $4,800,000) = $400,000Note that residual income will be unchanged after the purchase of Shrimp.

c. If the ROI for a division decreases then the ROI for the company will also decrease, holding everything else constant.

d. (2) and the manager might choose either (3) or (4). Using ROI to measure performance, the manager of Shellfish has incentives not to purchase Shrimp because that purchase will lower Shellfish’s ROI. Using residual income, the Shellfish manager would be indifferent about the purchase because the purchase would not affect Shellfish’s residual income. In our experience, managers are risk averse. The manager of Shellfish would not purchase Shrimp if risk averse because there is likely a 50% probability that the residual income will be negative instead of zero.

Solutions 11-18

11.38. (ROI and EVA)

The problem does not specify pre-tax or after-tax results. We generally accept either, but point out that many companies use the after-tax result for sales margin and ROI. EVA routinely uses after-tax amounts. In addressing requirement c, one should use after-tax amounts for ROI to make the measures comparable to EVA.

a Division A Sales margin = $60,000(1 - .30)/$230,000 = 18.26% (or $60,000/$230,000 = 26.09% before tax)

Division B Sales margin = $90,000(1 - .30)/$520,000 = 12.12%(or $90,000/$520,000 = 17.31% before tax)

Division A ROI = $60,000(1 - .30)/$180,000 = 23.33% (or $60,000/$180,000 = 33.33% before tax)

Division B ROI = $90,000(1 - .30)/$380,000 = 16.58%(or $90,000/$380,000 = 23.68% before tax)

Division A EVA = $60,000(1 - .30) - .12($180,000 - $40,000) = $42,000 - $16,800 = $25,200 Division B EVA = $90,000(1 - .30) - .12($380,000 - $50,000)

= $63,000 - $39,600 = $23,400

b. Division A has the higher ROI, implying that it uses its assets more efficiently. Division A is also generating more economic profit than Division B even though it is smaller. If the ROI numbers are recomputed using EVA’s measure of investment (assets – current liabilities) then the new ROI numbers are the following: A--$42,000/$140,000 = 30%; B--$63,000/$330,000 = 19.09%. Division A’s ROI is greater than Division B’s ROI. Division A wins.

c. ROI: New Division ROI using the same approach as in requirement a.

Division A, new ROI = ($60,000 + $10,000)(1 - .30)/($180,000 + $60,000) = 20.42%. Compare to 23.33% in requirement a.

Division A, new EVA = ($60,000 + $10,000)(1 - .30) - .12($180,000 + $60,000 - $40,000 -$4,000) = $49,000 - $23,520 = $25,480. Compare to $

11-19 Solutions

25,200 in requirement a.

ROI would drop, while EVA would increase a little. Using the ROI performance measure creates a conflict for the manager. Taking the project would be good for company value because it has a positive NPV, but the manager would look worse because divisional ROI would decrease.

Solutions 11-20

11.39 (ROI and EVA)

The problem does not specify pre-tax or after-tax results. We generally accept either, but point out that many companies use the after-tax result for sales margin and ROI. EVA routinely uses after-tax amounts. In addressing requirement c, one should use after-tax amounts for ROI to make the measures comparable to EVA.

a Division X Sales margin = $50,000(1 - .40)/$200,000 = 15%(or $50,000/$200,000 = 25% before tax)

Division Z Sales margin = $90,000(1 - .40)/$500,000 = 10.08%(or $90,000/$500,000 = 18.00% before tax)

Division X ROI = $50,000(1 - .40)/$180,000 = 16.67% (or $50,000/$180,000 = 27.78% before tax)

Division Z ROI = $90,000(1 - .40)/$360,000 = 15%(or $90,000/$360,000 = 25% before tax)

Division X EVA = $50,000(1 - .40) - .12($180,000 - $30,000) = $30,000 - $18,000 = $12,000 Division Z EVA = $90,000(1 - .40) - .12($360,000 - $50,000)

= $54,000 - $37,200 = $16,800

b. Division X has the higher ROI, implying that it uses its assets more efficiently. However, Division Z is also generating more economic profit than Division X because it is larger. If one could invest in only one or the other division, then the investor would choose Division Z because it generates more economic value than Division X.

c. ROI: New Division ROI using the same approach as in requirement a.

Division X, new ROI = ($50,000 + $10,000)(1 - .40)/($180,000 + $60,000) = 15%. Compare to 16.67% in requirement a.

Division X, new EVA = ($50,000 + $10,000)(1 - .40) - .12($180,000 + $60,000 - $30,000 - $4,000) = $36,000 - $24,720 = $11,280. Compare to $12,000 in

11-21 Solutions

requirement a.

ROI would drop. EVA would decrease very little. Using the ROI performance measure creates a conflict for the manager. Taking the project would be good for company value because it has a positive NPV, but the manager would look worse because divisional ROI would decrease. Using EVA, the division’s performance would look worse, but not by as much.

Solutions 11-22

11.40 (Evaluating profit impact of alternative transfer price [CMA adapted].)

(000 omitted in all calculations)

a. (1) The bottle division profits:

Revenue............ $10,000Cost................... 7,200 Profit................ $ 2,800

(2) The cologne division profits:

Revenue............ $63,900Cost................... 58,400 ($48,400 + $10,000)Profit.................. $ 5,500

(3) The corporation profits:

Revenue............ $63,900Cost................... 55,600 ($48,400 + $7,200)

$ 8,300

b.(1) Yes. Bottle Division:

Volume Cases.......................................... 2,000 4,000 6,000 Revenue..................................... $ 4,000 $ 7,000 $10,000Cost............................................ 3,200 5,200 7,200 Profit........................................... $ 800 $ 1,800 $ 2,800

(2) No. Cologne Division:

Volume Cases....................................... 2,000 4,000 6,000 Revenue................................... $25,000 $45,600 $63,900

Costa........................................ 20,400 39,400 58,400 Profit........................................ $ 4,600 $ 6,200 $ 5,500

(3) Yes. Corporation:

Volume Cases....................................... 2,000 4,000 6,000 Revenue................................... $25,000 $45,600 $63,900

Costb........................................ 19,600 37,600 55,600 Profit........................................ $ 5,400 $ 8,000 $ 8,300

a(In thousands) $20,400 = $16,400 Cologne Division costs plus $4,000 paid to Bottle Division; $39,400 = $32,400 + $7,000;

11-23 Solutions

$58,400 = $48,400 + $10,000.

b(In thousands) $19,600 = $3,200 cost to Bottle Division + $16,400 cost to Cologne Division; etc.

This apparent inconsistency, where the Bottle Division and the Corporation are the most profitable at 6,000,000 volume and the Cologne Division is most profitable at 4,000,000 volume, comes from the cost and revenues changing differently for the Bottle Division, Cologne Division, and the total Corporation as volume changes. Using market transfer prices, the divisions achieve maximum profit for themselves at different levels of sales based on the market price at the various levels relative to the division cost at these various levels. The corporation achieves maximum profit based on the selling price to outsiders relative to the total cost of making the product.

Solutions 11-24

11.41 (Impact of division performance measures on management incentives.)Reject Accept

New Project New ProjectDivision A

Income from:Existing Assets (.40 X $60,000)............. $24,000 $24,000New Project (.30 X $30,000).................. --- 9,000

(1) Net Income............................................... $ 24,000 $ 33,000 Assets Employed:

Existing Assets.................................. $60,000 $60,000New Project's Assets......................... --- 30,000

(2) Total Assets.............................................. $ 60,000 $ 90,000 Rate of Return on Investment (1)/(2)........ 40.0% 36.7% Net Income............................................... $24,000 $33,000Less Minimum Acceptable Return on

Invested Assets [= .20 X (2)]................. 12,000 18,000 Income in Excess of Company Minimum. . . $ 12,000 $ 15,000

Division BIncome from:

Existing Assets (.25 X $60,000)............. $15,000 $15,000New Project (.30 X $30,000).................. --- 9,000

(1) Net Income............................................... $ 15,000 $ 24,000 Assets Employed:

Existing Assets.................................. $60,000 $60,000New Project's Assets......................... --- 30,000

(2) Total Assets.............................................. $ 60,000 $ 90,000 Rate of Return on Investment (1)/(2)........ 25.0% 26.7% Net Income............................................... $15,000 $24,000Less Minimum Acceptable Return on

Invested Assets [= .20 X (2)]................. 12,000 18,000 Income in Excess of Company Minimum. . . $ 3,000 $ 6,000

11-25 Solutions

11.41 continued.

Discussion: Management of Division A is behaving rationally given the behavior of the home office staff. As the calculations above show, the rate of return on investment in Division A will decline if the new project is accepted. (Of course, one does not need to do a calculation to show that a new project earning only 30 percent will reduce the rate of return on a division already earning 40 percent.) If management of Division A believes that it is being evaluated on the rate of return on investment and on the changes in that rate, then management is correct to turn down a project that is better than the company average but worse than its own.

Professor Robert S. Kaplan likes to point out that if one evaluates with a ratio, then the evaluatee can increase his or her score not only by increasing the numerator, but also by decreasing the denominator. We have to be concerned that people may be achieving a good score by keeping the denominator artificially small.

Our suggestion to the home office staff is that it evaluate division management with a criterion based on a measure of income in excess of the minimum acceptable return on investment. This calculation is also shown for both divisions for both the "reject" and "accept" alternatives.

So long as a new investment project returns a rate larger than the minimum acceptable rate, the income in excess of the company minimum will increase. Evaluation of management ought, in our opinion, to be based on this measure of excess income, rather than on an ROI calculation.

If the home office staff will change its measurement criterion, then management of Division A will find the new project to be worth an “extra” $3,000 per year, as the management of Division B does.

Solutions 11-26

11.42 (Diversified Electronics; capital investment analysis and decentralized performance measurement—a comprehensive case.)

a. Ralph Browning's new product proposal was rejected because its ROI was less than 15 percent after tax.

Project ROI =

= [$230,000 (1.0.40)]/$1,000,000

= 13.8%.

The decision was not correct because it is inappropriate to use a short-term measure like ROI to evaluate a long-term decision, ignoring completely the project's cash flows. Also, a performance measure that is suitable for measuring past performance should not be used for an investment decision. (This is why accrual accounting might be appropriate for evaluating past performance while cash flows are used for decision making. If the company had used DCF (Discounted Cash Flows), the results would have been as shown on the following page.

11-27 Solutions

11.42 a. continued.

Project Year 0 1 2 3 4 5 6 7 8

Investment(1) Land $ (200,000) $400,000

(2) Plant and Equipment (800,000)

(3) Operating Cash Flows(10% Increase each year) $330,000a $363,000 $399,300 $439,230 $483,153 $531,468 $584,615 643,077

(4) Tax on Operating Cash Flowsat a 40% Rate (132,000) (145,200) (159,720) (175,692) (193,261) (212,587) (233,846) (257,231)

(5) Depreciation Tax Shieldb 64,000 102,400 60,800 46,400 46,400

(6) Tax on Land Sale (80,000 )cNet Cash Flow $ (1,000,000 ) $ 262,000 $ 320,200 $ 300,380 $ 309,938 $ 336,292 $ 318,881 $ 350,769 $ 705,846

PV Factors (15%) 1.000 .86957 .75614 .65752 .57175 .49718 .43233 .37594 .32690

PV of Cash Flows $(1,000,000) $227,827 $242,116 $197,506 $177,207 $167,198 $137,862 $131,868 $230,741

Net Present Value $ 512,325

aNet cash operating flows:Revenue.......................................... $700,000Variable costs.................................. (300,000)Fixed costs (excluding depreciation) (70,000 )

$ 330,000

bDepreciation tax shield:ACRS

Depreciation Tax Tax Year Base Rate Rate Shield

1 $800,000 X .20 X .40 = $ 64,0002 $800,000 X .32 X .40 = $102,4003 $800,000 X .19 X .40 = $ 60,8004 $800,000 X .145 X .40 = $ 46,4005 $800,000 X .145 X .40 = $ 46,400

c$80,000 = ($400,000 – $200,000) X 40%.

Solutions 11-28

11.42 continued.

b. It appears that Diversified Electronics' management wanted the focus of division managers to be profitability on assets rather than profits. Hence, the choice of the investment center concept for performance evaluation. Therefore, Diversified Electronics' choice of a measure like ROI makes sense since it is a measure of profitability of assets used. The possible benefits of this approach include reduction in cost of corporate administration, improvement in operational decision making, increased motivation at division level, and freeing corporate management up for more effective utilization. However, some unexpected ROI-related pitfalls that Diversified Electronics did not anticipate are:

1. It may be inappropriate to use one ROI performance standard for all divisions, considering differences in products, operations, risks, and differences in measurement because of asset age. These divisions cannot be compared with the same yardstick.

2. Diversified Electronics values its investments using net book value; hence, there may be a disincentive to make new investments which could, in most cases, increase the investment base more than the net income, lowering ROI.

3. The inclusion of allocated corporate administrative expenses in the ROI figure means that divisions and division managers are held accountable for costs over which they have no control.

Possible Modification to the Present System

1. Within a division there could be a corporate ROI for evaluating the division and another ROI for evaluating the manager. Each should only include items controllable by the division and manager, respectively.

2. There should be different ROIs for different divisions, each reflecting the characteristics peculiar to that industry to which the division belongs.

3. Use of gross book values and/or current values in the investment base would standardize performance measures.

4. The residual income method may be used if managers have incentives to reject projects having a return that is greater than the cost of capital but less than currently earned ROI.

11-29 Solutions

11.42 continued.

c. When a performance evaluation measure like ROI is used by divisions at the same time as DCF models for capital budgeting, managers often have conflicting incentives. Managers will have incentives to reject positive NPV projects if these projects do not have a positive impact on ROI for several years. Also, there will be a disincentive for them to invest in any positive NPV project that may lower division ROI by increasing the denominator by a relatively larger proportion than the numerator.

Solutions 11-30

11.43 (Custom Freight Systems (A); transfer pricing.)

a. The Logistics Division should accept the bid from the Forwarders Division. Custom Freight Systems is $72 better off if the Logistics division uses the Forwarders division for this contract.

Option I: Purchase Internally

AirCargo Forwarders Logistics

Division Division DivisionSales.........................................Variable Costs:

($155 X 60%)........................($175 – $155).......................(from Air Cargo Division).......(from Forwarders Division)....

Operating Profit/(Cost)...............

Total Company Cost...................

$ 155

93

$ 62

-0- 210 (210)

$ $

210

20 155

35

(113)

$ $ $

Option II: Purchase Externally (United Systems)

Total Company Cost = $(185)

b. If we assume it is optimal for the transfer to be made internally, then the question arises as to the appropriate transfer price. The economic transfer pricing rule for making transfers to maximize a company’s profits is to transfer at the differential outlay cost to the selling division plus the opportunity cost to the company of making the internal transfers.

OpportunityCost of

Differential + Transferring = TransferOutlay Cost Internally Price

If the seller (the division supplying the goods or services) has idle capacity......... $175 + $ 0 = $175

If the seller has no idlecapacity................................ $175 + $ 35 = $210

($210 sell-ing price– $175variablecost)

11-31 Solutions

11.43 continued.

c. Espinosa has many alternatives to intervention or to forcing the manager of the Forwarders division to lower his price below $210. Each has advantages and disadvantages.

• Espinosa must trade-off the benefits of intervention on this particular transaction against the impact of intervention on decentralization as a policy. Too much intervention by Espinosa will eliminate the benefits of decentralization.

• Tell the Logistics and Forwarders divisions that the transfer price will be between differential cost of $113 (which is the sum of the Air Cargo variable cost of $93 and the added variable cost for Forwarders of $20) and the lowest outside market price of $185 and allow them to negotiate the profit.

• Espinosa could reorganize the company combining the divisions into one operating company. However, Custom Freight Systems would lose all of the benefits of decentralization.

• Espinosa could simply do nothing and let the managers maintain their autonomy. This would not be in the best interests of Custom Freight Systems. However, it might be better to sub-optimize for this transaction and obtain more general benefits from decentralizing.

d. The reward system at Custom Freight Systems creates an environment that encourages managers to act in the best interests of their division rather than for the corporation. Managers are rewarded on their return on assets and profits, which discourages discounting to other divisions of Custom Freight Systems and ultimately costs the corporation more.

Solutions 11-32

11.44 (Custom Freight Systems (B); transfer pricing.)

Similar to Case A, the Logistics Division should accept the bid from the Forwarders Division. However, if we eliminate the Forwarders Division from the bidding process, the bid from World should be accepted. Emphasize that even though World’s bid is $10 per hundred higher than United’s, the overall cost to Custom Freight Systems is lower because other divisions of Custom Freight Systems are included in the bid.

Option I: Purchase Internally


DivisionDivisionDivision

Sales.........................................Variable Costs:

($155 X 60%)........................($175 – $155).......................(from Air Cargo Division).......(from Forwarders Division)....

Operating Profit/(Cost)...............


$ 155

93

$ 62

-0- 210 (210)

$ $

210

20 155

35

(113)

$ $ $

Option II: Purchase Externally (United Systems)

Total Company Cost = $(185)

Option III: Purchase Externally (World Services)


DivisionDivisionDivision

Sales.........................................Variable Costs:Operating Profit/(Cost)...............


$ 155 93

$ 62

-0- 195 (195)$ $

-0-

-0-

$ $ $(133)

11-33 Solutions

acct 620 chapter 11

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