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CHAPTER 10 SEGMENTED REPORTING, INVESTMENT CENTER

EVALUATION, AND TRANSFER PRICING

QUESTIONS FOR WRITING AND DISCUSSION

1. In centralized decision making, decisions are made at the very top level, and lower-level managers are responsible for imple-menting these decisions. For decentralized decision making, decisions are made and implemented by lower-level managers.

2. Decentralization is the delegation of deci-sion-making authority to lower levels.

3. Reasons for decentralization include access to local information, cognitive limitations, more timely responses, focusing of central management, training, and motivation.

4. The only difference is the way in which fixed overhead costs are assigned. Under varia-ble costing, fixed overhead is a period cost; under absorption costing, it is a product cost.

5. Absorption-costing income is greater be-cause some of the period’s fixed overhead is placed in inventory and not recognized on the absorption-costing income statement.

6. Absorption costing. Variable costing would recognize only the period’s fixed overhead as an expense. The additional fixed over-head expense must have come from inven-tory.

7. Variable costing does not distort product performance by allocating common fixed costs. It allows managers to identify the con-tributions individual segments are making toward coverage of fixed costs.

8. Variable costing allows managers to identify what the costs ought to be for various levels of activity. By knowing what the costs ought to be for the actual level of activity, meaning-ful comparisons can be made to the costs that actually occurred.

9. A direct fixed cost is traceable to a particular cost object. A common fixed cost is common

to several cost objects. The distinction is im-portant because direct fixed costs will vanish if the cost object is eliminated but common fixed costs will not.

10. Contribution margin is the amount available to cover fixed expenses and provide for prof-it. Segment margin is the amount available to cover common fixed expenses and pro-vide for profit for a segment. Contribution margin is the difference between revenues and variable expenses. Segment margin is contribution margin less direct fixed ex-penses for a segment.

11. Absorption-costing income can increase from one period to the next if more is pro-duced than what is sold. Even though the fixed costs may not have changed, the fixed costs recognized on the income statement can change (because of inventory changes).

12. Different customer groups cause different activities and costs. Understanding what ac-tivities are unique to the various customer groups can help the firm determine custom-er profitability and also help it set different prices for the customer groups.

13. Margin = Operating income/Sales, and Turnover = Sales/Average operating assets. By breaking ROI into margin and turnover, more information is available to assess per-formance. Knowledge of margin and turno-ver gives more insight into why the ROI may change from one period to the next.

14. ROI (1) encourages managers to pay atten-tion to the relationships among sales, ex-penses, and investment, (2) encourages cost efficiency, and (3) discourages exces-sive investment in operating assets. In-creased profitability can be achieved (all else being equal) by increasing revenues, decreasing expenses, or lowering invest-ment.

15. ROI may discourage managers from invest-ing in projects that would increase the profit-ability of the firm but decrease the division’s

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ROI. It also may encourage myopic behavior by encouraging managers to make deci-sions that are profitable in the short run but harmful in the long run (e.g., cutting re-search and development costs).

16. EVA is the difference between after-tax operating income and the total annual cost of capital.

17. Owners may have difficulty developing goal congruence with managers because man-agers may not want to work as hard as the owner would like and because managers may wish to use the company’s resources for their own benefit. Properly structured in-centive pay plans may be successful in overcoming these problems.

18. A transfer price is the price charged for goods that are transferred from one division to another.

19. Transfer prices impact the revenues of the transferring division and the costs of the buying division and, thus, the profits of both divisions. A transfer price can affect the prof-its of the firm because it can affect the out-put decision of the buying division. If the price is set too high (low), then the output of the buying division may be too low (high). Since the transfer price can affect firmwide profitability, higher management may be tempted to interfere with the autonomy of a division and dictate the price (rather than let-ting the divisional manager make the pricing decision).

20. The opportunity cost approach to transfer pricing identifies the minimum and maximum transfer prices. The minimum transfer price is the one that makes the transferring divi-sion no worse off, and the maximum transfer

price is the one that makes the buying divi-sion no worse off.

21. Agree. At least one division will be made better off, and firm profits will increase.

22. Market price. Minimum price = Maximum price = Market price. Any other price would make at least one division worse off, and firm profits may decrease if the price is not market price.

23. Negotiated transfer prices allow both divi-sions to be made better off whenever oppor-tunity costing signals that a transfer should take place. Because both can be made bet-ter off, no interference from headquarters is needed. Moreover, the price emerging is necessarily a mutually satisfactory price. In effect, negotiated prices can simultaneously satisfy the objectives of accurate perfor-mance evaluation, firmwide efficiency, and preservation of divisional autonomy. Disad-vantages of negotiated transfer prices are that (1) private information can be used for exploitation, (2) performance measures are distorted by relative negotiating skills of managers, and (3) it is costly.

24. Three cost-based transfer prices are full cost, full cost plus markup, and variable cost plus fixed fee. Disadvantages are that prices may not reflect the optimal outcome for the divisions and for the firm. Specifically, it is possible for the transfer price using one of the costing approaches to be less than the minimum price and greater than the maxi-mum price. The prices, however, are simple to use and, in some cases, may reflect the outcome of a negotiated agreement.

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EXERCISES

10-1

Cost center – Total cost Profit center – Operating income Revenue Center - Sales Investment center - Return on Investment

10–2

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

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

Cost of ending inventory = $11.85 × 650 = $7,702.50 3. Since absorption costing is required for external reporting, the amount re-

ported would be $9,912.50.

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10–3

1. Fixed overhead rate = $107,500/25,000 = $4.30 per unit

The difference is computed as follows:

Fixed overhead rate(Production – Sales) $4.30(25,000 – 23,000) = $8,600 2. a. Lextel, Inc. Variable-Costing Income Statement For the Year Ended December 31, 2008

Sales (23,000 × $26) ........................................ $ 598,000 Less variable expenses: Cost of goods sold (23,000 × $12.80) ...... $ 294,400 Selling (23,000 × $4) .................................. 92,000 386,400 Contribution margin ....................................... $ 211,600 Less fixed expenses: Overhead .................................................... $ 107,500 Selling and administrative ........................ 26,800 134,300 Operating income ........................................... $ 77,300 b. Lextel, Inc. Absorption-Costing Income Statement For the Year Ended December 31, 2008

Sales ..................................................................................... $ 598,000 Less: Cost of goods sold (23,000 × $17.10) ...................... 393,300 Gross margin ....................................................................... $ 204,700 Less: Selling and administrative expenses ...................... 118,800 Operating income ........................................................... $ 85,900

10–4

1. Cocino Company Product-Line Income Statements

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

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2. If the coffee-maker line is dropped, profits will decrease by $5,000, the prod-

uct margin. If the blender line is dropped, profits will decrease by $110,000. 3. Blenders Coffee Makers Total

Sales $ 2,405,000 $ 1,125,000 $ 3,530,000 Less: Variable cost of goods sold 2,200,000 1,075,000 3,275,000 Contribution margin $ 205,000 $ 50,000 $ 255,000 Less: Direct fixed expenses 90,000 45,000 135,000 Product margin $ 115,000 $ 5,000 $ 120,000 Less: Common fixed expenses 115,000 Operating income $ 5,000

Profits increase by $5,000. Alternatively,

Increased profit = ($20.50 - $20.00) × 10,000 = $5,000

10–5

1. Absorption costing: Direct materials $1.20 Direct labor 0.75 Variable overhead 0.65 Fixed overhead 3.10 Unit cost $5.70

Cost of ending inventory = $5.70 × 200 = $1,140 2. Variable costing: Direct materials $1.20 Direct labor 0.75 Variable overhead 0.65 Unit cost $2.60

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

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4. Sales ($7.50 × 17,600) ............................... $ 132,000 Less: Variable cost of goods sold ................ $45,760 Commissions ....................................... 13,200 58,960 Contribution margin .................................. $ 73,040 Less fixed expenses: Fixed overhead .................................... $27,900 Fixed administrative ............................ 23,000 50,900 Net income ................................................. $ 22,140

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

10–6

1. Operating income = Sales – Expenses = $50,000 − $48,000 = $2,000

2. Margin = Operating income/Sales = $2,000/$50,000 = 0.04

Turnover = Sales/Operating assets = $50,000/$10,000 = 5 3. ROI = Margin × Turnover = 0.04 × 5 = 0.20, or 20%

10–7

1. Average operating assets = ($78,650 + $81,350)/2 = $80,000 2. Margin = Operating income/Sales = $7,200/$240,000 = 0.03

Turnover = Sales/Operating assets = $240,000/$80,000 = 3.0

ROI = Margin × Turnover = 0.03 × 3.0 = 0.09, or 9.0%

10–8

1. a. ROI of division without radio = $480,000/$8,000,000 = 0.06 b. ROI of the radio project = $270,000/$1,500,000 = 0.18 c. ROI of division with radio = $750,000/$9,500,000 = 0.0789

2. Yes, Cheryl will decide to invest in the project, since overall division ROI will increase.

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10–9

1. After-tax cost of mortgage bonds = (1 – 0.3)(0.08) = 0.056 2. Cost of common stock = 0.06 + 0.06 = 0.12 3. Dollar After-Tax Weighted Amount Percent × Cost = Cost

Mortgage bonds $1,300,000 0.65 0.056 0.0364 Common stock 700,000 0.35 0.120 0.0420 Total $2,000,000

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

Because EVA is negative, Schipper is destroying wealth.

10–10

1. After-tax cost of mortgage bonds = (1 – 0.4)(0.08) = 0.048 2. Cost of common stock = 0.06 + 0.06 = 0.12 3. Dollar After-Tax Weighted Amount Percent × Cost = Cost

Mortgage bonds $1,300,000 0.65 0.048 0.0312 Common stock 700,000 0.35 0.120 0.0420 Total $2,000,000

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

EVA is now positive, and Schipper is creating wealth.

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10-11 1. MP3 player: RI = $116,000 – (0.12 × $800,000)

= $20,000 Voice Rec.: RI = $105,000 – (0.12 × $750,000) = $15,000

2. Add Only Add Only Add Both Maintain MP3 Player Voice Rec. Projects Status Quo

Operating income $2,816,000 $2,805,000 $2,921,000 $2,700,000 Minimum income* 2,256,000 2,250,000 2,346,000 2,160,000 Residual income $ 560,000 $ 555,000 $ 575,000 $ 540,000

*Minimum income = Operating assets × Minimum required rate of return

The manager will invest in both the MP3 player and the voice recorder.

3. ROI MP3 player = $116,000/$800,000 = 0.145 or 14.5% ROI voice recorder = $105,000/$750,000 = 0.14 or 14.0% 4. Add Only Add Only Add Both Maintain MP3 Player Voice Rec. Projects Status Quo

Operating income $2,816,000 $2,805,000 $2,921,000 $2,700,000 Operating assets 18,800,000 18,750,000 19,550,000 18,000,000 ROI 14.98% 14.96% 14.94% 15.00%

The manager will invest in neither project.

10-12 1. North Woods residual income = $140,000 − (0.08)($1,000,000) = $60,000 Midwest residual income = $330,000 − (0.08)($3,000,000) = $90,000 2. North Woods ROI = $140,000/$1,000,000 = 0.14 or 14% Midwest ROI = $330,000/$3,000,000 = 0.11 or 11 %

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10–13

1. Maximum transfer price = $42 Minimum transfer price = $15

Only variable costs are relevant for the minimum transfer price since the Fur-niture Division has excess capacity.

Yes, the transfer should take place. 2. Benefit to Furniture Division:

Revenue ($30 × 10,000) $ 300,000 Less: Variable cost ($15 × 10,000) 150,000 Benefit $ 150,000

Benefit to Motel Division: Outside supplier ($42 × 10,000) $ 420,000 Transfer price ($30 × 10,000) 300,000 Benefit $ 120,000

Benefit to company = $150,000 + $120,000 = $270,000 3. Maximum transfer price = $42 Minimum transfer price = $42

It does not matter whether or not the transfer takes place because the cost to the company is the same whether the Motel Division buys from the outside supplier or from the internal supplier (the Furniture Division).

10–14

1. The minimum and maximum transfer price for each division is $2.30. The company is indifferent to the transfer because it earns the same income whether or not it takes place. If the transfer takes place, the price should be $2.30.

2. The minimum transfer price is $2.10, and the maximum price is still $2.30. The

transfer should take place because the company would save $30,000 (150,000 × $0.20) each year.

3. The offer should be accepted because the Small Motor Division’s profits

would increase by $15,000 (representing an even split of the savings from in-ternal transfer).

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10–15

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

*Due to idle capacity of the Paper Division, the minimum price is a variable cost of $2.25 per package. Since selling costs of $0.40 are avoidable, they are not included.

Yes, the transfer should take place. 2. Penelope would definitely consider the $3.20 price because her income would

increase $112,500 ([$3.95 – $3.20] × 150,000). Tom would most likely nego-tiate a price less than $3.75 if he has knowledge of the excess capacity.

3. The full-cost transfer price is $3.45 ($2.25 + $1.20). If the transfer takes place,

the Paper Division will make an additional $180,000 (150,000 × $1.20) and the School Photography Division will save $75,000 ([$3.95 – $3.45] × 150,000).

10–16

A B C D Revenues $10,000 $ 45,000 $200,000 $19,20011 Expenses 7,800 27,0004 188,000 18,00012 Operating income 2,200 18,000 12,0007 1,20013 Assets 20,000 144,0005 100,000 9,600 Margin 22%1 40% 6%8 6.25% Turnover 0.502* 0.3125 29 2.00 ROI 11%3 12.5%6 12.0%10 12.5%14

*Indicates missing amount. 1$2,200/$10,000 = 0.22 8$12,000/$200,000 = 0.06 2$10,000/$20,000 = 0.50 9$200,000/$100,000 = 2 3$2,200/$20,000 = 0.11 10$12,000/$$100,000 = 0.12 4$45,000 - $18,000 = $27,000 11$9,600 × 2 = $19,200 5$45,000 × 0.3125 = $144,000 12$19,200 - $1,200 = $18,000 60.4 × 0.3125 = 0.125 13$19,200 × 0.0625 = 1,200 7$200,000 - $188,000 = $12,000 14$1,200/$9,600 = 0.125

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

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PROBLEMS 10–18

1. Diaz Company Absorption-Costing Income Statements

Year 1 Year 2 Sales ........................................................................... $ 572,000 $ 660,000 Less: Cost of goods sold* ........................................ 299,000 361,000 Gross margin ............................................................. $ 273,000 $ 299,000 Less: Selling and administrative expenses ............ 163,800 163,800 Net income ........................................................... $ 109,200 $ 135,200

*Beginning inventory ................................................ $ 0 $ 46,000 Cost of goods manufactured .................................. 345,000 315,000 Goods available for sale ......................................... $ 345,000 $ 361,000 Less: Ending inventory ........................................... 46,000 0 Cost of goods sold ............................................. $ 299,000 $ 361,000

Firm performance has improved from Year 1 to Year 2. 2. Diaz Company

Variable-Costing Income Statements

Year 1 Year 2 Sales ........................................................................... $ 572,000 $ 660,000 Less: Variable cost of goods sold* ......................... 195,000 225,000 Contribution margin ................................................. $ 377,000 $ 435,000 Less fixed expenses: Overhead .............................................................. (120,000) (120,000) Selling and administrative .................................. (163,800) (163,800) Net income ................................................................. $ 93,200 $ 151,200

*Beginning inventory ................................................ $ 0 $ 30,000 Variable cost of goods manufactured ................... 225,000 195,000 Goods available for sale ......................................... $ 225,000 $225,000 Less: Ending inventory ........................................... 30,000 0 Cost of goods sold ............................................. $ 195,000 $ 225,000

Firm performance has improved from Year 1 to Year 2. 3. Year 1 fixed overhead rate = $120,000/30,000 = $4.00

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

Variable-costing inventory = $7.50 × 4,000 = $30,000

10–19

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1. Ziemble Company Absorption-Costing Income Statement

Sales ........................................................................................... $ 1,512,000 Cost of goods sold* .................................................................. 1,048,000 Gross margin ............................................................................. $ 464,000 Selling and administrative expenses ...................................... 444,000 Net income ........................................................................... $ 20,000

*Fixed overhead rate = $300,000/75,000 = $4 per unit Applied fixed overhead = $4 × 74,000 = $296,000 Underapplied fixed overhead = $300,000 – $296,000 = $4,000 Cost of goods sold = ($4 × 72,000) + $4,000 + $756,000 = $1,048,000 2. The difference is $8,000 ($20,000 – $12,000) and is due to the fixed overhead

that would be attached to the ending inventory ($4 × 2,000 units).

IA – IV = Fixed overhead rate(Production – Sales) $20,000 – $12,000 = $4(74,000 – 72,000) $8,000 = $8,000

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10–20

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

Kathy should accept this proposal. The 30 percent sales increase, coupled with the increased advertising, reduces the loss from $1,000 to $200. Both scented and musical product-line profits increase. However, more must be done. If the scented and musical product margins remain negative, the two products may need to be dropped.

2. Regular Sales $ 20,000 Less: Variable expenses 10,000 Contribution margin $ 10,000 Less: Fixed expenses 10,500 Operating income (loss) $ (500)

Dropping the two lines would still result in a loss. Other options need to be developed.

3. Combinations would be beneficial. Dropping the musical line (which shows

the greatest segment loss) and keeping the scented line while increasing ad-vertising yields a profit (the optimal combination).

Scented Regular Total

Sales $ 13,000 $ 22,500 $ 35,500 Less: Variable expenses 9,100 11,250 20,350 Contribution margin $ 3,900 $ 11,250 $ 15,150 Less: Direct fixed expenses 4,250 3,000 7,250 Product margin $ (350) $ 8,250 $ 7,900 Less: Common fixed expenses 7,500 Operating income $ 400

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10–21

1. Direct materials $3.60 Direct labor 2.00 Variable overhead 0.40 Fixed overhead ($180,000/200,000) 0.90 Total $ 6.90

Per-unit inventory cost on the balance sheet is $6.90.

Sales (207,000 × $10) $ 2,070,000 Less: Cost of goods sold 1,428,300 Gross margin $ 641,700 Less: Selling and administrative expenses 132,100 Net income $ 509,600 2. Direct materials $ 3.60 Direct labor 2.00 Variable overhead 0.40 Total $ 6.00

Per-unit inventory cost under variable costing equals $6.00.

This differs from the per-unit inventory cost in Requirement 1 because the balance sheet is for external use and reflects absorption costing. Variable costing does not include per-unit fixed overhead.

Sales $ 2,070,000 Less variable expenses: Variable cost of goods sold 1,242,000 Variable selling and administrative 62,100 Contribution margin $ 765,900 Less fixed expenses: Fixed overhead 180,000 Fixed selling and administrative 70,000 Net income $ 515,900 3. IV – IA = FOR(Sales – Production) $515,900 – $509,600 = $0.90(207,000 – 200,000) $6,300 = $0.90(7,000) $6,300 = $6,300

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4. Sales (196,700 × $10) $ 1,967,000 Less: Cost of goods sold (196,700 × $6.90) 1,357,230 Gross margin $ 609,770 Less: Selling and administrative expenses 129,010 Absorption costing operating income $ 480,760

Sales $1,967,000 Less variable expenses: Variable cost of goods sold 1,180,200 Variable selling and administrative 59,010 Contribution margin $ 727,790 Less fixed expenses: Fixed overhead 180,000 Fixed selling and administrative 70,000 Variable costing operating income $ 477,790 5. IA – IV = FOR(Sales – Production) $480,760 – $477,790 = $0.90(200,000 – 196,700) $2,970 = $0.90(3,300) $2,970 = $2,970 10–22

1. Air conditioner, ROI = $67,500/$750,000 = 9.0%

Turbocharger, ROI = $89,700/$690,000 = 13.0% 2. With Air With With Both Neither

Conditioner Turbocharger Investments Investment Income $3,246,500 $3,268,700 $3,336,200 $3,179,000 Assets $29,650,000 $29,590,000 $30,340,000 $28,900,000 ROI 10.95% 11.05% 11.00% 11.00%

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

EVA = ($67,500 + $89,700) – $135,000 = $22,200

Yes, the two investments increase the wealth of the division, since EVA is positive.

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10–23

1. $310,000/$3,000,000 = 10.33%* 2. Margin: $310,000/$3,450,000 = 8.99% Turnover: $3,450,000/$3,000,000 = 1.15 ROI = 1.15 × 8.99% = 10.34%

*Difference due to rounding. 3. ($310,000 + $57,500)/($3,000,000 + $500,000*) = 10.5% *($600,000 + $400,000)/2

The manager will approve the investment. 4. Margin: ($310,000 + $57,500)/($3,450,000 + $575,000) = 9.13% Turnover: ($3,450,000 + $575,000)/($3,000,000 + $500,000) = 1.15

The margin has increased, and the turnover ratio has stayed the same. 5. With: ($310,000 + $57,500)/($3,000,000 + $500,000 – $800,000) = 13.61% Without: $310,000/($3,000,000 – $800,000) = 14.09%

The manager will most likely reject the investment because it lowers the divi-sional ROI. The investment should be accepted because it increases total profits.

6. Margin: $310,000/$3,450,000 = 8.99% Turnover: $3,450,000/$2,200,000 = 1.57

10–24

1. Year 1 Year 2 Year 3 ROI 8.00% 6.97% 6.30% Margin 12.00% 11.00% 10.50% Turnover 0.67 0.63 0.60 2. ROI: $1,200,000/$15,000,000 = 8% Margin: $1,200,000/$10,000,000 = 12% Turnover: $10,000,000/$15,000,000 = 0.67

The ROI increased because expenses decreased and assets turned over at a higher rate (sales increased).

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

ROI: $945,000/$12,000,000 = 7.88% Margin: $945,000/$9,000,000 = 10.5% Turnover: $9,000,000/$12,000,000 = 0.75

The ROI increased because assets decreased. 4. ROI: $1,200,000/$12,000,000 = 10% Margin: $1,200,000/$10,000,000 = 12% Turnover: $10,000,000/$12,000,000 = 0.83

The ROI increased because expenses decreased and assets turned over at a higher rate (sales increased and the amount of assets decreased). Both mar-gin and turnover increased.

10–25

1. After-tax cost of mortgage bonds = (1 – 0.4)(0.06) = 0.036

Cost of common stock = 0.08 + 0.03 = 0.11 Dollar After-Tax Weighted Amount Percent × Cost = Cost

Mortgage bonds $ 3,000,000 0.25 0.036 0.0090 Common stock 9,000,000 0.75 0.110 0.0825 Total $ 12,000,000

Weighted average cost of capital 0.0915

Cost of capital = $4,000,000 × 0.0915 = $366,000 2. After-tax operating income $ 350,000 Less: Cost of capital 366,000 EVA $( 16,000)

EVA is negative; Donegal is destroying wealth. 3. After-tax cost of new bonds = (1 – 0.4)(0.09) = 0.054 Dollar After-Tax Weighted Amount Percent × Cost = Cost

Unsecured bonds $ 2,000,000 0.143 0.054 0.0077 Mortgage bonds 3,000,000 0.214 0.036 0.0077 Common stock 9,000,000 0.643 0.110 0.0707 Total $ 14,000,000

Weighted average cost of capital 0.0861

Cost of capital = $5,000,000 × 0.0861 = $430,500

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4. After-tax operating income $430,000 Less: Cost of capital 430,500 EVA ($ 500)

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

10–26

1. Minimum: $26 Maximum: $31 2. ($26 + $31)/2 = $28.50. Thus, the transfer price would be expressed as full

cost plus 42.5% ($20 + $8.50/$20). 3. New minimum: $27 New maximum: $32

($27 + $32)/2 = $29.50 or full cost plus 47.5% ($20 + $9.50/20) 4. The two divisions would renegotiate because the buying division would prob-

ably be able to buy the necessary part at a lower price from another supplier. The Auxiliary Components Division might have to reduce its price.

10–27

1. Lorne should not reduce the price charged to Rosario if he can sell all he produces. It does not matter whether the two divisions trade internally or not.

2. The minimum price is $53, and the maximum is $75. Yes, Lorne should con-

sider the transfer, since his income will increase by $59,500 [3,500($70 – $53)].

3. The transfer price would be $75.60 ($63 × 1.2). No, the transfer would not

occur, since the transfer price is higher than the outside price that Rosario could get.

10–28

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

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2. The transfer price should be the market price of $12. This is the minimum price for the Components Division and the maximum price for the PSF Divi-sion.

3. Unless the PSF Division is able to increase the price of Model S667, the man-ager will discontinue production and will not purchase any of the compo-nents. (The cost of producing the scanner will increase from $38 to $43.50, a cost greater than the current selling price of $42.)

4. All 40,000 units of Component Y34 will be sold externally at the market price of $12 per unit.

5. Sales $480,000 Variable expenses 160,000 Contribution margin $320,000

The contribution margin decreases by $540,000. Cam made the wrong deci-sion.

10–29

1. Madengrad Company Variable-Costing Income Statement

Budgeted for Next Year

Sales (21,500 × $900) ................................................ $ 19,350,000 Less variable expenses: Cost of goods sold (21,500 × $525) .................... $11,287,500 Selling (21,500 × $75) .......................................... 1,612,500 12,900,000 Contribution margin ................................................. $ 6,450,000 Less: Fixed expenses ............................................... 6,600,000 Operating income (loss) ..................................... $ (150,000) 2. Madengrad Company Variable-Costing Income Statement

Budget Based on Technological Change

Sales (21,500 × $900) ................................................ $ 19,350,000 Variable cost of goods sold: Direct materials (21,500 × $180) ......................... $3,870,000 Direct labor (21,500 × $216) ................................ 4,644,000 Overhead (21,500 × $78.75) ................................. 1,693,125 10,207,125 Variable selling (21,500 × $75) ................................. 1,612,500 Contribution margin ................................................. $ 7,530,375 Less: Fixed expenses ............................................... 7,260,000 Operating income ................................................ $ 270,375

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10–30

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

10–31

1. The profit change can be explained by the following analysis: Increase in sales revenues $20,000 Increase in variable manufacturing costs ($3.90 × 2,000) (7,800) Increase in variable selling costs ($0.50 × 2,000) (1,000) Increase in fixed overhead: Year 1—2,000 units × $2.90 (5,800) Year 2—1,000 units × $3.00 (3,000) Year 3 underapplied fixed OH (3,000) Net change in income $ (600)

The problem is the increased fixed overhead. We expect variable costs to in-crease, but the increase in fixed overhead expenses is notable, because the actual fixed overhead incurred for Year 3 is the same as that of Year 2. This increase in fixed overhead recognized on the income statement is explained by the fact that in Year 3, the division sold units from prior years with fixed overhead attached to them, and by the fact that no fixed overhead was inven-toried (as was the case in Year 2).

2. Year 1 Year 2 Year 3 Sales $ 80,000 $100,000 $120,000 Less variable expenses: Cost of goods sold (31,200) (40,000) (47,800) Selling expense (3,200) (5,000) (6,000) Contribution margin $ 45,600 $ 55,000 $ 66,200 Less fixed expenses: Fixed overhead (29,000) (30,000) (30,000) Other fixed costs (9,000) (10,000) (10,000) Net income $ 7,600 $ 15,000 $ 26,200

FOH, ending inventory $ 5,800a $ 8,800b $ 0 FOH, beginning inventory 0 5,800 8,800 Change in fixed overhead $ 5,800 $ 3,000 $ 8,800 a$2.90 × 2,000 units b($3.00 × 1,000 units) + $5,800

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The difference between the absorption- and variable-costing incomes is due to the change in fixed overhead in the division’s inventories. In Year 1, $5,800 of the fixed overhead went into inventory; so, absorption-costing income ex-ceeds variable-costing income by $5,800. In Year 2, $3,000 more fixed over-head was inventoried, and absorption-costing income was $3,000 greater than variable-costing income. However, in Year 3, the inventory was sold, and absorption-costing income now recognizes that additional $8,800 of fixed overhead ($5,800 + $3,000), explaining why variable-costing income is greater by this amount.

3. Since variable-costing income provides an increase in income when sales in-

crease and costs do not change, the company vice president would have pre-ferred variable costing. Variable costing would have provided the expected bonus to the divisional manager and a consistent signal of improved perfor-mance.

10–32

1. The transfer price based on variable manufacturing costs to produce the cu-shioned seat and the Office Division’s opportunity cost is $1,869 for a 100-unit lot, or $18.69 per seat as summarized below:

Variable cost ......................................................... $1,329 Opportunity cost .................................................. 540 Transfer price ....................................................... $1,869

Variable cost: Cushioned material: Padding ............................................................ $ 2.40 Vinyl ................................................................. 4.00 Total ............................................................ $ 6.40 Cost increase 10% .......................................... × 1.10 Cost of cushioned seat ............................. $ 7.04 Cushion fabrication labor ($7.50 × 0.5) ..................................................... 3.75 Variable overhead ($5.00 × 0.5) ..................................................... 2.50 Total variable cost per cushioned seat .............. $13.29

Total variable cost per 100-unit lot ..................... $1,329

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10–32 Continued

Overhead Analysis

Variable Amount Fixed Amount Total Per DLH Total Per DLH

Supplies $ 420,000 $1.40 Indirect labor 375,000 1.25 Supervision $ 250,000 $0.83 Power 180,000 0.60 Heat and light 140,000 0.47 Property taxes and insurance 200,000 0.67 Depreciation 1,700,000 5.67 Employee benefits: 20% Direct labor 450,000 1.50 20% Supervision 50,000 0.16* 20% Indirect labor 75,000 0.25 Total $1,500,000 $5.00 $2,340,000 $7.80

*The per DLH amount for supervision has been adjusted down to $0.16 to eliminate the rounding error between the sum of the amounts per DLH and the total divided by 300,000 DLH.

Variable overhead rate = ($1,500,000/300,000) = $5.00 per DLH

Fixed overhead rate = ($2,340,000/300,000) = $7.80 per DLH Opportunity cost: Labor hour constraint:

DLH to make 100 deluxe office stools (1.50 × 100) 150 hours Less: DLH to make 100 cushioned seats (0.50 × 100) 50 hours Labor hours available for economy office stool 100 hours

Number of economy office stools = 100 DLH/0.8 hours per stool = 125 stools

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10–32 Concluded

Opportunity cost calculation:

Deluxe Economy Office Stool Office Stool

Selling price $58.50 $41.60 Costs: Materials $14.55 $15.76 Labor 11.25 ($7.50 × 1.5) 6.00 ($7.50 × 0.8) Variable overhead 7.50 ($5.00 × 1.5) 4.00 ($5.00 × 0.8) Total costs $33.30 $25.76 CM/unit $25.20 $15.84 Units produced × 100 × 125 Total CM $2,520 $1,980

Opportunity cost of shifting production to the economy office stool = $2,520 – $1,980 = $540.

2. Variable manufacturing cost plus opportunity cost would be the best transfer

pricing system to use because it would allow the supplying division to be in-different between selling the product internally to another division or selling the product in the external market. This transfer pricing method ensures that the supplying division’s contribution to profit would be the same under either alternative. The sum of the variable manufacturing cost and the opportunity cost represents the effort put forth by the supplying division to the overall well-being of the company.

An appropriate transfer price must attempt to fulfill the company objectives of autonomy, incentive, and goal congruence. While no one transfer price can necessarily satisfy each of these objectives fully in all situations, the variable manufacturing cost plus opportunity cost transfer price should be the most appropriate method for meeting these objectives in most situations.

10–33

1. Many legitimate reasons support the creation of inventory (e.g., the need to avoid stockouts and the need to ensure on-time delivery). Paul Chesser’s reasons, however, are based on self-interest and ignore what’s best for the company. Knowingly producing for inventory to obtain personal financial gain at the expense of the company certainly could be labeled as unethical behavior.

2. Since the decision to produce for inventory was not motivated by any sound

economic reasoning, and Ruth knows the real motive behind the decision, she should feel discomfort in the role she has been asked to assume. If she

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decides to appeal to higher-level management, the divisional manager can counter with arguments that inventory was created because he expected the economy to turn around and did not want to be in a position of not having enough goods to meet demand. Even though Ruth may have a difficult time proving any allegation of improper conduct, if she is convinced that the be-havior is truly unethical, then appeals to higher-level management with the prospect of ultimate resignation should be the route she takes.

Alternatively, Ruth might decide that the use of absorption costing for inter-nal reporting and bonus calculation has led to this situation. She could lobby higher management to begin using variable costing as a way of avoiding these dysfunctional decisions. Ruth will have a very hard time proving uneth-ical behavior—at worst, Paul may be accused of having poor judgment re-garding future economic upturns.

3. The following standards may apply:

Integrity. Refrain from engaging in any conduct that would prejudice carrying out duties ethically. (III-2)

Credibility. Communicate information fairly and objectively. (IV-1) Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommen-dations. (IV-2)

10–34

1. ROI based on initial estimates = $1,870,000/$15,600,000 = 11.99% ROI based on Mel’s estimates = $2,340,000/$15,600,000 = 15% 2. Jason is definitely facing an ethical dilemma. While it is true that the sales

and expense projections are estimates, they are the best ones available to him. If he uses a sales revenue projection from the top end of the range, he will be deliberately basing the ROI estimate on a highly unlikely sales figure. Sales and expense projections are not fantasy figures, they are supposed to be management’s best estimate of what will actually happen. If Jason pre-pares the report in accordance with Mel’s desires, he will be knowingly fabri-cating data.

One might wonder whether or not Mel’s offer to “back up” Jason is sufficient to let Jason off the hook. It is not. If Mel wants the false projections badly enough, let him sign them. Jason may have thought he had his dream job, but it is about to turn into a nightmare. Companies don’t take kindly to employees who lie, and this lie is sure to come out. If the project is approved, and the sales do not approach $2.34 million, you can bet that the vice president of

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sales will be quick to point out that she predicted only $1.87 million. Mel will surely pin the blame directly on Jason, the one whose name is on the report.

3. Jason should prepare the report using the figures he thinks are most descrip-

tive of the project’s potential. He should feel free to include information about the predicted range of sales, and to point out any other information that re-flects favorably on the project. If Mel continues to pressure Jason, then Jason might consider looking for another job.

RESEARCH ASSIGNMENTS

10–35

Answers will vary.

10–36

Answers will vary.