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Blue Transport Company operates a Truck Rental Division (that rents trucks to individuals) and a Transportation Division (that transports goods from one city to another). Some division financial measures for the year are as follows: Truck Rental Transportation Division Total Asset $11,000,000 $9,500...

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Blue Transport Company operates a Truck Rental Division (that rents trucks to individuals) and a Transportation Division (that transports goods from one city to another). Some division financial measures for the year are as follows: Truck Rental Transportation Division Total Asset $11,000,000 $9,500,000 Current liability $2,200,000 $2,800,000 Operating income $825,000 $855,000 Required rate return 12% 12% 1. Calculate return on investment (ROI) for each division using operating income as a measure of income and total assets as a measure of investment. ROI (based on total assets): ROI = $825,000/$11,000,000 = 7.5% ROI= $855,000/$9,500,000= 9% 2. Calculate residual income (RI) for each division using operating income as a measure of income and total assets minus current liabilities as a measure of investment. RI (based on total assets – current liabilities): RI= $855,000- (12% X $6,700,000)= RI= $825,000- (12% X $8,800,000) = $51,000 ($231,000) (11,000,000- 2,200,000= 8.8m) 3. Tony Red, the Truck Rental Division manager, argues that the Transportation Division has “loaded up on a lot of short-term debt” to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken on by the Transportation Division. Comment on the result. RI= $825,000- (12% X $11,000,000) = RI= $855,000- (12% X $9,500,000)= ($495,000) ($285,000) Even with this new measure that is insensitive to the level of short-term debt, the TRD has a relatively worse RI than the TD. Both RIs are negative, indicating that the divisions are not earning the 12% required rate of return on their assets. 4. Blue, whose tax rate is 40%, has two sources of funds: long term debt with a market value of $9,000,000 at an interest rate of 10%, and equity capital with a market value of $6,000,000 and a cost of equity of 15%. Applying the same weighted average cost of capital to each division, calculate EVA for each division. WACC = [10% × (1– 40%) × $9,000,000 + (15% × $6,000,000)]/ ($9,000,000 + $6,000,000) = 9.6% Investment charge: IC= ($11,000,000- $2,200,000) X 9.6% IC=($9,500,000 - $2,800,000) X 9.6%= = $844,800 $643,200 EVA: EVA = [$825,000(1-40%)] – $844,800 EVA = [$855,000(1-40%)]– $643,200 EVA = ($349,800) EVA = ($130,200) 5. Use your preceding calculations to comment on the relative performance of each division. Both the RI and EVA calculations indicate that TD is performing nominally better than the TRD. The TD has a higher RI. The negative EVA for both divisions indicates that, on an aftertax basis, the divisions are destroying value – the after-tax economic returns from them are less than the required returns 13.2 Explain how return on investment and residual income can be used as part of a responsibility accounting system. A responsibility accounting system assigns responsibility to managers of business units for achieving certain targets. Cost centre managers are responsible for attaining a particular physical target (such as a certain number of units produced) at an agreed cost. Profit centre managers are responsible for achieving a certain profit target, but without taking into consideration the capital invested in the profit centre. Both ROI and residual income are further refinements of the measurement process, in that they measure the profit made by the investment centre relative to the capital invested in the investment centre. 13.7 Why is there typically a rise in ROI or residual income over time? How can this be avoided? ROI or residual income rises over the life of a project, because the carrying amount of the assets decreases due to accumulated yearly depreciation. This can be avoided by using the acquisition costs of the assets, not the carrying amount, as the invested capital in the ROI or residual income calculations. 13.22 Components of ROI; improving ROI; residual income: retailer Zap is a retailer that specializes in electric goods. It is a division of a large retail company. The following data relate to the most recent year of operations: Profit $ 6,000,000; Sales Revenue $ 75,000,000; Average Invested Capital $ 30,000,000 Required: 1. Calculate Zap’s return on sales, investment turnover and return on investment. Return on sales = profit/sales revenue = $6,000,000/$75,000,000 = 8% Investment turnover = sales revenue/invested capital = $75,000,000/$30,000,000 = 2.5 Return on investment = profit/invested capital = $6,000,000/$30,000,000 = 20% 2. Use the two component ratios to demonstrate two ways in which the manager of Zap could improve ROI, increasing it to 25%. There are many ways to improve the division’s ROI to 25 per cent. Here are two of them: (a) Improve the return on sales to 10 per cent by increasing profit to $7,500,000: ROI = return on sales  investment turnover = $7,500,000/$75,000,000  $75,000,000/$30,000,000 = 10%  2.5 = 25% Since sales revenue remains unchanged, this implies a cost reduction of $1,500,000 at the same sales revenue. (b) Improve the investment turnover to 3.125 by decreasing average invested capital to $24,000,000: ROI = return on sales  investment turnover = $6,000,000/$75,000,000 × $75,000,000/$24,000,000 = 8%  3.125 = 25% Since sales revenue remains unchanged, this implies that the firm can divest itself of some productive assets without affecting sales revenue. 3. Assume that the retail company has a min required rate of return of 11%. Calculate the residual income for Zap. Residual income = $6,000,000 – ($30,000,000  11%) = $6,000,000 – $3,300,000 = $2,700,000 (Revision Question) Divisional contribution margin=$500k, profit margin controllable by div M=200k, profit margin traceable to div=180k, average asset investment=600k. Management bonuses based on ROI, co use responsibility accounting concepts when evaluate performance. Eastern division’s m is contemplate following 3 investments. He invest $300k. 1 2 3 Cost 160k 200k 300k Expected income 40k 34k 84k A) Calculate the ROIs of the three investments 1: $40k ÷ $160k = 25% 2: $34k ÷ $200k = 17% 3: $84k ÷ $300k= 28% B) What div m’s current ROI, computed by use responsibility accounting concepts? Controllable profit margin ($200,000) ÷ asset investment ($600,000) = 33.33% C) Which 3 investments m select? Why? None, as all will lower the current ROI D) If Cairo Co has imputed interest charge of 20%, compute residual income of investment no. 3. Is this investment attractive from Eastern Division’s perspective? From Cairo Co perspective? Why? Residual income= 84k-(300kx20%) =24k investment attractive from both Eastern &Cairo’s perspectives. positive residual income indicates investment meet corporate goal of 20%. E) Do company’s bonus plan encourage most effective investment policy for Cairo Co? Briefly explain if appropriate, tell how plan improved. No. bonus based on ROI, which ignores firm goals. Investment 3, should pursued by Eastern Division because exceeds 20% threshold; yet may be rejected because will decrease eastern’s ROI. Plan could be improved by switch to residual income. John Man, the manager of Kitchen Appliance Division is considering the opportunity to invest in two independent projects. The first is a toaster and the second is a blender. Without the investments, the division’s invested capital for the coming year will be $14.5 million and after-tax income will be $1.58 million. The invested capital required for each investment and the expected operating incomes are as follows: Toaster Blender After-tax operating income $33,750 $44,850 Invested capital $375,000 $345,000

Compute the budgeted divisional ROI for each of the following alternatives: A) The toaster investment is made B) The blender investment is made Assuming that divisional managers are evaluated and rewarded on the basis of ROI performance, which alternative do you think the divisional manager will choose? Explain your answer with calculation. Income Invested capital ROI A. With $1,580,000+ 33,750= $14,50,000+375,000= 10.85 Toaster $1613750 14.875,000 % B. with $ 1,580,000 $14,5000,000+345,000= 10.94 Blender +44,850= $1,624,850 14,845,000 % The manager will choose the blender, but not the toaster. Looney Corp, massive retailer of electronic products is organized in 4 separate div. 4 div managers are evaluate at year-end, bonuses awarded based on ROI. Last year, co as whole produced 13% return on its investment. During past week, management of c’s Asia-Pacific Division approached about possibility of buy competitor that decided to redirect its retail activities. Additional $375,000 of invested capital needed. Asia pacific Competitor Sale 8400k 5200k Variable cost 70% of sale 65%of sale Fixed cost 2150k 1670k Invested capital 1850k 625k A) Compute the current ROI of the Asia-Pacific Division and the Division ROI if the competitor require Current ROI of AP& division’s ROI if acquire competitor Asia pacific AP +Competitor Sale revenue 8400k 13600k(8400k+5200) (-)Variable (5880k) (8400kx70%) (9260k) (5880k + (5200x65%) Fixed cost (2150k) (3820k)(2150k+1670k) income 370k 520k ROI= income/invested k =370k/1850k=20% ROI=520k/ (18 50k+625k+ 375k) =18.25% b) What reaction of div management to acquisition? Division management against acquisition because ROI lower from 20% to 18.25%. Since bonuses awarded on basis of ROI, acquisition result in less compensation. C) What reaction of looney management to acquisition? Competitor’s financial statistics Sale revenue 5200k (-)Variable (3389k) (5200kx65%) Fixed cost (1670k) income 150k ROI= income/ invested capital= $150,000/625,000= 24%. Looney earn 13% return &competitor 24%. Even 375k is made, competitor’ ROI is 15% if past earning trend continue (150k/ (625k+375k) =15% D) Will div better with no upgrade? Yes. ROI increase to 21.01%. Absence of upgrade lead to long run problem, customer confused by 2 different retail, the retail environment they have to expect with other Looney outlets and newly acquired, non- upgraded competitors. Sale revenue 13600k (8400k+ 5200k) (-)Variable (9260k) (5880k+ (5200k x65%)) Fixed cost (3820k) (2150K+ 1670k) income 520k ROI= $520,000/ (1,850,000+ $ 625,000) = 21.01% Atlantic &Pacific. Total Asset: 1000k & 5000k. Current Liabilities: 250k &1500k. Operating Income: 200k&750k. 1. Calculate the ROI for each division using operating income as the measure of income and total assets as the measure of investment. 2. Potomac Electric has used RI as a measure of management performance, the variable it wants a manager to maximize. Using this criterion, what is the RI for each division using operating income and total assets, if the required rate of return on investment is 12%? Atlantic Division Pacific Division Total assets $1000k $5000k Operating income $200k $750 Return on investment $200k/$1000k=20% $750k/5000k=15% Residual income at 12 % $80k (200k-(0.12x $150k (750K-(0.12x required rate of return $1000K)) 5000k)) While the Atlantic division earn the highest return on investment, the pacific division earn the highest residual income at the 12% required rate of return. 3. Potomac Electric has two sources of funds: long-term debt with a market value of $3,500,000 and an interest rate of 10%, and equity capital with a market value of $3,500,000 at a cost of 14%. Potomac’s income tax rate is 40%. Potomac applies the same weighted average cost of capital to both divisions because each division faces similar risks. Calculate the EVA for each division. After-tax cost of debt = (1 – 0.4) x 10% = 6%. Cost of equity = 14%. The weighted-average cost of capital (WACC) is given by

Profit margin to provide an incentive for the Assembly Division to manufacture and transfer the Component to the Electrical Division. Refer to exercise 12.29. The assembly division's absorption cost of a component is $510, which Includes $60 of applied fixed overhead costs. The transfer price has been set at $561, which is The assembly division absorption cost plus a 10 per cent markup. The electrical division has a special offer of $697.50 for its product. The electrical division Incurs variable costs of $150 in addition to the transfer price for the assembly division Components. Both divisions currently have spare production capacity. 1. Is the electrical division manager likely to want to accept or reject the special offer? Why? The Electrical Division’s manager is likely to reject the special offer because the Electrical Division’s incremental cost on the special order exceeds the division’s incremental revenue: Incremental revenue per unit of the special order $697.50 Incremental cost per unit to the Electrical Division per unit for the special order: Transfer price $561.00 Additional variable cost 150.00 Total incremental cost 711.00 Loss per unit in special order for the Electrical Division $(13.50) 2. Is this decision in the best interests of Electro ltd as a whole? Explain. The Electrical Division manager’s decision to reject the special order is not in the best interests of The company as a whole, since the company’s incremental revenue on the special order exceeds the Company’s incremental cost. Incremental revenue per unit in special order $697.50 Incremental cost to company per unit in special order: Unit variable cost incurred in Assembly Division $450.00 Unit variable cost incurred in Electrical Division 150.00 Total unit variable cost 600.00 Profit per unit in special order for the company as a whole $97.50 3. How could the situation be remedied using the transfer price? The transfer price could be set in accordance with the general rule, as follows: Transfer price = outlay cost + opportunity cost = $450 + 0* = $450 * Opportunity cost is zero, since the Assembly Division has spare capacity. The Assembly Division will want to make a profit on the transfer, so that transfer price will be $450 Plus a profit margin. The Electrical Division manager will have an incentive to accept the special Order since the Electrical Division’s incremental revenue on the special order exceeds the Incremental cost. Any transfer price that is between $450 and $697.50will allow the Electrical Division to make a profit. Tanker Ltd has 2 div, Division A&B, which are profit centres. 2003, Division A purchase product call leggos from Division B at cost of $75 per unit. Division A processes leggos into final product, which sold to outside customers.2003, Division B plan to raise the transfer price of leggos to $90 per unit. Angered by this move, Division A has sought alternative suppliers for product. Best quote came from XYZ Co who agreed to supply leggos at $80 per unit for 2004. It is estimated Division A will require 8 k units during 2004, which will be processed at a cost of $15 per unit. Division A plans to sell final product for $135 in 2004. Variable costs per unit 70 Fixed costs for 2004 15k Production capacity 10k unit Selling price to outside customers 100perunit Division B estimates 2004, if it transfers leggos to Division A then it would supply 2000 units to outside customers. However, if did not supply Division A with leggos, max demand firm outside customers would be no greater than 4000 units. Manager of Division B has refused to supply leggos to Division A at transfer price lower than $90 per unit, as this would lower the overall profits of his division. A) Calculate contribution margins of each Division, and Tanker Ltd, result firm follow scenario I) Internal transfer takes place at $90 per unit Div A Div B Tanker ltd Sale revenue $1080,000 -(8k-90) (8000x$135) $920k 1280k (8kx$90)+(2kx$100 ) Variable cost (8kx$90)+(8kx15) 840k -(8k-90) (10kx$70) 700k 820k Contribution margin 240k 220k 460k II) Div A decides to purchase leggos firm outside supplier. Div A Div B Tanker ltd Sale revenue (8000x$135) $1080,000 (4k x $100) $400k 1480k Variable cost (8k x$95) 760k (4k x$70) 280k 1040k

Contribution margin 320k 120k 440k B) Should Division A purchase leggos from the outside supplier, or from Division B? Provide financial and qualitative reasons to support your argument. From the company’s point of view, it is preferable for Div B to transfer the product to Div A at (0.06 $3,500,000)  (0.14  $3,500,00) $210,000 $490,00 $90. Div B would also prefer this option as it provides the greatest profit BUT Div A would  $3,500,000 $3,500,000 $7,000,000 prefer to buy leggos from the outside supplier at $80 per unit. If the company is to convince Div =0.10. A to not buy from an outside supplier, Div B will have to be convinced to lower its transfer EVA: Atlantic= (200kx0.6)-(10%x (1000k-250k)) =45k. Pacific = (750kx0.6)-(10%x (5000kprice from $90 down to $80. Division B has excess capacity and hence if it insists on keeping 1500k)) =100k. Identify and explain the reasons why traditional financial performance measures may the transfer price high, Div A will refuse to purchase from B and Div B profit will drop to $ 120 000. General transfer pricing rule would suggest that Div B should transfer its product at a not be sufficient to manage an organization. minimum price of $70- any transfer price above $70 will yield an incremental profit. If Div B Traditional performance measures are not actionable; they describe consequences, not causes. will not drop its transfer price, and if Div A wants to buy outside, then Tanker Ltd will need to They are too aggregated and they do not tell operational managers what needs fixing. Also, consider whether it should intervene in the decision. Consider possible negative consequences financial measures tend to be reported at the end of each month, so they are not timely. of intervening in decisions of autonomous division and Impact on Div B managers, if they are Traditional performance measures emphasize only one perspective as they only focus on costs. Managers need a performance measurement system that assesses how well they perform across forced to accept a lower transfer price. Arguments in favour of keeping the transfer inside the company relate to savings for Div B in bad debts, cash management and sales and marketing. the full range of strategically important areas, such as quality and delivery performance, as Broad Industries has two divisions: the Single Division and the Double Division. The Single well as cost. Financial performance measures provide limited guidance for future actions, Division produces a component that is used by the Double Division. Information about that emphasizing only immediate financial outcomes of actions and decisions. Financial component is as follows: performance measures can encourage actions which limit future competitiveness. This is Sales $100 per unit Variable manufacturing costs $40 per unit Fixed manufacturing particularly the case when there is excessive pressure to achieve short-term financial results. overhead$25 per unit Expected sales in units 6,000 units The Single Division can produce up @@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@@ to 7,500 components per year. The Double Division needs 750 units of the component for a Explain the benefits of using transfer pricing within organization. product it manufactures. A transfer price is an internal selling price that is used when products (which may be goods or 1. Determine the minimum transfer price that the Single Division would accept. services) are transferred between business units in an organization. The transfer price allows 2. Determine the maximum transfer price that the Double Division would pay. costs (for the receiving business unit) and revenues (for the producing business unit) to be 3. If the Single Division produces and sells 7500 units in a highly competitive market, what recorded so that the responsibility center can measure their performance. would be the correct transfer price? When it is more appropriate to use market-based transfer prices rather than cost-based 1. Minimum TP =$40 (variable cost per unit) 2. Maximum TP=$10 (the market price) transfer prices? 3. TP = $10 (the market price) or, using the general rule: It is more appropriate to use market-based transfer prices than cost-based transfer prices when a TP =Additional outlay cost per unit + opportunity cost= $40+ $60 competitive external market exists. Q2 Connor Corp produce goods in US, to be sold by separate div locate in Switzerland. Explain why some organizations might prefer to use variable cost rather than absorption Swiss div imports units of product F546 from U.S. and sells them for $800 each. (Imports of cost as a basis for se...