Ch17 Full Test Bank Management Control Systems And Transfer

CHAPTER 17

Management Control Systems and Transfer Pricing

CHAPTER LEARNING OBJECTIVES

1. Describe the qualities of an effective management control system.

2. Explain how the four types of responsibility centers work: cost center, revenue center, profit center, and investment center.

3. Measure the performance of investment centers.

4. Explain how cost-based, market-based, and negotiated transfer pricing methods work.

Current count is:

Knowledge: 24

Comprehension: 24

Application: 41

Analysis: 44

Evaluation: 8

Synthesis: 0

Total: 141

Number and percentage of questions:

Easy: 14 questions, 10 percent (target of 25%)

Medium: 100 questions, 71 percent (target of 65%)

Hard: 27 questions, 19 percent (target of 10%)

Question types:

Multiple Choice: 110

Short Answer: 6

Brief Exercises: 12

Exercises: 10

Problems: 3

Multiple-Choice Questions

Management control systems can typically be placed into one of two broad categories: Centralized or Decentralized. While most businesses may start as centralized, they may shift towards a decentralized system over time. Which of the following would be considered a benefit of a decentralized system?
Duplication of activities
Faster decision-making
Less responsiveness to local needs
Less specialization

Ans: B, LO 1, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the general advantages and disadvantages of a decentralized management system. Choices A, C, and D all represent drawbacks or incorrect representations of the benefits of a decentralized system. Choice B is correct as faster decision-making is considered a benefit of a decentralized management system.

Management control systems can typically be placed into one of two broad categories: Centralized or Decentralized. While most businesses may start as centralized, they may shift towards a decentralized system over time. Which of the following would be considered a drawback of a decentralized system?
Duplication of activities
More specialization
Optimal decision-making
Slower decision-making

Ans: A, LO 1, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the general advantages and disadvantages of a decentralized management system. Choices B, C, and D all represent benefits or incorrect representations of drawbacks of a decentralized system. Choice A is correct as duplication of activities is considered a drawback of a decentralized management system.

In an effort to optimize decentralization, work towards accomplishing its mission, and achieve goal-congruence, an organization will strive to utilize a lot of planning in the design and implementation of their management system. Which of the following represents one of the four pillars of management control systems?
Irresponsibility centers
Performance measurement
Production
Unit pricing

Ans: B, LO 1, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the four pillars of management control systems. Choices A, C, and D represent incorrect choices as they are not included in the four pillars or do not exist at all. Choice B is the correct choice because performance measurement is one of the four pillars of management control systems.

As companies become established and shift from a centralized to a decentralized business model, employees start to become empowered to own and manage certain processes. While this comes with its own set of implementation challenges initially, it is usually considered worthwhile in the long run. Which of the following represents a benefit of decentralization?
1. Certain activities are likely to be duplicated, and that can mean that money will be saved as the work gets completed faster.
2. Increased levels of management mean the turnaround times for approvals will decrease.
3. Managers will likely show more initiative when they have the authority to make decisions for their own business unit.
4. The company increases its ability to place employees and managers in areas where they are not currently specialized.

Ans: C, LO 1, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the benefits of decentralized management systems. While some of the choices above appear to be correct, there is one aspect of three choices that makes the option either inaccurate or a drawback. Choice C is the only one of the four that represents a true benefit of a decentralized management system.

As companies become established and shift from a centralized to a decentralized model, employees start to become empowered to own and manage certain processes. While this comes with its own set of implementation challenges initially, it is usually considered worthwhile in the long run. Even so, there could be some drawbacks to this type of management system. Which of the following represents a drawback of decentralization?
1. Certain activities are likely to be duplicated across departments, and that can mean that money will be wasted.
2. High-level managers find they have increased distance from day-to-day operations and now have greater freedom to think strategically.
3. Managers will likely show less initiative when they are in control and have the authority to make decisions for their own business unit.
4. The organization chart is likely to take on a wide but shallow appearance from top-to-bottom indicating increased bureaucracy.

Ans: A, LO 1, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires that familiarity with the drawbacks of decentralized management systems. While some of the choices above appear to be correct, there is one aspect of three choices that makes the option either inaccurate or not a drawback. Choice A is the only one of the four that represents a true drawback of a decentralized management system.

In a well-structured organization, management will strive to achieve goal congruence. While managers may find that they are being evaluated on the performance of their own business unit, the overall congruence of goals must be kept in mind when setting objectives for these managers. Which of the following represents an optimal outcome that is aligned with the company-wide objective of saving money for short and long-term future goals?
1. Sanford, the plant manager, knows that a large machine needs to be replaced in order to get orders done on time, but Sanford chooses not to replace the machine as this is not in his budget for the year.
2. Susan, a manager, makes her employees clock-out during the last fifteen minutes of their shifts, but they must stay and complete their work to help the company save on expenses.
3. Teresa, an assembly line worker, has advocated for her department to hire an occupational therapist to evaluate repetitive work injuries and reduce sick time used to recover from these on-the-job injuries.
4. Trent, a production employee, chooses to donate some of his unused sick time to a fellow employee so the company will not penalize the department for having to cover that employee’s short-term leave.

Ans: C, LO 1, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with goal congruence and how managers can set goals that either do or do not align with overall company objectives. Choice C is the only choice that presents an optimal outcome that is also aligned with the company-wide objective of saving money in an ethical manner. Although hiring an occupational therapist costs money, it will save money for the company as people are able to avoid injuries and not miss time at work or incur large medical expenses that would impact employee insurance rates for the organization.

In a well-structured organization, management will strive to achieve goal congruence. While managers may find that they are being evaluated on the performance of their own business unit, the overall congruence of goals must be kept in mind when setting objectives for these managers. Which of the following represents a suboptimal outcome that is misaligned with the company-wide objective of saving money?
1. Sanford, the plant manager, knows that a large machine needs to be replaced in order to get orders done on time, but Sanford chooses not to replace the machine since this was not in his budget for the year.
2. Susan, a manager, makes her employees clock-out during the last fifteen minutes of their shifts, but they must stay to complete their work to help the company save on expenses.
3. Teresa, an assembly line worker, has advocated for her department to hire an occupational therapist to evaluate repetitive work injuries and reduce sick time used to recover from these on-the-job injuries.
4. Trent, a production employee, chooses to donate some of his unused sick time to a fellow employee so that the company will not penalize the department for having to cover that employee’s short-term leave.

Ans: A, LO 1, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with goal congruence and how managers can set goals that either do or do not align with overall company objectives. Choice A is the only choice of the four that presents a suboptimal outcome that is misaligned with the company-wide objective of saving money. This choice is suboptimal, and it is unlikely to save the company any money. While some of the options are also suboptimal in their execution, they do align with the company goal of cutting expenses albeit unethically.

When an organization wants to optimize decentralization, achieve goal-congruent outcomes, and accomplish its mission, management will look to implement a well-designed and well-planned management control system. A system such as this will utilize the four pillars of management control systems to achieve a major impact on employee behavior. Which of the following is an example of the proper usage of one of the pillars?
1. Allowing managers to spend money as it is needed as long as they have an accountable plan and submit their receipts and paperwork in a timely fashion
2. Dividing up work and responsibilities for the company into smaller departments with their own assigned manager
3. Encouraging a department to sell to another internal department at any price they feel is fair, even if it surpasses the current market rate
4. Setting a performance goal for management of a 50% increase in sales when a 10% increase in sales has been realized historically.

Ans: B, LO 1, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the four pillars of management and how they can be used to create a well-designed management control system. Choice B is the only choice of the four that appropriately uses one of the four pillars to improve their system. The other three options are likely to lead to a suboptimal outcome as they are not created to improve any existing operations.

When an organization wants to optimize decentralization, achieve goal-congruent outcomes, and accomplish its mission, management will look to implement a well-designed and well-planned management control system. A system such as this will utilize the four pillars of management control systems to achieve a major impact on employee behavior. Which of the following is an example of an improper usage of one of the pillars?
1. Asking all new employees to do any physical labor-intensive work to give more senior employees a break, regardless of their department
2. Asking management to create a formalized budget based on historical data for their department
3. Creating a logical and methodical system for determining the transfer price between two internal departments
4. Having yearly performance measurement for management based on department-specific benchmarks

Ans: A, LO 1, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the four pillars of management and how they can be used to create a well-designed management control system. Choice A is the only choice of the four above that improperly uses one of the four pillars to improve their system. By dividing up work by a class of people rather than implementing a logical division of work that does not target one specific group, this is an improper use of the pillars. The other three options are likely to lead to an optimal outcome as they are created to improve existing operations.

A large public University has been undergoing some changes as it attempts to modernize and adopt a more online-friendly learning environment. The University has decided that one step that must be taken is to decentralize its operations. Previously, the President of the University was charged with making all decisions ranging from final say on supply purchases to hiring decisions. Which of the following examples shows a way that the University might successfully decentralize?
1. Deans are assigned to each college and are permitted to make college-specific decisions.
2. The Basketball Coach has been instructed to request final approval from the University Vice President after an initial selection of players is complete.
3. The President is responsible for overseeing the administrative staff for the College of Fine Arts.
4. The President will have the final say on all faculty hires rather than each College’s Dean.

Ans: A, LO 1, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the concept of decentralization and how to apply it in a specific scenario. Choice A is the only choice of the four that shows the successful decentralization of this University. By allowing Deans who specialize in specific areas to run their own colleges, the University allows decisions to be made that will be in line with the overall goals of the organization. These disciplines can be nuanced and require someone who is intimately familiar to make these decisions. The other three choices are examples of centralization and will not achieve the goal of decentralization.

A large public University has been undergoing some changes as it attempts to modernize and adopt a more online-friendly learning environment. The University has decided that one step that must be taken is to decentralize its operations. Previously, the President of the University was charged with making all decisions ranging from final say on supply purchases to hiring decisions. Which of the following is an example of an unsuccessful attempt to decentralize?
1. Central executives will be placed in charge of recruiting and hiring faculty for all colleges and disciplines.
2. Faculty will be permitted to select teaching assistants for their courses.
3. Newly created Dean positions allow for a person to make college-specific decisions without having to await approval from an executive.
4. The football coach will make the final decision on which players make the team after initial tryouts.

Ans: A, LO 1, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the concept of decentralization and how to apply it in a specific scenario. Choice A is the only choice of the four that shows an unsuccessful attempt at implementing decentralization at this University. By allowing executives to make recruiting and hiring decisions of faculty for all colleges and disciplines, the needs of each discipline and the students at each college are not likely to be fully understood or taken into consideration. The other three choices are examples of successful decentralization.

Recently, a manager at a grocery store voiced concerns that the higher-ups have set completely unrealistic goals that the store can in no way achieve this year. This manager fears that the pressure of trying to succeed may lead some employees to make unethical decisions in order to achieve the unrealistic goals. Management and employees are evaluated on their abilities to meet these goals. Which of the following is an example that is indicative of unethical behavior that might be employed by someone to meet unrealistic goals?
1. A cashier has been ringing up some items twice when checking a customer out even though one of those items was purchased by the customer.
2. A manager has been working extra hours without clocking in to increase revenue and decrease labor costs.
3. An employee noticed that a coworker has been taking bottled drinks without paying while on their break.
4. Management has implemented a new membership program that costs $50 per year and would give some customers preferential treatment.

Ans: A, LO 1, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with ways that setting unrealistic goals on which performance is measured is not a proper implementation of one of the four management pillars. Choice A is the only choice that is an unethical behavior that is also trying to achieve the goal of increasing sales. The other three choices are in some cases unethical, but they do not aim to increase sales or are ethical and try to increase revenue.

Recently, a manager at a grocery store voiced concerns that the higher-ups have set completely unrealistic goals that the store can in no way achieve this year. This manager fears that the pressure of trying to succeed may lead some employees to make unethical decisions in order to achieve the unrealistic goals. Management and employees are evaluated on their abilities to meet these goals. Which of the following is an example that is indicative of ethical behavior that might be employed by someone to meet sales goals?
1. A cashier has been asking customers to round up their totals to give the excess funds to a charity.
2. A manager has been asking the employees to work extra hours without clocking in to increase revenue and decrease labor costs.
3. Cashiers have been encouraged to ask customers if they would like to sign up for a store credit card.
4. Management has approved a new customer incentive program where customers will receive a discount coupon for a future visit by spending a certain amount today.

Ans: D, LO 1, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the way that setting unrealistic goals on which performance is measured is not a proper implementation of one of the four management pillars. Choice D is the only choice that is an ethical behavior that is also trying to achieve the goal of increasing revenue. The other three choices are in some cases ethical, but they do not aim to increase sales or are unethical and try to increase sales.

As organizations grow and move towards a decentralized model, one goal will often be to empower employees. One way that this is accomplished is by creating responsibility centers and assigning managers to oversee the operations of their particular area of expertise. Which of the following best represents an accurate representation of a responsibility center?
1. John is overseeing the production department at his job, and he must create a budget to implement for the upcoming year.
2. Sarah has been promoted to manage the maintenance team at a local hotel, but she must get approval for all hiring through the company president.
3. The CEO of the company has decided to oversee the customer service department since they do not trust the current manager of the department.
4. The president of the organization will oversee all business units and delegate few tasks to managers.

Ans: A, LO 2, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the way that responsibility centers work and how they are set up. Choice A is the only choice of the four that describes an accurate representation of what a responsibility center should be. Choice A exemplifies a person who is assigned to run a business unit and is making decisions at their own discretion. The other three choices do not represent an appropriate use of a business unit where a manager is in charge of one area and can delegate tasks as needed.

As organizations grow and move towards a decentralized model, one goal will often be to empower employees. One way that this is accomplished is by creating responsibility centers and assigning managers to oversee the operations of a particular area of expertise. Which of the following represents an inaccurate representation of a responsibility center?
1. Aliyah, an owner and president of a retail store, appoints John to be the manager of the garden center at the store.
2. Arthur oversees the marketing department for a local sports bar, and he asks another employee to work on social media posts.
3. Samantha, a manager, runs the payroll processing department and reports to a regional manager.
4. The president of the organization will oversee all business units and delegate few tasks to managers.

Ans: D, LO 2, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the way that responsibility centers work and how they are set up. Choice D is the only choice of the four that describes an inaccurate representation of what a responsibility center should be. Choice D is more in line with what would be observed in a centralized management system where business units are not used. The other three choices represent an appropriate use of a business unit where a manager is in charge of one area and can delegate tasks as needed.

All business units are created with certain goals against which they are measured. Regardless of the type of business unit, evaluations are utilized to ensure that management is directing the team towards the achievement of goals that are congruent with the overall company goals set forth by the highest levels of management. Which of the following best represent metrics used to evaluate a profit center?
1. Return on Investment, Sales Mix, Dollar Value of Sales
2. Target Profit, Budget-to-Actual Profit Reports, Net Income
3. Target Profit, Dollar Value of Sales, Return on Investment
4. Year-to-Date Expenditures, Return on Sales, Residual Income

Ans: B, LO 2, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the evaluation of various responsibility centers. Choice B is the only choice of the four options that represent metrics that would be used to evaluate a profit center. The other choices are a mixture of metrics used to evaluate a profit center or other types of responsibility centers.

Decentralized organizations have the ability to create divisions of itself that are called responsibility centers. One of the features and advantages of this is that managers have decision-making independence and are empowered to run their own departments. Which of the following best represents the presence of authority, one of the three characteristics of a responsibility center?
1. A company moves from a model where a department is able to set working hours for its employees to a company-wide policy for all employees.
2. Carleigh, the divisional manager delegates analysis tasks to his employees and has the decision-making authority to purchase assets for his division.
3. The company CEO insists that they must approve any new hires selected by the accounting department.
4. The sales manager decides not to delegate paperwork to subordinates so that they can monitor all activity.

Ans: B, LO 2, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with authority, one of the three characteristics of a responsibility center. Choice B is the only one of the four choices that accurately depicts the presence of authority by allowing a divisional manager to delegate tasks and make decisions that will immediately impact their department and eventually the company as well. The other three choices represent a lack of authority where higher-level executives have not allowed the department to have the authority or ability to make decisions independent of them.

Decentralized organizations have the ability to create divisions of itself that are called responsibility centers. One of the features and advantages of this is that managers have decision-making independence and are empowered to run their own departments. Which of the following represents the lack of authority, one of the three characteristics of a responsibility center?
1. A bank branch manager has delegated the task of signing off on new accounts to lower-level employees.
2. A company moves from a model where there is a company-wide policy for set working hours to one where each department can determine what hours employees will work.
3. A hospital CEO would like to oversee the hiring of all nursing staff since they believe the manager has allowed too much turnover.
4. The sales manager has asked senior-level sales staff to take charge of the inventory count beginning next month.

Ans: C, LO 2, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with authority, one of the three characteristics of a responsibility center. Choice C is the only one of the four choices that accurately depicts the lack of authority by allowing the CEO to make a hiring decision for a specific department and not trusting in the manager to make this important decision. The other three choices represent the presence of authority where managers of a department have the authority or ability to make decisions independent of higher-level management.

One of the largest differences between a centralized and decentralized organization is the division of power. In a decentralized organization, power is given to managers of individual departments or business units. Responsibility is one of the three characteristics of a responsibility center. Which of the following best represents the delegation of responsibility within a decentralized organization?
1. Bobby is a sales associate who was just asked to assume responsibility for checking out guests but has not received any instruction regarding what needs to be done.
2. Sharon, the manager of the research department, has tasked a research assistant with doing an equipment inventory count each month and takes timely updates to be sure task is done.
3. The company CEO decides that they will continue to oversee the production department but places all responsibility for sales outcome on the department manager.
4. The women’s clothing manager of a retail store has assumed responsibility for overseeing the men’s department, delegated folding to a sales associate, but has not requested an update.

Ans: B, LO 2, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with responsibility, one of the three characteristics of a responsibility center. Choice B is the only one of the four choices that accurately depicts the implementation of responsibility since the manager has not only delegated a task but also taken steps to ensure that task is completed. The other three choices represent a lack of responsibility where higher-level executives and managers have not correctly or fully implemented responsibility.

In a decentralized organization, business units are created to better achieve a sense of independence amongst management. In a business unit, management is responsible for ensuring that tasks in their department are being completed and for overseeing their subordinates. One of the three main characteristics of a decentralized organization is accountability, which means that one will have to answer for the job when it is done. Which of the following best represents the existence of accountability in an organization?
1. A manager in charge of the product design team asked a lower-level associate to order supplies that are needed by the department to function. She is busy and did not follow up and ending up placing the order herself when supplies were about to run out.
2. A new office assistant was asked to check the company voicemail in the morning but has neglected to do it, so messages were missed.
3. A pharmaceutical sales representative does not submit a mileage report for the week and is denied a reimbursement by the manager for not following protocol.
4. The maintenance person was asked in passing by a manager to hang updated workplace safety posters and forgot to follow up.

Ans: C, LO 2, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with accountability, one of the three characteristics of a responsibility center. Choice C is the only one of the four choices that accurately depicts the existence of accountability since the sales representative was held accountable for not following the assigned protocol. This choice impacts their department and the company overall. The other three choices represent a lack of accountability from the managers for the subordinates.

In a decentralized organization, business units are created to better achieve a sense of independence amongst management. In a business unit, management is responsible for ensuring that tasks in their department are being completed and for overseeing their subordinates. One of the three main characteristics of a decentralized organization is accountability, which means that one will have to answer for the job when it is done. Which of the following represents the non-existence of accountability in an organization?
1. A paralegal has been issued a warning after neglecting to file some documents with the courts that will delay the trial her manager is involved with.
2. A receptionist was in charge of submitting the sales department timesheets and was reprimanded by a manager when this was not completed.
3. A staff accountant was asked by their manager to come in over the weekend to complete the work the accountant had overlooked that had a deadline of the Friday before.
4. The manager of the production department has decided to make the task of cleaning the employee bathroom a volunteer-based task rather than assigning it to one employee.

Ans: D, LO 2, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with accountability, one of the three characteristics of a responsibility center. Choice D is the only one of the four choices that accurately depicts the non-existence of accountability since the task of cleaning the bathroom has not been assigned to anyone, leaving accountability for that task out of the picture. This choice impacts their department and the company overall. The other three choices represent the existence of accountability in the organization.

A decentralized organization will have various responsibility centers including revenue centers, whose sole purpose is to generate revenue. These centers will also incur the cost of having employees work there, but their goal is to generate sales and hit targets set by management. Of the following examples, which best represents a revenue center?
Housekeeping at a small hotel
Payroll processing at a local bank
Sales department at an HVAC company
The pharmacy at a local grocery store

Ans: C, LO 2, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with responsibility centers and how the types of centers differentiate from one another. A revenue center will incur costs but is measured on its ability to generate revenue and hit targets. Choice C is the only choice listed that is a true revenue center. Choices A, B, and D all represent other types of centers.

A large home improvement retail company is moving towards a decentralized management system from a centralized system after years in business. They are aware that this will entail generating various responsibility centers and placing the appropriate people in charge. Which of the following would be considered a profit center for the company?
The garden center in the store
The home projects consulting department
The janitorial department
The payroll department

Ans: A, LO 2, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with responsibility centers and how the types of centers differentiate from one another. A profit center will make sales and incur costs and is measured on its ability to hit sales goals while also managing its expenses and achieving a certain amount of profit. Choice A is the only choice listed that is a true profit center. Choices B, C, and D all represent other types of centers.

A boutique hotel is in the process of upgrading all of its systems including its management control system. Since its inception, the hotel has employed a centralized system, but the hotel has grown enough to consider decentralization. Of the following units or departments, which would be considered a cost center for the boutique hotel?
Food and beverages department
The gift shop
The hotel bar
The housekeeping department

Ans: D, LO 2, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with responsibility centers and how the types of centers are different from one another. A cost center will incur costs and is measured on its ability to manage its expenses while also controlling certain nonfinancial metrics. Choice D is the only choice listed that is a true cost center. Choices A, B, and C all represent other types of centers.

Some organizations choose a responsibility center to focus on selecting assets to reach a target return and then putting those profits back into the business or other assets. Certain organizations have done this to great success including Amazon, Netflix, and the New York Yankees. Which of the following best represents the most accurate responsibility center as described?
Cost Center
Investment Center
Profit Center
Revenue Center

Ans: B, LO 2, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with responsibility centers and how the types of centers are different from one another. An investment center will focus on selecting assets to generate a target return that it will then reinvest with the goal of earning more. Choice B is the choice that correctly identifies an investment center as the kind of responsibility center described in the problem. Choices A, C, and D all represent other types of centers that do not fit this description.

One of the largest differences between a centralized and decentralized organization is the division of power. In a decentralized organization, power is given to managers of individual departments, or business units. Responsibility is one of the three characteristics of a responsibility center. Which of the following best represents the absence of delegation of responsibility within a decentralized organization?
Laura, the night clerk at a hotel, has been covering all of the phones as instructed since the manager believes Laura is ready to learn some additional skills.
The company CEO decides that they will continue to oversee the production department but places all responsibility for sales outcomes on the department manager.
The company CEO implements a new policy where managers will be responsible for all departmental budget information for areas they oversee.
The men’s clothing manager of a retail store has delegated cash register duties to a new sales associate and has followed up to ensure the task is being completed.

Ans: B, LO 2, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with responsibility, one of the three characteristics of a responsibility center. Choice B is the only one of the four choices that accurately depicts the absence of delegation of responsibility since the manager has not only delegated a task to Jeremy that he is not qualified to handle but also due to the reason this task was delegated. The other three choices represent a lack of responsibility where higher-level executives and managers have correctly and/or fully implemented responsibility.

Turner Inc. is a factory that creates laptop bags that contain an added sleeve for increased protection. The sewing department is currently debating on the best way to proceed with sourcing the materials needed to create the end product. What is most likely to impact a potential price with an internal department?
1. The maximum selling price established by the seller of the product
2. The minimum price that would be established by the buyer of the product
3. Whether the internal department has any idle capacity or not as this would impact the minimum acceptable transfer price
4. Whether the managers of the departments have good peer-to-peer relationship

Ans: C, LO 2, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with how internal transfer pricing could be established and what impact that would have on the potential price that is determined. Choice C is the best example of something that would be most likely to impact an internal price. When a department has idle capacity, they will establish a minimum acceptable transfer price that is different than a department that does not have idle capacity. The other choices are either less likely or unlikely to impact the price for an internal sale.

Jones Enterprises is evaluating their divisions over the past few months to determine what department has done the most effective job at meeting or exceeding the Return on Investment (ROI) metric of 16% required by the company. They begin by looking at Sheila’s division which purchased a new machine in the last year. This large piece of equipment cost $9,000, generated $3,420 of sales, and incurred $1,904 of operating expenses. Given this information, what is the profit margin of this new equipment, and was this a successful decision?
No, this would not be considered successful with a negative return of $0.44.
No, this would not be considered successful with a negative return of $0.80.
Yes, this would be considered successful with a positive return of $0.44.
Yes, this would be considered successful with a positive return of $0.80.

Ans: C, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for profit margin: Operating Income divided by Sales. In this question, the cost of the equipment is not relevant. To calculate the profit margin, first solve for Operating Income: Sales – Operating Expenses = $3,420 – $1,904 = $1,516. Now, divide this number by Sales = $1,516/$3,420 = 0.4433 or $0.44 is left over as Operating Income or return. This would be considered successful as the purchase of new equipment generated a positive return (Choice C).

Jones Enterprises is evaluating their divisions over the past few months to determine what department has done the most effective job at meeting or exceeding the Return on Investment (ROI) metric of 16% required by the company. They begin by looking at Sheila’s division, which purchased a new machine in the last year. This large piece of equipment cost $9,000, generated $3,420 of sales, and incurred $1,904 of operating expenses. Given this information, what is the ROI of this new equipment, and was this a good decision made by Sheila?
No, this would not be considered a good decision with a negative return of 16.84%.
Yes, this would be considered a good decision with a positive return of 16.84%.
Yes, this would be considered a good decision with a positive return of 21.16%.
Yes, this would be considered a good decision with a positive return of 28.63%.

The printing division at a small factory is in need of a new printer and is currently comparing their choices. They have narrowed it down to two options:

	Machine 1	Machine 2
Cost	$12,000	$9,500
Estimated Sales	$ 3,400	$2,200
Operating Expenses (including depreciation)	$ 1,100	$ 800

Which machine will have the higher investment turnover based on the information provided? (Do not round intermediate calculations.)

Machine 1’s investment turnover is higher than Machine 2’s by 4.43%.
Machine 1’s investment turnover is higher than Machine 2’s by 5.18%.
Machine 2’s investment turnover is higher than Machine 1’s by 4.43%.
Machine 2’s investment turnover is higher than Machine 1’s by 5.18%.

Ans: B, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Investment Turnover: Sales/Investment. Machine 1: $3,400/$12,000 = 0.2833, and Machine 2: $2,200/$9,500 = 0.2316. Now, calculate the difference in investment turnover by subtracting the value for Machine 2 from the value from Machine 1 = 0.2833 – 0.2316 = 0.0518. Machine 1 has a higher Investment turnover by 0.0518 or 5.18% when compared to Machine 2 (Choice B).

The printing division at a small factory is in need of a new printer and is currently comparing their choices. They have narrowed it down to two options:

	Machine 1	Machine 2
Cost	$12,000	$9,500
Estimated Sales	$ 3,400	$2,200
Operating Expenses (including depreciation)	$ 1,100	$ 800

What is the difference in Return on Investment between the two machines based on the information provided? (Do not round intermediate calculations.)

Machine 1 has an ROI that is 4.43% higher than Machine 2.
Machine 1 has an ROI that is 4.43% lower than Machine 2.
Machine 1 has an ROI that is 5.17% higher than Machine 2.
Machine 1 has an ROI that is 5.17% lower than Machine 2.

Ans: A, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for ROI: (Operating Income/Sales) times (Sales/Investment). The sales will cancel out, leaving: Operating Income/Investment. Now, calculate this value for each machine. Machine 1: ($3,400 – $1,100)/$12,000 = 19.17%, and Machine 2: ($2,200 – $800)/$9,500 = 14.74%. Now, find the difference between the two ROIs by subtracting Machine 2’s value from Machine 1’s value. 19.17% – 14.74% = 4.43% higher ROI for Machine 1 (Choice A).

A clothing company would like to purchase a new piece of equipment and has been debating the purchase of either (a) a new sewing machine that would improve the existing department or (b) an embellisher that would afford the company the opportunity to add new and unique clothing to their existing lines. They gathered the following prospective information:

	Sewing Machine	Embellisher
Cost	$3,420	$4,808
Useful Life	10 years	8 years
Estimated Sales	$5,430	$6,280
Operating Expenses (excluding depreciation)	$ 902	$1,176

Which machine choice yields the highest profit margin and by how much? (Do not round intermediate calculations.)

The embellisher has a 2.12% higher profit margin than the sewing machine.
The embellisher has a 5.39% higher profit margin than the sewing machine.
The sewing machine has a 2.12% higher profit margin than the embellisher.
The sewing machine has a 5.39% higher profit margin than the embellisher.

Ans: D, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires the formula for calculating Profit Margin: Operating Income divided by Sales. After calculating this figure for each machine, compare them to determine which has the highest profit margin. The operating expenses for each are incomplete, so calculate the depreciation expense. Sewing Machine: $3,420/10 years = $342 per year. Total Operating Expenses = $902 + $342 = $1,244. Embellisher: $4,808/8 years = $601. Total Operating Expenses = $1,176 + $601 = $1,777. Now, calculate profit margin for each. Sewing Machine: ($5,430 – $1,244)/$5,430 = 0.7709. Embellisher: ($6,280 – $1,777)/$6,280 = 0.7170. Now, compare the two: 0.7709 – 0.7170. The sewing machine has a 0.0539 or 5.39% higher profit margin than the embellisher (Choice D).

A clothing company would like to purchase a new piece of equipment and has been debating the purchase of either (a) a new sewing machine that would improve the existing department or (b) an embellisher that would afford the company the opportunity of adding new and unique clothing to their existing lines. They have gathered the following prospective information:

	Sewing Machine	Embellisher
Cost	$3,420	$4,808
Useful Life	10 years	8 years
Estimated Sales	$5,430	$6,280
Operating Expenses (excluding depreciation)	$ 902	$1,176

What is the Return on Investment (ROI) for each choice?

Sewing Machine: 93.66%, Embellisher: 122.4%
Sewing Machine: 106.16%, Embellisher: 132.4%
Sewing Machine: 122.40%, Embellisher: 93.66%
Sewing Machine: 132.40%, Embellisher: 106.16%

Ans: C, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires the formula for calculating Return on Investment: Operating Income divided by Investment. The operating expenses for each are incomplete, so calculate the depreciation expense. Sewing Machine: $3,420/10 years = $342 per year. Total operating expenses = $902 + $342 = $1,244. Embellisher: $4,808/8 years = $601 per year. Total operating expenses = $1,176 + $601 = $1,777. Now, calculate ROI for each. Sewing Machine: ($5,430 – $1,244)/$3,420 = 1.2240 or 122.40%. Embellisher: ($6,280 – $1,777)/$4,808 = 0.9366 or 93.66% (Choice C).

Sacha works for an organization that follows a decentralized model. Erin, the production manager of her business unit has come to Sacha to discuss the possibility of purchasing a new piece of equipment. Erin indicated that this new equipment could generate $23,500 of sales, and the expenses (after depreciation) to support it would be 70% of the new sales. After speaking to a supplier, Erin learns that the new equipment can be purchased for $15,750. What are the Profit Margin and the Investment Turnover for the new equipment?
Profit Margin: 0.30, Investment Turnover: 1.492
Profit Margin: 0.70, Investment Turnover: 1.044
Profit Margin: 1.044, Investment Turnover: 0.70
Profit Margin: 1.492, Investment Turnover: 0.30

Ans: A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: To answer this question, calculate both the Profit Margin and the Investment Turnover. Profit Margin is: Operating Income/Sales. Operating Income = $23,500 – ($23,500 × 70%) = $23,500 – $16,450 = $7,050. Profit Margin = $7,050/$23,500 = 0.30. Investment Turnover = Sales/Investment = $23,500/$15,750 = 1.492 (Choice A).

Sacha works for an organization that follows a decentralized model. Erin, the production manager of her business unit has come to Sacha to discuss the possibility of purchasing a new piece of equipment. Erin has indicated this new equipment could generate $23,500 of sales, and the expenses (after depreciation) to support it would be 70% of the new sales. After speaking to a supplier, Erin learns that the new equipment can be purchased for $15,750. What is the Return on Investment for the new equipment?
30.00%
44.76%
95.74%
104.44%

Ans: B, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: To answer this question, use the Return on Investment (ROI) formula: Operating Income/Investment. It is important to note that Sales is a part of the DuPont method but cancels itself out, leaving the aforementioned formula. Operating Income = $23,500 – ($23,500 × 70%) = $23,500 – $16,450 = $7,050. Now, calculate the ROI: $7,050/$15,750 = 0.4476 or 44.76% (Choice B).

The Riggs Company manufactures monogrammed t-shirts that are sold online. The manager of one of the business units would like to consider replacing their current embroidery machine and has a choice between buying either (a) a brand new one for $12,840 or (b) a refurbished model for $9,703. The new machine will incur $4,906 of expenses, and the refurbished machine will incur $4,677 of expenses. Both machines will have a Return on Investment (ROI) of 9%. How much Sales will the new machine generate? (Do not round calculations.)
$1,155.60
$5,550.27
$5,832.60
$6,061.60

Ans: D, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This formula requires knowledge of the formula for ROI: Operating Income/Investment. To begin, plug-in the information provided: 0.09 = (X – $4,906)/$12,840. Now, solve for X: $1,155.60 = X – $4,906, so X = $6,061.60. The new machine will generate $6,061.60 of Sales (Choice D).

The Riggs Company manufactures monogrammed t-shirts that are sold online. The manager of one of the business units would like to consider replacing their current embroidery machine and has a choice of buying either (a) a brand new one for $12,840 or (b) a refurbished model for $9,703. The new machine will incur $4,906 of expenses, and the refurbished machine will incur $4,677 of expenses. Both machines will have a Return on Investment (ROI) of 9%. How much Sales will the refurbished machine generate? (Do not round calculations.)
$873.27
$5,550.27
$5,779.27
$6,061.60

Ans: B, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This formula requires knowledge of the formula for ROI: Operating Income/Investment. To begin, plug-in the information provided: 0.09 = (X – $4,677)/$9,703. Now, solve for X: $873.27 = X – $4,677, so X = $5,550.27. The refurbished machine will generate $5,550.27 of sales (Choice B).

Residual Income represents an excess of income that is earned above a firm’s Required Rate of Return on its investment. Businesses often find that any Residual Income is the preferred outcome for both managers and the company as a whole. Which of the following correctly identifies the formula for Residual Income?
Operating Income – (Required Rate of Return × Investment)
Operating Income – Investment
Operating Income + (Required Rate of Return × Investment)
Required Rate of Return × Investment

Ans: A, LO 3, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income. Choice A is the only choice that correctly identifies the formula: Operating Income – Target Return or Operating Income – (Required Rate of Return × Investment).

Economic Value Added (EVA) is a very well-received metric used to evaluate a company’s success generating a return that exceeds the cost of capital. Some have claimed that a business should always strive to focus on and generate EVA. Which of the following correctly identifies the formula for Economic Value Added?
After-tax Operating Income – (Weighted Average Cost of Capital × Invested Capital)
After-tax Operating Income + (Weighted Average Cost of Capital/Invested Capital)
Pre-tax Operating Income – (Weighted Average Cost of Capital/Invested Capital)
Pre-tax Operating Income + (Weighted Average Cost of Capital × Invested Capital)

Ans: A, LO 3, Bloom: K, Difficulty: Easy, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Economic Value Added. Choice A is the only choice that correctly identifies the formula: After-tax Operating Income – (Weighted Average Cost of Capital × Invested Capital).

Jasmine Inc. is a small flower shop that is performing some analysis based on their most recent year. They have determined that their profit margin was 0.2876 and investment turnover was 0.2188. They had purchased a new piece of equipment for $3,000. Based upon this information, what was their Return on Investment (ROI)?
0.0629
0.0688
0.5064
0.7608

Ans: A, LO 3, Bloom: AP, Difficulty: Easy, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for ROI: Profit Margin × Investment Turnover. The cost of the equipment is not relevant to the answer for this question as it has already been factored into the investment turnover. To solve for ROI, multiply 0.2876 by 0.2188 to arrive at 0.0629 (Choice A).

A publishing company is finalizing data for their most recently completed year. The production department spent $5,000 on a new printer and $3,000 on a new supercomputer. The Operating Income tied to the new printer is expected to be $556 while the supercomputer is expected to have an Operating Income of $337. The company’s Required Rate of Return is 6%. Management would like to know how much Residual Income to expect from the new printer.
$219
$256
$300
$556

Ans: B, LO 3, Bloom: AP, Difficulty: Easy, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires the formula for Residual Income and knowledge about how to apply it. The formula is Operating Income – (Required Rate of Return × Investment). For the printer, do the following: $556 – (0.06 × $5,000) = $556 – $300 = $256 (Choice B).

A publishing company is finalizing data for their most recently completed year. The production department spent $5,000 on a new printer and $3,000 on a new supercomputer. The Operating Income tied to the new printer is expected to be $556 while the supercomputer is expected to have an Operating Income of $337. The company’s Required Rate of Return is 6%. Management would like to know how much Residual Income to expect from the supercomputer.
$157
$180
$219
$337

Ans: A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires the formula for Residual Income and knowledge about how to apply it. The formula is Operating Income – (Required Rate of Return × Investment). For the supercomputer, do the following: $337 – (0.06 × $3,000) = $337 – $180 = $157 (Choice A).

A small paper producer is considering the purchase of a new machine to add to their assembly line. This machine would afford them the opportunity to increase their production by 15%. They are currently gathering pricing information from vendors and are trying to figure out what they would want to invest. They have gathered the following information:

Expected operating income specifically tied to the new machine	$1,342
Residual Income	$ 58

If the company has a Required Rate of Return of 8%, then what amount would they want to spend on the new machine?

$102.72
$1,342.00
$8,560.00
$16,050.00

Ans: D, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). This question provides some of the numbers. Solve for investment as follows: $58 = $1,342 – (0.08 × Investment). $58 + (0.08 × Investment) = $1,342. (0.08 × Investment) = $1,284. Lastly, divide each side by 0.08. Investment = $16,050.00 (Choice D).

A small paper producer is considering the purchase of a new machine to add to their assembly line. This machine would afford them the opportunity to increase their production by 15%. They are currently gathering pricing information from vendors and are trying to figure out what they would want to invest. They have gathered the following information:

Expected operating income specifically tied to the new machine	$1,342
Residual Income	$ 58

If the company has a Required Rate of Return of 6.3%, then what is the amount they would want to spend on the new machine?

$84.55
$1,400.00
$8,560.00
$20,380.95

Ans: D, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). This question provides some of these numbers. Solve for investment as follows: $58 = $1,342 – (0.063 × Investment). $58 + (0.063 × Investment) = $1,342. (0.063 × Investment) = $1,284. Lastly, divide each side by 0.063. Investment = $20,380.95 (Choice D).

A bicycle manufacturer is in talks to invest in some new equipment for their production department, and they are exploring different options. The first option is equipment that will cost $13,000, have Operating Income of $999, and have Residual Income of $18. The second option will cost them $11,400, have Operating Income of $918, and have Residual Income of $37. If the company selects the first option, what is their Required Rate of Return? (Round the percentage to two decimal places.)
0.14%
7.55%
7.68%
8.61%

Ans: B, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). This question provides some of these numbers. Solve for the Required Rate of Return as follows: $18 = $999 – (Required Rate of Return × $13,000). $18 + (Required Rate of Return × $13,000) = $999. (Required Rate of Return × $13,000) = $981. Next, divide each side by $13,000. Required Rate of Return = 0.0755 or 7.55% (Choice B).

A bicycle manufacturer is in talks to investment in some new equipment for their production department, and they are exploring different options. The first option is equipment that will cost $13,000, have Operating Income of $999, and have Residual Income of $18. The second option will cost them $11,400, have Operating Income of $918, and have Residual Income of $37. If the company selects the second option, what is their required rate of return? (Round to the percentage to two decimal places.)
0.32%
6.78%
7.73%
8.05%

Ans: C, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). This question provides some of these numbers. Solve for the Required Rate of Return as follows: $37 = $918 – (Required Rate of Return × $11,400). $37 + (Required Rate of Return × $11,400) = $918. (Required Rate of Return × $11,400) = $881. Next, divide each side by $11,400. Required Rate of Return = 0.0773 or 7.73% (Choice C).

A small surveying company has decided they would like to move their accounting in-house and will be training a new employee. In anticipation of this new development, they have decided to purchase a new accounting software package that should service all of their needs. Bob, a manager, has put together the following information:

	Software 1	Software 2
Cost	$6,233	$6,899
Residual Income	$ 88	$ 104
Required Rate of Return	7.20%	7.20%

If the company selects Software 1, then how much Operating Income should they expect it to generate?

$88.00
$442.44
$448.78
$536.78

Ans: D, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). This question provides some of these numbers. Solve for Operating Income as follows: $88 = Operating Income – (0.072 × $6,233). $88 = Operating Income – $448.78. Therefore, Operating Income = $536.78 (Choice D).

A small surveying company has decided they would like to move their accounting in-house and will be training a new employee. In anticipation of this new development, they have decided to purchase a new accounting software package that should service all of their needs. Bob, a manager, has put together the following information:

	Software 1	Software 2
Cost	$6,233	$6,899
Residual Income	$ 88	$ 104
Required Rate of Return	7.20%	7.20%

If the company selects Software 2, then how much Operating Income should they expect it to generate?

$104.00
$489.24
$496.73
$600.73

Ans: D, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). This question provides some of these numbers. Solve for Operating Income as follows: $104 = Operating Income – (0.072 × $6,899). $104 = Operating Income – $496.73. Operating Income = $600.73 (Choice D).

Kit works for a company that creates brochures for travel agencies to distribute to their clients. The company’s printer has recently broken down and will need to be replaced immediately so they can meet several upcoming client deadlines. A manager has found a vendor that has a model available for sale and has compiled the following information and estimates:

Cost of Investment	$18,844
Estimates:
Sales	$18,965
Operating Expenses	$17,303

If the company has a Required Rate of Return of 8.25%, then what is the amount of Residual Income that they should anticipate after installing the new printer?

$107.37
$137.12
$1,662.00
$17,289.37

Ans: A, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). Operating Income is not given, so solve for it using the following formula: Sales – Operating Expenses = $18,965 – $17,303 = $1,662. Now, solve for Residual Income. Residual Income = $1,662.00 – (0.0825 × $18,844). Residual Income = $1,662.00 – $1,554.63. Residual Income = $107.37 (Choice A).

Kit works for a company that creates brochures for travel agencies to distribute to their clients. The company’s printer has recently broken down and will need to be replaced immediately so that they can meet several client deadlines. A manager has found a vendor that has a model available for sale and has compiled the following information and estimates:

Cost of Investment	$18,844
Estimates:
Sales	$18,965
Operating Expenses	$17,303

If the company has a Required Rate of Return of 7.75%, then what is the amount of Residual Income that they should anticipate after installing the new printer?

$121.00
$201.59
$1,460.41
$17,504.59

Ans: B, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). Operating Income is not given, so solve for it using the following formula: Sales – Operating Expenses = $18,965 – $17,303 = $1,662. Now, solve for Residual Income. Residual Income = $1,662.00 – (0.0775 × $18,844). Residual Income = $1,662.00 – $1,460.41. Residual Income = $201.59 (Choice B).

Crosby Inc. creates handmade silk neckties that it then sells on their website through a monthly subscription service. In an effort to increase membership, Crosby has promised their customers a one-day turnaround time on all orders. The largest bottleneck Crosby experiences is the cutting department due to the delicate nature of the material. To improve this process, Crosby has decided to buy a new cutting machine that would cost $12,400 with a useful life of 5 years. They estimated that this machine would generate $17,500 of sales and incur $8,788 of asset-specific expenses (excluding depreciation). If the company has a Required Rate of Return of 9.5%, then what is the Residual Income of this investment?
$5,054.00
$6,168.00
$6,232.00
$17,500.00

Ans: A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). While expenses are given, calculate depreciation to include with the other expenses. $12,400/5 years = $2,480 per year. Total Expenses will equal $8,788 + $2,480 = $11,268. Operating Income is not given, so solve for it using the following formula: Sales – Operating Expenses = $17,500 – $11,268 = $6,232. Now, solve for Residual Income. Residual Income = $6,232 – (0.095 × $12,400). Residual Income = $6,232.00 – $1,178.00. Residual Income = $5,054.00 (Choice A).

Crosby Inc. creates handmade silk neckties that it then sells on their website through a monthly subscription service. In an effort to increase membership, Crosby has promised their customers a one-day turnaround time on all orders. The largest bottleneck Crosby experiences is the cutting department due to the delicate nature of the material. To improve this process, Crosby has decided to buy a new cutting machine that would cost $12,400 with a useful life of 5 years. They estimated that this machine would generate $17,500 of sales and incur $8,788 of asset-specific expenses (excluding depreciation). If the company has a Required Rate of Return of 7.3%, then what is their Residual Income?
$5,100.00
$5,326.80
$6,232.00
$17,500.00

Ans: B, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). While expenses are given, calculate depreciation to include with the other expenses. $12,400/5 years = $2,480 per year. Total expenses will equal $8,788 + $2,480 = $11,268. Operating Income is not given, so solve for it using the following formula: Sales – Operating Expenses = $17,500 – $11,268 = $6,232. Now, solve for Residual Income. Residual Income = $6,232 – (0.073 × $12,400). Residual Income = $6,232.00 – $905.20. Residual Income = $5,326.80 (Choice B).

Esther is the manager of the sales department for a local appliance store. The employees have been voicing their concerns over the current Point-of-Sale (POS) system they use for various aspects of their job. A new machine would afford them the opportunity to better service customers, including real-time pricing and an on-the-spot checkout process. The new POS system would cost $31,828 and would generate $7,442 of Operating Income. The company has a Required Rate of Return of 8% and their tax rate is 23%. If the Weighted Average Cost of Capital (WACC) is 6.7%, then what would their Economic Value Added (EVA) be? (Do not round intermediate calculations.)
$3,184.10
$3,597.86
$4,895.76
$5,309.52

Esther is the manager of the sales department for a local appliance store. The employees have been voicing their concerns over the current Point-of-Sale (POS) system they use for various aspects of their job. A new machine would afford them the opportunity to better service customers, including real-time pricing and an on-the-spot checkout process. The new POS system would cost $31,828 and would generate $7,442 of Operating Income. The company has a Required Rate of Return of 8% and their tax rate is 23%. If the Weighted Average Cost of Capital (WACC) is 7.7%, then what would their Economic Value Added (EVA) be?
$3,184.10
$3,279.58
$4,895.76
$4,991.24

A company is debating replacing the GPS system in a company vehicle that is used every day of the work week. By replacing the current older model GPS system in the vehicle, the company anticipates being able to add an additional $1,324 of Operating Income this year that will ultimately result in an Economic Value Added (EVA) of $806.43. If the company has a tax rate of 24% and a Weighted Average Cost of Capital (WACC) of 6%, then what is the cost of the new investment?
$60.37
$1,812.67
$3,330.17
$13,440.50

Ans: C, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-tax Operating Income – (WACC × Invested Capital). In this case, solve for investment using the other variables provided. $806.43 = ($1,324 × (1 – 0.24)) – (0.06 × Investment). $806.43 = $1,006.24 – (0.06 × Investment). (0.06 × Investment) = $199.81. Lastly, divide each side by 0.06. Investment = $3,330.17 (Choice C).

A company is debating replacing the GPS system in a company vehicle that is used every day of the work week. By replacing the current older model GPS system in the vehicle, the company anticipates being able to add an additional $1,324 of Operating Income this year that will ultimately result in an Economic Value Added (EVA) of $806.43. If the company has a tax rate of 22% and a Weighted Average Cost of Capital (WACC) of 7.5%, then what is the cost of the new investment?
$2,130.43
$3,017.20
$10,752.40
$13,769.60

Ans: B, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-tax Operating Income – (WACC × Invested Capital). In this case, solve for investment using the other variables provided. $806.43 = ($1,324 × (1 – 0.22)) – (0.075 × Investment). $806.43 = $1,032.72 – (0.075 × Investment). (0.075 × Investment) = $226.29. Lastly, divide each side by 0.075. Investment = $3,017.20 (Choice B).

Brown Bag, Inc. is a company that manufactures colorful lunch bags made from compostable paper. Management would like to increase production and knows the only way to do this would be to add an additional industrial cutting machine. Brown Bag has a Required Rate of Return of 8.2%, a Weighted Average Cost of Capital (WACC) of 6.3%, and a tax rate of 25%. The cutting machine will cost $22,407 and has a useful life of 15 years. How much Operating Income (before tax) must be generated to achieve an Economic Value Added (EVA) of $1,356.00? (Do not round intermediate calculations.)
$55.64
$2,767.64
$3,690.19
$4,257.83

Ans: C, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-tax Operating Income – (WACC × Invested Capital). In this case, solve for Operating Income using the other variables provided. $1,356.00 = (Operating Income × (1 – 0.25)) – (0.063 × $22,407.00). $1,356.00 = (Operating Income × 0.75) – $1,411.64. $2,767.64 = (Operating Income × 0.75). Lastly, divide each side by 0.75. Operating Income = $3,690.19 (Choice C).

Brown Bag, Inc. is a company that manufactures colorful lunch bags made from compostable paper. Management would like to increase production and knows the only way to do this would be to add an additional industrial cutting machine. Brown Bag has a required rate of return of 8.2%, a Weighted Average Cost of Capital (WACC) of 6.3%, and a tax rate of 25%. The cutting machine will cost $22,407 and has a useful life of 15 years. How much Operating Income (before tax) must be generated to achieve an Economic Value Added (EVA) of $551.43? (Do not round intermediate calculations.)
$1,882.19
$1,963.07
$2,617.43
$3,185.07

Ans: C, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-Tax Operating Income – (WACC × Invested Capital). In this case, solve for Operating Income using the other variables provided. $551.43 = (Operating Income × (1 – 0.25)) – (0.063 × $22,407.00). $551.43 = (Operating Income × 0.75) – $1,411.64. $1,963.07 = Operating Income × 0.75. Lastly, divide each side by 0.75. Operating Income = $2,617.43 (Choice C).

Cordelia is a machine operator for Forever Twenty-Five and specifically works on handbags. Forever Twenty-Five would like to begin offering tie-dyed backpacks. In addition to a new product, Forever Twenty-Five will also need to purchase a piece of equipment that is able to stretch and then tie-dye the fabric for the backpack. Cordelia has priced out two different machines. The first will cost $5,674, generate $1,560 of sales, and will incur $992 of operating expenses. The second will cost $6,782, generate $1,733 of sales, and will incur $1,020 of operating expenses. The company has Weighted Average Cost of Capital (WACC) of 6.1% and a Required Rate of Return of 7.2%. Forever Twenty-Five has a current tax rate of 22%. What will the Economic Value Added (EVA) be for the first machine? (Do not round intermediate calculations.)
$96.93
$346.11
$443.04
$568.00

Ans: A, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-tax Operating Income – (WACC × Invested Capital). This question includes a required rate of return, but that information is not needed for this solution. Before solving for EVA, solve for Operating Income by subtracting operating expenses from sales: $1,560 – $992 = $568.00. EVA = ($568.00 × (1 – 0.22)) – (0.061 × $5,674.00). EVA = $443.04 – $346.11 = $96.93 (Choice A).

Cordelia is a machine operator for Forever Twenty-Five and specifically works on handbags. Forever Twenty-Five would like to begin offering tie-dyed backpacks. In addition to a new product, Forever Twenty-Five will also need to purchase a piece of equipment that is able to stretch and then tie-dye the fabric for the backpack. Cordelia has priced out two different machines. The first will cost $5,674, generate $1,560 of sales, and will incur $992 of operating expenses. The second will cost $6,782, generate $1,733 of sales, and will incur $1,020 of operating expenses. The company has Weighted Average Cost of Capital (WACC) of 6.1% and a Required Rate of Return of 7.2%. Forever Twenty-Five has a current tax rate of 22%. What will the Economic Value Added (EVA) be for the second machine? (Do not round intermediate calculations.)
$96.93
$142.44
$299.30
$413.70

Ans: B, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-tax Operating Income – (WACC × Invested Capital). This question includes a required rate of return, but that information is not needed for this solution. Before solving for EVA, solve for Operating Income by subtracting operating expenses from sales: $1,733 – $1,020 = $713.00. EVA = ($713.00 × (1 – 0.22)) – (0.061 × $6,782.00). EVA = $556.14 – $413.70 = $142.44 (Choice B).

A company has gathered the following information about a potential fixed asset purchase:

Cost of asset	$15,000
Useful life	10 years
Operating Income (Net of all expenses except depreciation)	$4,677
Company’s required rate of return	8.2%

If the company has a 20% tax rate and their Economic Value Added (EVA) is $112.00, then what is their Weighted Average Cost of Capital (WACC)?

8.2%
16.20%
16.94%
21.18%

Ans: B, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-tax Operating Income – (WACC × Invested Capital). Before solving for EVA, solve for the Operating Income after depreciation by subtracting depreciation. $15,000/10 years = $1,500 in depreciation expenses per year. Operating Income = $4,677 – $1,500 = $3,177. $112.00 = ($3,177.00 × (1 – 0.20)) – (WACC × $15,000.00). $112.00 = $2,541.60 – (WACC × $15,000.00). (WACC × $15,000.00) = $2,541.60 – $112.00. WACC × $15,000.00 = $2,429.60. Now, divide each side by $15,000 to solve for WACC. WACC = 16.20% (Choice B).

A company has gathered the following information about a potential fixed asset purchase:

Cost of asset	$15,000
Useful life	10 years
Operating Income (Net of all expenses except depreciation)	$4,677
Company’s required rate of return	8.2%

If the company has a 24% tax rate and their Economic Value Added (EVA) is $246.00, then what is their Weighted Average Cost of Capital (WACC)?

14.46%
16.10%
17.74%
21.28%

Ans: A, LO 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for EVA: After-tax Operating Income – (WACC × Invested Capital). Before solving for EVA, solve for the Operating Income after depreciation by subtracting depreciation. $15,000/10 years = $1,500 in depreciation expenses per year. Operating Income = $4,677 – $1,500 = $3,177. $246.00 = ($3,177.00 × (1 – 0.24)) – (WACC × $15,000.00). $246.00 = $2,414.52 – (WACC × $15,000.00). (WACC × $15,000.00) = $2,414.52 – $246.00. WACC × $15,000.00 = $2,168.52. Now, divide each side by $15,000 to solve for WACC. WACC = 14.46% (Choice A).

Oscar is the manager of the component division for a small manufacturing company, and his department is evaluated using various metrics each year including their Return on Investment (ROI). Oscar is debating whether he should purchase a new machine for his department. Oscar is determined to have an ROI of at least 7%. He is considering the purchase of Machine A with a return on sales of 0.3877, sales of $2,349, and a 10-year useful life or Machine B with a return on sales of 0.3994, sales of $2,560, and a 9-year useful life. Each machine would be depreciated using straight-line method. What is the yearly Depreciation Expense for Machine A? (Do not round intermediate calculations.)
1. $1,301.01
2. $1,310.64
3. $1,417.50
4. $1,445.18

Ans: A, LO 1, 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires the use of multiple steps in order to calculate the amount of yearly depreciation. The first step is to use the formula for ROI to determine the cost of the investment for Machine A. ROI = Return on Sales × Investment Turnover. 0.07 = 0.3877 × Investment Turnover. Investment Turnover = 0.1806. Now, use the formula for Investment Turnover to calculate the cost of the investment. Investment Turnover = Sales/Investment. 0.1806 = $2,349/Investment. Investment × 0.1806 = $2,349. Investment = $13,010.10. Lastly, divide this total by the machine’s useful life to calculate its yearly depreciation. $13,010.10/10 years = $1,301.01 (Choice A).

Oscar is the manager of the component division for a small manufacturing company, and his department is evaluated using various metrics each year including Return on Investment (ROI). Oscar is debating whether he should purchase a new machine for his department. Oscar is determined to have an ROI of at least 7%. He is considering the purchase of Machine A with a return on sales of 0.3877, sales of $2,349, and a 10-year useful life or Machine B with a return on sales of 0.3994, sales of $2,560, and a 9-year useful life. Each machine would be depreciated using straight-line machine. What is the yearly Depreciation Expense for Machine B? (Do not round intermediate calculations.)
1. $1,339.99
2. $1,460.35
3. $1,488.88
4. $1,622.96

Ans: D, LO 1, 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires the use of multiple steps in order to calculate the amount of yearly depreciation. The first step is to use the formula for ROI to determine the cost of the investment for Machine B. ROI = Return on Sales × Investment Turnover. 0.07 = 0.3994 × Investment Turnover. Investment Turnover = 0.1753. Now, use the formula for Investment Turnover to calculate the cost of the investment. Investment Turnover = Sales/Investment. 0.1753 = $2,560/Investment. Investment × 0.1753 = $2,560. Investment = $14,606.63. Lastly, divide this total by the machine’s useful life to calculate its yearly depreciation. $14,606.63/9 years = $1,622.96 (Choice D).

Smith Industries is in desperate need of a new press machine for their production department. The manager has been asked to select the most favorable option while keeping in mind that any decision made may also impact their department’s evaluation. Given this, the manager knows that performing a thorough analysis is crucial. A machine could be purchased from Grove Inc. for a total cost of $9,677 and would generate Operating Income of $3,705. A different machine could be purchased from Forest Inc. for a total cost of $9,003 and would generate Operating Income of $3,432. The company has provided the following information:

Required Rate of Return	8.12%
Cost of Debt	6.5%
Cost of Equity	8.3%
Proportion of Debt	65%
Proportion of Equity	35%
Economic Value Added (EVA)	$2,558

What is the tax rate for the press machine from Grove? Assume the company uses an effective tax rate that is rounded to the four places. (Do not round intermediate calculations.)

1. 12.34%
2. 14.66%
3. 17.84%
4. 18.62%

Ans: A, LO 1, 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: In order to solve for the tax rate, the formula for EVA must be used, but first, solve for the Weighted Average Cost of Capital (WACC). WACC = (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). WACC = (0.065 × 0.65) + (0.083 × 0.35) = 0.04225 + 0.02905 = 0.0713. Now, the EVA formula can be used to calculate the tax rate. EVA = After-Tax Operating Income – (WACC × Investment). $2,558 = ($3,705 × (1 – Tax Rate)) – (0.0713 × $9,677). $2,558 = ($3,705 × (1 – Tax Rate)) – $689.97. $3,247.97 = $3,705 × (1 – Tax Rate). So, the tax rate to four places is 0.1234. As a percentage, the tax rate is therefore 12.34% (Choice A).

Smith Industries is in desperate need of a new press machine for their production department. The manager has been asked to select the most favorable option while keeping in mind that any decision made may also impact their department’s evaluation. Given this, the manager knows that performing a thorough analysis is crucial. A machine could be purchased from Grove Inc. for a total cost of $9,677 and would generate Operating Income of $3,705. A different machine could be purchased from Forest Inc. for a total cost of $9,003 and would generate Operating Income of $3,432. The company has provided the following information:

Required Rate of Return	8.12%
Cost of Debt	6.5%
Cost of Equity	8.3%
Proportion of Debt	65%
Proportion of Equity	35%
Tax rate	22%

What is the percentage difference in EVA for the press machine from Grove when compared to the press machine from Forest? (Do not round intermediate calculations.)

1. The EVA of the press machine from Forest is 7.49% higher than the EVA of the press machine from Grove.
2. The EVA of the press machine from Forest is 8.1% higher than the EVA of the press machine from Grove.
3. The EVA of the press machine from Grove is 7.49% higher than the EVA of the press machine from Forest.
4. The EVA of the press machine from Grove is 8.1% higher than the EVA of the press machine from Forest.

Ans: D, LO 1, 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: In order to solve for the tax rate, the formula for EVA will eventually be used, but first, solve for the Weighted Average Cost of Capital (WACC). WACC = (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). WACC = (0.065 × 0.65) + (0.083 × 0.35) = 0.04225 + 0.02905 = 0.0713. Now, the EVA formula can be used to calculate the tax rate. EVA = After-Tax Operating Income – (WACC × Investment).

Grove Press Machine: EVA = ($3,705 × (1 – 0.22)) – (0.0713 × $9,677). EVA = $2,889.90 - $689.97. EVA = $2,199.93.

Forest Press Machine: EVA = ($3,432 × (1 – 0.22)) – (0.0713 × $9,003). EVA = $2,676.96 - $641.91. EVA = $2,035.05.

To calculate the percentage difference, use horizontal analysis. (Grove Machine EVA – Forest Machine EVA)/(Forest Machine EVA) = ($2,199.93 – $2,035.05)/$2,035.05 = $164.88/$2,035.05 = 0.0810. The Grove Press Machine has an EVA that is 8.1% higher than the Forest Press Machine (Choice D).

Landry Corp. is evaluating one of its recent investments and the financial aspects of their investment. The Investment Center has provided the following data:

Invested Capital	$13,422
Expected Annual Sales	$29,870
Expected Annual Expenses	$27,606
Tax Rate	23%
Required Rate of Return	8.6%
Economic Value Added (EVA)	$33.90
Proportion of Debt	72%
Cost of Debt	?
Proportion of Equity	28%
Cost of Equity	9%

Based on the information provided above, what is the company’s Cost of Debt? (Do not round intermediate calculations.)

10.22%
12.74%
14.19%
24.20%

Ans: C, LO 2, 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question involves multiple steps before arriving at the Cost of Debt. The first step is to use the formula for Economic Value Added (EVA) to determine the Weighted Average Cost of Capital (WACC). EVA = After-Tax Operating Income – (WACC × Investment). $33.90 = (($29,870 – $27,606) × (1 – 0.23)) – (WACC × $13,422). $33.90 = ($2,264 × 0.77) – (WACC × $13,422). $33.90 = $1,743.28 – (WACC × $13,422). –$1,709.38 = –WACC × $13,422. Next, divide each side by $13,422. –0.1274 = –WACC. Then, divide each side by –1 to find the WACC. WACC = 0.1274. Now, use the formula for WACC to calculate the Cost of Debt. WACC = (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). 0.1274 = (Cost of Debt × 0.72) + (0.09 × 0.28). 0.1274 = (Cost of Debt × 0.72) + 0.0252. 0.1022 = Cost of Debt × 0.72. Finally, divide each side by 0.72 to find the Cost of Debt. So, Cost of Debt = 0.1419 or 14.19% (Choice C).

Landry Corp. is evaluating one of its recent investments and the financial aspects of their investment. The Investment Center has gathered the following data:

Invested Capital	$13,422
Expected Annual Sales	$29,870
Expected Annual Expenses	$27,606
Tax Rate	23%
Required Rate of Return	8.6%
Economic Value Added (EVA)	$33.90
Proportion of Debt	72%
Cost of Debt	6.4%
Proportion of Equity	28%
Cost of Equity	?

Based on the information provided above, what is the company’s Cost of Equity? (Do not round intermediate calculations.)

1. 8.13%
2. 12.74%
3. 17.35%
4. 29.03%

Ans: D, LO 2, 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question involves multiple steps before arriving at the Cost of Debt. The first step will be to use the formula for Economic Value Added (EVA) to determine the Weighted Average Cost of Capital (WACC). EVA = After-tax Operating Income – (WACC × Investment). $33.90 = (($29,870 – $27,606) × (1 – 0.23)) – (WACC × $13,422). $33.90 = ($2,264 × 0.77) – (WACC × $13,422). $33.90 = $1,743.28 – WACC × $13,422. –$1,709.38 = –WACC × $13,422. Next, divide each side by $13,422. –0.1274 = –WACC. Then, divide each side by –1 to find the WACC. WACC = 0.1274. Now, use the formula for WACC to calculate the Cost of Equity. WACC = (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). 0.1274 = (0.064 × 0.72) + (Cost of Equity × 0.28). 0.1274 = 0.0461 + (Cost of Equity × 0.28). 0.0813 = Cost of Equity × 0.28. Lastly, divide each side by 0.28 to find the Cost of Equity. So, Cost of Equity = 0.2903 or 29.03% (Choice D).

All business units are created with certain goals against which they are measured. Regardless of the type of business unit, evaluations are utilized to ensure that management is directing the team towards the achievement of goals that are congruent with the overall company goals set forth by the highest levels of management. Which of the following best represent metrics used to evaluate an investment center?
1. Profit Margin, Investment Turnover, Year-to-Date Expenditures
2. Residual Income, Sales Order per Customer, Profit Margin
3. Return on Investment, Residual Income, Investment Turnover
4. Return on Investment, Target Profit, Economic Value Added

Ans: C, LO 2, 3, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the evaluation of various responsibility centers. Choice C is the only choice of the four options that represent metrics that would be used to evaluate an investment center. The other choices are a mixture of metrics used to evaluate an investment center or other types of responsibility centers.

The crinkle-cut division of a French fry company had the following results last year with all production sold to outside customers:

Sales (25,000 pounds of fries)	$10,000
Variable Expenses	4,000
Contribution Margin	$ 6,000
Fixed Expenses	3,500
Operating Income	$ 2,500

The crinkle-cut division has a 30,000 pound of processing capacity. If the crinkle-cut division were to transfer the remaining capacity to an internal division or unit, what would the minimum acceptable transfer price be?

$0.13
$0.14
$0.16
$0.40

Ans: C, LO 4, Bloom: AP, Difficulty: Easy, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with how transfer pricing is calculated when a company has excess capacity. In the given scenario, the minimum acceptable transfer price would be variable cost per unit, which is Variable Expenses/Number of Units Produced = $4,000/25,000 = $0.16 per pound (Choice C).

The crinkle-cut division for a French fry company had the following results last year with all production sold to outside customers:

Sales (25,000 pounds of fries)	$10,000
Variable Expenses	4,000
Contribution Margin	$ 6,000
Fixed Expenses	3,500
Operating Income	$ 2,500

The crinkle-cut division has a 30,000-pound processing capacity. If the crinkle-cut division were to transfer the remaining capacity to an internal division or unit, what would the minimum additional amount of profit be?

$0
$800
$4,000
$4,800

Ans: A, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with how transfer pricing is calculated when a company has excess capacity and the additional profit this would create. To determine the minimum acceptable transfer price, calculate the variable cost per unit: Variable Expenses/Number of Units Produced = $4,000/25,000 = $0.16 per pound. Selling 5,000 pounds at $0.16 would bring additional sales of 5,000 × $.016 = $800 and variable costs of $800. The question asked how much profit would be generated, and the answer is $0 as the variable costs cancel out the additional sales (Choice A).

A marble factory has two divisions: Kiln Division and Painting Division. The Kiln Division had Sales of $33,000 and Variable Costs of $25,000 while the Painting Division had Sales of $30,000 and Variable Costs of $21,000. Production and sales for each division are 66,000 pounds. The Kiln Division sells its all-unpainted marble to the Painting Division and does not sell to anyone else. What is the current transfer price?
$0.12 per pound
$0.14 per pound
$0.45 per pound
$0.50 per pound

Ans: D, LO 4, Bloom: AP, Difficulty: Easy, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the way that transfer pricing is calculated by dividing sales by the number of units sold. For this question, focus on the numbers attributable to the Kiln Division since it is they who will be transferring the materials rather than selling them to an outside market. Current transfer price = $33,000/66,000 = $0.50 per pound (Choice D).

A jewelry company has several business units, including their Silver Processing unit and their Earrings unit. The Silver Processing unit typically sells all of its silver to external companies unless an internal division or business unit decides to use them as their supplier. The Earrings unit has decided to add a line of silver hoops to the line of gold hoops they have been selling for several years. Prior to this request, the Silver Processing unit reported the following numbers for the year:

Sales (14,400 ounces of silver)	$318,528
Variable expenses	182,448
Contribution margin	$136,080
Fixed expenses	84,320
Operating Income	$ 51,760

The Silver Processing unit has a capacity of 15,000 ounces of silver, and the Earrings unit has expressed an interest in purchasing the remaining ounces in Silver’s processing capacity. What is the minimum acceptable transfer price on the ounces of silver if the Earrings division purchases them?

$3.59 per ounce
$9.45 per ounce
$12.67 per ounce
$22.12 per ounce

A jewelry company has several business units, including their Silver Processing unit and their Earrings unit. The Silver Processing unit typically sells all of its silver to external companies unless an internal division or business unit decides to use them as their supplier. The Earrings unit has decided to add a line of silver hoops to the line of gold hoops they have been selling for several years. Prior to this request, the Silver Processing unit reported the following numbers for the year:

Sales (14,400 ounces of silver)	$318,528
Variable expenses	182,448
Contribution margin	$136,080
Fixed expenses	84,320
Operating Income	$ 51,760

The Silver Processing unit has a capacity of 15,000 ounces of silver, and the Earrings unit has expressed an interest in purchasing 1,000 ounces from the Silver Processing unit. What is the total revenue generated on the ounces of silver sold to the Earrings unit?

1. $8,848.00
2. $12,670.00
3. $16,450.00
4. $22,120.00

Ans: C, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires determination of the minimum acceptable transfer price if this sale takes the Silver Processing unit to capacity and surpasses it. That means there will be two acceptable prices. In order to calculate the minimum acceptable transfer price for the 600 (15,000 – 14,400) ounces in capacity, that would be equal to the variable cost per unit for those 600 ounces. This is calculated by dividing the variable expenses by the ounces of silver processed. $182,448/14,400 ounces = $12.67 per ounce. The remaining units in this order (if any), would have a minimum acceptable transfer price of the variable cost per unit plus the contribution margin per unit for the units that surpass the unit’s capacity. This number would equal the market price per unit for those units. $12.67 + ($136,080/14,400 ounces) = $12.67 + $9.45 = $22.12 per ounce. The number of units at this price will be 1,000 – 600 = 400 ounces of silver. The total revenue will be (600 × $12.67) + (400 × $22.12) = $16,450.00 (Choice C).

Sally is compiling some numbers for the factory where she works. This factory has many business units, and some sell to external customers only, some sell internally only, and some sell to both internal and external customers. She is specifically looking at Business Unit A which sells primarily to external customers but will also sell to other internal business units. Business Unit A currently has no idle capacity, $2.97 per unit of opportunity cost, and $189,650 in fixed costs. Determine the overall variable cost if business unit A had sales of 75,000 units for a total of $322,500.
1. $33,100
2. $99,750
3. $222,750
4. $322,500

Ans: B, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for the minimum acceptable transfer price when there is no idle capacity: variable cost per unit + opportunity cost per unit. And, the minimum acceptable transfer price in this case will be equal to the sales price per unit to external customers = $322,500/75,000 units = $4.30 per unit. Now, substitute these numbers into the formula after rearranging it: $4.30 (minimum acceptable transfer price) – $2.97 (opportunity cost per unit) = $1.33 (variable cost per unit). Lastly, multiply the variable cost per unit by the number of units sold externally: $1.33 × 75,000 = $99,750 (Choice B).

Sally is compiling some numbers for the factory where she works. This factory has many business units, some sell to external customers only, some sell internally only, and some sell to both internal and external customers. She is specifically looking at Business Unit A which sells primarily to external customers but will also sell to other internal business units within the company. Business Unit A currently has no idle capacity, $2.97 per unit of opportunity cost, and $189,650 in fixed costs. Business Unit A had sales of 75,000 units for a total of $322,500. If an internal department wants to purchase 4,370 units, then what would Business Unit A’s additional profit be?
$0.00
$5,812.10
$12,978.90
$18,791.00

Ans: A, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the formula for the minimum acceptable transfer price when there is no idle capacity: variable cost per unit + opportunity cost per unit. The minimum acceptable transfer price in this case would be equal to the sales price per unit to external customers = $322,500/75,000 units = $4.30. The internal amount of the sale would be: 4,370 units × $4.30 = $18,791. Since the units are being sold to the internal entity for the same amount as they would be sold to an external party, the sale would result in additional profit of $0.00 (Choice A).

The Happy Coffee Company manufactures coffee mugs and sells them to external vendors. They have several divisions that are involved in the process and sell to one another internally. The very last department involved in this process is the Distribution department who sells the final product to local coffee shops. The Distribution department purchases all their units internally from the Glazing department. The sales from the Distribution department to the external vendors amounted to 19,412 mugs for a total of $181,725.72. If the Operating Incomes per unit were as follows for each division: Distribution, $4.56; and Glazing, $1.90; then what is the Cost of Goods Sold (COGS) for the Glazing department? (Do not round your calculations.)
1. $56,324.20
2. $88,518.72
3. $93,177.60
4. $181,725.72

Ans: A, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires understanding of how the overall Operating Income is calculated when total sales involve internal sales as well as sales of the end product to an external entity. If the sales value is divided by the number of mugs sold, then the per-unit selling price can be calculated: $181,725.72/19,412 = $9.36 per unit. Next, use the Operating Income formula to determine the COGS: Sales – COGS (cost to acquire from Glazing) = Operating Income, so $9.36 – COGS = $4.56, and COGS = $4.80 per unit. Now, calculate the COGS for the Glazing department by applying this same formula: Sales – COGS = Operating Income, so $4.80 – COGS = $1.90. COGS = $2.90 per coffee mug. Lastly, to calculate the total COGS, multiply this value by the number of mugs sold: $2.90 × 19,412 mugs = $56,324.20 (Choice A).

The Happy Coffee Company manufactures coffee mugs in-house that it then sells to external vendors. They have several divisions that are involved in the process and sell to one another internally. The very last department involved in this process is the Distribution department who sells the final product to local coffee shops. The Distribution department purchases all of their units internally from the Glazing department. The sales from the Distribution department to the external vendors amounted to 19,412 mugs for a total of $181,725.72. If the Operating Incomes per unit were as follows for each division: Distribution, $4.56; and Glazing, $1.90; then what is the Cost of Goods Sold (COGS) per unit for the Glazing department?
1. $1.90
2. $2.90
3. $4.56
4. $4.80

Ans: B, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires understanding of how the overall Operating Income is calculated when sales involve internal sales as well as sales of the end product to an external entity. If the sales value is divided by the number of mugs sold, then the per-unit selling price can be calculated: $181,725.72/19,412 = $9.36 per unit. Sales – COGS (cost to acquire from glazing) = Operating Income, so $9.36 – COGS = $4.56, and COGS = $4.80 per unit. Lastly, calculate the COGS for the Glazing department by applying this same formula: Sales – COGS = Operating Income. $4.80 – COGS = $1.90. COGS = $2.90 per coffee mug (Choice B).

Most companies begin with a centralized organizational model and gradually move towards a decentralized model. As some companies grow, they acquire other companies in an effort to streamline operations and become more efficient. One result of these acquisitions is integration. Which of the following is an example of vertical integration?
A company that manufactures coffee makers acquires their largest competitor in the market, making them the largest coffee maker manufacturers in the United States.
A company that manufactures handbags acquires a company that manufactures wallets so that they can expand their customer offerings.
A factory that manufactures furniture purchases a furniture marketing and distribution firm.
A factory that produces tortilla chips acquires a company that produces salsa so they can begin to offer deals on both products when purchased at the same time.

Ans: C, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with integration, specifically vertical integration. This type of integration involves a company acquiring another company that exists within the same value chain. Choice C is the only choice listed that accurately depicts a situation where a company is buying another company within the same value chain. The other choices are forms of mergers and acquisitions but not vertical integration.

Most companies begin with a centralized organizational model and gradually move towards a decentralized model. As some companies grow, they will acquire others in an effort to streamline operations and become more efficient. One result of these acquisitions is integration. Which of the following is an example of an integration type other than vertical integration?
A factory that produces paint acquires a factory that produces dyes.
A frozen pizza manufacturer acquires a factory that produces pizza sauce.
A peanut butter producer buys a factory that manufactures jelly.
An automobile manufacturer purchases a factory that produces tires.

Ans: C, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with integration, specifically vertical. A vertical type of integration involves a company acquiring another company that exists within the same value chain. Choice C is the only choice listed that accurately depicts a situation where a company is buying another company that is not within the same value chain, resulting in a different kind of merger. The other choices are examples of vertical integration.

As companies expand and become more decentralized, they will often seek ways in which they can save money. Additionally, management will seek ways to increase efficiency, and that may include purchasing other companies. These acquisitions will involve an integration of the supply chain and will help the company better achieve long-term company goals. Which of the following is an example of backward vertical integration?
1. A customer service company purchases their largest competitor, creating a market-dominating entity.
2. A factory that produces handbags has purchased a company with a fleet of trucks so they can deliver their own goods.
3. A hot dog producer purchases a company that creates hot dog buns.
4. A toy company that designs all products in-house has acquired a company with a strong research and development department to assist in testing new products.

Ans: D, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with integration, specifically backward vertical. This type of integration involves a company acquiring another company that exists within the same value chain. Choice D is the only choice listed that accurately depicts a situation where a company is buying another company within the same value chain that is also backward vertical as it is moving upstream. The other choices are forms of integrations but not necessarily backward vertical.

As companies expand and become more decentralized, they will often seek ways in which they can save money. Additionally, management will seek ways to increase efficiency, and that may include purchasing other companies. These acquisitions will involve an integration of the supply chain and will help the company better achieve long-term company goals. Which of the following is an example of an integration type other than backward vertical?
1. A busy carrier freight company buys a company that produces cardboard boxes to take advantage of internal transfer pricing.
2. A factory that produces handbags has purchased a company with a strong research and development department.
3. A farm that grows soybeans purchases a company that can convert the beans into soy milk that will be available for resale.
4. An auto mechanic at a small garage purchases the parts supply store next door to have quicker access to what they need to work efficiently.

Ans: C, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with integration, specifically backward vertical. This type of integration involves a company acquiring another company that exists within the same value chain. Choice C is the only choice listed that accurately depicts a situation where a company is buying another company within the same value chain that is an integration other than backward vertical. The other choices are forms of backward vertical integrations.

After a company has decided to vertically integrate with another, they will have to seriously consider whether to move upstream or downstream within their value chain. Each direction has its advantages and disadvantages and plays a crucial role in the improved efficiency post-acquisition. Which of the following is an example of forward vertical integration?
1. A local café purchases a small local coffee roaster to source their coffee beans locally.
2. A telecommunications company that manufactures cell phones acquires a marketing company to move the marketing process in-house.
3. A telecommunications company that manufactures cell phones acquires a product design firm to move the product design process in-house.
4. An auto mechanic at a small garage purchases the parts supply store next door to have quicker access to what they need to work efficiently.

Ans: B, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with integration, specifically forward vertical. This type of integration involves a company acquiring another company that exists within the same value chain. Choice B is the only choice listed that accurately depicts a situation where a company is buying another company within the same value chain that is also forward vertical as it is moving downstream. The other choices are forms of integrations but not necessarily forward vertical.

After a company has decided to vertically integrate with another, they will have to seriously consider whether to move upstream or downstream within their value chain. Each direction has its advantages and disadvantages and plays a crucial role in the improved efficiency post-acquisition. Which of the following is an example of an integration type other than forward vertical?
1. A carrier freight company buys a company that produces cardboard boxes to take advantage of internal transfer pricing.
2. A carrier freight company buys a customer service company to handle customer complaints.
3. A company that specializes in the research and development of new flavor combinations purchases a candy bar factory.
4. A farm that grows cocoa beans purchases a company that can refine the beans into cocoa powder that will be available for resale.

Ans: A, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with integration, specifically forward vertical. This type of integration involves a company acquiring another company that exists within the same value chain. Choice A is the only choice listed that accurately depicts a situation where a company is buying another company within the same value chain that is an integration other than forward vertical. The other choices are forms of forward vertical integrations.

Once companies have decentralized, they find themselves in a position where they will be able to attempt to establish transfer pricing between internal departments. In order to best accomplish this, the objectives for the buyer and seller must be considered, even if they are not fully disclosed to the other party. Which of the following represents a potential transfer price objective from the perspective of the seller?
1. A seller has no maximum selling price and has the desire to maximize profits.
2. A seller should keep in mind that they will definitely have an alternative market for its products other than an internal buyer.
3. The seller has a strong preference for selling to the internal buyer as opposed to an external, and potentially unfamiliar, vendor.
4. The seller wants to have a selling price that covers variable and fixed manufacturing costs, at a minimum.

Ans: A, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with transfer pricing and the potential objectives from an internal seller’s perspective. Choice A is the only choice that accurately depicts a potential transfer price objective from the perspective of the seller. The other three choices all contain incorrect portions of the objective and are not accurate as it pertains to a seller’s objectives.

Once companies have decentralized, they find themselves in a position where they will be able to attempt to establish transfer pricing between internal departments. In order to best accomplish this, the objectives for the buyer and seller must be considered, even if they are not fully disclosed to the other party. Which of the following represents a potential transfer price objective from the perspective of the buyer?
1. The buyer does not have a maximum purchase price in mind and would be willing to spend more if it meant they could keep all business in-house.
2. The buyer does not have a minimum purchase price in mind, but they would like to save as much money as possible.
3. If there is an existing supplier in place, then they would prefer to stay with them even if the internal department offers better pricing.
4. The buyer would be willing to pay more for an internal purchase than an external equivalent product.

Ans: B, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with transfer pricing and the potential objectives from an internal buyer’s perspective. Choice B is the only choice that accurately depicts a potential transfer price objective from the perspective of the buyer. The other three choices all contain incorrect portions of the objective and are not accurate as it pertains to a buyer’s objectives.

Turner Inc. is a factory that creates laptop bags that contain an added sleeve for increased protection. The sewing department is currently debating on the best way to proceed with sourcing the materials needed to create the end product. As compared to purchasing internally, what is most likely to impact a potential price with an external vendor?
1. High management turnover at the external vendor’s location has caused labor costs to increase overall.
2. The minimum selling price that the buyer is willing to pay would impact what the external vendor may charge.
3. The negotiation abilities of the manager arranging the deal with the external vendor will have the greatest impact.
4. Whether the internal department has any idle capacity or not would have the greatest impact on the minimum acceptable transfer price.

Ans: C, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with how external transfer pricing could be established and what impact the potential price that is determined. Choice C is the best choice of the four of something that would be most likely to impact a potential price with an external vendor. When a manager is good negotiator, they will likely have an impact on the price that is offered by the external vendor. The other choices are either less likely or unlikely to impact the price for an external sale.

When companies become decentralized and have additional departments, these departments will often begin to sell their products internally to one another. A crucial step in the process of creating a meaningful and worthwhile business relationship is to establish appropriate transfer prices. Which of the following represents the possible negotiated transfer price?
1. Fixed Manufacturing Costs plus Mark-Up
2. Only Fixed Manufacturing Costs
3. The minimum price as established by the buyer
4. Variable Manufacturing Costs

Ans: D, LO 4, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the continuum of negotiated transfer prices. While all of the choices listed above seem like definite possibilities, it is only Choice D that is likely to be a possible negotiated transfer price as it appears on the continuum. The other choices contain elements of what could be included, but they are missing one or more crucial elements to make it complete.

One of the potential ways in which transfer pricing can be established is to use market-based prices, which is often considered an alternative to cost-based transfer prices. In market-based costing, internal transfer prices may be based upon the same pricing structure offered to external customers. Of the choices provided below, which is most likely to be indicative of a pricing system such as market-based transfer pricing?
1. The minimum price as established by the seller
2. Variable manufacturing cost
3. Variable manufacturing cost plus fixed manufacturing cost
4. Variable manufacturing cost plus fixed manufacturing cost plus mark-up

Ans: D, LO 4, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the continuum of market-based transfer prices. While all of the choices listed above seem like definite possibilities, it is only Choice D that is likely to be a possible market price as it appears on the continuum. The other choices contain elements of what could be included, but they are missing one or more crucial elements to make it complete.

A company can choose not to set a particular transfer price policy and would instead prefer to empower business units to negotiate amongst themselves. When this occurs, this opens up the possibility of many options from the continuum of transfer prices to be an option for pricing. For this to be accurate, certain conditions exist. Which of the following best represents one of the conditions that must be present?
The market price available to the buyer has to be lower than the variable manufacturing costs of the seller.
The parties’ relative cost structures must not align, and their objectives should vary.
The selling unit has available capacity and is not currently selling all of its production to external customers.
The selling unit is currently selling all of its production to external customers.

Ans: C, LO 4, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with conditions that must be met in order to be able to negotiate a minimum transfer price. Choice C is the only choice of the four that represents one of the conditions that must be present in order to be able to establish a minimum acceptable transfer price. The other three choices are either entirely incorrect or at least contain parts that are incorrect.

Steven oversees the production department for a factory that makes plastic outdoor chairs. Currently department sells all of its production to external parties, and the department has an overall production capacity of 150,000 chairs. Their sales data is as follows: Sales (90,000 chairs) are $460,000, Variable Costs are $206,200, and Fixed Costs are $194,350. The internal Resale Division would like to purchase 26,700 chairs from the Production Department. They will be selling these to external retailers for $15.49 per chair. If the Resale Division negotiates a deal with the Production Department to purchase each chair for its absorption cost, then what is the amount of Operating Income the Resale Division would report for their sale of 26,700 chairs? Round per unit cost to nearest cents.
1. $294,768
2. $352,440
3. $400,500
4. $413,583

Ans: A, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculation of negotiated prices and operating income. The first step will be to calculate the absorption cost per unit which will be the sum of per unit variable costs and per unit fixed costs. Variable Cost per Unit = $206,200/90,000 chairs = $2.29 per chair. Next, calculate the Fixed Cost per Unit = $194,350/90,000 chairs = $2.16 per chair. Now, combine these two costs to arrive at the absorption cost per unit = $2.29 + $2.16 = $4.45 per chair. Next, calculate the Operating Income per unit for the Resale Division = $15.49 – $4.45 = $11.04 per chair. Lastly, multiply the Operating Income per chair by the 26,700 chairs sold. $11.04 per chair times 26,700 = $294,768 (Choice A).

Steven oversees the production department for a factory that makes plastic outdoor chairs. Currently department sells all of its production to external parties, and the department has an overall production capacity of 150,000 chairs. Their sales data is as follows: Sales (90,000 chairs) are $460,000, Variable Costs are $206,200, and Fixed Costs are $194,350. The internal Resale Division would like to purchase 26,700 chairs from the Production Department. They will be selling these to external retailers for $15.49 per chair. If the Resale Division negotiates a deal with the Production Department to purchase each chair for its absorption cost plus a 2.4% markup, then what is the amount of Operating Income the Resale Division would report for their sale of 26,700 chairs? Round per unit cost to nearest cents.
1. $291,831
2. $293,433
3. $294,768
4. $351,105

Ans: A, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculation of Negotiated Prices and Operating Income. The first step will be to calculate the absorption cost per unit which will be the sum of per unit variable costs and per unit fixed costs. Variable Cost per Unit = $206,200/90,000 chairs = $2.29 per chair. Next, calculate the Fixed Cost per Unit = $194,350/90,000 = $2.16 per chair. Now, combine these two costs to arrive at the absorption cost per unit = $2.29 + $2.16 = $4.45 per chair. Now, add the 2.4% markup onto the sales price. $4.45 × 1.024 = $4.56 per chair. Next, calculate the Operating Income per unit for the Resale Division = $15.49 – $4.56 = $10.93 per unit. Lastly, multiply the Operating Income per chair by the 26,700 chairs sold. $10.93 per chair times 26,700 = $291,831 (Choice A).

The assembly department of Mifflin Inc. has negotiated a deal with the distribution department (internal department) to sell them laser printers. The assembly department has operating capacity of 76,000 printers annually and has made the following external sales:

Sales (76,000 units) $378,000

Direct Materials 49,810

Direct Labor 88,230

Variable Overhead 94,220

Fixed Overhead 112,540

The negotiated deal will be to sell 19,804 printers to the distribution department for the minimum acceptable transfer price. If the distribution department would like to have an Operating Income of $32,680, then what is the overall amount of sales that they must have? Do not round intermediate calculations.

1. $55,454.60
2. $65,745.88
3. $93,280.24
4. $131,178.84

Ans: D, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculation of the minimum acceptable transfer price and then use of the formula for Operating Income to be able to calculate desired sales. Since the assembly department is operating at full capacity, their minimum acceptable transfer price would be equal to market price or the sum of variable cost per unit and the contribution margin per unit. To calculate this, divide the dollar amount of sales by the number of units sold: $378,000/76,000 printers = $4.97 per unit. Next, calculate the desired sales. Sales – Cost (cost to acquire from assembly department) = $32,680. Sales – ($4.97 × 19,804) = $32,680. Sales – 98,498.84 = $32,680. Sales = $131,178.84 (Choice D).

The assembly department of Mifflin Inc. has negotiated a deal with the distribution department (internal department) to sell them laser printers. The assembly department has operating capacity of 76,000 printers annually and has made the following external sales:

Sales (76,000 units) $378,000

Direct Materials 49,810

Direct Labor 88,230

Variable Overhead 94,220

Fixed Overhead 112,540

The negotiated deal will be to sell 19,804 printers to the distribution department for the minimum acceptable transfer price. If the distribution department would like to have an Operating Income of $8,456, then what is the overall amount of sales that they must have? Do not round intermediate calculations.

1. $98,425.88
2. $106,954.84
3. $127,751.44
4. $136,207.44

Ans: B, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculating the minimum acceptable transfer price and using the formula for Operating Income to be able to calculate desired sales. Since the assembly department is operating at full capacity, their minimum acceptable transfer price would be equal to market price or the sum of variable cost per unit and the contribution margin per unit. To calculate this, divide the dollar amount of sales by the number of units sold: $378,000/76,000 printers = $4.97 per unit. Now, calculate the desired sales. Sales – Cost (cost to acquire from assembly department) = $8,456. Sales – ($4.97 × 19,804) = $8,456. Sales – 98,498.84 = $8,456. Sales = $106,954.84 (Choice B).

The Production Department of Ollie Corp. has produced and sold 27,840 yards of fabric to local craft stores. The Sewing Department of Ollie Corp. would like to manufacture 12,300 scarves and needs fabric. Each scarf will require 1 yard of fabric and the Sewing Department has asked the Production Department for a quote. The Production Department’s Sales were $35,360, with Variable Costs of $11,300, Fixed Costs of $16,540, and production capacity of 60,000 yards of fabric. The negotiated sales price from the Production Department is the absorption cost. What should the sales price per unit for the Sewing Department be if they would like to have an Operating Income of $4,940?
1. $0.81 per yard
2. $1.00 per yard
3. $1.40 per yard
4. $1.41 per yard

Ans: C, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculating the minimum acceptable transfer price and then using the formula for Operating Income to be able to calculate desired sales and the per yard cost. The negotiated sales price will be the absorption cost which will be equal to the variable cost per yard plus the fixed cost per yard. Calculate the absorption cost per yard as: ($11,300 + $16,540)/27,840 yards = $27,840/27,840 = $1.00 per yard. Now, calculate the desired sales. Sales – Cost (cost to acquire from assembly) = $4,940. Sales – ($1.00 × 12,300 yards) = $4,940. Sales – $12,300 = $4,940. Sales = $17,240. Lastly, divide this by the number of yards sold = $17,240/12,300 yards = $1.40 per yard (Choice C).

The Production Department of Ollie Corp. has produced and sold 27,840 yards of fabric to local craft stores. The Sewing Department of Ollie Corp. would like to manufacture 12,300 scarves and needs fabric. Each scarf will require 1 yard of fabric and the Sewing Department has asked the Production Department for a quote. The Production Department’s Sales were $35,360, with Variable Costs of $11,300, Fixed Costs of $16,540, and production capacity of 60,000 yards of fabric. The negotiated sales price from the Production Department is the absorption cost. What should the sales price per unit for the Sewing Department be if they would like to have an Operating Income of $13,502?
1. $0.10 per yard
2. $1.51 per yard
3. $2.10 per yard
4. $2.91 per yard

Ans: C, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculating the minimum acceptable transfer price and then using the formula for Operating Income to be able to calculate desired sales and the per yard cost. The negotiated sales price will be the absorption cost which will be equal to the variable cost per yard plus the fixed cost per yard. Calculate the absorption cost per yard as: ($11,300 + $16,540)/27,840 yards = $27,840/27,840 = $1.00 per yard. Now, calculate the desired sales. Sales – Cost (cost to acquire from assembly) = $13,502 Sales – ($1.00 × 12,300 yards) = $13,502. Sales – $12,300 = $13,502. Sales = $25,802. Lastly, divide this by the number of yards sold = $25,802/12,300 yards = $2.10 per yard (Choice C).

The Saltine Cracker business unit of snack company called Salty Treatz, Inc. is selling all units produced to external customers. Salty Treatz has a processing capacity of 156,500 units for its saltine crackers. They have provided the following information:

Sales (118,000 units of saltines)	$70,800
Variable expenses	34,400
Contribution margin	$36,400
Fixed expenses	21,200
Operating income	$15,200

Due to an increase in sales of Party Platter division, an internal business unit of Salty Treatz, Party Platter would like to purchase 38,500 of the Saltine Cracker’s product. If Saltine Cracker does an internal transfer of all additional capacity in units to Party Platter, what will the minimum acceptable transfer price be?

$0.13
$0.22
$0.29
$0.31

Ans: C, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: The minimum acceptable transfer price would be equal to its variable cost per unit. This will be calculated by dividing the variable expenses by the units of saltine units produced. $34,400/118,000 = $0.29 per unit. They could agree to sell for more, but this is the amount needed to cover their expenses (Choice C).

The Saltine Cracker business unit of snack company called Salty Treatz, Inc. is selling all units produced to external customers. Salty Treatz has a processing capacity of 156,500 units for its saltine crackers. They have provided the following information:

Sales (118,000 units of saltines)	$70,800
Variable expenses	34,400
Contribution margin	$36,400
Fixed expenses	21,200
Operating income	$15,200

Due to an increase in sales of Party Platter division, an internal business unit of Salty Treatz, Party Platter would like to purchase 38,500 of the Saltine Cracker’s product. If Saltine Cracker does an internal transfer of all additional capacity in units to Party Platter for the minimum acceptable transfer price, how much profit could be generated from this sale? (Do not round intermediate calculation.)

$0.00
$8,470.00
$11,165.00
$11,935.00

Ans: A, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: In order to calculate the additional profit, calculate the minimum acceptable transfer price. In the given scenario, minimum acceptable transfer price would be equal to its variable cost per unit. This will be calculated by dividing the variable expenses by the units of saltine units produced. $34,400/118,000 = $0.29 per unit. They have additional capacity of 38,500 units, and if they sold them at $0.29 per unit, then they would have an additional amount of (38,500 × $0.29) = $11,223.73. Their variable costs would also be $11,223.73, so their total profit would be $0.00. (Choice A).

Pampered Pooches, Inc. is a factory that produces organic dog food and treats. The Oatmeal Biscuit business unit of Pampered Pooches made all sales of its product to external customers and is currently operating near their full capacity of 55,000 pounds. Oatmeal reported $42,350 of sales (50,000 pounds of biscuits), variable expenses of $26,809, and fixed expenses of $11,504. The Variety Box business unit of Pampered Pooches has asked if the Oatmeal Biscuit unit could sell them 8,700 pounds of biscuits to include with their upcoming run of new variety boxes. What will the minimum acceptable transfer price be if they do produce and sell the demanded pounds to Variety Box?
Idle Capacity units - $0.08 per pound, No Idle Capacity units - $0.31 per pound
Idle Capacity units - $0.31 per pound, No Idle Capacity units - $0.08 per pound
Idle Capacity units - $0.54 per pound, No Idle Capacity units - $0.85 per pound
Idle Capacity units - $0.85 per pound, No Idle Capacity units - $0.54 per pound

Ans: C, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with how to calculate the minimum acceptable transfer price if a seller has idle capacity and what the minimum acceptable transfer price would be if a seller has no idle capacity. When there is no idle capacity, the minimum acceptable transfer price would be equal to its variable cost per unit plus the contribution margin per unit on external sales. Or to simplify, it will be equal to the market price. This is calculated by dividing the sales by the pounds of biscuits sold. $42,350/50,000 pounds = $0.847 or $0.85 per pound. For units when there is idle capacity, the minimum acceptable transfer price would be the variable cost per unit: $26,809/50,000 pounds = $0.54 per pound (Choice C).

Pampered Pooches, Inc. is a factory that produces organic dog food and treats. The Oatmeal Biscuit business unit of Pampered Pooches made all sales of its product to external customers and is currently operating near their full capacity of 55,000 pounds. Oatmeal reported $42,350 of sales (50,000 pounds of biscuits), variable expenses of $26,809, and fixed expenses of $11,504. The Variety Box business unit of Pampered Pooches has asked if the Oatmeal Biscuit unit could sell them 8,700 pounds of biscuit to include with their upcoming run of new variety boxes. If Oatmeal Biscuit business unit uses the minimum acceptable transfer price to sell the required units to Variety Box, what would the total sales price be? (Do not round your calculations.)
$702.00
$4,698.00
$5,814.80
$7,395.00

Ans: C, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with how to calculate the minimum acceptable transfer price if a seller has idle capacity and what the minimum acceptable transfer price would be if a seller has no idle capacity. When there is no idle capacity, the minimum acceptable transfer price would be equal to the variable cost per unit plus the contribution margin per unit on external sales. Or to simplify, it will be equal to market price. This is calculated by dividing the sales by the pounds of biscuits sold. $42,350/50,000 pounds = $0.847 or $0.85 per pound. For units produced when a seller has idle capacity, the minimum acceptable transfer price would be the variable cost per unit. $26,809/50,000 pounds = $0.54 per pound. There are 5,000 idle capacity units and 3,700 no idle capacity units. (5,000 × $0.54) + (3,700 × $0.85) = $2,680.90 + $3,133.90 = $5,814.80 (Choice C).

Almond Delights is a farm that harvests almonds and sells them to both external customers and to some internal business units when the deal makes fiscal sense. Almond Delights’ Farm business unit is having a very successful year and provided the following information:

Sales (167,300 pounds of almonds)	$260,988
Direct Materials	15,460
Direct Labor	39,245
Variable Overhead	60,732
Fixed expenses	90,428

The Almond Milk business unit of Almond Delights would like to purchase 13,490 pounds of almonds from the Farm business unit. If the Farm business unit is operating at full capacity, then what will the minimum acceptable transfer price be? (Do not round your calculations.)

$0.69 per pound
$0.87 per pound
$1.56 per pound
$1.89 per pound

Almond Delights is a farm that harvests almonds and then sells them to both external customers and to some internal business units when the deal makes fiscal sense. Almond Delights’ Farm business unit is having a very successful year and provided the following information:

Sales (167,300 pounds of almonds)	$260,988
Direct Materials	15,460
Direct Labor	39,245
Variable Overhead	60,732
Fixed expenses	90,428

The Almond Milk business unit of Almond Delights would like to purchase an additional 13,490 pounds of almonds from the Farm business unit. If Almond Delights Farm business unit is not operating at full capacity and has the ability to produce all of the additional units, then what will the minimum acceptable transfer price be to sell to the Almond Milk business unit?

$0.33 per pound
$0.69 per pound
$0.87 per pound
$1.56 per pound

Ans: B, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: The minimum acceptable transfer price would be equal to its variable cost per unit. This will be calculated by dividing the variable expenses by the pounds of almonds harvested. Calculate the total variable costs which will be $15,460 + $39,245 + $60,732 = $115,437. Now, divide by the number of units sold externally. $115,437/167,300 pounds = $0.69 per pound. They could agree to sell for more, but this is the minimum amount needed to cover their expenses (Choice B).

The retail department of Dunder Corp. has been working out a deal with a new customer, Neal Inc. The Retail department will be selling ceramic houseplant pots created internally by the Molding department. The Retail department has agreed to sell 12,430 pots to Neal Inc. at a price of $157,115.20. The Molding department has been putting together an estimate and noted that its operating income is $2.64 per unit. If the company would like to see an overall operating income per unit of $3.98 for both the departments, then what is the sales price of the units supplied by the Molding department to the Retail department?
1. $12,441.30
2. $32,815.20
3. $107,643.80
4. $140,459.00

Ans: D, LO 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires understanding how the overall operating income is calculated when sales involve internal sales in addition to what the end product is sold for to an external entity. Overall operating income will equal operating income (of the molding Department) plus operating income (of the retail department). You can calculate the operating income of retail department from the given information: $3.98 = $2.64 + Operating income of retail department; Operating income of retail department = $3.98 – $2.64 = $1.34 per unit. Next, multiply the number of units expected to be sold by the per unit operating income to determine the total amount of operating income of the Retail department: 12,430 pots × $1.34 = $16,656.20. Now, subtract the operating income of the Retail department from the total amount of expected sales to determine the cost of goods sold for the retail department: $157,115.20 - $16,656.20 = $140,459.00. Cost of goods sold for Retail department will be equal to the sales from the Molding department to the Retail department (Choice D).

The retail department of Dunder Corp. has been working out a deal with a new customer, Neal Inc. The Retail department will be selling ceramic houseplant pots created internally by the Molding department. The Retail department has agreed to sell 12,430 pots to Neal Inc. at a price of $157,115.20. The Molding department has been putting together an estimate and noted that its operating income is $2.64 per unit. If the company would like to see an overall operating income per unit of $11.47, then what is the sales price of the units supplied by the Molding department to the Retail department?
1. $14,543.10
2. $32,815.20
3. $47,358.30
4. $157,115.20

Ans: C, LO 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires understanding how the overall operating income is calculated when sales involve internal sales in addition to what the end product is sold for to an external entity. Overall operating income will equal operating income (of the Molding department) plus operating income (of the Retail department). Calculate the operating income of the Retail department from the given information: $11.47 = $2.64 + Operating income of retail department; Operating income of the Retail department = $11.47 – $2.64 = $8.83 per unit. Next, multiply the number of units expected to be sold by the per unit operating income to determine the total amount of operating income of the Retail department: 12,430 pots × $8.83 = $109,756.90. Now, subtract the operating income of Retail department from the total amount of expected sales to determine the cost of goods sold for the Retail department: $157,115.20 - $109,756.90 = $47,358.30. Cost of goods sold for the Retail department will be equal to the sales from the Molding department to the Retail department (Choice C).

One of the potential ways that transfer pricing can be established is to use market-based prices. This is often considered an alternative to cost-based transfer prices. In market-based costing, internal transfer prices may be based upon the same pricing structure offered to external customers. Of the choices provided below, which is most likely to be indicative of a pricing system such as cost-based transfer pricing?
Only fixed manufacturing costs
The maximum price established by the buyer
The minimum price established by the seller
Fixed manufacturing costs plus mark-up

Ans: C, LO 4, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with the continuum of cost-based transfer prices. While all of the choices listed above seem like definite possibilities, it is only Choice C that is likely to be a possible cost-based transfer pricing as it appears on the continuum. The other choices contain elements of things that could be included but are missing one or more crucial elements to make the responses complete.

Income taxes and the IRS present challenges for all businesses, and it is crucial to have accurate calculations at all times. This scrutiny increases as a company becomes more global. If a company has divisions in more than one country, then it is known as a multinational company. When one division crosses national borders, international tax implications arise. Which of the following represents a challenge that is unique for multinational corporations?
Having inbound transactions that are originated by a U.S. based parent company
Having outbound transactions that are originated by a foreign parent company
Having to navigate the tax regulations of multiple countries as a buyer and seller
Having to file corporate tax documents with the Internal Revenue Service

Ans: C, LO 4, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires that you be familiar with the special issues encountered by multinational companies that also have transfer pricing happening across country lines. Choice C is the only choice that is a challenge that is unique to these types of organizations. Choices A and B are reversed, and Choice D is a challenge that all corporations will have to deal with.

The Tortilla Chip business unit at Chipz Corp has reported the following results for years 1 and 2 of their operation:

	Year 1	Year 2
Sales	$178,903	$194,617
Variable expenses	94,200	103,343
Contribution margin	$84,703	$91,274
Fixed expenses	50,732	55,892
Operating income	$33,971	$35,382

The Tortilla Chip business unit sold 69,870 bags in Year 1, and they sold 75,433 bags in Year 2. In the first year, they had an operating capacity of 75,000 bags and fulfilled a special order for an internal department of 12,465 bags. In the second year, they had an operating capacity of 80,000 bags and fulfilled a special order for an internal department of 14,788 bags. What is the difference in overall price for the special orders fulfilled for the internal department in years 1 and 2? (Round per unit cost to two decimal places.)

Year 1 is $6,923.87 higher than Year 2
Year 1 is $7,592.58 higher than Year 2
Year 2 is $6,923.87 higher than Year 1
Year 2 is $7,592.58 higher than Year 1

Ans: C, LO 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculation of the minimum acceptable price for both idle capacity and no idle capacity. This will result in two different minimum acceptable transfer prices. These calculations must be completed for both years.

Year 1: To determine how many are subject to each price, subtract the sales from the high threshold of the capacity. 75,000 – 69,870 = 5,130 units can still be produced before hitting capacity. The minimum acceptable transfer price of the 5,130 units will be equal to the variable cost per unit, which is equal to $94,200/69,870 = $1.35 per unit. Any units produced with no idle capacity will have a minimum acceptable transfer price of the variable cost per unit plus the contribution margin per unit. Contribution margin = $84,703. Now, divide this by the units sold: $84,703/69,870 bags = $1.21 per unit. The minimum acceptable transfer price = $1.35 + $1.21 = $2.56 per unit. The number of units that will be charged at this price will be the total requested minus the units with idle capacity = 12,465 – 5,130 = 7,335 units. The total price that will be quoted is: (7,335 × $2.56) + (5,130 × $1.35) = $18,777.6 + $6,925.5 = $25,703.10.

Year 2: To determine how many are subject to each price, subtract the sales from the high threshold of the capacity. 80,000 – 75,433 = 4,567 units can still be produced before hitting capacity. The minimum acceptable transfer price of the 4,567 units will be equal to the variable cost per unit, which is equal to $103,343/75,433 = $1.37 per unit. Any units produced with no idle capacity will have a minimum acceptable transfer price of the variable cost per unit plus the contribution margin per unit. Contribution margin = $91,274. Now, divide this by the units sold: $91,274/75,433 = $1.21 per unit. The minimum acceptable transfer price = $1.37 + $1.21 = $2.58 per unit. The number of units that will be charged at this price will be the total requested minus the units with idle capacity = 14,788 – 4,567 = 10,221 units. The total price that will be quoted is: (10,221 × $2.58) + (4,567 × $1.37) = $26,370.18 + $6,256.79 = $32,626.97.

Overall price difference: $32,626.97 – $25,703.10 = $6,923.87 (Choice C).

The Tortilla Chip business unit at Chipz Corp has reported the following results for years 1 and 2 of their operation:

	Year 1	Year 2
Sales	$178,903	$194,617
Variable expenses	94,200	103,343
Contribution margin	$84,703	$91,274
Fixed expenses	50,732	55,892
Operating income	$33,971	$35,382

The Tortilla Chip business unit sold 69,870 bags in year one, and they sold 75,433 bags in their second year. In the first year, they had operating capacity of 75,000 bags and fulfilled a special order for an internal department of 12,465 bags. In the second year, they had operating capacity of 80,000 bags and fulfilled a special order for an internal department of 14,788 bags. Which of the following is an accurate representation of the difference in minimum acceptable transfer price between the two years? (Round per unit cost to two decimal places.)

With idle capacity, the unit transfer price is $0.02 higher in Year 1 than Year 2.
With idle capacity, the unit transfer price is $0.02 higher in Year 2 than Year 1.
With no idle capacity, the unit transfer price is $0.04 higher in Year 1 than Year 2.
With no idle capacity, the unit transfer price is $0.04 higher in Year 2 than Year 1.

Ans: A, LO 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires calculation of the minimum acceptable price for both idle capacity and no idle capacity. This will result in two different minimum acceptable transfer prices. These calculations must be completed for both years. These are needed to perform comparison calculations.

Year 1: To determine how many are subject to each price, subtract the sales from the high threshold of the capacity. 75,000 – 69,870 = 5,130 units can still be produced before hitting capacity. The minimum acceptable transfer price of the 5,130 units will be equal to the variable cost per unit, which is equal to $94,200/69,870 = $1.35 per unit. Any units produced with no idle capacity will have a minimum acceptable transfer price of the variable cost per unit plus the contribution margin per unit. Contribution margin = $84,703. Now, divide this by the units sold: $84,703/69,870 = $1.21 per unit. The minimum acceptable transfer price = $1.35 + $1.21 = $2.56 per unit.

Difference in minimum acceptable transfer price with no idle capacity: Year 2: $2.58 – Year 1: $2.56 = $0.02.

Difference in minimum acceptable transfer price with idle capacity: Year 2: $1.37 – Year 1: $1.35 = $0.02.

In both the scenarios, Year 2’s minimum acceptable transfer price is $0.02 higher than Year 1 (Choice A).

A factory has several business units and is vertically integrated throughout most of its supply chain. One of the first ways the company moved in this direction was to purchase a Wholesale department where the Production department could directly sell its products. The Wholesale department purchases the final product from the Production department, packages the product, and then sells it to the external vendors. The results of this part of the operation are as follows:

	Production	Wholesale
Sales	$56,000	$111,040
Variable expenses	28,600	62,479
Contribution margin	$27,400	$48,561
Fixed expenses	19,745	26,701
Operating income	$7,655	$21,860

There is currently no external market for the Production department to sell its products, so all sales are from the 80,000 units sold to the Wholesale department. The product created by the Production department is very unique, and the Wholesale department cannot acquire it from another vendor or supplier. Assuming that the Production department uses the minimum acceptable transfer price, how much total variable costs are they incurring per unit once the Wholesale department sells overall?

$0.08
$0.44
$0.78
$1.14

Ans: B, LO 4, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: This question requires familiarity with calculating results once you factor in that part of the sale and costs between two departments within the same organization. To calculate this, it is best to determine the per unit cost of each number that will be needed. The variable costs from the Production department are needed to calculate the overall variable cost per unit. $28,600/80,000 units = $0.36 per unit. To calculate the additional variable costs incurred by the Wholesale department, subtract the transfer price from the variable costs, and divide by units sold. ($62,479 – $56,000)/80,000 units = $6,479/80,000 units = $0.08 per unit. Total variable cost per unit would be: $0.36 + $0.08 = $0.44 (Choice B).

A factory has several business units and is vertically integrated throughout most of its supply chain. One of the first ways the company moved in this direction was to purchase a Wholesale department where Production could directly sell its products. The Wholesale department purchases the final product from the Production department, packages the product, and then sells it to the external vendors. The results of this part of the operations are as follows:

	Production	Wholesale
Sales	$56,000	$111,040
Variable expenses	28,600	62,479
Contribution margin	$27,400	$48,561
Fixed expenses	19,745	26,701
Operating income	$7,655	$21,860

Currently, there is no intermediate market for the Production department to sell its products, so all of the sales are from the 80,000 units sold to the Wholesale department. The product created by the Production department is very unique, and the Wholesale department cannot acquire it from another vendor or supplier. Assume that the Production department finds an external vendor and can sell 40,000 units of its products for $0.72 per unit and that there was no change in the Production department’s current transfer price. Then, what is the percentage change in operating income that they would see?

10.45% increase
17.29% decrease
17.29% increase
20.9% decrease

Ans: A, LO 4, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: Under the given conditions, the Production department is reporting operating income of $7,655 by selling all products to the internal Wholesale department. If they found themselves with an external customer that would receive $0.72 per unit for the order of 40,000 units, then this would create sales of 40,000 × $0.72 per unit = $28,800. Next, calculate the sale generated from the wholesale department: 40,000 × 0.70 per unit = $28,000. Now, calculate the new operating income: $28,800 + $28,000 – $28,600 – $19,745 = $8,455. The percentage change can be measured as follows: ($8,455 – $7,655)/$7,655 = 0.1045 or 10.45% increase (Choice A).

Short Answers

State the four pillars of a management control system, and indicate how each fits into the overall design of an effective system and why it is crucial that they all function together.

Ans: NA, LO 1, Bloom: C, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: The four pillars of a management control system are: Budgeting, Responsibility Centers, Transfer Pricing, and Performance Measurement. Each of the pillars contains its own unique attributes but must also work together to create a complete and comprehensive system designed to help a business achieve its goals. Budgeting strives to create numerical goals that will guide other processes such as staffing and production. Responsibility Centers divide tasks between various employees and departments to ensure that necessary work is being completed. Transfer Pricing is used as a means to coordinate activities between and within business units, and it aims to fulfill these business units’ and the company’s objectives. Performance Measurement reflects upon a process from start to finish and determines whether certain goals or metrics have been achieved. Management can then provide additional guidance to make effective changes moving forward based on the results of measured performance. A truly effective system will have all four pillars working with and building upon one another. It is crucial that they function together as they have special mechanisms to guide employee decision-making and therefore company goals.

What is a responsibility center, and what are the four types? Discuss each in detail.

Ans: NA, LO 2, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: A responsibility center is a unit within a business that is organized by its area of control. The four types of responsibility centers are: cost center, revenue center, profit center, and investment center. A cost center has the objective of managing costs while fulfilling its purpose within the value chain as defined by the company. A revenue center has the task of generating revenues for a company, and its sole purpose is to generate sales within the parameters set by the company. A profit center has a defined responsibility of earning a profit, which entails generating revenues and simultaneously maintaining expenses. Investment centers have the assigned task of generating a target return with selected assets and then reinvesting the subsequent returns. Each responsibility center has its own tasks but creates a well-balanced company and management system when all centers are functioning as designed.

What are the three characteristics of effective responsibility centers, and what does each entail? Why are these characteristics so important to the overall functioning of responsibility centers of decentralized organizations?

Ans: NA, LO 2, Bloom: AN, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: The three characteristics of effective responsibility centers include authority, responsibility, and accountability. Authority initially resides at the top levels of a company before it is delegated to middle and lower levels of management in a decentralized organization. The goal of authority is to empower employees to make good decisions with consequences given by management when goals are not achieved. Responsibility entails being given ownership over a task or process where the responsibility of completion is shared by the owner of the task and the person that delegated it to them, typically a manager. Accountability is related to responsibility but is different in that accountability is needed to move responsibility from a suggestion to a real goal with enforceable consequences. These characteristics are integral to the overall functioning of responsibility centers of decentralized organizations because they all build upon one another and work in tandem. In a well-structured organization, these characteristics can flow upward and/or downward in support of goal congruence.

Company and employee performances are best measured through both quantitative and qualitative measures. Why are both components important to the overall picture of performance? Why are ratios the most fair and consistent means of comparing different organizations within the same industry?

Ans: NA, LO 3, Bloom: AN, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: When it comes to measuring the performance of an organization, it is crucial that as much bias as possible be eliminated. If you were to only observe quantitative data, such as ratios, without also considering qualitative factors, then an incorrect conclusion might be drawn. For example, a manager may measure labor percentages and note that one department has exceptionally high numbers. Upon further inquiry, this manager might learn that employees have been working overtime to compensate for so many people being out sick which is costing the company time and extra overtime wages that are one and one-half times higher than the normal labor rate. When this is factored in, the managers might actually be performing well given the circumstances. The overall picture of performance is nuanced and should be approached as such. Ratios are the fairest and most consistent means of comparing different organizations within the same industry as they remove biases like size and create a level playing field for comparison.

What is vertical integration, and when is it present in a business? What are the different directions associated with vertical integration, and how does each impact your position in the value chain as it relates to the customer?

Ans: NA, LO 4, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: Vertical integration often arises as a result of a merger of two companies or an acquisition where one company buys another with a focus on one company’s value chain. Vertical integration typically results when a company finds value in taking direct ownership of various activities that either precede or follow the existing firm in the value chain. Vertical integration can be upstream when the company is before you in the value chain and therefore further away from the final customer. Vertical integration can also be downstream when the company that is after you is in the value chain and therefore closer to the final customer.

What is transfer pricing, and why is it necessary? What is required before negotiating an optimal transfer price range?

Ans: NA, LO 4, Bloom: K, Difficulty: Medium, AACSB: Communication, AICPA: AC: Reporting, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: Transfer pricing is the internal transaction price at which goods or services are exchanged between two business units within the same company. The need to establish a transfer price arises when two parties to a transaction are related business units within the same company. These related business units use transfer pricing as a means to allocate total profit between them. The process will still deem one party/business unit as the seller and the other party/business unit as the buyer even though the transaction occurs within the same company. Before being able to establish or negotiate an optimal transfer price range, establish the buyer’s and seller’s objectives while also determining the capacity constraints of each. Establishing objectives involves thinking of the perspective of each party and then determining if an acceptable price range can be established between both parties. Determining capacity constraints involves observing supply and demand in both the internal and external markets while also factoring in any intermediate markets that might exist.

Brief Exercise

Shannon is a manager for Smith Corp., a factory that manufactures cotton scarves in a variety of colors and patterns. Her division is in charge of dying the fabric, and she would like to explore the possibility of replacing one of their machines. The current machine is attributed with $4,500 of sales, has $1,404 of operating expenses, and has a repair cost of $4,600. A new machine is estimated to generate $5,400 of sales, to have $2,560 of operating expenses, and has a cost of $4,850. What is the Return on Investment in each scenario?

Ans: NA, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: Retain and Repair: 67.30%, Purchase New: 58.56%

This question requires familiarity with the formula for Return on Investment: (Operating Income/Sales) × (Sales/Investment) where sales cancel one another out. To retain and repair the current machine: ($4,500 – $1,404)/$4,600 = 0.6730 or 67.30%. To purchase a new machine: ($5,400 – $2,560)/$4,850 = 0.5856 or 58.56%.

Forager Ltd. is a company that creates various home décor items including faux houseplants, planters, and picture frames. All the items they produce are created using recycled materials, and that has been a major selling point for their customers. The manager of the planter division requested that they look into purchasing a new kiln that will reduce production time and costs while increasing output. The head accountant has compiled the following estimates pertaining to the new kiln: Sales, $4,675; Cost of Goods Manufactured, $1,844; and Operating Expenses (including depreciation), $1,408. The cost of the kiln is estimated to be $9,630. What are the Return on Sales and the Investment Turnover values for a new kiln?

This question requires calculation of both the Return on Sales and the Investment Turnover. Return on Sales is calculated as follows: Operating Income/Sales. Investment Turnover is calculated as follows: Sales/Investment. Begin with Return on Sales. Operating Income is calculated by subtracting Cost of Goods Manufactured and Operating Expenses from Sales. Operating Income = $4,675 – $1,844 – $1,408 = $1,423. Now, divide that value by Sales to calculate the Return on Sales $1,423/$4,675 = 0.3044. Then, calculate Investment Turnover, $4,675/$9,630 = 0.4855.

Susan is considering the purchase of a new machine for her division at work. They had a busier year than expected, and that expedited wear and tear on the existing machine used by her division. She argued that purchasing a new machine instead of fixing the current machine would be the smarter investment for the company. Susan pulled together some information about the new machine (all figures listed are specifically tied to the new machine):

Sales: $2,428

Operating Expenses: $1,870

Cost (new machine): $9,764

The company has a Required Rate of Return of 5%. What is the Residual Income that would be generated by the new machine?

This question requires calculation of Residual Income for an investment. The formula is as follows: Operating Income – (Required Rate of Return × Investment). The first step is to calculate the Operating Income: $2,428 – $1,870 = $558. Now, complete the rest of the formula. $558 – (5% × $9,764) = $558 – $488.20 = $69.80.

Tate is the manager for the service division at Wilcox Inc., a company that provides a call center for various customer service organizations. They are in the process of analyzing some data for the current year and want to ensure that they are making wise choices. Their accountant has compiled the following information about certain financial statement balances:

Current Assets =	$10,000
Total Assets =	$35,000
Current Liabilities =	$14,500
Total Liabilities =	$18,000

Wilcox purchased a new phone system this year that cost them $6,700. They would like to calculate the Economic Value Added (EVA) but must first perform some sub-calculations. What is the invested capital value when calculating the EVA for the entire division? What about the new phone system?

This question requires familiarity with the way that invested capital is calculated under different circumstances. For the entire division, the formula is Total Assets – Current Liabilities. Entire Division: $35,000 – $14,500 = $20,500. When EVA is calculated using a specific investment, such as a new phone system, use the cost of the investment. In this case, that amount is $6,700.

Dottie is compiling some data for her boss who is interested in comparing last year to the current year. They will eventually work on calculating the Economic Value Added (EVA) by the new industrial assembly line conveyer belt added but must first determine their Weighted Average Cost of Capital (WACC). Dottie has gathered the following information:

	Current Year	Previous Year
Cost of Debt	6.5%	6.00%
Cost of Equity	8.5%	8.25%
Proportion of Debt	80.0%	78.00%
Proportion of Equity	20.0%	22.00%

What is the WACC for the current year? What is the WACC of the previous year? (Do not round intermediate calculations.)

In order to solve for the WACC, apply the following formula: (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). For the current year: (0.065 × 0.80) + (0.085 × 0.20) = 0.052 + 0.017 = 0.069, or 6.90%. For the previous year: (0.06 × 0.78) + (0.0825 × 0.22) = 0.04680 + 0.01815 = 0.06495, or 6.50%.

Jenna has decided to demonstrate to her manager that the new embroidery machine they purchased was a great investment for the company where they work. Management had originally wanted to repair the existing machine, but Jenna convinced them that acquiring a more modern machine would be a great fiscal decision. She is going to calculate the Economic Value Added (EVA) in the hopes that her prediction was correct. She has gathered the following data:

Embroidery machine	$8,650
Expected Operating Income tied to the embroidery machine	$794
Tax rate	21%
Cost of Debt	7%
Proportion of Debt	82%
Cost of Equity	7.8%
Proportion of Equity	18%

Using the information above, what is the EVA that Jenna will be able to present to management?

Ans: NA, LO 3, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: EVA = $9.30

This question requires the formula for EVA which is After-Tax Operating Income – (WACC × Investment). First, calculate WACC by using the following formula: (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). (0.07 × 0.82) + (0.078 × 0.18) = 0.0574 + 0.0140 = 0.0714. Now, complete the formula for EVA: (($794 × (1 – 0.21)) – (0.0714 × $8,650) = $627.26 – $617.956 = $9.30.

Sarah is the production manager for Smith Corp., and she is working on some pricing proposals for internal and external customers. Sarah is in charge of the Red Business Unit who produces spools of red yarn. They currently supply many craft stores in the area, have had a very busy year, and are operating at capacity. The manager of the Scarf Division, an internal business unit for Smith Corp. has asked if Sarah could fill an order for 5,700 spools of red yarn for them. Sarah has collected the following information to determine how to proceed: Sales to external customers (32,900 spools): $156,780, Variable Costs: $109,570, and Fixed Costs: $33,662. If Sarah wants to provide a quote to the Scarf Division, what is the minimum acceptable transfer price? (Do not round intermediate calculations.)

This question requires determining what amounts would factor into the minimum acceptable transfer price. Since Smith Corp. is currently operating at capacity and has no idle capacity, this means that internal buyers, including the Scarf Division, must pay the equivalent of the market price: variable cost per unit + contribution margin per unit on external sales. The latter part of this formula is also known as the opportunity cost, and that is how it is identified in this problem. To solve for the opportunity cost, subtract the variable costs from the sales and divide by the number of units sold externally: ($156,780 – $109,570)/32,900 = $47,210/32,900 = $1.43 contribution margin per unit. Variable cost per unit: $109,570/32,900 = $3.33. Therefore, the minimum acceptable transfer price = $3.33 + $1.43 = $4.77.

The Paper business unit of Home Supplies Inc. has had a busy year and has reported sales of 174,300 pounds of fully processed paper for $98,754. They also incurred $55,320 worth of variable expenses and are currently operating at capacity. The Plate division of Home Supplies Inc. would like to purchase 7,487 pounds of paper internally from the Paper business unit to continue making durable paper plates. The Paper division is considering taking on this order and has decided that a 12% markup would be needed to satisfy their own internal needs. The Plate division said that they won’t pay more than $4,800 total for this deal. What is the minimum acceptable transfer price? Will this be a deal that the Paper division can proceed with? (Round all calculations to two decimal places.)

Ans: NA, LO 4, Bloom: AP, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: Minimum Acceptable Transfer Price = $0.64 per pound; Yes, this is a deal that the Paper division would proceed with since the overall price they would charge of $4,791.68 is less than the $4,800.00 that the Plate division would pay.

This question requires determination of the minimum acceptable sales price under the circumstances presented, calculation of the marked-up price, and a decision about whether or not this deal can come to fruition based on the limit placed on the overall price by the buyer. When the seller is at capacity, the minimum acceptable transfer price will be the variable cost per unit plus the contribution margin per unit on external sales. Variable Cost per Unit: Total Variable Costs/Units Sold Externally = $55,320/174,300 pounds = $0.32 per pound. Contribution Margin per Unit on External Sales = (Sales – Variable Costs)/Units Sold Externally = ($98,754 – $55,320)/174,300 pounds = $43,434/174,300 pounds = $0.25 per pound. The minimum acceptable transfer price is ($0.32 + $0.25) × 1.12 = $0.57 × 1.12 = $0.64 per pound. The overall price of this sale would be $0.64 × 7,487 pounds = $4,791.68. At this price, the overall cost is less than the overall amount that the Plate Division stated they were willing to pay.

Stellar Notes is a factory that produces fun and colorful writing utensils marketed to students. Within the company, there are various business units including a Plastic Cap Division and a Pen Division. Tara, the production manager of the Pen division has been updating their production worksheets and realized that they will run out of caps before they have satisfied their current orders. They normally purchase their caps from a special supplier, but they are going to ask the internal Plastic Cap Division to see if they can assist with an order of 2,643 pen caps to meet the existing need. The Plastic Cap Division has a production capacity of 88,543 caps, and they have sold 87,433 caps to external customers resulting in external sales of $134,660. They had variable costs of $96,543. If the Plastic Cap Division provided a quote for the caps requested internally, what will the overall price quoted by Plastic Cap Division be for the 2,643 caps requested?

This problem requires familiarity with the formula for the minimum acceptable transfer price when a factory has both idle capacity and when it has no idle capacity. This will result in two different minimum acceptable transfer prices. To determine how many are subject to each price, you will subtract the current production from the highest threshold of their capacity. 88,543 – 87,433 = 1,110 caps can still be produced before hitting their capacity limit. The minimum acceptable transfer price of those 1,110 caps will be the Variable Cost per Unit: $96,543/87,433 caps = $1.10 per unit. The remaining units in this order will have a minimum acceptable transfer price of the variable cost per unit plus the contribution margin per unit. Contribution Margin = Sales – Variable Costs = $134,660 – $96,543 = $38,117. Now, divide this total by the number of units sold externally: $38,117/87,433 caps = $0.44 per unit. Therefore, the minimum acceptable transfer price will be $1.10 + $0.44 = $1.54 per unit. The number of units that will be charged at this price will be the total requested minus the units produced below their capacity threshold: 2,643 – 1,110 = 1,533 caps. Thus, the total price quoted is: (1,110 × $1.10) + (1,533 × $1.54) = $1,221.00 + $2,360.82 = $3,581.82.

The Assembly department of a factory has been asked to put together a sales quote for the Sales department, which is an internal division at the same company. The Assembly department has reported the following external sales information:

Sales (14,300 units) $38,930

Direct Labor 8,650

Direct Materials 6,304

Variable Overhead 9,998

Fixed Overhead 11,270

The Assembly department has an operating capacity of 14,300 units. The Sales department would like to purchase 5,000 units from the Assembly department. What is the minimum acceptable transfer price, and the absorption cost per unit? (Do not round intermediate calculations.)

This question requires familiarity with calculating various costs for the same order from the perspective of the internal seller. Since the Assembly department is currently operating at capacity, the minimum acceptable transfer price would be equal to the market price: $38,930/14,300 units = $2.72. To determine the absorption cost per unit, first calculate the overall variable costs: $8,650 + $6,304 + $9,998 = $24,952. Now, divide by the units sold externally to arrive at the variable cost per unit: $24,952/14,300 units = $1.74 per unit. Next, determine the fixed cost per unit as = $11,270/14,300 units = $0.79 per unit. Now, add fixed cost per unit to the variable cost per unit to get the absorption cost per unit: $1.74 + $0.79 = $2.53.

Janice is in charge of the Staining department of a local woodworking business. She is ramping up for what is likely to be her busiest year so far. She anticipates that the department will need 18,000 oak planks to meet their order fulfillment. The internal Materials department would be able to fulfill half of this order before it meets its capacity and has reported the following information about their external sales:

Sales (21,000 planks) $114,206

Variable Costs 42,840

Fixed Costs 57,600

The Materials department has agreed to a negotiated sales price of the minimum acceptable transfer price. An external vendor has also said it could fulfill the other half for $2.15 per plank, or they would agree to $2.10 if Janice bought all 18,000 planks from them. What is the difference in overall price if Janice purchases half internally and half externally versus purchasing all planks externally? Do not round intermediate calculations.

Ans: NA, LO 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: Overall difference in price is $90 higher for the external-only order.

This question requires familiarity with calculating the minimum acceptable transfer price and overall price in multiple situations. In this case, the Materials department has idle capacity so the minimum acceptable transfer price would be equal to the variable cost per unit. $42,840/21,000 planks = $2.04 per plank. The overall price for the half-internal and half-external order would be: (9,000 × $2.04) + (9,000 × $2.15) = $18,360 + $19,350 = $37,710. The overall total for the purchase with all 18,000 units coming from the external vendor would be: 18,000 × $2.10 = $37,800. The difference in price would be $37,800 – $37,710 = $90 higher for external only.

After much consideration, Trina has decided sever ties with her current plastic bottle supplier due to consistent shipping delays and yearly price increases. She has put inquiries in with a different external vendor who has agreed to a pricing structure as follows: first 12,000 bottles at $0.82 per bottle, next 10,000 bottles at $0.80 per bottle, next 12,000 bottles at $0.77 per bottle, and any remaining bottles at $0.72 per bottle. They will also ask for a 10% surcharge to cover shipping and handling. The internal Materials department has also provided a quote to Trina for the bottles needed. The Materials department has reported the following external sales data for this year: Sales (of 203,450 bottles) at $181,070.50, Variable Costs of $140,380.50, and Fixed Costs of $22,640.50. The Materials department has an operating capacity of 250,000 bottles and has agreed to supply the bottles at the minimum acceptable transfer price. Trina’s department needs 78,903 bottles in order to fulfill all of their upcoming orders. What is the average cost per unit under both the price quote from the external vendor and from the internal department? (Do not round intermediate calculations.)

Ans: NA, LO 4, Bloom: AP, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution: Average Cost per Unit for the External Supplier is $0.83, and for the Internal Department is $0.77.

This question requires familiarity with the formula for the minimum acceptable transfer price in addition to calculating an average per unit costs under different circumstances.

External Supplier: This overall cost must be calculated in layers: (12,000 × $0.82) + (10,000 × $0.80) + (12,000 × $0.77) + ((78,903 – 34,000) × $0.72) = $9,840 + $8,000 + $9,240 + $32,330.16 = $59,410.16 total cost. Now, add the surcharge: $59,410.16 × 1.10 = $65,351.18. Lastly, divide this number by the number of bottles needed to arrive at the average cost per unit: $65,351.18/78,903 bottles = $0.83 per bottle.

Internal Department- This overall cost must be calculated in layers. Some units are produced with idle capacity, and some are not. The idle capacity units will have a minimum acceptable transfer cost of the variable cost per unit and the over idle capacity units will have a minimum acceptable transfer cost of the variable cost per unit plus the contribution margin per unit. Variable cost per unit = $140,380.50/203,450 bottles = $0.69 per bottle. Contribution margin per unit = ($181,070.50 – $140,380.50)/203,450 bottles = $0.20. Cost of idle capacity units = 250,000 – 203,450 = 46,550 × $0.69 = $32,119.50. Over idle capacity units = 78,903 – 46,550 = 32,353 × ($0.69 + $0.20) = $28,794.17. Now, calculate total cost: $32,119.50 + $28,794.17 = $60,913.67. Lastly, divide this number by the number of bottles needed to arrive at the average cost per unit: $60,913.67/78,903 bottles = $0.77 per bottle.

Exercises

Dot Co. is a paint company, and it just completed its second quarter and is performing some analysis so that it can evaluate its top two paint divisions: Latex and Oil-Based. In their third quarter, the company has decided that it can give one or both divisions $15,000 of cash for investments if the analysis support it. Dot has requested that their head accountant gather some financial statement data and analyze it before they move forward with any potential investments. The accountant has compiled the following condensed income statements and selected balance sheet information for the second quarter:

	Latex	Oil-Based
Sales	$776,450	$548,010
COGS	402,300	306,708
Gross Margin	$374,150	$241,302
Operating Expenses	301,900	198,650
Operating Income	$72,250	$42,652

In the second quarter, each division purchased a new piece of mixing equipment that cost $286,000. The company’s effective tax rate is 23%, it has a Required Rate of Return of 8.5%, and its Weighted Average Cost of Capital (WACC) is 7.6%. Use this information to answer the following questions.

What are the Return on Investment (ROI), Residual Income (RI), and the Economic Value Added (EVA) for the Latex Division?
What are the Return on Investment (ROI), Residual Income (RI), and the Economic Value Added (EVA) for the Oil-Based Division?
Based on this initial analysis, will either department be granted money to pursue the additional investment?

Ans: NA, LO 1, 3, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

ROI = 25.26%, RI = $47,940.00, and EVA = $33,896.50

This question requires familiarity with three different formulas: ROI, which is operating income divided by Investment; RI, which is Operating Income – (Required Rate of Return × Investment); and EVA, which is After-Tax Operating Income – (WACC × Investment). ROI = $72,250/$286,000 = 0.2526 or 25.26%. RI = $72,250 – (0.085 × $286,000) = $72,250 – $24,310 = $47,940. EVA = ($72,250 × (1 – 0.23)) – (0.076 × $286,000) = $55,632.50 – $21,736 = $33,896.50.

ROI = 14.91%, RI = $18,342.00, EVA = $11,106.04

This question requires familiarity with three different formulas: ROI, which is operating income divided by investment; RI, which is Operating Income – (Required Rate of Return × Investment); and EVA, which is After-Tax Operating Income – (WACC × Investment). ROI = $42,652/$286,000 = 0.1491 or 14.91%. RI = $42,652 – (0.085 × $286,000) = $42,652 – $24,310 = $18,342. EVA = ($42,652 × (1 – 0.23)) – (0.076 × $286,000) = $32,842.04 – $21,736.00 = $11,106.04.

Based on this initial analysis, it would appear that both the Latex division and the Oil-Based division would be eligible to obtain the investment. This is because the Returns on Investment are 25.26% and 14.91%, respectively, both of which are higher than the required rate of return of 8.5%. Both divisions also have positive Residual Income and Economic Value Added, and that means that their metrics are strong enough to be allowed to have the additional funding offered by the company.
Jonathan is the manager of the equipment rental section of a large hardware store. Many customers have been requesting industrial wood floor sanders. Jonathan would be able to purchase one for the company for $3,675, but he knows that there are other costs and factors to consider. He believes that the sander would generate $1,342 of rental income in its first year and would incur $433 of expenses (not including depreciation). The sander has a 10-year useful life, and Jonathan suggests the use of straight-line depreciation. Jonathan is going to run some analysis prior to making a final suggestion to the store.

(Do not round intermediate calculations.)

1. What is the Return on Investment (ROI) for the industrial wood floor sander using the DuPont method?
2. How much Residual Income (RI) will the sander generate if the Required Rate of Return is 8%?
3. Jonathan’s section earned 15% ROI last year. If his evaluation is based upon ROI, then would he be likely to pursue the purchase of this Industrial Wood Floor Sander? Please explain your rationale.

Ans: NA, LO 1, 3, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

1. ROI = 14.73%

This question requires familiarity with the formula for calculating ROI using the DuPont method: Profit Margin × Investment Turnover. Profit margin = Operating Income/Sales. First, calculate the yearly depreciation to update expenses, and determine an accurate Operating Income. The company is using straight-line depreciation calculations. Annual depreciation is $3,675/10 years = $367.50. Operating Income = $1,342.00 – ($433.00 + $367.50) = $541.50. Now, calculate the profit margin. $541.50/$1,342.00 = 0.4035. Next, calculate Investment Turnover: Sales/Investment, or $1,342/$3,675 = 0.3652. Lastly, calculate the ROI: 0.4035 × 0.3652 = 0.1473 or 14.73%.

1. Residual Income = $247.50

This question requires familiarity with the formula for Residual Income: Operating Income – (Required Rate of Return × Investment). Operating Income was calculated for part a, so it can be used here as well. Residual Income = $541.50 – (0.08 × $3,675.00) = $541.50 – $294.00 = $247.50.

1. No, Jonathan would likely not pursue the purchase of the Industrial Wood Floor Sander. Since the ROI was calculated at 14.73%, this is lower than what they were able to achieve last year. This decreased percentage would drag down the overall ROI and therefore lead to a less appealing evaluation of his section. Had the sander’s ROI been at least 15% that would have been something, Jonathan would have seriously considered in an effort to continually increase the ROI for his section.

The lawn and garden center of a local hardware store would like to find additional ways to attract customers. One idea the manager of this section had was to purchase a machine that would allow customers to fill a reusable container of their choosing with grass seed. The customers would then pay by the ounce and could return to the store as often as needed to obtain more grass seed. The company also views this as an opportunity to promote a more earth-friendly approach to lawn center by reducing plastic waste from disposable bags of grass seed. A new dispenser machine could be purchased and installed at the store for $4,702. There would be yearly maintenance fee of $186 and other annual expenses (excluding depreciation) of $563. The machine would have a useful life of 15 years, and the company would like to use a straight-line depreciation calculation. The manager believes yearly sales would be $1,942. Prior to moving forward with this purchase, the manager would like to analyze some data. (Do not round your calculations.)
1. What is the Return on Sales or Profit Margin for the Dispenser? Discuss what this number means for the company.
2. What is the Investment Turnover for the Dispenser? Discuss what this number means for the company.
3. Should the manager seriously consider moving forward with this purchase if the ROI is 16% on average for the company? Would your answer change if the manager’s evaluation was based upon ROI?

Ans: NA, LO 1, 3, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

Profit Margin = 0.4529. Profit margin of 0.4529 means that for every sales dollar, $0.45 is left over as Operating Income.

This question requires familiarity with the formula for Return on Sales or Profit Margin: Operating Income/Sales. First, calculate Operating Income: Sales – Operating Expenses. The total for Operating Expenses is not provided, so it must be calculated and that will also include a calculation for depreciation. The company is using the straight-line method for depreciation calculation, so that calculation for annual depreciation is: $4,702/15 years = $313.47. Operating Expenses = $186 + $563 + $313.47 = $1,062.47. Now, calculate Operating Income: $1,942 – $1,062.47 = $879.53. Lastly, calculate Profit Margin: $879.53/$1,942 = 0.4529.

Investment Turnover = 0.4130. An investment turnover of 0.4130 means that the investment generates around 41% of its value in sales per year.

This question requires familiarity with the formula for Investment Turnover: Sales/Investment. So, Investment Turnover = $1,942/$4,702 = 0.4130.

In order to compare the ROI figures, calculate the ROI for this potential investment. This can be done by multiplying profit margin by investment turnover. 0.4529 × 0.4130 = 0.1871 or 18.71%. The manager should seriously consider the purchase of this dispenser since the ROI it achieves of 18.71% is higher than the company’s normal ROI of 16%. A purchase like this one would serve to increase the overall return that the company sees by increasing the overall average return. In this instance, the answer would not change if the manager’s evaluation was based on ROI, but the decision would be reinforced. If the ROI of the dispenser had been below 16%, then this would likely lead the manager to not pursue the purchase since the ROI would be lower than the company’s past average.
Sharon is the lead salesperson for U-Link, a telecommunications company. The company has been looking into ways that it can become more secure. One of the big decisions being considered by management is addressing the current security system they have in place at their corporate headquarters. In doing so, U-Link can expand its offerings to include on-site data storage. Sharon has narrowed the choices down to either fixing the existing system (Repair) or purchasing a replacement system (Replace). She has gathered pertinent information to perform some analysis:

	Repair	Replace
Cost	$12,945	$15,774
Useful Life	8 years	10 years
Sales	$ 5,334	$ 6,782
Operating Expenses (does not include depreciation)	$ 3,002	$ 3,898

U-Link has been in business for a number of years and knows that something must change in order for their business to continue to grow. U-link has a Required Rate of Return of 8.2%, has a Weighted Average Cost of Capital (WACC) of 6.4%, a tax rate of 21%, and will use the straight-line depreciation method.

(Do not round your calculations.)

What is the Return on Investment (ROI) for each option? Which would be the better choice if the decision was based upon ROI only?
What is the Residual Income of each option? What is the Economic Value Added (EVA) of each option?
Based upon all the percentages generated, how can all of this data be interpreted? Which choice is the better option for U-Link?

Ans: NA, LO 1, 3, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

For Repair, the ROI is 5.51%, and for Replace the ROI is 8.28%.

If ROI were the only determining factor, then Replace would be the better choice. Not only does it result in a higher return than the repair, but it is also the only option that surpasses the company Required Rate of Return of 8.2%.

These questions require familiarity with the formula for ROI: Operating Income/Investment. Both choices need to update their operating expenses to include depreciation expense prior to calculating Operating Income and ROI.

Repair: Depreciation expense = $12,945/8 years = $1,618.13 per year. Operating Expenses = $3,002 + $1,618.13 = $4,620.13. Operating Income = $5,334 – $4,620.13 = $713.88. Thus, ROI = $713.88/$12,945 = 0.0551 or 5.51%.

Replace: Depreciation expense = $15,774/10 years = $1,577.40 per year. Operating expenses = $3,898 + $1,577.40 = $5,475.40. Operating Income = $6,782 – $5,475.40 = $1,306.60. ROI = $1,306.60/$15,774 = 0.0828 or 8.28%.

For Repair, the RI is ($347.62), and for Replace, the RI is $13.13;

For Repair, the EVA is ($264.52), and for Replace, the EVA is $22.68.

These questions require familiarity with the formulas for Residual Income (RI): Operating Income – (Required Rate of Return × Investment), and EVA: After-Tax Operating Income – (WACC × Investment). Use figures calculated in parts a and b to assist with parts b and c of this exercise.

Repair: Residual Income = $713.88 – (0.082 × $12,945) = $713.88 – $1,061.49 = –$347.62. EVA = ($713.88 × (1 – 0.21)) – (0.064 × $12,945) = $563.96 – $828.48 = –$264.52.

Replace: Residual Income = $1,306.60 – (0.082 × $15,774) = $1,306.60 – $1,293.47 = $13.13. EVA = ($1,306.60 × (1 – 0.21)) – (0.064 × $15,774) = $1,032.21 – $1,009.54 = $22.68.

Each of the percentages and numbers calculated informs a different component of the overall picture for each investment. If they chose to repair, then they would not meet their minimum required rate of return, and that means that U-Link should not make the investment. Further, for Repair, both the RI and the EVA are negative, and that means that Repair will cost the company more than it will recoup or earn. Replace, on the other hand, has an ROI that exceeds the company required rate of return, so U-Link should make the investment. Both RI and EVA are positive, and that means the investment is outperforming the base targets set.

Replace would be the better choice for U-Link.

Tom and Jerry are both managers of sales teams at Journey Corp., a furniture company whose most popular item is a tweed couch. Tom and Jerry are very competitive and each attempt to outperform one another every year. Currently, Tom’s department has better metrics, which has resulted in larger bonuses for Tom and his team. Journey Corp. evaluates both departments based upon their Return on Investment and Economic Value Added. The departments reported the following financial data during the most recent year:

	Jerry	Tom
Operating Income	$126,700	$184,320
Sales	$2,789,400	$3,678,005
Average Operating Assets	$953,762	$1,320,991
Total Assets	$1,103,782	$1,521,001
Current Liabilities	$208,630	$296,755

It should be noted that Journey uses average operating assets as its definition of investment, and it has a minimum required rate of return of 8.72% and a tax rate of 22%. Journey has used a variety of ways to acquire capital and has the current makeup: Proportion of Equity is 38%, the Equity Rate is 6.5%, the Proportion of Debt is 62%, and the Debt rate is 9.3%. Use this information to answer the following questions.

(Do not round intermediate calculations.)

Based upon all of the information provided about Journey Corp, Tom, and Jerry, what type of responsibility center is run by each manager? Why do you believe this to be true, and what evidence exists to support your conclusion?
What are the Return on Sales, Investment Turnover, and Return on Investment for each department? Note which department has performed better for each calculation.
Determine the Weighted Average Cost of Capital, Residual Income, and Economic Value Added (EVA) for each department? Overall, which department had the best performance?

Ans: NA, LO 1, 2, 3, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

Tom and Jerry are each running an investment center. Since it is noted that each is evaluated on ROI and EVA, this is a hallmark evaluation of an investment center. If a manager has authority, responsibility, and accountability for their department or division’s asset, then ROI would be an appropriate way to evaluate them. Other types of responsibility centers rely on metrics like sales targets or target profit but are not focused on investments. In this question, Tom and Jerry are charged with investment decisions and are judged on these metrics, so this would be the more appropriate way in which to classify them.
Return on Sales for Jerry is 4.54%, and for Tom is 5.01%, so Tom has the better Return on Sales.

Investment Turnover for Jerry is 2.92 times, and for Tom is 2.78 times, so Jerry has the better Investment Turnover.

ROI for Jerry is 13.28%, and for Tom is 13.95%, so Tom has the better Return on Investment.

Return on Sales = Operating Income/Sales

For Jerry: $126,700/$2,789,400 = 0.0454 or 4.54%

For Tom: $184,320/$3,678,005 = 0.0501 or 5.01%

Investment Turnover = Sales/Investment*

*Investment for this company will be Average operating assets.

For Jerry: $2,789,400/$953,762 = 2.92 times

For Tom: $3,678,005/$1,320,991 = 2.78 times

Return on Investment = The formula for ROI is Profit Margin × Investment Turnover. Profit Margin = Operating Income/Sales. Investment Turnover = Sales/Investment

For Jerry: First, calculate Profit Margin. $126,700/$2,789,400 = 0.0454. Next, calculate Investment Turnover. $2,789,400/$953,762 = 2.925. Lastly, calculate ROI. ROI = 0.0454 × 2.925 = .1328 or 13.28%.

For Tom: First, calculate Profit Margin as $184,320/$3,678,005 = 0.0501. Next, calculate Investment Turnover as $3,678,005/$1,320,991= 2.784. Lastly, calculate ROI as 0.0501 × 2.784 = 0.1395 or 13.95%.

WACC = 8.24%

Residual Income for Jerry is $43,531.95, and for Tom is $69,129.58, so Tom’s department has a higher Residual Income.

EVA for Jerry is $20,274.16, and for Tom is $34,972.78, so Tom’s department has a higher EVA.

Overall, Tom’s department had the best overall performance during the year based on these metrics.

Weighted Average Cost of Capital (WACC): The WACC is calculated with the following formula: (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity) = (0.093 × 0.62) + (0.065 × 0.38) = 0.0577 + 0.0247 = 0.0824 or 8.24%.

Residual Income is Operating Income – (Minimum Required Rate of Return × Investment)

For Jerry: $126,700 – (0.0872 × $953,762) = $126,700 – $83,168.05 = $43,531.95

For Tom: $184,320 - (0.0872 × $1,320,991) = $184,320 – $115,190.42 = $69,129.58

EVA is After-Tax Operating Income – (WACC × Invested Capital)

For Jerry: ($126,700 × (1 – 0.22)) – (0.0824 × $953,762) = $98,826 – $78,551.84 = $20,274.16

For Tom: ($184,320 × (1 – 0.22)) – (0.0824 × $1,320,991) = $143,769.60 – $108,796.82 = $34,972.78

Overall, Tom’s department had the best overall performance during the year based upon these metrics.

Montana oversees the Coffee Bean Division at the Java Corp., and she is evaluating different options for the sale of their beans. In the past, the Coffee Bean Division has been selling to external customers only, and has been operating at full capacity. As the business grew and expanded, so did their production capacity. They are now operating with some idle capacity, and they have been debating whether to sell internally to another Business Unit. The Coffee Maker Division has recently decided that they will be giving away a free pound of coffee with each brewer machine purchase. They anticipate needing 12,500 pounds of coffee in the coming year and are obtaining quotes both internally and externally. The Coffee Bean Division has a capacity of 175,000 pounds of coffee and reported the following for their external sales: 160,000 pounds resulting in sales of $200,000, Variable Costs of $126,400, and Fixed Costs of $51,980. An external vendor has offered the Coffee Maker Division the following prices: $1.40 for the first 5,000 pounds, $1.20 for the next 5,000 pounds, $1.00 for any number of pounds above this, with an additional markup of 5% of the total. The Coffee Maker Division is evaluating their choices, and Montana is hopeful they will have the most appealing offer.
What is the minimum acceptable transfer price for their internal purchase from the Coffee Bean Division? What is the overall price that would be quoted?
What is the overall price offered by the external supplier to the Coffee Maker Division?
Which offer should the Coffee Maker Division pursue? Are there any additional avenues they could pursue if they would prefer to go with the alternate vendor?

Ans: NA, LO 4, Bloom: AN, Difficulty: Medium, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

The minimum acceptable transfer price is $0.79 per pound, and the overall price quoted is $9,875.

This question requires determination of what amounts would factor into the minimum acceptable transfer price. Since the Coffee Bean Division is not currently operating at capacity, this would mean that internal buyers, such as the Coffee Maker Division, must pay the variable cost per unit on external sales. Variable cost per unit = $126,400/160,000 pounds = $0.79 per pound, and that is the minimum acceptable transfer price.

The overall price quoted by the Coffee Bean Division would be $0.79 × 12,500 pounds = $9,875.

The overall price quoted from the external supplier is $16,275

The overall price offer to the Coffee Maker Division by the external supplier has to be calculated in layers. The first 5,000 pounds sold will be $1.40 per pound, the next 5,000 pounds will be $1.20 per pound, and the remaining 2,500 pounds will sold at be $1.00 per pound. (5,000 × $1.40) + (5,000 × $1.20) + (2,500 × $1.00) = $7,000 + $6,000 + $2,500 = $15,500. The final step is to add the 5% markup to that total: $15,500 × 1.05 = $16,275.

If the Coffee Maker is basing their decision solely on price, then they would select the internal division’s offer from the Coffee Bean Division. They may also want to consider the benefits of working within the same organization rather than purchasing from an external vendor. If they would prefer to use the external vendor, then they may want to consider asking them to negotiate their first offer. This could involve a change in the prices being asked, the removal of the markup, or some combination of these things. Additionally, the Coffee Maker Division could continue to seek other offers and options from more external vendors for further analysis and comparison.
Karen owns a small company that has several business units. The main product of this company is jackets sewn with a special insulated lining that can withstand extremely cold temperatures. One of her business units at the company is responsible for the production of the fancy decorative buttons sewn onto the front of this jacket. The button division has the capacity to meet both internal and external demand with an overall production capacity of 15,000 buttons annually. The company manufactured and sold 12,479 of its available units to the external companies. The Jacket Division just lost its main external button supplier and is in need of 8,788 buttons as soon as possible. The Jacket Division has been collecting external bids but has also requested that the Button Division provide a quote prior to making a final decision. The Button Division has produced the following numbers so far (all based upon sales to external customers):

Sales	$10,798
Variable Costs	$ 4,675
Fixed Costs	$ 4,227

The jacket division has been given the following offers from external suppliers

Supplier A: $1.09 per button plus a 2% markup to cover shipping

Supplier B: $1.14 per button plus a $250 total shipping rate

What is the minimum acceptable transfer price for their internal purchase from the Button Division? What is the overall price they would need to pay for these buttons?
What is the overall price for Supplier A? What is the overall price for Supplier B? Which supplier has created the more appealing offer?
Since the jacket division needs these buttons quickly, what option should they select? Would your answer change if Supplier A and Supplier B both waived their shipping charges?

Ans: NA, LO 4, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

1. The minimum acceptable transfer price: idle capacity = $0.37 per button and no idle capacity = $0.86; therefore, the overall price is $6,322.39.

This problem requires familiarity with the formula for the minimum acceptable transfer price when a factory has both idle capacity and when it has no idle capacity. This will result in two different minimum acceptable transfer prices. To determine how many are subject to each price, subtract the current production from the high threshold of the capacity. 15,000 – 12,479 = 2,521 buttons can still be produced using existing idle capacity. The minimum acceptable transfer price of these 2,521 buttons is the variable cost per unit, and that is equal to $4,675/12,479 buttons = $0.37 per button. The number of units charged at a different price other than the variable cost will be the total requested units minus the units able to be made before hitting capacity = 8,788 – 2,521 = 6,267 buttons. The minimum acceptable transfer price of these remaining 6,267 buttons will be the variable manufacturing cost per unit plus contribution margin per unit on external sales. Contribution margin = Sales – Variable Costs = $10,798 – $4,675 = $6,123. Now, divide this by the units sold externally: $6,123/12,479 buttons = $0.49 per button. The minimum acceptable transfer price = $0.37 + $0.49 = $0.86 per button. The total price that will be quoted is: (2,521 × $0.37) + (6,267 × $0.86) = $932.77 + $5,389.62 = $6,322.39.

Supplier A = $9,770.50, Supplier B = $10,268.32. Supplier A has created a more appealing offer between these two external vendors since their overall price is much lower even after the 2% markup

Supplier A = 8,788 buttons times $1.09 per button plus a 2% markup. (8,788 × $1.09) × 1.02 = $9,578.92 × 1.02 = $9,770.50.

Supplier B = 8,788 buttons times $1.14 per button plus a $250 shipping fee. (8,788 × $1.14) + $250 = $10,018.32 + $250 = $10,268.32.

Since the Jacket Division is in a hurry and must decide quickly, they are likely to select the offer from the Internal Button Division, assuming they can receive their order as soon as possible. If the Button Division is not able to deliver the buttons in an acceptable time frame, then the Jacket Division would then look more seriously at the offer from Supplier A. Even if Supplier A and Supplier B dropped their shipping surcharges, the internal Button Division would still offer a better price than either Supplier A or Supplier B. However, should the Button Division fall through, then the lack of shipping charges would make the offer from Supplier A more appealing than that quoted by Supplier B as the overall price would then be lower.
The Fizzy Drink Company is a large factory that produces soft drinks in a variety of flavors. Recently the Diet Drink division has been increasing production and is looking to obtain pricing on materials from a variety of vendors, both internally and externally for their bottling needs. Supplier A offered to sell them bottles for $0.80 per bottle for the first 10,000, $0.78 for the next 10,000 bottles, $0.76 for the next 15,000, and $0.73 for any remaining bottles. Supplier B offered to sell them bottles for $0.75 for the first 50,000 bottles and $0.74 for any remaining bottles. Supplier A is going to add 2% surcharge for shipping and handling costs, and Supplier B is going to add a 1.5% surcharge for shipping and handling costs. The Diet Drink division has also put in an inquiry with their internal Bottle division who currently has a capacity of 233,600 bottles, leaving some capacity idle. They have reported the following numbers for the year:

Sales (200,000 bottles) $223,780

Direct Labor $52,000

Direct Material $30,000

Variable Overhead $24,000

Fixed Overhead $38,000

The Diet Drink division is looking to order 76,430 bottles and will need to perform an analysis before making a final decision.

(Do not round intermediate calculations.)

What is the variable cost, contribution margin, and absorption cost of each unit sold by the Bottle Division? What is the minimum acceptable transfer price if the internal Bottle division agrees to supply required bottles to the Diet Drink division?
What are the overall prices quoted by Supplier A and Supplier B for 76,430 bottles?
What is the overall price quoted by the Internal Bottle Division? Which offer is the Diet Division most likely to pursue, and why? Support your conclusion.

Ans: NA, LO 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

Variable Cost per unit is $0.53, Contribution Margin per unit is $0.59, Absorption Cost per unit is $0.72,

Minimum acceptable transfer price for Idle capacity units is $0.53 per bottle, and no idle capacity units is $1.12 per bottle.

The variable cost per unit will be equal to the variable costs for units sold externally divided by the units sold externally. (Direct Labor + Direct Materials + Variable Overhead)/Units Sold Externally. ($52,000 + $30,000 + $24,000)/200,000 bottles = $0.53 per bottle. Contribution Margin per Unit will equal: (Sales made externally – Variable Costs)/Units sold externally. ($223,780 – ($52,000 + $30,000 + $24,000))/200,000 bottles = ($223,780 – $106,000)/200,000 bottles = $117,780/200,000 bottles = $0.59 per bottle. Absorption cost per unit will equal: (Variable Costs + Fixed Costs)/Units sold externally. [($52,000 + $30,000 + $24,000) + $38,000]/200,000 bottles = ($106,000 + $38,000)/200,000 bottles = $144,000/200,000 bottles = $0.72 per bottle. The minimum acceptable transfer price will have two different prices assigned: one for units produced with idle capacity and one for units produced with no idle capacity. Minimum transfer price in idle capacity will equal to variable cost per unit calculated above at $0.53 per bottle. Minimum transfer price when there is no idle capacity will be equal to the variable cost per unit plus the contribution margin per unit = $0.53 per bottle + $0.59 per bottle = $1.12 per bottle.

Overall Price for Supplier A is $58,592.78 and for Supplier B is $57,914.07.

Supplier A: The overall price offer to the Diet Drink division by Supplier A has to be calculated in layers. The first 10,000 bottles sold will be $0.80 per bottle, the next 10,000 bottles will be $0.78 per bottle, the next 15,000 bottles will be $0.76 per bottle, and the remaining bottles will be $0.73 per bottle. (10,000 × $0.8) + (10,000 × $0.78) + (15,000 × $0.76) + ((76,430 – 35,000) × $0.73) = $8,000 + $7,800 + $11,400 + $30,243.90 = $57,443.90. The last step will be to add the 2% surcharge: $57,443.90 × 1.02 = $58,592.78.

Supplier B: The overall price offer to the Diet Drink division by Supplier B has to be calculated in layers. The first 50,000 bottles sold at $0.75 per bottle and the remaining bottles at $0.74 per bottle. (50,000 × $0.75) + ((76,430 – 50,000) × $0.74) = $37,500 + $19,558.2 = $57,058.2. The last step will be to add the 1.5% surcharge: $57,058.2 × 1.015 = $57,914.07.

With an overall price of $65,777.60, they are more likely to pursue the offer from Supplier A.

The overall price quoted by the internal division has to be calculated in layers- No idle capacity and idle capacity. Idle capacity units = 233,600 – 200,000 = 33,600 units. These units will have the minimum acceptable transfer price calculated in part a) of $0.53 per bottle, which is the variable cost per unit. The remaining units will be calculated as no idle capacity units = 76,430 – 33,600 = 42,830 units. These units will have the minimum acceptable transfer price calculated in part a) of $1.12 per bottle. Overall price = (33,600 × $0.53) + (42,830 × $1.12) = $17,808.00 + $47,922.49 = $65,730.49.

The Diet Drink division is likely to pursue the offer from Supplier B as it has the lowest overall cost as supported by the calculations above and what is shown in part b). They could also ask Supplier B to drop their 1.5% surcharge to make that offer more competitive. Lastly, they could try to negotiate further with the internal division, using the external supplier quotes as leverage to attempt a lower quote.

Ingen Production manufactures a top-of-the-line record player, and the Needle division manufactures one of many of the components needed to create the final product. The Needle division has an overall capacity of 150,000 units, which covers all internal needs and leaves enough capacity to sell directly to the external market. Thanks to proper planning, the Needle division has been able to successfully meet all of its production orders, both internally and externally. Ingen evaluates its management on the profitability of their respective divisions, so the managers are very interested in performing analysis on a regular basis. The manager of the Needle division has determined the following costs to be associated with the production of one needle (unit):

Direct Material $0.50

Direct Labor $0.89

Variable-MOH $0.46

Fixed-MOH $1.15

The manager of the Record Player division mentioned that they can purchase needles externally for $3.70. Use this information to answer the following questions.

If the Needle Division sets the transfer price at $3.30, then would this be a good deal for both the Needle division and the Record Player division? Does this transfer price reflect variable cost, absorption cost, cost plus, market, or a cost of a different kind?
If the market price were to drop to $2.90, then would this still be a deal that the Needle division would find beneficial? Would they keep the same transfer price established in part a) or would they calculate a new one? Support your response with the appropriate calculations.
Assume the market continues to decrease in price. What is the lowest acceptable transfer price that the Needle division could accept? If this came to fruition, then what other measures could the Needle division take in order to try and increase their revenue or reduce their other costs?

Ans: NA, LO 1, 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

Prior to determining whether or not this is a good deal, it would be beneficial to calculate how much of the costs that $3.30 would cover. The overall costs incurred by the Needle division to produce one unit are: $0.50 + $0.89 + $0.46 + $1.15 = $3.00. At the transfer price of $3.30, this would be a good deal for the Needle division since they are not only covering the full absorption cost but also earning an extra $0.30 per unit sold internally. This is also a good deal for the Record Player division since they are paying $0.40 less per needle than they would be by purchasing the needles externally.
If the market price dropped to $2.90, then this would still cover most of the costs incurred by the Needle division. With the new market price being lower than the transfer price established in part (a), they would not keep the transfer price of $3.30 and would have to establish a new one. Their variable costs are: $0.50 + $0.89 + $0.46 = $1.85. The new market price would cover all of the variable costs while also adding an extra $1.05 in revenue per needle that would almost cover the full absorption cost. The new transfer price could now be in a range from $1.85 at the low end up to $2.90 at the high end per unit. Anything less than $2.90 is likely to be enticing for the Record Player division as it is still less than they would have to pay if they were purchasing externally.
If the market continues to decrease in price, then they would have to adjust their minimum acceptable transfer price as well. The lowest they would be able to accept would be their variable cost: $0.50 + $0.89 + $0.46 = $1.85. If the market price eventually dropped below $1.85, then this would present a difficult challenge for the Needle division. In order to increase revenues, they would have to seek out additional vendors that would want or need their product. To reduce their variable costs, they could also seek out a reduction in their direct materials cost if they were able to negotiate this with the supplier they buy from.
Spiral Company is a pasta company that specializes in fun-shaped pasta specifically marketed towards kids. Currently, they manufacture all of their pasta internally and purchase boxes from an external vendor for $0.58 per box. Carol, the manager of the Pasta department has big decisions to make for her department for the New Year as she creates a budget. One of their largest pasta-cutting machines will need to be replaced, and she finally found a great vendor who has offered to sell them a new model for $14,600. Carol has calculated the following estimates for the new machine:

Expected Sales (2,578 units) $3,428

Expected Operating Expenses (including depreciation) 2,040

Each unit contains 16 ounces of pasta and requires one cardboard box in which it will be packaged and shipped. Carol has also been speaking with their internal packaging department about purchasing boxes from them. The manager of that department is going to put together a sales quote and has gathered the following information about their sales for the year:

Sales (7,000 units) $3,920

Variable Expenses $1,540

Fixed Costs $1,904

Operating Capacity 7,000 units

The negotiated price will be the minimum acceptable transfer cost. Spiral Company has a tax rate of 25%, a weighted average cost of capital of 6.6%, and a minimum required rate of return of 8.1%. Use the above information to answer the following questions.

What is the Return on Investment and Economic Value Added from the new machine? If repairing the existing machine would also cost $14,600 but it had no Economic Value Added, then which deal should Carol select?
What is the per-unit minimum acceptable transfer price and overall price quoted by the internal packaging department? Calculate the percentage difference between the quotes from the internal packaging department and the external vendor?
Which offer will Carol select for her department? What is the highest amount Carol should be willing to pay internally per unit before she should consider it to be a bad decision?

Ans: NA, LO 1, 2, 3, 4, Bloom: AN, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

Return on investment is 9.51%, and economic value added is $77.40, so Carol should select the new machine.

ROI-This question requires familiarity with the formula for ROI which is Operating Income/Investment: $1,388/$14,600 = 0.0951 or 9.51%.

EVA-This question requires familiarity with the formula for EVA which is After-Tax Operating Income – (WACC × Invested capital): ($1,388 × (1 – 0.25)) – (0.066 × $14,600) = $1,041.00 – $963.60 = $77.40.

Carol would likely select the new machine as it does have a positive economic value added. The repair of the new machine is the same cost but adds nothing else, so it is a less appealing deal.

The minimum acceptable transfer price is $0.56 per box, and the internal price quote = $1,443.68. The external vendor’s quote is 3.6% higher than that of the internal department.

This question requires determination of the amounts would factor into the minimum acceptable transfer price. Since Spiral Company is currently operating at capacity and has no idle capacity, this would mean that any internal buyers, including the Pasta department, must pay the equivalent of the market price, and that is variable cost per unit plus the contribution margin per unit on external sales. To solve for the contribution margin, subtract the variable costs from the sales and divide by the number of units sold externally. ($3,920 – $1,540)/7,000 boxes = $2,380/7,000 boxes = $0.34 contribution margin per box. Variable cost per unit = $1,540/7,000 boxes = $0.22 per box. Minimum acceptable transfer price = $0.34 + $0.22 = $0.56 per box.

The overall price quote from the internal vendor will equal the negotiated price (the minimum acceptable transfer price) times the number of units to be purchased. $0.56 × 2,578 boxes = $1,443.68.

To calculate the difference in quotes, calculate the quote from the external vendor which is $0.58 per box. $0.58 × 2,578 boxes = $1,495.24. The percentage difference can be calculated using horizontal analysis. ($1,495.24 – $1,443.68)/$1,443.68 = 0.0357 or 3.57% higher with the external vendor.

Carol has had a productive round of analysis and has found some interesting information. Based on the analysis she performed, Carol is likely to move forward with purchasing the new machine and to purchase the boxes needed for packaging from their internal department. Carol would likely be willing to pay at most $0.58 per box, which is the current quoted price by the external vendor. Any price above this would be considered a counter-productive decision and should lead Carol to select an external vendor.

Problem

Comfy Critters is a factory that creates stylish and comfortable bedding for dogs of all sizes. They are entering their 6^th year of business, and they have decided that one of their largest sewing machines is nearing the end of its useful life. Their production manager, Todd, is trying to help management decide how best to proceed with their next steps. Todd has the choices narrowed down to repairing the current machine (Repair), or replacing the machine with one of two different replacement options (New Machine 1 or New Machine 2). The numbers associated with each of these options are as follows:

	Repair	New Machine 1	New Machine 2
Cost	$8,876	$14,268	$16,155
Useful Life	8 years	10 years	11 years
Sales	$7,423	$13,964	$15,897
Operating Expenses (does not include depreciation)	$6,163	$10,402	$12,705

The company has chosen to utilize the straight-line method of depreciation calculation. The company has utilized a variety means to raise capital, and it is allocated as follows:

Cost of Debt	5.3%
Proportion of Debt	73.0%
Cost of Equity	7.2%
Proportion of Equity	27.0%

Comfy Critters has a tax rate of 25% and a Required Rate of Return of 8.4%.

(Do not round your calculations.)

What is the Weighted Average Cost of Capital (WACC) for Comfy Critters?
What are the Return on Investment (ROI), Residual Income (RI), and Economic Value Added (EVA) for the Repair option?
What are the Return on Investment, Residual Income, and Economic Value Added for the New Machine 1 option?
What are the Return on Investment, Residual Income, and Economic Value Added for the New Machine 2 option?
What should Todd recommend to management based on the analyses in parts b, c, and d? Provide as much detail as possible to support that decision.

Ans: NA, LO 1, 2, 3, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

WACC = 5.81%

This question requires familiarity with the formula for WACC. This formula will be used to determine other figures as well. WACC = (Cost of Debt × Proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). WACC = (0.053 × 0.73) + (0.072 × 0.27) = 0.0387 + 0.0194 = 0.0581 or 5.81%.

For Repair: ROI = 1.70%, RI = ($595.08), and EVA = ($403.09)

This question requires familiarity with three different formulas: ROI, which is Operating Income divided by Investment; RI, which is Operating Income – (Required Rate of Return × Investment); and EVA, which is After-Tax Operating Income – (WACC × Investment). First, Operating Income must be calculated, and that also includes updating operating expenses to include the depreciation expenses. $8,876/8 years = $1,109.50. Operating Income = $7,423.00 – ($6,163.00 + $1,109.50) = $7,423.00 – $7,272.50 = $150.50. Now, calculate the ROI: ($150.50/$8,876.00) = 0.0170 or 1.70%; RI: $150.50 – (0.084 × $8,876.00) = $150.50 – $745.58 = –$595.08; and EVA: ($150.50 × (1 – 0.25)) – (0.0581 × $8,876.00) = $112.88 – $515.96 = –$403.09.

For New Machine 1: ROI = 14.96%, RI = $936.69, and EVA = $772

This question requires familiarity with three different formulas: ROI, which is Operating Income divided by Investment; RI, which is Operating Income – (Required Rate of Return × Investment); and EVA, which is After-Tax Operating Income – (WACC × Investment). First, Operating Income must be calculated, and that also includes updating operating expenses to include the depreciation expenses. $14,268/10 years = $1,426.80. Operating Income = $13,964.00 – ($10,402.00 + $1,426.80) = $13,964.00 – $11,828.80 = $2,135.20. Now, calculate the ROI: $2,135.20/$14,268.00 = 0.1496 or 14.96%; RI: $2,135.20 – (0.084 × $14,268.00) = $2,135.20 – $1,198.51 = $936.69; and EVA: ($2,135.20 × (1 – 0.25)) – (0.0581 × $14,268.00) = $1,601.40 – $829.40 = $772.00.

For New Machine 2: ROI = 10.67%, RI = $366.34, and EVA = $353.43

This question requires familiarity with three different formulas: ROI, which is Operating Income divided by Investment; RI, which is Operating Income – (Required Rate of Return × Investment); and EVA, which is After-Tax Operating Income – (WACC × Investment). First, Operating Income must be calculated, and that also includes updating operating expenses to include the depreciation expenses. $16,155/11 years = $1,468.64. Operating Income = $15,897.00 – ($12,705.00 + $1,468.64) = $15,897.00 – $14,173.64 = $1,723.36. Now, calculate the ROI: $1,723.36/$16,155.00 = 0.1067 or 10.67%; RI: $1,723.36 – (0.084 × $16,155.00) = $1,723.36 – $1,357.02 = $366.34; and EVA: ($1,723.36 × (1 – 0.25)) – (0.0581 × $16,155.00) = $1,292.52 – $939.09 = $353.43.

Todd’s analysis has helped management decide which of the three options is best for the company. Repair is not a viable option because it not only fails to meet the Required Rate of Return for the company of 8.4% but both its RI and EVA are negative. New Machine 2 is the second least likely option. This option did surpass the company’s Required Rate of Return and produced a positive RI and EVA, but New Machine 1 produced better numbers in all three categories. New Machine 1 would be the best option to recommend to management as the best performer of the three.
Fabulous Fanny Packs Co. has two divisions that are both profit centers: Materials and Sewing. Fabulous Fanny Packs is known for their luxurious, unique, handmade fanny packs, which is also its only product. In addition to external vendors, the Materials division sells some of its fabric to the Sewing division. The Sewing division uses this fabric to create the fanny packs. Yearly operating income generated from external sales is calculated as follows:

	Materials Division	Sewing Division
Sales	$119,600	$207,854
Variable Expenses	85,544	146,590
Contribution Margin	$34,056	$61,264
Fixed Expenses	25,762	37,868
Operating Income	$8,294	$23,396

One yard of fabric is needed to create each fanny pack. Although the fabric is very unique, the Materials division was able to find an intermediate market where they also sell to external vendors, as reflected in the numbers above. Their operating capacity is 100,000 yards of fabric and they sold 76,420 yards to external vendors. The Materials division received an order from the Sewing division for 20,000 yards of fabric. Fabulous Fanny Packs has been considering whether or not to vertically integrate further by purchasing a retailer so the Sewing division could sell their products internally and sell to external vendors. Use all of this information to answer the following questions.

(Do not round your calculations.)

What is the minimum acceptable transfer price for the sale of yards to the Sewing division? What is the overall price for the yards of fabric being sold to the Sewing division?
Now assume the Sewing division had sought external quotes for 20,000 yards of fabric they needed to purchase and were given a quote of $1.10 per yard plus an additional charge of 2.5% (of initial price) to cover packaging, shipping, and handling. What would the overall price be for this quote? What is the percentage difference between this option and the one calculated in part a)?
Which offer should the Sewing division pursue? What factors should be considered when making this decision, and are there any other things they could do that may impact that decision one way or the other?
Assume that the sewing department was actually looking to purchase 40,000 yards of fabric from the Materials division. What would the per-unit minimum acceptable transfer price be, and what would the new overall price be?
If the market shifted and the external vendors that the Materials division sells to are now going to be offered at $1.72 per yard, would this impact either of the responses provided in part a) or d)? Support this response with the appropriate calculations.

Ans: NA, LO 1, 2, 4, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

The minimum acceptable transfer price is $1.12 per yard of fabric, so the overall price quoted is $22,387.86.

This question requires determination of what amounts would factor into the minimum acceptable transfer price. The Materials division has idle capacity, so this means that the Sewing division would be charged the variable cost per unit on external sales as the minimum acceptable transfer price. Variable cost per unit = $85,544/76,420 yards = $1.12 per yard, so that is the minimum acceptable transfer price. The overall price quoted by the Materials division would be $1.12 × 20,000 yards = $22,387.86.

The External Price Quote is $22,550; the external vendor’s quote is 0.72% higher than the price quoted by the Materials division.

External Supplier = 20,000 yards times $1.10 per yard plus 2.5% of that in additional charges. (20,000 × $1.10) × 1.025 = $22,000 × 1.025 = $22,550. To calculate the percentage difference in price, compare the overall quotes from the Materials division and the external vendor. ($22,550 – $22,387.86)/$22,387.86 = 0.72%. The external vendor’s overall price quote is 0.72% higher than the quote from the Materials division.

One of the largest considerations when deciding which offer to pursue will be the overall cost. The Materials division offers the lowest overall price, and they will likely be the most appealing offer for the Sewing division.

Other things that may factor in could be the convenience of using a department that is vertically integrated within the company and a quicker turnaround time on order fulfillment. The Sewing division could also attempt to negotiate with the external vendor and ask them to reduce their per-yard cost or to waive the 2.5% additional charges. Doing the latter would reduce the overall price to $22,000, and that is lower than the overall price quoted from the Materials Division.

Minimum acceptable transfer price while using idle capacity is $1.12 per yard, and when there is no idle capacity is $1.57; so, the overall price is $52,093.16.

If the Sewing division is now looking to purchase 40,000 yards, this would stretch beyond the capacity that the Materials division has. This problem requires familiarity with the formula for the minimum acceptable transfer price when a factory has both idle capacity and when it has no idle capacity. This will result in two different minimum acceptable transfer prices. To determine how many are subject to each price, subtract the current production from the high threshold of the capacity. 100,000 – 76,420 = 23,580 yards can still be produced before hitting capacity. The minimum acceptable transfer price of 23,580 yards will be equal to the variable cost per unit, which is equal to $85,544/76,420 yards = $1.12 per yard. The number of units that will be charged at a different price other than the variable cost will be the total requested units minus the units below capacity = 40,000 – 23,580 = 16,420 yards. The minimum acceptable transfer price of 16,420 yards will be the variable manufacturing cost per unit plus contribution margin per unit on external sales. Contribution margin = Sales – Variable Costs = $119,600 – $85,544 = $34,056. Now, divide this by the units sold externally: $34,056/76,420 yards = $0.45 per yard. The minimum acceptable transfer price is $1.12 + $0.45 = $1.57 per yard. The total price that will be quoted is: (23,580 × $1.12) + (16,420 × $1.57) = $26,395.28 + $25,697.88 = $52,093.16.

If the market price shifted to $1.72 per yard, then this would affect the overall sales generated by the Materials division in addition to the contribution margin. In part (a), there was idle capacity, and that meant that the minimum transfer price on their sale to the Sewing division would be the variable cost per unit. The change in sales price to the external vendors would not affect or impact the price quote in part (a). The answer to part (d) would be impacted, though. The quote for work done when there is no idle capacity will change. First, recalculate sales and the contribution margin. 76,420 yards sold × $1.72 per yard = $131,442.40. The new contribution margin will equal sales minus variable costs = $131,442.40 – $85,544 = $45,898.40. New minimum transfer price = ($85,544/76,420 yards) + ($45,898.40/76,420 yards) = $1.12 + $0.60 = $1.72 (the same as the per unit sales price). Now, recalculate the overall price quote with the new figure. (23,580 × $1.12) + (16,420 × $1.72) = $26,395.28 + $28,242.40 = $54,637.68. This price is ($54,637.68 – $52,093.16) which is $2,544.52 more than it was before the external price increase.
Sandra has had a very busy year as the production manager for the Patio Chair Department for Younique Patio Designs, Inc. In addition to expanding into new markets, Sandra has been working with the design team to bring her dream of adding a wicker patio chair to their current list of offerings. The design team has provided a list of requirements that must be met in order to be able to produce the chairs, including a machine that will enable assembly workers to cut and weave the wicker material. After speaking with several vendors, Sandra was given the following quotes:

Machine A: $50,500 (10-year useful life)

Machine B: $44,600 (9-year useful life)

Machine C: $43,420 (8-year useful life)

Younique would use straight-line depreciation for their calculations. She used this information and her own data to assemble the following predictions:

	Machine A	Machine B	Machine C
Sales	$17,423	$23,964	$25,897
Operating Expenses	$ 4,663	$10,402	$12,705
(not including depreciation)

Cost of Equity	8.10%
Proportion of Equity	23%
Cost of Debt	5.7%
Proportion of Debt	77%
Income tax rate	24%
Required rate of return	8.3%

Sandra has the option to purchase the wicker material from an external vendor for $2.16 per sheet with a 5% surcharge to deliver the sheets. Each chair will need 1 sheet of wicker to be completed. Younique wants to purchase 16,783 sheets of wicker to meet their production projections. They could also get the supply from Younique’s internal Materials Department. Their Materials Department has provided the following information about their production:

Sales (external sales of 98,000 sheets)	$226,800
Variable Costs	157,420
Fixed Costs	62,340

The Materials Department has a production capacity of 110,000 units so they currently have idle capacity. Use all of this information to answer the following questions.

(Do not round your calculations.)

1. What are the Profit Margins and Investment Turnovers for Machines A, B, and C?
2. What are the Returns on Investment (ROIs) and Residual Incomes (RIs) for Machines A, B, and C?

What are the Economic Values Added (EVAs) for Machines A, B, and C? What is the percentage difference between the Machine with the highest EVA and the lowest EVA?
What is the minimum acceptable transfer price for using the internal Materials Department for purchasing the wicker sheets? What is the overall price quoted by this department to the Patio Chair Division?
Which machine will be the best choice for the Patio Chair Department? Which supplier would provide the best option for them to pursue? Please explain all answers.

Ans: NA, LO 1, 3, 4, Bloom: E, Difficulty: Hard, AACSB: Analytic, AICPA: AC: Measurement, Analysis, and Interpretation, IMA: Strategy, Planning, & Performance: Decision Analysis. Solution:

1. Machine A: Profit Margin is 0.4425, and Investment Turnover is 0.3450;

Machine B: Profit Margin is 0.3591, and Investment Turnover is 0.5373;

Machine C: Profit Margin is 0.2998, and Investment Turnover is 0.5964

This question requires familiarity with the formulas for Return on Sales (Profit Margin): Operating Income/Sales, and Investment Turnover: Sales/Investment. First, calculate Operating Income: Sales – Operating Expenses. The total for operating expenses is not provided, so it must be calculated and that should include a calculation for depreciation.

Machine A: Depreciation = $50,500/10 years = $5,050 per year. Operating Income = $17,423 – $4,663 – $5,050 = $7,710. Profit Margin = $7,710/$17,423 = 0.4425. Investment Turnover = $17,423/$50,500 = 0.3450.

Machine B: Depreciation = $44,600/9 years = $4,955.56 per year. Operating Income = $23,964 – $10,402 – $4,955.56 = $8,606.44. Profit Margin = $8,606.44/$23,964 = 0.3591. Investment Turnover = $23,964/$44,600 = 0.5373.

Machine C: Depreciation = $43,420/8 years = $5,427.50 per year. Operating Income = $25,897 – $12,705 – $5,427.50 = $7,764.50. Profit Margin = $7,764.50/$25,897 = 0.2998. Investment Turnover = $25,897/$43,420 = 0.5964.

1. Machine A: ROI is 0.1527, and RI is $3,518.50;

Machine B: ROI is 0.1930, and RI is $4,904.64;

Machine C: ROI is 0.1788, and RI is $4,160.64

This question requires familiarity with the formula for ROI: Profit Margin × Investment Turnover, and Residual Income: Operating Income – (Required Rate of Return × Investment). Profit Margin and Investment Turnover were calculated in part (a) for each Machine, so those numbers can be used here as well.

Machine A: Return on Investment = 0.4425 × 0.3450 = 0.1527. Residual Income = $7,710 – (0.083 × $50,500) = $7,710 – $4,191.50 = $3,518.50.

Machine B: Return on Investment = 0.3591 × 0.5373 = 0.1930. Residual Income = $8,606.44 – (0.083 × $44,600) = $8,606.44 – $3,701.80 = $4,904.64.

Machine C: Return on Investment = 0.2998 × 0.5964 = 0.1788. Residual Income = $7,764.50 – (0.083 × $43,420) = $7,764.50 – $3,603.86 = $4,160.64.

1. EVA for Machine A is $2,702.34, EVA for Machine B is $3,752.51, and EVA for Machine C is $3,186.40.

Machine B has an EVA that is 38.86% higher than the EVA of Machine A

These questions require familiarity with the formulas for EVA: After-Tax Operating Income – (WACC × Investment) and for the Weighted Average Cost of Capital (WACC): (Cost of Debt × proportion of Capital Financed with Debt) + (Cost of Equity × Proportion of Capital Financed with Equity). WACC = (0.057 × 0.77) + (0.081 × 0.23) = 0.04389 + 0.01863 = 0.06252

Machine A: ($7,710.00 × (1 – 0.24)) – (0.06252 × $50,500) = $5,859.60 – $3,157.26 = $2,702.34.

Machine B: ($8,606.44 × (1 – 0.24)) – (0.06252 × $44,600) = $6,540.90 – $2,788.39 = $3,752.51.

Machine C: ($7,764.50 × (1 – 0.24)) – (0.06252 × $43,420) = $5,901.02 – $2,714.62 = $3,186.40.

The Machine with the highest EVA is Machine B, and the Machine with the lowest EVA is Machine A. Use horizontal analysis to calculate their percentage difference. The formula would be: (Machine B EVA – Machine A EVA)/Machine A EVA = ($3,752.51 – $2,702.34)/$2,702.34 = 0.3886 or 38.86%.

1. Minimum acceptable transfer price: idle capacity = $1.61, No idle capacity = $2.31; therefore, the overall price = $30,345.15.

This problem requires familiarity with the formula for the minimum acceptable transfer price when a factory has both idle capacity and when it has no idle capacity. This will result in two different minimum acceptable transfer prices. To determine how many are subject to each price, subtract the current production from the high threshold of the capacity. 110,000 – 98,000 = 12,000 units can still be produced before hitting capacity. The minimum acceptable transfer price of those 12,000 wicker sheets will be equal to the variable cost per unit, which is equal to $157,420/98,000 = $1.61 per sheet. Any sheets produced when there is no idle capacity will have a minimum acceptable transfer price of the variable cost per unit plus the contribution margin per unit. Contribution margin = Sales – Variable Costs = $226,800 – $157,420 = $69,380. Now, divide this by the units sold externally: $69,380/98,000 sheets = $0.71 per sheet. The minimum acceptable transfer price = $1.61 + $0.71 = $2.31 per sheet. The number of units that will be charged at this price will be the total requested minus the units produced before hitting capacity which is 16,783 – 12,000 = 4,783 units. The total price that will be quoted is: (12,000 × $1.61) + (4,783 × $2.31) = $19,275.92 + $11,069.23 = $30,345.15.

1. The Machine that would be the best choice for Younique to purchase would be Machine B since it had higher ROI, RI, and EVA when compared to the other two choices. All three Machines would yield positive results for Younique, so Sandra could comfortably suggest any of them. Should Machine B not work out, then her next likely suggestion would be Machine C since it produced the second highest results.

Before deciding what supplier they select, calculate the overall price offered by the external vendor. They want $2.16 per sheet with a 5% surcharge to cover shipping. (16,783 sheets × $2.16 per sheet) × 1.05 = $36,251.28 × 1.05 = $38,063.84. At this price, it would make the most sense for Younique to select their internal Materials Department as the overall price they would be obligated to pay is ($38,063.84 – $30,345.15) = $7,718.70 less.

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Chapter 17 Management Control Systems And Transfer Pricing

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Ch17 Full Test Bank Management Control Systems And Transfer

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