Decentralizing And Performance Chapter 10 Verified Test Bank

Chapter 10

Decentralizing and Performance Evaluation

Chapter Learning Objectives

1. Identify the difference between a cost center, a profit center, and an investment center. (Unit 10.1)

The difference between a cost center, a profit center, and an investment center has to do with the level of decision-making and control the manager has. A cost center is an organizational unit in which the manager is responsible only for the costs that are incurred. The goal of a cost center manager is to minimize costs while providing an acceptable level of service or quality of product. A profit center is an organizational unit in which the manager is responsible for both revenues and costs incurred to generate a product or service sold. This center is expected to generate profits, not just revenues or costs. An investment center is an organizational unit in which the manager is expected to invest in assets and generate profits. Investment center managers have the broadest responsibility of the three types of manager.

1. Prepare a segment margin income statement and evaluate a segment’s financial performance. (Unit 10.2)

In evaluating a segment’s financial performance, only those revenues and costs over which the manager has control should be included. Following is an example of a segment margin income statement. Notice that the segment margin is calculated as a segment revenue minus variable expenses and traceable fixed expenses. Corporate expenses that support the organization as a whole are not allocated to segments. Instead, these common fixed expenses are subtracted only from the total corporate revenues.

If the segment margin is positive, then the segment is making a contribution to the corporate bottom line. Dropping the segment will decrease corporate income by the amount of the segment margin. If the segment margin is negative, then it is causing the corporation to lose money. Dropping the segment will increase corporate income by the amount of the segment margin.

1. Evaluate an operating segment or project using return on investment. (Unit 10.3)

Besides looking at the segment margin to evaluate segment performance, companies will calculate return on investment. The formula for return on investment (ROI) is:

Return on investment is a percentage that can be compared to a corporate minimum return or to other segments’ ROIs. All else held equal, the higher the ROI, the better. ROI can be broken down into two measures, margin and asset turnover, to focus on specific components in need of improvement.

1. Evaluate an operating segment or project using residual income and economic value added. (Unit 10.4)

Residual income is the income that is earned above a required minimum rate of return. As long as a project’s residual income is positive, it is earning a return in excess of the required minimum. Residual income is calculated as:

1. Calculate the minimum transfer price between divisions that maximizes corporate income. (Appendix)

When two divisions want to engage in a transfer, the selling division wants the price to be as high as possible, but the buying division wants the price to be as low as possible, since both are evaluated on how well their divisions perform financially. The minimum transfer price that will result in the best outcome for the corporation as a whole is:

This transfer price doesn’t guarantee that the transfer will occur. Instead, it is the price that encourages the divisional managers to act in the best interest of both their divisions and the corporation, whether that is to engage in the transfer, to transact with an external company, or to do nothing.

TRUE-FALSE STATEMENTS

1. An organizational structure in which decision-making authority for the entire organization rests in the hands of one person or a small group of people in a single location is called centralization.
2. An organizational structure in which decision-making authority for the entire organization rests in the hands of one person or a small group of people in a single location is called decentralization.
3. After an organization implements a certain level of decentralization, it is committed to maintaining that level for the life of the organization.
4. A disadvantage of decentralization is that the process does not give lower-level managers practice in developing their decision-making skills.
5. A disadvantage of decentralized decision-making is that two or more operational managers may evaluate and make the same decision, duplicating their efforts.
6. The goal of the cost center manager is to minimize total costs and to maximize profit.
7. A cost center manager’s performance is measured largely by comparing the actual costs incurred to the flexible budget.
8. Although a profit center is expected to generate profits, not just revenues or costs, the manager cannot commit funds to invest in assets.
9. A profit center manager’s performance is measured using methods such as return on investment or residual income.
10. An investment center manager’s performance is typically measured based on the unit’s overall profit compared to the flexible budget.
11. You cannot classify a unit as a cost, profit, or investment center by looking at its name or its location on the organizational chart.
12. A manager who is responsible for both the revenue and the costs incurred in generating a product is managing an investment center.
13. A segment of an organization is any part of the organization that management wishes to evaluate.
14. A segment margin income statement includes all allocated costs in the calculation of the segment margin.
15. In preparing a segment margin income statement, instead of looking for a certain phrase that describes the cost, look for the reason the cost was incurred.
16. If a cost was incurred to support the company as a whole, then it is a common cost.
17. If a cost is a traceable fixed cost at one level, it will remain a traceable cost at a lower level.
18. Generally accepted accounting principles require companies to report selected information about operating segments in the annual report.
19. Return on investment measures the rate of return generated by an investment in assets.
20. Net income after interest and taxes is a common income measurement choice used to calculate ROI for an entire organization, because all expenses are under the CEO’s control at the corporate level.
21. The most common measure used as the denominator in the ROI calculation is a simple average of the assets used during the year.
22. ROI is a relative measure of return, in other words, the result is a dollar amount of return.
23. Return on investment is based on the fair market value of operating assets.
24. The DuPont Model decomposes the original ROI formula into two components: margin and asset turnover.
25. The ROI formula decomposed into two components, margin and asset turnover, is referred to as the Deaumon Model.
26. Although managers’ actions may improve ROI in the short run, they may do so at the expense of the company’s long-term financial health.
27. Just because a project’s residual income is positive, does not mean that it is earning a return in excess of the corporate minimum.

LO: 4, Bloom: AN, Unit: 10-4, Difficulty: Moderate, Min: 1, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

1. As long as EVA is positive, the firm’s managers have used the invested capital to create additional value for shareholders.
2. In calculating EVA, invested capital is the company’s total assets minus its total liabilities.
3. Finance theory says that the rate of return required by creditors is the same as the return required by investors.

LO: 4, Bloom: K, Unit: 10-4, Difficulty: Easy, Min: 1, AACSB: Analytic, AICPA FN: Reporting, AICPA PC: None, IMA: Strategy

*31. The price at which an exchange between divisions is recorded is referred to as the intermediate price.

*32. The options for setting a transfer price include cost-based prices, market-based prices, and negotiated prices.

*33 The goal in setting a transfer price is to maximize the benefits to both divisions participating in the exchange.

* Appendix

MULTIPLE-CHOICE QUESTIONS

1. ABC Corporation has three divisions, a service division with two locations, a retail division with four locations, and a home office, each of which is evaluated individually. This is an example of which type of organization?
   1. Segmented decision-making
   2. Decentralization
   3. Centralization
   4. Investment center
2. For a small business producing a single product, having one location and few employees, the organizational structure that is most appropriate is
   1. centralized.
   2. decentralized.
   3. divisional stability.
   4. segmented decision-making.
3. The organizational structure in which decision-making authority for the entire organization rests in the hands of one person or a small group of people in a single location is called
   1. responsibility centered.
   2. centralization.
   3. decentralization.
   4. segmentation.
4. The organizational structure in which decision-making authority is dispersed throughout the organization is called
   1. Centralized.
   2. Decentralized.
   3. Divisional stability.
   4. Segmented decision-making.
5. If you think of an organization’s structure as a continuum, on the centralized end of the continuum, operational managers
   1. are never evaluated.
   2. are evaluated on costs, revenue, and profit.
   3. have complete control over operational decisions.
   4. have no authority to make decisions.
6. If you think of an organization’s structure as a continuum, on the decentralized end of the continuum, operational managers
   1. are never evaluated.
   2. are evaluated on costs and revenue.
   3. have complete control over operational decisions.
   4. have limited authority to make decisions.
7. Which of the following is an advantage of decentralization?
   1. Duplication of effort is minimized.
   2. The potential for sharing ideas throughout the organization is enhanced.
   3. Lower-level managers understand the company’s strategies and goals, and thus make decisions that are in the best interest of the organization as a whole.
   4. Top management is free to focus on the long-term strategies of the organization.
8. Which of the following is an advantage of decentralization?
   1. Managers at the upper level of the organization have the best knowledge of the actual day-to-day operations.
   2. Companies can develop their own managers internally by giving lower-level managers practice in developing their decision-making skills.
   3. Lower management focus on the long-term strategies of the organization.
   4. The is little or no duplication of efforts.
9. Which of the following would not be an advantage of decentralization?
   1. Duplication of effort is minimized.
   2. Companies can develop their own managers internally by giving lower-level managers practice in developing their decision-making skills.
   3. Top management is free to focus on the long-term strategies of the organization.
10. Which of the following would not be a focus of top managers in a decentralized organizational structure?
    1. Long-range projections
    2. Corporate goals
    3. Day-to-day operational issues
11. The accounting department of a large corporation is classified as a
    1. cost center.
    2. profit center.
    3. investment center.
    4. segment.
12. The packaging department in a large manufacturing company is classified as a
    1. cost center.
    2. profit center.
    3. investment center.
    4. segment.
13. A disadvantage of decentralization is that
    1. if lower-level managers do not understand the company’s strategies and goals, they may make decisions that are not in the best interest of the organization as a whole.
    2. two or more operational managers may evaluate and make the same decision, duplicating their efforts.
    3. managers tend to focus on their own units and often lose contact with others in the organization.
14. Which of the following is a reason why top managers would decide to increase the level of decentralized decision-making authority in their company?
    1. Managers at the operational level can respond to issues more quickly than top management.
    2. Top managers want to have input into day-to-day operations.
    3. Managers at the operational level need constant supervision.
    4. Top managers have too many tasks to complete so they prefer to allocate some to operational level managers.
15. A disadvantage of decentralization is that decision-making is spread throughout the organization. This is a disadvantage because
    1. managers tend to focus on interacting with others in the organization.
    2. the potential for sharing ideas throughout the organization is increased.
    3. lower-level managers may not fully understand the ramifications of their localized decisions on the organization as a whole.
    4. lower-level managers are often not trained well enough to run operations.
16. In a responsibility accounting environment, upper managers evaluate the performance of the unit managers based
    1. on those items over which the unit managers have control.
    2. not only on costs, but also on revenues.
    3. on the overall profit of the organization.
    4. on their units’ operations and an allocated share of common costs.
17. In a responsibility accounting environment, which of the following is not a classification of organizational units?
    1. Cost centers
    2. Revenue centers
    3. Profit centers
    4. Investment centers
18. In a responsibility accounting environment, which of the following managers is considered to have the broadest responsibility?
    1. Cost center manager
    2. Profit center manager
    3. Investment center manager
    4. Revenue center manager
19. In a responsibility accounting environment, which of the following managers has his or her performance typically measured based on the unit’s overall profit compared to the flexible budget?
    1. Cost center manager
    2. Profit center manager
    3. Investment center manager
    4. Revenue center manager
20. An organizational unit whose manager is responsible only for the expenses incurred in the unit is referred to as a
    1. expense center.
    2. cost center.
    3. product center.
    4. manufacturing center.
21. A cost center manager’s performance might be measured by
    1. the center’s ROI.
    2. direct material variances.
    3. segment profit.
    4. its return on invested assets.
22. A manager who is responsible for both the revenue and the costs incurred in generating a product or service is managing
    1. a cost center.
    2. a product center.
    3. a profit center.
    4. an investment center.
23. A manager of a profit center cannot
    1. incur cost to operate the center.
    2. set the selling price of the center’s product.
    3. commit funds to invest in assets.
    4. control the center for which he or she is responsible.
24. A profit center manager’s performance is typically measured based on the unit’s
    1. direct material and direct labor variances only.
    2. overall profit compared to the flexible budget.
    3. ROI.
    4. costs incurred.
25. At Devoe Manufacturing, the Southern Division is responsible for the production and selling of products in fifteen states. This division is an example of which of the following responsibility centers?
    1. Cost center
    2. Revenue center
    3. Profit center
    4. Investment center
26. The manager of which of the following responsibility centers is expected to invest in assets that generate profit?
    1. Cost center
    2. Revenue center
    3. Profit center
    4. Investment center
27. An investment center manager’s performance can be based on
    1. the same methods as managers of cost centers.
    2. the same methods as managers of profit centers.
    3. residual income.
28. An investment center manager’s performance is more thoroughly based on
    1. the same methods as managers of cost centers.
    2. a comparison with the flexible budget.
    3. an evaluation of the return on invested assets.
    4. profitability.
29. At Devoe Manufacturing, the vice-president of the Southern Division is responsible for the production and selling of products in fifteen states as well as securing the productive assets needed to create the product. This division is an example of which of the following responsibility centers?
    1. Cost center
    2. Revenue center
    3. Profit center
    4. Investment center
30. On an organizational chart, from bottom to top, which of the following is the order of responsibility centers?
    1. Cost, profit, investment
    2. Cost, investment, profit
    3. Profit, cost, investment
    4. Profit, investment, cost
31. In a centralized organization, decision-making authority
    1. is spread throughout the organization.
    2. always rests with profit center managers.
    3. rests with a small group of managers in a single location.
    4. is broader at the bottom of the organizational chart.
32. Any part of an organization that management wishes to evaluate is referred to as a
    1. department.
    2. segment.
    3. factory.
    4. center.
33. A segment margin income statement excludes all ________ costs in the calculation of the segment margin.
    1. selling
    2. traceable
    3. fixed
    4. allocated
34. Segment margin income statements are most useful to managers when they are prepared
    1. on a cash basis.
    2. using a segment contribution margin basis.
    3. on a GAAP basis.
    4. based on function.
35. What a company really need to best measure a segment’s performance is an income statement that highlights
    1. variable versus fixed costs.
    2. product versus period costs.
    3. all elements under the segment manager’s control.
    4. all revenues and expenses.
36. The segment margin income statement excludes
    1. all allocated costs in the calculation of the segment margin.
    2. all fixed costs.
    3. all period costs.
    4. non-cash expenses.
37. Which of the following items would not appear on a segment margin income statement?
    1. Direct material
    2. Traceable fixed costs
    3. Selling expense
    4. Common fixed costs
38. An income statement presented in a functional format is not very helpful in managerial decision-making because it does not show which expenses are
    1. fixed and which are variable.
    2. direct and which are indirect.
    3. product costs and which are period costs.
    4. common and which are allocated.
39. Which of the following terms are used in referring to common costs?
    1. Allocated cost
    2. Avoidable costs
    3. Fixed costs
    4. Discretionary
40. Which of the following terms is not used in referring to costs for which managers cannot control in calculating segment margin?
    1. Allocated cost
    2. Unavoidable cost
    3. Traceable cost
    4. Common costs
41. If a cost is incurred specifically for a segment of an organization, it is referred to as
    1. a common cost.
    2. a traceable cost.
    3. an allocated cost.
    4. an unavoidable cost.
42. If a cost is incurred to support the company as a whole, it is referred to as a
    1. a common cost.
    2. a traceable cost.
    3. a direct cost.
    4. an allowable cost.
43. When does a traceable fixed cost become a common cost?
    1. When it is at a lower level than where it is incurred
    2. When it is at a higher level than where it is incurred
    3. A traceable fixed cost is always a common cost at another level
    4. A traceable fixed cost is never a common cost at another level
44. Traceable fixed costs are the responsibility of
    1. top management only.
    2. managers who control them.
    3. investment center managers only.
    4. all centers within a company.
45. Common fixed costs are most likely the responsibility of
    1. top management only.
    2. managers who have no control of them.
    3. investment center managers only.
    4. cost center managers only.
46. Generally Accepted Accounting Principles (GAAP) require companies to report
    1. selected information about operating segments in the annual report.
    2. financial statements using a cash basis.
    3. information based on responsibility centers.
    4. information in a segment margin format.
47. One thing that is missing from GAAP-based segment reporting is a breakdown of
    1. product and period costs.
    2. cost of goods sold and operating costs.
    3. variable and fixed costs.
    4. gross margin and net income.
48. Kimble Industries’ production division reported a net operating loss of $500,000 in 2021. Included in that amount were common fixed corporate expenses of $720,000 that were allocated to divisions based on segment gross profit. The division’s segment margin was
    1. $220,000.
    2. $500,000.
    3. ($220,000).
    4. ($500,000).
49. City Retail sells two products: Standard and Deluxe. The company had sales of $800,000 during the current year. The company’s contribution margin ratio was 40% and total fixed costs totaled $300,000. Sales were $600,000 for Standard and $200,000 for Deluxe. Traceable fixed costs were $150,000 for Standard and $90,000 for Deluxe. Variable costs were $360,000 for Standard and $120,000 for Deluxe. What is the segment margin for the Standard product?
    1. $20,000
    2. $80,000
    3. $90,000
    4. $240,000
50. City Retail sells two products: Standard and Deluxe. The company had sales of $800,000 during the current year. The company’s contribution margin ratio was 40% and total fixed costs totaled $300,000. Sales were $600,000 for Standard and $200,000 for Deluxe. Traceable fixed costs were $150,000 for Standard and $90,000 for Deluxe. Variable costs were $360,000 for Standard and $120,000 for Deluxe. What is the segment margin for the Deluxe product?
    1. ($10,000)
    2. $10,000
    3. $20,000
    4. $80,000
51. Ruhlen Corporation’s Small Craft division reported a net operating loss of $2,300,000 in the most recent reporting period. The division absorbed common fixed corporate expenses of $2,500,000. The division’s segment margin is
52. $(2,500,000).
53. $(2,300,000).
54. $200,000.
55. $4,800,000.
56. In the most recent reporting period, Athens Corporation’s Legion division generated net revenues of $2,000,000 and variable expenses of $700,000. Direct fixed expenses were $500,000 and common corporate fixed expenses were $250,000. What is the division’s segment margin?
57. $550,000
58. $800,000
59. $1,050,000
60. $1,300,000
61. The Sphinx division of Shepherd Corporation generated net revenues of $12,000,000 and variable expenses of $7,700,000. If common corporate fixed costs were $1,000,000 and the segment margin was $1,300,000, what are the division’s direct fixed expenses?
62. $4,300,000
63. $3,000,000
64. $300,000
65. The Delta division of Georgia Corporation generated net revenues of $6,000,000 and variable expenses of $3,500,000 during the year. If direct fixed costs were $1,000,000 and the segment margin was $1,500,000, what are the common corporate fixed costs?
66. $1,500,000
67. $4,500,000
68. $5,00,000
69. Bethel Corporation’s Ambulance division reported net operating profits of $1,500,000 during the year. The division absorbed common fixed corporate expenses of $900,000. The division’s segment margin is
70. $(600,000).
71. $900,000.
72. $600,000.
73. $2,400,000.
74. If a company desires to increase ROI, it should consider methods that will decrease
    1. sales revenue.
    2. segment margin.
    3. asset turnover.
    4. average operating assets.
75. Which of the following assets would not be included in average operating assets used to calculate ROI?
    1. Building
    2. Equipment used in production
    3. Equipment no longer in use
    4. Factory machinery
76. A cost center manager should be evaluated by
    1. an examination of actual costs against budgeted costs.
    2. a review of both revenues and expenses, with a focus on operating income.
    3. how well assets have been used to generate income.
    4. a flexible budget income statement.
77. A profit center manager should be evaluated by
    1. an examination of actual costs against budgeted costs.
    2. a review of both revenues and expenses, with a focus on operating income.
    3. how well assets have been used to generate income.
    4. a review of the expenses of which the manager is able to control.
78. An investment center manager should be evaluated by
    1. an examination of actual costs against budgeted costs.
    2. a review of both revenues and expenses, with a focus on operating income.
    3. how well assets have been used to generate income.
    4. a flexible budget income statement.
79. Return on investment measures
    1. actual costs against budgeted costs.
    2. the rate of return generated by an investment in assets.
    3. the dollar amount of segment margin over operating income.
    4. profitability.
80. The formula for calculating ROI is
    1. net income divided by average operating assets.
    2. segment margin divided by average operating assets.
    3. operating Income divided by average operating assets.
    4. segment margin divided by assets minus liabilities.
81. The formula for calculating ROI is
    1. segment margin divided by average operating assets.
    2. segment margin divided by the internal rate of return.
    3. the internal rate of return divided by average operating assets.
    4. segment margin divided by assets minus liabilities.
82. The formula for calculating ROI is
    1. segment margin divided by the internal rate of return.
    2. internal rate of return divided by average operating assets.
    3. operating income divided by average operating assets.
    4. segment margin divided by assets minus liabilities.
83. In the calculation of ROI, the most common measure for average operating assets is
    1. ending balance.
    2. the fair value amounts.
    3. the appraised balance.
    4. average of the assets during the year.
84. ROI can be viewed as
    1. the required rate of return.
    2. an absolute measure of return.
    3. a rate of return.
    4. a dollar amount of return.
85. In calculating ROI, the return on investment is based on the
    1. book value of operating assets.
    2. fair market value of operating assets.
    3. historical cost of operating assets.
    4. cost in terms of the value at year end.
86. The DuPont model for calculating ROI contains which of the following components?
    1. Margin and asset turnover
    2. Asset turnover and net income
    3. Margin and operating assets
    4. Net income and asset turnover
87. The DuPont model for calculating ROI contains which of the following components?
    1. Asset turnover
    2. Internal rate of return
    3. Required rate of return
    4. Total assets less total liabilities
88. In the Dupont Model for calculating ROI, which of the following components appears on both the margin side of the expression and the asset turnover side?
    1. Operating income
    2. Sales revenue
    3. Average operating assets
    4. Segment margin
89. What advantage does the DuPont model offer compared to the standard ROI calculation?
    1. It classifies costs based on function.
    2. It is more accurate.
    3. It helps identify the actions required to improve the ROI.
    4. It separates costs by behavior.
90. Holding all other things equal, the ROI is affected by a change in

1. ROI can be improved by
   1. increasing revenue and assets.
   2. decreasing revenue and expenses.
   3. decreasing assets and expenses.
   4. increasing revenue and assets.
2. ROI will not be improved by
   1. increasing revenue.
   2. converting variable costs to traceable fixed costs.
   3. decreasing assets.
   4. decreasing variable costs.
3. If managers want to increase ROI, an increase in sales revenue will increase
   1. margin and sensitivity.
   2. asset turnover and total assets.
   3. margin and asset turnover.
   4. margin and total assets.
4. To increase both margin and asset turnover, a manager must
   1. increase sales revenue.
   2. decrease expenses.
   3. increase expenses.
   4. decrease sales revenue.
5. Which of the following accomplishes an increase in ROI through a reduction in the asset base?

1. Which of the following is a shortcoming of ROI as a performance measure?
   1. ROI can increase without any change in operations because of depreciation.
   2. It can encourage desirable behavior by managers.
   3. ROI can increase without any change in operations by acquiring more capital assets.
   4. It can encourage managers to increase sales revenue.
2. ABC Corporation’s North Division generates operating income of $100,000 on $900,000 in sales. The company had $400,000 in assets at the beginning of the year and $450,000 at the end of the year. What is the company’s return on investment for the year?
   1. 11.1%
   2. 23.5%
   3. 42.5%
   4. 100%
3. Noble Corporation had sales of $3,000,000 and operating income of $500,000. Noble also had $900,000 of assets on January 1 and $800,000 on December 31. What is the corporation’s ROI for the year?
   1. 26.7%
   2. 35.3%
   3. 58.8%
   4. 59.9%
4. Althea Corporation’s Perfume division has a segment margin is $85,000 for the current reporting period. Total assets at the beginning of the period were $800,000 and $900,000 at the end of the period. What is the division’s ROI?
5. 9.44%
6. 10.00%
7. 10.63%
8. 5.00%
9. Blanco Corporation’s Cajun Spice division has a segment margin is $432,500 for the current reporting period. The division has an asset turnover of 1.6. Segment margin as a percentage of sales is 10%. What is the division’s ROI?
10. 16%
11. 10%
12. 6%

1. Ronaldi Corporation’s Port division has a segment margin of $400,000 and net sales revenue of $4,400,000 for the current reporting period. The division has an asset turnover of 1.5. What is the division’s ROI?
2. 11%
3. 13.2%
4. 13.6%
5. Breton Corporation’s Longboat division’s segment margin as a percentage of net sales is 12% for the current reporting period. The division has net sales revenue of $2,500,000. Operating assets were $800,000 at the beginning of the period and $1,200,000 at the end. What is the division’s asset turnover?
6. 2.08
7. 2.8
8. 2.5
9. 3.13
10. Breton Corporation’s Longboat division’s segment margin as a percentage of net sales is 12% for the current reporting period. The division has net sales revenue of $2,500,000. Operating assets were $800,000 at the beginning of the period and $1,200,000 at the end. What is the division’s ROI?
11. 10%
12. 12%
13. 15%
14. 30%
15. Cleopatra Corporation’s Lingerie division has a segment margin of $729,000 and net sales revenue of $5,400,000 for the current reporting period. Average total assets for the period were $3,375,000. The division manager is considering implementing a new inventory system which would reduce inventory by $675,000. Assuming no change in sales or segment margin, the projected ROI with the reduction in inventory would be
16. 13.5%.
17. 20%.
18. 21.6%.
19. 24%.
20. When evaluating managerial actions, which of the following alternate measures overcomes many of the problems with ROI?
    1. Residual income and asset turnover
    2. EVA and flexible budgets
    3. Residual Income and EVA
    4. Asset turnover and EVA
21. Which of the following is the formula to calculate residual income?
    1. Operating income – average assets
    2. Operating income plus interest and depreciation expense
    3. Operating income – (average assets × required minimum rate of return)
    4. Operating income – (average assets + required minimum rate of return)
22. The income that is earned above the specified minimum level of return is referred to as
    1. EVA.
    2. residual income.
    3. segment income.
    4. operating income.
23. Which of the following is not a problem associated with residual income?
    1. It can change without any change in operations because of depreciation.
    2. It is an absolute measure that is stated in absolute dollars.
    3. Using it to compare divisions of different sizes is difficult.
    4. It allows managers to manipulate the outcome.
24. Economic value added (EVA) performance measures
    1. the fair market value of income.
    2. economic profit.
    3. segment margin.
    4. the percentage return generated on the use of assets.
25. The formula to calculate EVA is
    1. Net operating profit – (invested capital × weighted average cost of capital).
    2. Contribution margin – (invested capital × weighted average cost of capital).
    3. Net operating profit – (average capital assets × internal rate of return).
    4. Contribution margin – (average capital assets × internal rate of return).
26. Net operating profit after taxes is referred to as
    1. segment net income.
    2. NOPAT.
    3. net income.
    4. invested capital.
27. Which of the following is not a step in calculating EVA?
    1. Calculate net operating profit.
    2. Calculate invested capital.
    3. Calculate average operating assets.
    4. Calculate the weighted average cost of capital.
28. Which of the following is not a step in calculating EVA?
    1. Calculate net operating profit.
    2. Calculate invested capital.
    3. Calculate the weighted average cost of capital.
    4. Calculate asset turnover.
29. In calculating EVA, invested capital is determined by
    1. subtracting current liabilities from total assets.
    2. subtracting total liabilities from total assets.
    3. subtracting total liabilities from long-term assets.
    4. adding current liabilities to total assets.
30. To calculate the weighted-average cost of capital we need to know
    1. the relative percentage of capital provided by each source and the cost of invested capital.
    2. the required rate of return and the cost of invested capital.
    3. the cost of invested capital and the relative percentage of capital provided by each source.
    4. relative percentage of current liabilities and the required rate of return.
31. To calculate the weighted-average cost of capital we do not need to know
    1. the relative percentage of capital provided by each source.
    2. the required rate of return.
    3. the cost of invested capital of each source.
32. Net operating profit is defined as
    1. operating income minus income taxes.
    2. sales minus variable costs.
    3. contribution margin minus traceable fixed costs.
    4. segment margin minus income taxes.
33. People’s Construction Company has set a 15% required minimum rate of return. The company’s CFO is considering investing in a $125,000 crane that is expected to generate $25,000 in additional operating income. What is the crane’s residual income?
    1. $4,500
    2. $6,250
    3. $15,000
    4. $18,750
34. Jumbo Industries is considering the purchase of equipment costing $80,000. The company has a 15% required minimum rate of return. The equipment is expected to generate $20,000 in additional operating income. What is the equipment’s residual income?
    1. $8,000
    2. $9,000
    3. $12,000
    4. $15,000
35. People’s Construction Company has set a 15% required minimum rate of return. The company’s CFO is considering investing in a $125,000 crane that is expected to generate $25,000 of additional operating income. People’s weighted-average cost of capital is 10% and its tax rate is 30%. What is the crane’s EVA?
    1. $5,000
    2. $12,500
    3. $17,500
    4. $100,000
36. Jumbo Industries is considering the purchase of equipment costing $80,000. The company has a 12% required minimum rate of return. The equipment is expected to generate $20,000 in additional operating income. Jumbo’s tax rate is 25% and its weighted-average cost of capital is 12%. What is the equipment’s EVA?
    1. $2,400
    2. $5,400
    3. $7,200
    4. $9,600
37. Durango Corporation’s Midwestern region operates as an investment center. Rich Ruhlman, the division’s manager, has set a 15% required minimum rate of return. Ruhlman is considering investing in computerized manufacturing equipment with a cost of $220,000. The equipment is expected to generate $65,000 in additional operating income. What is the equipment’s residual income?
    1. $65,000
    2. $33,000
    3. $32,000
38. Cody Corporation’s Southern region operates as an investment center. The division’s director is considering investing in machinery which costs of $100,000 and is expected to generate $32,000 in additional operating income. If the residual income for the equipment is $12,000, what is the division’s required rate of return?
39. 12%
40. 20%
41. 32%
42. Diablo Corporation’s Western region operates as an investment center. John Mosby, the division’s director, is considering investing in manufacturing equipment with a cost of $120,000. The equipment is expected to generate $35,000 in additional net operating profit. If the weighted average cost of capital is 18%, what is the equipment’s EVA?
43. $35,000
44. $21,600
45. $13,400

EVA = $35,000 – ($120,000 × 18%) = $13,400

1. The division director for Natchez Corporation’s Mississippi division, which operates as an investment center, is considering investing in machinery which costs of $2,200,000 and is expected to generate $332,000 in additional operating income. If the division’s weighted average cost of capital is 11% and its tax rate is 20%, what is the equipment’s EVA?
2. $23,600
3. $90,000
4. $242,000
5. $332,000
6. Which of the following is not a measure on which transfer prices can be based?
   1. Market-based price
   2. Cost-based price
   3. Negotiated price
   4. Cost of capital price
7. The price at which the exchange between divisions takes place is referred to as
   1. intercompany relay price.
   2. transfer price.
   3. manufacturing price.
   4. trade price.
8. Which of the following is the formula for setting a minimum transfer price?
   1. Sales less variable cost
   2. Contribution less income taxes and interest
   3. Variable cost to produce/sell + contribution margin forgone from the transfer
   4. Variable cost to produce/sell + allocated fixed costs
9. The goal of setting a transfer price is to
   1. maximize the overall profit of the organization.
   2. maximize the profit of the transferring division.
   3. motivate managers to behave in the best interest of the firm as a whole.
   4. ensure that all divisions have the resources they need to operate.
10. Which of the following is the most unbiased transfer price?
    1. Market-based price
    2. Cost-based price
    3. Negotiated price
    4. Intercompany price
11. The market-based price is easily determined by
    1. monitoring competitor’s costs.
    2. the price that the selling division charges other customers.
    3. the price that the selling division pays its supplier.
    4. adding a markup to the cost.
12. A negotiated price is one that
    1. provides the selling division with a normal profit.
    2. provides the buying division with the lowest price available from outside suppliers.
    3. is agreed to by both the buying and selling division.
    4. is equal to the actual cost of resource being transferred.
13. Rivers Industries produces and sells electronic sound equipment. The company has production capacity of 20,000 units and currently production schedule is for 18,000 units. Each unit has a selling price of $25, variable product cost of $15, and variable selling cost of $2. Another division wishes to purchase 500 units. If Rivers sells the units to the other division, it will avoid $1 of the variable selling costs. What is the minimum transfer price that will maximize corporate profits?
    1. $25
    2. $17
    3. $16
    4. $15
14. Chute Company’s Extract division has collected the following information.

Normal selling price $2.90 per bottle

Variable product costs 1.25 per bottle

Fixed product costs 0.50 per bottle

Variable selling and administrative costs 0.25 per bottle

Production capacity 1,500,000 bottles

Assuming that the division has excess capacity of 300,000 and the Baked Goods division wants to buy 250,000 bottles, the minimum transfer price is

1. $2.90
2. $2.00
3. $1.50
4. $1.15
5. Winek Company’s Tackle division has collected the following information:

Normal selling price $18.00 per box

Variable product costs 10.25 per box

Fixed product costs 3.50 per box

Variable selling and administrative costs 2.75 per box

The Tackle division has no excess capacity. Winek’s Little Fisherman division sells complete fishing kits for children and wants to purchase 100,000 tackle boxes. The minimum transfer price would be

1. $18.00
2. $16.50
3. $13.00
4. $8.00
5. Kitty City Company’s Canned Foods division has collected the following information:

Normal selling price $3.90 per can

Variable product costs 2.20 per can

Fixed product costs 0.80 per can

Variable selling and administrative costs 0.30 per can

Production capacity 2,500,000 cans

The Canned Foods division is currently producing 2,000,500 cans. The company’s Dinner Pack division wants to buy 350,000 cans. The minimum transfer price would be

1. $1.10
2. $2.50
3. $3.00
4. $3.30

152. Wrightsville Beach Company produces ice packs and various sizes of cooler bags. The Lunch Box division would like to buy 125,000 packs from the Ice Pack division, which currently has excess capacity of 250,000 packs. The ice packs are normally sold for $1.65. The Ice Pack division’s variable cost per pack is $0.95 and fixed cost per pack are $0.30. The ice packs could be purchased from another company for $1.75. Both the Ice Pack and the Lunch Box divisions are operated as profit centers. If Wrightsville Beach Company choses to use a cost-plus-based transfer price based on variable cost for the ice packs, what transfer price would the company use assuming a 20% markup?

1. $1.14
2. $1.25
3. $1.65
4. $1.75
5. Warner Company produces flash drives. The Custom division would like to buy 1,000,000 units from the Thumb Drive division, which currently has sufficient excess capacity. The units are normally sold for $9.99. The Thumb Drive division’s variable production cost per unit is $2.10, variable selling and administrative expenses are $0.80 and fixed cost per unit are $1.65. The drives could be purchased from another company for $9.75. Both the Thumb Drive and the Custom divisions are operated as profit centers. If the company choses to use a cost-plus-based transfer price based on variable cost for the drives, what transfer price would the company use assuming a 50% markup?
6. $4.35
7. $4.55
8. $6.83
9. $9.75

Answers to Multiple-Choice Questions

MATCHING

1. Match the following terms to the appropriate statement by placing the letter to the left of each statement.

1. g – Profit center
2. j – Segment
3. i – Return on investment (ROI)
4. c – DuPont Model
5. a – Centralization
6. h – Residual income
7. d – Economic value added (EVA)
8. f – net operating profit
9. e – Intermediate product
10. b – Decentralization

BRIEF EXERCISES

1. An organization may be structured as a centralized or decentralized decision-making environment. Classify each of the following as a characteristic of a centralized or decentralized decision-making environment by placing an “X” in the appropriate column.

1. Dublin Corporation has operating income of $15,000 on $200,000 of sales. Dublin’s average operating assets total $100,000. The corporation has a minimum required return of 18%.

Required:

Calculate Dublin’s return on investment using the DuPont method.

1. In a decentralized organization, upper managers need a way to evaluate the performance of unit managers. Based on factors under the unit manager’s control, organizational units are categorized as cost centers, profit centers, or investment centers. Classify each of the following centers by placing an “X” in the appropriate column.

1. Mounce Corporation produces and sells two products, Basic and Super. Data for activity during March are as follows:

Required:

Prepare a segment margin income statement. Omit the heading. Common fixed costs of $25,000 are allocated Basic and $30,000 to Super.

1. Martin Company sells two products, Standard and Deluxe. Data for activity during January are as follows:

Required:

Prepare a segment margin income statement. Omit the heading. Common fixed costs of $25,000 are allocated one-half to Standard and one-half to Deluxe.

1. Marshall Industries has sales of $600,000 and net operating income of $30,000. Marshall’s average operating assets total $200,000. Use the Dupont model to calculate the company’s return on investment.

1. Marshall Industries operates as an investment center. Buddy Hall, the region’s division manager, has set a required minimum rate of return of 15%. Marshall’s total assets are $350,000, current liabilities are $150,000, and operating income is $60,000. The company’s weighted-average cost of capital is 18% and its tax rate is 28%.

Required:

Calculate Marshall’s EVA. Show your work.

Step 1 – $60,000 × (1 − 28%) = $43,200

Step 2 ̶ $350,000 ̶ $150,000 = $200,000

Step 3 – 18%

Step 4 ̶ $43,200 – ($200,000 × 18%) = $7,200

1. Burton Corporation’s Central region operates an investment center. John Meadows, the region’s director, has set a 15% required minimum rate of return. John is considering investing in a $50,000 machine that is expected to generate $20,000 in additional income.

Required:

Calculate the machine’s residual income. Show your work.

$20,000 – ($50,000 × 15%) = $12,500

1. Lakeside Industries’ operates as a decentralized organization. Its fishing gear division manufactures fishing lures. The fiberglass division manufactures one component needed by the fishing gear division. The fishing gear division has been purchasing the component from an outside supplier, but top management has suggested that all purchases be acquired from another Lakeside division if possible. Detailed unit cost for the fiberglass component needed to make lures is given below:

The manufacturing overhead is 60% fixed and 40% variable.

Required:

1. What is the transfer price if Lakeside uses the cost-based price?
2. What is the minimum transfer price?
3. $1.60
4. $0.80 + $0.60 + ($0.20 × 40%) = $1.48
5. Lakeside Industries’ operates as a decentralized organization. Its tent division manufactures small camping tents. The fabricating division manufactures one component needed by the tent division. The tent division has been purchasing the component from an outside supplier, but top management has conducted a study and believes the company could substantially cut costs by all divisions purchasing any components made by other divisions internally rather than an outside source. Detailed unit cost for the fabricating component needed to make tents is given below:

The manufacturing overhead is 60% fixed and 40% variable.

Required:

1. What is the transfer price if Lakeside uses the market-based price?
2. What is the minimum transfer price?
3. $32.00
4. $8.00 + $4.00 + ($6.00 x 40%) = $14.40

EXERCISES

1. An organization may be structured as a centralized or decentralized decision-making environment. Classify each of the following as a characteristic of a centralized or decentralized decision-making environment by placing an “X” in the appropriate column.

1. In a decentralized organization, upper managers need a way to evaluate the performance of unit managers. Based on factors under the unit manager’s control, organizational units are categorized as cost centers, profit centers, or investment centers. Classify each of the following centers by placing an “X” in the appropriate column.

1. In a decentralized organization, upper managers need a way to evaluate the performance of unit managers. Based on factors under the unit manager’s control, organizational units are categorized as cost centers, profit centers, or investment centers. Classify each of the following centers by placing an “X” in the appropriate column.

1. University Hospital provided the following income statement for two of its divisions: Diagnostic and Outpatient.

The CEO of the hospital is not pleased with the division’s performance, and he believes that the Diagnostic division is responsible for its dismal result and wants to consider outsourcing diagnostic procedures.

Required:

The controller has determined that the hospital’s headquarters allocated $98,000 and $32,000 in common administrative fixed costs, respectively, to Diagnostic and Outpatient divisions. Prepare a segment margin income statement that will provide the CEO with a better basis for evaluating the two divisions’ performance. Omit the heading.

Diagnostic: $180,000 − $98,000 = $82,000

Outpatient: $125,000 − $32,000 = $93,000

1. Bethel Corporation provided the following income statement for two of its divisions: North and South.

Required:

The home office allocated common fixed costs of $18,000 to North and $2,000 to South. Prepare a segment margin income statement. Omit the heading.

North: $20,000 − $18,000 = $2,000

South: $10,000 − $2,000 = $8,000

1. Nobles Corporation provided the following income statement for two of its divisions: East and West.

Required:

The home office allocated common fixed costs of $80,000 to East and $60,000 to West. Prepare a segment margin income statement. Omit the heading.

East: $100,000 − $80,000 = $20,000

West: $100,000 − $60,000 = $40,000

1. Bethlehem Corporation had $1,000,000 in sales which resulted in operating income of $62,000. On January 1, Bethlehem reported $920,000 in assets. Because of a downturn in the economy, Bethlehem sold several assets during the year. Its December 31 balance sheet reported only $580,000 in assets.

Required:

1. Calculate Bethlehem’s margin.
2. Calculate Bethlehem’s asset turnover.
3. Calculate Bethlehem’s return on investment.
4. $62,000 ÷ $1,000,000 = 6.2%
5. $1,000,000 ÷ [$920,000 + $580,000) ÷ 2] = 1.3333
6. 0.062 × 1.3333 = 8.27%
7. The Logan Company reported the following operating data for the past year:

Required:

1. Calculate Logan’s margin.
2. Calculate Logan’s asset turnover.
3. Calculate Logan’s ROI.
4. $30,000 ÷ $600,000 = 5%
5. $600,000 ÷ [($250,000 + $150,000) ÷ 2] = 3
6. 5% × 3 = 15%
7. Logan Corporation reported the following operating data for the past year:

Required:

1. Calculate Logan’s margin.
2. Calculate Logan’s asset turnover.
3. Calculate Logan’s ROI.
4. $20,000 ÷ $400,000 = 5%
5. $400,000 ÷ [($150,000 + $170,000) ÷ 2] = 2.5
6. 5% × 2.5 = 12.5%
7. Major Corporation operates a wholesale electrical supply company with two locations. Each location is evaluated as an investment center. Selected results from the latest year are as follows:

Required:

1. Calculate the residual income for Location #1.
2. Calculate the EVA for Location #2.
3. Operating income = $600,000 ̶ $460,000 ̶ $100,000 = $40,000

Residual income = $40,000 – ($890,000 × 10%) = ($49,000)

1. Net operating profit = $800,000 – $660,000 ̶ $80,000 = $60,000 ̶ $16,800 = $43,200

EVA = $43,200 – [($780,000 ̶ $180,000) × 6%] = $7,200

1. University Hospital provided the following segment margin income statements for two of its divisions: Diagnostic and Outpatient. Both divisions are structured as investment centers.

The average assets for the Diagnostic and Outpatient divisions total $400,000 and $600,000, respectively. The required minimum rate of return for both divisions is 10%.

Required:

1. Calculate the current residual income for each division.
2. Why is residual income a better measure of performance for managers of investment centers than the overall profit compared to the flexible budget?
3. Residual income calculations:

Diagnostic $48,000 – ($400,000 × 10%) = $8,000

Outpatient $87,000 – ($600,000 × 10%) = $27,000

1. Residual income is a better performance measure for investment center managers because it considers both the unit’s income and its level of assets. Evaluating on a flexible budget considers only on revenues and expenses, taking away the incentive of generating a return on assets.
2. Nobles Corporation provided the following segment margin income statement for two of its divisions: East and West.

Nobles’ actual weighted-average cost of capital is 10% and its tax rate is 30%. The East division balance sheet showed $300,000 of assets ($60,000 current and $240,000 long-term) and $320,000 of liabilities ($120,000 current and $200,000 long-term). The West division reported $360,000 of assets ($80,000 current and $280,000 long-term) and $260,000 of liabilities ($60,000 current and $200,000 long-term).

Required:

1. Calculate the economic value added for each division.
2. Which of the two managers will be rated higher on performance? Why?
3. EVA calculations for East and West:

East [$40,000 × (1 ̶ 30%)] – [($300,000 ̶ $120,000) × 10%] = $10,000

West [$92,000 × (1 ̶ 30%)] – [($360,000 ̶ $60,000) × 10%] = $34,400

1. The manager of the West division will receive higher performance ratings because the manager has earned a larger profit after covering the cost of operations and the cost of invested capital.
2. Springer Company produces and sells home-ground wheat flour. The flour mill division sells to the general public in its outlet store located at the mill. The mill division also is the supplier of flour for its bakery division located across the street from the flour mill. The following information has been collected by Springer’s controller for the flour mill division:

Production capacity 20,000 pounds

Selling price $0.90 per pound

Variable production cost $0.20 per pound

Variable selling cost $0.08 per pound

The bakery needs 6,000 pounds of flour. If the flour mill transfers flour to the bakery, it can avoid $0.03 of the variable selling cost.

Required:

1. If the flour mill can only sell 12,000 pounds at its outlet store to outside customers, what is the lowest acceptable transfer price per pound that the flour mill division should accept?
2. If the flour mill can sell all 20,000 pounds at its outlet store to outside customers, what is the lowest acceptable transfer price per pound the flour mill division should accept?
3. $0.20 + $0.08 ̶ $0.03 = $0.25
4. ($0.20 + $0.08 ̶ $0.03) + ($0.90 ̶ $0.28) = $0.87
5. The Transformer division of Lorman Industries produces transformers that can be sold to outside customers or transferred to the Electronics division of the company. The following information has been collected by Lorman’s controller:

Production capacity 100,000 units

Selling price $60 per unit

Variable production cost $36 per unit

Variable selling cost $4 per unit

Electronics need 6,000 transformers. If the Transformer division transfers its units to the Electronics division, it can avoid $2 of the variable selling cost.

Required:

1. If the Transformer division can only sell 80,000 units to outside customers, what is the lowest acceptable transfer price that it is willing to accept for the 6,000 units?
2. If the Transformer division can sell all 100,000 units to outside customers, list three courses of actions that the division might consider providing the units to Electronics.
3. $36 + $4 ̶ $2 = $38
4. Alternative courses of action:

• Sell the 6,000 units to Electronics for $60 per unit
• Sell the 6,000 units to Electronics for $58 each [($36 + $4 ̶ $2) + ($60 ̶ $40) = $58
• Negotiate a price that would be acceptable to both divisions

1. The Assembly Division of Mounds Corporation makes a component part that the Packaging Division needs to purchase. The Assembly Division’s variable cost of manufacturing the component is $25 per unit. The component is also available on the open market at a price of $52. The Packaging Division needs 800 units of the component and the Assembly Division has excess capacity of 1,000 units.

Required:

1. Calculate the total cost-based-transfer price that the Assembly division should charge the Packaging division.
2. Calculate the total market-based transfer price that the Assembly division should charge the Packaging division.
3. $25 × 800 units = $20,000
4. $52 × 800 units = $41,600

PROBLEMS

1. Bill Jones Flooring’s accountant, has prepared the following income statement for the month of May.

In preparing the income statement, Bill was unsure what to do with $240,000 in corporate fixed expenses that cannot be traced to a division. Since these costs were incurred to run the business, and he believed that each division benefited equally, he just allocated half to each division.

Required:

a. How do you think Bill should have handled the $240,000 in corporate fixed expenses?

b. Prepare a segment margin income statement that highlights each division’s contribution to corporate profits. Omit the heading.

a. Consistent with the principles of responsibility accounting, it is important that the profit calculation include only those items that are under the manager’s control. Therefore, Bill should remove the common fixed expenses from total fixed expenses, so that only traceable fixed expenses are shown in the segment margin.

b.

1. Jackson Brothers Instruments sells stringed instruments. Trent Jackson, the company’s president, just received the following income statement reporting the results of the past year.

Trent is concerned that two of the company’s divisions are showing a loss, and he wonders if the company should stop selling Banjos and Fiddles to concentrate solely on guitars.

Required:

a. Prepare a segment margin income statement. Omit the heading. Fixed cost of goods sold and fixed operating expenses can be traced to each division.

b. Should Trent close the banjos and fiddles divisions? Why or why not?

c. Trent wants to change the allocation method used to allocate common fixed costs to the divisions. His plan is to allocate these costs based on sales revenue. Will this new allocation method change your decision on whether to close the guitars and fiddles divisions? Why or why not?

b. Trent should not close the Banjos Division, since it has a positive segment margin. Closing the Banjos Division will result in a $30,000 decrease in total operating income. The Fiddles Division generates a negative segment margin, and the company can save $11,000 if it closed. However, the first step is to see if the division can be made profitable.

c. Changing allocation methods will not change the decision on which division to close. Common fixed costs should not be allocated to divisions when making decisions whether to close a division.

1. Tillamoke Company produces gourmet cheeses. Selected results from the most current year were as follows:

Sales revenue $3,500,000

Operating income 560,000

Average total assets 5,000,000

Production manager, Melinda Penland, is investing the purchase of a new fermenting station that will increase the plant’s production capacity. Based on her research, Melinda thinks the station would cost $140,000 and would increase sales revenue by $200,000 and operating profit by $32,000.

Required:

a. Calculate Tillamoke’s current margin, asset turnover, and return on investment.

b. Calculate Tillamoke’s margin, asset turnover, and return on investment assuming the company purchases the new fermenting station.

c. Assume Melinda Penland’s annual bonus is based on the company’s return on investment. Will Melinda support the purchase of the new fermenting station? Why or why not?

a.

ROI = 16% × .7 = 11.20%

b.

ROI = 16% × .72= 11.52%

c. Yes, Melinda will support the purchase of the fermenting station since the new machine will increase her segment’s ROI making it look as if she is performing well.

1. Brian Lochte operates a popular water park. Projections for the current year are as follows:

Sales revenue $8,000,000

Operating income 700,000

Average total assets 4,000,000

The park’s weighted-average cost of capital is 10%, and Brian requires that all new investments generate a return on investment of at least 13%. At last week’s board meeting, Brian told the board that he had up to $50,000 to invest in new facilities at the Park and asked them to recommend some projects. Today the board’s president presented Brian with the following list of three potential investments to improve the park facilities.

Wading Pool Diving Pool Hot Tub

Incremental operating income $ 3,250 $ 4,800 $ 2,700

Average total assets 25,000 45,000 16,000

Required:

a. Calculate the residual income and economic value added for each of the three projects.

b. Which of the three projects do you recommend Brian undertake? Why?

b. Both the wading pool and the hot tub produce positive residual incomes. The diving pool does not, so the investment should not be made. Since the total amount of the investments for the wading pool and the hot tub is $41,000, Brian may want to do both projects. If only one project can be completed, the hot tub provides the best return for the park.

1. Brooke Bundi, president of the Seco Corporation, has mandated a minimum 10% return on investment for any project undertaken by the company. Given the company’s decentralization, Brooke leaves all investment decisions to the divisional managers as long as they anticipate a minimum rate of return of at least 12%. The Flavored Water division, under the direction of manager Karl Martin, has achieved a 14% return on investment for the past three years. This year is not expected to be different from the past three. Martin has just received a proposal to invest $1,700,000 in a new line of flavored water that is expected to generate $221,000 in operating income.

Required:

a. Calculate the residual income for the proposed new line of flavored water.

b. If Karl Martin is evaluated based on residual income, will he choose to invest in the new line of flavored water? Why or why not?

a. Minimum required return = $1,700,000 × 12% = $204,000

Residual income = $221,000 − $204,000 = $17,000

b. Yes, Karl Martin will choose to invest in the new line of flavored water if he is evaluated based on residual income since the investment yields a positive residual income which will make him look as if he is performing well.

1. Gooding Custom Design generated $320,000 in operating income on sales revenue of $2,500,000. The company had $3,000,000 in assets on January 1 and $3,250,000 in assets on December 31.

Required:

a. Calculate Gooding’s margin.

b. Calculate Gooding’s asset turnover.

c. Calculate Gooding’s return on investment.

a. $320,000 ÷ $2,500,000 = 12.8%

b. $2,500,000 ÷ [($3,000,000 + $3,250,000) ÷ 2] = 0.80 times

c. 12.8% × 0.80 = 10.24%

1. The Machining division makes a component part that the Assembly division needs for a new product. The Machining division’s variable cost of manufacturing the component is $25 per unit. The component is also available on the open market at a price of $45 per unit. The Assembly division needs 900 units per year, and the Machining division has excess capacity of 1,000 units.

Required:

a. Determine the cost-based transfer price that the Machining division should charge the Assembly division.

b. Determine the market-based transfer price that the Machining division should charge the Assembly division.

c. What arguments will the Machining division’s manager and the Assembly division’s manager make in an attempt to get the price each wants?

a. $25 + $0 = $25

b. $45

c. The Machining division manager wants to sell the part for $45. He would argue that the value of the part is $45 and that is what the Assembly division should pay. The Machining division’s manager 67does not want to subsidize the operations of the Assembly division.

The Assembly division manager wants to pay as little as possible but knows that the Machining division manager is not willing to suffer a decline in profit on the transfer. The Assembly manager will argue for a $25 price or something in between $25 and $45. Since the Machining division has unused capacity, anything above the $25 variable cost provides an increase to the Machining division’s bottom line.

1. Gil Jargon Corporation produces lawn mowers. The Battery division makes a battery that the Electric Motor division needs for a new product. The Battery division’s variable cost of manufacturing the battery is $16 per unit. The battery is also available on the open market at a price of $21 per unit. The Electric Motor division needs 50,000 batteries per year.

Required:

a. If the Battery Division has adequate excess capacity to supply the 50,000 batteries, what is the minimum transfer price?

b. If the Battery Division has adequate excess capacity to supply the 50,000 batteries, what is the range of prices that is likely to be acceptable to both the Battery division and the Electric Motor division?

a. $16 + $0 = $16

b. Between $16 and $21

1. Before a company makes the decision to change the degree of decentralization, top management must consider the advantages and disadvantages of such a move.

Required:

1. List three advantages of decentralization.
2. List three disadvantages of decentralization.
3. Advantages

• Yields better information for operational decision-making
• Yields more timely information for operational decision-making
• Develops decision-making skills of next generation of top managers
• Allows top managers to focus on strategic planning and decision-making

1. Disadvantages

• Allows conflict between operational decisions and corporate strategy
• Duplicates work efforts across units
• Reduces communication across units
• Increases potential for errors in decisions made by inexperienced managers

1. What are two other terms used in referring to common costs?
2. Where are common allocated fixed costs shown on a segment margin income statement?
3. When do traceable fixed costs become common costs?
4. Two other terms used in referring to common costs are allocated costs and unavoidable costs.
5. Common allocated fixed costs are shown only in the corporate total column. They should not appear in the segment analysis of individual segments.
6. As an organization is broken down into finer segments, costs that were traceable fixed costs at one level may become common fixed costs at a lower level.
7. The DuPont Model decomposes the original ROI formula into two components to show the different choices managers have to improve ROI. What are the terms for the two components and how do you calculate the ratios?

The two components are margin and asset turnover. Margin is calculated by dividing operating income by sales revenue. Asset turnover is calculated by dividing sales revenue by average operating assets.

1. What is EVA and how is it calculated?

Economic Value Added (EVA) is a performance measure that is a variation of residual income that measures “economic profit.” The idea behind this measure is that to create value, a firm must earn enough income both to cover the cost of invested capital and to provide additional income to shareholders. It is calculated by first calculating net operating profit (operating income minus income taxes), calculating invested capital (total assets minus current liabilities), and calculating the weighted-average cost of capital (combined rate of return required by all capital projects). EVA is then calculated by subtracting invested capital times weighted average cost of capital from net operating profit.

192. What is the minimum acceptable transfer price for a division that has excess operating capacity?

The minimum acceptable transfer price for a division with excess operating capacity is the variable cost to produce/ sell plus the contribution margin forgone from not selling to regular customers.

1. What is a transfer price? List the four ways of determining a transfer price.

When organizations choose to decentralize its operations, divisions may end up exchanging goods and services with one another. A transfer price is the price at which the exchange between divisions takes place. The four ways of determining a transfer are:

• Market-based price
• Cost-based price
• Cost-plus-based price
• Negotiated price

ESSAY

1. When a small business begins, it is generally simple for the owner or manager to stay on top of everything going on in the business. However, as the business adds more product lines and locations. and hires more employees, it becomes more and more difficult for top management to remain informed about the company’s activities.

Required:

1. What is decentralization?
2. What are four advantages of decentralization?
3. Identify and describe the three organizational centers of responsibility under a unit manager’s control.
4. Decentralization is an organizational structure in which decision-making authority is dispersed throughout the organization rather than having decision-making authority for the entire organization in the hands of one person or a small group of people in a single location.
5. Four advantages of decentralization are

• Yields better information for operational decision-making
• Yields more timely information for operational decision-making
• Develops decision-making skills of next generation of top managers
• Allows top managers to focus on strategic planning and decision-making

1. The three responsibility centers are:

• Cost center – an organizational unit whose manager is responsible only for the costs incurred in the unit. The goal of the cost center manager is to minimize total costs while providing an acceptable level of service or quality of product. Their managers’ performance is measured largely by comparing the actual costs incurred to the flexible budget.
• Profit center – an organizational unit whose manager is responsible for both the revenue and costs incurred in generating a product or service. Though this unit is expected generate a profit, not just revenues or costs, the manager cannot commit funds to invest in assets. The manager’s performance is typically measured based on the unit’s overall profit compared to the flexible budget.
• Investment center – an organizational unit that is expected to invest in assets that generate profits. Investment center managers have the broadest responsibility of the three types of managers. Though their performance could be evaluated using the same methods as for cost and profit center managers, most organizations use measures such as ROI and residual income.

1. A segment of an organization is any part of the organization that management wishes to evaluate. Segment margin income statements highlight the elements under the segment manager’s control.

Required:

1. What is “segment margin” and how is it calculated?
2. What is the difference between “segment margin” and a segment’s “net operating income?”
3. Why are common allocated fixed costs an issue in evaluating the performance of a segment manager?
4. The segment margin is the amount of operating income under the control of the segment manager. The segment margin excludes all allocated costs. Segment margin is calculated by subtracting only the traceable fixed costs from the contribution margin of the segment.
5. Segment margin is the segment’s contribution margin less traceable fixed costs. Net operating income is the total of segment margins for each segment less common fixed costs. Segment margins relate to each individual segment and net operating income shows relates to the company as a whole.
6. Common allocated fixed costs are an issue in evaluating performance because the segment manager has no control over the common fixed cost. Common fixed costs are not traceable to individual segments.
7. You are assigned to a team responsible for evaluating segment managers’ performance measures. A team member has indicated that a friend who is a manager at a competitor’s company is evaluated using “ROI”, but does not know what “ROI” is.

Required:

1. Explain what ROI is and why it is a useful tool in measuring managers’ performance.
2. Give an example of when ROI would not be an appropriate performance measurement.
3. Return on investment (ROI) measures the rate of return generated by an investment in assets. It is calculated by dividing operating income by average operating assets. It is a useful tool in measuring investment managers’ performance because it includes a review of both revenue and expenses, with a focus on operating income. It also evaluates how well the assets have been used to generate revenue.
4. ROI would not be appropriate in evaluating a cost center manager’s performance because the manager has no control over revenue or how well assets are used to generate revenue. ROI is also not appropriate for a profit center manager’s performance because the manager has no control over how well the assets are used to generate revenue.
5. A disadvantage of evaluating managers’ performance based on ROI is that it can lead to undesirable managerial actions. Residual income can overcome many of the problems of ROI.

Required:

1. Define residual income and explain how it is calculated.
2. What are the shortcomings of residual income? Give an example of when ROI is a better measure than residual income.
3. Residual income is the income that is earned above a specified minimum level of return. As long as a project’s residual income is positive, it is earning a return in excess of the corporate minimum. Residual income is calculated as operating income minus (average assets times the required minimum rate of return).
4. While residual income may appear to solve problems associated with ROI, it has its own shortcomings. Because residual income is an absolute measure that is stated in absolute dollars, using it to compare divisions of different sizes is difficult. In comparing the performance of multiple units, ROI is a better performance measure than residual income, since it is a relative measure. In evaluating a single unit, however, residual income is the better measure of performance.
5. When organizations choose to decentralize their operations, divisions may end up exchanging goods and services with one another rather than with external suppliers or customer. Since managers are evaluated based on how well their divisions perform, they want any transaction with another division to generate positive results.

Required:

Discuss the four ways of determining a transfer price and explain the advantages and disadvantages of each.

The most unbiased transfer price is the market-based price, which is easily determined by monitoring similar trades that occur in the marketplace between unrelated parties. This is the price that the selling division would charge to other customers, and that the buying division would pay to other suppliers. Market-based prices are not always readily available. Without a market price to guide the transfer, the most appropriate price for the sale may not be used.

A second alternative is cost-based price, or the cost to produce the intermediate product. If the selling division is a cost center, this arrangement may be acceptable, but if the division is a profit center, the group’s management will want to earn a profit on the sale.

To provide some level of profit to the seller, the selling and buying divisions may agree to a cost-plus price, in which some markup is added to the product’s cost to arrive at the transfer price. The cost-based and cost-plus based transfer prices do not provide any incentive to the selling division to control costs. This method may work well for the selling division, but it may not be in the best interest of the corporation as a whole if the cost to produce the intermediate product is higher than it really should be.

The fourth option is negotiated price, or one that is agreed upon by both the buying and the selling division. Unlike a dictated cost-plus price, a negotiated price leaves the decision-making to the division managers. This price might be agreeable, but it does not necessarily maximize income for the corporation.