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Lecture

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ACCT 1022
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Ken Porter

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Chapter 13 - Investment Centers and Transfer Pricing CHAPTER 13 Investment Centers and Transfer Pricing ANSWERS TO REVIEW QUESTIONS 13-1 The managerial accountant's primary objective in designing a responsibility- accounting system is to provide incentives for the organization's subunit managers to strive toward achieving the organization's goals. 13-2 Goal congruence means a meshing of objectives, in which the managers throughout an organization strive to achieve goals that are consistent with the goals set by top management. Goal congruence is important for organizational success because managers often are unaware of the effects of their decisions on the organization's other subunits. Also, it is natural for people to be more concerned with the performance of their own subunit than with the effectiveness of the entire organization. In order for the organization to be effective, it is important that everyone in it be striving for the same ultimate objectives. 13-3 Under the management-by-objectives (MBO) philosophy, managers participate in setting goals that they then strive to achieve. These goals may be expressed in financial or other quantitative terms, and the responsibility-accounting system is used to evaluate performance in achieving them. The MBO approach is consistent with an emphasis on obtaining goal congruence throughout an organization. 13-4 An investment center is a responsibility-accounting center, the manager of which is held accountable not only for the investment center's profit but also for the capital invested to earn that profit. Examples of investment centers include a division of a manufacturing company, a large geographical territory of a hotel chain, and a geographical territory consisting of several stores in a retail company. 13-5 income income sales revenue Return on investment (ROI) = = × invested capital sales revenue invested capital 13-6 A division's ROI can be improved by improving the sales margin, by improving the capital turnover, or by some combination of the two. The manager of the Automobile Division of an insurance company could improve the sales margin by increasing the profit margin on each insurance policy sold. As a result, every sales dollar would generate more income. The capital turnover could be improved by increasing sales of insurance policies while keeping invested capital fixed, or by decreasing the invested assets required to generate the same sales revenue. 13-1 Chapter 13 - Investment Centers and Transfer Pricing 13-7 Example of the calculation of residual income: Suppose an investment center's profit is $100,000, invested capital is $800,000, and the imputed interest rate is 12 percent: investment center's imputed  Residual income = investment center'sprofit −  ×   invested capital interest rat Residual income = $100,000 − ($800,000) (12%) = $4,000 The imputed interest rate is used in calculating residual income, but it is not used in computing ROI. The imputed interest rate reflects the firm's minimum required rate of return on invested capital. 13-8 The chief disadvantage of ROI is that for an investment that earns a rate of return greater than the company's cost of raising capital, the manager in charge of deciding about that investment may have an incentive to reject it if the investment would result in reducing the manager's ROI. The residual-income measure eliminates this disadvantage by including in the residual-income calculation the imputed interest rate, which reflects the firm's cost of capital. Any project that earns a return greater than the imputed interest rate will show a positive residual income. 13-9 The rise in ROI or residual income across time results from the fact that periodic depreciation charges reduce the book value of the asset, which is generally used in determining the investment base to use in the ROI or residual-income calculation. This phenomenon can have a serious effect on the incentives of investment-center managers. Investment centers with old assets will show higher ROIs than investment centers with relatively new assets. This result can discourage investment-center managers from investing in new equipment. If this behavioral tendency persists for a long time, a division's assets can become obsolete, making the division uncompetitive. 13-10 The economic value added (EVA) is defined as follows: Economic Investmenc tenters' Investment Investment  Weighted -average  value = after-tax −  centers' − centers'  × costof  added operatingincome totalassets currentliabilitse capital     Residual income = investment center'sprofit − investment center's × imputed   invested capital interest rat Economic value added differs from residual income in its subtraction of the investment center’s current liabilities and its specific use of the weighted-average cost of capital. 13-2 Chapter 13 - Investment Centers and Transfer Pricing 13-11 a. Total assets: Includes all divisional assets. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets, including nonproductive assets. b. Total productive assets: Excludes assets that are not in service, such as construction in progress. This measure is appropriate when a division manager is directed by top management to keep nonproductive assets, such as vacant land or construction in progress. c. Total assets less current liabilities: All divisional assets minus current liabilities. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. This approach encourages investment-center managers to minimize resources tied up in assets and maximize the use of short-term credit to finance operations. 13-12 The use of gross book value instead of net book value to measure a division's invested capital eliminates the problem of an artificially increasing ROI or residual income across time. Also, the usual methods of computing depreciation, such as straight-line or declining-balance methods, are arbitrary. As a result, some managers prefer not to allow these depreciation charges to affect ROI or residual-income calculations. 13-13 It is important to make a distinction between an investment center and its manager, because in evaluating the manager's performance, only revenues and costs that the manager can control or significantly influence should be included in the profit measure. The objective of the manager's performance measure is to provide an incentive for that manager to adhere to goal-congruent behavior. In evaluating the investment center as a viable economic investment, all revenues and costs that are traceable to the investment center should be considered. Controllability is not an issue in this case. 13-14 Pay for performance is a one-time cash payment to an investment-center manager as a reward for meeting a predetermined criterion on a specified performance measure. The objective of pay for performance is to get the manager to strive to achieve the performance target that triggers the payment. 13-15 An alternative to using ROI or residual income to evaluate a division is to look at its income and invested capital separately. Actual divisional profit for a period of time is compared to a flexible budget, and variances are used to analyze performance. The division's major investments are evaluated through a postaudit of the investment decisions. This approach avoids the necessity of combining profit and invested capital in a single measure, such as ROI or residual income. 13-3 Chapter 13 - Investment Centers and Transfer Pricing 13-16 During periods of inflation, historical-cost asset values soon cease to reflect the cost of replacing those assets. Therefore, some accountants argue that investment-center performance measures based on historical-cost accounting are misleading. Most managers, however, believe that measures based on historical-cost accounting are adequate when used in conjunction with budgets and performance targets. 13-17 Examples of nonfinancial measures that could be used to evaluate a division of an insurance company include the following: (1) new policies issued and insurance claims settled in a specified period of time, (2) average time required to settle an insurance claim, and (3) number of insurance claims settled without litigation versus claims that require litigation. 13-18 Nonfinancial information is useful in measuring investment-center performance because it gives top management insight into the summary financial measures such as ROI or residual income. By keeping track of important nonfinancial data, top managers often can see a problem developing before it becomes a serious problem. For example, if a manufacturer's rate of defective products has been increasing over some period of time, management can observe this phenomenon and take steps to improve product quality before serious damage is done to customer relations. 13-19 The goal in setting transfer prices is to establish incentives for autonomous division managers to make decisions that support the overall goals of the organization. Transfer prices should be chosen so that each division manager, when striving to maximize his or her own division's profit, makes the decision that maximizes the company's profit. 13-20 Four methods by which transfer prices may be set are as follows: (a) Transfer price = additional outlay costs incurred because goods are transferred + opportunity costs to the organization because of the transfer. (b) Transfer price = external market price. (c) Transfer prices may be set on the basis of negotiations among the division managers. (d) Transfer prices may be based on the cost of producing the goods or services to be transferred. 13-21 When the transferring division has excess capacity, the opportunity cost of producing a unit for transfer is zero. 13-4 Chapter 13 - Investment Centers and Transfer Pricing 13-22 The management of a multinational company has an incentive to set transfer prices so as to minimize the income reported for divisions in countries with relatively high income-tax rates, and to shift this income to divisions with relatively low income-tax rates. Some countries' tax laws prohibit this practice, while other countries' laws permit it. 13-23 Multinational firms may be charged import duties, or tariffs, on goods transferred between divisions in different countries. These duties often are based on the reported value of the transferred goods. Such companies may have an incentive to set a low transfer price in order to minimize the duty charged on the transferred goods. SOLUTIONS TO EXERCISES EXERCISE 13-24 (10 MINUTES) income $4,000,000 Sales margin = sales revenue = $50,000,00 0 = 8% sales revenue $50,000,00 0 Capital turnover = invested capital = $20,000,00 0 = 2.5 income $4,000,000 Return on investment = invested capital = $20,000,00 0 = 20% EXERCISE 13-25 (15 MINUTES) There are an infinite number of ways to improve the division's ROI to 25 percent. Here are two of them: 1. Improve the sales margin to 10 percent by increasing income to $5,000,000: 13-5 Chapter 13 - Investment Centers and Transfer Pricing ROI = sales margin × capital turnover $5,000,000×$50,000,00 = $50,000,00 $20,000,00 = 10% × 2.5 = 25% Since sales revenue remains unchanged, this implies a cost reduction of $1,000,000 at the same volume. 2. Improve the turnover to 3.125 by decreasing average invested capital to $16,000,000: ROI = sales margin × capital turnover $4,000,000×$50,000,00 = $50,000,00 $16,000,00 = 8% × 3.125 = 25% Since sales revenue remains unchanged, this implies that the firm can divest itself of some productive assets without affecting sales volume. EXERCISE 13-26 (5 MINUTES) Residual = investment center income –inves iedpued income  ×  capiit atlratst = $4,000,000 – ($20,000,000 × 11%) = $1,800,000 EXERCISE 13-27 (15 MINUTES) The weighted-average cost of capital (WACC) is defined as follows: 13-6 Chapter 13 - Investment Centers and Transfer Pricing akkett dfqlliy abttll ooMarkeet cavalle efbtity Chapter 13 - Investment Centers and Transfer Pricing The interest rate on Golden Gate Construction Associates’ $60 million of debt is 10 percent, and the company’s tax rate is 40 percent. Therefore, Golden Gate’s after-tax cost of debt is 6 percent [10% × (1−40%)]. The cost of Golden Gate’s equity capital is 15 percent. Moreover, the market value of the company’s equity is $90 million. The following calculation shows that Golden Gate’s WACC is 11.4 percent. Weighted - average = (.06)($60, 000,000) + (.15)($90, 000,0= .114 cost of capital $60,000,00 0 + $90,000,00 0 EXERCISE 13-28 (20 MINUTES) The economic value added (EVA) is defined as follows: Economic Investmenc tenter'  Investment Investment  Weighted -average  value = after-tax −  centers' − centers'  × costof  added operatingincome  totalassets currentliabilitse capital     For Golden Gate Construction Associates, we have the following calculations of each division’s EVA. After-Tax Economic Operating Total Assets Current Value Income Liabilities Added Division (in millions) (in millions) (in millions) WACC (in millions) Real Estate $20(1−.40) − $100 − $6 × .114 = $1.284 Construction $18(1−.40) − $ 60 − $4 × .114 = $4.416 EXERCISE 13-29 (30 MINUTES) 1. Average investment in productive assets: Balance on 12/31/x1.......................................................$12,600,000..................... Balance on 1/1/x1 ($12,600,000 ÷ 1.05)........................................................ Beginning balance plus ending balance.....................................$24,600,000...... Average balance ($24,600,000 ÷ 2)............................................................... 13-8 Chapter 13 - Investment Centers and Transfer Pricing income from operations before income taxes a. ROI = average productive assets $2,460,000 = $12,300,00 0 = 20% b. Income from operations before income taxes..................................$ 2,460,000 Less: imputed interest charge: Average productive assets................................$12,300,000 Imputed interest rate................................................. ×    .15 Imputed interest charge....................................................1,845,000....... Residual income..............................................................$ 615,000.............. EXERCISE 13-29 (CONTINUED) 2. Yes, Fairmont’s management probably would have accepted the investment if residual income were used. The investment opportunity would have lowered Fairmont’s 20x1 ROI because the project's expected return (18 percent) was lower than the division's historical returns (19.3 percent to 22.1 percent) as well as its actual 20x1 ROI (20 percent). Management may have rejected the investment because bonuses are based in part on the ROI performance measure. If residual income were used as a performance measure (and as a basis for bonuses), management would accept any and all investments that would increase residual income (i.e., a dollar amount rather than a percentage) including the investment opportunity it had in 20x1. 3. In the electronic version of the solutions manual, press the CTRL key and click on the following link: Build a Spreadsheet 13-29.xls EXERCISE 13-30 (30 MINUTES) 1. Students’ calculation of return on investment and residual income will depend on the company selected and the year when the internet search is conducted. Students will need to decide how to determine the income and the invested assets to use in both calculations. The discussion in the text will serve as a guide in this regard. 13-9 Chapter 13 - Investment Centers and Transfer Pricing 2. Some companies’ annual reports include a calculation and discussion of ROI in the “management report and analysis” section or the “financial highlights” section. Students’ calculation of ROI may differ from management’s due to differing assumptions about the determination of income and invested capital. EXERCISE 13-31 (15 MINUTES) Memorandum Date: Today To: President, Sun Coast Food Centers From: I. M. Student Subject: Behavior of ROI over time When ROI is calculated on the basis of net book value, it will typically increase over time. The net book value of the bundle of assets declines over time as depreciation is recorded. The income generated by the bundle of assets often will remain constant or increase over time. The result is a steady increase in the ROI, as income remains constant (or increases) and book value declines. This effect will not exist (or at least will not be as pronounced) if the firm continues to invest in new assets at a roughly steady rate across time. EXERCISE 13-32 (10 MINUTES) 1. The same employee is responsible for keeping the inventory records and taking the physical inventory count. In addition, when the records and the count do not agree, the employee changes the count, rather than investigating the reasons for the discrepancy. This leaves open the possibility that the employee would steal inventory and conceal the theft by altering both the records and the count. Even without any dishonesty by the employee, this system is not designed to control inventory since it does not encourage resolution of discrepancies between the records and the count. 2. The internal control system could be strengthened in two ways: (a) Assign two different employees the responsibilities for the inventory records and the physical count. With this arrangement, collusion would be required for theft to be concealed. 13-10 Chapter 13 - Investment Centers and Transfer Pricing (b) Require that discrepancies between the inventory records and the physical count be investigated and resolved when possible. EXERCISE 13-33 (15 MINUTES) income £ 100,000 * 1. Sales margin = sales revenue = £ 2,000,000 = 5% *Income = £100,000 = £2,000,000 – £1,100,000 – £800,000 sales revenue £ 2,000,000 Capital turnover = invested capital = £ 1,000,000 = 2 income 100,000 ROI = invested capital = ££ 1,000,000 = 10% income income 2. ROI = 15% = invested capital = £ 1,000,000 Income = 15% × £1,000,000 = £150,000 Income = sales revenue – expenses = £150,000 Income = £2,000,000 – expenses = £150,000 Expenses = £1,850,000 Therefore, expenses must be reduced to £1,850,000 in order to raise the firm's ROI to 15 percent. £ income 150,000 = 7.5% 3. Sales margin = sales revenue = £ 2,000,000 ROI = sales margin × capital turnover = 7.5% × 2 = 15% 13-11 Chapter 13 - Investment Centers and Transfer Pricing EXERCISE 13-34 (10 MINUTES) 1. outlay opportunity Transfer price = cost + cost † = $300* + $80 = $380 *Outlay cost = unit variable production cost † Opportunity cost = forgone contribution margin = $380 – $300 = $80 2. If the Fabrication Division has excess capacity, there is no opportunity cost associated with a transfer. Therefore: outlay opportunity Transfer price = cost + cost = $300 + 0 = $300 EXERCISE 13-35 (25 MINUTES) 1. The Assembly Division's manager is likely to reject the special offer because the Assembly Division's incremental cost on the special order exceeds the division's incremental revenue: Incremental revenue per unit in special order........................ $465 Incremental cost to Assembly Division per unit in special order: Transfer price....................................................$374.............. Additional variable cost...........................................100........ Total incremental cost.............................................................. 474 Loss per unit in special order.................................................. $ (9) EXERCISE 13-35 CONTINUED) 2. The Assembly Division manager's likely decision to reject the special order is not in the best interests of the company as a whole, since the company's incremental revenue on the special order exceeds the company's incremental cost: Incremental revenue per unit in special order..................... $465 Incremental cost to company per unit in special order: Unit variable cost incurred in Fabrication Division......... $300 13-12 Chapter 13 - Investment Centers and Transfer Pricing Unit variable cost incurred in Assembly Division........... 100 Total unit variable cost.......................................................... 400 Profit per unit in special order.............................................. $ 65 3. The transfer price could be set in accordance with the general rule, as follows: Transfer price = outlay + opportunity cost cost = $300 + 0* = $300 *Opportunity cost is zero, since the Fabrication Division has excess capacity. Now the Assembly Division manager will have an incentive to accept the special order since the Assembly Division's incremental revenue on the special order exceeds the incremental cost. The incremental revenue is still $465 per unit, but the incremental cost drops to $400 per unit ($300 transfer price + $100 variable cost incurred in the Assembly Division). SOLUTIONS TO PROBLEMS PROBLEM 13-36 (25 MINUTES) The answer to the question as to which division is the most successful depends on the firm's cost of capital. To see this, compute the residual income for each division using various imputed interest rates. (a) Imputed interest rate of 10%: Division I Division II Divisional profit................................................$900,000.......$200,000 Less: Imputed interest charge: I: $6,000,000 × 10%................................................ II: $1,000,000 × 10%................................................  100,000 Residual income..................................................$300,000.......$100,000 (b) Imputed interest rate of 14%: Division I Division II Divisional profit................................................$900,000.......$200,000 Less: Imputed interest charge: I: $6,000,000 × 14%................................................ 13-13 Chapter 13 - Investment Centers and Transfer Pricing II: $1,000,000 × 14%................................................_  140,000 Residual income......................................................$ 60,000..... $ 60,000 (c) Imputed interest rate of 15%: Divisional profit.....................................................$900,000.......$200,000 Less: Imputed interest charge: I: $6,000,000 × 15%................................................000 II: $1,000,000 × 15%................................................_ 150,000 Residual income.......................................................$.......0... $ 50,000   If the firm's cost of capital is 10 percent, then Division I has a higher residual income than Division II. With a cost of capital of 15 percent, Division II has a higher residual income. At a 14 percent cost of capital, both divisions have the same residual income. This scenario illustrates one of the advantages of residual income over ROI. Since the residual income calculation includes an imputed interest charge reflecting the firm's cost of capital, it gives a more complete picture of divisional performance. PROBLEM 13-37 (45 MINUTES) Division A Division B Division C a l Sales revenue............................................$2,000,000... $10,000,000 $ 800,000 Income....................................................$ 400,000 $ 2,000,000 $ 200,000 k Average investment.......................................$2,000,000 b $ 2,500,000 $1,000,000 j Sales margin ....................................................20%.. 20% e 25% f i Capital turnover....................................................1c g .8 ROI.............................................................20%.......... 80% 20% Residual income...........................................$ 240,000 d $ 1,800,000 h $ 120,000 Explanatory notes: income aSales margin = sales revenue $400,000 20% = sales revenue Therefore, sales revenue = $2,000,000 13-14 Chapter 13 - Investment Centers and Transfer Pricing sales revenue bCapital turnover = invested capital $2,000,000 1 = invested capital Therefore, invested capital = $2,000,000 cROI = sales margin × capital turnover  ROI = 20% × 1 = 20% d Residual income = income – (imputed interest rate)(invested capital) = $400,000 – (8%)($2,000,000) = $240,000 e Sales margin = income = $2,000,000 = 20% sales revenue $10,000,00 0 PROBLEM 13-37 (CONTINUED) Capital turnover = sales revenue = $10,000,00 0 = 4 f invested capital $2,500,000 g ROI = sales margin × capital turnover = 20% × 4 = 80% h Residual income = income – (imputed interest rate)(invested capital) = $2,000,000 – (8%)($2,500,000) = $1,800,000 ROI = sales margin × capital turnover 20% = 25% × capital trunover Therefore, capital turnover = .8 income ROI = invested capital = 20% Therefore, income = (20%)(invested capital) 13-15 Chapter 13 - Investment Centers and Transfer Pricing Residual = income – (imputed interest rate)(invested capital) income = $120,000 Substituting from above for income: (20%)(invested capital) – (8%)(invested capital) = $120,000 Therefore, (12%)(invested capital) = $120,000 So, invested capital = $1,000,000 income kROI = investedcapital income 20% = $1,000,000 Therefore, income = $200,000 income Sales margin = salesrevenue $200,000 25% = salesrevenue Therefore, sales revenue = $800,000 PROBLEM 13-38 (20 MINUTES) 1. Three ways to increase Division B's ROI: (a) Increase income, while keeping invested capital the same. Suppose income increases to $2,250,000. The new ROI is: income $2,250,000 ROI= investedcapital= $2,500,000 = 90% (b) Decrease invested capital, while keeping income the same. Suppose invested capital decreases to $2,400,000. The new ROI is: income $2,000,000 ROI = = = 83.3%(rounded) investedcapital $2,400,000 (c) Increase income and decrease invested capital. Suppose income increases to $2,100,000 and invested capital decreases to $2,400,000. The new ROI is: 13-16 Chapter 13 - Investment Centers and Transfer Pricing income $2,100,000 ROI= = = 87.5% investedcapital $2,400,000 2. ROI = sales margin × capital turnover = 25% × 1 = 25% PROBLEM 13-39 (25 MINUTES) This problem is similar to Problem 13-36, except that here students are given a hint in answering the question about which division is the most successful by requiring the calculation of residual income for three different imputed interest rates. If the firm's cost of capital is 12 percent, then Division I has a higher residual income than Division II. With a cost of capital of 15 percent or 18 percent, Division II has a higher residual income. 1. Imputed interest rate of 12% Division I Division II Divisional profit................................................$900,000......$200,000 Less: Imputed interest charge: I: $6,000,000 × 12%................................................        120,000 II: $1,000,000 × 12%................................................ Residual income..................................................$180,000......$ 80,000 2. Imputed interest rate of 15% Division I Division II Divisional profit................................................$900,000......$200,000 Less: Imputed interest charge: I: $6,000,000 × 15%................................................. II: $1,000,000 × 15%.................................................   150,000 Residual income..................................................$.......0.....$ 50,000 13-17 Chapter 13 - Investment Centers and Transfer Pricing PROBLEM 13-39 (CONTINUED) 3. Imputed interest rate of 18% Division I Division II Divisional profit...........................................$ 900,000......$200,000.... Less: Imputed interest charge: I: $6,000,000 × 18%................................................... II: $1,000,000 × 18%...................................................0,000 Residual income.............................................$(180,000).....$ 20,000 The imputed interest rate r, at which the two divisions’ residual income is the same, is 14 percent, computed as follows: Division II’s residual = Division I's residual income income $200,000 – (r)($1,000,000) = $900,000 – (r)($6,000,000) (r)($5,000,000) = $700,000 r = $700,000/$5,000,000 r = 14% For any imputed interest rate less than 14 percent, Division I will have a higher residual income. For any rate over 14 percent, Division II's residual income will be higher. PROBLEM 13-40 (40 MINUTES) ROI ROI Based Based Average on Income Income Average on Gross Gross Before Annual Net of Net Book Net Book† Book Book Year Depreciation Depreciation Depreciation Value* Value Value Value 1 $150,000 $200,000 $(50,000) $400,000 — $500,000 — 2 150,000 120,000 30,000 240,000 12.5% 500,000  6.0% 3 150,000 72,000 78,000 144,000 54.2% 500,000 15.6% 4 150,000 54,000 96,000 81,000 118.5% 500,000 19.2% 5 150,000 54,000 96,000 27,000 355.6% 500,000 19.2% *Average net book value is the average of the beginning and ending balances for the year in net book value. In Year 1, for example, the average net book value is: $500,000 + $300,000 = $400,000 2 13-18 Chapter 13 - Investment Centers and Transfer Pricing †ROI rounded to the nearest tenth of 1 percent. 1. This table differs from Exhibit 13-3 in that ROI rises even more steeply across time than it does in Exhibit 13-3. With straight-line depreciation, ROI rises from 11.1 percent in Year 1 to 100 percent in Year 5. Under the accelerated depreciation schedule used here, we have a loss in Year 1 and then ROI rises from 12.5 percent in Year 2 to 355.6 percent in Year 5. 2. One potential implication of such an ROI pattern is a disincentive for new investment. If a proposed capital project shows a loss or very low ROI in its early years, a manager may worry about the effect on his or her performance evaluation in the early years of the project. In an extreme case, a manager may worry that he or she will no longer have the job when the project begins to show a higher return in its later years. 13-19 Chapter 13 - Investment Centers and Transfer Pricing PROBLEM 13-41 (40 MINUTES) Based on Net Book Value Based on Gross Book Value Average Income Income Average Imputed Gross Imputed Before Annual Net of Net Book Interes† Residual Book Interes† Residual Year Depreciation Depreciation Depreciation Value* Charge Income Value Charge Income 1 $150,000 $100,000 $50,000 $450,000 $45,000 $ 5,000 $500,000 $50,000   0 2 150,000 100,000 50,000 350,000 35,000 15,000 500,000 50,000   0 3 150,000 100,000 50,000 250,000 25,000 25,000 500,000 50,000   0 4 150,000 100,000 50,000 150,000 15,000 35,000 500,000 50,000   0 5 150,000 100,000 50,000 50,000 5,000 45,000 500,000 50,000   0 *Average net book value is the average of the beginning and ending balances for the year in net book value. † Imputed interest charge is 10 percent of the average book value, either net or gross. Notice in the table that residual income, computed on the basis of net book value, increases over the life of the asset. This effect is similar to the one demonstrated for ROI. It is not very meaningful to compute residual income on the basis of gross book value. Notice that this asset shows a zero residual income for all five years when the calculation is based on gross book value. 13-20 Chapter 13 - Investment Centers and Transfer Pricing PROBLEM 13-42 (35 MINUTES) 1. Current ROI of the Northeast Division: Sales revenue…………………………………… $8,400,000 Less: Variable costs ($8,400,000 x 70%)…… $5,880,000 Fixed costs……………………………….. 2,150,000 8,030,000 Income…………………………………………….. $ 370,000 ROI = Income ÷ invested capital = $370,000 ÷ $1,850,000 = 20% Northeast’s ROI if competitor is acquired: Sales revenue ($8,400,000 + $5,200,000)……. $13,600,000 Less: Variable costs [$5,880,000 + ($5,200,000 x 65%)]………………… $9,260,000 Fixed costs ($2,150,000 + $1,670,000)..3,820,000 13,080,000 Income……………………………………………... $ 520,000 ROI = Income ÷ invested capital = $520,000 ÷ [$1,850,000 + ($625,000 + $375,000)] = 18.25% 2. Divisional management will likely be against the acquisition because ROI will be lowered from 20% to 18.25%. Since bonuses are awarded on the basis of ROI, the acquisition will result in less compensation. 3. An examination of the competitor’s financial statistics reveals the following: Sales revenue…………………………………….. $5,200,000 Less: Variable costs ($5,200,000 x 65%)…….. $3,380,000 Fixed costs ……………………………….. 1,670,000 5,050,000 Income……………………………………………... $ 150,000 ROI = Income ÷ invested capital = $150,000 ÷ $625,000 = 24% 13-21 Chapter 13 - Investment Centers and Transfer Pricing PROBLEM 13-42 (CONTINUED) Corporate management would probably favor the acquisition. Megatronoics has been earning a 13% return, and the competitor’s ROI of 24% will help the organization as a whole. Even if the $375,000 upgrade is made, the competitor’s ROI would be 15% if past earnings trends continue [$150,000 ÷ ($625,000 + $375,000) = 15%]. 4. Yes, the divisional ROI would increase to 21.01%. However, the absence of the upgrade could lead to long-run problems, with customers being confused (and perhaps turned-off) by two different retail environments—the retail environment they have come to expect with other Megatronics outlets and that of the newly acquired, non-upgraded competitor. Sales revenue ($8,400,000 + $5,200,000)……. $13,600,000 Less: Variable costs [$5,880,000 + ($5,200,000 x 65%)]………………… $9,260,000 Fixed costs ($2,150,000 + $1,670,000)...3,820,000 13,080,000 Income……………………………………………... $ 520,000 ROI = Income ÷ invested capital = $520,000 ÷ ($1,850,000 + $625,000) = 21.01% 5. Current residual income of the Northeast Division: Divisional profit……………………………………………… $370,000 Less: Imputed interest charge ($1,850,000 x 12%)…… 222,000 Residual income…………………………………………….. $148,000 Residual income if competitor is acquired: Divisional profit ($370,000 + $150,000)……………... $520,000 Less: Imputed interest charge [($1,850,000 +
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