Docstoc

E12-11 _ E12-12 - Home - CSU_ Chico

Document Sample
E12-11 _ E12-12 - Home - CSU_ Chico Powered By Docstoc
					Exercise 12-11:               Working with a Segmented Income Statement
Given:
Marple Associates is a consulting firm that specializes in information systems for
construction and landscaping companies. The firm has two offices -- one in Houston
and one in Dallas. The firm classifies the direct costs of consulting jobs as variable
costs. A segmented contribution format income statement for the company's most
recent year is given below:

                                                                    Office
                                     Total Company        Houston              Dallas
Sales                               $750,000 100.00% $150,000 100.00% $600,000 100.00%
Variable expenses                    405,000  54.00%   45,000   30.00% 360,000       60.00%
Contribution margin                 $345,000  46.00% $105,000   70.00% $240,000      40.00%
Traceable fixed expenses             168,000  22.40%   78,000   52.00%     90,000    15.00%
Market segment margin               $177,000  23.60% $27,000    18.00% $150,000      25.00%
Common fixed expenses
(not traceable to markets)           120,000     16.00%
Net operating income                 $57,000      7.60%

Required:
1. By how much would the company's net operating income increase if Dallas
   increased its sales by $75,000 per year? Assume no change in cost behavior
   patterns.

   Increase in Dallas sale                      $75,000
   Contribution margin ratio                     40.00%
   Increase in Company's NOI                    $30,000

2. Refer to the original data. Assume that sales in Houston increased by $50,000
   next year and that sales in Dallas remain unchanged. Assume no change in
   fixed costs.
   a. Prepare a new segmented income statement for the company using the above
       format. Show both amounts and percentages.

                                                                             Office
                                      Total Company            Houston                     Dallas
       Sales                         $800,000    100.00%   $200,000      100.00%      $600,000      100.00%
       Variable expenses              420,000     52.50%     60,000      30.00%        360,000      60.00%
       Contribution margin           $380,000     47.50%   $140,000      70.00%       $240,000      40.00%
       Traceable fixed expenses       168,000     21.00%     78,000      39.00%         90,000      15.00%
       Market segment margin         $212,000     26.50%    $62,000      31.00%       $150,000      25.00%
       Common fixed expenses
       (not traceable to markets)     120,000     15.00%
       Net operating income           $92,000     11.50%


   b. Observe from the income statement you have prepared that the CM ratio for
      Houston has remained unchanged at 70% (the same as in the above data) but
      that the segment margin ratio has changed. How do you explain the change in
      the segment margin ratio?

       The traceable fixed expenses are spread over a larger base as sales increase.
       Therefore, the segment margin ratio increase from 18% to 31%.

       The contribution margin ratio remains stable at 70% because there is no
       information to suggest that the selling price per unit or the variable cost per
       unit have changed.

Exercise 12-12: Working with a Segmented Income Statement
Given:
Refer to the data in Exercise 12-11. Assume that Dallas' sales by major market

                                                                Dallas: Market Clients
                                       Dallas Office      Construction        Landscaping
Sales                                $600,000 100.00% $400,000 100.00% $200,000 100.00%
Variable expenses                     360,000    60.00% 260,000     65.00% 100,000     50.00%
Contribution margin                  $240,000    40.00% $140,000    35.00% $100,000    50.00%
Traceable fixed expenses               72,000    12.00%   20,000     5.00%   52,000    26.00%
Market segment margin                $168,000    28.00% $120,000    30.00% $48,000     24.00%
Common fixed expenses
(not traceable to markets)             18,000           3.00%
Net operating income                 $150,000          25.00%

The company would like to initiate an intensive advertising campaign in one of the
two markets during the next month. The campaign would cost $8,000. Marketing
studies indicate that such a campaign would increase sales in the construction
market by $70,000 or increase sales in the landscaping market by $60,000.

Required:
1. In which of the markets would you recommend that the company focus its
   advertising campaign?

   The company should focus its campaign on Landscaping Clients.

                                                    Construction                  Landscaping
                                                      Clients                       Clients
       Increased sales from campaign                   $70,000                       $60,000
       CM ratio for market client                       35.00%                        50.00%
       Increase in contribution margin                 $24,500                       $30,000
       Less cost of the campaign                          8,000                        8,000
       Increased segment margin & NOI                  $16,500                       $22,000


2. In Exercise 12-11, Dallas shows $90,000 in traceable fixed expenses. What
   happened to the $90,000 in this exercise?

   The $90,000 of traceable fixed cost to Dallas has been accounted for as follows:


                                                                   Construction                 Landscaping
                                         Dallas                      Clients                      Clients
       Traceable fixed costs              $72,000                      $20,000                     $52,000
       Common fixed expenses
       (not traceable to markets)          18,000
          Total                           $90,000
Exercise 12-13:         Contrasting Return on Investment (ROI) and Residual Income (RI)
Given:
Rains Nickless Ltd. Of Australia has two divisions that operate in Perth and Darwin. Selected
data on the two divisions follow:
                                                        Division
                                                  Perth         Darwin
   Sales                                       $9,000,000 $20,000,000
   Net operating income                          $630,000      $1,800,000
   Average operating assets                    $3,000,000 $10,000,000

Required:
1. Compute the ROI for each division.

   a. ROI = Net operating income / Average operating assets

   b. ROI = margin X turnover
      ROI = (Net operating income / Sales) X (Sales / Average operating assets)

                                                         Division
                                                 Perth          Darwin
                        Margin                    7%               9%
                        Turnover                   3                2
             b.         ROI                      21%              18%
             a.         ROI                      21%              18%

2. Assume that the company evaluates performance using residual income and that the
   minimal required rate of return for each division is 16%. Compute the residual income
   for each division.

   RI = Net operating income - Charge for use of capital
   RI = Net operating income - (Average operating assets X Minimum required rate of return)

                                                        Division
                                                  Perth         Darwin
      Minimum required rate of return             16%             16%
      Net operating income                       $630,000      $1,800,000
      Charge for use of capital                 ($480,000) ($1,600,000)
      Residual income                            $150,000        $200,000

3. Is the Darwin Division's greater residual income an indication that it is better managed?
   Explain.

   No, the Darwin Division is simply larger than the Perth Division and for this reason alone one
   would expect that it would have a greater amount of residual income. In fact, based on the
   data above, the Darwin Division does not appear to be as well managed as the Perth Division.
   The Darwin Division has an 18% return on investment as compared to 21% for the Perth
   Division.

   Residual income can not be used to compare the performance of divisions of different sizes.
   Larger divisions will almost always look better.
rth Division.
Exercise 12-8:         Evaluating New Investment Using ROI and Residual Income (RI)
Given:
Selected sales and operating data for three divisions of three different companies are
given below:

                                              Division A      Division B    Division C
   Sales                                      $6,000,000      $10,000,000   $8,000,000
   Average operating assets                   $1,500,000       $5,000,000   $2,000,000
   Net operating income                         $300,000         $900,000     $180,000
   Minimum required rate of return               15%              18%          12%

Required:
1. Compute the ROI for each division, using the formula stated in terms of margin and turnover.

   a. ROI = Net operating income / Average operating assets

   b. ROI = margin X turnover

      ROI = (Net operating income / Sales) X (Sales / Average operating assets)

                                              Division A      Division B    Division C
            Margin                              5.00%           9.00%         2.25%
            Turnover                               4               2             4
         b. ROI                                20.00%          18.00%         9.00%
         a. ROI                                20.00%          18.00%         9.00%

2. Compute the residual income for each division.

      RI = Net operating income - Charge for use of capital

      RI = Net operating income - (Average operating assets X Minimum required rate of return)

                                              Division A      Division B  Division C
      Net operating income                      $300,000        $900,000    $180,000
      Charge for use of capital                ($225,000)      ($900,000)  ($240,000)
      Residual income                            $75,000               $0   ($60,000)

3. Assume that each division is presented with an investment opportunity that would yield a
   rate of return of 17%.
   a. If performance is being measured by ROI, which division or divisions will probably accept
       the opportunity? Reject? Why?
                                                Division A Division B    Division C
       Current ROI                                 20%        18%            9%
       Investment opportunity return               17%        17%           17%
       Effect on ROI if opportunity is accepted Decrease   Decrease       Increase
       Accept or reject decision                  Reject     Reject        Accept

   b. If performance is being measured by RI, which division or divisions will probably accept
      the opportunity? Reject? Why?

                                              Division A      Division B    Division C
Current RI                                $75,000       $0      ($60,000)
Investment opportunity return               17%        17%        17%
Minimum required rate of return             15%        18%        12%
Effect on RI if opportunity is accepted   Increase   Decrease   Increase
Accept or reject decision                  Accept     Reject     Accept
Exercise 12-20:         Effects of Changes in Profits and Assets on Return on Investment
Given:
The Abs Shoppe is a regional chain of health clubs. The managers of the clubs, who have
authority to make investments as needed, are evaluated based largely on ROI. The Abs Shoppe
reported the following results for the past year:
                                                   Abs
                                                  Shoppe
   Sales                                          $800,000
   Net operating income                            $16,000
   Average operating assets                       $100,000

Required:
The following questions are to be considered independently. Carry out all computations to two
decimal places.
1. Compute the club's ROI

   a. ROI = Net operating income / Average operating assets

   b. ROI = margin X turnover
      ROI = (Net operating income / Sales) X (Sales / Average operating assets)

                                                 Abs
                                               Shoppe
                       Margin                   2.00%
                       Turnover                  8.00
             b.        ROI                     16.00%
             a.        ROI                     16.00%

2. Assume that the manager of the club is able to increase sales by $80,000 and that as a result
   net operating income increases by $6,000. Further assume that this is possible without any
   increase in operating assets. What would be the club's ROI?

                                               Original      Changes         New
   Sales                                       $800,000        $80,000      $880,000
   Net operating income                         $16,000         $6,000       $22,000
   Average operating assets                    $100,000             $0      $100,000

                                                                             Abs
                                                                           Shoppe
                                             Margin                         2.50%
                                             Turnover                        8.80
                                             ROI                           22.00%
                                             ROI                           22.00%

3. Assume that the manager of the club is able to reduce expenses by $3,000 without any
   change in sales or operating assets. What would be the club's ROI?

                                               Original      Changes         New
   Sales                                       $800,000             $0      $800,000
   Net operating income                         $16,000         $3,000       $19,000
   Average operating assets                    $100,000             $0      $100,000
                                                                           Abs
                                                                         Shoppe
                                            Margin                        2.38%
                                            Turnover                       8.00
                                            ROI                          19.00%
                                            ROI                          19.00%

4. Assume that the manager of the club is able to reduce operating assets $20,000 without any
   change in sales or net operating income. What would be the club's ROI?

                                              Original     Changes         New
   Sales                                      $800,000             $0     $800,000
   Net operating income                        $16,000             $0      $16,000
   Average operating assets                   $100,000       ($20,000)     $80,000

                                                                           Abs
                                                                         Shoppe
                                            Margin                        2.00%
                                            Turnover                      10.00
                                            ROI                          20.00%
                                            ROI                          20.00%
Exercise 12-17:        Sales Dollars as an Allocation Base for Fixed Costs
Given:
Lacey's Department Store allocates its fixed administrative expenses to its four operating
departments on the basis of sales dollars. During 2007, the fixed administrative expenses
totaled $900,000. These expenses were allocated as follows:

                                                Men's        Women's        Shoes    Housewares
Total sales -- 2007                             $600,000     $1,500,000   $2,100,000  $1,800,000
Percentage of total sales                            10%            25%          35%         30%

Allocation (based on the above percentages)      $90,000      $225,000      $315,000         $270,000

During 2008, the following year, the Women's Department doubled its sales. The sales levels in the
other three departments remained unchanged. The company's 2008 sales data were as follows:

                                                Men's        Women's        Shoes    Housewares
Total sales -- 2008                             $600,000     $3,000,000   $2,100,000  $1,800,000
Percentage of total sales                             8%            40%          28%         24%

Fixed administrative expenses remained unchanged at $900,000 during 2008.                    $900,000

Required:
1. Using sales dollars as an allocation base, show the allocation of the fixed administrative expenses
   among the four departments for 2008.

                                                Men's        Women's        Shoes      Housewares
                        Allocation for 2008     $72,000       $360,000      $252,000      $216,000

2. Compare your allocation from (1) above to the allocation for 2007. As the manager of the Women's
   Department, how would you feel about the administrative expenses that have been charged to you
   you for 2008?


                                                Men's        Women's        Shoes     Housewares
                        Allocation for 2008      $72,000      $360,000      $252,000     $216,000
                        Allocation for 2007      $90,000      $225,000      $315,000     $270,000
                        Increase/Decrease       ($18,000)     $135,000      ($63,000)    ($54,000)

   The manager of the Women's Department undoubtedly will be upset about the increased allocation
   to the department but will feel powerless to do anything about it. Such an increased allocation may
   viewed as a penalty for an outstanding performance.

   Note: The allocations to all of the other departments decreased.

3. Comment on the usefulness of sales dollars as an allocation base.

   Sales dollars is not ordinarily a good base for allocating fixed costs. The costs allocated to a
   department will be affected by the sales in other departments. In other words, how much fixed
   costs will be allocated to one department depends on the operations of another department.
   Note that if the department managers have bonus plans based on NOI, these managers will receive
   bonus increases because of the increased sales in the Women's Department.
                   Total
                 $6,000,000
                       100%

                  $900,000




                   Total
                 $7,500,000
                       100%




ve expenses


                   Total
                  $900,000

the Women's
arged to you



                   Total
                  $900,000
                  $900,000
                         $0

ed allocation
llocation may




s will receive
Exercise 12-5:       Service Department Charges

Given:
Gutherie Oil Company has a Transport Services department that provides trucks to transport crude
oil from docks to the company's Arbon Refinery and Beck Refinery. Budgeted costs for the transport
services consist of $0.30 per gallon variable cost and $200,000 fixed cost. The level of fixed cost is
determined by peak-period requirements. During the peak period, Arbon Refinery requires 60% of
the capacity and the Beck Refinery requires 40%.

During the year, the Transport Services Department actually hauled the following amounts of crude
oil for the two refineries: Arbon Refinery, 260,000 gallons; and Beck Refinery, 140,000 gallons. The
Transport Services Department incurred $365,000 in cost during the year, of which $148,000 was
variable cost and $217,000 was fixed cost.

       Break-even point: 400
Required:                                                         Total Expenses
                                                                Fixed Expenses
                                                              Total Sales
1. Determine how much of the $148,000 in variable cost should be charged to each refinery.
2. Determine how much of the $217,000 in fixed cost should be charged to each refinery.

                                                               Arbon           Beck           Total
         Peak period capacity needs                                  60%           40%        100%
         Gallons actually hauled                                  260,000       140,000      400,000
         Budgeted variable ($.30/gallon)           $0.30

         Allocation of Variable Costs:                         Arbon           Beck           Total
         Allocation: actual gallons X budgeted rate               $78,000       $42,000       $120,000
         Allocation of Fixed Costs:
         Allocation: Peak period % X budgeted FC                  120,000        80,000        200,000
            Total Costs Allocated                                $198,000      $122,000       $320,000

3. Will any of the $365,000 in the Transport Services Department cost not be charged to the
   refineries?
                                                         Variable Costs Fixed Costs         Total
   Total Transport Services Department Costs Incurred           $148,000      $217,000      $365,000
   Total Transport Services Department Costs Assigned           $120,000       200,000      $320,000
   Total Transport Services Department Costs Unassigned          $28,000       $17,000       $45,000

   The overall spending variance of $45,000 represents costs incurred in excess of the budgeted $.30
   per gallon variable cost and budgeted $200,000 in fixed costs. This $45,000 in unallocated cost is
   the responsibility of the Transport Services Department.
Problem 12-24:
Given:
In cases 1-3 below, assume that Division A has a product that can be sold either to Division B of the same
company or to outside customers. The managers of both divisions are evaluated based on their own
division's ROI. The managers are free to decide if they will participate in any internal transfers. All transfer
prices are negotiated. Treat each case independently.
                                                                                     Cases
                                                                       1             2             3              4
    Division A:
    Capacity in Units                                                 50,000       300,000       100,000         200,000
    Number of units now being sold to outside customers               50,000       300,000        75,000         200,000
    Selling price per unit to outside customers                         $100           $40           $60            $45
    Variable cost per unit                                                 63           19            35             30
    Contribution per unit                                                $37           $21           $25            $15
    Fixed costs per unit (based on capacity)                             $25            $8           $17             $6

   Division B:
   Number of units needed annually                                     10,000           70,000    20,000        60,000
   Purchase price now being paid to an outside supplier                  $92              $39       $60         -
                                                                                                    $57
           Before any purchase discount.

Required:
1. Refer to case 1 above. A study has indicated that Division A can avoid $5 per unit in variable costs on
   any sales to Division B. Will the managers agree to a transfer and if so, within what range will the
   transfer price be? Explain.

   Transfer Price to maximize company profits:
   TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
   TP = ($63 - $5) + ($37 X 10,000)/10,000 = $58 + $37 = $95

   Division A:
   Contribution margin generated per unit under the current situation                                              $37
   Contribution margin generated if a transfer takes place at $95 per unit                                          37
   Division A manager is indifferent to selling outside or transferring to Division B                               $0

   Division B:
   Cost per unit if purchased outside                                                                              $92
   Cost per unit if transferred at $95 per unit                                                                     95
   Division B manager would reject internal transfer because of $3 per unit increase in cost                       ($3)

   The managers will not agree to a transfer.
   Division A will not accept less than $95 and
   Division B will not pay more than $92, the outside price.
   There is no possible range of negotiation within which a transfer could take place.

2. Refer to case 2 above. Assume that Division A can avoid $4 per unit in variable costs on any sales to
   Division B.
   a. Would you expect any disagreement between the two divisional managers over what the transfer
       price should be? Explain.
      Transfer Price to maximize company profits:
      TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
      TP = ($19 - $4) + ($21 X 70,000)/70,000 = $15 + $21 = $36

      Division A:
      Contribution margin generated per unit under the current situation                                              $21
      Contribution margin generated if a transfer takes place at $36 per unit                                          21
      Division A manager is indifferent to selling outside or transferring to Division B                               $0

      Division B:
      Cost per unit if purchased outside                                                                              $39
      Cost per unit if transferred at $36 per unit                                                                     36
      Division B manager would accept an internal transfer because of a $3 decrease in cost                            $3

      The managers should agree to a transfer.
      Division A will be willing to accept a price of $36 or higher
      Division B will be willing to pay no more $39, the outside price.
      The range of negotiation within which a transfer should take place is $39 to $36.

      Even though the company would be better off with any transfer price within this range, each manager
      will negotiate for the transfer price that benefits their division the most. Division A's manager will try to
      hold out for a transfer price of $39, while Division B's manager will try to hold out for a transfer price of
      $36 per unit transferred.

   b. Assume that Division A offers to sell 70,000 units to Division B for $38 per unit and that Division B
      refuses this price. What will be the loss in potential profits for the company as a whole?

      70,000 X $3 =       $210,000

      Proof:
      Division A:
      TP per unit to Division B                                                                                    $38
      Variable cost per unit associated with transfer                                                               15
          Benefit per unit to Division A                                                                           $23
          Less CM given up to make transfer possible                                                                21
          Net per unit benefit to Division A                                                                        $2
          Number of units transferred                                                                           70,000
      Total increase in CM to Division A as a result of transfer                                              $140,000

      Division B:
      Cost per unit if purchased outside                                                                           $39
      Cost per unit if transferred at agreed upon TP                                                                38
          Benefit per unit to Division B                                                                            $1
          Number of units transferred                                                                           70,000
      Total increase in CM to Division A as a result of transfer                                               $70,000

      Total benefit to the company resulting from the transfer                                                $210,000

      Note: Transfer price allocates profit between Division A and Division B.

3. Refer to case 3 above. Assume that Division B is now receiving a 5% price discount from the outside
supplier.
a. Will the managers agree to a transfer? If so, within what range will the transfer price be?

   Transfer Price to maximize company profits:
   TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
   TP = $35 + ($0 X 20,000)/20,000 = $35 + $0 = $35

   Division A:
   Contribution margin generated per unit under the current situation (excess capacity)                               $0
   Contribution margin generated if a transfer takes place at $35 per unit                                             0
   Division A manager is indifferent to selling outside or transferring to Division B                                 $0

   Division B:
   Cost per unit if purchased outside                                                                                 $57
   Cost per unit if transferred at $35 per unit                                                                        35
   Division B manager would accept an internal transfer because of a $22 per unit decrease in cost                    $22

   The managers should agree to a transfer.
   Division A will be willing to accept a price of $35 or higher
   Division B will be willing to pay no more $57, the outside price.
   The range of negotiation within which a transfer should take place is $35 to $57.

   Even though the company would be better off with any transfer price within this range, each manager
   will negotiate for the transfer price that benefits their division the most. Division A's manager will try to
   hold out for a transfer price of $57, while Division B's manager will try to hold out for a transfer price of
   $35 per unit transferred.

b. Assume that Division B offers to purchase 20,000 units from Division A at $52 per unit. If Division A
   accepts this price, would you expect its ROI to increase, decrease, or remain unchanged? Why?

   Benefit to company as a whole resulting from transfers                   20,000 X $22 =                 $440,000

   Division A:
   TP per unit to Division B                                                                                    $52
   Variable cost per unit associated with transfer                                                               35
       Benefit per unit to Division A                                                                           $17
       Less CM given up to make transfer possible                                                                 0
       Net per unit benefit to Division A                                                                       $17
       Number of units transferred                                                                           20,000
   Total increase in CM to Division A as a result of transfer                                              $340,000

   Effect on ROI: Divisional income will increase by $340,000 with no change
   in investment (excess capacity). Thus, Division A's ROI will increase.

   Division B:
   Cost per unit if purchased outside                                                                           $57
   Cost per unit if transferred at agreed upon TP                                                                52
       Benefit per unit to Division B                                                                            $5
       Number of units transferred                                                                           20,000
   Total increase in CM to Division A as a result of transfer                                              $100,000
       Total benefit to the company resulting from the transfer                                     $440,000

       Note: Transfer price allocates profit between Division A and Division B.

4. Refer to case 4 above. Assume that Division B wants Division A to provide it with 60,000 units of a
   different product from the one that Division A is now producing. The new product would require $25
   per unit in variable costs and would require that Division A cut back production of its present product by
   30,000 units annually. What is the lowest acceptable transfer price from Division A's perspective?

   Transfer Price to maximize company profits:
   TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
   TP = $25 + ($15 X 30,000) / 60,000 = $25 + ($450,000 / 60,000) = $25 + $7.50 = $32.50

				
DOCUMENT INFO