# Profit Center Accounting Pros

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```					          Assignment 2
For the course

ACCT 615 – Management Accounting

(Summer)

Submitted by

Ashok Ambashanker
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

Chapter 4

NP 4.2

Which type of customer is more profitable for the bank?

Bank charge to college students = \$0.10 per check

Bank charge to Regular customers = \$0 per check

Average deposit for college students = \$300

Average deposit for regular customers = \$1,000

Average number of checks written by college students = 100 per year

Interest rate earned by bank on deposits = 10%

Interest rate paid by bank to customers = 5%

Other costs (accounting and mailing) = \$20

College student

Revenue for bank from college student = Income from checks + Interest from deposits

= 100 x 0.10 + 300 x 0.10

= 10 + 30 = \$40

Cost to bank due to college student = Interest paid + Other costs = 300 x 0.05 + 20

= 15 + 20 = \$35

Net benefit from college student = Revenue - Cost = 40-35 = \$5

Regular customers

Revenue for bank from regular customer = Interest from deposits = 1000 x 0.1 = 100

Cost to bank due to regular customer = Interest paid + Other costs = 1000 x 0.05 + 20

= 50 + 20 = \$70

Net benefit from regular customer = Revenue - Cost = 100 - 70 = \$30

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Comparing the net benefits, we see that the bank gains \$5 from a college student vs. \$30

from a regular customer.

Hence, the type of customer more profitable for the bank is the ‘regular customer’.

NP 4.4

At what output level should the firm operate?

Following table summarizes the added value, incremental revenue and incremental cost at

various production levels at Measer Enterprises:

Units    Revenue         Cost       Value          Revenue               Cost
10000          45000       58000         -13000                  45000            58000
11000          49500       62400         -12900                   4500             4400
12000          54000       67000         -13000                   4500             4600
13000          58500       71600         -13100                   4500             4600

The added value (Total Revenue - Total Cost) to the firm is highest when 11,000 units

are produced. Hence output level at which the firm should operate is 11,000 units.

Also, going by the incremental costs and incremental revenue - by increasing

production from 10,000 units to 11,000 units the incremental revenue is \$4,500 and

incremental cost of \$4,400, as against incremental revenue of \$4,500 and incremental

cost of \$4,600 at 12,000 and 13,000 units. Hence an output of 11,000 units is preferable

as only at this level incremental cost is lower than the incremental revenue.

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NP 4.7

a) If prices are set at 12% above cost, what is the profit of the grocery store for the

year?

Fixed cost = \$800,000

Cost of inventory = 1,000,000 x 8

= 8,000,000

Total cost = 800,000 + 8,000,000 = \$8,800,000

12% of cost = 8,800,000 x 0.12 = \$1,056,000

Total Revenue = \$9,856,000

Profit for the year = 9,856,000 - 8,800,000

= \$1,056,000

b) What is the profit of the grocery store if turnover increases to 10 times per year and

prices remain at 12% above costs?

Inventory cost, when turnover increased to 10 times = 1,000,000 x 10 = 10,000,000

Total cost = \$800,000 + \$10,000,000 = \$10,800,000

12% of cost = \$10,800,000 x 0.12 = \$1,296,000

Total Revenue = \$12,096,000

Profit for the year = \$12,096,000 - \$10,800,000

= \$1,296,000

c) What price mark-up is necessary for the company to have a \$300,000 profit if

inventory turnover occurs eight times per year?

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Fixed cost = \$800,000

Cost of inventory = 1,000,000 x 8

= \$8,000,000

Total cost = 800,000 + 8,000,000 = \$8,800,000

Expected profit = \$300,000

Price mark-up percentage = (300,000/8,800,000) x 100

= 3.4 %

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Chapter 5

NP 5.3

a) Which product should the shop promote if the promotion will result in sales of 100

kilograms more of the promoted type?

“If organizations are operating below capacity, the variable cost approximates the

marginal cost of making further units of different products. The use of the excess

capacity should be directed toward making and selling more of the product with the

highest contribution margin per unit.” (text book, pp. 152)

Contribution margin = Sales price - Variable cost

Variable cost = Direct costs + Variable overhead

Sales       Direct     Variable         Variable         Contribution
price/Kg    costs/Kg   overhead/Kg      cost/Kg          margin (\$)
Chocolate
filled                   3        1.5              0.6              2.1            0.9
Cream filled             2        0.5              0.5                1              1
Caramel filled         2.5          1                1                2            0.5

From the above table Cream filled candy has the highest contribution margin of \$1.00.

Hence the shop should promote Cream filled candy.

b) Should the caramel-filled candy be dropped from the product mix? Explain.

Caramel-filled candy should not be dropped from the product mix as there are no

avoidable fixed costs. Hence dropping caramel-filled candy from the product mix will

not reduce the costs for the candy shop.

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c) How does the product mix problem change if the candy shop is operating at

capacity?

“An organization should not use the variable product cost for a short-term pricing

decision if production is at capacity.” (text book, pp. 146).

Sales            Direct           Variable             Fixed
Chocolate
filled                        3              1.5                  0.6                 0.25       0.65
Cream filled                  2              0.5                  0.5                  0.5        0.5
Caramel filled              2.5                1                    1                    1        0.5

When candy shop is operating at capacity, the overall cost and profit needs to be

considered. Thus Chocolate filled candy contributes the highest profit and hence

Chocolate filled candy should be promoted when shop is operating at capacity.

NP 5.4

a) What is the break-even point in board-feet for factory A?

Factory A

Selling price = \$0.18/board-foot

Annual fixed costs = \$20 million

Variable costs = \$0.10/board-foot

At break-even,

Profit = 0 = Sales - Variable cost - Fixed cost

0 = 0.18 x Q - 0.10 x Q - 20,000,000

0.08 x Q = 20,000,000

Q = 20,000,000/0.08 = 250,000,000

Break-even point for factory A is 250 million board-feet.

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b) If the company wants to generate an after-tax profit of \$2 million with factory B,

how many board-feet would it have to process and sell?

Profit before tax = Profit after tax / (1 - Tax rate)

2,000,000 / (1 - 0.3) = 0.18 x Q - 0.12 x Q - 10,000,000

2,857,142.86 = 0.06 x Q - 10,000,000

0.06 x Q = 12,857,142.86

Q = 12,857,142.86/0.06 = 214,285,714.33

Factory B should process and sell 214,285,714.33 board-feet to generate an after-tax

profit of \$2 million.

c) If demand for lumber is uncertain, which factory is riskier?

“The ratio of fixed costs to total costs is known as operating leverage. The higher the

organization’s fixed costs, the higher is its risk.” (text book, pp. 157)

Factory A has a fixed cost of \$20 million and Factory B has a fixed cost of \$10 million.

Hence, Factory A is riskier.

d) At what level of board-feet would the after-tax profit of the two factories be the

same?

Profit before tax = Profit after tax / (1- Tax rate)

=> Profit after tax = Profit before tax x (1 - Tax rate)

Profit before tax = Revenues - Variable cost - Fixed cost

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Profit after tax of factory A = Profit after tax of factory B

=> Profit before tax of factory A x (1 - 0.3) = Profit before tax of factory B x (1 - 0.3)

=> Profit before tax of factory A = Profit before tax of factory B

=> (Revenues - Variable cost - Fixed cost) of factory A = (Revenues - Variable cost -

Fixed cost) of factory B

=> 0.18 x Q - 0.10 x Q - 20,000,000 = 0.18 x Q - 0.12 x Q - 10,000,000

=> 0.02 x Q = 10,000,000

=> Q = 10,000,000 / 0.02

=> Q = 500,000,000 = 500 million board-feet

At 500 million board-feet the after-tax profit of the two factories will be the same.

NP 5.6

How many tickets must be sold to have a profit of \$3,000,000? (Assume no taxes.)

Selling price for ticket = \$100 per person

Capacity = 100,000 people

Variable cost = \$10 per person

Fixed Cost = \$10,000,000

Sales price of food and trinkets = \$20 per person

Television Revenue = \$5,000,000

Expected Profit = \$3,000,000

Profit = Revenues - Variable Costs - Fixed Costs

3,000,000 = (100 x Q + 20 x Q + 5,000,000) - 10 x Q - 10,000,000

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= 110 x Q + 5,000,000 - 10,000,000

110 x Q = 3,000,000 + 5,000,000 = 8,000,000

Q = 8,000,000/110 = 72727.27

Number of tickets to be sold to have a profit of \$3,000,000 = 72727

(Selling 72727 tickets will get a profit of \$2,999,970 and 72728 tickets will get a profit of

\$3,000,080)

NP 5.8

Fixed Cost = \$200,000 per year

Variable Cost = \$25 per room per night

Number of rooms = 20

a) If you expect to rent the rooms for \$90, how many rooms must you rent during the

year to break even?

At Break even:

Revenue - Variable Costs - Fixed Costs = 0

90 x Q - 25 x Q - 200,000 = 0

65 x Q = 200,000

Q = 200,000/65

Q = 3076.93

Number of rooms to be rented during the year to break even = 3077

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b) If you want to have a profit of \$50,000 and expect to be at 70% of capacity for 365

days of the year, what price per room would you have to charge?

20 x 0.7 x 365 = 5110

50,000 = P x 5110 - 25 x 5110 - 200,000

50,000 = P x 5110 - 127,750 - 200,000

P x 5110 = 377,750

P = 377,750 / 5110 = 73.92

Price to be charged per room = \$73.92

NP 5.9

a) Should product C be dropped? Explain.

Product C should not be dropped since:

     The decision should depend on comparison of incremental costs with incremental

revenues. Also, in terms of overhead costs only avoidable costs should be

considered. “If avoidable costs are higher than the incremental revenue of a

product, it should be dropped from the product mix” (text book, pp. 162). Here

the fixed costs are sunk. Hence they are not avoidable costs.

b) Which product would provide the most profit if one more unit were sold?

“If organizations are operating below capacity, the variable cost approximates the

marginal cost of making further units of different products. The use of the excess

capacity should be directed toward making and selling more of the product with the

highest contribution margin per unit.” (text book, pp. 152)

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Contribution margin = Sales price per unit - Variable cost per unit

Variable        Number of                           Contribution
Revenues     Costs           units              P        VC      margin
Product A       300,000         200,000            1,000        300    200                 100
Product B       800,000         500,000          10,000          80     50                  30
Product C       100,000           40,000             100      1,000    400                 600
P - Sales price per unit; VC - Variable cost per unit; CM - Contribution margin per unit

Product C has the highest contribution margin and hence would provide the most profit

if one more unit were sold.

NP 5.10

a) If the paper machine were operating below capacity, which type of paper would

produce more profit if an additional ton of it can be made and sold?

“If organizations are operating below capacity, the variable cost approximates the

marginal cost of making further units of different products. The use of the excess

capacity should be directed toward making and selling more of the product with the

highest contribution margin per unit.” (text book, pp. 152)

Contribution margin = Sales price per unit - Variable cost per unit

Variable        Number of
Paper     Revenues    costs           tons            P       VC      CM/ton
A           900,000         600,000          4,000    225     150               75
B           500,000         300,000          3,000    167     100               67
C           100,000          50,000             500   200     100              100
P - Sales price per unit; VC - Variable cost per unit; CM - Contribution margin per unit

Hence, Paper C should be made and sold when the paper machines are operating below

capacity as it has the highest Contribution margin per ton.

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b) If the paper machine were operating at capacity, which type of paper would the

company prefer to make and sell?

“The product with the highest contribution margin per unit is not necessarily the one that

should have priority on a machine that is a constrained resource. Instead, the organization

should determine which product yields the highest contribution margin per use of the

machine.” (text book, pp.152)

Contribution margin per Machine hour = Contribution margin per ton x Tons per

Machine hour

Number of       Machine                       Tons/machine   CM/Machine
Paper    tons            hours          CM/ton         hour           hour
A               4,000           1,000             75              4           300
B               3,000             450             67              7        444.44
C                 500             250            100              2           200
CM - Contribution margin per unit

Since the machine is operating at capacity, we need to consider Contribution margin per

machine hour. Hence, Paper B should be chosen by the company as it has the highest

Contribution margin per machine hour.

NP 5.16

Widgets   Wangles
Annual capacity                        1000      2000     units
Price per unit                           50       100     \$
Variable cost per unit                   20         50    \$
Annual fixed costs                   10,000    10,000     \$
Polishing machine hours per unit          1          2    hour(s)
Units/Polishing machine hours             1        0.5    /hour
Contribution margin                      30         50
CM/Machine hour                          30         25

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a) What product mix creates the most profit for Judson Company, given all the

constraints?

The Contribution margin for Wangles is \$50 which is higher than the Contribution

margin for Widgets \$30. But Widgets has a better Contribution margin per machine hour

than Wangles (\$30 vs. \$25). Hence Widgets has a priority over Wangles in production.

But, since the annual capacity of Widgets is 1000, the combination than can be produced

for most profit will be 1000 Widgets and 1000 Wangles.

b) If there were only machine hour constraints, what product mix would create the

greatest profit mix for Judson?

As explained earlier, since Widgets have a better Contribution margin per machine hour

(a constrained resource), Widgets takes precedence over Wangles in production. Also

considering that there is only machine hour constraint and no annual capacity

constraint, greatest profit will be achieved by just producing Widgets i.e. producing

and selling 3000 Widgets.

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Chapter 6

AIP 6.6 (LO 5)

Critically evaluate the statement in terms of the issues presented in this chapter.

“What’s wrong is that the modern American accounting system is a very imperfect

measure of corporate performance.”

“A failure to adequately understand the system’s limitations-combined with our penchant

for treating things which seem to be quantifiable (such as profit) as more real than things

which are difficult to quantify (such as quality of a company’s [product]) - has, in my

view, contributed to serious mismanagement of American business during the last several

years.”

Donald Curtis has the following key criticisms

     corporate accounting systems are an imperfect measure of performance, and

     that quantifiable parameters like profit are being treated as more real performance

parameters than other parameters like quality, which are difficult to quantify

Both of the above points seem to be valid in the perspective of issues presented in this

chapter of the text book. The text book defines a good performance measure as one which

“reveals how well individuals have performed their duties and motivates them to achieve

organizational goals. Hence just going by readily available parameters like profit may not

be a good measure of the performance as well as a good motivating factor for individuals

of the organization. Also the text book declares that “good performance measures are not

always easy to find”. That accounting numbers are frequently used as performance

measures, but focusing on past transactions and looking at historical cost systems,

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managers can be better evaluated. Also a balanced scorecard, that relates performance

measures to the goals of the owners and the satisfaction of customers, is seen to provide a

more comprehensive view of the organization. Overemphasizing on just one performance

measure like Profit can only lead to an unbalanced scorecard.

AIP 6.7 (LO 3,8)

Describe some control problems that might arise and some mechanisms that Mary

could use to help monitor these problems.

The key control issues, as seen by our course book, that underlie any organization is:

   Self-interested behavior of individuals

   Monitoring costs to reduce self-interested behavior

When Mary was managing the candy shop all be herself, she was working a minimum of

10 hours a day, and there was no control issues. Now with the hiring of another person,

aspects like

   closing time of the shop (when Mary will not be present), and

   handling of cash register

needs to be controlled and monitored.

Proper monitoring measures need to be in place so that no mishandling at the cash

register happens. Additional checks and balances have to be put in place so that there is

no misappropriation of funds. Steps like additional software and inventory systems may

be needed to be put in place. In terms of closing time, since the hired person will be the

last to leave the shop, there might be situations of closing down the shop earlier than the

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stipulated 8 pm may happen (due to self-interested behavior). Due to this need to install

surveillance camera etc. may be needed to monitor store activity after Mary leaves.

AIP 6.9 (LO 4)

Discuss the pros and cons of monitoring by observing the engineers’ computer work.

Pros

    Monitoring the engineers’ will remove doubts on there performance.

    Self-interested behavior of the individuals will be reduced and they will work

more in the organizations interest.

Cons

    Monitoring will result in additional cost like monitoring software license etc.

    Also additional effort (from the president etc.) needs to be expended to monitor.

AIP 6.10 (LO 5)

Explain the costs and benefits of having only profit as a performance measure.

Costs

    All the actions of the top executives can seldom be revealed by a single

performance measure. There would be multiple organizational goals and

appropriate trade-offs will be possible is multiple performance measures are used

for evaluation.

    Profit as a performance measure may lead to compromise on quality or customer

satisfaction, which may have long term impact on the organization. Hence the top

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executive’s performance purely based on profits may not give the real value

addition provided by the individual to the organization.

   Profit being an accounting number, is not always a good performance measure, as

they are generally affected by factors outside the control of the individual being

evaluated.

Benefits

   The benefit of having profit alone as the performance measure is the reduced cost

in maintaining it as a performance measure.

   Also, profit is a measure already maintained as part of the accounting systems;

hence it is readily available and mostly free from manipulation.

   Profit is still an overall performance measure for the organization and can be seen

as a valid performance measure at any level of the organization.

AIP 6.17 (LO 1,3)

Using the framework presented in the text, critically analyze the Theory X-Theory Y

quotation above.

The text suggests the following procedures to form the control system within an

organization:

   Assigning responsibilities

   Measuring performance

   Providing compensation for performance

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The purpose of control is to make individuals to act in the best interest of the

organization. The text recognizes the fact that individual performance is driven by self

interest. This is somewhat inline with the Theory X concept, whereby individuals may

not take organization responsibilities on their own and need some sought of external

controls to align them to organizational interest. The text suggests the usage of

performance measures as the basis for rewarding individuals, which is one of the

approaches to motivate Theory X individuals. Also monitoring is suggested as a means to

reduce self-interested behavior. The term self-interested behavior brings in a degree of

Theory X and Theory Y behavior within the individuals, rather than totally classifying

under one of them. So based on the organizations perception of the extent of Theory X

behavior in the organization (assuming a Theory X personality totally works in his/her

own self interest), the organization will invest in various monitoring approaches and

invest in related costs.

So overall the text recognizes self-interested behavior and the need to align individuals

and measure there performance with respect to organization goals. Though the text does

not classify the individuals in an organization as either Theory X or Theory Y, it

recognizes the Theory X nature within an individual in the form of self-interested

behavior, applying usage of financial (performance based) rewards and monitoring in

order to motivate individuals towards organization goals. These are inline with

McGregor’s approach to handling Theory X nature in human behavior. Theory Y

individuals can be seen to be expected to perform naturally within the same control

structure of performance evaluation, monitoring and rewards, being already aligned to

organizational goals.

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Chapter 7

NP 7.1

a) If the investment manager were currently making a return on investment of 16%,

which project(s) should be pursued?

ROI = Annual Earnings/Investment

Project   Investment   Annual Earnings    ROI (%)
A            800,000            90,000         11.25
B            100,000            20,000            20
C            300,000            25,000          8.33
D            400,000            60,000            15
Project B should be pursued as the ROI is 20% which is greater than the opportunity

cost of 16%.

b) If the cost of capital is 10% and the annual earnings approximate cash flows

excluding finance charges, which project(s) should be chosen?

All three Projects A, B and D are viable projects when considering the opportunity cost

of capital of 10%.

c) Suppose that only one project can be chosen and the annual earnings approximate

cash flows excluding finance charges. Which project should be chosen?

Residual Income = Profit - Opportunity cost of capital x Investment

Annual                           Residual
Project   Investment   Earnings          ROI (%)        Income
A            800,000           90,000           11.25              10,000
B            100,000           20,000              20              10,000
C            300,000           25,000    8.333333333               -5,000
D            400,000           60,000              15              20,000
Taking into account both ROI and Residual income Project D should be chosen.

Residual income evaluation ensures that issues of underinvestment are addressed.

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NP 7.2

a) Given the current investment in existing assets, in which additional projects should

the division manager invest if the objective is to maximize ROI?

Currently obtained ROI from existing assets of \$1 million = 15%

Project   Investment (\$)   ROI (%)
A                100,000         14
B                400,000         20
C                200,000         14
D                300,000         12
E                500,000           8
In order to maximize ROI the division manager should invest in Project B, as the ROI is

20% which is greater than the ROI on existing assets of 15%.

b) Which projects have a negative residual income?

Residual income = (ROI - Opportunity cost of capital) x Investment

Opportunity cost of capital = 10%

Project   Investment (\$)   ROI (%)     Residual income (\$)
A                100,000         14                   4,000
B                400,000         20                  40,000
C                200,000         14                   8,000
D                300,000         12                   6,000
E                500,000           8                -10,000

Project E has a negative residual income.

c) Using this example, explain why underinvestment is a problem when using ROI for

evaluation purposes.

In this problem the cost of capital is 10% and the ROI from existing assets is 15%. If a

manager just attempts to increase the average ROI, the manager might end up in

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investing only in Project B (ROI of 20%), whereas Project A, C and D (ROI of 14, 14

and 12 respectively) also give returns greater than the opportunity costs of capital at 10%.

So organization’s value will increase by selecting Projects A, B, C and D as well. Hence

using ROI alone for evaluation purpose may lead to underinvestment. Residual income

on the other hand provides a better indication of the overall value addition to the

organization due to a project. A positive residual income itself is indicative of an added

value to the organization through higher return on the assets then the costs of using them.

Hence, if residual income is used as the performance measure the manager will invest in

all assets that have a positive residual income, without looking at incentives from

underinvestment.

NP 7.3

Product X

Variable cost = \$40 per unit

Fixed cost = \$20 per unit

Market price (sales price) = \$70 per unit

Product Y

Variable costs to convert X to Y = \$20 per unit

Fixed costs to convert X to Y = \$10 per unit

Sales price = \$80 per unit

a) What transfer price of X causes divisional managers to make decentralized decisions

that maximize Carlson Company’s profit if each division is treated as a profit centre?

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“The general rule of transfer pricing is to use the external market price of the

intermediate product of service if a competitive market exists.” (text book, pp. 213)

Since a market price exists, the transfer price of X should be the market price of X

which is \$70 per unit.

b) Given the transfer price from part (a), what should Beta Division’s manager do?

Since the transfer price is \$70 (which is the opportunity cost for product X), adding the

product conversion (X to Y) variable cost of \$20 and fixed cost of \$10 will result in a

product cost (Y) of \$100. This is greater than the product Y’s selling price of \$80, and

thus will result in a loss for Beta Division. Hence Beta Division’s manager should look at

closing the division and look for a more profitable opportunity.

c) Suppose there is no market price for product X. What transfer price should be used

for decentralized decision making?

“Opportunity costs are approximated by the variable cost if the fixed costs are sunk.”

(text book, pp. 214)

Hence, if no market price existed for product X then variable cost of \$40 per unit

should be used as the transfer price (since the Alpha’s fixed costs are sunk).

d) If there is no market for product X, are Beta Division’s operations profitable?

If there is no market for product X, then the variable cost of \$40 per unit gets treated as

the transfer price. Hence, the operation of Beta Division is profitable.

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Product cost = \$40 + \$20 + \$10 = \$70

Selling price = \$80

Profit = \$10 per unit

NP 7.7

Jefferson Bottles

Capacity = 10 million bottles per year

Fixed cost = \$100,000 per year

Variable cost = \$0.01/bottle

Sales price = \$0.03/bottle

Jefferson Juices

Capacity = 3 million bottles per year

a) What should Jefferson Bottles charge Jefferson Juice for bottles so that both

divisions make appropriate decentralized planning decisions?

“The general rule of transfer pricing is to use the external market price of the

intermediate product of service if a competitive market exists.” (text book, pp. 213)

So, Jefferson Bottles should charge Jefferson Juice \$0.03/bottle since that is the market

price of the bottles and hence the opportunity cost.

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b) If Jefferson Bottles can sell only 5 million bottles to outside buyers, what should

Jefferson Bottles charge Jefferson for bottles so that both divisions make appropriate

decentralized planning decisions?

Since Jefferson Bottles can only sell 5 million bottles, for the rest of 5 million bottles

market price does not exist. Hence variable cost of \$0.01/bottle should be used

(assuming no alternative use of capacity exists).

NP 7.9

a) What is the ROI of each boat using the book value of the investment in it?

ROI = Income/Book value

ROI in %
Book          (using Book
Boats     Income      value         value)
A         1,700,000            0                0
B           100,000    5,200,000             1.92
C         1,300,000    6,100,000            21.31
D         2,900,000    5,200,000            55.77
E         1,500,000    8,300,000            18.07

b) What is the ROI of each boat using the market value of the investment in it?

ROI = Income/Market value

ROI in %
Market         (using market
Boats     Income      value          value)
A         1,700,000     5,000,000                34
B           100,000     6,200,000               1.6
C         1,300,000     8,000,000             16.25
D         2,900,000    10,000,000                29
E         1,500,000    15,000,000                10

c) What is the residual income of each boat using its book value?

Residual income = Profits - (Opportunity cost of capital) (Total assets)

Cost of capital for the company = 10%

25
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

Residual income = Profits - (0.10) (Book value)

Residual income
Book          (using Book
Boats      Income      value         value)
A          1,700,000           0             1,700,000
B            100,000   5,200,000               -420,000
C          1,300,000   6,100,000                690,000
D          2,900,000   5,200,000             2,380,000
E          1,500,000   8,300,000                670,000

d) What is the residual income of each boat using its market value?

Residual income = Profits - (Opportunity cost of capital) (Total assets)

Cost of capital for the company = 10%

Residual income = Profits - (0.10) (Market value)

Residual income
Market         (using Market
Boats      Income      value          value)
A          1,700,000     5,000,000              1,200,000
B            100,000     6,200,000               -520,000
C          1,300,000     8,000,000                500,000
D          2,900,000    10,000,000              1,900,000
E          1,500,000    15,000,000                      0

e) Which trawler had the best year?

Trawler D had the best year, since it had the highest ROI and Residual income both in

terms of book value and market value.

ROI in %            ROI in %         Residual income     Residual income
(using Book         (using market    (using Book         (using Market
Boat       value)              value)           value)              value)
D                   55.77                  29           2,380,000             1,900,000

26
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

NP 7.10

a) Estimate the average cost per unit for each plant.

Average cost per unit = (Variable costs + Fixed costs)/Units produced

Average
Units           Variable       Fixed        cost per
Plant       produced        costs          costs        unit
A              10,000,000        200,000    1,000,000           0.12
B              20,000,000        450,000    1,000,000        0.0725
C              30,000,000        650,000    1,000,000         0.055

b) Why would the manager of plant A be unhappy using average cost as the

performance measure?

Since there can be variation in the bottles produced based on different demand levels the

plant manager will not be comfortable with average cost as the performance measure,

with fixed cost component contributing to most of the cost.

c) What alternative performance measure would make the manager of plant A

happier?

Plant A manager would be happier if variable cost is used as the performance measure,

as demand levels are not in his control and average costs include fixed costs over which

he doesn’t have control.

d) Under what circumstances might the average cost be a better performance measure?

Average cost would be a better performance measure when the plants are treated as a

Profit center, where demand for overall output is also in manager’s control.

27
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

NP 7.11

a) Calculate ROI and residual income (1) before any corporate overhead allocations

and (2) after corporate overhead allocation for each division.

(1) ROI and residual income before any corporate overhead allocations

ROI = Net income / Divisional net assets

Residual income = Net income - Target income

Target income = Divisional net assets x Cost of capital

Cost of capital = 8%

Cost                              Residual income
of        ROI % (before           (before corporate
income*          net assets*     %         allocations)            allocations)*
Australia          12                     80         8                    15                             5.6
Netherlands        22                   195          8                 11.28                             6.4
United
States                17                131          8                  12.98                        6.52
* millions of Dutch guilders

(2) ROI and residual income after any corporate overhead allocations

ROI = (Net income - Allocated corporate overhead) / Divisional net assets

Residual income = (Net income - Allocated corporate overhead) - Target income

Target income = Divisional net assets x Cost of capital

Cost of capital = 8%

Net income
(after                                                              Residual
subtracting                         Cost      ROI % (after          income (after
Allocated              allocated                           of        corporate             corporate
Australia          12                     4                    8              80         8                    10                   1.6
Netherlands        22                     4                   18            195          8                  9.23                   2.4
United
States             17                     6                   11            131         8                    8.4               0.52
* millions of Dutch guilders

28
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

b) Discuss the difference among the various performance measures.

Various performance measures considered here are ROI and Residual income before

considering corporate overhead allocations, and ROI and Residual income after

ROI gives the profitability of each division.

Residual income is appropriate for evaluating managers of investment centers of different

sizes since the managers have control of the size of the investment center.

If the managers do not control size and the division is more like a profit center, then ROI

is more appropriate as a relative performance measure for managers of differently sized

divisions.

Residual income = (ROI - Opportunity cost of capital) (Total assets)

To overcome the incentive problem of ROI, such as underinvestment and lack of risk

adjustment, some firms use residual income to evaluate performance.

Further, evaluation of ROI on excess assets gives a measure of how efficiently excess

assets between divisions have been used. Hence this can be treated as a more extensive

evaluation of performance across the divisions.

29
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

c) Based on the data presented in the case, evaluate the relative performance of the

three operating divisions. Which division do you think performed the best and

which performed the worst?

Residual        Residual
ROI %                              income          income
(before           ROI % (after     (before         (after
corporate         corporate        corporate       corporate
allocations)      allocations)     allocations)*   allocations)*
Australia                    15                10              5.6             1.6
Netherlands               11.28              9.23              6.4             2.4
United States             12.98               8.4             6.52            0.52

Also evaluating ROI on excess assets:

Between                             Additional           Excess assets*    ROI on excess

income*                                assets (%)

Netherlands and Australia           10                   115               8.7

United States and Australia         5                    51                9.8

Netherlands and United States       5                    64                7.8

Netherlands and Australia           10                   115               8.7

United States and Australia         3                    51                5.9

Netherlands and United States       7                    64                10.9

* millions of Dutch guilders

Overall evaluation:

Residual          Residual            ROI % on
income            income (after       excess assets
ROI % (before   ROI % (after       (before           corporate
allocations)    allocations)       allocations)*

30
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

Best           Australia       Australia         United States   Netherlands      Australia

Worst          Netherlands     United State      Australia       United States    United States

Based on ROI % Australia performed the best.

Based on ROI % (before corporate overhead allocations) Netherlands performed the worst.

Based on ROI % (after corporate overhead allocations) United States performed the worst.

Based on Residual income (before corporate overhead allocations) United States performed

the best and Australia performed the worst.

Based on Residual income (after corporate overhead allocations) Netherlands performed the

best and United States performed the worst.

Residual income is positive if the ROI is greater than the opportunity cost of capital.

Residual income = (ROI - Opportunity cost of capital) (Total assets)

The main intention of a division is to maximize organization’s value. Residual income is

a more extensive evaluation of performance than just ROI. Further applying corporate

overhead provides a more accurate coverage of actual expenditure from the organizations

perspective. Hence based on Residual income after corporate overhead allocations

Netherlands can be seen as the best performer and United States as the worst performer.

But evaluating the ROI on excess assets, and treating it as the relative measure of

financial performance overall, Australia looks to be the best performer (ROI on excess

assets for Netherlands and United States is lesser than that of Australia) and United

States the worst performer.

NP 7.14

31
ACCT 615 (Summer) –Assignment 2
Submitted by Ashok Ambashanker (aa227@njit.edu)

What is the total tax liability of the company if the transfer price is \$5 per unit?

Division A in Mexico

Product cost = \$3 per unit

Tax rate = 40%

Incremental cost = \$1 per unit

Selling price = \$8 per unit

Tax rate = 30%

Number of units produced, transferred, and sold = 100,000

Transfer cost = \$5.

Division A             Division B

Revenue from transferring (\$5 per unit)    \$500,000

Revenue from final sales                                          \$800,000

Cost of product transferred                                       \$500,000

Incremental costs                          \$300,000               \$100,000

Income before taxes                        \$200,000               \$200,000

Taxes                                      \$80,000                \$60,000

The total tax liability for the company is \$140,000

32

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