EVA Analysis

EXERCISE 13-33 (20 MINUTES)
The economic value added (EVA) is defined as follows:
Economic
Investment center' s
Investment
Investment Weighted - average
value
=
after - tax
center' s
center' s
cost of
total assets
added
operating income
current liabilities
capital
For Golden Gate Construction Associates, we have the following calculations of each
divisions EVA.
Division
Real Estate
Construction
After-Tax
Operating
Income
(in millions)
Total Assets
Current
Liabilities
(in millions)
(in millions)
Economic
Value
Added
(in millions)
WACC
$30(1.40)
$150
$9
.114
$1.926
$27(1.40)
$ 90
$6
.114
$6.624

1.
Transfer price
outlay
cost
opportunity
cost
= $450* + $120 = $570

*Outlay cost = unit variable production cost
Opportunity cost
= forgone contribution margin

= $570 $450 = $120
2.
If the Fabrication Division has excess capacity, there is no opportunity cost associated
with a transfer. Therefore:
Transfer price
outlay
cost +
opportunity
cost
= $450 + 0 = $450
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Managerial Accounting, 6/e
2005 The McGraw-Hill Companies,

13- 1

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........................
Incremental cost to Assembly Division per unit
in special order:
Transfer price......................................................................
Additional variable cost......................................................
Total incremental cost..............................................................
Loss per unit in special order..................................................
2.
$561
150
711
$ (11)
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.....................
Incremental cost to company per unit in special order:
Unit variable cost incurred in Fabrication Division.........
Unit variable cost incurred in Assembly Division...........
Total unit variable cost..........................................................
Profit per unit in special order..............................................
3.
$700
$700
$450
150
600
$100
The transfer price could be set in accordance with the general rule, as follows:
Transfer price
outlay
cost
opportunity
cost
= $450 + 0*
= $450
*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 $700 per unit, but the incremental
cost drops to $600 per unit ($450 transfer price + $150 variable cost incurred in the
Assembly Division).
McGraw-Hill/Irwin
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13- 2
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%:
Divisional profit....................................................................
Less: Imputed interest charge:
I: $18,000,000 10%..............................................
II: $ 3,000,000 10%..............................................
Residual income...................................................................
(b)
Division II
$600,000
1,800,000
________
$ 900,000
300,000
$300,000
Division I
$2,700,000
Division II
$600,000
2,520,000
________
$ 180,000
420,000
$180,000
$2,700,000
$600,000
2,700,000
________
$
0
450,000
$150,000
Imputed interest rate of 14%:

I: $18,000,000 14%..............................................
II: $ 3,000,000 14%..............................................
Residual income...................................................................
(c)
Division I
$2,700,000
Imputed interest rate of 15%:

I: $18,000,000 15%..............................................
II: $ 3,000,000 15%..............................................
Residual income...................................................................
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
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13- 3
a more complete picture of divisional performance.
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13- 4

Sales revenue.........................................................
Income....................................................................
Average investment...............................................
Sales margin .........................................................
Capital turnover.....................................................
ROI..........................................................................
Residual income....................................................
Division I
$40,000,000
$ 8,000,000
$10,000,000
20%a
4b
80%c
$ 7,200,000d
Division II
$8,000,000e
$ 1,600,000
$8,000,000f
20%
1
20%g
$ 960,000h
Division III
$3,200,000l
$ 800,000k
$4,000,000j
25%
.8i
20%
$ 480,000
Explanatory notes:
income
$8,000,000
=
= 20%
sales revenue $40,000,000
Sales margin =
Capital turnover =
sales revenue
$40,000,000
=
=4
invested capital $10,000,000
ROI = sales margin capital turnover = 20% 4 = 80%
Residual income = income (imputed interest rate)(invested capital)

= $8,000,000 (8%)($10,000,000) = $7,200,000
income
Sales margin
= sales revenue
$1,600,000
20% = sales revenue

Therefore, sales revenue = $8,000,000
f
sales revenue
invested capital
1 =
$8,000,000
invested capital
Capital turnover
Therefore, invested capital = $8,000,000

g
ROI
= sales margin capital turnover
ROI
= 20% 1 = 20%
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13- 5
PROBLEM 13-37 (CONTINUED)

h
Residual income = income (imputed interest rate)(invested capital)

= $1,600,000 (8%)($8,000,000)
= $960,000
ROI
= sales margin capital turnover
20%
= 25% capital trunover
Therefore, capital turnover = .8

j
ROI
income
invested capital
= 20%
Therefore, income = (20%)(invested capital)

Residual
income
= income (imputed interest rate)(invested capital)

= $480,000
Substituting from above for income:

(20%)(invested capital) (8%)(invested capital) = $480,000
Therefore, (12%)(invested capital) = $480,000
So, invested capital = $4,000,000
k
ROI
20% =
income
invested capital
income
$4,000,000
Therefore, income = $800,000

Sales margin =
income
sales revenue
25% =
$800,000
sales revenue
Therefore, sales revenue = $3,200,000
McGraw-Hill/Irwin
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13- 6

1.
Three ways to increase Division I's ROI:

(a)
Increase income, while keeping invested capital the same. Suppose income
increases to $9,000,000. The new ROI is:
ROI =
(b)
Decrease invested capital, while keeping income the same. Suppose invested
capital decreases to $9,600,000. The new ROI is:
ROI =
(c)
ROI
income
$8,000,000
=
= 83.3% (rounded)
Increase income and decrease invested capital. Suppose income increases to

$8,400,000 and invested capital decreases to $9,600,000. The new ROI is:
ROI =
2.
income
$9,000,000
=
= 90%
income
$8,400,000
=
= 87.5%
sales margin capital turnover
25% 1
25%
McGraw-Hill/Irwin
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13- 7

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%

I: $18,000,000 12%..............................................
II: $ 3,000,000 12%..............................................
Residual income...................................................................
2.
Division I
$2,700,000
Division II
$600,000
2,160,000
$ 540,000
360,000
$240,000
Division I
$2,700,000
Division II
$600,000
2,700,000
$
0
450,000
$150,000

Divisional profit......................................................................
I: $18,000,000 15%................................................
II: $ 3,000,000 15%................................................
Residual income....................................................................
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13- 8

3.

Divisional profit......................................................................
I: $18,000,000 18%.................................................
II: $ 3,000,000 18%.................................................
Residual income....................................................................
Division I
$2,700,000
Division II
$600,000
3,240,000
$(540,000)
540,000
$ 60,000
The imputed interest rate r, at which the two divisions residual income is the same, is
14 percent, computed as follows:
Division IIs residual
income
= Division I's residual income
$600,000 (r)($3,000,000) = $2,700,000 (r)($18,000,000)

(r)($15,000,000) = $2,100,000
r = $2,100,000/$15,000,000
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.
McGraw-Hill/Irwin
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13- 9

1.
Current ROI of the Western Division:

Sales revenue
Less: Variable costs ($4,200,000 x 70%)
Fixed costs..
Income..
$4,200,000
$2,940,000
1,075,000
4,015,000
$ 185,000
ROI = Income invested capital

= $185,000 $925,000
= 20%
Western Divisions ROI if competitor is acquired:
Sales revenue ($4,200,000 + $2,600,000).
Less: Variable costs [$2,940,000 +
($2,600,000 x 65%)] $4,630,000
Fixed costs ($1,075,000 + $835,000)...
1,910,000
Income...
$6,800,000
6,540,000
$ 260,000

= $260,000 [$925,000 + ($312,500 +
$187,500)]
= 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 competitors financial statistics reveals the following:

Sales revenue..
Less: Variable costs ($2,600,000 x 65%).. $1,690,000
Fixed costs ..
835,000
Income...
$2,600,000
2,525,000
$ 75,000

= $75,000 $312,500
= 24%
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13- 10

Corporate management would probably favor the acquisition. Megatronics has been
earning a 13% return, and the competitors ROI of 24% will help the organization as a
whole. Even if the $187,500 upgrade is made, the competitors ROI would be 15% if
past earnings trends continue [$75,000 ($312,500 + $187,500) = 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 environmentsthe retail environment they
have come to expect with other Megatronics outlets and that of the newly acquired,
non-upgraded competitor.
Sales revenue ($4,200,000 + $2,600,000).
Less: Variable costs [$2,940,000 +
($2,600,000 x 65%)] $4,630,000
Fixed costs ($1,075,000 + $835,000)...
1,910,000
Income...
$6,800,000
6,540,000
$ 260,000

= $260,000 ($925,000 + $312,500)
= 21.01%
5.
Current residual income of the Western Division:

Divisional profit $185,000
Less: Imputed interest charge ($925,000 x 12%)
111,000
Residual income.. $ 74,000
Residual income if competitor is acquired:
Divisional profit ($185,000 + $75,000)... $260,000
Less: Imputed interest charge [($925,000 +
($312,500 + $187,500)) x 12%]... 171,000
Residual income... $ 89,000
Yes, management most likely will change its attitude. Residual income will increase
by $15,000 ($89,000 - $74,000) as a result of the acquisition.
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13- 11
Income
Income
Average
Before
Annual
Net of
Net Book
Year Depreciation Depreciation Depreciation Value*
1
$150,000
$200,000
$(50,000) $400,000
2
150,000
120,000
30,000
240,000
3
150,000
72,000
78,000
144,000
4
150,000
54,000
96,000
81,000
5
150,000
54,000
96,000
27,000
ROI
Based
on
Net Book
Value
12.5%
54.2%
118.5%
355.6%
Average
Gross
Book
Value
$500,000
500,000
500,000
500,000
500,000
ROI
Based
on
Gross
Book
Value
6.0%
15.6%
19.2%
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
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.
McGraw-Hill/Irwin
Inc.

13- 12

Based on Net Book Value
Income
Income
Average Imputed
Before
Annual
Net of
Net Book Interest Residual
Year Depreciation Depreciation Depreciation Value*
Charge Income
1
$150,000
$100,000
$50,000 $450,000 $45,000
$ 5,000
2
150,000
100,000
50,000
350,000
35,000
15,000
3
150,000
100,000
50,000
250,000
25,000
25,000
4
150,000
100,000
50,000
150,000
15,000
35,000
5
150,000
100,000
50,000
50,000
5,000
45,000
Based on Gross Book Value

Average
Gross
Imputed
Book
Interest
Residual
Value
Charge
Income
$500,000 $50,000
0
500,000 50,000
0
500,000 50,000
0
500,000 50,000
0
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.
McGraw-Hill/Irwin
2005 The McGraw-Hill Companies, Inc.

13- 13

1.
Sales margin: income divided by sales revenue.

Capital turnover: sales revenue divided by invested capital
Return on investment: income divided by invested capital (or sales margin x
capital turnover).
Sales margin: $540,000 $7,200,000 = 7.5%
Capital turnover: $7,200,000 $9,000,000 = 80%
Return on investment: $540,000 $9,000,000 = 6%, or
7.5% x 80% = 6%
2.
Strategy (a): Income will be reduced to $450,000 because of the loss, and
invested capital will fall to $8,910,000 from the disposal. ROI = $450,000
$8,910,000, or 5.05%. This strategy should be rejected, since it further hurts
Washburns performance.
Strategy (b): In terms of ROI, this strategy neither hurts nor helps. The
acceleration of overdue receivables increases cash and decreases accounts
receivable, producing no effect on invested capital. Of course, it is possible
that the newly acquired cash could be invested in something that would
provide a positive return for the firm.
3.
Yes. A drastic cutback in advertising could lead to a loss of customers and a

reduced market share. This could translate into reduced profits over the long
term. With respect to repairs and maintenance, reduced outlays could prove
costly by unintentional shortening of the useful lives of plant and equipment.
Such action would likely result in an accelerated asset replacement program.
McGraw-Hill/Irwin
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13-14
2005 The McGraw-Hill

4.
Anderson Manufacturing ROI: ($4,500,000 - $3,600,000) $7,500,000 = 12%

Palm Beach Enterprises ROI: ($6,750,000 - $6,180,000) $7,125,000 = 8%
From the preceding calculations, both investments appear attractive given
the current state of affairs (i.e., the Hardware Divisions current ROI of 6%).
However, if Washburn desires to maximize ROI, he would be advised to
acquire only Anderson Manufacturing.
Current
Income. $ 540,000
Invested capital
9,000,000
ROI
6%
Current +
Anderson
Current +
Anderson +
Palm Beach
$ 1,440,000*
16,500,000
8.73%
$ 2,010,000**
23,625,000
8.51%
* $540,000 + ($4,500,000 - $3,600,000)

** $540,000 + ($4,500,000 - $3,600,000) + ($6,750,000 - $6,180,000)
1.
The weighted-average cost of capital (WACC) is defined as follows:
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13-15
After-axMarket CostfMarket
costf
debt value+ quityvalueof
eightd-W ofdebt capitl equity
averg capitl
=
costf Market Market
capitl value + value
ofdebt ofequity
The following calculation shows that the companys WACC is 9.72 percent.
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13-16
Weighted - average
cost of capital
McGraw-Hill/Irwin
Companies, Inc.
13-17
(.063)($400,000,000) + (.12)($600,000,000)
= .0972
$400,000,000 + $600,000,000

2.
The three divisions economic-value-added measures are calculated as

follows:
After-Tax
Operating
Income
(in millions)
Pacific...... $14 (1.30)

Plains....... $45 (1.30)
Atlantic.... $48 (1.30)
Division
3.
Total
Current
Economic
Assets
Liabilities
Value
WACC =
(in
(in
Added
millions)
millions)
(in millions)
[($ 70
[($300
[($480
$6)
$5)
$9)
.0972]
.0972]
.0972]
= $ 3,579,200
= $ 2,826,000
= $(12,181,200)
The EVA analysis reveals that the Atlantic Division is in trouble. Its
substantial negative EVA merits the immediate attention of the management
team.
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13-18

1.
a.
Transfer price
= outlay cost + opportunity cost

= $130 + $30 = $160
b.
Transfer price
= standard variable cost + (10%)(standard variable cost)

= $130 + (10%) ($130) = $143
Note that the Frame Division manager would refuse to transfer at this price.
2.
a.
Transfer price
= outlay cost + opportunity cost

= $130 + 0 = $130
b.
When there is no excess capacity, the opportunity cost is the forgone

contribution margin on an external sale when a frame is transferred to the Glass
Division. The contribution margin equals $30 ($160 $130). When there is excess
capacity in the Frame Division, there is no opportunity cost associated with a
transfer.
c.
Fixed overhead per frame (125%)($40) = $50

Transfer price
= variable cost + fixed overhead per frame

+ (10%)(variable cost + fixed overhead per frame)
= $130 + $50 + [(10%)($130 + $50)]
= $198
d.
Incremental revenue per window..................................

Incremental cost per window, for Weathermaster
Window Company:
Direct material (Frame Division)...............................
Direct labor (Frame Division)....................................
Variable overhead (Frame Division)..........................
Direct material (Glass Division)................................
Direct labor (Glass Division).....................................
Variable overhead (Glass Division)...........................
Total variable (incremental) cost...............................
$310
$30
40
60
60
30
60
Incremental contribution per window in special order

for Weathermaster Window Company.......................
280
$30
The special order should be accepted because the incremental revenue exceeds
the incremental cost, for Weathermaster Window Company as a whole.
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13-19

e.
Incremental revenue per window..................................

Incremental cost per window, for the Glass Division:
Transfer price for frame [from requirement 2(c)].....
Direct material (Glass Division)................................
Direct labor (Glass Division).....................................
Variable overhead (Glass Division)...........................
Total incremental cost...............................................
$ 310
$198
60
30
60
Incremental loss per window in special order

for Glass Division........................................................
348
$ (38)
The Glass Division manager has an incentive to reject the special order because
the Glass Division's reported net income would be reduced by $38 for every
window in the order.
f.
3.
One can raise an ethical issue here to the effect that a division manager should
always strive to act in the best interests of the whole company, even if that action
seemingly conflicts with the divisions best interests. In complex transfer pricing
situations, however, it is not always as clear what the companys optimal action is
as it is in this rather simple scenario.
The use of a transfer price based on the Frame Division's full cost has caused a cost
that is a fixed cost for the entire company to be viewed as a variable cost in the Glass
Division. This distortion of the firm's true cost behavior has resulted in an incentive for
a dysfunctional decision by the Glass Division manager.
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13-20

The owners analysis incorrectly includes the following allocated costs that will be
incurred regardless of whether the ice cream counter is operated:
Utilities ......................................................................................................................
Depreciation of building ..........................................................................................
Deli managers salary ..............................................................................................
Total ..........................................................................................................................
$ 4,350
6,000
4,500
$14,850
It is possible that closing the ice cream counter might save a portion of the
utility cost, but that is doubtful.
A better analysis follows:
Sales ....................................................................................................
Less: Cost of food ..............................................................................
Gross profit .........................................................................................
Less: Operating expenses
Wages of counter personnel ...............................................
Paper products ......................................................................
Depreciation of counter equipment and furnishings* ........
Total .......................................................................................
Profit on ice cream counter
$67,500
30,000
37,500
$18,000
6,000
3,750
27,750
$ 9,750
*Depreciation on the counter equipment and furnishings is included because it is traceable

to the ice cream operation and is an expense in the determination of income. If a cash-flow
analysis is desired, this noncash expense should be excluded.
1.
(a) $11,100 allocation of rent on factory building: Irrelevant, since Toon Town Toy
Company will rent the entire factory building regardless of whether it continues
to operate the Packaging Department. If the department is eliminated, the space
will be converted to storage space.
(b) $13,000 rental of storage space in warehouse: Relevant, since this cost will be
incurred only if the Packaging Department is kept in operation. If the department
is eliminated, this $13,000 rental cost will be avoided.
2.
The $13,000 warehouse rental cost is the opportunity cost associated with using
space in the companys factory building for the Packaging Department.
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13-21

(a)
$51,000 salary of Packaging Department manager: Irrelevant, since this

manager will be employed by the company at $51,000 per year regardless of
whether the Packaging Department is kept in operation.
(b)
$66,000 salary of Cutting Department manager if a new person must be hired:

Relevant, since this cost will be incurred only if the Packaging Department is
kept in operation. If the Packaging Department is eliminated, then that
departments current manager will move to the Cutting Department at $51,000
per year.
The following comparison may help to clarify the analysis:
ANNUAL SALARY COST INCURRED BY TOON TOWN TOY COMPANY
If Packaging
Department
is Kept
Salary of the person currently managing the

Packaging Department ................................... $ 51,000*
Salary of newly hired person to manage the
Cutting Department .......................................... 66,000
Total ..................................................................... $117,000
Difference ............................................................
*
If Packaging
Department
is Eliminated
$51,000
____
$51,000
$66,000
Continues to manage Packaging Department.
Moves to Cutting Department position.

Additional comment:
There are many possible reasons why it might cost Toon Town Toy Company
more to hire a new Cutting Department manager than to transfer a current employee
to the position. One possible scenario is that the current Packaging Department
manager is a relatively young and inexperienced manager, to whom top management
is willing to give the Cutting Department opportunity if the Packaging Department is
eliminated. However, if a new person must be hired, Toon Town Toy Company will be
forced to go into the job market for more senior and experienced managers. Other
possible reasons include existing contractual agreements, union contracts, and so
forth.
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13-22

1.
The owners reasoning probably reflects the following calculation:

Savings in annual operating expenses if old pizza oven is replaced .............
Write-off of old ovens remaining book value ($10,500 3) ...........................
Loss associated with replacement ................................................................
$3,000
(3,500)
$ (500)
2.
The owners analysis is flawed, because the book value of the old pizza oven is a sunk
cost. It should not enter into the equipment replacement decision.
3.
Correct analysis:
Savings in annual operating expenses if old pizza oven is replaced .............
Acquisition cost of new oven, which will be operable for one year ................
Net benefit from replacing old pizza oven ........................................................
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13-23
$3,000
(2,200)
$ 800

1.
The relevant cost of the theolite to be used in producing the special order is the
21,750p sales value that the company will forgo if it uses the chemical. This is an
example of an opportunity cost.
p denotes Argentinas peso.
2.
(a) 21,750p sales value: Discussed in requirement (1).

(b) 24,000p book value (8,000 kilograms 3p per kilogram): Irrelevant, since the
book value is a sunk cost.
(c) 28,800p current purchase cost (8,000 kilograms 3.60p per kilogram): Irrelevant,
since the company will not be buying any theolite.
McGraw-Hill/Irwin
Companies, Inc.
13-24

1.
The relevant cost of genatope is calculated as follows:

Cost of replacing the 1,000 kilograms to be used in the special order
(1,000 kilograms 13.05p) .............................................................................
*Additional cost incurred on the next order of genatope as a result of
having to place the order early [4,000 kilograms (13.05p 12.45p)] .......
Total relevant cost ..............................................................................................
13,050 P
2,400 P
15,450 p
p denotes Argentinas peso.

*This cost would not be incurred if the special order were not accepted.
2.
(a) 97,200p book value (8,000 kilograms 12.15p per kilogram): Irrelevant, since it is
a sunk cost.
(b) 1,000 kilograms to be used in the special order: Relevant, as shown in
requirement (1).
(c) 13.05p price if next order is placed early: Relevant, since this is the cost of
replacing the used genatope.
(d) 12.45p price if next order is placed on time: Relevant, because an additional 4,000
kilograms in the next order will be purchased at a .60p per kilogram premium.
This .60p premium is the difference between the 13.05p price and the 12.45p
price.
McGraw-Hill/Irwin
Companies, Inc.
13-25

The most profitable product is the one that yields the highest contribution margin
per unit of the scarce resource, which is direct labor. We do not know the amount of
direct-labor time required per unit of either product, but we do know that Beta
requires six times as much direct labor per unit as Alpha. Define an arbitrary time
period for which direct laborers earn $1.00, and call this a time unit. The two
products contribution margins per time unit are calculated as follows:
Unit contribution margin .....................................................
Time units required per unit of product .........................
Contribution margin per time unit
Alpha: ($9.00 3) .............................................................
Beta: ($36.00 18) ...........................................................
Alpha
$9.00
3
Beta
$36.00
18
$3.00
$2.00
Therefore, Alpha is a more profitable product. Any arbitrary amount of direct

labor time expended on Alpha production will result in a greater contribution margin
than an equivalent amount of labor time spent on Beta production.
McGraw-Hill/Irwin
Companies, Inc.
13-26

1.
Decision variables:
X = number of units of Alpha to be produced
Y = number of units of Beta to be produced
2.
Objective function:
Maximize 9X + 36Y
The coefficients of X and Y are the unit contribution margins for Alpha and Beta,
respectively. Maximizing this objective function will result in the highest
possible total contribution margin.
3.
Constraints:
(a) Direct-labor time constraint: .25X + 1.5Y 11,000
The coefficients of X and Y are the number of hours of direct labor required to
produce one unit of Alpha and one unit of Beta, respectively. For example,
the direct-labor cost per unit of Beta is $18.00, so it must require 1.5
direct-labor hours per unit of Beta.
(b) Machine time constraint: 1X + 2Y 9,000
The coefficients of X and Y are the number of hours of machine time required to
produce one unit of Alpha and one unit of Beta, respectively.
(c) Nonnegative production quantities: X, Y 0
The complete linear program is the following
Maximize 9X + 36Y
Subject to: .25X + 1.5Y
1X + 2Y
X, Y
McGraw-Hill/Irwin
Companies, Inc.
13-27
11,000
9,000
0

1.
(a) Notation: X denotes the quantity of zanide produced per day

Y denotes the quantity of kreolite produced per day
(b) Contribution margin:
Price ........................................................
Unit variable cost ...................................
Unit contribution margin .......................
Zanide
$108
84
$ 24
Kreolite
$126
84
$ 42
(c) Linear program:
2.
Maximize
24X + 42Y
Subject to:
2X + 2Y
24
1X + 3Y
24
X, Y
Graphical solution: See next page.

Corner points in feasible region:
Objective function value:
X=0
Y=0
$ 0
X=0
Y=8
336
X=6
Y=6
396
X = 12
Y=0
288
The maximum objective function value is achieved when X = 6 and Y = 6.

Thus, the company should produce 6 drums of zanide per day and 6 drums of
kreolite per day.
3.
The objective function value at the optimal solution is a $396 total

contribution margin as shown in requirement (2).
McGraw-Hill/Irwin
Companies, Inc.
13-28
EXERCISE 14-43 (CONTINUED)

Graphical solution:
Y
25
20
15
Machine I constraint
10
Optimal solution (X = 6, Y = 6)
Objective function
Machine II constraint
Feasible
region
5
McGraw-Hill/Irwin
Companies, Inc.
13-29
10
15
20
25
SOLUTIONS TO PROBLEMS
1.
Contemporary Trends will be worse off by $6,400 if it discontinues wallpaper

sales.
Sales..
Less: Variable costs.
Contribution margin.
Paint and
Supplies
Carpeting Wallpaper
$190,000
114,000
$ 76,000
$230,000
161,000
$ 69,000
$ 70,000
56,000
$ 14,000
If wallpaper is closed, then:

Loss of wallpaper contribution margin... $(14,000)
Remodeling.
(6,200)
Added profitability from carpet sales*
32,500
Fixed cost savings ($22,500 x 40%).
9,000
Decreased contribution margin from paint
and supplies ($76,000 x 20%)..
(15,200)
Increased advertising..
(12,500)
Income (loss) from closure $ (6,400)
* The current contribution margin ratio for carpeting is 30% ($69,000
$230,000). This ratio will increase to 35%, producing a new
contribution for the line of $101,500 [($230,000 + $60,000) x 35%].
The end result is that carpetings contribution margin will rise by
$32,500 ($101,500 - $69,000), boosting firm profitability by the same
amount.
2.
This cost should be ignored. The inventory cost is sunk (i.e., a past cost that
is not relevant to the decision). Regardless of whether the department is
closed, Contemporary Trends will have a wallpaper inventory of $11,850.
3.
The Internet- and magazine-based firms likely have several advantages:

These companies probably carry little or no inventory. When a customer
places an order, the firm simply calls its supplier and acquires the goods.
The result may be lower expenditures for storage and warehousing.
These firms do not need retail space for walk-in customers.
McGraw-Hill/Irwin
Companies, Inc.
13-30
Internet- and magazine-based firms can conduct business globally.

Contemporary Trends, on the other hand, is confined to a single store in
Baltimore.
McGraw-Hill/Irwin
Companies, Inc.
13-31

1.
Sets result in a 20% increase, or 1,500 dresses (1,250 1.20 = 1,500).
Complete sets..................................
Dress and accessory cape..............
Dress and handbag.........................
Dress only........................................
Total units if additional items are
introduced......................................
Less: Unit sales if additional items
are not introduced.........................
Incremental sales............................
Incremental contribution margin
per unit (excluding material and
cutting costs).................................
Total incremental contribution
margin............................................
Percent
of Total Dresses
70%
1,050
6%
90
15%
225
9% 135
100%
Total Number of
Accessory
Capes
Handbags
1,050
1,050
90
225
1,500
1,140
1,275
1,250
250
-1,140
--
1,275
$192.00
$48,000
Additional costs:
Additional cutting cost
(1,500 $14.40)...........................
Additional material cost
(250 $80.00)..............................
Lost remnant sales
(1,250 $8.00).............................
Incremental cutting for
extra dresses (250 $32.00)......
Incremental profit............................
2.
$12.80
$14,592
$4.80
$6,120
$68,712
$21,600
20,000
10,000
8,000
Qualitative factors that could influence the companys management team in

its decision to manufacture matching accessory capes and handbags
include:
accuracy of forecasted increase in dress sales.
accuracy of forecasted product mix.
McGraw-Hill/Irwin
Companies, Inc.
13-32
Total
59,600
$
9,112

company image of a dress manufacturer versus a more extensive supplier
of womens apparel.
competition from other manufacturers of womens apparel.
whether there is adequate capacity (labor, facilities, storage, etc.).
1.
Food
Blender Processor
Unit cost if purchased from an outside supplier ............................. $60
$114
Incremental unit cost if manufactured:
Direct material ................................................................................ $18
$ 33
Direct labor ..................................................................................... 12
27
Variable overhead
$48 $30 per hour fixed ............................................................ 18
$96 (2)($30 per hour fixed) .....................................................
36
Total ............................................................................................ $48
$ 96
Unit cost savings if manufactured .................................................... $12
$ 18
Machine hours required per unit ....................................................... 1
2
Cost savings per machine hour if manufactured
$12 1 hour ................................................................................... $12
$18 2 hours ..................................................................................
$ 9
Therefore, each machine hour devoted to the production of blenders saves
the company more than a machine hour devoted to food processor
production.
Machine hours available .....................................................................................
Machine hours needed to manufacture 20,000 blenders .................................
50,000
20,000
Remaining machine hours .................................................................................
30,000
Number of food processors to be produced (30,000 2) ................................

Conclusion: Manufacture 20,000 blenders
Manufacture 15,000 food processors
Purchase
13,000 food processors
15,000
McGraw-Hill/Irwin
Companies, Inc.
13-33

2.
If the companys management team is able to reduce the direct material cost
per food processor to $18 ($15 less than previously assumed), then the cost
savings from manufacturing a food processor are $33 per unit ($18 savings
computed in requirement (1) plus $15 reduction in material cost):
New unit cost savings if manufactured ..........................................

Machine hours required per unit ....................................................
Cost savings per machine hour if manufactured
$12 1 hour .................................................................................
$33 2 hours ...............................................................................
Food
Blender Processor
$12.00
$33.00
1 MH 2 MH
$12.00
$16.50
Therefore, devote all 50,000 hours to the production of 25,000 food

processors.
Conclusion:
Manufacture: 25,000 food processors

Purchase: 3,000 food processors
Purchase: 20,000 blenders

1.
2.
Incremental unit cost if purchased:

Purchase price .........................................................................................
Material handling .....................................................................................
Total ..........................................................................................................
$ 45,000
9,000
$ 54,000
Incremental unit cost if manufactured:

Direct material ..........................................................................................
Material handling .....................................................................................
Direct labor ..............................................................................................
Variable manufacturing overhead ($36,000 1/3) ................................
Total ..........................................................................................................
Increase in unit cost if purchased ($54,000 $39,600) .............................
$ 3,000
600
24,000
12,000
$ 39,600
$ 14,400
Increase in monthly cost of acquiring part RM67 if purchased

(10 $14,400, as computed above) ..........................................................
Less: rental revenue from idle space .........................................................
Increase in monthly cost .............................................................................
$144,000
75,000
$ 69,000
McGraw-Hill/Irwin
Companies, Inc.
13-34

3.
Contribution forgone by not manufacturing alternative product .............

Savings in the cost of acquiring RM67
(10 $14,400 as computed in requirement 1) .........................................
Net cost of using limited capacity to produce part RM67 .........................
$156,000
144,000
$ 12,000

The analysis prepared by the engineering, manufacturing, and accounting
departments of Cincinnati Flow Technology (CFT) was not correct. However, their
recommendation was correct, provided that potential labor-cost improvements are
ignored. An incremental cost analysis similar to the following table should have been
prepared to determine whether the pump should be purchased or manufactured. In
the following analysis, fixed factory overhead costs and general and administrative
overhead costs have not been included because they are not relevant; these costs
would not increase, because no additional equipment, space, or supervision would
be required if the pumps were manufactured. Therefore, if potential labor cost
improvements are ignored, CFT should purchase the pumps because the purchase
price of $102 is less than the $108 relevant cost to manufacture.
Incremental cost analysis:
Purchased components ..................................................................

Assembly labor ................................................................................
Variable manufacturing overhead ..................................................
Total relevant cost........................................................................
McGraw-Hill/Irwin
Companies, Inc.
13-35
Cost of
10,000 Unit
Assembly Run Per Unit
$ 180,000
$ 18
450,000
45
450,000
45
$1,080,000
$108

1.
Per-unit contribution margins:

Standard
Selling price..
Less: Variable costs:
Direct material
Direct labor..
Variable manufacturing overhead
Sales commission
$375 x 10%; $495 x 10%.
Total unit variable cost.
Unit contribution margin
Enhanced
$375.00
$42.00
22.50
36.00
$495.00
$67.50
30.00
48.00
37.50
49.50
138.00
$237.00
195.00
$300.00
2.
The following costs are not relevant to the decision:

Development costssunk
Fixed manufacturing overheadwill be incurred regardless of which
product is selected
Sales salariesidentical for both products
Market studysunk
3.
Martinez, Inc. expects to sell 10,000 Standard units (40,000 units x 25%) or
8,000 Enhanced units (40,000 units x 20%). On the basis of this sales
forecast, the company would be advised to select the Standard model.
4.
Standard
Enhanced
Total contribution margin:

10,000 units x $237; 8,000 units x $300. $2,370,000
Less: Marketing and advertising
195,000
Income... $2,175,000
$2,400,000
300,000
$2,100,000
The quantitative difference between the profitability of Standard and

Enhanced is relatively small, which may prompt the firm to look at other
factors before a final decision is made. These factors include:
-
Competitive products in the marketplace

Data validity
Growth potential of the Standard and Enhanced models
Production feasibility
Effects, if any, on existing product sales
Break-even points
McGraw-Hill/Irwin
Companies, Inc.
13-36
McGraw-Hill/Irwin
Companies, Inc.
13-37

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EXERCISE 13-33 (20 MINUTES)

The economic value added (EVA) is defined as follows:

EXERCISE 13-34 (10 MINUTES)

= $450* + $120 = $570

= forgone contribution margin

2005 The McGraw-Hill Companies,

EXERCISE 13-35 (25 MINUTES)

2005 The McGraw-Hill Companies,

PROBLEM 13-36 (25 MINUTES)

Imputed interest rate of 14%:

Imputed interest rate of 15%:

2005 The McGraw-Hill Companies,

a more complete picture of divisional performance.

2005 The McGraw-Hill Companies,

PROBLEM 13-37 (45 MINUTES)

ROI = sales margin capital turnover = 20% 4 = 80%

Residual income = income (imputed interest rate)(invested capital)

20% = sales revenue

Therefore, invested capital = $8,000,000

= sales margin capital turnover

2005 The McGraw-Hill Companies,

PROBLEM 13-37 (CONTINUED)

Residual income = income (imputed interest rate)(invested capital)

= sales margin capital turnover

= 25% capital trunover

Therefore, capital turnover = .8

Therefore, income = (20%)(invested capital)

= income (imputed interest rate)(invested capital)

Substituting from above for income:

Therefore, income = $800,000

Therefore, sales revenue = $3,200,000

2005 The McGraw-Hill Companies,

PROBLEM 13-38 (20 MINUTES)

Three ways to increase Division I's ROI:

Increase income and decrease invested capital. Suppose income increases to

sales margin capital turnover

2005 The McGraw-Hill Companies,

PROBLEM 13-39 (25 MINUTES)

Imputed interest rate of 12%

Imputed interest rate of 15%

2005 The McGraw-Hill Companies,

PROBLEM 13-39 (CONTINUED)

Imputed interest rate of 18%

= Division I's residual income

$600,000 (r)($3,000,000) = $2,700,000 (r)($18,000,000)

2005 The McGraw-Hill Companies,

PROBLEM 13-40 (35 MINUTES)

Current ROI of the Western Division:

ROI = Income invested capital

ROI = Income invested capital

An examination of the competitors financial statistics reveals the following:

ROI = Income invested capital

2005 The McGraw-Hill Companies,

PROBLEM 13-40 (CONTINUED)

ROI = Income invested capital

Current residual income of the Western Division:

2005 The McGraw-Hill Companies,

PROBLEM 13-41 (40 MINUTES)

ROI rounded to the nearest tenth of 1 percent.

2005 The McGraw-Hill Companies,

PROBLEM 13-42 (40 MINUTES)

Based on Gross Book Value

2005 The McGraw-Hill Companies, Inc.