CHAPTER 10

SEGMENTED REPORTING, INVESTMENT CENTER

EVALUATION, AND TRANSFER PRICING
QUESTIONS FOR WRITING AND DISCUSSION
1. In centralized decision making, decisions
are made at the very top level, and lowerlevel managers are responsible for implementing these decisions. For decentralized
decision making, decisions are made and
implemented by lower-level managers.

to several cost objects. The distinction is important because direct fixed costs will vanish
if the cost object is eliminated but common
fixed costs will not.
10.

Contribution margin is the amount available

to cover fixed expenses and provide for profit. Segment margin is the amount available
to cover common fixed expenses and provide for profit for a segment. Contribution
margin is the difference between revenues
and variable expenses. Segment margin is
contribution margin less direct fixed expenses for a segment.

11.

Absorption-costing income can increase

from one period to the next if more is produced than what is sold. Even though the
fixed costs may not have changed, the fixed
costs recognized on the income statement
can change (because of inventory changes).

12.

Different customer groups cause different

activities and costs. Understanding what activities are unique to the various customer
groups can help the firm determine customer profitability and also help it set different
prices for the customer groups.

2. Decentralization is the delegation of decision-making authority to lower levels.

3. Reasons for decentralization include access
to local information, cognitive limitations,
more timely responses, focusing of central
management, training, and motivation.
4. The only difference is the way in which fixed
overhead costs are assigned. Under variable costing, fixed overhead is a period cost;
under absorption costing, it is a product
cost.
5. Absorption-costing income is greater because some of the periods fixed overhead is
placed in inventory and not recognized on
the absorption-costing income statement.
6. Absorption costing. Variable costing would
recognize only the periods fixed overhead
as an expense. The additional fixed overhead expense must have come from inventory.

13. Margin = Operating income/Sales, and

Turnover = Sales/Average operating assets.
By breaking ROI into margin and turnover,
more information is available to assess performance. Knowledge of margin and turnover gives more insight into why the ROI may
change from one period to the next.

7. Variable costing does not distort product

performance by allocating common fixed
costs. It allows managers to identify the contributions individual segments are making
toward coverage of fixed costs.
8. Variable costing allows managers to identify
what the costs ought to be for various levels
of activity. By knowing what the costs ought
to be for the actual level of activity, meaningful comparisons can be made to the costs
that actually occurred.

14. ROI (1) encourages managers to pay attention to the relationships among sales, expenses, and investment, (2) encourages
cost efficiency, and (3) discourages excessive investment in operating assets. Increased profitability can be achieved (all
else being equal) by increasing revenues,
decreasing expenses, or lowering investment.

9. A direct fixed cost is traceable to a particular

cost object. A common fixed cost is common

15. ROI may discourage managers from investing in projects that would increase the profitability of the firm but decrease the divisions

321

ROI. It also may encourage myopic behavior

by encouraging managers to make decisions that are profitable in the short run but
harmful in the long run (e.g., cutting research and development costs).
16.

EVA is the difference between after-tax

operating income and the total annual cost
of capital.

17.

Owners may have difficulty developing goal

congruence with managers because managers may not want to work as hard as the
owner would like and because managers
may wish to use the companys resources
for their own benefit. Properly structured incentive pay plans may be successful in
overcoming these problems.

18.

A transfer price is the price charged for

goods that are transferred from one division
to another.

19.

Transfer prices impact the revenues of the

transferring division and the costs of the
buying division and, thus, the profits of both
divisions. A transfer price can affect the profits of the firm because it can affect the output decision of the buying division. If the
price is set too high (low), then the output of
the buying division may be too low (high).
Since the transfer price can affect firmwide
profitability, higher management may be
tempted to interfere with the autonomy of a
division and dictate the price (rather than letting the divisional manager make the pricing
decision).

20.

price is the one that makes the buying division no worse off.

The opportunity cost approach to transfer

pricing identifies the minimum and maximum
transfer prices. The minimum transfer price
is the one that makes the transferring division no worse off, and the maximum transfer

322

21.

Agree. At least one division will be made

better off, and firm profits will increase.

22.

Market price. Minimum price = Maximum

price = Market price. Any other price would
make at least one division worse off, and
firm profits may decrease if the price is not
market price.

23.

Negotiated transfer prices allow both divisions to be made better off whenever opportunity costing signals that a transfer should
take place. Because both can be made better off, no interference from headquarters is
needed. Moreover, the price emerging is
necessarily a mutually satisfactory price. In
effect, negotiated prices can simultaneously
satisfy the objectives of accurate performance evaluation, firmwide efficiency, and
preservation of divisional autonomy. Disadvantages of negotiated transfer prices are
that (1) private information can be used for
exploitation, (2) performance measures are
distorted by relative negotiating skills of
managers, and (3) it is costly.

24.

Three cost-based transfer prices are full

cost, full cost plus markup, and variable cost
plus fixed fee. Disadvantages are that prices
may not reflect the optimal outcome for the
divisions and for the firm. Specifically, it is
possible for the transfer price using one of
the costing approaches to be less than the
minimum price and greater than the maximum price. The prices, however, are simple
to use and, in some cases, may reflect the
outcome of a negotiated agreement.

EXERCISES
10-1
Cost center Total cost
Profit center Operating income
Revenue Center - Sales
Investment center - Return on Investment

102
1.
Direct materials
Direct labor
Variable overhead
Fixed overhead
Total

Total Cost
$ 120,600
90,000
26,400
68,000
$ 305,000

Per Unit
$ 6.03
4.50
1.32
3.40
$ 15.25

Cost of ending inventory = $15.25 650 = $9,912.50

2.
Direct materials
Direct labor
Variable overhead
Total

Total Cost
$ 120,600
90,000
26,400
$ 237,000

Per Unit
$ 6.03
4.50
1.32
$ 11.85

Cost of ending inventory = $11.85 650 = $7,702.50

3.

Since absorption costing is required for external reporting, the amount reported would be $9,912.50.

323

103
1.

Fixed overhead rate = $107,500/25,000 = $4.30 per unit

The difference is computed as follows:
Fixed overhead rate(Production Sales)
$4.30(25,000 23,000) = $8,600

2.

a.

Lextel, Inc.
Variable-Costing Income Statement
For the Year Ended December 31, 2008
Sales (23,000 $26) ........................................
Less variable expenses:
Cost of goods sold (23,000 $12.80) ......
Selling (23,000 $4) ..................................
Contribution margin .......................................
Less fixed expenses:
Overhead ....................................................
Selling and administrative ........................
Operating income ...........................................

b.

$ 598,000
$ 294,400
92,000
$ 107,500
26,800

386,400
$ 211,600
134,300
$ 77,300

Lextel, Inc.
Absorption-Costing Income Statement
For the Year Ended December 31, 2008
Sales .....................................................................................
Less: Cost of goods sold (23,000 $17.10) ......................
Gross margin .......................................................................
Less: Selling and administrative expenses ......................
Operating income ...........................................................

$ 598,000
393,300
$ 204,700
118,800
$ 85,900

104
1.

Cocino Company
Product-Line Income Statements
Blenders
Sales
$ 2,200,000
Less: Variable cost of goods sold
2,000,000
Contribution margin
$ 200,000
Less: Direct fixed expenses
90,000
Product margin
$ 110,000
Less: Common fixed expenses
Net income

324

Coffee Makers
$ 1,125,000
1,075,000
$
50,000
45,000
$
5,000

Total
$ 3,325,000
3,075,000
$ 250,000
135,000
$ 115,000
115,000
$
0

2.

If the coffee-maker line is dropped, profits will decrease by $5,000, the product margin. If the blender line is dropped, profits will decrease by $110,000.

3.

Blenders
Sales
$ 2,405,000
Less: Variable cost of goods sold
2,200,000
Contribution margin
$ 205,000
Less: Direct fixed expenses
90,000
Product margin
$ 115,000
Less: Common fixed expenses
Operating income

Coffee Makers
$ 1,125,000
1,075,000
$
50,000
45,000
$
5,000

Profits increase by $5,000. Alternatively,

Increased profit = ($20.50 - $20.00) 10,000 = $5,000
105
1.

Absorption costing:
Direct materials
Direct labor
Variable overhead
Fixed overhead
Unit cost

$1.20
0.75
0.65
3.10
$5.70

Cost of ending inventory = $5.70 200 = $1,140

2.

Variable costing:
Direct materials
Direct labor
Variable overhead
Unit cost

$1.20
0.75
0.65
$2.60

Cost of ending inventory = $2.60 200 = $520

3.

Selling price
Less:
Variable cost of goods sold
Commission
Contribution margin per unit

$ 7.50
(2.60)
(0.75)
$ 4.15

325

Total
$ 3,530,000
3,275,000
$ 255,000
135,000
$ 120,000
115,000
$
5,000

4.

Sales ($7.50 17,600) ...............................

Less:
Variable cost of goods sold ................
Commissions .......................................
Contribution margin..................................
Less fixed expenses:
Fixed overhead ....................................
Fixed administrative ............................
Net income .................................................

$ 132,000
$45,760
13,200
$27,900
23,000

58,960
$ 73,040
50,900
$ 22,140

Variable costing should be used, since the fixed costs will not increase as
production and sales increase.

106
1.

Operating income = Sales Expenses = $50,000 $48,000 = $2,000

2.

Margin = Operating income/Sales

= $2,000/$50,000 = 0.04
Turnover = Sales/Operating assets
= $50,000/$10,000 = 5

3.

ROI = Margin Turnover = 0.04 5 = 0.20, or 20%

107
1.

Average operating assets = ($78,650 + $81,350)/2 = $80,000

2.

Margin = Operating income/Sales

= $7,200/$240,000 = 0.03
Turnover = Sales/Operating assets
= $240,000/$80,000 = 3.0
ROI = Margin Turnover = 0.03 3.0 = 0.09, or 9.0%

108
1.

a. ROI of division without radio = $480,000/$8,000,000 = 0.06

b. ROI of the radio project = $270,000/$1,500,000 = 0.18
c. ROI of division with radio = $750,000/$9,500,000 = 0.0789

2.

Yes, Cheryl will decide to invest in the project, since overall division ROI will
increase.

326

109
1.

After-tax cost of mortgage bonds = (1 0.3)(0.08) = 0.056

2.

Cost of common stock = 0.06 + 0.06 = 0.12

3.
Mortgage bonds
Common stock
Total

Dollar
Amount
$1,300,000
700,000
$2,000,000

Percent
0.65
0.35

After-Tax

Cost
=
0.056
0.120

Weighted average cost of capital

Weighted
Cost
0.0364
0.0420
0.0784

4.

Cost of capital = $1,500,000 0.0784 = $117,600

5.

After-tax operating income

Less: Cost of capital
EVA

$115,000
117,600
$ (2,600)

Because EVA is negative, Schipper is destroying wealth.

1010
1.

After-tax cost of mortgage bonds = (1 0.4)(0.08) = 0.048

2.

Cost of common stock = 0.06 + 0.06 = 0.12

3.
Mortgage bonds
Common stock
Total

Dollar
Amount
$1,300,000
700,000
$2,000,000

Percent
0.65
0.35

After-Tax

Cost
=
0.048
0.120

Weighted average cost of capital

Weighted
Cost
0.0312
0.0420
0.0732

4.

Cost of capital = $1,500,000 0.0732 = $109,800

5.

After-tax operating income

Less: Cost of capital
EVA

$115,000
109,800
$ 5,200

EVA is now positive, and Schipper is creating wealth.

327

10-11

1.

MP3 player: RI = $116,000 (0.12 $800,000)

= $20,000
Voice Rec.: RI = $105,000 (0.12 $750,000)
= $15,000

2.

Add Only
MP3 Player

Add Only
Voice Rec.

Add Both
Projects

Maintain
Status Quo

Operating income $2,816,000

Minimum income*
2,256,000
Residual income
$ 560,000

$2,805,000
2,250,000
$ 555,000

$2,921,000
2,346,000
$ 575,000

$2,700,000
2,160,000
$ 540,000

*Minimum income = Operating assets Minimum required rate of return

The manager will invest in both the MP3 player and the voice recorder.
3.

ROI MP3 player = $116,000/$800,000 = 0.145 or 14.5%

ROI voice recorder = $105,000/$750,000 = 0.14 or 14.0%

4.

Operating income
Operating assets
ROI

Add Only
MP3 Player

Add Only
Voice Rec.

Add Both
Projects

Maintain
Status Quo

$2,816,000
18,800,000
14.98%

$2,805,000
18,750,000
14.96%

$2,921,000
19,550,000
14.94%

$2,700,000
18,000,000
15.00%

The manager will invest in neither project.

10-12
1. North Woods residual income = $140,000 (0.08)($1,000,000) = $60,000
Midwest residual income = $330,000 (0.08)($3,000,000) = $90,000
2. North Woods ROI = $140,000/$1,000,000 = 0.14 or 14%
Midwest ROI = $330,000/$3,000,000 = 0.11 or 11 %

328

1013
1.

Maximum transfer price = $42

Minimum transfer price = $15
Only variable costs are relevant for the minimum transfer price since the Furniture Division has excess capacity.
Yes, the transfer should take place.

2.

Benefit to Furniture Division:

Revenue ($30 10,000)
Less: Variable cost ($15 10,000)
Benefit

$ 300,000
150,000
$ 150,000

Benefit to Motel Division:

Outside supplier ($42 10,000)
Transfer price ($30 10,000)
Benefit

$ 420,000
300,000
$ 120,000

Benefit to company = $150,000 + $120,000 = $270,000

3.

Maximum transfer price = $42

Minimum transfer price = $42
It does not matter whether or not the transfer takes place because the cost to
the company is the same whether the Motel Division buys from the outside
supplier or from the internal supplier (the Furniture Division).

1014
1.

The minimum and maximum transfer price for each division is $2.30. The
company is indifferent to the transfer because it earns the same income
whether or not it takes place. If the transfer takes place, the price should be
$2.30.

2.

The minimum transfer price is $2.10, and the maximum price is still $2.30. The
transfer should take place because the company would save $30,000 (150,000
$0.20) each year.

3.

The offer should be accepted because the Small Motor Divisions profits
would increase by $15,000 (representing an even split of the savings from internal transfer).

329

1015
1.

Maximum price
Minimum price*
Difference
Number of packages
Increased profit

3.95
2.25
$
1.70
150,000
$ 255,000

*Due to idle capacity of the Paper Division, the minimum price is a variable
cost of $2.25 per package. Since selling costs of $0.40 are avoidable, they
are not included.
Yes, the transfer should take place.
2.

Penelope would definitely consider the $3.20 price because her income would
increase $112,500 ([$3.95 $3.20] 150,000). Tom would most likely negotiate a price less than $3.75 if he has knowledge of the excess capacity.

3.

The full-cost transfer price is $3.45 ($2.25 + $1.20). If the transfer takes place,
the Paper Division will make an additional $180,000 (150,000 $1.20) and the
School Photography Division will save $75,000 ([$3.95 $3.45] 150,000).

1016
Revenues
Expenses
Operating income
Assets
Margin
Turnover
ROI

A
$10,000
7,800
2,200
20,000
22%1
0.502*
11%3

B
$ 45,000
27,0004
18,000
144,0005
40%
0.3125
12.5%6

*Indicates missing amount.

1
$2,200/$10,000 = 0.22
2
$10,000/$20,000 = 0.50
3
$2,200/$20,000 = 0.11
4
$45,000 - $18,000 = $27,000
5
$45,000 0.3125 = $144,000
6
0.4 0.3125 = 0.125
7
$200,000 - $188,000 = $12,000

C
$200,000
188,000
12,0007
100,000
6%8
29
12.0%10

D
$19,20011
18,00012
1,20013
9,600
6.25%
2.00
12.5%14

$12,000/$200,000 = 0.06
$200,000/$100,000 = 2
10
$12,000/$$100,000 = 0.12
11
$9,600 2 = $19,200
12
$19,200 - $1,200 = $18,000
13
$19,200 0.0625 = 1,200
14
$1,200/$9,600 = 0.125
9

330

10-17
1. Company A residual income = $2,200 (0.12)($20,000) = $200
Company B residual income = $18,000 (0.12)($144,000) = $720
Company C residual income = $12,000 (0.12)($100,000) = 0
Company D residual income = $1,200 (0.12)($9,600) = $48

331

PROBLEMS
1018
1.

Diaz Company
Absorption-Costing Income Statements
Sales ...........................................................................
Less: Cost of goods sold* ........................................
Gross margin .............................................................
Less: Selling and administrative expenses ............
Net income ...........................................................
*Beginning inventory ................................................
Cost of goods manufactured ..................................
Goods available for sale .........................................
Less: Ending inventory ...........................................
Cost of goods sold .............................................

Year 1
$ 572,000
299,000
$ 273,000
163,800
$ 109,200

Year 2
$ 660,000
361,000
$ 299,000
163,800
$ 135,200

$ 46,000
315,000
$ 361,000
0
$ 361,000

0
345,000
$ 345,000
46,000
$ 299,000

Firm performance has improved from Year 1 to Year 2.

2.

Diaz Company
Variable-Costing Income Statements
Sales ...........................................................................
Less: Variable cost of goods sold* .........................
Contribution margin .................................................
Less fixed expenses:
Overhead ..............................................................
Selling and administrative ..................................
Net income .................................................................
*Beginning inventory ................................................
Variable cost of goods manufactured ...................
Goods available for sale .........................................
Less: Ending inventory ...........................................
Cost of goods sold .............................................

Year 1
$ 572,000
195,000
$ 377,000

Year 2
$ 660,000
225,000
$ 435,000

(120,000)
(163,800)
$ 93,200

(120,000)
(163,800)
$ 151,200

$ 30,000
195,000
$225,000
0
$ 225,000

0
225,000
$ 225,000
30,000
$ 195,000

Firm performance has improved from Year 1 to Year 2.

3. Year 1 fixed overhead rate = $120,000/30,000 = $4.00

4.

Absorption-costing inventory = ($7.50 + $4.00) 4,000 = $46,000

Variable-costing inventory = $7.50 4,000 = $30,000

1019
332

1.

Ziemble Company
Absorption-Costing Income Statement
Sales ...........................................................................................
Cost of goods sold* ..................................................................
Gross margin .............................................................................
Selling and administrative expenses ......................................
Net income ...........................................................................

$ 1,512,000
1,048,000
$ 464,000
444,000
$
20,000

*Fixed overhead rate = $300,000/75,000 = $4 per unit

Applied fixed overhead = $4 74,000 = $296,000
Underapplied fixed overhead = $300,000 $296,000 = $4,000
Cost of goods sold = ($4 72,000) + $4,000 + $756,000
= $1,048,000
2.

The difference is $8,000 ($20,000 $12,000) and is due to the fixed overhead
that would be attached to the ending inventory ($4 2,000 units).
IA IV = Fixed overhead rate(Production Sales)
$20,000 $12,000 = $4(74,000 72,000)
$8,000 = $8,000

333

1020
1.

Scented
Sales
$ 13,000
Less: Variable expenses
9,100
Contribution margin
$ 3,900
Less: Direct fixed expenses 4,250
Product margin
$ (350)
Less: Common fixed expenses
Net (loss)

Musical
$ 19,500
15,600
$ 3,900
5,750
$ (1,850)

Regular
$ 25,000
12,500
$ 12,500
3,000
$ 9,500

Total
$ 57,500
37,200
$ 20,300
13,000
$ 7,300
7,500
$ (200)

Kathy should accept this proposal. The 30 percent sales increase, coupled
with the increased advertising, reduces the loss from $1,000 to $200. Both
scented and musical product-line profits increase. However, more must be
done. If the scented and musical product margins remain negative, the two
products may need to be dropped.
2.
Sales
Less: Variable expenses
Contribution margin
Less: Fixed expenses
Operating income (loss)

Regular
$ 20,000
10,000
$ 10,000
10,500
$ (500)

Dropping the two lines would still result in a loss. Other options need to be
developed.
3.

Combinations would be beneficial. Dropping the musical line (which shows

the greatest segment loss) and keeping the scented line while increasing advertising yields a profit (the optimal combination).
Scented
$ 13,000
9,100
$ 3,900
4,250
$ (350)

Sales
Less: Variable expenses
Contribution margin
Less: Direct fixed expenses
Product margin
Less: Common fixed expenses
Operating income

334

Regular
$ 22,500
11,250
$ 11,250
3,000
$ 8,250

Total
$ 35,500
20,350
$ 15,150
7,250
$ 7,900
7,500
$
400

1021
1.

Direct materials
Direct labor
Variable overhead
Fixed overhead ($180,000/200,000)
Total

$3.60
2.00
0.40
0.90
$ 6.90

Per-unit inventory cost on the balance sheet is $6.90.

Sales (207,000 $10)
Less: Cost of goods sold
Gross margin
Less: Selling and administrative expenses
Net income
2.

Direct materials
Direct labor
Variable overhead
Total

$ 2,070,000
1,428,300
$ 641,700
132,100
$ 509,600

$ 3.60
2.00
0.40
$ 6.00

Per-unit inventory cost under variable costing equals $6.00.

This differs from the per-unit inventory cost in Requirement 1 because the
balance sheet is for external use and reflects absorption costing. Variable
costing does not include per-unit fixed overhead.
Sales
Less variable expenses:
Variable cost of goods sold
Variable selling and administrative
Contribution margin
Less fixed expenses:
Fixed overhead
Fixed selling and administrative
Net income
3.

IV IA
$515,900 $509,600
$6,300
$6,300

= FOR(Sales Production)
= $0.90(207,000 200,000)
= $0.90(7,000)
= $6,300

335

$ 2,070,000
1,242,000
62,100
$ 765,900

180,000
70,000
515,900

4.

5.

Sales (196,700 $10)

Less: Cost of goods sold (196,700 $6.90)
Gross margin
Less: Selling and administrative expenses
Absorption costing operating income

$ 1,967,000
1,357,230
$ 609,770
129,010
$ 480,760

Sales
Less variable expenses:
Variable cost of goods sold
Variable selling and administrative
Contribution margin
Less fixed expenses:
Fixed overhead
Fixed selling and administrative
Variable costing operating income

$1,967,000

IA IV
$480,760 $477,790
$2,970
$2,970

1,180,200
59,010
$ 727,790

180,000
70,000
477,790

= FOR(Sales Production)
= $0.90(200,000 196,700)
= $0.90(3,300)
= $2,970

1022
1.

Air conditioner, ROI = $67,500/$750,000 = 9.0%

Turbocharger, ROI = $89,700/$690,000 = 13.0%

2.
Income
Assets
ROI

With Air
Conditioner
$3,246,500
$29,650,000
10.95%

With
Turbocharger
$3,268,700
$29,590,000
11.05%

With Both
Investments
$3,336,200
$30,340,000
11.00%

Neither
Investment
$3,179,000
$28,900,000
11.00%

The manager will choose the turbocharger, but not the air conditioner.
3.

Cost of capital

= (1 0.25)(0.12)($1,500,000)
= $135,000

EVA = ($67,500 + $89,700) $135,000 = $22,200

Yes, the two investments increase the wealth of the division, since EVA is
positive.

336

1023
1.

$310,000/$3,000,000 = 10.33%*

2.

Margin:
$310,000/$3,450,000 = 8.99%
Turnover: $3,450,000/$3,000,000 = 1.15
ROI = 1.15 8.99% = 10.34%
*Difference due to rounding.

3.

($310,000 + $57,500)/($3,000,000 + $500,000*) = 10.5%

*($600,000 + $400,000)/2
The manager will approve the investment.

4.

Margin:
($310,000 + $57,500)/($3,450,000 + $575,000) = 9.13%
Turnover: ($3,450,000 + $575,000)/($3,000,000 + $500,000) = 1.15
The margin has increased, and the turnover ratio has stayed the same.

5.

With: ($310,000 + $57,500)/($3,000,000 + $500,000 $800,000) = 13.61%

Without: $310,000/($3,000,000 $800,000) = 14.09%
The manager will most likely reject the investment because it lowers the divisional ROI. The investment should be accepted because it increases total
profits.

6.

Margin:
$310,000/$3,450,000 = 8.99%
Turnover: $3,450,000/$2,200,000 = 1.57

1024
1.
ROI
Margin
Turnover
2.

Year 1
8.00%
12.00%
0.67

Year 2
6.97%
11.00%
0.63

Year 3
6.30%
10.50%
0.60

ROI:
$1,200,000/$15,000,000 = 8%
Margin:
$1,200,000/$10,000,000 = 12%
Turnover: $10,000,000/$15,000,000 = 0.67
The ROI increased because expenses decreased and assets turned over at a
higher rate (sales increased).

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3. Operating assets: $15,000,000 80% = $12,000,000

ROI:
$945,000/$12,000,000 = 7.88%
Margin:
$945,000/$9,000,000 = 10.5%
Turnover: $9,000,000/$12,000,000 = 0.75
The ROI increased because assets decreased.
4.

ROI:
$1,200,000/$12,000,000 = 10%
Margin:
$1,200,000/$10,000,000 = 12%
Turnover: $10,000,000/$12,000,000 = 0.83
The ROI increased because expenses decreased and assets turned over at a
higher rate (sales increased and the amount of assets decreased). Both margin and turnover increased.

1025
1.

After-tax cost of mortgage bonds = (1 0.4)(0.06) = 0.036

Cost of common stock = 0.08 + 0.03 = 0.11
Dollar
Amount
Percent
Mortgage bonds
$ 3,000,000
0.25
Common stock
9,000,000
0.75
Total
$ 12,000,000

After-Tax

Cost
=
0.036
0.110

Weighted average cost of capital

Weighted
Cost
0.0090
0.0825
0.0915

Cost of capital = $4,000,000 0.0915 = $366,000

2.

After-tax operating income

Less: Cost of capital
EVA

$ 350,000
366,000
$( 16,000)

EVA is negative; Donegal is destroying wealth.

3.

After-tax cost of new bonds = (1 0.4)(0.09) = 0.054

Dollar
After-Tax
Amount
Percent
Cost
=
Unsecured bonds
$ 2,000,000
0.143
0.054
Mortgage bonds
3,000,000
0.214
0.036
0.643
0.110
Common stock
9,000,000
Total
$ 14,000,000
Weighted average cost of capital

Weighted
Cost
0.0077
0.0077
0.0707
0.0861

Cost of capital = $5,000,000 0.0861 = $430,500

338

4.

After-tax operating income

Less: Cost of capital
EVA

$430,000
430,500
($ 500)

No, this is not a good idea. EVA is negative and Donegal is destroying wealth.

1026
1.

Minimum: $26
Maximum: $31

2.

($26 + $31)/2 = $28.50. Thus, the transfer price would be expressed as full
cost plus 42.5% ($20 + $8.50/$20).

3.

New minimum: $27

New maximum: $32
($27 + $32)/2 = $29.50
or full cost plus 47.5% ($20 + $9.50/20)

4.

The two divisions would renegotiate because the buying division would probably be able to buy the necessary part at a lower price from another supplier.
The Auxiliary Components Division might have to reduce its price.

1027
1.

Lorne should not reduce the price charged to Rosario if he can sell all he
produces. It does not matter whether the two divisions trade internally or not.

2.

The minimum price is $53, and the maximum is $75. Yes, Lorne should consider the transfer, since his income will increase by $59,500 [3,500($70
$53)].
3. The transfer price would be $75.60 ($63 1.2). No, the transfer would not
occur, since the transfer price is higher than the outside price that Rosario
could get.

1028
1.
Sales
Variable expenses
Contribution margin

Component Y34
$260,000
160,000
$100,000

339

Model SC67
$1,680,000
920,000
$ 760,000

Company
$1,940,000
1,080,000
$ 860,000

2.

The transfer price should be the market price of $12. This is the minimum
price for the Components Division and the maximum price for the PSF Division.

3.

Unless the PSF Division is able to increase the price of Model S667, the manager will discontinue production and will not purchase any of the components. (The cost of producing the scanner will increase from $38 to $43.50, a
cost greater than the current selling price of $42.)

4.

All 40,000 units of Component Y34 will be sold externally at the market price
of $12 per unit.

5.

Sales
Variable expenses
Contribution margin

$480,000
160,000
$320,000

The contribution margin decreases by $540,000. Cam made the wrong decision.

1029
1.

Madengrad Company
Variable-Costing Income Statement
Budgeted for Next Year
Sales (21,500 $900) ................................................
Less variable expenses:
Cost of goods sold (21,500 $525) .................... $11,287,500
Selling (21,500 $75) ..........................................
1,612,500
Contribution margin .................................................
Less: Fixed expenses ...............................................
Operating income (loss) .....................................

2.

$ 19,350,000
12,900,000
$ 6,450,000
6,600,000
$ (150,000)

Madengrad Company
Variable-Costing Income Statement
Budget Based on Technological Change
Sales (21,500 $900) ................................................
Variable cost of goods sold:
Direct materials (21,500 $180) .........................
Direct labor (21,500 $216) ................................
Overhead (21,500 $78.75) .................................
Variable selling (21,500 $75) .................................
Contribution margin .................................................
Less: Fixed expenses ...............................................
Operating income ................................................

340

$ 19,350,000
$3,870,000
4,644,000
1,693,125

10,207,125
1,612,500
$ 7,530,375
7,260,000
$
270,375

1030
A.
B.
C.
D.
E.

Cost; total manufacturing cost

Investment; ROI
Revenue; total sales revenue
Profit; operating income
Investment; ROI

1031
1. The profit change can be explained by the following analysis:
Increase in sales revenues
$20,000
Increase in variable manufacturing costs ($3.90 2,000)
(7,800)
Increase in variable selling costs ($0.50 2,000)
(1,000)
Increase in fixed overhead:
Year 12,000 units $2.90
(5,800)
Year 21,000 units $3.00
(3,000)
Year 3 underapplied fixed OH
(3,000)
Net change in income
$ (600)
The problem is the increased fixed overhead. We expect variable costs to increase, but the increase in fixed overhead expenses is notable, because the
actual fixed overhead incurred for Year 3 is the same as that of Year 2. This
increase in fixed overhead recognized on the income statement is explained
by the fact that in Year 3, the division sold units from prior years with fixed
overhead attached to them, and by the fact that no fixed overhead was inventoried (as was the case in Year 2).
2.
Year 1
Year 2
Year 3
Sales
$ 80,000
$100,000
$120,000
Less variable expenses:
Cost of goods sold
(31,200)
(40,000)
(47,800)
Selling expense
(3,200)
(5,000)
(6,000)
Contribution margin
$ 45,600
$ 55,000
$ 66,200
Less fixed expenses:
Fixed overhead
(29,000)
(30,000)
(30,000)
Other fixed costs
(9,000)
(10,000)
(10,000)
Net income
$ 7,600
$ 15,000
$ 26,200
$ 5,800a
0
$ 5,800

FOH, ending inventory

FOH, beginning inventory
Change in fixed overhead
a

$2.90 2,000 units

($3.00 1,000 units) + $5,800

341

$
$

8,800b
5,800
3,000

$
$

0
8,800
8,800

The difference between the absorption- and variable-costing incomes is due

to the change in fixed overhead in the divisions inventories. In Year 1, $5,800
of the fixed overhead went into inventory; so, absorption-costing income exceeds variable-costing income by $5,800. In Year 2, $3,000 more fixed overhead was inventoried, and absorption-costing income was $3,000 greater
than variable-costing income. However, in Year 3, the inventory was sold, and
absorption-costing income now recognizes that additional $8,800 of fixed
overhead ($5,800 + $3,000), explaining why variable-costing income is greater
by this amount.
3.

Since variable-costing income provides an increase in income when sales increase and costs do not change, the company vice president would have preferred variable costing. Variable costing would have provided the expected
bonus to the divisional manager and a consistent signal of improved performance.

1032
1.

The transfer price based on variable manufacturing costs to produce the cushioned seat and the Office Divisions opportunity cost is $1,869 for a 100unit lot, or $18.69 per seat as summarized below:
Variable cost .........................................................
Opportunity cost ..................................................
Transfer price .......................................................
Variable cost:
Cushioned material:
Padding............................................................
Vinyl .................................................................
Total ............................................................
Cost increase 10% ..........................................
Cost of cushioned seat .............................
Cushion fabrication labor
($7.50 0.5) .....................................................
Variable overhead
($5.00 0.5) .....................................................
Total variable cost per cushioned seat ..............
Total variable cost per 100-unit lot .....................

342

$1,329
540
$1,869

$ 2.40
4.00
$ 6.40
1.10
$ 7.04
3.75
2.50
$13.29
$1,329

1032 Continued
Overhead Analysis

Supplies
Indirect labor
Supervision
Power
Heat and light
Property taxes
and insurance
Depreciation
Employee benefits:
20% Direct labor
20% Supervision
20% Indirect labor
Total

Variable Amount
Per DLH
Total
$ 420,000
$1.40
375,000
1.25
180,000

Fixed Amount
Total
Per DLH
$ 250,000

$0.83

140,000

0.47

200,000
1,700,000

0.67
5.67

0.60

450,000

1.50

75,000
$1,500,000

0.25
$5.00

50,000
$2,340,000

0.16*
$7.80

*The per DLH amount for supervision has been adjusted down to $0.16 to
eliminate the rounding error between the sum of the amounts per DLH and
the total divided by 300,000 DLH.
Variable overhead rate = ($1,500,000/300,000) = $5.00 per DLH
Fixed overhead rate = ($2,340,000/300,000) = $7.80 per DLH
Opportunity cost:
Labor hour constraint:
DLH to make 100 deluxe office stools (1.50 100)
Less: DLH to make 100 cushioned seats (0.50 100)
Labor hours available for economy office stool
Number of economy office stools

150 hours
50 hours
100 hours

= 100 DLH/0.8 hours per stool

= 125 stools

343

1032 Concluded
Opportunity cost calculation:

Selling price
Costs:
Materials
Labor
Variable overhead
Total costs
CM/unit
Units produced
Total CM

Deluxe
Office Stool
$58.50
$14.55
11.25 ($7.50 1.5)
7.50 ($5.00 1.5)
$33.30
$25.20
100
$2,520

Economy
Office Stool
$41.60
$15.76
6.00 ($7.50 0.8)
4.00 ($5.00 0.8)
$25.76
$15.84
125
$1,980

Opportunity cost of shifting production to the economy office stool =

$2,520 $1,980 = $540.
2.

Variable manufacturing cost plus opportunity cost would be the best transfer
pricing system to use because it would allow the supplying division to be indifferent between selling the product internally to another division or selling
the product in the external market. This transfer pricing method ensures that
the supplying divisions contribution to profit would be the same under either
alternative. The sum of the variable manufacturing cost and the opportunity
cost represents the effort put forth by the supplying division to the overall
well-being of the company.
An appropriate transfer price must attempt to fulfill the company objectives of
autonomy, incentive, and goal congruence. While no one transfer price can
necessarily satisfy each of these objectives fully in all situations, the variable
manufacturing cost plus opportunity cost transfer price should be the most
appropriate method for meeting these objectives in most situations.

1033
1.

Many legitimate reasons support the creation of inventory (e.g., the need to
avoid stockouts and the need to ensure on-time delivery). Paul Chessers
reasons, however, are based on self-interest and ignore whats best for the
company. Knowingly producing for inventory to obtain personal financial
gain at the expense of the company certainly could be labeled as unethical
behavior.

2.

Since the decision to produce for inventory was not motivated by any sound
economic reasoning, and Ruth knows the real motive behind the decision,
she should feel discomfort in the role she has been asked to assume. If she

344

decides to appeal to higher-level management, the divisional manager can

counter with arguments that inventory was created because he expected the
economy to turn around and did not want to be in a position of not having
enough goods to meet demand. Even though Ruth may have a difficult time
proving any allegation of improper conduct, if she is convinced that the behavior is truly unethical, then appeals to higher-level management with the
prospect of ultimate resignation should be the route she takes.
Alternatively, Ruth might decide that the use of absorption costing for internal reporting and bonus calculation has led to this situation. She could lobby
higher management to begin using variable costing as a way of avoiding
these dysfunctional decisions. Ruth will have a very hard time proving unethical behaviorat worst, Paul may be accused of having poor judgment regarding future economic upturns.
3. The following standards may apply:
Integrity. Refrain from engaging in any conduct that would prejudice carrying
out duties ethically. (III-2)
Credibility. Communicate information fairly and objectively. (IV-1) Disclose
fully all relevant information that could reasonably be expected to influence
an intended users understanding of the reports, comments, and recommendations. (IV-2)

1034
1.

ROI based on initial estimates = $1,870,000/$15,600,000 = 11.99%

ROI based on Mels estimates = $2,340,000/$15,600,000 = 15%

2.

Jason is definitely facing an ethical dilemma. While it is true that the sales
and expense projections are estimates, they are the best ones available to
him. If he uses a sales revenue projection from the top end of the range, he
will be deliberately basing the ROI estimate on a highly unlikely sales figure.
Sales and expense projections are not fantasy figures, they are supposed to
be managements best estimate of what will actually happen. If Jason prepares the report in accordance with Mels desires, he will be knowingly fabricating data.
One might wonder whether or not Mels offer to back up Jason is sufficient
to let Jason off the hook. It is not. If Mel wants the false projections badly
enough, let him sign them. Jason may have thought he had his dream job, but
it is about to turn into a nightmare. Companies dont take kindly to employees
who lie, and this lie is sure to come out. If the project is approved, and the
sales do not approach $2.34 million, you can bet that the vice president of

345

sales will be quick to point out that she predicted only $1.87 million. Mel will
surely pin the blame directly on Jason, the one whose name is on the report.
3.

Jason should prepare the report using the figures he thinks are most descriptive of the projects potential. He should feel free to include information about
the predicted range of sales, and to point out any other information that reflects favorably on the project. If Mel continues to pressure Jason, then Jason
might consider looking for another job.

RESEARCH ASSIGNMENTS
1035
Answers will vary.

1036
Answers will vary.

346