RSM1222 Management Accounting Spring, 2012 (Q4)

Quiz #2 Questions and Solutions

This documents consists of the four quiz questions (one per section) followed by the four solutions. The last page is the quiz #2 cheat sheet.

Section 1 Question
(Total 9 points)

General comment: When you are explaining your reasoning, if appropriate, identify any assumptions you are making. Jack is the general manager of Analyze4U a company that provides specialized analytical services to retail companies. He is responsible for all aspects of the operations. For example, internally he makes all hiring decisions and assigns employees their tasks and responsibilities. Externally, he handles the process of identifying customers, calling on them and negotiating prices. Jack has hired Jenny as assistant manager. Her primary responsibility is to manage the large number of temporary workers who are hired on short, project-specific contracts. This includes choosing whom to hire and setting their pay and any other contract details. These temporary workers help keep Analyz4U flexible in meeting customer demand and are considered variable costs. While every client job varies somewhat in terms of resources, everything becomes standardized into work units. Assume this standardized process is reasonable. Below is the static financial budget created at the beginning of the period based on selling 800 work units. The other column shows the actual financial results, which is based on actual sales of 1,200 work units. Static Budget (1) Sales Temporary workers (variable) costs All other (fixed) costs Profit $480,000 (160,000) (250,000) $70,000 Actual (2) $700,000 (300,000) (260,000) $140,000

a) (6 points) Calculate the following sets of numbers: (i) the variances between the actual and static budget results; (ii) the flexible budget assuming 1,200 work units and using all other budgeting assumptions; and (iii) the variances between the actual and flexible budget results. b) (1 point) Assume that Jack is evaluated based on actual performance versus a flexible budget. Did Jack perform well or poorly? Explain (one to two sentences). c) (2 points) Argue (two to four sentences) that the static budget is better than the flexible budget to benchmark Jacks performance, while the flexible budget is better than the static budget to benchmark Jennys performance.

Section 2 Question
(Total 9 points)

General comment: When you are explaining your reasoning, if appropriate, identify any assumptions you are making. Delta Telecom, Inc., which produces telecommunications equipment in Canada, has a very strong local market for its circuit board. The variable production cost is $390, and the company can sell its entire supply domestically for $510. The Canadian tax rate is 40 percent. Alternatively, Delta can ship the circuit board to its division in Germany, to be used in a product that the German division will distribute throughout Europe. Information about the German product and the divisions operating environment follows. Selling price of final product Shipping fees to import circuit board from Canada Labour, overhead, and additional material costs of final product German tax rate * Does not include transfer price paid to Canadian operations. $1,080 $60 $345 60%

Assume that Canadian and German tax authorities allow a transfer price for the circuit board set at either Canadian variable manufacturing cost or the Canadian market price. Deltas management is in the process of exploring which transfer price is better for the firm as a whole. a) (2 points) Compute overall company profitability if all units are transferred and Canadian variable manufacturing cost is used as the transfer price. Show separate calculations for the Canadian operation and the German division. b) (2 points) Compute overall company profitability if all units are transferred and Canadian market price is used as the transfer price. Show separate calculations for the Canadian operation and the German division. c) (2 points) Which of the two transfer prices is better for Delta? Explain (two to four sentences). d) (1 point) Assume that the Canadian division can act autonomously. What is the minimum price the Canadian division would demand for selling its circuit board to Germany? Explain (one to two sentences). e) (2 points) Assume that the German division can obtain the circuit board in Germany for $465 and avoid paying the shipping fees to import the circuit boards from Canada. If the German division could act autonomously, what is the maximum price the German division would be willing to pay for the Canadian circuit board? Explain (two to four sentences).

Section 3 Question
(Total 9 points)

General comment: When you are explaining your reasoning, if appropriate, identify any assumptions you are making. PROTEIN+, one of the smaller divisions of AAA foods, produces protein and energy bars that taste much better than competitors products. The secret is in the Italian flavour system. PROTEIN+ is considering an acquisition of a company, Omega Drinks, which produces a variety of healthy ready-to-drink products. PROTEIN+ believes that Omegas assets could be acquired for an investment of $3.2 million, an amount equal to Omegas invested capital. This is a large acquisition for PROTEIN+, given that PROTEIN+s invested capital is $6.6 million. All of AAAs 20 divisions are evaluated based on change in ROI. In addition to compensation being tied to ROI, those division managers who achieve consistent increases in ROI are far more likely to be considered for promotion to manager of larger divisions, which have larger base salaries. The following are condensed financial statements for Omega and PROTEIN+ for the most recent year: Omega PROTEIN+ Sales $3,200,000 $9,500,000 Variable costs (1,400,000) (6,000,000) Fixed costs (1,200,000) (1,500,000) Income $ 600,000 $2,000,000 If the acquisition goes through, PROTEIN+ expects it can achieve one significant synergy. PROTEIN+ management believes it can apply its expertise in flavour technology to dramatically improve Omegas market share and income by producing better tasting drinks. In particular, PROTEIN+ expects to increase both Omegas sales and Omegas variable costs by about 50%. No change is expected to Omegas fixed costs or its invested capital. a) (3 points) Calculate PROTEIN+s ROI both before and after the Omega acquisition. b) (2 points) If AAA uses change in ROI as the sole measure of divisional performance, explain (two to four sentences) why PROTEIN+ would (or would not) like to acquire Omega. c) (2 points) Calculate PROTEIN+s residual income both before and after the Omega acquisition. Assume a hurdle rate of 20%. d) (1 point) If AAA used residual income to measure the performance of PROTEIN+, explain (one to two sentences) whether PROTEIN+s willingness to acquire Omega is different than if they use ROI.
e) (1 point) What is one other consideration (other than ROI or residual income) that

PROTEIN+ should factor into its acquisition decision? Explain (one to two sentences).

Section 4 Question
(Total 9 points) General comment: When you are explaining your reasoning, if appropriate, identify any assumptions you are making. ACME, Inc. is a seafood restaurant chain that consists of two divisions, the properties division and the food service division. The company generally has a low cost of capital and uses a hurdle rate of 8% for investment decisions for both divisions. The invested capital and income for the most recent year are as follows (in $ millions): Invested Capital $210.0 200.0 410.0 Income $43.5 22.5 66.0

Properties Food Service ACME, Inc

a) (3 points) Calculate: (i) the residual income of the Properties division; and (ii) the ROI for both the Food Service division and ACME, Inc. b) (1 point) The food service division is considering an acquisition with an income of $2 million and invested capital of 20 million. Assume there are no synergies. Calculate the revised ROI for the food service division if the acquisition is completed. c) (2 points) Assume the division presidents and ACME executives are compensated based on changes in ROI. Will the food service division manager want to do this deal? Will the ACME executives want to do this deal? Explain (two to four sentences). d) (1 point) Would ACME want to do the deal if residual income was used to evaluate the acquisition? Explain (one to two sentences). e) (2 points) Jill is the president of the Food Service division, reporting to the ACME CEO. You learn two things about Jills performance. First, part of her $22.5 million of income includes a $3 million charge that the division had to pay as a result of a legal settlement from a lawsuit filed one year before Jill was hired. Second, approximately $1.1 million of her income reflects a new client that she personally courted over the past year. Jill is evaluated annually primarily based on her divisions income. Should the ACME CEO adjust Jills income number for any of this information when determining her performance evaluation? Explain (two to four sentences).

Section 1 Solution
a) i. Variances between the actual and static budget results; Sales variance: $ 700,000 480,000 = 220,000 favourable Variable costs variance: $ 300,000 160,000 = (140,000) unfavourable Fixed costs variance: $ 260,000 250,000 = (10,000) unfavourable Profit variance: $ 140,000 70,000 = 70,000 favourable The flexible budget assuming 1,200 work units and using all other budgeting assumptions; Sales per unit: $480,000/800 = $600/unit; Variable cost per unit: $160,000/800 = $200/unit; Fixed costs remain constant under various units 250,000; Under 1,200 units Flexible budget sales: $600(1,200 units) = 720,000 Flexible budget variable costs: $200(1,200 units) = 240,000 Flexible fixed costs: 250,000; Flexible budget profit: [720,000-240,000-250,000] = 230,000; iii. Variance between the actual and flexible budget results: Sales variance: $ 700,000 720,000 = (20,000) unfavourable Variable costs variance: $ 300,000 240,000 = (60,000) unfavourable Fixed costs variance: $ 260,000 250,000 = (10,000) unfavourable Profit variance: $ 140,000 230,000 = (90,000) unfavourable

ii.

b) In comparison to the flexible budget Jack performed poorly because the profit at 1,200 units should be 230,000 and he only achieved 140,000. c) Reasonable answers were accepted. Please note that you need to relate your answers to Jack and Jennys job description given in the question. Answers that were too general and not related to situation given in question were considered inaccurate. Static budget is better than the flexible budget to benchmark Jacks performance because he is responsible for both sales volume and sales price (the overall business). Flexible budget is better than the static budget to benchmark Jennys performance because her job responsibility is to work with temporary workers and not responsible for sales volume.

Section 2 Solution
a) Transfer price is $390: Canadian operations: ($390 - $390)*(1 - 40%) = 0 German division: ($1,080 - $390 - $60 - $345)*(1 - 60%) = $114 Overall company profitability: $0 + $114 = $114 Please note that for both a) and b) you are required to explicitly calculate the overall company profitability. b) Transfer price is $510: Canadian operations: ($510 - $390)*(1 - 40%) = 72 German division: ($1,080 - $510 - $60 - $345)*(1 - 60%) = $66 Overall company profitability: $72 + $66 = $138 c) The Canadian market price is better for Delta because the overall company profitability is higher when more of the profit is shifted to Canada due to the lower Canadian tax rate. d) If the Canadian division can act autonomously, the minimum price the Canadian division would demand is the variable cost of $390 plus the opportunity cost to sell (510-390), which equal market price, $510. Full marks were also given to answers that the minimum price is $510, as that is what the Canadian division can get from selling the product to other customers. Please note that the question explicitly says that the company can sell its entire supply domestically for $510. Therefore, it is incorrect to assume that there is excess capacity. e) If the German division can act autonomously, the maximum price it would be willing to pay is $465 - $60 (shipping cost) = $405. That is the price that the German division would have otherwise needed to spend if it doesn't purchase the circuit board from the Canadian division.

Section 3 Solution
a) Before acquisition: $2,000,000/6,600,000 = 30.3% After acquisition: $(1,500,000+2,000,000)/(3,200,000+6,600,000) = 35.71%; using the new net income calculated below; new Omega net income: Sales 3,200,000+3,200,000(50%) = $4,800,000; Variable costs 1,400,000+1,400,000(50%) = $2,100,000; Fixed costs remain constant 1,200,000; [4,800,000-2,100,000-1,200,000] =$1,500,000 b) Since the ROI is higher after acquisition, therefore PROTEIN+ would like to acquire Omega. The increase in ROI after acquisition is: 35.71%-30.30% = 5.41% c) Before acquisition: $2,000,000-(20%) 6,600,000 = $680,000; After acquisition: $(1,500,000+2,000,000)-(20%)(3,200,000+6,600,000)=$1,540,000; using the new net income calculated in part a); d) Since the Residual income for PROTEIN+ is higher after the acquisition therefore PROTEIN+ would prefer to acquire Omega. The answer remains consistent with part b). e) Any reasonable answers were accepted. The following are example answers: Compatibility of the two organizations corporate culture; Economic added value after acquisition;

Section 4 Solution
a) (i) Residual income for Properties division: Income (hurdle rate Invested capital) = $43.5 - $210*8% = $26.70 (ii) ROI for Food Services = Income / Invested capital = $22.50 / $200 = 11.25% ROI for ACME = $66 / $410 = 16.1% b) The revised ROI = ($22.5 + $2) / ($200 + $20) = 11.14% c) The ROI for the acquisition is $2/$20 = 10%, which is less than both the food service divisions ROI (11.25%) and ACMEs ROI (16.1%), so neither the food service division manager nor the ACME executives will want to do this deal, as it will reduce the ROI of both the food service division and ACME. Another possible answer: The food service division manager will not want to do this deal because it will reduce the food divisions ROI from 11.25% to 11.14%. The ACME executives will not want to do this deal because it will reduce ACMEs ROI from 16.1% to 15.8% ( = (66+2)/(410+20) ). d) If the residual income was used to evaluate the acquisition, ACME will want to do the deal. Acceptable explanations: - 10% is more than the 8% hurdle rate. - Residual income of the deal is positive = $2 $20*8% = $0.4 - ACMEs residual income will increase from $26.70 to $33.60 ( = ($66+$2)($410+$20)*8% ). e) Jills performance should be evaluated based on the controllability principle. The $3 million lawsuit was before Jills employment, so it was out of her control and should not be included in her performance evaluation. The $1.1 million from the new client was under Jills control, and should therefore remain in the division income calculation used to evaluate Jills performance.

RSM1222 Quiz 2 Cheat Sheet The existence of companies : 1. Benefits: A) Relative to an individual, a company (i.e., group of individuals) can take advantage of: a) Economies of Scale; b) Economies of Scope; c) Economies of Speed; B) This allows companies to increase their efficiency by a) Reducing transaction costs; and b) Increasing specialization; C) One of the key factors that allow firms to take advantage of these economies is the allocation of decision rights within the firm; D) Decision rights = The duties that a particular individual in an organization is expected to perform. 2. Agency problems occurs when agents (e.g., managers) take actions to maximize their utility regardless of whether their actions maximize profits for the principal (e.g., shareholders or the managers boss); typically due to asymmetries (between the agent and the principal) in: i) Payoffs; ii) Information; iii) Risk tolerance; iv) Time horizon. Free-rider problem occurs when some individuals either consume more than their fair share or pay less than their fair share of the cost of a common resource. Influence cost is the time spent by employees on politicking and other non-productive activities, in an effort to influence decision makers. Agency problem is greater for large companies because there is large-scale dispersion of decision rights, and hence significant opportunity to incur agency costs. Management control is the use of procedures that help ensure the organizations strategy is implemented (i.e., that employees do what they are supposed to do). An objective is to minimize agency problems (employees acting strategically). Another objective is to minimize sub-optimal employee decisions and actions (albeit well-intentioned). Three dimensions of management control: A) Organizational architecture (placing restrictions on decision rights and maintaining a system of decision control); B) Performance measurement; C) Rewards for performance. Allocate decision rights based on the location of knowledge. This should increase the quality and timeliness of decision making, as well as employee motivation. Couple decision rights with knowledge when a) knowledge is specialized, b) knowledge is difficult to transmit from where it resides to a supervisor or other potential decision maker, c) environment is unstable and decision timeliness is critical. For control (if agency costs are potentially high), it may be necessary to detach knowledge and decision rights. Splitting up the decision rights is common it is useful in improving decision making, even assuming no agency costs (i.e., well-intention decisions/actions). Transfer pricing: A) the charge for a service, or intermediate good, transferred from one subunit to another within an organization. Two primary purposes are international taxation and performance measurement/resource allocation; B) can be based on: a) market price, b) variable cost, c) full cost, d) negotiated price; e) Dual Pricing C) One general solution is: Transfer price = outlay cost + opportunity cost, where outlay cost is the regular variable costs adjusted for other out-of-pocket costs/savings specific to the transaction and opportunity cost is some other benefit given up by the Seller. D) How are transfer price disputes resolved? Negotiation between affected parties, or mandated by central management; E) each division setting its own transfer price does not necessarily equate to optimal decision for the parent company. Controllability Principle: Hold managers responsible for only those decisions within their control (i.e., over which they have decision rights). This is consistent with risk-averse managers avoiding additional uncertainty associated with other factors not under control. Further, by adding more uncontrollable factors to the performance measure, there is less incentives for you to exert effort (make good decisions, take hard actions, etc.). Responsibility accounting: A) assigns decision rights to sub-units within the organization, based on the knowledge residing in the sub-unit. Responsibility accounting assigns accounting performance measures that are appropriate and consistent with decision rights; B) Cost center manager typically evaluated based on minimizing costs for a fixed level of output or minimizing average costs; has incentive to reduce

quality or overproduce; C) Profit center manager typically evaluated based on net income (or portion of the income statement, such as earnings before interest, taxes and depreciation and amortization (EBITDA); has incentive to encourage over-investment; D) Investment center manager typically evaluated based on Return on Investment (ROI), or Residual income (RI), or Economic value added (EVA). RI is superior to ROI, which is superior to Net income as a measure of profitability. E) Return on investment (ROI) = income/ invested capital; F) Residual income = profit imputed interest charge = Income (Hurdle rate Invested capital), where Hurdle rate = cost of capital and Invested capital can take on different definitions, such as (Total assets current liabilities); G) EVA is the same as residual income, but adjusts accounting earnings and uses Weighted average cost of capital (WACC) as the hurdle rate; Performance measures: A) An ideal measure: a) aligns with strategy, b) can be linked to firm value, c) can be measured effectively: i) Objective/reliable); ii) Excludes uncontrollable factors, sensitive to managers actions/decisions (e.g., if the performance measure is high (low) , then you know the manager truly made good (bad) decisions); iii) Captures all relevant dimensions of managers actions; B) Main point of Balanced Scorecard is to augment and balance financial measures with non-financial measures; Balanced scorecard has multiple perspectives: a) financial, b) customer perspective, c) internal processes, d) learning, growth and innovation; C) A cause-effect relationship is implicit in the design of a multidimensional performance scorecard; D) Subjective measures: i) Often necessary to capture a certain performance dimension (not always possible to have objective measures); ii) Will only work if boss has good information and the subordinate trusts that the boss will be fair; iii) To avoid personal tension linked to negative evaluations, subjective evaluation is linked to evaluation inflation; iv) Subjective evaluation leads to influence costs. E) Problems with accounting based measures: i) Accounting only captures historical events; accounting is backward looking; ii) Many economic events are not captured by accounting; iii) None of these measures will capture changes in expected long-term cash flows. Budgets serve many roles, including communicating private information, coordinating activities in decentralized organizations, resource allocation, decision rights allocation, performance evaluation and control, to motivate and reward performance, to compel planning and to guide action. Problems arise in budgeting because private information that is collected for decision making is also expected to be used for control (e.g., compensating employees based on deviation from budget). Variance analysis and management by exception (MBE): A) A common accounting-based performance metric is the managers variance from budget; B) Management by exception (MBE) implies focusing on operating activities that produce results that significantly differ from expected results. Said differently, in MBE the focus is on large variances between actual and budgeted amounts. C) Variance analysis of revenue: we can decompose a variance between the budgeted sales and actual sales into three parts: price variance; mix variance; and volume variance.
Actual Price Actual Mix Actual Volume Budgeted Price Actual Mix Actual Volume Budgeted Price Budgeted Mix Actual Volume Budgeted Price Budgeted Mix Budget Volume

Price Variance

Mix Variance

Volume Variance

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