Chapter 10 Practice Problems 1. Which of the following is NOT a benefit of decentralization? a.

Lower-level managers have the best information concerning local conditions and therefore may be able to make better decisions than their superiors. b. Managers acquire decision-making ability and other management skills that help them move upward in the organization, assuring continuity of leadership. c. Managers enjoy higher status from being independent and thus are better motivated. d. Managers save time dealing with managers from other segments regarding transfer prices. Use the following information for Questions 2 3. The following information pertains to Smith Company: Invested capital Net income Sales Imputed interest rate 2. The return on investment is a. b. c. d. 10 percent 50 percent 20 percent 12 percent $250,000 50,000 500,000 12 percent

3. The residual income is a. b. c. d. $50,000 $30,000 $20,000 $60,000

4. The following information pertains to Ex Company Total assets Total current liabilities Total expenses Total liabilities Total revenues $50,000 10,000 60,000 15,000 80,000

If invested capital is defined as total assets, and the imputed interest rate is 8 percent, the residual income is a. b. c. d. $4,000 $16,000 $20,000 $1,600

5. The following information pertains to Freedom Company Total assets Total current liabilities Total expenses Total liabilities Total revenues $100,000 20,000 120,000 30,000 160,000

If invested capital is defined as stockholders' equity, the return on investment is a. b. c. d. 175 percent 57 percent 229 percent 44 percent

Use the following information for Questions 6 7. Greek Shipping Corporation has three divisions: Alpha, Beta, and Gamma. The expected earnings (income) and amount of investment in these divisions for the coming year are: Division Alpha Beta Gamma Investment $ 200,000 1,600,000 2,000,000 Earnings $ 40,000 100,000 800,000

A proposed investment, that costs $200,000 and has projected earnings of $30,000, has been offered to each of the three divisions. All divisions can make this investment, and the company's cost of capital is 10%. 6. If division managers are being evaluated based on return on investment, a. b. c. d. the manager of division Alpha will invest in the project. the manager of division Beta will invest in the project. the manager of division Gamma will invest in the project. at least two managers will invest in the project.

7. If division managers are being evaluated based on residual income, a. b. c. d. the manager of division Alpha will invest in the project. the manager of division Beta will invest in the project. the manager of division Gamma will invest in the project. all three managers will invest in the project.

8. If Division A incurs costs to make a product of $4 and sells to Division B for $6, who then adds costs of $2 and sells a final product for $12, how much profit per unit did the firm earn? a. b. c. d. $2 $4 $6 $12

9. The Cup and Mug Divisions are part of the same company. Currently the Mug Division buys a part from Cup for $48. The Cup Division wants to increase the price of the part it sells to Mug by $12 to $60. The manager of Mug has stated that it cannot afford to go that high, as it will decrease the division's profit to near zero. Mug can buy the part from an outside supplier for $56. The cost data for the Cup Division is as follows: Direct materials Direct labor Variable overhead Fixed overhead $17.00 $25.00 $5.00 $4.80

If Cup ceases to produce the parts for Mug, it will be able to avoid one-third of the fixed manufacturing overhead. The Cup Division has excess capacity but no alternative uses for its facilities. From the standpoint of the company as a whole, should Mug continue to buy from Cup or start to buy from the outside supplier? a. b. c. d. Buy from Cup Division, because the company's profit would be $7.40 per unit larger. Buy from Cup Division, because the company's profit would be $4.00 per unit larger. Buy from an outside supplier. none of the above

10. If the selling subunit is operating at full capacity and can sell everything produced either internally or externally, the lowest transfer price it would be willing to accept would be a. b. c. d. Marginal cost Market price Variable cost Cost plus a markup

11. Optoca has 2 divisions, A and B. Division A makes a component for tables that it can sell only to Division B. It has no other outlet for sales and currently has excess capacity. Current information for the divisions is as follows: Incremental cost for Division A Incremental cost for Division B Transfer price for component Final Table selling price $100 $200 $175 $425

The transfer price is based on 175% of incremental costs. What is the profit per table for Optoca? a. b. c. d. $50 $75 $125 $150

12. Optoca has 2 divisions, A and B. Division A makes a component for tables that it can sell only to Division B. It has no other outlet for sales and currently has excess capacity. Current information for the divisions is as follows: Incremental cost for Division A Incremental cost for Division B Transfer price for component Final Table selling price Unit sales $100 $200 $175 $425 300

The transfer price is based on 175% of incremental costs. What is the amount of profit recognized by Division B? a. b. c. d. $15,000 $22,500 $37,500 $45,000

13. Optoca has 2 divisions, A and B. Division A makes a component for tables that it can sell only to Division B. It has no other outlet for sales and currently has excess capacity. Current information for the divisions is as follows: Incremental cost for Division A Incremental cost for Division B Transfer price for component Final Table selling price $100 $200 $175 $425

The transfer price is based on 175% of incremental costs. Aptica has offered to sell Division B the same component it currently gets from Division A for $150 per unit. If Division B accepts Apticas offer, the firm as a whole will be a. b. c. d. $25 per unit better off $25 per unit worse off $50 per unit better off $50 per unit worse off

14. Optoca has 2 divisions, A and B. Division A makes a component for tables that it can sell only to Division B. It has no other outlet for sales and currently has excess capacity. Current information for the divisions is as follows: Incremental cost for Division A Incremental cost for Division B Transfer price for component Final Table selling price $100 $200 $175 $425

The transfer price is based on 175% of incremental costs. Outside firms are offering to provide the part to Division B for a lower cost than the current transfer price of $175. Given this information, what is the minimum amount that Division A would be willing to sell to Division B? a. b. c. d. $100 per unit $125 per unit $150 per unit $175 per unit

Use the following information for Questions 15 18. The Bottling Division of Drink It Up, Inc. reported the following sales, costs and income for the prior quarter: Sales $300,000 COGS 180,000 Gross Margin $120,000 Selling & Admin 45,000 Income $ 75,000 The Bottling Division has invested capital of $500,000. Drink It Up, Inc. desires a 10% return on invested capital. 15. What is the Bottling Divisions return on investment (ROI)? a. b. c. d. e. 16. 25% 15% 40% 10% 60%

What is the Bottling Divisions residual income? a. b. c. d. e. $ 50,000 $ 75,000 $ 25,000 $120,000 $ 45,000

17.

Assume the Bottling Division can invest in a new project for $100,000 that is expected to generate income of $12,000. Would the manager of the Bottling Division be motivated to invest in the new project if his/her performance is evaluated based on the divisions ROI? Why or why not? a. b. c. d. Yes because the ROI of the new investment is higher than the divisions current ROI No because the ROI of the new project is lower than the divisions current ROI Yes because the ROI of the new project is lower than the divisions current ROI No because the ROI of the new project is higher than the divisions current ROI

18.

Assume the Bottling Division can invest in a new project for $100,000 that is expected to generate income of $12,000. Would the manager of the Bottling Division be motivated to invest in the new project if his/her performance is evaluated based on the divisions residual income? Why or why not? a. Yes because the residual income of the new project is positive and will therefore increase the divisions residual income b. No because the residual income of the new project is negative and will therefore decrease the divisions residual income c. Yes because the residual income of the new project is negative and will therefore decrease the divisions residual income d. No because the residual income of the new project is positive and will therefore decrease the divisions residual income

Use the following information for Questions 19 24. A Companys Division earns Income of $120,000 on $2,000,000 of Revenue, employing the following Balance Sheet: Total Assets Short-term Liabilities Long-term Liabilities Stockholders Equity $1,000,000 $200,000 $400,000 $400,000

The Companys required rate of return is 10%, and it uses total assets as invested capital. 19. What is the Divisions return on investment (ROI)? a. b. c. d. e. 10% 6% 20% 12% 30%

20.

What is the Divisions residual income? a. b. c. d. $120,000 $ 20,000 $100,000 $ 80,000

Assume the Division is considering an additional investment of $500,000 that would yield incremental income of $55,000 on sales of $1,100,000. 21. What is the ROI of the new investment? a. 10% b. 45% c. 5% d. 11%

22.

If ROI is the measure of profitability used by the Company, will the Division Manager be motivated to make the investment? Why or why not? a. b. c. d. Yes because the divisions ROI will increase if the investment in the new project is made No because the divisions ROI will decrease if the investment in the new project is made Yes because the divisions ROI will decrease if the investment in the new project is made No because the divisions ROI will increase if the investment in the new project is made

23.

What is the residual income of the new investment? a. b. c. d. e. $ 55,000 $500,000 $445,000 $ 5,000 $(55,000)

24.

If residual income is the measure of profitability used by the Company, will the Division Manager be motivated to make the investment? Why or why not? a. b. c. d. Yes because the residual income of the division would increase No because the residual income of the division would decrease Yes because the residual income of the division would decrease No because the residual income of the division would increase

Use the following information for questions 25 27. The Wheel Division of Golf Caddy Incorporated incurs $100 to produce a set of 4 golf cart wheels that it sells to the Assembly Division (also a division of Golf Caddy Inc.) for $125 per set of 4 wheels. The Assembly Division uses the wheels in the production of the final product, golf carts. The Assembly Division incurs an additional cost of $750 to produce each golf cart and sells the golf carts to outside customers for $1,200. 25. Assuming a production and sales volume of 500 golf carts, what is the profit for the Wheel Division, the Assembly Division, and the company as a whole? a. b. c. d. e. Wheel: Wheel: Wheel: Wheel: Wheel: $62,500; $12,500; $62,500; $62,500; $12,500; Assembly: Assembly: Assembly: Assembly: Assembly: $225,000; $225,000; $162,500; $112,500; $162,500; Total Company: Total Company: Total Company: Total Company: Total Company: $287,500 $237,500 $225,000 $175,000 $175,000

26.

Assume that Wheel Solutions, an entirely separate company, has offered to sell the Assembly Division the golf cart wheels for $115 per set of 4 wheels. From the standpoint of the company as a whole, should the Assembly Division buy the wheels from Wheel Solutions? Assume a production and sales volume of 500 golf carts. a. b. c. d. Yes, the company as a whole will be better off by $7,500 No, the company as a whole will be worst off by $7,500 Yes, the company as a whole will be better off by $5,000 No, the company as a whole will be worst off by $5,000

27.

Assume that the Wheel Division has excess capacity, what is the lowest transfer price the Wheel Division should be willing to accept from the Assembly Division? a. b. c. d. $125 $100 $450 $ 0

Solutions 1. D. By allowing lower level managers the ability to make decisions, you give them skills to move upward, they have the best information, and the have better morale. 2. C ___Net Income $50,000 Invested Capital $250,000 3. C Net Income = (Imputed Interest Rate x Invested Capital) = Residual Income 50,000 (12% x 250,000) = $20,000 4. B Net Income - (Imputed Interest Rate x Invested Capital) = Residual Income 20,000 (8% x 50,000) = $16,000 5. B Net Income = Return on Investment (ROI) Invested Capital $40,000 = 57% $70,000* *Total Assets = 100,000 and Total Liabilities =30,000, therefore Total Stockholders Equity has to equal $70,000. 6. B (see explanation below) 7. D (see explanation below) Explanation for 6 and 7: The project will earn a return of 15% (= $30,000/$200,000). Currently, the ROI of Alpha is 20% (= 40,000/200,000); the ROI of Beta is 6.25% (=$100,000/$1,600,000); and the ROI of Gamma is 40% (= $800,000/$2,000,000). Accepting a project with a return of 15% will be appealing to Beta Division, because it would raise Betas ROI. However, it would lower the ROI of the other two divisions, so they wouldnt invest in the project. If evaluations were based on residual income, all three managers would invest in the project because it returns more than the companys cost of capital. Thus, it would increase every divisions residual income. = Return on Investment (ROI) 20%

8. C. The transfer price is revenue to the selling division and a cost to the buying division. Therefore, from the overall firms perspective, the transfer price doesnt have any effect on firm profit (since the buying and selling divisions are part of the same company). The total cost of making the product for the firm as a whole is $6 ($4 incurred by Division A plus $2 incurred by Division B). If the product sells for $12 and it costs the firm $6 to make, the profit is the remaining $6. The profit for each division and total company would be as follows: Div A Sales - Costs ______ Profit $6 (transfer price) $4 ___ $2 Div B $12 $6 (transfer price) $2 $4 Total Company $12 $4 $2 $6

9. A. From the perspective of the company as a whole, this question is very similar to a make vs. buy problem. The alternatives are to either buy the part internally from the Cup Division (in other words, make the part within the company in the Cup Division) or buy the part externally from the outside supplier. From the companys perspective, if Mug buys from the Cup Division, the relevant costs to the company as a whole would be $48.60 ($17.00 + $25.00 + $5.00 + $1.60*). If Mug buys from an outside supplier, the relevant costs to the company as a whole would be $56.00. So the overall profit would be $7.40 per unit higher if Mug buys the part from the Cup Division (costs of $48.60 versus $56.00). Notice that the transfer price of $60.00 is not even a factor in our analysis. From the overall companys perspective, the transfer price has no effect on the firms profit. *1/3 X $4.80 = $1.60 ->this is the relevant (avoidable) portion of the fixed overhead costs

10. B. Remember the rules of thumb regarding transfer prices: If the selling division has idle or excess capacity, the LOWEST transfer price the division would accept is their variable (or avoidable) costs. If the selling division is at full capacity, the LOWEST transfer price the division would accept is the market price (whatever they are getting from their other customers, which is assumed to be the market price). Regardless of the capacity of the selling division, the HIGHEST transfer price the buying division would be willing to pay is the market price. The buying division would not want to pay more than they could pay someone else for the product.

11. C. Transfer prices have no effect on overall company profit. The table costs $300 to make (costs of Division A + costs of Division B) and it sells for $425. The difference of $125 is the profit for the company. (See illustration below answer to #12).

12. A. Division B has the following costs: $175 for the component (bought from Division A) 200 costs added in Division B 375 total costs Division B sells the table for $425, so the division profit is $50 (=$425 375) per unit. For 300 units, that amounts to $15,000 in total profit. (See illustration below). Illustration for #11 and #12: The profit for each division and total company would be as follows: Div A Sales - Costs ______ Profit $175 (transfer price) $100 ___ $ 75 Div B $425 $175 (transfer price) $200 $ 50 x 300 units $15,000 Total Company $425 $100 (Div A costs) $200 (Div B costs) $125

13. D. Currently, the firms cost to make the component in Division A is $100. If the Division B pays an outside firm $150 for the part, the company will be worse off by $50 per unit. 14. A. Because Division A sells only to Division B, they would be willing to transfer at any amount greater than or equal to its variable costs. Here, that is the incremental cost of $100. 15. B Income / Invested Capital = $75,000 / $500,000 = 15% 16. C Residual Income = Income (Cost of Capital % * Invested Capital) $75,000 (10% * $500,000) $75,000 $50,000 = $25,000

17. B. No, the manager would not be motivated to invest in the new project if s/he is evaluated based on ROI (even though the project is desirable from the Companys perspective) because the new projects ROI is less than the divisions current ROI. Therefore, the divisions ROI would drop from 15% (see #15 above) to 14.5% (see below). ROI of new project ROI of division (after investing in project) = = = $12,000 / $100,000 = 12% ($75,000 + $12,000) / ($500,000 + $100,000) $87,000 / $600,000 = 14.5%

18. A. Yes, the manager would be motivated to invest in the new project if s/he is evaluated based on residual income because the new project has a positive residual income (it earns a greater return than the companys desired rate of return). The divisions residual income would increase from $25,000 (see #16 above) to $27,000 (see below). RI of new project = $12,000 (10% * $100,000) = $2,000 ($75,000 + $12,000) [10% * ($500,000 + $100,000)] $87,000 (10% * $600,000) = $27,000*

RI of division = (after investing in project) =

*or just add the $2,000 RI from the new investment to the $25,000 of RI the division had prior to the new investment.

19. D ROI 20. B RI = Income (Cost of Capital % * Invested Capital) = $120,000 (10% * $1,000,000) = $120,000 $100,000 = $20,000 = Income / Invested Capital = $55,000 / $500,000 = 11% = Income / Invested Capital = $120,000 / $1,000,000 = 12%

21. D ROI

22. B. No, the manager would not be motivated to make the investment because his/her divisions ROI will decrease from 12% (see #19 above) to 11.67% (see below). ROI = Income / Invested Capital = ($120,000 + $55,000) / ($1,000,000 + $500,000) = $175,000 / $1,500,000 = 11.67%

23. D RI = Income (Cost of Capital % * Invested Capital) = $55,000 (10% * $500,000) = $55,000 $50,000 = $5,000

24. A. Yes, the manager would be motivated to make the investment because his/her divisions RI will increase from $20,000 (see #20 above) to $25,000(see below). RI = Income (Cost of Capital % * Invested Capital) = ($120,000 + $55,000) [10% * ($1,000,000 + $500,000)] = $175,000 (10% * $1,500,000) = $175,000 $150,000 = $25,000

*or just add the $5,000 RI from the new investment to the $20,000 of RI the division had prior to the new investment.

25. E Sales - Costs Profit

Wheel Division $62,500* $50,000 $12,500

Assembly Division $600,000 $375,000 $ 62,500* $162,500

Total Company $600,000 $ 50,000 $375,000 $175,000

*The $62,500 transfer price is revenue to the Wheel Division and a cost to the Assembly Division, but it has no impact on the overall company since the two divisions are part of the same company.

26. B. No, the Company as a whole will be better off by $15 per set of 4 wheels if the Assembly Division does not buy the wheels from Wheel Solutions ($100 cost per set of wheels if the wheels are made and sold internally versus $115 cost per set of wheels if they are purchased externally): Make Internally cost to make in Wheel Div. $100 cost to buy from Wheel Solutions Buy Externally $115

27. B. The lowest transfer price the Wheel Division should be willing to accept (assuming the Wheel Division is not at full capacity) is the costs incurred of $100.