11-43

(a) Return on investment is division income divided by historical cost of

investments, and residual income is division income minus 10% of historical
cost of investments.

Historical Division
Cost of Operating Return on Residual
Division Investments Income Investment Income
A $645,000 $70,600 10.95% $6,100
B 415,000 51,400 12.39% 9,900
C 588,000 71,250 12.12% 12,450

(b)
Net Book Division
Value of Operating Return on Residual
Division Investments Income Investment Income
A $258,000 $70,600 27.36% $44,800
B 166,000 51,400 30.96% 34,800
C 235,200 71,250 30.29% 47,730

(c) Return on investment and residual income do not necessarily produce the
same rankings, as seen in part (a), where Division B has the highest return on
investment but Division C has the highest residual income. Part (a) also
illustrates that smaller divisions (for example, Division B) will look less
favorable than larger divisions (Divisions A and C) under residual income.
Note, however, that Division A is the larger division in terms of investments but
has lower residual income than Division C. The results in (b) show that
Division B now has the largest return on investment and Division C now has
the largest residual income. Only the measurement of the value of the
investment is different between the parts (a) and (b), illustrating that the
measurement choice changes not only the return on investment and residual
income measures, but also potentially changes the relative rankings across
divisions.

(d) Managers will only find it attractive to invest in new, more costly equipment
if the investment brings a large enough increase in income to offset the
reduction in return on investment or residual income associated with the new
investment.

– 521 –
11-51
(a) Revenue center
(b) Revenue center
(c) Cost center
(d) Cost center
(e) Cost center
(f) Cost center
(g) Profit center

11-58
(a) ROI = Income = $600,000 = 12%
Investment $5,000,000

(b) ROI = Income = $750,000 = 13.39%

Investment $5,600,000

(c) Because the overall ROI is higher with the new investment, Michelle’s
compensation will be much higher if she undertakes the new investment.
Therefore, the compensation scheme provides incentives for a manager to
undertake an investment that would benefit the corporation.
11-63 Note: The solution below draws on net present value analysis, which is not
explicitly covered in this book, but important to understand (also for the exam).

(a) Strathcona Paper

Year Outflow Savings Depreciation
0 50,000,000 0 0
1 0 16,000,000 10,000,000
2 0 16,000,000 10,000,000
3 0 16,000,000 10,000,000
4 0 16,000,000 10,000,000
5 0 16,000,000 10,000,000

Year Taxes NCF PV

0 0 (50,000,000) (50,000,000)
1 2,100,000 13,900,000 12,410,714
2 2,100,000 13,900,000 11,080,995
3 2,100,000 13,900,000 9,893,745
4 2,100,000 13,900,000 8,833,701
5 2,100,000 13,900,000 7,887,233
Net present value $106,388

Since the net present value of this project is positive, from the point of
view of the company, it should be accepted.

(b) The manager is evaluated based on the after-tax return on investment of

assets managed. The current investment base is $50,000,000 and the
current net income after taxes is $7,000,000, which yields a return on
investment of 14% = $7,000,000 ÷ $50,000,000.
With the new investment in the first year, income after taxes will increase
to $10,900,000 = ($7,000,000 + $16,000,000 – $10,000,000 –
$2,100,000) and the new investment level will increase to $90,000,000 =
($50,000,000 + $50,000,000 – $10,000,000). Therefore, the return on
investment for the first year of operations with the new trucks will be
12.1% = $10,900,000 ÷ $90,000,000.
Therefore, evaluated by the first year of operations, the manager would
prefer not to make this investment. However, the return on investment
numbers for years 2 through 5 inclusive are 13.6%, 15.6%, 18.2%, and
 21.8%, respectively. Note that each year the income level will remain the
same while the investment level will be $80,000,000 in year 2,
$70,000,000 in year 3, $60,000,000 in year 4, and $50,000,000 in year 5.
Therefore, the manager’s attitude about this investment will reflect how
long the manager expects to remain in her current position.

(c) The after-tax residual income currently is $1,000,000 = [$7,000,000 −

($50,000,000 × 12%)]. The after-tax residual income in the first year
after the investment in the new trucks is $100,000 = [$10,900,000 −
($90,000,000 × 12%)]. If evaluated by the first year of operations, the
manager would not make the investment. The residual income numbers
in years 2 through 5 are: $1,300,000, $2,500,000, $3,700,000, and
$4,900,000. Therefore, the manager’s attitude about this investment will
reflect how long the manager expects to remain in his current position.

11-70 The major issue in choosing a transfer price is motivating the managers of the
two divisions to behave in a way that makes the organization’s profits as large
as possible.

For existing home kits, the manager of the sales division will want to buy home
kits as long as the sales division can realize a profit on selling the home kits to
the final customers. Therefore, the transfer price must not exceed $35,000,
which is the selling price of $40,000 less the selling division’s cost of $5,000
per home.

The manager of the manufacturing division will want to sell existing home kits
as long as the manufacturing division can realize a profit on selling the homes
to the selling division. Therefore, the transfer price must exceed $30,000
($33,000 ÷ 1.1), which is the variable cost of making the home kits.

Therefore, any transfer price between $30,000 and $35,000 for the existing
homes will cause the manufacturing division to make, and the selling division
to buy and sell, all the home kits that the manufacturing division is capable of
making.

Turning to the proposal to make cottage kits, recall that the manufacturing
division is currently operating at capacity and will therefore have to give up
production of home kits in order to manufacture cottage kits. From the
company’s perspective, the company’s contribution margin per home kit is
$5,000 = ($40,000 – $30,000 − $5,000). Let P = the price at which the
company is indifferent (with respect to profit) between selling all home kits or
all cottage kits. Home kits require 10 machine hours (mh) per unit and cottage
kits require 13 mh per unit, and 5,000 mh are available per year. Assuming that
the selling cost of the cottage kit is the same as the selling cost of the home kit
($5,000 per unit), equating the total contribution margins for the two options
requires the following:

(5,000 mh ÷ 13 mh per cottage) × (P – $30,000 – $3,000 – $5,000) =

(5,000 mh ÷ 10 mh per home) × ($40,000 – $30,000 − $5,000)

Thus, P – $38,000 = ($5,000 ÷ 10 mh per home) × (13 mh per cottage), so

P = $38,000 + $6,500 = $44,500.

Note that $6,500 is the opportunity cost of producing and selling a cottage kit
instead of a home kit. This opportunity cost is the $500 of contribution margin
per mh for home kits, multiplied by the 13 mh required per cottage kit. (If one
wishes to take into account only production in whole numbers, then 5,000 ÷ 13
= 384.62 will have to rounded down to 384, and the necessary price will be
approximately $44,511.)

The analysis from the manufacturing division’s point of view is similar.

Let TP = the transfer price for cottage kits at which the division is indifferent
between transferring home kits at variable cost plus 10% ($30,000 + $3,000) or
cottage kits at TP per unit. Assuming production of either all home kits or all
cottage kits and equating the total contribution margins for the two options
requires the following:

(5,000 mh ÷13 mh per cottage) × (TP – $30,000 – $3,000) =

(5,000 mh ÷ 10 mh per home) × ($33,000 − $30,000)

TP – $33,000 = ($3,000/10 mh per home) × (13 mh per cottage), so

TP = $33,000 + $3,900 = $36,900.

This transfer price incorporates the original variable cost of $30,000, the
incremental manufacturing cost of $3,000, and the $3,900 opportunity cost to
the manufacturing division for making a cottage kit instead of a home kit, given
the existing transfer price for home kits.

Thus, the manufacturing division will not be willing to accept a transfer price
less than $36,900 per cottage kit. Assuming a selling price per cottage kit of
$44,500, the selling division will not be willing to pay more than $39,500
($44,500 – $5000). Therefore, a transfer price between $36,900 and $39,500
should induce both managers to be willing to engage in the transfer.