Test your understanding

Divisional ROI

RETURN ON INVESTMENT = Net Operating Income ÷ Average Invested Assets

Or
= Net Profit Margin × Asset Turnover

1. Marsh Company that had current operating assets of one million and net income of P200,000 had an opportunity
to invest in a project that requires an additional investment of P250,000 and increased net income by P40,000.
After the investment, the company's ROI will be
A. 16.0% C. 19.2%
B. 18.0% D. 20.2%

Answer: C
New ROI: (200,000 + 40,000) ÷ (1M + 0.25M) 19.2%

2. The following data relate to the Motor Division of Eurosun Company:

Sales P10,000,000
Variable costs 3,000,000
Direct fixed costs 5,000,000
Invested capital 8,000,000
Allocated actual interest costs 800,000
Capital charge 12%
The divisional return on investment is:
A. 15 percent C. 13 percent
B. 25 percent D. 20 percent

Answer: B
Operating income: 10M – 3M – 5M = P2 Million
ROI = P2M ÷ P8M = 25%

Residual income

RESIDUAL INCOME = Net Operating Income – Required Income

 Where REQUIRED INCOME = Average Invested Assets × Hurdle Rate

 It compares the net operating income and the minimum acceptable profit based on the required
rate of return (aka hurdle rate). The hurdle rate will depend on a number of factors, including
the risk of the investment, the cost of financing it, and the return that could be earned in other
investments.
 It is the amount of net operating income earned over and above the minimum amount needed to
meet the required rate of return.
 It encourages managers to maximize pesos of profit after a required ROI has been achieved.
 It overcomes some of the problems associated with ROI.
 It encourages managers to accept projects with provide returns in excess of the company’s
required rate of return.

3. The current income for a subunit is P36,000. Its current invested capital is P200,000. The subunit is
considering purchasing for P20,000 equipment that will increase annual income by an estimated P2,800. The
firm's cost of capital is 12%. If the equipment is purchased, the residual income of the subunit will
A. increase by P2,800 C. increase by P400
B. increase by P16,000 D. increase by 4%

Answer: C
Increase in annual income P2,800
Additional required returns (P20,000 x 0.12) 2,400
Increase in residual value P 400
Economic Value Added

Economic value added (EVA) – it measures the economic wealth that is created when a company’s after-tax net
operating income exceeds its cost of capital. It is similar to the residual income computation, however, EVA makes
a number of important adjustments:

 Measures profitability based on after-tax net operating income rather than pre-tax net
operating income. (Note: this amount is earnings after taxes but before interest expense)
 Uses the cost of capital as the hurdle rate. Conceptually, the cost of capital represents the
after-tax cost of financing the company’s operations through some combination of debt and
equity.
 Uses total capital employed as the measure of investment rather than average invested
assets.
 Thus, the equation is:
EVA = Operating income after tax – [(Total assets – Current Liabilities) × WAC]

4. Consider the following:

Investment center’s after-tax operating profit P 50,000
Investment center’s total assets 800,000
Investment center’s current liabilities 80,000
Weighted-average cost of capital 6.5%
What is the economic value added (EVA)?
A. P60,000 C. P 6,000
B. P 3,200 D. P50,000

Answer: B
EVA = Investment center's after-tax operating income - (Investment center's total assets - Investment
center's current liabilities) x Weighted-average cost of capital].
Net operating profit P50,000
Cost of investment (P800,000 – P80,000) x 0.075 46,800
Economic Value Added P 3,200
Segmented Income Statement
Segmented income statement – The most common method of evaluating a profit center manager. This is an
income statement that is broken down by product line, region, or other business segment. This is a useful
evaluation tool because it separates those costs that are within the segment manager’s control from those costs
that are outside it. An example of a segment income statement is presented below:

Segment A Segment B Total

Sales x x x
Less: Variable costs (x) (x) (x)
C ontribution margin x x x
Less: C ontrollable fixed costs* (x) (x) (x)
C ontrollable segment margin x x x
Less: Uncontrollable fixed costs** (x) (x) (x)
Segment margin x x x
Less: Allocated costs (x) (x) (x)
Operating income x x x
*Costs that are controllable by managers of the segment and could be traced to that segments.
**Costs that are not controlled by managers of the segment but are definitely incurred by that segment.

Controllable segment profit margin

5. Segment A generated sales revenues of P400,000 and variable operating expenses of P180,000. Its
controllable fixed expenses were P40,000. It was assigned 20% of P200,000 of fixed costs controlled by
others. The common fixed costs were P25,000. What was Segment A's controllable segment profit margin?
A. P220,000 C. P140,000
B. P180,000 D. P160,000
Answer: B
Controllable segment profit margin = Revenue - (Segment's variable operating costs + Controllable fixed
costs).
(P400,000 – P180,000 – P40,000) P180,000
Use the following information for the next three (3) questions:

Comprehensive

Use the following information to answer questions 2 thru 6:

Carlyle Company had the following information pertaining to 2005:
Profit P100,000
Sales P1,000,000
Asset Turnover ratio 2 times
The desired minimum rate of return is 15 percent.

6. What is the ROI?

A. 10 percent C. 20 percent
B. 5 percent D. 15 percent

7. What is the return on sales?

A. 10 percent C. 20 percent
B. 5 percent D. 15 percent

8. What is the amount of assets?

A. P250,000 C. P1,000,000
B. P500,000 D. P2,000,000

1
. Answer: C
ROI = Operating Profit ÷ Average investment
Average Operating assets: (P1,000,000 ÷ 2) = P500,000
ROI: (P100,000 ÷ P500,000) = 20%

1
. Answer: A
Return on sales = Profit ÷ Net sales
P100,000 ÷ P1,000,000 = 10%

1
. Answer: B
Total assets = Sales ÷ Asset turnover
P1,000,000 ÷ 2 = P500,000

General Rule:
1. Maximum Transfer Price  Selling price / Market price
2. Minimum Transfer Price  Incremental cost + Opportunity cost of the selling division
 With excess capacity = VC
 Without excess capacity = VC + Contribution margin

Minimum transfer price

9. Family Enterprises has two divisions: Davy and Johnny. Davy Division has a capacity to produce 2,000 units and
is expecting to sell 1,500 units. Johnny Division wants to purchase 100 units of a product Davy produces. Davy
sells the product at a selling price of P100 per unit, the variable cost per unit is P25 and the fixed costs total
P30,000. The minimum transfer price that Davy will accept is?
A. P100 C. P43.75
B. P45 D. P25

Answer: D
The minimum Davy would accept is the opportunity cost to make the product, which would be the variable cost
of P25.
10. Assume that Division X has a product that can be sold either to outside customers on an intermediate market
or to Division Y of the same company for use in its production process. The managers of the division are
evaluated based on their divisional profits.
Division X:
Capacity in units 200,000
Number of units being sold on the intermediate market 160,000
Selling price per unit on the intermediate market P75
Variables costs per unit 60
Fixed costs per unit (based on capacity) 8

Division Y:
Number of units needed for production 40,000
Purchase price per unit now being paid to an outside supplier P74
The minimum transfer price to be charged by the Division X should be:
A. P60 C. P68
B. P75 D. P74

Answer: A
The minimum transfer price is P60 because the Division X has excess capacity

At capacity

Minimum transfer price

11. Company Y is highly decentralized. Division X, which is operating at capacity, produces a component that it
currently sells in a perfectly competitive market for P13 per unit. At the current level of production, the fixed
cost of producing this component is P4 per unit and the variable cost is P7 per unit. Division Z would like to
purchase this component from Division X. What would be the price that Division X should charge Division Z?
A. P 7 C. P 11
B. P 13 D. P 9

Answer: B
The division is operating at capacity (zero excess capacity). Any quantity of production to be transferred to
the Division Z must be at P13; Any price below P13, as transfer price, would decrease its profit.

12. Harem Corporation consists of two divisions, Mining and Builders. The Mining makes black steel, a product
that can be used in the product that the Builders division makes. Both divisions are considered profit centers.
The following data are available concerning black steel and the two divisions:
Mining Builders
Average units produced 150,000
Average units sold 150,000
Variable mfg cost per unit P2
Variable finishing cost per unit P5
Fixed divisional costs P75,000 P125,000
The Mining Division can sell all of its output outside the company for P4 per unit. The Builders Division can
buy the black steel from other firms for P4. The Builders Division sells its product for P12.

What is the optimal transfer price in this case?

A. P2 per unit C. P7 per unit
B. P4 per unit D. P9 per unit

Answer: B
The optimal transfer price is P4 per unit, which represents the value of using the black steel in the Builders
Division because the black steel will cost P2 to manufacture and each unit used internally is a unit that cannot
be sold to external buyers. If an intermediate market exists, the optimal transfer price is the market price.
13. Assume that Steel Division has a product that can be sold either to outside customers on an intermediate
market or to Fabrication Division of the same company for use in its production process. The managers of the
division are evaluated based on their divisional profits.
Steel Division:
Capacity in units 200,000
Number of units being sold on the intermediate market 200,000
Selling price per unit on the intermediate market P90
Variables costs per unit (including P3 of avoidable selling expense) 70
Fixed costs per unit (based on capacity) 13

Fabrication Division:
Number of units needed for production 40,000
Purchase price per unit now being paid to an outside supplier P86
The appropriate transfer price should be:
A. P90 C. P70
B. P87 D. P86

Answer: B
The division is operating at capacity, therefore, the minimum transfer price must be the amount of selling
price, less avoidable selling expense.
Selling price P90
Avoidable selling expense 3
Net Price 87