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Exercise 12-11: Working with a Segmented Income Statement Given: Marple Associates is a consulting firm that specializes in information systems for construction and landscaping companies. The firm has two offices -- one in Houston and one in Dallas. The firm classifies the direct costs of consulting jobs as variable costs. A segmented contribution format income statement for the company's most recent year is given below: Office Sales Variable expenses Contribution margin Traceable fixed expenses Market segment margin Common fixed expenses (not traceable to markets) Net operating income

Total Company Houston Dallas $750,000 100.00% $150,000 100.00% $600,000 100.00% 405,000 54.00% 45,000 30.00% 360,000 60.00% $345,000 46.00% $105,000 70.00% $240,000 40.00% 168,000 22.40% 78,000 52.00% 90,000 15.00% $177,000 23.60% $27,000 18.00% $150,000 25.00% 120,000 $57,000

16.00% 7.60%

Required: 1. By how much would the company's net operating income increase if Dallas increased its sales by $75,000 per year? Assume no change in cost behavior patterns. Increase in Dallas sale Contribution margin ratio Increase in Company's NOI

$75,000 40.00% $30,000

2. Refer to the original data. Assume that sales in Houston increased by $50,000 next year and that sales in Dallas remain unchanged. Assume no change in fixed costs. a. Prepare a new segmented income statement for the company using the above format. Show both amounts and percentages. Office Total Company Sales Variable expenses

$800,000

100.00%

Houston

Dallas

$200,000

100.00%

$600,000

100.00%

420,000

52.50%

60,000

30.00%

360,000

60.00%

$380,000

47.50%

$140,000

70.00%

$240,000

40.00%

168,000

21.00%

78,000

39.00%

90,000

15.00%

$212,000

26.50%

$62,000

31.00%

$150,000

25.00%

(not traceable to markets)

120,000

15.00%

Net operating income

$92,000

11.50%

Contribution margin Traceable fixed expenses Market segment margin Common fixed expenses

b. Observe from the income statement you have prepared that the CM ratio for Houston has remained unchanged at 70% (the same as in the above data) but that the segment margin ratio has changed. How do you explain the change in the segment margin ratio?

The traceable fixed expenses are spread over a larger base as sales increase. Therefore, the segment margin ratio increase from 18% to 31%. The contribution margin ratio remains stable at 70% because there is no information to suggest that the selling price per unit or the variable cost per unit have changed. Exercise 12-12: Working with a Segmented Income Statement Given: Refer to the data in Exercise 12-11. Assume that Dallas' sales by major market

Sales Variable expenses Contribution margin Traceable fixed expenses Market segment margin Common fixed expenses (not traceable to markets) Net operating income

Dallas Office $600,000 100.00% 360,000 60.00% $240,000 40.00% 72,000 12.00% $168,000 28.00% 18,000 $150,000

Dallas: Market Clients Construction Landscaping $400,000 100.00% $200,000 100.00% 260,000 65.00% 100,000 50.00% $140,000 35.00% $100,000 50.00% 20,000 5.00% 52,000 26.00% $120,000 30.00% $48,000 24.00%

3.00% 25.00%

The company would like to initiate an intensive advertising campaign in one of the two markets during the next month. The campaign would cost $8,000. Marketing studies indicate that such a campaign would increase sales in the construction market by $70,000 or increase sales in the landscaping market by $60,000. Required: 1. In which of the markets would you recommend that the company focus its advertising campaign? The company should focus its campaign on Landscaping Clients.

Increased sales from campaign

Construction

Landscaping

Clients

Clients

$70,000

CM ratio for market client Increase in contribution margin Less cost of the campaign Increased segment margin & NOI

$60,000

35.00%

50.00%

$24,500

$30,000

8,000

8,000

$16,500

$22,000

2. In Exercise 12-11, Dallas shows $90,000 in traceable fixed expenses. What happened to the $90,000 in this exercise? The $90,000 of traceable fixed cost to Dallas has been accounted for as follows:

Dallas

Construction

Landscaping

Clients

Clients

Traceable fixed costs

$72,000

Common fixed expenses (not traceable to markets) Total

18,000 $90,000

$20,000

$52,000

Exercise 12-13: Contrasting Return on Investment (ROI) and Residual Income (RI) Given: Rains Nickless Ltd. Of Australia has two divisions that operate in Perth and Darwin. Selected data on the two divisions follow: Division Perth Darwin Sales $9,000,000 $20,000,000 Net operating income $630,000 $1,800,000 Average operating assets $3,000,000 $10,000,000 Required: 1. Compute the ROI for each division. a. ROI = Net operating income / Average operating assets b. ROI = margin X turnover ROI = (Net operating income / Sales) X (Sales / Average operating assets)

b. a.

Margin Turnover ROI ROI

Division Perth Darwin 7% 9% 3 2 21% 18% 21% 18%

2. Assume that the company evaluates performance using residual income and that the minimal required rate of return for each division is 16%. Compute the residual income for each division. RI = Net operating income - Charge for use of capital RI = Net operating income - (Average operating assets X Minimum required rate of return)

Minimum required rate of return Net operating income Charge for use of capital Residual income

Division Perth Darwin 16% 16% $630,000 $1,800,000 ($480,000) ($1,600,000) $150,000 $200,000

3. Is the Darwin Division's greater residual income an indication that it is better managed? Explain. No, the Darwin Division is simply larger than the Perth Division and for this reason alone one would expect that it would have a greater amount of residual income. In fact, based on the data above, the Darwin Division does not appear to be as well managed as the Perth Division. The Darwin Division has an 18% return on investment as compared to 21% for the Perth Division. Residual income can not be used to compare the performance of divisions of different sizes. Larger divisions will almost always look better.

n alone one

rth Division.

erent sizes.

Exercise 12-8: Evaluating New Investment Using ROI and Residual Income (RI) Given: Selected sales and operating data for three divisions of three different companies are given below:

Sales Average operating assets Net operating income Minimum required rate of return

Division A $6,000,000 $1,500,000 $300,000 15%

Division B $10,000,000 $5,000,000 $900,000 18%

Division C $8,000,000 $2,000,000 $180,000 12%

Required: 1. Compute the ROI for each division, using the formula stated in terms of margin and turnover. a. ROI = Net operating income / Average operating assets b. ROI = margin X turnover ROI = (Net operating income / Sales) X (Sales / Average operating assets)

Margin Turnover b. ROI a. ROI

Division A 5.00% 4 20.00% 20.00%

Division B 9.00% 2 18.00% 18.00%

Division C 2.25% 4 9.00% 9.00%

2. Compute the residual income for each division. RI = Net operating income - Charge for use of capital RI = Net operating income - (Average operating assets X Minimum required rate of return)

Net operating income Charge for use of capital Residual income

Division A $300,000 ($225,000) $75,000

Division B Division C $900,000 $180,000 ($900,000) ($240,000) $0 ($60,000)

3. Assume that each division is presented with an investment opportunity that would yield a rate of return of 17%. a. If performance is being measured by ROI, which division or divisions will probably accept the opportunity? Reject? Why? Division A Division B Division C Current ROI 20% 18% 9% Investment opportunity return 17% 17% 17% Decrease Decrease Increase Effect on ROI if opportunity is accepted Accept or reject decision Reject Reject Accept b. If performance is being measured by RI, which division or divisions will probably accept the opportunity? Reject? Why?

Current RI Investment opportunity return Minimum required rate of return Effect on RI if opportunity is accepted

Accept or reject decision

Division A $75,000 17% 15% Increase Accept

Division B $0 17% 18% Decrease Reject

Division C ($60,000) 17% 12% Increase Accept

Exercise 12-20: Effects of Changes in Profits and Assets on Return on Investment Given: The Abs Shoppe is a regional chain of health clubs. The managers of the clubs, who have authority to make investments as needed, are evaluated based largely on ROI. The Abs Shoppe reported the following results for the past year: Abs Shoppe Sales $800,000 Net operating income $16,000 Average operating assets $100,000 Required: The following questions are to be considered independently. Carry out all computations to two decimal places. 1. Compute the club's ROI a. ROI = Net operating income / Average operating assets b. ROI = margin X turnover ROI = (Net operating income / Sales) X (Sales / Average operating assets)

b. a.

Margin Turnover ROI ROI

Abs Shoppe 2.00% 8.00 16.00% 16.00%

2. Assume that the manager of the club is able to increase sales by $80,000 and that as a result net operating income increases by $6,000. Further assume that this is possible without any increase in operating assets. What would be the club's ROI?

Sales Net operating income Average operating assets

Original $800,000 $16,000 $100,000

Changes $80,000 $6,000 $0

New $880,000 $22,000 $100,000 Abs Shoppe 2.50% 8.80 22.00% 22.00%

Margin Turnover ROI ROI

3. Assume that the manager of the club is able to reduce expenses by $3,000 without any change in sales or operating assets. What would be the club's ROI?

Sales Net operating income

Original $800,000 $16,000

Changes $0 $3,000

New $800,000 $19,000

Average operating assets

$100,000

$0

$100,000 Abs Shoppe 2.38% 8.00 19.00% 19.00%

Margin Turnover ROI ROI

4. Assume that the manager of the club is able to reduce operating assets $20,000 without any change in sales or net operating income. What would be the club's ROI?

Sales Net operating income Average operating assets

Original $800,000 $16,000 $100,000

Margin Turnover ROI ROI

Changes $0 $0 ($20,000)

New $800,000 $16,000 $80,000 Abs Shoppe 2.00% 10.00 20.00% 20.00%

Abs Shoppe

t as a result

Exercise 12-17: Sales Dollars as an Allocation Base for Fixed Costs Given: Lacey's Department Store allocates its fixed administrative expenses to its four operating departments on the basis of sales dollars. During 2007, the fixed administrative expenses totaled $900,000. These expenses were allocated as follows:

Total sales -- 2007 Percentage of total sales Allocation (based on the above percentages)

Men's $600,000 10%

Women's $1,500,000 25%

$90,000

$225,000

Shoes Housewares $2,100,000 $1,800,000 35% 30% $315,000

$270,000

During 2008, the following year, the Women's Department doubled its sales. The sales levels in the other three departments remained unchanged. The company's 2008 sales data were as follows:

Total sales -- 2008 Percentage of total sales

Men's $600,000 8%

Women's $3,000,000 40%

Shoes Housewares $2,100,000 $1,800,000 28% 24%

Fixed administrative expenses remained unchanged at $900,000 during 2008.

$900,000

Required: 1. Using sales dollars as an allocation base, show the allocation of the fixed administrative expenses among the four departments for 2008.

Allocation for 2008

Men's $72,000

Women's $360,000

Shoes $252,000

Housewares $216,000

2. Compare your allocation from (1) above to the allocation for 2007. As the manager of the Women's Department, how would you feel about the administrative expenses that have been charged to you you for 2008?

Allocation for 2008 Allocation for 2007 Increase/Decrease

Men's $72,000 $90,000 ($18,000)

Women's $360,000 $225,000 $135,000

Shoes Housewares $252,000 $216,000 $315,000 $270,000 ($63,000) ($54,000)

The manager of the Women's Department undoubtedly will be upset about the increased allocation to the department but will feel powerless to do anything about it. Such an increased allocation may viewed as a penalty for an outstanding performance. Note: The allocations to all of the other departments decreased. 3. Comment on the usefulness of sales dollars as an allocation base. Sales dollars is not ordinarily a good base for allocating fixed costs. The costs allocated to a department will be affected by the sales in other departments. In other words, how much fixed costs will be allocated to one department depends on the operations of another department. Note that if the department managers have bonus plans based on NOI, these managers will receive

bonus increases because of the increased sales in the Women's Department.

Total $6,000,000 100% $900,000

Total $7,500,000 100%

ive expenses

Total $900,000

the Women's arged to you

sed allocation allocation may

s will receive

Total $900,000 $900,000 $0

Exercise 12-5:

Service Department Charges

Given: Gutherie Oil Company has a Transport Services department that provides trucks to transport crude oil from docks to the company's Arbon Refinery and Beck Refinery. Budgeted costs for the transport services consist of $0.30 per gallon variable cost and $200,000 fixed cost. The level of fixed cost is determined by peak-period requirements. During the peak period, Arbon Refinery requires 60% of the capacity and the Beck Refinery requires 40%. During the year, the Transport Services Department actually hauled the following amounts of crude oil for the two refineries: Arbon Refinery, 260,000 gallons; and Beck Refinery, 140,000 gallons. The Transport Services Department incurred $365,000 in cost during the year, of which $148,000 was variable cost and $217,000 was fixed cost. Required: 1. Determine how much of the $148,000 in variable cost should be charged to each refinery. 2. Determine how much of the $217,000 in fixed cost should be charged to each refinery. Arbon Peak period capacity needs Gallons actually hauled Budgeted variable ($.30/gallon)

Beck

Total 100% 400,000

60% 260,000

40% 140,000

Arbon $78,000

Beck $42,000

Total $120,000

120,000 $198,000

80,000 $122,000

200,000 $320,000

$0.30

Allocation of Variable Costs: Allocation: actual gallons X budgeted rate Allocation of Fixed Costs: Allocation: Peak period % X budgeted FC Total Costs Allocated

3. Will any of the $365,000 in the Transport Services Department cost not be charged to the refineries? Variable Costs Fixed Costs Total $148,000 $217,000 $365,000 Total Transport Services Department Costs Incurred $120,000 200,000 $320,000 Total Transport Services Department Costs Assigned $28,000 $17,000 $45,000 Total Transport Services Department Costs Unassigned The overall spending variance of $45,000 represents costs incurred in excess of the budgeted $.30 per gallon variable cost and budgeted $200,000 in fixed costs. This $45,000 in unallocated cost is the responsibility of the Transport Services Department.

Problem 12-24: Given: In cases 1-3 below, assume that Division A has a product that can be sold either to Division B of the same company or to outside customers. The managers of both divisions are evaluated based on their own division's ROI. The managers are free to decide if they will participate in any internal transfers. All transfer prices are negotiated. Treat each case independently. Cases 1 2 3 4 Division A: Capacity in Units 50,000 300,000 100,000 200,000 Number of units now being sold to outside customers 50,000 300,000 75,000 200,000 Selling price per unit to outside customers $100 $40 $60 $45 Variable cost per unit 63 19 35 30 Contribution per unit $37 $21 $25 $15 Fixed costs per unit (based on capacity) $25 $8 $17 $6 Division B: Number of units needed annually Purchase price now being paid to an outside supplier

10,000 $92

70,000 $39

20,000 $60 $57

60,000 -

Before any purchase discount. Required: 1. Refer to case 1 above. A study has indicated that Division A can avoid $5 per unit in variable costs on any sales to Division B. Will the managers agree to a transfer and if so, within what range will the transfer price be? Explain. Transfer Price to maximize company profits: TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred TP = ($63 - $5) + ($37 X 10,000)/10,000 = $58 + $37 = $95 Division A: Contribution margin generated per unit under the current situation Contribution margin generated if a transfer takes place at $95 per unit Division A manager is indifferent to selling outside or transferring to Division B

Division B: Cost per unit if purchased outside Cost per unit if transferred at $95 per unit Division B manager would reject internal transfer because of $3 per unit increase in cost

$37 37 $0

$92 95 ($3)

The managers will not agree to a transfer. Division A will not accept less than $95 and Division B will not pay more than $92, the outside price. There is no possible range of negotiation within which a transfer could take place. 2. Refer to case 2 above. Assume that Division A can avoid $4 per unit in variable costs on any sales to Division B. a. Would you expect any disagreement between the two divisional managers over what the transfer price should be? Explain.

Transfer Price to maximize company profits: TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred TP = ($19 - $4) + ($21 X 70,000)/70,000 = $15 + $21 = $36 Division A: Contribution margin generated per unit under the current situation Contribution margin generated if a transfer takes place at $36 per unit

$21 21 $0

Division A manager is indifferent to selling outside or transferring to Division B

Division B: Cost per unit if purchased outside Cost per unit if transferred at $36 per unit

$39 36 $3

Division B manager would accept an internal transfer because of a $3 decrease in cost

The managers should agree to a transfer. Division A will be willing to accept a price of $36 or higher Division B will be willing to pay no more $39, the outside price. The range of negotiation within which a transfer should take place is $39 to $36. Even though the company would be better off with any transfer price within this range, each manager will negotiate for the transfer price that benefits their division the most. Division A's manager will try to hold out for a transfer price of $39, while Division B's manager will try to hold out for a transfer price of $36 per unit transferred. b. Assume that Division A offers to sell 70,000 units to Division B for $38 per unit and that Division B refuses this price. What will be the loss in potential profits for the company as a whole? 70,000 X $3 =

$210,000

Proof: Division A: TP per unit to Division B Variable cost per unit associated with transfer Benefit per unit to Division A Less CM given up to make transfer possible Net per unit benefit to Division A Number of units transferred Total increase in CM to Division A as a result of transfer

$38 15 $23 21 $2 70,000 $140,000

Division B: Cost per unit if purchased outside Cost per unit if transferred at agreed upon TP Benefit per unit to Division B Number of units transferred Total increase in CM to Division A as a result of transfer

$39 38 $1 70,000 $70,000

Total benefit to the company resulting from the transfer

$210,000

Note: Transfer price allocates profit between Division A and Division B. 3. Refer to case 3 above. Assume that Division B is now receiving a 5% price discount from the outside supplier. a. Will the managers agree to a transfer? If so, within what range will the transfer price be? Transfer Price to maximize company profits: TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred TP = $35 + ($0 X 20,000)/20,000 = $35 + $0 = $35 Division A: Contribution margin generated per unit under the current situation (excess capacity) Contribution margin generated if a transfer takes place at $35 per unit

$0 0 $0

Division A manager is indifferent to selling outside or transferring to Division B

Division B: Cost per unit if purchased outside Cost per unit if transferred at $35 per unit

$57 35 $22

Division B manager would accept an internal transfer because of a $22 per unit decrease in cost

The managers should agree to a transfer. Division A will be willing to accept a price of $35 or higher Division B will be willing to pay no more $57, the outside price. The range of negotiation within which a transfer should take place is $35 to $57. Even though the company would be better off with any transfer price within this range, each manager will negotiate for the transfer price that benefits their division the most. Division A's manager will try to hold out for a transfer price of $57, while Division B's manager will try to hold out for a transfer price of $35 per unit transferred. b. Assume that Division B offers to purchase 20,000 units from Division A at $52 per unit. If Division A accepts this price, would you expect its ROI to increase, decrease, or remain unchanged? Why? Benefit to company as a whole resulting from transfers

20,000 X $22 =

Division A: TP per unit to Division B Variable cost per unit associated with transfer Benefit per unit to Division A Less CM given up to make transfer possible Net per unit benefit to Division A Number of units transferred Total increase in CM to Division A as a result of transfer

$440,000

$52 35 $17 0 $17 20,000 $340,000

Effect on ROI: Divisional income will increase by $340,000 with no change in investment (excess capacity). Thus, Division A's ROI will increase. Division B: Cost per unit if purchased outside Cost per unit if transferred at agreed upon TP

$57 52

Benefit per unit to Division B Number of units transferred Total increase in CM to Division A as a result of transfer

$5 20,000 $100,000

Total benefit to the company resulting from the transfer

$440,000

Note: Transfer price allocates profit between Division A and Division B. 4. Refer to case 4 above. Assume that Division B wants Division A to provide it with 60,000 units of a different product from the one that Division A is now producing. The new product would require $25 per unit in variable costs and would require that Division A cut back production of its present product by 30,000 units annually. What is the lowest acceptable transfer price from Division A's perspective? Transfer Price to maximize company profits: TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred TP = $25 + ($15 X 30,000) / 60,000 = $25 + ($450,000 / 60,000) = $25 + $7.50 = $32.50