CHAPTER 12 12 PERFORMANCE EVALUATION IN DECENTRALIZED ORGANIZATIONS SOLUTIONS
R EVIEW EVIEW QUESTIONS 12.1
Firms decentralize because, as organizations grow, the number and types of decisions that need to be made increase substantially. A single individual will not have the relevant expertise and knowledge to make all of these decisions – thus, firms delegate decisionmaking responsibility. responsibility.
12.2
he benefits include !"# timely decisions, !$# tailoring managerial skills and specializations to %ob re&uirements, !'# empowering employees, and !(# training future managers. he costs include !"# an emphasis on local versus global goals, !$# re&uires coordination of decisions, and !'# can lead to improper decisions because of a divergence between individual and organizational goals.
12.3
!"# )ost centers, !$# *rofit centers, and !'# +nvestment centers.
12.4
inimize the cost of producing a specified level of output or service.
12.5
oth minimize costs and maximize revenues. hat is, maximize profit.
12.6
aximize the returns from invested capital, or to put the capital invested by owners and shareholders of the organizations to the most profitable uses.
12.7
)ontrollability and informativeness.
12.8
An ideal performance measure !"# aligns employee and organizational goals, !$# yields maximum information about the decision or actions of the individual or organizational unit, !'# is easy to measure, and !(# is easy to understand and communicate.
12.
+n the short-term, via budget variances. +n the long-term, by techni&ues such as benchmarking and kaizen.
12.1! aizen is a philosophy of continuous improvement. 12.11 y budget variances and comparing actual profit with past profit and industry profit. /rganizations also use revenue-oriented measures such as customer satisfaction and market share. Additional cost-oriented cost-oriented measures might focus on employee turnover or process improvements. 12.12 0/+ 1 return on investment 1 profit divided by investment. 0/+ is an effective summary of business profitability – it controls for size by expressing the return per investment dollar. dollar. )onse&uently, it is easy to compare the performance of investment centers of different size. 2e 2e also can decompose 0/+ into smaller pieces, p ieces, allowing managers to see how individual actions map into overall profitability p rofitability.. he ma%or criticism of 0/+ is that it can foster underinvestment. For example, if current 0/+ is $34, $ 34, a manager may not invest in a pro%ect with an 0/+ of o f "54 even though the firm6s firm6s cost of capital is "74. +t also favors divisions with older assets.
alakrishnan, anagerial Accounting "e
F/0 +890:)/0 :9; /8<=
"$-$ 12.13 0esidual income 1 *rofit – !re&uired return > +nvestment#. 0esidual income represents the additional profit or value generated by an investment after meeting the re&uired rate of return. ;conomic value added is a modified calculation of residual income – it uses a weighted average cost of capital and ad%usts for the operating and capital costs of a business, including taxes. 12.14 ecause multiple divisions often deal with each other in the normal course of business, diverting a portion of their resources from external business to serve internal needs. 12.15 !"# )ost-based transfer prices, !$# market-based transfer prices, and !'# negotiated transfer prices. arket based prices do best in evaluating opportunity costs and in preserving arms-length transactions. ut, the market may not exist. 8egotiated 8egotiated transfer prices truly respect autonomy but might be time consuming and tedious. )ost-based prices can be used under all situations but defining what is the right cost and the right markup to use can lead to many disputes. DISCUSSION QUESTIONS 12.16 he phase ?co-locates knowledge and decision rights@ means giving the decision making authority to individuals in the organization that have the re&uisite knowledge and information to make the right decision. For example, exa mple, decisions regarding material purchases in a manufacturing company such as when to purchase, how much to purchase, which suppliers to purchase from is best left to individuals dealing with the purchase function routinely. routinely. 9imilarly, sales promotion decisions are best made by marketing personnel who have the best knowledge of market conditions and consumer behavior. ecentralization of decision making is not always beneficial because it might to lead decision makers at lower levels to choose actions that are in their best interests and not necessarily in the best interests of the firm. firm. +t also re&uires considerable coordination across all levels in the organization to ensure that all decisions are properly coordinated.
responsibility to take out the garbageB mom cooks and cleans, and the 12.17 +t might be dad6s responsibility ten-year old son mows the lawn. he dad and mom may not need as much incentive to do their tasks because it is after all their house, and it is in their best interests to keep it clean. ut mom may need a bit of an incentive to cook well because cooking takes time away from other ?more fun@ activities such as shopping, or working out to look good. ut dad is interested in saving money and does not want to eat out routinely, and has to provide some ?inducement@ for mom to cook !your guess is as good as ours as to what he might do#. he son likely finds lawn mowing boring, but b ut a small monetary reward and some monitoring !to make sure that he does not cut corners# may do the trickC 12.18
=es. ecentralization promotes ?local@ maximization and not ?global@ maximization. ;ach divisional manager is interested in casting hisDher own pe rformance in the best possible light relative to other divisional managers. As long as divisional profit is used to evaluate performance, each divisional manager has a natural incentive to find ways in which to increase hisDher own divisional profit even if the chosen ways might hurt other divisions.
12.1
oth the :.9. Army and the :niversity of 2isconsin are not-for-profit organizations. he :.9. Army6s Army6s ob%ective is to defend the country and its borders. he :niversity of 2isconsin6s 2isconsin6s mission is to impart education. As we all know, know, discipline and preparedness
"$-$ 12.13 0esidual income 1 *rofit – !re&uired return > +nvestment#. 0esidual income represents the additional profit or value generated by an investment after meeting the re&uired rate of return. ;conomic value added is a modified calculation of residual income – it uses a weighted average cost of capital and ad%usts for the operating and capital costs of a business, including taxes. 12.14 ecause multiple divisions often deal with each other in the normal course of business, diverting a portion of their resources from external business to serve internal needs. 12.15 !"# )ost-based transfer prices, !$# market-based transfer prices, and !'# negotiated transfer prices. arket based prices do best in evaluating opportunity costs and in preserving arms-length transactions. ut, the market may not exist. 8egotiated 8egotiated transfer prices truly respect autonomy but might be time consuming and tedious. )ost-based prices can be used under all situations but defining what is the right cost and the right markup to use can lead to many disputes. DISCUSSION QUESTIONS 12.16 he phase ?co-locates knowledge and decision rights@ means giving the decision making authority to individuals in the organization that have the re&uisite knowledge and information to make the right decision. For example, exa mple, decisions regarding material purchases in a manufacturing company such as when to purchase, how much to purchase, which suppliers to purchase from is best left to individuals dealing with the purchase function routinely. routinely. 9imilarly, sales promotion decisions are best made by marketing personnel who have the best knowledge of market conditions and consumer behavior. ecentralization of decision making is not always beneficial because it might to lead decision makers at lower levels to choose actions that are in their best interests and not necessarily in the best interests of the firm. firm. +t also re&uires considerable coordination across all levels in the organization to ensure that all decisions are properly coordinated.
responsibility to take out the garbageB mom cooks and cleans, and the 12.17 +t might be dad6s responsibility ten-year old son mows the lawn. he dad and mom may not need as much incentive to do their tasks because it is after all their house, and it is in their best interests to keep it clean. ut mom may need a bit of an incentive to cook well because cooking takes time away from other ?more fun@ activities such as shopping, or working out to look good. ut dad is interested in saving money and does not want to eat out routinely, and has to provide some ?inducement@ for mom to cook !your guess is as good as ours as to what he might do#. he son likely finds lawn mowing boring, but b ut a small monetary reward and some monitoring !to make sure that he does not cut corners# may do the trickC 12.18
=es. ecentralization promotes ?local@ maximization and not ?global@ maximization. ;ach divisional manager is interested in casting hisDher own pe rformance in the best possible light relative to other divisional managers. As long as divisional profit is used to evaluate performance, each divisional manager has a natural incentive to find ways in which to increase hisDher own divisional profit even if the chosen ways might hurt other divisions.
12.1
oth the :.9. Army and the :niversity of 2isconsin are not-for-profit organizations. he :.9. Army6s Army6s ob%ective is to defend the country and its borders. he :niversity of 2isconsin6s 2isconsin6s mission is to impart education. As we all know, know, discipline and preparedness
"$-' are extremely important for the Army. Army. 9o it has a well established chain of command and decision structure. he Army Army does not use bonuses bon uses and monetary rewards to motivate its employees. 0ather, strict monitoring mechanisms are used and rules are rigidly enforced. Any deviations are punished severely. he employees of the :niversity are civilians. ilitary regimen does not work. 0ather, salary structure and monetary incentives are very much necessary to attract good faculty. ecision making is highly decentralized. ;ach branch of education is managed by a dean and his associates. he deans report to the *residentD)hancellor of the :niversity. :niversity. eing a state school, its actions and decisions have to conform con form to the state legislature6s policies and tenets. Any deviations can affect its access to state resources. 12.2!
As we learned in the chapter, a controllable performance measure reflects the conse&uences of the actions taken by the decision maker. 2e should hold a production manager accountable for production delays but not for the overall volume of production, which is driven by market demands. arketing managers have the authority to change prices and offer promotions that affect affect actual sales, which determine the re&uired production. Production managers, therefore, have little control over the volume of production. +t is not reasonable to hold them accountable for someone else6s else6s decisions or random market conditions. A performance measure is informative if it provides information about a manager6s manager 6s effort, effort, even if the manager does do es not have control over it. ost controllable con trollable measures are informative. For example, students control their performance on a &uiz, and their score is informative about their grasp of the sub%ect matter. Eowever, the student has little control over how the rest of the class performs. =et, =et, the overall class performance is useful information in evaluating each individual student6s performance because it tells us how hard the &uiz is. 9imilarly, 9imilarly, if a firm incurs losses when other firms in the industry are highly profitable, we may attribute those losses to poor managerial performance. Eowever, Eoweve r, if other firms in the industry are doing even worse, then the firm6s firm6s management may actually be doing a terrific %ob of dealing with adverse business conditions. hus, evaluating a firm relative to other firms in the industry, or relative performance evaluation, is useful, even though the firm6s firm6s managers may have little control over how other firms do.
12.21
he problem with this argument is that each manager cannot control actions of the other managers, and the impact of their actions on the firm6s profit. hus, it is possible that even though the division d ivision is doing extremely well, its manager may not receive commensurate reward if the firm as a whole is not doing well because of the actions of other managers.
12.22
ariance analysis is useful for both profit centers and cost centers. As we learned in )hapter 5, the overall variance of actual performance from budgeted performance can be split into sales volume variance and flexible budget budg et variance. 9ales volume variances point to the impact on profit of the difference between budgeted sales volume and actual sales volume. +t is useful in evaluating profit profit centers. Flexible budget variances are useful in analyzing the reasons for deviation of actual performance from expected performance at the actual volume. Flexible budget variances are useful for evaluating both profit centers and cost centers.
"$-( 12.23
2hen the net book value is used to measure investment, the asset6s age becomes a factor. As the asset becomes older, the accumulated depreciation increases and the net book value decreases. )onse&uently, 0/+ often is higher for older assets. As a result, managers may have less of an incentive to undertake timely asset replacement decisions.
12.24
)onsider the following example. ivision A has an income of G"3,333 on an investment of G"33,333. ivision has an income of G"33,333 on an investment of G",333,333. Assume that the re&uire rate of return is 54. he 0/+ for both the divisions is "34. ut the residual income for ivision A is G$,333 !1G"3,333 – !54 H G"33,333##, and the residual income for ivision is G$3,333 !1G"33,333 – !54 H G",333,333##. 2hyI his is because the residual income is sensitive to pro%ect size. All else e&ual, larger investments will have higher residual incomes.
12.25
=es, both 0/+ and 0+ are short-term performance measures. 0/+ is widely used because it is easy to compute and is well understood. As we learned in the chapter, 0/+ can be conveniently decomposed into profitability and asset turnover ratios. y evaluating the trends in these ratios, one can make reasonable assessments of the firm6s future. Also, 0/+ is but one of several measures that analysts and outsiders employ to evaluate the firm6s performance and its future potential.
12.26
2hen the supplying division is fully utilized, any transfer to the buying division is diverting capacity away from profitable use of its capacity. :nless the firm can earn a great profit by diverting capacity, it does not make sense to transfer. +n a decentralized environment in which both the buying and selling divisions are acting as profit centers, the transfer price must compensate the selling division for lost profit. he buying division will be willing to do so only if it is still able to make a profit for itself. +n this case, the company as a whole is better off because the selling division6s capacity will have been put to the most profitable useC
12.27
+n such instances, there is a natural incentive for the firm6s management to provide business to its subsidiaries even if the same services can be obtained from other sources for lower prices and at better &uality.
12.28
+ntellectual property is inherently difficult to price. +t is very much unlike a typical product which has a certain definite determinable life, and whose cost of production is determinable to a fair degree of accuracy. /n the other hand, the life of intellectual property is difficult to estimate. 9ometimes new technologies emerge suddenly rendering the intellectual property totally worthless immediately. /n the other hand, some intellectual property has indefinite lives. Another problem is that the dissemination of intellectual property is not easily controllable. he acute problem of piracy in the software industry is a good example.
12.2
+n such instances, most companies use some form of cost-based transfer prices i.e., variable cost plus some margin, or full cost plus some margin. Eowever, these transfer pricing schemes are arbitrary at best. 2hen the supplying division has no ready market for its product, it may be best to not view the supplying division as a profit center because it really has no discretion over its revenue sources. 0ather, it is better to structure the division as a cost center from a performance evaluation perspective.
"$-7 12.3!
+t is not advisable for the head office to interfere in transfer-pricing disputes because it would compromise the very purpose of decentralization. his said, however, if disputes take time, then some resolution mechanism would be necessary so that the company as a whole does not lose.
E"ERCISES 12.31 a. 2e believe that arl should be evaluated as a #$%& #'(&') . 2hile he provides a useful and visible service, there is no direct impact on revenue. Further, he does not influence prices or determine the level of output. Eis %ob is to keep up the buildings to specified &uality levels within allowed costs. his is a central characteristic of a cost center.
b. he university should use a *+, $- -+((#+/ (0 ($(-+((#+/ *'%)'% . 0elying on financial measures alone is not advisable because arl can always postpone maintenance to come in below budgeted expenditures. Eowever, we do need to make sure that the budget is not overspent by a lot. 8on-financial measures such as time to respond to complaints and general score on upkeep seem useful as a way to make sure that arl is providing the desired service &uality. 12.32 a. 2e believe that the branches should be evaluated as )$-+& #'(&')% . At first blush, it appears that the branches should be cost centers because branch managers do not decide on product choices or prices. Eowever, branch managers do influence volume – the other determinant of revenue. hey influence volume via the general atmosphere in the cantina, speed of service, cleanliness, and so on. ;valuation as a profit center would sensitize branch managers to the revenue implication of their actions.
b. From a financial perspective, Jordon should focus on 0'&'0 (0 #&/ )$-+& . Ee also would be wise to pay attention to budget-actual comparisons of key cost items such as labor, electricity, and so on. :nless he is using a transfer pricing scheme to charge branches for food used, tracking %$+/' seems useful. 2e also recommend that Jordon monitor key nonfinancial metrics such as &+*' &$ %')', &/' +/+/+& and so on. +ndeed, because of the many factors that affect success, it may be wise for Jordon to spend K a day to a full day per week at different branches %ust monitoring what is going on. 12.33 he following table provides the re&uired classification, along with a brief %ustification.
arketing
P)$-+& C'(&') . +t would appear that marketing should be evaluated based on revenues alone as it does not control costs. Eowever, the firm makes substantive commitments based on marketing forecasts and, in this way, marketing influences costs. *lus, few units only have revenues and no costs. ey performance measures include budget-actual comparisons of profit, as well as non-financial measures
"$-M such as customer satisfaction and market share. *lant
C$%& #'(&'). his unit6s primary %ob is to respond to marketing6s forecasts !i.e., they do not control &uantity or price# and to make the product at the budgeted cost or lower !sub%ect to &uality and other standards#. his is an '(+('')'0 #$%& #'(&') because we can reasonably relate output to expected cost. ey performance measures include budget-actual comparisons of cost, as well as non-financial measures such as average outgoing &uality and delivery reliability.
*lanning
C$%& #'(&'). his unit has no revenue responsibility or influence over it. Further, there is no direct link between their output !plans# and costs. hus, this function would be a 0+%#)'&+$() #$%& #'(&'). ey performance measures must be sub%ective.
aintenance C$%& #'(&'). his unit has no revenue responsibility or influence over it. 9ome portion of their operations are discretionary !e.g., general upkeep, planned overhauls#, while others relate to work done !e.g., machine hours run determine the maintenance needed.# /verall, we believe that the engineered portion will dominate the operations, and we lean toward evaluating the unit as an '(+('')'0 #$%& #'(&') . Eowever, we need to make sure the budget has both a fixed !for discretionary# and variable !for the output driven# portion to reflect the mixed nature of the operations. ey performance measures include budget-actual comparisons of cost, as well as non-financial measures such as uptime and time to respond to complaints. *urchasing
C$%& #'(&'). his unit has no revenue responsibility or influence over it. +t is difficult to determine a good measure of output because measures such as purchase orders, purchase order lines, and number of new items are deficient in measuring the multi-faceted nature of operations. hus, we lean toward evaluating this unit as a 0+%#)'&+$() #$%& #'(&') . ey performance measures include purchase price variances, as well as non-financial measures such as stock outs, new vendor development, and so on.
12.34 he strategic performance group should be evaluated as a 0+%#)'&+$() #$%& #'(&') . here is no clear identification of their output and the relation between their output and input is unclear. his group exists because management believes that it is worth spending money on the help regarding strategy formulation and implementation. he group6s performance has to be measured sub%ectively. At a less critical level, some cost comparison relative to budget is also appropriate. 12.35 a. T')' )' $& $%+&+' (0 ('&+' %'#&% $- ')-$)*(#' . /n the one hand, overall volume and revenue are significantly above target. Eowever, the average revenue per frame is down from G"$3 !GL.M million D 53,333 frames# to G""3 !G"" million D "33,333 frames#. his
"$-N reduction is bothersome in light of the division6s strategy to sell high-&uality products for premium prices. b. A+(9 &')' )' $& $%+&+' (0 ('&+' %'#&% $- ')-$)*(#' . Eere, while the overall margin is positive !G"'3 per frame 1 GL." million D N3,333 frames#, the volume is down nearly "34. oth situations are cause for concern. Additional data on market size and share would be useful. +t also might be prudent to revisit the forecasting process becau se such large swings should be the exception and not the norm. 8oteO =ou can also relate this analysis to the sales volume and price variances discussed in )hapter 5. 8ote that we cannot compute a volume variance exactly because we do not know the variable cost per frame. 12.36 he data pertain to an engineered cost center. hat is, volume affects total cost. 2e need to construct a flexible budget and perform cost variance analysis. 2e haveO
udget *roduction volume !units# otal variable costs otal fixed costs
"N7,333 GN,5N7,333 ",$33,333
Flexible budget> $33,333 GL,333,333 ",$33,333
Actual $33,333 GL,(73,333 G",'73,333
> As we know from )hapter 5, the flexible budget ad%usts costs for the actual volume of operations. hus, we have !GN,5N7,333D"N7,333# H $33,333 1 GL,333,333. Fi xed costs do not change.
After ad%usting for volume, the efficiency variance is G(73,333 : and the fixed cost spending variance is G"73,333 :. 2hile some of the cost over-runs might be legitimately attributed to the higher volume !e.g., poorer &uality materials, more supervisors hired etc#, the increase is significant and warrants investigation. /verall, &' 0& )'-/'#& #$(%+0')/' #%' -$) #$(#')(. 12.37 a. he data pertain to an engineered cost center. hat is, volume affects total cost. hat is, we need to construct a flexible budget and perform cost variance analysis. 2e haveO
udget *roduction volume !units# otal variable costs otal fixed costs
$33,333 GL,$33,333 ",'33,333
Flexible budget "73,333 GM,L33,333 ",'33,333
Actual "73,333 GM,5N7,333 G",'"7,333
> As we know from )hapter 5, the flexible budget ad%usts costs for the actual volume of operations. hus, we have !GL,$33,333D$33,333# H "73,333 1 GM,L33,333. Fi xed costs do not change.
After ad%usting for volume, the efficiency variance is G$7,333 F and the fixed cost spending variance is G"7,333 :. 2hile we would not be concerned about either variance !i.e., the
"$-5 production department seems to have done a fine %ob#, we would be very concerned about the substantial reduction in volume. he lower volume would be the primary focus of our investigation. /verall, &' 0& )'-/'#& #$(%+0')/' #%' -$) #$(#')( ''( &$ &' )+(#'% :-)$* &' )$0#&+$( 0')&*'(&;% ')%'#&+'< )' ('/++/'. b. he cost data, taken alone, seem to show that the production department did a very good %ob during the year. After ad%usting for costs associated with the breakdown, the production department has substantially favorable !G$7,333 F P G"$3,333 1 G"(7,333 in variable and G"7,333 : - GN7,333 1 GM3,333 F in fixed# variances. Eowever, we have to askO Why did the machine breakdown? 2ith proper maintenance, such a disaster should not occur. he firm must have lost considerable money from lost sales. :nless an investigation shows that the breakdown is due to unavoidable and unexpected causes !e.g., the machine was damaged when the plant flooded because of torrential rains#, we would be +(#/+('0 &$ =0' &' )$0#&+$( *(') )%/ . /verall, the manager’s job is to run the plan efficiently (as per variances) and effectively (get full use out of the resources.) t higher levels! effectiveness measures are perhaps more informative than measures of efficiency. 12.38 a. An alternate view of Jreg6s performance might be that he -$#%'% $( %$)&&')* )'%/&% & &' ','(%' $- /$(&')* ')-$)*(#' . ;xamples include channel stuffing !i.e., recognizing profit on units pushed out to dealers even if they cannot be sure of selling them#, sacrificing &uality, training and maintenance, and not investing in future products. 9uch actions might produce immediate gains but lead to ruin in the long run. ;ffective managers consider both the short- and long-term effects of their decisions.
b. N$(-+((#+/ *'%)'% might be a good way to constrain managers who seek to short-change the future. *eriodic measurements of key process measures such as &uality, machine up time, and customer satisfaction can help ensure that managers are investing in the drivers of future value in addition to taking care of current &uarter results.
"$-L
12.3 he following table provides the re&uired computations.
/perating income
+nvestment
0/+
0e&uired rate of return
"
G$$7,333
G",533,333
12.5> !see "."#
"(4
$
?25!9!!! !see $."#
G$,733,333 "34
'
G733,333
?59!!!9!!! !see '."#
"34
(
G"73,333
G",$33,333
12.5> !see (."#
etail of computationO "." G$$7,333DG",533,333 1 "$.74 $." G$,733,333 H 3."3 1 G$73,333 '." G733,333D3." 1 G7,333,333 (." G"73,333 D ",$33,333 1 "$.74
".$ $.$ '.$ (.$
54 7.5> !see '.$# 14.!> !see (.$#
0+ :?279!!!< !see ".$# ?5!9!!! !see $.$#
G"$7,333 !G"5,333#
G$$7,333 - !3."( H G",533,333# 1 !G$N,333# G$73,333 -!G$,733,333H3.35# 1 G73,333 G733,333 – !G7,333,333 H Q# 1 G"$7,333 G"73,333 – !G",$33,333 H Q# 1 !G"5,333#
12.4! a. 2e haveO
0esidual income !iv A#O G',N73,333 – !3." H G'",$73,333# 1 ?6259!!! 0esidual income !iv #O G","33,333 – !3." H G7,733,333# 1 ?55!9!!!. D++%+$( A +% +') )(@'0.
b. 0epeating the exercise, we haveO 0esidual income !iv A#O G',N73,333 – !3."( H G'",$73,333# 1 !?6259!!!< 0esidual income !iv #O G","33,333 – !3."( H G7,733,333# 1 ?33!9!!! D++%+$( +% +') )(@'0.
c. his problem shows that residual income is sub%ect to a %+B' '--'#& . 8otice that ivision A6s 0/+ is "$4 and the 0/+ for ivision is $34. 2hen we use a "34 re&uired rate, the size for division A propels its 0+ above that for division . Eowever, like leverage, the size also rapidly reduces 0+ when we increase the rate to "(4. hus, 0+ is not a good way to compare divisions that differ greatly on size.
"$-"3
12.41 a. 2e haveO
0esidual income !;ast#O G',333,333 – 3." H G$(,333,333 1 ?6!!9!!! 0esidual income !2est#O GN53,333 – 3." H G',L33,333 1 ?3!9!!!. T' E%&')( 0++%+$( % &' +') )'%+0/ +(#$*'.
b. 2e haveO 0eturn on +nvestment !;ast#O G',333,333 D G$(,333,333 1 12.5> 0eturn on +nvestment !2est#O GN53,333 D G',L33,333 1 2!>. T' W'%&')( 0++%+$( % &' +') ROI.
c. his problem shows that residual income is sub%ect to a %+B' '--'#& but 0/+ is not. +n part A, the larger size for the ;astern ivision !which is more than M times that of the 2estern ivision# overcomes its lower profitability, as measured by 0/+. hus, 0+ is not a good way to compare divisions that differ greatly on size. 12.42
a. Full cost is variable cost plus allocated manufacturing cost. hus, the full cost for this product is G"3 P G!",733,333D$73,333 units# 1 G"M per unit. hailand 0evenue ransfer out )ost of transfer in ariable cost Fixed cost *rofit
:9A GM,$73,333
otal GM,$73,333
?49!!!9!!! ?49!!!9!!!
G$,733,333 G",733,333 3
-G$,$73,333
G$,733,333 G",733,333 G$,$73,333
8ote that the cost of the transfers out and in cancel when we consolidate the two divisional statements.
"$-""
b. 2ith the new data, we haveO hailand 0evenue ransfer out ?59!!!9!!! )ost of transfer in ariable cost G$,733,333 Fixed cost G",733,333 *rofit ",333,333
:9A GM,$73,333
otal GM,$73,333
?59!!!9!!!
-G",$73,333
G$,733,333 G",733,333 G$,$73,333
he change in the transfer price redistributes the profit between the two divisions. Eowever, it does not change total profit in any way. c. /n a pre-tax basis, transfer prices only distribute the total profit among divisions. T' &)(%-') )+#' % ($ '--'#& $( &$&/ )'&, )$-+& . his conclusion is not true for after-tax profit because the different divisions might face different tax rates. hus, where we recognize profit matters. 12.43 a. he variable cost for an engine is 0s. M,333 P ',333 P ",333 1 0s. "3,333. Adding the $3 4 mark up gives a price of R%. 129!!! ') '(+(' .
b. he full cost is variable cost plus allocated manufacturing overhead. hus, the full cost for an engine is 0s. "3,333 P $,333 1 0s. "$,333. Adding the "3 4 mark up gives a price of R%. 1392!! ') '(+(' . c. he problem text indicates that there is a ready market for these engines. herefore, the market price of R%. 189!!! ') '(+(' is the appropriate transfer price. his is the only price that properly reflects the opportunity cost of using up the capacity in the ;ngines ivision. A lower, cost-based price would artificially depress profit at the ;ngines ivision and raise the profit reported in the Assembly ivision. 12.44 a. +f division A is only making "$,333 screens, they have considerable excess capacity of 5,333 screens !1$3,333 capacity – "$,333 used#. he opportunity cost of this excess capacity is zero. hus, their minimum price is %ust their variable cost of ?1!5 ') #%&$* %#)''( .
b. +f ivision A is at capacity, they will have to sacrifice making standard screens to make custom screens. ;ach standard screen generates a contribution margin of G$"3 - GL3 1 G"$3. his is the
"$-"$ opportunity cost of using capacity to make custom screens. hus, the minimum transfer price is G"37 P G"$3 1 ?225 ') #%&$* %#)''( . c. +n this case, ivision A has some !but not enough# excess capacity. hus, it will have to sacrifice ",333 standard screens. hus, the lost contribution is G"$3 per standard screen H ",333 1 G"$3,333, or G"$3,333D7,333 screens 1 G$( per custom screen. Adding this opportunity cost to the variable cost of G"37 gives the minimum price of ?12 ') #%&$* %#)''( . 8oteO his exercise illustrates how the opportunity cost of capacity changes as we change the baseline situation. PROLEMS 12.45 a. he )0J !)entral 0esearch Jroup# should be evaluated as a )$-+& #'(&') , with a target profit of zero. 2hile it has clearly defined customers and products, the group is not allowed to make a profit. )harging for the service is good because it sensitizes line managers to the idea that these services are costly. Eowever, pricing at cost encourages use !which might save the firm more money in the long run#. he downside to this approach is that there is no built-in incentive for the group to save costs or become more efficient. 2e can easily see the group6s budget growing each year, with the result that the users wind up paying a great deal for this service !they have no other option#.
b. +n addition to financial measures, it would be worthwhile to '(#*)@ &' #$%& !price per hour# with independent consultants. Further, there should be periodic %)'% $- #%&$*') %&+%-#&+$( (0 /+& . +ndeed, we advocate for the 0++%+$( *(')% &$ ' #$*/'&' #$(&)$/ $') '&') (0 $ *# &$ %' &' CRG . 8otice that the )0J has a built-in cost advantage both because it does not charge a profit markup and because it will always have greater institutional knowledge relative to outside consultants. +f the divisions still prefer to use outside consultants, the corporate office would get a strong indication that something is seriously wrong.
"$-"'
12.46 a.
ariance
!G(73,333# G(73,333 G$3,333 !G"L3,333# !G$33,333# !G'N3,333#
he variances, taken alone, show that the )$0#&+$( *(') 0+0 ') (+#' =$ . he department saved 74 relative to the variable cost in the flexible budget and was below the budget for fixed costs as well. he marketing department, however, seems to have dropped the ball. hey had to cut prices even though they incurred substantially more marketing costs than budgeted. T' /$%% -)$* *)@'&+( *$)' &( +'0 $& &' +( -)$* )$0#&+$( . b. I& +% #')&+(/ $%%+/' && *)@'&+( % /'+&+*&' #%'. he lower cost for production might have resulted for using lower &uality materials or rushing the product through. hese items translate to more difficult to sell items, as well as higher warranty expenses. 2e would have to look at the line item variances !i.e., variances for individual expense categories# to determine if there was substance to the allegations. c. T+% )$/'* *+& ' )+%'( '#%' &' -+)* -$#%'0 )'/ $( -+((#+/ *'%)'% . :sing non-financial metrics such as average outgoing &uality might help prevent such problems in the future. 9ome firms evaluate their production departments as profit centers !using a transfer price to value output and passing through costs related to &uality# to sensitize production managers to the market conse&uences of their decisions. 12.47
his problem highlights the 0'-+#+'(#+'% +( &' &)0+&+$(/ #/%%+-+#&+$( $- #$%& (0 )$-+& #'(&')% . )learly, an is not a cost center as he generates considerable revenues. irtually all of the money he expends on his labs are grant funds, and the :niversity has only a record keeping role. +ndeed, the :niversity collects a ?profit@ if the ov erhead charge is more than the direct costs of grant administration. !0esearch faculty often complain such is the case.# Further, an generates revenue via his clinical service. here, he does not control price, but surely influences the &uantity of patients he sees.
"$-"( an also is not a profit center. aking profit is not the reason the :niversity employs an, and it would be sending him wrong signals !and infuriating its own donors and other constituents# if it evaluated an as a profit center. ost :niversity administrators would take offense at the notion that their operations contain a profit component. 8evertheless, virtually all universities re&uire established medial researchers to support their research, and view the overhead recovery as an important component of their inflow of funds. +n practice, :niversities give considerable latitude to people such as an. hey are allowed to run their own show !sub%ect to broad oversight# because they are almost entrepreneurs working for the :niversity. 2e suspect that an would be sub%ect to little in the form of formal targets !e.g., number of patients, research papers or students# but be governed via broad policies that apply to many people. he %ob of his boss is to keep such a high-powered, self-motivated individual on track with respect to the :niversity6s goals. 12.48 a. 0/+ !travel# 1 GM33,333 D G(,333,333 1 15> 0/+ !leather# 1 G",$33,333 D GM,333,333 1 2!>. . 0esidual income !travel bags# 1 GM33,333 – !3."$ H G(,333,333# 1 ?12!9!!!. 0esidual income !leather# 1 G",$33,333 – !3."$ H GM,333,333# 1 ?48!9!!!.
c. First, let us calculate the firm6s weighted average cost of capital !2A))#. 0eferring to the formulaO 2A)) 1 R!" - 3.'# H 3.'H 3.35S P !3.N H 3."$# 1 "3.354. he first term reflects the tax shield !" - 3.'#, the proportion of debt financing !'34# and the cost of debt. he second term shows the proportion of e&uity financing and the cost of e&uity capital. 8ext, we haveO ;A !travel# 1 !GM33,333 H 3.N# – R3."335 H !G(,333,333-G"N7,333#S 1 ?34944! . ;A !leather# 1 !G",$33,333 H 3.N# – R3."335 H !GM,333,333 – G533,333#S 1 ?315984! . 8otice that we multiplied the pre-tax income by !" - tax rate# to determine the after tax operating income. d. As discussed in the text, each of the measures has costs and benefits. 0/+ is easy to compute and communicate but can spur poor investment decisions. ;A is conceptually the most accurate method but is complex to implement, particularly when we have to make substantive corrections to JAA* statements !as is traditionally the case#. 8evertheless, ' /'( &$)0 %+( EVA
"$-"7 mostly because it has stronger theoretical foundations. 12.4 a. 0/+ 1 /perating income D 8et book value of assets 1 G"$7,333 D G'73,333 1 35.71> . 0esidual income 1 G"$7,333 – !3."( H G'73,333# 1 ?769!!!.
c. First, let us calculate the firm6s weighted average cost of capital !2A))#. 0eferring to the formulaO 2A)) 1 !"- tax rate# H 4 debt H cost of debt P 4 of e&uity H cost of e&uity 1 R!" - 3.$5# H !"DN# H 3."$S P !MDN H 3."7# 1 "(.3L4. he first term reflects the tax shield !" - 3.$5#, the proportion of debt financing !73,333D'73,333# and the cost of debt. he second term shows the proportion of e&uity financing and the cost of e&uity capital. 8ext, we haveO ;A !leather# 1 !G"$7,333 H 3.N$# – R3."(3L H !G'73,333 – GN$,333#S 1 ?5!982.8! . 8otice that we multiplied the pre-tax income by !" - tax rate# to determine the after tax operating income. d. he 0/+ for Eercules seems particularly high at '7.N"4. 2e propose that a large portion of this value might arise because of a %*// /' -$) ('& %%'&% – the denominator in 0/+. he small value makes sense in this context because we know that Eercules relies more on personal service and attention for its business than on modern facilities. hus, we expect its e&uipment and buildings to be somewhat dated. 8aturally, the capital assets are mostly depreciated, leading to small book value and a high 0/+. e. 2e believe that om and
"$-"M in the first instanceO om and
a. ansoor6s ')-$)*(#' '/&+$( %%&'* *+& ' #$(&)+&+( &$ &' )$/'* . )urrently, the system rewards machine uptime, which seems to be a good thing to do. After all, if the machine is running well, it is because it has been repaired well. Eowever, the system does not reward &uick turnaround. 9uch a &uick %ob might be the best thing to do if a ma%or sale is on the line. ansoor6s reward system does not give him any rewards for cooperating with the production and sales managers. hus, his insistence on ?good &uality,@ because a super repair %ob !which might take a long time# ensures high run time !both because the machine has been fixed right and because the production manager cannot afford to let it go back to the shop#, which increases his budget.
b. +t might be useful to *'(& M(%$$);% ')-$)*(#' '/&+$( %%&'* '+&') 00+( *$)' ($(-+((#+/ *'%)'% :'..9 ')' &+*' ') )'+)< (0 00+( +') (+& ')-$)*(#' *'%)'% :'..9 &$&/ /' $- $$0% %+'0 ') *$(&< . oth measures, particularly the latter, give him an incentive to cooperate with the production and marketing folks to trade off the need for time to make good &uality repairs versus the need to get the machine back on line as &uickly as possible. 12.51 he use of upper-level performance measures is $(' &$ '(#$)' #$$')&+$( *$( /$')/''/ *(')%. For instance, if two branches had many shared customers, poor customer service by one branch could affect revenues at the other branch. Firms can sensitize managers to the firm-wide effects of their actions by using upper level performance units. asing bon us payments on the profits of both branches makes the manager in either branch consider the effects of their actions on the other branch as well. he downside is that upper level measures sever the direct link between the manager6s actions and their conse&uences. +t is easy to relate branch profit to a branch manager6s actions, but is far more difficult to relate corporate profit.
he problem highlights differing tradeoffs of these costs and benefits. Firm A appears to have considerable inter-linkages among branches. hus, it makes sense for the firm to use upper-level measures to induce team-based perspectives. +n contrast, branches in Firm are mostly independent of each other. hus, it makes sense to base performance on the directly measures at the branch level itself.
"$-"N
12.52 a. he following is the re&uired tableO
Eouston Atlanta 9eattle
0eturn on +nvestment 8et book Jross value book value 18.333> 17.857> 16.667> 1.277> 14.444> 18.662>
0esidual +ncome 8et book Jross book value value ?195!!9!!! ?194!!9!!!
?198!9!!! ?2931!9!!!
?192!!9!!!
?2946!9!!!
)onsider the first column. For Eouston, we have income with !8et book value# 1 G5.7 - G$.5 G$.( 1 G'.' million and net book value is G"5 million. hus, 0/+ is G','33,333 D G"5,333,333 1 "5.''4. )onsidering the third column, the residual income !with net book value# is G','33,333 – !3." H G"5,333,333# 1 G",733,333. 9imilar computations apply to the other locations. 8ow, let us turn to the computations with the gross book value. First, we calculate gross book value by adding back the annual depreciation H age of assets. hen, to be consistent, we remove depreciation from income as well. 0elevant data are as follows.
8et book value Eouston G"5,333,333 Atlanta G$",333,333 9eattle G$N,333,333
epreciation G",$33,333 G",'33,333 G",(33,333
Age M ' "
J 1 8et book value P age > depreciation G$7,$33,333 G$(,L33,333 G$5,(33,333
Ad%usted income with depreciation added back G(,733,333 G(,533,333 G7,'33,333
hus, for Eouston, we have income with !gross book value# 1 G','33,333 P ",$33,333 1 G(,733,333. hus, 0/+ is G(,733,333 D G$7,$33,333 1 "N.57N4. he residual income is G(,733,333 – !3." H G$7,$33,333# 1 G",L53,333. 9imilar computations apply to the other locations. b. 2e find the H$%&$( /$#&+$( &$ ' *$%& )$-+&/' % *'%)'0 ROI !8#, which is the traditional measure. Eowever, notice that age helps this location. /lder assets tend to have lower net book value !have had greater time to depreciate#, which lowers the denominator in the 0/+ calculation. Further, lower depreciation !if using accelerated depreciation# also helps increase the numerator. +n general, otherwise identical operations will report different 0/+ solely because of their age. 9witching measures to residual income does not solve this problem. 0+ has the same deficiency with respect to age.
"$-"5 )hanging measurements to gross book value might help us better understand these issues. 2ith J, we see that the three locations are approximately e&ual in terms of profitability. +ndeed, the Eouston location is the least profitable. he point to note here is that we have to ad%ust income and investment for depreciation to perform this computation. Eowever, even this ad%ustment is imperfect because it assumes that investment prices did not change over time. Further, it does not reflect our net investment in the assets, which might be a better measure of remaining life. !After all, we have ( more years of service from Eouston but L from 9eattle, if we assume a "3-year horizon#. he over-arching point is that variations in measurement affect the ranking of divisions. W' (''0 &$ &&'(&+$( &$ &' )$%' $- &' )(@+( (0 %' &' )$)+&' *'%)' -$) &' 0'#+%+$( & (0 . hus, if we are deciding whether to keep or sell the asset, current market value is the choice as it best reflects the opportunity cost of retaining the asset. 12.53 he main difficulty in this problem is calculating profit for the year $33L. 2e know that revenue will be G' million. 2e also know that )/J9 and selling expenses both are mixed costs !i.e., contain both fixed and variable components#. 2e need to break these portions out to generate an accurate profit estimate.
2e can write )/J9 asO G",533,333 1 )/J9fixed P ariable cost per sales G H G$,(33,333 G$,3"3,333 1 )/J9fixed P ariable cost per sales G H G$,N33,333 9ubtracting one e&uation from the other, we can calculate the variable portion asO ariable cost per sales G
1 !G$,3"3,333 -G",533,333#D !G$,N33,333 - G$,(33,333# 1 G$"3,333 D G'33,333 1 N34.
2e can then use either e&uation to calculate )/J9fixed as G"$3,333 1 G",533,333 - !3.N H G$,(33,333#. 2e can perform similar computations for selling expenses to calculate the variable selling cost at "34 of each sales G and the fixed selling cost at G$(3,333. 2ith these data in hand, we can pro%ect the income statement for $33L.
9ales )ost of goods sold Jross margin 9elling expenses *rofit before tax
=ear $33L G',333,333 $,$$3,333 N53,333 7(3,333 G$(3,333
Jiven G"$3,333 P !3.N H G',333,333# G$(3,333 P !3." H ',333,333#
"$-"L
hen, the 0/+ is !G$(3,333 D G$,$N7,333# 1 1!.55>. he division6s residual income is G$(3,333 – !3." H G$,$N7,333# 1 ?1295!! 12.54 a. For this problem, we have to think about the after-tax cash flows. 9uppose the machine were to be sold in ;urope. hen, we would want to recognize as much of the profit as possible in the :nited 9tates because the tax rate in ;urope is higher. hus, the transfer will take place at GN73,333, meaning that the :.9. division will recognize profit of G"$7,333 and the ;uropean division will recognize profit of zero. hen, )atlow6s total profit isO
1 After-tax profit in :.9. P After-tax profit in ;urope 1 R!" – 3.'7# H !GN73,333 - GM$7,333#S P R!"- 3.(7# H !GN73,333 - GN73,333#S 1 G5",$73. +f instead the machine were to be sold in Asia, we want the profit to be recognized in Asia. hat is, the transfer price would be GM$7,333, meaning that we have zero profit in the :nited 9tates. hen, )atlow6s profit is 1 After-tax profit in :.9. P After-tax profit in Asia 1 R!" – 3.'7# H !GM$7,333 - GM$7,333#S P R!"- 3.$3# H !GNN7,333 - GM$7,333#S 1 G"$3,333. )omparing the two profits, )atlow would prefer to sell the machine in Asia, set the transfer price at GM$7,333, and made G"$3,333 in after-tax profit. b. he :.9. division cares more about its profit. hus, left alone, it would prefer to take the GN33,333 bid from ;urope over the GMN7,333 bid from Asia. 8otice that the G73,333 forfeited fee is sunk for this purpose, as is the money spent on making the machine. +f this transfer were to take place at GN33,333, the net profit for )atlow isO 1 After-tax profit in :.9. P After-tax profit in ;urope 1 R!" – 3.'7# H !GN33,333 - GM$7,333#S P R!"- 3.(7# H !GN73,333 - GN33,333#S 1 GNM,$73. 8otice that this amount is lower than either of the two amounts calculated in part A. hus, allowing the divisions to bargain and decide for themselves might lead to a sub-optimal outcome from the corporate perspective. c. he benefit of allowing for decentralized operations is that division managers gain autonomy and can be held accountable for their output. his action is most consistent with the entire philosophy of decentralization. his might lead to profit being less than it could have been had the central
"$-$3 office intervened to force the ?right@ transfer. Eowever, such intervention might prove even more expensive in the long-run because it saps the division managers of their authority. 12.55 he division controller is in a difficult situation. 2hile some costs are clearly fixed and others clearly variable, many costs could be classified as mixed. here is legitimate disagreement about what portion of the cost is fixed and what portion is variable. he transfer pricing rule provides considerable incentives for the division to classify as many of the costs as possible as being variable in nature. he division manager also could take actions !e.g., outsource production# that convert fixed to variable costs. hus, it is not clear that the division controller can outright re%ect the manager6s re&uest. At the same time, ethical and professional considerations bar the controller from misrepresenting a fixed cost as being variable. :ltimately, we expect that most people in this situation would take another hard look at ?fixed@ costs to see if any of them have a reasonable basis !even with some stretching of definitions# to be a variable cost. Eowever, we also are sure that professional accountants would not cross the line and misrepresent the nature of a cost.
:ltimately, the conflict comes about because of a flaw in the transfer pricing system. Any system that imposes an arbitrary pricing rule creates incentives to reclassify costs, much like the reimbursement systems provided incentives to strategically allocate costs. he central office in *ackages would be wise to revisit the transfer pricing issue and consider alternate solutions. 12.56 a. he change might help the division by boosting the transfer price. After all, the new machines !which make the foil printers# consume very little labor while the old machines !which make the parts sold at full cost to other divisions# consume a great deal of labor. hus, a labor based system would shift the overhead to the old machines, and via the transfer price, to the other divisions. he co-mingling of costs into a single pool aids this process by mixing the costs of the new machines !likely a lot# with the costs of old machines.
b. 2e believe that the division controller should resist this suggestion vigorously. here is little basis !from a decision making perspective# for mingling the costs of unlike machines together into one pool. oreover, labor hours seem like a poor cost driver for allocating the costs of new machines. he method seems to be designed for strategically shifting costs, and such massaging of allocations do not appear to comply with the ethical rules promulgated by the +A.
"$-$"
12.57 a.
Full cost is variable cost plus allocated fixed cost. hus, the full cost is GM.M million and the transfer price is GM.M H "." 1 GN,$M3,333. 2ith this, we haveO ivision A ivision otal !firm# 0evenues G"$,733,333 G"$,733,333 ransfer revenue GN,$M3,333 otal revenue GN,$M3,333 G"$,733,333 G"$,733,333 ransfer cost GN,$M3,333 irect material costs G$,733,333 G",533,333 G(,'33,333 irect labor G$,333,333 G",733,333 G',733,333 ariable overhead G733,333 G'N7,333 G5N7,333 Allocated fixed overhead G",M33,333 G",$33,333 G$,533,333 otal cost GM,M33,333 G"$,"'7,333 G"",(N7,333 *rofit GMM3,333 G'M7,333 G",3$7,333 8otice that the total column eliminates the transfer revenue and cost as the amounts offset each other. +n particular, the total cost G"",(N7,333 1 GM,M33,333PG"$,"'7,333 -GN,$M3,333. b. he division6s variable cost is G7 million. he G7.3 H ".$ 1 GM,333,333 . 2ith this, we haveO ivision A ivision otal !firm# 0evenues G"$,733,333 G"$,733,333 ransfer revenue GM,333,333 otal revenue GM,333,333 G"$,733,333 G"$,733,333 ransfer cost GM,333,333 irect material costs G$,733,333 G",533,333 G(,'33,333 irect labor G$,333,333 G",733,333 G',733,333 ariable overhead G733,333 G'N7,333 G5N7,333 Allocated fixed overhead G",M33,333 G",$33,333 G$,533,333 otal cost GM,M33,333 G"3,5N7,333 G"",(N7,333 *rofit !GM33,333# G",M$7,333 G",3$7,333 Again, notice that G"",(N7,333 1 GM,M33,333 P G"3,5N7,333 - GM,333,333.
"$-$$
c. ivision A 0evenues ransfer revenue otal revenue ransfer cost irect material costs irect labor ariable overhead Allocated fixed overhead otal cost *rofit
G5,333,333 G5,333,333 G$,733,333 G$,333,333 G733,333 G",M33,333 GM,M33,333 G",(33,333
ivision G"$,733,333
otal !firm# G"$,733,333
G"$,733,333 G5,333,333 G",533,333 G",733,333 G'N7,333 G",$33,333 G"$,5N7,333 !'N7,333#
G"$,733,333 G(,'33,333 G',733,333 G5N7,333 G$,533,333 G"",(N7,333 G",3$7,333
d. he comparison shows that the chosen transfer price affects divisional profit significantly. Eowever, the choice does not affect corporate !pre-tax# profit because the revenue and cost cancel out when we consolidate. 8ote, however, that the choice would affect after-tax profit particularly if the two divisions were in different tax %urisdictions. 2e can %ustify each of the transfer prices. ariable cost based pricing might be appropriate when ivision A has considerable excess capacity. +n this case, such a price appropriately communicates the cost of idle capacity. A full cost based price is appropriate when the division is operating at capacity but there is no ready market price. +n this case, a full cost based price approximates market price. Finally, a market price is the best as it clearly separates the operations in the two divisions. 12.58 a. 2e would argue that the market price is the correct transfer price that appropriately reflects the opportunity cost of capacity in the microprocessor division. From the viewpoint of Tuest, the transfer should not happen. 8otice that Tuest obtains G$73-G"33 1 G"73 per micro-processor transferred. Eowever, it loses GN3 in the *) division for a net contribution of G53 per chip !1G",333 -G5$3 - G"33#. +t is better off if it sells the chip only and closes down the *) division.
b. 8ow, the problem is a bit different because there is unused capacity in the * division. his capacity has an opportunity cost of zero for "$,733 chips. !8o external sales would be displaced at this level#. hen, the minimum price that the * division would accept is G" 33 !its variable cost# and the maximum price that *) division would pay is G"53 1 G",333 - G5$3 !the value at which its contribution is zero#. Any price between G"33 and G"53 leaves both divisions better off relative to not transferring the chip. he transfer also is profitable from the firm6s perspective. +t makes G",333 - G5$3 - G"33 1 G53 per chip if it uses the unused capacity to make chips for use by the *) division.
"$-$' c. his new information changes the nature of the opportunity cost in the * division. )urrently, with sales of 'N,733 chips, it is making a contribution of 'N,733 H !G$73 - G"33# 1 G7,M$7,333. +f it were to lower the price, its contribution would be 73,333 H !G$$7- G"33# 1 GM,$73,333. hus, from the * division6s perspective, it needs to make GM,$73,333 in contribution for it to see the transfer as being profitable. 2e can calculate the minimum transfer price acceptable to the * division asO "$,733 H !Q – "33# P 'N,733 H G!$73-"33# 1 GM,$73,333 /r Q 1 G"73. 8ote that if it makes the transfer, there is no need to lower the price on the 'N,733 chips now being sold. At a price of G"73 per chip transferred, the * division is indifferent to the transfer or selling the product elsewhere. At this price, the *) division makes a contribution of G' 3 per chip transferred. hus, the transfer is worthwhile from the view point of the overall corporation as well. 8ote that the transfer is not at the market price, even though a ready market for the product exists. 9uch a situation has arisen because the market for chips does not appear to be efficient. +n the long-run, such discrepancies will not persist. 12.5 )alculating the 0/+ is straight forward as shown below. asis /perating Asset 0/+ 1 profit D *rofit base investment 8et book value G"$7,333 GL33,333 13.88> 0eplacement cost G"$7,333 ",$73,333 1!.!!> 9ales value "$7,333 ",N33,333 7.35>
he measures are all useful but in different contexts. he 0/+ with net book value is useful as a way of evaluating historical trends. +t is most useful when a business is stable and the replacement of capacity is on going process and the business is not growing or shrinking, and prices are stable. he 0/+ with replacement cost is useful for evaluating whether the business is a viable longterm entity. After all, the replacement cost 0/+ indicates that om and
"$-$( As is evident, we can compute 0/+ using differing measures of both income and investment. T' 0'#+%+$( #$(&',& 0'&')*+('% &' )'/'(& *'%)'. 12.6! 2e haveO
)urrent liabilities
)ost of debt capital !k #
)ost of e&uity capital !k ;#
*roportion of debt in total capital !d#
G",M33,333
G"73,333
54
"$4
G$33,333
G",M33,333
G"73,333
54
G$33,333
G",M33,333
G'73,333
54
8et operating profit after taxes !8/*A#
+nvested capital
"
G$33,333
$ '
2A))
;A
3.N7
7.5!>
?1925!
"$4
3.7
.!!>
?695!!
"$4
3.7
L.334
?8795!!
etail of computationO 0ow "O !!"-3.$7# > 3.N7 > 3.35# P !3.$7 > 3."$# 1 3.3N7 G$33,333 – R3.3N7 H !G",M33,333 - G"73,333#S 1 GL",$73 0ow $O R!"-3.$7# > 3.7 > 3.35S P !3.7 > 3."$# 1 3.3L3 G$33,333 – R3.3L3 H !G",M33,333 - G"73,333#S 1 GML,733 0ow 'O G$33,333 – R3.3L H !G",M33,333 - G'73,333#S 1 G5N,773 )omparing the rows shows the effect of financing strategies on ;A. he proportion of debt !a lower cost, and tax advantaged instrument relative to e&uity# decreases from row " to row $. hus, the cost of financing goes up, decreasing ;A. +n row ', the firm finances by relying on current liabilities !?free financing@ from suppliers# more so than in row $. 8aturally, ;A increases. 8oteO +n general, we expect a firm moving from row $ to row ' to also pay higher prices, which will depress current income and thus ;A.
"$-$7
M+(+#%'% 12.61 a. o evaluate the investment, let us first calculate the annual after-tax cash flow.
*re-tax cash flows are G533,333 - G'33,333 - G"33,333 1 G(33,333. axable income per year 1 G(33,333 - G"73,333 1 G$73,333. axes paid 1 3.' H G$73,333 1 GN7,333. hus, after tax cash flow per year 1 G(33,333 - GN7,333 1 G'$7,333. he 8* of this proposal !at "$4 rate# is ?3369332 . 2e can also treat the cash inflow as an annuity. he annuity tables !see )hapter ""# for "3 years and "$4 show a factor of 7.M73, meaning that the present value of the cash inflows is G",5'M,'$$. !8otice that this amount for the * of the cash inflows reconciles with the "et *resent alue of G''M,''$ 1 G",5'M,''$ - G",733,333.# he payback period is %ust under five years. hus, the pro%ect meets corporate standards for funding. T' )$='#& %$/0 ' ##'&'0. b. 2e know that 2endy6s expected 0/+ without the investment isO G$,(33,333 D GM,533,333 1 '7.$L4.
b.
G$3,333 G"5,333 G"(,333 G"3,333 GM,333 G$,333
+nvestment at the end of year G"5,333 G"(,333 G"3,333 GM,333 G$,333 3
Average investment
G"L,733 G"M,333 G"$,333 G5,333 G(,333 G",333
epreciati on
G$,333 G(,333 G(,333 G(,333 G(,333 G$,333
2ith this data in hand, we can calculate the income from the pro%ect, each year
"$-$N
)urrent year !year 3# =ear " =ear $ =ear ' =ear ( =ear 7
9ales !Jrowth at "$4
)ontribution margin !73#4
epreciation
G 5,733 G"N,733 G"L,M33 G$",L7$ G$(,75M G$N,7'N
G(,$73 G5,N73 GL,533 G"3,LNM G"$,$L' G"',NM5
G$,333 G(,333 G(,333 G(,333 G(,333 G$,333
Fixed costs
0eported +ncome
",$73 $,733 $,733 $,733 $,733 $,733
)ash flow from operations
G",333 G$,$73 G','33 G(,(NM G7,NL' GN,$M5
G',333 GM,$73 GN,'33 G5,(NM GL,NL' G"",$M5
+ncome )urrent year !year 3# =ear " =ear $ =ear ' =ear ( =ear 7 8* !at $34#
G",333 G$,$73 G','33 G(,(NM G7,NL' GL,$M5
Average investment G"L,733 G"M,333 G"$,333 G5,333 G(,333 G",333
0/+ 7."'4 "(.3M4 $N.734 77.L74 "((.5'4 L$M.5'4
)ash flow !G$3,333# P G',333 1 G!"N,333# GM,$73 GN,'33 G5,(NM GL,NL' G"",$M5 ?79434
hus, the pro%ect seems to meet all of the cash flow hurdles. Further, it is in line with Anne6s overall strategy. on would be reluctant to invest in this pro%ect because of the pattern of cash flows. he pro%ect has a negative 0/+ for the current year and is below $34 for the next year. Adding this pro%ect would therefore dilute on6s 0/+. 2ith the pro%ect, on6s current year 0/+ would be !GL$,(33 P G",333# D !G''3,333 P G"L,733# 1 $M.N4. Eis bonus ad%ustment factor would decrease from $5D$7 1 "."$ to $M.ND$7 1 ".3N. he pro%ect also drags his 0/+ !and therefore his bonus# down for the next year. he lower 0/+ numbers could potentially remove on from the running for region chief. eborah, who might take over, would reap the benefits of the investment. on might be inclined to go forward with the pro%ect if he is able to get it into next year6s budget . his way, the effect of the pro%ect would show up both in the budget and actual results. any managers would still be reluctant because a new pro%ect tends to lower year-over-year 0/+. A new pro%ect adds immediately to investment and only slowly to income. he resulting pattern of 0/+ tends to discourage new investments in firms that focus on 0/+ as a performance measure.
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c. A((';% $- #/#/&+( ROI +% +&' %&(0)0 . +n particular, it makes sense to average investment over the year to get the ?average@ amount at stake. /therwise, managers might be induced to play games with the timing of investments.
Eer use of net book value also is common. Eowever, it is sub%ect to the criticism that it favors older investments. Eer use of a budget as a benchmark would substantially alleviate this problem because she can ad%ust the budget to reflect the differing ages. 2e also agree with Anne6s strategy of using pre-tax income to calculate 0/+. After all, the managers have limited control over the taxes, which are computed at the corporate level in any case. 9ome might argue that Anne should leave out ?non-controllable@ investments such as land and buildings when computing the 0/+. wo factors work in favor of including these items. First, the inclusion sensitizes managers to the value of A<< assets that they use to generate income. 9econd, the inclusion would affect both the budget and the actual results in similar ways. :sing the budget as a benchmark substantially removes any negative effects from including the amounts in the investment base. Finally, Anne could use other measures such as residual income. 2e do not believe that such a move would confer great benefits, mostly because 0/+ is a simple, well-understood metric. Further, a move to 0+ would not eliminate the incentive to under-invest because a pro%ect6s 0+ would be sub%ect to the same pattern !increasing over time# that causes the problem with 0/+. d. T' #$*'(%&+$( /( ')% &$ ' '// 0'%+('0 . any plans start the payout at L34 of the target as a way to motivate managers to set stretch targets. his feature also reduces the incentive to play games with the target. he cap on the payout ratio likewise reduces the incentive to manage the target. +t also reduces the payout for random events that substantially and favorably affect operations. Eowever, the downside of the cap is that managers lose motivation to push operations beyond the level implied by the cap. +n general, basing at least a part of the compensation on upper-unit performance measures is useful for inducing cooperation. his way, a branch might be inclined to help another branch out because both contribute to regional performance. he benefit in Anne6s case seems small because we cannot visualize too much interaction across branches. +t is not likely that a customer at the )olumbus branch would also shop at the )leveland branch. 2e also like the idea of a formula-based plan because it increases the transparency in the system. Eowever, notice that the bonus pool itself is somewhat sub%ectively determined. hus, Anne can ad%ust the payout for factors that affected operations during the year. /verall, the system seems like it would
"$-$L work well.
12.63 a.
G$'3 per unit !G$'3 - G"$7# H $3,333 1 G$,"33,333
renda6s division
!G"N3 - G"N3# H $3,333 1 3
!G"N3 - G$33# H $3,333 1 !GM33,333#
!G"N3 - G$'3# H $3,333 1 !G",$33,333#
Firm as a whole
GL33,333
GL33,333
GL33,333
For 9eth6s division, notice that we focus only on the contribution margin. his view assumes that the division has enough extra capacity, which makes the opportunity cost of its capacity is zero. For renda6s division, the change in profit is directly proportional to the price differential paid. he firm6s overall profit is unchanged at GL33,333. I- +(0''09 &')' +% ($ $&') %' -$) &' ##+& +( S'&;% 0++%+$(9 &' -+)* '('-+&% &$ &' &(' $- ?!!9!!! -$)#+( ( +(&')(/ &)(%-') . b. he * confronts a difficult problem. /ne solution is to force a transfer. his solution has the benefit of increasing the firm6s overall short-term profit by GL33,333. his approach puts the excess capacity in 9eth6s division to good use. he price on the transfer is likely to be a sticking point as the price effectively apportions the surplus between the two divisions. renda will push for a price close to G"N3 as that is her opportunity cost. 9eth would push for a price close to G$'3, citing the development cost and the higher &uality. 8o matter the final price, this solution is unlikely to be acceptable to at least one of the two division mangers. An alternate solution is to do nothing. his solution seems odd at first blush because it leaves nearly a million dollars ?on the table.@ Eowever, this might be the preferred solution. o understand why, notice that the opportunity costs for 9eth and renda are key for the negotiations.
From renda6s perspective, her lowest estimate is G"N3 per unit. Eowever, she is likely to go higher because she recognizes the higher &uality from 9eth. 9he also surely recognizes the value from nurturing a long-term relationship with a ?reliable an d high &uality vendor.@ 8evertheless, she has incentives to claim a low opportunity cost purely as a negotiating tactic. After all, every dollar she shaves off the price adds G$3,333 to her bottom line.
