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Question
Meridian Investments has three divisions (A, B, C) organized for performance-evaluation purposes as investment centers. Each division's required rate of return for purposes of calculating residual income (RI) is 15%. Budgeted operating results for 2016 for each of the three divisions are as follows:
Division Operating income Investment
A $15,000,000 $100,000,000
B $25,000,000 $125,000,000
C $11,000,000 $50,000,000
The company is planning an expansion, which will require each division to increase its investments by $25,000,000 and its operating income by $4,500,000.
Required:
1. Compute the current ROI for each division.
2. Compute the current residual income (RI) for each division.
3. Rank the divisions according to their current ROIs and in terms of their residual incomes.
4. Determine the effects after adding the new project to each division's ROI and residual income (RI).
5. Assuming the managers are evaluated on either ROI or residual income (RI). Which divisions are pleased with the expansion and which ones are unhappy? Explain briefly.
Answer
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Related questions
Q:
Simmons Bedding Company manufactures an array of bedding-related products, including pillows. The Cover Division of Simmons makes covers, while the Assembly Division of the company produces finished pillows. The covers can be sold separately for $10.00 a piece, while the pillows sell for $12.00 per unit. For performance-evaluation purposes, these two divisions are treated as investment centers. Financial results from the most recent accounting period are as follows:
Cover Division Assembly Division
Traceable manufacturing costs $6,000,000 $1,500,000
External sales $4,000,000 $7,200,000
Market value of output transferred from Cover Division to the Assembly Division
$6,000,000
Required:
1. What is the operating income for each of the two divisions and for the company as a whole? (Use market value as the transfer price.)
2. Do you think each of the two divisional managers is happy with this transfer-pricing method? Explain.
Q:
Brown's Mill has two operating units, each of which is considered an investment center for evaluation purposes. The Cutting Division of the mill prepares timber at its sawmills. Afterwards, the Assembly Division prepares the cut lumber into finished wood, to be sold to furniture manufacturers. During the most recent year, the Cutting Division produced 120,000 cords of wood, at a total cost of $1,320,000. The entire output was transferred to the Assembly Division, where additional costs of $6 per cord were incurred. The 1,200,000 board-feet of finished wood were then sold in the open market for $5,000,000.
Required:
1. Determine the operating income for each division if the transfer price from the Cutting Division to the Assembly Division is set at full production cost, $11 per cord.
2. Determine the operating income for each division if the transfer price is set at $9 per cord.
3. Since the Cutting Division sells all of its output internally, does the manager care about what price is charged? Why? Should the Cutting Division in this case be considered a cost center or a(n) profit/investment center?
Q:
Eikelberry, Inc. has the following financial results for 2016 for its three regional divisions:
Current Cost Region Income Net Book Value Gross Book Value Replacement Cost Liquidation Value
FINANCIAL DATA
North Atlantic $45,000 $225,000 $450,600 $990,000 $350,000
Mid Atlantic 33,000 289,000 310,000 380,000 445,000
South Atlantic 22,000 115,000 166,000 650,000 980,000
Required:
Calculate return on investment (ROI), asset turnover (AT), and return on sales (ROS) for each of the three divisions for 2016. The sales in the North, Mid and South Atlantic regions are $2,350,000, $1,450,000, and $500,000, respectively. Calculate ROI and asset turnover (AT) for each of the four measures of investment (i.e., for each of four possible denominators in determining ROI and AT). Round all answers except ROI to 2 decimal places, e.g., round 0.12487 to 12.49%. Round ROI to whole percentage amounts, e.g., 0.1998 to 20%.
Q:
When the Bronx Company formed three divisions a year ago, the president told the division managers an annual bonus would be given to the most profitable division. The bonus would be based on either the return on investment (ROI) or residual income (RI) of the division. Investment, for both calculations, is to be measured using either gross book value (GBV) or net book value (NBV) of divisional assets. The following data are available:
Division Gross Book Value (GBV) Operating Income
A $500,000 $53,500
B $480,000 $52,000
C $300,000 $33,300
All the assets are long-lived assets that were purchased 15 years ago and have 15 years of useful life remaining. A zero terminal (disposal) value is predicted. Bronx's minimum rate of return (cost of capital) used for computing RI, for all three divisions, is 10%.
Required:
Which method for computing profitability would each manager likely choose? Show supporting calculations. Round percentage answers to 2 decimal places (e.g., 0.12344 = 12.34%). Where applicable, assume straight-line depreciation.
Q:
Accounting records from Division A, Alpha Manufacturing Company indicate the following:
Divisional Sales $1,500,000
Average Investment $1,000,000
Divisional operating income $169,500
Minimum Rate of Return 14%
Required:
1. Compute the return on sales (ROS) for Division A. (Round answer to one decimal point.)
2. Compute the asset turnover (AT) for Division A.
3. Compute return on investment (ROI) for this division, using answers to parts (1) and (2). (Round answer to two decimal points.)
4. Compute residual income (RI) for Division A.
5. Describe how Alpha Manufacturing would determine whether or not to invest in any particular project in the future.
Q:
Alice and Jon Harrison operate two full-service dry cleaning outlets in the St. Louis metropolitan area. One of the outlets generates over $800,000 revenue per year and has more than a million dollar investment in state-of-the-art equipment. The other outlet is older, generates $20,000 revenue per month, and has 20-25 year-old equipment currently worth approximately $85,000. Both outlets are profitable with growing market bases. (The ratio between operating income and sales for each unit, based on historical-cost accounting numbers, is roughly the same.) Managers at each location are currently paid a base salary, and receive a year-end bonus which is five percent of total operating profit produced by both outlets combined. Alice has just finished a workshop on investment center performance evaluation, and wants to change the evaluation and reward structure, hoping to motivate the two managers to produce greater revenue and profit.
Required:
What type of evaluation mechanisms should she propose for the two managers?
Q:
The major operating divisions of Grey Company are organized as investment centers for performance-evaluation purposes. The division managers are evaluated, in part, on the basis of the change in the return on investment (ROI) of their units. Operating results for the Division A for the coming year, 2016, based on its existing assets are budgeted as follows:
Sales $5,000,000
Less variable costs 2,500,000
Contribution margin 2,500,000
Less fixed expenses 1,800,000
Operating income $700,000
Operating assets for the Division A are currently $3,600,000. For 2016, the division can add a new product line for an investment of $600,000. The new product line is expected to generate sales of $1,600,000 and will incur fixed expenses of $600,000 annually. Variable costs of the new product are expected to average 60% of the selling price.
Required:
1. What is the effect on ROI of accepting the new product line?
2. If the company's required rate of return is 6% and residual income is used to evaluate managers, would this encourage the division to accept the new product line? Explain and show computations.
Q:
This question pertains to the use of market-based transfer prices.
Required:
What is the primary advantage and what is the primary difficulty in using market-based transfer prices?
Q:
A fellow student of yours who has just completed a course in management accounting recently made the following comment to you regarding the establishment of transfer prices for transnational transfers of goods and services within the same company: "In the process of preparing consolidated financial statements, all profit and loss attributable to internal transfers of goods and services are removed. The amount of profit a company reports is therefore affected only by transactions with external parties. Therefore, the subject of transfer pricing may be important for motivational purposes or some other managerial objective, but the choice of a transfer pricing system has no effect on the bottom line, even when transfers are made between units of a company operating in different countries."
Required:
Critically analyze and respond to the above assertion.
Q:
What special problems and opportunities arise in setting transfer prices in an international setting (i.e., for transfers between subunits that operate in different countries)? Hint: In terms of special problems, make sure you reference OECD requirements and practical implementation alternatives for general OECD requirements.)
Q:
A bonus plan differs from a salary in terms of:
A. Amount and timing.
B. Base, timing, and financial statement effect.
C. Tax implications.
D. Motivation effects.
E. Base, pool, and payment terms.
Q:
Which one of the following establishes an "arm's-length price" by using the sales prices of similar products made by unrelated firms?
A. Wholesale-price method.
B. Retail-price method.
C. Related-products method.
D. Cost-plus method.
E. Comparable-price method.
Q:
A dollar amount equal to the operating income of a division less a charge for the level of investment in the division is called:
A. Operating profit after tax.
B. Return on investment (ROI).
C. Earnings from continuing operations.
D. Return on equity (ROE).
E. Residual income (RI).
Q:
The estimated price that could be received for the sale of divisional assets is referred to as:
A. Gross book value (GBV), plus accumulated depreciation to date.
B. Gross book value (GBV).
C. Price-level adjusted cost.
D. Replacement cost.
E. Liquidation value.
Q:
Which one of the following is not a limitation shared by residual income (RI) and return on investment (ROI) divisional performance measures?
A. They are both short-term performance indicators.
B. They both may fail to capture significant value-creating activities of the organization.
C. They are both subject to short-term manipulation on the part of divisional managers.
D. Both are subject to a number of measurement issues that complicate their use in practice.
E. They both relate, in percentage terms, earnings to the level of investment in each division.
Q:
Replacement cost of a division's assets will most probably be greater than:
A. Gross book value (GBV) of the assets.
B. Historical cost of the assets.
C. Liquidation value of the assets.
D. Price-level adjusted cost of the assets.
E. Current cost of the assets.
Q:
A measure of the manager's ability to produce increased sales from a given level of investment is:
A. Residual income (RI) divided by level of invested capital.
B. Return on equity (ROE).
C. Return on investment (ROI).
D. Return on sales (ROS).
E. Asset turnover (AT).
Q:
If after-tax income of Grey Division, adjusted for economic value, is 15% of sales, capital employed is $5,000,000 (adjusted for equity-equivalents), the divisional cost of capital (discount rate) is 8%, and sales are $12,000,000, then Economic Value Added (EVA) is:
Q:
A primary limitation of return on investment (ROI) as a performance-evaluation metric for investment centers is that ROI:
A. Is a long-term, not short-term, performance indicator.
B. Understates the level of "investment" for organizations operating in the so-called knowledge-based economy.
C. Excludes the level of investment from the performance metric.
D. Cannot handle current-value estimates of assets.
E. Is not a relative performance indicator.
Q:
The difference between the historical cost and the net book value (NBV) of a plant asset is the:
A. Residual value of the asset.
B. Depreciation expense for the current period.
C. An estimate of the remaining useful life of the asset.
D. Accumulated depreciation expense on the asset.
E. Estimated replacement cost of the asset.
Q:
When investments in facilities are shared by different subunits in a firm, allocation of the cost of these common facilities to sharing units should be determined by:
A. Reference to Generally Accepted Accounting Principles (GAAP).
B. Relative sales dollars generated by the various units.
C. The relative amount of use of the facilities, or demand for the facilities, by the various investment centers in the organization.
D. Special techniques prescribed by the American Institute of Certified Public Accountants (AICPA).
E. Some measure of current value (e.g., replacement cost).
Q:
Which one of the following is an advantage of both Return on Investment (ROI) and Residual Income (RI)?
A. They both measure all elements important for measuring short-term financial performance of investment centers: revenues, costs, and investment.
B. They are both very widely used in practice today.
C. They both can use the minimum rate of return to adjust for differences in risk across different investment centers.
D. They are both comparable to interest rates and to rates of return on alternate investments.
E. They can both use a different minimum rate of return for different types of assets used by an investment center.
Q:
Firms with high operating leverage tend to have:
A. High asset turnover and high return on sales.
B. Low asset turnover and low return on sales.
C. Low asset turnover and high return on sales.
D. High asset turnover and low return on sales.
E. Decreased levels of short-term fixed costs.
Q:
Determination of the useful life of an asset and choice of a depreciation method will affect all of the following except:
A. The amount of operating income earned by an investment center for any given period.
B. The investment base for purposes of calculating ROI.
C. Amount of depreciation expense recorded for any given period.
D. Net book value (NBV) of an asset as of any point in time.
E. The opportunity cost of lost sales on alternative projects.
Q:
Which of the following is the most appropriate and comprehensive short-term financial-performance indicator for an investment center that is a division of a larger business entity?
A. Residual income (RI).
B. Operating income, pre-tax.
C. Return on equity (ROE).
D. Operating income, after-tax.
E. Return on sales (ROS).
Q:
Ruth's Chris Steak House is a chain of restaurants that began 43 years ago as a single location in New Orleans and has grown to more than 90 restaurants. RCSH went public, with an initial public offering of stock (IPO) in August 2005. A question at the time of the IPO was how to value the company, given available information. Ruth's had sales of $192.2 million in 2004, earnings of $23.3 million, and net debt less cash of $117 million. One analyst chose to use the enterprise value of comparable companies, noting that Smith and Wollensky Restaurant Group (another chain of steak restaurants) had a ratio of enterprise value to sales of 70 percent. Another restaurant chain, Morton's, had recently gone private and, in the last year as a public company, had an enterprise ratio to sales of 80 percent.
Required:
Develop an estimate of the market capitalization (market value of equity) of RCSH in August 2005 and explain your reasoning.
Q:
Ginyard Company has the following financial statements for the year ended December 31, 2016.
Balance Sheet 12/31/2016
Cash $1,600,000
Accounts Receivable 3,000,000
Inventory 2,500,000
Current Assets $7,100,000
Long-lived Assets 14,500,000
Total Assets $21,600,000
Current Liabilities $1,200,000
Long-term Debt $2,400,000
Shareholder Equity 18,000,000
Total Debt and Equity $21,600,000
Income Statement
For the year ended December 31, 2016
Sales $20,000,000
Cost of Sales 15,000,000
Gross Margin 5,000,000
Operating Expenses 2,500,000
Operating Income 2,500,000
Taxes 1,000,000
Net Income $1,500,000
Cash Flow From Operations
For the year ended December 31, 2016
Net Income $1,500,000
Plus Depreciation Expense 1,000,000
+Decrease (-inc) in AccRec. and Inv. -
+Increase (-dec) in Cur. Liabl. -
Cash Flow from Operations $2,500,000
Some additional information about 2016 includes:
Ginyard Industry Data
Year End Stock Price $23.00
Number of Outstanding Shares 1,800,000
Sales Multiplier 2.10
Free Cash Flow Multiplier 22.00
Earnings Multiplier 18.00
Cost of Capital 5.0%
Accounts Receivable Turnover 6.60
Inventory Turnover 5.80
Current Ratio 2.20
Quick Ratio 1.50
Cash Flow from Operations Ratio 1.50
Free Cash Flow Ratio 1.00
Gross Margin Percentage 30.0%
Return on Assets (Net Book Value) 18.0%
Return on Equity 22.0%
Training Expense 500,000
Income Tax Rate 40%
Depreciation Expense 1,000,000
Dividends -
Required:
1. Complete a business analysis of Ginyard Company for 2016.
2. Complete a business valuation for Ginyard Company for 2016.
Q:
Market value of equity is an objective measure which clearly shows what:
A. The firm's financial statements show the firm's value to be.
B. Investors think is the firm's value.
C. Stock analysts calculate as the firm's value.
D. Is the sales value of the firm.
E. Is the liquidation value of the firm.
Q:
Generally, the current and deferred types of bonus payment options currently in use tend to focus the manager's attention on short-term performance measures, most commonly:
A. Division profit.
B. After tax corporate profit.
C. Cash flow.
D. Growth in firm value.
E. Stock price.
Q:
The balanced scorecard critical success factors (CSFs) provide strong motivation in bonus compensation plans if the noncontrollable factors are:
A. Emphasized.
B. Separated.
C. Recognized.
D. Excluded.
E. Controlled.