Chapter 25, Problem 1CTC

a.

To determine

Compute the Return on investment (ROI) and residual income of Printer division.

Explanation of Solution

Return on investment (ROI): This financial ratio evaluates how efficiently the assets are used in earning income from operations. So, ROI is a tool used to measure and compare the performance of a units or divisions or a companies.

Residual income: It is an amount by which an operating income (earnings) exceeds a minimum acceptable return on the average capital invested.

Calculate the return on investment for Printer division:

Given, Operating margin $6,000,000 and average total assets $50,000,000.

$\begin{array}{c}\text{Return}\text{on}\text{investement}\left(\text{ROI}\right)\text{=}\frac{\text{Operating}\text{margin}}{\text{Average}\text{total}\text{assets}}\text{×100}\\ \text{=}\frac{\text{\$6,000,000}}{\text{\$50,000,000}}\text{×100}\\ \text{=}\text{12\%}\end{array}$

Therefore, Return on investment (ROI) is 12 %.

Calculate the residual income for Printer division:

$\begin{array}{c}\text{Residual income}\text{=}\left[\begin{array}{l}\text{Operating earnings}\text{–}\\ \left(\text{Minimum acceptable return}\text{×}\text{Average}\text{total}\text{assets}\right)\end{array}\right]\\ \text{=}\left[\text{\$6,000,000}-\left(\text{10\%×\$50,000,000}\right)\right]\\ \text{=}\text{\$1,000,000}\end{array}$

Therefore, the residual income is $1,000,000.

Note: Here, average total assets are considered invested capital.

b.

To determine

Evaluate the statements made by Person G and Person L.

Explanation of Solution

• Both statements are correct. Selling of printers at $300 each is more profitable rather than selling them for $250. If the Printer division transfers an additional of 10,000 XLC Printers to mail-order last year, then it would have lost contribution margin generated by selling these units to customers who are outside.
• Therefore, the operating margin will be only $4,500,000 (2), which results in a return on investment of only 9% (3).

Working notes:

Calculate the new contribution margin:

$\begin{array}{c}\text{New Contribution}\text{margin}\text{=}\left[\begin{array}{l}\left(\text{Sale}\text{price}\text{per}\text{unit}-\text{Manufacturing}\text{cost}\right)\\ \text{×}\text{Additionl}\text{units}\text{transferred}\end{array}\right]\\ \text{=}\left(\text{\$250}-\text{\$100}\right)\text{×10,000}\text{units}\\ \text{=}\text{1,500,000}\end{array}$

(1)

Calculate the new operating margin:

$\begin{array}{c}\text{New}\text{Operating}\text{margin}\text{=}\text{Existing}\text{Operating}\text{margin}-\text{New}\text{Contribution}\text{margin}\\ \text{=}\text{\$6,000,000}-\text{\$1,500,000}\text{(1)}\\ \text{=\$4,500,000}\end{array}$

(2)

Calculate the return on investment for Printer division:

$\begin{array}{c}\text{Return}\text{on}\text{investement}\left(\text{ROI}\right)\text{=}\frac{\text{New Operating}\text{margin}}{\text{Average}\text{total}\text{assets}}\text{×100}\\ \text{=}\frac{\text{\$4,500,000}\text{(2)}}{\text{\$50,000,000}}\text{×100}\\ \text{=}\text{9\%}\end{array}$

(3)

c.

To determine

Suggest some solution to resolve the situation and show the way in which the suggestions will affect the Printer division’s results last year.

Explanation of Solution

• The problem lies in using the cost as a transfer price for the output of a profit center. If market value is used as the transfer price, it will be profitable for Printer division to supply printers to Mail-Order for selling it to outsiders. This eliminates the interdepartmental friction and allows Company W to benefit from selling XLC printers at $300 instead of $250.
• If market price is been used as a transfer price last year, the Printer division will recognize $150 in contribution margin on every unit transferred to the Mail-Order Division ($250 sales price, less $100 manufacturing cost). Thus, the Printer division’s contribution margin and operating earnings would have been $750,000 (4) higher than actually reported. This in turn, will result in a ROI of 13.5% (5) and residual income of $1,750,000 (6).

Working notes:

Calculate the new contribution margin:

$\begin{array}{c}\text{New Contribution}\text{margin}\text{=}\left[\begin{array}{l}\left(\text{Actual}\text{sales}\text{price}\text{per}\text{unit}-\text{New}\text{sales}\text{price}\text{per}\text{unit}\right)\\ \text{×}\text{Additionl}\text{units}\text{produced}\text{and}\text{transferred}\end{array}\right]\\ \text{=}\left(\text{\$300}-\text{\$250}\right)\text{×}\left(\text{10,000}\text{units+}\text{5,000}\text{units}\right)\\ \text{=}\text{\$50×}\text{15,0000}\text{units}\\ \text{=}\text{\$750,000}\end{array}$

(4)

Calculate the return on investment for Printer division:

$\begin{array}{c}\text{Return}\text{on}\text{investement}\left(\text{ROI}\right)\text{=}\frac{\text{Operating}\text{Margin}}{\text{Average}\text{total}\text{assets}}\text{×100}\\ \text{=}\frac{\text{\$6,000,000+}\text{\$750,000}}{\text{\$50,000,000}}\text{×100}\\ \text{=}13.5\text{\%}\end{array}$

(5)

Note: Operating margin includes additional operating margin.

Calculate the residual income for Printer division:

$\begin{array}{c}\text{Residual income}\text{=}\left[\begin{array}{l}\text{New}\text{Operating margin}\text{–}\\ \left(\text{Minimum acceptable return}\text{×}\text{Invested}\text{capital}\right)\end{array}\right]\\ \text{=}\left[\text{\$6,750,000}-\left(\text{10\%×\$50,000,000}\right)\right]\\ \text{=}\text{\$1,750,000}\end{array}$

(6)

Note: New Operating margin include Existing operating margin and additional operating margin.

d.

To determine

Explain whether the comments stated in subpart c can raise an ethical dilemma to be resolved by management of Company W and explain the nature of the potential problem and suggest recommendations to resolve it.

Explanation of Solution

• It is suggested that transfer prices must reflect market prices rather than cost. Suppose, if this policy came into effect from last year, then the residual income of the printer will be $750,000(4) higher than the actually reported result. The division manager receives bonus equal to 1% of residual income, therefore Person L might feel that bonus of $7,500 is lost due to use of faulty accounting methods.
• Actually, using transfer price, $750,000(4) in contribution margin relating to $5,000 XLC Printers from the printer division to the mail-order division is transferred. Therefore, Person L complains that the bonus of $7,500 which is paid to Person G. It is advisable for management to take some corrective action, if needed.