Skip to main content
Business LibreTexts

11.E: Exercises (part 2)

  • Page ID
    27358
  • \( \newcommand{\vecs}[1]{\overset { \scriptstyle \rightharpoonup} {\mathbf{#1}} } \) \( \newcommand{\vecd}[1]{\overset{-\!-\!\rightharpoonup}{\vphantom{a}\smash {#1}}} \)\(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\) \(\newcommand{\id}{\mathrm{id}}\) \( \newcommand{\Span}{\mathrm{span}}\) \( \newcommand{\kernel}{\mathrm{null}\,}\) \( \newcommand{\range}{\mathrm{range}\,}\) \( \newcommand{\RealPart}{\mathrm{Re}}\) \( \newcommand{\ImaginaryPart}{\mathrm{Im}}\) \( \newcommand{\Argument}{\mathrm{Arg}}\) \( \newcommand{\norm}[1]{\| #1 \|}\) \( \newcommand{\inner}[2]{\langle #1, #2 \rangle}\) \( \newcommand{\Span}{\mathrm{span}}\)\(\newcommand{\AA}{\unicode[.8,0]{x212B}}\)

    1. Segmented Net Income. Photo Products, Inc., has three divisions—Digital, Film, and Video. The following segmented financial information is for the most recent fiscal year ended December 31.
      Digital Division Film Division Video Division
      Sales $22,000,000 $8,000,000 $18,000,000
      Cost of goods sold 10,000,000 2,000,000 7,000,000
      Allocated overhead 4,125,000 1,500,000 3,375,000
      Selling and administrative expenses 5,000,000 3,200,000 5,000,000

      Assume the tax rate is 35 percent.

      Required:

      1. Prepare a segmented income statement using the format presented in Figure 11.3. Include the profit margin ratio for each division at the bottom of the segmented income statement.
      2. Using net income as the measure, which division is most profitable? Explain why this conclusion might be misleading.
      3. What does the profit margin ratio tell us about each division? Why do organizations often use profit margin ratio to evaluate division performance rather than simply using net income?
    2. ROI. Photo Products, Inc., has three divisions—Digital, Film, and Video. (This is the same company as the previous exercise. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume average operating assets totaled $15,000,000 for the Digital division, $6,500,000 for the Film division, and $17,500,000 for the Video division.
      f82695d05049ce882d3a835270e472dc.jpg

      Required:

      1. Calculate ROI for each division.
      2. What does ROI tell us about each division? Indicate why this measure is useful in evaluating investment centers.
    3. ROI Using Operating Profit Margin and Asset Turnover. Photo Products, Inc., has three divisions—Digital, Film, and Video. (This is the same company as the previous exercises. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume average operating assets totaled $15,000,000 for the Digital division, $6,500,000 for the Film division, and $17,500,000 for the Video division.
      24e5816e6283fce782bb820f681b27f4.jpg

      Required:

      1. For each division, calculate operating profit margin, asset turnover, and resulting ROI.
      2. Which division has the highest ROI? For the division that has the lowest ROI, what can be done to improve this ratio?
    4. RI. Photo Products, Inc., has three divisions—Digital, Film, and Video. (This is the same company as the previous exercises. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume average operating assets totaled $15,000,000 for the Digital division, $6,500,000 for the Film division, and $17,500,000 for the Video division. Assume the cost of capital rate is 16 percent.
      2b05cbdae0faad9b9daf8f6c11b6fd3d.jpg

      Required:

      1. Calculate RI for each division.
      2. What does RI tell us about each division?
    5. Solving Unknowns for ROI. The following information is for two divisions at Arrowhead, Inc.
      North Division South Division
      Sales $1,200,000 $400,000
      Operating income $ 132,000 $ 40,000
      Operating profit margin ? ?
      Average operating assets $1,000,000 ?
      Asset turnover ? ?
      ROI ? 8.0 percent

      Required:

      Find the missing information for each division.

    6. EVA. Sailboats, Inc., sells sailboat parts and accessories and provides rigging services. The following information is for each division at Sailboats, Inc., for the most recent fiscal year.
      3fc94f4ecd46a62965409d6e37e27676.jpg

      To calculate EVA, management requires adjustments for marketing and noninterest bearing current liabilities as outlined in the following.

      Marketing will be capitalized and amortized over several years resulting in an increase to average operating assets of $100,000 for the Sales division and $65,000 for the Services division. On the income statement, marketing expense for the year will be added back to operating income; marketing amortization expense for one year will be deducted. The current year amortization expense will total $30,000 for the Sales division and $15,000 for the Services division.

      Noninterest bearing liabilities will be deducted from average operating assets.

      Required:

      Calculate EVA for each division and comment on your results.

    7. (Appendix) Transfer Pricing. Gail’s Gardening has two divisions—Retail and Nursery. The Retail division sells plants and supplies. The Nursery division takes tree seedlings and grows them to healthy young plants before selling the trees internally to the Retail division and to outside customers. Each division manager is evaluated based on profit produced by each division.

      The Nursery division sells its trees to the Retail division for $4 per tree to cover its variable costs. The Nursery division also sells to outside customers for $6 per tree.

      Required:

      1. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Nursery division is below capacity.
      2. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Nursery division is at capacity.

    Problems

    1. Segmented Net Income, ROI, and RI. Custom Auto Company has two divisions—East and West. The following segmented financial information is for the most recent fiscal year:
      East Division West Division
      Sales $2,000,000 $4,000,000
      Cost of goods sold 800,000 2,040,000
      Allocated overhead 600,000 1,200,000
      Selling and administrative expenses 360,000 380,000

      The East division had average operating assets totaling $1,800,000 for the year, and the West division had average operating assets of $2,600,000. Assume the cost of capital rate is 8 percent, and the company’s tax rate is 30 percent. Division managers are responsible for sales, costs, and investments in assets.

      Required:

      1. What type of responsibility center is each division at Custom Auto Company? Explain.
      2. Prepare a segmented income statement using the format presented in Figure 11.3. Include the profit margin ratio for each division at the bottom of the segmented income statement.
      3. Calculate ROI for each division.
      4. Calculate RI for each division.
      5. Summarize the answers to parts a, b, and c using the format presented in Figure 11.11. What does this information tell us about each division?
    2. Investment Decisions Using ROI and RI. (Note: the previous problem must be completed before working this problem.) Assume each division of Custom Auto Company is considering separate investment opportunities expected to yield a return of 10 percent, well above the company’s minimum required rate of return of 8 percent. Each investment opportunity will require $1,000,000 in average operating assets and yield operating income of $100,000.

      Required:

      1. Using the information presented in the previous problem, and the new investment proposal information presented previously, calculate each division’s overall ROI assuming the new investment is accepted.
      2. Compare your results in part a to each division’s ROI prior to the new investment (calculated in the previous problem). Which division(s) will likely accept the proposal and which will likely reject the proposal using ROI as the measure? Explain.
      3. Using the information presented in the previous problem, and the new investment proposal information presented previously, calculate each division’s overall RI assuming the new investment is accepted.
      4. Compare your results in part c to each division’s RI prior to the new investment (calculated in the previous problem). Which division(s) will likely accept the proposal and which will likely reject the proposal using RI as the measure? Explain.
      5. Assume the goal is to maximize company profit. Which measure do you think is best in deciding whether to accept a new investment proposal, ROI or RI? Explain.
    3. Segmented Net Income, ROI, and RI; Making Investment Decisions. Quality Cycles, Inc., has two divisions—Cruisers and Racers. The following segmented financial information is for the most recent fiscal year:
      Cruisers Division Racers Division
      Sales $6,000,000 $10,000,000
      Cost of goods sold 2,500,000 4,000,000
      Allocated overhead 375,000 625,000
      Selling and administrative expenses 2,100,000 3,950,000

      The Cruisers division had average operating assets totaling $5,700,000 for the year, and the Racers division had average operating assets of $9,600,000. Assume the cost of capital rate is 10 percent, and the company’s tax rate is 30 percent.

      Required:

      1. Prepare a segmented income statement using the format presented in Figure 11.3. Include the profit margin ratio for each division at the bottom of the segmented income statement.
      2. Calculate ROI for each division.
      3. Calculate RI for each division.
      4. Summarize the answers to parts a, b, and c using the format presented in Figure 11.11. What does this information tell us about each division?
      5. Assume each division of Quality Cycles, Inc., is considering separate investment opportunities expected to yield a return of 16 percent, well above the company’s minimum required rate of return of 10 percent. Each investment opportunity will require $4,000,000 in average operating assets and yield operating income of $640,000.
      1. Using the information presented at the beginning of this problem, and the new investment proposal information presented previously, calculate each division’s overall ROI assuming the new investment is accepted.
      2. Compare your results in requirement e.1 to each division’s ROI prior to the new investment (calculated in requirement b). Which division(s) will likely accept the proposal and which will likely reject the proposal using ROI as the measure? Explain.
      3. Using the information presented at the beginning of this problem, and the new investment proposal information presented previously, calculate each division’s overall RI assuming the new investment is accepted.
      4. Compare your results in requirement e.3 to each division’s RI prior to the new investment (calculated in requirement c). Which division(s) will likely accept the proposal and which will likely reject the proposal using RI as the measure? Explain.
      5. Assume the goal is to maximize company profit. Which measure do you think is best in deciding whether to accept a new investment proposal, ROI or RI? Explain.
    4. Operating Profit Margin, Asset Turnover, and ROI. Financial information for Computer Systems, Inc., for the most recent fiscal year appears as follows. All dollar amounts are in thousands.
      11d1e63f71dd54d0a18d35cc220bd980.jpg

      Required:

      1. Calculate average operating assets for each division. (Hint: land held for sale is not an operating asset.)
      2. Calculate operating profit margin, asset turnover, and ROI for each division.
      3. What does this information tell us about each division?
    5. Operating Profit Margin, Asset Turnover, ROI, and RI. Financial information for Web Design, LLP, for the most recent fiscal year appears as follows. All dollar amounts are in thousands.
      dc3b83055899b624d370113104b9dc49.jpg

      Required:

      1. Calculate average operating assets for each division. (Hint: land held for sale and investments in Global, Inc., are not operating assets.)
      2. Calculate operating profit margin, asset turnover, and ROI for each division.
      3. Calculate RI for each division assuming a cost of capital rate of 12 percent.
      4. What does the information from requirements b and c tell us about each division?
    6. EVA. Conner, Inc., produces brass and woodwind music instruments. The following information is for each division at Conner for the most recent fiscal year.
      08b71cc22b416367577c54bb680acaee.jpg

      To calculate EVA, management requires adjustments for R&D expenses, marketing expenses, and noninterest bearing current liabilities as outlined in the following.

      Research and development will be capitalized and amortized over several years resulting in an increase to average operating assets of $40,000 for the Brass division and $80,000 for the Woodwind division. On the income statement, R&D expenses for the year will be added back to operating income; R&D amortization expense for one year will be deducted. The current year amortization expense will total $20,000 for the Brass division and $30,000 for the Woodwind division.

      Marketing will be capitalized and amortized over several years resulting in an increase to average operating assets of $30,000 for the Brass division and $38,000 for the Woodwind division. On the income statement, marketing expenses for the year will be added back to operating income; marketing amortization expense for one year will be deducted. The current year amortization expense will total $10,000 for the Brass division and $12,000 for the Woodwind division.

      Noninterest bearing current liabilities will be deducted from average operating assets.

      Required:

      1. Calculate EVA for each division. What do the results show us for each division?
      2. Why does EVA typically require adjustments to operating income and average operating assets?
    7. (Appendix) Transfer Pricing, Service Company. Kathy Kraven is the CEO and president of Legal Solutions, Inc. She oversees the company’s two divisions—Human Resources and Litigation. The Human Resources division provides legal services to personnel departments at various clients who need help creating personnel policies and manuals. The Litigation division provides legal services to support clients in litigation. Litigation often asks for help from Human Resources when faced with issues surrounding personnel policies but also has the option of seeking help outside the firm. Currently, Human Resources is below capacity and uses variable cost as its price for providing services to Litigation.

      Since each division is evaluated by how much profit it generates, Human Resources would like to increase the price charged to Litigation. Litigation is steadfast against any such change. Kathy Kraven has stepped in and established the following policy: effective immediately, Human Resources will charge Litigation variable costs plus 20 percent for any services rendered internally.

      Required:

      1. Why is the Human Resources division manager concerned about the price it charges to Litigation?
      2. Why is the Litigation division manager concerned about an increase in price charged by the Human Resources division?
      3. Do you think Kathy’s plan is effective? Explain.
      4. What other options are available for establishing transfer pricing?
    8. (Appendix) Transfer Pricing, Retail Company. Fred’s Fishing Supplies has two divisions, Lake and Deep Sea. Each division manager is evaluated based on profit produced by each division. The Lake division often sells a certain graphite fishing rod internally to the Deep Sea division for $50 per rod to cover variable costs. The Lake division also sells the same graphite rod to outside customers for $60 per rod. The Deep Sea division manager has the option of purchasing a similar rod from an outside supplier for $56.

      Required:

      1. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Lake division is below capacity.
      2. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Lake division is at capacity.
      3. The company’s CEO recently established the following policy: all internal transfers will be made at variable cost plus 20 percent. Assume the Lake division is operating below capacity. As the Deep Sea division manager, what would you do: purchase internally or purchase from an outside supplier? Why? How will your decision impact overall company profit?

    One Step Further: Skill-Building Cases

    1. Segments at Hewlett-Packard. Refer to Note 11.12 "Business in Action 11.3" Why do you think Hewlett-Packard separates its operations into seven segments?
    2. Transfer Pricing at General Electric (Appendix). Refer to Note 11.50 "Business in Action 11.5" How does General Electric establish transfer prices? What does this approach imply with regards to the products and services being provided?
    3. Group Activity—Decentralizing Operations. Each of the following scenarios is being considered at two separate companies.
      1. Walker Wood Products manufactures custom garage doors and custom furniture. The company recently experienced significant growth and top management would like to separate the company into two divisions—Garage and Furniture.
      2. Iron Manufacturing produces iron fencing for residential and commercial properties. The company recently experienced significant growth and top management would like to separate the company into two divisions—Residential and Commercial.

      Required:

      Form groups of two to four students. Each group is to perform the following requirements for the scenario assigned:

      1. Identify the potential advantages and disadvantages of decentralizing into two divisions and allowing the manager of each division to have complete control over operations.
      2. Discuss the findings of your group with the class.
    4. Internet Project—Economic Value Added. Stern Stewart & Company is a global consulting firm that pioneered the development of the EVA concept. Go to the Stern Stewart & Company Web site at http://www.sternstewart.com. Review the information provided at this Web site and write a one-page report summarizing the information you found to be most interesting. Also submit a printed copy of the information from the Web site with your report.
    5. Creating a Segmented Income Statement Using Excel. Pool Accessories, Inc., has two divisions—Furniture and Supplies. The following segmented financial information is for the most recent fiscal year ended December 31.
      Furniture Division Supplies Division
      Sales $3,000,000 $1,000,000
      Cost of goods sold 1,600,000 430,000
      Allocated overhead 375,000 125,000
      Selling and administrative expenses 250,000 200,000

      Assume the tax rate is 30 percent.

      Required:

      1. Prepare an Excel spreadsheet similar to Figure 11.3 showing Pool Accessories’ segmented income statement and profit margin ratio for each division.

    Comprehensive Case

    1. Ethics and ROI. Computer chip makers incur significant costs for research and development. Some research and development projects result in technologies used in new computer chips. Other research and development projects do not result in a useable technology. Because of the unpredictable nature of R&D activities, U.S. GAAP require that R&D costs be expensed in the period incurred.

      Integrated Circuits, Inc. (ICI), produces computer chips and invests heavily in R&D. The firm has been struggling in recent years, and as a result, the board of directors hired a new top management group with the clear purpose of improving profitability. The board proposed a compensation package providing top managers with an annual bonus if the company’s operating income this coming year (year 2) increases 10 percent compared to year 1 and ROI remains above the 11 percent level achieved in year 1.

      The new top management group is willing to accept this proposal, but only if costs related to successful R&D activities are capitalized and amortized over five years for internal reporting purposes. Their argument is most R&D activities benefit future years, and U.S. GAAP unfairly requires all R&D costs to be expensed in the period incurred, regardless of whether the activities are successful. This treatment by U.S. GAAP provides a disincentive for managers to invest in R&D projects that are vital to the company’s future survival. The board of directors agrees with this assertion and grants the new management group their request to capitalize costs for successful R&D activities over five years.

      One year has passed with the new management group in place, and their financial results are presented as follows (for year two), along with last year’s information (year one). The entire $10,000,000 spent on R&D in year 2 was for unsuccessful projects since management decided to go a different direction with the company’s technology at the end of year 2. Nevertheless, top management capitalized the entire $10,000,000 and amortized these costs over 5 years as reflected in the year 2 financial results. (Note: of this amount, $2,000,000 is included in depreciation and amortization expense for year 2, and $8,000,000 is included in average operating assets for year 2.)

      aed581385cb901b44552bec6b3a58621.jpg

      Required:

      1. Based on the financial data presented, calculate ROI for each year and the percent change in operating income from year 1 to year 2. Does the new management group qualify for the bonus?
      2. Prepare revised financial information in the same format as presented previously assuming none of the $10,000,000 in year 2 R&D costs are capitalized and amortized. (Hint: Amounts for year 1 will remain the same. Income statement and balance sheet amounts for year 2 will change.) Calculate the revised ROI for year two, and the revised percent change in operating income from year one to year two. Based on your results, would the new management group qualify for the bonus?
      3. Is the new management group’s treatment of R&D costs for year 2 ethical?
      4. How should the board of directors respond to the new management group’s assertion that $10,000,000 in R&D costs should be capitalized in year 2?
    2. Performance Evaluation Methods. Casey Fashions, Inc., sells clothing throughout North America. The company’s compensation committee, made up of five members from the board of directors, is meeting to discuss the CEO’s contract, which expires next month. The committee is currently reviewing financial information for the three most recent fiscal years: year 3 (most recent), year 2, and year 1 (shown as follows).

      The income statement indicates sales increased 30 percent from year 1 to year 2 and 35 percent from year 2 to year 3. Net income increased 14 percent from year 1 to year 2, and 18 percent from year 2 to year 3. One member on the committee, Chris Carson, would like to offer the CEO a multiyear extension with a significant bump in salary and thousands of shares of stock options. When questioned why, Chris pointed to the positive results reflected on the income statement.

      Another committee member, Mary Nichols, agrees with Chris that income statement trends look great, but she would like to review other measures of performance as well. Mary has asked you to come up with two measures of performance that go beyond simply looking at the income statement.

      9edcccad6fcc0c9ea3f32e2e0b08368e.jpg

      Required:

      1. Calculate ROI for each of the three years. Note that balance sheet amounts presented for each year are already average balances (i.e., no need to calculate average balances). Assume land held for sale is not an operating asset.
      2. Calculate RI for each of the 3 years assuming the company’s cost of capital rate is 12 percent.
      3. Prepare a written report to the compensation committee summarizing and explaining your findings in part a and b.

    11.E: Exercises (part 2) is shared under a CC BY-NC-SA 2.5 license and was authored, remixed, and/or curated by LibreTexts.

    • Was this article helpful?