BKAM3023 Management Accounting II

Topic 4: Performance Measurement

Exercise 1

Toro, a national manufacturer of lawn-mowing and snow-blowing equipment, segments

its business according to customer type: Professional and Residential. Assume the
following divisional information was available for the past year:

Sales Operating Income Total Assets

Residential $850,000 $68,000 $200,000
Professional $1,095,000 $153,300 $365,000

Assume that management has a 25% target rate of return for each division. (All data in
this exercise is hypothetical.)

Requirements

1. Calculate each division’s ROI.

ROI = Net operating income / Average operating asset

Residential’s ROI = 68,000 / 200,000

= 34%

Professional’s ROI = 153,300 / 365,000

= 42%

Residential’s ROI is lower than Professional’s ROI.

2. Calculate each division’s sales margin. Interpret your results.

Margin = Net operating income / Sales

Residential’s sales margin = 68,000 / 850,000

= 8%

Professional’s sales margin = 153,300 / 1,095,000

= 14%
Residential’s sales margin is lower than Professional’s sales margin.

The Professional Division is earning about $0.14 on each dollar of sales whereas the
Residential Division is only earning about $0.08 on each dollar of sales. The
Professional Division’s higher sales margin helps to account for its higher ROI.

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3. Calculate each division’s capital turnover. Interpret your results.

Turnover = Sales / Average operating asset

Residential’s capital turnover = 850,000 / 200,000

= 4.25

Professional’s capital turnover = 1.095,000 / 365,000

=3

Residential’s capital turnover is higher than Professional’s capital turnover.

The Professional Division is generating $3.00 of sales for every dollar of assets invested
in the division. The Residential Division is generating $4.25 of sales for every dollar of
assets invested. The Residential Division is even more efficient.

4. Use the expanded ROI formula to confirm your results from Requirement 1. What
can you conclude?

ROI = Margin x Turnover

Residential’s ROI = 0.08 x 4.25

= 34%

Professional’s ROI = 0.14 x 3

= 42%

Even though the Residential Division’s efficiency (as measured by the capital turnover)
is higher than that of the Professional Division, the Professional Division’s profitability
(as measured by the sales margin) is so much higher that it causes the Professional
Division’s ROI to be much higher than the Residential Division’s.

5. Calculate each division’s residual income (RI). Interpret your results.

Residual income = Net operating income - (Average operating asset x rate of return)

Residential’s residual income = 68,000 - (200,000 x 25%)

= 18,000

Professional’s residual income = 153,300 - (365,000 x 25%)

= 62,050

Residential’s residual income is lower than Professional’s residual income.

Both divisions are exceeding management’s expectations.

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Exercise 2

Results from Pioneer Corporation’s most recent year of operations is presented in the
following table.

Operating income ………… $9,240

Total assets ……………….. $14,000
Current liabilities …………. $4,400
Sales ………………………. $38,500
Target rate of return ……… 14%

Requirements
1. Calculate the sales margin, capital turnover, and return on investment (ROI).

Sales margin = Net operating income / sales

= 9240 / 38500
= 24%

Capital turnover = sales / average operating asset

= 38500 / 14000
= 2.75

ROI = sales margin x capital turnover

= 0.24 x 2.75
= 66%

2. Calculate the residual income.

Residual income = Net operating income – (rate of return x average operating asset)
= 9240 – (0.14 x 14000)
= 9240 – 1960
= RM 7280

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Exercise 3

Sprint Company has the following data for 2013:

Division A Division B
Sales $400,000 $300,000
Contribution margin $160,000 $125,000
Operating income $80,000 $30,000
Average operating assets $320,000 $200,000
Weighted average cost of capital 15% 12%

Required:
1. Calculate EVA for each division.

Division A’s EVA = Operating income – (Weighted average cost of capital x total capital
employed / average operating asset)
= 80,000 – (0.15 x 320,000)
= 80,000 – 48,000
= RM 32,000

Division B’s EVA = Operating income – (Weighted average cost of capital x total capital
employed / average operating asset)
= 30,000 – (0.12 x 200,000)
= 30,000 – 24,000
= RM 6,000

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Exercise 4

Farid Company manufactures and sells wood-burning stoves through three divisions:
Local, Commercial and International. Each division is evaluated as a profit center. Data
for each division for 2012 are as follows:

Local Commercial International

Sales $1,620,000 $2,400,000 $1,000,000
Cost of goods sold $1,215,000 $1,710,000 $600,000
Selling and admin expenses $75,000 $180,000 $150,000

The income tax rate for Farid Company is 40 percent. Farid Company has two sources
of financing: bonds paying 8 percent interest, which account for 20 percent of total
investment, and common stock at a cost of equity of 18 percent, which account for the
remaining 80 percent of total investment. Farid’s total capital employed is $3 million
($2,100,000 for the Local Division, $500,000 for the Commercial Division and the
remainder for the International Division).

Required:

1. Calculate after-tax operating income for each division.

Local Commercial International
Sales $1,620,000 $2,400,000 $1,000,000
Cost of goods sold ($1,215,000) ($1,710,000) ($600,000)
Selling and admin expenses ($75,000) ($180,000) ($150,000)
Operating income before tax 330,000 510,000 250,000
Tax expense (132,000) (204,000) (100,000)
After-tax operating income 198,000 306,000 150,000

2. Calculate Farid’s weighted average cost of capital.

Sources of Percentage After tax x Cost Weighted average cost of capital
financing
Bonds 0.2 0.08 x 0.6 = 0.048 0.0096
Common stock 0.8 0.18 0.144
Total 100 0.1536

3. Calculate EVA for each division.

Local Commercial International
After-tax operating income 198,000 306,000 150,000
Cost of capital (total capital employed x WACOC)
($2,100,000 x 0.1536) 322,560
($500,000 x 0.1536) 76,800
($400,000 x 0.1536) 61,440
EVA (123,560) 229,200 88,560

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Exercise 5

KitchenAid makes a variety of products, including stand mixers. KitchenAid’s Stand

Mixer Division can use a component, K32, manufactured by KitchenAid’s Electrical
Division. The market price for K32 is $18 per unit. The variable cost per unit for K32 in
the Electrical Division is $13, while the absorption cost per unit is $16. The divisions at
KitchenAid use a negotiated price strategy to set transfer prices between divisions.

What is the lowest acceptable transfer price to the Electrical Division? What is the
highest acceptable transfer price that the Stand Mixer Division would pay? Explain your
answer.

Lowest – Variable cost of $13

Highest – Market price of $18
The Electrical Division would not transfer the component for less than its variable cost
($13) or it would be losing money on each transfer. The Stand Mixer Division would not
pay more than the price that it can buy the component on the market for, or $18.

Exercise 6

Greene Motors manufactures specialty tractors. It has two divisions: a Tractor Division
and a Tire Division. The Tractor Division can use the tires produced by the Tire Division.
The market price per tire is $55.

The Tire Division has the following costs per tire:

Direct material cost per tire $25
Conversion costs per tire $3

Fixed manufacturing overhead cost for the year is expected to total $100,000. The Tire
Division expects to manufacture 50,000 tires this year. The fixed manufacturing
overhead per tire is $2 ($100,000 divided by 50,000 tires).

Requirements
1. Assume that the Tire Division has excess capacity, meaning that it can produce
tires for the Tractor Division without giving up any of its current tire sales to
outsiders. If Greene Motors has a negotiated transfer price policy, what is the
lowest acceptable transfer price? What is the highest acceptable transfer price?

The lowest acceptable transfer price is RM28.

The highest acceptable transfer price is RM55.

2. If Greene Motors has a cost-plus transfer price policy of full absorption cost plus
20%, what would the transfer price be?

Transfer price = (28 + 2) x 120%

= RM36

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3. If the Tire Division is currently producing at capacity (meaning that it is selling

every single tire it has the capacity to produce), what would likely be the most fair
transfer price strategy to use? What would be the transfer price in this case?

Market price is RM55

Exercise 7 (Past Year Exam Semester A191)

The income statement for Division A is as follows:

Division A
Income statement for the year ended 31 December 2018

Sales RM120,000
(-) Cost of goods sold RM79,000
Gross income RM41,000
(-) Selling and administrative RM28,700
expenses
Operating income RM12,300
(-) Tax RM3,690
Net income RM8,610

Division A is an investment centre that uses return on investment (ROI) for its
performance measure. Management bonuses are also based on ROI. All investments
are expected to earn a minimum return of 15%. At the end of 2018, the division’s total
productive assets is RM63,000 which is a 5% increase over the beginning balance. The
total cost of capital is 10%.

Division A has an investment opportunity of RM60,000 that will generate additional

sales of RM16,000. This investment will incur additional variable cost of 6% on sales
and RM600 of fixed cost. By accepting this investment, Division A will increase current
liabilities by RM4,000.

REQUIRED:

(a) Calculate ROI for Division A for the following:

(i) Without new investment

63000 = Beginning asset x 105%

Beginning asset = 63000 / 105%
Beginning asset = 60000

Average operating asset = (60000 + 63000) / 2

= 61500
ROI = 12300 / 61500
= 0.2

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(ii) With new investment

Average operating asset = (60000 + 63000 + 60000) / 2

= 91500
Sales (120000 + 16000) RM136,000
(-) Cost of goods sold (79000 + 136000 x 6% + 600) RM87,760
Gross income RM48,240
(-) Selling and administrative expenses RM28,700
Operating income RM19,540
(-) Tax (19540 x 30%) RM5,862
Net income RM13,678

ROI = 19540 / 91500

= 0.2136

ROI with investment

= (RM12,300 + *RM14,440) / (RM61,500 + 60,000)
= RM26,740 / RM121,500
= 22%

*(Sales – VC – FC) = $16,000 x 0.94 - $600

(b) Determine whether Division A will accept the new investment if residual income
(RI) is used as performance measurement. Show all workings.

Residual income = 14440 – (60000 x 0.15)

= 14440 – 9000
= RM 5440
Accept because RI is positive.

(c) Determine whether Division A will accept the new investment if economic value
added (EVA) is used as performance measurement. Shows all workings.

EVA = (14440 X *70%) – [(60000 – 4000) X 10%]

= 10108 – 5600
= RM 4508
Accept because EVA is positive. *Tax = 30% (3690 x 12300)

(d) Discuss ONE (1) advantage of using RI as compared to ROI in evaluation of

investment centre.
Residual income encourages managers to make profitable investments that would be
rejected by managers using ROI.

The advantage of using residual income is that its use encourages managers to accept
any project that earns a return that is above the minimum rate. This prevents the
mistake of using ROI that may reject a profitable project that reduces divisional ROI.

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Exercise 8 (Past Year Exam Semester A191)

Syarikat Aman Damai Sdn Bhd (ADSB) produces electric components. ADSB has two
divisions, Division X and Division Y. Twenty percent (20%) of product produced by
Division X are sold to Division Y and the remainder are sold to outside market. ADSB
policy requires the divisions to use variable cost as transfer price. Currently, Division X
operates at maximum capacity of 100,000 units and sells to both Division Y and outside
as follows:
Division Y Outside Market
Sales RM450,000 RM4,000,000
(-) Variable costs RM450,000 RM1,800,000
Contribution margin RM0 RM2,200,000

Division X has an opportunity to increase the total sales for outside market by 20,000
units provided that the additional sales is at RM75 selling price. Division Y, on the other
hand, can alternatively purchase its requirements from outside supplier at a price of
RM85 per unit.

REQUIRED:

(a) Calculate the impact on Division X’s contribution margin if it accepts the new
opportunity.

Variable cost per unit = 1800000 / 80000 // 450000 / 20000

= 22.5
Outside Market
Sales (4000000 + 20000 x 75) RM5,500,000
(-) Variable costs (22.5 x 100000) RM2,250,000
Contribution margin RM3,250,000

(b) Calculate the impact on contribution margin for ADSB if Division X accepts the
new opportunity.

Sales (4000000 + 20000 x 75) RM5,500,000

(-) Variable costs (22.5 x 100000 + 85 x 20000) RM3,950,000
Contribution margin RM1,550,000

Contribution margin from Division X RM3,250,000

(-) Purchase cost at Division Y (20,000 x RM85)
= RM1,700,000
Contribution margin for ADSB RM1,550,000

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(c) Discuss TWO (2) advantages and TWO (2) disadvantages of transfer at market
price as compared to cost price.

Advantages:

1. Transfer price based on market prices are consistent with the responsibility
accounting concepts of profit center and investment center.
2. The use of market price helps to assess the contributions of each division to
overall company profit.

Disadvantages:
1. Is not suitable for the producing department has excess capacity or the external
market is imperfectly competitive.
2. Under distress market prices, where the industry experiencing significant excess
capacity and extremely low prices, basing transfer price on market prices can lead
to decisions that is not in the best interest of the overall company.
3. Not all products has market price (no demand in the market).

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