Chapter 19 Strategic Performance Measurement: Investment Centers & Transfer Pricing Homework: 19-25, 19-27, 19-31, Return on Investment; Goal Congruence Issues As indicated in the chapter, return on investment (ROI) is well entrenched in b

Chapter 19 Strategic Performance Measurement: Investment Centers & Transfer Pricing Homework: 19-25, 19-27, 19-31, 19-49 19-25 Return on Investment; Goal Congruence Issues As indicated in the chapter, return on investment (ROI) is well entrenched in business practice. However, its use can have negative incentive effects on managerial behavior. For example, assume you are the manager of an investment center and that your annual bonus is a function of achieved ROI for your division. You have the opportunity to invest in a project that would cost $500,000 and that would increase annual operating income of your division by $50,000. (This level of return is considered acceptable from top management’s standpoint.) Currently, your division generates annual operating profits of approximately $600,000, on an asset base (i.e., level of investment) of $4,000,000. Required 1. What is the current return on investment (ROI) being realized by your division (i.e., before considering the new investment)? 2. What would happen to the near-term ROI of your division after adding the effect of the new investment? 3. As manager of this division, given your incentive compensation plan, would you be motivated to make the new investment? Why or why not? 4. Can you offer any recommendations for improving the design of the incentive compensation plan under which you are working? That is, can you think of a plan that would result in increased alignment of your incentives with the goals of the company? 19-27 Return on Investment; Residual Income; EVA® Heather Smith Cosmetics (HSC) manufactures a variety of products and is organized into three divisions (investment centers): soap products, skin lotions, and hair products. Information about the most recent year’s operations follows. The information includes the value of intangible assets, including research and development, patents, and other innovations that are not included on HSC’s balance sheet. Were these intangibles to be included in the financial statements (as they are for EVA®), the increase in the balance sheet and the increase in after-tax operating income would be as given below: Division Operating Income Average Total Assets Value of Intangibles Intangibles’ Effect on Income Soap products $3,250,000 $60,000,000 $1,500,000 $1,000,000 Skin lotions 2,750,000 33,000,000 8,000,000 6,000,000 Hair products 5,000,000 55,000,000 1,000,000 700,000 Minimum desired rate of return 5.00% Cost of capital 4.00% Required 1. Calculate, to one decimal place, the return on investment (ROI) for each division. 2. Calculate, to the nearest whole dollar, the residual income (RI) for each division. 3. Calculate, to the nearest whole dollar, EVA® for each division and comment on your answers for ROI, RI, and EVA®. 19-31 General Transfer Pricing Rule Scottsdale Manufacturing is organized into two divisions: Fabrication and Assembly. Components transferred between the two divisions are recorded at a predetermined transfer price. Standard variable manufacturing cost per unit in the Fabrication Division is $500. At the present time, this division is working to capacity. Fabrication estimates that the units it produces could be sold on the external market for $650. The product under consideration is viewed as a commodity-type product, with no differentiating features or characteristics. Required 1. What roles are played by transfer prices? That is, why are transfer prices needed? 2. Use the general transfer pricing rule presented in the chapter to determine an appropriate transfer price. Why is the amount you calculated considered an appropriate transfer price? 3. What if the Fabrication Division had excess capacity? How would this change the indicated transfer price? Why is the amount you determined considered an appropriate transfer price? 4. Are there any downsides of using the general transfer pricing rule to determine the transfer price for internal transfers? 19-49 Transfer Pricing; Decision Making Phoenix Inc., a cellular communication company, has multiple business units, organized as divisions. Each division’s management is compensated based on the division’s operating income. Division A currently purchases cellular equipment from outside markets and uses it to produce communication systems. Division B produces similar cellular equipment that it sells to outside customers—but not to Division A at this time. Division A’s manager approaches Division B’s manager with a proposal to buy the equipment from Division B. If it produces the cellular equipment that Division A desires, Division B will incur variable manufacturing costs of $60 per unit. Relevant Information about Division B Sells 50,000 units of equipment to outside customers at $130 per unit Operating capacity is currently 80%; the division can operate at 100% Variable manufacturing costs are $70 per unit Variable marketing costs are $8 per unit Fixed manufacturing costs are $580,000 Income per Unit for Division A (assuming parts purchased externally, not internally from division B) Sales revenue $320 Manufacturing costs: Cellular equipment 80 Other materials 10 Fixed costs 40 Total manufacturing costs 130 Gross margin 190 Marketing costs: Variable 35 Fixed 15 Total marketing costs 50 Operating income per unit $140 Required 1. Division A proposes to buy 25,000 units from Division B at $75 per unit. What would be the effect (to the nearest whole dollar) of accepting this proposal on Division B’s operating income? What would be the effect on the operating income of Phoenix Inc. as a whole? 2. Now suppose Division A could purchase from multiple suppliers and would accept partial shipment from Division B. How many units should Division B sell to Division A at $75 per unit, if any? What would be the effect on Division B’s operating income (to the nearest whole dollar)? What would be the effect on the operating income of Phoenix Inc. as a whole? 3. What is the range of transfer prices over which the divisional managers might negotiate a final transfer price? Provide a rationale for the range you provide. 19-25 1. Annual operating profits = $600,000 Level of investment in the assets = $4,000,000 ROI= Annual operating profits/ Total Invested assets = / =0.15 =15% Therefore, the ROI prior to the new investment plan is 15%. 2. Level of Investment = $500,000 Annual operating income = $50,000 ROI= Annual operating profits/ Total Invested assets = (+40000)/ (+) = / =14.44% Hence the ROI after addition of new investment activity is 14.44% 3. The compensation incentive plan for the division manager is linked with ROI generated by the division from the investments which are done in the assets. The division manager would be motivated to make the new investment in the assets as it would increase the percentage of ROI to 14.44% from 10%, which is before the new investment. ROI of 14.44% is the acceptable percentage by the division's management for granting the incentive bonus to the division's manager. The option of new investment would definitely be taken into consideration. 4. An investment with the cost of $1,000,000 and operating revenue of 120,000 would give the highest ROI with 15%, which would be more than the acceptable level set by the company's management for sanctioning incentive bonuses to the division's manager. Thus, the goal congruency between the incentives of the manager and the organizational goal would be met with the highest ROI than expected.