Solution manual cost management measuring monitoring and motivating performance 1st by wolcott ch15

Cost Centers: In cost centers, managers are held responsible only for the costs under their control.. Revenue Centers: In revenue centers, managers are held responsible for the revenues

Chapter 15 Performance Evaluation and Compensation

LEARNING OBJECTIVES

Chapter 15 addresses the following questions:

Q1 What is agency theory?

Q2 How are decision-making responsibility and authority related to performance

evaluation?

Q3 How are responsibility centers used to measure, monitor, and motivate performance? Q4 What are the uses and limitations of return on investment, residual income, and

economic value added for monitoring performance?

Q5 How is compensation used to motivate performance?

Q6 What prices are used for transferring goods and services within an organization?

Q7 What are the uses and limitations of transfer pricing?

These learning questions (Q1 through Q7) are cross-referenced in the textbook to individual exercises and problems

COMPLEXITY SYMBOLS

The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems

Questions Having a Single Correct Answer:

No Symbol This question requires students to recall or apply knowledge as shown in the

textbook

e This question requires students to extend knowledge beyond the applications

shown in the textbook

Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10):

 Step 1 skills (Identifying)

 Step 2 skills (Exploring)

 Step 3 skills (Prioritizing)

 Step 4 skills (Envisioning)

QUESTIONS

15.1 ROI is calculated by dividing operating income by average assets, or income/assets It

can be decomposed as follows: ROI = sales/assets x income/sales

15.2 ROI can be increased by cutting costs or reducing assets Cost cutting can improve

short-term results but harm long-short-term results if discretionary expenditures such as advertising and research and development are cut Similarly, reducing investment in new projects could improve ROI in the short term, but harm the organization in the long term

15.3 Residual income = operating income – (required rate of return * average operating

assets) Many organizations have a minimum return that is expected on operations and new investments, this is their required rate of return

15.4 The size of investment affects residual income less than ROI because it is used only to

value the dollar amount of expected return, not as a denominator Residual income is therefore less influenced than ROI by changes in investment, but it is still subject to the same disadvantages as ROI that affect the operating income – such as cost cutting to

discretionary expenditures

15.5 General knowledge is usually easy to transfer throughout an organization Specific

knowledge is more detailed and is therefore more costly to transfer throughout an

organization General knowledge is needed in the food and beverage manufacturing, in clothing manufacture, and in restaurants and bars, among others Specific knowledge is important to software companies, bio-tech organizations, and healthcare organizations, among others

15.6 If general knowledge is required for success within an organization, a centralized form is

usually best because knowledge can easily be transferred to headquarters where decision making can be done from the perspective of the overall organization If specific

knowledge is required, it is costly to transfer to headquarters, so a decentralized form is usually best because the decision-making authority lies with the people with specific knowledge to make the best decision

15.7 Agency costs arise when agents do not act in the interest of principals because they do

not put in the effort required, or do not have the same tolerance for risk that principals have Examples of agency costs include the cost of forgoing appropriate projects because managers perceive them to be too risky, and poor decision making because of lack of effort to search for high quality information and high quality decision making processes

15.8 EVA is very similar to residual income because both subtract from operating income

some measure of interest times investment EVA is different than residual income

because many adjustments are made to all parts of the calculation For example, after tax operating income is usually used in EVA, whereas before tax operating income is usually used in RI The assets are also adjusted under EVA, for example long-term leases are usually capitalized There are over 160 possible adjustments that can be made to RI under EVA

15.9 The four responsibility center descriptions and objectives follow

Cost Centers: In cost centers, managers are held responsible only for the costs under

their control Some cost centers provide support services that are relatively easy to

monitor because their outputs are measurable Cost centers are also used for subunits that produce goods or services that eventually will be sold by others Managers in these cost centers are responsible for producing their goods or services efficiently In discretionary cost centers (marketing, research and development, for example), the output is not easily measurable in dollars or activities Cost centers are found in for-profit, not-for-profit, and government organizations Cost center managers are expected either to minimize costs for a certain level of output or to maximize output for a certain level of cost

Revenue Centers: In revenue centers, managers are held responsible for the revenues

under their control Revenue centers frequently sell products from manufacturing

subunits Managers are expected to maximize revenues

Profit Centers: Managers in profit centers are held responsible for both revenues and

costs under their control Profits centers produce and sell goods or services, and may include one or several cost centers Profit center managers are responsible for decisions about inputs, product mix, pricing, and volume of goods or services produced The

objective of profit centers is to maximize profits

Investment Centers: Managers of investment centers are held responsible for the

revenues, costs, and investments under their control Investments include any assets related to the investment center, such as fixed assets, inventory, intangible assets, and accounts receivable Investment centers resemble profit centers, where profitability is related to the assets used to generate the profits The objective of investment centers is to maximize the return on investments made by the organization This means the most profitable projects must be identified and selected for investment

15.10 From the overall organization’s point of view, it does not matter which branch pays for

shipping However, if each branch is held responsible for their own costs, each would prefer to have the other one pay for shipping charges because costs in the paying branch will be increased

15.11 Advantages of decentralization for this company: Because expansion is into other

countries, decision making will be timelier and probably more appropriate because local managers understand the local markets The need to communicate detailed information

up and down the organization will be reduced The people making the decisions have the most knowledge and expertise

Disadvantages: The decision makers may have objectives that are different from the

overall company’s objectives Decisions need to be coordinated among all of the

divisions to reduce non-optimal behavior such as duplication of products or services Investment in new projects may not reflect the best opportunities, but instead reflect the most persuasive decision maker

15.12 A suboptimal decision is one in which the overall organization does not receive as high a

contribution as is possible If it is cheaper to produce the product or service internally, but the transfer price is set so that the incentive is to purchase externally, more is being paid for the good or service than should be, and a suboptimal decision has been made

15.13 Transfer prices can be set based on cost (variable, variable plus some fixed costs, or

variable and a fully allocated fixed cost), or based on market price for the good or service (and there may be a variety of ways to estimate the market price) Alternatively, transfer prices can be negotiated between two divisions The seller could receive market price and the buyer could receive variable cost under a dual-rate method Lastly, an

organization could decide not to charge for transfers

EXERCISES

15.14 Brother’s Coffee Cart Business

A Each cart is a profit center because the employees who operate the carts buy baked goods and other items and are responsible for selling them—i.e., they are responsible for both costs and revenues

B My brother is the principal because he owns the business The coffee cart employees are his agents; they make decisions on his behalf The interests of the coffee cart employees may be different from my brother’s interests For example, the employees may want to purchase baked goods that they prefer to eat, rather than the baked goods that sell well or that earn the highest profit Or, they may not want to be too busy because it is tiring to wait on a lot of people all day My brother would prefer to have satisfied customers, keep volumes are as high as possible, and also keep costs under control He would like to have the largest contribution margin possible, and to provide high quality service so that return business is stable Agency theory also applies because my brother cannot perfectly observe his employees’ efforts or the quality of their work This inability provides an opportunity for the employees to shirk their responsibilities or to otherwise fail to work toward my brother’s best interests

C My brother could use measures that focus on revenues, costs, or profit Here are some possible measures: total revenue, revenue per hour, revenue growth, cost of goods sold

as a percent of revenue, supplies cost as a percent of revenue, and profit margin

(operating profit divided by revenue)

D Number or percentage of return customers is very important because a small cart cannot survive without regular customers Customer satisfaction is also important Cleanliness

of the cart could be an issue Students may think of other factors

[Note: Part C of this problem requires knowledge of breakeven analysis from Chapter 3.]

A Before calculating ROI, it is first necessary to calculate income:

C Variable cost per unit: $450,000/300,000 = $1.50

Breakeven number of units:

(a) Income tax calculations:

The Windsor plant has a loss The problem provides no information about whether Canadian tax law allows companies to carry losses back against prior income or forward against future income However, if the Windsor plant does not sell to outside customers, then it might always incur a loss if variable cost

is used as the transfer price Therefore, the income tax effect is estimated as zero

Tax for Detroit plant = $16,400,000 x 45% = $7,380,000

B ROI if the screens are transferred at market price:

(a) Income tax calculations:

Tax for Windsor plant: $2,000,000 x 30% = $600,000 Tax for Detroit plant = $12,400,000 x 45% = $6,820,000

C The firm will prefer the market transfer price because it maximizes company income Total income is increased through tax rate differences between Canada and the United States In addition, if variable costs are used, then there is a tax loss in Canada for which

no tax benefit is received The net tax advantage of using market value for the transfer price is:

Taxes if transfer price is the variable cost:

operations look best

E Use of either the dual rate or the negotiation method would give managers the

information they need to make the best decisions for the overall corporation A problem with the dual rate method is that both plants appear to be more profitable than they really are A problem with negotiating is that manager time can be tied up on activities that do not necessarily add value to the overall firm

15.19 Hand Held

A The contribution margin is $8 for the Cell Phone Division, so they will only be willing to

pay what they pay now ($12) plus up to $8 more or $20, although they may not want to assemble the cell phones at break even

B Chips should be sold in the division that has a $12 contribution margin rather than $8 contribution margin If market price is used for the transfer price, units will always be sold externally instead of internally

C If the Chip Division has plenty of excess capacity, the transfer price should be the

variable cost because the Chip Division could not sell the chips otherwise

Additional contribution margin for each pound of polystyrene $0.09

Times expected quantity of polystyrene sold 100 million pounds Expected increase in pretax profit from selling polystyrene $9 million

B Using the usual quantitative rules for short term decisions, the maximum transfer price Chemical would be willing to pay is the price at which Chemical’s contribution margin for Benzene would be zero, calculated as follows:

Per Pound

Contribution margin before cost of Benzene $ 0.27 Chemical’s managers would be willing to pay up to $0.27 per pound for the Benzene

C At a price of $0.27, the subsidiary would earn zero contribution margin, and it would report a net loss equal to its fixed costs Assuming that the fixed cost of $0.05 per pound was based on 100 million pounds of production, this means that Chemical would report

an operating loss on Benzene of $5 million At the same time, Oil would report a

sizeable profit on the Benzene:

Per Pound

In #1 above, the contribution margin of selling gasoline was calculated to be $0.08 per pound Thus, Oil would report an incremental contribution margin of $0.09 ($0.17 -

$0.08) per pound of Benzene produced In other words, Oil would receive all of the company-wide benefit of selling Benzene

Chemical’s managers would be unhappy with this arrangement, because they would be responsible for selling the product but would receive none of the company-wide

to produce a product for which they receive no incremental profit

F The most fair transfer price would be somewhere between $0.10 and $0.27 per pound (i.e., between the prices calculated in #2 and #4 above) In negotiations, however, the managers of Oil could have the upper hand Because Oil is operating at full capacity and can sell all of its production elsewhere, its managers might be able to require a transfer price of $0.27 In this case, Chemical’s managers may have no option but to accept a transfer price of $0.27 (and to report operating losses every year because of its fixed costs)

Sometimes companies establish transfer prices that reflect the degree of risk assumed by each responsibility center In the Prem International problem, this might mean that Chemical would receive most of the benefit, because it is assuming the risk of selling polystyrene to outside customers Oil might be given a transfer price sufficient to ensure that it does not report an operating loss from the sale of Benzene ($0.10 plus fixed costs

of $0.04 per pound)

15.21 Carlyle Corporation

There are several ways to solve this problem Here is one approach:

First, consider the per-unit differences in cost and revenue for the two options Ajax’s variable cost per unit is $45 If Ajax sells to outsiders at $75 per unit, the contribution margin is $30 to Ajax, so its gross margin improves by $600,000 ($30 x 20,000 units) If Bradley replaces Ajax’s units with $85 units from an outside supplier, the total cost per unit is $55 ($85 cost from outside vendor less the $30 contribution margin from outside customer) The variable cost of these units is $45 each, so Carlyle’s gross margin is maximized only by transferring the units internally at a savings of $10 per unit

Here is another approach:

Notice that none of Ajax division’s costs will change if it accepts the new opportunity; the division will continue to operate at full capacity The only change in its gross margin will be the difference in revenue:

15.23 Midwest Mining (continued)

RI = $105,000 – (0.10*$650,000) = $40,000

C If the performance measure causes managers to be indifferent (from the perspective of their compensation) to leasing or purchasing, they are more likely to base the decision on factors that create more value for the firm

15.24 International Woodworking

A No because at a price of $150, the variable cost to the furniture division under the current

transfer price policy is $155 and the Furniture Division would lose $5 per chair