Garrison 11ce SM ch11 Final

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Garrison 11ce SM Ch11 Final
Introduction to Management Accounting (Brock University)
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Chapter 11
Reporting for Control
Discussion Case (30 minutes)
MPC’s previous manufacturing strategy was focused on high-volume

production of a limited range of paper grades. The goal of this strategy
was to keep the machines running constantly to maximize the number of
tonnes produced. Changeovers were avoided because they lowered
equipment utilization. Maximizing tonnes produced and minimizing
changeovers helped spread the high fixed costs of paper manufacturing
across more units of output. The new manufacturing strategy is focused on
low-volume production of a wide range of products. The goals of this
strategy are to increase the number of paper grades manufactured,
decrease changeover times, and increase yields across non-standard
grades. While MPC realizes that its new strategy will decrease its
equipment utilization, it will still strive to optimize the utilization of its high
fixed cost resources within the confines of flexible production. In an
economist’s terms the old strategy focused on economies of scale while the
new strategy focuses on economies of scope.
Employees focus on improving those measures that are used to

evaluate their performance. Therefore, strategically-aligned performance
measures will channel employee effort towards improving those aspects of
performance that are most important to obtaining strategic objectives. If a
company changes its strategy but continues to evaluate employee
performance using measures that do not support the new strategy, it will
be motivating its employees to make decisions that promote the old
strategy, not the new strategy. And if employees make decisions that
promote the new strategy, their performance measures will suffer.
Some performance measures that would be appropriate for MPC’s old

strategy include: equipment utilization percentage, number of tonnes of
paper produced, and cost per tonne produced. These performance
measures would not support MPC’s new strategy because they would
discourage increasing the range of paper grades produced, increasing the
© McGraw-Hill Education Ltd. 2018. All rights reserved.

Solutions Manual, Chapter 11 1

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number of changeovers performed, and decreasing the batch size

produced per run.
Some performance measures that would suit the new strategy include
number of employee training hours to support manufacturing flexibility,
average changeover time, average manufacturing yield, number of grades
of paper produced, time to fill orders, customer satisfaction with the variety
of paper grades offered, revenues and contribution margin per unit.
© McGraw-Hill Education Ltd., 2018. All rights reserved.

2 Managerial Accounting, 11th Canadian Edition

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Solutions to Questions
11-1 In a decentralized organization, common cost of the geographic sales territories

decision-making authority isn’t confined to a few in which that product line is sold.
top executives, but rather is spread throughout
the organization with lower-level managers and 11-7 Three inappropriate methods for assigning
other employees empowered to make decisions. traceable costs are: treating traceable fixed
costs as indirect, using the wrong allocation
11-2 A segment is any part or activity of an base and arbitrarily dividing common costs
organization about which a manager seeks cost, among segments. Each of these practices is
revenue, or profit data. Examples of segments inappropriate because they can lead to distorted
include departments, operations, sales segment costs and consequently, distorted
territories, divisions, product lines, and so forth. segment margins.
11-3 Under the contribution approach, costs 11-8 A cost center manager has control over
are assigned to a segment if and only if the cost, but not revenue or the use of investment
costs are traceable to the segment (i.e., could funds. A profit center manager has control over
be avoided if the segment were eliminated). both cost and revenue. An investment center
Common costs are not allocated to segments manager has control over cost and revenue and
under the contribution approach. the use of investment funds. To evaluate cost
centre performance, standard cost variances and
11-4 The contribution margin is the difference flexible budget variances are often used. Profit
between sales revenue and variable expenses. centre managers are often evaluated by
The segment margin is the amount remaining comparing actual profit to targeted or budgeted
after deducting traceable fixed expenses from profit. Investment centre managers are usually
the contribution margin. The contribution margin evaluated using return on investment or residual
is useful as a planning tool for many decisions, income measures.
including those in which fixed costs don’t
change. The segment margin is useful in 11-9 Margin refers to the ratio of operating
assessing the overall profitability of a segment. income to total sales. Turnover refers to the
ratio of total sales to average operating assets.
11-5 If common costs were allocated to The product of the two numbers is the ROI.
segments, then the costs of segments would be
overstated and their margins would be 11-10 Return on investment (ROI) can be
understated. As a consequence, some segments improved by increasing sales, reducing operating
may appear to be unprofitable and managers expenses or reducing operating assets.
may be tempted to eliminate them. If a segment
were eliminated because of the existence of 11-11 Residual income is the operating income
arbitrarily allocated common costs, the overall an investment center earns above the
profit of the company would decline by the company’s minimum required rate of return on
amount of the segment margin because the operating assets.
common cost would remain. The common cost
that had been allocated to the segment would 11-12 If ROI is used to evaluate performance,
then be reallocated to the remaining segments— a manager of an investment center may reject a
making them appear less profitable. profitable investment opportunity whose rate of
return exceeds the company’s required rate of
11-6 There are often limits to how far down an return but whose rate of return is less than the
organization a cost can be traced. Therefore, investment center’s current ROI. The residual
costs that are traceable to a segment may income approach overcomes this problem since
become common as that segment is divided into any project whose rate of return exceeds the
smaller segment units. For example, the costs of company’s minimum required rate of return will
national TV and print advertising might be result in an increase in residual income.
traceable to a specific product line, but be a


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11-13 No, residual income should not be used

to compare the performance of divisions of
different sizes. The reason is that larger
divisions should, other factors held constant,
produce more residual income since they have a
larger asset base with which to generate profits.
However, it is appropriate to compare the
percentage growth in residual income (e.g.,
year-over-year) for divisions of different sizes.
11-14 The four groups of measures typically

included on a balanced scorecard are: learning
and growth; internal business process;
customer; and financial.


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Foundational Exercises
1. Last year’s margin is:
Net operating income

Margin =
Sales
$200,000
= = 20%
$1,000,000
2. Last year’s turnover is:

Sales
Turnover =
Average operating assets
$1,000,000
= = 1.6
$625,000
3. Last year’s return on investment (ROI) is:

ROI = Margin × Turnover
= 20% × 1.6 = 32%
4. The margin for this year’s investment opportunity is:

Margin =
Sales
$30,000
= = 15%
$200,000
5. The turnover for this year’s investment opportunity is:

Sales
Turnover =
$200,000
= = 1.67 (rounded)
$120,000
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Foundational Exercises (continued)
6. The ROI for this year’s investment opportunity is:

= 15% × 1.67 = 25% (rounded)
7, 8, and 9.
If the company pursues the investment opportunity, this year’s margin,
turnover, and ROI would be:
Margin =
Sales
$200,000 + $30,000
=
$1,000,000 + $200,000
$230,000
= = 19.2% (rounded)
$1,200,000
Sales
Turnover =
$1,000,000 + $200,000
=
$625,000 + $120,000
$1,200,000
= = 1.61 (rounded)
$745,000
= 19.2% × 1.61 = 30.9% (rounded)
10. The CEO would not pursue the investment opportunity because it low-
ers her ROI from 32% to 30.9%. The owners of the company would
want the CEO to pursue the investment opportunity because its ROI of
25% exceeds the company’s minimum required rate of return of 15%.


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Foundational Exercises (continued)
11. Last year’s residual income is:

Average operating assets...................... $625,000
Net operating income............................ $200,000
Minimum required return:
15% × $625,000................................ 93,750
Residual income.................................... $106,250
12. The residual income for this year’s investment opportunity is:
15% × $120,000................................ 18,000
Residual income.................................... $12,000
13. If the company pursues the investment opportunity, this year’s resid-
ual income will be:
15% × $745,000................................ 111,750
Residual income.................................... $118,250
14. The CEO would pursue the investment opportunity because it would
raise her residual income by $12,000.
15. The CEO and the company would not want to pursue this investment
opportunity because it does not exceed the minimum required return:
15% × $120,000................................ 18,000
Residual income.................................... $ (8,000)


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Exercise 11-1 (10 minutes)

Total
Company Weedban Greengrow
Sales*................................... $300,000 $90,000 $210,000
Variable expenses**.............. 183,000 36,000 147,000
Contribution margin............... 117,000 54,000 63,000
Traceable fixed expenses........ 66,000 45,000 21,000
Product line segment margin. . 51,000 $ 9,000 $ 42,000
Common fixed expenses not
traceable to products........... 33,000
Net operating income............. $ 18,000
* Weedban: 15,000 units × $6.00 per unit = $90,000.

Greengrow: 28,000 units × $7.50 per unit = $210,000.
** Weedban: 15,000 units × $2.40 per unit = $36,000.
Greengrow: 28,000 units × $5.25 per unit = $147,000.


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1.
Total Geographic Market
Company South Central North
Sales................................. $2,000,000 $600,000 $800,000 $600,000
Variable expenses
(52%, 30%, 40%).......... 792,000 312,000 240,000 240,000
Contribution margin........... 1,208,000 288,000 560,000 360,000
Traceable fixed expenses. . . 1,150,000 320,000 530,000 300,000
Geographic market seg-
ment margin................... 58,000 $(32,000) $ 30,000 $60,000
Common fixed expenses
not traceable to geo-
graphic markets*............ 155,000
Operating income (loss)..... $ (97,000)
*$1,305,000 – $1,150,000 = $155,000
2. Incremental sales ($800,000 × 15%).................... $120,000

Contribution margin ratio ($560,000 ÷ $800,000).. × 70%
Incremental contribution margin........................... 84,000
Less incremental advertising expense................... 25,000
Incremental operating income.............................. $ 59,000
Yes, the advertising program should be initiated.


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1. $75,000 × 40% CM ratio = $30,000 increased contribution margin in
Vancouver. Since the fixed costs in the office and in the company as a
whole will not change, the entire $30,000 would result in increased
operating income for the company.
It is incorrect to multiply the $75,000 increase in sales by Vancouver’s
25% segment margin ratio. This approach assumes that the segment’s
traceable fixed expenses increase in proportion to sales, but if they did,
they would not be fixed.
2. a. The segmented income statement follows:

Segments
Total Company Toronto Vancouver
Amount % Amount % Amount %
Sales........................
$800,000 100.0 $200,000 100 $600,000 100
Variable
expenses...............420,000 52.5 60,000 30 360,000 60
Contribution
margin...................380,000 47.5 140,000 70 240,000 40
Traceable fixed
expenses...............168,000 21.0 78,000 39 90,000 15
Office segment
margin...................212,000 26.5 $ 62,000 31 $150,000 25
Common fixed
expenses not
traceable to
segments...............120,000 15.0
Operating
income.............. $ 92,000 11.5
b. The segment margin ratio rises and falls as sales rise and fall due to
the presence of fixed costs. The fixed expenses are spread over a
larger base as sales increase.
In contrast to the segment ratio, the contribution margin ratio is
stable so long as there is no change in either variable expenses or the
selling price of a unit of service.


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1. The company should focus its campaign on Landscaping Clients. The
computations are:
Construction Landscaping
Clients Clients
Increased sales................................... $70,000 $60,000
Market CM ratio.................................. × 35% × 50%
Incremental contribution margin.......... $24,500 $30,000
Less cost of the campaign................... 8,000 8,000
Increased segment margin and
operating income for the company
as a whole....................................... $16,500 $22,000
2. The $90,000 in traceable fixed expenses in the previous exercise is now

partly traceable and partly common. When we segment Vancouver by
market, only $72,000 remains a traceable fixed expense. This amount
represents costs such as advertising and salaries that arise because of
the existence of the construction and landscaping market segments. The
remaining $18,000 ($90,000 – $72,000) is a common cost when
Vancouver is segmented by market. This amount would include such
costs as the salary of the manager of the Vancouver office that could
not be avoided by eliminating either of the two market segments.


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The completed segmented income statement should appear as follows:
Divisions
Total Company North South
Sales............................................... $500,000 100.0 $300,000 100.0 $200,000 100.0
Variable expenses............................. 270,000 54.0 150,000 50.0 120,000 60.0
Contribution margin.......................... 230,000 46.0 150,000 50.0 80,000 40.0
Traceable fixed expenses.................. 130,000 26.0 80,000 26.7 50,000 25.0
Territorial segment margin................ 100,000 20.0 $ 70,000 23.3 $30,000 15.0
Common fixed expenses................... 90,000 18.0
Net operating income....................... $ 10,000 2.0


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1. A responsibility centre is any part of an organization for which a man-

ager is accountable for performance.
2. A profit centre is a business segment where the manager has control
over revenue and cost.
3. An investment centre manager is held responsible for the residual in-
come of the segment.
4. A cost centre is often evaluated using flexible budget variances.
5. Investment centre managers are responsible for initiating investment
proposals.


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1. ROI computations:
ROI = Operating Income × Sales__________
Sales Average operating assets
Eastern Division: ($70,000/$800,000) × ($800,000/$300,000)
8.75% × 2.67 = 23.3%
Western Division: ($115,000/$1,850,000) × ($1,850,000/$400,000)
6.22% × 4.63 = 28.8%
2. The manager of the Western Division seems to be doing the better job.
Although her margin is about 2.5 percentage points lower than the
margin of the Eastern Division, her turnover is higher (a turnover of
4.63, as compared to a turnover of 2.67 for the Eastern Division). The
greater turnover more than offsets the lower margin, resulting in a
28.7% ROI, as compared to a 23.3% ROI for the other division.
Notice that if you look at margin alone, then the Eastern Division
appears to be the strongest division. This fact underscores the
importance of looking at turnover as well as at margin in evaluating
performance in an investment center.


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1. ROI computations:
ROI = Operating Income × Sales
Perth: ($630,000/$9,000,000) × ($9,000,000/$3,000,000)
7% × 3 = 21%
Darwin: ($1,800,000/$20,000,000) × ($20,000,000/$10,000,000)
9% × 2 = 18%
2. Perth Darwin
Average operating assets (a)............... $3,000,000 $10,000,000
Operating income............................... $630,000 $1,800,000
Minimum required return on average
operating assets—16% × (a)............ 480,000 1,600,000
Residual income................................. $150,000 $ 200,000
3. No, the Darwin Division is simply larger than the Perth Division and for
this reason one would expect that it would have a greater amount of
residual income. Residual income can’t be used to compare the
performance of divisions of different sizes. Larger divisions will almost
always look better. In fact, in the case above, Darwin does not appear to
be as well managed as Perth. Note from Part (1) that Darwin has only
an 18% ROI as compared to 21% for Perth


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Company A Company B Company C

Sales......................................... $400,000 * $750,000 * $600,000 *
Operating income....................... $32,000 $45,000 * $24,000
Average operating assets............ $160,000 * $250,000 $150,000 *
Return on investment (ROI)........ 20% * 18% * 16%
Minimum required rate of return:
Percentage.............................. 15% * 20% 12% *
Dollar amount......................... $24,000 $50,000 * $18,000
Residual income......................... $8,000 ($5,000) $6,000 *
*Given.9


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Division
Fab Consulting IT
Sales....................................... $800,000 * $650,000 $500,000
Operating income..................... 72,000 * 26,000 40,000 *
Average operating assets.......... 400,000 130,000 * 200,000
Margin..................................... 9% 4% * 8% *
Turnover.................................. 2.0 5.0 * 2.5
Return on investment (ROI)...... 18% * 20% 20% *
*Given.
Note that the Consulting and IT Divisions apparently have different
strategies to obtain the same 20% return. The Consulting Division has a
low margin and a high turnover, whereas the IT Division has just the op-
posite.


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1. Margin = Operating income  Sales
= $15,000/$500,000 = 3%
Turnover = Sales  Average operating assets

= $500,000/$80,000 = 6.25

= 3% × 6.25 = 18.75%

= ($15,000 + $6,000)/($500,000 + $80,000) = 3.62%

= ($500,000 + $80,000)/$80,000 = 7.25

= 3.62% × 7.25 = 26.25%

= ($15,000 + $3,200)/$500,000 = 3.64%

= $500,000/$80,000 = 6.25

= 3.64% × 6.25 = 22.75%


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Exercise 11-11 (continued)

= $15,000/$500,000 = 3%

= $500,000/($80,000-$20,000) = 8.33

= 3% × 8.33 = 25%


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1. Computation of ROI.
Fitness training: $30,000 × $600,000 = 5% × 3 = 15%
$600,000 $200,000
Spa services: $37,500 × $750,000 = 5% × 3 = 15%
$750,000 $250,000
Athletic wear: $24,000 × $400,000 = 6% × 4 = 24%
$400,000 $100,000
Fitness Spa Ser- Athletic

2. Training vices Wear
Average operating assets..... $200,000 $250,000 $100,000
Required rate of return........ × 10% × 12% × 10%
Required operating income... $20,000 $ 30,000 $ 10,000
Actual operating income....... $ 30,000 $ 37,500 $ 24,000
Required operating income
(above)............................ 20,000 30,000 10,000
Residual income.................. $ 10,000 $ 7,500 $ $14,000


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Fitness Train- Athletic

3. a. and b. ing Spa services wear
Return on investment (ROI). . . 15% 15% 24%
Therefore, if the division is
presented with an invest-
ment opportunity yielding
17%, it probably would....... Accept Accept Reject
Minimum required return for
computing residual income. . 10% 12% 10%
Therefore, if the division is
presented with an invest-
ment opportunity yielding
17%, it probably would....... Accept Accept Accept
If performance is being measured by ROI, the Athletic Wear division
probably would reject the 17% investment opportunity. The reason is
that this division is presently earning a return greater than 17%; thus,
the new investment would reduce the overall rate of return and place
the divisional managers in a less favourable light. The Fitness Training
and Spa Services divisions probably would accept the 17% investment
opportunity, since its acceptance would increase these divisions' overall
rate of return.
If performance is being measured by residual income, all three divisions
would accept the 17% investment opportunity. The 17% rate of return
promised by the new investment is greater than their required rates of
return of 10% and 12%, respectively, and would therefore add to the
total amount of their residual income.


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1. Net operating income
Margin =
Sales
$150,000
= = 5%
$3,000,000
Sales
Turnover =
$3,000,000
= =4
$750,000
= 5% × 4 = 20%

Margin =
Sales
$150,000(1.00 + 2.00)
=
$3,000,000(1.00 + 0.50)
$450,000
= = 10%
$4,500,000
Sales
Turnover =
$3,000,000(1.00 + 0.50)
=
$750,000
$4,500,000
= =6
$750,000
= 10% × 6 = 60%


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Margin =
Sales
$150,000 + $200,000
=
$3,000,000 + $1,000,000
$350,000
= = 8.75%
$4,000,000
Sales
Turnover =
$3,000,000 + $1,000,000
=
$750,000 + $250,000
$4,000,000
= =4
$1,000,000
= 8.75% × 4 = 35%


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1. (b) (c)
Net Average
(a) Operating Operating ROI
Sales Income* Assets (b) ÷ (c)
$2,500,000 $475,000 $1,000,000 47.5%
$2,600,000 $500,000 $1,000,000 50.0%
$2,700,000 $525,000 $1,000,000 52.5%
$2,800,000 $550,000 $1,000,000 55.0%
$2,900,000 $575,000 $1,000,000 57.5%
$3,000,000 $600,000 $1,000,000 60.0%
*Sales × Contribution Margin Ratio – Fixed Expenses
2. The ROI increases by 2.5% for each $100,000 increase in sales. This
happens because each $100,000 increase in sales brings in an additional
profit of $25,000. When this additional profit is divided by the average
operating assets of $1,000,000, the result is an increase in the
company’s ROI of 2.5%.


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Problem 11-15 (60 minutes)

1. The disadvantages or weaknesses of the company’s version of a
segmented income statement are as follows:
a. The company should include a column showing the combined results
of the three territories taken together.
b. The territorial expenses should be segregated into variable and fixed
categories to permit the computation of both a contribution margin
and a territorial segment margin.
c. The corporate expenses are probably common to the territories and
should not be allocated.
2. Corporate advertising expenses have apparently been allocated on the

basis of sales dollars; the general administrative expenses have
apparently been allocated evenly among the three territories. Such
allocations can be misleading to management because they seem to
imply that these expenses are caused by the segments to which they
have been allocated. The segment margin—which only includes costs
that are actually caused by the segments—should be used to measure
the performance of a segment. An operating income or loss after
allocating common expenses should not be used to judge the
performance of a segment.


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Problem 11-15 (continued)

3. Southern Northern
Total Europe Middle Europe Europe
Amount Amount Amount Amount
in €s % in €s % in €s % in €s %
Sales...................................... 1,800,000 100.0 300,000 100 800,000 100 700,000 100
Variable expenses:
Cost of goods sold................ 648,000 36.0 93,000 31 240,000 30 315,000 45
Shipping expense................. 89,000 4.9 15,000 5 32,000 4 42,000 6
Total variable expenses........... 737,000 40.9 108,000 36 272,000 34 357,000 51
Contribution margin................ 1,063,000 59.1 192,000 64 528,000 66 343,000 49
Traceable fixed expenses:
Salaries............................... 222,000 12.3 54,000 18 56,000 7 112,000 16
Insurance............................ 39,000 2.2 9,000 3 16,000 2 14,000 2
Advertising.......................... 590,000 32.8 105,000 35 240,000 30 245,000 35
Depreciation........................ 81,000 4.5 21,000 7 32,000 4 28,000 4
Total traceable fixed expenses. 932,000 51.8 189,000 63 344,000 43 399,000 57
Territorial segment margin...... 131,000 7.3 3,000 1 184,000 23 (56,000) (8)
Common fixed expenses:
Advertising (general)............ 90,000 5.0
General administration.......... 60,000 3.3
Total common fixed expense. . . 150,000 8.3
Operating loss........................ (19,000) ( 1.1)
Note: Columns may not total due to rounding.


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4. The following points should be brought to the attention of management:
a. Sales in Southern Europe are much lower than in the other two
territories. This is not due to lack of salespeople—salaries in Southern
Europe are about the same as in Middle Europe, which has the
highest sales of the three territories.
b. Southern Europe is spending less than half as much for advertising as
Middle Europe. Perhaps this is the reason for Southern Europe’s lower
sales.
c. Northern Europe has a poor sales mix; apparently it is selling a large
amount of low-margin items. Note that its contribution margin ratio is
only 49%, as compared to 64% or more for the other two territories.
d. Northern Europe may be overstaffed. Its total salaries are much
higher than in either of the other two territories.
e. Northern Europe is not covering its own traceable costs. Attention
should be given to changing the sales mix and reducing expenses in
this territory.

Solutions Manual, Chapter 11

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1. Sales Territory
Total Company Central Eastern
Sales............................................... $900,000 100.0 $400,000 100 $500,000 100
Variable expenses............................. 408,000 45.3 208,000 52 200,000 40
Contribution margin.......................... 492,000 54.7 192,000 48 300,000 60
Traceable fixed expenses.................. 290,000 32.2 160,000 40 130,000 26
Territorial segment margin................ 202,000 22.4 $ 32,000 8 $170,000 34
Common fixed expenses*................. 175,000 19.4
Operating income............................. $ 27,000 3.0
*465,000 – $290,000 = $175,000.
Product Line
Central Territory Kiks Dows
Sales............................................... $400,000 100.0 $100,000 100 $300,000 100
Variable expenses............................. 208,000 52.0 25,000 25 183,000 61
Contribution margin.......................... 192,000 48.0 75,000 75 117,000 39
Traceable fixed expenses.................. 114,000 28.5 60,000 60 54,000 18
Product line segment margin............. 78,000 19.5 $ 15,000 15 $ 63,000 21
Common fixed expenses*................. 46,000 11.5
Sales territory segment margin.......... $ 32,000 8.0
*$160,000 – $114,000 = $46,000.


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2. Two points should be brought to the attention of management. First,
compared to the Eastern territory, the Central territory has a low
contribution margin ratio. Second, the Central territory has high traceable
fixed expenses. Overall, compared to the Eastern territory, the Central
territory is very weak.
3. Again, two points should be brought to the attention of management.

First, the Central territory has a poor sales mix. Note that the territory
sells very little of the Kiks product, which has a high contribution margin
ratio. It is this poor sales mix that accounts for the low overall
contribution margin ratio in the Central territory mentioned in part (2)
above. Second, the traceable fixed expenses of the Kiks product
seem very high in relation to sales. These high fixed expenses may
simply mean that the Kiks product is highly leveraged; if so, then an
increase in sales of this product line would greatly enhance profits in the
Central territory and in the company as a whole.


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1. The segmented income statement follows:
Total Wheat Pancake
Company Cereal Mix Flour
Sales................................ $600,000 $200,000 $300,000 $100,000
Variable expenses:
Materials, labour & other. 204,000 60,000 126,000 18,000
Sales commissions.......... 60,000 20,000 30,000 10,000
Total variable expenses...... 264,000 80,000 156,000 28,000
Contribution margin........... 336,000 120,000 144,000 72,000
Advertising..................... 123,000 48,000 60,000 15,000
Salaries.......................... 66,000 34,000 21,000 11,000
Equipment depreciation*. 30,000 12,000 15,000 3,000
Warehouse rent**........... 12,000 4,000 7,000 1,000
Total traceable fixed ex-
penses........................... 231,000 98,000 103,000 30,000
Product line segment
margin........................... 105,000 $ 22,000 $ 41,000 $ 42,000
General administration.... 90,000
Operating income.............. $ 15,000
* $30,000 × 40%, 50%, and 10% respectively

** $0.50 per square metre × 8,000 square metres, 14,000 square
metres, and 2,000 square metres respectively


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2. a. No, the wheat cereal should not be eliminated. The wheat cereal
product is covering all of its own costs and is generating a $22,000
segment margin toward covering the company’s common costs and
toward profits. (Note: Problems relating to the elimination of a
product line are covered in more depth in Chapter 12.)
b.
Wheat Pancake
Cereal Mix Flour
Contribution margin (a).................. $120,000 $144,000 $72,000
Sales (b)........................................ $200,000 $300,000 $100,000
Contribution margin ratio (a) ÷ (b)... 60% 48% 72%
It is probably unwise to focus all available resources on promoting the

pancake mix. The company is already spending nearly as much on
the promotion of this product as on the other two products together.
Furthermore, the pancake mix has the lowest contribution margin
ratio of the three products. Therefore, a dollar of sales of the pancake
mix generates less profit than a dollar of sales of either of the two
other products. Nevertheless, we cannot say for sure which product
should be emphasized in this situation without more information. The
problem states that there is ample demand for all three products,
which suggests that there is no idle capacity. If the equipment is
being fully utilized, increasing the production of any one product would
probably require cutting back production of the other products. In
Chapter 12 we will discuss how to choose the most profitable product
when a production constraint forces such a trade-off among products.


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1. Segments defined as product lines:
Product Line
Leather
Division Garments Shoes Handbags
Sales......................................... R1,500,000 R500,000 R700,000 R300,000
Variable expenses...................... 761,000 325,000 280,000 156,000
Contribution margin................... 739,000 175,000 420,000 144,000
Advertising.............................. 312,000 80,000 112,000 120,000
Administration......................... 107,000 30,000 35,000 42,000
Depreciation............................ 114,000 25,000 56,000 33,000
Total traceable fixed expenses.... 533,000 135,000 203,000 195,000
Product line segment margin...... 206,000 R 40,000 R217,000 R (51,000)
Administrative*........................ 110,000
Divisional segment margin.......... R 96,000
*R217,000 – R107,000 = R110,000.


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2. Segments defined as markets for the handbag product line:
Sales Market
Handbags Domestic Foreign
Sales......................................... R300,000 R200,000 R100,000
Variable expenses...................... 156,000 86,000 70,000
Contribution margin................... 144,000 114,000 30,000
Advertising.............................. 120,000 40,000 80,000
Market segment margin.............. 24,000 R 74,000 R(50,000)
Administrative......................... 42,000
Depreciation............................ 33,000
Total common fixed expenses..... 75,000
Product line segment margin...... R(51,000)
3. Garments Shoes
Contribution margin (a)............................. R175,000 R420,000
Sales (b).................................................. R500,000 R700,000
Contribution margin ratio (a) ÷ (b)............ 35% 60%
Incremental contribution margin:

35% × R200,000 increased sales............ R70,000
60% × R145,000 increased sales............ R87,000
Less cost of the promotional campaign....... 30,000 30,000
Increased operating income....................... R40,000 R57,000
Based on these data, the campaign should be directed toward the shoes
product line. Notice that the analysis uses the contribution margin ratio
rather than the segment margin ratio because fixed expenses do not
change.


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1. Breaking the ROI computation into two separate elements helps the
manager to see important relationships that might remain hidden. First,
the importance of turnover of assets as a key element to overall
profitability is emphasized. Prior to use of the ROI formula, managers
tended to allow operating assets to swell to excessive levels. Second,
the importance of sales volume in profit computations is stressed and
explicitly recognized. Third, breaking the ROI computation into margin
and turnover elements stresses the possibility of trading one off for the
other in attempts to improve the overall profit picture. That is, a
company may shave its margins slightly hoping for a large enough
increase in turnover to increase the overall rate of return. Fourth, it
permits a manager to reduce important profitability elements to ratio
form, which enhances comparisons between units (divisions, etc.) of the
organization.
2. Companies in the Same Industry

A B C
Sales.................................. $1,000,000 * $300,000 * $1,200,000
Operating income................ $140,000 * $42,000 * $48,000
Average operating assets..... $500,000 * $600,000 $600,000 *
Margin................................ 14% 14% 4%*
Turnover............................. 2.0 0.5 2.0 *
Return on investment (ROI). 28% 7% * 8%
*Given.
Company B does as well as Company A in terms of profit margin, for
both companies earn 14% on sales. But Company B has a much lower
turnover of capital than does Company A. Whereas a dollar of
investment in Company A supports two dollars in sales each period, a
dollar investment in Company B supports only 50 cents in sales each
period. This suggests that the analyst should look carefully at Company
B’s investment. Is the company keeping an inventory larger than
necessary for its sales volume? Are receivables being collected
promptly? Or did Company A acquire its fixed assets at a price level,
which was much lower than that at which Company B purchased its
plant?

34 Managerial Accounting, 11th Edition

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Thus, by including sales specifically in ROI computations the manager is
able to discover possible problems, as well as reasons underlying a
strong or a weak performance. Looking at Company A compared to
Company C, notice that C’s turnover is the same as A’s, but C’s margin
on sales is much lower. Why would C have such a low margin? Is it due
to inefficiency, is it due to geographical location (thereby requiring
higher salaries or transportation charges), is it due to excessive
materials costs, or is it due to still other factors? ROI computations raise
questions such as these, which form the basis for managerial action.
To summarize, in order to bring B’s ROI into line with A’s, it seems
obvious that B’s management will have to concentrate its efforts on
increasing turnover, either by increasing sales or by reducing assets. It
seems unlikely that B can appreciably increase its ROI by improving its
margin on sales. On the other hand, C’s management should
concentrate its efforts on the margin element by trying to pare down its
operating expenses.


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1. Present New Line Total

(1) Sales......................... $21,000,000 $9,000,000 $30,000,000
(2) Operating income....... $1,680,000 $630,000 * $2,310,000
(3) Operating assets........ $5,250,000 $3,000,000 $8,250,000
(4) Margin (2) ÷ (1)......... 8.0% 7.0% 7.7%
(5) Turnover (1) ÷ (3)...... 4.00 3.00 3.64
(6) ROI (4) × (5)............. 32% 21% 28%
* Sales............................................................. $9,000,000
Variable expenses (65% x $9,000,000)............ 5,850,000
Contribution margin........................................ 3,150,000
Fixed expenses............................................... 2,520,000
Operating income........................................... $ 630,000
2. Stefan Grenier will be inclined to reject the new product line, since
accepting it would reduce his division’s overall rate of return.
3. The new product line promises an ROI of 21%, whereas the company’s
overall ROI last year was only 18%. Thus, adding the new line would
increase the company’s overall ROI.
4.
a. Present New Line Total
Operating assets...................... $5,250,000 $3,000,000 $8,250,000
Minimum required return.......... × 15% × 15% × 15%
Minimum operating income....... $787,500 $450,000 $1,237,500
Actual operating income........... $1,680,000 $ 630,000 $2,310,000
Minimum net operating income
(above)................................. 787,500 450,000 1,237,500
Residual income....................... $ 892,500 $ 180,000 $1,072,500
b. Under the residual income approach, Stefan Grenier would be inclined

to accept the new product line, since adding the product line would
increase the total amount of his division’s residual income, as shown
above.


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Problem 11-21(20 minutes)

1. Operating assets do not include investments in other companies or in
undeveloped land.
Ending Beginning
Balances Balances
Cash....................................... $ 150,000 $ 145,000
Accounts receivable.................. 500,000 360,000
Inventory................................ 510,000 590,000
Plant and equipment (net)........ 840,000 865,000
Total operating assets.............. $2,000,000 $1,960,000
Average operating assets = $1,960,000 + $2,000,000 = $1,980,000

2
Margin = Operating income ÷ Sales

= $627,000/$4,180,000 = 15%

= $4,180,000/$1,980,000 = 2.1
ROI = Margin x Turnover

= 15% × 2.1 = 31.5%
2. Operating income.............................................. $627,000

Minimum required return (20% × $1,980,000).... 396,000
Residual income................................................ $231,000


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1. The number of switches that must be sold would be:
Let X = units sold
$5X = $3X + $462,000 + $98,000*
$2X = $560,000
X = 280,000 switches, or $1,400,000 in sales
*$700,000 × 14% = $98,000.
a. Operating income $98,000

Margin = = = 7%
Sales $1,400,000
b. Sales $1,400,000
Turnover = = = 2.0
Operating assets $700,000
2. and 3. Sales Volume

Units sold.................................. 260,000 280,000 300,000
(1) Sales @ $5.20*, $5.00 and
$4.80*.................................... $1,352,000 $1,400,000 $1,440,000
Less variable expense @ $3........ 780,000 840,000 900,000
Contribution margin................... 572,000 560,000 540,000
Less fixed expenses................... 462,000 462,000 462,000
(2) Operating income...................... $ 110,000 $ 98,000 $ 78,000
(3) Total assets............................... $ 650,000 $ 700,000 $ 750,000
(4) Margin (2) ÷ (1)........................ 8.14% 7.00% 5.42%
(5) Turnover (1) ÷ (3)..................... 2.08 2.00 1.92
ROI (4) × (5)............................ 16.93% 14.00% 10.41%
*$5.00 × 1.04 = $5.20; $5.00 × 0.96 = $4.80.
Note: The $280,000 column is not required.


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1.
ROI = Operating Income × Sales__________
($40,000/$500,000) × ($500,000/$250,000)
8% × 2 = 16%
2.
ROI = ($50,000/$500,000) × ($500,000/$250,000)
10% × 2 = 20%
(increase) (unchanged) (increase)
3.
ROI = ($40,000/$500,000) × ($500,000/$200,000)
8% × 2.5 = 20%
(unchanged) (increase) (increase)
4. The company has a contribution margin ratio of 40% ($20 CM per unit
divided by $50 selling price per unit). Therefore, a $50,000 increase in
sales would result in a new net operating income of:
Sales..................................... $550,000 100%
Variable expenses.................. 330,000 60%
Contribution margin............... 220,000 40%
Fixed expenses...................... 160,000
Operating income................... $ 60,000


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ROI = ($60,000/$550,000) × ($550,000/250,000)

10.9% × 2.2 = 24%
(increase) (increase) (increase)
A change in sales affects both the margin and the turnover.
5. Interest is a financing expense and thus is not used to compute net

operating income.
ROI = ($44,000/$500,000) × ($500,000/325,000)
8.8% × 1.5 = 13.5%
(increase) (decrease) (decrease)
6.
ROI = ($40,000/$500,000) × ($500,000/$200,000)
8% × 2.5 = 20%
(unchanged) (increase) (increase)
7.
ROI = ($35,000/$500,000) × ($500,000/$245,000)
7% × 2.04 = 14.28%
(decrease) (increase) (decrease)


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Although both businesses are in the same industry (food service), they
serve very different markets and target customers that have very different
expectations. Consequently, there are likely to be more differences than
similarities between measures on the balanced scorecards of these two
restaurants. Some examples (although not comprehensive) of the types of
measures that might be included are as follows:
Sam's Pita Pit Classic Steakhouse Explanation
Number of orders Number of special Sam's is focused on

processed per hour occasion dining speed of service while
reservations taken per Classic is focused on
week special occasion dining
offerings; larger dining
parties that spend more
money per visit.
Number of sandwiches Number of orders sent Sam's allows customers

sent back - different back as over/under - to customize their
ingredients than cooked or due to poor sandwiches. Getting
ordered taste. something different
than ordered with
reduce the probability
the customer will return
to the restaurant.
Classic serves food at a

higher price point and
customers dine-in. They
expect their food to be
tasty and cooked to
order.


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Sam's Pita Pit Classic Steakhouse Explanation
Customer satisfaction Customer satisfaction While both restaurants

scores received via scores provided at the would likely collect
social media sources. end of the meal. Survey customer satisfaction
Survey would include would include measures survey data, each
measures such as of server attentiveness restaurant must collect
speed of service and and the quality of the this data from different
variety of food offerings overall dining sources considering
at low prices. experience. differences in their
target markets. The
scores collected should
reflect differences in
these target markets
and overall strategies
Number of sandwich Number of menu items Sam's is concerned with

offerings below $6 that are priced at or offering enough low
slightly above priced menu items
competitors while Classic is
concerned about
ensuring their higher
priced items are still
price-competitive.


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Target Actual
Return on assets employed by 14% 15%
department
Proportion of repeat customers 60% 57%
Sales generated by new product
lines as a percent of total 65% 64%
departmental sales
Average discount on goods sold 10% 18%
Based on the balanced scorecard results above, it appears that John's new
strategy is beginning to reap benefits, but he may need to persist a little
longer to be able to meet all of the targets the board has set for him. While
return on assets employed in the Women's Wear department exceeded
target, the department experienced less repeat customers than targeted.
Even so, taken together with the positive results in terms of satisfaction
scores from new customers, the lower proportion of repeat customers
might indicate fewer traditional customers are returning, while the return
rate of new customers could be much higher.
Results also indicate that sales by new product lines as a percent of total
sales was quite close to target, although the average discount on goods
sold was higher than expected (18%). This may indicate that John needs
to further refine his merchandise choices based on his experience with new
customers over the past year and be careful about the proportion of very
high priced he carries each season.


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The answers below are not the only possible answers. Ingenious people
can figure out many different ways of making performance look better
even though it really isn’t. This is one of the reasons for a balanced score-
card. By having a number of different measures that ultimately are linked
to overall financial goals, “gaming” the system is more difficult.
1. Speed-to-market can be improved by taking on less ambitious projects.

Instead of working on major product innovations that require a great
deal of time and effort, R&D may choose to work on small, incremental
improvements in existing products. There is also a danger that in the
rush to push products out the door, the products will be inadequately
tested and developed.
2. In this case, the ground crews raced from one arriving airplane to
another in an effort to unload luggage from these airplanes as soon as
possible. However, once the luggage was unloaded from the airplane it
was being left on the tarmac rather than being delivered in a timely
manner to carousels or appropriate connecting flights.
Another flaw of the CEO’s bonus system is that ground crews would
probably “smooth” their rate of improvement to earn as many monthly
bonuses as possible. They would not perform at their highest level
during the first month of the new bonus scheme because it would
diminish their chances of earning bonuses in subsequent months.
3. In real life, the production manager simply added several weeks to the
delivery cycle time. In other words, instead of promising to deliver an
order in four weeks, the manager promised to deliver in six weeks. This
increase in delivery cycle time did not, of course, please customers and
drove some business away, but it dramatically improved the percentage
of orders delivered on time.


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1. Students’ answers may differ in some details from this solution.
Financial Weekly profit +
Weekly sales +
Customer
Customer satisfac- Customer satisfac-
tion with service + tion with menu +
choices
Internal
Business Dining area Average time
Processes cleanliness
+ to prepare an –
order
Average time Number of
to take an – menu items +
order
Learning
and Percentage Percentage
Growth of dining of kitchen
room staff + staff com- +
completing pleting
hospitality cooking
course course


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2. The hypotheses underlying the balanced scorecard are indicated by the
arrows in the diagram. Reading from the bottom of the balanced
scorecard, the hypotheses are:
o If the percentage of dining room staff that complete the basic
hospitality course increases, then the average time to take an order
will decrease.
o If the percentage of dining room staff that complete the basic
hospitality course increases, then dining room cleanliness will
improve.
o If the percentage of kitchen staff that complete the basic cooking
course increases, then the average time to prepare an order will
decrease.
o If the percentage of kitchen staff that complete the basic cooking
course increases, then the number of menu items will increase.
o If the dining room cleanliness improves, then customer satisfaction
with service will increase.
o If the average time to take an order decreases, then customer
satisfaction with service will increase.
o If the average time to prepare an order decreases, then customer
satisfaction with service will increase.
o If the number of menu items increases, then customer satisfaction
with menu choices will increase.
o If customer satisfaction with service increases, weekly sales will
increase.
o If customer satisfaction with menu choices increases, weekly sales
will increase.
o If sales increase, weekly profits for the Lodge will increase.
Each of these hypotheses can be questioned. For example, the items
added to the menu may not appeal to customers. So even if the number
of menu items increases, customer satisfaction with the menu choices
may not increase. The fact that each of the hypotheses can be
questioned does not, however, invalidate the balanced scorecard. If the
scorecard is used correctly, management will be able to identify which,
if any, of the hypotheses are incorrect. [See below.]


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3. Management will be able to tell if a hypothesis is false if an

improvement in a performance measure at the bottom of an arrow does
not, in fact, lead to improvement in the performance measure at the tip of
the arrow. For example, if the number of menu items is increased, but
customer satisfaction with the menu choices does not increase,
management will immediately know that something was wrong with that
particular hypothesis.


lOMoARcPSD|7076069
Case 11-28 (60 minutes)

1. Both companies view training as important; both companies need to
leverage technology to succeed in the marketplace; and both companies
are concerned with minimizing defects. There are numerous differences
between the two companies. For example, Applied Pharmaceuticals is a
product-focused company and Destination Resorts International (DRI) is
a service-focused company. Applied Pharmaceuticals’ training resources
are focused on their engineers because they hold the key to the success
of the organization. DRI’s training resources are focused on their front-
line employees because they hold the key to the success of their
organization. Applied Pharmaceuticals’ technology investments are
focused on supporting the innovation that is inherent in the product
development side of the business. DRI’s technology investments are
focused on supporting the day-to-day execution that is inherent in the
customer interface side of the business. Applied Pharmaceuticals defines
a defect from an internal manufacturing standpoint, while DRI defines a
defect from an external customer interaction standpoint.


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Case 11-28 (continued)

2. Students’ answers may differ in some details from this solution.
Applied Pharmaceuticals
Financial
Return on
+
Shareholders’ Equity
Customer
Customer perception of Customer perception of
+ +
first-to-market capability product quality
Internal
Business R&D Yield + Defect rates –
Process
Learning
Percentage of job
and +
offers accepted
Growth
Dollars invested in Dollars invested in engineering

+ +
engineering technology training per engineer


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Destination Resorts International
Financial
Sales +
Customer
+
Number of repeat customers
Internal
Room
Business +
cleanliness
Process
Percentage of Average time to
error-free repeat resolve customer
customer check-ins + complaint –
Learning
and
– +
Growth
Employee
turnover
Survey of
employee morale
Number of employees re-
ceiving database training


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3. The hypotheses underlying the balanced scorecards are indicated by
the arrows in each diagram. Reading from the bottom of each balanced
scorecard, the hypotheses are:
Applied Pharmaceuticals
o If the dollars invested in engineering technology increase, then the
R&D yield will increase.
o If the percentage of job offers accepted increases, then the R&D
yield will increase.
o If the dollars invested in engineering training per engineer increase,
then the R&D yield will increase.
o If the R&D yield increases, then customer perception of first-to-mar-
ket capability will increase.
o If the defects per million opportunities decrease, then the customer
perception of product quality will increase.
o If the customer perception of first-to-market capability increases,
then the return on shareholders’ equity will increase.
o If the customer perception of product quality increases, then the re-
turn on stockholders’ equity will increase.
Destination Resort International
o If the employee turnover decreases, then the percentage of error-
free repeat customer check-ins and room cleanliness will increase
and the average time to resolve customer complaints will decrease.
o If the number of employees receiving database training increases,
then the percentage of error-free repeat customer check-ins will in-
crease.
o If employee morale increases, then the percentage of error-free re-
peat customer check-ins and room cleanliness will increase and the
average time to resolve customer complaints will decrease.
o If the percentage of error-free repeat customer check-ins increases,
then the number of repeat customers will increase.
o If the room cleanliness increases, then the number of repeat custom-
ers will increase.
o If the average time to resolve customer complaints decreases, then
the number of repeat customers will increase.
o If the number of repeat customers increases, then sales will increase.


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Each of these hypotheses is questionable to some degree. For example, in

the case of Applied Pharmaceuticals, R&D yield is not the sole driver of the
customers’ perception of first-to-market capability. More specifically, if
Applied Pharmaceuticals experimented with nine possible drug compounds
in year one and three of those compounds proved to be successful in the
marketplace it would result in an R&D yield of 33%. If in year two, it
experimented with four possible drug compounds and two of those
compounds proved to be successful in the marketplace it would result in an
R&D yield of 50%. While the R&D yield has increased from year one to
year two, it is quite possible that the customer’s perception of first-to-
market capability would decrease. The fact that each of the hypotheses
mentioned above can be questioned does not invalidate the balanced
scorecard. If the scorecard is used correctly, management will be able to
identify which, if any, of the hypotheses are invalid and the balanced
scorecard can then be appropriately modified.


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Case 11-29 (60 minutes)
To: CFO, Convenience Food Markets

From: Internal auditor
RE: Indicators of the effectiveness of the performance evaluation system

for CFM district managers
Earlier this year, I was asked to evaluate the effectiveness of our

performance evaluation system for district managers at CFM and to
examine whether John Nicholson, one of our district managers, should
open a new store in a new development in the suburbs. John and I have
prepared the following analysis based on the actual operating results for
the original store and the forecast for the new store. This analysis is
summarized in the table below:
Original New store

store
(actual) (forecast)
Operating Income less depreciation
$75,000 $145,000
Net book value of operating assets $195,000 $475,000
ROI 38.5% 30.5%
Residual Income:
Operating income less depreciation
$75,000 $145,000
Less: capital charge at 22% (42,900) (104,500)
Residual income $32,100 $40,500
As you can see, the original store is generating a quite strong return on
investment. The new store is forecasted to provide a relatively strong ROI,
but this return is still below the ROI generated by the original store. This
result puzzled me so I decided to examine the issue in more detail.
Although the numbers indicate ROI will be higher for the original store, we

lOMoARcPSD|7076069
all are aware that strategically, new stores with better layouts and modern
display areas and in locations with a growing population base should yield
better returns than stores in less popular locations. A closer look at the
calculations indicates both the operating income and the residual income of
the new store are higher than for the original store. The key then appears
to be in the asset base used to calculate ROI. We use the net book value
of operating assets as the denominator in the ROI calculation. The net
book value of operating assets of the original store will therefore be much
lower than that of the new store since those assets are almost fully
depreciated. Due to this quirk of our system, the ROI of older stores will
always be higher than the ROI of newer stores.
Based on this analysis, it is unlikely that John will decide open a store in
the newer neighbourhood even though a strategic analysis indicates he
should since this will have a negative effect on John’s performance
evaluation. Specifically, by closing a higher ROI store and replacing it with
a lower ROI store, the average ROI in John’s district will necessarily go
down and thus, his bonus will also be lower than if he keeps the original
store open. Since he is five years from retirement, John will probably want
to maximize the bonuses he receives in the next several years.
It appears the structure of our performance evaluation system for district

managers is sending signals that are contrary to good business strategy. It
appears we need to change the way we evaluate managers or at minimum,
the way we calculate ROI so the signal coming from the ROI calculation
leads to appropriate managerial decisions. Suggestions for change include:
 Basing district managers’ bonuses on residual income, not ROI
(downside is that residual income is not really comparable across
districts of different sizes and/or scales)
 Change the calculation of ROI for district managers to operating
income BEFORE depreciation (downside is they may then overinvest
in leasehold improvements)
 Make corporate managers, not district managers responsible for
making store opening and closing decisions assuming they may have
a longer term focus (i.e., maximizing long run ROI as opposed to
short-run ROI) than district managers.


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Connecting Concepts: Section 3 (30 minutes)
1. A segment report indicating the profitability of each of the company’s

divisions is presented below:
Total Geographic Market

South
Company Canada Europe America
Sales................................. $8,250,000 $6,950,000 $825,000 $475,000
Variable expenses 3,614,0
(52%, 40%, 40%).......... 4,134,000 00 330,000 190,000
Contribution margin........... 4,116,000 3,336,000 495,000 285,000
Traceable fixed expenses. . . 4,267,000 3,622,000 375,000 270,000
Geographic market seg-
ment margin................... (151,000) $(286,000) $ 120,000 $15,000
Common fixed expenses
not traceable to geo-
graphic markets*............ 145,000
Operating income (loss)..... $ (296,000)
*$4,412,000 – $4,267,000 = $145,000
As it turns out, the losses are occurring in the long-standing Canadian seg-
ment while the new European and South American segments are actually
generating a profit. Thus, the CEO may want to consider ways to better
manage costs and ensure accurate cost estimation processes so that prices
bid for new jobs are sufficient to cover costs and generate the expected
profit margin (see recommendations from Section 2 Connecting Concepts
analysis).
2. The divisional ROI for the European division is 12%

($120,000/$1,000,000). The divisional ROI for the South American divi-
sion is 3.1% ($15,000/$485,000). The European divisional manager is
eligible for a bonus, but the South American divisional manager is not.
Recommendations to increase ROI over the next year include the follow-
ing:


lOMoARcPSD|7076069
Connecting Concepts: Section 3 (continued)
 Attempt to generate more sales without any increase in operating as-

sets. This may be possible for the new divisions given they have likely
only just begun to explore the markets and build a reputation as a
high-quality vendor. Perhaps the initial investment in operating assets
has not yet been used to full capacity.
 Better control operating expenses with no change in sales or operat-
ing assets. Generating a good understanding of the activities that
drive costs is important as it will allow the division managers to tar-
get cost control activities to the places where they could make a sig-
nificant difference. In addition, much of this company’s work is done
by subcontractors. Better cost control over the subcontractor’s work
is also likely to yield benefits in terms of additional profit margin.
 Invest in operating assets to increase sales. The CEO should de-
termine if jobs are being turned away due to lack of capacity in
terms of either people or operating assets. Although less likely than
underutilization of operating assets for these new divisions, if
growth is outpacing investment, the divisions are leaving money on
the table and should be encouraged to request additional capital in-
vestments from head office.


lOMoARcPSD|7076069
Appendix 11A
Additional Control Topics
Solutions to Question
11A-1 If the selling division has idle capacity, decrease as prevention and appraisal costs
any transfer price above the variable cost of increase.
producing an item for transfer will generate
some additional profit. 11A-6 Operating departments are the units in
an organization within which the central
11A-2 Negotiated transfer prices preserve the purposes of the organization are carried out;
autonomy of the divisions and are in keeping these departments usually generate revenue. By
with decentralization. Also, the managers of the contrast, service departments provide support or
divisions tend to have much better information assistance to the operating departments.
than head office about potential costs and Examples of service departments include laundry
benefits of the transfer so they are in a better services in a hotel or hospital, internal auditing,
position to determine the best final transfer airport maintenance services (ground crews),
price. Disadvantages of negotiated transfer cafeteria, personnel, cost accounting, and so on.
prices include the risk of divisional managers
acting in their own interests instead of in the 11A-7 Service department costs are allocated to
interest of the company. Also, negotiation can products and services in two stages. Service
involve significant time and effort and may result department costs are first allocated to the
in an impasse that needs to be settled by head operating departments. These allocated costs
office in any case. are then included in the operating departments’
overhead rates, which are used to cost products
11A-3 When a market price is available it is and services.
usually the best transfer price because it
provides an objective yardstick with which to 11A-8 Interdepartmental services exist
measure what the internal cost/price should be. whenever two service departments provide
Neither manager gains or loses if the transfer is services to each other.
made a market price since neither manager
could buy/sell to the outside at a better 11A-9 Under the direct method,
price/cost. interdepartmental services are ignored; service
department costs are allocated directly to
11A-4 Quality costs can be broken down into operating departments. Under the step-down
prevention costs, appraisal costs, internal failure method, the costs of the service department
costs, and external failure costs. Prevention performing the greatest amount of service for
costs are incurred in an effort to keep defects the other service departments are allocated first,
from occurring. Appraisal costs are incurred to the costs of the service department performing
detect defects before they can create further the next greatest amount of service are
problems. Internal and external failure costs are allocated next, and so forth through all the
incurred as a result of producing defective units. service departments. Once a service
department’s costs have been allocated, costs
11A-5 No, total quality costs are usually are not reallocated back to it under the step-
minimized by increasing prevention and down method.
appraisal costs in order to reduce internal and
external failure costs. Total quality costs usually


lOMoARcPSD|7076069
Exercise 11A-1 (30 minutes)
1. Since the Valve Division has idle capacity, it does not have to give up
any outside sales to take on the Pump Division’s business. Applying the
formula for the lowest acceptable transfer price from the viewpoint of
the selling division, we get:
Transfer price ≥ Variable cost+ Total contribution margin on lost sales

per unit Number of units transferred
The Pump Division would be unwilling to pay more than $14, the price it
is currently paying an outside supplier for its valves. Therefore, the
transfer price must fall within the range:
2. Since the Valve Division is selling all that it can produce on the interme-
diate market, it would have to give up some of these outside sales to
take on the Pump Division’s business. Thus, the Valve Division has an
opportunity cost that is the total contribution margin on lost sales:
Since the Pump Division can purchase valves from an outside supplier at
only $14 per unit, no transfers will be made between the two divisions.
3. Applying the formula for the lowest acceptable price from the viewpoint
of the selling division, we get:
In this case, the transfer price must fall within the range:


lOMoARcPSD|7076069
Exercise 11A-1 (continued)
4. To produce the 20,000 special valves, the Valve Division will have to
give up sales to outside customers of 30,000 regular valves. Applying
the formula for the lowest acceptable price from the viewpoint of the
selling division, we get

Solutions Manual, Appendix 11A 59

lOMoARcPSD|7076069

1. The lowest acceptable transfer price from the perspective of the
selling division is given by the following formula:

There is no idle capacity, so each of the 20,000 units transferred from

Division X to Division Y reduces sales to outsiders by one unit. The
contribution margin per unit on outside sales is $20 (= $50 – $30).
Transfer price  ($30 - $2) + ($20 × 20,000)/20,000
= $28 + $20 - $48
The buying division, Division Y, can purchase a similar unit from an

outside supplier for $47. Therefore, Division Y would be unwilling to pay
more than $47 per unit.
Transfer price  Cost of buying from outside supplier = $47

The requirements of the two divisions are incompatible and no transfer
will take place.
2. In this case, Division X has enough idle capacity to satisfy Division Y’s
demand. Therefore, there are no lost sales and the lowest acceptable
price as far as the selling division is concerned is the variable cost of
$20 per unit.
Transfer price  $20 + ($0/20,000) = $20
The buying division, Division Y, can purchase a similar unit from an
outside supplier for $34. Therefore, Division Y would be unwilling to pay
more than $34 per unit.
In this case, the requirements of the two divisions are compatible and a
transfer will hopefully take place at a transfer price within the range:
$20  Transfer price  $34


lOMoARcPSD|7076069

1. Total Com-
Division A Division B pany
Sales............................ $2,500,000 $1,200,0002
1
$3,200,0003
Expenses:
Added by the division.. 1,800,000 400,000 2,200,000
Transfer price paid...... 500,000
Total expenses.............. 1,800,000 900,000 2,200,000
Net operating income.... $ 700,000 $ 300,000 $1,000,000
1
20,000 units × $125 per unit = $2,500,000.
2
4,000 units × $300 per unit = $1,200,000.
3
Division A outside sales
(16,000 units × $125 per unit).................... $2,000,000
Division B outside sales
(4,000 units × $300 per unit)...................... 1,200,000
Total outside sales........................................ $3,200,000
Note that the $500,000 in intracompany sales have been eliminated.
2. Division A should transfer the 1,000 additional circuit boards to Division

B. Note that Division B’s processing adds $175 to each unit’s selling
price (B’s $300 selling price, less A’s $125 selling price = $175 increase),
but it adds only $100 in cost. Therefore, each board transferred to
Division B ultimately yields $75 more in contribution margin ($175 –
$100 = $75) to the company than can be obtained from selling to
outside customers. Thus, the company as a whole will be better off if
Division A transfers the 1,000 additional boards to Division B.


lOMoARcPSD|7076069

1. Quality of conformance
2. Quality of conformance
3. Prevention costs, appraisal costs
4. Internal failure costs, external failure costs
5. External failure costs
6. Appraisal costs
7. Prevention costs
8. Internal failure costs
9. External failure costs
10. Prevention costs, appraisal costs
11. Quality circles
12. Quality cost report


lOMoARcPSD|7076069
1.
Internal External
Prevention Appraisal Failure Failure
Cost Cost Cost Cost
a. Product testing.................... X
b. Product recalls.................... X
c. Rework labor and overhead. X
d. Quality circles...................... X
e. Downtime caused by de-
fects................................ X
f. Cost of field servicing........... X
g. Inspection of goods............. X
h. Quality engineering............. X
i. Warranty repairs................. X
j. Statistical process control..... X
k. Net cost of scrap................. X
l. Depreciation of test equip-
ment................................ X
m. Returns and allowances
arising from poor quality. . . X
n. Disposal of defective prod-
ucts................................. X
o. Technical support to suppli-
ers................................... X
p. Systems development.......... X
q. Warranty replacements........ X
r. Field testing at customer
site.................................. X
s. Product design..................... X
2. Prevention costs and appraisal costs are incurred in an effort to keep

poor quality of conformance from occurring. Internal and external failure
costs are incurred because poor quality of conformance has occurred.


lOMoARcPSD|7076069
Service Departments Operating Departments

Physical
Admini- Plant Undergradu- Graduate
stration Services ate Programs Programs Total
Departmental costs before $36,694,00
allocations........................ $1,500,000 $654,000 $32,650,000 $1,890,000 0
Allocations:
Administration costs
(40/50, 10/50)............. (1,500,000) 1,200,000 300,000
Physical Plant costs 545,000 109,000
(25/30, 5/30)*............. (654,000)
Total costs after allocation. . $34,395,000 $2,299,000 $36,694,00
$ 0 $ 0 0
*Based on the space occupied by the two operating departments, which is 30,000 square metres.


lOMoARcPSD|7076069
Service Operating
Departments Departments
Admini- Janito-
stration rial Groceries Gifts Total
Departmental costs before allocations..... $2,320,00 $3,460,00
$150,000 $40,000 0 $950,000 0
Allocations:
Administration costs
(160/4,000, 3,100/4,000,
740/4,000)*.................................... (150,000) 6,000 116,250 27,750
Janitorial costs
(4,000/5,000, 1,000/5,000)†............ (46,000) 36,800 9,200
Total costs after allocation...................... $2,473,05 $3,460,00
$ 0 $ 0 0 $986,950 0
*Based on employee hours in the other three departments: 160 + 3,100 + 740 = 4,000.
†Based on space occupied by the two operating departments: 4,000 + 1,000 = 5,000.
Both the Janitorial Department costs of $40,000 and the Administration costs of $6,000 that have been
allocated to the Janitorial Department are allocated to the two operating departments.


lOMoARcPSD|7076069
Service Operating
Admini- Jani-to- Mainte-
strative rial nance Prep Finishing Total
Costs before allocation.......................... $84,000 $67,800 $36,000 $256,100 $498,600 $942,500
Allocation:
Administrative: (60/1,200; 240/1,200;
600/1,200; 300/1,200)..................... (84,000) 4,200 16,800 42,000 21,000
Janitorial: (1,000/10,000;
2,000/10,000; 7,000/10,000)............ (72,000) 7,200 14,400 50,400
Maintenance: (10,000/40,000;
30,000/40,000)................................ (60,000) 15,000 45,000
Total cost after allocations..................... $ 0 $ 0 $ 0 $327,500 $615,000 $942,500


lOMoARcPSD|7076069
Service Operating
Equip-
ment
Admini- Jani-to- Mainte-
strative rial nance Prep Finishing Total
Costs before allocation...................... $84,000 $67,800 $36,000 $256,100 $498,600 $942,500
Allocation:
Administrative: (600/900; 300/900) (84,000) 56,000 28,000
Janitorial:
(2,000/9,000; 7,000/9,000).......... (67,800) 15,067 52,733
Equipment Maintenance:
(10,000/40,000; 30,000/40,000). . (36,000) 9,000 27,000
Total cost after allocations................. $ 0 $ 0 $ 0 $336,167 $606,333 $942,500


lOMoARcPSD|7076069
Problem 11A-10 (60 minutes)

1. From the standpoint of the selling division, Division A:

Transfer price  ($63 - $5) +[($100 - $63) × 10,000]/10,000

 $58 + $37 = 95
But, from the standpoint of the buying division, Division B:
Division B won’t pay more than $92 and Division A will not accept less
than $95, so no deal is possible. There will be no transfer.
2. a. From the standpoint of the selling division, Division A:

Transfer price  ($19 - $4) +[($40 - $19) × 70,000]/70,000

 $15 + $21 = 36
From the standpoint of the buying division, Division B:

In this instance, an agreement is possible within the range:
Even though both managers would be better off with any transfer price
within this range, they may disagree about the exact amount of the
transfer price. It would not be surprising to hear the buying division
arguing strenuously for $36 while the selling division argues just as
strongly for $39.


lOMoARcPSD|7076069
Problem 11A-10 (continued)

b. The loss in potential profits to the company as a whole will be:
Division B’s outside purchase price.............................. $39
Division A’s variable cost on the internal transfer.......... 36
Potential added contribution margin lost to the com-
pany as a whole...................................................... $3
Number of units......................................................... ×70,000
Potential added contribution margin and company
profits forgone........................................................ $210,000
Another way to derive the same answer is to look at the loss in
potential profits for each division and then total the losses for the
impact on the company as a whole. The loss in potential profits in
Division A will be:
Suggested selling price per unit.................................. $38
Division A’s variable cost on the internal transfer.......... 36
Potential added contribution margin per unit............... $2
Number of units......................................................... ×70,000
Potential added contribution margin and divisional
profits forgone........................................................ $140,000
The loss in potential profits in Division B will be:
Outside purchase price per unit.................................. $39
Suggested price per unit inside................................... 38
Potential cost avoided per unit.................................... $1
Number of units......................................................... ×70,000
Potential added contribution margin and divisional
profits forgone........................................................ $70,000
The total of these two amounts ($140,000 + $70,000) equals the
$210,000 loss in potential profits for the company as a whole.


lOMoARcPSD|7076069

3. a. From the standpoint of the selling division, Division A:

Transfer price  $35 + ($0/20,000) = $35
From the standpoint of the buying division, Division B:

Transfer price  $60 – (0.05 × $60) = $57
In this case, an agreement is possible within the range:
If the managers understand what they are doing and are reasonably
cooperative, they should be able to come to an agreement with a
transfer price within this range.
b. Division A’s ROI should increase. The division has idle capacity, so
selling 20,000 units a year to Division B should require no increase in
operating assets. Therefore, Division A’s turnover should increase.
The division’s margin should also increase, because its contribution
margin will increase by $340,000 as a result of the new sales, with no
offsetting increase in fixed costs:
Selling price........................ $52
Variable costs...................... 35
Contribution margin............. $17
Number of units.................. ×20,000
Added contribution margin... $340,000
Thus, with both the margin and the turnover increasing, the division’s
ROI would also increase.


lOMoARcPSD|7076069

4. From the standpoint of the selling division, Division A:

Transfer price  $25 +[($45- $30) × 30,000]/60,000

 $25 + $7.50 = $32.50


lOMoARcPSD|7076069

1. The lowest acceptable transfer price from the perspective of the
selling division is given by the following formula:

The Tuner Division has no idle capacity, so transfers from the Tuner
Division to the Assembly Division would cut into normal sales of tuners
to outsiders. The costs are the same whether a tuner is transferred
internally or sold to outsiders, so the only relevant cost is the lost
revenue of $20 per tuner that could be sold to outsiders. This is
confirmed below:
Transfer price  $11 + ($20 - $11) × 30,000
30,000
 $11 + ($20 - $11) = $20
Therefore, the Tuner Division will refuse to transfer at a price less than
$20 per tuner.
The Assembly Division can buy tuners from an outside supplier for $20,
less a 10% quantity discount of $2, or $18 per tuner. Therefore, the
Division would be unwilling to pay more than $18 per tuner.
The requirements of the two divisions are incompatible. The Assembly
Division won’t pay more than $18 and the Tuner Division will not accept
less than $20. Thus, there can be no mutually agreeable transfer price
and no transfer will take place.
2. The price being paid to the outside supplier, net of the quantity
discount, is only $18. If the Tuner Division meets this price, then profits in
the Tuner Division and in the company as a whole will drop by $60,000
per year:
Lost revenue per tuner.......................... $20
Outside supplier’s price.......................... 18
Loss in contribution margin per tuner..... 2
Number of tuners per year..................... × 30,000
Total loss in profits................................ $60,000

lOMoARcPSD|7076069

Profits in the Assembly Division will remain unchanged, since it will be
paying the same price internally as it is now paying externally.
3. The Tuner Division has idle capacity, so transfers from the Tuner
Division to the Assembly Division do not cut into normal sales of tuners
to outsiders. In this case, the minimum price as far as the Assembly
Division is concerned is the variable cost per tuner of $11. This is
confirmed in the following calculation:
Transfer price  $11 + $0/30,000 = $11
The Assembly Division can buy tuners from an outside supplier for $18
each and would be unwilling to pay more than that in an internal
transfer. If the managers understand their own businesses and are
cooperative, they should agree to a transfer and should settle on a
transfer price within the range:
4. Yes, $16 is a bona fide outside price. Even though $16 is less than the
Tuner Division’s $17 “full cost” per unit, it is within the range given in
Part 3 and therefore will provide some contribution to the Tuner
Division.
If the Tuner Division does not meet the $16 price, it will lose $150,000
in potential profits:
Price per tuner........................... $16
Variable costs............................ 11
Contribution margin per tuner..... $5
30,000 tuners × $5 per tuner = $150,000 potential increased profits
This $150,000 in potential profits applies to the Tuner Division and to
the company as a whole.
5. No, the Assembly Division should probably be free to go outside and get
the best price it can. Even though this would result in lower profits for
the company as a whole, if the division is truly decentralized, the buying
division should not be forced to purchase inside if better prices are
available outside.


lOMoARcPSD|7076069

6. The Tuner Division will have an increase in profits:
Selling price............................... $20
Variable costs............................ 11
Contribution margin per tuner..... $9
30,000 tuners × $9 per tuner = $270,000 increased profits
The Assembly Division will have a decrease in profits:
Inside purchase price................. $20
Outside purchase price............... 16
Increased cost per tuner............ $4
30,000 tuners × $4 per tuner = $120,000 decreased profits
The company as a whole will have an increase in profits:
Increased contribution margin in the Tuner Division....... $9
Decreased contribution margin in the Assembly Division. 4
Increased contribution margin per tuner........................ $5
30,000 tuners × $5 per tuner = $150,000 increased profits
So long as the selling division has idle capacity and the transfer price is
greater than the selling division’s variable costs, profits in the company as a
whole will increase if internal transfers are made. However, there is a
question of fairness as to how these profits should be split between the
selling and buying divisions. The inflexibility of management in this
situation damages the profits of the Assembly Division and greatly
enhances the profits of the Tuner Division.


lOMoARcPSD|7076069

1. a. The lowest acceptable transfer price from the perspective of the
selling division, the Electrical Division, is given by the following
formula:
Total contribution margin
on lost sales
Transfer price ³ Variable cost +
Because there is enough idle capacity to fill the entire order from the
Motor Division, there are no lost outside sales. And because the
variable cost per unit is $21, the lowest acceptable transfer price as
far as the selling division is concerned is also $21.
$0
Transfer price ³ $21 + = $21
10,000
b. The Motor Division can buy a similar transformer from an outside
supplier for $38. Therefore, the Motor Division would be unwilling to
pay more than $38 per transformer.
Transfer price £ Cost of buying from outside supplier = $38
c. Combining the requirements of both the selling division and the
buying division, the acceptable range of transfer prices in this
situation is:
$21 ≤ Transfer Price ≤ $38
Assuming that the managers understand their own businesses and
that they are cooperative, they should be able to agree on a transfer
price within this range and the transfer should take place.
d. From the standpoint of the entire company, the transfer should take
place. The cost of the transformers transferred is only $21 and the
company saves the $38 cost of the transformers purchased from the
outside supplier.


lOMoARcPSD|7076069

2. a. Each of the 10,000 units transferred to the Motor Division must
displace a sale to an outsider at a price of $40. Therefore, the selling
division would demand a transfer price of at least $40. This can also
be computed using the formula for the lowest acceptable transfer
price as follows:
( $40 - $21) × 10,000
Transfer price ³ $21 +
10,000
= $21 + ( $40 - $21) = $40
b. As before, the Motor Division would be unwilling to pay more than

$38 per transformer.
c. The requirements of the selling and buying divisions in this instance

are incompatible. The selling division must have a price of at least
$40 whereas the buying division will not pay more than $38. An
agreement to transfer the transformers is extremely unlikely.
d. From the standpoint of the entire company, the transfer should not
take place. By transferring a transformer internally, the company
gives up revenue of $40 and saves $38, for a loss of $2.


lOMoARcPSD|7076069
1. If the transfer price is set at $15 per unit, the profit per unit of the two
divisions is:
Parts Division Assembly Division

Revenue per unit $15 Revenue per unit $25
Cost per unit 12 Parts cost per unit 15
Profit per unit $ 3 Assembly costs 6
Profit per unit $ 4
2. If the transfer price is set at $12 per unit, the profit per unit of the two
divisions is:

Profit per unit $ 7
By setting the transfer price at Parts division cost, profits are shifted to
the Assembly division from the Parts division. The Parts division
manager would be unlikely to agree to this transfer price since he/she
is evaluated based on divisional profit.
3. If the transfer price is set at the $13 cost per unit, the profit of the two
divisions is:

Profit per unit $ 6
4. By setting the transfer price at $13, the inefficiencies of the Parts

division get passed on to the Assembly division. As the Assembly
division manager, I would be unhappy with this transfer price since it

lOMoARcPSD|7076069
would re
duce my profit by $1 per unit. It is unfair that I have to be penalized in

my performance evaluation for inefficiencies due to poor management
by the Parts division manager.
5. The best transfer price from the perspective of the company as a whole
would be $15 per unit. This price allows for a reasonable profit per unit
for in each division. In addition, by setting the transfer price at $12, the
Parts division manager, if inefficient, would have to hold back the extra
cost in his/her division and it would affect his/her own division’s profit.
Thus, the Assembly division manager would not be penalized for poor
management in the Parts division. In addition, if the Parts division
manager can actually become more efficient and can actually produce
the parts for less than $12, he/she can increase the profit per unit of
the Parts division.
© McGraw-Hill Education Ltd. 2018 All rights reserved.


lOMoARcPSD|7076069

1.
Yedder Enterprises
Quality Cost Report (in thousands of dollars)
Last Year This Year
Amount Percent Amount Percent
Prevention costs:
Systems development.............. $ 120 0.13 % $ 680 0.68 %
Statistical process control — 0.00 % 270 0.27 %
Quality engineering.................. 1,080 1.14 % 1,650 1.65 %
Total prevention cost.................. 1,200 1.27 % 2,600 2.60 %
Appraisal costs:
Inspection............................... 1,700 1.79 % 2,770 2.77 %
Supplies used in testing........... 30 0.03 % 40 0.04 %
Cost of testing equipment 270 0.28 % 390 0.39 %
Total appraisal cost.................... 2,000 2.10 % 3,200 3.20 %
Internal failure costs:
Net cost of scrap..................... 800 0.84 % 1,300 1.30 %
Rework labour......................... 1,400 1.47 % 1,600 1.60 %
Downtime due to quality
problems.............................. 600 0.63 % 1,100 1.10 %
Total internal failure cost............ 2,800 2.94 % 4,000 4.00 %
External failure costs:
Product recalls......................... 3,500 3.68 % 600 0.60 %
Warranty repairs...................... 3,300 3.47 % 2,800 2.80 %
Customer returns of defective
goods................................... 3,200 3.37 % 200 0.20 %
Total external failure cost........... 10,000 10.52 % 3,600 3.60 %
Total quality cost........................ $16,000 16.84 % $13,400 13.40 %
* As a percentage of total sales in each year.

Note: Figures in the percent columns are subject to rounding error.
2. See the graph on the following page.


lOMoARcPSD|7076069

Quality Costs as a Percentage of Sales
18%
16%
14%
12%
External Failure
10% Internal Failure
8% Appraisal
Prevention
6%
4%
2%
0%
Last Year This Year


lOMoARcPSD|7076069

3. During the past year the company has more than doubled its spending
on prevention and it has increased its spending on appraisal activities by
60%. This increased emphasis on prevention and appraisal has resulted
in a decline of total quality costs from 16.84% of sales last year to
13.4% of sales this year. While the situation has improved, internal and
external failure costs still constitute the majority of the quality costs—
and this does not include the lost sales due to customer perceptions of
poor quality. However, if the company continues to emphasize
prevention and appraisal, the internal and external failure costs should
further decline until they are no longer dominant.
Probably due to the increased emphasis on appraisal activities, internal

failure costs have actually increased. This is because the increased
appraisal activities catch more defects before they are shipped to
customers. Thus, the company is incurring more costs for scrap and
rework, but it is saving large amounts on external failure costs as a
consequence of not releasing defective goods to customers. As better
quality is built into products and better defect prevention systems are
developed, defects should decrease and appraisal and internal failure
costs should also fall.


lOMoARcPSD|7076069
Out-pa-
Food Admin. X-Ray tient OB General
Services Services Services Clinic Care Clinic
Variable costs $73,150 $ 6,800 $38,100 $11,700 $ 14,850 $ 53,400
Food Services allocation:
$1.90 per meal × 1,000 meals (1,900) 1,900
$1.90 per meal × 500 meals (950) 950
$1.90 per meal × 7,000 meals (13,300) 0 13,300
$1.90 per meal × 30,000 meals (57,000) 57,000
Admin. Services allocation:
$0.50 per file × 1,500 files (750) 750
$0.50 per file × 3,000 files (1,500) 1,500
$0.50 per file × 900 files (450) 450
$0.50 per file × 12,000 files (6,000) 6,000
X-Ray Services allocation:
$4 per X-ray × 1,200 X-rays (4,800) 4,800
$4 per X-ray × 350 X-rays (1,400) 1,400
$4 per X-ray × 8,400 X-rays (33,600) 33,600
Total variable costs $ 0 $ 0 $ 0 $18,000 $ 30,000 $150,000


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Out-pa-
Food Admin. X-Ray tient OB General
Services Services Services Clinic Care Clinic
Fixed costs $48,000 $33,040 $59,520 $26,958 $ 99,738 $344,744
Food Services allocation:
2% × $48,000 (960) 960
1% × $48,000 (480) 480
17% × $48,000 (8,160) 0 8,160
80% × $48,000 (38,400) 38,400
Admin. Services allocation:
10% × $34,000 (3,400) 3,400
20% × $34,000 (6,800) 6,800
30% × $34,000 (10,200) 10,200
40% × $34,000 (13,600) 13,600
X-Ray Services allocation:
13% × $63,400 (8,242) 8,242
3% × $63,400 (1,902) 1,902
84% × $63,400 (53,256) 53,256
Total fixed costs $ 0 $ 0 $ 0 $42,000 $120,000 $450,000
Total overhead costs $ 0 $ 0 $ 0 $60,000 $150,000 $600,000


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Computation of allocation rates:
Variable Food Services:

Variable food service cost $73,150
= =$1.90 per meal
Total meals served 38,500 meals
Variable Admin. Services:
Variable administrative cost $6,800+$1,900
= =$0.50 per file
Files processed 17,400 files
Variable X-Ray Services:
Variable X-ray cost $38,100+$950+$750
= =$4.00 per X-ray
X-rays taken 9,950 X-rays


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1. Direct Method
Accounting dept. (AD) to Consulting: to AC 3/4 or $7,500
to LC 1/4 or $2,500
Cal: 3/4 = 60%/(60% + 20%); 1/4 = 20%/(60% + 20%)
Legal dept. (LD) to Consulting: to AC 1/5 or $3,000
to LC 4/5 or $12,000
Cal: 1/5 = 10%/(10% + 40%); 4/5 = 40%/(10% + 40%)
Income Statements
Income Statements
Accounting Legal
Consulting Consulting
Revenue..............................................................
$40,000 $25,500
Costs AC = 30% × $20,000
LC = 70% × $20,000 (6,000) (14,000)
Allocated AD*, LD**............................................ (10,500) (14,500)
Net income/(loss)................................................
$23,500 $ (3,000)
* ($7,500 + $3,000), ** ($2,500 + $12,000)
2. Step-down Method
Start with Legal Department costs:
Allocate to AD: 50% x $15,000 = $7,500
Allocate to AC: 10% x $15,000= $1,500
Allocate to LC: 40% x $15,000 = $6,000
Now Allocate Accounting Department costs:
Allocate to AC:
60%/ (60% + 20%) of ($10,000 + $7,500 from LD) = $13,125
Problem 11A-16 continued
Allocate to LC:
20%/(60% + 20%) x ($10,000 +$7,500 from LD) = $4,375


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Income Statements
Accounting Legal
Consulting Consulting
Revenue..............................................................
$40,000 $25,500
Costs AC = 30% × $20,000
LC = 70% × $20,000 (6,000) (14,000)
Allocated AD*, LD**............................................ (14,625) (10,375)
Net income..........................................................
$19,375 $ 1,125
* ($1,500+$13,125), ** ($6,000+$4,375)
The step-down method is preferable since it allows the firm to recognize

that some service departments use the services of other service
departments (in this case, it recognizes that the Accounting Department
uses services of the Legal Department). Although this method does not
also recognize that the Legal Department uses Accounting Department
services, it is still a more accurate method than the direct allocation
method. Sometimes accuracy comes at a higher cost, but in this case the
cost of a slightly more complex system is worthwhile. Note that Legal
Consulting operated at a loss under the Direct Method, but actually shows
a positive Net Income under the step-down method. This is due to the fact
that the Accounting Department uses a significant amount of Legal
Department services; therefore, the direct method under-allocates costs to
the Accounting Consulting department.


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Case 11A-17 (90 minutes)

1. Step-down method:
Custodial Machinery
Cafeteria Services Maintenance Milling Finishing
Total costs before allocations............... $320,000 $65,400 $ 93,600 $416,000 $166,000
Allocations:
Cafeteria (40/500; 60/500; 100/500;
300/500)1...................................... (320,000) 25,600 38,400 64,000 192,000
Custodial Services (10,000/70,000;
40,000/70,000; 20,000/70,000)2..... (91,000) 13,000 52,000 26,000
Machinery Maintenance
(160,000/200,000;
40,000/200,000)3.......................... (145,000) 116,000 29,000
Total overhead after allocations........... $ 0 $ 0 $ 0 $648,000 $413,000
1
Based on 40+60+100+300=500 employees
2
Based on 10,000+40,000+20,000=70,000 square metres
3
Based on 160,000+ 40,000 = 200,000 machine-hours
Milling predetermined = $648,000 = $4.05 per

overhead rate 160,000 machine hr. machine hr.
Finishing predeter- = $413,000 = $5.90 per

mined overhead rate
70,000 direct labour hr. DLH


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Case 11A-17 (continued)

2. Direct method:
Custodial Machinery
Cafeteria Services Maintenance Milling Finishing
Total costs before allocations................. $320,000 $65,400 $93,600 $416,000 $166,000
Allocations:
Cafeteria (100/400; 300/400)1............ (320,000) 80,000 240,000
Custodial Services (40,000/60,000;
20,000/60,000)2.............................. (65,400) 43,600 21,800
Machinery Maintenance
(160,000/200,000; 40,000/200,000)3. . (93,600) 74,880 18,720
Total overhead after allocations............. $ 0 $ 0 $ 0 $ 614,480 $446,520
Divide by machine-hours....................... ÷160,000
Divide by direct labour-hours................. ÷70,000
Predetermined overhead rate................ $ 3.84 $ 6.38
1
Based on 100 + 300 = 400 employees.
2
Based on 40,000 + 20,000 = 60,000 square metres.
3
Based on 160,000 + 40,000 = 200,000 machine-hours.


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Case 11A-17 (continued)

3. a. The amount of overhead cost assigned to the job would be:
Step-down method:
Milling Department:
2,000 machine-hours × $4.05 per machine-hour....... $ 8,100
Finishing Department:
13,000 DLHs × $5.90 per DLH................................. 76,700
Total overhead cost.................................................... $84,800
Direct method:
Milling Department:
2,000 machine-hours × $3.84 per machine-hour....... $ 7,680
Finishing Department:
13,000 DLHs × $6.38 per DLH................................. 82,940
Total overhead cost.................................................... $90,620
b. The step-down method provides a better basis for computing

predetermined overhead rates than the direct method because it
gives recognition to services provided between service departments.
If this interdepartmental service is not recognized, then either too
much or too little of a service department’s costs may be allocated to
a producing department. The result will be an inaccuracy in the
producing department’s predetermined overhead rate.
For example, notice from the computations in (2) above that using
the direct method and ignoring interdepartmental services causes the
predetermined overhead rate in the Milling Department to fall to
$3.84 per machine-hour (from $4.05 per machine-hour when the
step-down method is used), and causes the predetermined overhead
rate in the Finishing Department to rise to $6.38 per direct labour-
hour (from $5.90 per direct labour-hour when the step-down method
is used). These inaccuracies in the predetermined overhead rate
affect bids for jobs. Since the direct method in this case understates
the rate in the Milling Department and overstates the rate in the
Finishing Department, it is not surprising that the company tends to
bid low on jobs requiring a lot of milling work and tends to bid too
high on jobs that require a lot of finishing work.


Garrison 11ce SM ch11 Final

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Garrison 11ce SM Ch11 Final

Introduction to Management Accounting (Brock University)

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Discussion Case (30 minutes)

MPC’s previous manufacturing strategy was focused on high-volume

Employees focus on improving those measures that are used to

Some performance measures that would be appropriate for MPC’s old

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number of changeovers performed, and decreasing the batch size

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11-1 In a decentralized organization, common cost of the geographic sales territories

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11-13 No, residual income should not be used

11-14 The four groups of measures typically

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1. Last year’s margin is:

Net operating income

2. Last year’s turnover is:

3. Last year’s return on investment (ROI) is:

4. The margin for this year’s investment opportunity is:

5. The turnover for this year’s investment opportunity is:

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Foundational Exercises (continued)

6. The ROI for this year’s investment opportunity is:

= 19.2% × 1.61 = 30.9% (rounded)

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Foundational Exercises (continued)

11. Last year’s residual income is:

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Exercise 11-1 (10 minutes)

* Weedban: 15,000 units × $6.00 per unit = $90,000.

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Exercise 11-2 (20 minutes)

2. Incremental sales ($800,000 × 15%).................... $120,000

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Exercise 11-3 (20 minutes)

2. a. The segmented income statement follows:

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Exercise 11-4 (15 minutes)

2. The $90,000 in traceable fixed expenses in the previous exercise is now

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Exercise 11-5 (10 minutes)

The completed segmented income statement should appear as follows:

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Exercise 11-6 (10 minutes)

1. A responsibility centre is any part of an organization for which a man-

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Exercise 11-7 (15 minutes)

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