What is meant by the term residual income?

Hannibal Steel Company has a Transport Services Department that provides trucks to haul ore from the company's mine to its two steel mills-the Northern Plant and the Southern Plant. Budgeted costs for the Transport Services Department total $350,000 per year, consisting of$0.25 per ton variable cost and $300,000 fixed cost. The level of fixed cost is determined by peak period requirements. During the peak period, the Northern Plant requires$70 of the Transport Services Department's capacity and the Southern Plant requires 30%.

During the year, the Transport Services Department actually hauled 130,000 tons of ore to the Northern Plant and 50,000 tons to the Southern Plant. The Transport Services Department incurred $364,000 in cost during the year, of which$54,000 was variable cost and $310,000 was fixed cost.

Required:

1. How much of the Transport Services Department's variable costs should be charged to each plant.

2. How much of the Transport Services Department's fixed costs should be charged to each plant.

3. Should any of the Transport Services Department's actual total cost of$364,000 be treated as a spending variance and not charged to the plants? Explain.

Westerville Company reported the following results from last year's operations:

$$\begin{array}{lr} \text{Sales} & \$1,000,000\\ \text{Variable expenses} & \underline{\hspace{10pt} 300,000}\\ \text{Contribution margin} & 700,000\\ \text{Fixed expenses} & \underline{\hspace{10pt} 500,000}\\ \text{Net operating income} & \underline{\underline{\$\hspace{10pt} 200,000}}\\ \text{Average operating assets} & \underline{\underline{\$\hspace{10pt} 200,000}}\\ \end{array}$$

At the beginning of this year, the company has a $\$ 120,000$ investment opportunity with the following cost and revenue characteristics:

$$\begin{array}{lr} \text{Sales} & \$200,000\\ \text{Contribution margin ratio} & 60\% \text{ of sales}\\ \text{Fixed expenses} & \$90,000\\ \end{array}$$

The company's minimum required rate of return is 15%.

What is last year's return on investment (ROI)?

Sako Company's Audio Division produces a speaker that is used by manufacturers of various audio products. Sales and cost data on the speaker follow:

$$\begin{array}{lr} \text{Selling price per unit on the intermediate market} && \hspace{20pt}\$60\\ \text{Variable cost per unit} && \hspace{20pt} \$42\\ \text{Fixed cost per unit (based on capacity)} && \hspace{25pt}\$8\\ \text{Capacity in units} && \hspace{5pt} 25,000\\ \end{array}$$

Sako Company has a Hi-Fi Division that could use this speaker in one of its products. The Hi-Fi Division will need 5,000 speakers per year. It has received a quote of $57 per speaker from another manufacturer. Sako Company evaluates division managers on the basis of divisional profits.

Required:

1. Assume the Audio Division sells only 20,000 speakers per year to outside customers.

a. From the standpoint of the Audio Division, what is the lowest acceptable transfer price for speakers sold to the Hi-Fi Division?

b. From the standpoint of the Hi-Fi Division, what is the highest acceptable transfer price for speakers acquired from the Audio Division?

c. What is the range of acceptable transfer prices (if any) between the two divisions? If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 5,000 speakers from the Audio Division to the Hi-{Fi Division? Why or why not?

d. From the standpoint of the entire company, should the transfer take place? Why or why not?

2. Assume the Audio Division is selling 22,500 speakers per year to outside customers.

a. From the standpoint of the Audio Division, what is the lowest acceptable transfer price for speakers sold to the Hi-Fi Division?

b. From the standpoint of the Hi-Fi Division, what is the highest acceptable transfer price for speakers acquired from the Audio Division?

c. What is the range of acceptable transfer prices (if any) between the two divisions? If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 5,000 speakers from the Audio Division to the Hi-Fi Division? Why or why not?

d. From the standpoint of the entire company, should the transfer take place? Why or why not?

3. Assume the Audio Division is selling 25,000 speakers per year to outside customers.

a. From the standpoint of the Audio Division, what is the lowest acceptable transfer price for speakers sold to the Hi-Fi Division?

b. From the standpoint of the Hi-Fi Division, what is the highest acceptable transfer price for speakers acquired from the Audio Division?

c. What is the range of acceptable transfer prices (if any) between the two divisions? If left free to negotiate without interference, would you expect the division managers to voluntarily agree to the transfer of 5,000 speakers from the Audio Division to the Hi-Fi Division? Why or why not?

d. From the standpoint of the entire company, should the transfer take place? Why or why not?

Distinguish between a cost center, a profit center, and an investment center.

Weller Industries is a decentralized organization with six divisions. The company's Electrical Division produces a variety of electrical items, including an X52 electrical fitting. The Electrical Division (which is operating at capacity) sells this fitting to its regular customers for $7.50 each; the fitting has a variable manufacturing cost of$4.25.

The company's Brake Division has asked the Electrical Division to supply it with a large quantity of X52 fittings for only $5 each. The Brake Division, which is operating at 50% of capacity, will put the fitting into a brake unit that it will produce and sell to a large commercial airline manufacturer. The cost of the brake unit being built by the Brake Division follows

$$\begin{array}{ lr} \\ \text{Purchased parts (from outside vendors)} && \text{\$22.50} \\ \text{Electrical fitting X52} && \hspace{10pt}\text{5.00} \\ \text{Other variable costs} && \hspace{5pt} \text{14.00} \\ \text{Fixed overhead and administration} && \underline{\hspace{10pt}\text{8.00}} \\ \text{Total cost per brake unit} && \underline{\underline{\hspace{0pt}\text{\$49.50}}}\\ \end{array}$$

Although the $5 price for the X52 fitting represents a substantial discount from the regular$7.50 price, the manager of the Brake Division believes the price concession is necessary if his division is to get the contract for the airplane brake units. He has heard "through the grapevine" that the airplane manufacturer plans to reject his bid if it is more than $50 per brake unit. Thus, if the Brake Division is forced to pay the regular$7.50 price for the X52 fitting, it will either not get the contract or it will suffer a substantial loss at a time when it is already operating at only 50% of capacity. The manager of the Brake Division argues that the price concession is imperative to the well-being of both his division and the company as a whole. Weller Industries uses return on investment (ROI) to measure divisional performance.

Required:

1. What is the Electrical Division's lowest acceptable transfer price? If you were the manager of the Electrical Division, would you supply the X52 fitting to the Brake Division for $5 each as requested? Why or why not?

2. Assuming the airplane brakes can be sold for$50, what is the financial advantage (disadvantage) for the company as a whole (on a per unit basis) if the Electrical Division supplies fittings to the Brake Division? Explain your answer.

3. What is the Brake Division's highest acceptable transfer price? In principle, should it be possible for the two divisional managers to agree to a transfer price in this particular situation?

4. Discuss the organizational behavior problems, if any, inherent in this situation. What would you advise the company's president to do in this situation?

Alpha and Beta are divisions within the same company. The managers of both divisions are evaluated based on their own division's return on investment (ROI). Assume the following information relative to the two divisions:

$$\begin{array}{l c c} \\ & & \hspace{45pt} \text{Case} & \\ \hline & \text{1} & \text{2} & \text{3} & \text{4} \\ \text{Alpha Division:} \\ \quad \text{Capacity in units} & \hspace{0pt}80,000 \hspace{5pt} & 400,000 & \hspace{5pt}150,000 & \hspace{5pt}300,000 \\ \quad \text{Number of units now being sold to outside} \\ \qquad \text{customers} & \hspace{0pt}80,000 \hspace{5pt} & 400,000 & \hspace{5pt}100,000 & \hspace{5pt}300,000 \\ \quad \text{Selling price per unit to outside customers}& \hspace{10pt} \$30 & \hspace{20pt} \$90 & \hspace{25pt} \$75 & \hspace{25pt} \$50\\ \quad \text{Variable costs per unit} & \hspace{10pt} \$18& \hspace{20pt} \$65 & \hspace{25pt} \$40 & \hspace{25pt} \$26 \\ \quad\text{Fixed costs per unit (based on capacity} & \hspace{15pt} \$6 & \hspace{20pt} \$15 & \hspace{25pt} \$20& \hspace{30pt} \$9 \\ \text{Beta Division:} \\ \quad \text{Number of units needed annually}& \hspace{0pt}5,000 &\hspace{5pt} 30,000 & \hspace{10pt}20,000 &\hspace{5pt}120,000 \\ \quad \text{Purchase price now being paid to an} \\ \qquad \text{outside supplier} & \hspace{10pt} \$27 & \hspace{20pt} \$89 & \hspace{28pt} \$75\text{*}& \hspace{30pt} - \\ \end{array}$$

*Before any purchase discount.

Required:

1. Refer to case 1 shown above. Alpha Division can avoid $2 per unit in commissions on any sales to Beta Division.

a. What is Alpha Divisions' lowest acceptable transfer price?

b. What is Beta Division's highest acceptable transfer price?

c. What is the range of acceptable transfer prices (if any) between the two divisions? Will the managers probably agree to a transfer? Explain.

2. Refer to case 2 shown above. A study indicates that Alpha Division can avoid$5 per unit in shipping costs on any sales to Beta Division.

a. What is Alpha Divisions' lowest acceptable transfer price?

b. What is Beta Division's highest acceptable transfer price?

c. What is the range of acceptable transfer prices (if any) between the two divisions? Would you expect any disagreement between the two divisional managers over what the exact transfer price should be? Explain. d. Assume Alpha Division offers to sell 30,000 units to Beta Division for $88 per unit and that Beta Division refuses this price. What will be the loss in potential profits for the company as a whole?

3. Refer to case 3 shown above. Assume that Beta Division is now receiving an 8% price discount from the outside supplier.

a. What is Alpha Divisions' lowest acceptable transfer price?

b. What is Beta Division's highest acceptable transfer price?

c. What is the range of acceptable transfer prices (if any) between the two divisions? Will the managers probably agree to a transfer? Explain

d. Assume Beta Division offers to purchase 20,000 units from Alpha Division at$60 per unit. If Alpha Division accepts this price, would you expect its ROI to increase, decrease, or remain unchanged? Why?

4. Refer to case 4 shown above. Assume that Beta Division wants Alpha Division to provide it with 120,000 units of a different product from the one Alpha Division is producing now. The new product would require $21 per unit in variable costs and would require that Alpha Division cut back production of its present product by 45,000 units annually. What is Alpha Division's lowest acceptable transfer price?

The contribution format income statement for the Huerra Company for last year is given below:

$$\begin{array}{c} \begin{array}{l c c} & \text{Total} & \text{Unit} \\ \text{Sales} & \hspace{5pt}\text{\$4,000,000}& \hspace{5pt}\text{\$80.00} \\ \text{Variable expenses}& \underline{\hspace{10pt}\text{2,800,000}}& \underline{\hspace{10pt}\text{56.00}} \\ \text{Contribution margin}& \hspace{10pt}\text{1,200,000}& \hspace{10pt}\text{24.00} \\ \text{Fixed expenses}& \underline{\hspace{18pt}\text{840,000}}& \underline{\hspace{10pt}\text{16.80}} \\ \text{Net operating income}& \hspace{18pt}\text{360,000}& \hspace{15pt}\text{7.20} \\ \text{Income taxes @ 30\\\%}& \underline{\hspace{18pt}\text{108,000}}& \underline{\hspace{15pt}\text{2.16}} \\ \text{Net income}& \underline{\underline{\hspace{13pt}\text{\$252,000}}}& \underline{\underline{\hspace{10pt}\text{\$5.04}}} \\ \end{array} \end{array}$$

The company had average operating assets of $2,000,000 during the year.

Required:

1. Compute the company's margin, turnover, and return on investment (ROI) for the period. For each of the following questions, indicate whether the margin and turnover will increase, decrease, or remain unchanged as a result of the events described, and then compute the new ROI figure. Consider each question separately, starting in each case from the data used to compute the original ROI in (1) above.

2. Using Lean Production, the company is able to reduce the average level of inventory by$400,000.

3. The company achieves a cost savings of $32,000 per year by using less costly materials.

4. The company purchases machinery and equipment that increases average operating assets by$500,000. Sales remain unchanged. The new, more efficient equipment reduces production costs by $20,000 per year.

5. As a result of a more intense effort by salespeople, sales are increased by 20%; operating assets remain unchanged.

6. At the beginning of the year, obsolete inventory carried on the books at a cost of$40,000 is scrapped and written off as a loss, thereby lowering net operating income.

7. At the beginning of the year, the company uses $200,000 of cash (received on accounts receivable) to repurchase some of its common stock.

$$\begin{array}{ lr} \\ \text{Variable cost per screen} && \$\ \hspace{5pt}\text{70} \\ \text{Variable expenses} && \underline{\hspace{5pt}\text{30}\text{*}} \\ \text{Total cost per screen} && \underline{\underline{\$\ 100}} \\ \end{array}$$

Based on a capacity of 10,000 screens per year.

Part of the Screen Division's output is sold to outside manufacturers of HDTVs and part is sold to Stavos Company's Quark Division, which produces an HDTV under its own name. The Screen Division charges $140 per screen for all sales.

The net operating income associated with the Quark Division's HDTV is computed as follows:

$$\begin{array}{ lr} \\ \text{Selling price per unit}&&&& \$480 \\ \text{Variable cost per unit:} \\ \quad \text{Cost of the screen}&& \$140 \\ \quad \text{Variable cost of electric parts}&& \underline{\hspace{5pt} \text{210}} \\ \text{Total variable cost}&&&& \underline{\hspace{5pt}\text{350}} \\ \text{Contribution margin}&&&& \hspace{5pt}130 \\ \text{Fixed costs per unit}&&&& \underline{\hspace{5pt}\text{80*}} \\ \text{Net operating income per unit}&&&& \underline{\underline{\hspace{5pt}\text{\$50}}} \\ \end{array} \\$$

Based on a capacity of 3,000 units per year.

The Quark Division has an order from an overseas source for 1,000 HDTVs. The overseas source wants to pay only $340 per unit.

Required:

1. Assume the Quark Division has enough idle capacity to fill the 1,000-unit order. Is the division likely to accept the$340 price or to reject it? Explain.

2. Assume both the Screen Division and the Quark Division have idle capacity. Under these conditions, what is the financial advantage (disadvantage) for the company as a whole (on a per unit basis) if the Quark Division rejects the $340 price?

3. Assume the Quark Division has idle capacity but that the Screen Division is operating at capacity and could sell all of its screens to outside manufacturers. Under these conditions, what is the financial advantage (disadvantage) for the company as a whole (on a per unit basis) if the Quark Division accepts the$340 unit price.

4. What conclusions do you draw concerning the use of market price as a transfer price in intra-company transactions?

Sharp Motor Company has two operating divisions-an Auto Division and a Truck Division. The company has a cafeteria that serves the employees of both divisions. The costs of operating the cafeteria are budgeted at $40,000 per month plus$3 per meal served. The company pays all the cost of the meals.

The fixed costs of the cafeteria are determined by peak-period requirements. The Auto Division is responsible for 65% of the peak-period requirements, and the Truck Division is responsible for the other 35%.

For June, the Auto Division estimated it would need 35,000 meals served, and the Truck Division estimated it would need 20,000 meals served. However, due to unexpected layoffs of employees during the month, only 20,000 meals were served to the Auto Division. Another 20,000 meals were served to the Truck Division as planned.

The cafeteria's actual fixed costs for June totaled $42,000 and its actual meal costs totaled$128,000.

Required:

1. How much cafeteria cost should be charged to each division for June?

2. Assume the company follows the practice of allocating all cafeteria costs incurred each month to the divisions in proportion to the number of meals served to each division during the month. On this basis, how much cost would be allocated to each division for June?

3. What criticisms can you make of the allocation method used in part (2) above?

4. If managers of operating departments know that fixed service costs are going to be allocated on the basis of peak-period requirements, what will be their probable strategy as they report their estimate of peak-period requirements to the company's budget committee? As a member of top management, what would you do to neutralize such strategies?

"I know headquarters wants us to add that new product line," said Dell Havasi, manager of Billings Company's Office Products Division. "But I want to see the numbers before I make any move. Our division's return on investment (ROI) has led the company for three years, and I don't want any letdown."

Billings Company is a decentralized wholesaler with five autonomous divisions. The divisions are evaluated on the basis of ROI, with year-end bonuses given to the divisional managers who have the highest ROIs. Operating results for the company's Office Products Division for this year are given below:

$$\begin{array}{ lr} \\ \text{Sales} && \text{\$10,000,000} \\ \text{Variable expenses} && \underline{\hspace{10pt} \text{6,000,000}} \\ \text{Contribution margin} && \hspace{10pt} \text{4,000,000} \\ \text{Fixed expenses} && \underline{\hspace{10pt}\text{3,200,000}} \\ \text{Net operating income} && \underline{\underline{\$\ \hspace{10pt}\text{800,000}}}\\ \text{Divisional average operating assets} && \underline{\underline{\hspace{5pt}\text{\$4,000,000}}} \\ \end{array}$$

The company had an overall return on investment (ROI) of 15% this year (considering all divisions). Next year the Office Products Division has an opportunity to add a new product line that would require an additional investment that would increase average operating assets by $1,000,000. The cost and revenue characteristics of the new product line per year would be:

$$\begin{array}{ lr} \\ \text{Sales} && \hspace{5pt}\text{\$2,000,000} \\ \text{Variable expenses} && \hspace{0pt} \text{60\\\% of sales} \\ \text{Fixed expenses} &&\hspace{13pt}\text{\$640,000} \\ \end{array}$$

Required:

1. Compute the Office Products Division's margin, turnover, and ROI for this year.

2. Compute the Office Products Division's margin, turnover, and ROI for the new product line by itself.

3. Compute the Office Products Division's margin, turnover, and ROI for next year assuming that it performs the same as this year and adds the new product line.

4. If you were in Dell Havasi's position, would you accept or reject the new product line? Explain.

5. Why do you suppose headquarters is anxious for the Office Products Division to add the new product line?

6. Suppose that the company's minimum required rate of return on operating assets is 12% and that performance is evaluated using residual income.

a. Compute the Office Products Division's residual income for this year.

b. Compute the Office Products Division's residual income for the new product line by itself.

c. Compute the Office Products Division's residual income for next year assuming that it performs the same as this year and adds the new product line.

d. Using the residual income approach, if you were in Dell Havasi's position, would you accept or reject the new product line? Explain.

Hrubec Products, Inc., operates a Pulp Division that manufactures wood pulp for use in the production of various paper goods. Revenue and costs associated with a ton of pulp follow: $$ \begin{array}{lcc} \text{Selling price} & & $70\\ \text{Expenses:}\\ \qquad\text{Variable}& $42\\ \qquad\text{Fixed (based on a capacity of}\\ \qquad\qquad\qquad50,000 \text{ tons per year)} &\underline{18} & \underline{60}\\ \text{Net operating income} &&\underline{\underline{\$ 10}} \end{array} $$ Hrubec Products has just acquired a small company that manufactures paper cartons. Hrubec plans to treat its newly acquired Carton Division as a profit center. The manager of the Carton Division is currently purchasing 5,000 tons of pulp per year from a supplier at a cost of $63 per ton. Hrubec's president is anxious for the Carton Division to begin purchasing its pulp from the Pulp Division if the managers of the two divisions can negotiate an acceptable transfer price. Required: For (1) and (2) below, assume the Pulp Division can sell all of its pulp to outside customers for$70 per ton. 1. What is the Pulp Division's lowest acceptable transfer price? What is the Carton Division's highest acceptable transfer price? What is the range of acceptable transfer prices (if any) between the two divisions? Are the managers of the Carton and Pulp Divisions likely to voluntarily agree to a transfer price for 5,000 tons of pulp next year? Why or why not? 2. If the Pulp Division meets the price that the Carton Division is currently paying to its supplier and sells 5,000 tons of pulp to the Carton Division each year, what will be the effect on the profits of the Pulp Division, the Carton Division, and the company as a whole? For (3)-(6) below, assume that the Pulp Division is currently selling only 30,000 tons of pulp each year to outside customers at the stated $70 price. 3. What is the Pulp Division's lowest acceptable transfer price? What is the Carton Division's highest acceptable transfer price? What is the range of acceptable transfer prices (if any) between the two divisions? Are the managers of the Carton and Pulp Divisions likely to voluntarily agree to a transfer price for 5,000 tons of pulp next year? Why or why not? 4. Suppose the Carton Division's outside supplier drops its price to only$59 per ton. Should the Pulp Division meet this price? Explain. If the Pulp Division does not meet the $59 price, what will be the effect on the profits of the company as a whole? 5. Refer to (4) above. If the Pulp Division refuses to meet the$59 price, should the Carton Division be required to purchase from the Pulp Division at a higher price for the good of the company as a whole? 6. Refer to (4) above. Assume that due to inflexible management policies, the Carton Division is required to purchase 5,000 tons of pulp each year from the Pulp Division at $70 per ton. What will be the effect on the profits of the company as a whole?

Westerville Company reported the following results from last year's operations:

$$\begin{array}{lr} \text{Sales} & \$1,000,000\\ \text{Variable expenses} & \underline{\hspace{10pt} 300,000}\\ \text{Contribution margin} & 700,000\\ \text{Fixed expenses} & \underline{\hspace{10pt} 500,000}\\ \text{Net operating income} & \underline{\underline{\$\hspace{10pt} 200,000}}\\ \text{Average operating assets} & \underline{\underline{\$\hspace{10pt} 200,000}}\\ \end{array}$$

At the beginning of this year, the company has a $\$ 120,000$ investment opportunity with the following cost and revenue characteristics:

$$\begin{array}{lr} \text{Sales} & \$200,000\\ \text{Contribution margin ratio} & 60\% \text{ of sales}\\ \text{Fixed expenses} & \$90,000\\ \end{array}$$

The company's minimum required rate of return is 15%.

What is last year's turnover?

Juniper Design Ltd. of Manchester, England, provides design services to residential developers. Last year, the company had net operating income of $600,000 on sales of$3,000,000. The company's average operating assets for the year were $2,800,000 and its minimum required rate of return was 18%.

Required:

Compute the company's residual income for the year.