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Chapter 10 Performance Evaluation

Chapter 10

Performance Evaluation

Quick Check

Answers:

1. b 3. b 5. d 7. c 9. c

2. d 4. b 6. a 8. d 10. d

Short Exercises

(5 min.) S 10-1

a. A profit centerb. A responsibility centerc. Lowerd. A revenue centere. A profit centerf. A cost centerg. An investment centerh. A cost centeri. An investment centerj. A profit center

(5 min.) S 10-2

a. Costb. Profitc. Profitd. Revenuee. Profitf. Investmentg. Costh. Profit

Copyright 2013 Pearson Education, Inc. publishing as Prentice Hall 498

Managerial Accounting 3e Solutions Manual

(5 – 10 min.) S 10-3

Since the business is getting too large for Grandma Jones to handle, she would probably benefit from decentralizing her business. Some of the advantages of decentralization are:

Frees top managements (Grandma Jones) time Improves customer relations Increases employee motivation and satisfaction Support the use of expert knowledge

Grandma Jones should also be made aware of the potential disadvantages of decentralization.

Problems achieving goal congruence Duplication of costs or assets

Grandma Jones could decentralize in a number of different ways, for example:

customer type business function- for example baking, sales and marketing geographical area a combination of geographic area, customer type, and function

(5 – 10 min.) S 10-4

Revenue center 1. Manager of Holiday Inn’s central reservation office

Profit center 2. Managers of various corporate-owned Holiday Inn locations

Investment center 3. Manager of the Holiday Inn corporate division

Cost center 4. Manager of the Housekeeping Department at the Holiday Inn

Investment center 5. Manager of the Holiday Inn Express corporate division

Cost center 6. Manager of the complimentary breakfast buffet at a Holiday Inn Express

(10 min.) S 10-5

Midwest Division - Sales Revenue for Shasta’s Restaurants

For the month ending June 30

Product Actual Sales Budgeted Sales Variance Variance %

Food $ 156,000 $ 150,000 $6,000 F 4.0% F

Dessert $ 18,200 $ 20,000 $1,800 U 9.0% U

Bar $ 65,720 $ 62,000 $3,720 F 6.0% F

Catering $ 48,960 $ 48,000 $ 960 F 2.0% F



(10 min.) S 10-6

Sales margin

Capital turnover ROI

Functional Ingredients 25.0% 1.80 45.00%

Consumer Markets 10.0% 2.50 25.00%

Performance Materials 20.0% 1.50 30.00%

Functional Ingredients

Sales margin $5,445 / $21,780 = 25.0%

Capital turnover $21,780 / $12,100 = 1.8

ROI 25.0% x 1.8 = 45.0%

Consumer Markets

Sales margin $2,075 / $20,750 = 10.0%


ROI 10.0% x 2.5 = 25.0%

Performance Markets

Sales margin $3,000 / $15,000 = 20.0%


ROI 20.0% x 1.5 = 30.0%

(10 min.) S 10-7

1. Enter the formula, then calculate each division’s ROI.

Operating Income / Total Assets = ROISnow Sports $ 1,040,000 / $ 4,000,000 = 26.0 %

Non-Snow Sports $ 1,680,000 / $ 6,000,000 = 28.0 %

2. Top management has extra funds to invest. Which division will most likely receive those funds? Why?

The Non-Snow Sports division will most likely receive those funds because it has a higher ROI.

3. Can you explain why one division’s ROI is higher?

There is not enough information to explain why one ROI is greater.

How could management gain more insight?

Use the expanded ROI formula.



(10 - 15 min.) S 10-8

Req. 1Snow Sports Non-snow Sports

Operating income $1,040,000 $1,680,000÷ Sales ÷$5,200,000 ÷$8,400,000Sales margin 20% 20%

Based on the divisions’ sales margins, we know that the sales margin was not the reason the divisions had different ROIs.


Sales $5,200,000 $8,400,000÷ Total assets ÷$4,000,000 ÷$6,000,000 Capital turnover 1.30 1.40

Based on the divisions’ capital turnover rates, we know that the capital turnover rate was the reason that the divisions had different ROIs.


Sales margin (from S 10-7) 20% 20%× Capital turnover (from part 1) ×1.30 ×1.40ROI 26% 28%

Do your answers agree with the basic ROI? Yes

(5 - 10 min.) S 10-9

Snow Sports RI = $1,040,000 − ($4,000,000 × 16%) = $400,000

Non-Snow Sports RI = $1,680,000 − ($6,000,000 × 16%) = $720,000

Both divisions have positive residual income. This means that the divisions are earning income at a rate that exceeds management’s minimum expectations. This result is consistent with the ROI calculations.

(5 min.) S 10-10

Lowest – Variable cost of $13

Highest – Market price of $18

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



(10 - 15 min.) S 10-11

1. The master budget indicates that Sunshine planned to sell 5 pools in April.

2. The actual results indicate that Sunshine sold 6 pools in April.

3. The flexible budget for performance reports is always based on the actual output for the month. This is done so that managers can compare apples-to-apples, meaning they can compare actual revenues and expenses to those they would expect to achieve given the same volume. Therefore, Sunshine’s flexible budget is based on 6 pools.

4. The budgeted sales price is $18,000 per pool. ($90,000 / 5 = $18,000)

5. The budgeted variable price is $10,000 per pool. ($50,000 / 5 = $10,000)

6. The volume variance is the difference between the static (master) budget and the flexible budget. As the name suggests, this variance arises only because the number of units actually sold differs from the volume originally planned for in the static master budget.

7. As the name suggests, the flexible budget variance is the difference between the flexible budget and the actual results. Since both the actual results and the flexible budget are based on the same volume of output, this variance highlights unexpected revenues and expenses that are caused by factors other than volume.

8. See completed Performance Report below.

Sunshine Pools

Income Statement Performance ReportYear Ended April 30

Actual results at actual

prices

Flexible budget

variance

Flexible budget for

actual number of

output unitsVolume

varianceMaster budget

Output units 6 0 6 1 5

Sales revenue $ 102,000 $ 6,000 U $ 108,000 $ 18,000 F $ 90,000

Variable expenses 57000 3000 F 60000 10000 U 50000

Fixed expenses 21000 4000 F 25000 0 25000

Total expenses $ 78,000 $ 7,000 F $ 85,000 $ 10,000 U $ 75,000

Operating income $ 24,000 $ 1,000 F $ 23,000 $ 8,000 F $ 15,000



(10 -15 min.) S 10-12

Decadent Chocolates

Master Budget Performance Report - Sales and Operating Expenses

For Year Ended December 31

Actual

Flexible Budget

VarianceFlexible Budget

Volume Variance

Master Budget

12,700 batches

12,700 batches

11,600 batches

Sales Revenue ($30 per batch) $ 376,500

$ 4,500 U

$ 381,000

$ 33,000 F

$ 348,000

Variable Operating Expenses:

Sales Expense ($2 per batch sold) $ 23,400 $ 2,000 F

$ 25,400

$ 2,200 U

$ 23,200

Shipping Expense ($3 per batch sold)

36,500 1,600 F

38,100

3,300 U

34,800

Fixed Operating Expenses:

Salaries 9,500

800 U

8,700

-

8,700

Office Rent 2,500 -

2,500

-

2,500

Total Operating Expenses $ 71,900

$ 2,800 U

$ 74,700

$ 5,500 U

$ 69,200

Operating Income (Revenue less Expenses)

$ 304,600 $ 1,700 U

$ 306,300

$ 27,500 F

$ 278,800

(5 - 10 min.) S 10-13

a. Customer perspectiveb. Internal business perspectivec. Internal business perspective d. Financial perspectivee. Learning and growth perspectivef. Financial perspectiveg. Customer perspective h. Learning and growth perspective

(5 – 10 min.) S 10-14

a. Internal business perspectiveb. Internal business perspectivec. Learning and growth perspectived. Customer perspectivee. Financial perspectivef. Customer perspectiveg. Learning and growth perspectiveh. Internal business perspective

(10 min.) S 10-15

a. Investment centerb. Direct fixed expensesc. Sales margind. Key performance indicators (KPIs)e. Master budget variance



f. Goal congruenceg. Profit centerh. Common fixed expenses

(continued) S 10-15

i. Flexible budgetj. Flexible budget variancek. Return on Investment (ROI)l. Favorable variancem. Revenue centern. Volume varianceo. Capital turnoverp. Unfavorable varianceq. Management by exceptionr. Cost center

Exercises (Group A)

(5 - 10 min.) E 10-16A

a. Decentralizedb. Centralizedc. Centralizedd. Decentralizede. Decentralizedf. Centralizedg. Decentralized

(5 – 10 min.) E 10-17A

a. Investmentb. Investmentc. Costd. Revenuee. Profitf. Investmentg. Profith. Costi. Revenuej. Costk. Profit



(10 - 15 min.) E 10-18A

Req. 1

Hazelton—Water Sports Subunit Actual Budget

BudgetVariance(U or F)

% Variance(U or F)

Direct Materials $ 16,140 $15,000 $1,140 U 7.60% UDirect Labor 19,020 20,000 980 F 4.90% F

Indirect Labor 29,300 25,000 4,300 U 17.20% UUtilities 13,110 12,000 1,110 U 9.25% U

Depreciation 19,000 19,000 0 0Repairs and Maintenance 3,370 4,000 630 F 15 .75 % F Total $99,940 $95,000 $4,940 U 5 .20 % U

Req. 2This subunit must be a cost center.

Req. 3Repairs and maintenance

Req. 4No, favorable variances should be investigated to make sure they are not hurting the business in the long run.

(15 min.) E 10-19A

Performance Report

Northern Division - Sales Revenue for Irvin Chemical Corporation


(Dollars in millions)

Segment Actual Sales Budgeted Sales Variance Variance

%

Plastics $ 11,845 $

11,500 $ 345

F 3.0%FChemicals and Energy $ 3,710

$ 3,500

$ 210 F 6.0%F

Hydrocarbons $ 5,184 $

5,400 $ 216

U 4.0%U

Coatings $ 11,250 $

12,500 $ 1,250

U 10.0%U

Health Sciences $ 11,088 $

9,900 $ 1,188

F 12.0%F



(15 min.) E 10-20A

Performance Report

Caldrone Industries - Pharmaceutical Segment

For Fiscal Year Ending December 31

(all data is in millions)

Budgeted Variance Variance %

Sales $ 800,000 $ 80,000 10.00%

Less Variable Expenses:

Variable Cost of Goods Sold $ 200,000 $ 4,000 2.00%

Variable Operating Expenses $ 160,000 $ (6,400) -4.00%

Contribution Margin $ 440,000 $ 82,400 18.73%

Less Direct Fixed Expenses:

Fixed Manufacturing Overhead $ 80,000 $ 6,400 8.00%

Fixed Operating Expenses $ 21,000 $ 1,050 5.00%

Segment Margin $ 339,000 $ 74,950 22.11%

Less Common Fixed Expenses $ 18,000 $ 1,080 6.00%

Operating Income $ 321,000 $ 73,870 23.01%

(10 - 15 min.) E 10-21A

Req. 1Residential Professional

Operating income $ 68,000 $153,300÷ Total assets ÷$200,000 ÷$365,000Return on investment 34% 42%

Each division’s ROI is very high; however, the Professional Division has an even higher ROI than the Residential Division.


Operating income $ 68,000 $153,300÷ Sales ÷$850,000 ÷$1,095,000 Sales margin 8% 14%

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


Sales $850,000 $1,095,000÷ Total assets ÷$200,000 ÷$ 365,000 Capital turnover 4.25 3.00



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


Sales margin 8% 14%× Capital turnover ×4.25 ×3.00ROI 34% 42%

Does your answer for the residential ROI agree with the basic ROI? Yes

Does your answer for the professional ROI agree with the basic ROI? Yes

What can you conclude?

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

Req. 5Residential RI = $68,000 − ($200,000 × 26%) = $17,550Professional RI = $153,300 − ($365,000 × 26%) = $54,300

Both divisions are exceeding management’s expectations. (10 - 15 min.) E 10-22A

Anderson Company

Beatty Industries Carmen Inc.

Sales (S) $102,000 $815,000 $490,000

Operating income (OI) $35,700 $114,100 $39,200

Total assets (TA) $85,000 $163,000 $196,000

Sales margin (SM) 35% 14% 8%

Capital turnover (CT) 1.20 5.00 2.50

Return on investment (ROI) 41% 70% 20%

Target rate of return 11% 18% 19%

Residual income (RI) $26,350 $84,760 $1,960



(10 min.) E 10-23A

Req. 1Sales Margin = $9,240 ÷ $38,500

= 24%

Capital Turnover = $38,500 ÷ $14,000= 2.75 times

ROI = $9,240 ÷ $14,000= 66%

Req. 2RI = $9,240 − (14% x $14,000) = $7,280

(10 - 15 min.) E 10-24A

Req. 1The original return on investment (ROI) for Sinclair Ceramics is 20%

Req. 2If this investment opportunity were undertaken, the ROI would be 18%.If the manager of this division is evaluated based on ROI she would not want to make this investment. Investing in the new project would decrease the division’s ROI.

Req. 3The ROI of the investment opportunity is 13%.From the standpoint of Heisler Corporation this investment is desirable. The ROI of the investment opportunity exceeds Heisler’s required rate of return.

Req. 4The residual income (RI) for Sinclair Ceramics if this investment opportunity were to be undertaken is $40,180.If the manager of this division is evaluated based on RI she would want to make this investment. The positive RI indicates that the division is earning more than management’s expectations.

Req. 5The RI of the investment opportunity is $3,280.From the standpoint of Heisler Corporation this investment is desirable. The RI of the investment opportunity is positive, meaning the investment opportunity would earn more than management’s target required return.

Req. 6Of the two performance measurement methods, ROI and RI, RI is more likely to promote goal congruence. The RI of the investment alone is positive, meaning the investment will increase the division’s RI by that amount. This would motivate both the division manager and the company management to make the investment. The arrival at the same conclusion by both the manager and company management indicates goal congruence.



(10 min.) E 10-25A

Req. 1Lowest – Variable cost of $28 ($25 + $3.) Highest – Market price of $55

Req. 2 ($25 + $3 + $2) x 20% = $6; Transfer price = $25 + $3 + $2 + $6 = $36

Req. 3Market price; $55

(15 - 20 min.) E 10-26A

Main Street Muffins

Master Budget Performance Report - Sales and Operating Expenses

For Year Ended December 31

Actual

Flexible Budget

VarianceFlexible Budget

Volume Variance

Master Budget

8,300 cases 8,300 cases 8,000 cases

Sales Revenue ($30 per case) $ 215,400

$ 7,900 F

$ 207,500

$ 7,500 F

$ 200,000

Variable Operating Expenses: Packaging Expense ($1 per case sold)

$ 8,700

$ 400 U

$ 8,300

$ 300 U

$ 8,000

Shipping Expense ($3 per case sold) $ 25,900

$ 1,000 U

$ 24,900

$ 900 U

$ 24,000

Sales Commissions (2% of sales price)

$ 4,308

$ 158 U

$ 4,150

$ 150 U

$ 4,000

Fixed Operating Expenses:

Salaries $ 6,900

$ 700 U

$ 6,200

$ -

$ 6,200

Office Rent $ 3,500

$ -

$ 3,500

$ -

$ 3,500

Depreciation $ 2,500

$ -

$ 2,500

$ -

$ 2,500

Insurance Expense $ 1,800

$ 100 F

$ 1,900

$ -

$ 1,900

Office Supplies Expense $ 1,200

$ 200 F

$ 900

$ -

$ 900

Total Operating Expenses $ 54,808

$ 2,458 U

$ 52,350

$ 1,350 U

$ 51,000

Operating Income (Revenue less Expenses)

$ 160,592

$ 5,442 F

$ 155,150

$ 6,150 F

$ 149,000



(15-20 min.) E 10-27A

Req. 1

Landeau-Subunit XRevenue by Product Actual

FlexibleBudget

Variance Flexible BudgetSales Volume

Variance

Static(Master)Budget

Downhill—Model RI

$ 328,000$ 8,000 (F) $ 320,000 $16,000 (F) $ 304,000

Downhill—Model RII 157,000 14,000 (U) 171,000 20,000 (F) 151,000Cross-Country—Model EXI 280,000 2,000 (U) 282,000 18,000 (U) 300,000Cross-Country—Model EXII 253,000 8,000 (F) 245,000 18,500 (U) 263,500Snowboard—Model LXI 422,000 1,000 (F) 421,000 19,000 (F) 402,000 Total $1,440,000 $ 1,000 (F) $1,439,000 $18,500 (F) $1,420,500

Req. 2This subunit is a revenue center.

Req. 3The sales volume variance is always due strictly to volume — therefore, the number of units sold was different than budgeted for every model. The company sales mix appears to be shifting in the direction of downhill ski and snowboard sports. This could result in a build-up of cross-country ski inventory.

Management may need to do a better job marketing their cross-country skis. Additionally, the company may end up with delivery delays for downhill sports equipment if production schedules are not revised to accommodate the increasing demand for downhill skis and snowboards.

(15 - 20 min.) E 10-28A

a. Flexible budget varianceb. Sales volume variancec. 28,000 units d. $246,000 e. $173,600f. $6,500 favorableg. $54,300



(10 min.) E 10-29A

Lag indicators are performance measures that tend to reveal the results of past actions. They come after decisions and actions taken in the past. Lead indicators are performance measures that tend to indicate future performance. They come before, and drive, future performance.

Financial measures tend to be lag indicators. The financial results of a period are driven by actions taken in the past. For example, Ford’s earlier decisions about design, production, planning, pricing and whether to feature certain models in advertising.

Operational measures tend to be lead indicators. Current customer satisfaction ratings, defect rates, and cycle times predict how well the company will do in the future. For example, Ford Motor Company’s customers’ satisfaction can predict whether future sales will increase (if customers are satisfied) or decline (if customers are not satisfied).

(15 - 20 min.) E 10-30A

Cardinal Corporation

Balanced Scorecard Report

For Quarter Ended December 31

Perspective Objective KPI Goal Actual Goal Achieved?

Financial

Increase profitability of core product line

Core product line profit as % of core product line sales

12% 12%

Increase sales of core product line

Sales revenue growth 2,000,000 2,200,000 √

Customer

Increase market share Market Share % 19% 18% √

Increase customer satisfaction Customer Satisfaction rating

(1-5, with 1 being best)

1.3 1.2 √

Internal business process

Improve post-sales service Average repair time (# of days)

1.0 1.6

Develop new core products Number of new core products

26 24 √

Learning and growth

Improve employee job satisfaction

Employee Turnover rate 3% 6%

Improve employee product knowledge

Employee training hours 2,400 2,350 √



(10 - 15 min.) E 10-31A

a. Learning and growth perspectiveb. Internal business perspective OR Customer perspectivec. Financial perspectived. Internal business perspectivee. Learning and growth perspectivef. Customer perspectiveg. Learning and growth perspectiveh. Financial perspectivei. Internal business perspective j. Learning and growth perspectivek. Internal business perspective (post-sales service)l. Customer perspective

(15 - 20 min.) E 10-32A

a. Revenue from recycling packaging materials - Financialb. Total liters of water used – Internal businessc. Number of sustainability training hours – Learning and growthd. Number of employee hours devoted to local volunteering - Communitye. Charitable contributions as a percent of income - Communityf. Customer survey rating company's green reputation - Customerg. Number of employees on sustainability teams – Learning and growthh. Cubic meters of natural gas used for heating facilities – Internal businessi. Total megawatt hours of electricity purchased – Internal businessj. Percent of bottles and cans sold recovered through company-supported recovery programs - Customerk. Cost of water used - Financiall. Indirect greenhouse gas emissions from electricity purchased and consumed – Internal businessm. Number of functions with environmental responsibilities – Learning and growthn. Number of green products - Customero. Percentage of profit donated to local schools - Communityp. Volume of Global Greenhouse Gas (GHG) emissions – Internal businessq. Waste disposal costs - Financialr. Percentage of products reclaimed after customer use - Customer

(5 – 10 min.) E 10-33A

a. Decentralizedb. Decentralizedc. Centralizedd. Decentralizede. Decentralizedf. Centralizedg. Centralized



Exercises (Group B)

(5 – 10 min.) E 10-34B

a. Profitb. Costc. Profitd. Coste. Revenuef. Costg. Investmenth. Revenuei. Investmentj. Profitk. Investment

(10 - 15 min.) E 10-35B

Req. 1

River Sports–Subunit X Actual Budget

Budget

Variance

(U or F)

% Variance

(U or F)

Direct Materials $ 26,925 $25,000 $1,925 U 7.70% U

Direct Labor 14,235 15,000 765 F 5.10% F

Indirect Labor 29,275 26,000 3,275 U 12.59% U

Utilities 13,170 12,000 1,170 U 9.75% U

Depreciation 15,500 15,500 0 0

Repairs and Maintenance 6,315 7,500 1,825 F 15 .80 % F

Total $105,420 $100,000 $5,420 U 5 .42 % U

Req. 2This subunit is a cost center.

Req. 3Indirect labor

Repairs and maintenance

Req. 4No, favorable variances should be investigated to make sure they are not hurting the business in the long run.



(15 min.) E 10-36B

Performance Report

Northern Division - Sales Revenue for Wendell Chemical Corporation


(Dollars in millions)

Segment Actual Sales Budgeted Sales Variance Variance

%

Plastics $ 14,872 $

14,300 $

572 4.0%Chemicals and Energy $ 4,116

$ 4,200

$ (84) -2.0%

Hydrocarbons $ 7,420 $

7,000 $

420 6.0%

Coatings $ 10,580 $

11,500 $

(920) -8.0%

Health Sciences $ 9,570 $

8,700 $

870 10.0%

(15 min.) E 10-37B

Performance Report

Noble Industries - Pharmaceutical Segment

For Fiscal Year Ending December 31

(all data is in millions)

Actual Budgeted VarianceVariance

%

Sales $ 1,248,000 $ 1,200,000 $ 48,000 4.00%

Less Variable Expenses:

Variable Cost of Goods Sold $ 652,800

$ 640,000 $ 12,800 2.00%

Variable Operating Expenses $ 225,600

$ 240,000 $ (14,400) -6.00%

Contribution Margin $ 369,600

$ 320,000 $ 49,600 15.50%

Less Direct Fixed Expenses: Fixed Manufacturing Overhead

$ 156,600

$ 145,000 $ 11,600 8.00%

Fixed Operating Expenses $ 26,250

$ 25,000

$ 1,250 5.00%

Segment Margin $ 186,750

$ 150,000

$ 36,750 24.50%

Less Common Fixed Expenses $ 15,450

$ 15,000

$ 450 3.00%

Operating Income $ 171,300

$ 135,000 $ 36,300 26.89%



(10-15 min.) E 10-38B


Operating income $ 58,800 $152,000÷ Total assets ÷$210,000 ÷$380,000Return on investment 28% 40%

Each division’s ROI is very high; however, the Professional Division has an even higher ROI (46%) than the Residential Division.


Operating income $ 58,800 $152,000÷ Sales ÷$420,000 ÷$608,000 Sales margin 14% 25%

The Professional Division is earning about $0.25 on each dollar of sales whereas the Residential Division is only earning about $0.14 on each dollar of sales. The Professional Division’s higher sales margin helps to account for its higher ROI.


Sales $420,000 $608,000÷ Total assets ÷$210,000 ÷$ 380,000 Capital turnover 2.00 times 1.60 times

The Professional Division is generating $1.60 of sales for every dollar of assets invested in the division. The Residential Division is generating $2.00 of sales for every dollar of assets invested. The Residential Division is even more efficient.


Sales margin 14% 25%× Capital turnover ×2.00 ×1.60ROI 28% 40%

Does your answer for the residential ROI agree with the basic ROI? YesDoes your answer for the professional ROI agree with the basic ROI? YesWhat can you conclude?

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

Req. 5RI = Operating Income − Minimum acceptable income

= Operating Income − (Target rate of return × Total assets)

Residential RI = $58,800 − ($210,000 × 25%) = $17,550Professional RI = $152,000 − ($380,000 × 25%) = $54,300



Both divisions are exceeding management’s expectations.

(10 min.) E 10-39B

Abercrombie Company

Benson Industries

Cappela Inc.

Sales (S) $114,000 $780,000 $484,000

Operating income (OI) $39,900 $117,000 $48,400

Total assets (TA) $71,250 $150,000 $220,000

Sales margin (SM) 35% 15% 10%

Capital turnover (CT) 1.60 5.20 2.2.0

Return on investment (ROI) 56% 78% 22%

Target rate of return 10% 22% 20%

Residual income (RI) $32,775 $84,000 $4,400

(10 min.) E 10-40B

Req. 1

Sales Margin = Operating income ÷ SalesSales Margin = $8,800 ÷ $35,200

= 25%

Capital Turnover = Sales ÷ Total AssetsCapital Turnover = $35,200 ÷ $16,000

= 2.20 times

ROI = Operating income ÷ Total AssetsROI = $8,800 ÷ $16,000

= 55%

Req. 2

RI = Operating Income − (Target rate of return × Total assets)



RI = $8,800 − (14% x $16,000) = $6,560

(10-15 min.) E 10-41B

Req. 1The original return on investment (ROI) for the McKnight Ceramics division before the additional investment is 15%.

Req. 2If this investment opportunity were undertaken the ROI would be 14.5%.

If the manager of this division is evaluated based on ROI she would not want to make this investment. Investing in the new project would decrease the division’s ROI.

Req. 3The ROI of the investment opportunity is 13%.

From the standpoint of Piper Corporation this investment is desirable. The ROI of the investment opportunity is more than Piper’s required rate of return .

Req. 4The residual income (RI) for McKnight Ceramics if this investment opportunity were to be undertaken is $30,800.

If the manager of this division is evaluated based on RI she would want to make this investment. The positive RI indicates that the division is earning more than management’s expectations.

Req. 5The RI of the investment opportunity is $5,600.

From the standpoint of Piper Corporation this investment is desirable. The RI of the investment opportunity is positive, meaning the investment opportunity would earn more than management’s target required return.

Req. 6Of the two performance measurement methods, ROI and RI, RI is more likely to promotes goal congruence. The RI of the investment alone is positive, meaning the investment will increase the division’s RI by that amount. This would motivate both the division manager and the company management not to make the investment. The arrival at the same conclusion by both the manager and company management indicates goal congruence.

(10 min.) E 10-42B

Req. 1Lowest – Variable cost of $26 ($22 + $4.) Highest – Market price of $49

Req. 2 ($22 + $4 + $2) x 20% = $5.60; Transfer price = $22 + $4 + $2 + $5.60 = $33.60

Req. 3Market price; $49



(15 - 20 min.) E 10-43B



(15-20 min.) E 10-44B

Req. 1Gutierrez-Subunit

X

Revenue by Product Actual

Flexible

Budget

Variance Flexible BudgetSales Volume

Variance

Static

(Master)

Budget

Downhill—

Model RI $ 321,000 $ 6,000 (F) $ 315,000 $17,000 (F) $ 298,000

Downhill—

Model RII 158,000 10,000 (U) 168,000 18,000 (F) 150,000

Cross-Country—

Model EXI 289,000 1,000 (U) 290,000 17,000 (U) 307,000

Cross-Country—

Model EXII 254,000 6,000 (F) 248,000 19,500 (U) 267,500

Snowboard—

Model LXI 423,000 7,000 (F) 416,000 18,000 (F) 398,000

Total $1,445,000 $ 8,000 (F) $1,437,000 $16,500 (F) $1,420,500

Req. 2This subunit is a revenue center.

Req. 3Using the flexible budget variance as a guide, the following items will be investigated:

None of the items should be investigated.

Using the sales volume variance as a guide, the following items will be investigated:

Cross-Country Model EXI Cross-Country Model EXII Downhill Model R1 Downhill Model RII Snowboard Model LXI



(continued) E 10-44B

Interpret your results.

The sales volume variance is always due strictly to volume — therefore, the number of units sold was different than budgeted for every model. The company sales mix appears to be shifting in the direction of downhill ski and snowboard sports. This could result in a buildup of cross-country ski inventory.

Management may need to do a better job marketing their cross-country skis. Additionally, the company may end up with delivery delays for downhill sports equipment if production schedules are not revised to accommodate the increasing demand for downhill skis and snowboards.

(15 - 20 min.) E 10-45B

a. Flexible budget varianceb. Volume variancec. 27,000 units d. $248,000 e. $166,050f. $5,000 favorableg. $71,440

(10 min.) E 10-46B

Lag indicators are performance measures that tend to reveal the results of past actions. They come after decisions and actions taken in the past. Lead indicators are performance measures that tend to indicate future performance. They come before and drive future performance.

Financial measures tend to be lag indicators. The financial results of a period are driven by actions taken in the past. For example, iTunes revenue for the second quarter is a result of management’s earlier decisions to feature certain new releases and artists in their weekly emails to subscribers.

Operational measures tend to be lead indicators. Current customer satisfaction ratings, number of active subscribers and customer error rates predict how well the company will do in the future. For example, iTunes’s customers’ satisfaction can predict whether future sales will increase (if customers are satisfied) or decline (if customers are not satisfied).



(15 - 20 min.) E 10-47B

(10 - 15 min.) E 10-48B

a. Customer perspectiveb. Internal business perspectivec. Internal business perspectived. Learning and growth perspectivee. Internal business perspectivef. Financial perspectiveg. Internal business perspectiveh. Financial perspectivei. Internal business perspectivej. Customer perspectivek. Learning and growth perspectivel. Financial perspective



(15 - 20 min.) E 10-49B

a. Communityb. Internal businessc. Learning and growthd. Internal businesse. Financialf. Financialg. Internal businessh. Financiali. Communityj. Customerk. Communityl. Internal businessm. Learning and growthn. Learning and growtho. Customerp. Customerq. Internal businessr. Customer

Problems (Group A)

(15 - 20 min.) P 10-50A

Req. 1

Racer–Subunit X ActualFlexible Budget

Flexible Budget Percent

Variance Variance*

(U or F)

Sales $430,000 $400,000 $30,000 F 7.50% F

Cost of goods sold 325,000 312,500 12,500 U 4.00% U

Gross margin 105,000 87,500 17,500 F 20.00% F

Operating expenses 38,850 37,500 1,350 U 3.60% U

Operating income before service department charges 66,150 50,000 16,150 F 32.30% F

Service department charges (allocated) 37,500 25,000 12,500 U 50.00% U

Operating income $28,650 $25,000 $3,650 F 14.60% F

*flexible budget variance ÷ flexible budget

(15 - 20 min.) P 10-50A



(continued) P 10-50A

Req. 2This performance report includes both revenue and cost data; therefore, this subunit must be a profit center.

Req. 3Service department costs

Req. 4 Managers should investigate favorable as well as unfavorable variances. Favorable variances may be due to bookkeeping or budgeting errors. Management needs to evaluate large favorable as well as unfavorable variances to determine the root cause of the variance.

Req. 5 The flexible budget variances are not due to sales volume differences between budget and actual. Differences in sales volume are captured by the sales volume variance, not the flexible budget. The flexible budget variance is due to something other than sales volume.

Req. 6 Management will not place much weight on the cost of goods sold variance because it does not exceed 10%. Additionally, they may not place much weight on the service department charges because this is not a direct cost of the subunit.

Req. 7 This performance report addresses the financial perspective of the balanced scorecard. Financial performance measures tend to be lag indicators. They typically measure the results of past decisions.

Req. 8Customer perspective—customer satisfaction ratings Internal business perspective—number of new products developedLearning and Growth perspective—hours spent training employees

Each one of these performance measures is a lead indicator which tend to project future performance. The performance indicators listed above are often better at projecting future performance than past financial data.



(20 - 25 min.) P 10-51A

Req. 1

Great Bubbles, Inc.

Flexible Budget Income Statement

Month Ended March 31

Flexible Budget per Output Unit Output Units (Kits)

65,000 70,000 75,000

Sales revenue

$2.90 $188,500 $203,000 $217,500

Variable expenses:

Cost of goods sold 1.25 81,250 87,500 93,750

Sales commissions 0.30 19,500 21,000 22,500

Utilities expense 0.05 3,250 3,500 3,750

Fixed expenses:

Salary expense 30,000 30,000 33,000

Depreciation expense 20,000 20,000 23,000

Rent expense 8,000 8,000 12,000

Utilities expense 6,000 6,000 6,000

Total expenses 168,000 176,000 194,000

Operating income $ 20,500 $ 27,000 $ 23,500




Req. 2

Req. 3The advantage of the graph in the previous step is that Great Bubbles’ managers can look at the graph to estimate total expenses at any output level up to 75,000 bubble kits, not just the three levels shown in the columnar format in the first step. The disadvantage of the graph is that looking at the graph provides only an estimate of the budgeted cost.



(15 - 20 min.) P 10-52A

Req. 1

Great Bubbles, Inc.

Income Statement Performance Report


Actual Results at Actual

Prices

Flexible Budget

Variance

Flexible Budget for Actual Number of

Output Units

Sales Volume Variance

Static (Master) Budget

Output units (kits) 70,000 -0- 70,000 5,000 F 65,000

Sales revenue $208,000 $5,000 F $203,000 $14,500 F $188,500

Variable expenses:

Cost of goods sold

88,000 500U 87,500 6,250U 81,250

Sales commissions expense

24,000 3,000U 21,000 1,500U 19,500

Utilities expense 3,500 0 3,500 1,500U 3,250

Fixed expenses:

Salary expense 32,300 2,300U 30,000 0 30,000

Depreciation expense

20,000 0 20,000 0 20,000

Rent expense 7,000 1,000F 8,000 0 8,000

Utilities expense 6,000 0 6,000 0 6,000

Total expenses

180,800 4,800 U 176,000 8,000 U 168,000

Operating income $ 27,200 $200 F $ 27,000 $ 6,500 F $ 20,500

Req. 2The favorable sales volume variance for operating income is much larger than the favorable flexible budget variance. Most of the difference between master budget operating income and actual operating income resulted from selling 5,000 more bubble kits than expected.



(15 - 20 min.) P 10-53A

Req. 3Great Bubbles’ static target budget variance is $6,700 favorable, meaning that its operating income is higher than expected per the static budget.

A favorable sales volume variance reveals whether profits increased due to more units being sold.A favorable sales revenue flexible budget variance means the sale price was higher.

(15 - 20 min.) P 10-53A

Req. 1

Paint Stores ConsumerOperating income $ 507,000 $ 175,000÷ Total assets ÷$1,500,000 ÷$1,562,500 Return on investment 33.8% 11.2%

Req. 2

Paint Stores ConsumerOperating income $ 507,000 $ 175,000÷ Sales ÷$3,900,000 ÷$1,250,000 Sales margin 13% 14%

The Consumer Division is more profitable on each dollar of sales.

Req. 3

Paint Stores ConsumerSales $3,900,000 $1,250,000÷ Total assets ÷$1,500,000 ÷$1,562,500Capital turnover 2.6 times 0.8 times

The Paint Stores Division is more efficient in generating sales with its assets.

Req. 4

Paint Stores ConsumerSales margin 13% 14%× Capital turnover ×2 .6 ×0 .8 ROI 33 .8% 11 .2%

The Consumer Division’s profitability on each dollar of sales is higher than the Paint Stores Divisions’ profitability. However, the Paint Stores Division’s efficiency is significantly higher than the Consumer Division’s efficiency. These results cause the Paint Stores Division’s ROI to be higher than the Consumer Division’s ROI.

Req. 5RI = Operating income − Minimum acceptable income

= Operating income − (Target rate of return × Total assets)

Paint Stores RI = $507,000 − ($1,500,000 × 18%) = $237,000Consumer RI = $175,000 − ($1,562,500 × 18%) = $(106,250)




Only the Paint Stores Division is meeting management’s target rate of return. The Consumer Division should work on improving its capital turnover rate. Improving the capital turnover rate may help the division achieve positive residual income.

Req. 6Most companies use the average asset balance since the income used in the ROI calculation is earned over the course of the entire year.

Management must also decide whether they wish to use the gross book value of assets or the net book value of assets. The net book value is often used since the figure is easily pulled straight from the balance sheet. However, ROI using that value will artificially rise over time due to depreciation.

Req. 7Risk level of the division’s businessInterest rates on company debtInvestors’ expectationsCompetitors’ rate of returnReturn being earned by other divisionsGeneral economic conditions

Req. 8RI does a better job of goal congruence.

Req. 9Investment centers are responsible for both generating profit and efficiently managing the division’s assets. Budget versus actual performance reports are insufficient because they do not measure how efficiently the division uses its assets.

(15 - 20 min.) P 10-54A

Req. 1

(Millions of dollars) Net Revenue Operating Profit Total AssetsHome furnishings

$11,250 $3,150 $7,500Office furniture

9,000 1,710 7,500Store displays

12,500 1,500 15,625Health care furnishings

2,250 765 1,250

Req. 2

(Millions of dollars) Operating Profit Net Revenue Sales MarginHome furnishings

$3,150 $11,250 28.00%Office furniture

1,710 9,000 19.00%Store displays

1,500 12,500 12.00%Health care furnishings

765 2,250 34.00%




The Store Displays Division of QuickCo has a much lower sales margin than the other divisions. Store Displays is only earning $0.12 on every $1 of sales, whereas the other divisions range from $0.19 to $0.34 on every dollar of sales. Health-care Furnishings has the highest sales margin.

Req. 3

(Millions of dollars) Net Revenue Total Assets Capital TurnoverHome furnishings

$11,250 $7,500 1.5Office furniture

9,000 7,500 1.2Store displays

12,500 15,625 0.8Health care furnishings

2,250 1,250 1.8

The divisions have very different capital turnover rates. This means that the divisions vary greatly in their ability to generate sales revenue from their assets. Health-care furnishings has the highest capital turnover while Store Displays has the lowest capital turnover.

Req. 4

(Millions of dollars) Operating Profit Total Assets ROIHome furnishings




765 1,250 61.20%

Home furnishings and Health-care furnishings have the highest ROI. Both of these divisions had the highest sales margins which is a factor as to why they have the highest ROI. Store Displays had the lowest ROI, in part driven by the fact that it had the lowest sales margin of the four divisions.

Req. 5Financial reporting is for the benefit of external users, not internal management. Therefore, not all company information is disclosed in the financial statements. Residual income (RI) calculations involve management’s target rate of return. Since this information is not presented, residual income cannot be calculated by an external user without making an assumption about the rate.



Problems (Group B)

(15 - 20 min.) P 10-55B

Req. 1

Speed–Subunit X ActualFlexible Budget

Flexible Budget Percent

Variance Variance*

(U or F)

Sales $490,500 $450,000 $40,500 F 9% F

Cost of goods sold 261,500 250,000 11,500 U 4.6% U

Gross margin 229,000 200,000 29,000 F 14.5% F

Operating expenses 83,440 80,000 3,440 U 4.3% U

Operating income before service department charges 145,560 120,000 25,560 F 21.3% F

Service department charges (allocated) 57,500 46,000 11,500 U 25% U

Operating income $88,060 $74,000 $14,060 F 19% F

*flexible budget variance ÷ flexible budget

Req. 2This performance report includes both revenue and cost data; therefore, this subunit must be a profit center.

Req. 3Service department costs

Req. 4 Managers should investigate favorable as well as unfavorable variances. Favorable variances may be due to bookkeeping or budgeting errors. Management needs to evaluate large favorable as well as unfavorable variances to determine the root cause of the variance.

Req. 5 The flexible budget variances are not due to differences in sales volume between budget and actual. Differences in sales volume are captured by the sales volume variance, not the flexible budget. The flexible budget variance is due to something other than sales volume.

Req. 6 Management will not place much weight on the cost of goods sold variance because it does not exceed 10%. Additionally, they may not place much weight on the service department charges because this is not a direct cost of the subunit.



(continued) P 10-55B

Req. 7 This performance report addresses the financial perspective of the balanced scorecard. Financial performance measures tend to be lag indicators. They typically measure the results of past decisions.

Req. 8Customer perspective—customer satisfaction ratings Internal business perspective—number of new products developedLearning and Growth perspective—hours spent training employees

Each one of these performance measures is a lead indicator which tends to project future performance. The performance indicators listed above are often better at projecting future performance than past financial data.

(20 - 25 min.) P 10-56B

Req. 1

Everlasting Bubbles, Inc.

Flexible Budget Income Statement

Month Ended January 31

Flexible Budget per Output Unit Output Units (Kits)

55,000 60,000 55,000

Sales revenue

$3.10 $170,500 $186,000 $201,500

Variable expenses:

Cost of goods sold 1.25 68,750 75,000 81,250

Sales commissions 0.25 13,750 15,000 16,250

Utilities expense 0.10 5,500 6,000 16,5001,250

Fixed expenses:

Salary expense 30,000 30,000 33,000

Depreciation expense 1820000 20,000 23,000

Rent expense 15,000 15,000 19,000

Utilities expense 7,000 7,000 7,000

Total expenses 160,000 168,000 186,000

Operating income $ 10,500 $ 18,000 $ 15,500




Req. 2

Req. 3The advantage of the graph in the previous step is that Everlasting Bubbles’ managers can look at the graph to estimate total expenses at any output level up to 65,000 bubble kits, not just the three levels shown in the columnar format in the first step. The disadvantage of the graph is that looking at the graph provides only an estimate of the budgeted cost.



(15 - 20 min.) P 10-57B

Req. 1

Req. 2The favorable sales volume variance for operating income is much larger than the favorable flexible budget variance. Most of the difference between master budget operating income and actual operating income resulted from selling 5,000 more bubble kits than expected.

Req. 3Everlasting Bubbles’ static budget variance is $7,800 favorable, meaning that its operating income is higher than expected per the static budget.

A favorable sales volume variance reveals whether profits increased due to more units being sold.

A favorable sales revenue flexible budget variance means the sale price was higher.



P 10-58B

Req. 1

Paint Stores ConsumerOperating income $ 480,000 $ 150,000÷ Total assets ÷$1,500,000 ÷$1,250,000 Return on investment 32.00% 12.00%

Req. 2

Paint Stores ConsumerOperating income $ 480,000 $ 150,000÷ Sales ÷$3,750,000 ÷$1,000,000 Sales margin 12.8% 15%

The Consumer Division is more profitable on each dollar of sales.

Req. 3

Paint Stores ConsumerSales $3,750,000 $1,000,000÷ Total assets ÷$1,500,000 ÷$1,250,000Capital turnover 2.5 times 0.80 times

The Paint Stores Division is more efficient in generating sales with its assets.

Req. 4

Paint Stores ConsumerSales margin 12.8% 15.00%× Capital turnover ×2 .5 ×0 .80 ROI 32 .00% 12 .00%

The Consumer Division’s profitability on each dollar of sales is higher than the Paint Stores Division’s profitability. However, the Paint Stores Division’s efficiency is significantly higher than the Consumer Division’s efficiency. These results cause the Paint Stores Division’s ROI to be higher than the Consumer Division’s ROI.

Req. 5RI = Operating income − Minimum acceptable income

= Operating income − (Target rate of return × Total assets)

Paint Stores RI = $480,000 − ($1,500,000 × 20%) = $180,000Consumer RI = $150,000 − ($1,250,000 × 20%) = $(100,000)

Only the Paint Stores Division is meeting management’s target rate of return. The Consumer Division should work on improving its capital turnover rate. Improving the capital turnover rate may help the division achieve positive residual income.




Req. 6Most companies use the average asset balance since the income used in the ROI calculation is earned over the course of the entire year.

Management must also decide whether they wish to use the gross book value of assets or the net book value of assets. The net book value is often used because it is easily pulled straight from the balance sheet. However, ROI calculated using the net book value of assets may artificially rise over time simply due to depreciation.

Req. 7Risk level of the division’s businessInterest rates on company debtInvestors’ expectationsCompetitors’ rate of returnReturn being earned by other divisionsGeneral economic conditions

Req. 8RI does a better job of goal congruence.

Req. 9Investment centers are responsible for both generating profit and efficiently managing the division’s assets. Budget versus actual performance reports are insufficient because they do not measure how efficiently the division uses its assets.

(15 - 20 min.) P 10-59B

Req. 1

(Millions of dollars) Net Revenue Operating Profit Total AssetsHome furnishings

$11,000 $2,530 $6,875Office furniture

9,100 1,820 6,500Store displays

12,100 1,210 11,000Health care furnishings

1,500 495 625




Req. 2

(Millions of dollars) Operating Profit Net Revenue Sales MarginHome furnishings




495 1,500 33.00%

The Store Displays Division of Stride Inc. has a much lower sales margin than the other divisions. They are only earning $0.10 on every $1 of sales, whereas the other divisions range from $0.20 to $0.33 on every dollar of sales. Health Care Furnishings has the highest sales margin.

Req. 3

(Millions of dollars) Net Revenue Total Assets Capital TurnoverHome furnishings

$11,000 $6,875 1.6Office furniture

9,100 6,500 1.4Store displays

12,100 11,000 1.1Health care furnishings

1,500 625 2.4

The divisions have very different capital turnover rates. This means that the divisions vary greatly in their ability to generate sales revenue from their assets. Health-care furnishings has the highest capital turnover while Store Displays has the lowest capital turnover.

Req. 4

(Millions of dollars) Operating Profit Total Assets ROIHome furnishings


1,820 6,500 28%Store displays

1,210 11,000 11%Health care furnishings

495 625 79.2%

Home furnishings and Health-care furnishings have the highest ROI. Both of these divisions had the highest sales margins and capital turnover rates which accounts for their high ROI. Store Displays had the lowest ROI, in part driven by the fact that it had the lowest sales margin of the four divisions.




Req. 5 Financial reporting is for the benefit of external users, not internal management. Therefore, not all company information is disclosed in the financial statements. Residual income (RI) calculations involve management’s target rate of return. Since this information is not presented, residual income cannot be calculated by an external user without making an assumption about the rate.

EVA calculations involve the WACC, divisional current liabilities, and the effective income tax rate. This information is not presented on a divisional basis, so divisional EVA cannot be calculated by an external user without making several assumptions.

Discussion & Analysis(30-45 min.) A 10-60

1. Describe at least four advantages of decentralization. Also describe at least two disadvantages to decentralization.

Decentralization provides many potential benefits. It frees top management time. By delegating responsibility for daily operations to segment managers, top management can concentrate on long-term strategic planning and higher-level decisions that affect the entire company. Decentralization encourages the use of expert knowledge by allowing top management to hire the expertise each business segment needs to excel in its specific operations. Specialized knowledge often helps segment managers make better decisions than the top company managers could make. Segment managers can focus on just one segment of the company, allowing them to maintain close contact with important customers and suppliers. Thus, decentralization often leads to improved customer and supplier relations, which can result in quicker customer response times. Decentralization also provides segment managers with training and experience necessary to become effective top managers. Companies often groom their lower-level managers to move up through the company, taking on additional responsibility and gaining more knowledge of the company with each step. Finally, empowering segment managers to make decisions increases managers’ motivation and job satisfaction, which often improves job performance and retention.

Decentralization may also cause potential problems. Decentralization may cause a company to duplicate certain costs or assets. Also, decentralized companies often struggle to achieve goal congruence. Segment managers may not fully understand the big picture, or the ultimate goals that upper management is trying to achieve. They may make decisions that are good for their segment but may be detrimental to another segment of the company or the company as a whole.

2. Compare and contrast a cost center, a revenue center, a profit center, and an investment center. List a specific example of each type of responsibility center. How is the performance of managers evaluated in each type of responsibility center?

In a cost center, managers are accountable for costs only. Manufacturing operations, such as the Campbell’s Chicken Noodle Soup manufacturing plant, are cost centers. The plant manager controls costs by ensuring that the entire production process runs efficiently. The plant manager is not responsible for generating revenues because he or she is not involved in selling the product. The plant manager is evaluated on his or her ability to control costs by comparing actual costs to budgeted costs. In a revenue center, managers are accountable primarily for revenues. Many times, revenue centers are sales territories, such as Campbell’s Soups Midwest and Southeast sales regions. Managers of revenue centers may also be responsible for the costs of their own sales operations. Revenue center performance reports compare actual revenues to budgeted revenues. In a profit center, managers are accountable for both revenues and costs and, therefore, profits. For example, at Campbell’s, a manager is responsible for the entire line of Campbell’s ready- to- serve and condensed soup products. This manager is accountable for increasing sales revenue and controlling costs to achieve profit goals for the entire line of soups. Superiors evaluate the manager’s performance by comparing actual revenues, expenses, and profits to the budget.



(continued) A 10-60

In an investment center, managers are responsible for: generating revenues, controlling costs, and efficiently managing the division’s assets. Investment centers are generally large divisions of a corporation. Investment centers are treated almost as if they were stand-alone companies. Division managers generally have broad responsibility, including deciding how to use assets. As a result, managers are held responsible for generating as much profit as they can with those assets.

3. Explain the potential problem which could arise from using ROI as the incentive measure for managers. What are some specific actions a company might take to resolve this potential problem?

One serious drawback of ROI is the short-term focus of this measure. Companies usually prepare performance reports and calculate ROI using a time frame of one year or less. If upper management uses a short time frame, division managers have an incentive to take actions that will lead to an immediate increase in these measures, even if such actions may not be in the company’s long-term interest. On the other hand, many potentially positive actions may take longer than one year to generate income at the targeted level. Many product life cycles start slow, even incurring losses in the early stages, before generating profit. As a potential remedy, management can measure financial performance using a longer time horizon, such as three to five years. Extending the time frame gives segment managers the incentive to think long term rather than short term and make decisions that will positively impact the company over the next several years.

4. Describe at least two specific actions that a company could take to improve its ROI.

The ROI formula can be expanded to sales margin multiplied by capital turnover. By improving either of these ratios, the ROI will be improved. The sales margin can be improved by increasing the amount of operating income earned on every dollar of revenue. This can be achieved by cutting costs. Reducing or eliminating nonproductive assets can improve the capital turnover ratio. There are many specifics actions that may be used to achieve these objectives; therefore, student answers will vary.

5. Define residual income. How is it calculated? Describe the major weakness of residual income.

Residual income determines whether operations have created any excess income above and beyond management’s expectations. Residual income is calculated as: Operating Income – Minimum acceptable income, or Operating Income – (Target rate of return x Total assets).

6. Compare and contrast a master budget and a flexible budget.

A master budget is prepared before the beginning of the period. The master budget does not change with the actual volume of production. A flexible budget can be prepared for a different volume that was originally anticipated in the master budget.

7. Describe two ways managers can use flexible budgets.

Student answers will vary.

8. Define key performance indicator (KPI). What is the relationship between KPIs and a company’s objectives? Select a company of any size with which you are familiar. List at least four examples of specific objectives that company might have and one potential KPI for each of those specific objectives.

A key performance indicator (KPI) is a summary performance measure to assess how well a company is achieving its goals. The KPI is a measurement used by managers to determine is the company is achieving its objectives. Student answers for a specific company will vary.



(continued) A 10-60

9. List and describe the four perspectives found on a balanced scorecard. For each perspective, list at least two examples of KPIs which might be used to measure performance on that perspective.

The financial perspective helps managers answer the question, “How do we look to shareholders?” Shareholders are primarily concerned with the company’s profitability. Managers must continually attempt to increase profits through: increasing revenue, controlling costs, or increasing productivity. The customer perspective helps managers evaluate the question, “How do customers see us?” Customer satisfaction is a top priority for long-term success. If customers aren’t happy, they won’t come back. Therefore, customer satisfaction is critical for the company to achieve its financial goals.

Customers are typically concerned with four product or service attributes: price, quality, sales service, and delivery time. The internal business perspective helps managers address the question, “At what business processes must we excel to satisfy customer and financial objectives?” In other words, a company needs to tend to its internal operations if it is to please customers. And only by pleasing customers will it achieve its financial goals. Answer to that question incorporates three factors: innovation, operations, and post-sales support. The learning and growth perspective helps managers assess the question, “Can we continue to improve and create value?” Much of a company’s success boils down to its people. A company cannot be successful in the other perspectives (financial, customer, internal operations) if it does not have the right people in the right positions, a solid and ethical leadership team, and the information systems that employees need. Therefore, the learning and growth perspective lays the foundation needed for success in the other perspectives. The learning and growth perspective focuses on three factors: employee capabilities, information system capabilities, and the company’s “climate for action.”

10. Contrast lag indicators with lead indicators. Provide an example of each type of indicator.

Lag indicators reveal the results of past decisions. Financial performance measures such as ROI or RI, are lag indicators because they convey trends based on historical information. Lead indicators are performance measures that predict future performance.

11. Some companies integrate sustainability measures into the traditional four perspectives in their balanced scorecards. Other companies create a new perspective (or two) for sustainability. Which method do you think would result in better supporting sustainability efforts throughout the organization? Explain your viewpoint.


12. Find an annual report for a publicly held company (go to the company’s website and look for “Investor Relations” or a similar link.) How many sustainability initiatives can you find in the annual report? What internal balanced scorecard measures do you think they might use to measure progress on each sustainability initiative? (You will have to use your imagination, since typically most balanced scorecard measures are not publicly disclosed.)


(30-45 min.) A 10-61

Basic Discussion Questions

1. Locate the company’s annual report as outlined previously. Find the company’s segment information; it should be in the “Notes to Consolidated Financial Statements” or other similarly named section. Look for the word “Segment” in a heading—that is usually the section you need.

To create this SAMPLE set of solutions for this question, Starbucks Corporation was used.

Student answers will vary, depending upon the company chosen and the year used.

Starbucks Corporation has three reportable operating segments: United States, International, and Global CPG (Consumer Products Group).



2. List the segments as reported in the annual report. Make a table listing each operating segment, its revenues, income, and assets.

(in millions)

Segment Revenues Income Assets

US $7,882.0 $528.01 $2,362.9

International 2,103.4 110.0 1,272.7

Global CPG 392.6 205.3 116.0

3. Use the data you collected in Requirement 2 to calculate each segment’s sales margin. Interpret your results.

Sales margin = Operating income/SalesUS: $528.01/$7,882.0 = 6.7%International: $110.1/$2,103.4 = 5.2%Global CPG: $205.3/$392.6 = 52.3%

The CPG segment has the highest sales margin of the three segments at 52.3%. For every dollar of sales, the US segment earned $0.67 and the International segment earned $0.52.

4. Use the data you collected in Question 2 to calculate each segment’s capital turnover. Interpret your results.

Capital turnover = Sales/Total assetsUS: $7,882.0/$2,362.9 = 3.3International: $2,103.4/$1,272.7 = 1.7Global CPG: $392.6/$116.0 = 3.4

The capital turnover for the CPG and US segments are almost the same. The CPG segment generated $3.40 of sales for every $1 of assets and the US generated $3.30. The International segment only generated $1.70 of sales for every $1 of assets. The US and CPG segments use its assets more efficiently than the International segment.

5. Use the data you collected in Requirement 2 to calculate each segment’s ROI. Interpret your results.

ROI = Operating income/Total assetsUS: $528.01/$2,362.9 = 22.3%International: $110.0/$1,272.7 = 8.6%CPG: $205.3/$116.0 = 177.0%

The CPG segment has a very high ROI in comparison to the other two segments. This is due to its having the highest sales margin of the three segments.



(continued) A 10-61

6. Can you calculate RI using the data presented? Why or why not?

RI cannot be calculated for Starbucks because the target rate of return and WACC is not known.

7. The rules for how segments should be presented in the annual report are governed by external financial accounting rules. The information you gathered for the previous requirements would be used by investors and other external stakeholders in their analysis of the company and its stock. Internally, the company most likely has many segments. Based on what you know about the company and its products or services, list at least five potential segments that the company might use for internal reporting. Explain why this way of segmenting the company for internal reporting could be useful to managers.

Five potential segments for internal reporting for Starbucks are:

1. Regional territories

2. Product lines

3. Brand lines

4. Customer base

5. Business function

(30-45 min.) A 10-62

Req. 1The two product segments are: 1) Oral, Personal and Home Care, and 2) Pet Nutrition.

(Millions of dollars) Operating Profit Net Sales Identifiable AssetsOral, Personal and Home Care $3,062.6 $13,182.4 $8,870.5Pet Nutrition 541.8 2,147.5 1,025.1

Req. 2ROI calculation:

(Millions of dollars) Operating Profit Identifiable Assets ROIOral, Personal and Home Care $3,062.6 $8,870.5 34.53%Pet Nutrition 541.8 1,025.1 52.85%

Req. 3The Pet Nutrition Division has a much higher ROI than the Oral, Personal and Home Care Division. The expanded ROI formula may offer some clues as to why this is the case. Sales margin and capital turnover are calculated below:



(continued) A 10-62

Sales Margin calculation:

(Millions of dollars) Operating Profit Net Sales Sales MarginOral, Personal and Home Care $3,062.6 $13,182.4 23.23%Pet Nutrition 541.8 2,147.5 25.23%

Capital Turnover calculation:

(Millions of dollars) Net SalesIdentifiable

AssetsCapital

TurnoverOral, Personal and Home Care $13,182.4 $8,870.5 1.49Pet Nutrition 2,147.5 1,025.1 2.09

The primary reason Pet Nutrition has a higher ROI is that it has a much higher capital turnover. The Pet Nutrition Division has been able to generate $2.09 of sales on each dollar of its assets, whereas the Oral, Personal and Home Care Division has only been able to generate $1.49 of sales on each dollar of its assets. Additionally, the Pet Nutrition Division is earning about two cents more of income on every dollar of sales (25.23% vs. 23.23%). Both factors combined give the Pet Nutrition Division an extremely high ROI.

Req. 4The management team would most likely choose to allocate additional funds to the Pet Nutrition Division. The Pet Nutrition Division is earning about $0.53 on every dollar invested whereas the Oral, Personal and Home Care division is only earning about $0.35 on every dollar invested. The Pet Nutrition Division is yielding over 50% more return than the other division.



(30-45 min.) A 10-63

Req. 1

Roland Films, Inc.

Income Statement Performance Report


Actual Results at Actual Prices

Flexible Budget

Variance

Flexible Budget for

Actual Number of Output

Units

Sales Volume Variance

Static (Master) Budget

Output units (DVD movies)

82,000 a -0- 82,000 a 16,000 U 98,000 b

Sales revenue $1,640,000 $ 0 $1,640,000 $320,000 U $1,960,000

Variable expenses:

Cost of goods sold

773,750 46,250F 820,000 160,000F 980,000

Sales commissions

77,375 12,825F 90,200 17,600F 107,800

Shipping expense 42,850 2,250F 45,100 8,800F 53,900

Fixed expenses:

Salary expense 311,450 10,950U 300,500 0 300,500

Depreciation expense

208,750 5,250F 214,000 0 214,000

Rent expense 128,250 20,000U 108,250 0 108,250

Advertising expense

81,100 12,600 U 68,500 0 68,500

Total expenses 1,623,525 23,025 F 1,646,550 186,400 F 1,832,950

Operating income $ 16,475 $23,025 F $ (6,550 $133,600 U $ 127,050

__________

a Actual number of movies = $1,640,000 / $20 = 82,000 b Static budget number of movies = $1,960,000 / $20 = 98,000c

Variable expenses =Static budget amounts

× 82,000 actual movies98,000 movies



(continued) A 10-63

Req. 2The large unfavorable sales volume variance certainly requires investigation. The roughly 16% (16,000/98,000 = 0.163) shortfall in sales volume led to a $133,600U sales volume variance for operating income. Thus, the primary reason for the disappointing income is lower than expected sales volume, not rising costs.

Managers will also want to investigate all significant flexible budget variances. For example, a “5% variance from standard” investigation rule would suggest investigating the favorable sales commission variance and the unfavorable advertising and rent expense variances. Considering the poor sales volume, both the sales commission and advertising variances are of concern. Sales staff will not be very motivated if their commissions are below budget. The large unfavorable flexible budget variance for advertising may reflect higher advertising costs in an effort to stimulate sales but, if so, the ad campaign does not appear to have been successful. Management may also want to investigate the favorable cost of goods sold variance. It is just over 5% ($46,250 / $820,000 = 0.0564) and it is a relatively large dollar amount. Hopefully, Roland Films did not try to save money by skimping on the quality of the DVDs and perhaps exacerbating the unfavorable sales volume variance.

Req. 3If the shortfall in sales volume is attributable to concerns about a new format for recordable DVD players, Roland Films’ management has done a good job controlling costs in light of lower than expected sales. Operating income would have been $23,025 less than it actually was if the company had not done such a good job keeping operating expenses below flexible budget levels.

Perhaps management could have better anticipated customer demand falling, and taken steps to offset it, such as reducing the selling price or further increasing advertising to stimulate demand. However, the unfavorable advertising expense variance suggests that the sales shortfall may well have been beyond Roland Films’ control. A concern now is whether Roland Films will have the right DVD movie product mix in place to take advantage of the pent-up demand for DVD movies with any new DVD format.

Students’ responses to Reqs. 2 and 3 will probably be less detailed.


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