Ex 25-1 Differential analysis for a lease or sell decision

Steady Construction Company is considering selling excess machinery with a book value of $280,000 (original cost of $400,000 less accumulated depreciation of $120,000) for $244,000, less a 5% brokerage commission. Alternatively, the machinery can be leased for a total of $255,000 for five years, after which it is expected to have no residual value. During the period of the lease, Steady Construction Company’s costs of repairs, insurance, and property tax expenses are expected to be $23,800.

a. Prepare a differential analysis, dated April 16, 2014, to determine whether Steady should lease (Alternative 1) or sell (Alternative 2) the machinery.

b.  On the basis of the data presented, would it be advisable to lease or sell the machinery? Explain.


Answer:


a. Differential Analysis 
Lease Machinery (Alt. 1) or Sell Machinery (Alt. 2) 
April 16, 2014 
  
Lease 
Machinery 
(Alternative 1) 
Revenues $255,000 $244,000 –$11,000 
Costs –23,800 –12,200* 11,600 
Income (Loss) $231,200 $231,800 $ 600 
    
a. 
* $244,000 × 5% 
b. Sell the machinery. The net gain from selling is $600. 

Ex 24-21 Decision on transfer pricing

Based on Dart Industries’ data in Exercise 24–20, assume that a transfer price of $158 has been established and that 40,000 units of materials are transferred, with no reduction in the Components Division’s current sales.

a. How much would Dart Industries’ total income from operations increase?

b. How much would the Instrument Division’s income from operations increase?

c. How much would the Components Division’s income from operations increase?

d.  If the negotiated price approach is used, what would be the range of accept-

able transfer prices and why?

Answer:

a. Increase in Dart Industries’ 

Income from Operations 

 

= 

 Market 

Price 

 

– 

 Variable Cost 

per Unit 

 

× 

Units 

Transferred 

 $2,200,000 =  ($180 –  $125) × 40,000 

This amount is the same amount by which Dart Industries’ income from 

operations increased in Ex. 24–20, when a transfer price of $145 was used. 

b. Increase in the Instrument Division’s   Market   Transfer  Units 

 Income from Operations =  Price –  Price × Transferred 

 $880,000 = ($180 –  $158) × 40,000 

This is the amount the Instrument Division saves by purchasing from the 

Components Division at an internal price that is lower than the market price. 

c. Increase in the Components Division’s   Transfer   Variable Cost  Units 

 Income from Operations = Price –  per Unit × Transferred 

 $1,320,000 =  ($158 –  $125) × 40,000 

This is the amount the Components Division earns by using available excess capacity 

to produce and sell products above variable cost to the Instrument Division. 

d. Any transfer price will cause the total income of the company to increase, 

as long as the supplier division capacity is used toward making materials for 

products that are ultimately sold to the outside. However, transfer prices should 

be set between variable cost and selling price in order to give the division 

managers proper incentives. A transfer price set below variable cost would 

cause the supplier division to incur a loss, while a transfer price set above 

market price would cause the purchasing division to incur opportunity costs. 

Neither situation is an attractive alternative for an investment center manager. 

Thus, the general rule is to negotiate transfer prices between variable cost and 

market price when the supplier division has excess capacity. The range of 

acceptable transfer prices for Dart Industries would be between $180 and $125. 

Ex 24-20 Decision on transfer pricing

Materials used by the Instrument Division of Dart Industries are currently purchased from outside suppliers at a cost of $180 per unit. However, the same materials are available from the Components Division. The Components Division has unused capacity and can produce the materials needed by the Instrument Division at a variable cost of $125 per unit.

a. If a transfer price of $145 per unit is established and 40,000 units of materials are transferred, with no reduction in the Components Division’s current sales, how much would Dart Industries’ total income from operations increase?

b. How much would the Instrument Division’s income from operations increase?

c. How much would the Components Division’s income from operations increase?


Answer:

a. Increase in Dart Industries’ Market Variable Cost Unit 
 Income from Operations =  Price –  per Unit × Transferred 
$2,200,000 = ($180 –  $125) × 40,000 

b. 

Increase in the Instrument Division’s 
Income from Operations 

= 


Market 
Price 

– 


Transfer 
Price 

× 

Unit 
Transferred 
 $1,400,000 = ($180 –  $145) × 40,000 

c. 

Increase in the Components Division’s 
Income from Operations 

= 
  
Transfer 
Price 

– 


Variable Cost 
per Unit 

× 

Unit 
Transferred 
 $800,000 = ($145 –  $125) × 40,000 

Ex 24-19 balanced scorecard

Several years ago, United Parcel Service (UPS) believed that the Internet was going to change the parcel delivery market and would require UPS to become a more nimble and customer-focused organization. As a result, UPS replaced its old measurement system, which was 90% oriented toward financial performance, with a balanced scorecard. The scorecard emphasized four “point of arrival” measures, which were:

1. Customer satisfaction index—a measure of customer satisfaction.

2. Employee relations index—a measure of employee sentiment and morale.

3. Competitive position—delivery performance relative to competition.

4. Time in transit—the time from order entry to delivery.

a.  Why did UPS introduce a balanced scorecard and nonfinancial measures in
its new performance measurement system?

b.  Why do you think UPS included a factor measuring employee sentiment?


Answer:
a. UPS wanted a performance measurement system that would focus more on the underlying drivers, or levers, of financial success. It believed that focusing on the financial numbers by themselves would not reveal how financial objectives were to be achieved, especially with new demands coming from customers in the Internet age. The balanced scorecard provides information on how the financial targets are to be achieved. Using common measures throughout the organization also aligns the organization, while simultaneously communicating priorities. Apparently, UPS determined that its future success as an organization depended on “point of arrival” measures. These measures emphasized customer
performance to a much higher degree than would straight financial numbers.

b. The employee sentiment number is common in service businesses. The employees are the face of the company to the customer. If employees feel poorly about the organization, or if they feel that they don’t make a difference, then they are not likely to deliver premium service experiences to their customers. Just
think of the variety of fast food experiences you may have had in the past month. Sometimes, the service is excellent with a smile; at other times, it’s poor with a scowl. Measuring the improving employee morale is critical to organizations relying on front-line employees that deliver the customer experience.

Ex 24-18 balanced scorecard

American Express Company is a major financial services company, noted for its American Express® card. Below are some of the performance measures used by the company in its balanced scorecard.

Average card member spending           | Number of Internet features
Cards in force                                       | Number of merchant signings
Earnings growth                                   | Number of new card launches
Hours of credit consultant training       | Return on equity
Investment in information technology  | Revenue growth
Number of card choices

For each measure, identify whether the measure best fits the innovation, customer, internal process, or financial dimension of the balanced scorecard.


Answer:

Although there is some judgment in classifying each of these measures, the following represents the author’s assessment with explanations: 

Average card member spending | Customer—demonstrates the usefulness of the card to the customer. 
Cards in force | Customer—if customers did not value the 
card, they would not have one. 
Earnings growth | Financial 
Hours of credit consultant training | Internal process—advisors will do their job better if they are trained. 
Investment in information technology | Internal process (or innovation)—shows the investment in improving processes. 
Number of Internet features | Internal process (or innovation)—shows new process investments in a new channel. 
Number of merchant signings | Customer—the larger the number of 
merchants that honor the card, the more valuable it is to cardholders. 
Number of card choices | Customer—more choices are more valuable 
to customers. 
Number of new card launches | Innovation—measures the new cards  (affinity, regional, etc.) being developed and marketed. 
Return on equity | Financial 
Revenue growth | Financial 

Ex 24-17 rate of return on investment, residual income

Starwood Hotels & Resorts Worldwide provides lodging services around the world. The company is separated into two major divisions.

• Hotel Ownership: Hotels owned and operated by Starwood.

• Vacation Ownership: Resort properties developed, owned, and operated for timeshare vacation owners.

Financial information for each division, from a recent annual report, is as follows (in millions):


                                               Hotel           |     Vacation  
                                         Ownership         |    Ownership
Revenues                             $4,383            |     $  688
Income from operations            571           |         105
Total assets                              6,440          |      2,139

a. Use the DuPont formula to determine the return on investment for each of the Starwood business divisions. Round whole percents to one decimal place and investment turnover to two decimal places.

b. Determine the residual income for each division, assuming a minimum acceptable income of 5% of total assets. Round minimal acceptable return to the nearest million dollars.

c.  Interpret your results.


Answer:

a.  
Rate of Return 
on Investment   = 
Income from Operations 
Revenues 

× Revenues 
Hotel Ownership: $571 ×
 $4,383 
$4,383 $6,440 
=   13.0% × 0.68 
=   8.8% (rounded) 
Vacation Ownership: $105 ×
 $688 
$688 $2,139 
=   15.3% × 0.32 
=   4.9% (rounded) 
b. Hotel 
Ownership 
Income from operations……………………………… 
Less:  Minimum return (5% of assets)…………… 
Residual income (loss)……………………………… 
* $6,440 × 5% 
** $2,139 × 5% 

$571 
  322* 
$249 
c. The Vacation Ownership (VO) segment has the weakest return on investment, 
which is mainly the result of a weak investment turnover. The VO segment earns 
profit margins that are higher than the profit margins in the Hotel Ownership (HO) 
segment (15.3% vs. 13.0%). However, weak investment turnover is causing the 
ROI for the VO segment to be less than the assumed minimum acceptable return. 
The residual income is negative for VO, which is consistent with a ROI less than the 
acceptable 5% minimum return. This weak performance is due primarily to the 
deterioration in the real estate market that has occurred in recent years. The 
profit margin and investment turnover in the VO segment are closely tied to the 
strength of the real estate market and the overall economy, both of which 
deteriorated significantly in the preceding years. 
The HO segment ROI is also affected by the global economy, but is still generating 
a solid ROI. Stable profit margins and investment turnover generate a ROI that is 
above the minimum acceptable return. The residual income is positive, which is 
consistent with a ROI that is greater than the 5% minimum return. 

Ex 24-16 Determining missing items from computations

Data for the North, South, East, and West divisions of Free Bird Company are as follows:


Sales
income from  
Operations
invested  
Assets
rate of return  
on investment profit Margin
investment 
turnover
North $750,000 (a) (b) 20% 8% (c)
South (d) $75,600 (e) (f ) 12% 1.8
East $840,000 (g) $280,000 18% (h) (i)
West $1,100,000 $99,000 $550,000 (j) (k) (l)

a. Determine the missing items, identifying each by the letters (a) through (l). Round percents and investment turnover to one decimal place.

b. Determine the residual income for each division, assuming that the minimum acceptable rate of return established by management is 10%.

c. Which division is the most profitable in terms of (1) return on investment and (2) residual income?


Answer:
a.
 (a) $60,000 ($750,000 × 8%)
 (b) $300,000 ($60,000 ÷ 20%)
 (c) 2.5 (20% ÷ 8%) or $750,000 ÷ $300,000
 (d) $630,000 ($75,600 ÷ 12%)
 (e) $350,000 ($630,000 ÷ 1.8)
 (f) 21.6% (12% × 1.8)
 (g) $50,400 ($280,000 × 18%)
 (h) 6.0% ($50,400 ÷ $840,000)
 (i) 3.0 ($840,000 ÷ $280,000)
 (j) 18.0% ($99,000 ÷ $550,000)
 (k) 9.0% ($99,000 ÷ $1,100,000)
 (l) 2.0 ($1,100,000 ÷ $550,000)

b.
 North Division: $30,000 [$60,000 – ($300,000 × 10%)]
 South Division: $40,600 [$75,600 – ($350,000 × 10%)]
 East Division: $22,400 [$50,400 – ($280,000 × 10%)]
 West Division: $44,000 [$99,000 – ($550,000 × 10%)]
c.
 (1) The South Division has the highest return on investment    (21.6%).
 (2) The West Division has the largest residual income.