Exercise 12-11: Working with a Segmented Income Statement
Given:
Marple Associates is a consulting firm that specializes in information systems for
construction and landscaping companies. The firm has two offices -- one in Houston
and one in Dallas. The firm classifies the direct costs of consulting jobs as variable
costs. A segmented contribution format income statement for the company's most
recent year is given below:
Office
Total Company Houston Dallas
Sales $750,000 100.00% $150,000 100.00% $600,000 100.00%
Variable expenses 405,000 54.00% 45,000 30.00% 360,000 60.00%
Contribution margin $345,000 46.00% $105,000 70.00% $240,000 40.00%
Traceable fixed expenses 168,000 22.40% 78,000 52.00% 90,000 15.00%
Market segment margin $177,000 23.60% $27,000 18.00% $150,000 25.00%
Common fixed expenses
(not traceable to markets) 120,000 16.00%
Net operating income $57,000 7.60%
Required:
1. By how much would the company's net operating income increase if Dallas
increased its sales by $75,000 per year? Assume no change in cost behavior
patterns.
Increase in Dallas sale $75,000
Contribution margin ratio 40.00%
Increase in Company's NOI $30,000
2. Refer to the original data. Assume that sales in Houston increased by $50,000
next year and that sales in Dallas remain unchanged. Assume no change in
fixed costs.
a. Prepare a new segmented income statement for the company using the above
format. Show both amounts and percentages.
Office
Total Company Houston Dallas
Sales $800,000 100.00% $200,000 100.00% $600,000 100.00%
Variable expenses 420,000 52.50% 60,000 30.00% 360,000 60.00%
Contribution margin $380,000 47.50% $140,000 70.00% $240,000 40.00%
Traceable fixed expenses 168,000 21.00% 78,000 39.00% 90,000 15.00%
Market segment margin $212,000 26.50% $62,000 31.00% $150,000 25.00%
Common fixed expenses
(not traceable to markets) 120,000 15.00%
Net operating income $92,000 11.50%
b. Observe from the income statement you have prepared that the CM ratio for
Houston has remained unchanged at 70% (the same as in the above data) but
that the segment margin ratio has changed. How do you explain the change in
the segment margin ratio?
The traceable fixed expenses are spread over a larger base as sales increase.
Therefore, the segment margin ratio increase from 18% to 31%.
The contribution margin ratio remains stable at 70% because there is no
information to suggest that the selling price per unit or the variable cost per
unit have changed.
Exercise 12-12: Working with a Segmented Income Statement
Given:
Refer to the data in Exercise 12-11. Assume that Dallas' sales by major market
Dallas: Market Clients
Dallas Office Construction Landscaping
Sales $600,000 100.00% $400,000 100.00% $200,000 100.00%
Variable expenses 360,000 60.00% 260,000 65.00% 100,000 50.00%
Contribution margin $240,000 40.00% $140,000 35.00% $100,000 50.00%
Traceable fixed expenses 72,000 12.00% 20,000 5.00% 52,000 26.00%
Market segment margin $168,000 28.00% $120,000 30.00% $48,000 24.00%
Common fixed expenses
(not traceable to markets) 18,000 3.00%
Net operating income $150,000 25.00%
The company would like to initiate an intensive advertising campaign in one of the
two markets during the next month. The campaign would cost $8,000. Marketing
studies indicate that such a campaign would increase sales in the construction
market by $70,000 or increase sales in the landscaping market by $60,000.
Required:
1. In which of the markets would you recommend that the company focus its
advertising campaign?
The company should focus its campaign on Landscaping Clients.
Construction Landscaping
Clients Clients
Increased sales from campaign $70,000 $60,000
CM ratio for market client 35.00% 50.00%
Increase in contribution margin $24,500 $30,000
Less cost of the campaign 8,000 8,000
Increased segment margin & NOI $16,500 $22,000
2. In Exercise 12-11, Dallas shows $90,000 in traceable fixed expenses. What
happened to the $90,000 in this exercise?
The $90,000 of traceable fixed cost to Dallas has been accounted for as follows:
Construction Landscaping
Dallas Clients Clients
Traceable fixed costs $72,000 $20,000 $52,000
Common fixed expenses
(not traceable to markets) 18,000
Total $90,000
Exercise 12-13: Contrasting Return on Investment (ROI) and Residual Income (RI)
Given:
Rains Nickless Ltd. Of Australia has two divisions that operate in Perth and Darwin. Selected
data on the two divisions follow:
Division
Perth Darwin
Sales $9,000,000 $20,000,000
Net operating income $630,000 $1,800,000
Average operating assets $3,000,000 $10,000,000
Required:
1. Compute the ROI for each division.
a. ROI = Net operating income / Average operating assets
b. ROI = margin X turnover
ROI = (Net operating income / Sales) X (Sales / Average operating assets)
Division
Perth Darwin
Margin 7% 9%
Turnover 3 2
b. ROI 21% 18%
a. ROI 21% 18%
2. Assume that the company evaluates performance using residual income and that the
minimal required rate of return for each division is 16%. Compute the residual income
for each division.
RI = Net operating income - Charge for use of capital
RI = Net operating income - (Average operating assets X Minimum required rate of return)
Division
Perth Darwin
Minimum required rate of return 16% 16%
Net operating income $630,000 $1,800,000
Charge for use of capital ($480,000) ($1,600,000)
Residual income $150,000 $200,000
3. Is the Darwin Division's greater residual income an indication that it is better managed?
Explain.
No, the Darwin Division is simply larger than the Perth Division and for this reason alone one
would expect that it would have a greater amount of residual income. In fact, based on the
data above, the Darwin Division does not appear to be as well managed as the Perth Division.
The Darwin Division has an 18% return on investment as compared to 21% for the Perth
Division.
Residual income can not be used to compare the performance of divisions of different sizes.
Larger divisions will almost always look better.
n alone one
rth Division.
erent sizes.
Exercise 12-8: Evaluating New Investment Using ROI and Residual Income (RI)
Given:
Selected sales and operating data for three divisions of three different companies are
given below:
Division A Division B Division C
Sales $6,000,000 $10,000,000 $8,000,000
Average operating assets $1,500,000 $5,000,000 $2,000,000
Net operating income $300,000 $900,000 $180,000
Minimum required rate of return 15% 18% 12%
Required:
1. Compute the ROI for each division, using the formula stated in terms of margin and turnover.
a. ROI = Net operating income / Average operating assets
b. ROI = margin X turnover
ROI = (Net operating income / Sales) X (Sales / Average operating assets)
Division A Division B Division C
Margin 5.00% 9.00% 2.25%
Turnover 4 2 4
b. ROI 20.00% 18.00% 9.00%
a. ROI 20.00% 18.00% 9.00%
2. Compute the residual income for each division.
RI = Net operating income - Charge for use of capital
RI = Net operating income - (Average operating assets X Minimum required rate of return)
Division A Division B Division C
Net operating income $300,000 $900,000 $180,000
Charge for use of capital ($225,000) ($900,000) ($240,000)
Residual income $75,000 $0 ($60,000)
3. Assume that each division is presented with an investment opportunity that would yield a
rate of return of 17%.
a. If performance is being measured by ROI, which division or divisions will probably accept
the opportunity? Reject? Why?
Division A Division B Division C
Current ROI 20% 18% 9%
Investment opportunity return 17% 17% 17%
Effect on ROI if opportunity is accepted Decrease Decrease Increase
Accept or reject decision Reject Reject Accept
b. If performance is being measured by RI, which division or divisions will probably accept
the opportunity? Reject? Why?
Division A Division B Division C
Current RI $75,000 $0 ($60,000)
Investment opportunity return 17% 17% 17%
Minimum required rate of return 15% 18% 12%
Effect on RI if opportunity is accepted Increase Decrease Increase
Accept or reject decision Accept Reject Accept
Exercise 12-20: Effects of Changes in Profits and Assets on Return on Investment
Given:
The Abs Shoppe is a regional chain of health clubs. The managers of the clubs, who have
authority to make investments as needed, are evaluated based largely on ROI. The Abs Shoppe
reported the following results for the past year:
Abs
Shoppe
Sales $800,000
Net operating income $16,000
Average operating assets $100,000
Required:
The following questions are to be considered independently. Carry out all computations to two
decimal places.
1. Compute the club's ROI
a. ROI = Net operating income / Average operating assets
b. ROI = margin X turnover
ROI = (Net operating income / Sales) X (Sales / Average operating assets)
Abs
Shoppe
Margin 2.00%
Turnover 8.00
b. ROI 16.00%
a. ROI 16.00%
2. Assume that the manager of the club is able to increase sales by $80,000 and that as a result
net operating income increases by $6,000. Further assume that this is possible without any
increase in operating assets. What would be the club's ROI?
Original Changes New
Sales $800,000 $80,000 $880,000
Net operating income $16,000 $6,000 $22,000
Average operating assets $100,000 $0 $100,000
Abs
Shoppe
Margin 2.50%
Turnover 8.80
ROI 22.00%
ROI 22.00%
3. Assume that the manager of the club is able to reduce expenses by $3,000 without any
change in sales or operating assets. What would be the club's ROI?
Original Changes New
Sales $800,000 $0 $800,000
Net operating income $16,000 $3,000 $19,000
Average operating assets $100,000 $0 $100,000
Abs
Shoppe
Margin 2.38%
Turnover 8.00
ROI 19.00%
ROI 19.00%
4. Assume that the manager of the club is able to reduce operating assets $20,000 without any
change in sales or net operating income. What would be the club's ROI?
Original Changes New
Sales $800,000 $0 $800,000
Net operating income $16,000 $0 $16,000
Average operating assets $100,000 ($20,000) $80,000
Abs
Shoppe
Margin 2.00%
Turnover 10.00
ROI 20.00%
ROI 20.00%
Abs Shoppe
t as a result
Exercise 12-17: Sales Dollars as an Allocation Base for Fixed Costs
Given:
Lacey's Department Store allocates its fixed administrative expenses to its four operating
departments on the basis of sales dollars. During 2007, the fixed administrative expenses
totaled $900,000. These expenses were allocated as follows:
Men's Women's Shoes Housewares
Total sales -- 2007 $600,000 $1,500,000 $2,100,000 $1,800,000
Percentage of total sales 10% 25% 35% 30%
Allocation (based on the above percentages) $90,000 $225,000 $315,000 $270,000
During 2008, the following year, the Women's Department doubled its sales. The sales levels in the
other three departments remained unchanged. The company's 2008 sales data were as follows:
Men's Women's Shoes Housewares
Total sales -- 2008 $600,000 $3,000,000 $2,100,000 $1,800,000
Percentage of total sales 8% 40% 28% 24%
Fixed administrative expenses remained unchanged at $900,000 during 2008. $900,000
Required:
1. Using sales dollars as an allocation base, show the allocation of the fixed administrative expenses
among the four departments for 2008.
Men's Women's Shoes Housewares
Allocation for 2008 $72,000 $360,000 $252,000 $216,000
2. Compare your allocation from (1) above to the allocation for 2007. As the manager of the Women's
Department, how would you feel about the administrative expenses that have been charged to you
you for 2008?
Men's Women's Shoes Housewares
Allocation for 2008 $72,000 $360,000 $252,000 $216,000
Allocation for 2007 $90,000 $225,000 $315,000 $270,000
Increase/Decrease ($18,000) $135,000 ($63,000) ($54,000)
The manager of the Women's Department undoubtedly will be upset about the increased allocation
to the department but will feel powerless to do anything about it. Such an increased allocation may
viewed as a penalty for an outstanding performance.
Note: The allocations to all of the other departments decreased.
3. Comment on the usefulness of sales dollars as an allocation base.
Sales dollars is not ordinarily a good base for allocating fixed costs. The costs allocated to a
department will be affected by the sales in other departments. In other words, how much fixed
costs will be allocated to one department depends on the operations of another department.
Note that if the department managers have bonus plans based on NOI, these managers will receive
bonus increases because of the increased sales in the Women's Department.
Total
$6,000,000
100%
$900,000
Total
$7,500,000
100%
ive expenses
Total
$900,000
the Women's
arged to you
Total
$900,000
$900,000
$0
sed allocation
allocation may
s will receive
Exercise 12-5: Service Department Charges
Given:
Gutherie Oil Company has a Transport Services department that provides trucks to transport crude
oil from docks to the company's Arbon Refinery and Beck Refinery. Budgeted costs for the transport
services consist of $0.30 per gallon variable cost and $200,000 fixed cost. The level of fixed cost is
determined by peak-period requirements. During the peak period, Arbon Refinery requires 60% of
the capacity and the Beck Refinery requires 40%.
During the year, the Transport Services Department actually hauled the following amounts of crude
oil for the two refineries: Arbon Refinery, 260,000 gallons; and Beck Refinery, 140,000 gallons. The
Transport Services Department incurred $365,000 in cost during the year, of which $148,000 was
variable cost and $217,000 was fixed cost.
Required:
1. Determine how much of the $148,000 in variable cost should be charged to each refinery.
2. Determine how much of the $217,000 in fixed cost should be charged to each refinery.
Arbon Beck Total
Peak period capacity needs 60% 40% 100%
Gallons actually hauled 260,000 140,000 400,000
Budgeted variable ($.30/gallon) $0.30
Allocation of Variable Costs: Arbon Beck Total
Allocation: actual gallons X budgeted rate $78,000 $42,000 $120,000
Allocation of Fixed Costs:
Allocation: Peak period % X budgeted FC 120,000 80,000 200,000
Total Costs Allocated $198,000 $122,000 $320,000
3. Will any of the $365,000 in the Transport Services Department cost not be charged to the
refineries?
Variable Costs Fixed Costs Total
Total Transport Services Department Costs Incurred $148,000 $217,000 $365,000
Total Transport Services Department Costs Assigned $120,000 200,000 $320,000
Total Transport Services Department Costs Unassigned $28,000 $17,000 $45,000
The overall spending variance of $45,000 represents costs incurred in excess of the budgeted $.30
per gallon variable cost and budgeted $200,000 in fixed costs. This $45,000 in unallocated cost is
the responsibility of the Transport Services Department.
Problem 12-24:
Given:
In cases 1-3 below, assume that Division A has a product that can be sold either to Division B of the same
company or to outside customers. The managers of both divisions are evaluated based on their own
division's ROI. The managers are free to decide if they will participate in any internal transfers. All transfer
prices are negotiated. Treat each case independently.
Cases
1 2 3 4
Division A:
Capacity in Units 50,000 300,000 100,000 200,000
Number of units now being sold to outside customers 50,000 300,000 75,000 200,000
Selling price per unit to outside customers $100 $40 $60 $45
Variable cost per unit 63 19 35 30
Contribution per unit $37 $21 $25 $15
Fixed costs per unit (based on capacity) $25 $8 $17 $6
Division B:
Number of units needed annually 10,000 70,000 20,000 60,000
Purchase price now being paid to an outside supplier $92 $39 $60 -
$57
Before any purchase discount.
Required:
1. Refer to case 1 above. A study has indicated that Division A can avoid $5 per unit in variable costs on
any sales to Division B. Will the managers agree to a transfer and if so, within what range will the
transfer price be? Explain.
Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = ($63 - $5) + ($37 X 10,000)/10,000 = $58 + $37 = $95
Division A:
Contribution margin generated per unit under the current situation $37
Contribution margin generated if a transfer takes place at $95 per unit 37
Division A manager is indifferent to selling outside or transferring to Division B $0
Division B:
Cost per unit if purchased outside $92
Cost per unit if transferred at $95 per unit 95
Division B manager would reject internal transfer because of $3 per unit increase in cost ($3)
The managers will not agree to a transfer.
Division A will not accept less than $95 and
Division B will not pay more than $92, the outside price.
There is no possible range of negotiation within which a transfer could take place.
2. Refer to case 2 above. Assume that Division A can avoid $4 per unit in variable costs on any sales to
Division B.
a. Would you expect any disagreement between the two divisional managers over what the transfer
price should be? Explain.
Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = ($19 - $4) + ($21 X 70,000)/70,000 = $15 + $21 = $36
Division A:
Contribution margin generated per unit under the current situation $21
Contribution margin generated if a transfer takes place at $36 per unit 21
Division A manager is indifferent to selling outside or transferring to Division B $0
Division B:
Cost per unit if purchased outside $39
Cost per unit if transferred at $36 per unit 36
Division B manager would accept an internal transfer because of a $3 decrease in cost $3
The managers should agree to a transfer.
Division A will be willing to accept a price of $36 or higher
Division B will be willing to pay no more $39, the outside price.
The range of negotiation within which a transfer should take place is $39 to $36.
Even though the company would be better off with any transfer price within this range, each manager
will negotiate for the transfer price that benefits their division the most. Division A's manager will try to
hold out for a transfer price of $39, while Division B's manager will try to hold out for a transfer price of
$36 per unit transferred.
b. Assume that Division A offers to sell 70,000 units to Division B for $38 per unit and that Division B
refuses this price. What will be the loss in potential profits for the company as a whole?
70,000 X $3 = $210,000
Proof:
Division A:
TP per unit to Division B $38
Variable cost per unit associated with transfer 15
Benefit per unit to Division A $23
Less CM given up to make transfer possible 21
Net per unit benefit to Division A $2
Number of units transferred 70,000
Total increase in CM to Division A as a result of transfer $140,000
Division B:
Cost per unit if purchased outside $39
Cost per unit if transferred at agreed upon TP 38
Benefit per unit to Division B $1
Number of units transferred 70,000
Total increase in CM to Division A as a result of transfer $70,000
Total benefit to the company resulting from the transfer $210,000
Note: Transfer price allocates profit between Division A and Division B.
3. Refer to case 3 above. Assume that Division B is now receiving a 5% price discount from the outside
supplier.
a. Will the managers agree to a transfer? If so, within what range will the transfer price be?
Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = $35 + ($0 X 20,000)/20,000 = $35 + $0 = $35
Division A:
Contribution margin generated per unit under the current situation (excess capacity) $0
Contribution margin generated if a transfer takes place at $35 per unit 0
Division A manager is indifferent to selling outside or transferring to Division B $0
Division B:
Cost per unit if purchased outside $57
Cost per unit if transferred at $35 per unit 35
Division B manager would accept an internal transfer because of a $22 per unit decrease in cost $22
The managers should agree to a transfer.
Division A will be willing to accept a price of $35 or higher
Division B will be willing to pay no more $57, the outside price.
The range of negotiation within which a transfer should take place is $35 to $57.
Even though the company would be better off with any transfer price within this range, each manager
will negotiate for the transfer price that benefits their division the most. Division A's manager will try to
hold out for a transfer price of $57, while Division B's manager will try to hold out for a transfer price of
$35 per unit transferred.
b. Assume that Division B offers to purchase 20,000 units from Division A at $52 per unit. If Division A
accepts this price, would you expect its ROI to increase, decrease, or remain unchanged? Why?
Benefit to company as a whole resulting from transfers 20,000 X $22 = $440,000
Division A:
TP per unit to Division B $52
Variable cost per unit associated with transfer 35
Benefit per unit to Division A $17
Less CM given up to make transfer possible 0
Net per unit benefit to Division A $17
Number of units transferred 20,000
Total increase in CM to Division A as a result of transfer $340,000
Effect on ROI: Divisional income will increase by $340,000 with no change
in investment (excess capacity). Thus, Division A's ROI will increase.
Division B:
Cost per unit if purchased outside $57
Cost per unit if transferred at agreed upon TP 52
Benefit per unit to Division B $5
Number of units transferred 20,000
Total increase in CM to Division A as a result of transfer $100,000
Total benefit to the company resulting from the transfer $440,000
Note: Transfer price allocates profit between Division A and Division B.
4. Refer to case 4 above. Assume that Division B wants Division A to provide it with 60,000 units of a
different product from the one that Division A is now producing. The new product would require $25
per unit in variable costs and would require that Division A cut back production of its present product by
30,000 units annually. What is the lowest acceptable transfer price from Division A's perspective?
Transfer Price to maximize company profits:
TP = Out of pocket costs / unit + (Total contribution margin given up on lost sales) / units transferred
TP = $25 + ($15 X 30,000) / 60,000 = $25 + ($450,000 / 60,000) = $25 + $7.50 = $32.50
