Question 1.
Discuss the differences between centralized and decentralized
decision making.
Answer: In centralized decision making, decisions are made at the
very top level, and lower-level managers are charged with
implementing these decisions. On the other hand, decentralized
decision making allows managers at lower levels to make and
implement key decisions pertaining to their areas of responsibility.
Question 2. What is decentralization?
Answer: Decentralization is the practice of delegating decision-
making authority to lower levels of management in a company.
Question 3. Explain why firms choose the decentralize.
Answer: To increase overall efficiency, many companies choose to
decentralize. The essence of decentralization is decision-making
freedom. In a decentralized organization lower-level managers
make and implement decisions, whereas in a centralized
organization, lower-level managers are responsible only for
implementing decisions. Reasons for decentralization are
numerous. Companies decentralize because local managers can
make better decisions using local information. Local managers can
also provide a more timely response to changing conditions.
Additionally, decentralization for large, diversified companies is
necessary because of cognitive limitations–it is impossible for
anyone central manager to be fully knowledgeable about all
products and markets. Other reasons include training and
motivating local managers and freeing top management from day-
to-day operating conditions so that they can spend time on more
long-range activities, such as strategic planning. A decentralized
company sets up responsibility centers. The four types of
responsibility centers are cost centers, revenue centers, profit
centers, and investment centers. The actual results for each
responsibility center can be compared with expected results.
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Question 13. What are margin and turnover? Explain how these concepts can
improve the evaluation of an investment center.
Answer: Margin is the ratio of operating income to sales. It tells
how many cents of operating income result from each dollar of
sales; it expresses the portion of sales that is available for interest,
taxes and profit. And turnover is sales divided by average operating
assets. Turnover tells how many dollars of sales result from every
dollar invested in operating assets; it shows how productively
assets are being used to generate sales.
Question 14. What are the three benefits of ROI? Explain how each can lead to
improved profitability.
Answer: Three positive results stem from the use of ROI:
1. It encourages mangers to focus on the relationship among sales,
expenses, and investment as should be the case for a manager of
an investment center.
2. It encourages managers to focus on cost efficiency.
3. It encourages managers to focus on operating asset efficiency.
Question 15. What are two disadvantages of ROI? Explain how each can lead to
decreased profitability.
Answer: Two negative aspects associated with ROI are frequently
mentioned:
1. It can produce a narrow focus on divisional profitability at the
expense of profitability for the overall firm.
2. It encourages managers to focus on the short run at the expense
of the long run.
Question 16. What is EVA?
Answer: Economic valued added (EVA) is a way of calculating
residual income; net income (operating income minus taxes) minus
the total annual cost of capital.
10-6. Classen Company had sales of $50,000, expenses of $48,000, and
operating assets of $10,000.
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Required
1. Compute the operating income.
2. Compute the margin and turnover ratios.
3. Compute the ROI.
Solution
1. Operating income = sales – expenses
= $50,000 – $48,000 = $2,000
2. Margin = Operating income = $2,000 = 0.04 or 4%
Sales 50,000
Turnover = Sales = $50,000 = 5
Average operating assets $10,000
3. ROI = Margin x Turnover
= 0.04 x 5
= 0.2 or 20%
10-7. Seere Company provided the following income statement for last year.
Sales $240,000
Less: Variable expenses 195,000
Contribution margin 45,000
Less: Fixed expenses 37,800
Operating income $ 7,200
At the beginning of last year, Seere had $78,650 in operating assets. At the
end of the year, Seere had $81,350 in operating assets.
Required
1. Compute average operating assets.
2. Compute the margin and turnover ratios for last year. Compute ROI.
Solution
1. Average operating assets = (Beginning assets + Ending assets)
2
= ($78,650 + $81,350)
2
= $ 80,000
2. Margin = Operating income = $7,200 = 0,03 or 3%
Sales 240,000
Turnover = Sales = $240,000 = 3
Average operating assets $80,000
ROI = Margin x Turnover
= 0.03 x 3
= 0.09 or 9%
10-8 Cheryl Manners, division manager of Radiotech, Inc., was debating the
merits of new product–a weather radio that would put out a warning if the
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country in which the listener lived was under a severe thunderstorm or
tornado alert. The budget income of the division was $480,000 with
operating assets of $8,000,000. The proposed investment would add
income of $270,000 and would require an additional investment in
equipment of $1,500,000.
Required
1. Compute the ROI of :
a. The division if the radio project is not undertaken
b. The radio project alone
c. The division if the radio project is undertaken
2. Do you suppose that Cheryl will decide to invest in the new radio? Why
or why not?
Solution
1. a) ROI of division without radio = $480,000 = 0.06
$8,000,000
b) ROI of the radio project = $270,000 = 0.18
$1,500,000
c) ROI of division with radio = $750,000 = 0.0789
$9,500,000
2. Yes, Cheryl will decide to invest in the project. Since, overall division
ROI will increase
10-9 Schipper Company had after-tax operating income last year $115,000. Two
sources of financing were used by the company: $1.3 million of mortgage
bonds paying 8 percent interest and $700,000 in common stock, which was
considered to be no more or less risky than other stocks. The rate of return
on long-term government bonds is 6 percent. Schiper Company pays a
marginal tax rate of 30 percent. Total capital employed is $1.5 million.
Required
1. What is the after-tax cost of the mortgage bonds?
2. What is the after-tax cost of common stock?
3. What is weighted average cost of capital for Schipper?
4. What is the dollar cost of capital for Schipper?
5. Calculate EVA for Schipper. Is Schipper creating wealth or not?
Solution
1. After-tax cost of the mortgage bonds = [(1 – 0.3)(0.08)] = 0.056
2. After-tax of common stock
= Return on long-term government bonds + average premium
= 6% + 6% = 12 % or 0.12
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3.
Weighted
Amount Percen After-Tax Cost
t Cost =
Mortgage bonds $1,300,000 0.65 0.056 0.0364
Common stock 700,000 0.35 0.120 0.0420
Total $2,000,000
Weighted average cost of capital 0.0784
4. Dollar cost of capital for Schipper = $1,500,000 x 0.0784
= $117,600
5. After-tax operating income = $115,000
Less: Cost of capital = $117,600
EVA = $ (2,600)
Because EVA is negative, Schipper is destroying wealth.
10-22 The manager of division that produces add-on products for the automobile
industry has just been presented the opportunity to invest in two
independent projects. The first is an air conditioner for the back seats of
vans and minivans. The second is a turbocharger. Without the investments,
the division will have average assets for the coming year of $28.9 million
and after-tax income of $3.179 million. The outlay required for each
investment and the expected operating incomes are as follows:
Air Conditioner Turbocharger
After-tax operating income $67,500 $89,700
Outplay 750,000 690,000
Corporate headquarters will borrow up to $1.5 million for the automotive
add-on division for further investments. The amount borrowed will be
through unsecured bonds at rate of 12 percent. The marginal tax rate is 25
percent.
Required
1. Compute the ROI for each investment project.
2. Compute the budgeted divisional ROI for each of the following four
alternatives:
a. The air conditioner investment is made.
b. The turbocharger investment is made.
c. Both investments are made.
d. Neither additional investment is made.
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Assuming that divisional managers are evaluated and rewarded on the
basis of ROI performance, which alternative do you think the divisional
manager will choose?
3. Suppose that the borrowing must be for the entire $1.5 million.
Calculate the EVA of the two investments taken as a package. Based on
EVA, are the investments profitable?
Solution
1. Air conditioner, ROI = $67,500 = 0.09 or 9%
750,000
Turbocharger, ROI = $89,700 = 0.13 or 13 %
690,000
2.
With Air With With both Neither
Conditioner Turbocharger investments investments
Income $ $ 3,268,700 $ 3,336,200 $ 3,179,000
3,246,500
Assets $29,650,00 $29,590,000 $30,340,000 $28,900,000
0
ROI 10.95% 11.05% 11.00% 11.00%
The manager will choose the turbocharger, but not the air conditioner.
3. Cost of capital = [(1-0.25)(0.12)($1,500,000)]
= $135,000
EVA = [($67,500 + $89,700) - $135,000]
= $22,200
Yes, both investments increase the wealth of division, because EVA is
positive.
10-24 Ready Electronics is facing stiff competition from imported goods. Its
operating income margin has been declining steadily for the past several
years; the company has been forced to lower prices so that it can maintain
its market share. The operating results for the past three years are as
follows:
Year 1 Year 2 Year 3
Sales $10,000,000 9,500,000 9,000,000
Operating income 1,200,000 1,045,000 945,000
Average assets 15,000,000 15,000,000 15,000,000
For the coming year, Ready’s president plants to install a JIT purchasing
and manufacturing system. She estimates that inventories will be reduced
by 70 percent during the first year of operations, producing a 20 percent
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reduction in the average operating assets of the company, which would
remain unchanged without the JIT system. She also estimates that sales
and operating income will be restored to Year 1 levels because of
simultaneous reductions in operating expenses and selling prices. Lower
selling prices will allow Ready to expand its market share.
Required
1. Compute the ROI, margin, and turnover for Years 1, 2, and 3.
2. Suppose that in Year 4 the sales and operating income were achieved as
expected but inventories remained at the same level as in Year 3.
Compute the expected ROI, margin, and turnover. Explain why the ROI
increased over the Year 3 level.
3. Suppose that the sales and operating income for Year 4 remained the
same as in Year 3 but inventory reductions were achieved as projected.
Compute the ROI, margin, and turnover. Explain why the ROI
exceeded the Year 3 level.
4. Assume that all expectations for Year 4 were realized. Compute the
expected ROI, margin, and turnover. Explain why the ROI increased
over the Year 3 level.
Solution
1.
Year 1 Year 2 Year 2
ROI 8.00 % 6.97 % 6.30 %
Margin 12.00 % 11.00 % 10.50 %
Turnover 0.67 0.63 0.60
2. ROI = $1,200,000 = 8%
$15,000,000
Margin = $1,200,000 = 12%
$10,000,000
Turnover = $10,000,000 = 0.67
$15,000,000
The ROI increased because expenses decreased and assets turnover at a
higher rate (saless increased).
3. Operating assets : $15,000,000 x 80% = $12,000,000
ROI = $945,000 = 7.88%
$12,000,000
Margin = $945,000 = 10.5%
$9,000,000
Turnover = $9,000,000 = 0.75
$12,000,000
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The ROI increased because assets decreased.
4. ROI = $1,200,000 = 10%
$12,000,000
Margin = $1,200,000 = 12%
$10,000,000
Turnover = $10,000,000 = 0.83
$12,000,000
The ROI increased because expenses decreased and assets turnover at a
higher rate (sales increased and the amount of assets decreased). Both
margin and turnover increased.
10-30 Consider each of the following scenarios.
A. Terrin Belson, plant manager for the laser printer factory of Compugear,
Inc., brushed his hair back and sighed. December had been a bad
month; two machines had broken down, and some direct laborers (all
on salary) were idled for part of the month. Materials prices increased,
and insurance premiums on the factory increased. No way out of it–
costs were going up. He hoped that the marketing VP would be able to
push through some price increases, but that really wasn’t his
department.
B. Joanna Pauly was delighted to see that her ROI figures had increased
for the third straight year. She was sure that her campaign to lower costs
and use machinery more efficientlly (enabling her factories to sell
several older machines) was the reason. Joanna planned to take full
credit for the improvements at her semiannual performance review.
C. Gil Rodriguez, sales manager for CompuGear, was not pleased with a
memo from headquarters detailing the recent cost increases for the laser
printer line. Headquarters suggested raising prices. “Great”, thought
Gil, “An increase in price will kill sales–and revenue will go down.
Why can’t the plant shape up and cut costs like every other company in
America is doing? Why turn this into my problem?
D. Susan Whitehorse looked at the quarterly profit/loss statement with
disgust. Revenue was down and cost was up–what a combination!
Then, she had an idea. If she cut back on maintenance of equipment and
let a product engineer go, expenses would decrease–perhaps enough to
reverse the trend in operating income.
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E. Shonna Abbakian had just been hired to improve the fortunes of the
Southern Division of ABC, Inc. She met with top staff and hammered
out a three-year plan to improve the situation. A centerpiece of the plan
is the retiring of obsolete equipment and the purchasing of state-of-the-
art, computer-assisted machinery. The new machinery would take time
for the workers to learn to use, but once that was done, waste would be
virtually eliminated.
Required
For each the above independent scenarios, indicate the type of
responsibility center involved (cost revenue profit or investment) and the
accounting numbers on which performance evaluation is likely based.
Solution
A. Cost; total manufacturing cost
B. Investment; ROI
C. Revenue; total sales revenue
D. Profit; operating income
E. Investment; ROI
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