Lecture 8: Exercises

19.11 ROI and residual profit (Adopted by Horngren, C.T., Bhimani, A., Datar, S.M. and
Foster, G. (2012). Management and cost accounting. Prentice Hall, 5th eds.)
Récré-Gaules SARL produces and distributes a wide variety of recreational products.
One of its divisions, the Idefix Division, manufactures and sells 'menhirs', which are very popular
with cross-country skiers. The demand for these menhirs is relatively insensitive to price
changes. The Idefix Division is considered to be an investment centre and in recent years has
averaged a return on investment of 20%. The following data are available for the Idefix Division
and its product:
Total annual fixed costs €1000 000
Variable costs per menhir €300
Average number of menhirs sold each year 10000
Average operating assets invested in the division €1600000
Required:

1 What is the minimum selling price per unit that the Idefix Division could charge in order
for Marie-Aimée Obelix, the division manager, to get a favourable performance rating?
Management considers an ROI below 20% to be unfavourable.
2 Assume that Récré-Gaules judges the performance of its investment centre managers
on the basis of residual income rather than ROI, as was assumed in requirement 1. The
company's required rate of return is considered to be 15%. What is the minimum selling
price per unit that the Idefix Division should charge for Obelix to receive a favourable
performance rating?

Suggested solution:
Income Revenues Income
ROI = = x
Investment Investment Revenues
Operating profit = ROI × Investment
[No. of menhirs sold (Selling price – Var. cost per unit)] – Fixed costs = ROI  Investment
Let X = minimum selling price per unit to achieve a 20% ROI.
1 10,000 (X – €300) – €1,000,000 = 20% (€1,600,000)
10,000X = €320,000 + €3,000,000 + €1,000,000
= €4,320,000
X = €432
2 10,000 (X – €300) – €1,000,000 = 15% (€1,600,000)
10,000X = €240,000 + €3,000,000 + €1,000,000
= €4,240,000
X = €424

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19.12 Pricing and return on investment (Adopted by Horngren, C.T., Bhimani, A., Datar, S.M.
and Foster, G. (2012). Management and cost accounting. Prentice Hall, 5th eds.)
Salvador SA assembles motorcycles and uses long-run (defined as 3-5 years) average
demand to set the budgeted production level and costs for pricing. Prices are then adjusted
only for large changes in assembly wage rates or direct materials prices. You are given the
following data:
Direct materials, assembly wages and other variable costs €1 320 per unit
Fixed costs €300 000 000 per year
Target return on investment 20%
Normal utilisation of capacity (average output) 1 000 000 units
Investment (total assets) €900 000 000

Required:
1. What operating profit percentage on revenues is needed to attain the target return on
investment of 20%? What is the selling price per unit?
2. Using the selling price per unit calculated in requirement 1, what rate of return on
investment will be earned if Salvador assembles and sells 1500 000 units? 500 000 units?
3. The company has a management bonus plan based on yearly division performance.
Assume that Salvador assembled and sold 1000 000 units, 1500 000 units and 500 000
units in three successive years. Each of three people served as divisional manager for
one year before being killed in a car accident. As the principal heir of the third manager,
comment on the bonus plan.

Suggested solution:

Operating profit
1 ROI =
Investment
Operating profit
20% =
€900,000,000
Operating profit = €180,000,000

Target revenues:
Fixed overhead €300,000,000
Variable costs, 1,000,000  €1,320 1,320,000,000
Desired operating income 180,000,000
Revenues €1,800,000,000

Operating profit as a percentage of revenues is €180,000,000 or 10%.

€1,800,000,000
The selling price per unit is €1,800,000,000 ÷ 1,000,000 units = €1,800.

2
 2

ROI at various sales volumes over 3 years

Units sold 1,000,000* 1,500,000* 500,000*

Revenues, €1,800 per unit €1,800** €2,700** €900**

Variable costs, €1,320 per unit 1,320 1,980 660
Fixed costs 300 300 300
Total costs 1,620 2,280 960
Operating profit € 180 €420 €(60)
Return on investment 20% 46.67% –6.67%
*Row not directly used in calculations.
**All revenues, costs and operating profit are in millions of euros.

A summary analysis of these three cases follows:

OperatingProfit Revenues
Volume  Return on investment
Total Assets
Revenues
1,000,000 10.00%  2 20.00%
1,500,000 15.55%  3 46.65%
500,000 –6.67%  1 –6.67%

3 One year may often be too short a time span in the use of an operating income measure for
gauging performance or for paying bonuses. For instance, motorcycle sales may be heavily
influenced by general economic conditions that are not controllable by the division
managers whose bonuses are significantly affected thereby. Also, some short-run savings
in manufacturing costs may have long-run damaging effects. Examples include repairs,
maintenance, quality control and exerting severe pressures on employees for productivity.
Thus, the heir to the third manager may have much justification for being unhappy with any
bonus plan that is tied solely to a one-year operating income measure.

19.13 Residual income, economic value added® (Adopted by Horngren, C.T., Bhimani, A.,
Datar, S.M. and Foster, G. (2012). Management and cost accounting. Prentice Hall, 5th eds.)
Intervilles SA operates two divisions, a Lorry Rental Division that rents to individuals
and a Transportation Division that transports goods from one city to another. Results reported
for the last year are as follows:
Lorry Rental Division Transportation Division
Total assets €650 000 €950 000
Current liabilities 120 000 200 000
Operating profit before tax 75 000 160 000

Required:
1. Calculate the residual income for each division using operating profit before tax and
investment equal to total assets minus current liabilities. The required rate of return on
investments is 12%.
2. The company has two sources of funds: long-term debt with a market value of €900
000 at an interest rate of 10% and equity capital with a market value of €600 000 at a

3
 cost of equity of 15%. Intervilles' income tax rate is 40%. Intervilles applies the same
weighted-average cost of capital to both divisions, since each division faces similar risks.
Calculate the economic value added (EVA®) for each division.
3. Using your answers to requirements 1 and 2, what would you conclude about the
performance of each division? Explain briefly.

Suggested solution:

1.

Lorry Rental Transportation

Division Division
Total assets €650 000 €950 000
Less: current liabilities 120 000 200 000
Investment €530 000 €750 000

Required return (12% x investment) 63 600 90 000

Operating profit before tax 75 000 160 000
Residual income (profit - return) €11 400 €70 000

2.
After-tax cost of debt financing = (1 - 0.4) x 10% = 6%
After-tax cost of equity financing = 15%
Weighted average cost of capital = 9.6%

Required return for EVA®:

Lorry Rental Transportation
Division Division
Investment €530 000 €750 000
9.6% x investment 50 880 72 000
Operating profit before tax
= 0.6 x operating profit before tax 45 000 96 000
EVA® (profit after tax - required return) (€5 880) €24 000

3
Both the residual profit and the EVA® calculations indicate that the Transportation Division is
performing better than the Lorry Rental Division. The Transportation Division has a higher
residual profit (€70000 versus €11400) and a higher EVA® (€24 000 versus negative €5880). The
negative EVA® for the Lorry Rental Division indicates that on an after-tax basis the division is
destroying value - the after-tax economic return from the Lorry Rental Division's assets is less
than the required return. If EVA® continues to be negative, Intervilles may have to consider
shutting down the Lorry Rental Division.

4
19.15 Return on investment; comparisons of three companies. [CMA, adapted] [(Adopted
by Horngren, C.T., Bhimani, A., Datar, S.M. and Foster, G. (2012). Management and cost
accounting. Prentice Hall, 5th eds.)
Return on investment is often expressed as follows:
Income Revenues Income
= x
Investment Investment Revenues
Required

1. What advantages are there in the breakdown of the computation into two separate
components?
2. Fill in the following blanks:
Companies in same industry
A B C
Revenue €1 000 000 €500 000 ?
Profit €100 000 €50 000 ?
Investment €500 000 ? €5 000 000
Profit as % of revenue ? ? 0.5%
Investment turnover ? ? 2
Return on investment ? 1% ?
After filling in the blanks, comment on the relative performance of these companies as
thoroughly as the data permit.

Suggested solution:

1.
The separate components highlight several features of return on investment not revealed by a
single calculation:
The importance of investment turnover as a key to profit is stressed.
The importance of revenues is explicitly recognised.
The important components are expressed as ratios or percentages instead of euro figures. This
form of expression often enhances comparability of different divisions, businesses and time
periods.
The breakdown stresses the possibility of trading-off investment turnover for income as a
percentage of revenues so as to increase the average ROI at a given level of output.

5
2.
(Filled-in blanks are in bold face.)
Companies in same industry
A B C
Revenue €1 000 000 €500 000 € 10 000 000
Profit €100 000 €50 000 € 50 000
Investment €500 000 € 5 000 000 €5 000 000
Profit as % of revenue 10% 10% 0.5%
Investment turnover 2.0 0.1 2.0
Return on investment 20% 1% 1%

Income and investment alone shed little light on comparative performances because
of disparities in size between Company A and the other two companies. Thus, it is impossible
to say whether B's low return on investment in comparison with A's is attributable to its larger
investment or to its lower profit. Furthermore the fact that Companies B and C have identical
profit and investment may suggest that the same conditions underlie the low ROI, but this
conclusion is erroneous. B has higher margins but a lower investment turnover. C has very small
margins (1/20 of B's) but turns over investment 20 times faster.
The following analysis of the situation could be made:
Introducing revenues to measure level of operations helps to disclose specific areas for
more intensive investigation. Company B does as well as Company A in terms of profit margin,
for both companies earn 10% on revenues. But Company B has a much lower turnover of
investment than does Company A. Whereas a euro of investment in Company A supports 2 euros
in revenues each period, a euro investment in Company B supports only 10 cents in revenues
each period. This suggests that the analyst should look carefully at Company B's investment. Is
the company keeping a level of stocks larger than necessary for its revenue level? Are debts being
collected promptly? Or did Company A acquire its fixed assets at a price level that was much
lower than that at which Company B purchased its plant?
On the other hand, C's investment turnover is as high as A's, but C's profit as a percentage
of revenue is much lower. Why? Are its operations inefficient, are its material costs too high, or
does its location entail high transportation costs?
Analysis of ROI raises questions such as the foregoing. When answers are obtained, basic
reasons for differences between rates of return may be discovered. For example, in Company B's
case, it is apparent that the emphasis will have to be on increasing turnover by reducing
investment or increasing revenues. Clearly, B cannot appreciably increase its ROI simply by
increasing its profit as a percentage of revenue. In contrast, Company C's management should
concentrate on increasing the percentage of profit on revenue.

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19.16 Financial and non-financial performance measures, goal congruence. [CMA,
adapted] [(Adopted by Horngren, C.T., Bhimani, A., Datar, S.M. and Foster, G. (2012).
Management and cost accounting. Prentice Hall, 5th eds.)
Thor-Equip AS specialises in the manufacture of medical equipment, a field that has
become increasingly competitive. Approximately two years ago, Knut Solbaer, president of
Thor-Equip, decided to revise the bonus plan (based, at the time, entirely on operating profit)
to encourage divisional managers to focus on areas that were important to customers and that
added value without increasing cost. In addition to a profitability incentive, the revised plan
also includes incentives for reduced rework costs, reduced sales returns and on-time deliveries.
Bonuses are calculated and awarded semi-annually on the following basis. A base bonus is
calculated at 2% of operating profit. The bonus amount is then adjusted by the following
amounts:
a (i) Reduced by excess of rework costs over 2% of operating profit.
(ii) No adjustment if rework costs are less than or equal to 2% of operating
profit.
b Increased by €5000 if over 98% of deliveries are on time, by €2000 if 96-98% of
deliveries are on time and by €0 if on-time deliveries are below 96%.
c (i) Increased by €3000 if sales returns are less than or equal to 1.5% of sales.
(ii) Decreased by 50% of excess of sales returns over 1.5% of sales.
Note: If the calculation of the bonus results in a negative amount for a particular period, the
manager simply receives no bonus and the negative amount is not carried forward to the next
period.
Results for Thor-Equip's Kari and Sih Divisions for the year 2004, the first year under the
new bonus plan, follow. In the previous year, 2003, under the old bonus plan, the Karl Division
manager earned a bonus of €27 060 and the Siri Division manager a bonus of €22 440.
Kari Division Siri Division
1 January 2004 1 July 2004 to 31 1 January 2004 1 July 2004 to 31
to 30 June 2004 December 2004 to 30 June 2004 December 2004
Sales €4 200000 €4 400 000 €2 850 000 €2 900 000
Operating profit €462 000 €440 000 €342 000 €406 000
On-time
delivery 95.4% 97.3% 98.2% 94.6%
Rework costs €11500 €11000 €6000 €8000
Sales returns €84 000 €70 000 €44 750 €42 500

Required:
1. Why did Knut need to introduce these new performance measures? That is, why does
he need to use these performance measures over and above the operating profit
numbers for the period?
2. Calculate the bonus earned by each manager for each six-month period and for the
year 2004.

7
Suggested solution:

1 Operating income is a good summary measure of short-term financial performance. By

itself, however, it does not indicate whether operating income in the short run was earned
by taking actions that would lead to long-run competitive advantage. For example, Thor-
Equip’s divisions might be able to increase short-run operating income by producing more
product while ignoring quality or rework. Knut, however, would like to see division
managers increase operating income without sacrificing quality. The new performance
measures take a balanced scorecard approach by evaluating and rewarding managers on the
basis of direct measures (such as rework costs, on-time delivery performance and sales
returns). These motivate managers to take actions that Knut believes will increase operating
income now and in the future. The non-operating income measures serve as surrogate
measures of future profitability.
2 The semi-annual installments and total bonus for the Kari Division are calculated as follows:
Kari Division Bonus Calculation
for the year ended 31 December 2004
1 January 2011 to 30 June 2011
Profitability (0.02) (€462,000) €9,240
Rework (0.02  €462,000) – €11,500 (2,260)
On-time delivery No bonus – under 96% 0
Sales returns [(0.015 v €4,200,000) – €84,000]  50% (10,500)
Semi-annual installment (3,520)
Semi-annual bonus awarded €0
1 July 2011 to 31 December 2011
Profitability (0.02) (€440,000) €8,800
Rework (0.02  €440,000) – €11,000 (2,200)
On-time delivery 96–98% 2,000
Sales returns [(0.015 v €4,400,000) – €70,000]  50% (2,000)
Semi-annual installment 6,600
Semi-annual bonus awarded € 6,600
Total bonus awarded for the year € 6,600

8
The semi-annual installments and total bonus for the Siri Division are calculated as follows:

Siri Division Bonus Calculation

for year ended 31 December 2004

1 January 2011 to 30 June 2011

Profitability (0.02) (€342,000) € 6,840
Rework (0.02  €342,000) – €6,000 0
On-time delivery Over 98% 5,000
Sales returns [(0.015  €2,850,000) – €44,750]  50% (1,000)
Semi-annual bonus installment €10,840
Semi-annual bonus awarded €10,840

1 July 2011 to 31 December 2011

Profitability (0.02) (€406,000) € 8,120
Rework (0.02  €406,000) – €8,000 0
On-time delivery No bonus – under 96% 0
Sales returns [(0.015  €2,900,000) – €42,500] which is greater
than zero, yielding a bonus of 3,000
Semi-annual bonus installment €11,120
Semi-annual bonus awarded €11,120
Total bonus awarded for the year €21,960

19.18 Relevant costs, performance evaluation, goal congruence (Adopted by Horngren,

C.T., Bhimani, A., Datar, S.M. and Foster, G. (2012). Management and cost accounting. Prentice
Hall, 5th eds.)
Mikkeli Oy has three operating divisions. The managers of these divisions are evaluated
on their divisional operating profit, a figure that includes an allocation of corporate overhead
proportional to the revenues of each division. The operating profit statement (in thousands) for
the first quarter of 2005 is as follows:
Tampere Oulu Kotka
Total
Division Division Division
Revenues €2000 €1200 €1600 €4800
Cost of goods sold 1050 540 640 2230
Gross profit 950 660 960 2570
Division overhead 250 125 160 535
Corporate overhead 400 240 320 960
Divisional operating profit €300 €295 €480 €1075

The manager of the Tampere Division is unhappy that his profitability is about the same as the
Oulu Division's and is much less than the Kotka Division's, even though his revenues are much
higher than either of these other two divisions'. The manager knows that he is carrying one
line of products with very low profitability. He was going to replace this line of business as soon
as more profitable product opportunities became available, but he has kept it because the line
is marginally profitable and uses facilities that would otherwise be idle. That manager now
realises, however, that the sales from this product line are attracting a fair amount of corporate

9
overhead because of the allocation procedure and maybe the line is already unprofitable for
him. This low-margin line of products had the following characteristics for the most recent
quarter (in thousands):
Revenues €800
Cost of goods sold 600
Avoidable division overhead 100

Required:
1. Prepare the operating profit statement for Mikkeli Oy for the second quarter of 2005.
Assume that revenues and operating results are identical to the first quarter except that
the manager of the Tampere Division has dropped the low-margin product line from
his product group.
2. Is Mikkeli Oy better off from this action?
3. Is the Tampere Division manager better off from this action?
4. Suggest changes for Mikkeli's system of division reporting and evaluation that will
motivate division managers to make decisions that are in the best interest of Mikkeli
Oy as a whole. Discuss any potential disadvantages of your proposal.

Suggested solution:

This exercise illustrates the dysfunctional behaviour that could be motivated by arbitrary
allocations of corporate overhead to profit-conscious divisional managers.
1 Without the €800,000 in sales from the low-margin product line in the Tampere Division,
the second quarter operating statements (in thousands) will be:

Tampere Oulu Kotka Total

Net sales €1,200 €1,200 €1,600 €4,000
Cost of sales 450 540 640 1,630
Divisional overhead 150 125 160 435
Divisional contribution 600 535 800 1,935
Corporate overhead 288 288 384 960
Operating income € 312 € 247 € 416 € 975

2 The company is worse off as a result of dropping the low-profitability line of products
because it has lost €100,000 in contribution margin from the dropped product line with no
reduction in corporate overhead. Total operating income decreases from €1,075,000 in the
first quarter to €975,000 in the second quarter.
3 The Tampere Division manager’s performance evaluation measure (divisional operating
income) is higher (€312,000 in the second quarter compared with €300,000 in the first
quarter) as a result of dropping the low-profitability product line. The Tampere Division
manager is able to show a €12,000 higher operating income because the €100,000 in lost
contribution margin from the dropped product line is more than offset by the €112,000
reduction in corporate overhead that is charged to the Tampere Division. Tampere Division
sales are now only 30% of corporate sales rather than the previous 41.7% of sales (so 30%
of total corporate overhead costs of €960,000 equalling €288,000 are allocated to the
Tampere Division in the second quarter, whereas 41.7% of €960,000 equalling €400,000
were allocated to the Tampere Division in the first quarter).
4 The easiest solution is to not allocate fixed corporate overhead to divisions. Then the
problem of dysfunctional behaviour will not arise. But central management may want the
division managers to ‘see’ the cost of corporate operations so that they will understand that

10
 the corporation as a whole is not profitable unless the combined divisions’ contribution
margins exceed corporate overhead. In this case, an allocation basis should be chosen that
is not manipulable or under the control of division managers. It must also have the property
that the action taken by one division does not affect the corporate overhead allocations that
get made to the other divisions (as occurred in the second quarter for the company).
In general, a lump-sum allocation based on, say, budgeted net income or budgeted assets,
rather than an allocation that varies proportionately with an actual measure of activity (such
as sales or actual net income) will minimise dysfunctional behaviour. The allocation should
be such that managers treat it as a fixed, unavoidable charge, rather than a charge that will
vary with the decisions they take. Of course, a potential disadvantage of this proposal is that
managers may try to underbudget the amounts that serve as the cost-allocation bases, so that
their divisions get less of the corporate overhead charges.

19.19 Evaluating managers, ROI, value-chain analysis of cost structure (Adopted by

Horngren, C.T., Bhimani, A., Datar, S.M. and Foster, G. (2012). Management and cost accounting.
Prentice Hall, 5th eds.) [40-50 minutes]
User Friendly Computer is one of the largest personal computer companies in the
world. The board of directors was recently (March 2005) informed that User Friendly's
president, Felix Lechat, was resigning to 'pursue other interests'. An executive search firm
recommends that the board consider appointing Peter Diamond (current CEO of Computer
Power) or Rachida Kamel (current CEO of Plum Computer). You collect the following financial
information on Computer Power and Plum Computer for 2003 and 2004 (in millions):
Computer Power Plum Computer
2003 2004 2003 2004
Total assets €360.0 €340.0 €160.0 €240.0
Revenues €400.0 €320.0 €200.0 €350.0
Costs
R&D 36.0 16.8 18.0 43.5
Design 15.0 8.4 3.6 11.6
Production 102.0 112.0 82.8 98.6
Marketing 75.0 92.4 36.0 66.7
Distribution 27.0 22.4 18.0 23.2
Customer service 45.0 28.0 21.6 46.4
Total costs 300.0 280.0 180.0 290.0
Operating profit €100.0 €40.0 €20.0 €60.0

In early 2005, a computer magazine gave Plum Computer's main product five stars (its highest
rating on a five-point scale). Computer Power's main product was given three stars, down from
five stars a year ago because of customer-service problems. The computer magazine also ran
an article on new-product introductions in the personal computer industry. Plum Computer
received high marks for new products in 2004. Computer Power's performance was called
'mediocre'. One 'unnamed insider' of Computer Power commented: 'Our new-product
cupboard is empty.'

11
Required:
1. Use the DuPont method to analyse the ROI of Computer Power and Plum Computer in
2003 and 2004. Comment on the results.
2. Calculate the percentage of costs in each of the six business-function cost categories
for Computer Power and Plum Computer in 2003 and 2004. Comment on the results.
3. Rank Diamond and Kamel as potential candidates for CEO of User Friendly Computer.

Suggested solution:

1.
Computer Power
2003 1.111 0.250 0.278
2004 0.941 0.125 0.118
Plum Computer
2003 1.250 0.100 0.125
2004 1.458 0.171 0.250

Computer Power's ROI has declined sizably from 2003 to 2004, largely because of a decline in
operating profit to revenues. Plum Computer's ROI has doubled from 2003 to 2004, in large
part due to an increase in operating profit to revenues.

2.

Computer Power Plum Computer

Business function 2003 2004 2003 2004
R&D 12.0% 6.0% 10.0% 15.0%
Design 5.0 3.0 2.0 4.0
Production 34.0 40.0 46.0 34.0
Marketing 25.0 33.0 20.0 23.0
Distribution 9.0 8.0 10.0 8.0
Customer service 15.0 10.0 12.0 16.0
Total costs 100.0% 100.0% 100.0% 100.0%
Business functions with increases/decreases in the percentage of total costs from 2003 to 2004
are:
Computer Power Plum Computer
Increases Production R&D
Marketing Design
Marketing
Customer service
Decreases R&D Production
Design Distribution
Distribution
Customer service

Computer Power has decreased expenditures in several key business functions that are critical
to its long-term survival, notably research and development and design. These costs are (using

12
the Chapter 8 appendix terminology) discretionary and can be reduced in the short run without
any short-run effect on customers, but such action is likely to create serious problems in the
long run.

3.
Based on the information provided, Kamel is the better candidate for president of User Friendly
Computer. Both Computer Power and Plum Computer are in the same industry. Kamel has
headed Plum Computer at a time when it has considerably outperformed Computer Power:
The ROI of Plum Computer has increased from 2003 to 2004 while that of Computer Power has
decreased.
The computer magazine has increased the ranking of Plum Computer’s main product, while it
has decreased the ranking of Computer Power’s main product.
Plum Computer has received high marks for new products (the lifeblood of a computer
company), while Computer Power new-product introductions have been described as
‘mediocre’.

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