Chapter 10 Practice Problems

Chapter 10 Practice Problems

1. Which of the following is NOT a benefit of decentralization?

a. Lower-level managers have the best information concerning local conditions and therefore may be able to make better decisions than their superiors.

b. Managers acquire decision-making ability and other management skills that help them move upward in the organization, assuring continuity of leadership.

c. Managers enjoy higher status from being independent and thus are better motivated.d. Managers save time dealing with managers from other segments regarding transfer prices.

Use the following information for Questions 2 – 3.

The following information pertains to Smith Company: Invested capital $250,000 Net income 50,000

Sales 500,000Imputed interest rate 12 percent

2. The return on investment is

a. 10 percentb. 50 percent c. 20 percentd. 12 percent

3. The residual income is

a. $50,000b. $30,000c. $20,000d. $60,000

4. The following information pertains to Ex Company Total assets $50,000 Total current liabilities 10,000

Total expenses 60,000Total liabilities 15,000Total revenues 80,000

If invested capital is defined as total assets, and the imputed interest rate is 8 percent, the residual income is

a. $4,000b. $16,000c. $20,000d. $1,600

5. The following information pertains to Freedom Company

Total assets $100,000Total current liabilities 20,000Total expenses 120,000Total liabilities 30,000Total revenues 160,000

If invested capital is defined as stockholders' equity, the return on investment is

a. 175 percentb. 57 percentc. 229 percentd. 44 percent


Greek Shipping Corporation has three divisions: Alpha, Beta, and Gamma. The expected earnings (income) and amount of investment in these divisions for the coming year are:

Division Investment Earnings Alpha $ 200,000 $ 40,000 Beta 1,600,000 100,000 Gamma 2,000,000 800,000

A proposed investment, that costs $200,000 and has projected earnings of $30,000, has been offered to each of the three divisions. All divisions can make this investment, and the company's cost of capital is 10%. 6. If division managers are being evaluated based on return on investment,

a. the manager of division Alpha will invest in the project.b. the manager of division Beta will invest in the project.c. the manager of division Gamma will invest in the project.d. at least two managers will invest in the project.

7. If division managers are being evaluated based on residual income,

a. the manager of division Alpha will invest in the project.b. the manager of division Beta will invest in the project.c. the manager of division Gamma will invest in the project.d. all three managers will invest in the project.

8. If Division A incurs costs to make a product of $4 and sells to Division B for $6, who then adds costs of $2 and sells a final product for $12, how much profit per unit did the firm earn?

a. $2b. $4c. $6d. $12

9. The Cup and Mug Divisions are part of the same company. Currently the Mug Division buys a part from Cup for $48. The Cup Division wants to increase the price of the part it sells to Mug by $12 to $60. The manager of Mug has stated that it cannot afford to go that high, as it will decrease the division's profit to near zero. Mug can buy the part from an outside supplier for $56. The cost data for the Cup Division is as follows:

Direct materials $17.00Direct labor $25.00Variable overhead $5.00Fixed overhead $4.80

If Cup ceases to produce the parts for Mug, it will be able to avoid one-third of the fixed manufacturing overhead. The Cup Division has excess capacity but no alternative uses for its facilities. From the standpoint of the company as a whole, should Mug continue to buy from Cup or start to buy from the outside supplier?

a. Buy from Cup Division, because the company's profit would be $7.40 per unit larger.b. Buy from Cup Division, because the company's profit would be $4.00 per unit larger.c. Buy from an outside supplier.d. none of the above

10. If the selling subunit is operating at full capacity and can sell everything produced either internally or externally, the lowest transfer price it would be willing to accept would be

a. Marginal costb. Market pricec. Variable costd. Cost plus a markup

11. Optoca has 2 divisions, A and B. Division A makes a component for tables that it can sell only to Division B. It has no other outlet for sales and currently has excess capacity. Current information for the divisions is as follows:

Incremental cost for Division A $100

Incremental cost for Division B $200

Transfer price for component $175

Final Table selling price $425

The transfer price is based on 175% of incremental costs.

What is the profit per table for Optoca?

a. $50b. $75c. $125d. $150






Unit sales 300


What is the amount of profit recognized by Division B?

a. $15,000b. $22,500c. $37,500d. $45,000







Aptica has offered to sell Division B the same component it currently gets from Division A for $150 per unit. If Division B accepts Aptica’s offer, the firm as a whole will be

a. $25 per unit better offb. $25 per unit worse offc. $50 per unit better offd. $50 per unit worse off

14. Optoca has 2 divisions, A and B. Division A makes a component for tables that it can sell only to Di-vision B. It has no other outlet for sales and currently has excess capacity. Current information for the divisions is as follows:






Outside firms are offering to provide the part to Division B for a lower cost than the current transfer price of $175. Given this information, what is the minimum amount that Division A would be willing to sell to Division B?

a. $100 per unitb. $125 per unitc. $150 per unitd. $175 per unit


The Bottling Division of Drink It Up, Inc. reported the following sales, costs and income for the prior quarter:

Sales $300,000COGS 180,000Gross Margin $120,000Selling & Admin 45,000Income $ 75,000

The Bottling Division has invested capital of $500,000. Drink It Up, Inc. desires a 10% return on invested capital.

15. What is the Bottling Division’s return on investment (ROI)?

a. 25%b. 15%c. 40%d. 10%e. 60%

16. What is the Bottling Division’s residual income?

a. $ 50,000b. $ 75,000c. $ 25,000d. $120,000e. $ 45,000

17. Assume the Bottling Division can invest in a new project for $100,000 that is expected to generate income of $12,000. Would the manager of the Bottling Division be motivated to invest in the new project if his/her performance is evaluated based on the division’s ROI? Why or why not?

a. Yes because the ROI of the new investment is higher than the division’s current ROIb. No because the ROI of the new project is lower than the division’s current ROIc. Yes because the ROI of the new project is lower than the division’s current ROId. No because the ROI of the new project is higher than the division’s current ROI

18. Assume the Bottling Division can invest in a new project for $100,000 that is expected to generate income of $12,000. Would the manager of the Bottling Division be motivated to invest in the new project if his/her performance is evaluated based on the division’s residual income? Why or why not?

a. Yes because the residual income of the new project is positive and will therefore increase the division’s residual income

b. No because the residual income of the new project is negative and will therefore decrease the division’s residual income

c. Yes because the residual income of the new project is negative and will therefore decrease the division’s residual income

d. No because the residual income of the new project is positive and will therefore decrease the division’s residual income


A Company’s Division earns Income of $120,000 on $2,000,000 of Revenue, employing the following Balance Sheet:

Total Assets $1,000,000Short-term Liabilities $200,000Long-term Liabilities $400,000Stockholder’s Equity $400,000

The Company’s required rate of return is 10%, and it uses total assets as invested capital.

19. What is the Division’s return on investment (ROI)?

a. 10%b. 6%c. 20%d. 12%e. 30%

20. What is the Division’s residual income?

a. $120,000b. $ 20,000c. $100,000d. $ 80,000

Assume the Division is considering an additional investment of $500,000 that would yield incremental income of $55,000 on sales of $1,100,000.

21. What is the ROI of the new investment?

a. 10%b. 45%c. 5%d. 11%

22. If ROI is the measure of profitability used by the Company, will the Division Manager be motivated to make the investment? Why or why not?

a. Yes because the division’s ROI will increase if the investment in the new project is madeb. No because the division’s ROI will decrease if the investment in the new project is madec. Yes because the division’s ROI will decrease if the investment in the new project is maded. No because the division’s ROI will increase if the investment in the new project is made

23. What is the residual income of the new investment?

a. $ 55,000b. $500,000c. $445,000d. $ 5,000e. $(55,000)

24. If residual income is the measure of profitability used by the Company, will the Division Manager be motivated to make the investment? Why or why not?

a. Yes because the residual income of the division would increaseb. No because the residual income of the division would decreasec. Yes because the residual income of the division would decreased. No because the residual income of the division would increase

Use the following information for questions 25 – 27.

The Wheel Division of Golf Caddy Incorporated incurs $100 to produce a set of 4 golf cart wheels that it sells to the Assembly Division (also a division of Golf Caddy Inc.) for $125 per set of 4 wheels. The Assembly Division uses the wheels in the production of the final product, golf carts. The Assembly Division incurs an additional cost of $750 to produce each golf cart and sells the golf carts to outside customers for $1,200.

25. Assuming a production and sales volume of 500 golf carts, what is the profit for the Wheel Division, the Assembly Division, and the company as a whole?

a. Wheel: $62,500; Assembly: $225,000; Total Company: $287,500b. Wheel: $12,500; Assembly: $225,000; Total Company: $237,500c. Wheel: $62,500; Assembly: $162,500; Total Company: $225,000d. Wheel: $62,500; Assembly: $112,500; Total Company: $175,000e. Wheel: $12,500; Assembly: $162,500; Total Company: $175,000

26. Assume that Wheel Solutions, an entirely separate company, has offered to sell the Assembly Division the golf cart wheels for $115 per set of 4 wheels. From the standpoint of the company as a whole, should the Assembly Division buy the wheels from Wheel Solutions? Assume a production and sales volume of 500 golf carts.

a. Yes, the company as a whole will be better off by $7,500b. No, the company as a whole will be worst off by $7,500c. Yes, the company as a whole will be better off by $5,000d. No, the company as a whole will be worst off by $5,000

27. Assume that the Wheel Division has excess capacity, what is the lowest transfer price the Wheel Division should be willing to accept from the Assembly Division?

a. $125b. $100c. $450d. $ 0

Solutions

1. D. By allowing lower level managers the ability to make decisions, you give them skills to move upward, they have the best information, and the have better morale.

2. C

___Net Income $50,000 = Return on Investment (ROI) 20%Invested Capital $250,000

3. C

Net Income = (Imputed Interest Rate x Invested Capital) = Residual Income50,000 – (12% x 250,000) = $20,000

4. B

Net Income - (Imputed Interest Rate x Invested Capital) = Residual Income 20,000 – (8% x 50,000) = $16,000

5. B

Net Income = Return on Investment (ROI)Invested Capital

$40,000 = 57%$70,000*

*Total Assets = 100,000 and Total Liabilities =30,000, therefore Total Stockholders Equity has to equal $70,000.

6. B (see explanation below)

7. D (see explanation below)

Explanation for 6 and 7:

The project will earn a return of 15% (= $30,000/$200,000). Currently, the ROI of Alpha is 20% (= 40,000/200,000); the ROI of Beta is 6.25% (=$100,000/$1,600,000); and the ROI of Gamma is 40% (= $800,000/$2,000,000). Accepting a project with a return of 15% will be appealing to Beta Division, because it would raise Beta’s ROI. However, it would lower the ROI of the other two divisions, so they wouldn’t invest in the project.

If evaluations were based on residual income, all three managers would invest in the project because it returns more than the company’s cost of capital. Thus, it would increase every division’s residual income.

8. C. The transfer price is revenue to the selling division and a cost to the buying division. Therefore, from the overall firm’s perspective, the transfer price doesn’t have any effect on firm profit (since the buying and selling divisions are part of the same company).

The total cost of making the product for the firm as a whole is $6 ($4 incurred by Division A plus $2 incurred by Division B). If the product sells for $12 and it costs the firm $6 to make, the profit is the remaining $6.

The profit for each division and total company would be as follows:

Div A Div B Total Company

Sales $6 (transfer price) $12 $12

- Costs $4 $6 (transfer price) $4______ ___ $2 $2 Profit $2 $4 $6

9. A. From the perspective of the company as a whole, this question is very similar to a make vs. buy problem. The alternatives are to either buy the part internally from the Cup Division (in other words, make the part within the company in the Cup Division) or buy the part externally from the outside supplier. From the company’s perspective, if Mug buys from the Cup Division, the relevant costs to the company as a whole would be $48.60 ($17.00 + $25.00 + $5.00 + $1.60*). If Mug buys from an outside supplier, the relevant costs to the company as a whole would be $56.00. So the overall profit would be $7.40 per unit higher if Mug buys the part from the Cup Division (costs of $48.60 versus $56.00). Notice that the transfer price of $60.00 is not even a factor in our analysis. From the overall company’s perspective, the transfer price has no effect on the firm’s profit.

*1/3 X $4.80 = $1.60 ->this is the relevant (avoidable) portion of the fixed overhead costs

10. B. Remember the rules of thumb regarding transfer prices:

If the selling division has idle or excess capacity, the LOWEST transfer price the division would accept is their variable (or avoidable) costs.

If the selling division is at full capacity, the LOWEST transfer price the division would accept is the market price (whatever they are getting from their other customers, which is assumed to be the market price).

Regardless of the capacity of the selling division, the HIGHEST transfer price the buying division would be willing to pay is the market price. The buying division would not want to pay more than they could pay someone else for the product.

11. C. Transfer prices have no effect on overall company profit. The table costs $300 to make (costs of Division A + costs of Division B) and it sells for $425. The difference of $125 is the profit for the company. (See illustration below answer to #12).

12. A. Division B has the following costs:$175 for the component (bought from Division A) 200 costs added in Division B 375 total costs

Division B sells the table for $425, so the division profit is $50 (=$425 – 375) per unit. For 300 units, that amounts to $15,000 in total profit. (See illustration below).

Illustration for #11 and #12:

The profit for each division and total company would be as follows:

Div A Div B Total Company

Sales $175 (transfer price) $425 $425

- Costs $100 $175 (transfer price) $100 (Div A costs)______ ___ $200 $200 (Div B costs) Profit $ 75 $ 50 $125

x 300 units$15,000

13. D. Currently, the firm’s cost to make the component in Division A is $100. If the Division B pays an outside firm $150 for the part, the company will be worse off by $50 per unit.

14. A. Because Division A sells only to Division B, they would be willing to transfer at any amount greater than or equal to its variable costs. Here, that is the incremental cost of $100.

15. B Income / Invested Capital = $75,000 / $500,000 = 15%

16. CResidual Income = Income – (Cost of Capital % * Invested Capital)

$75,000 – (10% * $500,000)$75,000 – $50,000 = $25,000

17. B. No, the manager would not be motivated to invest in the new project if s/he is evaluated based on ROI (even though the project is desirable from the Company’s perspective) because the new project’s ROI is less than the division’s current ROI. Therefore, the division’s ROI would drop from 15% (see #15 above) to 14.5% (see below).

ROI of new project = $12,000 / $100,000 = 12%

ROI of division = ($75,000 + $12,000) / ($500,000 + $100,000)(after investing in project)

= $87,000 / $600,000 = 14.5%

18. A. Yes, the manager would be motivated to invest in the new project if s/he is evaluated based on residual income because the new project has a positive residual income (it earns a greater return than the company’s desired rate of return). The division’s residual income would increase from $25,000 (see #16 above) to $27,000 (see below).

RI of new project = $12,000 – (10% * $100,000) = $2,000

RI of division = ($75,000 + $12,000) – [10% * ($500,000 + $100,000)](after investing in project)

= $87,000 – (10% * $600,000) = $27,000*

*or just add the $2,000 RI from the new investment to the $25,000 of RI the division had prior to the new investment.

19. DROI = Income / Invested Capital

= $120,000 / $1,000,000 = 12%

20. BRI = Income – (Cost of Capital % * Invested Capital)

= $120,000 – (10% * $1,000,000)= $120,000 – $100,000 = $20,000

21. DROI = Income / Invested Capital

= $55,000 / $500,000 = 11%

22. B. No, the manager would not be motivated to make the investment because his/her division’s ROI will decrease from 12% (see #19 above) to 11.67% (see below).

ROI = Income / Invested Capital = ($120,000 + $55,000) / ($1,000,000 + $500,000) = $175,000 / $1,500,000 = 11.67%

23. DRI = Income – (Cost of Capital % * Invested Capital)

= $55,000 – (10% * $500,000)= $55,000 – $50,000 = $5,000

24. A. Yes, the manager would be motivated to make the investment because his/her division’s RI will increase from $20,000 (see #20 above) to $25,000(see below).

RI = Income – (Cost of Capital % * Invested Capital)= ($120,000 + $55,000) – [10% * ($1,000,000 + $500,000)]= $175,000 – (10% * $1,500,000)= $175,000 – $150,000 = $25,000

*or just add the $5,000 RI from the new investment to the $20,000 of RI the division had prior to the new investment.

25. E Wheel Division Assembly Division Total Company

Sales $62,500* $600,000 $600,000

- Costs $50,000 $375,000 $ 50,000 $ 62,500* $375,000Profit $12,500 $162,500 $175,000

*The $62,500 transfer price is revenue to the Wheel Division and a cost to the Assembly Division, but it has no impact on the overall company since the two divisions are part of the same company.

26. B. No, the Company as a whole will be better off by $15 per set of 4 wheels if the Assembly Division does not buy the wheels from Wheel Solutions ($100 cost per set of wheels if the wheels are made and sold internally versus $115 cost per set of wheels if they are purchased externally):

Make Internally Buy Externallycost to make cost to buyin Wheel Div. $100 from Wheel Solutions $115

27. B. The lowest transfer price the Wheel Division should be willing to accept (assuming the Wheel Division is not at full capacity) is the costs incurred of $100.

Chapter 10 Practice Problems

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