3 32 21 1

CHAPTER 10
SEGMENTED REPORTING, INVESTMENT CENTER
EVALUATION, AND TRANSFER PRICING
QUESTIONS FOR WRITING AND DISCUSSION
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
3 32 22 2
16.
17.
18.
19.
20.
21.
22.
23.
24.

3 32 23 3
EXERCISES
10-1
Cost center Total cost
Profit center Operating income
Revenue Center - Sales
Investment center - Return on Investment

102
1. Total Cost Per Unit
Direct materials $ 120,600 $ 6.03
Direct labor 90,000 4.50
Variable overhead 26,400 1.32
Fixed overhead 68,000 3.40
Total $ 305,000 $ 15.25
Cost of ending inventory = $15.25 650 = $9,912.50

2. Total Cost Per Unit
Direct materials $ 120,600 $ 6.03
Direct labor 90,000 4.50
Variable overhead 26,400 1.32
Total $ 237,000 $ 11.85
Cost of ending inventory = $11.85 650 = $7,702.50

3. Since absorption costing is required for external reporting, the amount re-
ported would be $9,912.50.
3 32 24 4
103
1. Fixed overhead rate = $107,500/25,000 = $4.30 per unit
The difference is computed as follows:
Fixed overhead rate(Production Sales)
$4.30(25,000 23,000) = $8,600

2. a. Lextel, Inc.
Variable-Costing Income Statement
For the Year Ended December 31, 2008
Sales (23,000 $26) ........................................ $ 598,000
Less variable expenses:
Cost of goods sold (23,000 $12.80) ...... $ 294,400
Selling (23,000 $4) .................................. 92,000 386,400
Contribution margin ....................................... $ 211,600
Less fixed expenses:
Overhead .................................................... $ 107,500
Selling and administrative ........................ 26,800 134,300
Operating income ........................................... $ 77,300

b. Lextel, Inc.
Absorption-Costing Income Statement
For the Year Ended December 31, 2008
Sales ..................................................................................... $ 598,000
Less: Cost of goods sold (23,000 $17.10) ...................... 393,300
Gross margin ....................................................................... $ 204,700
Less: Selling and administrative expenses ...................... 118,800
Operating income ........................................................... $ 85,900

104
1. Cocino Company
Product-Line Income Statements
Blenders Coffee Makers Total
Sales $ 2,200,000 $ 1,125,000 $ 3,325,000
Less: Variable cost of goods sold 2,000,000 1,075,000 3,075,000
Contribution margin $ 200,000 $ 50,000 $ 250,000
Less: Direct fixed expenses 90,000 45,000 135,000
Product margin $ 110,000 $ 5,000 $ 115,000
Less: Common fixed expenses 115,000
Net income $ 0
3 32 25 5

2. If the coffee-maker line is dropped, profits will decrease by $5,000, the prod-
uct margin. If the blender line is dropped, profits will decrease by $110,000.

3. Blenders Coffee Makers Total
Sales $ 2,405,000 $ 1,125,000 $ 3,530,000
Less: Variable cost of goods sold 2,200,000 1,075,000 3,275,000
Contribution margin $ 205,000 $ 50,000 $ 255,000
Less: Direct fixed expenses 90,000 45,000 135,000
Product margin $ 115,000 $ 5,000 $ 120,000
Less: Common fixed expenses 115,000
Operating income $ 5,000
Profits increase by $5,000. Alternatively,
Increased profit = ($20.50 - $20.00) 10,000 = $5,000
105
1. Absorption costing:
Direct materials $1.20
Direct labor 0.75
Variable overhead 0.65
Fixed overhead 3.10
Unit cost $5.70
Cost of ending inventory = $5.70 200 = $1,140

2. Variable costing:
Direct materials $1.20
Direct labor 0.75
Variable overhead 0.65
Unit cost $2.60
Cost of ending inventory = $2.60 200 = $520

3. Selling price $ 7.50
Less:
Variable cost of goods sold (2.60)
Commission (0.75)
Contribution margin per unit $ 4.15

3 32 26 6
4. Sales ($7.50 17,600) ............................... $ 132,000
Less:
Variable cost of goods sold ................ $45,760
Commissions ....................................... 13,200 58,960
Contribution margin .................................. $ 73,040
Less fixed expenses:
Fixed overhead .................................... $27,900
Fixed administrative ............................ 23,000 50,900
Net income ................................................. $ 22,140
Variable costing should be used, since the fixed costs will not increase as
production and sales increase.
106
1. Operating income = Sales Expenses = $50,000 $48,000 = $2,000
2. Margin = Operating income/Sales
= $2,000/$50,000 = 0.04
Turnover = Sales/Operating assets
= $50,000/$10,000 = 5
3. ROI = Margin Turnover = 0.04 5 = 0.20, or 20%
107
1. Average operating assets = ($78,650 + $81,350)/2 = $80,000

2. Margin = Operating income/Sales
= $7,200/$240,000 = 0.03
Turnover = Sales/Operating assets
= $240,000/$80,000 = 3.0
ROI = Margin Turnover = 0.03 3.0 = 0.09, or 9.0%
108
1. a. ROI of division without radio = $480,000/$8,000,000 = 0.06
b. ROI of the radio project = $270,000/$1,500,000 = 0.18
c. ROI of division with radio = $750,000/$9,500,000 = 0.0789
2. Yes, Cheryl will decide to invest in the project, since overall division ROI will
increase.
3 32 27 7
109
1. After-tax cost of mortgage bonds = (1 0.3)(0.08) = 0.056

2. Cost of common stock = 0.06 + 0.06 = 0.12

3. Dollar After-Tax Weighted
Amount Percent Cost = 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. Cost of capital = $1,500,000 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.
1010
1. After-tax cost of mortgage bonds = (1 0.4)(0.08) = 0.048

2. Cost of common stock = 0.06 + 0.06 = 0.12

3. Dollar After-Tax Weighted
Amount Percent Cost = Cost
Mortgage bonds $1,300,000 0.65 0.048 0.0312
Common stock 700,000 0.35 0.120 0.0420
Total $2,000,000
Weighted average cost of capital 0.0732

4. Cost of capital = $1,500,000 0.0732 = $109,800

5. After-tax operating income $115,000
Less: Cost of capital 109,800
EVA $ 5,200
EVA is now positive, and Schipper is creating wealth.
3 32 28 8
10-11
1. MP3 player: RI = $116,000 (0.12 $800,000)
= $20,000
Voice Rec.: RI = $105,000 (0.12 $750,000)
= $15,000
2. Add Only Add Only Add Both Maintain
MP3 Player Voice Rec. Projects Status Quo
Operating income $2,816,000 $2,805,000 $2,921,000 $2,700,000
Minimum income* 2,256,000 2,250,000 2,346,000 2,160,000
Residual income $ 560,000 $ 555,000 $ 575,000 $ 540,000
*Minimum income = Operating assets Minimum required rate of return
The manager will invest in both the MP3 player and the voice recorder.
3. ROI MP3 player = $116,000/$800,000 = 0.145 or 14.5%

ROI voice recorder = $105,000/$750,000 = 0.14 or 14.0%

4. Add Only Add Only Add Both Maintain
MP3 Player Voice Rec. Projects Status Quo
Operating income $2,816,000 $2,805,000 $2,921,000 $2,700,000
Operating assets 18,800,000 18,750,000 19,550,000 18,000,000
ROI 14.98% 14.96% 14.94% 15.00%
The manager will invest in neither project.

10-12

1. North Woods residual income = $140,000 (0.08)($1,000,000) = $60,000
Midwest residual income = $330,000 (0.08)($3,000,000) = $90,000

2. North Woods ROI = $140,000/$1,000,000 = 0.14 or 14%

Midwest ROI = $330,000/$3,000,000 = 0.11 or 11 %

3 32 29 9
1013
1. Maximum transfer price = $42
Minimum transfer price = $15
Only variable costs are relevant for the minimum transfer price since the Fur-
niture Division has excess capacity.
Yes, the transfer should take place.

2. Benefit to Furniture Division:
Revenue ($30 10,000) $ 300,000
Less: Variable cost ($15 10,000) 150,000
Benefit $ 150,000
Benefit to Motel Division:
Outside supplier ($42 10,000) $ 420,000
Transfer price ($30 10,000) 300,000
Benefit $ 120,000
Benefit to company = $150,000 + $120,000 = $270,000

3. Maximum transfer price = $42
Minimum transfer price = $42
It does not matter whether or not the transfer takes place because the cost to
the company is the same whether the Motel Division buys from the outside
supplier or from the internal supplier (the Furniture Division).
1014
1. The minimum and maximum transfer price for each division is $2.30. The
company is indifferent to the transfer because it earns the same income
whether or not it takes place. If the transfer takes place, the price should be
$2.30.

2. The minimum transfer price is $2.10, and the maximum price is still $2.30. The
transfer should take place because the company would save $30,000 (150,000
$0.20) each year.

3. The offer should be accepted because the Small Motor Divisions profits
would increase by $15,000 (representing an even split of the savings from in-
ternal transfer).
3 33 30 0
1015
1. Maximum price $ 3.95
Minimum price* 2.25
Difference $ 1.70
Number of packages 150,000
Increased profit $ 255,000
*Due to idle capacity of the Paper Division, the minimum price is a variable
cost of $2.25 per package. Since selling costs of $0.40 are avoidable, they
are not included.
Yes, the transfer should take place.

2. Penelope would definitely consider the $3.20 price because her income would
increase $112,500 ([$3.95 $3.20] 150,000). Tom would most likely nego-
tiate a price less than $3.75 if he has knowledge of the excess capacity.

3. The full-cost transfer price is $3.45 ($2.25 + $1.20). If the transfer takes place,
the Paper Division will make an additional $180,000 (150,000 $1.20) and the
School Photography Division will save $75,000 ([$3.95 $3.45] 150,000).

1016
A B C D
Revenues $10,000 $ 45,000 $200,000 $19,200
11

Expenses 7,800 27,000
4
188,000 18,000
12

Operating income 2,200 18,000 12,000
7
1,200
13

Assets 20,000 144,000
5
100,000 9,600
Margin 22%
1
40% 6%
8
6.25%
Turnover 0.50
2
* 0.3125 2
9
2.00
ROI 11%
3
12.5%
6
12.0%
10
12.5%
14

*Indicates missing amount.
1
$2,200/$10,000 = 0.22
8
$12,000/$200,000 = 0.06
2
$10,000/$20,000 = 0.50
9
$200,000/$100,000 = 2
3
$2,200/$20,000 = 0.11
10
$12,000/$$100,000 = 0.12
4
$45,000 - $18,000 = $27,000
11
$9,600 2 = $19,200
5
$45,000 0.3125 = $144,000
12
$19,200 - $1,200 = $18,000
6
0.4 0.3125 = 0.125
13
$19,200 0.0625 = 1,200
7
$200,000 - $188,000 = $12,000
14
$1,200/$9,600 = 0.125

3 33 31 1
10-17

1. Company A residual income = $2,200 (0.12)($20,000) = $200
Company B residual income = $18,000 (0.12)($144,000) = $720
Company C residual income = $12,000 (0.12)($100,000) = 0
Company D residual income = $1,200 (0.12)($9,600) = $48



3 33 32 2
PROBLEMS

1018
1. Diaz Company
Absorption-Costing Income Statements
Year 1 Year 2
Sales ........................................................................... $ 572,000 $ 660,000
Less: Cost of goods sold* ........................................ 299,000 361,000
Gross margin ............................................................. $ 273,000 $ 299,000
Less: Selling and administrative expenses ............ 163,800 163,800
Net income ........................................................... $ 109,200 $ 135,200
*Beginning inventory ................................................ $ 0 $ 46,000
Cost of goods manufactured .................................. 345,000 315,000
Goods available for sale ......................................... $ 345,000 $ 361,000
Less: Ending inventory ........................................... 46,000 0
Cost of goods sold ............................................. $ 299,000 $ 361,000
Firm performance has improved from Year 1 to Year 2.

2. Diaz Company
Variable-Costing Income Statements
Year 1 Year 2
Sales ........................................................................... $ 572,000 $ 660,000
Less: Variable cost of goods sold* ......................... 195,000 225,000
Contribution margin ................................................. $ 377,000 $ 435,000
Less fixed expenses:
Overhead .............................................................. (120,000) (120,000)
Selling and administrative .................................. (163,800) (163,800)
Net income ................................................................. $ 93,200 $ 151,200
*Beginning inventory ................................................ $ 0 $ 30,000
Variable cost of goods manufactured ................... 225,000 195,000
Goods available for sale ......................................... $ 225,000 $225,000
Less: Ending inventory ........................................... 30,000 0
Cost of goods sold ............................................. $ 195,000 $ 225,000
Firm performance has improved from Year 1 to Year 2.
3. Year 1 fixed overhead rate = $120,000/30,000 = $4.00
4. Absorption-costing inventory = ($7.50 + $4.00) 4,000 = $46,000
Variable-costing inventory = $7.50 4,000 = $30,000
1019
3 33 33 3
1. Ziemble Company
Absorption-Costing Income Statement
Sales ........................................................................................... $ 1,512,000
Cost of goods sold* .................................................................. 1,048,000
Gross margin ............................................................................. $ 464,000
Selling and administrative expenses ...................................... 444,000
Net income ........................................................................... $ 20,000
*Fixed overhead rate = $300,000/75,000 = $4 per unit
Applied fixed overhead = $4 74,000 = $296,000
Underapplied fixed overhead = $300,000 $296,000 = $4,000
Cost of goods sold = ($4 72,000) + $4,000 + $756,000
= $1,048,000

2. The difference is $8,000 ($20,000 $12,000) and is due to the fixed overhead
that would be attached to the ending inventory ($4 2,000 units).
I
A
I
V
= Fixed overhead rate(Production Sales)
$20,000 $12,000 = $4(74,000 72,000)
$8,000 = $8,000

3 33 34 4
1020
1. Scented Musical Regular Total
Sales $ 13,000 $ 19,500 $ 25,000 $ 57,500
Less: Variable expenses 9,100 15,600 12,500 37,200
Contribution margin $ 3,900 $ 3,900 $ 12,500 $ 20,300
Less: Direct fixed expenses 4,250 5,750 3,000 13,000
Product margin $ (350) $ (1,850) $ 9,500 $ 7,300
Less: Common fixed expenses 7,500
Net (loss) $ (200)
Kathy should accept this proposal. The 30 percent sales increase, coupled
with the increased advertising, reduces the loss from $1,000 to $200. Both
scented and musical product-line profits increase. However, more must be
done. If the scented and musical product margins remain negative, the two
products may need to be dropped.

2. Regular
Sales $ 20,000
Less: Variable expenses 10,000
Contribution margin $ 10,000
Less: Fixed expenses 10,500
Operating income (loss) $ (500)
Dropping the two lines would still result in a loss. Other options need to be
developed.

3. Combinations would be beneficial. Dropping the musical line (which shows
the greatest segment loss) and keeping the scented line while increasing ad-
vertising yields a profit (the optimal combination).

Scented Regular Total
Sales $ 13,000 $ 22,500 $ 35,500
Less: Variable expenses 9,100 11,250 20,350
Contribution margin $ 3,900 $ 11,250 $ 15,150
Less: Direct fixed expenses 4,250 3,000 7,250
Product margin $ (350) $ 8,250 $ 7,900
Less: Common fixed expenses 7,500
Operating income $ 400
3 33 35 5
1021
1. Direct materials $3.60
Direct labor 2.00
Variable overhead 0.40
Fixed overhead ($180,000/200,000) 0.90
Total $ 6.90
Per-unit inventory cost on the balance sheet is $6.90.
Sales (207,000 $10) $ 2,070,000
Less: Cost of goods sold 1,428,300
Gross margin $ 641,700
Less: Selling and administrative expenses 132,100
Net income $ 509,600

2. Direct materials $ 3.60
Direct labor 2.00
Variable overhead 0.40
Total $ 6.00
Per-unit inventory cost under variable costing equals $6.00.
This differs from the per-unit inventory cost in Requirement 1 because the
balance sheet is for external use and reflects absorption costing. Variable
costing does not include per-unit fixed overhead.

Sales $ 2,070,000
Less variable expenses:
Variable cost of goods sold 1,242,000
Variable selling and administrative 62,100
Contribution margin $ 765,900
Less fixed expenses:
Fixed overhead 180,000
Fixed selling and administrative 70,000
Net income $ 515,900

3. I
V
I
A
= FOR(Sales Production)
$515,900 $509,600 = $0.90(207,000 200,000)
$6,300 = $0.90(7,000)
$6,300 = $6,300

3 33 36 6
4. Sales (196,700 $10) $ 1,967,000
Less: Cost of goods sold (196,700 $6.90) 1,357,230
Gross margin $ 609,770
Less: Selling and administrative expenses 129,010
Absorption costing operating income $ 480,760
Sales $1,967,000
Less variable expenses:
Variable cost of goods sold 1,180,200
Variable selling and administrative 59,010
Contribution margin $ 727,790
Less fixed expenses:
Fixed overhead 180,000
Fixed selling and administrative 70,000
Variable costing operating income $ 477,790

5. I
A
I
V
= FOR(Sales Production)
$480,760 $477,790 = $0.90(200,000 196,700)
$2,970 = $0.90(3,300)
$2,970 = $2,970

1022
1. Air conditioner, ROI = $67,500/$750,000 = 9.0%
Turbocharger, ROI = $89,700/$690,000 = 13.0%

2. With Air With With Both Neither
Conditioner Turbocharger Investments Investment
Income $3,246,500 $3,268,700 $3,336,200 $3,179,000
Assets $29,650,000 $29,590,000 $30,340,000 $28,900,000
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, the two investments increase the wealth of the division, since EVA is
positive.

3 33 37 7
1023
1. $310,000/$3,000,000 = 10.33%*

2. Margin: $310,000/$3,450,000 = 8.99%
Turnover: $3,450,000/$3,000,000 = 1.15
ROI = 1.15 8.99% = 10.34%
*Difference due to rounding.

3. ($310,000 + $57,500)/($3,000,000 + $500,000*) = 10.5%
*($600,000 + $400,000)/2
The manager will approve the investment.

4. Margin: ($310,000 + $57,500)/($3,450,000 + $575,000) = 9.13%
Turnover: ($3,450,000 + $575,000)/($3,000,000 + $500,000) = 1.15
The margin has increased, and the turnover ratio has stayed the same.

5. With: ($310,000 + $57,500)/($3,000,000 + $500,000 $800,000) = 13.61%
Without: $310,000/($3,000,000 $800,000) = 14.09%
The manager will most likely reject the investment because it lowers the divi-
sional ROI. The investment should be accepted because it increases total
profits.

6. Margin: $310,000/$3,450,000 = 8.99%
Turnover: $3,450,000/$2,200,000 = 1.57
1024
1. Year 1 Year 2 Year 3
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/$15,000,000 = 8%
Margin: $1,200,000/$10,000,000 = 12%
Turnover: $10,000,000/$15,000,000 = 0.67
The ROI increased because expenses decreased and assets turned over at a
higher rate (sales increased).
3 33 38 8
3. Operating assets: $15,000,000 80% = $12,000,000
ROI: $945,000/$12,000,000 = 7.88%
Margin: $945,000/$9,000,000 = 10.5%
Turnover: $9,000,000/$12,000,000 = 0.75
The ROI increased because assets decreased.

4. ROI: $1,200,000/$12,000,000 = 10%
Margin: $1,200,000/$10,000,000 = 12%
Turnover: $10,000,000/$12,000,000 = 0.83
The ROI increased because expenses decreased and assets turned over at a
higher rate (sales increased and the amount of assets decreased). Both mar-
gin and turnover increased.
1025
1. After-tax cost of mortgage bonds = (1 0.4)(0.06) = 0.036
Cost of common stock = 0.08 + 0.03 = 0.11
Dollar After-Tax Weighted
Amount Percent Cost = Cost
Mortgage bonds $ 3,000,000 0.25 0.036 0.0090
Common stock 9,000,000 0.75 0.110 0.0825
Total $ 12,000,000
Weighted average cost of capital 0.0915
Cost of capital = $4,000,000 0.0915 = $366,000

2. After-tax operating income $ 350,000
Less: Cost of capital 366,000
EVA $( 16,000)
EVA is negative; Donegal is destroying wealth.

3. After-tax cost of new bonds = (1 0.4)(0.09) = 0.054
Dollar After-Tax Weighted
Amount Percent Cost = Cost
Unsecured bonds $ 2,000,000 0.143 0.054 0.0077
Mortgage bonds 3,000,000 0.214 0.036 0.0077
Common stock 9,000,000 0.643 0.110 0.0707
Total $ 14,000,000
Weighted average cost of capital 0.0861
Cost of capital = $5,000,000 0.0861 = $430,500
3 33 39 9
4. After-tax operating income $430,000
Less: Cost of capital 430,500
EVA ($ 500)
No, this is not a good idea. EVA is negative and Donegal is destroying wealth.
1026
1. Minimum: $26
Maximum: $31

2. ($26 + $31)/2 = $28.50. Thus, the transfer price would be expressed as full
cost plus 42.5% ($20 + $8.50/$20).

3. New minimum: $27
New maximum: $32
($27 + $32)/2 = $29.50
or full cost plus 47.5% ($20 + $9.50/20)

4. The two divisions would renegotiate because the buying division would prob-
ably be able to buy the necessary part at a lower price from another supplier.
The Auxiliary Components Division might have to reduce its price.
1027
1. Lorne should not reduce the price charged to Rosario if he can sell all he
produces. It does not matter whether the two divisions trade internally or not.

2. The minimum price is $53, and the maximum is $75. Yes, Lorne should con-
sider the transfer, since his income will increase by $59,500 [3,500($70
$53)].

3. The transfer price would be $75.60 ($63 1.2). No, the transfer would not
occur, since the transfer price is higher than the outside price that Rosario
could get.

1028
1. Component Y34 Model SC67 Company
Sales $260,000 $1,680,000 $1,940,000
Variable expenses 160,000 920,000 1,080,000
Contribution margin $100,000 $ 760,000 $ 860,000
3 34 40 0
2. The transfer price should be the market price of $12. This is the minimum
price for the Components Division and the maximum price for the PSF Divi-
sion.
3. Unless the PSF Division is able to increase the price of Model S667, the man-
ager will discontinue production and will not purchase any of the compo-
nents. (The cost of producing the scanner will increase from $38 to $43.50, a
cost greater than the current selling price of $42.)
4. All 40,000 units of Component Y34 will be sold externally at the market price
of $12 per unit.
5. Sales $480,000
Variable expenses 160,000
Contribution margin $320,000
The contribution margin decreases by $540,000. Cam made the wrong deci-
sion.

1029
1. Madengrad Company
Variable-Costing Income Statement
Budgeted for Next Year
Sales (21,500 $900) ................................................ $ 19,350,000
Less variable expenses:
Cost of goods sold (21,500 $525) .................... $11,287,500
Selling (21,500 $75) .......................................... 1,612,500 12,900,000
Contribution margin ................................................. $ 6,450,000
Less: Fixed expenses ............................................... 6,600,000
Operating income (loss) ..................................... $ (150,000)

2. Madengrad Company
Variable-Costing Income Statement
Budget Based on Technological Change
Sales (21,500 $900) ................................................ $ 19,350,000
Variable cost of goods sold:
Direct materials (21,500 $180) ......................... $3,870,000
Direct labor (21,500 $216) ................................ 4,644,000
Overhead (21,500 $78.75) ................................. 1,693,125 10,207,125
Variable selling (21,500 $75) ................................. 1,612,500
Contribution margin ................................................. $ 7,530,375
Less: Fixed expenses ............................................... 7,260,000
Operating income ................................................ $ 270,375

3 34 41 1
1030
A. Cost; total manufacturing cost
B. Investment; ROI
C. Revenue; total sales revenue
D. Profit; operating income
E. Investment; ROI
1031
1. The profit change can be explained by the following analysis:
Increase in sales revenues $20,000
Increase in variable manufacturing costs ($3.90 2,000) (7,800)
Increase in variable selling costs ($0.50 2,000) (1,000)
Increase in fixed overhead:
Year 12,000 units $2.90 (5,800)
Year 21,000 units $3.00 (3,000)
Year 3 underapplied fixed OH (3,000)
Net change in income $ (600)
The problem is the increased fixed overhead. We expect variable costs to in-
crease, but the increase in fixed overhead expenses is notable, because the
actual fixed overhead incurred for Year 3 is the same as that of Year 2. This
increase in fixed overhead recognized on the income statement is explained
by the fact that in Year 3, the division sold units from prior years with fixed
overhead attached to them, and by the fact that no fixed overhead was inven-
toried (as was the case in Year 2).
2. Year 1 Year 2 Year 3
Sales $ 80,000 $100,000 $120,000
Less variable expenses:
Cost of goods sold (31,200) (40,000) (47,800)
Selling expense (3,200) (5,000) (6,000)
Contribution margin $ 45,600 $ 55,000 $ 66,200
Less fixed expenses:
Fixed overhead (29,000) (30,000) (30,000)
Other fixed costs (9,000) (10,000) (10,000)
Net income $ 7,600 $ 15,000 $ 26,200
FOH, ending inventory $ 5,800
a
$ 8,800
b
$ 0
FOH, beginning inventory 0 5,800 8,800
Change in fixed overhead $ 5,800 $ 3,000 $ 8,800

a
$2.90 2,000 units

b
($3.00 1,000 units) + $5,800
3 34 42 2
The difference between the absorption- and variable-costing incomes is due
to the change in fixed overhead in the divisions inventories. In Year 1, $5,800
of the fixed overhead went into inventory; so, absorption-costing income ex-
ceeds variable-costing income by $5,800. In Year 2, $3,000 more fixed over-
head was inventoried, and absorption-costing income was $3,000 greater
than variable-costing income. However, in Year 3, the inventory was sold, and
absorption-costing income now recognizes that additional $8,800 of fixed
overhead ($5,800 + $3,000), explaining why variable-costing income is greater
by this amount.

3. Since variable-costing income provides an increase in income when sales in-
crease and costs do not change, the company vice president would have pre-
ferred variable costing. Variable costing would have provided the expected
bonus to the divisional manager and a consistent signal of improved perfor-
mance.

1032
1. The transfer price based on variable manufacturing costs to produce the cu-
shioned seat and the Office Divisions opportunity cost is $1,869 for a 100-
unit lot, or $18.69 per seat as summarized below:
Variable cost ......................................................... $1,329
Opportunity cost .................................................. 540
Transfer price ....................................................... $1,869
Variable cost:
Cushioned material:
Padding ............................................................ $ 2.40
Vinyl ................................................................. 4.00
Total ............................................................ $ 6.40
Cost increase 10% .......................................... 1.10
Cost of cushioned seat ............................. $ 7.04
Cushion fabrication labor
($7.50 0.5) ..................................................... 3.75
Variable overhead
($5.00 0.5) ..................................................... 2.50
Total variable cost per cushioned seat .............. $13.29
Total variable cost per 100-unit lot ..................... $1,329
3 34 43 3
1032 Continued
Overhead Analysis
Variable Amount Fixed Amount
Total Per DLH Total Per DLH
Supplies $ 420,000 $1.40
Indirect labor 375,000 1.25
Supervision $ 250,000 $0.83
Power 180,000 0.60
Heat and light 140,000 0.47
Property taxes
and insurance 200,000 0.67
Depreciation 1,700,000 5.67
Employee benefits:
20% Direct labor 450,000 1.50
20% Supervision 50,000 0.16*
20% Indirect labor 75,000 0.25
Total $1,500,000 $5.00 $2,340,000 $7.80
*The per DLH amount for supervision has been adjusted down to $0.16 to
eliminate the rounding error between the sum of the amounts per DLH and
the total divided by 300,000 DLH.
Variable overhead rate = ($1,500,000/300,000) = $5.00 per DLH
Fixed overhead rate = ($2,340,000/300,000) = $7.80 per DLH

Opportunity cost:

Labor hour constraint:
DLH to make 100 deluxe office stools (1.50 100) 150 hours
Less: DLH to make 100 cushioned seats (0.50 100) 50 hours
Labor hours available for economy office stool 100 hours
Number of economy office stools = 100 DLH/0.8 hours per stool
= 125 stools
3 34 44 4
1032 Concluded
Opportunity cost calculation:
Deluxe Economy
Office Stool Office Stool
Selling price $58.50 $41.60
Costs:
Materials $14.55 $15.76
Labor 11.25 ($7.50 1.5) 6.00 ($7.50 0.8)
Variable overhead 7.50 ($5.00 1.5) 4.00 ($5.00 0.8)
Total costs $33.30 $25.76
CM/unit $25.20 $15.84
Units produced 100 125
Total CM $2,520 $1,980
Opportunity cost of shifting production to the economy office stool =
$2,520 $1,980 = $540.

2. Variable manufacturing cost plus opportunity cost would be the best transfer
pricing system to use because it would allow the supplying division to be in-
different between selling the product internally to another division or selling
the product in the external market. This transfer pricing method ensures that
the supplying divisions contribution to profit would be the same under either
alternative. The sum of the variable manufacturing cost and the opportunity
cost represents the effort put forth by the supplying division to the overall
well-being of the company.
An appropriate transfer price must attempt to fulfill the company objectives of
autonomy, incentive, and goal congruence. While no one transfer price can
necessarily satisfy each of these objectives fully in all situations, the variable
manufacturing cost plus opportunity cost transfer price should be the most
appropriate method for meeting these objectives in most situations.

1033
1. Many legitimate reasons support the creation of inventory (e.g., the need to
avoid stockouts and the need to ensure on-time delivery). Paul Chessers
reasons, however, are based on self-interest and ignore whats best for the
company. Knowingly producing for inventory to obtain personal financial
gain at the expense of the company certainly could be labeled as unethical
behavior.

2. Since the decision to produce for inventory was not motivated by any sound
economic reasoning, and Ruth knows the real motive behind the decision,
she should feel discomfort in the role she has been asked to assume. If she
3 34 45 5
decides to appeal to higher-level management, the divisional manager can
counter with arguments that inventory was created because he expected the
economy to turn around and did not want to be in a position of not having
enough goods to meet demand. Even though Ruth may have a difficult time
proving any allegation of improper conduct, if she is convinced that the be-
havior is truly unethical, then appeals to higher-level management with the
prospect of ultimate resignation should be the route she takes.
Alternatively, Ruth might decide that the use of absorption costing for inter-
nal reporting and bonus calculation has led to this situation. She could lobby
higher management to begin using variable costing as a way of avoiding
these dysfunctional decisions. Ruth will have a very hard time proving uneth-
ical behaviorat worst, Paul may be accused of having poor judgment re-
garding future economic upturns.

3. The following standards may apply:
Integrity. Refrain from engaging in any conduct that would prejudice carrying
out duties ethically. (III-2)
Credibility. Communicate information fairly and objectively. (IV-1) Disclose
fully all relevant information that could reasonably be expected to influence
an intended users understanding of the reports, comments, and recommen-
dations. (IV-2)

1034
1. ROI based on initial estimates = $1,870,000/$15,600,000 = 11.99%
ROI based on Mels estimates = $2,340,000/$15,600,000 = 15%

2. Jason is definitely facing an ethical dilemma. While it is true that the sales
and expense projections are estimates, they are the best ones available to
him. If he uses a sales revenue projection from the top end of the range, he
will be deliberately basing the ROI estimate on a highly unlikely sales figure.
Sales and expense projections are not fantasy figures, they are supposed to
be managements best estimate of what will actually happen. If Jason pre-
pares the report in accordance with Mels desires, he will be knowingly fabri-
cating data.
One might wonder whether or not Mels offer to back up Jason is sufficient
to let Jason off the hook. It is not. If Mel wants the false projections badly
enough, let him sign them. Jason may have thought he had his dream job, but
it is about to turn into a nightmare. Companies dont take kindly to employees
who lie, and this lie is sure to come out. If the project is approved, and the
sales do not approach $2.34 million, you can bet that the vice president of
3 34 46 6
sales will be quick to point out that she predicted only $1.87 million. Mel will
surely pin the blame directly on Jason, the one whose name is on the report.

3. Jason should prepare the report using the figures he thinks are most descrip-
tive of the projects potential. He should feel free to include information about
the predicted range of sales, and to point out any other information that re-
flects favorably on the project. If Mel continues to pressure Jason, then Jason
might consider looking for another job.
RESEARCH ASSIGNMENTS
1035
Answers will vary.
1036
Answers will vary.