Managerial Accounting

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Tenth Edition

Accounting for Decision Making and Control

Jerold L. Zimmerman University of Rochester

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ACCOUNTING FOR DECISION MAKING AND CONTROL, TENTH EDITION Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright ©2020 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions ©2017, 2014, and 2009. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

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ISBN 978-1-259-96949-2 (bound edition) MHID 1-259-96949-5 (bound edition) ISBN 978-1-260-48096-2 (loose-leaf edition) MHID 1-260-48096-8 (loose-leaf edition)

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Library of Congress Cataloging-in-Publication Data Names: Zimmerman, Jerold L., 1947- author. Title: Accounting for decision making and control / Jerold L. Zimmerman, University of Rochester. Description: Tenth Edition. | Dubuque : McGraw-Hill Education, [2019] | Revised edition of the author’s Accounting for decision making and control, [2017] Identifiers: LCCN 2019013940| ISBN 9781259969492 (bound edition : alk. paper) | ISBN 9781260480962 (loose-leaf edition) Subjects: LCSH: Managerial accounting. Classification: LCC HF5657.4 .Z55 2019 | DDC 658.15/11—dc23 LC record available at https://lccn.loc.gov/2019013940

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About the Author

Jerold L. Zimmerman Jerold Zimmerman is Professor Emeritus at the Simon Business School, University of Rochester. He holds an undergraduate degree from the University of Colorado, Boulder, and a doctorate from the University of California, Berkeley.

While at Rochester, Dr. Zimmerman taught a variety of courses spanning accounting, finance, and economics. Accounting courses include nonprofit accounting, inter- mediate accounting, accounting theory, and managerial accounting. A deeper appreciation of the challenges of managing complex organizations was acquired while serving as the Simon School’s Deputy Dean and on the board of directors of several public corporations.

Professor Zimmerman publishes widely in accounting on topics as diverse as cost allocations, corporate governance, disclosure, financial accounting theory, capi- tal markets, and executive compensation. His paper “The Costs and Benefits of Cost Allocations” won the American Accounting Association’s Competitive Manuscript Contest. He is recognized for developing Positive Accounting Theory. This work, co-authored with colleague Ross Watts at the Massachusetts Institute of Technology, received the American Institute of Certified Public Accountants’ Notable Contribution to the Accounting Literature Award for “Towards a Positive Theory of the Determi- nation of Accounting Standards” and “The Demand for and Supply of Accounting Theories: The Market for Excuses.” Both papers appeared in the Accounting Review. Professors Watts and Zimmerman are also co-authors of the highly cited textbook Positive Accounting Theory (Prentice Hall, 1986). Professors Watts and Zimmerman received the 2004 American Accounting Association Seminal Contribution to the Literature award. Professor Zimmerman’s textbooks also include Managerial Eco- nomics and Organizational Architecture with Clifford Smith and James Brickley, 6th ed. (McGraw-Hill, 2016) and Management Accounting in a Dynamic Environment with Cheryl McWatters (Routledge UK, 2016). He is a founding editor of the Journal of Accounting and Economics, published by Elsevier. This scientific journal is one of the most highly referenced accounting publications. In 2016, Professor Zimmerman received the American Accounting Association Outstanding Accounting Educator Award, in part for this this textbook’s contribution to accounting education.

He and his wife Dodie have two daughters, Daneille and Amy. Jerry has been known to occasionally engage friends and colleagues in an amicable diversion on the links.

©Charla Kucko

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Preface

iv

During their professional careers, managers in all organizations, profit and nonprofit, rely on their accounting systems. Sometimes managers use the accounting system to acquire information for decision making. At other times, the accounting system measures their performance and thereby influences the managers’ behavior. The accounting system is both a source of information for decision making and part of the organization’s control mechanisms—thus, the title of the book, Accounting for Decision Making and Control.

The purpose of this book is to provide students and managers with an understand- ing and appreciation of the strengths and limitations of an organization’s accounting system, thereby allowing them to be more intelligent users of these systems. This book provides a framework for understanding accounting systems and a basis for analyzing proposed changes to these systems. The text demonstrates that managerial accounting is an integral part of the firm’s organizational architecture, not just an isolated set of computational topics.

Changes in the Tenth Edition Feedback from reviewers and instructors using the prior editions and my own teaching experience provided the basis for the revision. In particular, the following changes have been made:

• Each chapter in the tenth edition was heavily edited with an eye to make it more con- cise, remove redundancy, and enhance readability while presenting the same funda- mental concepts, learning objectives, and challenging critical thinking end-of-chapter materials as in prior editions.

• References to actual company practices have been updated. • Users were uniform in their praise of the problem material. They found it challenged

their students to critically analyze multidimensional issues while still requiring numer- ical problem-solving skills.

• The end-of-chapter problem material was revised by updating problems with the new tax rates stated in the 2018 U.S. Tax Cuts and Jobs Act.

• Each chapter and all end-of-chapter problems were revised in light of the 2018 tax reform (Tax Cuts and Jobs Act).

• Outdated and obsolete problems were deleted.

• Discussions of how data analytics and Big Data are changing managerial accounting were added.

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Preface v

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Overview of Content Chapter 1 describes the book’s conceptual framework and illustrates the framework using a simple decision context regarding accepting an incremental order from a current customer. The chapter describes why firms use a single accounting system and the con- cept of economic Darwinism, among other important topics. This chapter is an integral part of the text.

Chapters 2, 4, and 5 present the underlying conceptual framework. The importance of opportunity costs in decision making, cost–volume–profit analysis, and the difference between accounting costs and opportunity costs are discussed in Chapter 2. Chapter 4 employs the economic theory of organizations as the conceptual foundation to understand the role of the accounting system as part of the organization’s control mechanism. Chapter 5 describes the crucial role of accounting as part of the firm’s organizational architecture. Chapter 3 on capital budgeting extends opportunity costs to a multiperiod setting. This chapter can be skipped without affecting the flow of later material. Alternatively, Chapter 3 can be assigned at the end of the course.

Using budgeting, Chapter 6 applies the conceptual framework and illustrates the trade- off managers face between decision making and control. Budgets are a decision-making tool to coordinate activities within the firm and a device to control behavior. This chapter provides an in-depth illustration of how budgets are an important part of an organization’s decision-making and control apparatus.

Chapter 7 presents a general analysis of why managers allocate certain costs and the behavioral implications of these allocations. Cost allocations affect both decision making and incentives. Again, managers face a trade-off between decision making and control. Chapter 8 continues the cost allocation discussion by describing the “death spiral” that can occur when significant fixed costs exist and excess capacity arises. This leads to an analy- sis of how to treat capacity costs—a trade-off between underutilization and overinvest- ment. Finally, the chapter describes several specific cost allocation methods such as service department costs and joint costs.

Chapter 9 applies the general analysis of overhead allocation described in Chapters 7 and 8 to the specific case of absorption costing in a manufacturing setting. Chapters 10 and 11describe the managerial implications of traditional absorption costing. Chapter 10 analyzes variable costing, and activity-based costing is the topic of Chapter 11. Variable costing is an interesting example of economic Darwinism. Proponents of variable costing argue that it does not distort decision making and therefore should be adopted. Nonethe- less, variable costing is not widely practiced, probably because of tax, financial reporting, and control considerations.

Chapter 12 discusses the decision-making and control implications of standard labor and material costs. Chapter 13 extends the discussion to overhead and marketing vari- ances. Chapters 12 and 13 can be omitted without interrupting the flow of later material. Finally, Chapter 14 synthesizes the course by reviewing the conceptual framework and applying it to various organizational innovations, such as six sigma/total quality manage- ment, lean production/just in time, and the balanced scorecard. These innovations provide an opportunity to apply the analytic framework underlying the text.

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viii Preface

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Acknowledgments The genesis for this book and its approach reflect the oral tradition of my colleagues, past and present, at the University of Rochester. William Meckling and Michael Jensen stimu- lated my thinking and provided much of the theoretical structure underlying the book, as anyone familiar with their work will attest. My long and productive collaboration with Ross Watts further refined the approach. He also furnished most of the intellectual capi- tal for Chapter 3, including the problem material. Ray Ball offered transformative ideas. Clifford Smith and James Brickley continue to enhance my economic education. Three colleagues, Andrew Christie, Dan Gode, and Scott Keating, supplied particularly insightful comments that enriched the analysis at critical junctions. Valuable comments from Anil Arya, Ron Dye, Andy Leone, Dale Morse, Ram Ramanan, K. Ramesh, Shyam Sunder, and Joseph Weintrop are gratefully acknowledged.

This project benefited greatly from the honest and intelligent feedback of numerous instructors. I wish to thank Mahendra Gupta, Susan Hamlen, Badr Ismail, Charles Kile, Leslie Kren, Don May, William Mister, Mohamed Onsi, Stephen Ryan, Michael Sandretto, Richard Sansing, Deniz Saral, Gary Schneider, Joe Weber, and William Yancey. This book also benefited from three of my other textbook projects. Writing Management Accounting: Analysis and Interpretation (McGraw-Hill Companies, 1997) with Dale Morse, Manage- rial Economics and Organizational Architecture (McGraw Hill Education, 2016) with James Brickley and Clifford Smith, and Management Accounting in a Dynamic Environ- ment (Routledge, 2016) with Cheryl McWatters helped me to better present key concepts.

To the numerous students who endured the development process, I owe an enormous debt of gratitude. I hope they learned as much from the material as I learned teaching them. Some were even kind enough to provide critiques and suggestions—in particular, Jan Dick Eijkelboom. Others supplied, either directly or indirectly, the problem material in the text. The able research assistance of P. K. Madappa, Eamon Molloy, Jodi Parker, Steve Sanders, Richard Sloan, and especially Gary Hurst contributed amply to the manuscript and problem material. Janice Willett and Barbara Schnathorst did a superb job of editing the manuscript and problem material.

The very useful comments and suggestions from the following reviewers are greatly appreciated:

Urton Anderson Howard M. Armitage Vidya Awasthi Kashi Balachandran Da-Hsien Bao Ron Barden Howard G. Berline Margaret Boldt David Borst Eric Bostwick Marvin L. Bouillon Wayne Bremser David Bukovinsky Linda Campbell Jane Cote

William M. Cready James M. Emig Gary Fane Anita Feller Tahirih Foroughi Ivar Fris Jackson F. Gillespie Irving Gleim Jon Glover Gus Gordon Sylwia Gornik-Tomaszewski Tony Greig Susan Haka Bert Horwitz Steven Huddart

Robert Hurt Douglas A. Johnson Lawrence A. Klein Thomas Krissek A. Ronald Kucic Wikil Kwak Daniel Law Chi-Wen Jevons Lee Suzanne Lowensohn James R. Martin Alan H. McNamee Marilyn Okleshen Shailandra Pandit Sam Phillips Frank Probst

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Preface ix

To my wife, Dodie, and daughters, Daneille and Amy, thank you for setting the right priorities and for giving me the encouragement and environment to be productive. Finally, I wish to thank my parents for all their support.

Jerold L. Zimmerman University of Rochester

Kamala Raghavan William Rau Jane Reimers Thomas Ross Harold P. Roth P. N. Saksena Donald Samaleson Michael J. Sandretto Richard Saouma Arnold Schneider

Henry Schwarzbach Elizabeth J. Serapin Steve Shively Norman Shultz James C. Stallman William Thomas Stevens Monte R. Swain Heidi Tribunella Suneel Udpa Robert Wesoloskie

Clark Wheatley Lourdes F. White Paul F. Williams Robert W. Williamson Peggy Wright Jeffrey A. Yost S. Mark Young Mustafa Younis

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Brief Contents

1 Introduction 1

2 The Nature of Costs 21

3 Opportunity Cost of Capital and Capital Budgeting 84

4 Organizational Architecture 124

5 Responsibility Accounting and Transfer Pricing 156

6 Budgeting 211

7 Cost Allocation: Theory 273

8 Cost Allocation: Practices 319

9 Absorption Cost Systems 384

10 Criticisms of Absorption Cost Systems: Incentive to Overproduce 439

11 Criticisms of Absorption Cost Systems: Inaccurate Product Costs 473

12 Standard Costs: Direct Labor and Materials 527

13 Overhead and Marketing Variances 563

14 Management Accounting in a Changing Environment 597

Solutions to Concept Questions 644 Glossary 654 Index 658

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Contents

1 Introduction 1 A. Managerial Accounting: Decision Making and Control 2 B. Design and Use of Cost Systems 4 C. Marmots and Grizzly Bears 7 D. Management Accountant’s Role in the Organization 9 E. Evolution of Management Accounting: A Framework for Change 11 F. Vortec Medical Probe Example 14 G. Outline of the Text 17 H. Summary 18

2 The Nature of Costs 21 A. Opportunity Costs 22

1. Characteristics of Opportunity Costs 23 2. Examples of Decisions Based on Opportunity Costs 23

B. Cost Variation 27 1. Fixed, Marginal, and Average Costs 27 2. Linear Approximations 30 3. Other Cost Behavior Patterns 31 4. Activity Measures 32

C. Cost–Volume–Profit Analysis 33 1. Copier Example 33 2. Calculating Break-Even and Target Profits 34 3. Limitations of Cost–Volume– Profit Analysis 38 4. Multiple Products 40 5. Operating Leverage 41

D. Opportunity Costs versus Accounting Costs 43 1. Period versus Product Costs 45 2. Direct Costs, Overhead Costs, and Opportunity Costs 45

E. Cost Estimation 47 1. Account Classification 47 2. Motion and Time Studies 48

F. Summary 48 Appendix: Costs and the Pricing Decision 49

3 Opportunity Cost of Capital and Capital Budgeting 84 A. Opportunity Cost of Capital 85 B. Interest Rate Fundamentals 88

1. Future Values 88

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2. Present Values 89 3. Present Value of a Cash Flow Stream 90 4. Perpetuities 91 5. Annuities 91 6. Multiple Cash Flows per Year 92

C. Capital Budgeting: The Basics 94 1. Decision to Acquire an MBA 94 2. Decision to Open a Day Spa 95 3. Essential Points about Capital Budgeting 96

D. Capital Budgeting: Some Complexities 97 1. Risk 97 2. Inflation 99 3. Taxes and Depreciation Tax Shields 100

E. Alternative Investment Criteria 102 1. Payback 102 2. Accounting Rate of Return 103 3. Internal Rate of Return 105 4. Methods Used in Practice 108

F. Summary 108

4 Organizational Architecture 124 A. Basic Building Blocks 125

1. Self-Interested Behavior, Team Production, and Agency Costs 125 2. Decision Rights and Rights Systems 130 3. Role of Knowledge and Decision Making 131 4. Markets versus Firms 132 5. Influence Costs 134

B. Organizational Architecture 135 1. Three-Legged Stool 135 2. Decision Management versus Decision Control 138

C. Accounting’s Role in the Organization’s Architecture 140 D. Example of Accounting’s Role: Executive Compensation Contracts 143 E. Summary 143

5 Responsibility Accounting and Transfer Pricing 156 A. Responsibility Accounting 157

1. Cost Centers 158 2. Profit Centers 160 3. Investment Centers 161 4. Economic Value Added (EVA®) 165 5. Controllability Principle 168

B. Transfer Pricing 169 1. International Taxation 169 2. Economics of Transfer Pricing 171 3. Common Transfer-Pricing Methods 175 4. Reorganization: The Solution if All Else Fails 180 5. Recap 180

C. Summary 182

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6 Budgeting 211 A. Generic Budgeting Systems 213

1. Country Club 213 2. Large Corporation 217

B. Trade-Off between Decision Management and Decision Control 220 1. Communicating Specialized Knowledge versus Performance

Evaluation 220 2. Budget Ratcheting 220 3. Participative Budgeting 223 4. New Approaches to Budgeting 224 5. Managing the Trade-Off 226

C. Resolving Organizational Problems 226 1. Short-Run versus Long-Run Budgets 227 2. Line-Item Budgets 229 3. Budget Lapsing 229 4. Static versus Flexible Budgets 230 5. Incremental versus Zero-Based Budgets 233

D. Summary 234 Appendix: Comprehensive Master Budget Illustration 235

7 Cost Allocation: Theory 273 A. Pervasiveness of Cost Allocations 274

1. Manufacturing Organizations 276 2. Hospitals 277 3. Universities 277

B. Reasons to Allocate Costs 279 1. External Reporting/Taxes 279 2. Cost-Based Reimbursement 280 3. Decision Making and Control 281

C. Incentive/Organizational Reasons for Cost Allocations 282 1. Cost Allocations Are a Tax System 282 2. Taxing an Externality 283 3. Insulating versus Noninsulating Cost Allocations 289

D. Summary 292

8 Cost Allocation: Practices 319 A. Death Spiral 320 B. Allocating Capacity Costs: Depreciation 325 C. Allocating Service Department Costs 325

1. Direct Allocation Method 327 2. Step-Down Allocation Method 329 3. Service Department Costs and Transfer Pricing of Direct and Step-Down

Methods 331 4. Reciprocal Allocation Method 334 5. Recap 336

D. Joint Costs 336 1. Joint Cost Allocations and the Death Spiral 338 2. Net Realizable Value 340 3. Decision Making and Control 344

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E. Segment Reporting and Joint Benefits 345 F. Summary 346 Appendix: Reciprocal Method for Allocating Service Department Costs 346

9 Absorption Cost Systems 384 A. Job Order Costing 386 B. Cost Flows through the T-Accounts 388 C. Allocating Overhead to Jobs 390

1. Overhead Rates 390 2. Over/ Underabsorbed Overhead 392 3. Flexible Budgets to Estimate Overhead 395 4. Expected versus Normal Volume 398

D. Permanent versus Temporary Volume Changes 402 E. Plantwide versus Multiple Overhead Rates 403 F. Process Costing: The Extent of Averaging 406 G. Summary 407 Appendix A: Process Costing 408 Appendix B: Demand Shifts, Fixed Costs, and Pricing 413

10 Criticisms of Absorption Cost Systems: Incentive to Overproduce 439 A. Incentive to Overproduce 441

1. Example 441 2. Reducing the Overproduction Incentive 444

B. Variable (Direct) Costing 445 1. Background 445 2. Illustration of Variable Costing 445 3. Overproduction Incentive under Variable Costing 448

C. Problems with Variable Costing 449 1. Classifying Fixed Costs as Variable Costs 449 2. Variable Costing Excludes the Opportunity Cost of Capacity 451

D. Beware of Unit Costs 452 E. Summary 453

11 Criticisms of Absorption Cost Systems: Inaccurate Product Costs 473 A. Inaccurate Product Costs 474 B. Activity-Based Costing 479

1. Choosing Cost Drivers 479 2. Absorption versus Activity-Based Costing: An Example 485

C. Analyzing Activity-Based Costing 489 1. Reasons for Implementing Activity-Based Costing 490 2. Benefits and Costs of Activity-Based Costing 491 3. ABC Measures Costs, Not Benefits 493

D. Acceptance of Activity-Based Costing 495 E. Summary 498

12 Standard Costs: Direct Labor and Materials 527 A. Standard Costs 528

1. Reasons for Standard Costing 529

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2. Setting and Revising Standards 530 3. Target Costing 533

B. Direct Labor and Materials Variances 535 1. Direct Labor Variances 535 2. Direct Materials Variances 539 3. Risk Reduction and Standard Costs 543

C. Incentive Effects of Direct Labor and Materials Variances 543 1. Build Inventories 544 2. Externalities 544 3. Discouraging Cooperation 545 4. Mutual Monitoring 545 5. Satisficing 545

D. Disposition of Standard Cost Variances 546 E. The Costs of Standard Costs 548 F. Summary 550

13 Overhead and Marketing Variances 563 A. Budgeted, Standard, and Actual Volume 564 B. Overhead Variances 567

1. Flexible Overhead Budget 567 2. Overhead Rate 568 3. Overhead Absorbed 569 4. Overhead Efficiency, Volume, and Spending Variances 569 5. Graphical Analysis 573 6. Inaccurate Flexible Overhead Budget 575

C. Marketing Variances 576 1. Price and Quantity Variances 576 2. Mix and Sales Variances 577

D. Summary 579

14 Management Accounting in a Changing Environment 597 A. Integrative Framework 598

1. Organizational Architecture 599 2. Business Strategy 600 3. Environmental and Competitive Forces Affecting Organizations 602 4. Implications 603

B. Organizational Innovations and Management Accounting 604 1. Six Sigma/Total Quality Management 604 2. Lean/Just-in-Time Production 609 3. Balanced Scorecard 613 4. Big Data/Data Analytics 619

C. When Should the Internal Accounting System Be Changed? 621 D. Summary 622

Solutions to Concept Questions 644 Glossary 654 Index 658

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1

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Chapter One

Introduction

Chapter Outline A. Managerial Accounting: Decision Making

and Control B. Design and Use of Cost Systems C. Marmots and Grizzly Bears D. Management Accountant’s Role in the

Organization E. Evolution of Management Accounting:

A Framework for Change F. Vortec Medical Probe Example G. Outline of the Text H. Summary

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2 Chapter 1

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A. Managerial Accounting: Decision Making and Control Managers at Hyundai must decide which car models to produce, the quantity of each model to produce given the selling prices for the models, and how to manufacture the auto- mobiles. They must decide which car parts, such as headlight assemblies, Hyundai should manufacture internally and which parts should be outsourced. They must decide not only on advertising, distribution, and product positioning to sell the cars, but also the quantity and quality of the various inputs. For example, they must determine which models will have leather seats and the quality of the leather to be used. Similarly, in deciding which investment projects to accept, capital budgeting analysts require data on future cash flows. How are these numbers derived? How does one coordinate the activities of hundreds or thousands of employees in the firm so that these employees accept senior management’s leadership? At Hyundai, and at other organizations small and large, managers must have good information to make all these decisions.

Information about firms’ future costs and revenues must be estimated by managers. Organizations’ internal information systems provide some of the knowledge for these pric- ing, production, capital budgeting, and marketing decisions. These systems range from the informal and the rudimentary to very sophisticated, electronic management information systems. The term information system should not be interpreted to mean a single, inte- grated system. Most information systems consist not only of formal, organized, tangible records such as payroll and purchasing documents, but also informal, intangible bits of data such as memos, special studies, and managers’ impressions and opinions. The firm’s information system also contains nonfinancial information such as customer and employee satisfaction surveys. As firms grow from single proprietorships to large global corpora- tions with tens of thousands of employees, managers lose the knowledge of enterprise affairs gained from personal, face-to-face contact in daily operations. Higher-level manag- ers of larger firms come to rely more and more on formal operating reports.

The internal accounting system, an important component of a firm’s information system, includes budgets, data on the costs of each product and current inventory, and periodic financial reports. In many cases, especially in small companies, these accounting reports are the only formalized part of the information system providing the knowledge for decision making. Many larger companies have other formalized, nonaccounting–based information systems, such as production planning systems. This book focuses on how internal accounting systems provide knowledge for decision making.

After making decisions, managers must implement them in organizations in which the interests of the employees and the owners do not necessarily coincide. Just because senior managers announce a decision does not ensure that the decision will be implemented.

Organizations do not have objectives; people do. One common objective of owners of the organization is to maximize profits, or the difference between revenues and expenses. Maximizing firm value is equivalent to maximizing the stream of profits over the organiza- tion’s life. Employees, suppliers, and customers also have their own objectives—usually maximizing their self-interest.

Not all owners care only about monetary flows. An owner of a professional sports team might care more about winning (subject to covering costs) than maximizing profits. Nonprof- its do not have owners with the legal rights to the organization’s profits. Moreover, nonprof- its seek to maximize their value by serving some social goal such as education or health care.

No matter what the firm’s objective, the organization will survive only if its inflow of resources (such as revenue) is at least as large as the outflow. Accounting information is useful to help manage the inflow and outflow of resources and to help align the owners’ and employees’ interests, no matter what objectives the owners wish to pursue.

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Throughout this book, we assume that individuals maximize their self-interest. The owners of the firm usually want to maximize profits, but managers and employees will do so only if it is in their interest. Hence, a conflict of interest exists between owners—who, in general, want higher profits—and employees—who want easier jobs, higher wages, and more fringe benefits. To control this conflict, senior managers and owners design systems to monitor employees’ behavior and incentive schemes that reward employees for generat- ing more profits. Not-for-profit organizations face similar conflicts. Those people responsi- ble for the nonprofit organization (boards of trustees and government officials) must design incentive schemes to motivate their employees to operate the organization efficiently.

All successful firms must devise mechanisms that help align employee interests with maximizing the organization’s value. All of these mechanisms constitute the firm’s control system; they include performance measures and incentive compensation systems, promo- tions, demotions and terminations, security guards and video surveillance, internal audi- tors, and the firm’s internal accounting system.

As part of the firm’s control system, the internal accounting system helps align the interests of managers and shareholders to cause employees to maximize firm value. It sounds like a relatively easy task to design systems to ensure that employees maximize firm value. But a significant portion of this book demonstrates the exceedingly complex nature of aligning employee interests with those of the owners.

Internal accounting systems serve two purposes: (1) to provide some of the knowledge necessary for planning and making decisions (decision making) and (2) to help moti- vate and monitor people in organizations (control). Preventing fraud and embezzlement is the most basic control use of accounting. Maintaining inventory records helps reduce employee theft. Accounting budgets, discussed more fully in Chapter 6, provide an exam- ple of both decision making and control. Asking each salesperson in the firm to fore- cast his or her sales for the upcoming year generates useful information for planning next year’s production (decision making). However, if the salesperson’s sales forecast is used to benchmark performance for compensation purposes (control), he or she has incentives to underestimate those forecasts.

Using internal accounting systems for both decision making and control gives rise to the fundamental trade-off in these systems: A system cannot be designed to perform two tasks as well as a system that must perform only one task. Some ability to deliver knowl- edge for decision making is sacrificed to provide better motivation (control). The trade-off between providing knowledge for decision making and motivation/control arises continu- ally throughout this text.

This book is applications oriented: It describes how the accounting system assembles knowledge necessary for implementing decisions using the theories from microeconomics, finance, operations management, and marketing. It also shows how the accounting system helps motivate employees to implement these decisions. Moreover, it stresses the continual trade-offs that must be made between the decision making and control functions of accounting.

Chief financial officers (CFOs), responsible for their company’s accounting system, identify “managing costs and profitability” as their most important goal. Other top priori- ties include setting budgets and measuring performance. These findings indicate that firms use their internal accounting system both for decision making (managing costs and profit- ability) and for controlling behavior (setting budgets and measuring performance).1

1S. White, “How CFOs Can Support the Transformation to a Digital Business Model,” Financial Management, November 4, 2015, https://www.fm-magazine.com/news/2015/nov/how-cfos-can-support- digital-business-model-201513323.html.

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The firm’s accounting system provides much of the fabric that helps hold the orga- nization together. It contains knowledge for decision making, and it provides information for evaluating and motivating the behavior of individuals within the firm. Being such an integral part of the organization, the accounting system cannot be studied in isolation from the other mechanisms used for decision making or for aligning incentives. A firm’s inter- nal accounting system should be examined from a broad perspective, as part of the larger organization design question facing managers.

This book uses an economic perspective to study how accounting can motivate and control behavior in organizations. Besides economics, a variety of other paradigms also are used to investigate organizations: scientific management (Taylor), the bureaucratic school (Weber), the human relations approach (Mayo), human resource theory (Maslow, Rickert, Argyris), the decision-making school (Simon), and the political science school (Selznick). Behavior is a complex topic. No single theory or approach is likely to capture all the ele- ments. However, understanding managerial accounting requires addressing the behavioral and organizational issues. Economics offers one useful and widely adopted framework.

B. Design and Use of Cost Systems Managers make decisions and monitor subordinates who make decisions. Both manag- ers and accountants must acquire sufficient familiarity with cost systems to perform their jobs. Accountants (often called controllers) are charged with designing, improving, and operating the firm’s accounting system—an integral part of both the decision-making and performance evaluation systems. Both managers and accountants must understand the strengths and weaknesses of current accounting systems. Internal accounting systems, like all systems within the firm, are constantly being refined and modified. Accountants’ responsibilities include making these changes.

Internal accounting systems:

1. Provide information to assess the profitability of products or services and to optimally price and market these products or services.

2. Provide information to detect production inefficiencies to ensure that the proposed products and volumes are produced at minimum cost.

3. When combined with the performance evaluation and reward systems, create incentives for managers to maximize firm value.

4. Support the financial accounting and tax accounting reporting functions. 5. Contribute more to firm value than it costs.

Figure 1–1 portrays the functions of the accounting system. In it, the accounting system supports both external and internal reporting systems. Examine the top half of Figure 1–1. The accounting procedures chosen for external reports to shareholders and taxing authorities are dictated in part by regulators. In the United States, the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) regulate the financial statements issued to shareholders. The Internal Revenue Service (IRS) administers the accounting procedures used in calculating corporate income taxes. If the firm is involved in international trade, foreign tax authorities prescribe the accounting rules applied in calculating foreign taxes. Regulatory agencies constrain public utilities’ and financial institutions’ accounting procedures.

Management compensation plans and debt contracts often rely on external reports. Senior managers’ bonuses are often based on accounting net income. Likewise, if the firm issues long-term bonds, it agrees in the debt covenants not to violate specified

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accounting-based constraints. For example, the bond contract might specify that the debt- to-equity ratio will not exceed some limit. Like taxes and regulation, compensation plans and debt covenants create incentives for managers to choose particular accounting procedures.2

As companies expand into international markets, external users of the firm’s financial statements become global. No longer are the firm’s shareholders, tax authorities, and regu- lators domestic. Rather, the firm’s internal and external reports are used internationally in a variety of ways.

The bottom of Figure 1–1 illustrates that internal reports are used for decision mak- ing as well as control of organizational problems. As discussed earlier, managers use a variety of sources of data for making decisions. The internal accounting system provides one important source. These internal reports affect the behavior of managers in the firm. The internal accounting system reports on managers’ performance and therefore provides incentives for them. Any changes to the internal accounting system can affect all the vari- ous uses of the resulting accounting numbers.

The internal and external accounting reports are closely linked. The internal account- ing system affords a more disaggregated view of the company. These internal reports are generated more frequently, usually monthly or even weekly or daily, whereas the external reports are provided quarterly for publicly traded U.S. companies. The internal reports offer costs and profits by specific products, customers, lines of business, and divisions of the company. For example, the internal accounting system computes the unit cost of individual products produced. These unit costs are then used to value the work-in-process and finished goods inventory, and to compute cost of goods sold. Chapter 9 describes the details of product costing.

2For further discussion of the incentives of managers to choose accounting methods, see R. Watts and J. Zimmerman, Positive Accounting Theory (Englewood Cliffs, NJ: Prentice Hall, 1986).

FIGURE 1–1

The multiple role of accounting systems

Taxing Authorities

Shareholders

Regulation Board of Directors

Senior Management Compensation Plans

Regulatory Authorities

SEC/FASB

IRS & Foreign Tax Authorities

External Reports

Accounting System

Internal Reports

Decision Making

Control of Organizational

Problems

Debt Covenants Bondholders

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Because internal accounting systems serve multiple users and have several purposes, the firm employs either multiple systems (one for each function) or one basic system that serves all three functions (decision making, performance evaluation, and external report- ing). Firms can either maintain a single set of books and use the same accounting methods for both internal and external reports, or they can keep multiple sets of books. The decision depends on the costs of writing and maintaining contracts based on accounting numbers, the costs from the dysfunctional internal decisions made using a single system, the addi- tional bookkeeping costs arising from the extra system, and the confusion of having to reconcile the different numbers arising from multiple accounting systems.

Inexpensive accounting software packages and falling costs of information technology reduce some of the costs of maintaining multiple accounting systems. However, confu- sion arises when the systems report different numbers for the same concept. For example, when one system reports the manufacturing cost of a product as $12.56 and another sys- tem reports it at $17.19, managers wonder which system is producing the “right” number. Some managers may be using the $12.56 figure while others are using $17.19, causing inconsistency and uncertainty. Whenever two numbers for the same concept are produced, the natural tendency is to explain (i.e., reconcile) the differences. Managers involved in this reconciliation could have used their time more productively. Also, using the same accounting system for multiple purposes increases the credibility of the financial reports for each purpose. With only one accounting system, the external auditor monitors the inter- nal reporting system at little or no additional cost.

A survey of large U.S. firms found that managers typically use the same accounting procedures for both external and internal reporting. More than 80 percent of chief financial officers (CFOs) report using the same accounting methods and report the same earnings internally and externally. In other words, most firms use “one number” for both external and internal communications. One CFO stated, “We make sure that everything that we have underneath—in terms of the detailed reporting—also rolls up basically to the same

Multiple accounting systems are confusing and can lead to errors. An extreme example of this occurred in 1999 when NASA lost its $125 million Mars spacecraft. Engineers at Lockheed Martin built the spacecraft and specified the spacecraft’s thrust in English pounds. But NASA scientists, navigating the craft, assumed the information was in metric newtons. As a result, the spacecraft was off course by 60 miles as it approached Mars and crashed. Multiple systems for the same underlying construct often produce confusion and decision making errors. SOURCE: A. Pollack, “Two Teams, Two Measures Equaled One Lost Spacecraft,” The New York Times. October 1, 1999, p. 1.

Managerial Application: Spaceship Lost Because Two Mea- sures Used

“. . . cost accounting has a number of functions, calling for different, if not inconsistent, information. As a result, if cost accounting sets out, determined to discover what the cost of everything is and convinced in advance that there is one figure which can be found and which will furnish exactly the information which is desired for every pos- sible purpose, it will necessarily fail, because there is no such figure. If it finds a figure which is right for some purposes it must necessarily be wrong for others.” SOURCE: J. Clark, Studies in the Economics of Overhead Cost (Chicago: University of Chicago Press, 1923), p. 234.

Historical Application: Different Costs for Different Purposes

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story that we’ve told externally.”3 Nothing prevents firms from using separate accounting systems for internal decision making and internal performance evaluation except the con- fusion generated and the extra data processing costs.

Probably the most important reason firms use a single accounting system is it allows reclassification of the data. An accounting system does not present a single, bottom-line number, such as the “cost of publishing this textbook.” Rather, the system reports the components of the total cost of this textbook: the costs of proofreading, typesetting, paper, binding, cover, and so on. Managers in the firm then reclassify the information on the basis of different attributes and derive different cost numbers for different decisions. For exam- ple, if the publisher is considering translating this book into Chinese, not all the compo- nents used in calculating the U.S. costs are relevant. The Chinese edition might be printed on different paper stock with a different cover. The point is, a single accounting system usually offers enough flexibility for managers to reclassify, recombine, and reorganize the data for multiple purposes.

A single internal accounting system requires the firm to make trade-offs. A system that is best for performance measurement and control is unlikely to be the best for decision making. It’s like configuring a motorcycle for both off-road and on-road racing: Riders on bikes designed for both racing conditions probably lose to riders on bikes designed for just one racing surface. Wherever a single accounting system exists, additional analyses arise. Managers making decisions find the accounting system less useful and devise other systems to augment the accounting numbers for decision-making purposes.

3SOURCE: I. D. Dichev, J. R. Graham, H. Campbell, and S. Rajgopal, S., “Earnings Quality: Evidence from the Field,” Journal of Accounting and Economics 56, no. 2–3 (2013), pp. 1–33.

4This example is suggested by J. McGee, “Predatory Pricing Revisited,” Journal of Law & Economics XXIII (October 1980), pp. 289–330.

Q1–1 What causes the conflict between using internal accounting systems for decision making and control?

Q1–2 Describe the different kinds of information provided by the internal accounting system.

Q1–3 Give three examples of the uses of an accounting system. Q1–4 List the characteristics of an internal accounting system. Q1–5 Do firms have multiple accounting systems? Why or why not?

Concept Questions

C. Marmots and Grizzly Bears Managers often criticize accounting’s usefulness for making pricing or outsourcing deci- sions. Accounting data are based on historical costs rather than current values, and hence contain stale information. Why then do managers persist in using (presumably inferior) accounting information?

Before addressing this question, consider the parable of the marmots and the grizzly bears.4 Marmots are small groundhogs that are a principal food source for certain bears. Zoologists studying the ecology of marmots and bears observed bears digging and mov- ing rocks in the autumn in search of marmots. They estimated that the calories expended searching for marmots exceeded the calories obtained from their consumption. A zoologist

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relying on Darwin’s theory of natural selection might conclude that searching for marmots is an inefficient use of the bear’s limited resources and thus these bears should become extinct. But fossils of marmot bones near bear remains suggest that bears have been searching for marmots for tens of thousands of years.

Because the bears survive, the benefits of consuming marmots must exceed the costs. Bears’ claws might be sharpened as a by-product of the digging involved in hunting for marmots. Sharp claws help bears searching for food under the ice after winter’s hiberna- tion. Therefore, the benefit of sharpened claws and the calories derived from the marmots offset the calories consumed gathering the marmots.

What does the marmot-and-bear parable say about why managers persist in using apparently inferior accounting data in their decision making? As it turns out, the marmot- and-bear parable is an extremely important proposition in the social sciences known as economic Darwinism. In a competitive world, if surviving organizations use some oper- ating procedure (such as historical cost accounting) over long periods of time, then this procedure likely yields benefits in excess of its costs. Firms survive in competition by selling goods or services at lower prices than their competitors while still covering costs. Companies cannot survive by making more mistakes than their competitors.

Economic Darwinism suggests that successful (surviving) firms should not change internal processes unless they are clearly broken. Currently, considerable attention is being directed at revising and updating firms’ internal accounting systems because many man- agers believe their current accounting systems are “broken” and require major overhaul. Alternative internal accounting systems are being proposed, among them activity-based costing (ABC), balanced scorecards, economic value added (EVA), and lean accounting systems. These systems are discussed and analyzed later in terms of their ability to help managers make better decisions, as well as to help provide better measures of performance for managers in organizations, thereby aligning managers’ and owners’ interests.

Although internal accounting systems often appear inconsistent with some particular theory, these systems (like the bears searching for marmots) have survived the test of time and therefore are likely yielding unobserved benefits (like claw sharpening). This book discusses these additional benefits. Two caveats exist concerning too strict an application of economic Darwinism:

1. Some surviving operating procedures can be neutral mutations. Just because a system survives does not mean that its benefits exceed its costs. Benefits less costs might be close to zero.

2. Just because a given system survives does not mean it is optimal. A better system might exist but has not yet been discovered.

Benchmarking is a technique where a company compares its performance against the best firms, determines how those firms achieved their superior performance, and uses the knowledge to improve its own performance.

Economic Darwinism predicts that managers copy the practices of highly success- ful companies through benchmarking studies. The practice of benchmarking dates back to 607, when Japan sent teams to China to learn the best practices in business, govern- ment, and education. Today, most large enterprises routinely conduct benchmarking studies to discover the best business practices and then imple ment them in their firms. SOURCE: American Society for Quality http://asq.org/learn-about-quality/benchmarking/overview/overview.html.

Terminology: Benchmark- ing and Economic Darwinism

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The well-known Italian Medici family had extensive banking interests and owned tex- tile plants in the fifteenth and sixteenth centuries. They used sophisticated cost records to maintain control of their cloth production. These cost reports contained detailed data on the costs of purchasing, washing, beating, spinning, and weaving the wool, of sup- plies, and of overhead (tools, rent, and administrative expenses). Modern costing meth- odologies closely resemble these fifteenth-century cost systems, suggesting they yield benefits in excess of their costs. SOURCE: P. Garner, Evolution of Cost Accounting to 192 (Montgomery, AL: University of Alabama Press, 1954), pp. 12–13. Original source: R. de Roover, “A Florentine Firm of Cloth Manufacturers,” Speculu. XVI (January 1941), pp. 3–33.

Historical Application: Sixteenth- Century Cost Records

The fact that most managers use their accounting system as the primary formal infor- mation system suggests that these accounting systems yield total benefits that exceed their total costs. These benefits include financial and tax reporting, providing information for decision making, and creating internal incentives. The proposition that surviving firms have efficient accounting systems does not imply that better systems do not exist, only that they have not yet been discovered. What is, is not necessarily the “best.” Economic Darwinism helps identify the costs and benefits of alternative internal accounting systems and is applied repeatedly throughout the book.

D. Management Accountant’s Role in the Organization Describing how firms organize their accounting functions provides further understand- ing of internal accounting systems. No single organizational structure applies to all firms. Figure 1–2 presents one common organization chart. The design and operation of the inter- nal and external accounting systems are the responsibility of the firm’s chief financial offi- cer. The firm’s line-of-business or functional areas, such as marketing, manufacturing, and research and development, are combined and shown under a single organization, “operat- ing divisions.” The remaining staff and administrative functions include human resources, chief financial officer, legal, and other. In Figure 1–2, the CFO oversees all the financial and accounting functions in the firm and reports directly to the president. The CFO’s three major functions include controllership, treasury, and internal audit. Controllership involves tax administration, the internal and external accounting reports (including statutory filings with the Securities and Exchange Commission if the firm is publicly traded), and the plan- ning and control systems (including budgeting). Treasury involves short- and long-term financing, banking, credit and collections, investments, insurance, and capital budgeting. Depending on their size and structure, firms organize these functions differently. Figure 1–2 shows the internal audit group reporting directly to the CFO. In other firms, internal audit reports to the controller, the chief executive officer (CEO), or the board of directors.

The controller, the firm’s chief management accountant, has responsibility for data collection and reporting. The controller compiles the data to prepare the firm’s balance sheet, income statement, and tax returns. In addition, this person prepares the internal reports for the various divisions and departments within the firm and helps other managers by providing them with the data to make decisions—as well as the data to evaluate these managers’ performance.

Usually, each operating division or department has its own controller. For example, if a firm has several divisions, each division has its own division controller, who reports to both the division manager and the corporate controller. In Figure 1–2, the operating

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divisions have their own controllers. The division controller provides the corporate con- troller with periodic reports on the division’s operations. The division controller oversees the division’s budgets, payroll, inventory, and product costing system (which reports the cost of the division’s products and services). While most firms have division-level con- trollers, some firms centralize these functions to reduce staff so that all the division-level controller functions are performed centrally out of corporate headquarters.

The controllership function at the corporate, division, and plant levels involves assist- ing decision making and control. The controller must balance providing information to

FIGURE 1–2

Organization chart for a typical corporation

Board of Directors

President and Chief Executive Officer (CEO)

Human Resources

Chief Financial Officer (CFO) Legal Other

Operating Divisions

Treasury Controller InternalAudit

Controller– Operating Divisions

Tax FinancialReporting Cost

Accounting

In a 1960 study of 400 of the largest U.S. corporations, none of the firms had a posi- tion entitled “Chief Financial Officer.” By 2000, 80 percent had a person holding the title “CFO.” Prior to 1960, most large firms called their top accounting manager “Chief Accountant,” who typically was not part of the senior executive team. Several factors caused the elevation of “Chief Accountant” to “CFO,” who also became an integral member of the firm’s senior executives. First, between 1960 and 2000, large U.S. firms became global, with operations in numerous countries requiring more complex financial transactions involving foreign currency hedging and multinational banking relations. Large firms also started new lines of business. These firms became more complex, which necessitated more sophisticated reporting and control systems such as budgeting and monthly reports. To enter new markets, large firms acquired other com- panies. The CFO played an integral role in valuing and financing acquisitions. In addi- tion, accounting rules became significantly more complicated, requiring sophisticated compliance capabilities. Thus, today’s CFOs have a much broader skill set and manage a larger portfolio of activities than their predecessors, and as such, their role and title in their firms has been elevated. SOURCES: L. Sjoblom and N. Michels-Kim, “Leading Nestlé’s House of Finance,” Strategic Finance, September 2011, pp. 29–33; and D. Zorn, “Here a Chief, There a Chief: The Rise of the CFO in the American Firm,” American Sociological Review, June 2004, pp. 345–364.

Historical Application: The Rise of the CFO

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other managers for decision making against providing monitoring information to top exec- utives for use in controlling the behavior of lower-level managers.

Besides overseeing the controllership and treasury functions in the firm, the chief financial officer usually has responsibility for the internal audit function. The internal audit group seeks to eliminate internal fraud and to provide internal consulting and risk manage- ment. Since 2002 federal regulation increased the CFO’s role by requiring companies to continuously test the effectiveness of the internal controls over their financial statements. The internal audit group now works closely with the audit committee of the board of direc- tors to help ensure the integrity of the firm’s financial statements by testing whether the firm’s accounting procedures are free of internal control deficiencies.

Federal law also requires companies with publicly traded stock or bonds to have cor- porate codes of conduct (ethics codes). While many firms had ethics codes prior to this act, these codes define honest and ethical conduct, including conflicts of interest between personal and professional relationships, compliance with applicable governmental laws, rules and regulations, and prompt internal reporting of code violations to the appropriate person in the company. The audit committee of the board of directors is responsible for overseeing compliance with the company’s code of conduct.

The importance of the internal control system cannot be stressed enough. Throughout this book, we use the term control to mean aligning the interests of employees with maxi- mizing the value of the firm. The most basic conflict of interest between employees and owners is employee theft. In fact, one study reports that the typical firm loses 5 percent of its revenues to fraud.5 To reduce the likelihood of embezzlement, firms install internal control systems, which are an integral part of their control system. Internal and external auditors’ first responsibility is to test the integrity of the firm’s internal controls. Fraud and theft are prevented not just by having security guards and door locks but also through a variety of procedures such as requiring checks above a certain amount to be authorized by two people. Internal control systems include internal procedures, codes of conduct, and policies that prohibit corruption, bribery, and kickbacks. Finally, internal control systems should prevent intentional and accidental financial misrepresentation by managers.

5Association of Fraud Examiners, “Report to the Nations: 2018 Global Studies on Occupational Fraud and Abuse,” http://www.acfe.com/report-to-the-nations/2018/.

Q1–6 Define economic Darwinism. Q1–7 Describe the major functions of the chief financial officer.

Concept Questions

E. Evolution of Management Accounting: A Framework for Change

Management accounting evolved as their organizations changed. Prior to 1800, most businesses were small, family-operated organizations. Management accounting was less important for these small firms. It was not critical for planning decisions and control rea- sons because the owner could directly observe the organization’s entire environment. The owner, who made all of the decisions, delegated little decision-making authority and had no need to devise elaborate formal systems to motivate employees. The owner observ- ing slacking employees simply replaced them. As organizations grew larger with remote operations, management accounting became ever more important.

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Most of today’s modern management accounting techniques developed between 1825 to 1925 with the growth of large organizations.6 Textile mills in the early nineteenth cen- tury grew by combining the multiple processes (spinning the thread, dying, weaving, etc.) of making cloth. These large firms developed systems to measure the cost per yard or per pound for the separate manufacturing processes. The cost data allowed managers to com- pare the cost of conducting a process inside the firm versus purchasing the process from external vendors. Similarly, the railroads of the 1850s to 1870s developed cost systems that reported cost per ton-mile and operating expenses per dollar of revenue. These mea- sures allowed managers to increase their operating efficiencies. In the early 1900s, Andrew Carnegie (at what was to become U.S. Steel) devised a cost system that reported detailed unit cost figures for material and labor on a daily and weekly basis. This system allowed senior managers to maintain very tight controls on operations and gave them accurate and timely information on costs for pricing decisions. Merchandising firms such as Marshall Field’s and Sears, Roebuck developed gross margin (revenues less cost of goods sold) and stock-turn ratios (sales divided by inventory) to measure and evaluate performance. Manu- facturing companies such as Du Pont Powder Company and General Motors developed performance measures to control their growing organizations.

In the period from 1925 to 1975, management accounting was heavily influenced by external considerations. Income taxes and financial accounting requirements (e.g., those of the Financial Accounting Standards Board) were major factors affecting management accounting.

Since 1975, two major environmental forces have changed organizations and caused managers to question the appropriateness of traditional management accounting proce- dures. These environmental forces are (1) factory automation and computer/information technology and (2) global competition. These environmental changes force managers to reconsider their organizational structure and their management accounting procedures.

Information technology advances such as the Internet, intranets, wireless communica- tions, and faster microprocessors have had a big impact on internal accounting processes. More data are now available faster than ever before. Electronic data interchange, XHTML, social media, data analytics, B2B (business-to-business) e-commerce, bar codes, data

6P. Garner, Evolution of Cost Accounting to 1925 (Montgomery, AL: University of Alabama Press, 1954); and A. Chandler, The Visible Hand (Cambridge, MA: Harvard University Press, 1977).

Every day, we create 2.5 quintillion bytes of data. Ninety percent of the data in the world was generated in the last two years. This data comes from web searches, sensors used to gather climate information, social media posts, digital pictures and videos, purchase transaction records, and cell phone GPS signals to name a few. This data is “big data.”

Finance and accounting professionals at many firms struggle to learn how to apply statistical and computer science techniques called “data analytics” to extract valuable insights about their customers, products, and competitors from their big data. For exam- ple, large online retailers constantly monitor the prices of products offered by competi- tors to adjust their prices dynamically throughout the day. Managers pore over data to uncover the causes behind the company’s sales, costs, and profits and to better under- stand what drive revenues and operating and sales expenses. Why are certain stores or factories more profitable? What are customers Tweeting or Facebook postings saying about our products and our competitors? SOURCES: www-01.ibm.com/software/data/bigdata/what-is-big-data.html. D. Katz “Accounting’s Big Data Problem,” CFO .com. (March 4, 2014).

Managerial Application: Big Data and Data Analytics

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warehousing, and online analytical processing (OLAP) are just a few examples of new technology impacting management accounting. For example, managers now have access to daily sales and operating costs in real time, as opposed to having to wait two weeks after the end of the calendar quarter for this information. Firms have cut the time needed to prepare budgets for the next fiscal year by several months because the information is transmitted electronically in standardized formats and uploaded to the cloud where any authorized person in the firm can access it.

The history of management accounting illustrates how it has evolved in parallel with organizations’ structure. Management accounting provides information for planning decisions and control. It is useful for assigning decision-making authority, measuring performance, and determining rewards for individuals within the organization. Because management accounting is part of the organizational structure, it is not surprising that management accounting evolves in a parallel and consistent fashion with other parts of the organizational structure.

Figure 1–3 presents a framework for understanding the role of accounting systems within firms and the forces that cause accounting systems to change. As described more fully in Chapter 14, environmental forces such as technological innovation and global competition change the organization’s business strategies. For example, the Internet has allowed banks to offer electronic, online banking services. To implement these new strategies, companies must adapt their organizational structure or architecture, which includes management accounting. An organization’s architecture (the topic of Chapter 4) is composed of three related processes: (1) the assignment of decision-making responsi- bilities, (2) the measurement of performance, and (3) the rewarding of individuals within the organization.

The first component of the organizational architecture assigns responsibilities to the different members of the organization. Decision rights define the duties each member of an organization is expected to perform. A person’s job description specifies the decision rights assigned to that particular individual. Checkout clerks in grocery stores have the decision rights to collect cash from customers but don’t have the decision rights to accept checks above a specific amount. A manager must be called for that decision. A division manager may have the right to set prices on products but not the right to borrow money. The president usually retains the right to issue debt, subject to board of directors’ approval.

FIGURE 1–3

Framework for organizational change and management accounting

Business Environment

Business Strategy

Incentive and Actions

Firm Value

Organizational Architecture

• Decision-Right Assignment • Performance Evaluation System

• Reward System

Incentives and Actions

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The next two parts of the organizational architecture are the performance evalua- tion and reward systems. To motivate individuals within the organization, organizations must have a system for measuring their performance and rewarding them. Performance measures for a salesperson could include total sales and customer satisfaction based on a survey of customers. Performance measures for a manufacturing unit might be number of units produced, total costs, and percentage of defective units. The internal accounting system is often an important part of the performance evaluation system.

Performance measures are extremely important because rewards are generally based on these measures. Rewards for individuals within organizations include wages and bonuses, prestige and greater decision rights, promotions, and job security. Tying rewards to performance measures creates incentives for individuals and groups whose performance is being measured to influence the performance measures. Therefore, the performance measures chosen influence individual and group efforts within the organization. These people can work hard to achieve better performance and, hence, rewards. Or they can game the performance metrics. A poor choice of performance measures often leads to conflicts within the organization and derails efforts to achieve organizational goals. For example, measuring the performance of a college president based on the number of stu- dents attending the college encourages the president to enroll ill-prepared students, thereby reducing the quality of the educational experience for other students.

As illustrated in Figure 1–3, changes in the business environment lead to new strate- gies and ultimately to changes in the firm’s organizational architecture. These changes include altering the accounting system to better align the interests of the employees with the objectives of the firm. The new organizational architecture provides incentives for members of the organization to make decisions that enhance the value of the organization. Within this framework, accounting assists in the control of the organization through the organization’s architecture and provides information for decision making. This framework for change is referred to throughout the book.

F. Vortec Medical Probe Example To illustrate some of the basic concepts developed in this text, evaluate the following deci- sion. Vortec Inc. manufactures a single product, a medical probe. Vortec sells the probes to distributors who then market them to physicians. Vortec has two divisions. The manufac- turing division produces the probes; the marketing division sells them to distributors. The marketing division is rewarded on the basis of sales revenues. The manufacturing division is evaluated and rewarded on the basis of the average unit cost of making the probes. The plant’s current volume is 100,000 probes per month. The following income statement sum- marizes last month’s operating results.

VORTEC MANUFACTURING Income Statement

Last Month

Sales revenue (100,000 units @ $5.00) $500,000 Cost of sales (100,000 units @ $4.50) 450,000 Operating margin $ 50,000 Less: Administrative expenses 27,500 Net income before taxes $ 22,500

Medsupplies is one of Vortec’s best distributors. Vortec sells 10,000 probes per month to Medsupplies at $5 per unit. Last week, Medsupplies asked Vortec’s marketing division

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to increase its monthly shipment to 12,000 units, provided that Vortec would sell the additional 2,000 units at $4 each. Medsupplies would continue to pay $5 for the original 10,000 units. Medsupplies argued that because this would be extra business for Vortec, no overhead should be charged on the additional 2,000 units. In this case, a $4 price should be adequate.

Vortec’s finance department estimates that with 102,000 probes, the average cost is $4.47 per unit, and hence the $4 price offered by Medsupplies is too low. The current  administrative expenses of $27,500 consist of office rent, property taxes, and interest and will not change if this special order is accepted. Should Vortec accept the Medsupplies offer?

Before examining whether the marketing and manufacturing divisions will accept the order, consider Medsupplies’ offer from the perspective of Vortec’s owners, who are interested in maximizing profits. The decision hinges on the cost to Vortec of selling an additional 2,000 units to Medsupplies. If the cost is more than $4 per unit, Vortec should reject the special order.

It is tempting to reject the offer because the $4 price does not cover the average total cost of $4.47. But will it cost Vortec $4.47 per unit for the 2,000-unit special order? Is $4.47 the cost per unit for each of the next 2,000 units?

To begin the analysis, two simplifying assumptions are made that are relaxed later:

• Vortec has excess capacity to produce the additional 2,000 probes. • Past historical costs are unbiased estimates of the future cash flows for producing the

special order.

Based on these assumptions, we can compare the incremental revenue from the addi- tional 2,000 units with its incremental cost:

Incremental revenue (2,000 units × $4.00) $8,000 Total cost @ 102,000 units (102,000 × $4.47) $455,940 Total cost @ 100,000 units (100,000 × $4.50) 450,000 Incremental cost of 2,000 units 5,940 Incremental profit of 2,000 units $2,060

The estimated incremental cost per unit of the 2,000 units is then

Change in total cost _________________ Change in volume  =  $455,940  −  $450,000 ___________________ 2,000  = $2.97

The estimated cost per incremental unit is $2.97. Therefore, $2.97 is the average per-unit cost of the extra 2,000 probes. The $4.47 cost is the average cost of producing 102,000 units, which is more than the $2.97 incremental cost per unit of producing the extra 2,000 probes.

Based on the $2.97 estimated cost, Vortec should take the order. Is this the right deci- sion? Not necessarily. There are some other considerations:

1. Will these 2,000 additional units affect the $5 price of the 100,000 probes? Will Vortec’s other distributors continue to pay $5 if Medsupplies buys 2,000 units at $4? What prevents Medsupplies from reselling the probes to Vortec’s other distributors at less than $5 per unit but above $4 per unit? Answering these questions requires management to acquire knowledge of the market for the probes.

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2. What is the alternative use of the excess capacity consumed by the additional 2,000 probes? As plant utilization increases, congestion occurs, production becomes less efficient, and the cost per unit rises. Congestion costs include the wages of the additional production employees and supervisors required to move, store, expedite, and rework products as plant volume increases. The $2.97 incremental cost computed from the average cost data provided above might not include the higher congestion costs as capacity is approached. This suggests that the $4.47 average cost estimate is wrong. Who provides this cost estimate and how accurate is it? Management must acquire knowledge of how costs behave at a higher volume. If Vortec accepts the Medsupplies offer, will Vortec be forced at some later date to forgo using this capacity for a more profitable project?

3. What costs will Vortec incur if the Medsupplies offer is rejected? Will Vortec lose the normal 10,000-unit Medsupplies order? If so, can this order be replaced?

4. Does the Robinson-Patman Act apply? The Robinson-Patman Act is a U.S. federal law prohibiting charging customers different prices if doing so is injurious to competition. It may be illegal to sell an additional 2,000 units to Medsupplies at less than $5 per unit. Knowledge of U.S. antitrust laws must be acquired. More- over, if Vortec sells internationally, it will have to research the antitrust laws of the various jurisdictions that might review the Medsupplies transaction.

We have analyzed the question of whether Medsupplies’ 2,000-unit special order max- imizes the owners’ profit. Will the marketing and manufacturing divisions accept Medsup- plies’ offer? Recall that marketing is evaluated based on total revenues, and manufacturing is evaluated based on average unit costs. Marketing will want to accept the order as long as Medsupplies does not resell the probes to other Vortec distributors and as long as other Vortec distributors do not expect similar price concessions. Manufacturing will accept the order as long as it believes average unit costs will fall. Increasing production lowers aver- age unit costs and makes it appear as though manufacturing has achieved cost reductions.

Suppose that accepting the Medsupplies offer will not adversely affect Vortec’s other sales, but the incremental cost of producing the 2,000 extra probes is really $4.08, not $2.97, because there will be overtime charges and additional factory congestion costs. Under these conditions, both marketing and manufacturing will want to accept the offer. Marketing increases total revenue and thus appears to have improved its performance. Manufacturing still lowers average unit costs from $4.50 to $4.4918 per unit:

($4.50 × 100,000) + ($4.08 × 2,000) ______________________________ 102,000  = $4.4918

Unfortunately, the shareholders are worse off. Vortec’s cash flows fall by $160 [or 2,000 units × ($4.00 − $4.08)]. The problem is not that the marketing and manufactur- ing managers are “making a mistake.” The problem is that their measures of performance create the wrong incentives. In particular, rewarding marketing for increasing total rev- enues and rewarding manufacturing for reducing average unit costs does not ensure that the incremental revenues from the order ($8,000 = $4 × 2,000) are greater than the incre- mental costs ($8,160 = $4.08 × 2,000). Both marketing and manufacturing are doing what they were told to do (increase revenues and reduce average costs), but the firm’s cash flow falls because of poorly designed incentive systems.

Four key points emerge from this example:

1. Beware of average costs. The $4.50 unit cost tells us little about how costs will vary with changes in volume. Just because a cost is stated in dollars per unit does not mean that producing one more unit adds that amount of incremental cost.

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2. Use opportunity costs. Opportunity costs measure what the firm forgoes when it chooses a specific action. The notion of opportunity cost is crucial in decision making. The opportunity cost of the Medsupplies order is what Vortec  forgoes by accepting the special order. What is the best alternative use of the plant capacity consumed by the Medsupplies special order? (More on this in Chapter 2.)

3. Supplement accounting data with other information. The accounting system contains important data relevant for estimating the cost of this special order from Medsupplies. But other knowledge, not contained in the accounting system, must be assembled, such as what Medsupplies will do if Vortec rejects its offer. Managers must augment accounting data with other knowledge such as customer demands, competitors’ plans, future technology, and government regulations.

4. Use accounting numbers as performance measures cautiously. Accounting numbers such as revenues or average unit manufacturing costs are often used to evaluate managers’ performance. Just because managers are maximizing particular performance measures tailored for each manager does not necessarily cause firm profits to be maximized.

The Vortec example illustrates the importance of understanding how accounting num- bers are constructed, what they mean, and how they are used in decision making and con- trol. The accounting system provides a very important source of information to managers, but it is not the sole source of all knowledge. Also, in the overly simplified context of the Vortec example, the problems with the incentive systems and with using unit costs are easy to detect. In a complex company with hundreds or thousands of products or services, such errors become more difficult to detect. Finally, for the sake of simplicity, the Vortec illustration ignores the use of the accounting system for external reporting.

G. Outline of the Text Internal accounting systems provide data for both decision making and control. The organization of this book follows this dichotomy. The first part of the text (Chapters 2 through 5) describes how accounting systems are used in decision making and provid- ing incentives in organizations. These chapters provide the conceptual framework for the remainder of the book. The next set of chapters (Chapters 6 through 8) describes basic top- ics in managerial accounting, budgeting, and cost allocations. Budgets not only communi- cate knowledge within the firm for decision making but also serve as a control device and as a way to partition decision-making responsibility among the managers. Likewise, cost allocations serve decision-making and control functions. In analyzing the role of budgeting and cost allocations, these chapters draw on the first part of the text.

The next section of the text (Chapters 9 through 13) describes the prevalent account- ing system used in firms: absorption costing. Absorption cost systems are built around cost allocations. The systems used in manufacturing and service settings generate product or service costs built up from direct labor, direct material, and allocated overheads. After first describing these systems, we critically analyze them. Absorption cost systems often produce inaccurate unit cost information, which can lead to dysfunctional decision mak- ing. Two alternative accounting systems (variable cost systems and activity-based cost systems) are compared and evaluated against a traditional absorption cost system. The next topic describes the use of standard costs as extensions of absorption cost systems. Standard costs provide benchmarks to calculate accounting variances: the difference between the actual costs and standard costs. These variances provide performance measures and thus are part of the firm’s motivation and control system described earlier.

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The last chapter (Chapter 14) expands the integrative approach summarized in sec- tion E of this chapter. This approach is then used to analyze four modifications of internal cost systems: quality measurement systems, just-in-time production, six sigma and lean production, and balanced scorecards. These modifications are evaluated within a broad historical context. Just because these systems are new does not suggest they are better. Some have stood the test of time, while others have not.

H. Summary This book provides a framework for the analysis, use, and design of internal accounting systems. It explains how these systems are used for decision making and motivating people in organizations. Employees care about their self-interest, not the owners’ self-interest. Hence, owners must devise incen- tive systems to motivate their employees. Accounting numbers provide measures of managers’ perfor- mance and hence are part of the control system used to motivate managers. Most organizations use a single internal accounting system as the primary data source for external reporting and internal uses. Applying the economic Darwinism principle, the costs of multiple systems likely outweigh the benefits for most firms. The costs are not only the direct costs of operating the system but also the indirect costs from dysfunctional decisions resulting from faulty information and poor performance evaluation sys- tems. The remainder of this book addresses the costs and benefits of internal accounting systems.

Problems P 1–1: MBA Students

One MBA student was overheard saying to another, “Accounting is baloney. I worked for a genetic engineering company and we never looked at the accounting numbers and our stock price was always growing.”

“I agree,” said the other. “I worked in a rust bucket company that managed everything by the numbers and we never improved our stock price very much.”

Evaluate these comments.

P 1–2: One Cost System Isn’t Enough Source: Robert S. Kaplan in “One Cost System Isn’t Enough” (Harvard Business Review. January– February 1988, pp. 61–66):

No single system can adequately answer the demands made by diverse functions of cost sys- tems. While companies can use one method to capture all their detailed transactions data, the processing of this information for diverse purposes and audiences demands separate, custom- ized development. Companies that try to satisfy all the needs for cost information with a single system have discovered they can’t perform important managerial functions adequately. More- over, systems that work well for one company may fail in a different environment. Each com- pany has to design methods that make sense for its particular products and processes. Of course, an argument for expanding the number of cost systems conflicts with a strongly ingrained financial culture to have only one measurement system for everyone.

Describe the costs and benefits of having a single measurement system.

P 1–3: U.S. and Japanese Tax Laws Tax laws in Japan tie taxable income directly to the financial statements’ reported income. That is, to compute a Japanese firm’s tax liability, multiply the net income as reported to shareholders by the appropriate tax rate to derive the firm’s tax liability. In contrast, U.S. firms typically have more discretion in choosing different accounting procedures for calculating net income for shareholders (financial reporting) and taxes.

What effect would you expect these institutional differences in tax laws between the United States and Japan to have on internal accounting and reporting?

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P 1–4: Using Accounting for Planning The owner of a small software company felt his accounting system was useless. He stated, “Account- ing systems only generate historical costs. Historical costs are useless in my business because every- thing changes so rapidly.”

Required:

a. Are historical costs useless in rapidly changing environments? b. Should accounting systems be limited to historical costs?

P 1–5: Budgeting Salespeople at a particular firm forecast what they expect to sell next period. Their supervisors then review the forecasts and make revisions. These forecasts are used to set production and purchasing plans. In addition, salespeople receive a fixed bonus of 20 percent of their salary if they meet or exceed their forecasts.

Discuss the incentives of the salespeople to forecast next-period sales accurately. Discuss the trade-off between using the budget for decision making versus using it as a control device.

P 1–6: All Things Tennis All Things Tennis (ATT), a French company, manufactures a variety of tennis gear, such as racket covers, tennis bags, and embroidered towels. ATT sells all its products exclusively in Europe through independent distributors. ATT’s most popular line is a series of racket covers with various animal pictures on the cover.

ATT is currently making 500 animal racket covers a week at an average per unit cost of 3.50 €, which includes both variable costs and allocated fixed costs. The variable cost of each racket cover is 1.10 €. ATT sells the racket covers to distributors for 4.25 €. A distributor in Canada, Toronto Sports, wants to purchase 100 racket covers per week from ATT and sell them in Canada. Toronto offers to pay ATT 2 € per racket cover. ATT has enough capacity to produce the additional 100 racket covers and estimates that if it accepts Toronto’s offer, the per unit cost of all 600 racket covers will be 3.10 €. Assume the cost data provided (3.50 € and 3.10 €) are accurate estimates of ATT’s costs of producing the racket covers. Further assume that ATT’s variable cost per racket cover does not vary with the number of racket covers manufactured.

Required:

a. Given the data in the problem, what is ATT’s weekly fixed cost of producing the animal racket covers?

b. To maximize firm value, should ATT accept Toronto’s offer? Explain why or why not. c. Besides the data provided in the problem, what other factors should ATT consider before

making a decision to accept Toronto’s offer?

P 1–7: Parkview Hospital Parkview Hospital, a regional hospital, serves a population of 400,000 people. The next closest hospi- tal is 50 miles away. Parkview’s accounting system is adequate for patient billing. The system reports revenues generated per department but does not break down revenues by unit within departments. For example, Parkview knows patient revenue for the entire psychiatric department but does not know revenues in the child and adolescent unit, the chemical dependence unit, or the neuropsychiatric unit.

Parkview receives its revenues from three principal sources: the federal government (Medi- care), the state government (Medicaid), and private insurance companies (Blue Cross–Blue Shield). Until recently, the private insurance companies continued to pay Parkview’s increasing costs and passed these on to the firms through higher premiums for their employees’ health insurance.

Last year Trans Insurance (TI) entered the market and began offering lower-cost health insur- ance to local firms. TI cut benefits offered and told Parkview that it would pay only a fixed dollar amount per patient. A typical firm could cut its health insurance premium 20 percent by switching

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to TI. TI was successful at taking 45 percent of the Blue Cross–Blue Shield customers. Firms that switched to TI faced stiff competition and sought to cut their health care costs.

Parkview management estimated that its revenues would fall 6 percent, or $3.2 million, next year because of TI’s lower reimbursements. Struggling with how to cope with lower revenues, Parkview began the complex process of deciding what programs to cut, how to shift the delivery of services from inpatient to outpatient clinics, and what programs to open to offset the revenue loss (e.g., open an outpatient depression clinic). Management can forecast some of the costs of the pro- posed changes, but many of its costs and revenues (such as the cost of the admissions office) have never been tracked to the individual clinical unit.

Required:

a. Was Parkview’s accounting system adequate 10 years ago? b. Is Parkview’s accounting system adequate today? c. What changes should Parkview make in its accounting system?

P 1–8: Montana Pen Company Montana Pen Company manufactures a full line of premium writing instruments. It has 12 differ- ent styles, and within each style, it offers ballpoint pens, fountain pens, mechanical pencils, and a roller ball pen. Most models also come in three finishes—gold, silver, and black matte. Montana Pen’s Bangkok, Thailand, plant manufactures four of the styles. The plant is currently producing the gold clip for the top of one of its pen styles, no. 872. Current production is 1,200 gold no. 872 pens each month at an average cost of 185 baht per gold clip. (One U.S. dollar currently buys 32 baht.) A Chinese manufacturer has offered to produce the same gold clip for 136 baht. This manufacturer will sell Montana Pen 400 clips per month. If it accepts the Chinese offer and cuts the production of the clips from 1,200 to 800, Montana Pen estimates that the cost of each clip it continues to produce will rise from 185 baht to 212.5 baht per gold clip.

Required:

a. Should Montana Pen outsource 400 gold clips for pen style no. 872 to the Chinese firm? Provide a written justification of your answer.

b. Given your answer in part (a), what additional information would you seek before decid- ing to outsource 400 gold clips per month to the Chinese firm?

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Chapter Two

The Nature of Costs

Chapter Outline A. Opportunity Costs

1. Characteristics of Opportunity Costs

2. Examples of Decisions Based on Opportunity Costs

B. Cost Variation 1. Fixed, Marginal, and Average Costs

2. Linear Approximations

3. Other Cost Behavior Patterns

4. Activity Measures

C. Cost–Volume–Profit Analysis 1. Copier Example

2. Calculating Break-Even and Target Profits

3. Limitations of Cost–Volume–Profit Analysis

4. Multiple Products

5. Operating Leverage

D. Opportunity Costs versus Accounting Costs 1. Period versus Product Costs

2. Direct Costs, Overhead Costs, and Opportunity Costs

E. Cost Estimation 1. Account Classification

2. Motion and Time Studies

F. Summary Appendix: Costs and the Pricing Decision

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As described in Chapter 1, accounting systems measure costs that managers use for external reports, decision making, and controlling the behavior of people in the organization. Under- standing how accounting systems calculate costs requires a thorough understanding of what cost means. Unfortunately, that simple term has multiple meanings. Saying a product costs $3.12 does not reveal what the $3.12 measures. Additional explanation is often needed to clar- ify the assumptions that underlie the calculation of cost. A large vocabulary exists to commu- nicate more clearly which cost meaning is being conveyed. Some examples include average cost, common cost, full cost, historical cost, joint cost, marginal cost, period cost, product cost, standard cost, fixed cost, opportunity cost, sunk cost, and variable cost, just to name a few.

We begin this chapter with the concept of opportunity cost, a powerful tool for under- standing the myriad cost terms and for structuring managerial decisions. In addition, opportunity cost provides a benchmark against which accounting-based cost numbers can be compared and evaluated. Section B discusses how opportunity costs vary with changes in output. Section C extends this discussion to cost–volume–profit analysis. Section D compares and contrasts opportunity costs and accounting costs (which are very different). Section E describes some common methods for cost estimation.

A. Opportunity Costs Nobel Prize–winning economist Ronald Coase noted, “The cost of doing anything con- sists of the receipts that could have been obtained if that particular decision had not been taken.”1 This notion is called opportunity cost—the benefit forgone as a result of choosing one course of action rather than another. Cost is a sacrifice of resources. Using a resource for one purpose prevents its use elsewhere. The return forgone from its use elsewhere is the opportunity cost of its current use. The opportunity cost of a particular decision depends on the other alternatives available.

The alternative actions comprise the opportunity set. Before making a decision and calculating opportunity cost, the opportunity set itself must be enumerated. Thus, it is important to remember that opportunity costs can be determined only within the context of a specific decision and only after specifying all the alternative actions. For example, the opportunity set for this Friday night includes the movies, a concert, staying home and studying, staying home and watching television, inviting friends over, and so forth.

The opportunity cost concept focuses managers’ attention on the available alterna- tive courses of action. Suppose you are considering three job offers. Job A pays a salary of $100,000, job B pays $102,000, and job C pays $106,000. In addition, you value each job differently in terms of career potential, developing your human capital, and the type of work. Suppose you value these nonpecuniary aspects of the three jobs at $8,000 for A, $5,000 for B, and only $500 for C. The following table summarizes the total value of each job offer. You decide to take job A because it has the highest total pecuniary and nonpe- cuniary compensation. The opportunity cost of job A is $107,000 (or $102,000 + $5,000), representing the amount forgone by not accepting job B, the next best alternative.

1SOURCE: R. Coase, “Business Organization and the Accountant,” originally published in Accountant, 1938. Reprinted in L.S.E. Essays in Cost, ed. J. Buchanan and G. Thirlby (New York University Press, 1981), p. 108.

Job Offer Salary $ Equivalent of Intangibles Total Value

A $100,000 $8,000 $108,000 B 102,000 5,000 107,000 C 106,000 500 106,500

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The decision to continue to search for more job offers has an opportunity cost of $108,000 if job offer A expires. If you declined job offer L last week, which had a total value of $109,000, this job offer is no longer in the opportunity set and hence is not an opportunity cost of accepting job A now. Besides jobs A, B, and C, you learn there is a 0.9 probability of receiving job offer D, which has a total value of $110,000. If you wait for job D and you do not get it, you will be forced to work in a job valued at $48,000. Job D has an expected total value of $103,800 (or $110,000 × 0.9 + $48,000 × 0.1). Since job D’s opportunity cost of $108,000 (the next best alternative forgone) exceeds its expected value ($103,800), you should reject waiting for job offer D.

Opportunity costs are not necessarily the same as payments. The opportunity cost of taking job A included the forgone salary of $102,000 plus the $5,000 of intangibles from job B. The opportunity cost of going to a movie involves both the cash outlay for the ticket and popcorn, and also forgoing spending your time studying or attending a concert. Remem- ber, the opportunity cost of obtaining some good or service is what must be surrendered or forgone in order to get it. By taking job A, you forgo job B at $107,000.

Opportunity costs are forward looking. They are the estimated forgone benefits from actions that could, but will not, be undertaken. In contrast, accounting is based on his- torical costs in general. Historical costs are the resources expended for actions actually undertaken. Opportunity cost is based on anticipations; it is necessarily a forward-looking concept. Job offers B, C, and D are part of the opportunity set when you consider job A, but job offer L, which expired, is no longer part of the opportunity set. Your refusal of job L last week is not an opportunity cost of accepting job A now.

Opportunity costs differ from (accounting) expenses. Opportunity cost is the sacrifice of the best alternative for a given action. An (accounting) expense is a cost incurred to generate a revenue. For example, consider an auto dealer who sells a used car for $7,500. Suppose the dealer paid $6,500 for the car and the best alternative use of cars like this one is to sell them at auction for $7,200. The car’s opportunity cost in the decision to keep it for resale is $7,200. However, in matching expenses to revenues, the accounting expense is $6,500. Financial accounting is concerned with matching expenses to revenues. In deci- sion making, the concern is with estimating the opportunity cost of a proposed decision. We return to the difference between opportunity and accounting costs in section D.

Several examples illustrate opportunity costs. The first four examples pertain to raw mate- rials and inventories.

Opportunity cost of materials (no other uses) What is the opportunity cost of materials for a special order if the materials have no other use and they are in in stock? The firm paid $16,000 for the materials and anticipates no other orders in which it can use these materials. The opportunity cost of these materials is whatever scrap value they may have. If the materials have no alternative use and they have no storage or disposal cost, their opportunity cost is zero. If the firm incurs costs for stor- ing the materials and if disposal is costly, then these materials have a negative opportunity cost. By using them in a special order, the firm saves their storage or disposal costs.

Opportunity cost of materials (other uses) The opportunity cost of materials not yet purchased for a job is the estimated cash outflow necessary to secure their delivery. If the materials are already in stock, their opportunity cost is their highest-valued use elsewhere. If the materials will be used in another order,

1. Characteristics of Opportunity Costs

2. Examples of Decisions Based on Opportunity Costs2

2Some of the examples presented here are drawn from Coase (1938), pp. 10–22.

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using them now requires us to replace them in the future. Hence, the opportunity cost is the cost of replacement.

Cost of capital on inventory as an opportunity cost An automobile manufacturer plans to introduce a new car model. Included in the opportu- nity cost of the new model are the payments for materials, labor, capital, promotion, and administration. Opportunity cost also contains the cost of capital forgone on the additional inventory of cars and parts the firm carries as part of the normal operations of manufactur- ing and selling cars. If the average inventory of materials, work in process, and finished cars is $125 million and the cost of capital for this type of investment is 10 percent, then the opportunity cost on this investment is $12.5 million per year.

The next raw material example introduces the concept of sunk costs, expenditures that have already been made and are irrelevant for evaluating future alternatives.

Sunk costs and opportunity costs A firm paid $15,000 for a coil of stainless steel used in a special order. Twenty percent (or $3,000 of the original cost) of the coil remains. The remaining steel in the coil has no alternative use; a scrap steel dealer is willing to haul it away at no charge. The remaining $3,000 of the original cost is a sunk cost. Sunk costs are expenditures incurred in the past that cannot be recovered. The $3,000 is sunk because it has already been incurred and is not recoverable. Because it cannot be recovered, the $3,000 should not influence any decision. In this case, the remaining steel coil has a zero opportunity cost. Sunk costs are irrelevant for future uses of this stainless steel. Suppose the scrap dealer is willing to pay $500 for the remaining coil. Using the remainder in another job now has an opportunity cost of $500.

Many large corporations utilize sustainability programs to create long-term shareholder value by identifying opportunities and managing risks from economic, environmen- tal, and social developments. For example, in 2013 the catastrophic collapse of the Rana Plaza building in Bangladesh killed more than 1,100 garment workers. This plant produced clothing for some of the world’s largest retailers such as H&M, Marks and Spencer, and Zara. Even though these retailers did not own this plant, they came under intense criticism by the media, governments, and customers for not imposing tighter building inspections on their Bangladesh supplier. Sustainability programs seek to iden- tify, measure, and integrate social, environmental, and economic impacts into corporate strategy to manage those impacts and increase long-run profitability. As such, firms that outsource significant amounts of their products now proactively monitor the work- place safety of their suppliers. Before Nike introduces new footwear, the product design team compares alternative materials in terms of not just cost, but also environmental impacts such as energy use, greenhouse gas emissions, water use, land use, and waste and chemical use. By improving the environment, Nike hopes to increase the future demand for its products.

Well-functioning sustainability programs capture the opportunity cost of decisions managers make today on future cash flows of the firm arising from social, environmen- tal, and political processes. For example, Home Depot drops suppliers that violate its workplace standards for safety and child labor. By avoiding such firms, Home Depot reduces its risk of bad publicity if a supplier experiences an adverse event. SOURCES: M. Epstein and A. Buhovac, “A New Day for Sustainability,” Strategic Finance, July 2014, pp. 25–33. www.pepsico.com/Purpose/Environmental-Sustainability/Water.

Managerial Application: Sustain- ability and Opportunity Costs

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Remember that sunk costs are irrelevant for decision making unless you are the one who sunk them. However, sunk costs are not irrelevant as a control device. Holding manag- ers responsible for past actions causes them to take more care in future decisions. Suppose $4 million was spent on new software that doesn’t work and the firm buys a commercial package to replace it. The manager responsible for the failed software development will be held accountable for the failure and will have incentives to consume more firm resources trying to either fix it or cover up its failure before this knowledge becomes widely known.

The next example applies the opportunity cost concept to evaluating alternatives regarding labor.

Opportunity cost of labor Suppose a firm’s work force cannot be changed because of existing labor agreements. Employees are guaranteed 40 hours of pay per week. For the next three weeks, only 35 hours of work per week per employee exists. What is the cost of taking a special order that will add five hours of work per employee? One is tempted to cost the five hours of labor in the special order at zero because these employees must be paid anyway. But the question remains: What will these employees do with the five hours if this special order is rejected? If they would do preventive maintenance on the machines or do general maintenance or improve their skills through training, then the opportunity cost of the labor for the special order is not zero but the value of the best forgone alternative use of the employees’ time.

Public accounting firms confront this issue. The summer months tend to be low- demand periods relative to year-end. How the firm prices summer (off-peak) audits depends in part on the perceived opportunity cost of the staff’s time.

If a firm owns long-lived assets such as buildings and equipment, understanding their opportunity costs involves alternative uses of these assets. The next three examples describe the opportunity costs of capital assets.

Asset depreciation as an opportunity cost Using assets can affect their value. Suppose a delivery van used four days a week can be sold next year for $34,000. If additional business is taken and the delivery van is used six

Data breaches generate large costs for companies. Consider Equifax, the credit-reporting company. In 2017, it revealed that cyber criminals gained access to names and Social Security numbers of up to 143 million people in its files. Not only did Equifax incur significant costs to upgrade its software and hardware, it paid for identity theft protec- tion and credit file monitoring services for possible victims. These costs likely exceed $439 million. In addition to these out-of-pocket costs, cyber breaches generate signifi- cant indirect costs.

If a company shuts down its e-commerce site after a cyber-attack, lost sales occur. IBM reports the “biggest financial consequence to organizations that experienced a data breach is lost business.” Sales also decline because of damage to the firm’s brand name as customers lose confidence in the firm’s ability to protect their identity.

Opportunity cost represents “the benefit forgone as a result of choosing one course of action rather than another.” If the firm chooses to spend too little on cyber security, it forgoes reducing the risk of a data breach. The benefits of high cyber security are avoid- ing the costs of a data breach—the out-of-pocket costs plus the indirect costs. SOURCES: www.pymnts.com/news/security-and-risk/2018/equifax-cost-275m/; and N. Amato, “The Hidden Costs of a Data Breach,” Journal of Accountancy, July 25, 2016, www.journalofaccountancy.com/news/2016/jul/hidden-costs-of-data- breach-201614870.html.

Managerial Application: The Oppor- tunity Costs of a Data Breach

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days a week, its market value next year will be $28,000. Depreciation due to use for the additional business is $6,000 ($34,000 − $28,000).

The opportunity cost of using an asset is the decline in its value. Accounting depre- ciation (such as straight-line depreciation) is based on historical costs. Accounting depre- ciation unlikely reflects the actual opportunity cost of the van (its decline in value from use). However, accounting depreciation can be a reasonably accurate approximation of the decline in the market value of the asset. In any given year, accounting depreciation may not exactly capture the decline in the asset’s market value. However, over the asset’s economic life, accumulated accounting depreciation equals the decline in value. Holding managers responsible for accounting depreciation commits them to recovering the histori- cal cost of the asset in either additional revenues or cost savings.

Opportunity cost of excess capacity Suppose a plant operates at 75 percent capacity. Is the firm forgoing profits on the 25 percent of idle capacity? It is usually optimal to have some “excess” capacity in order to absorb random shocks to normal production, such as machine breakdowns and demand fluctuations, which increase production time and costs. When plants are built, rarely are they expected to run at 100 percent capacity. As plant utilization increases, per-unit costs increase as congestion rises. The opportunity cost of increasing the plant’s expected utilization—say, from 75 percent to 85 percent of capacity—is the higher production cost imposed on the existing units that currently utilize 75 percent of the capacity.

Consider this illustration. The following table lists the output of a plant in units of production and the average cost per unit. Average costs rise as volume increases because congestion increases. This causes more machine breakdowns, and indirect labor (expedit- ers, material handlers, production schedulers) must be hired to manage the increased con- gestion. The plant is currently operating at 75 percent capacity (150 units) and incurring average costs of $6.04 per unit.

Units Capacity Average Cost

130 65% $6.00 140 70 6.02 150 75 6.04 160 80 6.06 170 85 6.08 180 90 6.11 190 95 6.15 200 100 6.20

Suppose production increases from 150 units (75 percent capacity) to 170 units (85 percent capacity). Increasing production by an extra 20 units causes the average cost of the base production of 150 units to rise from $6.04 to $6.08, or 4¢ per unit. The opportunity cost of producing 20 more units is not the average cost of $6.08 but the incremental cost of the last 20 units, $6.38 {or [(170 × $6.08) − (150 × $6.04)] ÷ 20 units}. Another way of comput- ing the opportunity cost of the last 20 units is

$6.38 = $6.08 + (4¢ × 150) ÷ 20

Or the opportunity cost of producing 20 more units is composed of their average cost ($6.08) plus the cost increase that each of the 20 units imposes on the first 150 units [(4¢ × 150) ÷ 20].

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The final example describes evaluating the opportunity costs of introducing new products.

Opportunity cost of product line cannibalization A company that produces tablet computers has 60 percent of a particular market niche. The company plans to introduce a new, high-end, faster tablet with additional features. The major competition for the new tablet is the firm’s current high-end tablet. In the first year, management projects sales of the new model to be 20,000 units. Sales of the exist- ing tablet are expected to fall by 7,000 units. Thus, the new tablet “cannibalizes” the old tablet’s sales by 7,000 units. Are the forgone profits from the 7,000 units that could have been sold an opportunity cost of introducing the new tablet? It depends on the opportunity set. If management expects competitors to introduce a device that competes with the old tablet, meaning that the company is likely to have lost those units anyway, then the profits forgone on the 7,000 units are not an opportunity cost of introducing the new tablet.

Q2–1 Define opportunity cost. Q2–2 What are some characteristics of opportunity costs? Q2–3 A firm paid $8,325 last year for some raw material it planned

to use in production. When is the $8,325 a good estimate of the opportunity cost of the material?

Q2–4 Define sunk cost and give an example. Q2–5 What are avoidable and unavoidable costs? How are they

related to opportunity costs?

Concept Questions

B. Cost Variation Managers commonly decide how many units to produce or how much service to provide during a certain time period. Apple must decide how many Apple watches of a partic- ular model to manufacture next quarter. United Airlines must decide whether to fly a 90- passenger jet or a 130-passenger jet between Denver and Palm Springs next month. Making these decisions requires an understanding of how costs change with volume—the topic of this section.

Cost behavior is defined relative to some activity, such as the number of units produced, hours worked, pounds of ore mined, miles driven, or meals served. Usually, units produced is the measure of activity. For example, consider Figure 2–1, which illustrates the general relation between cost and units produced. Two important points emerge from Figure 2–1. First, even with no units produced, the firm still must incur some costs. The costs incurred when there is no production are called fixed costs. If the plant is idle, some costs such as property taxes, insurance, plant management, security, and so on must be incurred to pro- vide production capacity. For example, Intel acquires land and builds a plant to manufac- ture a specific quantity of microprocessors. It pays annual property taxes of $1.75 million on this land. The $1.75 million expenditure on property taxes is part of the cost Intel pays to have this manufacturing capacity at this plant.

Second, in general the cost curve is not a straight line as output expands, but rather is curvilinear. The particular shape of the curve arises because marginal cost varies with the level of production. Marginal cost is the cost of producing one more unit. In Figure 2–1, marginal cost is the slope of a line drawn tangent to the total cost curve. For the first few

1. Fixed, Marginal, and Average Costs

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X Y

A

B

Total cost

Fixed cost

Units produced

CostFIGURE 2–1

Nonlinear cost curve

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units, such as to the left of output level X, the slope of the tangent is quite steep. The mar- ginal cost for the first few units is high because employees must be hired, suppliers must be found, and marketing channels must be opened. Therefore, the cost of starting opera- tions and producing the first few units may be extremely high. Expanding output beyond the first few units allows the organization to achieve smooth, efficient production tech- niques. At normal production rates, the marginal cost of making additional units is rela- tively low. At high levels of output (output level Y), additional costs are incurred because of constraints on the use of space, machines, and employees. Machines are more likely to fail when operating at or near capacity. Labor costs increase because employees are paid for overtime. Therefore, the marginal cost of making additional units when operating near capacity is higher than under normal operations.

By definition, a fixed cost is not an opportunity cost of the decision to change the level of output. The decision to expand output usually does not affect property insurance premi- ums. Therefore, property insurance is a fixed cost with respect to volume and is not a cost when deciding to increase output.

Just because a cost is fixed with respect to volume changes, it can still be managed and reduced. A firm can reduce insurance premiums by increasing deductibles or by lowering the risks being insured (installing fire alarms and sprinkler systems). Many fixed costs can be altered in the long run by closing a plant. If a cost is fixed, this does not mean it is a constant and known with certainty. Fixed costs vary over time due to changes in prices. But fixed costs do not vary with changes in the number of units produced.

Another important cost term is average cost. Average cost per unit is calculated by dividing total cost by the number of units produced. Average cost is the slope of the line drawn from the origin to the total cost curve and is depicted in Figure 2–2 as the slope of the line from point O through point C.3 The average cost at output level Z represents the cost per unit of producing Z units. For the pattern of costs in Figure 2–2, the average cost per unit is very high at low levels of output but declines as output increases. The average cost per unit increases as output nears capacity. Notice that at Z units of production, the average cost is larger than the marginal cost. (The slope of OC is steeper than the slope of the tangent at point C.)

3Recall that the slope of a line is the ratio of the change in its vertical distance divided by the change in its horizontal distance. In Figure 2–2 , the slope of the line OC is the distance CZ divided by the distance OZ. CZ ÷ OZ is the total cost of producing Z units divided by Z units, which is the average cost of producing Z units.

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Exercise 2–1

Suppose that a plant making steam boilers has the following costs per month:

FIGURE 2–2

Average and marginal cost

O Z

C

Total cost

Fixed cost

Units produced

Cost

Marginal cost at Z is the slope of the line tangent at C

Average cost at Z is slope of the line from O to C

MGM Studios produces and distributes entertainment products worldwide, including motion pictures, television programming, home video, interactive media, and music. The company owns a large film library, consisting of approximately 4,000 titles. MGM significantly improved its operating performance after a careful analysis of the fixed and variable costs of distributing movies to local cinemas. It reduced head count 10 percent and stopped distributing independent films through United International Pic- tures. It now distributes these films itself. This allowed MGM to convert a large fixed cost into a variable cost. SOURCE: L. Calabro, “Everything in Moderation,” CFO, February 2004, pp. 59–65.

Managerial Application: Metro- Goldwyn- Mayer Inc.

Number of Boilers Total Cost

1 $  50,000 2 98,000 3 144,000 4 184,000 5 225,000 6 270,000 7 315,000 8 368,000 9 423,000

10 480,000

Required:

a. What are the marginal and average costs for each level of output?

b. The plant is currently making and selling eight boilers per month. The company can sell another steam boiler for $53,000. Should the company accept the offer?

continued

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Solution:

Number of Boilers Total Cost Marginal Cost Average Cost

1 $ 50,000 $50,000 $50,000 2 98,000 48,000 49,000 3 144,000 46,000 48,000 4 184,000 40,000 46,000 5 225,000 41,000 45,000 6 270,000 45,000 45,000 7 315,000 45,000 45,000 8 368,000 53,000 46,000 9 423,000 55,000 47,000

10 480,000 57,000 48,000

b. The company should reject the offer because the marginal cost of making the ninth boiler is $55,000, whereas the price is only $53,000. The average cost of $47,000 should not be used in this decision.

The cost of changing production levels is not always easy to estimate. Estimating the total cost curve in Figure 2–1 requires knowledge of both fixed cost and how the total costs of facilities, labor, and materials vary as the rate of production increases. Such estimates are difficult to obtain, so managers often approximate these costs. One such approximation assumes the curve is linear instead of curvilinear.

An approximation of total cost in Figure 2–1 using a linear cost curve is displayed in Figure 2–3. In this figure, estimating total cost requires an estimate of the y-axis intercept and the slope of the straight line. The intercept, FC, approximates the fixed costs. The slope of the line is the variable cost per unit. Variable costs are the additional costs incurred when output is expanded. When Honda expands the production of minivans at a particular plant from 200 to 250 vans per day, it must buy more parts, hire more employees, use more power, and so forth. Variable costs include all costs that increase as more minivans are produced.4

In Figure 2–3, the straight line represents the sum of the fixed and variable cost approximations of total cost. The line is closest to the total cost in the range of normal operations. This range between output levels X and Y is called the relevant range. The relevant range encompasses the rates of output for which the sum of fixed and variable costs closely approximates total cost. Because the slopes of the total cost curve and the straight-line approximation are about the same, the variable cost is a close approximation of the marginal cost. In the relevant range, variable cost can be used to estimate the cost of making additional units of output.

Notice that variable cost per unit approximates marginal cost per unit. The slope of the variable cost line is constant as the activity measure increases. Variable cost per unit is usually assumed to be constant. Later chapters relax this assumption. The terms marginal cost and variable cost are often used interchangeably, but the two are not necessarily the

2. Linear Approximations

4While most managers understand intuitively the difference between fixed and variable costs, not everyone does. When asked the difference between a fixed cost and a variable cost, one employee replied, “A fixed cost? If it’s broke, I fix it and it costs me.” See R. Suskind, “Guys Holding Axes and Chainsaws Get to Use Any Name They Like,” The Wall Street Journal, February 26, 1992, p. B–1.

a.

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same. Marginal cost refers to the cost of the last unit produced and in most cases varies as volume changes. In some situations, marginal cost per unit does not vary with volume. Then marginal cost (per unit) and variable cost per unit are equal.

The straight-line approximation of total cost can be represented by the following equations:

Total cost = Fixed cost + Variable cost Total cost = Fixed cost + (Variable cost per unit)(Units produced) 

TC = FC + VC × Q

where TC represents total cost, FC represents fixed cost, VC is variable cost per unit, and Q is the number of units. For example, suppose the fixed cost is $100,000 per month, the variable cost per unit is $3, and 15,000 units are to be manufactured. Total cost is calcu- lated to be $145,000 (or $100,000 + $3 × 15,000 units). The total cost of $145,000 is an estimate of the cost of manufacturing 15,000 units.

FIGURE 2–3

Linear approximation of total cost

Y

A

Total cost

Fixed cost,

FC

Units produced

Costs

B

Total variable cost at Y

Straight-line approximation

Fixed cost

X Relevant range

3. Other Cost Behavior Patterns

Some costs vary with output (variable costs) and others do not (fixed costs). Between these two extreme cases are step costs and mixed (semivariable) costs. Each of these is described in turn and illustrated in Figure 2–4.

Step costs One type of cost behavior involves step costs, expenditures fixed over a range of output levels (line I in Figure 2–4). For example, each supervisor can monitor a fixed number of employees. As output expands, more employees are needed and eventually another super- visor is added. Hence, supervisory personnel expenditures are a step function. Likewise, once the number of transactions a computer system can process is exceeded, the firm must acquire a larger machine. Expenditures on data centers often behave as step costs.

Mixed (semivariable) costs Many costs cannot be neatly categorized as purely fixed or variable. The cost of electricity used by a firm is a good example. Producing more output requires some additional electric- ity. But some portion of the electric bill is just for turning on the lights and heating or cooling the plant whether the plant produces 1 unit or 50,000 units. In this case, the cost of electricity is a mixture of fixed and variable costs. Mixed or semivariable costs are cost categories that cannot be classified as being purely fixed or purely variable (line II in Figure 2–4).

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FIGURE 2–4

Step and mixed costs

II

Units produced

Total dollars

I Step cost

Mixed (semivariable)

cost

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4. Activity Measures

The discussion so far has focused on how total cost varies with changes in output (units produced). Output is the measure of activity. Consider a steel mill that makes 1 million tons of two-inch steel plate in one month and 1 million tons of one-inch steel plate in the next month. The cost of the one-inch steel plate will likely be higher because more work is required to roll out the thinner plate. In this factory, costs vary not only with weight of the output but also with its thickness. In general, costs vary based on units produced as well as on the size, weight, and complexity of the product.

In many costing situations, managers choose a single activity measure, such as the total number of toys painted or pounds of toys painted. This activity measure is then assumed to be the primary cost driver. The cost driver is that measure of physical activity most highly associated with variations in cost. For example, in the painting department, the quantity of paint used often will be chosen as the cost driver if it has the highest association with total costs in the painting department.

An input measure, such as the quantity of paint used, is often used as a single cost driver to capture the many factors and to simplify the process of estimating total cost. The choice of the activity/volume measure is often critical to the perceived variation of costs. This issue is discussed in greater detail in Chapter 11.

The problem with using a single activity measure is that it can be correct for one class of decisions but incorrect for others. Such categorizations indicate how costs vary but only for that particular decision. For example, expanding the volume of an existing product in a given plant will cause a different set of costs to vary than will adding a new product line in the same plant or expanding the volume of a given product by building a new plant. Consider an automobile assembly line producing a single car model. Adding 125 cars per day of a second car model costs more than increasing production of the existing model by 125 cars. More labor is required to schedule, order parts, and store them for two different models than if just one model is produced. Thus, the variable costs of 125 cars depend on whether the additional cars are for an existing model or a new model.

Some costs are fixed with respect to some decisions but not others. Consider machine setups. Before a computer-controlled milling machine can begin milling parts, a technician must set up the machine by loading the proper computer program, loading the correct tools into the machine, adjusting the settings, making a few parts, and checking their tolerances. Once set up, the machine can produce a large number of parts without another machine setup. The cost of the setup is the cost of the technician’s time, the material used to check the machine, and the forgone profits of not using the machine while it is being set up.

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This setup cost is independent of the number of units produced and thus is a fixed cost. However, if the machine produces 1,000 parts per batch, expanding volume from 1,000 parts to 2,000 parts doubles the number of setups and doubles the setup costs. On the other hand, if the plant increases volume to 2,000 parts by doubling batch size, setup costs remain fixed. Therefore, classifying setup costs as being either fixed or variable can be right for some decisions and wrong for others, depending on whether batch sizes change. If some decisions cause batch sizes to change and others do not, then any classification of setup costs as fixed or variable will be wrong for some decisions.

Exercise 2–2

Total cost in the painting department of a toy factory varies not only with the number of toys painted but also with the sizes of the toys, the types of surfaces painted, the kinds of paint applied, and so on.

Paint costs $15 per gallon. To set up the painting machines to paint a part costs $500, which includes cleaning out the old color. Using the paint machine for one hour costs $70, which also includes the labor to operate it.

A particular part with 4,200 pieces in the batch requires 10 gallons of paint and eight hours of paint machine time.

Required:

Calculate the total cost to paint this batch.

Solution:

Using multiple activity bases, the cost of painting this part is calculated as

Setup cost $ 500 Paint (10 gallons × $15 per gallon) 150 Machine time (8 hours × $70 per hour) 560 Total painting cost $ 1,210

Notice that the cost of painting the parts includes a fixed setup cost of $500, which does not vary with the number of parts painted.

Q2–6 Define mixed cost and give an example. Q2–7 Define step cost and give an example. Q2–8 Define fixed cost. Q2–9 Define variable cost. Is it the same as marginal cost? Explain.

Concept Questions

C. Cost–Volume–Profit Analysis 1. Copier Example

Once costs are classified into fixed/variable categories, managers can perform cost– volume–profit analysis. The following example illustrates the essential features of this analysis. Suppose Xerox Corp. has a walk-up copy division that places coin-operated

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color photocopying machines in public areas such as libraries, bookshops, and super- markets. Customers pay 25¢ per copy and the store providing the space receives 5¢ per copy. Xerox provides the machine, paper, toner, and service. Machines are serviced every 20,000 copies at an average cost of $200 per service call. Paper and toner cost 4¢ per copy. Xerox’s walk-up copy division is charged $150 per month per machine placed (the oppor- tunity cost of the machine). The variable costs per copy are

Paper and toner $  0.04 Store owner 0.05 Service ($200 ÷ 20,000) 0.01 Variable costs $  0.10

The contribution margin is the difference between the price and the variable cost per copy. The contribution margin is the net receipts per copy that are contributed toward covering fixed costs and providing profits. In this example, the contribution margin is calculated as

Price $ 0.25 Less variable costs (0.10) Contribution margin $ 0.15 

Given the contribution margin and monthly fixed costs, the number of copies each machine must sell monthly to recover fixed costs is the ratio of fixed costs to the contri- bution margin. This quantity of copies is called the break-even point and is calculated as

Break-even point = Fixed costs _________________ Contribution margin = $150 _____ $0.15 = 1,000 copies

In other words, if the copier makes 1,000 copies each month, it produces net receipts (after variable costs) of $150 (or 1,000 × $0.15), which is just enough to recover the fixed costs.

The Xerox copier example illustrates that classifying costs into fixed and variable components provides a simple decision rule as to where to place copiers. If a store is expected to produce (or actually produces) fewer than 1,000 copies per month, a copier should not be located there. The break-even volume provides a useful management tool for where to place machines.

2. Calculating Break-Even and Target Profits

Let us study the cost–volume–profit analysis further. For simplicity, assume that production  equals sales (to avoid inventory valuation issues such as the LIFO/FIFO choice). Also assume that the firm produces a single product. Figure 2–5 displays the total cost and revenue of producing various levels of output. The total revenue curve has a decreasing slope beyond some quantity because more unit sales can be achieved only at lower prices. At high prices, volumes are low. As prices fall, volume increases and the slope of the total revenue curve becomes less steep. The total cost curve, also nonlinear, is the same cost curve depicted in Figure 2–1. Break-even occurs when total revenues equal costs. In Figure 2–5, two break-even volumes exist, labeled “Break-even point 1” and “Break-even point 2.” The profit-maximizing point of output occurs when marginal

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Dollars Total cost

MR Total revenue

MC

FC

Break-even point 1

Profit- maximizing

point

Break-even point 2

Units produced

MC: Marginal cost is the slope of the total cost curve. MR: Marginal revenue is the slope of the total revenue curve. MC and MR are equal at the profit-maximizing point.

FIGURE 2–5

Total cost and revenue curves

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revenue equals marginal cost (MR = MC). Marginal revenue refers to the receipts from the last unit sold. At any point, marginal revenue is the slope of the line just tangent to the total revenue curve.

As described in section B, it is difficult to estimate nonlinear functions. Linear approx- imations are often used. Figure 2–6 substitutes linear cost and linear revenue approxi- mations for nonlinear curves. Instead of allowing price to vary with quantity, assume a constant price, P. The total revenue function, TR, is then

TR = P × Q

Dollars

Profit

Loss FC

Break-even point 1

TR

TC

Units produced

FC: Fixed cost TR: Total revenue equals a constant price times total output (P × Q) TC: Total cost equals fixed costs plus the variable cost per unit times output (FC + VC × Q)

FIGURE 2–6

Straight-line approximations of cost and revenue curves and cost– volume–profit analysis

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where Q is output. If the firm can sell as much as it wants without affecting price, then assuming a linear revenue function, TR, does not distort the analysis. Likewise, total cost is assumed to follow a linear function of the form

TC = FC + VC × Q

where FC is the fixed cost and VC is the variable cost per unit. For the moment, ignore income taxes.

Using straight-line approximations of total revenue and total cost allows managers to simplify analyzing how profits vary with output. In particular,

Profit = TR − TC = P × Q − VC × Q − FC (2.1) Profit = (P − VC) × Q − FC (2.2)

Break-even volume is the number of units sold that just covers fixed and variable costs. To find break-even volume, QBE, set equation (2.2) equal to zero and solve for QBE.

Profit = 0 = (P − VC) × Q BE − FC (2.3)

Q BE = FC ______ P − VC = FC _________________ Contribution margin =

FC ____ CM

Price minus variable costs (P − VC), the contribution margin per unit (CM), is the profit per unit sold that can be used to cover fixed costs (FC). Contribution margin is important because it measures the incremental net receipts of selling one more unit. Refer to Figure 2–6. If units produced is less than the break-even point, a loss occurs. If output exceeds break-even quantity, a profit is earned.

Note that the estimated break-even point, QBE, will not exactly correspond to the “real” break-even point, where total revenue equals total cost. The discrepancy occurs because TR and TC do not represent exactly total revenue and total costs, respectively.

Suppose we want to make a target after-tax profit of ProfitT and the income tax rate is t. We can compute the number of units needed to make an after-tax profit by modifying equation (2.2) and solving for QT, target output:

Profit t = [ Q T × (P − VC) − FC ] × (1 − t) (2.4)

Q T = Profit t __________ (1 − t) × CM +

FC ____ CM

(2.5)

Instead of memorizing this formula, it is better to start with equation (2.1) or (2.2) and make the necessary modifications to solve the particular problem at hand. Exercise 2–3 illustrates how to modify the formula.

Exercise 2–3

DGA Tile manufactures ceramic flooring tiles. DGA’s annual fixed costs are $740,000. The variable cost of each tile is $0.25, and tiles are sold for $6.50. DGA has a combined state and federal tax rate of 30 percent.

Required:

a. How many tiles does DGA need to make and sell each year to earn an after-tax profit of $85,000?

b. DGA must pay 10 percent of before-tax profits as a royalty payment to its founder. Now how many tiles must DGA make and sell to generate $85,000 after taxes? (Assume the royalty payment is not a tax-deductible expense.)

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Solution:

a. Let Q denote the number of tiles made and sold that generates $85,000 of after-tax profit. Given the preceding data, we can write

($6.50Q − $0.25Q − $740,000) (1 − 0.30)

=

$85,000

(6.25Q − $740,000) × 0.70

=

$85,000

Solving for Q:

$4.375Q

=

$85,000 + $740,000 × 0.70

Q

=

137,829 tiles

Therefore, to generate an after-tax profit of $85,000, about 138,000 tiles must be sold.

b. The formula with the royalty payment, R, is

($6.25Q − $740,000) × 0.70 − R = $85,000

where

R = ($6.25Q − $740,000) × 0.10

Substituting R into the earlier equation,

($6.25Q − $740,000) (0.70 − 0.10)

=

$85,000

Q

=

141,067

Exercise 2-4 illustrates another use of contribution margins. It involves choosing the most profitable product to produce when capacity is constrained.

Exercise 2–4

The Ralston Company produces three shirts. It only has 200 machine hours per day to produce shirts and has the following cost and production information:

  Basic Deluxe Super

Selling price $7.50 $9 $13 Variable cost of production $6.00 $7 $7 Machine hours to complete one shirt   0.6  2   3 Demand per day (shirts) 50 50  50

Ralston has fixed costs of $75 per day. How many shirts of each type should be produced?

Solution:

The opportunity cost of producing one type of shirt arises from not using those machine hours to produce another type of shirt. In this problem, to maximize firm profits in light of a capacity constraint, we must produce those products with the highest contribution margin per unit of capacity. First calculate the contribution margin per shirt and then convert this to the contribu- tion margin per machine hour. continued

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  Basic Deluxe Super

Selling price $7.50 $9 $13 Variable cost of production $6.00 $7 $7 Contribution margin per shirt $1.50 $2 $6 Hours to complete one shirt ÷  0.6 ÷ 2 ÷ 3 Contribution margin per machine hour $2.50 $1 $ 2 Demand per day (shirts) 50 50  50 Production schedule (shirts) 50 10  50 × Hours to complete one shirt 0.6 2  3 Hours consumed 30 20 150

To maximize profits, Ralston should produce the shirt(s) with the highest contribution margin per unit of scarce resource (machine hours). This is an application of the opportunity cost principle. Even though Super has the highest contribution margin per unit, Basic has the highest contribution margin per machine hour. Therefore, to maximize profits, produce 50 units of Basic, which will consume 30 hours (or 50 units × 0.6 hours per unit). Next, produce 50 units of Super, which consumes 150 hours of capacity. This leaves 20 hours of capacity to be used to produce 10 units of Deluxe.

The preceding analysis suggests producing the market demand for Basic and Super but not for Deluxe. Fixed costs never enter the analysis. By definition, fixed costs are fixed and cannot be relevant to the decision, which depends only on selling price, variable cost, and the capacity constraint.*

*One artificial aspect of this exercise is that the quantity demanded and the price are taken as constants. Clearly, at lower prices, more shirts will be demanded. Fixed demand is assumed to simplify the problem.

The Ralston Company example illustrates a very simple situation in which there is only one constraint. If there are multiple constraints, linear programming is a useful tech- nique for identifying the profit-maximizing mix of products. The next section describes some of the shortcomings of cost–volume–profit analysis.

3. Limitations of Cost–Volume– Profit Analysis

Exercise 2–5

Using equation (2.2), find the output, Q, that maximizes profits.

Solution:

Profits are maximized by setting output to infinity. That is, equation (2.2) cannot be used to maximize profits.

Exercise 2–5 illustrates that cost–volume–profit analysis is not useful for choosing the profit-maximizing output quantity when both revenues and costs are assumed linear. Given this conclusion, what good is it? Cost–volume–profit analysis offers a useful place to start analyzing business problems. It gives managers an ability to do sensitivity analysis

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and ask simple what-if questions. And, as we saw in the copier example, break-even analy- sis can prove useful for certain types of decisions. However, several limitations of cost– volume–profit analysis exist:

1. Price and variable cost per unit must not vary with volume. 2. Cost–volume–profit is a single-period analysis. All revenues and costs occur in

the same time period. 3. Cost–volume–profit analysis assumes a single-product firm. All fixed costs are

incurred to produce a single product. If the firm produces multiple products, and fixed costs such as property taxes are incurred to produce multiple products, then the break-even point or target profit for any one of the products depends on the volume of the other products. With multiple products and common fixed costs, it is not meaningful to discuss the break-even point for just one product.

Although these limitations are important, cost–volume–profit analysis forces managers to understand how costs and revenues vary with changes in output.

Notice in the earlier Xerox copier example that the assumptions underlying break- even analysis are not violated:

• Price does not vary with quantity. • Variable cost per unit does not vary with quantity. • Fixed costs are known. • There is a single product (copies). • All output is sold.

To manufacture a green, battery-powered automobile generates 30,000 pounds of carbon-dioxide emissions, compared to 14,000 pounds of carbon-dioxide emissions to produce a conventional gasoline-powered car. Much of the difference is due to the additional carbon dioxide needed to produce lithium batteries. Each mile driven by the green car generates six ounces of carbon dioxide to produce the electricity to recharge the batteries, whereas an equivalent size gasoline-powered car generates 12 ounces per mile. Based on these data, one can calculate the number of miles a green car owner must drive before the battery-powered car produces less carbon-dioxide emissions than a conventional car. First, convert pounds of carbon dioxide to ounces of carbon dioxide:

30,000 pounds

=

16 ounces per pound × 30,000 pounds = 480,000 ounces

14,000 pounds

=

16 ounces per pound × 14,000 pounds = 224,000 ounces

Next, calculate the break-even number of miles (M) where carbon dioxide is the same for the electric car and a conventional car.

480,000 + 6M = 224,000 + 12M

Solving for M:

256,000

=

6M

M

=

42,667 miles

If, over the life of the green car, the owner drives less than about 43,000 miles, the green car generates more carbon dioxide than a conventional car. SOURCE: B. Lomberg, “Green Cars Have a Dirty Little Secret,” Wall Street Journal (March 11, 2013), p. A15.

Managerial Application: Break-Even Analysis of Carbon- Dioxide Emissions of Electric Car Batteries

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4. Multiple Products

Exercise 2–6

Using the preceding winery example, how many cases of merlot and chablis must be produced and sold to make an after-tax profit of $100,000 if the tax rate is 20 percent?

Solution:

The after-tax profit is calculated from the following equation:

After-tax profit = (1 − Tax rate) × (Revenues − Variable cost − Fixed costs) $100,000 = (1 − 20%) × ($90B − $65B − $500,000)

where B is the number of bundles. Solving for B yields:

$100,000

=

.8 × ($25B − $500,000)

$100,000 = $20B − $400,000 B

=

$500,000 / $20

B

=

25,000 bundles

In other words, 25,000 cases of merlot and 75,000 cases (3 × 25,000) of chablis must be sold to generate $100,000 after taxes. At these production levels, $100,000 of after-tax profit is generated as demonstrated by the following income statement:

As we saw earlier, one limitation of cost–volume–profit analysis is that it applies only to firms making a single product. One way to overcome this limitation is to assume a constant output mix of bundles with fixed proportions of the multiple products. Then a break-even or a target profit number of bundles can be calculated.

For example, suppose a winery produces two types of wine: merlot and chablis. The following table summarizes prices and variable costs of the winery, which has fixed costs of $500,000 per year.

  Merlot Chablis

Price per case $ 30 $ 20 Variable cost per case    20   15 Contribution margin per case $ 10 $   5

For every case of merlot produced, three cases of chablis are produced. Define a wine bundle to consist of four cases of which one is merlot and three are chablis. Each wine bundle has revenues of $90 (1 × $30 + 3 × $20), variable costs of $65 (1 × $20 + 3 × $15), and a contribution margin of $25 (1 × $10 + 3 × $5). The number of bundles required to break even is:

Break-even number of bundles = Fixed costs _________________ Contribution margin = $500,000 ________ $25 = 20,000 bundles

Twenty thousand bundles needed to break even translate into 20,000 cases of merlot and 60,000 cases of chablis. Hence, if a firm produces a variety of products in fixed pro- portions, then break-even analysis can be conducted by creating a bundle of products.

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5. Operating Leverage

Revenue—Merlot 25,000 × $30 $ 750,000 Revenue—Chablis 75,000 × $20 1,500,000 Total revenue $ 2,250,000 Less: Variable costs Merlot 25,000 × $20 $500,000 Chablis 75,000 × $15 1,125,000 Fixed costs 500,000 Total costs $ 2,125,000 Income before taxes $ 125,000 Taxes (20%) 25,000 Net income after taxes $ 100,000

Q2–10 What are the underlying assumptions in a cost–volume–profit analysis?

Q2–11 What are the benefits and limitations of cost–volume–profit analysis?

Concept Questions

TABLE 2–1 Operating Leverage (Production and Sales Are 10,000 Units)

LoLev HiLev

Revenue 10,000 units @ $8 $80,000 $80,000 Variable costs 10,000 units @ $4 40,000

10,000 units @ $2 20,000 Fixed costs 30,000 50,000 Net income $10,000 $10,000

Separating costs into fixed and variable components is useful for calculating break-even points and for pricing decisions, and for deciding to take new orders. Understanding a product’s fixed and variable costs is also useful for strategic reasons.

The higher a firm’s fixed costs, the higher its operating leverage, which is the ratio of fixed costs to total costs. Operating leverage measures the sensitivity of profits to changes in sales. The higher the operating leverage, the greater the firm’s risk. In firms with high operating leverage, small percentage changes in sales lead to large percentage changes in net cash flows (and profits). Therefore, firms with high operating leverage have greater variability in cash flows and hence greater risk than firms with a lower ratio of fixed costs to total costs. High-operating leverage firms face greater risk of failing if volumes stay low because they are unable to continue to generate enough cash to pay their high fixed costs.

To illustrate the importance of operating leverage, consider the illustration in Table 2–1. Two companies, HiLev and LoLev, each sell 10,000 units of an identical prod- uct for $8 per unit. At that level of production, both companies have identical total costs of $70,000, and both companies are making $10,000 in profits. Since three-sevenths of

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LoLev’s costs are fixed, whereas five-sevenths of HiLev’s costs are fixed, HiLev has more operating leverage.

Suppose volume falls 25 percent. Table 2–2 indicates the impact on net income. In LoLev, net income falls to zero; in HiLev, a loss of $5,000 results. Table 2–3 illustrates that when volume increases 25 percent, HiLev has a greater increase in profits than LoLev. Operating leverage amplifies the earnings impact of a given percentage change in sales.

Firms with low variable costs per unit can sustain larger short-term price cuts when faced with increased competition. For example, a firm selling a product for $10 per unit that has a variable cost of $7 per unit can cut the price to just above $7 (for short peri- ods of time) and still cover the variable costs of each unit. If that same firm has variable costs of $8 per unit, a price cut to below $8 causes a cash drain with each incremen- tal unit. Knowledge of a competitor’s cost structure is valuable strategic information in designing marketing campaigns. Estimating a firm’s riskiness also requires knowledge of operating leverage.

TABLE 2–2 Operating Leverage (Production and Sales Are 7,500 Units)

LoLev HiLev

Revenue 7,500 units @ $8 $60,000 $60,000 Variable costs 7,500 units @ $4 30,000

7,500 units @ $2 15,000 Fixed costs 30,000 50,000 Net income (loss) $         0 $ (5,000)

TABLE 2–3 Operating Leverage (Production and Sales Are 12,500 Units)

LoLev HiLev

Revenue 12,500 units @ $8 $ 100,000 $  100,000 Variable costs 12,500 units @ $4     50,000

12,500 units @ $2     25,000 Fixed costs      30,000      50,000 Net income $   20,000  $   25,000

Exercise 2–7

Two Internet retailers have the following data:

(millions) BuyEverything.com SportsWhere.com

Sales $120 $186 Variable costs    70  150 Fixed costs     40     24 Net income $  10 $  12

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Required:

a. Which retailer has more operating leverage?

b. Suppose the sales of each retailer double. Which one’s net income shows the greatest percentage increase?

c. Calculate the percentage change in each retailer’s net income if sales fall 50 percent.

Solution:

a. BuyEverything.com’s operating leverage (as measured by the ratio of fixed to total cost) is .36 ($40/$110), and SportsWhere.com’s operating leverage is .14 ($24/$174). Hence, BuyEverything.com has more operating leverage.

b. The following table calculates how net income changes with a doubling of sales:

(millions) BuyEverything.com SportsWhere.com

Sales $240 $372 Variable costs 140 300 Fixed costs     40     24 Net income $  60 $  48 Prior net income $  10 $  12 % change 500%*         300%†        

*($60 − $10)/$10 †($48 − $12)/$12

BuyEverything.com (a) which has more operating leverage from part shows the greatest percentage increase in net income.

c. The following table calculates how net income changes when sales fall 50 percent:

(millions) BuyEverything.com SportsWhere.com

Sales $60 $93 Variable costs 35 75 Fixed costs 40 24 Net income   ($15)   ($  6) Prior net income $10 $12 % change   −250%*  −150%†

*(−$15 − $10)/$10 †(−$6 − $12)/$12

BuyEverything.com (a) which has more operating leverage from part shows the greatest percentage decrease in net income.

D. Opportunity Costs versus Accounting Costs The theoretically correct way to evaluate choices requires estimating opportunity costs. Estimating opportunity costs requires the decision maker to formulate all possible actions (the opportunity set) and the forgone net receipts from each of those alternatives so that the highest net cash flows from the set of actions not undertaken can be calculated. This yields

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the opportunity cost of the selected action. Such an exercise requires a special study for every decision, a time-consuming and costly activity. And after completing the study, the opportunity cost changes as the opportunity set changes. It is little wonder that managers devise shortcut approximations to estimating opportunity costs. Accounting-based costs offer such a shortcut.

Accounting systems record “costs” after making the decisions. Accounting systems track asset conversions. When the firm acquires assets such as raw material, accountants record them in monetary terms (historical cost valuation). As the raw inputs are converted into work in process, accountants value the intermediate products at the historical costs of the raw inputs converted into the intermediate products. If an employee, paid $20 per hour, completes an intermediate product in two hours, the accounting system increases the cost of the intermediate product by $40. Completion and sale of the manufactured unit causes the historical costs attached to it to be transferred from the inventory accounts to the expense account “cost of goods sold.” Accounting costs are not forward-looking opportunity costs; they look backward at the historical cost of the resources consumed to produce the product. Accounting systems produce accounting costs, not opportunity costs. However, accounting costs often provide a reasonable approximation of opportunity costs. Over short periods of time, prices and costs do not change very much. Thus, accounting costs can be reasonably accurate estimates of opportunity costs of producing the same products again.

Besides providing data for decision making, internal accounting systems also provide data for controlling the behavior of people in organizations, as well as the data for external financial reporting. The resources consumed to produce this textbook might differ from the opportunity cost of a new textbook. But the historical cost of this book provides infor- mation about how well the persons responsible for producing this book discharged their duties. Valuing the ending inventory of books, calculating taxes payable, and computing net income require the historical cost of this textbook.

Cost systems do not focus on opportunity costs, nor can they, because opportunity costs depend on the particular decision being contemplated. Accounting systems can- not anticipate all future decisions. For example, suppose you purchased land on a busy

High-technology firms incur large fixed costs and relatively low variable costs to pro- duce intellectual property such as software and websites. This combination creates high operating leverage that causes these firms to be very risky. In good times, they are fly- ing high. In weak times, it is difficult to trim expenses.

Inktomi Corp. was a high-flying software company. It spent $10 million develop- ing research engines and software to manage web content. Once those fixed costs were incurred, each additional sale was almost pure profit. The president remarked, “You have no cost of goods. We don’t even ship a physical diskette anymore. Next to the federal government, this is the only business that’s allowed to print money.” All this has changed. Software development costs rose and sales nosedived, causing Inktomi to report a very large loss. Enormous fixed costs were required to research, develop, design, test, and market software. Intense competition and rapid obsolescence required high levels of spending each year. The result was a dramatic reversal of fortune lead- ing to big swings in profits, stock prices, and hiring when sales sagged. Inktomi did not survive the Internet bubble and was sold to Yahoo! in 2002. SOURCE: B. McClure, “Operating Leverage Captures Relationships,” December 28, 2006, www.investopedia.com.

Managerial Application: New Econ- omy Firms and High Operating Leverage

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commercial street last month, paying $1 million. If you open a fast-food restaurant on this land, you estimate it will be worth $1.6 million. If, on the other hand, you open a gas station, its value is estimated at $1.7 million. Using the land for a gas station costs you $1.6 million in terms of the next best forgone opportunity (the fast-food restaurant). The $1 million historical cost of the land, even though only one month old, is not the oppor- tunity cost. Thus, the term cost can refer to accounting cost (historical amounts) or to opportunity cost (the amount forgone by some decision), two very different concepts. In some cases, the user’s meaning is obvious, but it is always important to question whether the term cost means opportunity cost or accounting cost.

1. Period versus Product Costs

To further understand how accounting costs differ from opportunity costs, we distinguish between product costs and period costs. Product costs include all those accounting costs incurred to manufacture a product. Product costs are inventoried and expensed only when the product is sold. Period costs are those costs that are expensed in the period in which they are incurred. They include all nonmanufacturing accounting costs incurred to sell the product. For example, administration, distribution, warehousing, selling, and advertising expenditures are period costs. Research and development is a period cost. Period costs are not part of the product’s cost included in inventory valuation.

Product costs include both fixed and variable manufacturing components. Likewise, period costs, the costs of distributing and selling the product, contain both fixed and variable components. Fixed period costs include salespersons’ salaries, advertising, and marketing costs. Examples of variable period costs include distribution costs and sales commissions.

Accounting systems, even those used for internal purposes, distinguish between prod- uct and period costs. In most situations, unit cost figures refer to product costs excluding all period costs. Suppose that the unit manufacturing cost of a particular cell phone is $23. Selling and distributing this product costs an additional $4 per unit. This $4 period cost includes both fixed and variable period costs. The total cost of manufacturing and selling each unit is $27. Many firms refer to the $23 product cost as a unit manufacturing cost (UMC). For decision-making purposes, both period ($4) and product ($23) costs must be considered, so it is important to remember that a UMC usually excludes period costs.

Period costs and product costs are historical costs. They are not opportunity costs. However, to the extent that the future looks a lot like the past, these historical costs can be useful predictors of opportunity costs.

2. Direct Costs, Overhead Costs, and Opportunity Costs

The accounting concepts of direct costs versus overhead costs also illustrate the difference between opportunity and accounting costs. Direct costs and overhead costs form the core of this book, to which we will return in later chapters, particularly Chapters 9 through 13. But it is useful to introduce the terms now.

Direct costs of a product or service are those items that are easily traced to the product or service. Direct labor and direct material costs are direct costs. An employee producing a product is classified as direct labor. If this employee is idled by a machine breakdown, that idle time is classified as indirect labor. Indirect materials include those used in maintaining and testing machines as well as those lost in the machine during a breakdown. Overhead includes indirect labor and indirect material costs as well as other types of general manu- facturing costs that cannot be directly traced, or are not worth tracing, to units being pro- duced. Examples include the cost of the purchasing department; factory property taxes, maintenance, depreciation, insurance, and security guards; and some engineering services. Indirect cost is another term for overhead.

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Direct costs are usually variable. For example, to produce more printed copies of this book requires additional paper and ink (direct materials) and additional time by the person running the printing press (direct labor). However, producing more digital copies of this book requires no additional paper, ink, or printing press time. In some situations, direct costs can be fixed. For example, the costs associated with a machine (depreciation, elec- tricity, and routine maintenance) dedicated to one product are direct costs of that product and are largely fixed. Or, if the firm has a material supply contract to purchase a fixed amount of noninventoriable input, then this direct material is a fixed cost over the life of the contract. For example, if a steel mill has a long-run supply contract to purchase a fixed amount of natural gas per year over the life of the contract, this direct material (natural gas) is largely a fixed cost. If the company can sell what it does not use, the natural gas is a vari- able cost. Overhead costs contain both fixed costs and variable costs.

The following chart summarizes the relations among accounting cost terminology:

Direct materialDirect costs Direct labor

Product costs

Factory overhead Conversion costs • Variable factory overhead • Fixed factory overhead

Selling, general, and administrative (SG&A) costs • Variable SG&A Period costs • Fixed SG&A

Product costs consist of direct material, direct labor, and overhead. The term conversion costs refers to direct labor and factory overhead. Period costs consist of selling, general, and administrative costs.

By definition, overhead costs cannot be directly traced to products. Instead, they must be allocated to products. The most common allocation bases are direct labor hours, direct material, machine hours, and direct labor dollars. Managers usually choose the allocation base that most closely approximates the factors that cause overhead to vary in the long run.

To illustrate the distinction between accounting and opportunity costs with respect to overheads, consider the following example: All expenses in a department containing 10 machines are allocated to the machines in the department. All 10 machines in the depart- ment are identical. Utilities, supervision, labor, depreciation, and engineering support are assigned to this department. The total cost divided by machine hours gives an hourly rate for allocating this department’s costs to jobs. For example, suppose the total annual cost of this department is $525,000. Each machine normally operates 35 hours per week, 50 weeks per year, for 1,750 (or 35 × 50) hours per year. So the 10 machines normally operate 17,500 hours per year. This department has an overhead rate of $30 per machine hour ($525,000 ÷ 17,500 hours). If a particular job takes nine hours on the machines in this department, it is allocated $270 of “cost” (9 × $30). But did the firm actually incur $270 to process this job in the depart- ment? We don’t know. The machine-hour rate ($30/hour) is an average accounting cost. It is a mixture of both fixed and variable costs, and it gives a false impression of variability. It does not tell us whether we made money on this job. In bidding for future jobs, the $30 per hour does not tell us what competitors will bid or what additional overhead costs will be incurred.

As plant volumes rise, congestion costs rise. Queues form. More expediters are hired to track inventory. Machine scheduling becomes more difficult. Marginal overhead costs may be more or less than $30 per hour.

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In the long run, if the firm cannot charge prices (and generate sales) that cover all overhead costs (including depreciation of the assets), it will not be able to replace its assets. Of course, charging prices that cover overhead may price the firm out of the market completely. But by applying overhead costs (fixed and variable costs) to products, man- agement can see whether the firm is viable under current conditions. The other reason for applying overhead costs to products is to control organizational problems. If the machine- hour rate is $30 this year and rises to $35 next year, senior managers are alerted that some- thing has changed. By reporting the higher overhead cost, managers will investigate the reason for the change and presumably take corrective action.

In the 1870s, the railroads developed detailed and highly accurate cost estimates of hauling one ton of freight one mile. This has come to be known as the cost per ton mile. The calculation first involved separating the accounting records into four groups of accounts: costs that did not vary with the volume of traffic (general superintendence), costs that varied with the volume of freight but not the length of the haul (stations and agents), costs that varied with the number of trains run (conductors, engineers, and fuel), and interest on the capital investment. Each of these four costs was converted into a unit rate, and each freight shipment was costed based on its weight and how many miles it was carried.

These cost data allowed senior managers to monitor costs and to evaluate the per- formance of the managers responsible for the various segments of track. By studying how the unit cost data varied over time and across various branches of the railroad, managers could evaluate the performance of the parts of the railroad and its managers. SOURCE: A. Chandler, The Visible Hand (Cambridge, MA: Harvard University Press, 1977), pp. 116–19.

Historical Application: Railroads Develop Unit Cost Data

Q2–12 Why are opportunity costs costly to estimate? Q2–13 Define direct costs. Q2–14 Define overhead costs. How are they allocated? Q2–15 What are period costs?

Concept Questions

E. Cost Estimation Now that the important concepts of opportunity cost and how opportunity costs vary with changes in output have been introduced, they must be put into practice. Costs must be esti- mated, either from the accounting records or by some other method. This section describes two approaches to cost estimation: account classification and motion and time studies.

1. Account Classification

The simplest and the most common method of estimating fixed and variable costs is account classification. Each account in the accounting system is classified as being either fixed or variable. The sum of all the variable cost accounts, divided by a measure of vol- ume (e.g., units produced), yields variable cost per unit. Likewise, the sum of all the accounts classified as fixed costs yields an estimate of the total fixed costs. While this method is quick and simple, it is not very precise. Its accuracy depends on the knowledge and intuition of the person classifying the accounts as fixed or variable.

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2. Motion and Time Studies

Q2–16 What are motion and time studies? What are their objectives?Concept Question

F. Summary This chapter emphasizes that decision making requires knowledge of opportunity costs, or the ben- efits forgone from actions precluded by the alternative selected. Opportunity costs can be determined only within a specific decision context by specifying all the alternative actions. While opportunity cost is the theoretically correct concept to use in decision making, it can be costly to estimate. Spe- cial studies are required to identify the alternative actions and forecast their likely consequences. Accounting costs often provide useful and less costly approximations for opportunity costs. How- ever, costs reported by accounting systems are not opportunity costs. Opportunity costs are forward- looking and are usually not recorded by accounting systems. Accounting costs measure the monetary resources expended for a particular activity. They pro- vide a useful database to begin the process of estimating opportunity costs. Accounting costs also serve the important function of influencing the behavior of the firms’ employees and managers. The accounting system reports the accounting cost of making the sofa this month and what the cost was last month to make the same sofa. Senior managers can then assess the performance of sofa produc- tion, providing incentives for the sofa-producing managers to pay attention to costs. If the accounting cost of the sofa is $208 this month, this number is not the opportunity cost of making the sofa. But if the same type of sofa had an accounting cost of $150 last month, something has happened that senior management will want to investigate. Managers must decide how many units of each product to manufacture. This decision also requires opportunity costs. One method of estimating opportunity costs for these decisions assumes that total costs are linear; hence, total costs are the fixed costs and variable costs per unit. A linear cost curve is also useful for cost–volume–profit analyses. These analyses focus managers’ attention on how costs and profits vary with some volume measure. However, such analyses require assump- tions to be made. These include assuming a single-period, single-product plant and linear cost and revenue curves.

In motion and time studies, industrial engineers estimate how much time a particular task or work activity requires with the goal of determining the optimal work method. Motion studies involve the systematic analysis of work methods considering the raw materials, the design of the product or process, the process or order of work, the tools, and the activ- ity of each step. Besides estimating how long a particular activity should take, industrial engineers often redesign the product or process to reduce the required time. Time stud- ies employ a wide variety of techniques for determining the duration required for a par- ticular activity under certain standard conditions. Work sampling (one type of time study) involves selecting a large number of observations taken at random intervals and observing how long employees take to perform various components of the job. It tells management how employees spend their time, not how efficiently they could be spending their time. No benchmarks exist to judge performance. Work sampling tends to institutionalize existing inefficiencies. Motion and time studies are often expensive in terms of engineering time used in the studies. They also suffer from potential bias because of employees’ incentives to underperform during the study period to set lower quotas.

Most of the problems presented in this and other books furnish the necessary cost data to solve the problem. However, deriving the cost data is often more difficult than making a decision. Besides engineering cost estimation techniques, accounting records are often the most prevalent source of cost data.

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When someone asks what something costs, the first reaction should be to find out for what purpose the cost number is to be used. If the cost number will be used for decision making, an oppor- tunity cost must be generated for that decision context, which requires the decision maker to specify all the relevant alternative actions. If the number is to be used for financial reporting or taxes, a dif- ferent cost number will be produced. If the cost number is being used to control behavior within the firm, probably a different number will be used. Cost numbers can vary significantly according to the purpose for which they are being produced.5

Appendix: Costs and the Pricing Decision One of the most important decisions managers make involves pricing the firm’s goods and services. Clearly, the cost of producing the good or service is a crucial variable entering the pricing decision. This appendix discusses how managers use cost information in setting prices. There are two cases to consider: (1) the firm is a “price taker” and (2) the firm has “market power.”

5It has long been recognized that no single cost concept can serve all purposes. J. Clark, writing in Studies in the Economics of Overhead Costs (Chicago: University of Chicago Press, 1923), p. 175, states, “We may start with the general proposition that the terminology of costs is in a state of much confusion and that it is impos- sible to solve this confusion by discovering and adopting the one correct usage, because there is no one correct usage, usage being governed by the varying needs of varying business situations and problems.”

Price Takers Some markets are very competitive. With many buyers and sellers of the same product, no single producer or consumer can influence the market price. For example, consider wheat farmers. With thousands of wheat farmers, no single farmer can affect the price of wheat by altering the amount of wheat the farmer produces. In this case, wheat farmers are price takers who do not set the price. They do, however, use cost information when deciding to grow (or not to grow) wheat. While price takers understand that the price is given, they still must decide how much, if any, of the product to produce. Here, cost data are extremely important. Suppose a wheat farmer leases land and equipment for $2,200,000 per year and expects to produce 1 million bushels of wheat. The variable cost per bushel is $1.60 and the market price of wheat is expected to be $3.90 per bushel when the wheat is harvested. The farmer expects to make $100,000 of profit [1 million bushels × ($3.90 − $1.60) − $2,200,000]. If this is adequate compensation for the farmer’s time and risk, she will lease the land and equipment and plant the wheat. So in this case, before the farmer decides to lease the land and plant wheat, she uses cost data to determine if the production decision (growing wheat) is worthwhile. Suppose the land and equipment have been leased (and paid), but before the wheat is planted and the variable costs have been incurred, the price of wheat is expected to be only $3.65. Taking into account the fixed costs that have already been incurred, the farmer now expects to lose $150,000 [1 million bushels × ($3.65 − $1.60) − $2,200,000]. However, the lease payments are sunk. The farmer still generates $2,050,000 of contribution margin, but not enough to recoup her fixed costs. She will still go ahead and plant the wheat. Not doing so will cost her the entire fixed cost of $2.2 million. If she thinks wheat prices next year will remain at $3.65 per bushel, she will not lease the land and equipment again. To summarize, price takers use cost data to determine whether to undertake production, not to set prices. Fixed costs that have not yet been incurred are relevant in this production decision. Once incurred, the fixed costs are irrelevant in making production decisions.

Market Power A more complicated pricing situation arises when producers have market power. Firms have market power if perfect substitutes do not exist for their products. This means that they can raise prices without losing all their customers to competitors. For instance, although Colgate and Crest compete directly, many customers do not view these toothpaste brands as perfect substitutes. Each company can raise their price and some consumers will not switch to the other toothpaste. But with higher prices, more customers will defect to competitors. This is not the situation with price takers. If a

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wheat farmer were to ask for a price above the prevailing market price, no buyers would pay this price because they can purchase identical wheat at a lower price. Firms with market power must decide not only whether to produce but also what price to charge. The next example illustrates how managers use cost data in the pricing decision. Consider a tennis racket company with a patent for a unique, high-performance tennis racket. The number of rackets sold depends on the price charged for the racket. At low prices, more rackets can be sold than at higher prices. After extensive study of competitors’ prices for high-performance rackets, management expects the relation between price and quantity of rackets sold to be as depicted in Table 2–4. For example, at a price of $1,050 per racket, only 500 are sold, but if the price is dropped to $100 per racket, 10,000 can be sold. The cost of producing the rackets consists of annual fixed costs of $1.9 million and variable costs of $100 per racket. The fixed costs include all fixed marketing, production, and administration expenses, and the variable costs include all variable production and distribution expenses. Thus, total annual costs, TC, can be expressed as:

TC = $1,900,000 + $100Q (where Q is the number of rackets)

Notice that with this linear cost function, marginal cost (the cost of the last racket) and variable cost are both $100. Given the data in Table 2–4 and the total cost curve, management can determine the profit- maximizing price to charge for tennis rackets. Table 2–5 provides the calculations. As Table 2–5 shows, 500 rackets will be sold when the price per racket is $1,050, thereby pro- ducing total revenues of $525,000 ($1,050 × 500), total cost of $1,950,000 ($1,900,000 + $100 × 500), and thus a loss of $1,425,000. Clearly, this is not the right price to charge. By calculating prof- its at all the other price–quantity combinations, we see that profits are maximized at $600,000 when price is set at $600 per racket and 5,000 rackets are sold. Total costs are $2.4 million ($1,900,000 + $100 × 5,000). Notice that profits are not maximized where revenues are maximized. Maximum revenues occur at a price–quantity combination of $550 per racket and 5,500 rackets, which is a lower-price–higher-quantity combination than the profit-maximizing combination. Now let’s study more closely how fixed and variable costs enter the profit-maximizing pricing decision. We will examine two types of cost changes: an increase in fixed costs and an increase in variable costs.

Increase in fixed costs Table 2–6 reflects a rise in fixed costs from $1.9 million to $2.4 million, or a $500,000 increase. Suppose that the $2.4 million of fixed costs have not been incurred yet. Will the $500,000 increase in fixed costs change the pricing decision?

TABLE 2–4 The Relation between the Price per Racket and the Quantity of Rackets Sold at That Price

Price per Racket Number of Rackets Price per Racket Number of Rackets

$1,050      500  $550 5,500 1,000  1,000   500 6,000   950 1,500   450 6,500   900 2,000   400 7,000   850 2,500   350 7,500   800 3,000   300 8,000   750 3,500   250 8,500   700 4,000   200 9,000   650 4,500   150 9,500   600 5,000   100 10,000

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Price per Racket Number of Rackets Total Revenue Total Cost Total Profit (Loss)

$1,050   500 $ 525,000 $1,950,000 $(1,425,000)   1,000 1,000 1,000,000 2,000,000  (1,000,000)      950 1,500 1,425,000 2,050,000    (625,000)      900 2,000 1,800,000 2,100,000    (300,000)      850 2,500 2,125,000 2,150,000   (25,000)      800 3,000 2,400,000 2,200,000 200,000      750 3,500 2,625,000 2,250,000 375,000      700 4,000 2,800,000 2,300,000 500,000      650 4,500 2,925,000 2,350,000 575,000      600 5,000 3,000,000 2,400,000 600,000      550 5,500 3,025,000 2,450,000 575,000      500 6,000 3,000,000 2,500,000 500,000      450 6,500 2,925,000 2,550,000 375,000      400 7,000 2,800,000 2,600,000 200,000      350 7,500 2,625,000 2,650,000   (25,000)      300 8,000 2,400,000 2,700,000 (300,000)      250 8,500 2,125,000 2,750,000 (625,000)      200 9,000 1,800,000 2,800,000 (1,000,000)      150 9,500 1,425,000 2,850,000 (1,425,000)      100 10,000 1,000,000 2,900,000 (1,900,000)

TABLE 2–5 Determining the Profit-Maximizing Price–Quantity Relation

In Table 2–6, we see that a change in fixed costs does not alter the profit-maximizing pricing decision. Managers still set the price at $600 and expect to sell 5,000 rackets. In general, fixed costs do not enter the pricing decision. Fixed costs only determine whether the firm produces at all. If the

Price per Racket Number of Rackets Total Revenue Total Cost Total Profit (Loss)

$1,050   500 $525,000 $2,450,000 $(1,925,000)  1,000 1,000 1,000,000 2,500,000  (1,500,000)

950 1,500 1,425,000 2,550,000 (1,125,000) 900 2,000 1,800,000 2,600,000 (800,000) 850 2,500 2,125,000 2,650,000 (525,000) 800 3,000 2,400,000 2,700,000 (300,000) 750 3,500 2,625,000 2,750,000 (125,000) 700 4,000 2,800,000 2,800,000 0 650 4,500 2,925,000 2,850,000 75,000 600 5,000 3,000,000 2,900,000 100,000 550 5,500 3,025,000 2,950,000 75,000 500 6,000 3,000,000 3,000,000 0 450 6,500 2,925,000 3,050,000 (125,000) 400 7,000 2,800,000 3,100,000 (300,000) 350 7,500 2,625,000 3,150,000 (525,000) 300 8,000 2,400,000 3,200,000 (800,000) 250 8,500 2,125,000 3,250,000 (1,125,000) 200 9,000 1,800,000 3,200,000 (1,500,000) 150 9,500 1,425,000 3,350,000 (1,925,000) 100 10,000 1,000,000 3,400,000 (2,400,000)

TABLE 2–6 Determining the Profit-Maximizing Price–Quantity Relation: Fixed Costs Increased by $500,000

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contribution margin at the profit-maximizing price–quantity combination fails to cover the fixed costs (and the fixed costs have not yet been paid), the firm should not produce. For example, if fixed costs increased to $2.55 million, the profit-maximizing price–quantity combination would still be $600 and 5,000 rackets. But now the firm loses $50,000 at this price–quantity combination and it should not produce any rackets.

Increase in variable costs We now consider how variable costs affect the pricing decision. Fixed costs are $1.9 million. If the variable cost of rackets increases from $100 to $200 per racket, the profit-maximizing price rises from $600 to $650 per racket and fewer rackets are sold (4,500 instead of 5,000). See Table 2–7. Notice that only $50 of the $100 variable cost increase is passed on to consumers. If the price were raised to $700 to recover all the $100 variable cost increase, even fewer rackets would be sold and the revenue decline would be greater than the cost increase. Tables 2–5 to 2–7 illustrate a central point from economics: Only variable cost (which equals marginal cost in our linear cost function) affects the pricing decision. Fixed costs do not affect the pricing decision. Fixed costs only determine whether the firm should produce the product. Econom- ics texts demonstrate that the profit-maximizing price is determined where marginal (variable) cost equals marginal revenue.

Price per Racket Number of Rackets Total Revenue Total Cost Total Profit (Loss)

$1,050 500  $ 525,000 $2,000,000 $(1,475,000)  1,000 1,000 1,000,000 2,100,000 (1,100,000)

950 1,500 1,425,000 2,200,000 (775,000) 900 2,000 1,800,000 2,300,000 (500,000) 850 2,500 2,125,000 2,400,000 (275,000) 800 3,000 2,400,000 2,500,000 (100,000) 750 3,500 2,625,000 2,600,000 25,000 700 4,000 2,800,000 2,700,000 100,000 650 4,500 2,925,000 2,800,000 125,000 600 5,000 3,000,000 2,900,000 100,000 550 5,500 3,025,000 3,000,000 25,000 500 6,000 3,000,000 3,100,000 (100,000) 450 6,500 2,925,000 3,200,000 (275,000) 400 7,000 2,800,000 3,300,000 (500,000) 350 7,500 2,625,000 3,400,000 (775,000) 300 8,000 2,400,000 3,500,000 (1,100,000) 250 8,500 2,125,000 3,600,000 (1,475,000) 200 9,000 1,800,000 3,700,000 (1,900,000) 150 9,500 1,425,000 3,800,000 (2,375,000) 100 10,000 1,000,000 3,900,000 (2,900,000)

TABLE 2–7 Determining the Profit-Maximizing Price–Quantity Relation: Variable Costs Increased by $100 per Racket

Cost-Plus Pricing A common pricing method used by firms is cost-plus pricing. Firms that use this technique calculate average total cost and mark up the cost to yield the selling price. Or,

Selling price = Cost + (Markup percentage × Cost)

To solve for the selling price, managers begin by calculating a unit cost:

Unit cost = Variable cost + (Fixed costs / Unit sales)

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Using our tennis racket example and 5,000 rackets,

Unit cost = $100 + ($1,900,000 / 5,000 rackets) = $480

Managers using a markup of 25 percent would set the price as:

Selling price = $480 + (25 percent × $480) = $600

In this example, the formula yields the same price as our profit-maximizing price–quantity combina- tion from Table 2–5. However, we started with the profit-maximizing quantity and markup. So by construction, we had to end up with the profit-maximizing price. Suppose that fixed costs increase to $2 million and variable costs decrease to $80. Managers still expect to sell 5,000 rackets. Unit costs remain at $480 ($80 + $2,000,000/5,000). If managers maintain the same 25 percent markup, they will keep the price at $600. But this is no longer the profit-maximizing price. Variable costs have fallen, so managers should lower the price to $590 and sell 5,100 rackets.6 Profit-maximizing pricing considers only variable (marginal) costs and depends on the price sensitivity of customers. Cost-plus pricing appears to ignore both of these considerations. The cost- plus price marks up average total cost (both fixed and variable cost) and seems to ignore the demand for the product. Just because managers target a 25 percent markup on average cost does not mean that customers will necessarily buy the product in the required quantities at the implied price. Firms that consistently use bad pricing policies find themselves earning lower profits than they could with better pricing techniques and may even go out of business. If cost-plus pricing is so unsound, why is it so widely used? One explanation is that managers implicitly consider market demand in choosing the markup and unit sales in calculating the unit cost. If managers know that they face little competition, more units can be sold and higher markups will be chosen than when fac- ing greater competition. Conceptually, there is always some target volume and markup that produces the profit-maximizing price. The idea that managers choose markups and unit volumes based on market power when they use cost-plus price is supported empirically. Consider the price markups by a typical grocery store employing cost-plus pricing. Price sensitivity is a primary consideration in setting margins. Staple products such as bread, hamburger, milk, and soup are relatively price sensitive and carry low mar- gins (markups of under 10 percent above cost). Products with high margins (markups as high as 50 percent or more) tend to be those where consumers are less price sensitive, such as spices, sea- sonal fresh fruit, and nonprescription drugs.

6To derive this new price–quantity combination, note that the price–quantity combinations in Table 2–4 are based on the following formula: Price = $1,100 − 0.1 × Quantity. This equation is used to calculate price– quantity combinations in 100-racket increments.

Q2–17 How do fixed costs enter the pricing decision?Concept Question

Self-Study Problems Self-Study Problem 1: Exclusive Billiards

In each month, Exclusive Billiards produces between 4 and 10 pool tables. The plant operates one 40-hour shift to produce up to seven tables. Producing more than seven tables requires the crafts- men to work overtime. Overtime work is paid at a higher hourly wage. The plant can add overtime hours and produce up to 10 tables per month. The following table contains the total cost of producing between 4 and 10 pool tables.

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Pool Tables Total Cost

4 5 6 7 8 9

10

$62,800   66,000   69,200   72,400   75,800   79,200   82,600

Required:

a. Prepare a table computing the average cost per pool table for 4 to 10 tables. b. Estimate Exclusive Billiards’ fixed costs per month. c. Suppose Exclusive Billiards sells its tables for $13,200 each. How many tables must it sell

to break even? d. Next month, Exclusive Billiards has orders for eight tables. Another order for two tables is

received. What is the absolute lowest price Exclusive Billiards should accept for the two additional tables?

Solution: a. Average cost is calculated in the following table:

Tables Total Cost Variable Cost Average Cost

4 $62,800 — $15,700 5 66,000 $3,200 13,200 6 69,200 3,200 11,533 7 72,400 3,200 10,343 8 75,800 3,400 9,475 9 79,200 3,400 8,800

10 82,600 3,400 8,260

b. Since the variable cost of five to seven pool tables is $3,200, it appears reasonable to assume the first four pool tables also have variable costs equal to $3,200. Hence, we can estimate fixed cost as:

FC

=

TC − VC

= $62,800 − 4 × $3,200 =

$50,000

c. Variable cost is $3,200 if seven or fewer tables are produced. For seven or fewer tables, the break-even point occurs where

($13,200 − $3,200)Q − $50,000 = 0

or

$50,000 _______ $10,000 = 5 tables

d. The lowest price for two additional tables = 2 × $3,400 = $6,800

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Self-Study Problem 2: Sandler Company Sandler Company produces circuit boards for various products. Before being shipped to customers, each board is tested to make sure it meets the customers’ specifications. Sandler produces 6,400 boards and scraps approximately 10 percent of all boards because of defects. The remaining 5,760 boards are sold for $124,800. Currently, material cost is $42,000. The manager has two options for buying more expensive material to decrease the percentage of bad boards produced. The first option is to buy mate- rial for $44,000 that would result in 7 percent being scrapped. The second option is to buy material for $54,000 that would result in only 1 percent being scrapped. The firm can sell as many “good” boards as produced. Production capacity, not demand, is limiting the number of units sold each month.

Evaluate the two proposals for reducing the defect rates, and recommend which one should be accepted.

Solution: To begin, notice that the selling price of a board is $21.67 (or $124,800 ÷ 5,760 boards). Under the current situation in which the firm has a 10 percent defect rate, the current margin is $82,800, calculated as

Current Situation:

10% Defects

Number of boards 5,760 Revenues $124,800 Cost of raw materials     42,000 Margin $  82,800

Sandler currently sells 5,760 boards. A 7 percent defect rate (6,400 × 93%) would yield, 5,952 boards. At a 1 percent defect rate (6,400 × 99%), 6,336 good boards would be produced. The margins on 7 percent and 1 percent defect rates are as follows:

7% Defects 1% Defects

Number of boards 5,952  6,336 Revenues $128,960   137,280 Cost of raw materials     44,000     54,000 Margin $  84,960 $  83,280

The profit-maximizing decision is to spend $44,000 on material, resulting in a 7 percent defect rate and an increase in the margin to $84,960. Pushing the defect rate down to 1 percent improves the margin over the status quo but not over the 7 percent defect rate option.

Self-Study Problem 3: Fast Oil Franchise Mike Hurst earns $10 per hour as assistant manager at a pet store in the mall. He can work as many hours as he likes but would never consider working more than 72 hours per week. In his will, Mike’s Uncle Paul, western New York’s oil-change king, leaves him the Jefferson Road Fast Oil Franchise. In an effort to boost its franchising campaign, the Fast Oil Co. has guaranteed that any franchise can be sold back to the parent company for $150,000. Because nobody is willing to offer a higher price for the Jefferson Road franchise, Mike is considering exercising this option.

As part of the franchise agreement, a Fast Oil franchisee must keep the business open 72 hours per week. Furthermore, the franchisee must lease all facilities and equipment on an annual basis, as well as buy all supplies from the parent corporation. The parent company also requires that all

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franchises be capable of continually operating at full capacity. In the case of the Jefferson Road franchise, this requirement entails having two oil-change technicians and one oil-change manager at the facility at all times.

Fast Oil franchises offer only one service, oil change and lube, at one price, $22.95. Facilities and equipment are leased at $50,000 per year. Materials are sold to franchisees at the following prices: oil at $0.75 per quart, filters at $1 each, and lubrication material at $1 per 16 ounces. Each oil change and lube requires five quarts of oil, one filter, and four ounces of lubrication materials. Oil- change technicians are paid $8 per hour; managers earn $10 per hour. On average, an oil change and lube require one man-hour of work.

According to reliable studies, the number of customers at any given franchise is solely contin- gent upon the volume of drive-by traffic. On average, one out of every 1,723 cars that drive by a Fast Oil will stop in for an oil change. The Henrietta Chamber of Commerce knowledgeably states that 289,464 cars per week drive by the Jefferson Road franchise at a constant rate during its hours of business. If he keeps the franchise, Mike will work there 72 hours a week as the oil change manager. His sole compensation will be the profits of the business. This will be his only job. If he sells the franchise, Mike will invest the proceeds in Treasury bills that yield 7 percent per annum, with a time to maturity of one year.

Mike lives in a tax-free world and all cash flows are risk free. Assume a one-year time horizon, and assume exactly 52 weeks per year.

Required:

a. How many oil changes is the Jefferson Road franchise expected to perform in a year? Assuming that Mike keeps the franchise and ignoring opportunity costs of Mike’s time and the interest on the proceeds from selling the franchise, what is the annual break-even point (in oil changes) for the franchise?

b. Define Mike’s alternatives. If opportunity costs excluded in part (a) are considered, calculate his break-even point (in number of oil changes).

c. If opportunity costs mentioned in part (a) are not considered, calculate Mike’s profit/loss. What would it be if opportunity costs were considered? What alternative should Mike choose?

Solution: a. Given that 289,464 cars pass by weekly and one out of every 1,723 will stop in for an oil

change and lube, the franchise is expected to perform 289,464/1,723 × 52 = 8,736 oil changes per year. The rest of the solution requires identification of the fixed and variable components of the franchise’s costs. The most obvious fixed cost is the annual lease cost of $50,000 per year. Since employee pay does not vary with output, labor costs are fixed. Employees must be paid simply for being at work, and the quantity of labor required is defined by the franchise agreement. (The  time required to perform an oil change is relevant only as a capacity constraint. Because there are 216 man-hours per week, 52 weeks per year, and each oil change requires one man-hour, total capacity for the facility is 11,232 changes per year.) Mike will work as oil-change manager, so the labor cost will apply only to the two oil-change technicians (2 technicians × $8/hour × 72 hours/week × 52 weeks per year = $59,904 per year). The only variable costs are materials costs. Cost per oil change is the most logical unit to consider, and one year is the obvious time horizon for consideration.

Variable Costs per Oil Change

Oil costs:     $0.75/quart × 5 quarts  $3.75 Lubrication costs:     $1/pound × 4/16 0.25 Oil filter   1.00

$5.00

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The price of an oil change is $22.95. The accompanying table summarizes the break-even analysis:

Fixed costs (annual)         Lease $50,000     Technicians 59,904   Total fixed costs $109,904     ÷ Contribution margin (per unit)         Price  $ 22.95       Variable cost      5.00   Contribution margin per unit     $   17.95 Break-even (in oil changes)        6,123

b. Opportunity costs are defined as “the benefits forgone from actions that are precluded by the alternative selected.” To assess the opportunity costs of a particular action, the set of mutually exclusive opportunities must be considered. Mike faces two choices:

• Quit his present job, work as oil-change manager, and keep the profits of the franchise. • Keep his present job, sell the franchise to the parent company, and invest the proceeds in

Treasury bills.

If Mike keeps the franchise, the following benefits are forgone:

• Income from the pet store job and value of free time given up. Mike earns $10 per hour. Therefore, the annual opportunity cost of the time he gives up to work at the oil-change franchise is $10 × 72 × 52 = $37,440 per year.

• Income lost from not selling the franchise and investing in Treasury bills. At 7 percent per year, $150,000 would provide income of $10,500.

The total opportunity cost of keeping the franchise is:

Opportunity cost of Mike’s time $37,440 Investment proceeds from sale of franchise   10,500

$47,940

This cost should be considered a fixed cost, bringing break-even volume to 8,794 oil changes [($109,904 + $47,940) ÷ $17.95].

c. Ignoring Mike’s opportunity costs, annual fixed costs for the business are covered at the 6,123rd oil change. The franchise “profit,” therefore, is the contribution margin of all addi- tional oil changes done during the year. For Mike, the profit is (8,736 − 6,123) × $17.95 = $46,907. Since $46,907 is far more than Mike could earn at the pet store, he might be tempted to keep and operate the oil-change franchise. However, when opportunity costs are consid- ered, it would be better for Mike to sell the franchise back to the parent company. Since his opportunity costs are $47,940, Mike would in reality lose $1,033 by keeping the franchise.

This analysis ignores a number of additional factors that Mike should consider before mak- ing a final decision:

• How much growth is likely to occur in the oil-change business? • What is the likelihood of losing the pet store job? • Is it likely that technological or market changes will reduce the value of the franchise? • How do the alternatives differ in risk? • Does Mike like working in the pet store or would he prefer managing the oil-change

franchise?

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Problems P 2–1: Fox Industries

Fox Industries operates a cafeteria for its employees. The operation of the cafeteria requires fixed costs of $4,700 per month and variable costs of 40 percent of sales. Cafeteria sales are currently averaging $12,000 per month.

Fox has an opportunity to replace the cafeteria with vending machines. Gross customer spend- ing at the vending machines is estimated to be 40 percent greater than current sales because the machines are available at all hours. By replacing the cafeteria with vending machines, Fox would receive 16 percent of the gross customer spending and avoid all cafeteria costs. How much does monthly operating income change if Fox Industries replaces the cafeteria with vending machines?

P 2–2: Negative Opportunity Costs Can opportunity costs be negative? Give an example.

P 2–3: NPR In its radio fund-raising campaign, National Public Radio (NPR) stated, “On-air radio membership campaigns are the most cost-effective means we have for raising the funds necessary to bring you the type of programming you expect.” NPR is commercial-free, member-supported radio. Most of its operating funds come from private individuals, corporations, and foundations. Twice a year, it interrupts its regularly scheduled programming for fund-raising pledge campaigns where listeners are encouraged to call in and make pledges.

Critically evaluate the passage quoted above.

P 2–4: Silky Smooth Lotions Silky Smooth lotions come in three sizes: 4, 8, and 12 ounces. The following table summarizes the selling prices and variable costs per case of each lotion size.

Per Case 4 Ounces 8 Ounces 12 Ounces

Price $36.00 $66.00 $72.00 Variable cost   13.00   24.50   27.00

Fixed costs are $771,000. Current production and sales are 2,000 cases of 4-ounce bottles; 4,000 cases of 8-ounce bottles; and 1,000 cases of 12-ounce bottles. Silky Smooth typically sells the three lotion sizes in fixed proportions as represented by the preceding sales amounts.

Required:

How many cases of 4-, 8-, and 12-ounce lotion bottles must be produced and sold for Silky Smooth to break even, assuming that the three sizes are sold in fixed proportions?

P 2–5: J.P. Max Department Stores J.P. Max is a department store carrying a large and varied stock of merchandise. Management is considering leasing part of its floor space for $72 per square foot per year to an outside jewelry company that would sell merchandise. Two areas currently in use are being considered: home appli- ances (1,000 square feet) and televisions (1,200 square feet). These departments had annual profits of $64,000 for appliances and $82,000 for televisions after allocated fixed occupancy costs of $7 per square foot were deducted. Allocated fixed occupancy costs include property taxes, mortgage inter- est, insurance, and exterior maintenance for the department store.

Required:

Considering all the relevant factors, which department should be leased and why?

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P 2–6: Vintage Cellars Vintage Cellars manufactures a 1,000-bottle wine storage system that maintains optimum tempera- ture (55–57°F) and humidity (50–80 percent). The system has a backup battery for power failures and can store red and white wines at different temperatures. The following table depicts how average cost varies with the number of units manufactured and sold (per month):

Quantity Average Cost

1 $12,000 2 10,000 3 8,600 4 7,700 5 7,100 6 7,100 7 7,350 8 7,850 9 8,600

10 9,600

Required:

a. Prepare a table that computes the total cost and marginal cost for each quantity between 1 and 10 units.

b. What is the relation between average cost and marginal cost? c. What is the opportunity cost of producing one more unit if the company is currently pro-

ducing and selling four units? d. Vintage Cellars sells the units for $9,000 each. This price does not vary with the number of

units sold. How many units should Vintage manufacture and sell each month?

P 2–7: ETB ETB plans to manufacture a slim bamboo hard case for the Apple iPad, which will be sold for $65. ETB estimates that it can produce and sell between 3,000 and 5,000 bamboo cases a month. The following data summarize ETB’s cost structure at various output (sales) levels:

Production (Units) 3,000 3,500 4,500 5,000

Variable manufacturing cost $36,000 $35,000 $36,000 $60,000 Fixed manufacturing cost $60,000 $60,000 $60,000 $60,000 Variable selling and admin cost $26,100 $28,000 $31,500 $35,000 Fixed selling and admin cost $40,000 $40,000 $40,000 $40,000

Required:

a. What monthly production (sales) level minimizes the average cost of the bamboo iPad case?

b. How many bamboo iPad cases should ETB produce monthly?

P 2–8: Taylor Chemicals Taylor Chemicals produces a particular chemical at a fixed cost of $1,000 per day. The following table displays how marginal cost varies with output (in cases):

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Quantity (Cases) Marginal Cost

1 $500 2 400 3 325 4 275 5 325 6 400 7 500 8 625 9 775

10 950

Required:

a. Given the preceding data, construct a table that reports total cost and average cost at various output levels from 1 to 10 cases.

b. At what quantity is average cost minimized? c. Does marginal cost always intersect average cost at minimum average cost? Why?

P 2–9: Marsh Processing Marsh Processing is a small custom stainless steel parts processor. Customers send new and used stainless steel parts to Marsh for cleaning in various acid baths to remove small imperfections or films on the surface. These parts are used in a variety of applications, ranging from nuclear reactors to chemical and medical applications. Depending on the foreign substance to be removed, Marsh chooses the acid bath mixture and process.

Such chemical cleaning operations require highly skilled technicians to handle the dan- gerous  acids. Environmental Protection Agency (EPA) and Occupational Safety and Health Administration (OSHA) regulations are closely followed. Once the part is treated in the proper chemical bath using other chemicals, a benign waste solution results that can be disposed of via the city sewer system.

On May 12, Marsh ordered a 50-gallon drum of a specialty acid known as GX-100 for use in a May 15 job. It used 25 of the 50 gallons in the drum. The 50 gallons cost $1,000. GX-100 has a shelf life of 30 days after the drum is opened before it becomes unstable and must be discarded. Because of the hazardous nature of GX-100 and the other chemicals Marsh uses, Marsh works closely with Environ Disposal, a company specializing in the disposal of hazardous wastes. At the time of order- ing the GX-100, Marsh anticipated no other orders in the May–June time period that could use the remaining 25 gallons of GX-100. Knowing it would have 25 gallons remaining, it built $1,000 into the cost of the job to cover the cost of the GX-100 plus an additional $400 to cover the cost of having Environ dispose of the remaining 25 gallons.

On June 1, a customer called and asked for a price bid for a rush job to be completed on June 5. This job will use 25 gallons of GX-100. Marsh is preparing to bid on this order. What cost amount for the GX-100 must be considered in preparing the bid? Justify your answer.

P 2–10: Verdi Opera or Madonna? You won a free ticket to see Verdi’s Aida opera. The ticket has no resale value, but since you enjoy Verdi operas, you would be willing to pay $30 for the ticket had you not received it for free. Madonna is performing on the same night. There is absolutely nothing else you can do that night other than either attending the Verdi opera or the Madonna concert. Tickets to the Madonna concert cost $160. On any given day, you would be willing to pay up to $200 to see Madonna because you are such a big fan. Assume there are no other costs of seeing either the Verdi opera or Madonna. What is the opportunity cost of attending the Verdi opera?

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P 2–11: Dod Electronics Dod Electronics manufactures various RFID (radio-frequency identification) chips for medical device companies. The RFID chips track the location and movement of medical personnel. A non- medical device company, Xtron Systems, has approached Dod Electronics for a one-time special order of 10,000 RFID chips. The RFID chip that Xtron is seeking to purchase is virtually identical to Dod’s existing RFID chip model FQ4503. The Dod manufacturing cell that produces model FQ4503 currently is producing 60,000 FQ4503 chips for medical customers and has excess capacity to run the 10,000 special order without disrupting Dod’s regular production/delivery schedule. Xtron will purchase the chips for $38 per chip. If Dod accepts this special order, assume that it will have NO impact on the pricing of Dod’s existing FQ4503 contracts/customers. Dod’s average cost of produc- ing its current level of 60,000 RFID chips is $35 per chip. Management does not know precisely what it will cost to produce the extra 10,000 chips for Xtron.

Required:

a. Management is very confident that the average cost of FQ4503 chips is falling at their current production level of 60,000. Should Dod accept Xtron’s offer to purchase the 10,000 chips for $38 per chip? Explain the logic supporting your answer.

b. Management is very confident that the average cost of FQ4503 chips is rising at their current production level of 60,000. Should Dod accept Xtron’s offer to purchase the 10,000 chips for $38 per chip? Explain the logic supporting your answer.

P 2–12: Napoli Pizzeria Gino Potestio, owner of Napoli Pizzeria, is evaluating leasing an espresso/cappuccino machine. A number of patrons have inquired about espresso and cappuccino beverages. Napoli currently does not offer these beverages. Gino believes adding these beverages will increase the demand for his piz- zas. A good espresso/cappuccino machine can be leased for $300 month. Each espresso/cappuccino will sell for $3 and the coffee and milk will average $1 per serving. No additional labor cost is needed because the restaurant staff has enough idle time to prepare and serve the espresso/cappuccino. Gino estimates that the machine will add about $75 of additional pizza profits per month.

Required:

a. How many espresso/cappuccino beverages must Napoli sell to break even? b. Gino doesn’t want to offer espresso/cappuccino beverages unless he makes at least $1,000

per month after taxes including the additional sales of pizzas from adding espresso/cappuc- cino beverages. Napoli’s income tax rate is 20 percent. How many servings of espresso/ cappuccino must Gino sell to meet his after-tax profit goal?

P 2–13: JLT Systems JLT Systems sells and installs a firewall program to protect mobile apps from hacking an e-tailer’s servers. Each sale and installation requires JLT to incur a variable cost to sell and install the JLT firewall. JLT has a linear cost structure meaning that JLT has a fixed cost each month and a variable cost per sale and installation that does not vary with the number of sales and installs. At 200 sales and installs per month, JLT’s average cost is $2,700 per sale and install. JLT incurs fixed costs of $400,000 per month.

Required:

a. What is JLT’s variable cost per sale and install? b. JLT Systems sets the price for its firewall software at the market price of $2,000 per sales

and installation. Being a small competitor in this market, JLT is a price taker, and varying the number of JLT sales and installs does not affect the market price of $2,000. JLT Sys- tems wants to show an after-tax profit of $18,000 per month and has an income tax rate of

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20 percent. How many sales and installs per month does JLT need to make to achieve its after-tax profit goals?

c. Instead of being a price taker as in part (b), now assume that JLT faces the following demand schedule.

Quantity Price

250 $2,100 275 $2,050 300 $2,000 325 $1,950 350 $1,900 375 $1,850 400 $1,800 425 $1,750 450 $1,700 475 $1,650 500 $1,600 525 $1,550 550 $1,500

(JLT’s demand curve is represented by the equation: P = 2600 – 2Q.) What is JLT Systems’ profit maximizing number of sales and installs of its firewall

software per month?

P 2–14: Volume and Profits Assuming the firm sells everything it produces and assuming that variable cost per unit does not change with volume, total profits are higher as volume increases because fixed costs are spread over more units.

Required:

a. True or false? b. Explain your answer in part (a).

P 2–15: American Cinema American Cinema shows first-run movies. It pays the company distributing the movies a fixed fee of $1,000 per week plus a percentage of the gross box office receipts. In the first two weeks a movie is released, the theater pays the fixed fee of $1,000 per week plus 90 percent of gross box office receipts to the distributor. If the theater keeps the movie for weeks 3 and 4, the theater pays the dis- tributor $1,000 per week plus 80 percent of its gross box office receipts received during those two weeks. American Cinema charges $6.50 per ticket for all movies, including those shown for two weeks and those shown for four weeks.

American Cinema must decide what movies to show and for how many weeks to show each movie (either two weeks only or four weeks) before the movie is released. For most movies, the audience demand is higher in the first two weeks than in the next two weeks.

American Cinema is evaluating two similar comedies. The first one, Paris Is for Lovers, is scheduled for release on October 1. The second comedy, I Do, is scheduled for release on October 14. American Cinema has decided to rent Paris Is for Lovers but must decide whether to run it for four weeks or to run it for two weeks and then replace it with I Do. Based on all the information about the stars in the movie, production costs, and prerelease publicity, management expects the two movies will have the same demand in the first two weeks and will have the same (lower) demand in weeks 3 and 4.

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Required:

a. The only movie being released on October 14 is I Do. How should management go about deciding whether to rent Paris for four weeks or to rent it for two weeks and then replace it with I Do? In other words, provide American Cinema management with a decision-making rule to use in choosing between renting Paris for four weeks or just two weeks. American Cinema’s tax rate is zero. Be sure to justify your advice with clearly described analysis.

b. How does your answer in part (a) change if American Cinema’s income tax rate is 30 percent?

c. American Cinema’s average movie patron purchases soda, popcorn, and candy that yields profits of $2 after supplies and labor. How does profit on these concession items affect your answer to part (a)? (Ignore taxes.)

P 2–16: Home Auto Parts Home Auto Parts is a large retail auto parts store selling the full range of auto parts and supplies for do-it-yourself auto repair enthusiasts. The store is arranged with three prime displays in the store: front door, checkout counters, and ends of aisles. These display areas receive the most cus- tomer traffic and contain special stands that display the merchandise with attractive eye-catching designs. Each display area is set up at the beginning of the week and runs for one week. Three items are scheduled next week for special display areas: Texcan Oil, windshield wiper blades, and floor mats. The accompanying table provides information for the three promotional areas scheduled to run next week:

Planned Displays for Next Week

Ends of Aisles

Front Door

Checkout Counter

Item Texcan Oil Wiper blades Floor mats Sales price 69¢/can $9.99 $22.99 Projected weekly volume 5,000 200 70 Unit cost 62¢ $7.99 $17.49

Based on past experience, management finds that virtually all display-area sales are made by impulse buyers. The display items are extra purchases by consumers attracted by the exhibits.

Before the store manager sets up the display areas, the distributor for Armadillo car wax visits the store. She says her firm wants its car wax in one of the three display areas and is prepared to offer the product at a unit cost of $2.50. At a retail price of $2.90, management expects to sell 800 units during the week if the wax is on special display.

Required:

a. Home Auto has not yet purchased any of the promotion items for next week. Should man- agement substitute the Armadillo car wax for one of the three planned promotion displays? If so, which one?

b. A common practice in retailing is for the manufacturer to give free units to a retail store to secure desirable promotion space or shelf space. The Armadillo distributor decides to sweeten the offer by giving Home Auto 50 free units of car wax if it places the Armadillo wax on display. Does this change your answer to part (a)?

P 2–17: Stahl Inc. Stahl produces and sells a single product and faces an inelastic demand curve, meaning it can sell as many units as it wants without affecting the selling price. Stahl has a cost structure consisting of fixed costs that are incurred each month, and a variable cost of $12 per unit produced that is

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independent of (i.e., does not vary with) the number of units produced. Stahl’s income tax rate is 30 percent, and its break-even quantity is 24,000 units each month. If Stahl produces 30,000 units during the month, it has an after-tax net income of $33,600. Calculate Stahl’s selling price and monthly fixed costs.

P 2–18: Affording a Hybrid With gasoline prices at $3.00 per gallon, consumers are flocking to purchase hybrid vehicles (with a combination of gasoline and electric motors) that get 50 miles per gallon of gasoline. The monthly payment on a three-year lease of a hybrid is $499 compared to $399 per month on a conventional, equivalent traditional gasoline car that gets 25 miles per gallon. Both vehicles require a one-time $1,500 payment for taxes, license, and dealer charges. Both vehicles have identical lease terms for the residual value, maximum number of miles allowed without penalty, and so forth.

Required:

a. Calculate how many miles the consumer must drive per year to make the hybrid the economical choice over the conventional gasoline-only vehicle.

b. How does your answer to part (a) change if the price of gasoline is $4.00 per gallon?

P 2–19: Easton Diagnostics Easton Diagnostics is a large medical testing laboratory that services a four-county region. Easton runs a van that picks up specimens from clinics and hospitals and takes them to the Easton laboratory where various tests are conducted. Easton currently has a large chemical blood analysis system. This system runs a battery of standard tests for which Easton is reimbursed $750 per blood sample. The cost structure of the current blood analysis system consists of annual fixed costs (lease payment of $1.6 million, supervisory costs of $400,000, and occupancy costs of $100,000) and variable costs per blood sample (direct labor, including transporting the blood samples, technicians, and so forth of $175, direct materials of $125, and a royalty fee of $150). [Note: The current equipment is leased for $1.6 million per year plus $150 (royalty) for every blood sample analyzed.]

A competing vendor has approached Easton Diagnostics with a comparable system that per- forms the same set of tests. The reliability and quality of both the proposed and the existing systems are the same. The competing vendor is willing to lower the annual lease payment to $1.2 million but raise the royalty fee by $30 per blood sample to $180. Both the existing and proposed leases have the same contractual terms in all other respects. If Easton adopts the competing vendor’s proposal, the current fee it charges ($750) and the direct labor costs per blood sample ($175) are unaffected. However, the proposed equipment adds $10 per blood sample analyzed to direct materials.

Required:

a. How does Easton Diagnostic’s break-even point for standard blood tests change if the com- peting vendor’s proposal is accepted?

b. Easton Diagnostic currently analyzes 10,300 blood samples per year, and this number has remained constant over the past few years. Moreover, Easton management does not fore- see any growth in the number of standard blood tests it performs. Make a recommendation to management as to whether Easton should stay with its existing blood analysis equip- ment or accept the competing vendor’s proposal. Justify your recommendation. (Assume that there are no cancellation payments on the existing equipment and there are no costs of converting from the existing equipment to the new equipment other than the costs described in the problem.)

P 2–20: Spa Salon The Spa Salon is a full-service day spa specializing in massage and manicures. One out of every three massage clients also purchases a manicure. Last month, Spa Salon did 90 massages and 30 manicures and reported the following net loss:

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Revenues: Massage $ 8,100 Manicures 1,500

$ 9,600 Variable costs: Massage $ (3,600) Manicures (600)

$ (4,200) Fixed costs (7,020) Net income (loss) $ (1,620)

After reviewing the income statement for last month, the owner was quite upset about the net loss. She thought the spa was making money.

Required:

How many massages and manicures does Spa Salon have to conduct each month to break even, assuming that the prices and the variable costs of massages and manicures remain the same as last month’s, as do the fixed costs?

P 2–21: Manufacturing Cost Classification A company makes DVD players and incurs a variety of different costs. Place a check in the appropri- ate column if the cost is a product cost or a period cost. Further, classify each product cost as direct materials, direct labor, or manufacturing overhead.

Period Cost

Product Cost

Direct Labor

Direct Materials Overhead

Advertising expenses for DVD Depreciation on PCs in marketing department Fire insurance on corporate headquarters Fire insurance on plant Leather carrying case for the DVD Motor drive (externally sourced) Overtime premium paid assembly workers Factory building maintenance department Factory security guards Plastic case for the DVD Property taxes paid on corporate headquarters Salaries of public relations staff Salary of corporate controller Wages of engineers in quality control Wages paid assembly line employees Wages paid employees in finished goods

warehouse

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P 2–22: Australian Shipping In the 1800s, Australia was a colony of England and most of its trade was with England. Aus- tralia primarily exported agricultural products such as wheat and imported manufactured goods such as steel, machinery, and textiles. The volume of trade measured in British pounds (£) was roughly equal in the sense that exports equaled imports. (Imports were slightly larger as there were net positive investments being made in Australia.) However, in cubic feet of cargo being shipped, exports to England exceeded imports. A British pound (£) of wheat required more cubic feet than £1 of manufactured goods. Hence, an imbalance of shipping existed. Numerous ships would carry agricultural products to England but return to Australia empty because no cargo of manufactured goods existed.

Large sail-powered ships required substantial ballast (weight) in the hold to keep the ship sail- ing properly, especially in rough seas. Before leaving England empty, the ships would purchase stone from local quarries for ballast. However, once in Australia, the stone had no market value, and in fact had to be hauled from the harbor area.

Consider the following facts for a particular ship in England with a shipment of Australian cargo for England.

1. The ship has contracted to sail to Australia and return with a cargo of Australian wheat. The ship has no cargo scheduled for London to Sydney.

2. The wheat-shipping contract calls for paying the captain and crew £4,900 for the round trip. The wheat seller will arrange for and pay Australian dock hands £250 to load the wheat in Sydney, and the wheat purchaser will arrange for and pay English dock hands to unload the wheat in London. The ship’s crew does not load or unload the cargo.

3. To sail to Australia, the ship requires 10 tons of ballast (1 ton = 2,000 pounds). 4. Stone can be quarried in England, transported to the docks, and loaded as ballast for

£40 per ton. In Sydney, the stone can be unloaded and hauled away for £15 per ton. 5. Wrought iron bars of 10-foot lengths can also be used as ship ballast. Wrought iron bars can

be purchased in England at £1.20 per bar. Each bar weighs 20 pounds. Wrought iron bars sell for £0.90 per bar in Sydney. The cost of loading the wrought iron in London is £15 per ton, and the cost of unloading it and transporting it to the Sydney market is £10 per ton.

Required:

a. Write a memo to the ship’s captain describing what actions he should take with respect to using stone or wrought iron as ballast. Assume that interest rates are zero and all prices and quantities are known with certainty. Support your recommendation with a clearly labeled financial analysis.

b. Why do you think the price of wrought iron is lower in Sydney than in London?

P 2–23: iGen3 The Xerox DocuColor iGen3 digital production press is a high-volume, on-demand, full-color printer capable of producing up to 6,000 impressions (pages) per hour. It weighs nearly 3 tons, stretches 30 feet long, and holds more than 40 pounds of dry ink. It sells for over $500,000, and its principal market is print shops that produce mail order catalogs (e.g., L.L.Bean). Xerox offers two leasing options for the iGen3. Option A requires a three-year agreement with a monthly lease fee of $10,000 plus $0.01 per impression. Option B (also a three-year agreement) does not include a monthly lease fee but requires a charge of $0.03 per impression.

ColorGrafix is a print shop considering leasing the iGen3 to begin producing customized mail- order catalogs. Besides leasing the iGen3, ColorGrafix estimates that it will have to buy ink for the iGen3 at a cost of $0.02 per impression and hire an operator to run the iGen3 to produce the cus- tomized catalogs at a cost of $5,000 per month. ColorGrafix estimates that it can charge $0.08 per impression for customized color catalogs. (Note: The customer provides the paper stock on which the color impressions are printed.)

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Required:

a. If ColorGrafix leases the iGen3 and chooses Option A, how many impressions per month will ColorGrafix have to sell and produce to break even?

b. If ColorGrafix leases the iGen3 and chooses Option B, how many impressions per month will ColorGrafix have to sell and produce to break even?

c. Should ColorGrafix choose Option A or Option B? Explain why. d. ColorGrafix is a fairly new firm (only three years old) and has a substantial amount of debt

that was used to help start the company. ColorGrafix has positive net cash flow after ser- vicing the debt, but the owners of ColorGrafix have not felt it wise to withdraw any cash from the business since its inception, except for their salaries. ColorGrafix expects to sell and produce 520,000 impressions per month. Which lease option would you recommend ColorGrafix choose? Explain why.

P 2–24: Adapt Inc. You work for the strategy group of Adapt Inc., a firm that designs and manufactures memory cards for digital cameras. Your task is to gather intelligence about Adapt’s key competitor, DigiMem, a privately held company. Your boss has asked you to estimate DigiMem’s fixed costs. Industry sources, such as trade associations, provide the following information on DigiMem:

DigiMem Last Fiscal Year

Revenues (millions) $6.200       Net income after taxes (millions) $1.700       Income tax rate      25% Operating margin*       70%

*Ratio of revenues less variable costs divided by revenues

Required:

a. Using the preceding data, estimate DigiMem’s annual fixed costs. b. Why might your boss be interested in knowing DigiMem’s fixed costs?

P 2–25: Tesla Motors You work in the long-run strategic planning group of a large automotive firm and are tasked with following the development of electric vehicles. Your firm has electric cars in development but has not yet decided to enter the battery-powered car market. One company you follow is Tesla Motors, founded by Silicon Valley engineers, that specializes in high-performance luxury electric vehicles. A recent article in The Wall Street Journal, entitled “Tesla Motors Approaches Crossroad,” describes Tesla’s current and expected operating performance. Last quarter, Tesla lost $49 million when it was making 200 cars a week. To break even, Tesla needs to make 400 cars a week. Tesla operates its plant 50 weeks out of the year and is shut down for the remainder of the days in the year for holidays and planned maintenance. While the list price of a Tesla ranges between $60,000 and $100,000 depending on battery capacity and other options, the average price is $75,000.

Required:

a. What is the variable cost of a Tesla automobile and what are Tesla’s quarterly fixed costs? b. Why would your firm be interested in knowing about Tesla’s fixed and variable cost structure?

P 2–26: Oppenheimer Visuals Oppenheimer Visuals manufactures state-of-the-art flat-panel plasma display screens that large com- puter companies like Dell and Gateway assemble into flat-panel monitors. Oppenheimer produces just the display panels, not any of the electronics, cases, or stands needed to make a complete unit. It is about to launch a new product employing TN polarized glass with a unique microscopic groove

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pattern. Two different technologies exist that can produce the unique groove pattern. One technology has a fixed cost of $34,000 per day and a variable cost of $200 per panel. The second technology has a fixed cost of $16,000 per day and a variable cost of $400 per panel. The fixed costs of the two technologies consist entirely of three-year leases for equipment to produce the panels. Both technolo- gies are equally reliable and produce panels of equal quality. The only difference between the two technologies is their cost structures.

Because Oppenheimer holds a patent on the new YN polarized glass flat-panel displays, it has some market power and expects to sell the new display panels to computer companies based on the following demand schedule:

Price per Display Panel

Quantity (per Day)

$760 60 740 65 720 70 700 75 680 80 660 85 640 90 620 95 600 100 580 105 560 110

In other words, if Oppenheimer sets the price per panel at $760, it expects to sell 60 panels per day. If it sets the price at $560, it expects to sell 110 panels per day.

Required:

a. To maximize firm value, should Oppenheimer Visuals choose technology 1 or technology 2 to manufacture the new flat-panel display?

b. Given the technology choice you made in part (a), what price should Oppenheimer charge for the new flat-panel display?

c. Using Oppenheimer Visuals as an example, explain what is meant by the often used expression, “All costs are variable in the long run.”

P 2–27: Eastern University Parking Eastern University faces a shortage of parking spaces and charges for parking. For nearby parking (e.g., behind the business school), faculty and staff pay $180 per year. Parking in lots Z and B, which are north and south of the campus and involve about a 10-minute walk to the business school, costs $124 per year. In setting these prices, the university seeks to recover the costs of parking and to manage the queue of people wishing to park on campus. The current $180 and $124 fees cover the costs of surface spaces. Lots Z and B have lower fees to compensate people for the longer walks and to encourage them to park in outlying lots. University officials say this fee structure, when multiplied by the number of parking stickers of each type sold, covers the cost of running the parking office and building new spaces.

The cost of providing a parking space consists of costs of construction of the space, mainte- nance, and security. The construction cost is the annual amount required to repay the cost of grad- ing, draining, and asphalting the space. Maintenance includes snow removal, line painting, fixing the gates after the arms are broken by irate faculty members searching for a space, and patching the asphalt. Security costs include all costs of the parking officers who ticket the cars of staff and students parked illegally.

The university recently evaluated a proposal to construct an enclosed, multifloor parking facil- ity. Design estimates place the construction cost at $12,000 per enclosed space. The equivalent cost of a surface space is $900. The university uses a 10 percent cost of capital. (Assume that this is an

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appropriate interest rate.) To compensate the university for the cost of the capital involved in build- ing parking garages, parking fees would have to be at least $1,200 per space per year, as opposed to $90 per space per year for the surface space. Because the university does not believe that faculty, staff, and students are willing to pay more than $1,200 per year for a covered parking space, no plans exist to build a parking building.

Required:

Critically evaluate Eastern University’s costing of parking permits. What do you think accounts for the university administration’s reluctance to build a parking garage?

P 2–28: GRC GRC currently manufactures and sells computer-controlled gear-cutting machines used by automo- bile companies to produce gears for car and truck transmissions and differentials. GRC has decided to produce gear-cutting machines that wind-powered, electric-generating turbine companies (e.g., Siemens and General Electric) will purchase to manufacture gear sets used in their turbines. Because of the tremendous torque generated by the 160-foot blades on the windmills, the gears in the electric power generators must be able to withstand unusually large forces. GRC has designed a gear-cutting machine to produce gears that can withstand such forces.

The following table describes the demand curve for the number of wind-powered turbine gear- cutting machines GRC expects to sell per year.

Price ($000s) Quantity

$440 3 420 4 400 5 380 6 360 7 340 8 320 9 300 10 280 11 260 12

(Note: The demand curve in the table can be represented as P = 500 – 20Q.) GRC can produce its new gear-cutting machines for wind-powered turbines using one of two

technologies. One technology (HI Automation) involves more capital investment but results in lower variable costs. The other technology (LO Automation) requires less capital investment but results in higher variable costs. The following table summarizes how the average costs of the two technologies vary with different production levels of wind-powered turbine gear-cutting machines.

Number of Machines Produced

Average Cost Hi Auto

Average Cost Low Auto

3 $525.00 $308.33 4 425.00 300.00 5 365.00 295.00 6 325.00 291.67 7 296.43 289.29 8 275.00 287.50 9 258.33 286.11

10 245.00 285.00 11 234.09 284.09 12 225.00 283.33

(All numbers in thousands)

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In other words, if five wind-powered turbine gear-cutting machines are produced, the average cost of each machine is $365 using the Hi Automation technology but only $295 if the Low Automa- tion technology is used. On the other hand, if 10 machines are produced, the Hi Automation technol- ogy is less expensive ($245) than the Low Automation technology ($285). (Note: The average cost estimates above include the annual lease cost of the automation technology.)

Required:

a. Should GRC purchase the Hi Automation or the Low Automation technology? Justify your answer with convincing supporting analyses.

b. Given your choice of production technology (Hi or Low Automation) in part (a), what price should GRC set for its gear-cutting machines for wind-powered turbines and how many machines will GRC expect to sell at this price?

P 2–29: Wagner Counters Wagner Counters manufactures a material used to fabricate kitchen counters. It is a very durable, high-fashion, and expensive product that is installed in luxury homes. The manufacturing process is complicated and requires highly skilled employees, supervisors, and engineers. Wagner employs 450 people in its manufacturing operation. Most of the production employees are cross-functionally trained to perform several manufacturing tasks.

The firm’s vacation policy gives employees three hours of paid vacation for every week of work. An employee who works 52 weeks accrues 156 hours or 3.9 weeks (156 ÷ 40) of paid vaca- tion. In the past, Wagner allowed employees unlimited accumulation of vacation time. Some long- time employees had accumulated six months of vacation. When they retired from the firm, they continued to be paid for six months after leaving.

Management decided that allowing employees unlimited accumulation of vacation was costing the firm too much money when they left. Not only were the employees who left being paid, but so were their replacements. To correct this problem, management instituted a policy that an employee could not accumulate more than 156 hours of vacation. Once an employee’s accumulated vacation exceeded 156 hours, these additional hours would not be added to his or her account. In addition, employees with more than 156 hours of accrued vacation had two years from the date of the policy change to bring their balance down to the maximum 156 hours. After the two-year phase-in period, the “take it or lose it” policy was strictly enforced.

While there was much grumbling about the “take it or lose it” policy, after the two-year phase- in period, the following comments were collected at a focus group held by the personnel department to assess the new policy:

• Manager A: “In some cases it has been very beneficial. Some of our people in high-stress positions were burned out. These people never took all their vacation. One woman took every Friday off for six months to use her excess vacation time. For the four days she worked, she was like a new person—refreshed, invigorated, and enthused.”

• Manager B: “Well, that may be true, but this new policy, especially during the phase-in period, has been hell on our staffing. Some days, especially around weekends and holidays, we’ve had 30 percent of the plant on vacation. What impact do you think this has had on our production schedule and quality programs?”

• Manager C: “I have looked at the data and very few employees lose any accrued vacation. Fewer than 1 percent of the accrued vacation hours were lost last year after the phase-in period because employees did not use them.”

Required:

Evaluate the costs and benefits of the new policy that limits accumulated vacation to 156 hours.

P 2–30: Prestige Products Prestige manufactures a line of female cosmetics, including lipsticks, face creams, eyeliners, and so forth. Prestige manufactures its own products to maintain proprietary information and to assure

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high-quality standards. They have just developed a new exfoliating masque face cream in a unique tube and applicator that they expect to sell for $12.00 per unit. To manufacture the new face cream, Prestige will have to lease new equipment. Only two companies manufacture the necessary equip- ment for producing the face cream, a German company and a Swedish company. The following table lists the two alternative production technologies that Prestige can use to produce the new face cream.

Technology German Swedish

Fixed cost (annual) $500,000 $900,000 Variable cost/unit  $ 8.00  $ 6.00 Maximum annual capacity (units)  215,000  380,000

The German equipment has an annual capacity of 215,000 units per year, whereas the Swedish equipment can produce up to 380,000 units per year. Both companies require Prestige Products to sign a five-year, noncancelable lease for the annual lease payment ($500,000 for the German equip- ment and $900,000 for the Swedish equipment). The variable costs include the labor and material ($8 if the German equipment is used and $6 if the Swedish equipment is used).

Required:

a. Calculate the break-even point if Prestige were to lease the German equipment. b. Calculate the break-even point if Prestige were to lease the Swedish equipment. c. Which equipment (German or Swedish) should Prestige lease (and why)? d. Suppose that Prestige management expects to sell 180,000 masques per year. Calculate

the average cost (fixed plus variable cost) of the German and Swedish equipment at 180,000 units.

e. What is operating leverage and what is the relation between operating leverage and firm value?

P 2–31: JLE Electronics JLE Electronics is an independent contract manufacturer of complex printed circuit board assemblies. Computer companies and other electronics firms engage JLE to assemble their boards. Utilizing computer-controlled manufacturing and test machinery and equipment, JLE provides manufacturing services employing surface mount technology (SMT) and pin-through-hole (PTH) interconnection technologies. The customer purchases the subcomponents and pays JLE a per-board fee to assemble the components.

JLE has a new one-of-a-kind, state-of-the-art board assembly line. The line can be operated 20 hours per day, seven days a week, in each three-week (21-day) period. Four customers have asked that their boards be manufactured on this line over the next three-week period. The following table summarizes the number of units of each board requested, the price JLE will charge for each board, JLE’s variable and fixed cost per board, and the number of assembly line minutes each board requires. Fixed cost per board is the allocated cost of property taxes, fire insurance, accounting, depreciation, and so forth.

Customers

A B C D

Number of boards requested 2,500 2,300 1,800 1,400 Price $   38 $   42 $  45 $  50 Variable cost/board*     23     25    27     30 Fixed cost/board      9    10   10     15 Number of machine minutes/board      3      4    5      6 *Allocated based on both machine minutes and direct labor cost.

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Make the following assumptions: • The four customer orders can be produced only on the new JLE line. • If JLE rejects an order, future orders from that customer are not affected. • There is no setup or downtime between orders. • Customers are willing to have any number of boards produced by JLE up to the number of

units specified in the preceding table. For example, customer A has requested 2,500 boards in the 21-day period, but would accept a smaller number.

• The four customers comprise the entire set of potential customers who would want to use the new JLE line in the next 21-day period.

Required:

Which customer orders should be accepted? In other words, complete the following table:

Customers

A B C D

Number of boards requested to be produced in the next 21 days 2,500 2,300 1,800 1,400 Number of boards scheduled to be produced in the next 21 days ? ? ? ?

P 2–32: News.com News.com is a website that offers users access to current national and international news stories. News.com does not charge users a fee for accessing the site, but rather charges advertisers $0.05 per hit to the website. A “hit” is a user that logs on the website.

News.com is considering two alternate Internet service providers (ISPs) that will link News .com’s computer system to the World Wide Web—NetCom and Globalink. These firms are identical in access speeds and the number of users able to connect to the site per minute. Both ISPs are equally reliable. NetCom proposes to charge $3,000 per month plus $0.01 per hit to News.com. Globalink proposes to charge $2,000 per month plus $0.02 per hit. Assume that the only costs News.com incurs are the access fees charged by the ISP.

Required:

a. Calculate the number of hits to its website needed to break even if News.com uses NetCom.

b. Calculate the number of hits to its website needed to break even if News.com uses Globalink.

c. Which ISP do you recommend that News.com use? Explain why. d. Monthly demand (in number of hits) for News.com is expected to be either 50,000

if the economy is slumping or 150,000 if the economy is booming, each equally probable. Which ISP should News.com choose and why?

P 2–33: Molton Waste Removal (A) Molton Waste Removal now only collects garbage from private residences (houses) because it does not own trucks with the capability of lifting and emptying garbage dumpsters used by apartment complexes. Molton currently is reassessing this decision. To lease, license, insure, and get the vari- ous permits to operate a refuse collection truck with a fork-lift capable of emptying a dumpster costs $54,000 per month. This includes the cost of the driver, fuel, and oil. Molton prices each apartment complex based on the number of apartment units in the complex based on a standard of 25 units.

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The following table indicates how Molton expects the number of apartment customers to vary with the price (per 25 apartment units)

Number of Customers Price per Month

100 1,560 105 1,538 110 1,516 115 1,494 120 1,472 125 1,450 130 1,428 135 1,406 140 1,384 145 1,362

(Table is based on the demand curve: P = 2000 – 4.4Q.) In other words, if Molton wants 100 apartment customers, it will set the price at $1,560 per

25 units per month. If an apartment has 50 units, then at this price point, this apartment complex pays $3,120 (2 × $1,560) per month. Since garbage is collected once per week at each apartment complex, the single truck has the capacity to handle up to 145 25-unit apartment complexes per month.

Molton uses a landfill in the county to dispose of the waste. The landfill charges $1,750 per truck load of garbage the size Molton would acquire. Molton estimates that 10 apartment complexes (each with 25 units) will fill the truck once and will require dumping at the landfill. And, Molton will remove the refuse at each 25-unit complex exactly four times per month. Each 25-unit apartment complex requires Molton to lease a dumpster that can be lifted and emptied by its fork-lift–equipped garbage truck. Molton can lease these dumpsters for $200 per month per 25-unit dumpster.

Required:

a. What is Molton’s monthly fixed cost of adding an apartment-complex refuse disposal service to its existing residential services? And what is Molton’s monthly variable cost of servicing each 25-unit apartment complex?

b. Given the demand curve Molton expects to face in the apartment refuse collection business, what price should it choose to maximize profits, and how much profit will it make at this price?

c. Based on the profit maximizing price computed in part (b), what is the break-even point at this price?

d. After preparing the analysis in part (b), Molton discovers it has forgotten to include an additional cost of $72,000 per year to cover the cost of the new person needed to contact potential apartment complexes, sign contracts for waste removal, and manage the apartment refuse collection business. After incorporating the $72,000 cost of the manager to market and manage the apartment collection business, how do your answers to parts (b) and (c) change? In other words, what price should Molton set to maximize profits, how much profit will Molton make at this price, and what is the break-even point at this new price?

e. Discuss why your answers in parts (a) and (c) are either the same or differ from your answers in part (d).

P 2–34: Littleton Imaging Dr. Na Gu plans to open a radiology office that provides CAT scans. She can lease the CAT scanner for $1,200 per month plus $45 for each imaging session. In addition to the $45 lease cost per imag- ing session, Dr. Gu must purchase film for each session at a cost of $55. She plans to charge $250 for each session. Dr. Gu has identified a suitable office that she can rent for $1,400 per month. The monthly cost of a receptionist is $2,400 and two radiology technicians are $3,200 each per month. Office furnishings, phones, and office equipment cost $600 per month. She expects that her salary will be $15,000 per month.

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Required:

a. How many imaging sessions per month must Littleton Imaging conduct in order for the office to break even?

b. How many imaging sessions per month must Littleton Imaging conduct in order for the office to yield an after-tax profit of $5,000 if the tax rate is 25 percent?

c. Dr. Gu expects that the office will perform 200 imaging sessions per month. How much must she charge per session to break even?

P 2–35: Candice Company Candice Company has decided to introduce a new product that can be manufactured by either of two methods. The manufacturing method will not affect the quality of the product. The estimated manu- facturing costs of the two methods are as follows:

Method A Method B

Raw materials $5.00 $5.60 Direct labor 6.00 7.20 Variable overhead 3.00 4.80 Directly traceable incremental fixed

manufacturing costs per year $2,440,000 $1,320,000

Candice’s market research department has recommended an introductory unit sales price of $30. The incremental selling expenses are estimated to be $500,000 annually plus $2 for each unit sold, regardless of manufacturing method.

Required:

a. Calculate the estimated break-even point in annual unit sales of the new product if Candice Co. uses

(i) Manufacturing method A. (ii) Manufacturing method B.

b. Which production technology should the firm use and why?

P 2–36: Cost Behavior Patterns For each of the following questions draw a graph that depicts how costs vary with volume. Completely label each graph and axis.

a. Plant XXX works a 40-hour week. Management can vary the number of employees. Currently, 200 employees are being paid $10 per hour. The plant is near capacity. To increase output, a second 40-hour shift is being considered. To attract employees to the second shift, a 20 percent wage premium will be offered. Plot total labor costs as a func- tion of labor hours per week.

b. Plant YYY has a contract with the Texas Gas Company to purchase up to 150 million cubic feet of natural gas per month for a flat fee of $1.5 million. Additional gas can be purchased for $0.0175 per cubic foot. Plant YYY manufactures aluminum cans. One thou- sand cans require 10 cubic feet of gas. Plot total gas costs as a function of can production.

c. Use the same facts as in part (b), but plot the gas cost per can as a function of can production.

P 2–37: Royal Holland Line Royal Holland is a cruise ship company. It currently has six ships and plans to add two more. It offers luxury passenger cruises in the Caribbean, Alaska, and the Far East. Management is currently addressing what to do with an existing ship, the S.S. Amsterdam, when she is replaced by a new ship.

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The S.S. Amsterdam was built 20 years ago for $100 million. For accounting purposes, she was assumed to have a 20-year life and hence is now fully depreciated. To replace the S.S. Amsterdam would cost $500 million, but her current market value is $371,250,000. The Holland Line can bor- row or lend money at 10 percent.

The S.S. Amsterdam is now sailing the Caribbean and will be replaced next year by a new ship. The S.S. Amsterdam might be moved to the Mediterranean for a new seven-day Greek island tour. A seven-day cruise would depart Athens Sunday night, stop at four ports before returning to Athens Sunday morning, and prepare for a new cruise that afternoon. The S.S. Amsterdam can carry as many as 1,500 passengers. The accompanying data summarize the operating cost for this seven-day cruise.

Estimated Operating Cost of Seven-Day Greek Island Cruise (S.S. Amsterdam)

Variable Cost* Fixed Cost†

Labor $ 60,000 $ 80,000 Food  236,000      10,500 Fuel    177,000 Port fees and services      62,000 Marketing, advertising, promotion    240,000 Supplies     28,000      38,000 Totals $324,000   $607,500

*Based on 1,200 passengers. †Fixed costs per weekly cruise. Assume there are 50 weeks (and hence 50 cruises) in a year.

Required:

a. Assuming the seven-day Greek island cruise can be priced at an average of $1,620, calculate the break-even number of passengers per cruise using the data provided.

b. What major cost component is not included in management’s estimates? c. If you were to include the omitted cost component identified in part (b), recalculate the

break-even point for the S.S. Amsterdam’s Greek island cruise. d. Passengers purchase beverages, souvenirs, and services while on the ship. The ship makes

money on the purchases. If the ship line has a margin of 50 percent on all such on-board purchases, how much would the average passenger have to purchase for the break-even point to be 900 passengers?

P 2–38: Roberts Machining Roberts Machining specializes in fabricating metal racks that hold electronic equipment such as tele- phone switching units, power supplies, and so forth. Roberts designs and produces the metal stamp- ing dies used to fabricate the racks. It is currently fabricating several racks for GTE. A new rack, the 1160, is scheduled to begin production. The die used to fabricate this rack cost Roberts $49,000 to design and build. This die was completed last week, and production of the 1160 is scheduled to begin next week. Rack 1160 is a specialized custom product only for GTE. GTE and Roberts have a one-year contract whereby Roberts agrees to manufacture and GTE agrees to purchase a fixed number of 1160 racks over the next 12 months for a fixed price per rack. The 1160 rack will not be produced beyond one year. This contract generates profits of $358,000 (after deducting the die’s cost of $49,000). Roberts’s accounting system recorded all expenditures for the 1160 die as a fixed asset with a one-year life. If this die is scrapped today or in one year’s time, it has a scrap value of $6,800.

Easton, another metal fabricator, has offered to buy the 1160 die from Roberts for $588,000 and will supply 1160 racks to GTE. GTE has agreed to this supplier substitution. Roberts estimates that if it sells the 1160 tools and dies to Easton, it will lose a current cash equivalent of $192,000 of future profits that would have been generated from GTE and similar customers, but now this business will go to Easton. (Ignore all tax effects.)

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Required:

a. List all the alternatives in Roberts’s opportunity set with respect to the 1160 die. b. Calculate the net cash flows associated with each alternative in Roberts’s opportunity set

listed in part (a). c. What is the opportunity cost of each alternative in the opportunity set listed in part (a)? d. What action should Roberts take with respect to the 1160 die?

P 2–39: Fuller Aerosols Fuller Aerosols manufactures six different aerosol can products (room deodorants, hair sprays, furniture polish, and so forth) on its fill line. The fill line mixes the ingredients, adds the propellant, fills and seals the cans, and packs the cans in cases in a continuous production process. These aerosol products are then sold to distributors. The following table summarizes the weekly operating data for each product.

Fuller Aerosols Weekly Operating Data

AA143 AC747 CD887 FX881 HF324 KY662

Price/case $ 37 $ 54 $ 62 $ 21 $ 34 $ 42 Fill time/case (minutes)    3    4    5    2    3    4 Fixed cost per product per week $900   $240   $560   $600   $1,800      $600   Cases ordered per week 300 100 50 200 400 200 Variable cost/case $28 $50 $48 $17 $28 $40

Each product has fixed costs that pertain only to that product. If the product is discontinued for the week, the product’s fixed costs are not incurred that week.

Required:

a. Calculate the break-even volume for each product. b. Suppose the aerosol fill line can operate only 70 hours per week. Which products should

be manufactured? c. Suppose the aerosol fill line can operate only 50 hours per week. Which products should

be manufactured?

P 2–40: Happy Feet Dr. Lucy Zang, a noted local podiatrist, plans to open a retail shoe store specializing in hard-to-find footwear for people with feet problems such as bunions, flat feet, mallet toes, diabetic feet, and so forth. Because of the wide variety of foot ailments and shoe sizes needed, Dr. Zang estimates that she would have to stock a large inventory of shoes, perhaps as much as $1.5 million (at her cost). She found a 4,000-square-foot store in a popular mall that provides adequate retail space and storage for her inventory. Store improvements including carpeting, lighting, shelving, computer terminals, and so forth, require an additional $0.2 million investment. Initial advertising, hiring expenses, legal fees, and working capital are projected to add another $0.1 million of initial investment. To finance this $1.8 million investment, Dr. Zang and her family will invest $0.4 million, and the balance of the $1.4 million will be borrowed from a bank.

The mall charges rent of $40 per square foot per year, payable in equal monthly installments, plus 3 percent of her retail sales. So, to rent the 4,000-square-foot store, the annual rent is $160,000, or $13,333 per month PLUS 3 percent of her sales. Besides the rent, Dr. Zang estimates other monthly expenses for labor, utilities, and so on to be $38,000. These expenses will not vary with the amount of shoe sales. She plans to mark up the shoes 100 percent, so a pair of shoes she buys whole- sale for $110 will be sold at retail for $220. Based on her research, she expects monthly retail sales to be $150,000, but in any given month, total sales can be $80,000 or $220,000 with equal probability.

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Dr. Zang talks to her local banker and lays out her business plan; the banker tells her the bank would make a three-year interest-only loan at 10 percent interest, with the principal of $1.4 million due in three years (or it could be refinanced). The high interest rate of 10 percent was caused by the rather large risk of default due to the substantial fixed costs in the business plan. The banker explains that the monthly rent ($13,333), other expenses ($38,000), and interest ($11,667), or $63,000, require the shoe store to generate a fairly large minimum level of sales to pay these expenses.

Required:

a. Calculate the amount of sales the Happy Feet store must do each month to break even. b. After calculating the break-even point in part (a), Dr. Zang still believes that her

Happy Feet store can be commercially successful and provide a valuable service to her patients. She goes back to the mall leasing agent and asks if the mall would take a lower fixed monthly rental amount and a larger percentage fee of her sales. The mall leasing agent (who happens to have sore feet and believes the Happy Feet store will drive new customers to his mall) says the mall would accept a rental fee of $1,000 per month plus 12.5 percent of her monthly sales. While Dr. Zang likes the idea of dropping her monthly rent from $13,333 to $1,000, she feels that raising the percentage of sales from 3 percent to 12.5 percent is a bit steep. But she goes back to the bank and presents the revised rental agreement. The banker says the bank would lower the annual interest rate from 10 percent to 9 percent if Dr. Zang accepts the new lease agreement. Both the original lease and the new lease are for three years and can be renegotiated at the end of the three years. Should Dr. Zang accept the new lease agreement ($1,000 per month plus 12.5 percent) or the original lease terms ($13,333 per month plus 3 percent)? Support your recommendation with both a written analysis and a quantitative analysis backing up your recommendation. (Hint: First, conduct an analysis comparing the two options, using the expected monthly sales of $150,000. Second, conduct an analysis comparing the two options, using the two extreme sales of $80,000 and $220,000.)

P 2–41: Digital Convert Digital Convert (DC) is a three-year-old startup company with most of its capital coming from banks and personal investments by the founders. DC manufactures a high-resolution scanner (MXP35). At the heart of the MXP35 is a photoelectric light sensor that converts light into digital pixels. DC currently produces the MXP35 for $480 (variable cost) per unit and incurs virtually no fixed manu- facturing costs. All of its equipment is leased, and the leases are structured whereby DC only pays for the actual units produced. DC operates out of a building that is provided free by New York State for entrepreneurial startups. New York State also pays utilities, taxes, insurance, and administrative costs. DC does have fixed financing costs to service its existing loans, and these financing costs consume most of its profits from sales of the MXP35.

DC faces the following monthly demand schedule for the MXP35 (where price is the wholesale price DC receives):

Quantity Price

19 $1,278  20 1,240 21 1,202 22 1,164 23 1,126 24 1,088 25 1,050 26 1,012

The equation of the demand curve for the preceding table is P = $2,000 – 38Q. In other words, if DC wants to sell 20 MXP35s per month, it would charge a wholesale price of $1,240 per unit.

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Required:

a. Given DC’s current cost structure of $480 variable cost and zero fixed costs, what is its profit-maximizing price–quantity combination for MXP35?

b. DC learns of a new manufacturing process for their photoelectric light sensor that lowers the variable cost from $480 per unit to $100 per unit. But the equipment must be leased for $7,000 per month for 24 months. If DC leases the new equipment, then over the next 24 months DC commits to paying $7,000 each month. If DC installs the new equipment, what is the price–quantity combination that maximizes profits? (Assume the quality and quantity of sensors produced by the existing and new technologies are identical.)

c. Before deciding to adopt the new photoelectric light sensor production technology, DC does some further research into its cost of financial distress. While the demand curve DC faces represents its normal demand, random monthly variation can cause demand to shift up or down unexpectedly. Given its existing bank loans, its variable costs of $480 per unit, no fixed manufacturing costs, and its small cash balances, DC faces a 15 percent chance of defaulting on its loans sometime over the next 24 months. If DC defaults on its loans, the owners of DC estimate the costs of default (legal costs, bank fees, lost sales, and so forth) to be $500,000. With the additional fixed leasing cost of the new sensor manufactur- ing technology, the owners of DC predict that the likelihood of defaulting on their fixed monthly commitments (bank loans and the $7,000 equipment lease) increases to 25 per- cent over the next 24 months. Prepare an analysis supporting your recommendation as to whether DC should adopt the new sensor manufacturing process or stay with their current manufacturing technology. (To simplify your analysis, assume a zero discount rate.)

P 2–42: APC Electronics APC is a contract manufacturer of printed circuit board assemblies that specializes in manufacturing and test engineering support of complex printed circuit boards for companies in the defense and med- ical instruments industries. The assembly process begins with raw printed circuit boards, into which preprogrammed robotic machines insert various integrated circuits and other components, and then these parts are soldered onto the board. The board is then tested before shipment to the customer.

Four separate assembly lines, each with roughly the same type of equipment, are used to assem- ble the circuit boards. Before running a particular board assembly, the insertion equipment must be loaded with the correct components, and the equipment programmed and tested before production begins. Setup time varies between three to six hours depending on the complexity of the board being assembled. Setup labor costs APC $40 per hour, and technicians assembling and testing the com- pleted boards cost $28 per hour. Not every assembly line can manufacture every type of board. Some lines have older insertion and testing equipment inappropriate for more complex assemblies. The assignment of boards to assembly lines depends on the number and complexity of the component insertions, the type of soldering to be applied, and the testing required.

Each assembly line has an hourly cost consisting of the accounting depreciation on the equip- ment (straight line) and occupancy costs (factory depreciation, taxes, insurance, and utilities). Occu- pancy costs are fixed with respect to volume changes. Direct labor to set up and test the line as well as the direct labor to manufacture the complete board assemblies and the testing of each board is tracked separately to each batch of boards. The following table summarizes the costs of operating each line and the annual number of hours each line is expected to run assembling boards (excluding setup and testing time).

Line I Line II Line III Line IV

Equipment depreciation $   840,000 $1,300,000 $480,000 $   950,000 Occupancy costs      213,000      261,000   189,000      237,000 Total annual line costs $1,053,000 $1,561,000 $669,000 $1,187,000 Expected hours of operations 1,800 2,200 1,600 2,000

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The equipment depreciation cost varies widely across the two lines because some of the lines (espe- cially Line III) have older machines, some of which are fully depreciated.

Required:

a. Calculate the hourly cost of operating each of the four lines. b. One of APC’s customers, Healthtronics, has requested a special order for one of its boards

APC currently builds. Healthtronics needs 150 boards by next week. These boards have to be run on Line I because that is the only one with the specialized soldering capability needed for these boards. Healthtronics will ship APC the raw boards and components to be inserted, so APC will not have to buy any of the parts. Setup time is expected to be four hours, and run time for these boards is expected to be 30 hours. Three technicians, each working 30 hours, are needed to staff Line I while the Healthtronics boards are being assembled and tested. Healthtronics splits the production of this particular board between APC and another contract manufacturer. So, if APC refuses this special offer, the customer will take the work to the other manufacturer. APC does not expect refusing this order to adversely affect Healthtronics’ demand for future APC work. If APC accepts the special order, the line will be set up next Monday during the day. The job will start Monday after- noon and be finished by Wednesday. Sixteen of the 30 hours of run time will be during an evening shift when the technicians are paid time and a half, or $42 an hour ($28 × 1.5). Calculate the cost APC will record as cost of goods sold when it ships the special order to Healthtronics.

c. Assume that accepting this special order from Healthtronics does not adversely affect the delivery schedules of any of APC’s other customers. What is APC’s out-of-pocket cash flow of accepting this Healthtronics special order?

d. Instead of assuming no other APC customers’ deliveries are affected by accepting the special order from Healthtronics as in part (c), assume that another APC customer, SonarTech, will be affected. SonarTech’s boards are currently running on Line I. They will have to be pulled from the line (two hours of tear-down time using setup technicians to unload the automatic parts feeders and return the parts to the storeroom), and Line I will have to be set up and tested as described in part (b). Healthtronics boards are run as in part (b). Then on Wednesday, six hours of setup time is needed to unload the remaining Healthtronics parts and reload and retest the SonarTech parts. To partially catch up on the SonarTech job, 14 hours of line run time that would have been done during the day is shifted to the evening, when the four technicians needed to run the SonarTech boards are paid time and a half ($42 per hour). Instead of shipping all the SonarTech boards in one shipment, two overnight shipments will be made—the first occurring when the first half is produced, and the second batch when the order is completed, costing an additional $2,300 of freight. SonarTech is willing to have its boards delayed a few days, as long as it can receive the boards in two overnight shipments. But SonarTech is unwilling to pay the additional freight. What is the opportunity cost of accepting the Healthtronics special order?

P 2–43: Amy’s Boards Amy Laura is opening a snowboard rental store. She rents snowboards for skiing on a weekly basis for $75 per week, including the boots. The skiing season is 20 weeks long. Laura can buy a snowboard and boots for $550, rent them for a season, and sell them for $250 at the end of the season.

The store rent is $7,200 per year. During the off-season, Laura sublets the store for $1,600. Salaries, advertising, and office expenses are $26,000 per year.

On average, 80 percent of the boards in any given week are rented. After each rental, the boards must be resurfaced and the boots deodorized. Labor (not included in the $26,000) and materials to prepare the board and boots to be re-rented cost $7.

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Required:

a. How many boards must Laura purchase in order to break even? b. Suppose that Laura purchases 50 boards. What profit does she expect? c. Laura purchases 50 boards. What fraction of her boards must she rent each week to break

even (including covering the cost of the boards)? d. Explain why the percentage utilization you calculated in part (c) differs from the expected

rental rate of 80 percent.

P 2–44: Blue Sage Mountain Blue Sage Mountain produces hinged snowboards. The price charged affects the quantity sold. The following equation captures the relation between price and quantity each month:

Selling price = $530 − .2 × Quantity sold

In other words, if they wish to sell 500 boards a month, the price must be $430 ($530 − .2 × 500). Fixed costs of producing the boards are $70,000 a month and the variable costs per board are $90.

Required:

a. Prepare a table with quantities between 100 and 2,000 boards in increments of 100 that cal- culates the price, total revenue, total costs, and profits for each quantity-price combination.

b. Determine the profit-maximizing quantity-price combination. c. Fixed costs fall from $70,000 a month to $50,000 a month. Should Blue Sage change its

pricing decision? d. Variable costs fall from $90 per unit to $50 per unit. Should Blue Sage change its pricing

decision?

Cases Case 2–1: Old Turkey Mash

Old Turkey Mash is a whiskey manufactured by distilling grains and corn and then aging the mixture for five years in 50-gallon oak barrels. Distilling requires about a week and aging takes place in care- fully controlled warehouses. Before it ages, the whiskey is too bitter to be consumed. Aging mellows the brew (and ultimately the consumer). The cost of the product prior to aging is $100 per barrel (direct plus indirect costs of distilling). In the aging process, each barrel must be inspected monthly and any leaks repaired. Every six months the barrels are rotated and sampled for quality. Costs of direct labor and materials in the aging process (excluding the cost of oak barrels) amount to $50 per barrel  per year (all variable). As the whiskey ages, evaporation and leakage cause each 50-gallon barrel to produce only 40 gallons of bottled whiskey. New oak barrels cost $75 each and cannot be reused. After aging, they are cut in half and sold for flowerpots. The revenues generated from sales of the pots just cover the costs of disposing of the used barrels. As soon as the whiskey is aged five years, it is bottled and sold to wholesalers.

While domestic consumption of whiskey is falling, an aggressive international marketing cam- paign has opened up new international markets. The firm is in the third year of a five-year campaign to double production. Because it takes five years to increase production (an additional barrel of mash produced today does not emerge from the aging process for five years), the firm is adding 100,000 gallons of distilled product each year. Prior to the expansion, 500,000 distilled gallons were produced each year. Distilled output is being increased 100,000 gallons a year for five years until it reaches 1 million gallons. Distilled output is currently 800,000 gallons and is projected to rise to 900,000 gallons next year. The accompanying table describes production, sales, and inventory in the aging process.

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Base Year Year 1 Year 2 Year 3

Production (distilled gallons) 500,000 600,000 700,000 800,000 Aged gallons sold 400,000 400,000 400,000 400,000 Warehouse Inventory at Beginning of Year 4-year-old bbls 10,000 10,000 10,000 10,000 3-year-old bbls 10,000 10,000 10,000 10,000 2-year-old bbls 10,000 10,000 10,000 12,000 1-year-old bbls 10,000 10,000 12,000 14,000 New bbls added 10,000 12,000 14,000 16,000 Total bbls to be aged in year 50,000 52,000 56,000 62,000 (bbls = barrels)

Warehousing rental costs to age the base-year production of 10,000 barrels per year are $1 mil- lion per year. Additional warehouse rental costs of $40,000 per year must be incurred to age each additional 2,000 barrels (100,000 distilled gallons). All costs incurred in warehousing are treated as handling or carrying costs and are written off when incurred. Bottled Old Turkey is sold to distributors for $15 per gallon. These income statements summarize the firm’s current operating performance:

Base Year Year 1 Year 2 Year 3

Revenues $6,000,000 $6,000,000 $6,000,000 $ 6,000,000 Less:    Cost of goods sold:       10,000 bbls @ $100/bbl 1,000,000 1,000,000 1,000,000 1,000,000    Oak barrels 750,000 900,000 1,050,000 1,200,000    Warehouse rental 1,000,000 1,040,000 1,120,000 1,240,000    Warehouse direct costs  2,500,000   2,600,000 2,800,000   3,100,000 Net income (loss) before taxes $ 750,000 $ 460,000 $ 30,000 $ (540,000) Income taxes (30%)     225,000      138,000         9,000     (162,000) Net income after taxes $  525,000 $   322,000 $    21,000 $  (378,000)

Management is quite concerned about the loss that is projected for the third year of the expan- sion (the current year). The president has scheduled a meeting with the local bank to review the firm’s current financial performance. This bank has been lending the firm the capital to finance the production expansion.

Required:

a. Instead of writing off all the warehousing and oak barrel costs, prepare revised income statements for years 1 through 3, treating the warehousing and barrel costs as product costs.

b. Which set of income statements (those given or the ones you prepared) should the presi- dent show the bank at the meeting? Justify your answer.

Case 2–2: Mowerson Division The Mowerson Division of Brown Instruments manufactures testing equipment for the automobile industry. Mowerson’s equipment is installed in several places along an automobile assembly line for component testing and is also used for recording and measurement purposes during track and road tests. Mowerson’s sales have grown steadily, and revenue will exceed $200 million for the first time in 2019.

Mowerson designs and manufactures its own printed circuit boards (PCBs) for use in the test equipment. The PCBs are manually assembled in the Assembly Department, which employs 45 tech- nicians. Because of a lack of plant capacity and a shortage of skilled labor, Mowerson is considering having the printed circuit boards manufactured by Tri-Star, a specialist in this field. Quality control restrictions and vendor requirements dictate that all PCBs be either manufactured by Mowerson or

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contracted to an outside vendor. The per-board cost of outside manufacture is higher than the in- house cost; however, management thinks that savings could also be realized from this change.

Jim Wright, a recently hired cost analyst, has been asked to prepare a financial analysis of the outside manufacturing proposal. Wright’s report includes the assumptions he used in his analysis, along with his recommendation. His financial analysis appears next, and his notes and assumptions follow the analysis.

Required:

a. Discuss whether Jim Wright should have analyzed only the costs and savings that Mowerson will realize in 2020.

b. For each of the 10 items listed in Wright’s financial analysis, indicate whether (i) The item is appropriate or inappropriate for inclusion in the report. If the item is

inappropriate, explain why it should not be included in the report. (ii) The amount is correct or incorrect. If the amount is incorrect, state what the correct

amount is. c. What additional information about Tri-Star would be helpful to Mowerson in evaluating its

manufacturing decision?

Annual Cost Savings Analysis for Tri-Star Contract

Savings 1. Reduction in assembly technicians         ($28,500 × 40) $1,140,000 2. Assembly supervisor transferred       35,000 3. Floor space savings         [(1,000 × $9.50) + (8,000 × $6.00)]      57,500 4. Purchasing clerk, 1/2 time on special project        6,000 5. Purchase order reduction         (2,000 orders @ $1.25 each)        2,500 6. Reduced freight expense        7,500      Total savings $1,248,500 Costs 7. Increased production cost         [($60.00 × 52.00) × 100,000 units] $ 800,000 8. Hire junior engineer      20,000 9. Hire quality control inspector      22,000 10. Increased storage cost for safety stock        (Expected value of 4,200 units @ $2.00/unit)       8,400       Total costs      850,400       Net annual savings $   398,100

Notes and Assumptions Personnel Assembly department technicians will be reduced by 40 at an annual savings (salary plus benefits) of $28,500 each. Five assemblers will remain to assist the field service department with repair work on the printed circuit boards; assemblers have always assisted in repair work. The supervisor of the assembly department will remain with Mowerson because he has only two years until retirement; a position will be created for him in the machining department, where he will serve as a special consultant.

Because of the elimination of purchasing and stocking of component parts required for PCB assembly, one purchasing clerk will be assigned half-time to a special project until his time can be more fully utilized.

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A junior engineer will be hired to act as liaison between Mowerson and the manufacturer of the PCBs. In addition, a third quality control inspector will be needed to monitor the vendor’s adherence to quality standards. Floor Space For the past two years, Mowerson has rented, on a month-to-month basis, 1,000 square feet of space for $9.50 per square foot in a neighboring building to accommodate the over- flow of assembly work. The 8,000 square feet currently being used in Mowerson’s main plant by the assembly department will be used for temporary stockroom storage. However, this space could be reclaimed for manufacturing use without overloading the stockroom facilities. This floor space is valued at $6 per square foot. Production Costs and Volume Mowerson’s cost for manufacturing printed circuit boards is as follows:

Direct material $24.00 Direct labor   12.50 Variable overhead     6.25 Fixed overhead     9.25 Total cost $52.00

The direct material cost includes normal scrap and other such material-related costs as incoming freight and issuing costs. Mowerson’s annual cost for incoming freight attributed to PCBs is $7,500. Tri-Star will charge $60 per board, including the cost of delivery.

Mowerson’s production volume of printed circuit boards for the past two years has been 80,000 and 90,000 boards, respectively. Projected production volumes for the next three years are:

2020 100,000 2021 120,000 2022 130,000

Storage Costs Because Mowerson will not have direct control over the manufacture of the PCBs, the level of safety stock will be increased over the current level of 1,800 boards. The supervisor of the assembly department has provided the accompanying probabilities associated with reductions in Tri-Star’s ability to produce and/or deliver PCBs.

Percentage of Time Tri-Star Deliveries

Will Be Late Probability

(1)

Safety Stock of PCBs

(2)

Expected Value

(1) × (2)

     4% 0.30 2,500    750   6 0.40 4,000 1,600   8 0.25 6,000 1,500 10 0.05 7,000    350

New safety stock level 4,200

The variable cost to store the PCBs is $2 per board per year. Other The variable cost of executing a purchase order at Mowerson is $1.25 for items such as postage, forms, and telephone. Since Mowerson will no longer have to purchase all the component parts required for the printed circuit boards, there will be a reduction of 2,000 purchase orders pre- pared annually. Recommendation Based on the annual savings of $398,100 projected above, Mowerson should enter into an agreement with Tri-Star to manufacture the printed circuit boards.

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Chapter Three

Opportunity Cost of Capital and Capital Budgeting

Chapter Outline A. Opportunity Cost of Capital B. Interest Rate Fundamentals

1. Future Values

2. Present Values

3. Present Value of a Cash Flow Stream

4. Perpetuities

5. Annuities

6. Multiple Cash Flows per Year

C. Capital Budgeting: The Basics 1. Decision to Acquire an MBA

2. Decision to Open a Day Spa

3. Essential Points about Capital Budgeting

D. Capital Budgeting: Some Complexities 1. Risk

2. Inflation

3. Taxes and Depreciation Tax Shields

E. Alternative Investment Criteria 1. Payback

2. Accounting Rate of Return

3. Internal Rate of Return

4. Methods Used in Practice

F. Summary

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Chapter 2 defined opportunity cost as the benefit forgone from a specific decision. Oppor- tunity cost is the analytic framework underlying all decision making. If undertaking a par- ticular action does not involve forgoing a better alternative, then the proposed action is optimum relative to the alternatives in the opportunity set.

The discussion in Chapter 2 focused on alternatives in the opportunity set that occurred in the same time period. In the job offer example, all of the offers were presumed to be in the same calendar period. In the raw materials examples, the alternative uses of the material were assumed to be immediate. However, there is no reason to presume that all alternatives to the present decision occur in the same time period. A recent college gradu- ate can defer accepting a current job offer and either continue to search for another year or return to school. The existing stock of raw materials can be used in current production or else stored and used next year. Decisions usually have a time element. At any point in time prior to accepting the pending decision, there is always the option of delaying the decision and continuing to search for better alternatives. An alternative to all decisions is “procras- tination”—wait for something better to emerge.

Many decisions explicitly involve a trade-off in cash receipts and expenditures over time. For example, the decision to invest in research and development (R&D) involves postponing current cash payments to investors in order to fund R&D in hopes of higher cash payments to investors in the future (when the R&D projects produce profitable new products). The decision to buy a government savings bond involves trading current con- sumption for future consumption. In fact, most decisions span several time periods and therefore involve cash flows over different time periods.

The decision to earn an MBA degree involves comparing cash flows over time. Instead of working and earning a salary, the MBA student pays tuition in anticipation of a higher-paying job in the future. Current income is sacrificed to make payments on books and tuition in order to invest in human capital and thereby earn higher wages in the future. The sacrifices occur in the first two years, while the benefits of higher wages and better jobs occur in the future. The decision to study for an MBA involves comparing the alterna- tives of getting a different advanced degree or no advanced degree at all. The opportunity cost of the MBA is what is forgone by not getting the degree. However, the cash flows from the various alternatives occur in different time periods.

Calculating the opportunity cost of alternatives that involve cash flows occurring at different points in time is complicated because a dollar today is not equivalent to a dollar tomorrow. Time is money! A dollar received today can be invested and earn interest and is therefore worth more than a dollar tomorrow.

This chapter describes how to derive the opportunity cost of alternatives for which cash receipts and disbursements occur at different points in time. Section A discusses the opportunity cost of capital. Section B then describes how to compare and aggregate cash flows that occur in different time periods. Section C illustrates the basic concepts in ana- lyzing capital investment projects. The analysis of investment alternatives involving cash flows received or paid over time is called capital budgeting. Section D discusses some complexities of capital budgeting. Alternative methods of evaluating capital investments are described and critiqued in section E. Finally, section F summarizes the chapter.

A. Opportunity Cost of Capital A fundamental law of finance is that a dollar today is worth more than a dollar tomorrow. Today’s dollar can be invested to start earning interest and will therefore grow to more than a dollar tomorrow. A $1,000 deposit in a bank account paying 5 percent interest will grow to $1,050 by the end of the year. A loan of $1,000 to a relative should be repaid with

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at least $50 in interest; otherwise, there has been an opportunity loss. Actually, the relative should pay more than $50 interest because the loan is probably riskier than depositing the money in a bank, where federal deposit insurance guarantees the bank account. For the moment, however, all investments are assumed to be riskless.

If all investments are riskless, then all investments must pay the same return. Other- wise, borrow money from banks with lower interest rates and invest in banks or projects with higher rates and pocket the difference. Everyone would see this profit opportunity and borrow from the lower-interest banks and invest the funds at the higher interest rates. Eventually, the lower interest rate would rise and the higher interest rate would fall, elimi- nating the profit opportunity. We also assume that there are no transactions costs in bor- rowing and lending. These assumptions give rise to the law of one price. Only one interest rate will prevail in a riskless and zero-transactions-cost world. (Later, we will relax these assumptions.)

Suppose it is possible to buy young bonsai trees for $1,000 today, hire someone to tend them for $145 a year (paid in advance), and sell them one year later for $1,200, with no risk. Is this a good investment? The accounting profit is $55 (or $1,200 − $1,000 − $145). But notice that the cash flows occur at different times. The tree purchases and maintenance cash flows occur at the beginning of the year and the sales occur at the end of the year. If the interest rate is 5 percent, the $1,000 initial investment is really costing $1,050 (or $1,000 + 0.05 × $1,000 = $1,000 × 1.05) in terms of the interest forgone by not investing this money in the bank. Similarly, the $145 is really costing $152.25 (or $145 × 1.05) in terms of end-of-year dollars. Table 3–1 calculates the economic, as opposed to accounting, profits on the bonsai business.

While the accounting statement on the bonsai business shows a profit of $55, the project shows an economic loss of $2.25. The reason for the difference is that accounting profits exclude the opportunity cost of money tied up in the project, whereas economic profits include these costs. The arrows in Table 3–1 represent the conversion of beginning- of-year cash flows into end-of-year cash flows. The conversion factor is 1 plus the interest rate, or 1.05 (principal plus interest).

Table 3–1 illustrates that end-of-year cash flows are worth less than beginning-of-year cash flows. Adding beginning-of-year cash flows to end-of-year cash flows without any conversion factors is like adding apples to oranges. If alternative decisions have cash flows that occur in different time periods, one must convert all the cash flows into equivalent cash flows as though they were all received or paid at the same time.

The costs of acquiring an MBA can be $150,000 or more once you factor in tuition, books, and two years of forgone salary. A large statistical study of people with the MBA degree identified four economic benefits of obtaining an MBA degree: a higher starting salary, greater compensation growth, more stable long-term employment, and a higher likelihood of participating in the workforce. After quantifying these factors, the study found that MBA graduates earn significantly more than those without it, and the difference is large enough to recover the cost of acquiring the MBA. In fact, the cash- in-hand value of the MBA (its net present value) is more than half a million dollars, which includes the opportunity cost of the forgone wages for two years while pursuing the degree. SOURCE: J. Byrne, “Can An MBA Add $1 Million to Your Income? A New Study Says So,” Poets & Quants, February 22, 2016, poetsandquants.com/2016/02/22/the-roi-on-an-mba-degree/.

Managerial Application: The Costs and Benefits of an MBA Degree

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Table 3–1 converted all the cash flows into equivalent dollars at the end of the first year. We could instead convert all the cash flows into beginning-of-period dollars, which is like asking how much one would be willing to pay today to receive a dollar in one year. How much must be invested today to get a dollar in one year? The following equation illustrates the relation between beginning- and end-of-year dollars:

Beginning-of-year dollars × (1 + Interest rate) = End-of-year dollars

Substituting, we know that

Beginning-of-year dollars × 1.05 = $1.00

Solving for the unknown variable,

Beginning-of-year dollars = 1 ____ 1.05 × $1.00 Beginning-of-year dollars = $0.9524

If $0.9524 is invested at 5 percent interest, in one year it will grow to $1. The $0.9524 is called the present value of that dollar. Now we can recompute Table 3–1 and, in Table 3–2, convert all the cash flows into beginning-of-year dollars instead of end-of-year dollars. The arrow in Table 3–2 represents the conversion of end-of-period cash flows into beginning-of-year cash flows.

The bonsai project still shows an economic loss. But now the economic loss is smaller, $2.14 versus $2.25. What accounts for the difference? Remember, $2.14 is in beginning- of-year dollars and $2.25 is in end-of-year dollars. However,

$2.14 × 1.05 = $2.25

The two figures are equivalent. They are like Celsius and Fahrenheit temperature; they both measure temperature but in different units.

Two points emerge from this illustration: (1) Cash flows occurring at different points of time must be converted to flows as if they all occurred at the same time, and (2) the answers are equivalent whether we are converting all cash flows to beginning-of-year or end-of-year dollars. However, it is easier to convert all cash flows into beginning-of-year cash flows. Suppose there are three alternatives. The first involves cash flows today, the second involves cash flows today and next year, and the third involves cash flows in the third year only. Which end-of-year should be used, the second or third year? It simplifies the analysis to convert all future cash flows to present dollars.

TABLE 3–1 The Profitability of Bonsai Tree Investment after Opportunity Cost Is Considered (End-of-Year Dollars)

Dollars in Begin- ning of Year

Conversion Factor

Dollars at End of Year

Revenues $1,200.00 Cost of trees $(1,000.00) × 1.05 (1,050.00) Maintenance (145.00) × 1.05 (152.25)

Total costs (1,145.00) × 1.05 (1,202.25) Economic loss $     (2.25)

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TABLE 3–2 The Profitability of Bonsai Tree Investment after Opportunity Cost Is Considered (Beginning of Year Dollars)

Dollars in Beginning of Year

Conversion Factor

Dollars at End of Year

Revenues $ 1,142.86 1 ____ 1.05 × $1,200Cost of trees (1,000.00) Maintenance (145.00) Total costs $(1,145.00)

Economic loss $       (2.14)

B. Interest Rate Fundamentals This section develops the relations for converting cash flows received or paid at differ- ent times. Describing the various equations clarifies the logic of the calculations and the underlying concepts. The basic equation relates beginning-of-year dollars to end-of-year dollars and is derived first.

We continue to assume that all cash flows are riskless and that there are no transactions costs. These two assumptions imply that only one interest rate exists whether people are borrowing or lending. We continue to assume an interest rate of 5 percent and an initial investment of $1,000. Now, however, the investment period is two years at 5 percent per year. How much will the investment be worth at the end of two years? At the end of the first year, it is worth $1,050 (or $1,000 principal plus $50 of interest). Reinvesting this amount yields $1,102.50 (or $1,050 principal plus interest of $52.50). Of the $52.50 of interest in the second year, $50 is interest on the original $1,000 and $2.50 is interest on the first-year interest ($50 × 5%). Or, at the end of the second year,

$1,000 + 2(0.05 × $1,000)

+

[0.05 × (0.05 × $1,000)]

= $1,000 + $100 + $2.50

= $1,102.50

The interest earned on the interest in the second year is called compounding. Compound interest describes the interest earned on the reinvested interest. To simplify the computations, Table 3–14 on page 122 contains compound interest factors. For example, the entry in Table 3–14 for two periods and 5 percent is 1.103. This 1.103 is the amount $1 will grow to in two years at 5 percent. One thousand dollars invested will grow to $1,103 (1.103 × $ 1,000).

1. Future Values

Q3–1 Why is a dollar today not worth the same as a dollar in the future?

Q3–2 How could there be an economic profit but not an accounting profit?

Concept Questions

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We will now generalize the preceding illustration. Let PV represent the amount of money invested today at r percent per year and let FV represent the amount that will be available at the end of the two years. The general formula relating present dollars to dollars in two years at r percent per year is

PV(1 + r ) 2 = PV(1 + 2r + r 2 ) = FV

The 2r term represents interest for two years on the original investment of PV, and r2 is the interest on the interest (compound interest).

Figure 3–1 illustrates how $1,000 invested at 5 percent interest will increase in value. At the end of the first year, it has grown to $1,050 as we saw earlier. At the end of the second year, the $1,000 has grown to $1,103 (actually $1,102.50). By the end of the tenth year, the $1,000 amounts to $1,629. Notice that the values in Figure 3–1 correspond to the compound interest factors contained in Table 3–14 under the 5 percent column. The general formula for leaving money in the bank for n years and allowing the interest to accumulate and earn interest is

PV(1 + r ) n = FV (Future value formula)

All of the formulas of interest rate mathematics are just algebraic manipulations of this basic equation. The next formula derived is used to calculate present values.

Suppose that instead of asking how much an investment will be worth at the end of n years, the question is how much money must be invested today at r percent per year to have FV tomorrow? For example, how much money must be invested today to be able to buy a $25,000 boat in six years? FV and r are known, but PV is unknown. This equation has three variables. For any two given variables, the equation can be solved for the third:

PV = FV ______ (1 + r ) n (Present value formula)

To solve for the boat example,

PV

=

$25,000 _________ (1 + 0.05 ) 6

= $25,000 _______ 1.3401

=

$18,655.38

2. Present Values

FIGURE 3–1

Future value of $10 invested at 5 percent

$1,800

1,600

1,400

1,200

1,000

800

600

400

200

0 0 1 2 3 4 109

Year 85 6 7

$1,000 $1,050 $1,103

$1,158

$1,551 $1,629

$1,407

$1,216 $1,276 $1,340

D ol

la rs

$1,477

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A deposit of $18,655.38 in the bank at 5 percent (allowing the principal and interest to compound) will grow to $25,000 at the end of six years. For the time being, we ignore the effects of taxes. Again, there is a table to help simplify the computation. Table 3–12 on page 120 contains the factor 0.746, which is what $1 received at the end of six years is worth today if the interest rate is 5 percent. Multiplying $25,000 by 0.746 yields $18,650, the same answer (except for rounding error).

So far, we have been dealing with just a single cash flow invested today or received in the future. Suppose there is a series of cash flows occurring at the end of each year for the next n years. That is, FV1 is the cash received at the end of the first year, FV2 is the cash received at the end of the second year, and FVn is the cash received at the end of the nth year. What is the present value of this cash flow stream? We can apply the preceding PV formula to each cash flow:

PV = FV 1 ______ (1 + r ) 1

+ F V 2 ______ (1 + r ) 2

+ FV 3 ______ (1 + r ) 3

+ · · · + FV n ______ (1 + r ) n

For example, suppose an investor will receive payments of $500 at the end of the first year, $1,000 at the end of the second year, and $1,500 at the end of the third year. How much is this stream of cash flows worth? Using the preceding formula,

PV

=

$500 _________ (1 + 0.05 ) 1

+ $1,000 _________ (1 + 0.05 ) 2

+ $1,500 _________ (1 + 0.05 ) 3

= $2,678.98

Therefore, receiving the three cash flows is the same as receiving $2,678.98 today if the interest rate is 5 percent.

The same answer can be found using Table 3–12. The first three numbers under the 5 percent column are 0.952, 0.907, and 0.864. These factors correspond to the numbers used in the preceding calculation of $2,678.98. The following illustrates how the factors in Table 3–12 can be used to compute the present value of the three cash flows just described:

3. Present Value of a Cash Flow Stream

Year Cash Flow ×

Table 3–12 Factor =

Discounted Cash Flow

1 $  500 0.952 $   476 2 1,000 0.907 907 3 1,500 0.864 1,296

Total $ 2,679

Each of the cash flows, FVt, is said to be discounted (or divided) by (1 + r)t where t is the year in which the cash flow is received. Notice that 1 ÷ (1 + r)t is always less than 1 for all positive interest rates. Therefore, a dollar received in the future is always worth less than a dollar today for positive interest rates. We will see that discounting is central to the concept of comparing alternatives involving cash flows received at different points of time. By discounting the future cash flows from each alternative to present values (or dollars today), we can compare which alternative is best.

The net present value (NPV) of a stream of cash flows represents the increment to the value of the firm from accepting the investment. For example, suppose the current value of a firm is $400 million. This is the current market value of all the firm’s outstanding debt and equity claims. If the firm makes an investment with a net present value of $17 million, then the value of all the outstanding debt and equity claims will rise to $417 million. The net present

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value of a cash flow stream is the change in the value of the firm from accepting the project. In perfectly competitive capital and product markets, the net present value of all investment proj- ects should be zero. Under perfect competition, firms cannot earn abnormal profits; all invest- ments return the market rate of interest. Therefore, investments can have a positive net present value only if the firm has some market power that allows it to charge prices that exceed long- run average cost; markets are not perfectly competitive. When analyzing investment projects with positive net present values, it is important to understand the source of the abnormal prof- its. (What factors are allowing the firm to earn a return more than its cost of capital?)

We next consider perpetuities, or infinite streams of equal payments received each year. Some government bonds issued by the British government promise to pay a fixed amount of cash each year forever. How much would investors be willing to pay for such bonds? All of the future payments, FV1, FV2, . . . , FVn are the same and equal to FV. Substituting FV into the general equation yields

PV = FV ______ (1 + r ) 1

+ FV ______ (1 + r ) 2

+ FV ______ (1 + r ) 3

+ · · ·

Fortunately, using a bit of algebra, this expression simplifies to

PV = FV ___ r (Perpetuity formula )

This is the basic formula for a perpetuity, or an infinite cash flow stream, when the inter- est rate is r percent. If a bond pays $100 per year in perpetuity and the interest rate is 5 percent, then investors would be willing to pay

PV = $100 _____ 0.05

= $2,000

The next basic formula that is useful in many applications is the present value of an annuity, a stream of equal cash flows for a fixed number of years. Many financial instru- ments are annuities. For example, car loans and mortgage payments involve a fixed num- ber of equal monthly payments. Corporate bonds pay a fixed amount twice a year over the term of the bond (usually 20 years). To derive the formula for an annuity, let FV again denote the annual cash flow received at the end of each of the next n years. The following diagram shows the timing of the n cash flows of each FV:

Year 0 1 2 3 . . . n n + 1 n + 2

Cash flow

0 FV FV FV . . . FV 0 0

The formula for this annuity stream is

FV ___ r [1 − 1 ______ (1 + r ) n ] (Present value of annuity formula )

To illustrate the application of the formula, suppose a prospective borrower can afford to pay $1,000 per year for 10 years. How large a loan can be taken out today at an interest rate of 5 percent? Using our annuity formula, we get

PV

=

$1,000 ______ 0 05 (1 −

1 ______ 1.05 10

) = $20,000 (0.386087)

=

$7,721.73

4. Perpetuities

5. Annuities

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Therefore, the bank will lend $7,721.73 today, with payments of $1,000 per year for 10 years. Instead of having to calculate a somewhat messy formula, let alone remember it, present value tables of annuity factors exist. Table 3–13 (on page 121) under the 5 percent column and 10 periods row contains the factor 7.722. This factor represents the present value of 10 annual cash flows discounted at 5 percent. If each annual cash flow is $1,000, then the present value of this cash flow stream is $7,722 (7.722 × $1,000). This is the same answer we got using the formula.

Another useful formula is the future value of an annuity. For example, how much will an investment of $1,000 a year for 18 years generate for a child’s college education? Start with the present value of an annuity and then convert this amount to a future value by tak- ing the present value formula for an annuity and multiplying it by (1 + r)n. Or,

FV ___ r [1 −

1 ______ (1 + r ) n ] (1 + r ) n

= FV [ (1 + r ) n − 1 ________ r ] (Future value of annuity formula )

To solve for how much money will be available for a child’s education, substitute into the preceding equation:

$1,000 [ ( 1.05 18 − 1 ) _________ 0 05 ] = $1,000 (28.13238)

=

$28,132.38

Therefore, if interest is left to accumulate in the bank, an investment of $1,000 a year for 18 years at an interest rate of 5 percent will grow to over $28,000. Table 3–15 on page 123 simplifies the computation of future values of annuities. For the preceding example, the factor in Table 3–15 for 5 percent and 18 years is 28.132. This represents the future value of a stream of 18 annual payments of $1, discounted at 5 percent. Since $1,000 is received each year, the future value of this annuity stream at 5 percent is $28,132, as we computed using the future value of annuity formula.

So far we have considered only cash flows that occur once per year. How do we handle cash flows that occur more frequently, say, monthly? We could add up the monthly flows and treat them as a single annual cash flow on the last day of the year. But this ignores the interest we could earn on the monthly receipts. To illustrate, consider the difference between the following two alternatives: (1) receiving 12 monthly $1,000 payments or (2) receiving a single $12,000 payment at the end of the year. Before we can calculate which option is worth more, we first have to understand the relation between monthly and annual interest rates.

An annual interest rate involves only a single compounding interval. A monthly interest rate involves 12 compounding intervals. If the annual interest rate is 6 percent, what is the interest rate per month? It might be tempting to say 0.06 ÷ 12 = 0.005, but this is wrong. To derive the monthly interest rate, recall the law of one interest rate. With no transactions costs and no risk, there can be only one interest rate in the mar- ket. The monthly and annual interest rates must be such that no one can earn more by investing at the monthly interest rate than the annual interest rate. A dollar invested at the monthly interest rate, rm, must accumulate to the same amount at the end of the year as a dollar invested at the annual interest rate, r. The opportunity cost of invest- ing at the monthly interest rate must be the same as the opportunity cost of investing at the annual interest rate or else a profit opportunity exists. Therefore, the following equation must hold:

6. Multiple Cash Flows per Year

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(1 + r m ) 12

=

( 1 + r )

(1 + r m )

=

(1 + r ) 1/12

r m = (1 + r) 1/12 − 1

=

1. 06 1/12 − 1

=

0.004868

Now we can return to the original question and value the two alternatives. The monthly interest rate just derived is 0.004868, and the annual interest rate is 6 percent. Using the present value of the annuity formula to calculate the stream of 12 monthly $1,000 payments,

FV ___ r [1 − 1 ______ (1 + r ) n ]

=

$1,000 ________ 0.004868 (1 − 1 __________

1.004868 12 )

= $205,423(0.056609)

=

$11,628.79

The present value of the single $12,000 payment is

FV ______ (1 + r) n = $12,000 _______

1.06 1 = $11,320.75

Therefore, the 12 payments of $1,000 received at the end of each month are worth $308.04 more today than a single $12,000 payment received at the end of the year. The 12 monthly $1,000 payments are worth more than a single $12,000 payment at the end of the year because the monthly payments can earn interest during the year.

The preceding example illustrates that the earlier a payment is received, the more valuable is the payment. It also introduces the notion of the compounding interval. The key point is that the annual interest rate cannot be used to discount cash flows received more frequently than yearly. Some banks quote interest rates in annual terms—say, 5 percent— but then compound the interest monthly. In this case, the effective annual interest is

(1 +

r ___ 12 ) − 1 =

(1 +

0.05 ____ 12 ) 12

− 1 = 1. 0041666667 12 − 1

=

0.05116

Therefore, if the bank has a stated annual interest rate of 5 percent but compounds monthly, the effective annual interest rate is 5.116 percent. If the bank’s interest rate is 5 percent but it compounds interest daily, the effective annual rate is 5.127 percent.1 Depositors wanting the highest effective interest rate will always choose the bank with the most frequent com- pounding interval, if the banks are all offering the same annual interest rate.

Besides using Tables 3–12 through 3–15 at the end of this chapter to simplify the computations, computer spreadsheet programs compute present values and future val- ues. For example, Table 3–3 calculates the present value of the following cash flows (at r = 5%): $2,000 for the first 10 years, $1,000 for the next 10 years, and $3,000 at the end of year 21.

Note how the calculations were simplified. In particular, the $2,000 stream for years 1 through 10 and the $1,000 stream for years 11 through 20 are equivalent to a $1,000

1 0.05127 = (1 + 0.05 _ 365 )

365 − 1

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C. Capital Budgeting: The Basics Section A presented the concept of the opportunity cost of capital (a dollar today is not the same as a dollar tomorrow). Section B described how to convert dollars in different time periods into equivalent dollars. This section applies these concepts to capital budgeting.

Suppose Sue Koerner is considering returning to school to get an MBA degree. Her cur- rent wages are $50,000. Tuition, books, and fees cost $35,000 per year for two years. After earning her MBA, Sue’s starting salary will be $100,000. Therefore, the MBA degree adds $50,000 per year to her salary. However, Sue must give up two years of current salary dur- ing graduate school plus pay tuition, books, and fees. At a current age of 31 and with an expected retirement age of 60, should Sue pursue the MBA? The market rate of interest is 5 percent. To illustrate the basic concepts, this example focuses on just the monetary aspects of the MBA and ignores the additional utility Sue receives from the prestige of earning an advanced degree. Table 3–4 calculates the net present value of the MBA—the difference between the present value of the cash inflows and outflows.

In Table 3–4, the additional wages of $50,000 are treated as an annuity beginning in year 1, and then a two-year annuity of $50,000 beginning in year 1 is subtracted. This is the simplest way to perform the calculation. The computations in Table 3–4 assume that all cash flows occur at the end of the year. To keep the example simple, the additional wages from having the MBA degree are assumed to be constant at $50,000 per year over Sue’s career. Given these assumptions, the decision to get an MBA is worth $517,635 in today’s dollars. That is, the present value of the additional wages from receiving the MBA is greater than the amount forgone (two years’ wages plus schooling costs) to acquire the degree by over half a million dollars.

1. Decision to Acquire an MBA

stream for the first 20 years and a $1,000 stream for the first 10 years. The discount fac- tors for these two streams are taken from the annuity table (Table 3–13 on page 121). The single $3,000 payment in year 21 is discounted using the present value factor (Table 3–12 on page 120). Adding the three discounted cash flows together yields a present value of $21,261. As always, $21,261 represents the opportunity cost or the value of the cash flows when they are certain and the market rate of interest is 5 percent.

Cash Flow

Discount Factor

Source of Factor

Present Value

Years 1–20 $1,000 12.462 Table 3–13 $12,462 Years 1–10 1,000 7.722 Table 3–13 7,722 Year 21 3,000 0.359 Table 3–12 1,077

Total present value $21,261

TABLE 3–3 Example Using Compound Interest Tables (Interest Rate = 5%)

Q3–3 Define the present value of a future amount. Q3–4 Define the future value of a present amount. Q3–5 Define compound interest. Q3–6 How do perpetuities differ from annuities?

Concept Questions

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The MBA degree example illustrates how to compare alternatives that have cash flows occurring at different points of time. The next example considers a slightly more complicated investment decision.

Suppose Paul Woolf is considering opening a day spa providing massage therapy and skin care treatments. The initial investment for skin care products sold in the spa, lease improvements, supplies, and equipment is $500,000. Suppose the spa will be operated for four years and then sold at the end of the fourth year for $200,000 cash. Table 3–5 shows the projections of the spa’s annual operating profitability.

In this day spa business, all the sales are for cash. Hence, all sales represent cash inflows. Depreciation amounts in Table 3–5 are based on accelerated depreciation tables allowed by the federal government in calculating taxable income. The after-tax profit in Table 3–5 is not the same as the net cash flow stream from the day spa. The difference is the accounting accrual process of depreciation. The $500,000 initial investment is not writ- ten off in the first year but rather is capitalized and expensed via the accounting accrual of depreciation. In order to calculate the net present value of this investment, we must convert the accounting profit numbers in Table 3–5 into cash flows. Table 3–6 presents the result- ing cash flows and the net present value.

The net present value of the day spa is $293,102. The net cash flows in each year (line 7) are composed of the cash flows from operations (line 4), the initial investment

2. Decision to Open a Day Spa

TABLE 3–4 The Decision to Get an MBA Degree

Net Cash Flow

Discount Factor

Present Value

Years 1–2 Forgone wages + Cost of school $(85,000) 1.859 $(158,015)

Years 1–30 Additional wages with MBA 50,000 15.372 768,600

Years 1–2 Higher MBA wages not earned in first two years* (50,000) 1.859 (92,950)

Total present value $ 517,635

*The present value of $30,000 for two years is being deducted in this line because the line above includes the first two years. However, the higher salaries do not begin until year 3.

TABLE 3–5 Day Spa Projected Profits, Years 1–4

Year 1 Year 2 Year 3 Year 4

1. Sales (cash inflows) $300,000 $450,000 $500,000 $500,000 2. Operating costs (cash outflows) 180,000 200,000 220,000 220,000 3. Depreciation 71,450 122,450 87,450 62,450

4. Pretax profit (1 − 2 − 3) $ 48,550 $127,550 $192,550 $217,550

5. Tax at 34% 16,507 43,367 65,467 73,967

6. Net income after tax (4 − 5) $ 32,043 $ 84,183 $127,083 $143,583

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(line 5), and the cash flows from disposal (line 6). Cash flows from operations (line 4) are sales (line 1) less operating expenses (line 2) less taxes (line 3). At the end of the fourth year, the spa is sold for $200,000. Under U.S. tax regulations, disposal values are ignored in calculating depreciation, and any gain on disposal is taxed as ordinary income when received. Thus, cash flow from disposal (line 6) is the disposal value less the 34 percent tax on the gain when the gain is the salvage value less book value. All of the initial cash out- flow of $500,000 is assumed to occur immediately and therefore is discounted with a value of 1.000. The cash flows in years 1 through 4 are assumed to occur at the end of each year.

Instead of calculating the annual net cash flows as the sum of the component cash flows, as in Table 3–6, just add depreciation back to net income and subtract out new investments. Table 3–7 presents these calculations, which yield identical cash flows to those in Table 3–6.2

Discount cash flows, not accounting earnings The important lesson in Table 3–6 is to discount cash flows, not accounting earnings. The rea- son for focusing on cash flows is that accounting earnings contain accounting accruals. The accounting process by its very nature keeps certain cash flows out of earnings. Investments

2In general, adding back to net income all non-cash flow expenses, such as depreciation, and subtracting from net income all non-cash flow revenues, such as accrued bond interest income, yields cash flow from operations.

3. Essential Points about Capital Budgeting

TABLE 3–6 Day Spa Net Present Value, Years 1–4

Initial Investment Year 1 Year 2 Year 3 Year 4

1. Sales (cash inflows) $300,000 $450,000 $500,000 $500,000 2. Operating costs (cash outflows) 180,000 200,000 220,000 220,000 3. Tax at 34% (cash outflows) 16,507 43,367 65,467 73,967 4. Cash flow from operations

(1 − 2 − 3) 103,493 206,633 214,533 206,033 5. Cash flow from investment $(500,000) 6. Cash flow from disposal 185,108* 7. Net cash flow (4 + 5 + 6) $(500,000) $103,493 $206,633 $214,533 $391,141 8. Discount rate 1÷ 1.05n 1.000 0.952 0.907 0.864 0.823 9. Present value at 5% $(500,000) $ 98,565 $187,422 $185,322 $321,793

10. Net present value $293,102

* Cash flow from disposal = $200,000 less tax on excess of $200,000 over depreciated book value = $200,000 − 0.34($200,000 − $156,200) = $185,108

TABLE 3–7 Calculating Day Spa Annual Cash Flows Starting with Net Income, Years 1–4

Initial Investment Year 1 Year 2 Year 3 Year 4

1. Net income after tax (Table 3–5) $ 32,043 $ 84,183 $127,083 $143,583 2. Depreciation (3–5) 71,450 122,450 87,450 62,450 3. Cash flow from investment $(500,000) 4. Cash flow from disposal 0 0 0 185,108 5. Net cash flow (1 + 2 + 3 + 4) $(500,000) $103,493 $206,633 $214,533 $391,141

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are capitalized and then depreciated. Earnings do not contain amounts spent until the eco- nomic benefits of the investments are received. Likewise, sales are usually recorded when the legal liability arises, not when the cash is collected. Therefore, dollars earned, as computed by accounting earnings, do not reflect the dollars actually received. Table 3–7 illustrates that accounting income differs from cash flows due to the timing of depreciation and investment.

The reason we discount cash flows and not accounting earnings is because cash flows can be invested in the bank to generate interest. Accounting earnings, however, cannot be used to open a bank account. You cannot go to the store and buy soda and pretzels with accounting earnings.

Include working capital requirements The day spa example is simple and does not include cash needed for working capital. Work- ing capital consists of current assets (cash, marketable securities, accounts receivable, inven- tory) less current liabilities (accounts payable, notes payable, and current portion of long-term debt). Many businesses carry significant accounts receivable and inventories. Such invento- ries represent cash tied up that could be earning interest if invested. Therefore, cash invested in such inventories should be included in the analysis. Likewise, many businesses allow cus- tomers to make purchases on credit. In these cases, additional cash must be invested to finance these accounts receivable. On the other hand, to the extent that the firm acquires goods and services on credit, the accounts payable offset the cash needed to finance current assets.

Include opportunity costs but not sunk costs In the MBA example, the opportunity cost of getting the MBA includes the current wages forgone by attending graduate school. They are included in the analysis and discounted as cash flows forgone. However, sunk costs are ignored. For example, the costs of acquiring the under- graduate degree (wages forgone, undergraduate tuition, and housing) necessary for admission into an MBA program are not included. The expenses incurred to receive the undergraduate degree are sunk costs because they were incurred prior to the decision to attend graduate school.

Exclude financing costs Do not include the interest charges on the debt used to finance the project. The costs of financing the project are implicitly included when future cash flows are discounted. If the project has a positive net present value, then its cash flows yield a return in excess of the firm’s cost of capital, which more than compensates the firm for the financing costs.

The discounted cash flow analyses of both the MBA and day spa examples exclude all mention of how either of these projects would be financed. Were savings or student loans used to finance the MBA degree? Was the investment in the day spa financed by a bank loan or by bringing in a partner who contributed cash? These considerations are excluded because the discount rate incorporates the cost of financing the project. Under the assump- tion of complete certainty and perfect capital markets, there can be only one interest rate in the market. Therefore, the firm can borrow all the necessary funds at this interest rate, and the financing of the project is irrelevant.

D. Capital Budgeting: Some Complexities The preceding section presented two simplified capital budgeting examples: the MBA decision and the day spa decision. These examples illustrate the basic mechanics of discounted cash flow (DCF) analysis. This section adds more complexities: risk, inflation, and depreciation tax shields.

One of our assumptions has been that all cash flows are riskless. This assumption, when coupled with the zero-transactions-costs assumption, led to the result that there would be only one interest rate prevailing in the market and that all future cash flows would be

1. Risk

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discounted at this riskless interest rate. But few cash flow streams are riskless, so we must have a way to deal with risky cash flows.

Once we allow the possibility of risk, then the law of one interest rate no longer holds. Instead, we have the law of one interest rate for each risk class. Investments that have dif- ferent risk will have different interest rates. In order to induce investments in higher-risk projects, a higher expected return is required. This is another law of finance: A safe dollar is more valuable than a risky dollar. Risky projects are discounted at a higher interest rate than safe projects.

What we mean by risk, how it is measured, and how to choose risk-adjusted discount factors are the subject of corporate finance. We will not concern ourselves with deriving risk-adjusted discount rates. For any given risky cash flow stream, we assume that an equivalent risk-adjusted interest rate exists.

Recall Paul Woolf’s investment in a day spa. One of Paul’s alternatives is to invest at 5 percent in U.S. Treasury bonds, which are very unlikely to default. If the day spa cash flows are risky, then 5 percent is not the opportunity cost of investing in the day spa. Since a risky dollar is less valuable than a safe dollar, Paul must discount the day spa cash flows using an interest rate from an investment with a comparable degree of risk. Suppose that the equity of a national chain of day spas returns 13 percent per year, and the stock in this company is comparable in risk to Paul’s day spa. Then 13 percent is the relevant, risk- adjusted interest rate to use in discounting the day spa cash flows.3

Let ri be the risk-adjusted discount rate for the ith investment project and let rf be the risk-free rate of interest on government bonds. The following equation describes the rela- tion between the risk-adjusted rate, the riskless rate of interest, and the risk premium:

r i = r f + Risk premium i

This equation states that the required rate of return on an investment in risk class i is com- posed of two pieces. The first piece is the return that must be paid for investing in a riskless asset, rf, and the second piece is a risk premium associated with risk class i. Thus, the first adjustment we must make when valuing risky cash flows is to choose a higher discount rate that corresponds to the risk inherent in the project’s cash flows.

The second adjustment is to discount the expected cash flows. Since the cash flows are uncertain, one of several possible cash flows can result. Instead of discounting the highest or lowest cash flow that can occur, we discount the expected or average anticipated cash flow. For example, if the cash flows next year can be either $100 or $200 with equal probability, we would discount the expected cash flow of $150. The general formula for discounting risky cash flows is

PV = ∑ t=0

n

E( ̃ C F t ) ______ (1 + r i ) t

̃ C F t is the risky cash flow in year t and E( ̃ C F t ) is the expected value of the uncertain cash flow. This formula says to discount expected cash flows using a risk-adjusted dis- count rate, ri, appropriate for the risk inherent in the project. For example, if cash flows for the next five years will be either $100 or $200 per year with equal probability, the expected cash flows are $150. Suppose the discount rate for equivalent risky investments is 30  percent. Using Table 3–13 on page 121, the present value of this risky five-year annu- ity is $365.40 (or $150 × 2.436).

3Note that the expected return on the stock of the day spa chain has comparable risk to the day spa only if the chain has no debt. If the chain has debt, then the expected return on the stock is higher than the firm’s cost of capital.

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So far, we have ignored the effects of inflation. In fact, we have implicitly assumed there was no inflation. In the MBA example, the difference of $50,000 between Sue Koerner’s current salary ($50,000) and her salary with the MBA ($100,000) was assumed to remain constant over time. However, even a small inflation rate of 3 percent per year can cause cash flows in 20 years to be very different from what they would be without inflation. At 3 percent inflation per year, a dollar will grow to about $1.81 in 20 years. Therefore, one should not ignore inflation in a DCF analysis.

Absent any inflation, people prefer a dollar today instead of a dollar tomorrow. In such an inflation-free world, the interest rate is the compensation paid to postpone con- sumption. Let rreal denote the real interest rate, or the rate of interest that would occur if there were no inflation. The real interest rate consists of the risk-free rate of return plus a risk premium. It is the market price that equates the supply and demand for capital for a given amount of risk.

If inflation is f percent per year, and $1 of consumption is delayed for one year, it will take $(1 + f) at the end of the year to buy the same $1 bundle of goods as could have been purchased at the beginning of the year. If inflation is 7 percent per year, buying the same $1 bundle costs $1.07 at the end of the year. To compensate for delaying consumption for one year when inflation is running at i percent, the nominal interest rate is

1 + r nominal = (1 + r real )(1 + f )

The nominal interest rate is the interest rate observed in the market. It includes both the real component, rreal, and expected inflation. If the real interest rate is 3 percent and expected inflation is 7 percent, then the nominal interest rate is (1.03)(1.07) − 1 = 0.1021 = 10.21%. A loan from a bank is repaid in future dollars whose purchasing power will be eroded by inflation. When lending money, the bank will impound the expected rate of inflation into the interest rate.

If discount rates are stated in nominal interest rates, then the cash flows being dis- counted should be stated in nominal terms. That is, they should be adjusted for inflation as well. If nominal interest rates are used in the denominator of the present value equation and the cash flows in the numerator are not adjusted, then inconsistent results are produced. To illustrate how to adjust cash flows for inflation, return to the day spa example in Tables 3–5 and 3–6. There was no explicit statement about whether the cash flows in Table 3–6 were in real or nominal terms. Suppose the cash flows are real, meaning they do not account for inflation. Table 3–8 makes the following inflation assumptions: Price inflation for sales and disposal value will be 2 percent per year, and price inflation on operating costs will be 3 percent per year. First, restate the cash flows into nominal dollars. Then discount these dollars using the nominal interest rate. Assume the nominal interest rate is 9 percent.

Sales (line 1) are restated at an inflation rate of 2 percent per year and operating costs (line 4) are restated at 3 percent per year. This produces inflation-adjusted sales (line 3) and inflation-adjusted operating costs (line 6). Depreciation is not adjusted because the tax laws do not allow historical cost depreciation to be adjusted for inflation. Nominal cash flows from operations are nominal sales less nominal operating costs less taxes. The remainder of Table 3–8 follows directly from Table 3–6, except the discount rate is 9 percent. The only other difference is that the disposal value of $200,000 is increased by a 2 percent inflation factor. After adjustment for inflation, the net present value of the day spa is $234,585, compared with a net present value of $293,102 before. The net pres- ent value is lower because the future cash inflows, while increased by inflation, are being discounted at an even higher discount rate (9 percent versus the 5 percent in Table 3–6).

The important point to remember from this section is to discount nominal (inflation- adjusted) cash flows using nominal interest rates.

2. Inflation

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Taxes are a very significant cash flow item in most discounted cash flow analyses. A cor- porate income tax rate of 34 percent implies that about a third of any project’s profitability is taxed away. Therefore, taxes and how to minimize them become a very important ele- ment in capital budgets.

Accounting depreciation reduces taxes. The intuition is really quite simple. Sup- pose a company car costs $50,000 and taxable income will exceed $50,000 into the foreseeable future. For tax purposes, it would be highly preferable to reduce tax- able income by expensing the entire $50,000 purchase price against this year’s taxable income. However, tax laws prohibit this and require that the car be depreciated over its useful life—say, five years. The car has already been purchased, so the $50,000 is gone. The question becomes how quickly the cost of the car can be written off against taxable income. As long as the firm has taxable income, then accounting depreciation shields some portion of that income from taxes. And it is preferable to shield a dollar of taxable income today rather than tomorrow because a dollar saved today is worth more than a dollar saved tomorrow. Hence, a depreciation schedule for the car for the next five years of $20,000, $12,000, $7,200, $4,320, and $6,480 is preferable to a deprecia- tion schedule of $10,000 per year for five years. Both schedules depreciate a total of $50,000, but the first recognizes the depreciation sooner, thereby reducing the present value of taxes paid.

Most firms use different depreciation methods for external reports to shareholders than for the Internal Revenue Service (IRS). The IRS allows firms to elect straight-line depreciation for shareholder reports and accelerated depreciation for tax returns. There are other accounting methods that can cause tax expenses reported to shareholders to differ

3. Taxes and Depreciation Tax Shields

TABLE 3–8 Day Spa Net Present Value, Years 1–4 (Cash Flows Adjusted for Inflation)

Initial Investment Year 1 Year 2 Year 3 Year 4

  1. Sales (real) $300,000 $450,000 $500,000 $500,000   2. Inflation factor (1.02)n 1.020 1.040 1.061 1.082   3. Sales (nominal) (1 × 2) $306,000 $468,180 $530,604 $541,216   4. Operating costs (real) 180,000 200,000 220,000 220,000   5. Inflation factor (1.03)n 1.030 1.061 1.093 1.126   6. Operating costs (nominal) (4 × 5) $185,400 $212,180 $240,400 $247,612   7. Depreciation 71,450 122,450 87,450 62,450   8. Pretax profit (3 − 6 − 7) $ 49,150 $133,550 $202,754 $231,154   9. Tax at 34% (8 × 0.34) 16,711 45,407 68,936 78,592 10. Cash flow from operations

(3 − 6 − 9) $103,889 $210,593 $221,268 $215,012 11. Cash flow from investment $(500,000) 12. Cash flow from disposal 195,989* 13. Net cash flow (10 + 11 + 12) $(500,000) $103,889 $210,593 $221,268 $411,001 14. Discount rate 1 ÷ (1.09)n 1.000 0.917 0.842 0.772 0.708 15. Present value at 9% $(500,000) $ 95,311 $177,252 $170,859 $291,163 16. Net present value $234,585

* Cash flow from disposal = Nominal sales price less tax on excess of nominal sales price over depreciated book value = $200,000(1.02)4 − 0.34[$200,000(1.02)4 − 156,200] = $195,989

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from the firm’s actual tax bill. For example, the expected costs of product warranties are included in financial reports to shareholders when the product is sold. However, the cost of the warranty work is included for tax purposes only when actually incurred. When cal- culating a project’s net present value, it is important to use the tax accounting rules rather than the accounting rules for shareholders. Taxes are a cash flow, and the accounting rules used to compute taxes affect the tax cash flows. The accounting methods used only for shareholder reports, however, do not affect tax cash flows.

As illustrated in the day spa example, the treatment of accounting depreciation requires care. The following points should be noted:

• Depreciation is not a cash flow. • Net income after deducting depreciation is not a cash flow. • Depreciation is a tax-allowed expense. • Depreciation affects taxes and therefore has an indirect effect on cash flows via taxes. • When considering the cash flow effect of depreciation, use the depreciation method

allowed for tax purposes.

Some simple algebra illustrates the indirect cash flow effect of depreciation. Let

τ = Tax rate R = Revenue E = All cash expenses (except depreciation) D = Depreciation allowed for tax purposes

Using this notation, we can write down the following familiar formulas:

Net income = NI = (R − E − D)(1 − τ) Taxes = TAX = (R − E − D)τ

Cash flow = CF = R − E − TAX = R − E − (R − E − D)τ = (R − E)(1 − τ) + Dτ

Notice the last term in the last cash flow equation, Dτ. This is the annual depreciation charge, D, times the tax rate, τ. The product of the two is added to the annual after-tax operating net cash flow, (R − E) (1 − τ), to arrive at the after-tax net cash flow, as long as the firm has taxable income. From the last formula, we can clearly see that the larger the depreciation expense, the higher the firm’s cash flow because the tax liability is lower. In this sense, depreciation is said to be a tax shield because it results in lower taxes and thus higher after-tax cash flow. The total amount of depreciation that can be deducted from taxes is limited to the original cost of the asset. Therefore, the sooner the depreciation is taken (assuming the firm has positive taxable income), the higher is the present value of the depreciation tax shield. Accelerated tax depreciation methods that allow earlier recog- nition of depreciation increase a project’s net present value.

To illustrate the importance of early recognition of depreciation, consider the fol- lowing example that captures the flavor of the tax code but avoids many of the technical complexities. An asset is purchased for $500,000. The asset has a five-year life and no salvage value. The tax rate is 34 percent. Table 3–9 lays out the calculation of the pres- ent value of the tax shields under the straight-line and double-declining-balance depre- ciation methods.

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E. Alternative Investment Criteria So far we have presented discounted cash flow (DCF) analysis, also called net present value (NPV) analysis, as the correct way to compare alternatives involving cash flows occurring at different points in time. Cash flows received or paid in different years cannot simply be added together, because a dollar today is worth more than a dollar tomorrow. Therefore, a future dollar must be discounted before it can be added to today’s dollars. However, DCF analysis is not the only way to evaluate investment projects. Some firms use payback, accounting rates of return, or internal rates of return. These methods are first described and then critically evaluated. The last section presents survey data on how fre- quently they are used in practice.

A much simpler method of evaluating projects is the payback method. Payback is the number of years or months it takes to return the initial investment. Suppose a project’s ini- tial investment is $700,000 and subsequent yearly cash inflows are $200,000 for five years.

1. Payback

Double-declining-balance depreciation writes off the $500,000 original cost faster than straight-line depreciation. Therefore, its tax shield has a higher present value by $5,061. Using double-declining-balance depreciation instead of straight-line depreciation for tax purposes (assuming the tax regulations allow this), increases the net present value of the project by $5,061. This represents about 1 percent of the asset’s cost.

TABLE 3–9 Net Present Value of Depreciation Tax Shields*

Straight-Line Depreciation Double-Declining-Balance Depreciation

Year Deprec. Expense

Tax Shield (Dτ)

PV of Tax Shield

DDB Rate†

Book Value at Beg. of Year

Deprec. Expense

Tax Shield (Dτ)

PV of Tax Shield

1 $100,000 $34,000 $ 32,381 0.4 $500,000 $200,000 $68,000 $ 64,762 2 100,000 34,000 30,839 0.4 300,000 120,000 40,800 37,007 3 100,000 34,000 29,370 0.4 180,000 72,000 24,480 21,147 4 100,000 34,000 27,972 0.4 108,000 43,200 14,688 12,084 5 100,000 34,000 26,640 64,800 64,800 22,032 17,213

$500,000 $147,202 $500,000 $152,263

*$500,000 asset, no salvage, five-year life, 34% tax rate, 5% interest. †DDB rate (double-declining-balance rate) is twice the straight-line rate; or, 40% = 2 × 1 __ 5 .

Q3–7 Define net present value. Q3–8 Explain why the interest rate on a one-year bank account

paying interest monthly is not just one-twelfth the interest rate on a one-year bank account paying interest annually.

Q3–9 What does it mean to say depreciation is a tax shield when evaluating capital projects?

Q3–10 What are the components of the real interest rate? Q3–11 What are the components of the nominal interest rate?

Concept Questions

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This project has a payback of three and one-half years ($700,000 ÷ $200,000). In three and one-half years, the cash inflows just equal the initial investment of $700,000. Payback is easy to compute and understand. No assumptions are required about the appropriate oppor- tunity cost of capital for the particular project.

However, payback ignores the time value of money. Two projects are viewed as equally attractive if they have the same payback, even though all of the payback may occur in the payback year for one project but be spread out evenly over time for the other. For example, suppose two projects each require $300,000 investments but one pays $100,000 for three years and the other pays nothing for two years and $300,000 in the third year. Each has a three-year payback, but the first is more valuable because the $100,000 pay- ments in years 1 and 2 can be earning interest.

Payback also ignores the cash flows beyond the payback period. Thus, payback ignores the “profitability” of the project. Two projects with the same investments and same cash flows per year up to the payback year have the same payback. But if one investment has no cash flows beyond the payback year and the other investment does, clearly the latter investment has a higher net present value.

Finally, payback lacks a benchmark for deciding which projects to accept and which to reject. What payback cutoff should the firm use as a criterion for project selection? Is a three-year payback good or bad? In contrast, if a project has a positive NPV using the opportunity cost of capital, the project is accepted. The benchmark in DCF analysis is the existence of a positive NPV. No such benchmark exists for payback.

Advocates of payback argue that net present value, even after future cash flows are discounted, places too much emphasis on cash flows received in the future. Some manag- ers believe that it is very difficult to forecast cash flows accurately beyond three or four years. Thus, they place very little weight on these cash flows. However, net present value mathematics automatically incorporates the higher uncertainty of the more distant cash flows. These inherently riskier future cash flows are discounted by larger discount factors. The cash flow in year t is discounted by 1/(1 + r)t where r is the appropriate risk-adjusted discount rate. As t increases, the discount rate becomes smaller. The exclusive use of pay- back to evaluate investment projects tends to cause a firm to focus on short-term cash flows and ignore long-term rewards.

Another method for project evaluation is the accounting rate of return. A project’s account- ing rate of return, also called return on investment (ROI), is

ROI = Average annual income from project __________________________________ Average annual investment in the project

Consider the following investment of $10 million in a project that has a five-year life and no salvage value. The project’s income in each of the next five years is

2. Accounting Rate of Return

Operating income 3,500,000    Depreciation (straight-line) (2,000,000) Net income before taxes $1,500,000    Taxes (40%) (600,000) Net income $   900,000 

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The average net income and average investment are calculated in Table 3–10. Given the average net income and average investment, we can compute the project’s ROI:

ROI = Average annual income from project _________________________________ Average annual investment in the project

= $900,000 __________ $5,000,000 = 18%

The accounting rate of return has the advantage of being easy to calculate, and it relates to the firm’s accounting statements, which are familiar to managers. The problem is that it can lead to incorrect investment decisions. For example, suppose that a security purchased today for $100 pays $2,000 in 50 years. This security has the following ROI:

Average annual cash inflow = $2,000 _______ 50 years

= $40

ROI = $40 _____ $100

= 40%

This security has a 40 percent accounting rate of return. Suppose the market rate of return is 10 percent. Using the accounting rate of return as our investment criterion, this investment appears quite attractive. But compute its net present value:

NPV = − Initial investment + FV _______ (1 + r ) n

= −$100 + $2,000 __________

(1 + 0.10) 50

= −$100 + $2,000 _______ 117.391

= −$100 + $17.04 = −$82.96

Actually, this investment has a negative net present value. Alternatively, investing the $100 at 10 percent would yield $11,739 in 50 years.

The accounting rate of return results in incorrect decisions because it ignores the time value of money. Calculating ROI involves computing the average annual income from

TABLE 3–10 Average Net Income and Average Book Value of Investment

Year Net Income Average Book Value of Investment

1 $900,000 $9,000,000 2 900,000 7,000,000 3 900,000 5,000,000 4 900,000 3,000,000 5 900,000 1,000,000

Average $900,000 $5,000,000

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the project. A dollar of income received today is treated the same as a dollar of income received in the future. The fact that these dollars are worth different amounts is ignored when accounting ROI is computed.

The internal rate of return (IRR) method for comparing different projects appears on the surface to be very similar to the DCF method. The IRR method finds the interest rate that equates the initial outlay to the discounted future cash flows. If the project’s internal rate of return exceeds a certain cutoff rate (e.g., the project’s cost of capital), the project should be undertaken. For example, suppose an investment of $1,000 today generates $1,070 in a year. We can solve for the internal rate of return (IRR) or the interest rate that equates the two cash flows:

PV = FV ________ (1 + IRR)

$1,000 = $1,070 ________ (1 + IRR)

(1 + IRR) = $1,070 ______ $1,000

IRR = 0.07 = 7%

In this very simple example, the internal rate of return on an investment of $1,000 today that generates a $1,070 payment in one year is 7 percent. If the cost of capital is 5 percent, then this investment offers a return in excess of its opportunity cost. The net present value of this investment is

NPV = −$1,000 + $1,070 ______ 1.05

= −$1,000 + $1,019.05 = $19.05

Since the internal rate of return exceeds the cost of capital and the net present value is posi- tive, both investment criteria give the same answer. The investment should be undertaken.

The advantage of IRR is that an investment project’s return is stated as an interest rate. Some argue that it is easier to understand a project’s return as 14 percent than to under- stand that it has a net present value of $628,623.

But the IRR and DCF (or net present value) methods do not always give consistent answers. Consider the following two mutually exclusive investments:

Investment 1: Invest $1,000 today and receive $1,070 in one year. Investment 2: Invest $5,000 today and receive $5,300 in one year.

We know from the above that Investment 1 has an IRR of 7 percent and an NPV of $19.05. For Investment 2,

$ 5,000 = $5,300 ________ (1 + IRR)

(1 + IRR) = $5,300 ______ $5,000

IRR = 0.06 = 6%

NPV = −$5,000 + $5,300 ______ 1.05

= −$5,000 + $5,047.62 = $47.62

3. Internal Rate of Return

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Which investment is better? IRR says Investment 1 is better because it has the higher IRR. But the net present value (DCF) criterion says Investment 2 is better because it has the higher NPV. Which is more valuable: a rate of return or cash? Net present value indicates how much cash in today’s dollars an investment is worth, or the magnitude of the invest- ment’s return. The IRR indicates only the relative return on the investment. A 20 percent return on $1,000 ($20) is preferable to a 200 percent return on $1 ($2).

The fact that IRR and DCF can give inconsistent answers is not the only problem with the internal rate of return method. The IRR method also can give multiple rates for the same cash flows. Consider the following investment: $72,727 is received today in exchange for a promise to pay $170,909 next year; at the end of year 2, another $100,000 is received. To compute the IRR of this investment, solve the following equation:

PV = $72,727 − $170,909 ________ (1 + IRR) + $100,000 _________ (1 + IRR) 2

= 0

Let

x = 1 ______ 1 + IRR

Then rewrite the formula as

PV = $100,000 x 2 − $170,909x + $72,727

Figure 3–2 plots the net present value of the preceding equation as a function of the discount rate. Notice that at discount rates of 10 percent and 25 percent, the net present value of the investment is zero; the curve crosses the x-axis in two places.4 Thus, this

4An exact numerical solution for the IRR can be found using the quadratic formula:

ax2 + bx + c = 0

where

x = −b ± √ _________

b 2 − 4ac ___________ 2a a = $100,000 b = −$170,909 c = $72,727

Substitute the values of a, b, and c into the quadratic formula and solve for x:

x = $170,99 ± $10,913 ________________ $200,000

or x1 = 0.90911 and x2 = 0.79998

Since

x = 1 _______ 1 + IRR then

IRR = 1 __ x − 1

and IRR1 = 1 _______ 0.90911 − 1 = 0.10 = 10%

IRR2 = 1 ______ 0.7998 − 1 = 0.25 = 25%

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particular investment has two discount rates that equate the investment cash inflows and outflows: 10 percent and 25 percent. Which is the right IRR for evaluating this project? As it turns out, if the cost of capital is less than 10 percent or greater than 25 percent, this project has a positive NPV and should be accepted. If the cost of capital is between 10 and 25 percent, the project has a negative NPV and should be rejected.

So far, the examples have illustrated how internal rates of return are computed when there are two or three cash flows. With more than three cash flows, trial-and-error search is used to compute the IRR. Set up the problem as a standard discounted cash flow com- putation except you do not know the discount rate. Guess at a beginning discount rate (for example, 15 percent) and use this rate to compute the NPV. If the resulting NPV is posi- tive, raise the discount rate (20 percent) and recompute the NPV. If the new NPV is now negative with the revised discount rate, try a lower discount rate (18 percent). Continue this trial-and-error procedure until the NPV of the project is very close to zero. The dis- count rate that causes the NPV to be zero is the IRR.

Figure 3–2 illustrates that in some cases IRR yields multiple internal rates of return. In other cases, no internal rate of return can be computed even though the project has a posi- tive NPV. These problems complicate the IRR method.

But perhaps the most serious problem with the internal rate of return method involves its reinvestment rate. The reinvestment rate is the interest rate used to compound cash flows received or paid over the life of the project. In the discounted cash flow method, each cash flow is discounted at the opportunity cost of capital. The implicit assumption in DCF is that intermediate cash flows are being reinvested at the market’s rate of interest. The IRR method assumes that all of the intermediate cash flows are being automatically reinvested at the project’s constant internal rate of return. Thus, the IRR method implicitly assumes that the intermediate cash flows can be invested in projects identical to the one being considered and that the same internal rate of return can be achieved. If this is a one- time project, there are no projects like it in the future in which to reinvest the project’s cash flows. Therefore, the internal rate of return method overstates a project’s rate of return if other investments with the same reinvestment rate do not exist.

Based on the preceding discussions, the discounted cash flow (net present value) method provides the theoretically correct method for comparing cash inflows and outflows that occur at different points of time.

Net present value

0 10% 25%

Internal rate of return

FIGURE 3–2

The net present value of investment as a function of the internal rate of return (IRR). Investment: Receive $72,727 today and $100,000 in two years, but pay $170,909 next year.

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F. Summary Chapter 2 discusses opportunity cost as the benefit forgone from a specific decision. The benefit forgone by delaying a dollar today for a dollar in the future is the interest that could be earned on that dollar. A fundamental law of finance states that a dollar today is worth more than a dollar tomorrow. Making a decision that affects cash flows over time requires a mechanism for comparing current

This section describes a survey of capital budgeting methods used in practice.5 Table 3–11 reports the results of a survey of the capital budgeting procedures of around 400 large and small publicly traded U.S. firms. The following capital budgeting evaluation techniques were listed: net present value, payback, accounting rate of return, and internal rate of return. Each firm was asked to score how frequently it used each of the capital budgeting techniques on a scale of 0 to 4 where 0 means “never” and 4 means “always.” Firms can, and usually do, use multiple methods.

The first thing to note from Table 3–11 is the relatively high usage of the two discounting methods: net present value and internal rate of return. Results show 74.9 percent of the firms always or almost always (responses of 4 and 3) use net present value and 75.6 percent always or almost always use internal rate of return. Payback is used always or almost always by 56.7 percent of firms, but only 20.3 percent of the firms always or almost always use account- ing rate of return. It is somewhat surprising that payback is used to this extent given its known drawbacks. The second noteworthy fact is that large firms (those with at least $1 billion sales) are much more likely to use net present value (3.42) than small firms (2.83). The same holds for internal rate of return. Large firms are more likely to use IRR than small firms. However, small firms are more likely to use payback (2.72) than large firms (2.25). Large and small firms use accounting rate of return with roughly the same level of infrequency.

4. Methods Used in Practice

5J. Graham and C. Harvey, “How Do CFOs Make Capital Budgeting and Capital Structure Decision?” Journal of Applied Corporate Finance, Spring 2002, pp. 8–23.

TABLE 3–11 Survey of Basic Capital Budgeting Techniques Used in Practice

Percent Using Always or Almost

Always

Mean Score (Max 4)

Small Firms Large Firms

Net present value 74.9 2.83 3.42 Payback period 56.7 2.72 2.25 Accounting rate of return 20.3 1.41 1.25 Internal rate of return 75.6 2.87 3.41

SOURCE: J. Graham and C. Harvey, “How Do CFOs Make Capital Budgeting and Capital Structure Decision?” Journal of Applied Corporate Finance (Spring 2002), pp. 8–23.

Q3–12 What are three problems with basing investment decisions on internal rate of return?

Q3–13 Why is a dollar of initial investment in a building more valuable than a dollar of initial investment in land or working capital?

Q3–14 Why are cash flows but not accounting earnings discounted in capital budgeting analyses?

Concept Questions

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cash flows with future cash flows. This chapter demonstrates that discounted cash flow (net pres- ent value) analysis is the theoretically correct way to evaluate decisions that have multiperiod cash flow implications. Therefore, compound interest formulas are important mechanisms for comparing multiyear cash flow streams.

To simplify the presentation of concepts, the analysis initially assumed a zero-inflation, riskless world with no transactions costs. In such a world, a single risk-free rate of return would prevail; this riskless return is the opportunity cost of capital. All cash flow streams would be discounted at this riskless rate of return. If a cash flow stream’s net present value is positive, then this stream should be accepted because its benefits exceed its opportunity cost.

But the world is not inflation-free and riskless. Therefore, the simple discounting mechanisms were modified in the following ways:

• Discount expected cash flows using the rate of return offered by an investment of comparable risk. The discount rate from an investment of comparable risk is the opportunity cost for bearing the risk in the project being evaluated.

• Discount nominal cash flows using nominal discount rates. Market interest rates are stated in nominal terms; they contain both a real interest rate and an inflation element. Therefore, in projecting cash flows, be sure to increase future cash flows by the amount of expected infla- tion when using nominal (market) discount rates. However, some future cash flows are con- tractually fixed, such as home or car loans or government and corporate bond repayments. These should not be increased for inflation.

Another important consideration in valuing future cash flow streams is the effect of taxes, espe- cially depreciation tax shields. Depreciation tax shields reduce future tax payments by the amount of the tax-allowed depreciation expense for initial capital investments. The tax-allowed depre- ciation methods should be used, not the depreciation methods used for external financial reports to shareholders.

Remember that the value of the firm increases by the net present value of the investment project. For example, suppose the firm can invest $10 million in a project generating discounted cash flows of $13 million. This investment project with a net present value of $3 million increases the value of the firm by $3 million.

The final topic was alternative investment criteria: payback, accounting rate of return, and inter- nal rate of return. Payback and accounting rate of return are simpler than net present value, but they can often lead to incorrect decisions because they do not incorporate the opportunity cost of capital. Internal rate of return is very similar to net present value, but it too has some problems. First, people want to maximize dollars in their pocket, not rates of return. Second, internal rate of return can yield multiple rates of return or no rates of return on projects, which is confusing and can lead to errors in accepting or rejecting projects. But the most serious problem is that IRR assumes there are other projects with the same rate of return as the project under consideration in which to invest the interim cash flows from the original project. This assumption can distort the project’s profitability and lead to decision errors.

Managers can avoid these problems by following the net present value rule: Accept projects with positive expected nominal after-tax cash flows discounted using risk-adjusted nominal rates of return.

Self-Study Problems Self-Study Problem 1:  Avroland

Avroland is an amusement park in California. It currently uses a computer system to perform general accounting functions, including tracking ticket sales and payroll as well as employee and mainte- nance scheduling functions. The original system cost $300,000 when purchased two years ago. It has been depreciated for tax purposes using straight-line depreciation with an expected useful life of four more years and a zero salvage value. However, due to recent expansion, the computer system is no longer large enough. Upgrading the system to increase the storage capacity and processing

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speed to accommodate the extra data processing demands costs $65,000, and the upgraded system becomes obsolete in four years. These system additions also would be depreciated using straight-line depreciation and would have a zero salvage value. The company’s accountant estimates that the firm will increase operating spending by $28,000 a year after taxes for data processing, payroll (including Avroland personnel), and annual updates of software for the upgraded system. Alternatively, the firm could outsource payroll to a local payroll processing firm at the cost of $40,000 a year after taxes. This would free up enough capacity in the computer to avoid upgrading the machine. Assume a real cost of capital of 4 percent and a tax rate of 40 percent.

What should Avroland do?

Solution: If Avroland continues to process its payroll internally, it must pay to upgrade the computer plus pay the variable cost of processing the information minus the tax savings from depreciating the upgraded machine. Outsourcing payroll costs $40,000 per year. Over the next four years, Avroland’s cash flows would be as follows under the two possibilities:

Note that the original system will depreciate whether the system is upgraded or payroll is outsourced. Therefore, it is not relevant to the decisions under consideration.

Since the net present value of the cash outflows are lower by keeping the payroll inside rather than outside the firm, the computer should be upgraded.

Self-Study Problem 2: Car Lease There it was on the cover of the August edition of Boy Racer Illustrated: the Englander Double Five HRM Special Edition Saloon. The stuff of dreams. For a mere $80,000 it could be his. Magazine in hand, Jonathan rushed down to the Englander dealer.

Initial Investment Year 1 Year 2 Year 3 Year 4 NPV

Keep Payroll Inside Cost of upgrade $65,000 Labor plus software $28,000 $28,000 $28,000 $28,000 Tax savings from depreciation* (6,500) (6,500) (6,500) (6,500) Total cash outflows $65,000 $21,500 $21,500 $21,500 $21,500 Discount rate 1.000 0.962 0.925 0.889 0.855 Present value at 4% $65,000 $20,683 $19,878 $19,113 $18,383 $14 3,067

Outsource Payroll Annual cost of service $40,000 $40,000 $40,000 $40,000 Discount rate 0.962 0.925 0.889 0.855 Present value at 4% $38,480 $37,000 $35,560 $34,200 $145,240

* $65,000 ___________ 4 years × 40% tax rate = $6,500

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Jonathan knew he would buy the car. After all, who deserved it more than he? The only issue left was financing. Jonathan could pay cash or he could put $20,000 down and take a bank loan for the rest. “What would my payments be with $20,000 down?” he inquired. “About $1,200 a month,” replied the dealer.

That sounded like a lot. Before discouragement had time to set in, the dealer made his pitch: “Have you considered the Englander Double Five Double Win Jubilee Lease? It would halve your down payment and take your monthly payments all the way down to $800. I know it sounds too good to be true. It’s a rare special incentive promotion from Englander Finance. You pay only for the por- tion of the car that you use, so it comes out a lot cheaper than if you bought it outright. It’s so cheap that it’s almost as good as paying cash for the whole thing.”

Jonathan’s alternatives were now clear. He could put $20,000 down and borrow the rest from the bank at 10 percent per year, making payments for the next 66 months. Or he could go for the lease instead. The lease looked cheaper but it was harder to understand. It called for $10,000 down for something called capital cost reduction, and then he would pay only $800 for 36 months. The small print mentioned a “residual” of $60,000. This meant that if he wanted to buy the car after 36 months, the price would be $60,000. He could, of course, simply return the car at the end of the lease and owe nothing. Maybe he would just save some money by paying the full $80,000 out of his personal savings, which he has invested at 10 percent per year.

Required:

a. Calculate Jonathan’s monthly payments if he took the bank loan. What would his total cash outlay be if he purchased the car in this manner? Does your answer demonstrate that Jonathan could save money by self-financing the purchase? Why or why not?

b. Compare the present value of leasing against that of buying. Which is the better choice? Suppose that Jonathan had good reason to expect that his Double Five would be worth at least $65,000 at the end of three years. Would this fact change your analysis? What if the expected value would be $55,000? What does your analysis of these hypothetical situations tell you about the economic value of the Englander lease?

Solution: a. To calculate Jonathan’s monthly payments, we must convert the given annual rate, r, to a

monthly rate, rm. As explained in this chapter’s discussion of multiple cash flows within a year, the formula is

r m = (1 + r) 1/12 − 1

For r = 10%, the monthly rate would be

rm = (1 + 0.1)1/12 − 1 = (1.1)1/12 − 1 = 0.007974

The present value of the loan is, obviously, the amount being borrowed, which is the cost of the car less the down payment. PV = $80,000 − $20,000 = $60,000. The number of monthly payments is given in the problem as 66. With these figures, one can solve for the monthly payment by using the present value of an annuity formula:

PV

=

FV ___ r [1 − 1 _ (1 + r) n ]

60,000

=

FV ________ 0.007974 (1 −

1 _ 1.007974 66

)

FV

=

$60,000 _______ 51.162

=

$1,172.74

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Jonathan’s monthly payments would be $1,172.74 for the life of the loan. The total of his monthly payments would be the amount of each payment times the number of months. Adding the down payment, the total cash outlay via borrowing is

$1,172.74 × 66 + $20,000 = $97,401

The fact that this figure is greater than the $80,000 purchase price of the car is probably the source of the contention that paying the whole amount up front is cheaper than bank financing. This analysis is fallacious because it ignores the opportunity cost of money; it should not be taken as a demonstration of any cost savings. Indeed, given that 10 percent is a fair market price for such a loan, there is no reason to suppose that Jonathan would have a preference between paying cash and bank financing.

b. Although the terms of the lease are somewhat different from those of the loan, it is reason- able to accept, for determining the present value of the lease, the annual discount rate of 10 percent and, therefore, the monthly discount rate of 0.7974 percent. The present value of an annuity formula is used. In this case, n = 36 and FV = $800:

PV

=

FV ___ r [ 1 − 1 _ (1 + r) n ]

=

$800 × 1.007974

36 − 1 __________________ 0.007974 (1.007974) 36

=

$800 ________ 0.007974 (1 + 1 _

1.007974 36 )

=

$24,950

To buy the car through the Double Five lease, Jonathan would have to pay the residual of $60,000 at the end of the lease. As stated in the text,

PV = FV ÷ (1 + r ) n

The period of the lease is three years and the annual rate is 10 percent. (Monthly figures could, of course, be used for r and n, but calculations are simpler in this case if annual figures are used.) FV is the single payment of $60,000. Accordingly,

PV

=

$60,000 _______ 1.1 3

= $60,000 _______ 1.331

=

$45,079

Additionally, the $10,000 up-front fee also must be considered. Since it is paid at the time of acquisition, it is not discounted. When all stated cash flows for purchasing via the lease are considered,

PV lease = $80,029 − $3,757 = $76,272 = $80,029

On the face of it, it looks as if Jonathan should be indifferent between leasing and buying. However, the preceding analysis does not tell the entire story. Suppose Jonathan lives in an area where Englanders are particularly desirable. If the market value of the car is expected to be $65,000 at the end of the lease, Jonathan could then expect to buy the car at $5,000 below market value. This expectation ought to have value and could fairly be considered to be worth $5,000 ÷ 1.13 = $3,757. One could then argue that, in this circumstance, leasing is cheaper than buying:

PV lease = $80,029 − $3,757 = $76,272

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What is most interesting here is that the same conclusion can be reached even if the residual is overpriced. Suppose Jonathan conducted business with the Englander dealer based upon the expectation that his Double Five would be worth $60,000 after three years, but the real market value turns out to be only $55,000 at the end of the lease. If Jonathan buys the car, he will bear the risk of such unexpected devaluation. However, if he leases it, he does not bear the risk of an unexpected decline in value. The option to purchase at the residual price at the end of the lease allows the lessee to reap the rewards for which the lessor bears the risk.

Obviously, such an option has economic value and deserves to be part of any analysis of Jonathan’s alternatives. Although assigning a value to such an option is beyond the scope of this problem, one is inclined to believe that it would be worth more than $29. If this option is included and all other factors are held constant, Jonathan should prefer leasing to buying.

Problems

P 3–1: IRR Problem A present investment of $50,000 is expected to yield receipts of $8,330 a year for seven years. What is the internal rate of return on this investment? (Show your calculations.)

P 3–2: Accelerated Depreciation Problem Is it preferable to use an accelerated depreciation method rather than the straight-line method for tax purposes?

P 3–3: Jasper Inc. Jasper Inc. is considering two mutually exclusive investments. Alternative A has a current outlay of $300,000 and returns $100,300 a year for five years. Alternative B has a current outlay of $150,000 and returns $55,783 a year for five years.

Required:

a. Calculate the internal rate of return for each alternative. b. Which alternative should Jasper take if the required rate of return for similar projects in the

capital market is 15 percent?

P 3–4: Just One Inc. Just One Inc. has two mutually exclusive investment projects, P and Q, shown next. Suppose the market interest rate is 10 percent.

Project Initial

Investment Year 1 Year 2 IRR NPV (r = 10%)

P −$200.00 $140.00 $128.25 22.4% $33.26 Q − 100.00 80.00 56.25 25.0 19.21

The ranking of projects differs, depending on the use of IRR or NPV measures. Which project should be selected? Why is the IRR ranking misleading?

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P 3–5: Equity Corp. Equity Corp. paid a consultant to study the desirability of installing some new equipment. The con- sultant recently submitted the following analysis:

Cost of new machine $100,000 Present value of after-tax revenues from operation 90,000 Present value of after-tax operating expenses 20,000 Present value of depreciation expenses 87,500 Consulting fees and expenses 750

The corporate tax rate is 40 percent. Should Equity Corp. accept the project?

P 3–6: Declining Market Inc. Declining Market Inc. is considering the problem of when to stop production of a particular product in its product line. Sales of the product in question have been declining and all estimates are that they will continue to decline. Capital equipment used to manufacture the product is specialized but can be readily sold as used equipment. What, if anything, is wrong with a decision rule for this case that says, “Keep producing the product as long as its contribution to net earnings is positive”? [Contri- bution to net earnings, where τ is the tax rate, is (1 − τ) (Sales − Variable cost − Depreciation on equipment used to manufacture product).]

P 3–7: Northern Sun Inc. At the beginning of year 1, Northern Sun Inc., a food processing concern, is considering a new line of frozen entrees. The accompanying table shows projected cash outflows and inflows. Assume that all inflows and outflows are end-of-period payments.

Cash Outflows ($000s)

Initial Investment

Year 1 Year 2 Year 3 Year 4 Year 5

R&D $(200)         Packaging and design (55)         Product testing (100)       $ (50) Marketing   $ (15) $ (10) $ (10) (10) Distribution   (30) (50) (50) (50) Cash inflow 100 250 300 300 Net cash flows $(355) $ 55 $190 $240 $190

Required:

The company’s cost of capital is 10 percent. Compute the following: a. Net present value. b. Payback.

P 3–8: Ab Landlord Ab Landlord owns a dilapidated 30-year-old apartment building in Los Angeles. The net cash flow from renting the apartments last year was $200,000. She expects that inflation will cause

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the net cash flows from renting the apartments to increase at a rate of 10 percent per year (next year’s net cash flows will be $220,000, the following year’s $242,000, etc.). The remaining useful life of the apartment building is 10 years. A developer wants to buy the apartment building from Landlord, demolish it, and construct luxury condominiums. He offers Landlord $1.5 million for the apartments.

Assume there are no taxes. The market rate of return for investments of this type is 16 percent and is expected to remain at that level in the future. The 16 percent interest rate includes an expected inflation rate of 10.5 percent. The real rate of interest is 5 percent:

1.16 = (1.05)(1.105)

Required:

a. Evaluate the developer’s offer and make a recommendation to Landlord. Support your conclusions with neatly labeled calculations where possible. Note that the $1.5 million purchase offer would be paid immediately, whereas the first cash flow from retaining the building is not received until the end of the first year.

b. Suppose that Los Angeles imposes rent controls, so that Landlord will not be able to increase her rents except to the extent justified by increases in costs such as main- tenance. Effectively, the future net cash flows from rents will remain constant at $200,000 per year. Does the imposition of rent controls change Landlord’s decision on the developer’s offer? Support your answer with neatly labeled calculations where possible.

P 3–9: Lottery Suppose the market rate of interest is 10 percent and you have just won a $1 million lottery that entitles you to $100,000 at the end of each of the next 10 years.

Required:

a. What is the minimum lump-sum cash payment you would be willing to take now in lieu of the 10-year annuity?

b. What is the minimum lump sum you would be willing to accept at the end of the 10 years in lieu of the annuity?

c. Suppose three years have passed; you have just received the third payment and you have seven left when the lottery promoters approach you with an offer to settle up for cash. What is the minimum you would accept at the end of year 3?

d. How would your answer to part (a) change if the first payment came immediately (at t = 0) and the remaining payments were at the beginning instead of the end of each year?

P 3–10: Mr. Jones’s Retirement Mr. Jones intends to retire in 20 years at the age of 65. As yet, he has not provided for retirement income, and he wants to set up a periodic savings plan to do this. If he makes equal annual pay- ments into a savings account that pays 4 percent interest per year, how large must his payments be to ensure that after retirement he will be able to draw $30,000 per year from this account until he is 80?

P 3–11: Clean Tooth Several years ago, your firm paid $25,000,000 for Clean Tooth, a small, high-technology company that manufactures laser-based tooth cleaning equipment. Unfortunately, due to extensive produc- tion line and sales resistance problems, the company is considering selling the division as part of a “modernization program.” Based on current information, the following are the estimated accounting numbers if the company continues to operate the division:

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Assume: 1. The firm is in the 0 percent tax bracket (no income taxes). 2. There are no additional expenses associated with the sale. 3. After year 10, the division will have sales (and expenses) of 0. 4. Estimates are completely certain.

Should the firm sell the division for $250,000?

P 3–12: New Car You are considering buying a $50,000 car. The dealer has offered you a 13.6 percent loan with 30 equal monthly payments. On questioning him, you find that the interest charge of $17,000 (or 0.136 × $50,000 × 2.5 years) is added to the $50,000 for a total amount of $67,000. The payments are $2,233.33 a month ($67,000 ÷ 30). What is the approximate effective annual interest rate?

P 3–13: Federal Dam Project Farmers in a valley are subject to occasional flooding when heavy rains cause the river to overflow. They have asked the federal government to build a dam upstream to prevent flooding. The construc- tion cost of this project is to be repaid by the farm owners without interest over a period of years. The cost is $300 an acre. If a farm has 100 acres, a total of $30,000 is to be repaid. No payments at all are to be made for the first five years. Then, $1,000 is to be paid at the end of each year for 30 years to pay off the $30,000.

Is the farmer receiving a subsidy? Why? If the interest rate is 10 percent, what is the approxi- mate capitalized value of the subsidy (if any)? Show all calculations.

P 3–14: South American Mining Suppose that a mining operation has spent $8 million developing an ore deposit in South America. Cur- rent expectations are that the deposit will require two years of development and will result in a realizable cash flow of $10 million at that time. The company engineer has discovered a new way of extracting the ore in only one year, but the procedure would necessitate an immediate outlay of $1 million.

Required:

a. Compute the IRR for the new outlay. (Note: There are two solutions! One is 787 percent. Find the other one.)

b. Based on your answer to part (a), use the IRR criterion to determine if the company should make the outlay. Assume the market interest rate is 15 percent on one- and two-year bonds.

P 3–15: House Mortgage You have just purchased a house and have obtained a 30-year, $200,000 mortgage with an interest rate of 10 percent.

Required:

a. What is your annual payment? b. Assuming you bought the house on January 1, what is the principal balance after 1 year?

After 10 years? c. After four years, mortgage rates drop to 8 percent for 30-year fixed-rate mortgages. You

still have the old 10 percent mortgage you signed four years ago and you plan to live in the house for another five years. The total cost to refinance the mortgage is $3,000, including

Estimated cash receipts, next 10 years $500,000/year Estimated cash expenditures, next 10 years $450,000/year Current offer for the division from another firm $250,000

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legal fees, closing costs, and points. The rate on a five-year CD is 6 percent. Should you refinance your mortgage or invest the $3,000 in a CD? The 6 percent CD rate is your opportunity cost of capital.

P 3–16: Flower City Grocery The Flower City Grocery is faced with the following capital budgeting decision. Its display freezer system must be repaired. The cost of this repair will be $1,000, and the system will be usable for another five years. Alternatively, the firm could purchase a new freezer system for $5,000 and sell the old one for $500. The new freezer system has more display space and will increase the profits attributable to frozen foods by 30 percent. Profits for that department were $5,000 in the last fiscal year. The company’s cost of capital is 9 percent. Ignoring taxes, what should the firm do?

P 3–17: Toledo Stadium The city of Toledo has received a proposal to build a new multipurpose outdoor sports stadium. The expected life of the stadium is 20 years. It will be financed by a 20-year bond paying 8 percent inter- est annually. The stadium’s primary tenant will be the city’s Triple-A baseball team, the Red Hots. The plan’s backers anticipate that the site also will be used for rock concerts and college and high school sports. The city does not pay any taxes. The city’s cost of capital is 8 percent. The costs and estimated revenues are presented next:

Cash Outflows Construction costs $12,000,000 General maintenance (including labor) $250,000 per year Cash Inflows Red Hots’s lease payment $650,000 per year Concerts $600,000 per year College and high school sports $50,000 per year

Required:

a. Should the city build the stadium? (Assume payments are made at the end of the year.) b. The Red Hots have threatened to move out of Toledo if they do not get a new stadium. The

city comptroller estimates that the move will cost the city $350,000 per year for 10 years in lost taxes, parking, and other fees. Should the city build the stadium now? State your reasoning.

P 3–18: PQR Coal Company The PQR Coal Company has several conventional and strip mining operations. Recently, new legisla- tion has made strip mining, which produces coal of high sulfur content, unprofitable, so those opera- tions will be discontinued. Unfortunately, PQR purchased $1 million of earth-moving equipment for the strip mines two years ago and this equipment is not particularly well-suited to conventional mining.

Ms. Big, the president, suggests that since the equipment can be sold for $500,000, it should be scrapped. In her words, “I learned a long time ago that when you make mistakes it’s best to admit them and take your lumps. By ignoring sunk costs you aren’t tempted to throw good money after bad. The original value of the equipment is gone.”

A new employee, Mr. Embeay, has suggested that the equipment should be adapted to the con- ventional operations. He argues, “We are about to spend $800,000 on some new conventional equip- ment. However, for a smaller expenditure of $250,000 we can adapt the old equipment to perform the same task. Of course, it will cost about $20,000 per year more to operate over the assumed 10-year lives of each alternative. But at an interest rate of 10 percent, the inclusion of the present value of $20,000 per year for 10 years and the initial $250,000 is still less than $800,000 for new equipment. While it’s true that we should ignore sunk costs, at least this way we can cut our losses somewhat.”

Who’s correct? Why? What should PQR do? Why?

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P 3–19: Student Loan Program The National Direct Student Loan (NDSL) program allows college students to borrow funds from the federal government. The contract stipulates that the annual percentage rate of interest is 0 percent until 12 months after the student ceases his or her formal education (defined as at least half-time enrollment). At that time, interest becomes 4 percent per year. The maximum repayment period is 10 years. Assume that the student borrows $10,000 in the beginning of the first year of college and completes his or her education in four years. Loan repayments begin one year after graduation.

Required:

a. Assuming that the student elects the maximum payment period, what are the uniform annual loan repayments? (Assume all repayments occur at the end of the year.)

b. If the rate of interest on savings deposits is 6 percent, what is the minimum amount the student has to have in a bank account one year after graduation to make the loan payments calculated in part (a)?

c. Are recipients of the NDSL program receiving a subsidy? If so, what is the present value of the subsidy when the loan is taken out?

P 3–20: Geico Geico is considering expanding an existing plant on a piece of land it already owns. The land was purchased 15 years ago for $325,000 and its current market appraisal is $820,000. A capital bud- geting analysis shows that the plant expansion has a net present value of $130,000. The expansion will cost $1.73 million, and the discounted cash inflows are $1.86 million. The expansion cost of $1.73 million does not include any provision for the cost of the land. The manager preparing the analysis argues that the historical cost of the land is a sunk cost, and, since the firm intends to keep the land whether or not the expansion project is accepted, the current appraisal value is irrelevant.

Should the land be included in the analysis? If so, how?

P 3–21: Depreciation Tax Shield An investment project involves the purchase of equipment at a cost of $100 million. For tax pur- poses, the equipment has a life of five years and will be depreciated on a straight-line basis. Inflation is expected to be 5 percent and the real interest rate is 5 percent. The tax rate is 40 percent.

What is the present value of the depreciation tax shield for the machine?

SOURCE: R. Watts

P 3–22: Housing Markets A condo identical to yours in your neighborhood sold last week for $150,000. Your condo has a $120,000 assumable, 8 percent mortgage (compounded annually) with 30 years remaining. An assumable mortgage is one that the new buyer can assume at the old terms, continuing to make pay- ments at the original interest rate. The condo that recently sold did not have an assumable mortgage; that is, the buyers had to finance the condo at the current market rate of interest, which is 15 percent. What price should you ask for your condo?

A third condo, again identical to the one that sold for $150,000, is also being offered for sale. The only difference between this third condo and the $150,000 condo is the property taxes. The $150,000 condo’s property taxes are $3,000 per year, while the third condo’s property taxes are $2,000 per year. The differences in the property taxes are due to vagaries in how the property tax assessors assessed the taxes when the condos were built. In this tax jurisdiction, once annual taxes are set, they are fixed for the life of the condo. Assuming the market rate of interest is still 15 percent, what should be the price of this third condo?

P 3–23: Mortgage Department Suppose you are the manager of a mortgage department at a savings bank. Under the state usury law, the maximum interest rate allowed for mortgages is 10 percent compounded annually.

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Required:

a. If you granted a $50,000 mortgage at the maximum rate for 30 years, what would be the equal annual payments?

b. If the current market internal rate on similar mortgages is 12 percent, how much money does the bank lose by issuing the mortgage described in part (a)?

c. The usury law does not prohibit banks from charging points. One point means that the bor- rower pays 1 percent of the $50,000 loan back to the lending institution at the inception of the loan. That is, if one point is charged, the repayments are computed as in part (a), but the borrower receives only $49,500. How many points must the bank charge to earn 12 percent on the 10 percent loan?

P 3–24: Electric Generator A firm that purchases electric power from the local utility is considering the alternative of generating its own electricity. The current cost of obtaining the firm’s electricity from its local utility is $42,000 per year. The cost of a steam generator (installed) is $140,000 and annual maintenance and fuel expenses are estimated at $22,000. The generator is expected to last for 10 years, at which time it will be worthless. The cost of capital is 10 percent and the firm pays no taxes.

Required:

a. Should the firm install the electric generator? Why or why not? b. The engineers have calculated that with an additional investment of $40,000, the excess steam

from the generator can be used to heat the firm’s buildings. The current cost of heating the buildings with purchased steam is $21,000 per year. If the generator is to be used for heat as well as electricity, additional fuel and maintenance costs of $10,000 per year will be incurred. Should the firm invest in the generator and the heating system? Show all calculations.

P 3–25: Overland Steel Overland Steel operates a coal-burning steel mill in New York State. Changes in the state’s air qual- ity control laws will result in this mill’s incurring a $1,000 per day fine (which will be paid at the end of the year) if it continues to operate. The mill currently operates every day of the year.

The mill was built 20 years ago at a cost of $15 million and has a remaining undepreciated book value of $3 million. The expected remaining useful life of the mill is 30 years.

The firm can sell the mill to a developer who wants to build a shopping center on the site. The buyer will pay $1 million for the site if the company demolishes the mill and prepares the site for the developer. Demolition and site preparation costs are estimated at $650,000.

Alternatively, the firm could install pollution control devices and other modernization devices at an initial outlay of $2.75 million. These improvements do not extend the useful life or salvage value of the plant, but they do reduce net operating costs by $25,000 per year in addition to eliminating the $1,000 per day fine. Currently, the net cash flows of operating the plant are $450,000 per year before any fines.

Assume:

1. The market rate of interest is 14 percent. 2. There are no taxes. 3. The annual cash flow estimates given above are constant over the next 30 years. 4. At the end of the 30 years, the mill has an estimated salvage value of $2 million whether or

not the pollution equipment has been installed.

Required:

Evaluate the various courses of action available to management and make a recommendation. Support your conclusions with neatly labeled calculations where possible.

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123

zim69495_ch03_084-123.indd 123 04/15/19 01:00 PM

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124

zim69495_ch04_124-155.indd 124 04/15/19 01:02 PM

Chapter Four

Organizational Architecture

Chapter Outline A. Basic Building Blocks

1. Self-Interested Behavior, Team Production, and Agency Costs

2. Decision Rights and Rights Systems

3. Role of Knowledge and Decision Making

4. Markets versus Firms

5. Influence Costs

B. Organizational Architecture 1. Three-Legged Stool

2. Decision Management versus Decision Control

C. Accounting’s Role in the Organization’s Architecture

D. Example of Accounting’s Role: Executive Compensation Contracts

E. Summary

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Organizational Architecture 125

zim69495_ch04_124-155.indd 125 04/15/19 01:02 PM

Chapter 2 described the important concept of opportunity cost and its relation to other costing terms. Understanding the nature of costs is critical to making decisions. Inter- nal accounting systems are used not only in decision making but also for influencing the behavior of individuals within organizations.

This chapter addresses the general problem of controlling behavior. Individuals work- ing in firms will maximize their welfare, sometimes to the detriment of the organization’s objectives, unless provided incentives to do otherwise. Accounting systems are often used to provide these incentives. For example, incentive bonuses are often based on account- ing earnings. Section A presents some building blocks underlying the analysis. Section B describes how the firm’s organizational architecture creates incentives for employees to maximize the organization’s objectives. Sections C and D describe how accounting controls conflicts of interest inside the organization. The next chapter discusses two more accounting tools that are used to resolve organizational problems: responsibility account- ing and transfer pricing.

A. Basic Building Blocks1

Before describing the general problem of how to motivate and control behavior in orga- nizations (the economics of organizations), this section first describes some underlying concepts:

1. Self-interested behavior, team production, and agency costs. 2. Decision rights and rights systems. 3. Role of knowledge and decision making. 4. Markets versus firms. 5. Influence costs.

One of the fundamental tenets of economics is that individuals act in their self-interest to maximize their utility. Employees, managers, and owners are assumed to be rational, utility-maximizing people. Individuals have preferences for a wide variety of not only goods and services but also intangibles such as prestige, love, and respect, and they are willing to trade one thing they value for another. People evaluate the opportunities they face and select those that they perceive will make them better off. Moreover, individuals are not generally able to satisfy all their preferences. Limited resources (time, money, or skills) force people to make choices. When confronted with constraints or a limited set of alternatives, individuals will use their resourcefulness to relax the constraints and generate a larger opportunity set. For example, after reducing the maximum highway speed limit to 55 miles per hour, the CB radio and radar detector industries emerged to help resourceful, self-interested people circumvent the new law.2

Individuals coalesce to form a firm because it can (1) presumably produce more goods or services collectively than individuals are capable of producing alone and (2) thus generate a larger opportunity set. Team production is the key reason that firms exist. Firms are con- tracting intermediaries. They facilitate exchanges among resource owners who voluntarily

1Much of the next two sections is based on M. Jensen and W. Meckling, “Specific and General Knowledge and Organizational Structure,” Contract Economics, ed. L. Werin and H. Wijkander (Oxford: Blackwell, 1992), pp. 251–74. Also see J. Brickley, C. Smith, and J. Zimmerman, Managerial Economics and Organizational Architecture, 6th ed. (Boston: McGraw-Hill, 2016).

2W. Meckling, “Values and the Choice of the Model of the Individual in the Social Sciences,” Schweizerische Zeitschrift Für Volkswirtschaft und Statistik, December 1976.

1. Self-Interested Behavior, Team Production, and Agency Costs

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contract among themselves to benefit each party.3 People choose to enter contracts because these exchanges make them better off; there are gains to each party in contracting.

Team production implies that the productivity of any one resource owner affects the productivity of all the other team members because output is a joint product of all the inputs. Suppose Sally and Terry can produce more working together than working separately because they assist each other. Hence, Sally can increase Terry’s output and vice versa. This interdependency has important implications for organizations and inter- nal accounting. For one thing, measuring the productivity of one team member requires observing the inputs of all the other team members. However, inputs (such as effort) are typically difficult to observe. If two people are carrying a large, awkward box and it slips and falls, which employee do you blame? Did one of them let it go? Or did it slip out of one employee’s hands because the other employee tripped?

In most cases, a resource owner’s input cannot be directly observed. Hence, team mem- bers have incentives to shirk their responsibilities. If it is difficult to observe Sally’s effort, she has incentives to shirk when working with Terry. She can always blame either Terry or random uncontrollable events such as bad weather or missing parts as the reason for low joint output. If Sally and Terry are paid based on their joint output, each still has an incentive to shirk because each bears only half the cost of the reduced output. As the team size is increased, the incentive to shirk becomes greater because the reduced output is spread over more team members. The incentive to shirk in team production is called the free-rider problem. Teams try to overcome the free-rider problem through the use of team loyalty—pressure from other team members—and through monitoring. Team production clearly has advantages, but it also causes a variety of organizational problems, in particular the free-rider problem.4

Another organizational problem arises when principals hire agents to perform tasks for them. For example, the chief executive officer (CEO) is the agent of the board of direc- tors, who are in turn the elected agents of the shareholders. Vice presidents of the firm are agents of the president, managers are agents of vice presidents, and employees are agents of supervisors. Most employees in a chain of command are both principals to those who report to them and agents to those to whom they report. These principal–agent relation- ships pervade all organizations: profit and nonprofit firms and governments.

3C. Barnard, The Functions of the Executive (Cambridge, MA: Harvard University Press, 1938), p. viii, defines organizations as “a system of consciously coordinated activities or forces of two or more persons.” See also M. Jensen and W. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3 (1976), pp. 305–60.

4A. Alchian and H. Demsetz, “Production, Information Costs, and Economic Organization,” American Economic Review 62 (1972), pp. 777–95.

Depending on the study, most employees spend between one and three hours a day while at work on personal social media or surfing the web. The time spent on such non- work-related matters is increasing, causing many senior executives to worry about the loss of pro- ductivity. Surfing and social media are nothing more than employee shirking, and firms deploy a variety of policies and systems to control this “on-the-job leisure” activity. Firms purchase software that identifies inappropriate social-media activity. Some firms require employees to access social-media sites via company-controlled technology. In some cases, these technologies cost as much as $20 a month per employee. SOURCE: A. Adamczyk, “Yes, Your Employer Knows Exactly What You’re Doing Online,” Money (August 9, 2017). //time.com/money/4890303/employer-browsing-data/.

Managerial Application: Shirking, Surfing, and Social Media While at Work

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When hired to do a task, agents maximize their utility, which may or may not maximize the principal’s utility. Agents’ pursuit of their self-interest instead of the principal’s is called the principal–agent problem or simply the agency problem.5 The extreme example of an agency problem is employee theft of firm property. If undetected, such theft benefits the agent at the expense of the principal. The agent would prefer to see firm resources directed into activities that improve the agent’s welfare even if these expenditures do not benefit the principal to the same degree. For example, agents prefer excessive perquisites such as gour- met company-provided lunches and on-the-job leisure. Differences among employees’ risk tolerances, working horizons, and desired levels of job perks generate agency costs—the decline in firm value that results from agents pursuing their own interests to the detriment of the principal’s interest. Agency costs can also arise when agents seek larger organizations to manage (empire building) for the sole purpose of increasing either their job security or their pay. (Many firms base pay on the number of employees reporting to the manager.)

In general, agency problems arise because of information asymmetries. The princi- pal possesses less information than the agent. In the classic principal–agent problem, the principal hires the agent to perform some task, such as managing the principal’s invest- ment portfolio. If the agent works hard, the portfolio grows more than if the agent shirks. But the principal cannot observe how hard the agent is working (information asymmetry). Moreover, the investment portfolio’s performance depends not just on how hard the agent works, but also on random events, such as general market movements or embezzlement by managers in a company in the investment portfolio. If the principal could observe the agent’s effort, then a simple contract that pays the agent for effort expended forces the

5Jensen and Meckling (1976); H. Simon, “A Formal Theory of the Employment Relationship,” Economet- rica 19 (1951), pp. 293–305; S. Ross, “The Economic Theory of Agency: The Principal’s Problem,” American Economic Review 63 (1973), pp. 134–39; and O. Williamson, The Economic Institutions of Capitalism (New York: The Free Press, 1985).

In their quest to make employees happier, companies around the world install play equipment, slides, foosball tables, computer games, scooters, and even Formula One simulators. This quest assumes an old cliché that a happy worker is a good worker. Unfortunately, research shows the place where people feel most miserable is at work. Another study found that supermarket stores with the least satisfied employees were the most productive and profitable. While having a fun work environment does not guar- antee higher productivity, it might help attract and retain a more qualified workforce. SOURCE: A. Spicer, “The Cult of Compulsory Happiness Is Ruining Our Workplaces” Guardian, December 12, 2016.

Managerial Application: Happy Employees Are Not More Productive

General Electric’s (GE) former CEO Jeff Immelt received lavish perquisites while in office, including his own bathroom, corporate jets, leased vehicles, two helicopter pads, a shoeshine station, and an executive dining room linked to the kitchen below by dumbwaiters. Immelt and his senior GE leaders and their assistants occupied 44,000 square feet in GE’s sprawling 66-acre Fairfield, Connecticut, campus. In 2016, Immelt received total compensation of over $17 million. This ended abruptly when Immelt was forced to retire in 2017 after serving as CEO for 16 years. GE’s sagging earnings and stock price caused an investor revolt. SOURCE: N. Schwartz, “The Decline of the Baronial CEO,” The New York Times Business Day, June 17, 2017. www.nytimes.com/2017/06/17/business/ge-whole-foods-ceo.html.

Managerial Application: Agency Problems at General Electric

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agent to work hard. But since the agent’s effort is not observable by the principal, the prin- cipal must contract on some other basis. One such contract could pay the agent a fraction of the portfolio’s growth. But since part of the portfolio’s performance depends on random factors, the agent could work hard, but adverse random events outside the agent’s control could negate that hard work. While this contract induces hard work, it also imposes risk on the agent for which he or she must be compensated. Hence, most agency problems involve balancing stronger incentives for the agent to work hard against the higher risk premium required by the agent to compensate for the additional risk imposed on the agent.

Consider another example of an agency problem, that of senior executives paid a fixed salary. Because executives have less incentive to maximize shareholder value than if they owned the entire firm themselves, incentive compensation plans are introduced to tie the executive’s welfare more closely to shareholder welfare. The agent may have a lower tolerance for risk than the principal and therefore will choose more conservative actions. Principal–agent problems can also arise because most supervisors find it person- ally unpleasant to discipline or dismiss poorly performing subordinates. Instead of tak- ing these unpopular actions, supervisors allow underperforming subordinates to remain in their positions, which reduces firm value. The difference between the value of the firm with and without the poorly performing subordinate is the agency cost imposed on the owners of the firm by the shirking supervisor.

If the agent expects to leave the organization before the principal, the agent will tend to focus on short-run actions. This leads to the horizon problem: Managers expecting to leave the firm in the near future place less weight than the principal on those consequences occurring after they leave. As an example of the horizon problem, consider the case of a divisional manager, Henry Metz, who expects to retire in three years. Henry is paid a fixed salary plus 5 percent of his division’s profits. To simplify the example, assume that Henry cares only about cash compensation. He can spend $100,000 on process improvements this year and next year that will yield $150,000 of cost savings for each of the following four years. Table 4–1 illustrates the cash flows.

The process improvements are clearly profitable, so they should be accepted.6 But Henry, who has a three-year horizon, rejects the project because it reduces his total bonus. He bears much of the cost while his successor receives most of the benefits in years 4, 5, and 6. Nonpecuniary interests of the manager, such as peer pressure, tend to reduce the horizon problem. However, the basic point remains: Agents facing a known departure date place less weight on events that occur after they leave than on events that occur while they are still there; the short-term consequences of current decisions will matter far more to them than the long-term consequences.

TABLE 4–1 Example of the Horizon Problem

Year Outlay Cost Savings Effect on Henry Metz’s Bonus Compensation

1 $100,000 — −$5,000 2 100,000 — −5,000 3 0 $150,000 +7,500 4 0 150,000 0 5 0 150,000 0 6 0 150,000 0

6These process improvements have a positive net present value unless the discount rate is greater than 45 percent. Hence, under most market discount rates, they are profitable.

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To reduce agency costs such as employee theft and the free-rider and horizon prob- lems, firms incur costs. These costs include hiring security guards to prevent theft, hiring supervisors to monitor employees, installing accounting and reporting systems to measure and reward output, and paying legal fees to enforce compliance with contracts. However, as long as it is costly to monitor agents, some divergence of interests between agents and principals remain. It is usually not cost-efficient to eliminate all divergent acts.

Société Générale was founded in the 1860s and in 2008 was France’s second largest bank. It pioneered some of the most complex international financial instruments, earned billions of dollars, and gained the respect of bankers throughout the world. In January 2008, the bank discovered fraudulent securities trading by one of its low-level traders, Jérôme Kerviel. The fraud was estimated to cost a staggering $7.14 billion, making it one of the largest financial frauds in history. The bank asserted that the fraud was the result of one employee’s illegal activities, did not involve other employees at the bank, and represented the aberrant actions of one “rogue trader.”

Kerviel’s job involved arbitraging small differences between various stock market indexes by selling a security on the exchange with the higher price and simultaneously buying an equivalent instrument on the exchange with the lower price. Small price dif- ferences on the two exchanges can produce a substantial profit when done in sufficient volume. Purchasing and selling equal amounts on the two exchanges should produce little net exposure to price changes. However, Kerviel had bought securities on both markets, betting that European stock prices would increase. When they fell, the bank incurred a substantial loss. Kerviel told investigators that he wanted to be respected and earn a large bonus.

Prior to becoming a trader, Kerviel had worked in the bank’s trading accounting office, where he gained knowledge of the bank’s risk management system. This allowed him to conceal the trades and bypass the firm’s control system. An investigation of this incident concluded that Société Générale “allowed a culture of risk to flourish, creating major flaws in its operations” that enabled Kerviel’s actions to proceed. Traders were rewarded for making risky investments with the bank’s money. Top executives at the bank received large bonuses because of the bank’s successful trading operations.

This example illustrates that agency problems (including fraud) can impose enor- mous costs on firms. SOURCE: J. Brickley, C. Smith, and J. Zimmerman, Managerial Economics and Organizational Architecture, 6th ed. (Boston: McGraw-Hill, 2016). p. 11.

Managerial Application: Agency Problems at Société Générale

In 2016, Whole Foods fired nine Washington, D.C., area store managers after they blew the whistle about senior managers allegedly tampering with store bonuses paid to employees. These managers reportedly gamed the chain’s bonuses paid to employees whose departments came in under budget. Apparently, the company avoided paying bonuses by shifting labor costs to other departments. This practice existed in more than 450 stores. The fired managers sued Whole Foods for $20 million in damages, alleging defamation of character. SOURCE: J. Moyer, “Whole Foods Managers Sue Chain after Being Fired after Allegedly Stealing bonuses” The Washington Post, December 23, 2016.

Managerial Application: Agency Problems at Whole Foods

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The existence of a job market for managers, the market for corporate control, and competition from other firms also constrain agency costs. The job market for managers causes managers to limit their divergent actions to avoid being replaced by other (out- side) managers. Replacements will occur if the board of directors has access to these job markets and incentives to replace the managers. If the board fails to reduce the firm’s agency costs, the firm’s stock price declines. Low stock prices encourage takeovers. The market for corporate control will then limit the agency costs of existing management via unfriendly takeovers. Finally, if both the job and corporate control markets fail, other firms in the same product market will supply better products at lower prices and eventually force firms with high agency costs out of business. However, to the extent that there are transac- tions costs in all these markets, it will not be cost-beneficial to drive agency costs to zero. For example, if the transactions costs of a corporate takeover, including legal, accounting, and underwriting fees, are 3 percent of the value of the firm, then it will not pay outsiders to acquire the firm if the magnitude of the agency costs they hope to eliminate are less than 3 percent. Thus, this level of agency costs will persist.

Agents maximize their utility, not the principal’s. This problem is commonly referred to as goal incongruence, which simply means that individual agents have different goals from their principal. The term is misleading because it suggests that the firm can secure congruence by changing personal preferences (i.e., utility functions) so that all individu- als in the organization adopt the principal’s goal. However, self-interested individuals’ preferences are not easily altered. The firm can reduce the agency problem, if not goal incongruence, by structuring agents’ incentives so that when agents maximize their utility (primarily incentive-based compensation), the principal’s utility (or wealth) is also maxi- mized. In other words, the agents’ and principals’ goals become congruent through the agents’ incentive scheme, not through a change in the agents’ underlying preferences.

All economic resources or assets are bundles of decision rights with respect to how they can or cannot be used. For example, ownership of a car includes a bundle of decision rights over its use, although not unrestricted use. The car owner can drive, sell, paint, or even destroy the car, but it is illegal to drive the car over the speed limit. The police powers of the state enforce private decision rights over assets; the threat of legal sanctions is brought

2. Decision Rights and Rights Systems

Two types of agency problems have been given specific names. Adverse selection refers to the tendency of individuals with private information about something that benefits them to make offers that are detrimental to the trading partner. For example, individu- als have more information regarding their health than do life insurance companies. If unconstrained, people who buy life insurance are likely to have more severe health problems than the average person assumed by the insurance company when setting its rates. After the insurance company sets its rates based on an average person, an adverse group of individuals will buy the insurance and the insurance company will lose money. To protect itself from adverse selection, insurance companies require medical exams to exclude the overly ill or to charge them higher prices (e.g., smokers).

Moral hazard problems arise when an individual has an incentive to deviate from the contract and take self-interested actions because the other party has insufficient information to know if the contract was honored. An example of a moral hazard prob- lem often occurs in automobile accident claims. The insured may claim that the door was dented in the accident when in fact it was already damaged. To reduce moral haz- ard problems, a variety of solutions exist, including inspections and monitoring.

Academic Application: Adverse Selection and Moral Hazard Problems

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to bear against someone interfering with another’s rights. If someone prevents you from driving your car by stealing it, the thief can be imprisoned. Our system of private property rights, including the courts and the police, enforces and limits individual decision rights.

Decision rights over the firm’s assets are assigned to various people within the firm who are then held accountable for the results. If an individual is given decision-making authority over some decision (such as setting the price of a particular product), we say that person has the decision right for that product’s price. Throughout the remainder of the book, we describe the importance of assigning decision rights to various individuals within the organization and the role of accounting in the assignment process. Who or what group of individuals has the decision rights to set the price, hire employees, accept a new order, or sell an asset? A key decision for many managers is whether to retain the right to make a particular decision or delegate the right to someone else. The question of whether the organization is centrally managed or decentralized is an issue of decision right assignment. Employee empowerment is a term that means assigning more decision rights to employees (i.e., decentralization). Accounting-based budgets assign decision rights to make expenditures to specific employees.

While rational and self-interested, individuals have limited capacities to gather and process knowledge. Since information (knowledge) is costly to acquire and process, individual decision-making capacities are limited. Jeff Bezos does not make all decisions at Amazon because he lacks the time to acquire the knowledge necessary for decision making. The process of generating the knowledge necessary to make a decision and then transferring that knowledge within the firm drives the assignment of decision rights.7

Because knowledge is valuable in decision making, knowledge and decision making are generally linked; the right to make the decision and the knowledge to make it usually reside within the same person. In fact, a key organizational architecture issue is whether and how to link knowledge and decision rights. Some knowledge, such as price and quan- tity, is easy (inexpensive) to transfer. In these cases, the knowledge is transferred to the person with the right to make the decision. Other knowledge is more difficult and hence costlier to transfer. Technical knowledge, such as how to design a computer chip, is costly to transfer. Knowledge that changes quickly, such as whether a machine is idle for the next hour, is costly to transfer in time to be useful; therefore, the decision right to schedule the machine is transferred to the person with the knowledge.

Ideally, knowledge and decision rights are linked, but they do not always reside with the same person. Suppose it is very difficult to transfer knowledge and very difficult to monitor the person with the knowledge. Moreover, suppose large agency costs arise if the person with the knowledge has the decision rights. Firm value might be higher if another manager with less knowledge makes the decision. This will occur if the costs from the inferior decisions made by the manager with less knowledge are smaller than the agency costs that result from giving the decision rights to the person with the better knowledge. For example, in many firms, salespeople do not have the decision right to negotiate prices directly with the customer, even though they have specialized knowledge of the customer’s demand curve. Pricing is determined centrally by managers with less information, perhaps to reduce the likelihood that the salesperson will offer a low price and receive a kickback from the customer.

Within all organizations, decision rights and knowledge must be linked. As we will see, accounting systems, especially budgets (Chapter 6) and standard costs (Chapter 12), are important devices for transferring knowledge to the individuals with the decision rights or giving the decision rights to individuals with the knowledge.

3. Role of Knowledge and Decision Making

7Jensen and Meckling (1992), p. 255.

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Production occurs either within a firm or across markets. For example, some computer software is produced by computer hardware companies and bundled with the computer, while other software is produced and sold separately. As another example, stereos can be purchased as entire systems. Here, the manufacturer designs, assembles, and ships complete units composed of a tuner-amplifier, CD player, and speakers. Alternatively, the consumer can purchase the components separately and assemble a complete system.

Nobel Prize winner in economics Ronald Coase argued that firms lower certain trans- actions costs below what it would cost to acquire equivalent goods or services in a series of market transactions.8 He conjectured that firms exist when they have lower costs than markets. Team production, discussed earlier, is one way firms can have lower costs than markets. Total contracting costs fall when a firm substitutes one internal transaction for a series of external market contracts.

4. Markets versus Firms

How do high-ranking managers with the decision rights acquire the knowledge to make good decisions? Visiting customers provides one way. Safety-Cleen, a $1.3 billion recycler of oil and environmental services, hired a new CFO. He visited customers with “ride-alongs” to pick up oil and containerized waste and, thereby, to “really get to learn the company.” The new CFO explains, “It’s easier to approve a capital project related to a facility when you’ve actually been to the facility and you know the facility manager and understand his opportunity.” SOURCE: S. Leibs, “Going for the Green,” CFO Magazine, April 15, 2012, pp. 37–38.

Managerial Application: Linking Knowledge and Decision Rights at Safety-Cleen Systems

Much of the world’s economic activity is conducted within firms. In fact, it is hard to envision a world where large firms do not play an important role in the production and distribution of products. The importance of firms, however, is a relatively recent phenomenon. Prior to the middle of the nineteenth century, there were almost no large firms. Most production was conducted by small owner-managed operations. The activi- ties of these operations were coordinated almost entirely through market transactions.

The traditional American business (before 1950) was a single-unit business enterprise. In such an enterprise an individual or a small number of owners operated a shop, factory, bank, or transportation line out of a single office. Normally, this type of firm handled only a sin- gle economic function, dealt in a single product line, and operated in one geographic area. Before the rise of the modern firm, the activities of one of these small personally owned and managed enterprises were coordinated and monitored by market and price mechanisms.

The large firm became feasible only with the development of improved energy sources, transportation, and communications. In particular, coal provided a source of energy that made it possible for the factory to replace artisans and small mill owners, while railroads enabled firms to ship large quantities of goods to newly emerging urban centers. The telegraph allowed firms to coordinate activities of employees over larger geographic areas. These developments made it less expensive to coordinate production and distribution using administrative controls, rather than relying on numerous market transactions among numerous small firms. SOURCE: A. Chandler, The Visible Hand: The Managerial Revolution in American Business (Cambridge, MA: Harvard University Press, 1977).

Historical Application: Firms versus Markets When Markets Ruled

8R. Coase, “The Nature of the Firm,” Economica 4 (1937), pp. 386–405.

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The costs of acquiring knowledge and enforcing contracts drive some production to occur within firms and other production to occur in markets. If knowledge were costless to acquire and process and there were no transactions costs, there would be no multiperson firms. To purchase an automobile, the consumer would enter into thousands of separate contracts with individual assemblers. If knowledge were free, these contracts would be costless. But knowledge is not free; our ability to acquire and process it is limited. Firms emerge because they economize on repetitive contracting. For example, individuals usu- ally hire general contractors to build custom homes. The general contractor has specialized knowledge of the various skilled tradespeople (plumbers, carpenters, and electricians) and can monitor these subcontractors more cheaply than the individual home owner.

Coase’s analysis has led to an important proposition in economics. Firms that survive in competition must have a comparative advantage in constructing contracts for internal production. Surviving firms have lower transactions costs than the market. This is an appli- cation of economic Darwinism (discussed in Chapter 1).

Nonetheless, markets perform certain functions better than firms. Ultimately, markets exist because of the right to transfer ownership of an asset and receive the proceeds. As noted earlier, individuals or firms have decision rights with respect to resources they own, includ- ing the right to use those resources as they see fit (within the limits of the law), the right to sell the resources, and the right to the sales proceeds. Markets discipline those who have the resources to use them in their highest-valued way. If owners lower the value of their assets by not properly maintaining them, markets punish them by lowering the resale price. Thus, mar- kets not only measure decision makers’ performance but also reward or punish that behavior. In fact, markets do three things automatically that organizations (firms) can accomplish only through elaborate administrative devices: (1) measure performance, (2) reward performance, and (3) partition rights to their highest-valued use. When Adam Smith described the invisible hand of the market and how the market allocates resources to their most highly valued use, he was describing how the market influences behavior and assigns decision rights.9

Because an asset’s current price reflects the future cash flows associated with it, deci- sion rights over how assets will be used in the future tend to be assigned to those who value them the highest. In markets, decision rights are linked with knowledge. Individuals or firms with “better” knowledge in using the asset will be willing to pay a higher price for the asset, thereby linking knowledge with decision rights.

To illustrate how markets help to control human behavior, consider the example of privately owned and operated cabs versus cabs owned by a taxi company and driven by different-salaried drivers. Which cabs will have a higher market value after being driven 50,000 miles? The owners of privately owned cabs have a greater incentive to maintain their cabs than the drivers of company-owned cabs. The resale price of each cab reflects wear and tear and maintenance. Since private cab drivers, as the sole drivers, bear all the financial consequences of their actions, they have an incentive to provide the correct amount of maintenance and generally operate the cab to maximize the market value of the cab at resale. Drivers for the taxi company do not bear the consequences of abusive driving and/or poor maintenance, unless the taxi company implements costly proce- dures to monitor the condition of the cabs after each driver’s shift. To provide incen- tives for the cabbies not to damage the cabs, the taxi company must install monitoring devices, but it is prohibitively costly to detect all abuse (such as transmission damage).

Managerial Application: Markets versus Firms: Taxicabs

9A. Smith, The Wealth of Nations, 1776, Cannan edition (New York: Modern Library, 1937).

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Up to this point, we have assumed that when decision-making authority is granted to an indi- vidual or a team within the firm, that agent or team is then actively involved in decision mak- ing (subject to ratification and monitoring from others). Sometimes, however, firms use bureaucratic rules that purposely limit active decision making. For example, airlines allo- cate routes to flight attendants based on seniority—there is no supervisor deciding who gets which route. Similarly, some firms base promotions solely on years worked with the firm.

One potential benefit of limiting discretion in making decisions is that it reduces the resources consumed by individuals in trying to influence decisions. Employees are often very concerned about the personal effects of decisions made within the firm. For example, flight attendants care about which routes they fly. Employees are not indifferent to which colleagues are laid off in an economic downturn. These concerns motivate politicking and other potentially nonproductive activities. For instance, employees might waste valuable time trying to influence decision makers. In vying for promotions, employees might take dysfunctional actions to make other employees look bad.

By not assigning the decision right to a specific individual, influence costs are lowered because there is no one to lobby. This policy, however, can impose costs on an organiza- tion. For example, consider individuals who are competing for a promotion. Each of these individuals has an incentive to provide evidence to the supervisor that he or she is the most qualified person for the promotion. Such information is often useful in making better promotion decisions. However, the information comes at a cost—employees spend time trying to convince the supervisor that they are the most qualified candidate rather than performing some other activity such as selling products.

In some cases, the firm’s profits are largely unaffected by decisions that greatly affect individual employee welfare. For example, firm profits might be invariant as to which flight attendant gets the Hawaii route versus the Sioux Falls route. It is in this setting that bureaucratic rules for decision making are most likely. The firm benefits from a reduction in influence costs but is little affected by the particular outcome of the decision process.

5. Influence Costs

Fraud and embezzlement remain major problems in all organizations. Bernie Madoff’s $65 billion Ponzi scheme, where he pleaded guilty and was sentenced to 150 years in prison, continues to be a prominent example. The PwC 2018 Global Crime and Fraud  Survey found that 49 percent of the respondents reported that their firm had experienced economic crime. A typical firm loses 5 percent of its revenues to fraud. People inside the organization perpetrate 52 percent of all frauds. Most reported an increase in cybercrime. SOURCE: “PwC 2018 Global Crime and Fraud Survey” at https://www.pwc.com/gx/en/services/advisory/forensics/ economic-crime-survey.html.

Managerial Application: Frauds

Q4–1 What generates agency costs? Q4–2 How are agency costs reduced, and what limits them? Q4–3 Define goal incongruence. Q4–4 How does one achieve goal congruence? Q4–5 Why are knowledge and decision making linked within a firm? Q4–6 Name three things markets do automatically that must be

replaced with elaborate administrative systems in the firm. Q4–7 What are influence costs? Q4–8 Why do firms exist?

Concept Questions

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B. Organizational Architecture When firms undertake certain repetitive transactions instead of contracting for them in outside markets, market prices for resources used inside the firm no longer exist. For example, the firm can be thought of as a bundle of resources used jointly to produce a product. Suppose one of the many joint resources is a machine used in manufacturing. There is not a specific market price for the machine used inside the firm. There is not a price for an hour of time on the machine because the firm does not sell time on this machine. There may be market prices for leasing time on other firms’ machines, but if buy- ing outside machine time was cheaper than using the internal machine, the machine would not exist inside the time. The cost of buying outside services includes the external price and the transactions costs of using the market. Even if prices for seemingly equivalent transactions occurring in markets exist, they are unlikely to represent the opportunity cost for transactions within the firm. The transaction exists within the firm because the firm can perform the transaction more cheaply than the market. Hence, the external market price for the machine, while indicative of what the firm can charge for time on its machine, does not capture the opportunity cost of using the machine inside the firm. The market price does not entirely capture the transactions cost savings of owning the machine.10

The firm cannot always use the external market’s price (even if available) to guide internal transactions. More important, in the absence of the discipline of the market, the parties to the firm must design administrative devices to (1) measure performance, (2) reward performance, and (3) partition decision rights. These three activities (called organizational architecture) are performed automatically by markets but must be performed by (costly) administrative devices inside the firm.11

Performance evaluation can involve either objective or subjective performance mea- sures or combinations of both. Objective criteria include explicit, verifiable measures such as paying employees on piece rates or sales. Subjective criteria focus on multiple hard-to-measure factors. For example, subjective performance measures include a variety of factors such as improving team spirit, getting along with peers, meeting budgets and schedules, and affirmative action hiring. Firms use implicit, subjective performance mea- sures because jobs typically have multiple dimensions. If a few explicit characteristics are chosen to reward performance, employees will ignore the hard-to-quantify aspects of their

10“Observed market prices cannot directly guide the owner of the input to perform in the same manner as if every activity he performs were measured and priced.” S. Cheung, “The Contractual Nature of the Firm,” Journal of Law & Economics 26 (April 1983), p. 5.

11Jensen and Meckling (1992), p. 265.

1. Three-Legged Stool

This example illustrates how members of one local management team who did not want to lose their jobs successfully gamed the performance-evaluation system their company used in deciding when to close unprofitable mines.

In this particular company, mines were shut down after the yield per ton of ore dropped below a certain level. One mine managed to stay open for several years because of the strategic behavior of its management. It happened that the mine contained one very rich pocket of ore. Instead of mining this all at once, the management used it as its reserve. Every time the yield of the ore it was mining fell below an acceptable level, it would mix in a little high-grade ore so the mine would remain open. SOURCE: E. Lawler and J. Rhode, Information and Control in Organizations(Santa Monica, CA: Goodyear Publishing, 1976), pp. 87–88.

Managerial Application: Gaming Objective Performance- Evaluation Systems

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work. Although firms must measure and reward performance, the performance measure need not be objective. Firms that use objective performance measures supplement them with subjective measures to ensure that employees do not focus entirely on the objective criteria to the detriment of their other responsibilities.

Besides measuring performance, organizations must reward favorable performance and in some cases punish unwanted behaviors (sometimes by firing employees). Pay increases, bonuses, promotions, and perquisites reward agents meeting or exceeding per- formance expectations. Superior performance is rewarded with both monetary and non- monetary compensation. Monetary rewards involve salary, bonus, and retirement benefits. Nonmonetary rewards include prestigious job titles, better office location and furnishings, reserved parking spaces, and country club memberships.

Another administrative device in firms is partitioning decision rights. Within organi- zations, all decision rights initially reside with the board of directors. The vast majority of these rights are assigned to the chief executive officer (CEO), with the exception of the right to replace the CEO and set his or her pay. The CEO retains some rights and reassigns the rest to subordinates. This downward cascading of decision rights within an organiza- tion gives rise to the familiar pyramid of hierarchies. Centralization and decentralization revolve around the issues of partitioning decision rights between higher versus lower lev- els of the organization and linking knowledge and decision rights.

Ultimately, all organizations must construct three systems:

1. A system that measures performance. 2. A system that rewards and punishes performance. 3. A system that assigns decision rights.

These three systems make up the firm’s organizational architecture. They are like the legs of a three-legged stool. For the stool to remain level, all three legs must be coordinated

Lincoln Electric manufactures electric welding machines and welding disposables (electrodes). At the heart of Lincoln Electric’s success is a strategy of building quality products at a lower cost than its competitors and passing the savings on to customers. Lincoln implements this strategy, in part, by fostering labor-productivity increases via a pay-for-performance compensation plan.

The two components of Lincoln’s performance evaluation scheme are pieces produced and merit rating. The first component is an objective, readily quantifiable performance measure for each production employee (i.e., the number of good units pro- duced). Employees are paid the piece rate times the number of good pieces produced. (Employees are not paid for defects.) By working hard, in some cases even through lunch and breaks, employees can double and sometimes triple their pay.

The second component of Lincoln’s evaluation scheme is the employee’s merit rating, which determine the employee’s share of the bonus pool. The size of the bonus pool approximately equals wages and is about twice Lincoln’s net income after taxes. Each employee’s merit evaluation is based on employee dependability, quality, output, and ideas and cooperation, assessed primarily by the employee’s immediate supervisor.

Two important observations emerge from Lincoln Electric. First, the output from the performance evaluation system is used as an input by the performance reward sys- tem; the two systems are linked. Second, Lincoln uses objective, explicit measures of performance (piecework) as well as subjective measures (ideas and cooperation). SOURCE: www.lincolnelectric.com.

Managerial Application: Objective and Subjective Performance Criteria at Lincoln Electric Company

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with the other two. Similarly, each of the three systems that compose the organization’s architecture must be coordinated with the other two. The performance measurement sys- tem must measure the agent’s performance in areas over which he or she has been assigned the decision rights. Likewise, the reward system must be matched to those areas over which performance is being measured. A person should not be assigned decision rights if the exercise of these rights cannot be measured and rewarded. Though this sounds obvious, changing one system often requires changing the other two systems.

The internal accounting system is a significant part of the performance measure- ment system. Changes are often made to this system without regard to their impact on the performance-reward and decision-assignment systems. Managers making changes to the accounting system are surprised when the stool is no longer level because one leg is now a different length than the other two.

Performance measurement systems generally use financial and nonfinancial measures of performance. Nonfinancial metrics include percentage of on-time deliveries, order complete- ness, excess inventory, employee turnover, manufacturing quality, percentage of defects and units of scrap, and customer complaints. Financial indicators are collected and audited by the firm’s accountants, whereas nonfinancial measures are more likely to be self-reported. There- fore, financial measures are usually more objective and less subject to managerial discretion. Nonfinancial indicators usually relate to important strategic factors. For example, airline profitability is very sensitive to the fraction of airline seats occupied. Thus, load factors are an important strategic measure in airlines. Nonfinancial measures provide information for making decisions. Financial measures of performance tend to be for controlling behavior.

Beware of proliferating too many performance measures. Numerous performance measures dilute attention. If several key indicators are used, senior managers must implic- itly specify the relative weights for each indicator for performance evaluation. Which indi- cator is really the most important in assessing performance? If senior management does not specify the weights, subordinates are uncertain which specific goal should receive the most attention. Chapter 14 describes the balanced scorecard and, specifically, the problem of using multiple performance measures.

Haier, one of China’s largest companies, stresses customer service, product quality, efficiency, and speed to market. It manufactures more than 15,000 different home appli- ances such as refrigerators, air conditioners, microwaves, and washing machines that are sold in 160 countries through 59,000 sales outlets. In the 1980s, it was near bank- ruptcy. What explains Haier’s phenomenal success?

Haier utilizes sophisticated employee performance measurement and reward sys- tems. Each day, every factory worker receives a detailed report card outlining his or her production quantity, quality, defects, equipment use, and safety record. Each employee is expected to improve 1 percent over the previous day. Realizing these improvements results in higher wages, bonuses, more job training, and additional social benefits. Peo- ple not achieving their targets are demoted and eventually fired. Managers are reviewed weekly based on their achieving both qualitative and quantitative goals such as process improvement and innovation. Managers, like factory workers, are rewarded with addi- tional pay and promotions for meeting their targets or demoted or even fired for poor performance. Dozens of Haier employees are fired every month. “Whoever tarnishes the brand of the company will be dismissed by the company.” SOURCE: J. Windust, “Zhang Ruimin – The Would-Be Unknown Leader,” June 29, 2017, https://www.cognology.com.au/ zhang-ruimin-unknown-leader/.

Managerial Application: Performance Evaluation and Rewards at the Haier Group

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Markets automatically control behavior and partition decision rights. The firm must design administrative devices to do what the market does. These mechanisms include hierarchies to separate decision management from control, budgeting systems, periodic performance evaluation systems, standard operating rules and policy manuals, executive compensa- tion schemes, and accounting systems. Some of these administrative devices, such as hierarchies and performance evaluation systems, are described in greater detail next. Later chapters discuss budgeting systems and accounting systems.

2. Decision Management versus Decision Control

Most federal agencies pay executive bonuses to increase accountability in government by tying pay to performance. Federal bonuses are designed to retain and reward knowl- edgeable and professional career public servants. While bonuses can help retain key employees, performance-based bonuses can be gamed, leading to counterproductive actions.

The Secretary of the U.S. Department of Veterans Affairs, General Eric Shinseki, was forced to resign following the disclosure of secret waiting lists at several VA hos- pitals serving former U.S. military personnel, many of whom were wounded in action. Administrators at veterans’ hospitals were told to alter data to make patient-access numbers look good for their supervisors. These superiors did not want long reported wait times because their bonuses were tied directly to the waiting times of the veterans. Reporting long wait times generated unfavorable performance reviews and, hence, a lower bonus. In one hospital, many veterans were not entered into the official elec- tronic waiting list, thereby distorting actual delays in providing care. Another VA clinic changed its bonus system, whereby bonuses would be paid only to doctors who limited patient follow-up visits to an average of two a year as a way to reduce waiting times by persuading veterans to make fewer appointments.

This example illustrates that pay-for-performance creates incentives to game the system. In other words, employees will attempt to game all performance measures, especially when they are used to determine rewards. The critical managerial question is: “By how much?” SOURCE: J. Gomez, “Remember the VA Healthcare Scandal? It’s Still Happening,” The Washington Post, October 31, 2017, https://www.washingtonexaminer.com/remember-the-va-healthcare-scandal-its-still-happening.

Managerial Application: VA Admin- istrators Game Their Performance Measures

This example illustrates how dysfunctional decisions can result when the three legs of the stool do not match. A plane was grounded for repairs at an airport. The nearest qualified mechanic was stationed at another airport. The manager at the other airport refused to send the mechanic immediately because it would entail an overnight stay and a $150 motel bill charged to the other airport manager’s budget. Since that manager’s compensation was tied to meeting her budget, she did not want her budget charged for the motel bill because it would lower her compensation. The mechanic was dispatched the next morning so that he could return the same day. A multimillion-dollar aircraft was grounded, costing the airline thousands of dollars. The manager, however, avoided a $150 hotel bill. The mechanic would probably have been dispatched immediately had the manager been rewarded on the overall profit of the company or had the decision right been held by someone else with this objective. SOURCE: M. Hammer and J. Champy, Reengineering the Corporation (New York: Harper Business, 1993).

Managerial Application: When the Legs of the Stool Don’t Balance

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Perhaps the most important mechanism for resolving agency problems is a hierarchi- cal structure that separates decision management from decision control. All organizations have hierarchies with higher-level managers supervising lower-level employees. Decision management refers to those aspects of the decision process in which the manager either initiates or implements a decision. Decision control refers to those aspects of the decision process whereby managers either ratify or monitor decisions. See Figure 4–1. Manag- ers rarely have all the decision rights to make a particular decision. Rather, an elaborate system of approvals and monitoring exists. Consider a typical decision to hire a new employee. First, a manager requests authorization to add a new position. This request is reviewed by higher-level managers. Once the position is authorized, the manager mak- ing the request usually begins the recruiting and interviewing process. Eventually a new employee is hired. After a certain period, the employee’s performance is evaluated. In gen- eral, the following steps in the decision process occur (categorized according to decision management or decision control): (1) initiation (management), (2) ratification (control), (3) implementation (management), and (4) monitoring (control). Initiation is the request to hire a new employee. Ratification is the approval of the request. Implementation is hiring the employee. Monitoring involves assessing the performance of the hired employee at periodic intervals to evaluate the person who hires the employee.

Individual managers typically do not have the authority to undertake all four steps in this decision process. The manager requesting a new position does not have the decision right to ratify (approve) the request. There is a separation of decision management from control. The same principle in the U.S. Constitution separates the powers of the various branches of government. The executive branch requests spending, which is approved by the legislature. The executive branch is then charged with making the expenditures. The judicial branch ultimately monitors both the executive and legislative branches.

As another example of how knowledge is linked with initiation rights and how hier- archies separate decision management from decision control, consider the decision to acquire capital assets. The decision to build a new plant usually begins with division man- agers who make a formal proposal to senior management. This is decision initiation. The initiating managers have specialized knowledge of their production process and product demand. The formal proposal usually takes the form of a capital budget request. Senior managers then ask the finance department to evaluate the discounted cash flow assump- tions in the capital budget request. The finance department possesses specialized knowl- edge to judge risk-and-return assumptions in the discount rate and the analysis of the cash flows in the plan. Senior management assembles other knowledge from the human resource, real estate, and legal departments in the ratification process. Construction of the project—implementation—is the responsibility of the proposing managers or a separate

FIGURE 4–1

Steps in the decision-making process: Decision management versus decision control

1. Initiation

Decision Management Decision Control

2. Ratification

4. Monitoring

3. Implementation

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facilities department within the firm. After construction is completed, accountants prepare monthly, quarterly, and annual reports on the division requesting and operating the capital project. This is part of the monitoring process.

Organizations separate decision management from decision control. Before imple- menting a decision, someone higher up in the organization must ratify it. Management and control are not separated, however, when it is too costly to separate them. For exam- ple, managers are often assigned the decision rights to make small purchases (perhaps under $500) without ratification because the cost of separating management from control exceeds the benefits. Since it takes time to receive ratification, lost opportunities or other adverse consequences can occur. The most vivid illustration of delay costs is in the mili- tary. Fighter pilots flying in noncombat situations do not have the decision rights to fire at unauthorized or potential enemy planes. They first must notify their superiors and seek authority. But in combat situations, decision management and decision control are not sep- arated because it would hamper the pilots’ ability to respond in situations when delays can be catastrophic. In combat, pilots have the authority to fire at enemy aircraft. An example of avoiding a delay that could possibly be deadly: In some states, paramedics can adminis- ter certain drugs in life-threatening situations without first getting a physician’s approval.

Most large firms have internal audit groups, and one important function of these groups is to monitor capital investment projects. For example, Caterpillar Inc. monitors strategic capital projects such as a new plant over the life of each project. Once a capital project is approved and installed, the internal auditors review it every six months. Only large strate- gic projects (often composed of several individual capital assets), such as an axle factory or an assembly line, are evaluated. The internal auditors prepare a report that compares the actual results with the budgeted results. Reasons for any differences are listed, includ- ing a detailed report that reconciles why the project’s current results differ from what was expected at the time the capital project was approved. In addition, the monitoring team issues a list of recommendations to improve the performance of the project. The moni- toring team’s findings are distributed to the manager of the project being evaluated, the plant manager, the group presidents, and the corporate board of directors. SOURCES: J. Hendricks, R. Bastian, and T. Sexton, “Bundle Monitoring of Strategic Projects,” Management Accounting, February 1992, pp. 31–35; and Ernst & Young, “The Future of Internal Auditing Is Now,” July 2012.

Managerial Application: Capital Project Monitor- ing at Caterpillar

Q4–9 Define decision management and decision control, and give an example of each.

Q4–10 Describe the three systems all organizations must construct to control agency problems.

Q4–11 Describe the four major steps in the management decision process. How are agency problems reduced in this process?

Concept Questions

C. Accounting’s Role in the Organization’s Architecture The preceding section described the separation of decision management from decision control. One way to limit agency costs is to separate the decision rights to initiate and implement decisions (decision management) from the ratifying and monitoring functions (decision control). Accounting systems play a very important role in monitoring as part of

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the performance evaluation system. Accounting numbers probably are more useful in deci- sion monitoring and least useful in decision initiation and implementation. For decision management, managers want opportunity costs (described in Chapter 2). Accounting data are often criticized as not being useful for decision management, but their usefulness for decision control is frequently overlooked.

To provide an effective monitoring device, accountants who prepare the performance measures of operating managers cannot report to these managers. The reason for this sepa- ration is obvious. Accounting, as part of the firm’s monitoring technology, is designed to reduce agency costs, including theft and embezzlement. Since accounting reports bring subordinates’ performance to the attention of their superiors, the reports should not be under the control of the subordinates. Internal accounting reports provide an overall review of subordinates’ performance by giving senior managers reasonably objective and inde- pendent information. Shareholders and the board of directors use the accounting system to check on the performance of the CEO and senior managers. The CEO often has sub- stantial influence over the accounting system since the corporate controller usually reports ultimately to the CEO. Some firms have the controller report to the independent audit committee of the board of directors. To use the accounting system for control of the CEO

Large department stores with multiple lines of goods such as clothing, furniture, jew- elry, and glassware began to appear in the United States in the latter half of the 1800s (Lord & Taylor in 1858 and Macy’s in 1870). These successful retailers had high vol- ume and high inventory turnover by selling at low prices and low margins. They marked down slow-moving lines and did extensive local advertising.

In rural areas, mass marketing was done by mail-order houses. Montgomery Ward began in 1872; Sears and Roebuck began in 1887. The 1887 Montgomery Ward mail- order catalog was 540 pages long and contained 24,000 items. The success of the mail-order houses, like the department stores, was due to low prices and high volumes. Mail-order houses could process 100,000 orders per day.

At the heart of both the department stores and mail-order houses were the operat- ing departments (such as women’s and children’s clothing, furniture, and housewares) and their buyers. The buyers had to acquire specialized knowledge of their customers’ preferences. They committed their departments to purchase millions of dollars of goods before they knew whether the items could be sold.

Two types of information generated by the accounting department were used to evaluate the operating managers and their buyers: gross margin and stock turn. Gross margin is income (sales less cost) divided by sales. Stock turn or inventory turnover is sales divided by average inventory; it measures the number of times stock on hand is sold and replaced during the year. Departments with higher stock turns are using their capital invested in inventories more efficiently. For example, the large Chicago merchandiser Marshall Field’s had a stock turn of around five in the 1880s. The devel- opment of gross margin and stock turn illustrates how accounting-based performance- evaluation measures develop to match the decision rights partitioned to particular managers. Critical to the success of large mass distributors was partitioning decision rights to the buyers with the specialized knowledge and then evaluating and rewarding them based on their decision rights. SOURCE: A. Chandler, The Visible Hand: The Managerial Revolution in American Business (Cambridge, MA: Harvard University Press, 1977), pp. 223–36.

Historical Application: Performance Measures in Retailing

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and senior management, the shareholders and outside directors on the board insist on an external, third-party audit of the financial results.

To the extent financial measures are used for decision control and nonfinancial mea- sures are used for decision management, the following implications arise:

1. Financial measures are not under the control of the people being monitored (i.e., the operating managers).

2. Nonaccounting measures, such as customer complaints and defect rates, are often more timely than accounting measures. Nonfinancial data can be reported more frequently than quarterly or monthly, as is usually the case for accounting data.

3. Not every decision requires ratification or monitoring. Decision control can be based on aggregate data to average out random fluctuations. Instead of moni- toring every machine setup, it is usually cost-efficient to aggregate all setups occurring over the week and make sure the average setup time or cost is within acceptable levels.

4. Operating managers tend to be dissatisfied with financial measures for mak- ing operating decisions. The accounting numbers are not especially timely for operating decisions. They often are at too aggregate a level and do not provide sufficient detail for the particular decision. In response, these operating managers develop their own, often nonfinancial, information systems to provide the more timely knowledge they require for decision management. But at the same time, they rely on accounting data to monitor the managers who report to them.

A number of specific internal accounting procedures, such as standard costs, bud- geting, and cost allocations (described in later chapters), help reduce agency problems. Many accounting procedures are better understood as control mechanisms than as aids in decision management. For example, economists have long cautioned against using accountants’ allocation of fixed costs to compute “average” unit costs in making short- term decisions. These unit costs bear little relation to short-term variable cost, which is necessary for determining the short-term profit-maximizing level of output. However, average unit accounting costs can be useful as a control mechanism for detecting changes in a department’s cost performance.

The economic Darwinism (discussed in Chapter 1) suggests that these seemingly irra- tional accounting procedures must be yielding benefits in excess of their costs. Economists describe the dysfunctional output/pricing decision that can result when accounting average costs are used instead of variable costs. These dysfunctional decisions are the indirect costs of using the accounting procedures. Reducing the firm’s agency problems provides the necessary offsetting benefits to explain the preponderance of so-called irrational account- ing procedures. In addition to the benefits provided via organizational reasons, such proce- dures can provide benefits (or costs) via external reporting, tax reporting, and/or as a cost control device (see Figure 1–1).

So far, this chapter has focused on the conflicts of interest between shareholders and managers of the firms, and how accounting numbers can be used to measure the perfor- mance of the managers to help align the shareholders’ and managers’ interests. Another important agency conflict exists between the shareholders and debt holders of the firms. Debt holders in corporations worry about the shareholders paying excessive dividends and eventually driving the firm into bankruptcy at their expense. To protect debt holders (including banks and insurance companies), the loan agreements contain provisions that prevent excessive dividend payments by tying dividends to accounting earnings. These agreements also contain covenants that often link the interest rate on the loan to accounting- based ratios, prevent future borrowings unless earnings are above a certain multiple of

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interest charges, and require the firm to maintain minimum ratios of current assets to cur- rent liabilities. Again, we observe accounting numbers used in debt contracts to better align the interests of shareholders and debt holders.

The next section provides a specific example of how accounting earnings are used in executive compensation plans to better align managers’ and shareholders’ interests.

D. Example of Accounting’s Role: Executive Compensation Contracts

Executive compensation contracts illustrate how accounting numbers help reduce agency costs. To better align the interests of shareholders and senior managers, most large U.S. corporations have incentive compensation contracts. This section briefly describes the design of these contracts and their reliance on accounting numbers. It illustrates how accounting performance measures are used to reduce agency problems.

Senior executives in most publicly held firms typically are paid a salary plus an annual bonus. The compensation committee of the board of directors, which usually consists of outside nonmanagement directors, administers the annual bonus and the annual salary adjustment. The committee annually sets performance goals for each senior executive and establishes how large a bonus each will receive if the goals are achieved. The goals often consist of earnings growth targets, market share, new product introduction schedules, affir- mative action hiring targets, and other strategic measures appropriate for the particular manager. If executives meet their targets, they receive some combination of cash, stock options, restricted stock, or deferred compensation.

To protect shareholders from excessive payouts to senior executives and to give senior executives a sense of the whole organization rather than just their own part, the total bonus payout to all eligible managers is limited to some fraction of accounting earnings. Besides defining who is eligible for awards and how they are administered and paid, these con- tracts constrain the total annual bonus payments to be paid out of an annual fund.

Accounting numbers enter executive compensation in two ways. First, accounting earn- ings often are used as individual performance measures (such as divisional profits). Second, accounting earnings constrain the total amount of compensation paid out to executives.

Surveys of compensation practices in publicly traded firms find that almost all of them rely on some measure of accounting profit to measure and reward the performance of senior executives.12 Large-scale empirical studies routinely find a strong positive associa- tion between changes in accounting profits and changes in executive pay. In these studies, accounting profits are usually one of the most important explanatory variables of executive pay among firm size, stock returns, and industry classification. Thus, it appears as if accounting profits either are used directly in setting executive compensation or are highly correlated with performance measures used in setting pay.

E. Summary Besides providing information for making operating decisions, accounting numbers also are used in controlling conflicts of interest between owners (principals) and employees (agents). Agency prob- lems arise because self-interested employees maximize their welfare, not the principal’s welfare, and principals cannot directly observe the agents’ actions.

The free-rider problem, one specific agency problem, arises because, for agents working in teams, the incentive to shirk increases with team size. Each agent bears a smaller fraction of the reduced output from his or her shirking as team size increases. The horizon problem, another agency

12J. Core, W. R. Guay, and D. Larcker, “Executive Equity Compensation and Incentives: A Survey,” Federal Reserve Bank of New York Economic Policy Review, April 2003, pp. 27–50.

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problem, arises when employees expecting to leave the firm in the future place less weight than the principal does on those consequences occurring after they leave.

Transactions that occur across markets have fewer agency problems because the existence of market prices gives owners of an asset the incentive to maximize its value by linking knowledge with decision rights. But once transactions occur within firms, administrative devices must replace market-induced incentives. In particular, firms try to link decision rights with knowledge and then provide incentives for people with the knowledge and decision rights to maximize firm value.

To maximize firm value, which involves minimizing agency costs, managers design the organiza- tion’s architecture—three interrelated and coordinated systems that measure and reward performance and assign decision rights. The analogy of the three-legged stool illustrates the importance of coor- dinating the three legs to one another. Changing one leg usually requires changing the other two to keep the stool balanced.

The internal accounting system, used to measure agents’ performance, provides an important monitoring function. Hence, the accounting system usually is not under the control of those agents whose performance is being monitored. Primarily a control device, accounting is not necessarily as useful for decision making as managers would like.

The performance evaluation system, one leg of the stool, consists of both financial and nonfinan- cial measures of performance. Executive compensation plans routinely use accounting earnings as a performance measure both to evaluate managers and to reduce agency costs by constraining the total bonus payouts to managers. Chapter 5 describes two more accounting tools that are used to reduce agency problems: responsibility accounting and transfer pricing.

Self-Study Problem Self-Study Problem 1: Span of Control

Span of control is defined as the number of subordinates whom a superior directly controls. Whether the span of control is large or small depends on several factors, including training. “(I)f a person was well trained, he or she would need little supervision. The span of control would be wide. If personnel were not well trained, they would need more supervision, and the span of control would be narrow and the hierarchy higher.” But the evidence shows “the more qualified the people, the less the span of control” and the higher the hierarchy.

In some situations, we observe a span of control of 40 or 50 (e.g., the faculty in a business school). In other situations, we observe spans of control of two to five (e.g., card dealers in a casino). What factors would you expect to be important in determining the optimum span of control? Give examples where appropriate.

Solution: Span of control (or the height/shape of the organization chart) is a central feature of the control prob- lem faced by organizations. The amount of monitoring required by each individual in the firm affects the span of control. High levels of monitoring decrease the span of control because supervisors have limited processing capacities.

A number of factors will affect the span of control:

1. Knowledge—it is useful to try to link knowledge and decision rights. If decision manage- ment rights are delegated, decision control rights are usually retained, thereby decreasing the span of control.

2. If monitoring costs are reduced, span of control increases, other things being equal. A case of reduced monitoring costs is grouping subordinates close to the supervisor. Performance eval- uation and reward systems that reduce agency costs (including monitoring costs) increase the span of control. If agency costs are high because the residual loss is large (e.g., bank tellers or card dealers in casinos), the span of control is smaller, other things being equal.

3. Perrow argues that one can change behavior via training to induce people to behave in the organization’s interest. This is inconsistent with the view that people are self-interested, rational maximizers.

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Problems P 4–1: Empowerment

It is frequently argued that for empowerment to work, managers must “let go of control” and learn to live with decisions that are made by their subordinates. Evaluate this argument.

P 4–2: Pay for Performance Communities are frequently concerned about whether or not police are vigilant in carrying out their responsibilities. Several communities have experimented with incentive compensation for police. In particular, some cities have paid members of the police force based on the number of arrests that they personally make. Discuss the likely effects of this compensation policy.

P 4–3: Course Packets Faculty members at a leading business school receive a budget to cover research expenditures, soft- ware and hardware purchases, travel expenses, photocopying for classroom use, and so forth. The budget is increased $250 for each class taught (independent of the number of students enrolled). For example, a faculty member receives a base budget of $14,000 for this year and teaches three courses—hence, the faculty’s total budget is $14,750.

Finance professors teach much larger classes than any other functional area (e.g., accounting), and they tend to have larger course packets per student. Faculty can photocopy their course packets and have their budgets reduced by the photocopying charges. Or the faculty can distribute course materials via the school’s network where students can download them and print them on their personal printers.

Required:

a. Which faculty members are more likely to put course packets and lecture notes on their web pages, and which faculty are more likely to photocopy the material and distribute it to their students?

b. Is this partitioning of faculty members distributing materials electronically versus making paper copies efficient?

P 4–4: Allied Van Lines Why are drivers for long-haul (cross-country) moving companies (e.g., Allied Van Lines) often fran- chised, while moving companies that move households within the same city hire drivers as employ- ees? Franchised drivers own their own trucks. They are not paid a fixed salary but rather receive the profits from each move after paying the franchiser a fee.

P 4–5: Voluntary Financial Disclosure Prior to the Securities Acts of 1933 and 1934, corporations with publicly traded stock were not required to issue financial statements, yet many voluntarily issued income statements and balance sheets. Discuss the advantages and disadvantages of such voluntary disclosures.

P 4–6: University Physician Compensation Physicians practicing in Eastern University’s hospital have the following compensation agreement. Each doctor bills the patient (or Blue Cross Blue Shield) for his or her services. The doctor pays for all direct expenses incurred in the clinic, including nurses, medical malpractice insurance, secretar- ies, supplies, and equipment. Each doctor has a stated salary target (e.g., $100,000). For patient fees collected over the salary target, less expenses, the doctor retains 30 percent of the additional net fees. For example, if $150,000 is billed and collected from patients, and expenses of $40,000 are paid, then the doctor retains $3,000 of the excess net fees [30 percent of ($150,000 – $40,000 – $100,000)] and Eastern University receives $7,000. If $120,000 of fees are collected and $40,000 of expenses are incurred, the physician’s net cash flow is $80,000 and Eastern University receives none of the fees.

Required:

Critically evaluate the existing compensation plan and recommend any changes.

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P 4–7: American InterConnect I Employee satisfaction is a major performance measure used at American InterConnect (AI), a large communications firm. All employees receive some bonus compensation. The lower-level employees receive a bonus that averages 20 percent of their base pay, whereas senior corporate officers receive bonus pay that averages 80 percent of their base salary. Bonus payments for all employees are linked to their immediate work group’s performance on the following criteria: income, revenue growth, customer satisfaction, and employee satisfaction. Managers can have these criteria supplemented with additional specific measures, including hiring targets and some other specific objective for each manager, such as meeting a new product introduction deadline or a market share target.

Employee satisfaction usually has a weight of between 15 and 20 percent in determining most employees’ overall bonus. To measure employee satisfaction, all employees in the group com- plete a two-page survey each quarter. The survey asks a variety of questions regarding employee satis- faction. One question in particular asks employees to rate how satisfied they are with their job using a seven-point scale (where 7 is very satisfied and 1 is very dissatisfied). The average score on this ques- tion for all employees in the group is used to calculate the group’s overall employee satisfaction score.

Required:

Describe what behaviors you would expect to observe at AI.

P 4–8: Raises A company recently raised the pay of employees by 20 percent. The productivity of the employees, however, remained the same. The CEO of the company was quoted as saying, “It just goes to show that money does not motivate people.” Provide a critical evaluation of this statement.

P 4–9: Vanderschmidt’s Jan Vanderschmidt was the founder of a successful chain of restaurants located throughout Europe. He died unexpectedly last week at the age of 55. Jan was sole owner of the company’s common stock and was known for being very authoritarian. He made most of the company’s personnel decisions himself. He also made most of the decisions on the menu selection, food suppliers, advertising pro- grams, and so on. Employees throughout the firm are paid fixed salaries and have been heavily moni- tored by Vanderschmidt. Jan’s son, Joop, spent his youth driving BMWs around the Netherlands and Germany at high speeds. He spent little time working with his dad in the restaurant business. Never- theless, Joop is highly intelligent and just received his MBA degree from a prestigious school. Joop has decided to follow his father as the chief operating officer of the restaurant chain. Explain how the organization’s architecture might optimally change now that Joop has taken over.

P 4–10: Sales Commissions Sue Koehler manages a revenue center of a large national manufacturer that sells office furniture to local businesses in Detroit. She has decision rights over pricing. Her compensation is a fixed wage of $23,000 per year plus 2 percent of her office’s total sales. Critically evaluate the organizational architecture of Koehler’s revenue center.

P 4–11: Formula 409 “I used to run the company that made Formula 409, the spray cleaner. From modest entrepreneurial beginnings, we’d gone national and shipped the hell out of P&G, Colgate, Drackett, and every other giant that raised its head. From the beginning, I’d employed a simple incentive plan based on ‘case sales’: Every month, every salesman and executive received a bonus check based on how many cases of 409 he’d sold. Even bonuses for the support staff were based on monthly case sales. It was a happy time, with everyone making a lot of money, including me.

“We abandoned our monthly case-sales bonus plan and installed an annual profit-sharing plan, based on personnel evaluations. It didn’t take long for the new plan to produce results.” SOURCE: Wilson Harrell, “Inspire Action: What Really Motivates Your People to Excel?” Success, September 1995.

Required:

What do you think happened at this company after it started the annual profit-sharing plan?

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P 4–12: Pratt & Whitney A Wall Street Journal article (December 26, 1996) describes a series of changes at the Pratt & Whitney plant in Maine that manufactures parts for jet engines. In 1993, it was about to be closed because of high operating costs and inefficiencies. A new plant manager overhauled operations. He broadened job descriptions so inspectors do 15 percent more work than they did five years ago. A “results-sharing” plan pays hourly employees if the plant exceeds targets such as cost cutting and on-time delivery. Now, everyone is looking to cut costs.

Hourly employees also helped design a new pay scheme that is linked to the amount of train- ing, not seniority, that an employee has. This was after the plant manager drafted 22 factory-floor employees, gave them a conference room, and told them to draft a new pay plan linked to learning.

Shop-floor wages vary between $9 and $19 per hour with the most money going to people run- ning special cost studies or quality projects, tasks previously held by managers.

This text emphasizes the importance of keeping all three legs of the stool in balance. Identify the changes Pratt & Whitney made to all three legs of the stool at its Maine plant.

P 4–13: American InterConnect II Employee bonuses at American InterConnect (AI), a large communications firm, depend on meeting a number of targets, one of which is a revenue target. Some bonus is awarded to the group if it meets or exceeds its target revenue for the year. The bonus is also tied to meeting targets for earnings, employee satisfaction, hiring goals, and other specific objectives tailored to the group or manager.

AI has several product development groups within the firm. Each is assigned the task of devel- oping new products for specific divisions within the firm. Product developers, primarily engineers and marketing people, are assigned to a new product development team to develop a specific new product. Afterward, they are assigned to new development teams for a different division or are reas- signed back to their former departments. Sometimes they become product managers for the new product. Product development teams take roughly 18 months to develop and design the product. For example, Network Solutions is one group of products AI sells. The employees in the product devel- opment group for Network Solutions receive part of their bonus based on whether Network Solutions achieves its revenue target for that year.

It typically takes AI three years from the time a product development team is formed until the product reaches the market. Once a new product idea is identified and researched, a prototype must be built and tested. Finally, it is introduced. Another 18 months is required for approval, manufactur- ing design, further testing, and marketing. These functions are performed after the product develop- ment team has been reassigned.

Required:

Analyze the incentives created by basing a portion of each current product developer’s bonus on revenues for products now being sold.

P 4–14: Tipping One of the main tenets of economic analysis is that people act in their narrow self-interest. Why then do people leave tips in restaurants? If a study were to compare the size of tips earned by servers in restaurants on interstate highways with those in restaurants near residential neighborhoods, what would you expect to find? Why?

P 4–15: Cope’s Department Store Employees at Cope’s Department Store are observed engaging in the following behavior: (1) They hide items that are on sale from the customers and (2) they fail to expend appropriate effort in designing merchandise displays. They are also uncooperative with one another. What do you think might be causing this behavior, and what might you do to improve the situation?

P 4–16: Coase Farm Coase Farm grows soybeans near property owned by Taggart Railroad. Taggart can build zero, one, or two railroad tracks adjacent to Coase Farm, yielding a net present value of $0, $9 million, or $12 million.

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Value of Coase Farm (in millions) as a Function of the Number of Fields Planted

and the Number of Train Tracks

Zero Fields One Field Two Fields

Zero tracks $0 $15 $18 One track 0 11 10 Two tracks 0 7 2

Coase Farm can grow soybeans on zero, one, or two fields, yielding a net present value of $0, $15 million, or $18 million before any environmental damages inflicted by Taggart trains. Environ- mental damages inflicted by Taggart’s trains are $4 million per field per track. Coase Farm’s payoffs as a function of the number of fields it uses to grow soybeans and the number of tracks that Taggart builds are shown next.

Value of Taggart Railroad (in millions)

as a Function of the Number of Train Tracks

(before any damages)

Zero tracks $ 0 One track 9 Two tracks 12

It is prohibitively expensive for Taggart Railroad and Coase Farm to enter into a long-term contract regarding either party’s use of its land.

Required:

a. Suppose Taggart Railroad cannot be held liable for the damages its tracks inflict on Coase Farm. Show that Taggart Railroad will build two tracks and Coase Farm will plant soy- beans in one field.

b. Suppose Taggart Railroad can be held fully liable for the damages that its tracks inflict on Coase Farm. Show that Taggart Railroad will build one track and Coase Farm will plant soybeans in two fields.

c. Now suppose Taggart Railroad and Coase Farm merge. Show that the merged firm will build one track and plant soybeans in one field.

d. What are the implications of the merger for the organizational architecture of the newly merged firm in terms of decision rights, performance measurement, and employee compensation?

SOURCE: R. Sansing.

P 4–17: Rothwell Inc. Rothwell Inc. is the leader in computer-integrated manufacturing and factory automation products and services. The Rothwell product offering is segmented into 15 product categories, based on prod- uct function and primary manufacturing location.

Rothwell’s sales division sells all 15 product categories and is composed of 25 district offices located throughout the United States. The company is highly decentralized, with district offices responsible for setting sales price, product mix, and other variables.

District offices are rewarded based on sales. Some large customers have plants in more than one of Rothwell’s sales districts. In cases where sales are made to these customers, the district offices participate jointly and sales credits are shared by each district involved.

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The sales division compensation plan designed by L. L. Rothwell, founder of the firm, was structured so that the staff would pursue sales in each of the 15 product categories. The selling pro- gram has the following features:

• Each sales representative receives a commission based on a percentage of the sales revenue generated.

• Each district (approximately 160 sales reps) is assigned a quota for each product line, defined in terms of dollar sales.

• In addition to commission, sales reps are eligible for an annual bonus. The company calculates individual bonuses by multiplying the number of bonus points earned by the individual target bonus amount. Points are credited at the district level.

• In order for all sales reps in a district to qualify for a bonus, the district must achieve 50 percent of quota in all 15 product groups and 85 percent of quota in at least 13 groups.

• Bonus points are awarded for sales greater than 85 percent of quota. • Five product groups have been identified as strategic to Rothwell. These “pride-level”

products are weighted more heavily in bonus point calculations.

Over the past three years, Rothwell generated exceptionally high sales—and awarded record bonuses. Profits, however, were lackluster. L. L. was befuddled!

Required:

a. Evaluate the compensation situation at Rothwell. b. Identify the types of behavior the existing system promotes and explain how such behavior

may be contributing to the firm’s declining profitability. Suggest improvements.

P 4–18: Gong-Fen “It was in Deyang in 1969 that I came to know how China’s peasants really lived. Each day started with the production team leader allocating jobs. All the peasants had to work, and they each earned a fixed number of ‘work points’ (gong-fen) for their day’s work. The number of work points accumu- lated was an important element in the distribution at the end of the year. The peasants got food, fuel, and other daily necessities, plus a tiny sum of cash, from the production team. After the harvest, the production team paid part of it over as tax to the state. Then the rest was divided up. First, a basic quantity was meted out equally to every male, and about a quarter less to every female. Children under three received a half portion.

“The remainder of the crop was then distributed according to how many work points each person had earned. Twice a year, the peasants would all assemble to fix the daily work points for each person. No one missed these meetings. In the end, most young and middle-aged men would be allocated 10 points a day, and women 8. One or two whom the whole village acknowledged to be exceptionally strong got an extra point. ‘Class enemies’ like the former village landlord and his fam- ily got a couple of points less than the others, in spite of the fact that they worked no less hard and were usually given the toughest jobs.

“Since there was little variation from individual to individual of the same gender in terms of daily points, the number of work points accumulated depended mainly on how many days one worked, rather than how one worked.” SOURCE: J. Chang, Wild Swans: Three Daughters of China, (New York: Anchor Books, 1991), pp. 414–15.

Required:

What predictable behavior do you expect the Chinese agricultural system will generate?

P 4–19: International Computer Company International Computer Company (ICC) has annual revenues of $2 billion primarily from selling and leasing large networked workstation systems to businesses and universities. The manufacturing divi- sion produces the hardware that is sold or leased by the marketing division. After the expiration of the lease, leased equipment is returned to ICC, where it is either disassembled for parts by the field

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service organization or sold by the international division. Internal studies have shown that equipment leased for four years is worth 36.5 percent of its original manufacturing cost as parts or sold over- seas. About half of ICC’s systems are leased and half are sold, but the fraction being leased by ICC is a falling proportion of total sales.

The leasing department is evaluated on profits. Its annual profits are based on the present value of the lease payments from new leases signed during the year, less

1. The unit manufacturing cost of the equipment. 2. Direct selling, shipping, and installation costs. 3. The present value of the service agreement costs.

Each leased piece of equipment will be serviced over its life by ICC’s field service organiza- tion. The leasing division arranges a service contract for each piece of leased equipment from the field service organization. The field service organization commits to servicing the leased equipment at a fixed annual cost, determined at the time the lease is signed. The leasing department then builds the service cost into the annual lease payment.

The leasing department negotiates the lease terms individually for each customer. In general, the leasing division sets the annual lease terms to recover all three cost components plus a 25 percent markup (before taxes). The 25 percent markup for setting the annual lease payment seemed to work well in the past and provided the firm with a reasonable return on its investment when ICC had domi- nance in the workstation market niche. However, in recent years, new entrants have forced the ICC leasing department to reduce its markup to as low as 10 percent to sign leases. At this small margin, senior management is considering getting out of the lease business and just selling the systems.

The following lease to Gene Science is being priced by the leasing department. A four-year lease of a small network of three workstations is being negotiated. The unit manufacturing cost of the network is $30,000. The service costs, which are payable to the field service department at the beginning of each year, are $2,000 (payable at installation), $3,000, $4,000, and $5,000 (payable at the beginning of each of the next three years, respectively). Selling, shipping, and installation costs are $7,000. The leasing department has an 8 percent cost of capital.

To simplify the analysis, ignore all tax considerations.

Required:

a. Using a 25 percent markup on costs and an 8 percent discount rate, calculate the fixed annual lease payment for the four-year lease to Gene Science.

b. Comment on some likely reasons why a 25 percent markup on leased equipment is proving more difficult to sustain. Should ICC abandon the lease market? What are some alternative courses of action?

P 4–20: Repro Corporation Repro Corporation is the leading manufacturer and seller of office equipment. Its most profitable business segment is the production and sale of large copiers. The company is currently organized into two divisions: manufacturing and sales. Manufacturing produces all products; sales is respon- sible for the distribution of all finished products to the final customers. Each division is evaluated on profits. Market research shows an existing demand for a facilities management service whereby Repro installs its equipment and personnel at a client’s site and operates the client’s copy center. To meet this demand, Repro is considering a proposal to expand its operations to include a service division responsible for contracting with firms to install Repro’s equipment in a copy service agree- ment. This copy service is named Facilities Management (FM).

A contract for FM includes the leasing of a complete copy center from the service division, including all necessary equipment and personnel. The client provides space for FM on site.

The value offered by the service division is threefold. The service division will be organized so that a base center in each city covered will be responsible for acting as both an independent copy cen- ter and a backup to the FMs contracted in the local area. Any FM processing shortfalls due to equip- ment failure or shop overflows would result in a transfer of copy needs to the center. Additionally,

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since the equipment used in FM contracts is leased and not purchased, contracting companies are not strapped with showing a return on assets for this equipment (allowing the flexibility of adjusting the lease as company needs vary). Nor are they responsible for equipment maintenance. Finally, the personnel to run the equipment in the FM sites are service division employees, not employees of the client. Thus, no additional headcount is needed by the client. For this complete value-added service, firms are charged based on projected monthly copy volume, with an agreed-upon surcharge for cop- ies processed in excess of the contracted volume.

With the introduction of this new division, Repro would reorganize itself into three divisions: manufacturing, products, and service. The responsibility of selling business equipment (copiers, fax machines, etc.) would be assigned to the products division, and the service division would become responsible for the sale of FM sites (products and services would utilize separate sales forces). Both divisions would buy hardware from manufacturing at similar costs.

Currently, Repro’s sales comprise approximately 80 percent repeat-purchase customers (who are either replacing existing equipment with similar equipment or upgrading to new Repro products) and 20 percent new customers. It has been estimated that 30 percent of the current market base would, given the opportunity, choose a Facilities Management contract rather than purchase equip- ment outright.

Repro’s current sales force compensation is a function of a fixed salary plus a commission based on a percentage of sales. The average salesperson’s compensation consists of a $25,000 base salary and a 2 percent sales commission. Over the last four years, the average piece of copy equipment from Repro sold for $80,000 and the average salesperson sold $1 million of equipment (adjusted for infla- tion). If the proposal for a service division is undertaken, this compensation scheme will be applied to both the products and service divisions’ sales force.

Required:

a. Discuss the conflict that will result if the service division is introduced. b. Propose a solution to solve this conflict.

Cases Case 4–1: Christian Children’s Fund

Christian Children’s Fund Inc. (CCF), established in 1938, is an international, nonsectarian, nonprofit organization dedicated to assisting children. With program offices around the world, it provides health and educational assistance to more than 4.6 million children and families through over 1,000 projects in 30 countries, including the United States. CCF’s programs promote long-term develop- ment designed to help break the cycle of poverty by improved access to health care, safe water, immunizations, better nutrition, educational assistance, literacy courses, skills training, and other services specific to improving children’s welfare.

Most of CCF’s revenues come from individual donors who are linked with a specific child. About 75 percent of the sponsors are in the United States, and in 2003, CCF had total revenues of about $143 million. (See Exhibit 1.)

In 1995, CCF began developing an evaluation system, nicknamed AIMES (Annual Impact Monitoring and Evaluation System), to assess the performance of its programs and whether they are making a positive, measurable difference in children’s lives. A working group of national directors, program managers, CCF finance and audit managers, and outside consultants developed a series of metrics that allowed CCF to be more accountable to its sponsors, as well as an evaluation tool to continually assess the impact of its programs on children. The working group wanted metrics that (1) captured critical success factors for CCF’s projects; (2) focused on a program’s impact, not its activities; (3) measured the program’s impact on children; and (4) could be measured and tracked.

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EXHIBIT 1 CHRISTIAN CHILDREN’S FUND INC.

Consolidated Statements of Activities and Changes in Net Assets For the Years Ended June 30, 2003, and 2002

Total

2003 2002

Public support Sponsorships: U.S. sponsors $ 76,838,477 $ 74,077,556 International sponsors 22,086,375 18,151,969 Special gifts from sponsors for children 12,351,284 11,838,912 Total sponsorships $111,276,136 $104,068,437 Contributions: General contributions $ 13,657,676 $ 13,642,476 Major gifts and bequests 4,712,032 4,751,059 Gifts in kind 804,247 637,977 Total contributions $ 19,173,955 $ 19,031,512 Grants: Grants and contracts $ 10,164,264 $ 7,768,755 Total public support $140,614,355 $130,868,704 Revenue Investment and currency transactions $ 264,893 $ 350,841 Service fees and other 1,636,717 1,522,652 Total revenue $ 1,901,610 $ 1,873,493 Net assets released from restrictions Satisfaction of program and time restrictions — — Total public support and revenue $142,515,965 $132,742,197 Expenses Program: Basic education $ 41,263,708 $ 40,964,478 Health and sanitation 28,767,904 29,442,196 Nutrition 13,824,871 15,635,046 Early childhood development 11,850,954 10,717,133 Micro enterprise 14,555,029 9,183,004 Emergencies 2,802,575 2,861,528 Total program expenses $113,032,041 $108,803,385 Supporting services Fund-raising $ 16,777,149 $ 15,484,634 Management and general 12,651,014 11,156,134 Total supporting services 29,428,163 26,640,768 Total expenses from operations 142,493,204 135,444,153 Change in net assets from operations $ 22,761 $ (2,701,956) Non-operating revenues (expenses) Realized (loss) gain on investments $ (602,619) $ 387,223 Unrealized gain (loss) on investments 696,584 (1,967,114) Total non-operating revenues (expenses) 93,965 (1,579,890) Change in net assets $ 116,726 $ (4,281,847)

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The following indicators were chosen:

Under 5-year-old mortality rate Under 5-year-old moderate and severe malnutrition rate Adult literacy One-to-two-year-old immunizations Tetanus vaccine-protected live births Families that correctly know how to manage a case of diarrhea Families that correctly know how to manage acute respiratory infection Families that have access to safe water Families that practice safe sanitation Children enrolled in a formal or informal educational program

Each family in a community with a CCF program is given a family card that tracks each of the preceding 10 indicators for that family. In 1997, the first year of implementation, AIMES captured the health status of about 1.9 million children in approximately 850 projects in 18 countries. Annual visits by project staff or volunteers update each family’s card. The family cards are aggregated at the com- munity level, national level, and then in total for CCF, and provide a reporting system. CCF managers then track trends and compare performance at the community, national, and organizational levels.

It took CCF two years to develop these metrics, test them, and train the staff in all the national offices in how to use the system. AIMES does not prescribe the strategy each community should adopt but rather allows each community to design programs that promote the well-being of children in that community. Program directors can use the AIMES data as a tool to monitor and manage their programs. If child mortality is high, local program directors decide how best to reduce the rate. The 10 AIMES metrics have made project managers more focused and better able to concentrate resources in those areas that make a measurable difference in children’s health. CCF uses the infor- mation to make program and resource allocation decisions at the community level. The family card has promoted better nutrition via appropriate feeding and child care practices because there is now more direct contact between CCF staff and volunteers and families.

Required:

Using this chapter’s organizational architecture framework, discuss the strengths and weaknesses of CCF’s AIMES project. SOURCES: D. Henderson, B. Chase, and B. Woodson, “Performance Measures for NPOs,” Journal of Accountancy (January 2002), pp. 63–68; and www.christianchildrensfund.org.

Case 4–2: Woodhaven Service

Background Woodhaven Service is a small, independent gas station located in the Woodhaven section of Queens. The station has three gasoline pumps and two service bays. The repair facility specializes in automo- tive maintenance (oil changes, tune-ups, etc.) and minor repairs (mufflers, shock absorbers, etc.). Woodhaven generally refers customers who require major work, such as transmission rebuilds and electronics, to shops that are better equipped to handle such repairs. Major repairs are done in-house only when both the customer and mechanic agree that this is the best course of action.

During the 20 years that he has owned Woodhaven Service, Harold Mateen’s competence and fairness have built a loyal customer base of neighborhood residents. In fact, demand for his services has been more than he can reasonably meet, yet the repair end of his business is not especially prof- itable. Most of his competitors earn the lion’s share of their profits through repairs, but Harold is making almost all of his money by selling gasoline. If he could make more money on repairs, Wood- haven would be the most successful service station in the area. Harold believes that Woodhaven’s weakness in repair profitability is due to the inefficiency of his mechanics, who are paid the industry average of $500 per week. While Harold does not think he overpays them, he feels he is not getting his money’s worth.

Harold’s son, Andrew, is a student at the university, where he has learned the Socratic dictum, “To know the Good is to do the Good.” Andrew provided his father with a classic text on employee

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morality, Dr. Weisbrotten’s Work Hard and Follow the Righteous Way. Every morning for two months, Harold, Andrew, and the mechanics devoted one hour to studying this text. Despite many lively and fascinating discussions on the rights and responsibilities of the employee, productivity did not improve one bit. Harold figured he would just have to go out and hire harder-working mechanics.

The failure of the Weisbrotten method did not surprise Lisa, Harold’s daughter. She knew that Andrew’s methods were bunk. As anyone serious about business knows, the true science of produc- tivity and management of human resources resides in Professor von Drekken’s masterful Modify- ing Organizational Behavior through Employee Commitment. Yes, employee commitment was the answer to everything! Harold followed the scientific methods to the letter. Yet, despite giving out gold stars, blowing up balloons, and wearing a smiley face button, he found Lisa’s approach no more successful than Andrew’s.

Compensation Plans Harold thinks that his neighbor Jack Myers, owner of Honest Jack’s Pre-Enjoyed Autorama, might be helpful. After all, one does not become as successful as Jack without a lot of practical knowledge. Or maybe it is Jack’s great radio jingle that does it. Jack tells Harold,

It’s not the jingle, you idiot! It’s the way I pay my guys. Your mechanics make $500 a week no matter what. Why should they put out for you? Because of those stupid buttons? My guys—my guys get paid straight commission and nothing more. They do good by me and I do good by them. Otherwise, let ’em starve.

Look, it’s real simple. Pay ’em a percent of the sales for the work they do. If you need to be a nice guy about it, make that percent so that if sales are average, then they make their usual $500. But if sales are better, they get that percent extra. This way they don’t get hurt but got real reason to help you out.

This hurt Harold. He really liked those buttons. Still, Jack did have a point. Straight commis- sion, however, seemed a little radical. What if sales were bad for a week? That would hurt the mechanics.

Harold figured that it would be better to pay each mechanic a guaranteed $300 a week plus a commission rate that would, given an average volume of business, pay them the extra $200 that would bring their wage back to $500. Under this system, the mechanics would be insulated from a bad week, would not be penalized for an average week, and would still have the incentive to attempt to improve sales. Yes, this seemed more fair.

On the other hand, maybe Jack knows only about the used car business, not about business in general. Harold figured that he should look for an incentive pay method more in line with the way things are done in the auto repair business. Perhaps he should pay his mechanics as he is paid by his customers—by the job. It is standard practice for service stations to charge customers a flat rate for the labor associated with any job. The number of labor hours for which the customer is charged is generally taken from a manual that outlines expected labor times for specific jobs on specific vehicles. The customer pays for these expected hours regardless of how many actual labor hours are expended on the job. Many shops also pay their mechanics by the job. Harold thinks that this approach makes sense because it links the mechanic’s pay to the labor charges paid by the customer.

Required:

a. This case presents some popular approaches to alleviating agency costs. Although certain aspects of each of these methods are consistent with the views presented in the text, none of these methods is likely to succeed. Discuss the similarities and differences between the ideas of the chapter and

(i) Dr. Weisbrotten’s approach. (ii) Harold Mateen’s idea of hiring “harder-working” mechanics.

b. Discuss the expected general effect on agency costs at Woodhaven Service of the new incentive compensation plans. How might they help Woodhaven? Assuming that Harold wants his business to be successful for a long time to come, what major divergent behav- iors would be expected under the new compensation proposals? How damaging would you

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expect these new behaviors to be to a business such as Woodhaven Service? Also, present a defense of the following propositions:

(i) Harold’s plan offers less incentive for divergent behavior than Honest Jack’s. (ii) Limiting a mechanic’s pay by placing an upper bound of $750 per week on his or her

earnings reduces the incentive for divergent behavior. c. Suppose Harold owned a large auto repair franchise located in a department store in a

popular suburban shopping mall. Suppose also that this department store is a heavily pro- moted, well-known national chain that is famous for its good values and easy credit. How should Harold’s thinking on incentive compensation change? What if Harold did not own the franchise but was only the manager of a company-owned outlet?

d. In this problem, it is assumed that knowledge and decision rights are linked. The mechanic who services the car decides what services are warranted. Discuss the costs and benefits of this fact for Woodhaven Service and the independently owned chain-store repair shop.

e. Suppose that Woodhaven’s problems are not due to agency costs. Briefly describe a likely problem that is apparent from the background description in this problem.

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Chapter Five

Responsibility Accounting and Transfer Pricing

Chapter Outline A. Responsibility Accounting

1. Cost Centers

2. Profit Centers

3. Investment Centers

4. Economic Value Added (EVA®)

5. Controllability Principle

B. Transfer Pricing 1. International Taxation

2. Economics of Transfer Pricing

3. Common Transfer-Pricing Methods

4. Reorganization: The Solution if All Else Fails

5. Recap

C. Summary

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Chapter 4 described the general agency problem of motivating and thereby influencing indi- vidual behavior. Chapter 4 also described how the organization’s architecture can reduce this problem. The firm’s organizational architecture consists of three interrelated systems: the performance evaluation system, the performance reward system, and the system that assigns decision rights. The accounting system plays an integral part in most firms’ performance evaluation. This chapter discusses two additional examples of how accounting systems can be applied to reduce agency problems: responsibility accounting and transfer pricing.

While this chapter and other chapters in the text focus on the use of accounting num- bers as performance measures, it is important to recognize that publicly traded firms also use their stock price as a performance measure. Executives in these firms usually receive (and hold) stock and stock options as part of their compensation packages as a way to align the interests of shareholders and managers. Accounting earnings create incentives for managers to take actions in the current period that increase the current period’s reve- nues, decrease expenses, or use assets more efficiently. Accounting earnings do not reflect actions taken by managers in the current period that will increase future period revenues or decrease future period expenses. For example, investments in research and development, new product development, or marketing that enhance earnings next year or the year after are not incorporated into this year’s accounting earnings. Only when the additional reve- nues are generated or expenses are reduced will accounting earnings reflect these changes. On the other hand, the stock market will reflect these investments in the form of higher stock prices as soon as the market becomes aware of the nature of the investment. Because stock prices are forward looking, they reflect the future anticipated benefits of actions taken in the current period. Accounting earnings are not forward looking and, hence, do not incorporate the effect of managerial actions taken today that will affect future periods. To reward managers for current actions that will impact future periods, publicly traded firms include stock and stock options in their managers’ compensation packages.

A. Responsibility Accounting1

All but the smallest organizations are divided into subunits, each of which is granted decision rights and then evaluated based on performance objectives for that subunit. For example, the firm might be organized into marketing, manufacturing, and distribution departments. Manufacturing is further subdivided into parts manufacturing and assem- bly, and assembly is further organized by product assembled. These basic building blocks of the organization form the work groups that define and characterize what each part of the firm does. Assigning decision rights to the subunits is a critical part of solving the limited processing capacity of humans discussed in Chapter 4. Responsibility accounting begins with formal recognition of these subunits as responsibility centers. A responsibility accounting system is part of the performance evaluation system used to measure the oper- ating results of the responsibility center.

The decision rights assigned to a subunit categorize the unit as a cost center, a profit center, or an investment center. The particular decision rights assigned to a subunit are the key determinants of how the unit’s performance is evaluated and rewarded. Each of these categories implies a different assignment of decision rights and, accordingly, a dif- ferent performance metric. In each case, decision rights are linked with the specialized knowledge necessary to exercise them. Responsibility accounting then dictates that the

1This section draws heavily on M. Jensen and W. Meckling, “Divisional Performance Measurement,” manu- script (Boston: Harvard Business School, 1986); and J. Brickley, C. Smith, and J. Zimmerman, Managerial Economics and Organizational Architecture, 6th ed. (New York: McGraw-Hill/Irwin, 2016).

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performance measurement system (the accounting system) measures the performance that results from the decision rights assigned to the responsibility center. For example, if an agent is assigned decision rights to sell products to customers in New York, the perfor- mance metric of this agent should not include sales to customers in Maine.

Matching the decision rights assigned to a subunit to its performance measure reduces the agency problems described in Chapter 4. A subunit is assigned a set of decision rights. A performance measure then evaluates how the subunit performed. Finally, the managers in the subunit receive rewards based on the performance measure. In this way, the subunit focuses on those tasks the principal wants performed. Table 5–1 describes the various responsibility centers. (In all cases, accounting numbers are used in the performance mea- surement system.)2

Firms create cost centers to measure the costs and outputs of a subunit. Cost center man- agers are assigned decision rights for determining the mix of inputs (labor, outside ser- vices, and materials) used to produce the output. Managers of cost centers are evaluated on their efficiency in applying inputs to produce outputs. Since they are not responsible for selling the final services or products, they are not judged on revenues or profits.

To evaluate the performance of a cost center, its output must be measurable. More- over, some higher unit in the organization with the specialized knowledge and decision rights must specify the department’s output or budget. Manufacturing departments like a parts manufacturing department in a factory are usually cost centers. The output of a parts

2In this chapter, we focus on three centers (cost, profit, and investment centers). Other types, such as expense and revenue centers, are not as prevalent as the three discussed. For discussion of these additional types of centers, see Jensen and Meckling (1986), and Brickley et al. (2016).

1. Cost Centers

TABLE 5–1 Comparison of Cost, Profit, and Investment Centers

Decision Rights Performance Measures Typically Used When

Cost center ∙ Input mix (labor, materials, supplies)

∙ Minimize total cost for a fixed output

∙ Maximize output for a fixed budget

∙ Central manager can measure output, knows the cost functions, and can set the optimal quantity and appropriate rewards

∙ Central manager can observe the quality of the cost center’s output

∙ Cost center manager has knowledge of the optimal input mix

Profit center ∙ Input mix ∙ Product mix ∙ Selling prices (or

output quantities)

∙ Actual profits ∙ Actual compared to

budgeted profits

∙ Profit center manager has the knowledge to select the optimal price/quantity

Investment center

∙ Input mix ∙ Product mix

∙ Actual ROI ∙ Actual residual

income

∙ Investment center manager has the knowledge to select the optimal price/ quantity

∙ Selling prices (or output quantities)

∙ Investment center manager has the knowledge to select the optimal product mix

∙ Capital invested in center

∙ Actual compared with budgeted ROI or residual income

∙ Investment center manager has knowledge about investment opportunities

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department is measured by counting the number of parts produced. Service organizations like banks use cost centers for functions such as check processing in a bank (number of checks processed) or food services in a hospital (number of meals served). In addition to measuring the quantity of output, its quality must be monitored. If not, cost center manag- ers who are evaluated on costs can meet their targets by cutting quality.

Various objectives are used for evaluating cost center performance. One is to mini- mize costs for a given output; another is to maximize output for a given budget. Mini- mizing costs for a given output is consistent with profit maximization, as long as central management has selected the profit-maximizing level of output. For example, the manager of a metal stamping department is told to produce 10,000 stampings per day of a fixed specification and quality. The manager is evaluated on meeting the production schedule and on reducing the cost of the 10,000 stampings while maintaining quality. The cost cen- ter manager does not have the decision rights to set the price or scale of operations.

Another possible evaluation criterion, maximizing output for a specified budget, pro- vides incentives equivalent to the first criterion, as long as the specified budget is the mini- mal budget necessary for producing the profit-maximizing quantity of output. For example, the manager has a fixed budget ($27,500 per week) and is evaluated based on the number of metal stampings produced that meet quality specifications within the fixed budget.

For both objectives, the manager is constrained either by total output or by bud- get. The two objectives are optimal if the central management chooses (1) the profit- maximizing output level or (2) the correct budget for efficient production of this output level. Nonetheless, under both cost center arrangements, the cost center manager has incentives to reduce costs (or increase output) by lowering quality. Therefore, the quality of the cost center’s output must be monitored.

Sometimes cost center managers are evaluated based on minimizing average cost. In this case, the manager has the incentive to choose the output at which average costs are minimized and to produce this output efficiently. It is important to emphasize that profit maximization need not occur when average costs are minimized. In general, minimizing average unit cost is not the same as maximizing profit. For example, suppose a cost center

In 1922, James O. McKinsey, founder of the consulting firm McKinsey & Co., described responsibility accounting:

In the modern business organization, control is exercised through individuals who compose the organization. If control of expenses is to be effected through members of the organiza- tion, it is necessary that they be classified so as to show responsibility for each class. If responsibility is taken as the controlling factor in an expense classification, each department will be charged with those expenses over which the executive head of the department exer- cises control. In addition it may be charged with some items of expense the amount of which is fixed or at least beyond the control of any officer.

To illustrate, the production department will be charged for the supplies used in produc- tion, for these are under the control of the production manager, and in addition it will be charged with the depreciation on production equipment, the estimated amount of which is determined in most cases by others than the production manager.*

Notice that McKinsey advocates the use of responsibility accounting and he also argues in favor of charging not only expenses over which managers have direct control but also expenses they control indirectly, such as depreciation. SOURCE: J. McKinsey, Budgetary Control (New York: Ronald Press, 1922), p. 281.

Historical Application: Respon­ sibility Accounting Not New

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has fixed and variable costs. In this case, average unit costs will continue to fall with increases in output. To illustrate, assume total costs are

TC = $300,000 + $6Q

Here, fixed costs are $300,000 and variable costs are a constant $6 per unit. Given this equation, average costs are derived by dividing both sides of the equation by Q to get

AC = TC ___ Q

= $300,000 ________ Q

+ $6

With a constant variable cost, the average cost falls as the quantity produced increases. In this situation, a cost center manager who is evaluated based on minimizing average unit costs has incentives to increase output, even as inventories mount. Focusing on minimiz- ing average unit cost can provide incentives for cost center managers to either overproduce or underproduce; it depends on how the profit-maximizing output level compares to the quantity where average costs are minimized.

Table 5–2 provides another example that minimizing average cost is not equivalent to profit maximization. This table shows that profits are maximized by selling six units, while minimum average cost occurs by producing nine units.

Cost centers work most effectively if (1) the central managers have a good under- standing of the cost functions, can measure quantity, and can set the profit-maximizing output level and appropriate rewards; (2) the central managers can observe the quality of the cost center’s output; and (3) the cost center manager has specific knowledge of the optimal input mix.

Profit centers often are composed of several cost centers. Profit center managers are given a fixed capital budget and have decision rights for input mix, product mix, and selling prices (or output quantities). Profit centers are most appropriate when the knowledge required to make the product mix, quantity, pricing, and quality decisions is specific to the division and costly to transfer.

Profit centers usually are evaluated on the difference between actual and budgeted accounting profits for their division. Although measuring profit centers’ profits seems straightforward, two complications often consume managers’ attention: how to price trans- fers of goods and services between business units (transfer pricing) and which corporate

2. Profit Centers

TABLE 5–2 Example Demonstrating that Minimizing Average Cost May Not Yield the Profit-Maximizing Level of Sales

Quantity Price Revenue Total Cost Total Profits Average Cost

1 $35 $35 $78 $−43 $78.0 2 33 66 83 −17 41.5 3 31 93 90 3 30.0 4 29 116 99 17 24.8 5 27 135 110 25 22.0 6 25 150 123 27 20.5 7 23 161 138 23 19.7 8 21 168 155 13 19.4 9 19 171 174 −3 19.3 10 17 170 195 −25 19.5

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overhead costs to allocate to business units. Managers constantly debate these two issues. We examine the transfer pricing problem in the next section. Chapters 7 and 8 discuss the allocation of corporate overhead costs to responsibility centers.

When interdependencies exist among business units, motivating individual profit cen- ters to maximize their unit’s profits generally will not maximize profits for the firm as a whole. For example, individual units focusing on their own profits frequently ignore how their actions affect the sales and costs of other units. One division might free-ride on another division’s quality reputation, thereby reaping short-run gains at the expense of the other division. For example, Chevrolet and Buick are two profit centers within Gen- eral Motors. Suppose Chevrolet, in pursuit of higher profits, decides to raise the quality of its cars. This might affect consumers’ perceptions of the average quality of all Gen- eral Motors cars, including Buick’s perceived quality. An enhanced reputation for all General Motors cars helps Buick. But if Chevrolet receives no credit for Buick’s profits, Chevrolet managers will likely ignore the positive effects they generate for Buick and tend to underinvest in quality enhancements. To help managers internalize both the positive and negative effects that their actions impose on other profit center managers, firms often base incentive compensation not just on the manager’s own profit center profits, but also on a group of related profit centers’ profits and/or firm-wide profits. Unless the entire firm makes a certain profit target, no individual profit center manager earns a bonus.

Investment centers are similar to profit centers. However, they have additional decision rights for capital expenditures and are evaluated on measures such as return on investment (ROI). Investment centers are most appropriate when the manager of the unit has spe- cific knowledge about investment opportunities as well as information relevant for making operating decisions for the unit.

Several profit centers often comprise one investment center. They have all the deci- sion rights of cost and profit centers, as well as the decision rights over the amount of capital invested. For example, suppose the consumer electronics group of an electronics firm consists of three profit centers: the television division, the Blu-ray division, and

3. Investment Centers

Virgin Air Lines employees do not do baggage delivery, heavy maintenance, reserva- tions, catering, and many other jobs. Rather, Virgin uses contractors. People unload- ing shipping containers at Walmart work for a trucking company. Google has about the same number of full-time employees and outsourced workers. Estimates place the number of contract workers in the United States at as many as 20 million people, and the number is growing.

Greater cost control is the primary reason for replacing employees with contract workers. Outsourcing firms compete to get a company’s business. They guarantee a level of cost and service of their contract workers. After signing the contract, the outside firm assumes the daily scheduling, hiring, and firing of workers. Outsourcing firms only make money if they keep costs down. The external market for contract workers pro- vides these labor services cheaper than if they are provided inside the firm. Why? Inside the firm, managers must supervise the full-time employees and these managers shirk their supervisory duties. They do not want to appear too tough. Competition among outsourcing firms provides much stronger incentives for these companies to lower labor costs than if these workers were supervised by managers inside the company. SOURCE: L Weber, “Contracted: The End of Employees” The Wall Street Journal, February 2, 2017.

Managerial Application: Outsourcing Workers to Control Costs

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the stereo division. Consumer electronics has decision rights over the amount of capital invested in the group.

Responsibility centers can interact in many ways and can have adverse or favorable impacts on other centers. Debasing the firm’s reputation by lowering the quality of its products is one example of an adverse effect that one responsibility center can have on another. A plant’s operating efficiency can be affected by the quantity and timing of the orders it receives from the marketing department. A purchasing department can affect the manufacturing department’s operations by the timing and quality of the raw materi- als purchased. A responsibility center sharing a newly discovered cost-saving idea with other centers is an example of a favorable (or positive) interaction. Managing these inter- actions (eliminating the negative ones and encouraging the positive ones) is critical to the successful linking of decision rights to individual(s) with the specialized knowledge. As discussed throughout the remaining chapters, the firm’s internal accounting system can play a powerful role in either enhancing the positive interactions or exacerbating the negative ones.

In all of the responsibility centers in Table 5–1, the measure of performance is linked to the decision rights vested in the management. Investment center performance can be measured in at least three ways: net income, return on investment, and residual income. Each of these is described next.

Net income The simplest of the three performance measures is accounting net income generated by the investment center (revenues minus expenses). However, net income does not consider all the investment used in the investment center to generate that income. Net income usu- ally incorporates interest on any debt used to finance the assets, but it does not include any equity financing charge. Measuring investment center performance using net income creates dysfunctional incentives in investment centers to overinvest. Managers have incen- tives to overinvest as long as the new investment yields positive net income, no matter how small it is relative to the investment. Two investment centers can have the same net income, but if one has more investment than the other, the one with the smaller investment is yielding a higher rate of return. If investment center managers have the decision rights over capital investments but are not held accountable for how efficiently that capital is employed, they likely will over invest.

Return on investment A commonly used investment center performance measure is return on investment (ROI). ROI is the ratio of accounting net income generated by the investment center divided by the total assets invested in the investment center. The other variants of ROI are ROA (return on total assets) and RONA (return on net assets, where net assets are total assets less current liabilities). Exactly how the denominator is measured is unimportant for under- standing the key conceptual issues. In subsequent discussion, ROI, ROA, and RONA are used interchangeably.

ROI reduces the overinvestment problem of net income by holding the investment center manager responsible for earning a return on the capital employed in the center. It has intuitive appeal because ROI can be compared with external market-based yields to provide a benchmark for a division’s performance. However, using ROI creates problems. ROI is not a measure of the division’s economic rate of return because accounting net income (the numerator) excludes some value increases, such as land value appreciation, until the land is sold. Accounting net income tends to be conservative in that it recognizes most losses and defers most gains. The denominator of ROI, total assets invested, excludes many intangible assets such as patents and the firm’s brand-name capital.

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The E.I. Du Pont de Nemours Powder Company, the leading firm manufacturing high explosives in the early 1900s, would later grow into one of the world’s largest chemical companies. To control and evaluate its operations, Du Pont managers developed the concept of return on investment.

The financial staff traced the cost and revenues for each product produced. This gave management accurate information on profits, which provided a more precise way of evaluating financial performance. However, managers found product-line profits to be an incomplete measure of performance because these did not indicate the rate of return on capital invested. One manager said, “The true test of whether the profit is too great or too small is the rate of return on the money invested in the business and not the percent of profit on the cost.”

Developing a rate of return on each segment of business required accurate data on investment. Du Pont undertook a careful valuation of each of its plants, properties, and inventories by product line. These data, along with profits, allowed management to track ROI by product line. In addition, Du Pont managers decomposed ROI (Profits ÷ Invest- ment) into its component parts. The accompanying figure illustrates this decomposition.

ROI is the product of sales turnover (Sales ÷ Total investment) and return on sales (Earnings ÷ Sales). These data allowed managers to determine the causes of a product’s change in ROI. Also, these data benchmarked new capital appropriations by establish- ing the policy that there “be no expenditures for additions to the earnings equipment if the same amount of money could be applied to some better purpose in another branch of the company’s business.” SOURCE: A. Chandler, The Visible Hand: The Managerial Revolution in American Business (Cambridge, MA: Harvard University Press, 1977), pp. 445–49.

Historical Application: The Du Pont Company ROI Method

Return on investment

Sales turnover

Return on sales

Sales

Total investment

divided by

Sales

Earnings

divided by

multiplied by

Whereas net income as an investment center performance measure creates an overin- vestment problem, using ROI typically creates an underinvestment problem. Managers have incentives to reject profitable projects with ROIs below the mean ROI for the division because accepting these projects lowers the division’s overall ROI. For example, suppose the division has an average ROI of 19 percent, 4 percent above its 15 percent cost of capital.3 A new investment project that is 10 percent the size of the combined division is available. Its

3Cost of capital is the rate of return the firm must pay the market to raise capital. If the firm can raise money at 15 percent and invest in projects earning 16 percent, the firm’s value increases.

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ROI is 16 percent, which is above the cost of capital of 15 percent, so that taking this project would increase the value of the firm. However, accepting this project lowers the division’s average ROI to 18.7 percent (or 0.90 × 19% + 0.10 × 16%). If the division is evaluated based on increasing ROI, the division management will reject the project, even though its return exceeds the opportunity cost of capital. Underinvesting results. In some cases, overin- vestment also can occur using ROI. For example, suppose a division has a 15 percent cost of capital, but only a 10 percent ROI. This division has incentive to seek out and accept a 12 percent ROI project. Doing so raises the division’s ROI. But clearly this project is unprof- itable because it is earning less than its cost of capital.

Riskier projects require a higher cost of capital to compensate investors for bearing this risk. If managers are rewarded solely for increasing their division’s ROI without being charged for any additional risk imposed on the firm, they have an incentive to plunge the firm into risky projects. Also, a manager with a short time horizon who is evaluated based on ROI would prefer projects that boost ROI in immediate years (the horizon problem) even if they were expected to be unprofitable over the life of the project.

Residual income To overcome some of the deficiencies of ROI, such as over- or underinvesting, some firms use residual income to evaluate performance. Residual income measures divisional perfor- mance by subtracting the opportunity cost of capital employed from division profits (after excluding any interest expense included in division profits). The opportunity cost of capital is measured using the firm’s weighted-average cost of capital, which reflects the cost of equity and debt. The cost of equity is the price appreciation and dividends that the share- holders could have earned in a portfolio of companies of similar risk. This is the opportu- nity cost that the shareholders bear by buying the company’s stock. The cost of debt is the current market yield on debt of similar risk. The costs of debt and equity are weighted by the relative amounts of debt and equity. Suppose the cost of equity is 18 percent, the cost of debt is 10 percent, and the firm’s capital structure is 40 percent debt and 60 percent equity. Then the weighted-average cost of capital is 14.8 percent (or 0.60 × 18% + 0.40 × 10%). Suppose a division has profits of $20 million and investment (total assets) of $100 million. This division also has a cost of capital of 15 percent. Its ROI of 20 percent exceeds its cost of capital (15 percent). Residual income is $5 million (or $20M – 15% × $100M). Under the residual income approach, divesting a project with an ROI of less than 20 percent, but above 15 percent, lowers residual income, although it raises average ROI.

Strattec Security, with sales of $400 million, manufactures and markets automotive access control products, including mechanical locks and keys and steering column and instrument panel ignition locks. It uses EVA to measure and reward managers. As described in its proxy statement,

Our “Economic Value Added Bonus Plan for Executive Officers and Senior Managers” provides for annual bonus payouts based on (1) the achievement of specific company-wide objective financial criteria, including minimum financial performance targets that must be met as a condition to payouts under the Plan, and (2) achievement of individual per- formance objective. .  .  . We believe that an improvement in the Economic Value Added measure is the financial performance measure most closely correlated with increases in our shareholder value. . . . In general, Economic Value Added (EVA) is our net operating profit after cash basis taxes, less a capital charge. The capital charge is intended to represent the return expected by the providers of our capital.

SOURCE: //strattec.com/application/files/7115/0481/2741/2017Proxy_2.pdf.

Managerial Application: Strattec Security Corp Uses EVA

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Nonetheless, residual income is not without its own problems. Residual income is an absolute number, and thus larger divisions typically have larger residual incomes than smaller divisions, making relative performance-evaluation comparisons across investment centers of different sizes more difficult. To implement residual income measures, senior managers must estimate the cost of capital for each division. In principle, each division will have a different cost of capital to allow more precise performance evaluations by con- trolling for risk differences.

Like ROI, residual income measures performance over one year. It does not measure the impact of actions taken today on future firm value. For example, cutting maintenance increases current period residual income (and ROI) but jeopardizes future cash flow and hence firm value.

A number of large companies, including AT&T, Best Buy, Coca-Cola Company, DirecTV, Kaiser Aluminum, and Whirlpool Corp., use or have used economic value added, or EVA®, as a measure of performance.4 Other EVA-like terms have been created such as economic profit, shareholder value added, total business return, and cash-flow return on investment. And like EVA, these other metrics are variants of residual income. The for- mula for EVA is:

EVA = Adjusted accounting earnings − ( Weighted−average cost of capital × Total capital )

This formula is basically the same as residual income. EVA, like residual income, measures the total return after deducting the cost of all capital employed by the division or firm. Even though the formula is the same as the residual income formula, the two differ in a couple of ways. First, different accounting procedures are often used to calculate “adjusted accounting earnings” than are used in reporting to shareholders.5 For example, U.S. accounting rules require that the entire amount spent on research and development each year be deducted from earnings. This creates incentives for managers with a short horizon to cut R&D spending. EVA advocates suggest adding back R&D spending and treating it as an asset to be amortized, usually over three to seven years. Total capital in the EVA formula consists of all the division’s or firm’s assets, including the amount of capi- talized R&D and other capitalized accounting adjustments. However, many firms using EVA choose not to make any accounting adjustments.

4. Economic Value Added (EVA®)

4EVA is a registered trademark of Stern Value Management; http://sternvaluemanagement.com/. 5For a more complete description of EVA, see B. Stewart, The Quest for Value (New York: Harper

Business, 1991).

Exercise 5–1

R&D spending at one company was $1.2 million in 2016, $1.5 million in 2017, $1.8 million in 2018, and $2.4 million in 2019. Calculate the amount of R&D assets and R&D expense from 2016 to 2019 under two alternative accounting procedures: (1) all current-year R&D is expensed immediately, and (2) R&D is capitalized and then amortized over three years. (Assume that all R&D spending for the year occurs on the first day of the year.)

continued

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Solution:

If R&D is expensed immediately, the R&D asset on the balance sheet is $0 and the 2019 expense is $2.4 million. The following table amortizes R&D spending over three years. For example, $1.2 million was spent on R&D in 2016. If this amount is capitalized, its annual amortization would be $0.4 million per year. But this $1.2 million would have been completely amortized before 2019 begins; none of its amortization would be in 2019. The amortization expense of $1.9 million in 2019 consists of one-third of the R&D spending in 2017, 2018, and 2019 (1/3 × $5.7 million).

Using the amortization amounts in the previous table, the next table calculates the amount of the R&D asset at the end of the current year.

The $2.2 million of R&D asset remaining after the end of 2019 consists of the remain- ing unamortized portion of 2018’s R&D spending ($0.6 million) plus the unamortized portion from 2019’s R&D spending ($1.6 million). The $1.2 million spent in 2016 and $1.5 million spent in 2017 are fully amortized, and hence no remaining portion of these amounts is in the R&D asset balance at the end of 2019.

Amortization of R&D Spending Incurred in Total R&D

Amortization Expenses in

2017 R&D

Spending 2016 2017 2019 2019

2014 $1.2 $0.4 2015 1.5 0.4 $0.5 2016 1.8 0.4 0.5 $0.6 2017 2.4 0.5 0.6 $0.8 $1.9

Balance of the R&D Asset Acquired in Total R&D Asset in

20192016 2017 2018 2019

Beginning of 2016 $1.2 Beginning of 2017 0.8 $1.5 Beginning of 2018 0.4 1.0 $1.8 Beginning of 2019 0.0 0.5 1.2 $2.4 End of 2019 0.0 0.0 0.6 1.6 $2.2

Exercise 5–2

The company in Exercise 5–1 has EVA before R&D of $15.2 million and a weighted- average cost of capital of 20 percent. Calculate its EVA under two alternative accounting procedures: (1) All current year R&D is expensed immediately, and (2) R&D is capitalized and then amortized over three years.

continued

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Second, many companies implementing EVA not only adopt EVA as their perfor- mance measure, but also link compensation to performance measured by EVA. For exam- ple, bonuses are paid only if managers achieve pre-stated EVA targets. Usually, firms adopting EVA put more of the total compensation paid to managers at risk. Instead of the bonus being 10 percent of the base salary, it becomes 30 percent or more. They expanded the pool of managers eligible to earn bonuses. Thus, firms adopting EVA increase the sen- sitivity of their managers’ pay to performance. While adopting EVA-based compensation plans imposes more risk on managers, EVA also increases their incentives to maximize firm value.

Adopting EVA and then linking pay to EVA performance involves several steps. Employees receiving EVA-based bonuses must be trained in how EVA is measured and how their actions affect EVA. For example, EVA creates incentives for managers to reduce unused assets, plant, equipment, and inventory. Eliminating underutilized assets lessens the capital charge applied to these assets and hence increases EVA.

Accounting earnings, ROI, residual income, and EVA enhance goal congruence by aligning managers’ and shareholders’ interests. But the four performance measures have subtle differences in achieving goal congruence. Earnings create incentives to increase revenues and decrease expenses. But earnings do not create incentives for managers to use assets efficiently. ROI gives managers incentives to shed unproductive assets (i.e., by decreasing the denominator, the ratio increases). Residual income and EVA charge manag- ers for the capital employed, thereby providing incentives to use assets efficiently. How- ever, these metrics focus on short-run accounting earnings. They do not reward managers for actions taken today that improve future accounting earnings. Some of the accounting adjustments, such as capitalizing R&D, help reduce this problem. Nonetheless, the future cash inflows from R&D are not recognized in EVA (or ROI or residual income) until they are received. Thus, a company can be making very profitable investments, but the returns from these investments will not show up in EVA (or earnings, ROI, and residual income) until the cash inflows from these investments are received.

Eaton, a maker of transmissions for large trucks, divided its transmission components into three categories: those for which other firms were more cost-effective because they had economies of scale, those for which Eaton was the most efficient producer or for which it had proprietary technology, and all other component parts of its transmissions. Eaton then outsourced the manufacturing of all component parts other than those for which it was the most efficient producer or for which it had proprietary technology. By doing this, Eaton significantly decreased the asset intensity of its business, thereby lead- ing to better returns on capital. SOURCE: D. Katz, “Lite Makes Right,” CFO, November 2010, pp. 35–36.

Managerial Application: Boosting Return on Capital

Solution:

1. If all R&D is expensed immediately, the company’s EVA is $12.8 million ($15.2 – $2.4).

2. If R&D is capitalized and then amortized, the company’s EVA is $12.86 million ($15.2 – $1.9 – 20% × $2.2).

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Responsibility accounting seeks to identify the objectives of each part of the organization and then develop performance measures that report the achievement of those objectives. For example, the department handling customer complaints might be evaluated based on how long customers wait for a representative or how many callers hang up. Holding managers responsible for only those decisions for which they have authority is called the controllability principle. Controllable costs are all costs affected by a manager’s decisions. Uncontrollable costs are those that are not affected by the manager.

Some people argue that managers should be judged solely on those items under their control, not on costs over which they have no influence. However, a strict application of the controllability principle has two major drawbacks. First, holding managers accountable for only those variables directly under their control does not give them an incentive to take actions that can affect the consequences of the uncontrollable event. For example, if the marina manager is not held accountable for damage done by hurricanes, the manager has less incentive to prepare the marina for severe storms. While managers cannot influence the like- lihood of hurricanes, they can certainly influence the costs incurred when a hurricane strikes.

Consider whether profit center managers should be evaluated based on their profits before or after taxes. One argument is that since profit center managers cannot control changes in state and federal tax policies, they should not be evaluated on after-tax profits. However, profit center managers’ decisions affect corporate tax payments in a variety of ways. Export sales affect tax credits. Charitable contributions and inventory write-offs affect taxes. Charging taxes to profit center managers lowers the amount of taxes paid by the corporation. This example illustrates an important point. Evaluating managers on items that they can at least influence, if not control, such as corporate taxes, changes the manag- ers’ incentives regarding those items.

The second drawback of the controllability principle is that it ignores the often use- ful role of relative performance evaluation, in which performance is judged relative to how some comparison group performed instead of by absolute standards. The comparison group helps control for random events that affect both the person being evaluated and the comparison group. For example, many instructors curve grades. Instead of awarding As for scores of 94 to 100, they give As to the top 15 percent of the class. Curving grades controls for unusually easy or hard exams and removes some of the risk from students.

Whenever the controllability principle is applied and managers are held accountable for their actions, dysfunctional actions can occur. All of the performance measures in Table 5–1 are prone to managerial opportunism in the form of accounting manipulations. Managers can choose depreciation methods or estimates that reduce expenses and increase reported earnings (e.g., straight-line depreciation or longer estimated asset lives). These accounting choices artificially raise ROI. Investment center managers can increase ROI by rejecting or divesting profitable projects with ROIs below the division average. All of the accounting measures in Table 5–1 are short-term measures of performance that suffer from the horizon problem, whereby managers emphasize short-term performance at the expense of long-term returns. Each measure requires careful monitoring by senior managers to reduce dysfunctional suboptimal subordinate behavior from the viewpoint of the owners.

5. Controllability Principle

At one call center, operators taking queries from customers about their accounts were evaluated on the number of calls answered per day. Customers with difficult, time- consuming questions had their calls forwarded to other departments. Customer satis- faction fell. Now most call centers record all calls and base operator performance on a subjective evaluation of a random sampling of their calls. SOURCE: C. Day, Call Center Operations: Profiting from Teleservices (McGraw-Hill Professional, 2000).

Managerial Application: Gaming in Call Centers

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Two important points must be stressed regarding the controllability principle:

1. Performance measurement schemes (including accounting-based methods) used mechanically and in isolation from other measures are likely to produce mislead- ing results and induce dysfunctional behavior. For example, in the former Soviet Union, Moscow cab drivers were evaluated on the number of miles driven. This scheme caused cab drivers to circle the city on the uncongested outer highways while most of the demand for cabs remained in the congested center of Moscow, where there were no cabs.

2. No performance measurement and reward system works perfectly. There always remains some managerial action that enhances the manager’s welfare at the expense of the shareholders. In other words, all incentive schemes will be gamed. One should avoid discarding a system because some managerial opportunism exists and the system proves to be less than perfect. The key question is whether the current system outperforms the next best alternative after considering all costs and benefits.

B. Transfer Pricing When goods are transferred from one profit (or investment) center to another, an internal price (the transfer price) is assigned to the units transferred. If Chevrolet manufactures an engine that is installed in a Buick, the transfer price is the internal charge paid by the Buick division of General Motors to the Chevrolet division of General Motors. Transfer prices are much more prevalent in organizations than most managers realize. Consider the charge that the advertising department receives from the maintenance department for janitorial service, or the monthly charge for telephones, security services, e-mail, legal and person- nel services, and so on. Most firms use cost allocations as a method of charging internal users for goods or services received from another part of the organization. These cost allo- cations are, in reality, transfer prices. Hence, transfer pricing and cost allocations are two closely related topics. (The specifics of cost allocations are discussed in Chapters 7 and 8.)

There are basically two main reasons for transfer pricing within firms: international taxation and performance measurement of profit and investment centers. Each of these is described next.

When products are transferred overseas, the firm’s corporate tax liability in both the export- ing and importing country is affected if the firm files tax returns in both jurisdictions. For example, when a copier is manufactured in Rochester, New York, by Xerox Corp. and

1. International Taxation

Q5–1 What is responsibility accounting? Q5–2 What role does the firm’s internal accounting system play in

resolving organizational problems? Q5–3 Describe three different types of responsibility centers.

Include any shortcomings the centers might have. Q5–4 How does EVA differ from residual income? Q5–5 What is the controllability principle, and what are its

limitations? Q5–6 What two points must be kept in mind when examining

performance-based measurement systems?

Concept Questions

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shipped to England to be sold, U.S. and British taxes paid by Xerox are affected. The trans- fer price of the copier is a revenue for U.S. tax purposes and a tax-deductible expense in England. To the extent allowed by the tax regulations, the firm will set a transfer price that minimizes the joint tax liability in the two countries. If the two tax jurisdictions tax income at different rates, then the firm will set the transfer price to shift as much of the profit into the lower-rate jurisdiction as possible, subject to the taxing authorities’ guidelines.

For example, suppose Bausch & Lomb manufactures a box of contact lenses in the Netherlands and ships the lenses to an Australian subsidiary that sells them for 85 Austra- lian dollars. The variable out-of-pocket cost of manufacturing the contact lenses is € 50. The exchange rate is 0.70 Australian dollars to 1 euro. Suppose the Dutch corporate tax rate is 30 percent and the Australian corporate tax rate is 40 percent. Bausch & Lomb will want to set the transfer price on the lenses as high as permissible to recognize more profits in the lower tax-rate jurisdiction, which is the Netherlands in this case. The transfer price of the contacts can vary, depending on what fixed costs are allocated to them and how. Suppose Australian and Dutch tax treaties allow Bausch & Lomb to set a transfer price at anywhere between € 80 and 110. Table 5–3 illustrates how the combined tax liability var- ies with the transfer price.

By choosing the highest allowed transfer price, € 110, Bausch & Lomb can recognize more profits in the country with the lowest corporate income tax rate. If Australia had the lower tax rate, then Bausch & Lomb would select the lowest transfer price, 80 euros, thereby reducing its Dutch tax liability and raising its Australian tax liability. But the higher taxes paid in Australia would be offset by the lower taxes paid in the Netherlands.

Each country has tax regulations that define how companies in its jurisdiction cal- culate the price of goods transferred in and out of the country. Section 482 of the U.S.

TABLE 5–3 Bausch & Lomb: Effect of Transfer Pricing on Combined Tax Liability

Transfer Price at

€ 80

Transfer Price at € 110

Taxes Paid in the Netherlands Revenue (transfer price) €80 €110 Variable cost –50 –50 Taxable income €30 €60 Tax rate 30% 30% Dutch taxes €9 €18

Taxes Paid in Australia Revenue† A$85 A$85 Transfer price in euros €80 €110 × Exchange rate 0.70 A$/Euro × 0.70 × 0.70 Transfer price as A$† –A$56 –A$77 Taxable income A$29 A$8 Tax rate 40% 40% Australian taxes A$11.6 A$3.2 Converted to euros (÷ 0.70) €16.57 €4.57

Sum of Dutch and Australian taxes €25.57 €22.57

†A$ denotes Australian dollars.

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Internal Revenue Code authorizes the Internal Revenue Service to regulate the allocation of revenues and costs to prevent tax evasion. International tax treaties regulate allowable transfer pricing methods. Because tax codes vary across jurisdictions, we ignore the role of international taxation in setting transfer prices in this chapter and focus instead on the organizational issues. Small differences in tax rates can generate large cash flow differ- ences, depending on the transfer prices. Thus, in many firms international taxation is the primary factor determining the firm’s transfer pricing policy.

Firms can have two sets of transfer prices: one for taxes and one for internal pur- poses. However, maintaining two such systems is costly. Additional bookkeeping costs are incurred and are confusing to users. In addition, some tax jurisdictions may argue that the transfer prices used for internal purposes should also be used for taxes, especially if they result in higher taxes than the transfer prices used for taxes.

As discussed earlier, firms are organized into responsibility centers. Whenever responsi- bility centers transfer goods or services among themselves, measuring their performance requires that a “transfer price” be established for the goods and services exchanged. For example, suppose a large chemical company is organized into profit centers. Besides producing for and selling to outside customers, these profit centers also sell intermedi- ate products to other profit centers within the company, which then further process the intermediate products into final products that are sold to outside customers. To measure the performance of the profit centers, each of these internal transactions requires a transfer price. The purchasing division pays the transfer price and the producing division receives the transfer price.

Some managers mistakenly view the transfer pricing problem as unimportant. They think that alternative transfer pricing methods merely shift income among divisions and that, except for relative performance evaluation, little else is affected. But this is a mistake: The choice of transfer pricing method does not merely reallocate total company profits among business units; it also affects the firm’s total profits. Think of the firm’s total profit as a pie. Choice among transfer pricing methods not only changes how the pie is divided among responsibility centers, it also changes the size of the pie to be divided.

Managers make investment, purchasing, and production decisions based on the trans- fer prices they face. If, from the firm’s perspective, these transfer prices do not reflect the true value of the resources, managers will make inappropriate decisions and the value of the firm will be reduced. For example, if the opportunity cost to the firm of producing an intermediate chemical is $20 per kilogram but the transfer price is $30, the purchasing division will consume too little of the chemical relative to the quantity it would purchase if

2. Economics of Transfer Pricing

Some consultants advocate using two separate transfer pricing systems, one for tax pur- poses and another for internal decision making, even though maintaining two systems can be costly. Some consultants believe that two systems provide senior management with more accurate information about profitability. However, many tax experts advise against two systems because if the single transfer pricing system reflects economic real- ity, the firm does not need two systems. If the firm has two systems because the one used for taxes does not reflect the firm’s economic reality, the tax authorities may disal- low the transfer prices used for tax calculations. SOURCE: M. Hiemann and S. Reichelstein, “The Dual Role of Transfer Prices in Multinational Firms: Divisional Perfor- mance Measurement and Tax Optimization,” The European Financial Review, October 2, 2012.

Managerial Application: Dual Transfer Pricing Systems?

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the transfer price were $20, and total firm profits fall. Purchasing-unit managers will shift away from using the chemical toward using other inputs that, in reality, are more expen- sive for the firm. Also, because transfer prices affect the managers’ performance evalua- tions, incorrect transfer prices can result in inappropriate promotion and bonus decisions.

Because transfer prices (including chargeback systems) are widespread in many firms and because transfer pricing affects performance evaluation and hence the rewards manag- ers receive, disputes over the transfer price between divisions are inevitable. Transfer pric- ing creates tension within firms. It is not uncommon for managers in most multidivisional firms to be involved in transfer-pricing disputes over the course of their careers.

The transfer price that maximizes firm value is quite simple to state: The optimal transfer price for a product or service is its opportunity cost—it is the value forgone by not using the transferred product in its next best alternative use. Unfortunately, as we will see, this simple rule is often difficult to implement in practice.

Transfer pricing with perfect information To illustrate the concept of using opportunity cost to set the transfer price, suppose the firm has two profit centers: Manufacturing and Distribution. Senior management is con- sidering making a product in Manufacturing and transferring it to Distribution. Assume also that Manufacturing’s variable cost of production is $3 per unit, and that it has excess capacity. If the product is transferred to Distribution, Distribution can sell it and receive $5 for each unit, net of its own variable cost. Also, everyone knows each division’s cost and revenue data.

When U.S. companies faced a 35 percent federal income tax rate, one of the high- est in the world, many firms lowered their total tax bill by a third using transfer pricing. For example, one U.S.-headquartered firm manufactures products in Ireland, sells them primarily in the United States, and uses subsidiaries in the Netherlands and Bermuda to recognize the income tax. Setting high transfer prices between the United States and Ireland shifts the income first to Ireland. Then transfer prices shift that income to the Netherlands and Bermuda, which have even lower tax rates than Ireland. By not returning the profits to the United States in the form of cash, firms legally avoid most U.S. taxes on their income. Apple Inc. reduced its federal tax bill by billions of dollars. Apple conducts most of its research in the United States, and most of its key employees, long-lived assets, and retail stores are in the United States. By employ ing legal transfer-pricing rules, Apple reported only 30 percent of its prof- its as being from the United States, thereby lowering its worldwide effective tax rate to 13 percent.

The 2017 U.S. Tax Cut and Jobs Act lowered the federal income tax rate to 21 percent, making obsolete the previous transfer-pricing–income-shifting schemes. Now U.S. multinationals have an incentive to recognize income in the United States because the U.S. corporate tax rate is lower than a majority of its trading partners.

U.S. multinational firms with elaborate transfer-pricing schemes designed to lower effective worldwide taxes now must spend millions of dollars on tax lawyers and accountants to revise their outdated transfer-pricing models. SOURCES: M. Sullivan, “Apple Reports High Rate but Saves Billions on Taxes,” Tax.com, February 13, 2012; and W. James, “BEAT or GILTI? Tax Reform’s Effect on Transfer Pricing,” January 2018, www.bkd.com/articles/2018/beat-or- gilt-tax-reforms-effect-on-transfer-pricing.htm.

Managerial Application: Transfer Pricing and Taxes

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If the unit is not manufactured, the firm saves $3 but forgoes $5, thus reducing profits by $2. If the unit is manufactured and transferred, the firm forgoes $3 (variable cost to produce) and receives $5 for a net receipt of $2. The better alternative is to manufacture and transfer the unit. The resources forgone by transferring the unit from Manufacturing to Distribution—and hence the opportunity cost of such a transfer—is $3 per unit, the same as Manufacturing’s variable cost of production.

As this example is meant to suggest, the variable cost of producing the unit is often the opportunity cost. But this is not always the case. Sometimes, the opportunity cost is the revenue of selling the intermediate good externally. For example, suppose Manu- facturing can produce one unit for $3 and can either transfer that unit to Distribution or sell it for $5.50 outside the firm—but, because of limited capacity, it cannot do both. In this case, by having Manufacturing transfer the unit to Distribution, the firm forgoes selling the intermediate good in the market. Even though the variable cost of produc- ing the unit is $3, the opportunity cost of the transfer is $5.50. It is now optimal to sell it externally rather than transfer it to Distribution. Selling it externally yields profits of $2.50 ($5.50 – $3.00). Transferring it to Distribution, who sells it for $5, yields profits of only $2 ($5 – $3).

When opportunity cost is used to set the transfer price, Manufacturing will produce to the point at which the variable cost of the last unit equals the transfer price. Likewise, Distribution will buy units from Manufacturing as long as Distribution’s net receipts just cover the transfer price. When opportunity cost is used to set the transfer price and both Manufacturing and Distribution are maximizing their respective profits, assuming there are no interdependencies between the business units (a case we consider later), total firm profits are maximized. If the transfer price is too high or too low relative to opportunity cost, too few units are transferred and firm profits are not maximized.

Transfer pricing with asymmetric information The preceding discussion assumes everyone knows (1) Manufacturing’s variable produc- tion cost, (2) Distribution’s revenue, and (3) whether Manufacturing has excess capacity. If all of this knowledge were readily available, there is no reason to decentralize deci- sion making within the organization. Central management, with all the knowledge, makes the decision about how many units to transfer. In reality, much of the information is not readily available to central management. In large, multidivisional firms, such knowledge generally resides at lower levels of the firm where it is private knowledge, costly to either transfer or verify by senior management. In some circumstances, lower-level managers have incentives to distort the information they pass up to senior managers. To illustrate these incentives, we consider the role of market power.

Consider a situation where the manager of Manufacturing is the only person with knowledge of his division’s variable costs, and assume that Burt seeks to maximize the profits of his division. Even if Distribution is allowed to purchase the product on the out- side, if Manufacturing has market power in setting the transfer price, it will attempt to set the price above its variable cost to increase its measured profits. When this happens, the firm manufactures and sells too few units of the product. The Manufacturing division, pos- sessing what amounts to monopoly rights in information, behaves like a monopolist. Just as monopolists earn “monopoly profits” by raising prices and restricting output, Manufac- turing’s higher profits lead to lower-than-optimal production levels and lower total firm profits. Example 5–1 illustrates how firm profits are reduced when the transfer price is not set at opportunity cost.

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Example 5–1

There are two profit centers: the Seller and Buyer divisions. The Seller division produces and sells an intermediate product (electric motors) to the Buyer Division. The Buyer Division uses the motors in making a toy car. Both divisions are profit centers and maximize their division’s profits. The following outlines the cost structure of the two divisions:

Cost Structure of the Two Divisions

Selling Division (Seller) Buying Division (Buyer)

Fixed costs $150/day $100 (1st 100 units per day) Variable costs $0.10/unit $0.20/unit (over 100 units)

Demand for Buyer Division’s Toy Car

Quantity Sold Price/Car Total Revenue

100 $2.00 $200 200 1.80 360 300 1.50 450 400 1.30 520 500 1.20 600 600 1.04 624

Buying Division’s Costs and Revenues

Output (Units)

Buyer’s Own Cost

($100 + .20/Unit over 100)

Cost from Seller

($0.95/Unit)

Total Cost (Buyer’s Own

Cost + Transfer)

Total Revenue (Price × Quantity)

Profit (Revenue − Cost)

100 $100 $ 95 $195 $200 $ 5 200 120 190 310 360 50 300 140 285 425 450 25 400 160 380 540 520 −20 500 180 475 655 600 −55 600 200 570 770 624 −146

The Buyer Division faces a downward-sloping demand curve for its final product (the toy car), which includes the intermediate product with the following price–quantity relationship:

Suppose the transfer price is set at $0.95 per unit and 200 motors are transferred. The $0.95 was set by taking Seller’s variable cost of $0.10 per unit and adding $0.75 for fixed costs (Unit fixed cost = $0.75 = $150/200) and $0.10 for profits. Seller’s profit is $20 = 200 × $0.10.

The Buyer Division produces 200 cars and maximizes profits at $50. These relations are summarized in the next table.

Both divisions seem to be operating well, and both are making a profit. The Buyer Division is maximizing its profit. The selling division, Seller, is making $20 profit and could make more motors if only the Buyer Division would buy more. But the company is not maximizing firmwide profits. continued

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Company profits are maximized at 500 motors. The accompanying table indicates the total companywide costs and revenues at the various output levels.

Company profits rise from $70 at 200 motors per day to $220 at 500 motors per day. In this example, the correct transfer price is at variable cost ($0.10). Transferring at $0.10/motors maximizes company profits. Charging more than variable cost causes the Buyer Division to purchase too few motors. But the Seller Division shows a loss (its fixed costs, if the transfer price is set at variable cost).

Firm Profits

Output Seller Costs

Buyer Costs

Total Costs

Total Revenue

Firm Profit

100 $160 $100 $260 $200 $−60 200 170 120 290 360 70 300 180 140 320 450 130 400 190 160 350 520 170 500 200 180 380 600 220 600 210 200 410 624 214

The correct transfer price is opportunity cost. But, as noted earlier, determining opportu- nity costs is difficult—in part because the information necessary to calculate such costs resides with operating managers who have incentives to distort it. To address this problem, companies sometimes commission special studies of the firm’s cost structure by outside experts. However, not only are such studies costly but their findings become outdated whenever the firm’s business opportunities or productive capacities change. On the other hand, if senior management simply vests the right to set the transfer price with either Man- ufacturing or Distribution, these opportunistic managers will set the transfer price to maxi- mize their division’s profits, not firmwide profits. Hence, too few units get transferred, and the firm’s value will be lower than it could be.

Because determining opportunity costs is itself an expensive undertaking, managers resort to various lower-cost approximations. Firms regularly use four different methods to approximate the opportunity cost of the units transferred: market price, variable production cost, full cost, and negotiated pricing. As discussed next, each one of these four methods is better than the others in some situations, but not in others. One size doesn’t fit all. For example, if the divisions operate in different countries with different tax rates, then tax considerations often drive the choice of method. The remainder of this section describes the various methods and their advantages and disadvantages.

Market-based transfer prices The standard transfer pricing rule offered by most textbooks is: Given a competitive exter- nal market for the good, the product should be transferred at the external market price. If Manufacturing cannot make a long-run profit at the external price, then the company is better off not producing internally and instead should purchase in the external market. If the purchasing division cannot make a long-run profit at the external price, then the company is better off not processing the intermediate product and instead should sell it in the external market. Using the external market price of goods and services transferred internally is often an objective way to set transfer prices. Unlike accounting-based transfer

3. Common Transfer­Pricing Methods

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prices, market-based transfer prices can not be manipulated by managers in the selling division. (Discussed later.)

Some managers believe that market-based transfer prices lead to correct make-versus- buy decisions. In many situations, however, market prices create inaccurate estimates of opportunity cost. If the firm and the market both are making the intermediate good, the fundamental question arises, Can both survive in the long run? If one can produce the good at a lower, long-run, average cost than the other, the high-cost producer should not be producing the intermediate product.

Transactions generally take place inside rather than outside firms whenever the cost of repetitive internal contracting is cheaper than outsourcing.6 For example, firms often pro- duce products inside even though they could purchase them externally. Firms produce internally when there are important interdependencies or synergies among those products. And, of course, the more valuable these synergies, the more likely the firm will continue producing internally.

As the synergies from internal production increase, the external market price becomes a more inaccurate estimate of the opportunity cost of internal production. For example, it is often the case that an intermediate good is not being produced by other firms or that the good produced externally is not identical to the good produced internally. In the first case, there is no market price; in the second, the market price is often an unreliable guide to opportunity cost. And, even when there are virtually identical “cheaper” external prod- ucts, producing internally can still make sense insofar as it provides greater quality control, more timely supply, or better protection of proprietary information. When these factors are included in the analysis, the external market may no longer be “cheaper.”

In such cases, using the market price as the transfer price understates the profitability of the product and its contribution to the value of the firm. Suppose, for example, that an intermediate product can be purchased but not sold externally for $3 per unit. Synergies such as high transactions costs of using the market make it beneficial to produce the item internally. Internal production avoids the costs of writing and enforcing contracts. Sup- pose there are $0.50 worth of synergies, so that the “correct” transfer price is $2.50 in the sense that $2.50 is the opportunity cost to the firm. But, if the market price of $3.00 is used as the transfer price, Distribution will purchase fewer units than if $2.50 were used, and the value of the firm will not be maximized.

Variable-cost transfer prices If no external market for the intermediate good exists or if large synergies that exist from internal production cause the market price to be an inaccurate estimate of opportunity cost,

6Advantages to internal transactions include the elimination of credit risk, lower marketing costs, and learn- ing from production. See R. Coase, “The Nature of the Firm,” Economica (1937), pp. 386–405.

“The economist’s first instinct is to set the transfer price equal to marginal cost. But it may be difficult to find out marginal cost. As a practical matter, marginal cost informa- tion is rarely known to anybody in the firm, because it depends on opportunity costs that vary with capacity use. And even if marginal cost information were available, there is no guarantee that it would be revealed in a truthful fashion for the purpose of deter- mining an optimal transfer price.” SOURCE: B. Holmstrom and J. Tirole, “Transfer Pricing and Organizational Form,” Journal of Law, Economics, & Organi- zations 7 (1991), pp. 201–28.

Academic Application: Why Trans­ fer Pricing Is So Hard

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then variable production cost offers an effective alternative transfer price. As we saw ear- lier, variable cost represents the value of the resources forgone to produce one more unit.

As with other transfer-pricing methods, however, problems exist with variable cost as an estimate of opportunity cost. One is that Manufacturing does not recover its fixed costs. If Manufacturing’s entire output is transferred internally, Manufacturing’s fixed costs are not recovered. Thus, Manufacturing appears to be losing money. If central management knows Manufacturing’s fixed costs, they can budget for this loss. But, if central manage- ment knows the fixed costs, then they know variable cost, and thus there is little reason to have a separate responsibility center and transfer pricing system in the first place.

One variant of variable-cost transfer pricing is to price all transfers at variable cost while also charging Distribution a fixed fee for these services. Distribution pays the vari- able cost for the additional units and buys the number of units that maximizes firm profits. Unlike straight variable-cost pricing, however, this variant allows Manufacturing to cover its full cost and earn a profit. The fixed fee represents the right of Distribution to acquire the product at variable cost and is set to cover Manufacturing’s fixed cost plus a return on equity.

Another problem with variable-cost transfer pricing occurs in situations where the variable cost per unit is not constant as volume changes. Suppose the variable cost per unit increases as volume expands (say, a night shift is added at a higher hourly wage). If all users are charged the higher variable cost, the total cost charged to all the users is greater than the total cost incurred by the firm. Users not increasing their volume see their costs increase. In such cases, internal conflicts arise over the appropriate measure of variable cost and whether all users should pay variable cost or just those users who expanded their output and caused the addition of the night shift.

A similar problem arises when Manufacturing approaches capacity. Assume that Manufacturing is considering a $2.5 million outlay to add more capacity. These additional capacity costs of $2.5 million are variable in the long run but become short-run fixed costs (depreciation and higher utilities and maintenance). Thus, conflicts arise between Manu- facturing and Distribution as to whether these additional capacity costs should be included in the transfer price or not. Such conflicts are difficult to resolve because no indisputably

Teva Pharmaceutical Industries Ltd. in Israel implemented a variable-cost transfer pric- ing system defined as only material cost. Labor was largely fixed because of the high cost of firing and hiring employees in Israel. Manufacturing produced drugs that several geographic marketing divisions sold. These marketing divisions could also sell other producers’ pharmaceuticals. Market-based transfer pricing was rejected because many of Teva’s products did not sell in intermediate markets. Senior executives rejected negotiated transfer pricing because they believed it would lead to endless arguments.

Variable-cost transfer pricing proved very unpopular. Senior managers worried that marketing divisions would show extremely high profits because they were not being charged for fixed costs. They also worried that manufacturing would have little incentive to control labor and other so-called fixed expenses. Finally, if manufacturing was less efficient than outside suppliers, variable-cost transfer pricing would provide little incentive to the marketing divisions to buy internally.

Teva replaced the variable-cost transfer pricing system with one based on full cost, including materials, labor, and overhead. SOURCE: A. Ovadia, “Restructuring Can Help Teva’s Copaxone Woes,” Globes, November 17, 2013.

Managerial Application: Teva Abandons Variable­ Cost Transfer Pricing

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objective method exists for calculating variable costs. They are not reported in The Wall Street Journal. Instead, they have to be estimated from accounting records. Although most of the components of variable cost are easily observed, such as the cost of direct labor and direct material, some components are difficult to estimate. For example, the additional costs incurred by the purchasing department when additional units are manufactured are not easily observed and hence difficult to estimate precisely.

Variable-cost transfer pricing also creates incentives for Manufacturing to distort vari- able cost upward, perhaps by misclassifying fixed costs as variable costs. For example, how much of the electricity bill is fixed and how much is variable? Since these classifica- tions are to some extent arbitrary, managers generate influence costs as Manufacturing and Distribution managers debate various cost terms and their applications—and as senior executives spend time arbitrating these disputes.

Moreover, under variable-cost transfer pricing, Manufacturing has an incentive to convert a dollar of fixed costs into more than a dollar of variable costs—for example, by using high-priced outsourcing of parts instead of cheaper internal manufacturing—even though this clearly reduces the value of the firm. For Manufacturing, the use of outsourc- ing can remove the burden of any fixed costs while Distribution, as well as the firm as a whole, bears the extra cost of such decisions.

Exercise 5–3

Scoff Division of Worldwide Paint is currently losing money, and senior management is considering selling or closing Scoff. Scoff’s only product, an intermediate chemical called Binder, is used principally by the latex division of the firm. If Scoff is sold, the latex divi- sion can purchase ample quantities of Binder in the market at sufficiently high-quality levels to meet its requirements. Worldwide requires all of its divisions to supply product to other Worldwide divisions before servicing the external market.

Scoff’s statement of operations for the latest quarter is given in the following table:

SCOFF DIVISION Profit/Loss Last Quarter ($ thousands)

Revenues Inside $200 Outside Operating expenses

75 $275

Variable costs $260 Fixed costs 15 Allocated corporate overhead 40 315 Net income (loss) before taxes ($40)

NOTES: 1. Worldwide Paint has the policy of transferring all products internally at variable cost.

In Scoff’s case, variable cost is 80 percent of the market price. 2. All of Scoff’s fixed costs are avoidable cash flows if Scoff is closed or sold. 3. $4,000 of the $40,000 allocated corporate overhead will be avoided if Scoff is closed

or sold.

continued

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Required:

Calculate the annual net cash flows to Worldwide Paint of closing or selling Scoff.

Solution:

The key to this problem is recognizing that the variable cost transfer price is very favorable to Latex and is causing Scoff to appear unprofitable. If Scoff is closed or sold, Latex will have to pay the market price for Binder, which is higher than the current transfer price. Also, not all the corporate overhead is saved by closing or selling Scoff.

Selling or closing Scoff changes the potential synergies within the firm. Can Worldwide Paint maintain the same quality/delivery times on Binder? One question to raise is what these are worth. Analyzing these “intangibles” will be necessary only if an outside offer is larger than the value of the cash flows forgone from selling Scoff. The following table indicates that Scoff is generating positive cash flow to Worldwide despite the operating losses reported.

SCOFF DIVISION Quarterly Net Cash Flows to Worldwide Paint of Closing

Last Quarter Ending ($ thousands)

Operating expenses saved: Variable costs $260 Fixed costs 15 Allocated corporate overhead 4 Scoff’s operating expenses avoided $279 Revenues forgone: Outside (75) Market purchases by Latex Division of Binder ($200 ÷ 80%) (250) Decline in quarterly cash flows × ($46) 4 quarters per year × 4 Annual decline in Worldwide cash flows ($184)

Full-cost transfer prices The information and incentive problems described earlier can lead the firm to select simple, objective, hard-to-change transfer price rules where responsibility center man- agers cannot easily game the transfer price. Firms adopt objective transfer pricing rules such as full cost to avoid unproductive disputes over measuring variable costs. Full cost includes both direct materials and labor, as well as a charge for overhead. Since full cost is the sum of fixed and variable cost, full cost cannot be changed simply by reclassifying a fixed cost as a variable cost.

The problem, however, is that full-cost transfer pricing frequently overstates the opportunity cost to the firm of producing and transferring one more unit internally, espe- cially if Manufacturing has excess capacity. And so Distribution buys too few units inter- nally. Full cost also allows Manufacturing to shift its inefficiencies to Distribution. Thus, Manufacturing has less incentive to be efficient under a full-cost transfer price rule. To be sure, variable-cost transfer prices also allow the selling division to export some of its inefficiencies to the purchasing division. However, the problem is not as pronounced as under full cost because under full cost, both fixed- and variable-cost inefficiencies

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can  be  shifted. Allowing the purchasing division to purchase externally reduces the inefficiency- shifting problem. This forces the selling division to remain competitive.

Despite all these problems, however, full-cost transfer pricing is quite common. Vari- ous surveys of firms report 40–50 percent usage of full-cost transfer prices. One reason for the popularity of full-cost transfer prices is their ability to deal with the problem of changes in capacity. As a plant begins to reach capacity, opportunity cost is likely to rise because of congestion and the cost of alternative uses of now-scarce capacity. Hence, opportunity cost is likely to be higher than direct materials and labor costs. In this case, full cost might be a closer approximation to opportunity cost than just variable cost.

Perhaps the most important benefit of full-cost transfer pricing is its simplicity and hence low cost of implementation. Because operating managers have much less ability to manipulate full-cost than variable-cost calculations, senior management arbitrates fewer disputes over calculating the transfer price. Nevertheless, managers should consider care- fully whether full-cost pricing is optimal for their particular situation. If the opportunity cost is substantially different from full cost, the firm’s forgone profits can be large.

Negotiated transfer prices Manufacturing and Distribution can negotiate the transfer price. This method can result in transfer prices that approximate opportunity cost because Manufacturing will not agree to a price that is below its opportunity cost and Distribution will not pay a price above the product’s price elsewhere.

With negotiated transfer prices, the two divisions have the incentive to set the number of units to maximize the combined profits of the two divisions. Once the value-maximizing number of units is agreed upon, the negotiated transfer price determines how the total profits are divided between the two divisions. If the two divisions negotiate both price and quantity, they have the joint incentive to maximize the total profit to be split. Yet, if the two divisions only negotiate the price, there is no guarantee that they will arrive at the transfer price that maximizes firm value.

While negotiation is a fairly common method, it too has drawbacks. It is time- consuming and can produce conflicts among divisions. Divisional performance measure- ment becomes sensitive to the relative negotiating skills of the two division managers. Moreover, if the two divisions negotiate a transfer price without at the same time agreeing on the quantity to be transferred at that price, there is no guarantee that they will arrive at the transfer price that maximizes the firm’s value.

In some cases, transfer pricing conflicts among responsibility centers become sufficiently divisive as to impose large costs on the firm. These costs arise when non-firm-value- maximizing transfer prices are chosen. Costly transfer pricing disputes usually occur when the relative volume of transactions among divisions is large. In such cases, a small change in the transfer price can have a large effect on the division’s reported profits. Hence, destruc- tive effects of opportunistic transfer pricing actions by operating managers are substantial.

If transfer pricing becomes sufficiently dysfunctional, reorganize the firm. For exam- ple, senior management could combine two profit centers with a large volume of transfers into a single division. Alternatively, it might convert Manufacturing into a cost center rather than a profit center and compensate the operating head based on cost efficiency. Or both divisions might be reorganized as cost centers and keep the pricing and quantity deci- sions at a higher level in the firm.

To review the discussion on transfer pricing, firms decentralize and create responsibil- ity centers to take advantage of the divisional manager’s specialized knowledge of local conditions. Incentives must then be provided for these managers to use their specialized

4. Reorganization: The Solution if All Else Fails

5. Recap

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knowledge to make profit-maximizing decisions for their firms. Forming responsibility cen- ters and linking performance measures to their decision rights (as described in Table 5–1) provides these incentives. When one responsibility center buys or sells goods or services from another center, a transfer price must be established for this internal transaction in order that each center’s performance measures, such as earnings, can be calculated. This gives each center the incentive to engage in internal transactions that benefit the firm. Hence, transfer pricing permits managers to exploit the specialized information they possess about local opportunities. Various methods exist for calculating transfer prices. Table 5–4 sum- marizes the advantages and disadvantages of each method.

No single method is best in all circumstances. Because each method has advantages and disadvantages, managers must choose the method that trades off decision making, con- trol, and taxes given their unique circumstances. Market-based transfer pricing is objec- tive, but might not capture interdependencies that exist within the firm. While variable-cost transfer pricing approximates the opportunity cost of producing one more unit when excess capacity exists, it is not commonly used. While we do not know exactly why variable cost- ing is used infrequently, we can speculate on some plausible reasons. Full-cost transfer pricing approximates the costs of adding fixed capacity (in the absence of inflation and productivity changes). Also, with variable-cost transfer pricing it is difficult to separate fixed and variable costs. Finally, as discussed earlier, variable costing gives the selling division significant discretion in altering the transfer price by reclassifying fixed costs as variable costs.

The trade-off between decision making and control discussed in Chapter 1 also applies to transfer prices. The transfer price that most accurately measures the opportunity cost to the firm of transferring one more unit inside the firm may not be the transfer- pricing method that gives internal managers the incentive to maximize firm value. For example, the transfer-pricing method that most accurately measures the opportunity cost

TABLE 5–4 Advantages and Disadvantages of Common Transfer-Pricing Methods

Method Advantages Disadvantages

Market-based transfer prices

∙ Objective ∙ Less subject to manipulation ∙ Often leads to correct long-run make/

buy decisions

∙ Might not exist for specialty items ∙ Might not capture interdependencies among

divisions

Variable-cost transfer prices

∙ Can approximate the opportunity cost of transferring one more unit

∙ Gives the buying division incentive to purchase the correct number of units if the selling division has excess capacity

∙ Does not allow the selling division to recover its fixed costs

∙ Variable cost might vary with output ∙ The selling division has the incentive to

classify fixed costs as variable costs Full-cost transfer prices ∙ Avoids disputes over which costs are

fixed and which are variable ∙ Simplicity

∙ The selling division can export its inefficiencies to the buying division

∙ The buying division purchases too few units Negotiated transfer prices ∙ Both selling and buying divisions have

incentives to transfer the number of units that maximize their combined profits

∙ Time-consuming ∙ Depends on the relative negotiating skills of

the two divisions

Reorganize the buying and selling divisions

∙ Eliminates costly disputes over transfer pricing

∙ Reduces the benefits from having two decentralized responsibility centers

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of transferred units requires managers producing these units to reveal privately held and hard-to-verify data of their costs. These managers then have considerable discretion over the transfer price. If these transfer prices are important in rewarding managers, the produc- ing managers can distort the transfer price to their benefit. Alternatively, a transfer-pricing scheme that estimates opportunity cost less accurately, but more objectively, might pro- duce a higher firm value than a transfer-pricing scheme that more closely approximates opportunity costs.

Managers often have authority for external sourcing. The ability to buy/sell outside is an important control device on the transfer-pricing scheme. No matter how the internal transfer price is set, the ability to go outside limits the monopoly profits that can be earned by one responsibility center at the expense of another.

Changing transfer-pricing methods does more than shift income among responsibility centers. The level of the firm’s output changes, as does firmwide profitability. The transfer price not only changes how the total profit pie is divided among responsibility centers; it also affects the size of the pie.

Finally, transfer pricing is more ubiquitous in organizations than many managers real- ize. Most organizations recharge inside users for information technology, telecommunica- tions, janitorial service, maintenance, and so forth. In effect, these recharge schemes, based on cost allocations, are cost-based transfer prices. Since much of management accounting and cost accounting deals with cost allocations, many of the same issues that apply to transfer pricing also arise in later chapters.

Q5–7 What are the two main reasons for transfer pricing within firms? Q5–8 Name four alternative methods for determining transfer prices. Q5–9 Is the choice of transfer pricing methods a zero-sum game?

Concept Questions

C. Summary Besides making operating decisions that involve pricing, marketing, and financing, managers must also ensure that employees perform tasks that add value to the firm. Chapter 4 described the gen- eral agency problem and how the firm’s organizational architecture can provide incentives for self- interested employees to take value-adding actions. In particular, the organizational architecture, which consists of the three legs of the stool (the performance evaluation system, the performance reward system, and the partitioning of decision rights), helps align employees’ and owners’ inter- ests. Accounting systems are an integral part of the firm’s organizational architecture. This chapter described two central ways in which accounting systems are used: responsibility accounting and transfer pricing.

In responsibility accounting, decision rights within the firm are partitioned to cost, profit, and investment centers. Cost centers usually have decision rights over the mix of inputs used to produce the product or service. Cost centers are then evaluated based on the ability of the center to maximize output for a given cost or to minimize cost for a predetermined amount of output. Profit centers have decision rights over input mix and pricing and are evaluated based on profits. Investment centers have all the decision rights of profit centers plus the rights over how much capital is invested in the center. They are evaluated based on either return on investment or residual income.

Also, accounting often is used in setting transfer prices. Whenever goods or services are trans- ferred across responsibility centers and the performance of these centers is measured, a transfer price for the transferred item must be calculated. Market prices, cost-based transfer prices, or negotiated transfer prices are used. Cost-based transfer prices include both variable costs and full costs (vari- able plus fixed costs). Each transfer-pricing scheme has pros and cons that depend on the particular

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circumstances of the firm. Hence, each firm must determine the transfer-pricing scheme that is best for its situation. In general, no transfer-pricing scheme, just as no particular organizational architec- ture, is best for all firms or even best for a single firm over time. In transfer-pricing schemes, as in other internal accounting methods, a trade-off exists between decision making and control. Transfer- price schemes that are best for decision making are not always the best for control and vice versa.

Chapter 6 describes another example of how accounting systems are used to reduce agency problems: budgeting systems.

Self­Study Problems Self-Study Problem 1: Tam Burger

In the past five years, Tam Burger has expanded to more than 200 stores, 80 percent of which are franchised. Two of the company-operated units, Northside and Southside, are among the fastest- growing stores. Both are considering expanding their menus to include pizza. Purchase and instal- lation of the necessary equipment costs $180,000 per store. The current investment in the Northside store totals $890,000. Store revenues are $1,100,500 and expenses are $924,420. Expansion of the Northside’s menu should increase profits by $30,600. The current investment in the Southside store totals $1,740,000. The store’s revenues are $1,760,800 and expenses are $1,496,680. Adding pizza to Southside’s menu should increase its profits by $30,600.

Tam Burger evaluates its managers based on return on investment. Managers of individual stores have decision rights over the pizza expansion.

Required:

a. Calculate the return on investment for both stores before pizza is added, for the pizza proj- ect only, and for the stores after expansion.

b. Assuming a 14 percent cost of capital, calculate residual income for both stores before and after the potential expansion.

c. Will the Tam Burger stores choose to expand? How would the answer change if the stores were franchised units?

Solution: a. Return on investment before and after the pizza expansion:

Northside Southside

ROI before Pizza Revenue $1,100,500 $1,760,800 Expenses 924,420 1,496,680 Net income $ 176,080 $ 264,120 ÷ Assets 890,000 1,740,000 ROI 19.78% 15.18%

ROI of Pizza Only Increased profits from pizza $ 30,600 $ 30,600 ÷ Expansion cost 180,000 180,000 ROI of project 17.00% 17.00%

ROI after Pizza Total income $ 206,680 $ 294,720 4 Total assets 1,070,000 1,920,000 Total ROI 19.32% 15.35%

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b. Residual income before and after the pizza expansion:

c. The two units currently have different ROIs. The smaller Northside store is earning an ROI of just under 20 percent, while the larger Southside store is earning an ROI of just over 15 percent. Since the project’s ROI is 17 percent, adding the project to the Northside store lowers its average ROI; adding the project to the Southside store raises its average ROI. The Northside manager will avoid adding pizza to the menu, because the store’s ROI would drop as a result. The Southside manager, however, will want to add pizza since the store’s ROI would subsequently rise.

If the stores were franchised units, both owners would definitely expand. The ROI of the project is higher than the cost of capital. This ensures a positive residual income for the project. As long as the residual income is positive, any franchise owner would jump at the opportunity. Franchise owners would not care if the store’s ROI dropped, as long as the residual income increased.

Self-Study Problem 2: BioScience Tomato beetles, a major pest to the tomato crop, are now being controlled by toxic pesticides. The firm BioScience invested $5 million in R&D over the last five years to produce a genetically engi- neered, patented microbe, MK-23, which controls tomato beetles in an environmentally safe way. BioScience built a plant with capacity to produce 10,000 pounds of MK-23 per month. The plant cost $12 million and has a 10-year life. MK-23 has a variable cost of $3 per pound. Fixed costs are $50,000 per month for such costs as plant management, insurance, taxes, and security. Plant depre- ciation is not included in the $50,000 fixed cost.

The following table summarizes the full cost of producing MK-23:

Northside Southside

Cost of capital 14.00% 14.00%

Residual Income before Pizza Net income $176,080 $264,120 Less: Assets × 14% (124,600) (243,600) Residual income $ 51,480 $ 20,520

Residual Income of Pizza Only Increased profits from pizza $ 30,600 $ 30,600 Less: 14% × Expansion cost (25,200) (25,200) Residual income $ 5,400 $ 5,400

Residual Income after Pizza Net income $206,680 $294,720 Less: 14% × Assets (149,800) (268,800) Residual income $ 56,880 $ 25,920

Depreciation per month ($12 million ÷ 120 months) $100,000 Other fixed costs 50,000 Total fixed costs $150,000 ÷ Capacity per month (pounds) 10,000 Fixed costs per unit of capacity (pound) $ 15.00 Variable costs per pound 3.00 Full cost per pound $ 18.00

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MK-23 is sold for $30 per pound. BioScience is currently selling 8,000 pounds per month to tomato farmers.

Another division of BioScience, Home Life, wants to secure 1,000 pounds per month of MK-23 that it will process further into a consumer product, Tomato Safe, for gardeners. Home Life is willing to pay an internal transfer price of $5 per pound. Home Life will incur an additional $4 of variable cost per pound of MK-23 in packaging and reducing the potency of MK-23 to make Tomato Safe more appropriate for home gardeners. Tomato Safe will sell for $20 per pound of MK-23.

Required:

a. Should the internal transfer be allowed? b. What happens if the transfer price is set at full cost, $18? What happens if the transfer

price is set at variable cost, $3? c. After deciding to use variable cost as the transfer price, new farm orders for 2,000 pounds

of MK-23 at $30 per pound per month are received. Suppose plants come only in fixed sizes of 10,000-pound capacities of $12 million each. Analyze the various options facing BioScience.

d. What is the opportunity cost of the excess capacity prior to producing MK-23 for Tomato Safe?

e. What happened to the $5 million R&D costs incurred to invent MK-23?

Solution: a. The following table indicates that BioScience generates incremental cash flow of $13 for

every pound of MK-23 it transfers to Home Life to be converted to Tomato Safe, assuming it does not forgo selling this pound of MK-23 directly to farmers for $30 per pound.

Clearly, if BioScience has excess capacity of 2,000 pounds of MK-23 production per month, then transferring 1,000 pounds of MK-23 enhances overall firm profits.

b. If a full-cost transfer price of $18 per pound is charged for MK-23, Home Life will not accept the transfer because its total cost of $22 ($18 transfer price plus $4 for further pro- cessing) is above the market price of $20. If the firm has unused capacity, then transfer- ring at full cost causes it to forgo selling Tomato Safe and receiving $13 per pound for its unused capacity. Transferring at variable cost ($3) allows Tomato Safe to be produced. In the case where the firm has unused excess capacity, full-cost transfer pricing leads to the wrong decision.

If variable-cost transfer pricing is used, each month 1,000 pounds of MK-23 are trans- ferred to Home Life.

c. After receiving new farm orders for 2,000 pounds of MK-23, management has three options. First, it can fill 1,000 pounds of the 2,000-pound order, because this is all the capacity available after transferring 1,000 pounds to Home Life. Second, management can cancel the 1,000 pounds transferred for Tomato Safe and fill all 2,000 pounds of the new farm order. Or third, management can build a new plant to increase capacity. Canceling

Contribution Margins for MK-23 and Tomato Safe

MK-23 Tomato Safe

Selling price $30.00 $20.00 Variable costs Manufacturing MK-23 3.00 3.00 Additional processing 4.00 Contribution margin $27.00 $13.00

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the 1,000-pound transfer to Home Life and using this production capacity to fill the new farm orders increases BioScience’s cash flows:

Contribution from new order 2,000 × $27 $54,000 Contribution forgone from Tomato Safe 1,000 × $13 13,000 Additional contribution $41,000

Every additional pound of MK-23 sold to farmers instead of converted to Tomato Safe contributes $14 (or $27 − $13) to BioScience’s cash flows, assuming the firm does not have enough capacity to meet demand in the farm market. The third option of adding capacity to meet both farm and home demand is not profitable. Each pound, including new capacity for MK-23, costs $18, and Tomato Safe cannot recover these costs. Therefore, full-cost transfer pricing includes the cost of adding additional capacity.

The managers of Home Life will object to canceling the internal transfer because their divisional profits will fall. They will most likely construct reasons that such a decision will adversely affect their other products. Undoing the decision to transfer MK-23 will require senior managers’ time and patience. Thus, influence costs are likely to be generated. In general, internal transfers tend to be permanent and difficult to change.

d. Prior to accepting the internal transfer of MK-23 to produce Tomato Safe, BioScience has 2,000 pounds of unused capacity. If the demand for MK-23 is growing, then either consuming this capacity with an internal transfer causes the firm to forgo the contribu- tion margin on lost sales of MK-23 or else the firm has to add capacity. The decision to permanently consume fixed capacity should not be based on the short-run incremental cost of the transfer unless it is highly likely that the internal transfer is the only long-run use of the unused capacity. Full-cost transfer pricing includes an estimate of the cost of adding capacity and reveals the past (historical) cost of a unit of capacity. A new unit of capacity will cost more than historical cost if there has been construction cost inflation. However, a unit of capacity can cost less than the historical cost if adding a second plant creates productivity enhancements or synergies.

e. These R&D costs were not included in the manufacturing costs of MK-23. The accounting system writes these costs off when incurred. The firm has an unrecorded but real economic asset, the patent on MK-23. The profit of $12 per pound of MK-23 ($30 – $18) represents the firm’s return on this investment.

Problems

P 5–1: Canadian Subsidiary The following data summarize the operating performance of your company’s wholly owned Canadian subsidiary for 2009 to 2011. The cost of capital for this subsidiary is 10 percent.

($000,000)

2009 2010 2011

Subsidiary net income $14.0 $14.3 $14.4 Total assets in subsidiary 125 130 135 Return on net investment* in subsidiary 20% 22% 24%

*Net investment is calculated as total assets less all liabilities.

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Required:

Critically evaluate the performance of this subsidiary.

P 5–2: Phipps Electronics Phipps manufactures circuit boards in Division Low in a country with a 30 percent income tax rate and transfers them to Division High in a country with a 40 percent income tax. An import duty of 15 percent of the transfer price is paid on all imported products. The import duty is not deductible in computing taxable income. The circuit boards’ full cost is $1,000 and variable cost is $700; they are sold by Division High for $1,200. The tax authorities in both countries allow firms to use either variable cost or full cost as the transfer price.

Required:

Analyze the effect of full-cost and variable-cost transfer pricing methods on Phipps’ cash flows.

P 5–3: Sunder Properties Brighton Holdings owns private companies and hires professional managers to run its companies. One company in Brighton Holdings’ portfolio is Sunder Properties. Sunder owns and operates apart- ment complexes and has the following operating statement.

Brighton Holdings estimates Sunder Properties’ before-tax weighted average cost of capital to be 15 percent. Brighton Holdings rewards managers of their operating companies based on the oper- ating company’s before-tax return on assets. (The higher the operating company’s before-tax ROA, the more Sunder managers are paid.) Sunder Properties’ total assets at the end of the last fiscal year are $64 million.

Required:

a. Calculate Sunder’s ROA last year. b. Sunder management is considering purchasing a new apartment complex called Valley

View that has the following operating characteristics (millions $):

Will the managers of Sunder Properties purchase Valley View? c. If they had the same information about Valley View as Sunder’s management, would

the shareholders of Brighton Holdings accept or reject the acquisition of Valley View in part (b)?

d. What advice would you offer the management team of Brighton Holdings?

SUNDER PROPERTIES (Last Fiscal Year)

(Millions)

Revenues $86.50 Expenses* (72.30) Net income before taxes $14.20

*Includes interest expense of $2.6 million.

Revenues $16.60 Expenses* $13.30 Total assets of new apartment $20.00

*Includes interest expense of $0.71.

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P 5–4: Economic Earnings A large consulting firm is looking to expand the services currently offered its clients. The firm has developed a new performance metric called “Economic Earnings,” or EE for short. The performance metric is argued to be a better measure of both divisional performance and firmwide performance, and hence “a more rational platform for compensating employees and managers.” The consulting firm is seeking to convince clients they should replace their current metrics, such as accounting net income, ROA, EVA, and so forth, with EE.

EE starts with traditional accounting net income but then makes a series of adjustments. The primary adjustment is to add back depreciation and then subtract a required return on invested capital. The consultants argue for adding accounting depreciation back because it is a sunk cost. It does not represent a current cash flow. For example, suppose a client has accounting net income calculated as:

Suppose the client has total assets of $6,000 and a risk-adjusted weighted-average cost of capi- tal (WACC) of 25 percent. Then this client’s EE is calculated as follows:

Required:

Critically evaluate EE as a performance measure. What are its strengths and weaknesses?

P 5–5: Performance Technologies Sylvia Zang is president of the Wilson Division of Performance Technologies, a multinational con- glomerate. Zang manages $100 million of assets and is currently generating earnings before inter- est (EBI) of $12 million. The corporate office of Performance Technologies has determined that Wilson’s existing assets have a risk-adjusted cost of capital of 11 percent. All division presidents (including Zang) are rewarded based on their individual division’s ROA. If Zang is able to increase the Wilson Division’s current ROA, she can earn a substantial bonus whereby the larger the increase

Client’s Traditional Income Statement

Revenues $5,700 Cost of goods sold (2,000) Gross margin $3,700 Depreciation (900) Selling, general, other (700) Interest (500) Earnings before taxes $1,600 Income taxes (20%) (320)

Net income $1,280

Client’s Economic Earnings

Net income $1,280 Depreciation 900 Capital charge* (1,500) Economic earnings $ 680

*Total assets $6,000 WACC 25% Capital charge

$1,500

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in the division’s ROA, the larger is Zang’s bonus. Performance Technology computes ROA as EBI divided by total assets.

Currently, Zang is considering two new investment opportunities: Project A and Project B. She can accept one or the other, or both, or neither. Each project, A and B, has a risk profile that differs from that of her existing portfolio of assets. Project A (with a risk-adjusted cost of capital of 15 percent) requires her purchasing new assets for $25 million that will generate EBI of $3.5 million. Project B (with a risk-adjusted cost of capital of 9 percent) requires her purchasing new assets for $30 million that will generate EBI of $3 million.

Assume there are no synergies between Wilson’s existing assets and either project A and B, and there are no synergies between project A and project B.

Required:

a. Assuming that Zang is rewarded based on improving the ROA of the Wilson Division, will she accept or reject projects A and B? Support your answer with detailed computations.

b. Instead of basing divisional managers’ bonuses on ROA, Performance Technologies switches to residual income as the methodology used to measure divisional performance and reward divisional managers, including Zang. Assuming that Zang is rewarded based on improving the residual income of the Wilson Division, what decision(s) will she make regarding accepting or rejecting projects A and B? Support your answer with detailed computations.

c. Discuss why your answers differ or are the same in parts (a) and (b). d. Should Performance Technologies use ROA or residual income to evaluate and reward

division managers? Justify your recommendation with sound logical analysis.

P 5–6: Metal Press Your firm uses return on assets (ROA) to evaluate investment centers and is considering changing the valuation basis of assets from historical cost to current value. When the historical cost of the asset is updated, a price index is used to approximate replacement value. For example, a metal fabrication press, which bends and shapes metal, was bought seven years ago for $522,000. The company will add 19 percent to this cost, representing the change in the wholesale price index over the seven years. This new, higher cost figure is depreciated using the straight-line method over the same 12-year assumed life (no salvage value).

Required:

a. Calculate depreciation expense and book value of the metal press under both historical cost and price-level-adjusted historical cost.

b. In general, what is the effect on ROA of changing valuation bases from historical cost to current values?

c. The manager of the investment center with the metal press is considering replacing it because it is becoming obsolete. Will the manager’s incentives to replace the metal press change if the firm shifts from historical cost valuation to the proposed price-level-adjusted historical cost valuation?

P 5–7: ICB Intl. ICB has four manufacturing divisions, each producing a particular type of cosmetic or beauty aid. These products are then transferred to five marketing divisions, each covering a particular geo- graphic region. Manufacturing and marketing divisions are free to negotiate among themselves the transfer prices for products transferred internally. The manufacturing division that produces all the hair care products wants a particular hair conditioner it developed and produces for Asian markets priced at full cost plus a 5 percent profit markup, which amounts to $105 per case.

The South American marketing division believes it can sell this conditioner in South America after redesigning the labels. However, most South American currencies have weakened against the

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dollar, putting further pressure on the prices of U.S.–produced products. The South American mar- keting division estimates it can make money on the hair conditioner only if it can buy it from manu- facturing at $85 per case.

Manufacturing claims that it cannot make a profit at $85 per case. Moreover, the other ICB mar- keting divisions that are paying around $105 per case will likely want to renegotiate the $105 transfer price if South America marketing buys it for $85.

You work for the corporate controller of ICB Intl. She has asked you to write a short, nontechni- cal memo to her that spells out the key points she should consider in her upcoming meeting with the two division heads regarding transfer pricing. You are not being asked to recommend a particular transfer price, but rather to list the important issues the controller should be aware of for the meeting.

P 5–8: Shop and Save Shop and Save (S&S) is a large grocery chain with 350 supermarkets. Twenty-eight S&S stores are located within the Detroit metropolitan region and serviced by the S&S Detroit Bakery, a large cen- tral bakery producing all of the fresh-baked goods (breads, rolls, donuts, cakes, and pies) sold in the 28 individual S&S stores in the Detroit region. Besides selling S&S baked goods, the stores also sell other nationally branded commercial baked goods both in the baked goods section of the store and in the frozen section as well. But all freshly baked items sold in the 28 S&S stores come from the S&S Detroit Bakery. Each store orders all the baked goods from the S&S Detroit Bakery the day before. The S&S Detroit Bakery also is a profit center and sells only to the 28 Detroit S&S stores. Each store pays the bakery 60 percent of the retail selling price. So, for example, if a store manager orders from the bakery a loaf of whole grain bread that has a retail price of $5.00, that store is charged $3.00 (60% × $5.00) and the Detroit Bakery records revenues of $3.00.

Each store manager is evaluated and compensated as a profit center and has some decision rights over the particular items stocked in each store. But roughly 85 percent of all SKUs (stock keeping units) carried by each store and the retail price of each SKU are dictated centrally by the S&S Detroit Regional headquarters, which oversees both the 28 stores and the bakery. Each store manager has decision rights over the quantity of the various baked goods ordered from the S&S Detroit Bakery. The retail price of each freshly baked item produced by the S&S Detroit Bakery and sold in the grocery stores is set by the Detroit Regional headquarters, not the individual grocery stores or the S&S Detroit Bakery.

The manager of the Detroit Bakery complains that the reason her central bakery loses money is that the 60 percent rate is too low to cover her costs. The individual grocery store managers complain that the quality and variety of fresh baked goods they receive from the S&S Detroit Bakery are not competitive with high-end private specialty bake shops in the Detroit area.

Required:

a. Evaluate the advantages and disadvantages of the S&S policy of each S&S grocery store paying the S&S Detroit Bakery 60 percent of the retail price of the bakery item.

b. Suggest ways that S&S can improve the relationship between its grocery stores and its central bakery.

P 5–9: Microelectronics Microelectronics is a large electronics firm with multiple divisions. The circuit board division manu- factures circuit boards, which it sells externally and internally. The phone division assembles cellular phones and sells them to external customers. Both divisions are evaluated as profit centers. The firm has the policy of transferring all internal products at market prices.

The selling price of cellular phones is $400, and the external market price for the cellular phone circuit board is $200. The outlay cost for the phone division to complete a phone (not including the cost of the circuit board) is $250. The variable cost of the circuit board is $130.

Required:

a. Will the phone division purchase the circuit boards from the circuit board division? (Show calculations.)

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b. Suppose the circuit board division is currently manufacturing and selling externally 10,000 circuit boards per month and has the capacity to manufacture 15,000 boards. From the standpoint of Microelectronics, should 3,000 additional boards be manufactured and transferred internally?

c. Discuss what transfer price should be set for part (b). d. List the three most important assumptions underlying your analysis in parts (b) and (c).

P 5–10: US Copiers US Copiers manufactures a full line of copiers, including desktop models. The Small Copier Division (SCD) manufactures desktop copiers and sells them in the United States. A typical model has a retail price of less than $500. An integral part in the copier is the toner cartridge that contains the black powder used to create the image on the paper. The toner cartridge can be used for about 10,000 pages and must then be replaced. The typical owner of an SCD copier purchases four replacement cartridges over the life of the copier.

SCD buys the initial toner cartridges provided with the copier from the Toner Division (TD) of US Copiers. TD sells subsequent replacement cartridges to distributors that sell them to U.S. retail stores. Toner cartridges sell to the end consumer for $50. TD sells the cartridges to distributors for about 70 percent of the final retail price paid by the consumer. The Toner Division manager argues that the market price to TD of $35 (70% × $50) is the price SCD should pay to TD for each toner cartridge transferred.

Required:

a. Why does US Copiers manufacture both copiers and toner cartridges? Why don’t separate firms specialize in either copiers or toner cartridges like Intel specializes in making com- puter chips and Gateway specializes in assembling and selling PCs?

b. You work for the president of SCD. Write a memo to your boss identifying the salient issues she should raise in discussing the price SCD should pay TD for toner cartridges included in SCD copiers.

P 5–11: Cogen Cogen’s Turbine Division manufactures gas-powered turbines for generating electric power and hot water for heating systems. Turbine’s variable cost per unit is $150,000 and its fixed cost is $1.8 mil- lion per month. It has excess capacity. Cogen’s Generator Division buys gas turbines from Cogen’s Turbine Division and incorporates them into electric steam-generating units. Both divisional manag- ers are evaluated and rewarded as profit centers.

The Generator Division has variable cost of $200,000 per completed unit, excluding the cost of the turbine, and fixed cost of $1.4 million per month. The Generator Division faces the following monthly demand schedule for its complete generating unit (turbine and generator):

Required:

a. If the transfer price of turbines is set at Turbine’s variable cost ($150,000), how many tur- bines will the Generator Division purchase to maximize its profits?

b. The Turbine Division expects to sell a total of 20 turbines a month, which includes both external and internal sales. Calculate the (average) full cost of a turbine (fixed cost plus variable cost) at this level of sales.

Quantity Price ($000) Quantity Price ($000)

1 $1,000 5 $800 2  950 6 750 3  900 7 700 4  850 8 650

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c. If the transfer price of turbines is set at Turbine’s (average) full cost calculated in part (b), how many turbines will the Generator Division purchase?

d. Should Cogen use a variable-cost transfer price or a full-cost transfer price to transfer tur- bines between the Turbine and Generator divisions? Why?

P 5–12: Wegmans Wegmans, a privately owned regional supermarket chain founded in Rochester, New York, in 1916, focuses on the more affluent market by providing a unique shopping experience and value. Wegmans’ much larger stores stock roughly twice as many items as other supermarkets and offer more displays of fresh produce, artisan breads, fresh seafood, and take-out or in-store dining of res- taurant-quality entrees. The company with revenues of over $9 billion currently operates 100 stores in six states stretching from New York to Virginia. Their most recent expansion is into Virginia with three new stores and a new Wegmans Virginia distribution center serving the three new stores, but with capacity to serve more Virginia stores as they are opened.

As Wegmans expands geographically, it must open regional distribution centers that are respon- sible for accurate and on-time selection, inventorying, and delivery of the thousands of products (fresh produce, meats, seafood, frozen goods, etc.) sold in the stores in that distribution center’s region. Each store in the region is allocated a share of the costs of its distribution center based on total store revenues served by the distribution center.

Senior management uses residual income to evaluate the performance of each store (and reward store management). All Wegmans stores face the same weighted-average cost of capital (13 percent) applied to direct investment in each store (working capital and property, building, and fixtures). The following table summarizes last year’s operations of the newest Virginia store (Virginia 3), Wegmans flagship store (Rochester 1), and the Wegmans store with median rev- enues across the entire 80-store chain (Median). Virginia 3’s results in the table represent the first complete year of operations since opening the store. “Rochester 1” is Wegmans’ first megastore, rebuilt and expanded in 1990, with a very large and loyal customer base. All figures are in thou- sands of dollars.

Required:

a. Compute the residual incomes for the Virginia 3, Rochester 1, and the Median stores. b. Write a memo to senior Wegmans management evaluating the performance of Virginia 3

relative to Rochester 1 and to the Median store. Be sure to provide credible explanations for all material differences in performance between Virginia 3 and the other two Wegmans stores.

Last Year

(000s) Virginia 3 Rochester 1 Median

Working capital* $ 1,100 $ 1,500 $ 1,300 Revenues 59,300 110,250 70,000 Property, building, and fixtures† 58,300 28,740 44,000 Cost of goods sold 41,510 74,970 48,300 Store administration‡ 5,930 8,820 6,300 Distribution center charges§ 5,100 4,900 3,900

*Current assets less current liabilities of the store. †Net of accumulated depreciation. ‡Includes all other costs of operating the store, including utilities, occupancy, and store management. §Allocation of the fixed and variable costs of the regional distribution center to all the stores served by the distribution center. Allocation based on the store revenues served by the center.

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P 5–13: Zee Spin Wedges Zee Spin manufactures a line of golf club wedges (sand wedge, pitching wedge, lob wedge, and attack wedge) that vary with loft and club head sole design. The wedges have become very popular among professional and serious golfers because of their unique club head design and shafts. All Zee Spin wedges consist of three parts: club head, shaft, and grip. Zee Spin manufactures the club heads and shafts and purchases the grips. The three components are assembled to produce a wedge that is sold to distributors, who then sell them to golf pro shops and websites. The shafts are specially designed to match the playing characteristics of the Zee Spin wedge club head.

The following table summarizes the total costs of producing a complete Zee Spin wedge. All the various models of Zee Spin wedges (sand wedge, pitching wedge, lob wedge, and attack wedge) have the same cost structure.

Zee Spin traditionally only sold complete wedges (club head, shaft, and grip), and the company was treated as a single profit center. But with the success of the Zee Spin brand and recent inquiries from other club makers about purchasing just Zee Spin shafts, which are unique in the industry, Zee Spin is going to sell both complete wedges (as they do now) and individual shafts. To implement this strategy, Zee Spin will create two profit centers: Wedges and Shafts. The Shafts profit center will produce shafts for external customers, as well as for the Zee Spin Wedge profit center. There will be two profit center managers in Zee Spin that will be rewarded based on the profits of their respective profit centers. The Zee Spin wedges will continue to be sold for $75 per complete wedge, while the shafts will be sold for $23 per shaft.

Shafts that are sold externally will incur variable selling costs of $2.43 (primarily sales commis- sion and shipping). These costs are not incurred for shafts sold internally to the Wedges profit center.

Required:

a. The owners of Zee Spin want to maximize profits and realize that, to properly motivate the managers of the Wedges and Shafts profit centers, they need to set the proper transfer price for the shafts produced by the Shafts profit center and sold to the Wedges profit center. Using the actual data provided in the problem, what transfer price should be used for the shafts produced by the Shafts profit center and sold to the Wedges profit center? (Your answer should be a specific number, such as $18.00.)

b. After implementing the transfer price policy you described in part (a), what problems should the owners of Zee Spin anticipate? Stated differently, what non-firm-value maxi- mizing behaviors by the two profit center managers should the owners of Zee Spin expect to occur?

P 5–14: Creative Learning Centers Creative Learning Centers (CLC), a for-profit firm, operates over 100 preschools primarily located in the northeast for children ages 4–6. CLC’s innovative curriculum utilizes the latest technology and offers young minds creative expression, language and social skills, physical movement, music, and number skills—all provided by professional trained teachers. CLC leases buildings for their schools and invests substantial resources in leasehold improvements for classrooms, technology, and play- ground equipment. CLC’s cost of capital is 12 percent. Typical tuition is about $6,300 per year for a

Club Head Shaft Total

Variable manufacturing cost $16.05 $11.48 $27.53 Variable selling cost 5.43 Fixed manufacturing cost 4.17 6.52 10.69 Other common fixed costs 6.43 Grip 2.50 Total cost $52.58

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five-day-a-week, four-hour-per-day program. Maria Schnelling manages 15 CLC schools in the state of Virginia. She has decision-making responsibility for staffing and operating her schools, as well as the responsibility for recommending adding new schools and closing existing schools. The fol- lowing table provides current operating data on all of her 15 preschools, and breaks out her top- and bottom-performing schools:

“After-tax operating income” represents all revenues less all expenses (including depreciation and taxes but excluding any interest on debt to finance the investment) of running a school for the last 12 months.

Ms. Schnelling has identified three possible locations for new CLC preschools in Virginia (denoted as NVA1, NVA2, and NVA3). The following table provides current projected data on the three new preschools:

Required:

a. If Maria Schnelling is evaluated and rewarded based on after-tax operating income, which of her 15 existing schools will she recommend closing, and which of her three new schools will she recommend opening? (Justify your answers.)

b. If Maria Schnelling is evaluated and rewarded based on return on investment, which of her existing 15 schools will she recommend closing, and which of her three new schools will she recommend opening? (Show computations.)

c. You have been hired as a consultant to the board of directors to advise the board as to how CLC should measure and reward the performance of CLC managers, such as Ms. Schnelling in Virginia. How should CLC measure and reward its state managers? Provide a compel- ling rationale to support your recommendation. (Support your recommendation with rel- evant computations.)

P 5–15: Warm Boots Warm Boots manufactures and sells a patented ski boot with 9-volt batteries designed to keep a skier’s feet warm even when the outside temperature reaches –10 °Celsius. Warm Boots is organized into three divisions: Administration (accounting, finance, human resources, CEO, and CFO), Manu- facturing, and Marketing and Sales. To promote cost efficiency, Manufacturing is treated as a cost center, where its manager is evaluated and paid a bonus based on minimizing the actual average cost

After-Tax Operating Income

Total Investment

All 15 Virginia preschools $1,811,250 $11,625,000 Best 3 Virginia performers VA4 $184,230 $801,000 VA12 $156,030 $743,000 VA9 $151,000 $755,000 Worst 3 Virginia performers VA2 $34,000 $680,000 VA8 $14,200 $710,000 VA5 −$23,700 $790,000

After-Tax Operating Income

Total Investment

NVA1 $132,000 $880,000 NVA2 $110,500 $850,000 NVA3 $79,200 $720,000

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of manufacturing boots in the week. The manager of Manufacturing has the discretion to choose its production level. Marketing and Sales (M&S) is treated as a profit center, where its profits are com- puted as the sales revenue it generates less the manufacturing cost of the boots. The manufacturing cost of the boots is the number of boots sold in the week times the actual average cost of manufactur- ing the boots in that week. The manager of M&S has the discretion to set the price per pair of boots and is paid a bonus based on M&S reported profits.

The following table summarizes how price and total cost varies with the number of boots pro- duced and sold per week. “Total Cost” includes both fixed and variable costs where the fixed cost is the annual fixed cost divided by 52 (the number of weeks in the year).

Required:

a. As the head of Manufacturing, how many boots will you manufacture if given the discre- tion to set production levels? Show calculations to support your answer.

b. If you managed the M&S Division of Warm Boots, and given the production level (and its resulting average cost) chosen by the Manufacturing manager in part (a), what price (and quantity level) would you choose for a pair of boots that maximizes your bonus? Show cal- culations to support your answer.

c. Given the decisions of the Manufacturing and M&S managers in parts (a) and (b), is the firm maximizing profits? Explain why profits are or are not being maximized.

P 5–16: University Lab Testing Joanna Wu manages the University Lab Testing department within the University Hospital. Lab Testing, a profit center, performs most of the standard medical tests (such as blood tests) for other university clinical care units as well as for outside health care providers (independent hospitals, clin- ics, and physician groups). These outside health care providers are charged a price for each lab test using a predetermined rate schedule. University Hospital health care providers reimburse University Lab Testing using a transfer price formula. Roughly 70 percent of all Lab Testing procedures are performed for University Hospital units and the remainder for outside health care providers. Other lab testing firms in the community perform many of the same tests as Lab Testing. Lab Testing oper- ates at about 85 percent capacity, on average. But when Lab Testing is operating at 100 percent of capacity, it must refuse outside work and even sends some inside- (University Hospital–) generated specimens to other community testing labs.

Quantity Price Total Manufacturing Cost

20 $300 $ 645.00 21 290 672.30 22 280 700.20 23 270 728.70 24 260 757.80 25 250 787.50 26 240 817.80 27 230 848.70 28 220 880.20 29 210 912.30 30 200 945.00 31 190 978.30 32 180 1012.20 33 170 1046.70 34 160 1081.80 35 150 1117.50

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A standard blood test (code Q796) performed by Lab Testing has the following cost structure:

The predetermined rate paid by the outsiders (non–University Hospital health care providers) for this test (Q796) is $68.90.

Required:

a. Suppose Lab Testing has excess capacity. What transfer price maximizes University Hospi- tal’s profits?

b. Using the transfer price you chose in part (a), how much profit does Joanna Wu generate for her department if she performs one more Q796 test for an internal University Hospital user?

c. Suppose Lab Testing has no excess capacity. What transfer price maximizes University Hospital’s profits?

d. Using the transfer price you chose in part (c), how much profit does Joanna Wu generate for her department if she performs one more Q796 test for an internal University Hospital user?

e. What transfer pricing policy should University Hospital implement regarding other Uni- versity Hospital clinical care units reimbursing Lab Testing for Q796 blood tests? Be sure to describe the logic (and any administrative problems that you considered) underlying your proposed transfer pricing policy for Q796.

P 5–17: Beckett Automotive Group Beckett is a large car dealership that sells several automobile manufacturers’ new cars (Toyota, Ford, Lexus, and Subaru). Beckett also consists of a Pre-owned Cars Department and a large service department. Beckett is organized into three profit centers: New Cars, Pre-owned Cars, and Service. Each profit center has a manager who is paid a fixed salary plus a bonus based on the net income generated in his or her profit center.

When customers buy new cars, they first negotiate a price with a new car salesperson. Once they have agreed on a price for the new car, if the customer has a used car to trade in, the Pre-owned Cars Department manager gives the customer a price for the trade-in. If the customer agrees with the trade-in price offered by Pre-owned Cars, the customer pays the difference between the price of the new car and the trade-in price.

Suppose a customer buys a new car for $47,000 that has a dealer cost of $46,200. The same cus- tomer receives and accepts $11,000 for the trade-in of her used car and pays the balance of $36,000 in cash (ignoring taxes and license). In this case, New Cars shows a profit of $800 (before any com- mission to the salesperson). If the customer does not accept the trade-in value, she does not purchase the new car from Beckett.

Once the deal is struck, the trade-in is then either sold by Pre-owned Cars to another customer at retail or is taken to auction where it is sold at wholesale. Continuing the preceding example, suppose the customer accepts $11,000 as the trade-in for her used car. The Pre-owned Cars Department can sell it on its used car lot for $15,000 at retail or sell it at auction for $12,000. If the trade-in is sold for

Cost Structure for Q796

Variable Costs Chemical and supplies $ 8.90 Labor 13.15 $22.05 Fixed Costs Equipment $17.20 Supervision and administration 2.05 Occupancy 6.68 25.93 Total Cost $47.98

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$15,000, Pre-owned Cars would have a profit of $4,000 ($15,000 – $11,000). If it is sold at auction, Pre-owned Cars reports a profit of $1,000 ($12,000 – $11,000).

Required:

a. Describe some of the synergies that exist within Beckett. In other words, why does Beckett consist of three departments (New Cars, Pre-owned Cars, and Service) as opposed to just selling new cars, or just selling used cars, or just providing service?

b. What potential conflicts of interest exist between the New Cars and Pre-owned Cars department managers? For example, describe how in pursuing their own self-interest, the manager of New Cars or Pre-owned Cars will behave in a way that harms the other manager.

c. Suggest two alternative mechanisms to reduce the conflicts of interest you described in part (b).

P 5–18: WBG WBG manufactures and sells electronic transducers that are used in military and commercial products. WBG has three divisions: Transducer Division, Military Division, and Commercial Division. The Transducer Division designs and produces transducers that are sold externally as well as internally to the Military Division and the Commercial Division. Both the Military Division and the Commercial Division incorporate transducers in their final products that are sold to non-WBG end users. Because of the unique proprietary design of the WBG transducers, Military and Commercial Divisions only use WBG transducers in their products. All of WBG’s sales are in the United States.

The three divisions are profit centers and about 50 percent of the Transducer Division output is sold externally, while the remainder is sold internally to the Military Division and the Commercial Division. WBG currently uses a full-cost transfer pricing policy for the transducers. The senior man- agers of the three divisions receive about 40 percent of their compensation tied to the performance of their division and the balance is received as base salary.

Because of the incessant bickering among WBG’s three divisions’ management teams over its current transfer pricing policy, the CEO of WBG attended a seminar on transfer pricing. After attending the seminar, the CEO proposed the following new policy for transducers: “Each month the transfer price of transducers will be the same as the external market price the Transducer Division receives for transducers sold to external customers, if, and only if, the Transducer Division is at capacity for the month. Otherwise, the transfer price is the Transducer Division’s variable cost for the month.”

Required:

You work for the CEO. Write a memo to the CEO that (a) explains the benefits of the proposed policy, (b) explains the likely changes in behavior among the three divisions that the new policy is likely to produce, and (c) states what additional data the CEO and you should collect and how you would analyze the data before making a decision regarding whether or not the new transfer pricing policy should be adopted.

P 5–19: CJ Equity Partners CJ Equity Partners is a privately held firm that buys small family-owned firms, installs professional managers to run the firms, and then sells them three to five years later, often for a substantial profit. CJ Equity is owned by four partners who raise capital from wealthy investors and invest this money in unrelated firms. Their aim is to provide a 15 percent rate of return on their investors’ capital after paying the partners of CJ Equity a management fee. CJ Equity currently owns three operating com- panies: a tool and die company (Jasco Tools), a chemical bottling company (Miller Bottling), and a janitorial supply company (JanSan). The professional managers running these three companies are paid a fixed salary and bonus based on the performance of their company. Currently, CJ Equity is measuring and rewarding its three professional managers based on the net income after taxes of their

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individual companies. The following table summarizes the current year’s operations of each of the three companies (all dollar amounts in millions):

CJ Equity charges each of the three operating companies an annual management fee of $200,000 for managing the companies, including filing the various tax returns. The weighted average cost of capital represents CJ Equity’s estimate of the risk-adjusted, after-tax rate of return of similar compa- nies in each operating company’s industry.

You have been hired by CJ Equity as a consultant to recommend whether CJ Equity should change the way it measures the performance of the three companies (net income after taxes), which is then used to compute the professional managers’ bonuses.

Required:

a. Design and prepare a performance report for the three operating companies that you believe best measures each operating company’s performance and which will be used in computing the three professional managers’ bonuses. In other words, using your perfor- mance measure, compute the performance of each of the three operating companies.

b. Write a short memo explaining why you believe the performance measure you chose in part (a) best measures the performance of the three professional managers.

P 5–20: R&D Inc. R&D Inc. has the following financial data for the current year (millions):

Assume the tax rate is zero.

Required:

a. R&D Inc. writes off R&D expenditures as an operating expense. Calculate R&D Inc.’s EVA for the current year.

b. R&D Inc. decides to capitalize R&D and amortize it over three years. R&D expenditures for the last three years have been $6.0 million per year. Calculate R&D Inc.’s EVA for the current year after capitalizing the current year and previous years’ R&D and amortizing the capitalized R&D balance.

c. In the specific case of R&D Inc., how does capitalizing and amortizing R&D expenditures instead of expensing R&D affect the incentive for managers approaching retirement to underspend on R&D at R&D Inc.

Jasco Tools

Miller Bottling JanSan

Weighted average cost of capital 14% 12% 10% CJ Equity management fee* $0.200 $0.200 $0.200 Number of employees 84 120 85 Interest expense* $1.600 $1.800 $0.800 Income tax rate 20% 20% 20% Operating expenses $33.600 $36.800 $18.200 Revenues $38.600 $42.900 $21.200 Total assets $20.1 $31.2 $16.3

*Not included in the operating expenses of the three companies.

Earnings before R&D expenditures $21.5 Interest expense $0.0 R&D expenditures $6.0 Total invested capital (excluding R&D assets) $100.0 Weighted average cost of capital 14%

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P 5–21: Flat Images Flat Images develops and manufactures large, state-of-the-art flat-panel television screens that con- sumer electronic companies purchase and incorporate into a complete TV unit by adding the case, mounting brackets, tuner, amplifier, other electronics, and speakers. Flat Images has just introduced a new high-resolution, high-definition 60-inch screen. Flat Images is composed of two profit centers: Manufacturing and Marketing. Manufacturing produces sets that are sold internally to Marketing. Each profit center has the following cost structure:

Note that Marketing’s fixed cost of $150,000 and variable cost of $200 per screen do not con- tain any transfer price from Manufacturing. The numbers in the preceding table consist only of their own costs, not any costs transferred from the other department.

The selling price that Marketing receives for each 60-inch screen depends on the number of screens sold that month, according to the following table.

(An equivalent way to express the price-quantity relation in the table is P = $9,000 – 20Q, where P = price and Q = quantity.)

Required:

a. Suppose that Manufacturing sets a transfer price for each screen at $4,800. How many screens will Marketing purchase to maximize Marketing’s profits (after Marketing pays Manufacturing $4,800 per screen), and how much profit will Marketing make?

b. At a transfer price of $4,800 per screen, and assuming Marketing buys the number of screens you calculated in part (a), how much profit is Manufacturing reporting?

c. At an internal transfer price of $4,800, and assuming Marketing purchases the number of screens you calculate in part (a), what is Flat Images’ profit?

d. Given the cost structures of Manufacturing and Marketing, and the price-quantity relation given in the problem, how many 60-inch screens should Flat Image manufacture and sell to maximize firmwide profits?

e. If parts (c) and (d) are the same, explain why they are the same. If they are different, explain why they are different.

f. What transfer price should Flat Images set to maximize firmwide profits? (Give a quantita- tive number.)

Manufacturing Marketing

Fixed cost (per month) $300,000 $150,000 Variable cost per screen $800 $200

Quantity Price

50 $8,000 75 7,500 100 7,000 125 6,500 150 6,000 175 5,500 200 5,000 225 4,500 250 4,000 275 3,500

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P 5–22: Premier Brands Premier Brands buys and manages consumer personal products brands such as cosmetics, hair care, and personal hygiene. Premier management purchases underperforming brands and redesigns their marketing strategy and brand equity positioning, and then promotes the repositioned brand to the mega–retail chains (Walmart and Kmart). Each product line manager is evaluated and rewarded based on return on net assets (RONA). RONA is calculated as net income divided by net assets where net assets is total assets invested in the product line less current liabilities in the product line [RONA = Net income / (Total assets – Current liabilities)]. For every 1 percent of RONA (or fraction thereof) in excess of 12 percent of the product line returns, the product line manager receives a bonus of $250,000. So, if a manager’s RONA is 13.68 percent, his or her bonus is $420,000 [(13.68% – 12.00%) × 100 × $250,000]. Premier’s weighted average cost of capital (WACC) is 12.43 percent.

Amy Guttman, one of Premier’s three product line managers, manages a portfolio of four brands in the hair care business. These four brands currently generate a net income of $708,000, requiring $6.5 million of total assets and $1.3 million of current liabilities. Guttman is evaluating two possible brand acquisitions: Brand 1 and Brand 2. The following table summarizes the salient information about each brand (thousands).

Required:

a. Given Premier’s incentive plan, will Amy Guttman acquire Brand 1 and/or Brand 2, or nei- ther? Justify your answer with supporting calculations.

b. Suppose that Premier’s WACC is 15.22 percent instead of 12.43 percent, and the bonus system remains as described in the problem. How do Guttman’s decisions in part (a) change? Explain your answer.

c. Given the facts as stated in the problem, if you were the sole owner of Premier Products, would you acquire Brand 1 and/or Brand 2, or neither? Justify your answer with supporting calculations.

d. Given the facts as stated in the problem, except that Premier’s WACC is 15.22 per- cent instead of 12.43 percent, if you were the sole owner of Premier Products, would you acquire Brand 1 and/or Brand 2, or neither? Justify your answer with supporting calculations.

e. Why do some companies use RONA instead of ROA (net income/total assets)? In other words, describe how the incentives generated by using RONA differ from the incentives from using ROA.

P 5–23: Easton Electronics Easton Electronics in Irvine, California, is a contract manufacturer that assembles complex solid- state circuit boards for advanced technology companies in the aerospace and health sciences indus- tries. The contract manufacturing industry is very competitive in terms of pricing and performance (quality and on-time delivery). Outsourcing clients specialize in the design of sophisticated electron- ics products and then rely on their contract manufacturing partners (like Easton) to produce their designs. Once a new product is designed, the advanced technology firm solicits firm, fixed-price bids for the electronic components.

A completed electronic component consists of several assembled circuit boards, a box con- taining the boards, cables connecting the boards inside the box, cables connecting the box to other

Brand 1 Brand 2

Current liabilities $ 82 $ 498 Net assets 522 1,546 Net income 67 228 Total assets 604 2,044

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components, and exhaustive testing of the complete box build. The technology firm either solicits bids for each separate component (box, boards, and cables) or selects an integrated supplier that can deliver a completely assembled box that has been tested. After receiving the initial bids but prior to selecting the winning bidder, the technology firm selects two or three finalists and then spends considerable resources to qualify new suppliers by sending teams of engineers and purchasing spe- cialists to inspect the bidders’ manufacturing facility, procurement process, and quality programs.

Once a contract manufacturer is chosen, most clients are reluctant to switch to new suppliers because of the high search and startup costs of moving to a new supplier. Although some Easton customers source their metal boxes, boards, and cables from different contractors and then assemble the final electronic components into a complete unit that they test, most Easton clients rely on Easton to provide a complete unit (box, circuit boards, connecting cabling, and final testing).

Easton has recently acquired a wholly owned cable company (TT Cabling). With the acquisition, Easton has two profit centers: Irvine (which manufactures the boards, builds the complete box, and assembles and tests it) and TT Cabling (which only makes and tests the cables). Currently, TT sells most of its cables to a different set of customers than those who have their boards built by Easton. After the acquisition, Easton has a single sales force that sells board assembly, box build, and cables.

Easton assembles the electronic controller for a particular health imaging system for Scopics Imaging (SI). Easton manufactures the circuit boards, buys a sheet metal box designed specifically to house the boards, buys the cables to connect the boards within the box and other cables to connect the box to other components, tests the box, and delivers the completed unit to SI to plug the box into its imaging system.

Irvine currently purchases four cables for the SI program. The following table summarizes Irvine’s cost for one complete SI box:

Although Irvine purchases the cables for the SI program from an outside cable company, Easton senior managers are analyzing whether to have TT Cabling supply these cables. The managers of TT Cabling have submitted a bid to Irvine of $1,700 for the four cables in the SI assembly. The Irvine managers oppose buying the cables from TT because the TT bid of $1,700 is significantly higher than the outside cable supplier ($1,275). The bid of $1,700 submitted by TT for the four SI cables consists of variable costs of $1,000, fixed manufacturing costs of $300, and profits of $400. The quality of the TT cables (including reliability of delivery schedule) is the same for both the TT cables and the outside supplier of cables.

When bidding on new proposals that involve complete box builds, Easton management wonders whether they should continue to solicit price quotes from outside cable suppliers only, solicit bids from both outside cable suppliers and TT, or only get price quotes from TT Cabling.

Required:

Write a memo to the senior managers of Easton electronics proposing a policy that describes how Easton should decide whether to purchase cables externally or internally (through TT). The memo should describe the decision-making process, the relevant considerations, and the underlying objec- tives of such a policy. Use the SI cables as an example of how your Easton cable sourcing policy should be applied.

Fixed Costs Variable Costs Total Costs

Metal box $ 347 $ 347 Circuit boards $1,460* 9,375 10,835 Cable harnesses 1,275 1,275 Box build and test 998* 720 1,718 Total $2,458 $11,717 $14,175

*Represents the proportionate utilization of both equipment necessary to populate the circuit boards with components and the testing equipment.

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P 5–24: Evergreen Nursery and Landscape Evergreen Nursery and Landscape has two profit centers: Nursery and Landscape. Nursery buys young evergreen trees, grows them for a year, and then sells them to Landscape. Landscape then sells and plants them for residential customers. Nursery only sells its trees to Landscape, and Landscape only buys trees from Nursery. Landscape faces the following demand curve per month for planted trees by residential customers:

(Note: The demand curve in the table can be represented as P = 300 – 20Q.) Nursery has variable costs of $10 per tree and fixed costs of $210 per month. Landscape has

variable costs of $50 per tree (before paying Nursery a transfer price for the tree) and fixed costs of $290 per month.

Required:

a. Assume the owner of Evergreen Nursery and Landscape knows all the costs of both divi- sions and the demand curve. If the owner sets the price for trees planted by Landscape, what final price for a planted tree would the owner set to maximize her profits and how many trees per month get planted?

b. Suppose the owner does not know the demand curve faced by Landscape, but she does know each division’s fixed and variable costs. What transfer price would the owner set to maximize her profits?

c. Suppose that Nursery sets the transfer price at $75 per tree. How many trees will Land- scape purchase from Nursery and plant per month in order to maximize Landscape’s prof- its (including the transfer price of $75 per tree)?

d. What is Nursery’s profit from setting a transfer price of $75, assuming Landscape maxi- mizes its profits as in part (c)?

e. Compare the firm-wide profits that result from the transfer price chosen in part (b) and the firmwide profits that result from a $75 transfer price chosen in part (c), and explain why they are either the same or different.

P 5–25: Transfer Price Company The Transfer Price Company has two divisions (Intermediate and Final) that report to the corporate office (Corporate). The two divisions are profit centers. Intermediate produces a proprietary product (called “intermed”) that it sells both inside the firm to Final and outside the firm. Final can only purchase intermed from Intermediate because Intermediate holds the patent to manufacture intermed. Intermed’s variable cost is $15 per unit, and Intermediate has excess capacity in the sense that it can satisfy demand from both its outside customers and Final. Final buys one intermed from Intermedi- ate, incurs an additional variable cost of $5 per unit, and sells the product (called “final”) to external consumers. Final faces the following demand schedule for final.

Trees Sold Price per Tree

2 $260 3 240 4 220 5 200 6 180 7 160 8 140 9 120

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(The preceding demand schedule can be represented algebraically as P = $500 – 20Q.)

Required:

a. Calculate the quantity–price combination of final that maximizes firm value. In other words, if Corporate knew the variable costs of the two divisions, for what price would they sell final, and how many units of intermed would Corporate tell Intermediate to produce and transfer to Final?

b. Assume that the managers in Corporate do not know the variable costs in the two divi- sions. Intermediate has the decision rights to set the transfer price of intermed to Final. Intermediate knows Final’s variable cost of $5 and the demand schedule Final faces for selling final to its customers. Intermediate, therefore, knows that the following schedule explains how many units of intermed Final will purchase given the transfer price Interme- diate sets:

In other words, if Intermediate sets a transfer price of $260, Final will purchase six units of intermed and produce 6 units of final. Given the above schedule of possible transfer prices that Intermediate can choose, what transfer price will Intermediate set to maximize its profits?

c. While Corporate does not know intermed’s variable cost, it does know that the total cost of intermed is $48 per unit. This $48 per unit cost consists of both the variable costs to manu- facture intermed plus the allocated fixed manufacturing costs. Intermediate allocates all its fixed costs over all the products it produces, including intermed. If Corporate sets the transfer price of intermed at $48, how many units of intermed will Final purchase?

d. What is the dollar impact on Intermediate’s profits if Final purchases the number of inter- meds calculated in part (c)?

e. Should Corporate allow Intermediate to set the transfer price for intermed that you calcu- lated in part (b), or should Corporate set the transfer price at $48 as in part (c)? Support your recommendation with a quantitative analysis.

Quantity Price

4 $420 5 400 6 380 7 360 8 340 9 320 10 300 11 280 12 260 13 240

Transfer Price

Quantity of intermed Purchased by Final

$220 7 230 7 240 6 250 6 260 6 270 6 280 5 290 5

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P 5–26: XBT Keyboards The keyboard division of XBT, a personal computer manufacturing firm, fabricates 50-key key- boards for both XBT and non-XBT computers. Keyboards for XBT machines are included as part of the XBT personal computer and are also sold separately. The keyboard division is a profit center. Keyboards included as part of the XBT PCs are transferred to the PC division at variable cost ($60) plus a 20 percent markup. The same keyboard, when sold separately (as a replacement part) or sold for non-XBT machines, is priced at $100. Projected sales are 50,000 keyboards transferred to the PC division (included as part of the XBT PC) and 150,000 keyboards sold externally.

The keys for the keyboard are fabricated by XBT on leased plastic injection-molding machines and then placed in purchased key sockets. These keys and sockets are assembled into a base, and connectors and cables are attached. Ten million keys are molded each year on four machines to meet the projected demand of 200,000 keyboards. Molding machines are leased for $500,000 per year per machine; maximum practical capacity is 2.5 million keys per machine per year. The variable overhead account includes all of the variable factory overhead costs for both key manufacturing and assembly. Studies have shown that variable overhead is more highly correlated with direct labor dol- lars than any other volume measure.

Sara Litle, manager of the keyboard division, is considering a proposal to buy some keys from an outside vendor instead of fabricating them inside XBT. These keys (which do not include the sockets) will be used in the keyboards included with XBT PCs but not in keyboards sold separately or sold to non-XBT computer manufacturers. The lease on one of XBT’s key injection-molding machines is about to expire and the capacity it provides can be easily shifted to the outside vendor.

The outside vendor will produce keys for $0.39 per key and will guarantee capacity of at least 2.5 million keys per year. Litle is compensated based on the profits of the keyboard division. She is considering returning one of the injection-molding machines when its lease expires and purchasing keys from the outside vendor.

Required:

a. How much will XBT save per key if it outsources the 2.5 million keys rather than produc- ing them internally?

b. What decision do you expect Sara Litle to make? Explain why. c. If you were a large shareholder of XBT and knew all the facts, would you make the same

decision as Litle? Explain. d. What changes in XBT’s accounting system and/or organizational structure would you sug-

gest, given the facts of the case? Explain why.

Cost Data per XBT Keyboard

Variable Costs Materials Plastic for keys $ 3.00 Base 11.00 Key sockets 13.00 Connectors and cables 9.00 Direct labor, keys 4.00 Direct labor, assembly 12.00 Variable overhead* 8.00 $60.00 Fixed Costs† Key injection molding $10.00 Fixed overhead 18.00 28.00 Unit manufacturing cost $88.00

*Based on direct labor dollars. †At projected production of 200,000 keyboards.

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P 5–27: Nieder Toyota Nieder Toyota is a car dealership that has been in business for 40 years at the same 20-acre location selling and servicing new and “pre-owned” (used) Toyotas. Two years ago, Nieder Toyota replaced its aging showroom and service center with a new, state-of-the-art facility. When Ms. Nieder’s father started the dealership, the business was on the outskirts of town. Now with city sprawl, the dealership is located on a busy commercial street surrounded by other dealerships, restaurants, and shopping centers.

The market for new cars is very competitive because many buyers shop on the Internet before visiting new car dealers. Once customers decide to purchase a new car from a dealer, they usually trade in their used car to avoid the hassle of selling the car themselves, and hence these new car buy- ers are willing to accept lower prices from car dealers for their trade-ins. Also, pre-owned cars have higher margins because there is less competition for used cars, as each used car differs in terms of mileage, condition, and options. Suppose a new car is sold for $45,000 ($500 over dealer cost) and the buyer receives a trade-in allowance on his old car of $8,000 and pays the difference in cash. That used car is then sold for $10,800. The dealer makes $500 on the new car and $2,800 on the used car. Nieder also offers parts and service for the new and pre-owned cars it sells.

Nieder Toyota is organized into three departments: New Cars, Pre-owned Cars, and Service. All three share the same building and lot where the new and used cars are displayed. Ms. Nieder com- pensates her three department heads based on residual income. After careful analysis by her financial manager, they determine that all three departments should be charged for the capital invested in their departments at 16 percent.

The new building cost $12 million and the land cost $900,000. The following table summarizes the land and building utilization by each department, each department’s net income, and other net assets invested in each department:

For example, the new car department occupies 50 percent of the land and 30 percent of the building. It had net income of $600,000 and other assets of $2,500,000. Other assets consist of all inventories and receivables invested in the department. For example, the new car department has a substantial inventory of new cars. Each department’s income consists of all revenues and expenses directly traceable to that department. Income taxes are not included in each department’s net income reported in the table. Nieder Toyota uses the trade-in allowance of used cars taken in trade as the transfer price of used cars in calculating the net incomes of the new and pre-owned car departments.

Required:

a. Calculate the residual income of each of the three divisions of Nieder Toyota. b. Discuss the relative profitability of the three departments. Which is making the most

money and which is making the least amount of money? c. Discuss whether the residual incomes of the three departments capture the true profitability

of each department. What problems do you see in the way Ms. Nieder is evaluating the performance of the three department managers and of Nieder Toyota as a whole?

P 5–28: Wujo Wujo is a Shanghai company that designs high-end software to enhance and edit digital images. Its software, EzPhoto, is more powerful and easier to use than Adobe Photoshop, but sells at a much lower price. Currently, EzPhoto is written in Chinese for the Chinese market, but Wujo is entering the English-speaking market. This requires a substantial investment to convert EzPhoto to English.

New Cars Pre-owned Cars Parts and Service Total

Percent of land 50% 40% 10% 100% Percent of building 30% 10% 60% 100% Department income $600,000 $1,725,000 $1,813,000 $ 4,138,000 Other assets $2,500,000 $6,700,000 $1,300,000 $10,500,000

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Wujo has established a UK wholly owned subsidiary (Wujo UK, or WUK for short) to sell EzPhoto to North American and European consumers—professional and serious amateur photographers. The following table displays the various combinations of prices and quantities it expects in sales of EzPhoto to English-speaking users:

For example, at a price of €270 it expects to sell 130,000 units of EzPhoto, or at €225 it can sell 175,000 units. To enter this market, WUK must spend €15 million to convert EzPhoto from Chinese to English, advertise EzPhoto, establish a website where purchasers can download EzPhoto, and hire an administrative staff to market and maintain the website. For each English version of EzPhoto sold, WUK expects to incur costs of €70 for sales commissions paid to third parties who market EzPhoto (e.g., Amazon, ZDNet.com, and Buy.com) and technical support for customers purchasing EzPhoto. EzPhoto will be distributed only via the WUK website. There are no packaging or CD-ROM costs.

WUK is evaluated and its managers compensated based on reported WUK profits. Wujo China, the parent company, is considering charging WUK a transfer price (actually a royalty) for each unit of EzPhoto WUK sells.

Required:

a. If Wujo China does not charge WUK a royalty for each unit of EzPhoto WUK sells (i.e., the transfer price is zero), what price–quantity combination will WUK select, and how much profit will WUK make?

b. If Wujo China charges WUK a royalty of €50 for each unit of EzPhoto WUK sells (i.e., the transfer price is €50), what price–quantity combination will WUK select, and how much profit will WUK make?

c. Ignoring any income taxes, what is the firm-value maximizing royalty (either zero euros or €50) that Wujo should charge WUK for each unit of EzPhoto WUK sells? Explain your answer.

d. Wujo (the parent) has to pay income taxes to the People’s Republic of China (PRC) at the rate of 15 percent on any royalty payments it receives from WUK, while WUK faces a UK tax rate of 33 percent on profits of EzPhoto. Note that WUK’s taxable income is calculated after deducting any transfer price (royalties) paid to Wujo. What is the firm-value maximiz- ing royalty (either zero euros or €50) that Wujo should charge WUK for each unit of EzPhoto WUK sells? Whichever transfer price Wujo charges WUK (zero or €50), that transfer price is used to (i) measure and reward WUK managers, and (ii) calculate income taxes in the PRC and the UK. Provide a detailed explanation supported by calculations justifying your answer.

e. Suppose that Wujo is able to use a different transfer price for determining WUK’s profits (and hence the compensation paid to WUK management) than it uses for calculating income taxes on its PRC and UK tax returns. What transfer prices should Wujo use for calculating WUK’s net income in determining WUK’s managers’ bonuses and for use on its two tax returns? The same transfer price has to be used on the two tax returns, but this transfer price need not be the same transfer price used for calculating WUK’s income for management bonuses.

f. Why might you expect Wujo will be unable to implement the two transfer prices you pro- pose in part (e)?

Price (euros) Quantity (000)

270 130 265 135 260 140 255 145 250 150 245 155 240 160 235 165 230 170 225 175

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Cases Case 5–1: Celtex

Celtex is a large and very successful decentralized specialty chemical producer organized into five independent investment centers. Each of the five investment centers is free to buy products either inside or outside the firm and is judged based on residual income. Most of each division’s sales are to external customers. Celtex has the general reputation of being one of the top two or three companies in each of its markets.

Don Horigan, president of the synthetic chemicals (Synchem) division, and Paul Juris, presi- dent of the consumer products division, are embroiled in a dispute. It all began two years ago when Juris asked Horigan to modify a synthetic chemical for a new household cleaner. In return, Synchem would be reimbursed for out-of-pocket costs. After Synchem spent considerable time perfecting the chemical, Juris solicited competitive bids from Horigan and some outside firms and awarded the contract to an outside firm that was the low bidder. This angered Horigan, who expected his bid to receive special consideration because he developed the new chemical at cost and the outside vendors took advantage of his R&D.

The current conflict involves Synchem’s production of chemical Q47, a standard product, for consumer products. Because of an economic slowdown, all synthetic chemical producers have excess capacity. Synchem was asked to bid on supplying Q47 for the consumer products division. Consumer products is moving into a new, experimental product line, and Q47 is one of the key ingre- dients. While the order is small relative to Synchem’s total business, the price of Q47 is very impor- tant in determining the profitability of the experimental line. Horigan bid $3.20 per gallon. Meas Chemicals, an outside firm, bid $3.00. Juris is angry because he knows that Horigan’s bid contains a substantial amount of fixed overhead and profit. Synchem buys the base raw material, Q4, from the organic chemicals division of Celtex for $1.00 per gallon. The organic chemical division’s out-of- pocket costs (i.e., variable costs) are 80 percent of the selling price. Synchem then further processes Q4 into Q47 and incurs additional variable costs of $1.75 per gallon. Synchem’s fixed manufacturing overhead adds another $0.30 per gallon.

Horigan argues that he has $3.05 of cost in each gallon of Q47. If he turned around and sold the product for anything less than $3.20, he would be undermining his recent attempts to get his salespeople to stop cutting their bids and start quoting full-cost prices. Horigan has been trying to enhance the quality of the business he is getting, and he fears that if he is forced to make Q47 for consumer products, all of his effort the last few months will be for naught. He argues that he already gave away the store once to consumer products and he won’t do it again. He asks, “How can senior managers expect me to return a positive residual income if I am forced to put in bids that don’t recover full cost?”

Juris, in a chance meeting at the airport with Debra Donak, senior vice president of Celtex, described the situation and asked Donak to intervene. Juris believed Horigan was trying to get even after their earlier clash. Juris argued that the success of his new product venture depended on being able to secure a stable, high-quality supply of Q47 at low cost.

Required:

a. Calculate the incremental cash flows to Celtex if the consumer products division obtains Q47 from Synchem versus Meas Chemicals.

b. What advice would you give Debra Donak? Case 5–2: Executive Inn

Sarah Adams manages Executive Inn of Toronto, a 200-room facility that rents furnished suites to executives by the month. The market is for people relocating to Toronto and waiting for permanent housing. Adams’s compensation contains a fixed component and a bonus based on the net cash flows from operations. She seeks to maximize her compensation. Adams likes her job and has learned a lot, but she expects to be working for a financial institution within five years.

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