Question

Question 2 (10 Marks) Division P of Copy Ltd manufactures and sells portable printers that have a selling price of $80 per unit in 2018. A competitor is introducing a new portable printer that will sell for $70. The manager of Division P believes it must lower the price in 2019 to $70 to compete in the printers market. The manager believes that the new price will maintain the current sales level of 10,000 printers per year in 2019. Division P carries no inventories. Budgeted data of Division P for 2019 are as follows: $100,000 Current assets $300,000 Non-current assets $400,000 Total assets Production output (printers per year) 10,000 Target Return on Investment (ROI- Operating income/Total assets) 20% Current fixed costs per year (2018) $300,000 Current variable cost per printer (2018) $40 Consider each of the following three situations independently. Required: a. What is the target cost per unit for the new price per printer to achieve the target Return On Investment (ROI)? What is the cost reduction per unit to achieve this (4 marks) target cost? b. Assume that current fixed costs per year cannot be reduced, total assets in 2018 are $400,000, and the minimum required rate of return is 15%. If the manager of Division P is evaluated and compensated on the basis of Residual Income (RI), what should be the target variable cost per unit to increase 2018's RI by 10% in 2019? (3 marks) c. The CEO of Copy Ltd has heard about Economic Value Added (EVA) as an alternative method to evaluate performance of its Divisions. She asks you for advice to decide whether to change RI as the current basis for performance evaluation, and use EVA to evaluate performance. Explain briefly how EVA is similar to RI. In addition, identify one advantage and one disadvantage of EVA compared with RI. (3 marks)

Answer 1

Answer: The value provided in the question as below:

Selling price will be $ 70 in 2019.

Variable cost per unit of printer $ 40

Fixed Cost $ 300000

Target ROI is 20%

a) Target return of the printer is $ 80000 i.e. 20% of total assets.

Per unit target return of the printer = Target return / estimated production during the year

= $ 80000 / 10000 units

= $ 8

Target cost for the new price per printer for achieve the target return on investment = New selling price - per unit target return of the printer

= $ 70 - $ 8

= $ 62

Existing Cost per unit of printer is Variable cost plus fixed cost per unit of printer.

Fixed cost per unit = Total Fixed cost / Estimated production during the year

= $ 300000 / 10000 units

= $ 30

Existing cost per unit of printer is $ 40 + $ 30 = $

Cost reduction per unit = Existing cost per unit - Target cost per unit

= $ 70 - $ 62

= $ 8

b) Target ROI is 15%

Target return of the printer is $ 60000 i.e. 15% of total assets.

Target return per unit = Target return of the printer / Production during the year

= $ 60000 / 10000 units

= $ 6

Per unit fixed cost is $ 30 (as per above solution).

Residual income in 2018 is below:

Selling price per unit in 2018 $ 80

Variable cost per unit in 2018 $ 40

Contribution (Selling price - Variable cost) per unit in 2018 $ 40

Fixed Cost per unit $ 30

Required Return per unit $ 6

Residual income per unit (Contribution - Fixed cost & Required return) $ 4

Total unit produced in 2018 10000 units

Total Residual income $ 40000

Required reduction in variable cost is under:

Estimated increase in Residual income $ 4000

Total required residual income in 2019 $ 44000

Per unit of required residual income in 2019 $ 4.4

Required contribution in 2019 = Fixed cost per unit + Target return on per unit + Required residual income per unit

= $ 30 + $ 6 + $ 4.4

= $ 40.4 per unit

Target Variable cost per unit for required residual income = Selling price in 2019 - required contribution in 2019

= $ 70 - $ 40.4

+ $ 29.6 per unit

c) Economic value added (EVA) = Net profit after tax - (Capital invested * Cost of capital of the company)

Residual income (RI) = Profit - interest cost for capital invested in the business

EVA and RI both are considering the cost of capital of the company for evaluation of performance of the company.

Advantage: EVA is a tool which helps to focus managers’ attention on the impact of their decisions in increasing shareholders’ wealth.

Disadvantage : For EVA, we need to find a correct cost of equity. It is not suitable for all kinds of companies. It may not correctly understand efficiency as the EVA of a larger company will always be more than a smaller company even when they are more efficient and maintain a better return on investment comparatively.