Question

Part 5-Decentralization (13 pts) Jenny is the president of the West division of Newton Inc. In December she reviews the division's projected accounting statements for the year. If she does nothing, she expects the division to have $5 million in revenue, $2.4 million in variable costs, and $1.6 million in fixed costs, on volume of 100,000 units. The division has $6 million in assets. Newton has a cost of capital of 12% i-4 pts) Calculate the projected value of the West division's performance metrics. ROI RI -9 pts) Jenny will receive a $100,000 bonus if she can achieve an ROI of 18%. Clearly, she would ike to do that. She considers the following schemes to earm the bonus. A) West division could ship a lot of extra product to customers at year-end (called channel stuffing). Assume the extra products sell at the typical cost and have the typical variable cost. How many extra units would West division need to sell to reach the ROI target? B) West division could defer some of its costs (such as maintenance) until next year. This would decrease fixed costs this year. How much fixed cost would need to be deferred to reach the ROI target? C West division could hide some of its assets from the year-end balance sheet. There are several ways to do that (e.g.. repurchase agreements, special purpose entities, or early pay down of operating liabilities). How much assets would need to be hidden to reach the ROI targer?

Answer 1

i) Return on Investment(ROI):

It is a managerial tool used to calculate efficiency of an investment. so it will be easier to compare with other investment oppurtunities.

ROI = Net Profits / Total Investments * 100

Calculation of Net Profits:

Net Profits = Revenue - (Variable Cost + Fixed Cost)

= $5,000,000 - (2,400,000 +1,600,000)

= $ 5,000,000 - 4,00,000

Net Profits = $1,00,000

ROI = 1,000,000 \ 6,00,000 * 100

ROI = 16.67%

Residual Income (RI):

RI is another management accounting tool used to compare relative success of the business. It is the income earned in excess of minimum Rate of return.

RI = Operating Income - ( Operating assets * Cost of Capital)

Calculation of Operating Income:

we have many formulas to calculate operating Income. we are using the below one because we have only the information in the question to use below one.

Operating Income = Net Profit + Interest Expense + Taxes

= $1,000,000 + $ 720,000 ( Total Assets $6,000,000 * Cost of Capital )

= $ 1,720,000

RI = $1,720,000 - (6,000,000 * 12 %)

= 1,720,000 - 720,000

RI = $1,000,000

ii) If Required Rate of Return is 18%

Net Profits = Total assets * 18%

= 6,000,000 * 18%

Net Profits = $1,080,000

Calculation of extra no. of units to be sold Inorder to reach target ROI :

if 100,000 units were sold to earn Net profits of $1,000,000 then to earn a profit of $1,080,000

No. of units to be sold = 100,000 \ 1,000,000 * 1,080,000

= 108,000

Inorder to reach target ROI extra no. of units to be sold = No. of units to be sold @ 18% ROI - no. of units sold @12% ROI

= 108,000 - 100,000

extra no. of units to be sold = 8,000

Calculation of amount of fixed cost to be deferred Inorder to reach target ROI :

To reach target ROI the Net Profits should be $1,080,000.

Increase in Net Profit at 18% ROI = 1,080,000 - 1,000,000

= $ 80,000

So Inorder to Increase ROI from 12% to 18% the Net profit should be increased by $80,000.

Increase in Net Profit can be done by Increasing Revenue or Decresing Cost.

In First Subdivision we increased the net profit by Increasing the Revenue. In this subdivision we are going to increase the Net Profit by decreasing the Fixed Cost ( As instructed in the question )

Inorder to Increase ROI from 12% to 18% the Fixed Cost should be decreased by $80,000.

Net Profits = Revenue - (Variable Cost + Fixed Cost)

= $5,000,000 - (2,400,000 +1,520,000)

= $ 5,000,000 - 3,920,000

Net Profits = $1,080,000

Calculation of Amount of Assets Inorder to reach target ROI :

Net Profits = Total assets * 18%

1,000,000 = Total assets * 18%

Total Assets = 1,000,000 * 100\18

Total Assets = 5,555,556

Inorder to reach target ROI decrease in Total Assets  = Total Assets @ 12% ROI - Total Assets@18% ROI

= 6,000,000 - 5,555,556

= $444,444

Inorder to Increase ROI from 12% to 18% the Assets should be decreased by $444,444