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EXAM REVIEW
ACCOUNTING 102 - UNIT IV
CHAPTERS 10, 11, 12
STUDY SUGGESTIONS
Review your class notes, homework exercises and problems. Review Summary, Review Problem and Glossary at the end of each chapter. Use your Study Guide, especially Multiple Choice and True & False questions Review the resource materials and practice quizzes and exams available on the Textbook Website : http://highered.mcgraw-hill.com/sites/0073048836/informationcenterview0/ Additional review materials are available online at sites such as: http://www.cliffsnotes.com/WileyCDA/Section/id-305261.html
Chapter 10 - Decentralization Distinguish between a traceable fixed cost and a common fixed cost. Understand segments of a business. Distinguish between centralized and decentralized organizations. Distinguish between a cost center, profit center, and investment center. Know how to calculate ROI and residual income : Margin = Net operating income/Sales Turnover = Sales/Average operating assets ROI = Margin X Turnover OR Net operating income/Average operating assets Minimum required income = Required Rate of Return * Average operating assets Residual Income = Net Income minus Minimum required income Understand the strengths and weaknesses of the ROI and residual income methods of measuring performance.
Chapter 11 – Relevant Costs for Decision Making Relevance refers to whether a revenue or cost will change as the result of the decision made. Relevant revenues or costs always change as the result of the decision. An avoidable cost is always a relevant cost. Differential revenues or costs are the differences in revenues or costs between the alternatives. Incremental revenues or costs are the additional costs or revenues that may be incurred. A sunk cost is any cost that has already been incurred and that cannot be changed by any decision made now or in the future.
Sunk costs and future costs that do not differ between the alternatives are never included in the decision-making. An opportunity cost represents those economic benefits that are forgone as a result of pursuing some course of action. Know how to analyze whether to keep or replace old equipment. Know how to determine the most profitable allocation of a constrained or scarce resource. Know how to analyze make or buy decisions. Know how to analyze whether a special order should be accepted or rejected. Know how to analyze a decision to drop a segment or to drop a product line.
Chapter 12 – Capital Budgeting Decisions Understand the concept of the time value of money, i.e., present value of $1 and present value of an annuity of $1. Determine the typical cash inflows and cash outflows that are associated with an investment project. Be able to compute using the following: Net Present Value (NPV) Method Payback: Investment required/Net annual cash inflow = Payback period OR Summation of each year’s net cash inflow or outflow until investment is recouped Simple Rate of Return: Simple Rate of Return = Net Income/Initial Investment Net Income = Incremental revenues – Incremental expenses including depreciation Rank investment projects using the profitability index.
Problem 3 – Return on Investment and Residual Income The following data pertains to Timmins Company’s operations last year: Return on investment 20% Sales $800, Margin 5% Minimum Rate of Return 16% Required: a. Compute the company’s average operating assets. b. Compute the company’s residual income for the year.
Problem 4 – Sample Multiple Choice Questions
- Consider the following three conditions: I. An increase in sales II. An increase in operating assets III. A reduction in expenses
Which of the following conditions provide a way in which a manager can improve return on investment?
a. Only I b. Only I and II c. Only I and III d. Only II and III
- Given the following data: Return on investment (ROI) 15% Sales $120, Average Operating Assets 60, Minimum required rate of return 12% Margin 7.5%
The residual income would be:
a. $1, b. $5, c. $2, d. $3,
- Last year a company had sales of $400,000, a turnover of 2.4, and a return on investment of 36%. The company’s net operating income for the year was:
a. $144, b. $120, c. $ 80, d. $ 60,
Problem 5- Sunk Cost The Bombay Bicycle Company has 1,000 obsolete bicycles that are included in inventory at their cost of $35,000. If new parts are added, at a total cost of $15,000, the bicycles could be sold for $40,000. Alternatively, they could be sold to a "flea market" as-is for $10,000. (a) Which is the correct decision? (b) What is the sunk cost?
Problem 6- Purchase of new equipment The Fogle Company production manager is trying to decide if he should acquire a new machine to replace one of its older machines. The new machine would cost $100,000; have a five year life and no salvage value. Variable operating costs would be $50,000 per year. The present machine has a book value of $125,000 and a remaining life of five years. Its disposal value now is $10,000, but it would be zero after five years. Variable operating costs of the present machine are $100,000 per year. (a) Considering the five years in total, what would be the impact on operating income if the new machine is acquired? (b) What is the sunk cost?
Problem 7 - Discontinue a product The Otter Manufacturing Company has been producing a certain sleeping bag for many years. However, sale of this particular sleeping bag have been declining. Otter currently produces and sells 10,000 each year. Each unit sells for $25.00 and has a contribution margin of $10.00. If this sleeping bag is discontinued, $50,000 of fixed expenses would be eliminated. If the sleeping bag were discontinued, would the company's operating income increase or decrease, and by how much?
Problem 8 - Make or Buy Advanced Products Company currently produces a part used in the manufacture of one of its products. The production cost is $28 per unit computed as follows:
Direct materials $ Direct labor 5 Variable manufacturing overhead 3 Fixed manufacturing overhead 10 Total manufacturing cost $
Problem 11 – Sample Multiple Choice Questions
- The Milham Company has two divisions – East and West. The divisions have the following revenues and expenses:
East West Sales $720,000 $350, Variable costs 370,000 240, Traceable fixed costs 130,000 80, Allocated common corporate costs 120,000 50, Operating income (loss) $100,000 ($20,000)
The management at Milham is pondering the elimination of the West division since it has shown an operating loss for the past several years. If the West division were eliminated, its traceable fixed costs could be avoided. The total common corporate costs would be unaffected by this decision. Given these data, the elimination of the West Division would result in an overall company operating income of:
a. $100, b. $ 80, c. $120, d. $ 50,
Use the following information to answer question 2.
(Ignore taxes and the time value of money in this problem.) The Bernard Company has a piece of equipment with an original cost of $126,000, accumulated depreciation of $90,000, and a current resale value of $15,000. Bernard is now pondering the possibility of buying a new piece of equipment to replace the existing equipment. This new machine would cost $154,000 and have no salvage value at the end of its useful life of five years. The annual operating cost of the equipment is $18,000.
Alternatively, Bernard can continue using the existing equipment for the next five years at an annual operating cost of $45,000. The old equipment would have no salvage value at the end of five years.
- If Bernard chooses to buy the new equipment, the increase or decrease in total operating income over the next five years should be: a. $ 5,000 increase b. $19,000 decrease c. $ 4,000 decrease d. $71,000 decrease
Use the following information to answer question 3.
The Molis Company has the capacity to produce 15,000 widgets each month. Current regular production and sales are 10,000 widgets per month at a selling price of $15 each. Based on this level of activity, the following unit costs are incurred:
Direct materials $5. Direct labor 3. Variable manufacturing overhead 0. Fixed manufacturing overhead 1. Variable selling expense 0. Fixed administrative expense 1.
The fixed costs, both manufacturing and administrative, are constant in total within the relevant range of 10,000 to 15,000 widgets per month.
The Molis Company has received a special order from a customer who wants to pay a reduced price of $10 per widget. There would be no selling expense in connection with this special order. And this order would have no effect on the company’s other sales.
- Suppose the special order is for 4,000 widgets this month. If this offer is accepted by Molis, the company’s operating income for the month will: a. increase by $6, b. decrease by $6, c. increase by $5, d. decrease by $5,
Use the following information to answer questions 4-6.
Smithtone Company uses 8,000 units of a certain part in production each year. Presently, this part is purchased from an outside supplier at $12 per unit. For some time now there has been idle capacity in the factory that could be utilized to make this part. The following information has been assembled on the unit costs of making this part internally: Direct materials $3. Direct labor 2. Variable manufacturing overhead 2. Fixed manufacturing overhead 5.
The fixed manufacturing overhead listed above represents an allocation of existing costs to this part. However, there would be an increase of $12,000 in fixed manufacturing overhead costs for the salary of a new supervisor.
Revised September 2007
Problem 13 – Net Present Value, Cash Payback and Simple Rate of Return (Ignore income taxes in this problem) Tranter, Inc., is considering a project that would have a ten-year life and would require a $1,500,000 investment in equipment. At the end of ten years, the project would terminate and the equipment would have no salvage value. The project would provide net income each year as follows:
Sales $2,000, Less: Variable Expenses 1,100, Contribution Margin 900, Less: Fixed Expenses: Other fixed expenses $500, Depreciation 150,000 650, Net Income $ 250,
All of the above items, except depreciation, represent cash flows. The company’s required rate of return is 12%. Required: a. Compute the project’s net present value and its profitability index. b. Compute the project’s payback period. c. Compute the project’s simple rate of return.
Problem 14 – Sample Multiple Choice Questions Questions 1-3 refer to the following:
(Ignore income taxes in this problem.) Morrel University has a small shuttle bus that is in poor mechanical condition. The bus can be either overhauled now or replaced with a new shuttle bus. The following data have been gathered concerning these two alternatives:
Present Bus New Bus Purchase cost new $32,000 $40, Remaining net book value 21, Major repair needed now 9, Annual cash operating costs 12,000 8, Salvage value now 10, Trade-in value in seven years 2,000 5,
The University could continue to use the present bus for the next seven years. Whether the present bus is used or a new bus is purchased, the bus would be traded in for another bus at the end of seven years. The University uses a discount rate of 12% and the total cost approach to net present value analysis in evaluating its investment decisions.
- If the new bus is purchased, the net present value of this alternative is: a. $(74,252) b. $(64,252) c. $(66,512) d. $(76,512)
- If the present bus is repaired, the net present value of this alternative is: a. $(53,864) b. $(54,768) c. $(63,768) d. $(62,864)
- What is the net disadvantage of buying the new bus? a. $3,640 disadvantage b. $10,484 disadvantage c. $12,744 disadvantage d. $1,388 disadvantage
- (Ignore income taxes in this problem.) Harrison Company is studying a project that would have an eight-year life and would require a $300,000 investment in equipment which has no salvage value. The project would provide net income each year as follows for the life of the project:
Sales $500, Less: cash variable expenses 200, Contribution margin 300, Less: Fixed Expenses: Fixed cash expenses $150, Depreciation expense 37,500 187, Net Income $112,
The company’s required rate of return is 10%. What is the payback period for this project?
- 3 years
- 2 years
- 2.5 years
- 2.67 years
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SOLUTIONS TO SAMPLE PROBLEMS
Problem 1 – ROI and Residual Income a. Margin (Net operating income/Sales): $100,000/$1,000,000 = 10% Turnover (Sales/Avg. Operating Assets): $1,000,000/$$400,000 = 2.
b. ROI (Margin * Turnover): 10% * 2.5 = 25% Minimum Income Required (Avg. Operating Assets * Min. ROI): $400,000 * 20% = $80, Current Income $100, Less: Minimum income 80, Residual Income $ 20,
Problem 2 - ROI and Residual Income
Missing data in the tabulation below is indicated with an asterisk ().*
Case A Case B Case C Case D Sales $120,000 50,000 400,000 100,000* Net operating income 9,000* 5,000 48,000 10,000** Margin 7.5% 1 0 % * 1 2 % *** 10% Avg. operating assets 60,000 25,000 160,000 40, Turnover 2.0* 2 .0* 2.5 2. ROI 15% 20%* 30% 25%* Minimum required rate of return Percentage 12% 1 5 % *** 20% 18% Dollar amount 7,200 3,750 32,000 7,200 * Residual income 1,800* 1,250 16,000 2,800**
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Problem 3 – Return on Investment and Residual Income a. Calculate Turnover from the ROI formula: ROI = Margin X Turnover Turnover: 5% * X = 20% X = 4 Turnover: (Sales/Avg. Operating Assets) $800,000/X = 4 X = $200,
c. Minimum Required Income = Avg. Operating Assets * Min. ROI $200,000 * 16% = $32, Use Margin to compute current income: Net Operating Income/Sales X/$800,000 = 5% X = $40, Residual Income: $40,000 - $32,000 = $8,
Problem 4 – Sample Multiple Choice Questions
- C Increasing assets (II) will decrease turnover and decrease ROI
- A Min. Income: 60,000 * 12% = $7,200, Current Income: X/60,000 = 15%, X = $9, Residual Income: $9,000 - $7,200 = $1,
- D ROI: 2.4 * X = 36%, so ...... Margin = 15% Margin: 15% = X/$400,000, so....... Net Operating Income = $60,
Problem 5 - Sunk Cost If new parts are added, at a total cost of $15,000, the bicycles could be sold for $40, making "profit" of $25,000. Alternatively, they could be sold to a "flea market” as is for $10,000. (a) The correct decision is to add the new parts. (b) The sunk cost is the current inventory value of $35,000; it is irrelevant.
Problem 6 - Purchase of new equipment (a) Savings in operating costs of $50,000 per year X 5 years $250, Plus the disposal value of present equipment 10, 260, Less the cost of the new equipment (100,000) Increase in operating income $160, (b) The sunk cost is the book value of the old equipment $125,
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Plus: Salvage of old equipment 15, Less: Cost of new equipment (154,000) Net decrease in total operating income over 5 years $( 4,000)
- C Special Order Price $10. Differential Cost to make (DM + DL + VOH) 8. Increase in operating income per unit $ 1. Overall increase in operating income (1.25 * 4,000 units) $5,
- B Cost to Buy (8,000 * $12/unit) $(96,000) Avoidable Cost to Make: Variable cost to make (DM + DL + VOH) 64, Additional fixed costs 12,000 76, Increase in operating income due to decreased cost $20,
- D Variable Cost of making the part (DM + DL + VOH) $8. Addi fixed cost per unit ($12,000/8,000 units) 1. Indifferent price $9.
- C Cost to Buy (8,000 * $12/unit) $ 96, Differential Cost to Make: Variable cost to make (8,000 * 8) 64, Additional fixed cost 12, Opportunity cost 32,000 108, Net disadvantage of making $12,
Problem 12 - Net Present Value Method
Amount Time
Fact
Present Value
Investment required $10,000 Now 1.00 (10, Net cash Inflows 2,400 1-8 5.335 12, Working capital required 5,000 Now 1.00 (5,000) Working capital released 5,000 8 .467 2, Salvage value 1,000 8 .467 467 Net Present Value $ 606
Problem 13 – Net Present Value, Cash Payback and Simple Rate of Return
a. Net Present Value 12% Present Amount Time Factor Value Investment required $1,500,000 Now 1. Cash Inflows* 400,000 1-10 5.65 2,260, Net Present Value 760,
Profitability Index = 760,000/1,500,000 =.
b. Payback Period : $1,500,000/$400,000 = 3. c. Simple Rate of Return: $250,000/$1,500,000 = 16.67%
