Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 44

Capital Investment Analysis and Decentralized Performance Measurement

The following exchange occurred just after the finance staff at Diversified Electronics rejected a capital investment proposal.

David Parker (Product Development): I just don’t understand why you rejected my proposal. We can expect to make $230,000 on it before tax.

Shannon West (Finance): David, get real. This product proposal does not meet our short-term

ROI target of 15 percent after tax.

David: I’m not so sure about the ROI target, but it is profitable—$230,000 worth.

Shannon: We believe that a company like Diversified Electronics should have a return on investment of 15 percent after tax. The Professional Services division consistently comes in with a 15 percent or better ROI, while your division, Residential Products, has managed to get only 10 percent. The performance of the Aerospace Products division has been especially dismal, with an ROI of only 6 percent. We expect divisions in the future to carry their share of the load.

Diversified Electronics, a growing company in the electronics industry, had grown to its present size of more than $140 million in sales. (See Exhibits 14.17 and 14.18 for Diversified’s year 1 and year 2 income statements and balance sheets, respectively.) Diversified Electronics has three divisions, Residential Products, Aerospace Products, and Professional Services, each of which accounts for about one-third of Diversified Electronics’s sales. Residential Products, the oldest division, produces furnace thermostats and similar products. The Aerospace Products division is a large job shop that builds electronic devices to customer specifications. A typical job or batch takes several months to complete. About one-half of Aerospace Products’s sales are to the U.S. Defense Department. The newest of the three divisions, Professional Services, provides consulting engineering services. This division has grown tremendously since Diversified Electronics acquired it seven years ago.

DIVERSIFIED ELECTRONICS Income Statements for Year 1 and Year 2 (all dollar amounts in thousands, except earnings-per-share figures) Year Ended December 31
	Year 1	Year 2
Sales	$141,462	$148,220
Cost of goods sold	108,118	113,115
Gross margin	$ 33,344	$ 35,105
Selling and general	13,014	13,692
Profit before taxes and interest	$ 20,330	$ 21,413
Interest expense	1,190	1,952
Profit before taxes	$ 19,140	$ 19,461
Income tax expense	7,886	7,454
Net income	$ 11,254	$ 12,007
Earnings per share	$5.63	$6.00

DIVERSIFIED ELECTRONICS Balance Sheets for Year 1 and Year 2 (all dollar amounts in thousands) Year Ended December 31
		December 31
		Year 1	Year 2
Assets
Cash and temporary investments		$1,404	$ 1,469
Accounts receivable		13,688	15,607
Inventories		42,162	45,467
Total current assets		$57,254	$ 62,543
Plant and equipment:
Original cost		107,326	115,736
Accumulated depreciation		42,691	45,979
Net		$64,635	$ 69,757
Investments and other assets		3,143	3,119
Total assets		$125,032	$135,419
Liabilities and owners’ equity
Accounts payable		$10,720	$ 12,286
Taxes payable		1,210	1,045
Current portion of long-term debt		-0-	1,634
Total current liabilities		$11,930	$ 14,965
Deferred income taxes		559	985
Long-term debt		12,622	15,448
Total liabilities		$25,111	$ 31,398
Common stock		47,368	47,368
Retained earnings		52,553	56,653
Total owners’ equity		$99,921	$104,021
Total liabilities and owners’ equity		$125,032	$135,419

Each division operates independently of the others, and corporate management treats each as a separate entity. Division managers make many of the operating decisions. Corporate management coordinates the activities of the various divisions, including the review of all investment proposals over $400,000.

Diversified Electronics measures return on investment as the division’s net income divided by total assets. Each division’s expenses include the allocated portion of corporate administrative expenses. Since each of Diversified Electronics’s divisions is located in a separate facility, management can easily attribute most assets, including receivables, to specific divisions. Management allocates the corporate office assets, including the centrally controlled cash account, to the divisions on the basis of divisional revenues.

Exhibit 14.19 shows the details of David Parker’s rejected product proposal.

Required

a. Was the decision to reject the new product proposal the right one? If top management used the discounted cash flow (DCF) method instead, what would the results be? The company uses a 15 percent after-tax cost of capital (i.e., discount rate) in evaluating projects such as these.

---

b. Evaluate the manner in which Diversified Electronics has implemented the investment center concept. What pitfalls did it apparently not anticipate? What, if anything, should be done with regard to the investment center approach and the use of ROI as a measure of performance?

---

c. What conflicting incentives for managers can occur when yearly ROI is used as a performance measure and DCF is used for capital budgeting?

1. Projected asset investment:
Land purchase	$ 200,000
Plant and equipmenta	800,000
	$1,000,000
2. Cost data, before taxes (first year):
Variable cost per unit	$3.00
Differential fixed costb	$170,000
3. Price/market estimate (first year):
Unit price	$7.00
Sales volume	100,000 units
4. Taxes: The company assumes a 40 percent tax rate for income and gains on land sale. Depreciation of plant and equipment according to tax law is as follows: year 1: 20 percent; year 2: 32 percent; year 3: 19 percent; year 4: 14.5 percent; and year 5: 14.5 percent. Taxes are paid for taxable income in year 1 at the end of year 1; taxes are paid for taxable income in year 2 at the end of year 2, and so on.
5. The new product is in a growth market with expected price increases of 10 percent per year. This 10 percent applies to revenues and costs except depreciation and land for years 2 through 8 (i.e., year 2 amounts will reflect a 10 percent increase over the year 1 amounts shown in the data above).
6. The project has an eight-year life. Land will be sold for $400,000 at the end of year 8.
7. Assume the gain on the sale of land is taxable at the 40 percent rate.

Step 1 of 8

a.?David Parker's new product proposal was rejected because its ROI was less than 15 percent after tax.

Project ROI	=	Profit [1.0 – Tax rate]
		Investment
	=	$230,000 [1.0 – .40]
		$1,000,000
	=	13.8%

?The decision was not correct because it is inappropriate to use a short-term measure like ROI to evaluate a long-term decision, ignoring completely the project's cash flows.  Also, a performance measure that is suitable for measuring past performance should not be used for an investment decision.    (This is why accrual accounting might be appropriate for evaluating past performance while cash flows are used for decision making.  If the company had used DCF (Discounted Cash Flows) analysis, the results would have been as shown in the spreadsheet on the following page.