Question 1

Compared to return on investment (ROI), residual income (RI) may be a better measure of the financial performance of an investment center because:

Accepted Answer

ROI can be misleading because it only considers the return on the assets invested, not the level of investment required to generate that return. In contrast, RI takes into account the cost of capital and the level of investment required to generate a given level of income. By using RI, divisions will be incentivized to pursue investments that generate incremental income above and beyond the cost of capital, rather than simply maximizing the ROI on their current assets. This will lead to better overall financial performance for the entire organization.

Question 2

The primary limitation of using Economic Value Added (EVA®) to evaluate the financial performance of investment centers is:

Accepted Answer

The answer of The primary limitation of using Economic Value...

Question 3

The major criticism of using return on investment (ROI) for evaluating the financial performance of business units considered investment centers is that ROI:

Accepted Answer

ROI can create a disincentive for managers to undertake long-term, high-return projects that may initially lower profitability but ultimately be in the best interest of the organization. This is because ROI focuses on short-term profitability and does not take into account the potential long-term benefits of certain projects. As a result, managers may reject projects that have a lower immediate return but a higher long-term value, leading to missed opportunities for the organization as a whole.

Question 4

All of the following are true of market-based transfer prices except:

Accepted Answer

Market-based transfer prices cannot be determined for all goods and services transferred internally as some products may not have external market values. For example, it would be difficult to determine a market-based transfer price for an internal transfer of a specialized machine that is only used by one department within a company.

Question 5

The greatest advantage of using a negotiated transfer price is:

Accepted Answer

The greatest advantage of using a negotiated transfer price is that it can be the most practical approach when conflicts exist between selling and buying divisions. This allows for the divisions to come to an agreement that is most beneficial for both parties.

Question 6

A company currently earning a profit can increase its return on investment (ROI) by:

Accepted Answer

Increasing sales revenues and operating expenses by the same percentage would be the best choice to increase ROI while maintaining profitability. This is because it would result in a higher profit margin, which is the ratio of profit to revenue. By increasing both sales revenues and operating expenses, the company can maintain or improve its profit margin while generating more profit, leading to a higher ROI. The other options either don't result in an increase in profit or could lead to decreased profitability.

Question 7

A primary goal of transfer pricing is to:

Accepted Answer

The primary goal of transfer pricing is to motivate decision makers to act in the best interests of the organization by ensuring that prices for internal transfers are set at a level that encourages optimal performance and profitability. Transfer pricing should not be used to benefit one unit of the organization at the expense of another, as this can lead to inefficiencies and conflicts. Instead, transfer prices should be set to promote cooperative behavior and the overall success of the organization.

Question 8

A primary characteristic of a negotiated transfer price is that it:

Accepted Answer

Negotiated transfer prices typically require a significant amount of negotiation and agreement between the divisions involved, which can be costly and time-consuming to implement. Therefore, option C is the correct choice. Option A is incorrect because negotiated transfer prices still hold each division accountable for their performance. Option B is incorrect because negotiated transfer prices typically increase sub-unit autonomy, as they allow each division to negotiate prices independently based on their own cost structures. Option D is incorrect because negotiated transfer prices aim to transfer the optimum number of units between the buying and selling divisions, not more than necessary. Option E is incorrect because negotiated transfer prices take into account the negotiating skills of each division's managers when determining the transfer price, making performance indicators partially dependent on these skills.

Question 9

All of the following are true of cost-based transfer prices except:

Accepted Answer

Cost-based transfer prices may not always promote optimal decision-making from the standpoint of the organization as a whole as they may not take into account external market conditions or opportunity costs. The other options are true of cost-based transfer prices.

Question 10

A segment of an organization is referred to as an investment center if it has:

Accepted Answer

An investment center is a segment of an organization that has authority to make decisions affecting the major determinants of profit, including the power to choose its markets and sources of supply, and significant control over the amount of invested capital. Option B is the only choice that includes both of these characteristics. Option A only mentions the power to choose markets and sources of supply, while Option C only mentions the control over sources of supply. Options D and E describe other types of organizational segments.

Question 11

Under the notion of controllability, it is appropriate to evaluate the profitability of each investment center based on each center's:

Accepted Answer

Controllability is evaluated based on profit earned in relation to the amount of capital invested in the subunit. This is commonly measured using return on investment (ROI), which is calculated as operating income divided by the amount of capital invested in the subunit. Therefore, choice D is the most appropriate option in evaluating the profitability of each investment center.

Question 12

EVA® (economic value added):

Accepted Answer

EVA® measures the economic profit of an investment center, indicating how much value was added beyond the required return on capital. An EVA of $100,000 means the center's economic profit was $100,000.

Question 13

Each of the following represents a way of calculating ROI (return on investment) for a division except:

Accepted Answer

Choices A, B, and D all involve calculating ROI using some variation of operating income and divisional investment/assets. Choice C, however, involves calculating ROI by multiplying the return on sales (ROS) with inventory turnover, which is not a traditional calculation of ROI.

Question 14

The basic objective of the residual income (RI) approach to performance measurement of a business unit considered an investment center is to have the investment center maximize its:

Accepted Answer

The residual income (RI) approach focuses on ensuring that the operating income of an investment center exceeds a certain minimum dollar return, which is typically based on a desired rate of return on the investment. This approach encourages managers to make decisions that generate income above the cost of capital used, rather than just focusing on maximizing overall returns or cash flows.

Question 15

Which of the following specifications for calculating EVA® is correct?

Accepted Answer

The correct formula for calculating EVA® is EVA® = NOPAT − Imputed charge on EVA® capital, where NOPAT = net operating profit after (cash) taxes. Choice A is incorrect because accounting income does not take into account the cost of capital. Choice B is incorrect because equity equivalents alone do not provide an accurate measure of invested capital. Choice C is partially correct, but it is missing the imputed charge on invested capital. Choice E is incorrect because it uses reported operating profit rather than net operating profit after taxes.

Question 16

Which of the following statements regarding the calculation of Economic Value Added (EVA®) is not true?

Accepted Answer

EVA® NOPAT represents after-tax cash operating income, before depreciation. The other options are true statements regarding the calculation of EVA®.

Question 17

Return on investment (ROI) can be directly increased by:

Accepted Answer

The answer of Return on investment (ROI) can be directly...

Question 18

Assume that an organization's weighted-average cost of capital (minimum rate of return) is 8% and that Division A currently has a 12% return on investment (ROI). The manager of Department A, who is evaluated on the basis of divisional ROI, would most likely accept an investment that is expected to return:

Accepted Answer

The manager of Department A is evaluated on divisional ROI, which is currently 12%. This means that the manager has already exceeded the organization's weighted-average cost of capital (8%). Therefore, the manager would most likely accept an investment that is expected to return more than the existing ROI of 12%, which is option B.

Question 19

The most likely result of using a negotiated transfer price is that:

Accepted Answer

Using a negotiated transfer price may result in the end decision being influenced by the relative bargaining skills of the managers involved. This means that the transfer price may not necessarily reflect purely economic considerations, and more or fewer units may be transferred than optimal. Additionally, it takes away the buying and selling units' responsibility for determining the transfer price.

Question 20

Which one of the following statements pertaining to the return on investment (ROI) as a performance measure is incorrect?

Accepted Answer

The statement that ROI relies on financial measures that are capable of being independently verified while other forms of performance measures are subject to manipulation is incorrect. Other financial measures can also be subject to manipulation, and non-financial measures such as customer satisfaction or employee engagement can be objectively measured and independently verified.

Quiz 19: Strategic Performance Measurement: Investment Centers and Transfer Pricing

Compared to return on investment (ROI) , residual income (RI) may be a better measure of the financial performance of an investment center because: