Question

Deborah Lewis, general manager of the Northwest Division of Berkshire Co., has significant authority over pricing decisions as well as programs that involve cost reduction/control. The data that follow relate to upcoming divisional operations:

           

            Average invested capital: $15,000,000

            Annual total fixed costs: $3,900,000

            Variable cost per unit: $80

            Number of units expected to be sold: 120,000

Assume the unit selling price is $132 and that Berkshire has a 16% imputed interest charge.

Top management will promote Deborah to corporate headquarters if her division can generate $200,000 of residual income (RI). If Deborah desires to move to corporate, what adjustment must the division do to the amount of annual total fixed costs?

Answer 1

First of all we need to calculate the current residual income in order to identify the adjustment to be made to the amount of annual total fixed costs.

Calculation of Residual Income:

Residual Income = Net income - (Invested capital * Minimum required rate of return)

Net Income = Sales - Variable costs - Fixed costs

Net Income = (120,000*132) - (120,000*80) - 3,900,000

Net Income = $2,340,000

Invested capital = $15,000,000 (given in question)

Minimum required rate of return = 16% (given in question)

Therefore, residual income = $2,340,000 - ($15,000,000*16%)

Residual Income = -$60,000

Hence, adjustment to be made to the amount of fixed costs so that residual income becomes $200,000 = $200,000+$60,000 = $260,000

Therefore, revised fixed costs = $3,900,000 - $260,000 = $3,640,000