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Back Country Hiking Company (BCHC) is an international company that manufactures specialty camping equipment. Over the years, the company has grown both in terms of product offerings and geographic distribution. Five years ago, the now twenty-year-old company moved to a decentralized organization structure, with two strategic business units (divisions) in East and West. After initial growing pains, the company has started to thrive under the decentralized format.

Three years ago, the company switched from a profit centre approach to an investment centre approach, reflecting corporate management's confidence in the decision-making ability of their managers. The company measures the performance of the business units by determining the return on investment for each unit. Management has full autonomy in decision making. Each manager's compensation package comprises a base salary, with bonuses based on achieving a return on investment in excess of the minimum required by the company. A further bonus is awarded to managers based on the overall company's success. See Exhibit One for more information.

In fiscal 2019, both divisions exceeded the minimum required return on investment and they are optimistic that they will be able to, in future years, maintain an ROI of at least 10% as the divisions has been growing steadily over the past three years. Selected financial information for the past two years for both divisions is included in Exhibit Two.

BCHC is considering an investment that would add production capacity for both divisions for fiscal 2020. In particular, they are considering the purchase of equipment that will allow them to make a new solar powered camp stove, known as Sun Stove. Sun Stove is new to the market and was developed in the West Division in response to a need from a particular region. However, BCHC is now certain that product will be beneficial for many of their customers. The marketing manager wants to ensure that the BCHC is first to market with the product. Due to the nature of the product, it is difficult to patent and it would be almost impossible to enforce, in any event. Information about the product is provided in Exhibit Three. Information about the investment proposal is provided in Exhibit Four.

Exhibit One

Information on Incentive Compensation

Bases of compensation 1. Base salary

2. Bonus for achieving a return on

investment of 10% is achieved

3 Additional bonus for improving return on

investment on a year-over-year basis

Return on Investment formula:

Numerator Divisional controllable income

Denominator Average operating assets (property, plant &

equipment is evaluated using gross book value)

Exhibit Two

Selected Financial Information

East West

Sales revenue $10,000,000 $11,000,000

Cost of Goods Sold 6,000,000 6,500,000

Gross margin 4,000,000 4,500,000

Controllable operating expenses 2,650,000 3,000,000

Controllable divisional income 1,350,000 1,500,000

Allocated administration costs 400,000 350,000

Net income $950,000 $1,150,000

Average operating assets:

Current assets $3,000,000 $4,000,000

Property, plant & equipment 7,000,000 9,500,000

Total average operating assets $10,000,000 $13,500,000

Exhibit Three

Product Information for Sun Stove

East West

Average Unit selling price $150 $170

Variable costs Direct materials $50 $55

Direct labour $15 $20

Variable overhead $42 $47

Variable marketing $20 $20

Incremental fixed costs $300,000 $350,000

Projected annual sales 45,000 60,000

Exhibit Four

Information about Investment Proposal

East West

Cost of equipment $3,500,000 $3,750,000

Useful life 10 years 10 years

Depreciation Method Straight-line Straight-line

Residual value of the equipment $0 $0

You can ignore tax effects and the time value of money for this question.

Required: 1. Calculate the return on investment for each division and the company overall according to the formula provided in Exhibit One. (4 marks)

2. Assuming that the projected sales and cost of equipment are as expected for each division:

a. Calculate the incremental income generated by this new investment net of any incremental costs and depreciation for each division. Assume the equipment will be ready for use by the first day of Fiscal 2020. (2 marks)

b. Determine the projected incremental return on investment for the new equipment for each division. (2 marks)

c. Determine the return on investment for each division including the new equipment. You can assume that operations for all products, except the Sun Stove, in fiscal 2020 will remain consistent with fiscal 2019. (4 marks)

d. Based on your analysis above, which division will accept the investment proposal? Explain (4 marks)

3. Assume that the West Division acquired the equipment at a total cost of $4,250,000. Moreover, it is now six months into the 2020 fiscal year and sales have been less than anticipated. In fact, the West Division is now estimating that total sales for the year will only be 55,000 units, significantly less than capacity. The rest of the business is performing at a level equal to fiscal 2019 and the division manager assumes that income from that part of the business will be $1,500,000 in fiscal 2020. What is the anticipated incremental return on investment for the investment in fiscal 2020 based on the new costs and sales volumes provided? What is the return on investment for the West Division? (4 marks)

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