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Electronic Arts: Target rate of ROI; ABC; relevant costs and

Problem One: Target rate of return on investment, activity- based costing. Electronic Arts ( EA) distributes video games to retail stores and video- game parlors. It has a simple business model: Order the video games, cat-alog the games on EA's Web site, deliver and provide on- site support, and bill and collect from the cus-tomers. EA reported the following costs in April 2009:

Activity Cost Driver Quantity Cost per unit of Cost Driver (Ordering) Number of game vendors 40 $ 250 per vendor (Cataloging) Number of new titles 20 $100 per title (Delivery and support) Number of deliveries 400 $ 15 per delivery (Billing and collection) Number of customers 300 $ 50 per customer

In April 2009, EA purchased 12,000 video- game disks at an average cost of $ 15 per disk, and it sold them at an average price of $ 22 per disk. The catalog on the Web site and the customer interactions that occur dur-ing delivery are EAĆ¢??s main marketing inputs. EA incurs no other costs.

1. Calculate EA's operating income for April 2009. If the monthly investment in EA is $ 300,000, what rate of return on investment does the business earn?

2. The current crop of game systems is maturing, and prices for games are beginning to decline. EA anticipates that from May onward, it will be able to sell 12,000 game disks each month for an average of $ 18 per disk, and it will have to pay vendors an average of $ 12 per disk. Assuming other costs are the same as in April, will EA be able to earn its 15% target rate of return on investment?

3. EA's small workforce gathers as a team and considers process improvements. They recommend 'firing' the marginal vendors' those who need a lot of 'hand holding' but whose titles are not very popular.

They agree that they should shift some of their resources from vendor relationships and cataloging to delivery and customer relationships. In May 2009, EA reports the following support costs:

Activity Cost Driver Quantity Cost per Unit of Cost Driver (Ordering) Number of game vendors 30 $ 200 per vendor (Cataloging) Number of new titles 15 $ 100 per title (Delivery and support) Number of deliveries 450 $ 20 per delivery
(Billing and collection) Number of customers 300 $ 50 per customer

At a selling price of $ 18 and a cost of $ 12 per disk, how many game disks must EA sell in May 2009 to earn its 15% target rate of return on investment?

Problem Two:
Quality improvement, relevant costs, and relevant revenues. The Thomas Corporation sells 300,000 V262 valves to the automobile and truck industry. Thomas has a capacity of 110,000 machine- hours and can produce 3 valves per machine- hour. V262's contribution margin per unit is $ 8. Thomas sells only 300,000 valves because 30,000 valves ( 10% of the good valves) need to be reworked. It takes 1 machine- hour to rework 3 valves, so 10,000 hours of capacity are used in the rework process. Thomas's rework costs are $ 210,000. Rework costs consist of:

--Direct materials and direct rework labor ( variable costs): $ 3 per unit
--Fixed costs of equipment, rent, and overhead allocation: $ 4 per unit

Thomas's process designers have developed a modification that would maintain the speed of the process and ensure 100% quality and no rework. The new process would cost $ 315,000 per year. The following additional information is available:

--The demand for Thomas's V262 valves is 370,000 per year.
--The Jackson Corporation has asked Thomas to supply 22,000 T971 valves ( another product) if Thomas implements the new design. The contribution margin per T971 valve is $ 10. Thomas can make two T971 valves per machine- hour with 100% quality and no rework.

1. Suppose Thomas's designers implement the new design. Should Thomas accept Jackson's order for 22,000 T971 valves? Show your calculations.
2. Should Thomas implement the new design? Show your calculations.
3. What nonfinancial and qualitative factors should Thomas consider in deciding whether to implement the new design?

Solution Preview

See Excel attached for solution on Problem 1 & 2

Problem 2

1. Suppose Thomas' designers implement the new design. Should Thomas accept Jackson's order for 22,000 T971 valves? Show your calculations.

No, the contribution margin per machine hour is lower for the T971 (see Excel computation). Since ...

Solution Summary

Computations are done in excel (click in cells to see formulas and computations). A few sentences explain the strategy and six non-financial factors are mentioned.

$2.19