Pharmaceutical firms, oil and gas companies, and other ventures inevitably incur
ID: 2541434 • Letter: P
Question
Pharmaceutical firms, oil and gas companies, and other ventures inevitably incur costs on unsuccessful investments in new projects (e.g., new drugs or new wells). For oil and gas firms, a debate continues over whether those costs should be written off as a period expense or capitalized as part of the full cost of finding profitable oil and gas ventures. For pharmaceutical firms, GAAP in the United States is clear that R&D costs are to be expensed when incurred.
Pharm-It has been writing R&D costs off to expense as incurred for both financial reporting and internal performance measurement. However, this year a new management team was hired to improve the profit of Pharm-It's Cardiology Division. The new management team was hired with the provision that it would receive a bonus equal to 10 percent of any profits in excess of base-year profits of the division. However, no bonus would be paid if profits were less than 20 percent of end-of-year investment. The following information was included in the performance report for the division:
aIncludes other investments not at issue here.
During the year, the new team spent $5 million on R&D activities, of which $4,500,000 was for unsuccessful ventures. The new management team has included the $4,500,000 in the current end-of-year investment base because "You can't invent successful drugs without missing on a few unsuccessful ones."
Required:
a. What is the ROI for the base year and the current year? Ignore taxes. (Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).)
a-1. If R&D is expensed:
Base year ?
current year ?
a-2. If R&D is capitalized:
b. What is the amount of the bonus that the new management team is likely to claim? (Enter your answer in dollars, not in millions.)
This Year Base Year Increase over Base Year Sales revenues $ 21,400,000 $ 21,000,000 Costs incurred R&D Expense 0 3,800,000 Depreciation and other amortization 3,650,000 3,500,000 Other costs 7,700,000 7,500,000 Division profit $ 10,050,000 $ 6,200,000 $ 3,850,000 End-of-year investment $ 40,500,000 a $ 34,500,000Explanation / Answer
Part (a)(1) - ROI Calculation
ROI = Profit/Investment*100
Base Year = ($6200000/$34500000)*100 = 17.97%
Current Year = ($10050000 - $4500000)/$40500000*100 = 13.70%
Note - $4500000 (R&D) is deducted since it is to be expensed out.
Part (a)(2) - If R&D ($4500000) is Capitalised
Current Year = ($10050000/$40500000)*100 = 24.81%
Base year = same as 17.97%
Part b - Amount Of bonus management likely to claim
Bonus = 10% of Excess Profit
Excess Profits = ($10050000 - $6200000) = $3850000
Bonus = ($3850000*10%) = $385000