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CHAPTER 14
I. Questions
1. Cost centers are evaluated by means of performance reports. Profit
centers are evaluated by means of contribution income statements
(including cost center performance reports), in terms of meeting sales
and cost objectives. Investment centers are evaluated by means of the
rate of return which they are able to generate on invested assets.
2. Overall profitability can be improved (1) by increasing sales, (2) by
reducing expenses, or (3) by reducing assets.
3. ROI may lead to dysfunctional decisions in that divisional managers may
reject otherwise profitable investment opportunities simply because they
would reduce the divisions overall ROI figure. The residual income
approach overcomes this problem by establishing a minimum rate of
return which the company wants to earn on its operating assets, thereby
motivating the manager to accept all investment opportunities promising
a return in excess of this minimum figure.
4. A cost center manager has control over cost, but not revenue or
investment funds. A profit center manager, by contrast, has control over
both cost and revenue. An investment center manager has control over
cost and revenue and investment funds.
5. The term transfer price means the price charged for a transfer of goods
or services between units of the same organization, such as two
departments or divisions. Transfer prices are needed for performance
evaluation purposes.
6. The use of market price for transfer purposes will create the actual
conditions under which the transferring and receiving units would be
operating if they were completely separate, autonomous companies. It is
generally felt that the creation of such conditions provides managerial
incentive, and leads to greater overall efficiency in operations.
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Chapter 14 Responsibility Accounting and Transfer Pricing
7. Negotiated transfer prices should be used (1) when the volume involved
is large enough to justify quantity discounts, (2) when selling and/or
administrative expenses are less on intracompany sales, (3) when idle
capacity exists, and (4) when no clear-cut market price exists (such as a
sister division being the only supplier of a good or service).
8. Suboptimization can result if transfer prices are set in a way that benefits
a particular division, but works to the disadvantage of the company as a
whole. An example would be a transfer between divisions when no
transfers should be made (e.g., where a better overall contribution
margin could be generated by selling at an intermediate stage, rather
than transferring to the next division). Suboptimization can also result if
transfer pricing is so inflexible that one division buys from the outside
when there is substantial idle capacity to produce the item internally. If
divisional managers are given full autonomy in setting, accepting, and
rejecting transfer prices, then either of these situations can be created,
through selfishness, desire to look good, pettiness, or bickering.
II. Exercises
No. Although Department 3 does not cover all of the cost allocated to it. It
contributes P21,000 to the total operations over and above its direct costs.
Without Department 3, the company would earn P21,000 less as compared
with the original over-all income of P47,000.
Department
1 2 4 Total
Revenue P132,000 P168,000 P98,000 P398,000
Direct cost of department 82,000 108,000 61,000 251,000
Contribution of the
department P 50,000 P 60,000 P37,000 P147,000
Allocated cost 121,000
Net income P 26,000
With the discontinuance of Department 3, the revenue and direct cost of the
department are eliminated, but there is no reduction in the total allocated
cost.
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement 1
ROI RI
Operating assets P400,000 P400,000
Operating income P100,000 P100,000
ROI (P100,000 P400,000) 25%
Minimum required income
(16% x P400,000) P64,000
RI (P100,000 - P64,000) P36,000
Requirement 2
The manager of the Cling Division would not accept this project under the
ROI approach since the division is already earning 25%. Accepting this
project would reduce the present divisional performance, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000* P112,000
ROI 25% 20% 24.35%
* P60,000 x 20% = P12,000
Under the RI approach, on the other hand, the manager would accept this
project since the new project provides a higher return than the minimum
required rate of return (20 percent vs. 16 percent). The new project would
increase the overall divisional residual income, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000 P112,000
Minimum required
return at 16% 64,000 9,600* 73,600
RI P 36,000 P 2,400 P 38,400
* P60,000 x 16% = P9,600
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Chapter 14 Responsibility Accounting and Transfer Pricing
Requirement 1
Requirement 2
Requirement 1
P630,000 P9,000,000
Division A : X = ROI
P9,000,000 P3,000,000
7% X 3 = 21%
P1,800,000 P20,000,000
Division B : X = ROI
P20,000,000 P10,000,000
9% X 2 = 18%
Requirement 2
Division A Division B
Average operating assets (a) ........ P3,000,000 P10,000,000
Net operating income................... P 630,000 P 1,800,000
Minimum required return on average
operating assets - 16% x (a) .... 480,000 1,600,000
Residual income........................... P 150,000 P 200,000
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement 3
No, Division B is simply larger than Division A and for this reason one
would expect that it would have a greater amount of residual income. As
stated in the text, residual income cant be used to compare the performance
of divisions of different sizes. Larger divisions will almost always look
better, not necessarily because of better management but because of the
larger peso figures involved. In fact, in the case above, Division B does not
appear to be as well managed as Division A. Note from Part (2) that
Division B has only an 18 percent ROI as compared to 21 percent for
Division A.
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Chapter 14 Responsibility Accounting and Transfer Pricing
Requirement 1
Computation of ROI
Division A:
P300,000 P6,000,000
ROI = x = 5% x 4 = 20%
P6,000,000 P1,500,000
Division B:
P900,000 P10,000,000
ROI = x = 9% x 2 = 18%
P10,000,000 P5,000,000
Division C:
P180,000 P8,000,000
ROI = x = 2.25% x 4 = 9%
P8,000,000 P2,000,000
Requirement 2
Requirement 3
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement 1
Division A Division B Total Company
Sales P3,500,000 1 P2,400,000 2
P5,200,000 3
Less expenses:
Added by the division................................
2,600,000 1,200,000 3,800,000
Transfer price paid................................
700,000
Total expenses................................
2,600,000 1,900,000 3,800,000
Net operating income................................
P 900,000 P 500,000 P1,400,000
1
20,000 units P175 per unit = P3,500,000.
2
4,000 units P600 per unit = P2,400,000.
3
Division A outside sales (16,000 units P175 per unit) ................................ P2,800,000
Division B outside sales (4,000 units P600 per unit)................................ 2,400,000
Total outside sales ................................................................................................
P5,200,000
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Chapter 14 Responsibility Accounting and Transfer Pricing
Requirement 2
Requirement 1
The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred
.
There is no idle capacity, so each of the 20,000 units transferred from
Division X to Division Y reduces sales to outsiders by one unit. The
contribution margin per unit on outside sales is P20 (= P50 P30).
P20 x 20,000
Transfer price (P30 P2) +
20,000
Transfer price = P28 + P20 = P48
The buying division, Division Y, can purchase a similar unit from an outside
supplier for P47. Therefore, Division Y would be unwilling to pay more
than P47 per unit.
The requirements of the two divisions are incompatible and no transfer will
take place.
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement 2
The buying division, Division Y, can purchase a similar unit from an outside
supplier for P34. Therefore, Division Y would be unwilling to pay more
than P34 per unit.
In this case, the requirements of the two divisions are compatible and a
transfer will hopefully take place at a transfer price within the range:
Requirement 1
Requirement 2
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Chapter 14 Responsibility Accounting and Transfer Pricing
The additional savings in Division B means that now Division A should buy
outside.
Requirement 3
III. Problems
Requirement (a)
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement (b)
The complaint of the manager of Product T is justified on the ground that his
product line shows a positive contribution margin and therefore, contributes
to the recovery of non-controllable fixed expenses. This observation is, of
course, made under the assumption that the preceding years figures (which
are not given) were less favorable than the current year.
Requirement 1
Product
A B C
Incremental sales P71,000 P46,000 P117,000
Less: Incremental costs 42,000 15,000 96,000
Net income P29,000 P31,000 P 21,000
Requirement 2
The sunk costs are:
Depreciation of equipment P 6,400
Operating cost of the equipment 4,600
Total P11,000
Requirement 3
Opportunity cost of selling Product B is
From Product A P29,000
From Product C 21,000
Total P50,000
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Chapter 14 Responsibility Accounting and Transfer Pricing
Actual Based on
Cost-Volume 4,200 4,200 Variance
Formula Hours Hours U (F)
Variable Overhead Costs:
Utilities P0.80 per hour P 3,600 P 3,360 P240
Supplies 1.80 7,400 7,560 (160)
Indirect labor 1.20 5,300 5,040 260
Total P3.80 P16,300 P15,960 P340
Fixed Overhead Costs:
Utilities P 1,600 P 1,600 -
Supplies 2,200 2,200 -
Depreciation 6,000 6,000 -
Indirect labor 5,400 5,400 -
Insurance 1,200 1,200 -
Total P16,400 P16,400 -
Total Factory Overhead Costs P32,700 P32,360 P340
Requirement 1
The cost of raw materials rose significantly, possibly because of (1) deficient
machinery due to the cutback in maintenance expenditures and/or (2) to the
lower labor cost, possibly due to the use of less-skilled workers. Supplies
decreased, indicating possible inadequacies for next periods production run.
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement 2
The marketing division is behind its cost allotment. The personnel division
came in somewhat under its budgeted costs. Perhaps there has been a
cutback in hiring, indicating possible reduction in future production.
Requirement 1
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Chapter 14 Responsibility Accounting and Transfer Pricing
Requirement 2
Note how the change in income follows the change in revenues, as predicted
by operating leverage. Operating leverage multiplied times the percentage
change in sales gives the percentage change in income. Thus, the greater the
operating leverage ratio, the larger the effect on income and ROI of a given
percentage change in sales. This exercise provides an opportunity to review
the relationship between volume and profit. See the illustration below:
% change in income
If volume goes to 2,000 units: (P280 P160) / P160 = 75%
If volume goes to 1,000 units: (P160 P40) / P160 = 75%
% change in ROI
If volume goes to 2,000 units: (35% - 20%) / 20% = 75%
If volume goes to 1,000 units: (20% - 5%) / 20% = 75%
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement 1
ROI computations:
P1,800,000 P20,000,000
Quezon: x = 9% x 2 = 18%
P20,000,000 P10,000,000
Requirement 2
Pasig Quezon
Average operating assets (a) ................................
P3,000,000 P10,000,000
Net operating income ................................ P 630,000 P 1,800,000
Minimum required return on average
operating assets16% (a) ................................ 480,000 P 1,600,000
Residual income................................................................
P 150,000 P 200,000
Requirement 3
No, the Quezon Division is simply larger than the Pasig Division and for this
reason one would expect that it would have a greater amount of residual
income. Residual income cant be used to compare the performance of
divisions of different sizes. Larger divisions will almost always look better,
not necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Quezon does not appear to be as
well managed as Pasig. Note from Part (1) that Quezon has only an 18%
ROI as compared to 21% for Pasig.
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Chapter 14 Responsibility Accounting and Transfer Pricing
Requirement 1
Since the Valve Division has idle capacity, it does not have to give up any
outside sales to take on the Pump Divisions business. Applying the formula
for the lowest acceptable transfer price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable on lost sales
Transfer price cost per unit +
Number of units transferred
P0
Transfer price P16 +
10,000
= P16
The Pump Division would be unwilling to pay more than P29, the price it is
currently paying an outside supplier for its valves. Therefore, the transfer
price must fall within the range:
Requirement 2
Since the Valve Division is selling all of the valves that it can produce on the
outside market, it would have to give up some of these outside sales to take
on the Pump Divisions business. Thus, the Valve Division has an
opportunity cost, which is the total contribution margin on lost sales:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred
Since the Pump Division can purchase valves from an outside supplier at
only P29 per unit, no transfers will be made between the two divisions.
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Responsibility Accounting and Transfer Pricing Chapter 14
Requirement 3
Applying the formula for the lowest acceptable price from the viewpoint of
the selling division, we get:
In this case, the transfer price must fall within the range:
To produce the 20,000 special valves, the Valve Division will have to give
up sales of 30,000 regular valves to outside customers. Applying the
formula for the lowest acceptable price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred
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Chapter 14 Responsibility Accounting and Transfer Pricing
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