MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 14

RESPONSIBILITY ACCOUNTING AND
TRANSFER PRICING

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 division’s 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.

14-1

000 Net income P 26. and (4) when no clear-cut market price exists (such as a sister division being the only supplier of a good or service). Without Department 3. but there is no reduction in the total allocated cost.000 P398.000 P 60. Exercises Exercise 1 (Evaluation of a Profit Center) No. pettiness. It contributes P21.000 Allocated cost 121.000 P168.Chapter 14 Responsibility Accounting and Transfer Pricing 7.000 P37. and rejecting transfer prices. 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. Department 1 2 4 Total Revenue P132.000 to the total operations over and above its direct costs. 8..000 Contribution of the department P 50.000 P98. rather than transferring to the next division). Although Department 3 does not cover all of the cost allocated to it.000 less as compared with the original over-all income of P47. (3) when idle capacity exists.000 P147.000.000 Direct cost of department 82.000 108. then either of these situations can be created. where a better overall contribution margin could be generated by selling at an intermediate stage. accepting. the revenue and direct cost of the department are eliminated. If divisional managers are given full autonomy in setting.000 With the discontinuance of Department 3.g. 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. 14-2 . desire to “look good”. Negotiated transfer prices should be used (1) when the volume involved is large enough to justify quantity discounts. through selfishness. (2) when selling and/or administrative expenses are less on intracompany sales.000 251. the company would earn P21.000 61. or bickering. Suboptimization can result if transfer prices are set in a way that benefits a particular division. II.

600 14-3 .000) P64. Responsibility Accounting and Transfer Pricing Chapter 14 Exercise 2 (Evaluation of an Investment Center) Requirement 1 ROI RI Operating assets P400.000 P460. as shown below: Present New Project Overall Operating assets P400.400 P 38.600 RI P 36.000 RI (P100.000 P12.000) P36.000* P112.000 P60.000 x 16% = P9.000  P400.000 Under the RI approach.000 x 20% = P12.000 Requirement 2 The manager of the Cling Division would not accept this project under the ROI approach since the division is already earning 25%.000 Operating income P100.600* 73.000 P460.000 .000 P112.000 ROI 25% 20% 24.000 P100. as shown below: Present New Project Overall Operating assets P400. the manager would accept this project since the new project provides a higher return than the minimum required rate of return (20 percent vs.000 9.000 Operating income P100.000 P12. on the other hand. The new project would increase the overall divisional residual income.000) 25% Minimum required income (16% x P400.000 P 2.400 * P60.000 Minimum required return at 16% 64.35% * P60.000 P60.000 Operating income P100. 16 percent).P64.000 P400.000 ROI (P100. Accepting this project would reduce the present divisional performance.

000 1......000 P12..000 Requirement 2 Division X would reject this investment opportunity since the addition would lower the present divisional ROI..... Comparisons of Two Divisions) Requirement 1 Net Operating income X Sales = ROI Sales Average Operating Assets P630.800 = 25% = 18% = 16% P40.. RI.. Comparison of Three Divisions) Requirement 1 Division X Division Y Division Z ROI: P10.000 P10.. P 630.000 P10.. Divisions Y and Z would accept it because they would look better in terms of their divisional ROI.000 14-4 .Chapter 14 Responsibility Accounting and Transfer Pricing Exercise 3 (ROI...000.000 Minimum required return on average operating assets ...000 P9.000.000 Net operating income......800..000 7% X 3 = 21% P1. P 150.000 P70..000 9% X 2 = 18% Requirement 2 Division A Division B Average operating assets (a) .000.000. 480.... P3.000 P180..000...16% x (a) ..........000 P20.000 P 200.000.600 P 28.000 P3.600......000.000 Division B : X = ROI P20..800.000..000 Division A : X = ROI P9.. Exercise 4 (ROI.....000 P 1...000 Residual income.

Department 10 (3) Costs allocated to Factory Department are: a. Supplies. in the case above. General office salaries 14-5 . As stated in the text. Sales salaries and commissions b. supervisor of Department 10 b. Supplies. not necessarily because of better management but because of the larger peso figures involved. Department 10 b. factory c. 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. Note from Part (2) that Division B has only an 18 percent ROI as compared to 21 percent for Division A. Department 10 c. Labor Cost. Division B does not appear to be as well managed as Division A. Salary of factory superintendent (4) Costs which do not pertain to factory operations are: a. Department 10 c. Larger divisions will almost always look better. Repairs and Maintenance. Factory insurance d. In fact. Department 10 d. Depreciation. Repairs and Maintenance. Salary. heat and light b. Factory. Exercise 5 (Evaluation of a Cost Center) (1) Controllable Costs by supervisor of Department 10 are as follows: a. Labor Cost. Department 10 (2) Direct Costs of Department 10 are a. residual income can’t be used to compare the performance of divisions of different sizes. Responsibility Accounting and Transfer Pricing Chapter 14 Requirement 3 No.

.......000............... 225.. it probably would .....Chapter 14 Responsibility Accounting and Transfer Pricing Exercise 6 (Evaluating New Investments Using Return on Investment (ROI) and Residual Income) Requirement 1 Computation of ROI Division A: P300.....000 P6......000 Required rate of return..000...............× 15% × 18% × 12% Required operating income.. and b.........000.......000...25% x 4 = 9% P8.000 P1......000...P1...........000 Division C: P180...000 Required operating income (above) ....Reject Reject Accept 14-6 ........... P 75.....000 P 240.......... 20% 18% 9% Therefore..........000.......000 P 900......000 P 180...000 Residual income ....000 P5..000 Requirement 2 Division A Division B Division C Average operating assets......500.....000...........000..................000 P8...000.000 240....000 P 900............000 ROI = x = 2........ if the division is presented with an investment opportunity yielding 17%.000.. P 300.....000 ROI = x = 9% x 2 = 18% P10....P 225......000 P10........500................000 P5................000 P2......000 ROI = x = 5% x 4 = 20% P6......000 Actual operating income...........000 P 0 P (60......... Division A Division B Division C Return on investment (ROI) .000) Requirement 3 a..000 900....000 Division B: P900.000 P2..

...... 2....... since the 17% return on the new investment is less than B’s 18% required rate of return......... P5. Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company) Requirement 1 Division A Division B Total Company Sales P3.. since its acceptance would increase the Division’s overall rate of return......... 15% 18% 12% Therefore......400. 2..200.......................... it probably would .000 Net operating income.000 3..400.000 3 Less expenses: Added by the division.......000. thus......... both Division A and Division B probably would reject the 17% investment opportunity.............800.............000 P1.. The 17% rate of return promised by the new investment is greater than their required rates of return of 15% and 12%...............600......000 in intracompany sales has been eliminated....... Responsibility Accounting and Transfer Pricing Chapter 14 Minimum required return for computing residual income.. respectively..600.......000 Total outside sales .. P2.... P 900.... the new investment would reduce the overall rate of return and place the divisional managers in a less favorable light.000 2 P5................. Division C probably would accept the 17% investment opportunity. and would therefore add to the total amount of their residual income....000 Transfer price paid....Accept Reject Accept If performance is being measured by ROI..000 1 P2...... — 700..000 units × P600 per unit = P2...000 Observe that the P700..... 2......000 P 500.000..200................800.....000 3.. both Division A and Division C probably would accept the 17% investment opportunity..........000 units × P600 per unit)..........900.....200.........400.....000 — Total expenses...........000 Division B outside sales (4. If performance is being measured by residual income... 14-7 ............ if the division is presented with an investment opportunity yielding 17%....000 1. 2 4........................800.......... 3 Division A outside sales (16............ The reason is that these companies are presently earning a return greater than 17%.000 1.......500.000 1 20..000 units × P175 per unit) .500.....400....................000 units × P175 per unit = P3.. Division B would reject the opportunity.........

Division Y. but it adds only P300 in cost. There is no idle capacity. so each of the 20. can purchase a similar unit from an outside supplier for P47.000 units transferred from Division X to Division Y reduces sales to outsiders by one unit. Transfer price  Cost of buying from outside supplier = P47 The requirements of the two divisions are incompatible and no transfer will take place.000 Transfer price = P28 + P20 = P48 The buying division. Thus. Therefore.Chapter 14 Responsibility Accounting and Transfer Pricing Requirement 2 Division A should transfer the 1.000 Transfer price  (P30 – P2) + 20. the company as a whole will be better off if Division A transfers the 1.000 additional units to Division B. P20 x 20. each tube transferred to Division B ultimately yields P125 more in contribution margin (P425 – P300 = P125) to the company than can be obtained from selling to outside customers. Exercise 8 (Transfer Pricing Situations) 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 . Note that Division B’s processing adds P425 to each unit’s selling price (B’s P600 selling price. Therefore. 14-8 .000 additional tubes to Division B. less A’s P175 selling price = P425 increase). The contribution margin per unit on outside sales is P20 (= P50 – P30). Division Y would be unwilling to pay more than P47 per unit.

000 x P150 = P1. Division Y.000 Less: Savings of Divisions B’s variable costs 10. Division X has enough idle capacity to satisfy Division Y’s demand.000. Therefore. can purchase a similar unit from an outside supplier for P34. Division B saves an additional P200. 14-9 . P0 Transfer price  P20 + 20. Requirement 2 As above.000 = P20 The buying division. Transfer price  Cost of buying from outside supplier = P34 In this case. Division A should buy inside from Division B for the benefit of the entire firm. if Division A buys outside.400. but in addition.000 x P140 = 1. there are no lost sales and the lowest acceptable price as far as the selling division is concerned is the variable cost of P20 per unit. Therefore. the requirements of the two divisions are compatible and a transfer will hopefully take place at a transfer price within the range: P20  Transfer price  P34 Exercise 9 (Transfer Pricing: Decision Making) Requirement 1 Division A’s purchase decision from the overall firm perspective: Purchase costs from outside 10.000 Net Cost (Benefit) for A to buy outside P 100.500. Division Y would be unwilling to pay more than P34 per unit. Responsibility Accounting and Transfer Pricing Chapter 14 Requirement 2 In this case.000 Assuming Division B has no outside sales.

000 x P140 = 1.000 Contribution to the recovery of non-controllable fixed expenses P1.000 Less: Variable Costs 3.000 x P140 = 1.000 P2.000 P 525.400.000 14-10 .269.000 Contribution Margin P1.000 Less: Savings of B material assignment 200. 2005 Total Product S Product T Sales P5.000 1.000 x P130 = P1.000 P 810.000 P 744.700.000 Less: Controllable fixed expenses 501.400.300.440.000 Net Cost (Benefit) for A to buy outside P (100.100.000 435.770.890.000 66.000 1.400.000 Net Cost (Benefit) for A to buy outside P (100. III.000 x P150 = P1.Chapter 14 Responsibility Accounting and Transfer Pricing Purchase costs from outside 10. Requirement 3 Assuming the outside price drops from P150 to P130: Purchase costs from outside 10. Problems Problem 1 (Evaluation of Profit Centers) Requirement (a) Jadlow Manufacturing Corporation Income Statement For the Year Ended December 31.000 Less: Savings in variable costs 10.000) Division A should buy outside.000) The additional savings in Division B means that now Division A should buy outside.000 P2.500.000 P 960.330.000 Less: Savings in variable costs 10.

made under the assumption that the preceding year’s figures (which are not given) were less favorable than the current year.000 Net income P29.000 P31.000 From Product C 21.000 Product B seems to offer the best profit potential.200 Budget 14-11 . contributes to the recovery of non-controllable fixed expenses. This observation is.400 Operating cost of the equipment 4.000 Actual Labor Hours 4.000 P117. Requirement 2 The sunk costs are: Depreciation of equipment P 6.000 15.000 P46.000 P 21. Problem 2 (Evaluation of Profit Centers) Requirement 1 Product A B C Incremental sales P71. 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. of course.600 Total P11.000 Less: Incremental costs 42.000 Total P50.000 Problem 3 (Evaluation of Performance) Ranjie Tool Company Performance Report For the Year 2005 Budgeted Labor Hours 4.000 Requirement 3 Opportunity cost of selling Product B is From Product A P29.000 96.

indicating possible inadequacies for next period’s production run.300 5.80 P16.80 7.200 - Depreciation 6.000 (F) Total P79.000 50.000 2.400 5.360 P240 Supplies 1.000 (F) Supplies 4.000 P1.000 (F) Maintenance 3. possibly due to the use of less-skilled workers.200 - Total P16.000 P80.200 1.200 Variance Formula Hours Hours U (F) Variable Overhead Costs: Utilities P0.000 P20.000 2.360 P340 Problem 4 (Evaluation of Performance) Requirement 1 Performance Report for the Production Manager Actual Flexible Variance Cost Budget Cost (U) or (F) Controllable costs: Direct material P24.560 (160) Indirect labor 1.000 4.000 P4. possibly because of (1) deficient machinery due to the cutback in maintenance expenditures and/or (2) to the lower labor cost.200 4.20 5. Supplies decreased.000 6. 14-12 .600 - Supplies 2.700 P32.200 2.000 (F) The cost of raw materials rose significantly.000 1.300 P15.80 per hour P 3.Chapter 14 Responsibility Accounting and Transfer Pricing Actual Based on Cost-Volume 4.400 - Total Factory Overhead Costs P32.400 P16.600 P 1.000 - Indirect labor 5.000 6.400 7.600 P 3.960 P340 Fixed Overhead Costs: Utilities P 1.040 260 Total P3.400 - Insurance 1.000 (U) Direct labor 48.

800 70.200 (F) The marketing division is behind its cost allotment.000 x P300 450.000 Target Operating Income = P160.000 1. Return on Investment) Requirement 1 Return on investment = Operating income / Investment 20% = X / P800.000 4. calculated as follows: Fixed overhead P200.000 Target revenues. The personnel division came in somewhat under its budgeted costs.000 Revenues P810.000 / 1.200 (F) Total P323.000 1. Perhaps there has been a cutback in hiring.000 P4.000 The selling price per units is P540 = P810.000 P2.000 Variable costs 1.000 80.000 (U) Production division 79.000 (F) Personnel division 72. Responsibility Accounting and Transfer Pricing Chapter 14 Requirement 2 Performance Report for the Vice President Actual Flexible Variance Cost Budget Cost (U) or (F) Controllable costs: Marketing division P104.500.500 14-13 . Problem 5 (Target Sales Price. indicating possible reduction in future production.000 Desired operating income 160.000 (F) Other costs 68.000 P102.000 76.800 P328.

This exercise provides an opportunity to review the relationship between volume and profit.000 units: (35% .25 x 33.25 % change in income = operating leverage x % change in revenues = 2. the larger the effect on income and ROI of a given percentage change in sales. Units 1. Thus.500 2. See the illustration below: Operating leverage = contribution margin / operating income = (P810 – P450) / P160 = 2. the greater the operating leverage ratio.000 units: (P160 – P40) / P160 = 75% % change in ROI If volume goes to 2. Operating leverage multiplied times the percentage change in sales gives the percentage change in income.000 Revenues P810 P1.080 P540 Variable costs 450 600 300 Fixed costs 200 200 200 Total costs 650 800 500 Operating income P160 P280 P 40 Return on investment 20% 35% 5% = P160 / P800 = P280 / P800 = P40 / P800 Note how the change in income follows the change in revenues.33% = 75% % change in income If volume goes to 2.Chapter 14 Responsibility Accounting and Transfer Pricing Requirement 2 Data are in thousands.20%) / 20% = 75% If volume goes to 1. as predicted by operating leverage.000 1.5%) / 20% = 75% 14-14 .000 units: (20% .000 units: (P280 – P160) / P160 = 75% If volume goes to 1.

.000 P 200.. in the case above...........000........000... Quezon does not appear to be as well managed as Pasig. P3.. not necessarily because of better management but because of the larger peso figures involved.000 P10..........000 x = 7% x 3 = 21% P9.....................000..........000.000 P20.600..000 Requirement 3 No... In fact......000........... Residual income can’t be used to compare the performance of divisions of different sizes........000 Residual income.000 Minimum required return on average operating assets—16% × (a) .... P 150......... 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. 14-15 .000..... Note from Part (1) that Quezon has only an 18% ROI as compared to 21% for Pasig.000 Net operating income .000 P 1........... Larger divisions will almost always look better.....000 P3..000.. 480.000 P9.....000 P 1..000 P10..... Responsibility Accounting and Transfer Pricing Chapter 14 Problem 6 (Contrasting Return on Investment (ROI) and Residual Income) Requirement 1 ROI computations: Net operating income Sales ROI = x Sales Average operating assets Pasig: P630......000 P1.800.........000.....000 Quezon: x = 9% x 2 = 18% P20....800........ P 630..000 Requirement 2 Pasig Quezon Average operating assets (a) ....

Thus. 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 (P30 – P16) x 10. 14-16 . the price it is currently paying an outside supplier for its valves. the Valve Division has an opportunity cost.000 = P16 The Pump Division would be unwilling to pay more than P29.000 Transfer price  P16 + 10. we get: Total contribution margin Variable on lost sales Transfer price  cost per unit + Number of units transferred P0 Transfer price  P16 + 10. it does not have to give up any outside sales to take on the Pump Division’s business. no transfers will be made between the two divisions.Chapter 14 Responsibility Accounting and Transfer Pricing Problem 7 (Transfer Pricing) Requirement 1 Since the Valve Division has idle capacity.000 = P16 + P14 = P30 Since the Pump Division can purchase valves from an outside supplier at only P29 per unit. it would have to give up some of these outside sales to take on the Pump Division’s business. the transfer price must fall within the range: P16  Transfer price  P29 Requirement 2 Since the Valve Division is selling all of the valves that it can produce on the outside market. Therefore. 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 (P30 – P16) x 30. the transfer price must fall within the range: P27  Transfer price  P29 Problem 8 (Transfer Pricing) To produce the 20.000 Transfer price  P20 + 20.000 regular valves to outside customers.000 = P20 + P21 = P41 14-17 .000 special valves.000 Transfer price  (P16 – P3) + 10. Applying the formula for the lowest acceptable price from the viewpoint of the selling division. the Valve Division will have to give up sales of 30.000 = P13 + P14 = P27 In this case. 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: Total contribution margin Variable on lost sales Transfer price  cost per unit + Number of units transferred (P30 – P16) x 10.

A 14. B 2. B 25. C 31. D 39. D 9. A 37. C 24. A 36. D 17. A 30. D 14-18 . D 4. A 16.Chapter 14 Responsibility Accounting and Transfer Pricing IV. D 22. C 23. D 34. A 33. B 32. D 3. A 28. B 10. B 27. B 38. C 6. E 21. A 13. B 29. A 18. A 40. Multiple Choice Questions 1. D 7. C 26. A 20. C 19. B 35. C 11. D 12. B 8. C 15. D 5.