Professional Documents
Culture Documents
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 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.
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
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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.
Requirement 1
ROI RI
Operating assets P400,000 P400,000
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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
Requirement 1
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Requirement 2
Division X would reject this investment opportunity since the addition would
lower the present divisional ROI. Divisions Y and Z would accept it because
they would look better in terms of their divisional ROI.
Requirement 1
Division A : P630,000
P9,000,000 X P9,000,000 = ROI
P3,000,000
7% X 3 = 21%
Division B : P20,000,000
P1,800,000 X P10,000,000 = ROI
P20,000,000
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
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 can’t 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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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
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Division C:
P180,000 P8,000,000
ROI = P8,000,000 x P2,000,000 = 2.25% x 4 = 9%
Requirement 2
Requirement 3
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rates of return of 15% and 12%, respectively, and would therefore add to the
total amount of their residual income. Division B would reject the
opportunity, since the 17% return on the new investment is less than B’s 18%
required rate of return.
Requirement 1
Division A Division B Total Company
1 2 3
Sales P3,500,000 P2,400,000 P5,200,000
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
Division A should transfer the 1,000 additional units to Division B. Note that
Division B’s processing adds P425 to each unit’s selling price (B’s P600
selling price, less A’s P175 selling price = P425 increase), but it adds only
P300 in cost. Therefore, 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. Thus, the company as a
whole will be better off if Division A transfers the 1,000 additional tubes to
Division B.
Requirement 1
The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable cost on lost sales
Transfer price per unit + Number of units transferred
.
There is no idle capacity, so each of the 20,000 units transferred from Division
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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.
Requirement 2
In this case, Division X has enough idle capacity to satisfy Division Y’s
demand. Therefore, 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.
P0
Transfer price P20 + 20,000 = P20
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
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Assuming Division B has no outside sales, Division A should buy inside from
Division B for the benefit of the entire firm.
Requirement 2
The additional savings in Division B means that now Division A should buy
outside.
Requirement 3
Requirement (1)
Net operating income
Margin = Sales
P5,400,000
= P18,000,000 = 30%
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Requirement (2)
Sales
Turnover = Average operating assets
P18,000,000
= P36,000,000 = 0.5
Requirement (3)
III. Problems
Requirement (a)
Requirement (b)
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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 year’s 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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Budget
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 period’s production run.
Requirement 2
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Requirement 1
Requirement 2
Note how the change in income follows the change in revenues, as predicted
by operating leverage. Operating leverage multiplied times the percentage
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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%
Requirement 1
ROI computations:
Net operating income Sales
ROI = x
Sales Average operating assets
Requirement 2
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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 assets—16% × (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 can’t 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.
Requirement 1
Since the Valve Division has idle capacity, it does not have to give up any
outside sales to take on the Pump Division’s business. Applying the formula
for the lowest acceptable transfer price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable cost on lost sales
Transfer price 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
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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 Division’s business. Thus, the Valve Division has an opportunity
cost, which is the total contribution margin on lost sales:
Total contribution margin
Variable cost on lost sales
Transfer price per unit + Number of units transferred
Requirement 3
Applying the formula for the lowest acceptable price from the viewpoint of the
selling division, we get:
Total contribution margin
Variable cost on lost sales
Transfer price per unit + Number of units transferred
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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 cost on lost sales
Transfer price per unit + Number of units transferred
P800,000
= P8,000,000 = 10%
2. Sales
Turnover = Average operating assets
P8,000,000
= P3,200,000 = 2.5
3.
ROI = Margin x Turnover
= 10% x 2.5 = 25%
Requirement (1)
a. The lowest acceptable transfer price from the perspective of the selling
division, the Electrical Division, is given by the following formula:
Because there is enough idle capacity to fill the entire order from the
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Motor Division, there are no lost outside sales. And because the variable
cost per unit is P21, the lowest acceptable transfer price as far as the
selling division is concerned is also P21.
c. Combining the requirements of both the selling division and the buying
division, the acceptable range of transfer prices in this situation is:
P21 : Transfer price : P38
Assuming that the managers understand their own businesses and that they
are cooperative, they should be able to agree on a transfer price within this
range and the transfer should take place.
d. From the standpoint of the entire company, the transfer should take place.
The cost of the transformers transferred is only P21 and the company
saves the P38 cost of the transformers purchased from the outside
supplier.
Requirement (2)
a. Each of the 10,000 units transferred to the Motor Division must displace a
sale to an outsider at a price of P40. Therefore, the selling division would
demand a transfer price of at least P40. This can also be computed using
the formula for the lowest acceptable transfer price as follows:
Transfer price = P21 + (P40 – P21) x 10,000
10,000
c. The requirements of the selling and buying divisions in this instance are
incompatible. The selling division must have a price of at least P40
whereas the buying division will not pay more than P38. An agreement to
transfer the transformers is extremely unlikely.
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d. From the standpoint of the entire company, the transfer should not take
place. By transferring a transformer internally, the company gives up
revenue of P40 and saves P38, for a loss of P2.
Requirement (1)
The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable cost + on lost sales
Transfer price =
per unit Number of units transferred
The Tuner Division has no idle capacity, so transfers from the Tuner Division
to the Assembly Division would cut directly into normal sales of tuners to
outsiders. The costs are the same whether a tuner is transferred internally or
sold to outsiders, so the only relevant cost is the lost revenue of P200 per tuner
that could be sold to outsiders. This is confirmed below:
The Assembly Division can buy tuners from an outside supplier for P200, less
a 10% quantity discount of P20, or P180 per tuner. Therefore, the Division
would be unwilling to pay more than P180 per tuner.
Requirement (2)
The price being paid to the outside supplier, net of the quantity discount, is
only P180. If the Tuner Division meets this price, then profits in the Tuner
Division and in the company as a whole will drop by P600,000 per year:
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Requirement (3)
The Tuner Division has idle capacity, so transfers from the Tuner Division to
the Assembly Division do not cut into normal sales of tuners to outsiders. In
this case, the minimum price as far as the Assembly Division is concerned is
the variable cost per tuner of P11. This is confirmed in the following
calculation:
Transfer price = P110 + P0 = P110
30,000
The Assembly Division can buy tuners from an outside supplier for P180 each
and would be unwilling to pay more than that in an internal transfer. If the
managers understand their own businesses and are cooperative, they should
agree to a transfer and should settle on a transfer price within the range:
Requirement (4)
Yes, P160 is a bona fide outside price. Even though P160 is less than the
Tuner Division’s P170 “full cost” per unit, it is within the range given in Part
3 and therefore will provide some contribution to the Tuner Division.
If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in
potential profits:
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This P1,500,000 in potential profits applies to the Tuner Division and to the
company as a whole.
Requirement (5)
No, the Assembly Division should probably be free to go outside and get the
best price it can. Even though this would result in lower profits for the
company as a whole, the buying division should probably not be forced to
purchase inside if better prices are available outside.
Requirement (6)
So long as the selling division has idle capacity and the transfer price is
greater than the selling division’s variable costs, profits in the company as a
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whole will increase if internal transfers are made. However, there is a question
of fairness as to how these profits should be split between the selling and
buying divisions. The inflexibility of management in this situation damages the
profits of the Assembly Division and greatly enhances the profits of the Tuner
Division.
Requirement (1)
Requirement (2)
The key is to realize that the P100 in fixed overhead and administrative costs
contained in the Clock Division’s P697.50 cost per timing device is not
relevant. There is no indication that winning this contract would actually affect
any of the fixed costs. If these costs would be incurred regardless of whether
or not the Clock Division gets the oven timing device contract, they should be
ignored when determining the effects of the contract on the company’s profits.
Another key is that the variable cost of the Electronics Division is not relevant
either. Whether the circuit boards are used in the timing devices or sold to
outsiders, the production costs of the circuit boards would be the same. The
only difference between the two alternatives is the revenue on outside sales
that is given up when the circuit boards are transferred within the company.
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Therefore, the company as a whole would be better off by P67.50 for each
timing device that is sold to the oven manufacturer.
Requirement (3)
As shown in part (1) above, the Electronics Division would insist on a transfer
price of at least P125.00 for the circuit board. Would the Clock Division make
any money at this price? Again, the fixed costs are not relevant in this decision
since they would not be affected. Once this is realized, it is evident that the
Clock Division would be ahead by P67.50 per timing device if it accepts the
P125.00 transfer price.
Selling price of the timing devices................................................................P700.00
Less:
Purchased parts (from outside vendors)....................................................
P300.00
Circuit board KK8 (assumed transfer price).............................................
125.00
Other variable costs.................................................................................
207.50 632.50
Clock Division contribution margin.............................................................. P 67.50
In fact, since the contribution margin is P62.50, any transfer price within the
range of P125.00 to P192.50 (= P125.00 + P67.50) will improve the profits of
both divisions. So yes, the managers should be able to agree on a transfer
price.
Requirement (4)
It is in the best interests of the company and of the divisions to come to an
agreement concerning the transfer price. As demonstrated in part (3) above,
any transfer price within the range P125.00 to P192.50 would improve the
profits of both divisions. What happens if the two managers do not come to an
agreement?
In this case, top management knows that there should be a transfer and could
step in and force a transfer at some price within the acceptable range.
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Our advice to top management would be to ask the two managers to meet to
discuss the transfer pricing decision. Top management should not dictate a
course of action or what is to happen in the meeting, but should carefully
observe what happens in the meeting. If there is no agreement, it is important
to know why. There are at least three possible reasons. First, the managers
may have better information than the top managers and refuse to transfer for
very good reasons. Second, the managers may be uncooperative and unwilling
to deal with each other even if it results in lower profits for the company and
for themselves. Third, the managers may not be able to correctly analyze the
situation and may not understand what is actually in their own best interests.
For example, the manager of the Clock Division may believe that the fixed
overhead and administrative cost of P100 per timing device really does have to
be covered in order to avoid a loss.
If the refusal to come to an agreement is the result of uncooperative attitudes
or an inability to correctly analyze the situation, top management can take
some positive steps that are completely consistent with decentralization. If the
problem is uncooperative attitudes, there are many training companies that
would be happy to put on a short course in team building for the company. If
the problem is that the managers are unable to correctly analyze the
alternatives, they can be sent to executive training courses that emphasize
economics and managerial accounting.
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