Results Accountability - PPT Notes

• TOPIC 2
• RESULTS
ACCOUNTABILITY
Chapter 22 Management Control Systems

Decentralization
Chapter 7 Financial responsibility Center
Chapter 22 Management Control Systems
Transfer Pricing and Multinational Considerations
Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
Decentralization
Decentralization
• Decentralization is an organizational structure that
gives managers at lower levels the freedom to
make decisions.
• Autonomy is the degree of freedom to make
decisions. The greater the freedom, the greater
the autonomy.
• Subunit refers to any part of an organization. It
may be a large division or a small group.
Benefits of Decentralization
• Creates greater responsiveness to the needs of a
subunit’s customers, suppliers, and employees.
• Leads to gains from faster decision making by
subunit managers.
• Assists management development and learning.
• Sharpens the focus of subunit managers and
broadens the reach of top management.
Costs of Decentralization
• Leads to suboptimal decision making, which
arises when a decision’s benefit to one subunit is
more than offset by the costs or loss of benefits to
the organization as a whole.
– Also called incongruent decision making or
dysfunctional decision making
• Leads to unhealthy competition
• Results in duplication of output
• Results in duplication of activities
Comparing Benefits and Costs
• Top managers must compare the benefits and costs of
decentralization, often on a function-by-function basis,
when choosing an organizational structure.
• Companies report that the decisions made most
frequently at the decentralized level are related to
product mix and advertising.
• Decisions related to the type and source of long-term
financing are made least frequently at the
decentralized level.
• Centralizing its income tax strategies allows an
organization to optimize across subunits by offsetting
the income in one subunit with losses in others.
Decentralization in Multinational
Companies
• Multinational firms, companies that operate in multiple
countries, are often decentralized because centralizing the
control of their subunits around the world can be physically
and practically impossible.
• Decentralization enables managers in different countries to
make decisions that exploit their knowledge of local
business and political conditions and enables them to deal
with uncertainties in their individual environments.
• Biggest drawback to international decentralization: loss or
lack of control and the resulting risks.
• Multinational corporations that implement decentralized
decision making usually design their management control
systems to measure and monitor the performance of
divisions.
Financial Responsibility
Centers
Financial results controls
• Three core elements
– Financial responsibility centers

 The apportioning of accountability for financial
results within the organization
– Formal management processes (planning and
budgeting)
 To define performance expectations and
standards for evaluating performance
– Motivational contracts
 To define the links between results and various
organizational incentives
Responsibility centers
• Responsibility center
 An organization unit (entity) headed
by a manager with responsibility for
a particular set of inputs and/or
outputs
• Financial responsibility center
 A responsibility center in which the
manager’s responsibilities are
defined primarily in financial terms
Choices about Responsibility Centers
• To measure the performance of subunits in
centralized or decentralized companies, the
management control system uses one or a mix of
the four types of responsibility centers:
Revenue centers
Cost (Expense) centers
Profit centers
Investment centers
Revenue centers (RCs)
 Managers of revenue centers are held accountable for generating
revenues (a financial measure of outputs)
» For example, sales departments in commercial organizations
» For example, fundraising managers in not-for-profit organizations
 No formal attempt is made to relate inputs (measured as expenses)
to outputs
» However, most revenue center managers are also held
accountable for some expenses (e.g., salespeople’s salaries and
commissions)
» But, still they are not profit centers because:
 Such costs are only a small fraction of the revenues
generated
 Revenue centers are not charged for the costs of the goods
they sell
 If sales are not “equally endowed”, then revenue responsibility
will not necessarily lead to the most profitable sales
Cost (Expense) centers (ECs)
 Managers of expense (cost) centers are held accountable
for expenses (a financial measure of the inputs consumed
by the responsibility center)
» “Standard” or “engineered” expense centers (EEC)
 Inputs and outputs can be measured in monetary terms
 There is a ‘causal’ relationship between inputs and
outputs
– For example, manufacturing departments
» “Managed” or “discretionary” expense centers(DEC)
 Outputs produced are difficult to measure
 Relationship between inputs and outputs is hard to
establish
– For example, R&D, human resources departments
Control in Cost (expense) centers
 Engineered expense centers
» Standard cost vs. actual cost
 Analysis of the cost of inputs that should have been
consumed in producing the output vs. the cost that was
actually incurred
» Additional controls
 Volume produced, quality, etc.
 Discretionary expense centers

» Ensuring that managers adhere to the budgeted expenses
while successfully accomplishing the tasks of their center
» Subjective, non-financial controls
 For example, quality of service provided
» Personnel controls
Profit centers (PCs)
 Managers of profit centers are held accountable for
generating profits (a financial measure of the difference
between revenues and costs)
 As a measure of performance, profit is ...
» Comprehensive
 That is, it incorporates many aspects of performance
» Unobtrusive
 That is, the profit center manager makes the revenue/cost
tradeoffs
 Has the manager significant influence over both revenues and
costs?
» Charge standard cost of goods sold to sales-focused entities
» Assign revenues to cost-focused entities
» Pseudo profit centers
Measuring “profit” in profit centers
Gross Incomplete Before-tax Complete

Margin Profit Profit Profit
Center Center Center Center
Revenue    
Cost of goods sold    
Gross margin    
Advertising + promotion   
Research + development
 
Profit before tax
 
Income tax

Profit after tax

Note:  signifies that the responsibility center manager is held accountable for that financial statement line item.
Source: K. A. Merchant, Modern Management Control Systems: Text and Cases (Upper Saddle River, NJ: Prentice Hall, 1998), p. 306
Investment centers (ICs)
 Managers of investment centers are held accountable for
the accounting returns (profits) on the investment made
to generate those returns
» Objective = return on capital
» Absolute differences in profits are not meaningful if the
various organizational entities use different amounts of
resources
 In fact, managers have two performance objectives

» Generate maximum profits from the resources at their
disposal
» Invest in additional resources only when such an
investment will produce an adequate return
Organization structure
President
(IC)
Administrative
and Financial
Vice Presidents
Group Group (DEC)
Vice President Vice President
(IC) (IC)
SBU Manager SBU Manager SBU Manager SBU Manager

(PC) (PC) (PC) (PC)
... ... Divisional Staff Functions (DEC)
... ... ... ...
Procurement Manufacturing Sales
(EEC) (EEC) (RC)
Transfer pricing
Definition
• The price at which products or services are transferred
between profit centers within the same firm
– It affects the revenues of the producing profit center (PC),
the costs of the buying PC, and, hence, the profits of both
entities
• Purposes
– Provide proper economic signals so that PC managers
make good economic decisions from a corporate
standpoint
– Provide information for evaluating PC performance
– Purposely move profits between company
entities/locations
 For example, for tax purposes, or in joint-ventures
Transfer Pricing
Transfer price—the price one subunit (department or
division) charges for a product or service supplied to
another subunit of the same organization.
In a decentralized organization, much of the decision-
making power resides in its individual subunits.
Those subunits often supply goods or services to one
another.
• In that case, top management uses transfer prices
to coordinate the actions of the subunits and to
evaluate the performance of their managers.
Transfer Pricing
• The transfer price creates revenues for the selling
subunit and purchase costs for the buying subunit
affecting each subunit’s operating income.
• The operating incomes can be used to evaluate the
subunits’ performances and to motivate their
managers.
• Intermediate product—the product or service
transferred between subunits of an organization.
• In a well-designed transfer-pricing system, managers
focus on maximizing the performance of their subunits
and in doing so optimize the performance of the
company as a whole.
Criteria for Evaluating Transfer Prices
To help a company achieve its goals, transfer prices should
meet four key criteria:
1. Promote goal congruence so that division managers
acting in their own interest will take actions that are
aligned with the objectives of top management.
2. Induce managers to exert a high level of effort.
3. Help top managers evaluate the performance of
individual subunits.
4. Preserve autonomy of subunits if top managers favor a
high degree of decentralization.
Calculating Transfer Prices
There are three broad categories of methods top
managers can use to determine transfer prices.
They are as follows:
1. Market-based transfer prices.
2. Cost-based transfer prices.
3. Hybrid transfer prices.
Under what circumstances should each of these
options be used? Let’s look in more detail at each
category.
1. Market-Based Transfer Prices
• Transferring products or services at market
prices generally leads to optimal decisions when
three conditions are satisfied:
1. The market for the intermediate product is
perfectly competitive.
2. The interdependencies of subunits are
minimal.
3. There are no additional costs or benefits to
the company as a whole from buying or
selling in the external market instead of
transacting internally.
1. Market-Based Transfer Prices
Imperfect Competition
• If markets are not perfectly competitive, selling
prices affect the quantity of product sold.
• When the market for the intermediate good is
imperfectly competitive, the transfer price must
generally be set below the external market price
(but above the selling division’s variable cost) in
order to induce efficient transfers.
2. Cost-Based Transfer Prices
Useful when market prices are unavailable, inappropriate, or
too costly to obtain, such as when markets are not perfectly
competitive, when the product is specialized or when the
internal product is different from the products available
externally in terms of its quality and the customer service
provided for it.
• Top managers choose a transfer price based on the
costs of producing the intermediate product.
Examples include:
Full-cost bases
Variable-cost bases
- Full cost transfer prices
• Popular in practice
• Relatively easy to implement
 Firms have cost systems in place to calculate
the full cost of production
 But, full costs rarely reflect actual, current costs
of producing the products because of financial
accounting conventions (e.g., depreciation)
and arbitrary overhead cost allocations
• There is no incentive for the selling PC to transfer
internally since there is no profit margin
• The profit of the selling PC is understated
- Full cost + markup
• It allows the selling PC to earn a profit on
internally transferred products/services
• Crude approximation of the market price in

cases where no competitive external market
price exists
– Such transfer prices, however, are not
(quite) responsive to market conditions
• Despite its limitations, managers generally
prefer to use full-cost-based transfer prices
because:
• They represent relevant costs for long-
run decisions.
• They facilitate external pricing based on
variable and fixed costs.
• They are the least costly to administer.
• Full-cost transfer pricing also raises many
issues:
1. How are the subunit’s indirect costs
allocated to products?
2. Have the correct activities, cost pools,
and cost-allocation bases been
identified?
3. Should the chosen fixed-cost rates be
actual or budgeted?
3. Hybrid Transfer Prices
• Takes into account both cost and market information.
• Top management may set the prices by specifying a
transfer price that is an average of the cost of producing
and transporting the product internally (the minimum
price) and the market price for comparable products (the
maximum price).
• Types of hybrid transfer prices:
 Prorating the difference between maximum and
minimum transfer prices.
 Negotiated pricing (most common hybrid type).
 Dual pricing.
- Negotiated Transfer Prices
• Occasionally, subunits of a firm are free to
negotiate the transfer price between themselves
and then to decide whether to buy and sell
internally or deal with external parties.
• May or may not bear any resemblance to cost or
market data.
• Often used when market prices are volatile.
• Represent the outcome of a bargaining process
between the selling and buying subunits.
- Negotiated Transfer Prices
• Transfer prices are negotiated between the selling and
buying PC managers themselves
 Both PC managers should have some
bargaining power
(i.e., some possibilities to sell or source outside)
 The outcome is often not economically optimal,
but rather depends on the negotiating skills of
the managers involved
• It is costly (management time), accentuates conflicts

between PC managers, and often requires corporate
management intervention
- Dual-rate transfer prices
• Prorating the difference between the
maximum and minimum cost-based
transfer prices.
• Dual-pricing—using two separate transfer-
pricing methods to price each transfer from
one subunit to another. Example: selling
division receives full cost pricing, and the
buying division pays market pricing.
• Method
 The selling PC is credited with the outside
sales price
 The buying PC is charged the (marginal)
cost of production only
 The difference is charged to a corporate
account and eliminated
at the time of financial statement
consolidation
• )
• Advantages
 It provides proper economic signals for decision-
making
 It maintains proper information for evaluation
purposes
 It ensures that internal transactions will take place
• Disadvantages
 It destroys incentives to negotiate favorable outside
prices for supplies (buying PC now only pays the
marginal cost)
 It destroys incentives to improve productivity
(selling PC finds “easy” sales inside)
Comparison of Transfer-pricing Methods
Exhibit 22.3 Comparison of Different Transfer-Pricing Methods
General Guideline for Transfer-pricing
Situations
Accountants indicate that the full-cost-based transfer price is
generally the most frequently used method around the world,
followed by market-based transfer price and negotiated
transfer prices.
The transfer price a company will eventually choose
depends on the economic circumstances and the decision
being made.
Minimum Transfer Price
The minimum transfer price in many situations should be:
Incremental cost per unit

Minimum incurred up to the point of Opportunity Cost per unit
Transfer Price = transfer + to the selling subunit
Incremental cost is the additional cost of producing and

transferring the product or service.
Opportunity cost is the maximum contribution margin
forgone by the selling subunit if the product or service is
transferred internally.
How Multinationals Use Transfer
Pricing to Minimize their Taxes
• Transfer pricing is an important accounting
priority for managers around the world.
• The reason is that parent companies can
save large sums of money in taxes
depending on the transfer pricing methods
they use.
How Multinationals Use Transfer
Pricing to Minimize Their Taxes
• Transfer prices affect not just income taxes,
but also payroll taxes, customs duties,
tariffs, sales taxes, value-added taxes,
environment-related taxes, and other
government levies.
• Tax factors, particularly income taxes, are
an important consideration for managers
when determining transfer prices.
EXAMPLES
• EXAMPLE 1 (22-19) Transfer-pricing methods, goal
congruence.
• Calgary Lumber has a raw lumber division

and a finished lumber division. The variable
costs are as follows:
• ■ Raw lumber division: $125 per 100
board-feet of raw lumber
• ■ Finished lumber division: $145 per 100
board-feet of finished lumber
• Assume that there is no board-feet loss in
processing raw lumber into finished lumber. Raw
lumber can be sold at $175 per 100 board-feet.
Finished lumber can be sold at $345 per 100
board-feet. Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
• EXAMPLE 1 (22-19) Transfer-pricing methods, goal
congruence.
• REQUIREMENTS
• 1. Should Calgary Lumber process raw lumber into its

finished form? Show your calculations.
• 2. Assume that internal transfers are made at 130% of
variable cost. Will each division maximize its division
operating-income contribution by adopting the action that
is in the best interest of Calgary Lumber as a whole?
Explain.
• 3. Assume that internal transfers are made at market
prices. Will each division maximize its division operating-
income contribution by adopting the action that is in the
best interest of Calgary Lumber as a whole? Explain.
• 1. Alternative 1: Sell as raw lumber for $175 per 100 board
feet:
• Revenue $175
• Variable costs 125
• Contribution margin $ 50 per 100 board feet
• Alternative 2: Sell as finished lumber for $345 per 100
board feet:
• Revenue $345
• Variable costs:
• Raw lumber $ 125
• Finished lumber145 270
• Contribution margin $ 75 per 100 board feet
• Calgary Lumber will maximize its total contribution margin by
processing raw lumber into finished lumber.
• An alternative approach (Incremental approach) is to
examine the incremental revenues and incremental costs
in the Finished Lumber Division:
•
• Incremental revenues, $345 – $175 $170
• Incremental costs 145
• Incremental gain $ 25 per 100 b.f.
• Calgary Lumber will maximize its total contribution margin

by processing raw lumber into finished lumber.
2. Assume that internal transfers are made at 130% of variable cost. Will
each division maximize its division operating-income contribution by
adopting the action that is in the best interest of Calgary Lumber as a
whole? Explain.
Transfer price at 130% of variable costs:=$125+($1250.30)=$162.50per100bf
Sell as Sell as
Raw Lumber Finished Lumber
Raw Lumber Division
Division revenues $175 $162.50
Division variable costs 125 125.00
Division operating income $ 50 $ 37.50

Finished Lumber Division
Division revenues $ 0 $345.00
Transferred-in costs — 162.50
Division variable costs 145.00
Division operating income $ 0 $ 37.50
2. Assume that internal transfers are made at 130% of variable cost. Will
each division maximize its division operating-income contribution by
adopting the action that is in the best interest of Calgary Lumber as a
whole? Explain.
Transfer price at 130% of variable costs:=$125+($1250.30)=$162.50per100bf
The Raw Lumber Division will maximize reported

division operating income by selling raw lumber, which is
not the action preferred by the company as a whole. The
Finished Lumber Division will maximize division
operating income by processing raw lumber further,
which coincides with the action preferred by the company
as a whole.
3. Transfer price at market price = $175 per 100 board
feet.
Sell as Sell as
Raw Lumber Finished Lumber
Raw Lumber Division

Division revenues $175 $175
Division variable costs 125 125
Division operating income $ 50 $ 50

Finished Lumber Division
Division revenues $ 0 $345
Transferred-in costs — 175
Division variable costs — 145
Division operating income $ 0 $ 25
3. Transfer price at market price = $175 per 100 board
feet.
Since the Raw Lumber Division will be indifferent
between selling the lumber in raw or finished form,
it would be willing have the raw lumber processed
further, which is the action preferred by the
company as a whole. The Finished Lumber
Division will maximize division operating income by
processing raw lumber further and this is preferred
by the company as a whole.
Thus, transfer at market price will result in division
actions that are also in the best interest of the
entire organization.
• EXAMPLE 2 (22-20)Multinational transfer pricing,
effect of alternative transfer-pricing methods, global
income tax minimization.
• Tech Friendly Computer, Inc., with headquarters in
San Francisco, manufactures and sells a desktop
computer. Tech Friendly has three divisions, each of
which is located in a different country:
• a. China division—manufactures memory devices
and keyboards
• b. South Korea division—assembles desktop
computers using locally manufactured parts, along
with memory devices and keyboards from the China
division
• c. U.S. division—packages and distributes desktop
computers
• EXAMPLE 2 (22-20)Multinational transfer pricing
• Each division is run as a profit center. The costs for the work
done in each division for a single desktop computer are as
follows:
• China division: Variable cost = 900 yuan Fixed cost = 1,980 yuan
• South Korea division: Variable cost = 350,000 won Fixed cost = 470,000 won
• U.S. division: Variable cost = $125 Fixed cost = $325
• ■Chinese income tax rate on the China division’s operating income:

40%
• ■South Korean income tax rate on the South Korea division’s
operating income: 20%
• ■U.S. income tax rate on the U.S. division’s operating income: 30%
• Each desktop computer is sold to retail outlets in the United

States for $3,800. Assume that the current foreign exchange
rates are as follows:
• 9 yuan = $1 U.S. 1,000 won = $1 U.S.
• EXAMPLE 2 (22-20)Multinational transfer pricing
• Required:
• Both the China and the South Korea divisions sell part of their production
under a private label. The China division sells the comparable
memory/keyboard package used in each Tech Friendly desktop computer
to a Chinese manufacturer for 4,500 yuan. The South Korea division sells
the comparable desktop computer to a South Korean distributor for
1,340,000 won.
• 1. Calculate the after-tax operating income per unit earned by each
division under the following transfer-pricing methods:
• (a) market price,
• (b) 200% of full cost, and
• (c) 350% of variable cost.
• (Income taxes are not included in the computation of the cost-based
transfer prices.)
• 2. Which transfer-pricing method(s) will maximize the after-tax
operating income per unit of Tech Friendly Computer?
• 1. This is a three-country, three-division transfer-pricing problem with
three alternative transfer-pricing methods. Summary data in U.S.
dollars are:
• China Plant
• Variable costs: 900 Yuan ÷ 9 Yuan per $ = $100 per subunit
• Fixed costs: 1,980 Yuan ÷ 9 Yuan per $ = $220 per subunit
• South Korea Plant
• Variable costs: 350,000 Won ÷ 1,000 Won per $ = $350 per unit
• Fixed costs: 470,000 Won ÷ 1,000 Won per $ = $470 per unit
• U.S. Plant
• Variable costs: = $125 per unit
• Fixed costs:= $325 per unit
•
• Market prices for private-label sale alternatives:
• China Plant:4,500 Yuan ÷ 9 Yuan per $ = $500 per subunit
• South Korea Plant: 1,340,000 Won ÷ 1,000 Won per $ = $1,340 per unit
•
• The transfer prices under each method are:
• a. Market price
•China to South Korea = $500 per subunit
• •South Korea to U.S. Plant = $1,340 per unit
• b. 200% of full costs
•China to South Korea
2.0  ($100 + $220) = $640 per subunit
•South Korea to U.S. Plant
2.0  ($640 + $350 + $470) = $2,920 per unit
c. 350% of variable costs
• •China to South Korea
• 3.5  $100 = $350 per subunit
• •South Korea to U.S. Plant
• 3.5  ($350 + $350) = $2,450 per unit
• Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
Method A Method B Method C
Internal Internal Internal
Transfers Transfers Transfers
at Market at 200% of at 350% of
Price Full Costs Variable Costs
1. China Division
Division revenue per unit $ 500 $ 640 $ 350
Cost per unit:
Division variable cost per unit 100 100 100
Division fixed cost per unit 220 220 220
Total division cost per unit 320 320 320
Division operating income per unit 180 320 30
Income tax at 40% 72 128 12
Division net income per unit $ 108 $ 192 $ 18
2. South Korea Division

Division revenue per unit $1,340 $2,920 $2,450
Cost per unit:
Transferred-in cost per unit 500 640 350
Total division cost per unit 1,320 1,460 1,170
Division operating income per unit 20 1,460 1,280
Income tax at 20% 4 292 256
Division net income per unit $ 16 $1,168 $1,024
3. United States Division

Division revenue per unit $3,800 $3,800 $3,800
Cost per unit:
Transferred-in cost per unit 1,340 2,920 2,450
Total division cost per unit 1,790 3,370 2,900
Division operating income per unit 2,010 430 900
Income tax at 30% 603 129 270
Division net income per unit $1,407 $ 301 $ 630
2.Which transfer-pricing method(s) will maximize the after-tax operating
income per unit of Tech Friendly Computer?
Market 200% of 350% of

Price Full Costs Variable Costs
China Division $ 108 $ 192 $ 18

South Korea Division 16 1,168 1,024
U.S. Division 1,407 301 630
Tech Friendly Computer, Inc. $1,531 $1,661 $1,672
Tech Friendly will maximize its net income by using the third method, 350% of variable costs, as
the transfer price. This is because this method sources relatively little income in China, the country
with the highest income tax rate.
• EXAMPLE 3 (22-28)Effect of alternative transfer-pricing
methods on division operating income.
• Cran Health Products is a cranberry cooperative that operates
two divisions, a harvesting division and a processing division.
Currently, all of harvesting’s output is converted into cranberry
juice by the processing division, and the juice is sold to large
beverage companies that produce cranberry juice blends. The
processing division has a yield of 500 gallons of juice per 1,000
pounds of cranberries. Cost and market price data for the two
divisions are as follows:
• EXAMPLE 3 (22-28)Effect of alternative transfer-pricing methods
on division operating income.
• Required:
• 1. Compute Cran Health’s operating income from harvesting 480,000
pounds of cranberries during June 2017 and processing them into
juice.
• 2. Cran Health rewards its division managers with a bonus equal to
6% of operating income. Compute the bonus earned by each division
manager in June 2017 for each of the following transfer-pricing
methods:
• a. 225% of full cost
• b. Market price
• 3. Which transfer-pricing method will each division manager prefer?
How might Cran Health resolve any conflicts that may arise on the
issue of transfer pricing?
1. Compute Cran Health’s operating income from harvesting
480,000 pounds of cranberries during June 2017 and processing
them into juice.
1.
Pounds of cranberries harvested 480,000
Gallons of juice processed (500 gals per 1,000 lbs.) 240,000
Revenues (240,000 gals.  $2.45 per gal.) $588,000

Costs:
Harvesting Division:
Variable costs (480,000 lbs.  $0.10 per lb.) $ 48,000
Fixed costs (480,000 lbs.  $0.30 per lb.) 144,000
Total Harvesting Division costs 192,000
Processing Division:
Variable costs (240,000 gals.  $0.18 per gal.) $ 43,200
Fixed costs (240,000 gals.  $0.35 per gal.) 84,000
Total Processing Division costs 127,200
Total costs 319,200
Operating income $268,800
2.Cran Health rewards its division managers with a bonus equal to 6% of
operating income. Compute the bonus earned by each division manager in
June 2017 for each of the following transfer-pricing methods:
2.a.225% of full cost b.Market price
225% of Market
Full Costs Price
Transfer price per pound (($0.10 + $0.30)  2.25; $0.68) $0.90 $0.68
1. Harvesting Division
Revenues (480,000 lbs.  $0.90; $0.68) $432,000 $326,400
Costs
Division variable costs (480,000 lbs.  $0.10 per lb.) 48,000 48,000
Division fixed costs (480,000 lbs.  $0.30 per lb.) 144,000 144,000
Total division costs 192,000 192,000
Division operating income $240,000 $134,400
Harvesting Division manager's bonus (6% of operating income) $ 14,400 $8,064
2. Processing Division
Revenues (240,000 gals.  $2.45 per gal.) $588,000 $588,000
Costs:
Transferred-in costs 432,000 326,400
Division variable costs (240,000 gals.  $0.18 per gal.) 43,200 43,200
Division fixed costs (240,000 gals.  $0.35 per gal.) 84,000 84,000
Total division costs 559,200 453,600
Division operating income $ 28,800 $134,400
Processing Division manager’s bonus (6% of operating income) $1,728 $8,064
3. Which transfer-pricing method will each division manager prefer?
How might Cran Health resolve any conflicts that may arise on the
issue of transfer pricing?
• 3. Bonus paid to division managers at 6% of division

operating income is computed above and summarized
below:
• Internal Transfers Internal Transfers
at 225% of Full Costs at Market Prices
Harvesting Division manager’s bonus
(6% × $240,000; 6% × $134,400) $14,400 $8,064
Processing Division manager’s bonus

(6% × $28,800; 6% × $134,400) $1,728 $8,064
• 3. Which transfer-pricing method will each division manager prefer? How
might Cran Health resolve any conflicts that may arise on the issue of
transfer pricing?
• The Harvesting Division manager will prefer to transfer at 225% of full costs
because this method gives a higher bonus. The Processing Division
manager will prefer transfer at market price for its higher resulting bonus.
• Cran Health may resolve or reduce transfer pricing conflicts by:
• Basing division managers’ bonuses on overall Cran Health profits in

addition to division operating income. This will motivate each manager to
consider what is best for Cran Health Products overall and not be concerned
with the transfer price alone.
• Letting the two divisions negotiate the transfer price between themselves.
However, this may result in constant re-negotiation between the two managers
each accounting period.
• Using dual transfer prices. However, a cost-based transfer price will not motivate
cost control by the Harvesting Division manager. It will also insulate that division
from the discipline of market prices.
• EXAMPLE 4 (22-29) Goal-congruence problems with
cost-plus transfer-pricing methods, dual-pricing
system (continuation of 22-28).
• Assume that Pat Borges, CEO of Cran Health, had
mandated a transfer price equal to 225% of full cost. Now
he decides to decentralize some management decisions
and sends around a memo that states the following:
“Effective immediately, each division of Cran Health is free
to make its own decisions regarding the purchase of direct
materials and the sale of finished products.”
• Required:
• 1. Give an example of a goal-congruence problem that
will arise if Cran Health continues to use a transfer price of
225% of full cost and Borges’s decentralization policy is
adopted.
• EXAMPLE 4 (22-29) Goal-congruence problems with cost-
plus transfer-pricing methods, dual-pricing system
(continuation of 22-28).
• 2. Borges feels that a dual transfer-pricing policy will improve
goal congruence. He suggests that transfers out of the
harvesting division be made at 225% of full cost and transfers
into the processing division be made at market price. Compute
the operating income of each division under this dual transfer-
pricing method when 480,000 pounds of cranberries are
harvested during June 2017 and processed into juice.
• 3. Why is the sum of the division operating incomes computed
in requirement 2 different from Cran Health’s operating income
from harvesting and processing 480,000 pounds of
cranberries?
• 4. Suggest two problems that may arise if Cran Health
implements the dual transfer prices described in requirement
2.
• 1. Give an example of a goal-congruence problem that will arise
if Cran Health continues to use a transfer price of 225% of full
cost and Borges’s decentralization policy is adopted.
• 1. Two examples of goal congruence problems that arise

if a transfer price of 225% of full costs is mandated and
Borges’s decentralization policy is adopted are:
• The Processing Division manager will prefer to buy
cranberries from an external supplier at $0.68 per pound,
incurring some extra purchasing costs and lowering
Crane’s overall operating income. Cran Health will incur
costs of $0.68 per pound and save variable costs of only
$0.10 per pound.
• The Harvesting Division manager is forced to sell to an
outside purchaser (because the Processing Division
prefers to purchase from an external supplier) when it is
better for Cran Health Products to process internally.
• 2. Borges feels that a dual transfer-pricing policy will improve
goal congruence. He suggests that transfers out of the
harvesting division be made at 225% of full cost and transfers
into the processing division be made at market price. Compute
the operating income of each division under this dual transfer-
pricing method when 480,000 pounds of cranberries are
harvested during June 2017 and processed into juice.
• 2. Transfer into buying division at market price

• Harvesting Division to Processing Division = $0.68 per
pound of cranberries
• Transfer out of selling division at 225% of full costs
• Harvesting Division to Processing Division = 2.25 ×
($0.10 + $0.30) = $0.90 per pound of cranberries
As calculated in Requirement 2 of 22-28 and also shown below, under the dual
transfer-pricing policy, the Harvesting Division will earn an operating income of
$240,000 and the Processing Division will earn an operating income of $134,400.

225% of Market
Full Costs Price
Harvesting Division
Revenues (480,000 lbs.  $0.90 per lb.) $432,000
Costs
Division variable costs (480,000 lbs.  $0.10 per lb.) 48,000
Division fixed costs (480,000 lbs.  $0.30 per lb.) 144,000
Total division costs 192,000
Division operating income $240,000
Processing Division
Revenues (240,000 gals.  $2.45 per gal.) $588,000
Costs
Transferred in costs (480,000 lbs.  $0.68 per lb.) 326,400
Division variable costs (240,000 gals.  $0.18 per gal.) 43,200
Division fixed costs (240,000 gals.  $0.35 per gal.) 84,000
Total division costs 453,600
Division operating income $134,400
• 3. Why is the sum of the division operating incomes computed
in requirement 2 different from Cran Health’s operating income
from harvesting and processing 480,000 pounds of cranberries?
• 3. Under the dual transfer pricing policy,
• Division Operating Income
• HARVESTING DIVISION $240,000
• Processing Division 134,400
• Cran Health Products $374,400
• The overall company operating income from harvesting and
processing 480,000 pounds of cranberries is $268,800 (see Problem
22-28, requirement 1).
• A dual transfer-pricing method entails using different transfer
prices for transfers into the buying division and transfers out of
the supplying division. As a result, the sum of division operating
incomes does not equal the total company operating income.
•
• 4. Suggest two problems that may arise if Cran Health
implements the dual transfer prices described in
requirement 2.
• 4. Problems which may arise if Cran Health Products
uses the dual transfer-pricing system include:
• It may reduce the incentives of the supplying division to
control costs since every $1 of cost of the supplying
division is transferred out to the buying division at $2.25.
• A dual transfer-pricing system does not provide clear
signals to the individual divisions about the level of
decentralization top management seeks.
• It insulates the Harvesting Division manager from the
frictions and the discipline of the marketplace because
costs, not market prices, affect the revenues of the
supplying division.
END OF PPT NOTES

Results Accountability - PPT Notes

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Results Accountability - PPT Notes

Uploaded by

Copyright:

Available Formats

• TOPIC 2

Chapter 22 Management Control Systems

– Financial responsibility centers

 Discretionary expense centers

Gross Incomplete Before-tax Complete

 In fact, managers have two performance objectives

SBU Manager SBU Manager SBU Manager SBU Manager

• Crude approximation of the market price in

• It is costly (management time), accentuates conflicts

Incremental cost per unit

Incremental cost is the additional cost of producing and

• Calgary Lumber has a raw lumber division

• 1. Should Calgary Lumber process raw lumber into its

• Calgary Lumber will maximize its total contribution margin

The Raw Lumber Division will maximize reported

Raw Lumber Division

• ■Chinese income tax rate on the China division’s operating income:

• Each desktop computer is sold to retail outlets in the United

2. South Korea Division

3. United States Division

Market 200% of 350% of

China Division $ 108 $ 192 $ 18

Revenues (240,000 gals.  $2.45 per gal.) $588,000

• 3. Bonus paid to division managers at 6% of division

Processing Division manager’s bonus

• Basing division managers’ bonuses on overall Cran Health profits in

• 1. Two examples of goal congruence problems that arise

• 2. Transfer into buying division at market price

You might also like