Chapter 14 - Answer

MANAGEMENT ACCOUNTING - 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. 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 14-1

Chapter 14 Responsibility Accounting and Transfer Pricing

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 Exercise 1 (Evaluation of a Profit Center) 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.

Revenue Direct cost of department Contribution of the department Allocated cost Net income

Department 1 2 4 Total P132,000 P168,000 P98,000 P398,000 82,000 108,000 61,000 251,000 P 50,000

P 60,000

P37,000 P147,000 121,000 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. Exercise 2 (Evaluation of an Investment Center) Requirement 1 ROI P400,000

Operating assets 14-2

RI P400,000

Responsibility Accounting and Transfer Pricing Chapter 14

Operating income ROI (P100,000  P400,000) Minimum required income (16% x P400,000) RI (P100,000 - P64,000)

P100,000 25%

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: Operating assets Operating income ROI

Present P400,000 P100,000 25%

New Project P60,000 P12,000* 20%

Overall P460,000 P112,000 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: Operating assets Operating income Minimum required return at 16% RI

Present P400,000 P100,000

New Project P60,000 P12,000

Overall P460,000 P112,000

64,000 P 36,000

9,600* P 2,400

73,600 P 38,400

* P60,000 x 16% = P9,600

Exercise 3 (ROI, Comparison of Three Divisions) Requirement 1 ROI:

Division X Division Y Division Z P10,000 P12,600 P 28,800 = 25% = 18% = 16% P40,000 P70,000 P180,000 14-3


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. Exercise 4 (ROI, RI, Comparisons of Two Divisions) Requirement 1 Net Operating income X Sales Division A :

Division B :

Sales Average Operating Assets

P630,000 P9,000,000 X P9,000,000 P3,000,000 X 7% 3 P1,800,000 X P20,000,000 X

9%

= ROI

= ROI = 21%

P20,000,000 P10,000,000 = ROI 2

= 18%

Requirement 2 Average operating assets (a).......... Net operating income.................... Minimum required return on average operating assets - 16% x (a)..... Residual income............................

Division A P3,000,000 P 630,000

Division B P10,000,000 P 1,800,000

480,000 P 150,000

P

1,600,000 200,000

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. 14-4


Exercise 5 (Evaluation of a Cost Center) (1) Controllable Costs by supervisor of Department 10 are as follows: a. Supplies, Department 10 b. Repairs and Maintenance, Department 10 c. Labor Cost, Department 10 (2) Direct Costs of Department 10 are a. Salary, supervisor of Department 10 b. Supplies, Department 10 c. Repairs and Maintenance, Department 10 d. Labor Cost, Department 10 (3) Costs allocated to Factory Department are: a. Factory, heat and light b. Depreciation, factory c. Factory insurance d. Salary of factory superintendent (4) Costs which do not pertain to factory operations are: a. Sales salaries and commissions b. General office salaries

Exercise 6 (Evaluating New Investments Using Return on Investment (ROI) and Residual Income) Requirement 1 Computation of ROI Division A: ROI

=

P300,000 P6,000,000

x

P6,000,000 P1,500,000

= 5% x 4 = 20%

P900,000 P10,000,000

x

P10,000,000 P5,000,000

= 9% x 2 = 18%

Division B: ROI

=

14-5


Division C: ROI

=

P180,000 P8,000,000

x

P8,000,000 P2,000,000

= 2.25% x 4 = 9%

Requirement 2 Average operating assets Required rate of return Required operating income Actual operating income Required operating income (above) Residual income

Division A P1,500,000 × 15% P 225,000 P 300,000 225,000 P 75,000

Division B P5,000,000 × 18% P 900,000 P 900,000 900,000 P 0

Division C P2,000,000 × 12% P 240,000 P 180,000 240,000 P (60,000)

Division A 20%

Division B 18%

Division C 9%

Reject

Reject

Accept

15%

18%

12%

Accept

Reject

Accept

Requirement 3 a. and b. Return on investment (ROI) Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would Minimum required return for computing residual income Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would

If performance is being measured by ROI, both Division A and Division B probably would reject the 17% investment opportunity. The reason is that these companies are presently earning a return greater than 17%; thus, the new investment would reduce the overall rate of return and place the divisional managers in a less favorable light. Division C probably would accept the 17% investment opportunity, since its acceptance would increase the Division’s overall rate of return. If performance is being measured by residual income, both Division A and Division C probably would accept the 17% investment opportunity. The 17% rate of return promised by the new investment is greater than their required 14-6


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. Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company) Requirement 1 Sales Less expenses: Added by the division Transfer price paid Total expenses Net operating income 1 2 3

Division A P3,500,000

1

2,600,000 — 2,600,000 P 900,000

Division B P2,400,000 1,200,000 700,000 1,900,000 P 500,000

2

Total Company P5,200,000

3

3,800,000 — 3,800,000 P1,400,000

20,000 units × P175 per unit = P3,500,000. 4,000 units × P600 per unit = P2,400,000. 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

Observe that the P700,000 in intracompany sales has been eliminated. Requirement 2 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. 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 on lost sales Variable cost + Transfer price  Number of units transferred per unit . There is no idle capacity, so each of the 20,000 units transferred from Division 14-7


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. Transfer price  Cost of buying from outside supplier = P47 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. Transfer price



P20 +

P0 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. Transfer price  Cost of buying from outside supplier = P34 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: P20  Transfer price  P34 Exercise 9 (Transfer Pricing: Decision Making) Requirement 1 Division A’s purchase decision from the overall firm perspective: 14-8


Purchase costs from outside 10,000 x P150 = P1,500,000 Less: Savings of Divisions B’s variable costs 10,000 x P140 = 1,400,000 Net Cost (Benefit) for A to buy outside P 100,000 Assuming Division B has no outside sales, Division A should buy inside from Division B for the benefit of the entire firm. Requirement 2 As above, but in addition, if Division A buys outside, Division B saves an additional P200,000.

Purchase costs from outside Less: Savings in variable costs Less: Savings of B material assignment Net Cost (Benefit) for A to buy outside

10,000 x P150 = P1,500,000 10,000 x P140 = 1,400,000 200,000 P (100,000)

The additional savings in Division B means that now Division A should buy outside. Requirement 3 Assuming the outside price drops from P150 to P130: Purchase costs from outside Less: Savings in variable costs Net Cost (Benefit) for A to buy outside

10,000 x P130 = P1,300,000 10,000 x P140 = 1,400,000 P (100,000)

Division A should buy outside. Exercise 10 (Compute the Return on Investment (ROI)) Requirement (1) Margin = =

Net operating income Sales P5,400,000 P18,000,000 14-9

= 30%


Requirement (2) Sales Average operating assets

Turnover = =

P18,000,000 P36,000,000

= 0.5

Requirement (3) ROI

=

Margin x Turnover

=

30% x 0.5 = 15%

Exercise 11 (Residual Income) Average operating assets (a).............................................. Net operating income........................................................ Minimum required return: 16% × (a)................................ Residual income................................................................

P2,200,000 P400,000 352,000 P 48,000

III. Problems Problem 1 (Evaluation of Profit Centers) Requirement (a) Jadlow Manufacturing Corporation Income Statement For the Year Ended December 31, 2005 Sales Less: Variable Costs Contribution Margin Less: Controllable fixed expenses Contribution to the recovery of non-controllable fixed expenses

Total P5,100,000 3,330,000 P1,770,000

Product S P2,700,000 1,890,000 P 810,000

Product T P2,400,000 1,440,000 P 960,000

501,000

66,000

435,000

P1,269,000

P 744,000

P 525,000

Requirement (b) 14-10


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.

Problem 2 (Evaluation of Profit Centers) Requirement 1 Incremental sales Less: Incremental costs Net income

A P71,000 42,000 P29,000

Product B P46,000 15,000 P31,000

C P117,000 96,000 P 21,000

Product B seems to offer the best profit potential. Requirement 2 The sunk costs are: Depreciation of equipment Operating cost of the equipment Total

P 6,400 4,600 P11,000

Requirement 3 Opportunity cost of selling Product B is From Product A From Product C Total Problem 3 (Evaluation of Performance) Ranjie Tool Company Performance Report For the Year 2005 Budgeted Labor Hours Actual Labor Hours

4,000 4,200 14-11

P29,000 21,000 P50,000

Chapter 14 Responsibility Accounting and Transfer Pricing Budget Based on 4,200 Hours

Variance U (F)

P 3,600 7,400 5,300 P16,300

P 3,360 7,560 5,040 P15,960

P240 (160) 260 P340

P 1,600 2,200 6,000 5,400 1,200 P16,400 P32,700

P 1,600 2,200 6,000 5,400 1,200 P16,400 P32,360

-

Actual 4,200 Hours

Cost-Volume Formula Variable Overhead Costs: Utilities P0.80 per hour Supplies 1.80 Indirect labor 1.20 Total P3.80 Fixed Overhead Costs: Utilities Supplies Depreciation Indirect labor Insurance Total Total Factory Overhead Costs

P340

Problem 4 (Evaluation of Performance) Requirement 1 Performance Report for the Production Manager

Controllable costs: Direct material Direct labor Supplies Maintenance Total

Actual Cost

Flexible Budget Cost

Variance (U) or (F)

P24,000 48,000 4,000 3,000 P79,000

P20,000 50,000 6,000 4,000 P80,000

P4,000 (U) 2,000 (F) 2,000 (F) 1,000 (F) P1,000 (F)

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 Performance Report for the Vice President Actual Cost Controllable costs: 14-12

Flexible Budget Cost

Variance (U) or (F)


Marketing division P104,000 P102,000 P2,000 (U) Production division 79,000 80,000 1,000 (F) Personnel division 72,000 76,000 4,000 (F) Other costs 68,800 70,000 1,200 (F) Total P323,800 P328,000 P4,200 (F) 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. Problem 5 (Target Sales Price; Return on Investment) Requirement 1 Return on investment = Operating income / Investment 20% = X / P800,000 Target Operating Income = P160,000 Target revenues, calculated as follows: Fixed overhead Variable costs Desired operating income Revenues

1,500,000 x P300

P200,000 450,000 160,000 P810,000

The selling price per units is P540 = P810,000 / 1,500 Requirement 2 Data are in thousands. Units Revenues Variable costs Fixed costs Total costs Operating income Return on investment

1,500 P810

2,000 P1,080

1,000 P540

450 200 650

600 200 800

300 200 500

P160 20% = P160 / P800

P280 35% = P280 / P800

P 40 5% = P40 / P800

Note how the change in income follows the change in revenues, as predicted by operating leverage. Operating leverage multiplied times the percentage 14-13


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: Operating leverage = contribution margin / operating income = (P810 – P450) / P160 = 2.25 % change in income = =

operating leverage x % change in revenues 2.25 x 33.33% = 75%

% 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% Problem 6 (Contrasting Return on Investment (ROI) and Residual Income) Requirement 1 ROI computations: ROI

=

Net operating income Sales

x

Sales Average operating assets

Pasig:

P630,000 P9,000,000

x

P9,000,000 P3,000,000

= 7% x 3 = 21%

Quezon:

P1,800,000 P20,000,000

x

P20,000,000 P10,000,000

= 9% x 2 = 18%

Requirement 2 14-14


Average operating assets (a) Net operating income Minimum required return on average operating assets—16% × (a) Residual income

Pasig P3,000,000 P 630,000

Quezon P10,000,000 P 1,800,000

480,000 P 150,000

P 1,600,000 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. Problem 7 (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 Division’s business. Applying the formula for the lowest acceptable transfer price from the viewpoint of the selling division, we get:

Transfer price



Variable cost + per unit

Transfer price



P16 +

Total contribution margin on lost sales Number of units transferred P0 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: P16  Transfer price  P29 Requirement 2

14-15


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: Variable cost + per unit



Transfer price

Total contribution margin on lost sales Number of units transferred

Transfer price

(P30 – P16) x 10,000 10,000



P16 +

=

P16 + P14

=

P30

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. Requirement 3 Applying the formula for the lowest acceptable price from the viewpoint of the selling division, we get:

Transfer price



Variable cost + per unit

Transfer price




(P16 – P3) +

=

P13 + P14

=

(P30 – P16) x 10,000 10,000 P27

In this case, the transfer price must fall within the range: P27  Transfer price  P29

Problem 8 (Transfer Pricing)

14-16


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: Variable cost + per unit



Transfer price

Transfer price

Total contribution margin on lost sales Number of units transferred (P30 – P16) x 30,000 20,000



P20 +

=

P20 + P21

=

P41

Problem 9 (Effects of Changes in Sales, Expenses, and Assets in ROI) 1.

Net operating income Sales

Margin = =

2.

P800,000 P8,000,000

= 10%

Sales Average operating assets

Turnover = =

P8,000,000 P3,200,000

= 2.5

3. ROI

=

Margin x Turnover

=

10% x 2.5 = 25%

Problem 10 (Transfer Pricing Basics) Requirement (1) a. The lowest acceptable transfer price from the perspective of the selling division, the Electrical Division, is given by the following formula:

Transfer price =

Variable cost per unit

+


Because there is enough idle capacity to fill the entire order from the 14-17


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. Transfer price = P21 +

P0 10,000

= P21

b. The Motor Division can buy a similar transformer from an outside supplier for P38. Therefore, the Motor Division would be unwilling to pay more than P38 per transformer. Transfer price: Cost from buying from outside supplier = P38 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: (P40 – P21) x 10,000 Transfer price = P21 + 10,000 = P21 + (P40 – P21) = P40 b. As before, the Motor Division would be unwilling to pay more than P38 per transformer. 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. 14-18


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. Problem 11 (Transfer Pricing with an Outside Market) 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: Transfer price = P110 +

(P200 – P110) x 30,000 30,000

= P110 + (P200 – P110) = P200 Therefore, the Tuner Division will refuse to transfer at a price less than P200 per tuner. 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. Transfer price : Cost of buying from outside supplier = P180 The requirements of the two divisions are incompatible. The Assembly Division won’t pay more than P180 and the Tuner Division will not accept less than P200. Thus, there can be no mutually agreeable transfer price and no transfer will take place. 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: 14-19


Lost revenue per tuner....................................................... Outside supplier’s price..................................................... Loss in contribution margin per tuner................................ Number of tuners per year................................................. Total loss in profits............................................................

P200 P180 P20 × 30,000 P600,000

Profits in the Assembly Division will remain unchanged, since it will be paying the same price internally as it is now paying externally. 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: P0 Transfer price = P110 + = 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: P110 : Transfer price : P180

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: Price per tuner.................................................. P160 Variable costs................................................... 110 Contribution margin per tuner........................... P 50 30,000 tuners × P50 per tuner = P1,500,000 potential increased profits 14-20


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) The Tuner Division will have an increase in profits: Selling price...................................................... P200 Variable costs................................................... 110 Contribution margin per tuner........................... P 90 30,000 tuners × P90 per tuner = P2,700,000 increased profits

The Assembly Division will have a decrease in profits: Inside purchase price........................................ P200 Outside purchase price..................................... 160 Increased cost per tuner.................................... P 40 30,000 tuners × P40 per tuner = P1,200,000 decreased profits The company as a whole will have an increase in profits: Increased contribution margin in the Tuner Division............................................ P 90 Decreased contribution margin in the Assembly Division..................................... 40 Increased contribution margin per tuner............................................................... P 50 30,000 tuners × P50 per tuner = P1,500,000 increased profits 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 14-21


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. Problem 12 (Transfer Pricing; Divisional Performance) Requirement (1) The Electronics Division is presently operating at capacity; therefore, any sales of the KK8 circuit board to the Clock Division will require that the Electronics Division give up an equal number of sales to outside customers. Using the transfer pricing formula, we get a minimum transfer price of: Total contribution margin on lost sales Number of units transferred

Transfer price =

Variable cost per unit

Transfer price =

P82.50 + (P125.00 – P82.50)

Transfer price =

P82.50 + P42.50

+

Transfer price = P125.00 Thus, the Electronics Division should not supply the circuit board to the Clock Division for P90 each. The Electronics Division must give up revenues of P125.00 on each circuit board that it sells internally. Since management performance in the Electronics Division is measured by ROI and dollar profits, selling the circuit boards to the Clock Division for P9 would adversely affect these performance measurements. 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. 14-22


Selling price of the timing devices................................................................. P700.00 Less: The cost of the circuit boards used in the timing devices (i.e. the lost revenue from sale of circuit boards to outsiders)............................................................................................... P125.00 Variable costs of the Clock Division excluding the circuit board (P300.00 + P207.50)................................................................... 507.50 632.50 Net positive effect on the company’s profit.................................................... P 67.50 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. 14-23


However, such an action, if done on a frequent basis, would undermine the autonomy of the managers and turn decentralization into a sham. 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. IV. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

C D A A C A D A C A

11. 12. 13. 14. 15. 16. 17. 18. 19. 20.

E D C C B C B A B A

21. 22. 23. 24. 25. 26. 27. 28. 29. 30.

14-24

C B A D B A A B D A

31. 32. 33. 34. 35. 36. 37. 38. 39. 40.

B D D D C D B D B D

Chapter 14 - Answer

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