CHAPTER 13
Investment Centers and Transfer Pricing ANSWERS TO REVIEW QUESTIONS 13-1 Goal congruenc congruence e means a meshing meshing of objectives objectives,, in which which the the man manager agers s thr throug oughou hout an orga organ nizati zation on str strive ive to achieve goals that are consistent with the goals set by top top mana manage geme ment nt.. Goal Goal cong congru ruen ence ce is impo import rtan antt for for orga organi niza zati tion onal al succ succes ess s beca becaus use e mana manage gers rs ofte often n are are unaware of the effects of their decisions on the organization's other subunits. lso, it is natural for people to be more concerned with the performance of their own subunit than with the effective iveness of the entire organization. !n order for the organization to be effective, it is important that everyone in it be striving for the same ultimate objectives. 13-" #he #he manag anager eria iall acco ccountan ntant' t's s prim primar ary y obje object ctiive in designing a responsibility-accounting system is to provide ince incent ntiv ives es for for the the orga organi niza zati tion on's 's subu subuni nitt mana manage gers rs to strive toward achieving the organization's goals. 13-3 $nder the management management-by-by-objec objectives tives %&() %&() philosoph philosophy, y, mana manage gers rs part partic icip ipat ate e in sett settin ing g goal goals s that that they they then then str strive ive to achie chieve ve.. #hese ese goal goals s may may be e*pr *presse essed d in financial or other +uantitative terms, and the resp respon onsi sibi bili lity ty-a -acc ccou ount ntin ing g syst system em is used used to eval evalua uate te perf perfor orma manc nce e in achi achiev evin ing g them them.. #he #he &( &( appr approa oach ch is consistent with an emphasis on obtaining goal congruence throughout an organization. 13- 13 - n inve invest stme ment nt cent center er is a resp respon onsi sibi bili lity ty-a -acc ccou ount ntin ing g center, the manager of which is held accountable not only for the investment center's profit but also for the capital inve invest sted ed to earn earn that that prof profit it.. *am *ampl ples es of inve invest stme ment nt centers centers include a division division of a manufactu manufacturing ring company, company, a lar large geog eograph aphica ical terr territ ito ory of a hote hotell chain ain, and a geogra geographi phical cal territ territor ory y consis consistin ting g of severa severall stores stores in a retail company. McGraw-Hill/Irwin Inc. Managerial Accounting, 5/e
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oninvestment %/(!)= 13- /eturn
income income sales reven = × invested capital sales revenueinvested capit
13-0 13 -0 divisi division on's 's /(! can be improved improved by improv improving ing the sales sales margin margin,, by improv improving ing the capita capitall turnov turnover, er, or by some some combination of the two. #he manager of the automobile division of an insurance company could improve the sales margin by increasing the profit margin on each insurance policy sold. s a result, every sales dollar would generate more income. #he capital turnover could be improved by incr increa easi sing ng sale sales s of insu insura ranc nce e poli polici cies es whil while e eep eepin ing g inve invest sted ed capi capita tall fi*e fi*ed, d, or by decr decrea easi sing ng the the inve invest sted ed assets re+uired to generate the same sales revenue. 13-2 *ample of the calculation calculation of residual residual income 4uppose 4uppose an investment center's profit is 5166,666, invested capital is 5766,666, and the imputed interest rate is 1" percent /esidual incomeinvestment center' sprofit
investment center' s imputed invested capital interest rat
/esidual income 8 5166,666 %5766,666) %1"9) 8 5,666 #he imputed interest rate is used in calculating residual income, but it is not used in computing /(!. #he imputed interest rate reflects the firm's minimum re+uired rate of return on invested capital. 13-7 13 -7 #he chief chief disadv disadvant antage age of /(! is that that for an invest investmen mentt that earns a rate of return greater than the company's cost of raising capital, the manager in charge of deciding about that investment may have an incentive to reject it if the invest investmen mentt would would resul resultt in reduc reducing ing the manage manager's r's /(! /(!. #he resid esidu ual-i al-inc nco ome meas measur ure e elim elimin inat ates es this this disadvantage by including in the residual-income calculation the imputed interest rate, which reflects the firm firm's 's cost cost of capi capita tal. l. ny ny proj projec ectt that that earn earns s a retu return rn grea greate terr than han the the imp imputed uted inte interrest est rate rate will sho show a positive residual income. 13-: 13 -: #he #he rise rise in /(! /(! or resi residu dual al inco income me acro across ss time time resu result lts s from the fact that periodic depreciation charges reduce the boo value of the asset, which is generally used in McGraw-Hill/Irwin Inc. 13-2 13-2
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dete determ rmin inin ing g the the inve invest stme ment nt base base to use use in the the /(! /(! or residual-income calculation. #his phenomenon can have a seri seriou ous s effe effect ct on the the ince incent ntiv ives es of inve invest stme ment nt-ce -cent nter er managers. !nvestment centers with old assets will show higher /(!s than investment centers with relatively new asse assets ts.. #his #his resu result lt can can disc discou oura rage ge inve invest stme ment nt-c -cen ente terr mana manag gers ers fro from invest vestin ing g in new new e+u e+uipm ipment. ent. !f this behavioral tendency persists for a long time, a division's assets can become obsolete, maing the division uncompetitive. 13-16 follows
#he economic value added %;) is defined as
conomic value added
!nvestment center' s after - ta* operating income
!nvestment !nvestment
/esidual incomeinvestment center' sprofit
investment center' s imputed invested capital interest rat
conomic value added differs from residual income in its subtraction of the investment center=s current liabilities and and its its spec specif ific ic use use of the the weig weight hted ed-a -ave vera rage ge cost cost of capital.
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13-11 a. #otal assets !ncludes all divisional assets. #his measure of invested capital is appropriate if the division manager has considerable authority in maing decisions about all of the division's assets, including nonproductive assets. b. #otal productive assets *cludes assets that are not in service, such as construction in progress. #his measure is appropriate when a division manager is directed by top management to eep nonproductive assets, such as vacant land or construction in progress. c. #otal assets less current liabilities ll divisional assets minus current liabilities. #his measure is appropriate when the division manager is allowed to secure shortterm ban loans and other short-term credit. #his approach encourages investment-center managers to minimize resources tied up in assets and ma*imize the use of short-term credit to finance operations. 13-1" #he use of gross boo value instead of net boo value to measure a division's invested capital eliminates the problem of an artificially increasing /(! or residual income across time. lso, the usual methods of computing depreciation, such as straight-line or declining-balance methods, are arbitrary. s a result, some managers prefer not to allow these depreciation charges to affect /(! or residual-income calculations. 13-13 !t is important to mae a distinction between an investment center and its manager, because in evaluating the manager's performance, only revenues and costs that the manager can control or significantly influence should be included in the profit measure. #he objective of the manager's performance measure is to provide an incentive for that manager to adhere to goal-congruent behavior. !n evaluating the investment center as a viable economic investment, all revenues and costs that are traceable to the investment center should be considered. >ontrollability is not an issue in this case. 13-1 ?ay for performance is a one-time cash payment to an investment-center manager as a reward for meeting a McGraw-Hill/Irwin Inc. 13-!
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predetermined criterion on a specified performance measure. #he objective of pay for performance is to get the manager to strive to achieve the performance target that triggers the payment. 13-1 n alternative to using /(! or residual income to evaluate a division is to loo at its income and invested capital separately. ctual divisional profit for a period of time is compared to a fle*ible budget, and variances are used to analyze performance. #he division's major investments are evaluated through a postaudit of the investment decisions. #his approach avoids the necessity of combining profit and invested capital in a single measure, such as /(! or residual income. 13-10 @uring periods of inflation, historical-cost asset values soon cease to reflect the cost of replacing those assets. #herefore, some accountants argue that investmentcenter performance measures based on historical-cost accounting are misleading. &ost managers, however, believe that measures based on historical-cost accounting are ade+uate when used in conjunction with budgets and performance targets. 13-12 *amples of nonfinancial measures that could be used to evaluate a division of an insurance company include the following %1) new policies issued and insurance claims settled in a specified period of time, %") average time re+uired to settle an insurance claim, and %3) number of insurance claims settled without litigation versus claims that re+uire litigation. 13-17 Aonfinancial information is useful in measuring investment-center performance because it gives top management insight into the summary financial measures such as /(! or residual income. y eeping trac of important nonfinancial data, top managers often can see a problem developing before it becomes a serious problem. Bor e*ample, if a manufacturer's rate of defective products has been increasing over some period of time, management can observe this phenomenon and tae steps to improve product +uality before serious damage is done to customer relations. McGraw-Hill/Irwin Inc. Managerial Accounting, 5/e
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13-1: #he goal in setting transfer prices is to establish incentives for autonomous division managers to mae decisions that support the overall goals of the organization. #ransfer prices should be chosen so that each division manager, when striving to ma*imize his or her own division's profit, maes the decision that ma*imizes the company's profit. 13-"6 Bour methods by which transfer prices may be set are as follows %a) #ransfer price 8 additional outlay costs incurred because goods are transferred C opportunity costs to the organization because of the transfer. %b)
#ransfer price 8 e*ternal maret price.
%c) #ransfer prices may be set on the negotiations among the division managers.
basis
of
%d) #ransfer prices may be based on the cost producing the goods or services to be transferred.
of
13-"1
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13-"" #he management of a multinational company has an incentive to set transfer prices so as to minimize the income reported for divisions in countries with relatively high income-ta* rates, and to shift this income to divisions with relatively low income-ta* rates. 4ome countries' ta* laws prohibit this practice, while other countries' laws permit it. 13-"3 &ultinational firms may be charged import duties, or tariffs, on goods transferred between divisions in different countries. #hese duties often are based on the reported value of the transferred goods. 4uch companies may have an incentive to set a low transfer price in order to minimize the duty charged on the transferred goods.
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SO%UTIONS TO E&ERCISES D/>!4 13-" %16 &!A$#4) income 5,666, 8 8 79 sales reven 56,666, 6 sales reven 56,666, 6 >apital 8 8 8 ". invested capit 5"6,666, 6 turnover income 5,666, /eturn on 8 8 8 "69 5"6,666, 6 invested capit investment
4ales margin 8
D/>!4 13-" %1 &!A$#4) #here are an infinite number of ways to improve the division's /(! to " percent. Eere are two of them 1 .
!mprove the sales margin to 16 percent by increasing income to 5,666,666 /( 8 sales margin !
capital turnover
5,666,666 56,666, 6 × 8 56,666,66 6 5"6,666, 6 8 169
". 8 "9
4ince sales revenue remains unchanged, this implies a cost reduction of 51,666,666 at the same volume. " .
!mprove the turnover to 3.1" by decreasing average invested capital to 510,666,666 /( 8 sales margin ! 8
capital turnover
5,666,666 56,666, 6 × 56,666,66 6 510,666, 6
8 79
3.1" 8 "9
4ince sales revenue remains unchanged, this implies that the firm can divest itself of some productive assets without McGraw-Hill/Irwin Inc. 13-'
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affecting sales volume. D/>!4 13-"0 % &!A$#4) /esidual income
8 investment center income 8 5,666,666 F %5"6,666,666
F
invested imputed capital interest rat
119)
8 51,766,666 D/>!4 13-"2 %"6 &!A$#4) #he weighted-average cost of capital %<>>) is defined as follows
fter - ta*cost &ar1et >ost of &ar1e of debt value e+uity value capital of debt capitalof e+uit &ar1et &ar1et value value of debt of e+uity
#he interest rate on Golden Gate >onstruction ssociates= 506 million of debt is 16 percent, and the company=s ta* rate is 6 percent. #herefore, Golden Gate=s after-ta* cost of debt is 0 percent 169 %1 69)H. #he cost of Golden Gate=s e+uity capital is 1 percent. &oreover, the maret value of the company=s e+uity is 5:6 million. #he following calculation shows that Golden Gate=s <>> is 11. percent.
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%.60)%506, 666,666) %.1)%5:6, 666,666) .11 506,666,66 6 5:6,666,66 6
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D/>!4 13-"7 %"6 &!A$#4) #he economic value added %;) is defined as follows conomic value added
!nvestment center' s after - ta* operating income
!nvestment !nvestment
Bor Golden Gate >onstruction ssociates, following calculations of each division=s ;. fter-#a* (peratin g !ncome @ivision /eal st ate >onstruc tion
we
have
the
#otal ssets %in millions)
>urrent Iiabiliti es %in millions )
<> >
5"6%1 . 6)
5166
50
.11
8
51."7
517%1 . 6)
5 06
5
.11
8
5.10
%in millions)
conom ic ;alue dded %in millions )
D/>!4 13-": %36 &!A$#4) 1 .
verage investment in productive assets alance on 1"J31J*1........................................... alance on 1J1J*1 %51",066,666
1.6)...............
eginning balance plus ending balance............... verage balance %5",066,666
a.
/ (!
8
").....................
51",066 ,666 1",666, 666 5",066 ,666 51",366 ,666
income from operations before income ta* average productive assets
5",06, 8 51",366, 6 8 "69 McGraw-Hill/Irwin Inc. 13-1)
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b. !ncome from operations before income ta*es. . Iess imputed interest charge verage productive assets............
5 ",06,6 66
51",366 ,666
!mputed interest rate................... . 1 !mputed interest charge.............................. /esidual income.............................................
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D/>!4 13-": %>(A#!A$@) " Kes, Bairmont=s management probably would have . accepted the investment if residual income were used. #he investment opportunity would have lowered Bairmont=s "6*1 /(! because the project's e*pected return %17 percent) was lower than the division's historical returns %1:.3 percent to "".1 percent) as well as its actual "6*1 /(! %"6 percent). &anagement may have rejected the investment because bonuses are based in part on the /(! performance measure. !f residual income were used as a performance measure %and as a basis for bonuses), management would accept any and all investments that would increase residual income %i.e., a dollar amount rather than a percentage) including the investment opportunity it had in "6*1. D/>!4 13-36 %36 &!A$#4) 1. 4tudents= calculation of return on investment and residual income will depend on the company selected and the year when the internet search is conducted. 4tudents will need to decide how to determine the income and the invested assets to use in both calculations. #he discussion in the te*t will serve as a guide in this regard. ". 4ome companies= annual reports include a calculation and discussion of /(! in the Lmanagement report and analysisM section or the Lfinancial highlightsM section. 4tudents= calculation of /(! may differ from management=s due to differing assumptions about the determination of income and invested capital.
D/>!4 13-31 %1 &!A$#4) &emorandum @ate
#oday
#o
?resident, 4un >oast Bood >enters
Brom !. &. 4tudent McGraw-Hill/Irwin Inc. 13-12
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4ubje ct
ehavior of /(! over time
!4 13-3" %16 &!A$#4) 1 .
#he same employee is responsible for eeping the inventory records and taing the physical inventory count. !n addition, when the records and the count do not agree, the employee changes the count, rather than investigating the reasons for the discrepancy. #his leaves open the possibility that the employee would steal inventory and conceal the theft by altering both the records and the count. ven without any dishonesty by the employee, this system is not designed to control inventory since it does not encourage resolution of discrepancies between the records and the count.
" .
#he internal control system could be strengthened in two ways %a ssign two different employees the responsibilities for ) the inventory records and the physical count.
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D/>!4 13-33 %1 &!A$#4) 1 .
income 4ales 8 sales reven margin
£
8£
166,66 N ",666,
8 9
N!ncome 8 O166,666 8 O",666,666 F O1,166,666 F O766,666 £ sales reven ",666, >apital 8 invested capit 8£ 1,666, turnover 166,6 income £ /(! 8 invested capit 8£ 1,666,
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D/>!4 13-33 %>(A#!A$@) income /(! 8 8 invested capit 19
" .
8£
!ncome 8 19 O1,666,666
incom 1,666,
8 O16,666
!ncome 8 sales revenue F e*penses 8 O16,666 !ncome 8 O",666,666 F e*penses 8 O16,666 *penses 8 O1,76,666 #herefore, e*penses must be reduced to O1,76,666 in order to raise the firm's /(! to 1 percent. 3.
4ales margin
income 8 sales reven
£
8£
/(! 8 sales margin 8 2.9
16,666 2. ",666,666
capital turnover
"
8 19 D/>!4 13-3 %16 &!A$#4) 1 .
#ransfer price
8
outla opportu C y nity cost cost
8 5366N C 576P 8 5376 N(utlay cost 8 unit variable production cost P
(pportunity 8 forgone contribution margin cost 8 5376 F 5366 8 576 " .
!f the Babrication @ivision has e*cess capacity, there is no opportunity cost associated with a transfer. #herefore
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#ransfer price
8
outl opportu C ay nity cost cost
8 5366 C 6 8 5366
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D/>!4 13-3 %" &!A$#4) 1 .
#he ssembly @ivision's manager is liely to reject the special order because the ssembly @ivision's incremental cost on the special order e*ceeds the division's incremental revenue !ncremental revenue per unit in special order..................................................... !ncremental cost to ssembly @ivision per unit in special order #ransfer price.................................... dditional variable cost...................... #otal incremental cost........................... Ioss per unit in special order.................
" .
532 166 2 5 %:)
#he ssembly @ivision manager's liely decision to reject the special order is not in the best interests of the company as a whole, since the company's incremental revenue on the special order e*ceeds the company 's incremental cost !ncremental revenue per unit in special order................................................... !ncremental cost to company per unit in special order $nit variable cost incurred in Babrication @ivision............................. $nit variable cost incurred in ssembly @ivision................................ #otal unit variable cost........................ ?rofit per unit in special order..............
3 .
50
50
5366 166 66 5 0
#he transfer price could be set in accordance with the general rule, as follows #ransfer price
8
outla opportu C y nity cost cost
8 5366 C 6N 8 5366 McGraw-Hill/Irwin Inc. Managerial Accounting, 5/e
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N(pportunity cost is zero, since the Babrication @ivision has e*cess capacity. Aow the ssembly @ivision manager will have an incentive to accept the special order since the ssembly @ivision's incremental revenue on the special order exceeds the incremental cost. #he incremental revenue is still 50 per unit, but the incremental cost drops to 566 per unit %5366 transfer price C 5166 variable cost incurred in the ssembly @ivision).
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SO%UTIONS TO PRO*%E+S ?/(I& 13-30 %" &!A$#4) #he answer to the +uestion as to which division is the most successful depends on the firm's cost of capital. #o see this, compute the residual income for each division using various imputed interest rates. % !mputed interest rate of 169 a)
@ivisional profit.................................. Iess.............!mputed interest charge ! 50,666,666 169.................... !! ....................51,666,666 169 /esidual income..................................
@ivision ! 5:66,66 6
@ivision !! 5"66,66 6
066,666 QQQQQQQ 5366,66 6
166,666 5166,66 6
@ivision ! 5:66,66 6
@ivision !! 5"66,66 6
%b !mputed interest rate of 19 )
@ivisional profit.................................. Iess.............!mputed interest charge ! 50,666,666 19.................... !! ....................51,666,666 19 /esidual income.................................. %c )
76,666 QQQQQQQQ 5 06,666
16,666 5 06,666
5:66,66 6
5"66,66 6
:66,666 QQQQQQQQ
16,66
!mputed interest rate of 19 @ivisional profit.................................. Iess.............!mputed interest charge ! 50,666,666 19.................... !! ....................51,666,666 19
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/esidual income..................................
5 6
6 5 6,666
!f the firm's cost of capital is 16 percent, then @ivision ! has a higher residual income than @ivision !!.
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?/(I& 13-32 % &!A$#4)
4ales revenue............................ !ncome...................................... verage investment................... 4ales margin.............................. >apital turnover......................... /(!............................................ /esidual income.........................
@ivision @ivision @ivision > 5",666, 516,666 5 e 666 ,666 766,666 l 5 5 5 66,666 ",666,6 "66,666 66 5",666, 5 51,666, f 666 ",66,6 666 j 66 "69 "69 a "9 b 1 .7i "69 g 769c "69 5 5 5 "6,666 1,766,6 1"6,666 h 66d
*planatory notes a
b
c
4ales margin
income 5",666,666 "6 sales revenue516,666,66 6
sales revenue516,666,6 6 >apital turnover invested capital5",66,66
/(! 8 sales margin
d
/esidual income %invested capital)
capital turnover 8 "69
8
8 769
income F %imputed interest rate)
8 5",666,666 F %79)%5",66,666) 8 51,766,666 e
4ales margin
income 8 sales reven
"69 8
566,66 sales reven
#herefore, sales revenue 8 5",666,666 f
>apital
sales reven 8 invested capit
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turnover 5",666,6 1 8 invested capit #herefore, invested capital 8 5",666,666 g
/(
8 sales margin
capital turnover
! /(! 8 "69
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?/(I& 13-32 %>(A#!A$@) h
/esidual income
8 income F %imputed interest rate)%invested capital) 8 566,666 F %79) %5",666,666) 8 5"6,666
i
/(! 8 sales margin
"6 9
capital turnover
8 "9 capital trunover
#herefore, capital turnover 8 .7 j
income /(! 8 8 "69 invested capit
#herefore, income 8 %"69)%invested capital) /esidual income
8 income F %imputed interest rate)%invested capital) 8 51"6,666
4ubstituting from above for income %"69)%invested capital) F %79)%invested capital) 8 51"6,666 #herefore, %1"9)%invested capital) 8 51"6,666 4o, invested capital 8 51,666,666
/(
8
!
income invested capit incom
"6 8 51,666, 9 #herefore, income 8 5"66,666 income 4ales 8 sales reven margin l
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"9 8
5"66,66 sales reven
#herefore, sales revenue 8 5766,666 ?/(I& 13-37 %"6 &!A$#4) 1 .
#hree ways to increase @ivision 's /(! %a !ncrease income, while eeping invested capital the ) same. 4uppose income increases to 5","6,666. #he new /(! is /(!=
income 5","6,666 = = :6 invested capital5",66,666
%b @ecrease invested capital, while eeping income the ) same. 4uppose invested capital decreases to 5",66,666. #he new /(! is /(!
%c )
5",666,666
investedcapital
5",66,666
73.39%rounded)
!ncrease income and decrease invested capital. 4uppose income increases to 5",166,666 and invested capital decreases to 5",66,666. #he new /(! is
/(!= " .
income
income 5",166,666 = = 72. invested capital5",66,666
/( 8 sales margin ! 8 "9
capital turnover
1
8 "9
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?/(I& 13-3: %" &!A$#4) #his problem is similar to ?roblem 13-30, e*cept that here students are given a hint in answering the +uestion about which division is the most successful by re+uiring the calculation of residual income for three different imputed interest rates. !f the firm's cost of capital is 1" percent, then @ivision ! has a higher residual income than @ivision !.
!mputed interest rate of 1"9
@ivisional profit.................................. Iess ............!mputed interest charge ! ....................50,666,666 1"9 !! ...................51,666,666 1"9 /esidual income.................................
" .
@ivision ! 5:66,66 6
@ivision !! 5"66,66 6
2"6,666
5176,66 6
1"6,666 5 76,666
@ivision ! 5:66,66 6
@ivision !! 5"66,66 6
!mputed interest rate of 19
@ivisional profit................................... Iess .............!mputed interest charge ! .....................50,666,666 19 !! ....................51,666,666 19 /esidual income...................................
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16,666 5 6,666
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?/(I& 13-3: %>(A#!A$@) 3 !mputed interest rate of 179 .
@ivisional profit................................... Iess..............!mputed interest charge ! ......................50,666,666 179 !! .....................51,666,666
@ivision ! 5 :66,666
@ivision !! 5"66,66 6
1,676,6 66
179
/esidual income...................................
5%176,6 66)
176,666 5 "6,666
#he imputed interest rate r, at which the two divisions= residual income is the same, is 1 percent, computed as follows @ivision !!=s residual income
8 @ivision !'s residual income
5"66,666 F (r) 8 5:66,666 F (r)%50,666,666) %51,666,666) (r)%5,666,666) 8 5266,666 r 8 5266,666J5,666,666 r 8 19
Bor any imputed interest rate less than 1 percent, @ivision ! will have a higher residual income. Bor any rate over 1 percent, @ivision !!'s residual income will be higher.
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?/(I& 13-6 %6 &!A$#4)
Ke ar
1 " 3
!ncome !ncome efore nnual Aet of @eprecia @eprecia @eprecia tion tion tion
516,6 66 16,66 6 16,66 6 16,66 6 16,66 6
5"66,666 5%6,666 ) 1"6,666 36,666 2",666
27,666
,666
:0,666
,666
:0,666
/(! ased vera on ge Aet Aet oo oo ;alueP ;alue N 566, R 666 "6,6 1".9 66 1,6 ."9 66 71,66 117. 6 9 "2,66 3.0 6 9
/(! ase vera d on ge Gross Gross oo oo ;alue ;alue
566, 666 66,6 66 66,6 66 66,6 66 66,6 66
R 0.69 1.0 9 1:." 9 1:." 9
Nverage net boo value is the average of the beginning and ending balances for the year in net boo value. !n Kear 1, for e*ample, the average net boo value is 566,6665366,666 566, " P
/(! rounded to the nearest tenth of 1 percent.
1 .
#his table differs from *hibit 13-3 in that /(! rises even more steeply across time than it does in *hibit 13-3.
" .
(ne potential implication of such a /(! pattern is a disincentive for new investment. !f a proposed capital project shows a loss or very low /(! in its early years, a manager may worry about the effect on his or her
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performance evaluation in the early years of the project. !n an e*treme case, a manager may worry that he or she will no longer have the job when the project begins to show a higher return in its later years.
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?/(I& 13-1 %6 &!A$#4) ased on Aet oo ;alue
Ke ar
1
!ncome !ncome efore nnual Aet of @eprecia @eprecia @eprecia tion tion tion
5166,66 6 166,666
56,666
"
516,66 6 16,666
3
16,666
166,666
6,666
16,666
166,666
6,666
16,666
166,666
6,666
6,666
vera ge Aet oo ;alue N 56, 666 36,6 66 "6,6 66 16,6 66 6,66 6
!mput ed /esid !nter ual est !ncom >har e P ge 5,6 5 66 ,666 3,66 1,66 6 6 ",66 ",66 6 6 1,66 3,66 6 6 ,666 ,66 6
ased on Gross oo ;alue vera ge !mpute Gross d /esidu oo !nteres al ;alue t !ncom >harge e P
566, 666 66,6 66 66,6 66 66,6 66 66,6 66
56,66 6 6,666
6
6,666
6
6,666
6
6,666
6
6
Nverage net boo value is the average of the beginning and ending balances for the year in net boo value. P
!mputed interest charge is 16 percent of the ave rage boo value, either net or gross.
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Aotice in the table that residual income, computed on the basis of net boo value, increases over the life of the asset. #his effect is similar to the one demonstrated for /(!. !t is not very meaningful to compute residual income on the basis of gross boo value. Aotice that this asset shows a zero residual income for all five years when the calculation is based on gross boo value.
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?/(I& 13-" %3 &!A$#4) 1.
>urrent /(! of the Aortheast @ivision 4ales revenueSSSSSSSSSSSS SS Iess ;ariable costs %57,66,666 * 269)SS Bi*ed costsSSSSSSSSSSSS.. !ncomeSSSSSSSSSSSSS SSSS..
57,66, 666 5,776, 666 ",16, 7,636, 666 666 5 326,66 6
/(! 8 !ncome T invested capital 8 5326,666 T 51,76,666 8 "69 Aortheast=s /(! if competitor is ac+uired 4ales revenue %57,66,666 C 5,"66,666)SS. Iess ;ariable costs 5,776,666 C %5,"66,666 * 09)H SSSSSSS Bi*ed costs %5",16,666 C 51,026,666)... !ncomeSSSSSSSSSSSSS SSSS...
513,066 ,666 5:,"06, 666 3,7"6, 13,676 666 ,666 5 "6,666
/(! 8 !ncome T invested capital 8 5"6,666 T 51,76,666 C %50",666 C 532,666)H 8 17."9 ".
@ivisional management will liely be against the ac+uisition because /(! will be lowered from "69 to
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17."9. 4ince bonuses are awarded on the basis of /(!, the ac+uisition will result in less compensation. 3.
n e*amination of the competitor=s financial statistics reveals the following 4ales revenueSSSSSSSSSSSS SS.. Iess ;ariable costs %5,"66,666 * 09) SS.. Bi*ed costs SSSSSSSSSSSS.. !ncomeSSSSSSSSSSSSS SSSS...
5,"66, 666 53,376, 666 1,026, ,66, 666 666 5 16,66 6
/(! 8 !ncome T invested capital 8 516,666 T 50",666 8 "9
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?/(I& 13-" %>(A#!A$@) >orporate management would probably favor the ac+uisition. &egatronoics has been earning a 139 return, and the competitor=s /(! of "9 will help the organization as a whole. ven if the 532,666 upgrade is made, the competitor=s /(! would be 19 if past earnings trends continue 516,666 T %50",666 C 532,666) 8 19H. .
Kes, the divisional /(! would increase to "1.619. Eowever, the absence of the upgrade could lead to longrun problems, with customers being confused %and perhaps turned-off) by two different retail environmentsR the retail environment they have come to e*pect with other &egatronics outlets and that of the newly ac+uired, non-upgraded competitor. 4ales revenue %57,66,666 C 5,"66,666)SS. Iess ;ariable costs 5,776,666 C %5,"66,666 * 09)H SSSSSSS Bi*ed costs %5",16,666 C 51,026,666)... !ncomeSSSSSSSSSSSSS SSSS...
513,066 ,666 5:,"06, 666 3,7"6, 13,676 666 ,666 5 "6,666
/(! 8 !ncome T invested capital 8 5"6,666 T %51,76,666 C 50",666) 8 "1.619 .
>urrent residual income of the Aortheast @ivision @ivisional profitSSSSSSSSSSSSSSSSS S Iess !mputed interest charge %51,76,666 * 1"9)SS /esidual
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5326, 666 """, 666 517,
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incomeSSSSSSSSSSSSSSSS S..
666
/esidual income if competitor is ac+uired @ivisional profit %5326,666 C 516,666)SSSSS... Iess !mputed interest charge %51,76,666 C %50",666 C 532,666)) * 1"9H SSSS... /esidual incomeSSSSSSSSSSSSSSS. ..
5"6, 666 3", 666 5127, 666
Kes, management most liely will change its attitude. /esidual income will increase by 536,666 %5127,666 517,666) as a result of the ac+uisition.
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?/(I& 13-3 %36 &!A$#4) 1.
4ales margin income divided by sales revenue. >apital turnover capital
sales revenue divided by invested
/eturn on investmenti income divided by invested capital %or sales margin * capital turnover). 4ales margin 5306,666 T 5,766,666 8 2.9 >apital turnover 5,766,666 T 50,666,666 8 769 /eturn on investment 5306,666 T 50,666,666 8 09, or 2.9 * 769 8 09 ".
4trategy %a) !ncome will be reduced to 5366,666 because of the loss, and invested capital will fall to 5,:6,666 from the disposal. /(! 8 5366,666 T 5,:6,666, or .69. #his strategy should be rejected, since it further hurts
3.
Kes. drastic cutbac in advertising could lead to a loss of customers and a reduced maret share. #his could translate into reduced profits over the long term.
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?/(I& 13-3 %>(A#!A$@) .
nderson &anufacturing /(! %53,666,666 - 5",66,666) T 5,666,666 8 1"9 ?alm each nterprises /(! %5,66,666 - 5,1"6,666) T 5,26,666 8 79 Brom the preceding calculations, both investments appear attractive given the current state of affairs %i.e.,/eliable=s current 09 /(!). Eowever, if
>urrent
!ncomeSSSS 5 SS. 306,66 6 !nvested 0,666, capitalSS 666 /(!SSSSSS 09 SS
>urrent C nderso n 5 :06,666 N 11,666, 666 7.239
>urrent C nderson C ?alm each 5 1,36,666 NN 1,26,6 66 7.19
N 5306,666 C %53,666,666 - 5",66,666) NN 5306,666 C %53,666,666 - 5",66,666) %5,66,666 - 5,1"6,666)
C
?/(I& 13- %3 &!A$#4) 1. #he weighted-average cost of capital %<>>) is defined as follows
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fter - ta*cost &ar1et >ost of &ar1e of debt value e+uity value capital of debt capitalof e+uit &ar1et &ar1et value value of debt of e+uity
#he interest rate on >>I4=s 576 million of debt is : percent, and the company=s ta* rate is 6 percent. #herefore, the afterta* cost of debt is . percent :9 %1 69)H. #he cost of >>I4=s e+uity capital is 1 percent. &oreover, the maret value of the company=s e+uity is 51"6 million. #he following calculation shows that >ape >od Iobster 4hacs= <>> is 16.0 percent.
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%.6)%576 ,666,666) %.1)%51"6 ,666,666) .16 576,666,66 6 51"6,666,6 66
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?/(I& 13- %>(A#!A$@) ".
#he economic value added %;) is defined as follows
conomic value added
!nvestment center' s after - ta* operating income
!nvestment !nvestment
Bor >ape >od Iobster 4hacs, !nc., we have the following calculations of ; for each of the company=s divisions. fter-#a* (peratin g !ncome @ivision ?roperties
Bood 4ervice
#otal ssets %in millions)
>urrent Iiabiliti es %in millions )
5":%1 . 6)
51
53
. 8 5".67 160
51%1 . 6)
5 0
50
. 8 5".72" 160
%in millions)
<> >
conom ic ;alue dded %in millions )
?/(I& 13- %3 &!A$#4) 1.
#he weighted-average cost of capital %<>>) is defined as follows
fter - ta* &ar1et costof value debt of debt capital &ar1et value of debt
>ostof &ar1e e+uity value of capital e+uity &ar1et value of e+uity
#he following calculation shows that ll->anadian=s <>> is :.2" percent.
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%.603)%56 6,666,666) %.1")%5066 ,666,666) .6:2 566,666,6 66 5066,666,6 66
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?/(I& 13- %>(A#!A$@) ".
#he three divisions= economic-value-added measures are calculated as follows #otal sset s %in millio ns)
?acific.
51 %1 .36)
%5 26
50)
?lains..
5 %1 .36)
%536 6
5)
tlantic 57 %1 .36)
%57 6
5:)
@ivisio n
3.
>urren t Iiabilit ies %in million s)
fter-#a* (peratin g !ncome %in millions)
conomic ;alue <> 8 dded > %in millions) . 6:2 "H . 6:2 "H . 6:2 "H
85 3,2:,"6 6 85 ",7"0,66 6 8 5%1",171, "66)
#he ; analysis reveals that ll->anadian=s tlantic @ivision is in trouble. !ts substantial negative ; merits the immediate attention of the management team.
?/(I& 13-0 %6 &!A$#4) 1 .
a.
#ransfer price
8 outlay cost C opportunity cost 8 50 C 51 8 576
b. #ransfer price
8 standard variable cost C %169)%standard variable cost) 8 50 C %169) %50) 8 521.6
Aote that the Brame @ivision manager would refuse to transfer at this price. "
a.
#ransfer
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price 8 50 C 6 8 50 b.
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?/(I& 13-0 %>(A#!A$@) c.
Bi*ed overhead per frame %1"9)%5"6) 8 5" #ransfer price
8 variable cost C fi*ed overhead per frame C %169)%variable cost C fi*ed overhead per frame) 8 50 C 5" C %169)%50 C 5")H 8 5::
d. !ncremental revenue per window..... !ncremental cost per window, for >learview ompany @irect material %Brame @ivision).... @irect labor %Brame @ivision)........ ;ariable overhead %Brame @ivision) @irect material %Glass @ivision)..... @irect labor %Glass @ivision).......... ;ariable overhead %Glass @ivision) #otal variable %incremental) cost...
51 51 "6 36 36 1 36 16
!ncremental contribution per window in special order for >learview ompany.....
5 1
#he special order should be accepted because the incremental revenue e*ceeds the incremental cost, for >learview ompany as a whole. e.
!ncremental revenue per window..... !ncremental cost per window, for the Glass @ivision #ransfer price for frame from re+uirement "%c)H............................ @irect material %Glass @ivision)..... @irect labor %Glass @ivision).......... ;ariable overhead %Glass @ivision) #otal incremental cost.................. !ncremental loss per window in special order for Glass @ivision...........................
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#he Glass @ivision manager has an incentive to reject the special order because the Glass @ivision's reported net income would be reduced by 51: for every window in the order.
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?/(I& 13-0 %>(A#!A$@) f. (ne can raise an ethical issue here to the effect that a division manager should always strive to act in the best interests of the whole company, even if that action seemingly conflicts with the division=s best interests. !n comple* transfer pricing situations, however, it is not always as clear what the company=s optimal action is as it is in this rather simple scenario. 3 .
#he use of a transfer price based on the Brame @ivision's full cost has caused a cost that is a fi*ed cost for the entire company to be viewed as a variable cost in the Glass @ivision. #his distortion of the firm's true cost behavior has resulted in an incentive for a dysfunctional decision by the Glass @ivision manager.
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#he irmingham divisional manager will liely be opposed to the transfer. >urrently, the division is selling all the units it produces at 522 each.
".
lthough #ampa is receiving a 5" Lprice breaM on each unit purchased from irmingham, the 526 transfer price would probably be deemed too high. #he reason #ampa will lose 5"6 on each satellite positioning system produced and sold. 4ales revenueSSSSSSSSSSSS S.. Iess ;ariable manufacturing 50 costsSSS. 26 #ransfer price paid to 2 irminghamS 6 !ncome %loss) SSSSSSSSSSSSSS
51, 66
1, "6 5 %"6)
3.
lthough top management desires to introduce the positioning system, it should not lower the price to mae the transfer attractive to #ampa. >ortez uses a responsibility accounting system, awarding bonuses based on divisional performance. #op management=s interventionJprice-lowering decision would undermine the authority and autonomy of irmingham=s and #ampa=s divisional managers. !deally, the two divisional managers %or their representatives) should negotiate a mutually agreeable price.
.
>ortez would benefit more if it sells the diode reducer e*ternally. (bserve that the transfer price is ignored in this evaluationRone that loos at the firm as a whole. ?ut simply, irmingham would record the transfer price as revenue whereas #ampa would record the transfer price as a cost, thereby creating a LwashM on the part of the overall entity.
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4ales revenueSSSSSS . Iess ;ariable cost 566SSSS SS.. 566 C 5026SSS >ontribution marginSSS..
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?roduce @iodeU 4ell *ternally
?roduce @iodeU #ransferU 4ell ?ositioning 4ystem
522
51,66
66 1,126
5"2
5
� 2002
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?/(I& 13-7 %36 &!A$#4) 1.
!f the transfer price is set e+ual to the $.4. variable manufacturing cost, lpha >ommunications will mae 53".76 per circuit board $.4. operation 4ales revenue %transfer price) SSSSSSSSSSS... Iess ;ariable manufacturing costSSSSSSSSS.. >ontribution marginSSSSSSSSSSSSSSSS. German operation 4ales revenueSSSSSSSSSSSS SS Iess #ransfer priceSSSSSSSSSSS. 4hipping feesSSSSSSSSSSS. dditional processing costsSSSS.. !mport duties %5136.66 * 169)SSSS !ncome before ta*SSSSSSSSSSSS. Iess !ncome ta* e*pense %57".66 * 069)S. !ncome after ta*SSSSSSSSSSSSS
".
5136.6 6 136.6 6 5 --
5306.6 6 5136. 66 "6. 66 11. 66 13. "27.6 66 6 5 7".66 :." 6 5 3".76
!f the transfer price is set e+ual to the $.4. maret price, lpha will mae 53:."6 per circuit board 5".66 C 51."6 8 53:."6. #he $.4. maret price is therefore more attractive as a transfer price than the $.4. variable manufacturing cost. $.4. operation 4ales revenueSSSSSSSSSSSSSSSS
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SSS. Iess ;ariable manufacturing costSSSSSSSSS.. !ncome before ta*SSSSSSSSSSSSSSSSS. Iess !ncome ta* e*pense %56.66 * 69)SSSSSS. !ncome after ta*SSSSSSSSSSSSSSSSSS. German operation 4ales revenueSSSSSSSSSSSS SS Iess #ransfer priceSSSSSSSSSSS. 4hipping feesSSSSSSSSSSS. dditional processing costsSSSS.. !mport duties %5126.66 * 169)SSSS !ncome before ta*SSSSSSSSSSSS. Iess !ncome ta* e*pense %537.66 * 069)S. !ncome after ta*SSSSSSSSSSSSS
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5126. 66 "6. 66 11. 66 12. 3"".6 66 6 5 37.66 "".7 6 5 1."6
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?/(I& 13-7 %>(A#!A$@) 3.
%a) #he head of the German division should be a team playerU however, when the circuit board can be obtained locally for 51, it is difficult to get e*cited about doing business with the $.4. operation. >ourtesy of the shipping fee and import duty, both of which can be avoided, it is advantageous to purchase in Germany. ven if the lower of the two transfer prices is adopted, the German division would be better off to ac+uire the circuit board at home %51 vs. 5136 C 5"6 C 513 8 5103). %b)
Kes. lpha will mae 506.66 per circuit board %5".66 C 530.66) if no transfer taes place and all circuit boards are sold in the $.4. $.4. operation 4ales revenueSSSSSSSSSSSSSSSS SS. Iess ;ariable manufacturing costSSSSSSSS.. !ncome before ta*SSSSSSSSSSSSSSSS.. Iess !ncome ta* e*pense %56.66 * 69)SSSSS.. !ncome after ta*SSSSSSSSSSSSSSSSS. German operation 4ales revenueSSSSSSSSSSSS S.. Iess ?urchase 51 priceSSSSSSSSSS. .66 dditional processing 11 costsSSSS .66 !ncome before ta*SSSSSSSSSSS... Iess !ncome ta* e*pense
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%5:6.66 * 069)S !ncome after ta*SSSSSSSSSSSS... .
66 5 30.66
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mon mong g the the reas reason ons s tran transf sfer er pric prices es based based on tota totall actu actual al costs costs are not appro appropri priate ate as a divisi divisiona onall perfor performan mance ce measure are the following #hey provide little incentive for the selling division to control control manufactu manufacturing ring costs, because because all costs incurred incurred will be passed on to the buying division. •
#hey #hey ofte often n lead lead to subo subopt ptim imal al deci decisi sion ons s for for the the comp compan any y as a whol whole, e, beca becaus use e they they can can obsc obscur ure e cost cost behavior. >osts that are fi*ed for the company company as a whole can be made to appear variable to the division buying the transferred goods. •
".
$sing the maret price as the transfer price, the contribution margin for both the &ining @ivision and the &etals @ivision is calculated as follows &ining @ivision
&etals @ivision
5:6
516
1" 10 "N
0 "6 16† :6 5 "
4elling price......................................... Iess ;ariable costs @irect material.............................. @irect labor............................. labor................................... ...... &anufacturing &anufacturing overhead................ #ransfer price................................ $nit contribution margin....................... ;olume................................................. #otal contribution margin......................
537 *66,666 * 66, 6 6,66 666 6 51,"66, 5:,066, 666 666
N;ariable overhead 8 53" * 29 8 5" †;ariable overhead 8 5" * 69 8 516 McGraw-Hill/Irwin Inc. 13-") 13-")
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Aote Aote the the 5 vari variab able le sell sellin ing g cost cost that that the the &ini &ining ng @ivi @ivisi sion on would ould incu incurr for for sales ales on the the open pen mar aret shou should ld not be included, because this is an internal transfer.
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?/(I& 13-: %>(A#!A$@) 3.
!f ?>/> instituted the use of a negotiated transfer price that also permitted the divisions to buy and sell on the open maret, the price range for toldine that would be acceptable to both divisions would be determined as follows. #he &ining @ivision would lie to sell to the &etals @ivision for the same price is can obtain on the outside maret, 5:6 per unit. Eowever, &ining would be willing to sell the toldine for 57 per unit, because the 5 variable selling cost would be avoided. #he &etals @ivision would lie to continue paying the bargain price of 500 per unit. Eowever, if &ining does not sell to &etals, &etals would be forced to pay 5:6 on the open maret. #herefore, &etals would be satisfied to receive a price concession from &ining e+ual to the costs that &ining would avoid by selling internally. #herefore, a negotiated transfer price for toldine between 57 and 5:6 would be acceptable to both divisions and benefits the company as a whole.
.
General transfer-pricing rule #ransfer price 8 outlay cost C opportunity cost 8 %51" C 510 C 5")N C %537 - 5) ** 8 5" C 533 8 57 N(utlay cost 8 direct material C direct labor C variable overhead see re+uirement %")H NN(pportunity cost 8 forgone contribution margin from outside sale on open maret 8 537 contribution margin from internal sale calculated in re+uirement %"), less the additional 5 variable selling cost incurred for an e*ternal sale #herefore, the general rule yields a minimum acceptable transfer price to the &ining @ivision of 57, which is consistent with the conclusion in re+uirement %3).
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.
negotiated transfer price is probably the most liely to elicit desirable management behavior, because it will do the following ncourage the management of the &ining @ivision to be more conscious of cost control. •
enefit the &etals @ivision by providing toldine at a lower cost than that of its competitors. •
?rovide the basis for a more realistic measure of divisional performance. •
SO%UTIONS TO CASES >4 13-6 %6 &!A$#4) 1 .
!f Aew ge !ndustries continued to use return on investment as the sole measure of division performance, Eoliday ntertainment >orporation %E>) would be reluctant to ac+uire /ecreational Ieasing, !nc. %/I!), because the post-ac+uisition combined /(! would decrease.
(perating income................... #otal assets............................ /eturn on investment %incomeJassets)......................
/eturn on !nvestment E> /I! >ombin ed 5",666, 5 5 666 066,666 ",066,6 66 7,666,6 3,666,6 11,666, 66 66 666 "9 "69 "3.09N
N/ounded. #he result would be that E>'s management would either lose their bonuses or have their bonuses limited to 6 percent of the eligible amounts. #he assumption is that management could provide convincing e*planations for the decline in return on investment. McGraw-Hill/Irwin Inc. Managerial Accounting, 5/e
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/esidual income is the profit earned that e*ceeds an amount charged for funds committed to a business unit. #he amount charged for funds is e+ual to an imputed interest rate multiplied by the business unit's invested capital. !f Aew ge !ndustries could be persuaded to use residual income to measure performance, E> would be more willing to ac+uire /I!, because the residual income of the combined operations would increase.
#otal assets.......................... !ncome.................................
/esidual !ncome E> /I! >ombin ed 57,666, 53,"66,6 511,"66 666 66N ,666 5",666, 5 5 666 066,666 ",066,6 66
Iess !mputed interest charge %assets 19)................... /esidual income....................
1,"66,6 66 5 766,666
76,666 5 1"6,666
1,076,6 66 5 :"6,666
N>ost to ac+uire /I!.
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>4 13-6 %>(A#!A$@) 3 .
a. #he liely effect on the behavior of division managers whose performance is measured by return on investment includes incentives to do the following •
?ut off capital improvements or modernization to avoid capital e*penditures.
•
4hy away from profitable opportunities or investments that would yield more than the company's cost of capital but that could lower /(!.
b. #he liely effect on the behavior of division managers whose performance is measured by residual income includes incentives to do the following •
4ee any opportunity or investment that will increase overall residual income.
•
4ee to reduce the level of assets employed in the business.
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>4 13-1 % &!A$#4) 1. Kes, ir >omfort @ivision should institute the 9 price reduction on its air conditioner units because net income would increase by 513",666. 4upporting calculations follow efore 9 ?rice /eduction
4ales revenue ;ariable costs >ompressor (ther direct material @irect labor ;ariable overhead ;ariable selling #otal variable costs >ontribution margin
?er $ni t 5 66 5 26
fter 9 ?rice /eduction
#otal %in ?er thousand $ni s) t 50,666 53 76 51,66
52 6
#otal %in thousand s)
#otal @ifferenc e %in thousand s)
50,01".6
501".6
51,"17.6
5107.6
03.7
77.7
"".6
2".6
273.6
167.6
32 36 17
6 02 "26
32 36 17
313." 5" 66 5" 66
53,666 53,666
5" 66 51 76
3."
53,76.6
576.6
53,13".6
513".6
4ummarized presentation >ontribution margin of sales increase %5176 ",66) 53",666 Ioss in contribution margin on original volume arising from decrease in selling price %5"6 McGraw-Hill/Irwin Inc. 13-"#
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366,666 !ncrease in net income before ta*es 513",666 ". Ao, the >ompressor @ivision should not sell all 12,66 units to the ir >omfort @ivision for 56 each. !f the >ompressor @ivision does sell all 12,66 units to ir >omfort, >ompressor will only be able to sell 2,066 units to outside customers instead of 0,666 units due to the capacity restrictions. #his would decrease the >ompressor @ivision=s net income before ta*es by 53,66. >ompressor @ivision would be willing to accept any orders from ir >omfort above the 0,666 unit level at 56 per unit because there would be a positive contribution margin of 5"1.6 per unit. 4upporting calculations follow.
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>4 13-1 %>(A#!A$@) (utside ir 4ales >omfort 4ales 4elling price .......................................... 5166 56.66 ;ariable costs @irect material..................................... 1" 516.6 @irect labor ......................................... 7 7.66 ;ariable overhead .......................... 16 16.66 ;ariable selling e*penses .................... 0 R #otal variable costs ............................. 5 30 5"7.6 >ontribution margin ............................... 5 0 5"1.6 >apacity calculation in units #otal capacity ................................................. 4ales to ir >omfort ........................................ alance ....................................................... ?rojected sales to outsiders ............................ Iost sales to outsiders ....................................
2,666 12,66 2,066 0,666 0,66
4olution >ontribution from sales to ir >omfort %5"1.6 532,1 12,66) ........................................................... 66 Ioss in contribution from loss of sales to outsiders 6:,06 %50 0,66) ................................................ 6 @ecrease in net income before ta*es ............... 5 3,66 3. Kes, it would be in the best interests of !nterGlobal !ndustries for the >ompressor @ivision to sell the units to the ir >omfort @ivision at 56 each. #he net advantage to !nterGlobal !ndustries is 531",66 as shown in the following analysis. #he net advantage is the result of the cost savings from purchasing the compressor unit internally and the contribution
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margin lost from the 0,66 units that the >ompressor @ivision otherwise would sell to outside customers.
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>4 13-1 %>(A#!A$@) >ost savings by using compressor unit from >ompressor @ivision >ompressor @ivision (utside purchase price ............................
5 26.66
>ompressor @ivision=s variable cost to produce %see re+. "). ....................................... 4avings per unit...................................... * Aumber of units....................................
"7.6 5 1.6 * 12,66 #otal cost savings ..................... 52"",166 >ompressor @ivision=s loss in contribution from loss of sales to outsiders %see re+. ") 50 0,66 .............................................................. 6:,066 !ncrease in net income before ta*es for !nterGlobal !ndustries ..................................... 531",66 . s the answers to re+uirements %") and %3) show, 56 is not a goal-congruent transfer price. lthough a transfer is in the best interests of !nterGlobal !ndustries as a whole, a transfer of 56 will not be perceived by the >ompressor @ivision=s management as in that division=s best interests.
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>4 13-" %6 &!A$#4) 1. @iagram of scenario
GA/I !A4#/$&A##!(A >(&?AK #op &anagement
E$@4(A K @!;!4!(A Vac+ueline @ucharme
;(IW&/ #>E(&#/ @!;!4!(A ertram &ueller
Iow@ensity ?anels %I?@)
lternative lternative 1 Eigh" @ensity #ransfer uy the the ?anels >ontrol >ontrol %E?@) #>E-3"6 ?ac #achometer !mported
(utside &aret
(utside &aret (utside &aret
" .
Birst, compute the unit contribution margin of an I@? and an E@? as follows
?rice...................................... Iess..................;ariable cost $nsilled labor................. 4illed labor..................... /aw material.................... ?urchased components..... ;ariable overhead............ McGraw-Hill/Irwin Inc. Managerial Accounting, 5/e
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E@? 5 11 5 36 7 1" 1
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#otal variable cost............ $nit contribution margin.........
"" 5 0
26 5
>4 13-" %>(A#!A$@) 4econd, compute the unit contribution margin of ;olmar's #>E-3"6 under each of its alternatives, as follows
?rice................................... Iess ;ariable cost $nsilled labor.............. 4illed labor................. /aw material................ ?urchased components. ;ariable overhead......... ;ariable cost of manufacturing E@? ;ariable cost of transporting E@?................. #otal variable cost........ $nit contribution margin......
#>E-3"6 $sing !mported >ontrol ?ac 5"26.6 6
#>E-3"6 $sing an E@? 5"26. 66
5 .6 1.66 11.6 16.66 11.66 -6-
5 .6 7.66 0.66 .66 11.66 26.66
-6-
.6 ""7.66 5 ".66
170.6 6 5 7.66 @ifference is 5".
Brom the perspective of the entire company, the scarce resource that will limit overall company profit is the limited silled labor time available in the Eudson ay @ivision. #he +uestion, then, is how can the company as a whole best use the limited silled labor time available at Eudson ayX #he division has two products I@? and E@?. (ne can view these as three products, though, in the sense that the E@? units can be produced either for outside sale or for transfer to the ;olmar #achometer @ivision. McGraw-Hill/Irwin Inc. 13-#2
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Eudson ay's Y#hreeY ?roducts E@? for e*ternal sale E@? for transfer I@?
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>4 13-" %>(A#!A$@) E-3"6 when it is manufactured with the E@? instead of the imported control pac. #o summarize
Eudson ay's ?roduct E@? sold e*ternally E@? transferred internally I@?
$nit >ontribution to >overing the >ompany's Bi*ed >ost and ?rofit 5 " 0
#he analysis of these three products' contribution margins %to General !nstrumentation as a whole) has not gone far enough, because the products do not re+uire the same amount of the scarce resource, silled labor time. #he important +uestion is how much one hour of limited silled labor at Eudson ay spent on each of the three products will contribute toward the overall firm's fi*ed cost and profit.
Eudson ay's ?roduct E@? sold e*ternally E@? transferred internally I@? McGraw-Hill/Irwin Inc. 13-#!
$nit >ontributio n &argin 5
4illed Iabor per $nit /e+uired at Eudson ay 1.6
>ontribution &argin per Eour
536
"
1.6
"7
0
."
"
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>4 13-" %>(A#!A$@) #his analysis shows that from the perspective of the entire company, Eudson ay's best use of its limited silled labor resource is to produce E@?s for e*ternal sale, up to the ma*imum demand of 0,666 units per year. #he second best use of Eudson ay's limited silled labor is to produce E@?s for internal transfer, up to the ma*imum number of units needed by the ;olmar #achometer @ivision. #his number is 16,666 E@?s, since that is the demand for ;olmar's #>E-3"6. Eudson ay's least profitable product is the I@?. #herefore, from the perspective of General !nstrumentation as a whole, the Eudson ay @ivision should use its limited silled labor time as follows 4illed labor time available at Eudson ay.. %1 )
?roduce 0,666 E@?s for e*ternal sale %0,666 units
1. hours)..........................
Eours remaining........................................ %" )
:,666 hour s 31,666 hour s
?roduce 16,666 E@?s for internal transfer %16,666 units
1. hours)........................
Eours remaining........................................ %3 )
6,666 hour s
?roduce 0,666 I@?s %0,666 units ." hours)........................................................ Eours remaining........................................
1,666 hour s 10,666 hour s 10,666 hour s -6-
#he final answer to re+uirement %") is that all of the re+uired 16,666 #>E-3"6 tachometers should be manufactured using the E@? unit from the Eudson ay @ivision. 3 .
Given that 16,666 E@?s are transferred, there is no effect on General !nstrumentation >ompany's overall income. #he transfer price affects only the way the company's overall profit is divided between the two divisions.
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.
Eudson ay's minimum acceptable transfer price is given by the general transfer-pricing rule, as follows
&inimum acceptable transfer price
additional opportunit outlay y cost to 8 C costs the incurred organizatio because n because goods are of the transferred transfer 8 526 C 530 8 5160
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>4 13-" %>(A#!A$@) *planatory notes %a) #he outlay cost is e+ual to the variable cost of manufacturing an E@?. %b )
.
#he opportunity cost is e+ual to the forgone contribution margins on the I@? units that Eudson ay will be unable to produce because it is manufacturing an E@? for transfer. !n the 1. hours of silled labor time re+uired to produce an E@? for transfer, Eudson ay could manufacture si* I@?s, since each I@? re+uires only ." hours. #hus, the forgone contribution margin is 530 %0 units 50 unit contribution margin).
#he ma*imum transfer price that the ;olmar #achometer @ivision would find acceptable is 511", computed as follows 4avings if #>E-3"6 is produced using an E@? !mported control pac.................................... (ther raw material......................................... #otal savings................................................. Iess !ncremental costs if #>E-3"6 is produced using an E@? #ransportation cost........................................ 4illed labor................................................... Aet savings if E@? is used.................................
51.66 .6 516.6 %.6) %3.66) 511".66
!f ;olmar's management must pay 511" for an E@?, it will be indifferent between using the E@? and the imported control pac. !f the transfer price is lower than 511", the ;olmar #achometer @ivision will be better off with the E@?. t a transfer price in e*cess of 511", ;olmar's management will prefer the control pac. 0 .
#he transfer is in the overall company's best interest. #hus, any transfer price in the interior of the range 5160 to 511" will provide the proper incentives to the management of each division to agree to a transfer. Bor e*ample, a transfer price of 516: would split the range evenly, and mae each
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division better off by maing the transfer.
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CURRENT ISSUES IN +ANA,ERIA% ACCOUNTIN, !44$ 13-3 L(A(&K E,Y FORTUNE, &K 1, "666, 4#</# I4(?. &oney invested in /Z@ is tied up for the long term and cannot be turned over many times generating more profit in the short-run. (s to add value to their companies, short-term investments loo better on the balance sheet in the short-run.
!44$ 13- L#Z#  AIK4#4, ((4#4 G(I4 B(/ /;A$, $# 4#(>W @(4A'# /4?(A@,Y THE WALL STREET JOURNAL , @>&/ 2, 1:::, />> I$&A4#!A A@ A!>(I E//!4. #Z# intends to provide local phone service nationwide. #he company will serve customers it cannot reach through its cable holdings or cable joint ventures.
!44$ 13- LE/;/@ $A!;/4!#K -- 4(/(4 4$!# /!AG4 /$44!A AW/$?#>K B!GE# #( $.4. >($/#,Y THE WALL STREET JOURNAL, A(;&/ "3, 1:::, 4#; I!4&A. #yumen (il allegedly used transfer-pricing methods to divert oil revenue from the subsidiaries. #he investors say oil was sold cheaply to buyers related to #yumen (il, which then sold the crude at world prices but failed to revert the profits to the 4idanco units.
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!44$ 13-0 L>((?/#!(A (/ >(&?#!#!(A,Y B/$/K "666, @A E!II.
STRATE!"
F!NAN"E ,
#hree core principles 1. Bocus a. mployee rewards based on overall company results b. mployee rewards not based on local merits ".
&otivation that is fair a.
ll employees share in the company's wealth
creation b.
&eaningful rewards for superior company
performance 3.
bility to succeed a.
>omprehensive information feedbac loop
b. !nformation for improvement, not measurement c. /esult is cooperation and unlocing of resources
!44$ 13-2 LD>$#!; ?K,Y #US!NESS WEE$ , ?/!I "1, 1::2, VAA!B/ /!AG(I@. 1. &anagement performance can be lined to financial and nonfinancial measures. Binancial factors, such as earnings-per-share %?4), profit, return on assets %/() and return on sales %/(4), could be used to assess management performance. >ompensation pacages could then be based on items other than share price.
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