chapter 14 - answer

MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 14

RESPONSIBILITY ACCOUNTING AND TRANSFER PRICING

I. Questions

1. Cost centers are evaluated by means of performance reports. Profit centers are evaluated by means of contribution income statements (including cost center performance reports), in terms of meeting sales and cost objectives. Investment centers are evaluated by means of the rate of return which they are able to generate on invested assets.

2. Overall profitability can be improved (1) by increasing sales, (2) by reducing expenses, or (3) by reducing assets.

3. ROI may lead to dysfunctional decisions in that divisional managers may reject otherwise profitable investment opportunities simply because they would reduce the division’s overall ROI figure. The residual income approach overcomes this problem by establishing a minimum rate of return which the company wants to earn on its operating assets, thereby motivating the manager to accept all investment opportunities promising a return in excess of this minimum figure.

4. A cost center manager has control over cost, but not revenue or investment funds. A profit center manager, by contrast, has control over both cost and revenue. An investment center manager has control over cost and revenue and investment funds.

5. The term transfer price means the price charged for a transfer of goods or services between units of the same organization, such as two departments or divisions. Transfer prices are needed for performance evaluation purposes.

6. The use of market price for transfer purposes will create the actual conditions under which the transferring and receiving units would be operating if they were completely separate, autonomous companies. It is generally felt that the creation of such conditions provides managerial incentive, and leads to greater overall efficiency in operations.

7. Negotiated transfer prices should be used (1) when the volume involved is large enough to justify quantity discounts, (2) when selling and/or

14-1

Chapter 14 Responsibility Accounting and Transfer Pricing

administrative expenses are less on intracompany sales, (3) when idle 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.

Department 1 2 4 Total

Revenue P132,000 P168,000 P98,000 P398,000Direct cost of department 82,000 108,000 61,000 251,000Contribution of the

department P 50,000 P 60,000 P37,000 P147,000Allocated cost 121,000Net income P 26,000

With the discontinuance of Department 3, the revenue and direct cost of the department are eliminated, but there is no reduction in the total allocated cost.

Exercise 2 (Evaluation of an Investment Center)

14-2

Responsibility Accounting and Transfer Pricing Chapter 14

Requirement 1

ROI RIOperating assets P400,000 P400,000Operating income P100,000 P100,000ROI (P100,000 P400,000) 25%Minimum required income (16% x P400,000) P64,000RI (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:

Present New Project OverallOperating assets P400,000 P60,000 P460,000Operating income P100,000 P12,000* P112,000ROI 25% 20% 24.35%

* P60,000 x 20% = P12,000

Under the RI approach, on the other hand, the manager would accept this project since the new project provides a higher return than the minimum required rate of return (20 percent vs. 16 percent). The new project would increase the overall divisional residual income, as shown below:

Present New Project OverallOperating assets P400,000 P60,000 P460,000Operating income P100,000 P12,000 P112,000Minimum required

return at 16% 64,000 9,600* 73,600RI P 36,000 P 2,400 P 38,400

* P60,000 x 16% = P9,600

Exercise 3 (ROI, Comparison of Three Divisions)

Requirement 1

14-3


Division X Division Y Division ZROI: P10,000

P40,000P12,600P70,000

P 28,800P180,000

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

Division A :

Division B :

Requirement 2

Division A Division BAverage operating assets (a)......... P3,000,000 P10,000,000Net operating income................... P 630,000 P 1,800,000Minimum required return on average

operating assets - 16% x (a)..... 480,000 1,600,000Residual income.......................... P 150,000 P 200,000

Requirement 3

14-4

= 25% = 18% = 16%

Net Operating incomeSales

Sales Average Operating Assets

X = ROI

P630,000P9,000,000 X

P9,000,000P3,000,000

= ROI

7% X 3 = 21%

P1,800,000P20,000,000

P20,000,000P10,000,000 = ROI X

9% X 2 = 18%


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.

Exercise 5 (Evaluation of a Cost Center)

(1) Controllable Costs by supervisor of Department 10 are as follows:a. Supplies, Department 10b. Repairs and Maintenance, Department 10c. Labor Cost, Department 10

(2) Direct Costs of Department 10 area. Salary, supervisor of Department 10b. Supplies, Department 10c. Repairs and Maintenance, Department 10d. Labor Cost, Department 10

(3) Costs allocated to Factory Department are:a. Factory, heat and lightb. Depreciation, factoryc. Factory insuranced. Salary of factory superintendent

(4) Costs which do not pertain to factory operations are:a. Sales salaries and commissionsb. General office salaries

Exercise 6 (Evaluating New Investments Using Return on Investment (ROI) and Residual Income)

Requirement 1

14-5


Computation of ROI

Division A:

Division B:

Division C:

Requirement 2

Division A Division B Division CAverage operating assets P1,500,000 P5,000,000 P2,000,000 Required rate of return × 15% × 18% × 12% Required operating income P 225,000 P 900,000 P 240,000 Actual operating income P 300,000 P 900,000 P 180,000 Required operating income (above)

225,000 900,000 240,000 Residual income P 75,000 P 0 P (60,000)

Requirement 3

a. and b. Division A Division B Division CReturn on investment (ROI) 20% 18% 9%Therefore, if the division is

presented with an investment opportunity yielding 17%, it probably would Reject Reject Accept

Minimum required return for computing residual income 15% 18% 12%

Therefore, if the division is presented with an investment opportunity yielding 17%, it

Accept Reject Accept

14-6

ROI = P300,000P6,000,000 x P6,000,000

P1,500,000 = 5% x 4 = 20%

ROI = P900,000P10,000,000 x P10,000,000

P5,000,000 = 9% x 2 = 18%

ROI = P180,000P8,000,000 x P8,000,000

P2,000,000 = 2.25% x 4 = 9%


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 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 1Division A Division B Total Company

Sales P3,500,000 1 P2,400,000 2 P5,200,000 3

Less expenses:Added by the division 2,600,000 1,200,000 3,800,000Transfer price paid — 700,000 —

Total expenses 2,600,000 1,900,000 3,800,000 Net operating income P 900,000 P 500,000 P1,400,000

1 20,000 units × P175 per unit = P3,500,000.2 4,000 units × P600 per unit = P2,400,000.3 Division A outside sales (16,000 units × P175 per unit)...................................................P2,800,000

Division B outside sales (4,000 units × P600 per unit)..................................................... 2,400,000 Total outside sales...........................................................................................................P5,200,000

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

14-7


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:

.There is no idle capacity, so each of the 20,000 units transferred from Division X to Division Y reduces sales to outsiders by one unit. The contribution margin per unit on outside sales is P20 (= P50 – P30).

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.

14-8

Transfer price P20 +P0

20,000 =P20

Transfer price

+

Total contribution margin on lost sales

Number of units transferredVariable cost

per unit

Transfer price (P30 – P2) +P20 x 20,000

20,000

Transfer price = P28 + P20 = P48


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:

Purchase costs from outside 10,000 x P150 = P1,500,000Less: Savings of Divisions B’s variable costs 10,000 x P140 = 1,400,000Net 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 10,000 x P150 = P1,500,000Less: Savings in variable costs 10,000 x P140 = 1,400,000Less: Savings of B material assignment 200,000Net Cost (Benefit) for A to buy outside P (100,000)

The additional savings in Division B means that now Division A should buy outside.

Requirement 3

14-9


Assuming the outside price drops from P150 to P130:

Purchase costs from outside 10,000 x P130 = P1,300,000Less: Savings in variable costs 10,000 x P140 = 1,400,000Net Cost (Benefit) for A to buy outside P (100,000)

Division A should buy outside.

III. Problems

Problem 1 (Evaluation of Profit Centers)

Requirement (a)

Jadlow Manufacturing CorporationIncome Statement

For the Year Ended December 31, 2005

Total Product S Product TSales P5,100,000 P2,700,000 P2,400,000Less: Variable Costs 3,330,000 1,890,000 1,440,000Contribution Margin P1,770,000 P 810,000 P 960,000Less: Controllable fixed

expenses 501,000 66,000 435,000Contribution to the recovery

of non-controllable fixed expenses P1,269,000 P 744,000 P 525,000

Requirement (b)

The complaint of the manager of Product T is justified on the ground that his product line shows a positive contribution margin and therefore, 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)

14-10


Requirement 1Product

A B CIncremental sales P71,000 P46,000 P117,000Less: Incremental costs 42,000 15,000 96,000

Net income P29,000 P31,000 P 21,000

Product B seems to offer the best profit potential.

Requirement 2

The sunk costs are:Depreciation of equipment P 6,400Operating cost of the equipment 4,600

Total P11,000

Requirement 3

Opportunity cost of selling Product B isFrom Product A P29,000From Product C 21,000

Total P50,000

Problem 3 (Evaluation of Performance)

Ranjie Tool CompanyPerformance ReportFor the Year 2005

Budgeted Labor Hours 4,000Actual Labor Hours 4,200

Cost-Volume Formula

Actual 4,200 Hours

Budget Based on

4,200 Hours

Variance U (F)

Variable Overhead Costs:Utilities P0.80 per hour P 3,600 P 3,360 P240Supplies 1.80 7,400 7,560 (160)Indirect labor 1.20 5,300 5,040 260

Total P3.80 P16,300 P15,960 P340Fixed Overhead Costs:

Utilities P 1,600 P 1,600 -Supplies 2,200 2,200 -

14-11


Depreciation 6,000 6,000 -Indirect labor 5,400 5,400 -Insurance 1,200 1,200 -

Total P16,400 P16,400 - Total Factory Overhead Costs P32,700 P32,360 P340

Problem 4 (Evaluation of Performance)

Requirement 1

Performance Report for the Production Manager

Actual Cost

Flexible Budget Cost

Variance (U) or (F)

Controllable costs:Direct material P24,000 P20,000 P4,000 (U)Direct labor 48,000 50,000 2,000 (F)Supplies 4,000 6,000 2,000 (F)Maintenance 3,000 4,000 1,000 (F)

Total P79,000 P80,000 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

Flexible Budget Cost

Variance (U) or (F)

Controllable costs: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)

14-12


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 / Investment20% = X / P800,000

Target Operating Income = P160,000

Target revenues, calculated as follows:

Fixed overhead P200,000Variable costs 1,500,000 x P300 450,000Desired operating income 160,000Revenues P810,000

The selling price per units is P540 = P810,000 / 1,500

Requirement 2

Data are in thousands.

Units 1,500 2,000 1,000Revenues P810 P1,080 P540

Variable costs 450 600 300Fixed costs 200 200 200Total costs 650 800 500

Operating income P160 P280 P 40

14-13


Return on investment 20% 35% 5%= P160 / P800 = P280 / P800 = P40 / P800

Note how the change in income follows the change in revenues, as predicted by operating leverage. Operating leverage multiplied times the percentage 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 incomeIf volume goes to 2,000 units: (P280 – P160) / P160 = 75%If volume goes to 1,000 units: (P160 – P40) / P160 = 75%

% change in ROIIf 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:

Pasig:

14-14

ROI =Net operating income

Sales xSales

Average operating assets

P630,000P9,000,000 x

P9,000,000P3,000,000 = 7% x 3 = 21%

P1,800,000P20,000,000 x

P20,000,000P10,000,000 = 9% x 2 = 18%


Quezon:

Requirement 2

Pasig QuezonAverage operating assets (a) P3,000,000 P10,000,000Net operating income P 630,000 P 1,800,000Minimum required return on average

operating assets—16% × (a) 480,000 P 1,600,000Residual income P 150,000 P 200,000

Requirement 3

No, the Quezon Division is simply larger than the Pasig Division and for this reason one would expect that it would have a greater amount of residual income. Residual income can’t be used to compare the performance of divisions of different sizes. Larger divisions will almost always look better, not necessarily because of better management but because of the larger peso figures involved. In fact, in the case above, Quezon does not appear to be as well managed as Pasig. Note from Part (1) that Quezon has only an 18% ROI as compared to 21% for Pasig.

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:

14-15

Transfer price

+



per unit

Transfer price P16 +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:


Requirement 2

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:

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:

14-16

Transfer price

+



per unit

Transfer price P16 +(P30 – P16) x 10,000

10,000

= P16 + P14 = P30

Transfer price

+



per unit

Transfer price (P16 – P3) +(P30 – P16) x 10,000

10,000

= P13 + P14 = P27


In this case, the transfer price must fall within the range:


Problem 8 (Transfer Pricing)

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:

IV. Multiple Choice Questions

1. C 11. E 21. C 31. B2. D 12. D 22. B 32. D3. A 13. C 23. A 33. D4. A 14. C 24. D 34. D5. C 15. B 25. B 35. C6. A 16. C 26. A 36. D7. D 17. B 27. A 37. B8. A 18. A 28. B 38. D9. C 19. B 29. D 39. B10. A 20. A 30. A 40. D

14-17

Transfer price

+



per unit

Transfer price P20 +(P30 – P16) x 30,000

20,000

= P20 + P21 = P41

chapter 14 - answer

Documents