CHAPTER 10

PAGE

CHAPTER 10

DECENTRALIZATION:

RESPONSIBILITY ACCOUNTING, PERFORMANCE EVALUATION, AND TRANSFER PRICING

QUESTIONS FOR WRITING AND DISCUSSION

1.Decentralization is the delegation of decision-making authority to lower levels. In centralized decision making, decisions are made at the very top level, and lower-level managers are responsible for implementing these decisions. For decentralized decision making, decisions are made and implemented by lower-level managers.

2.Reasons for decentralization include the following: access to local information, more timely response, focusing of central management, exposure of segments to market forces, enhanced competition, training, and motivation.

3.Knowledge of local conditions may be critical for decisions; local managers are aware of these conditions, whereas higher-level managers may not be. This can lead to more informative decision making.

4.Margin = Net income/Sales, and Turnover = Sales/Average operating assets. By breaking ROI into margin and turnover, more insight into why ROI may change from one period to the next is possible.

5.Three advantages of ROI include: (1) ROI encourages managers to pay attention to the relationships among sales, expenses, and investment. (2) ROI encourages cost efficiency. (3) ROI discourages excessive investment in operating assets. Increased profitability can be achieved (all other things being equal) by increasing revenues, decreasing expenses, or lowering investment.

6.Two disadvantages of ROI are: (1) ROI may discourage managers from investing in proj-ects that would increase the profitability of the firm but decrease the divisions ROI. (2) It also may encourage managers to focus on short-run profitability and to take actions that may harm long-run profitability.

7.Residual income is the difference between net income and the minimum dollar return required on an investment. Residual income encourages investment in all projects that earn at least the minimum rate of return.

8.EVA is economic value added. It is the difference between after-tax income and the cost of the capital employed. EVA is an absolute dollar amount, not a percentage rate of return like ROI. EVA differs from residual income in EVAs use of after-tax income and the true cost of capital (rather than a hurdle rate).

9.A stock option is the right to purchase a certain amount of stock at a fixed price. It can encourage goal congruence by giving managers an ownership stake in the firm, encouraging them to view operations from a long-run perspective.

10.A transfer price is the price charged for goods that are transferred from one division to another division of the same company.

11.The transfer pricing problem is finding a transfer price that simultaneously satisfies three objectives: accurate performance evaluation, goal congruence, and preservation of divisional autonomy.

12.Agree. Because at least one division will be made better off and firm profits will increase.

13.If a perfectly competitive outside market exists, the transfer price should be market price. Minimum price = maximum price = market price. Any other price would make at least one division worse off, and firm profits may decrease if the price is not market price.

14.Full cost, full cost plus, variable cost plus. The major disadvantage is that cost-based transfer prices may not reflect the optimal outcome for the divisions and the firm. Specifically, it is possible for the transfer price, using one of the costing approaches, to be less than the minimum price or greater than the maximum price. The prices, however, are simple to use and, in some cases, may reflect the outcome of a negotiated agreement.

15.Internal Revenue Code Section 482 outlines the transfer pricing methods acceptable for

income tax purposes. The four acceptable methods are the comparable uncontrolled price method, the resale price method, the cost-plus method, and any method jointly acceptable to the IRS and the company.

EXERCISES

101

1.Sporting Goods Division ROI:

Year 1: $2,800,000/$20,000,000 = 14%

Year 2: $3,000,000/$20,000,000 = 15%

Sporting Goods Division Margin:

Year 1: $2,800,000/$70,000,000 = 4.0%

Year 2: $3,000,000/$75,000,000 = 4.0%

Sporting Goods Division Turnover:

Year 1: Turnover: $70,000,000/$20,000,000 = 3.5

Year 2: Turnover: $75,000,000/$20,000,000 = 3.75

2.Camping Division ROI:

Year 1: $1,200,000/$10,000,000 = 12%

Year 2: $1,000,000/$10,000,000 = 10%

Camping Division Margin:

Year 1: $1,200,000/$24,000,000 = 5.0%

Year 2: $1,000,000/$25,000,000 = 4.0%

Camping Division Turnover:

Year 1: Turnover: $24,000,000/$10,000,000 = 2.4

Year 2: Turnover: $25,000,000/$10,000,000 = 2.5

3.ROI for the Sporting Goods Division increased from 14% to 15%. This increase is due entirely to the increase in turnover from 3.5 to 3.75. (Margin for this division stayed the same from Year 1 to Year 2.) The Camping Division, on the other hand, experienced a drop in ROI from 12% to 10%. Margin in this division decreased from 5% to 4%, and the small increase in turnover (from 2.4 to 2.5) was not enough to overcome the margin decline.

102

1.Ever-Tent ROI= $55,000/$500,000

= 11.0%

KiddieKamp ROI = $38,000/$400,000

= 9.5%

2.

Add Only

Add Only

Add Both

Maintain

Ever-Tent

KiddieKamp

Projects

Status Quo

Operating income

$ 1,055,000$ 1,038,000$ 1,093,000$ 1,000,000

Operating assets

10,500,00010,400,00010,900,00010,000,000

ROI

10.05%9.98%10.03%10%

The manager will invest only in the Ever-Tent since that alternative has the highest ROI.

103

1.Ever-Tent residual income= $55,000 (0.09 $500,000)

= $10,000

KiddieKamp residual income= $38,000 (0.09 $400,000)

= $2,000

2.

Add Only

Add Only

Add Both

Maintain

Ever-Tent

KiddieKamp

Projects

Status Quo

Operating income

$1,055,000$1,038,000$1,093,000$1,000,000

Minimum income*

945,000 936,000 981,000 900,000Residual income

$ 110,000$ 102,000$ 112,000$ 100,000*Minimum income = Operating assets Minimum required rate of return.

The manager will invest in both the Ever-Tent and the KiddieKamp because residual income is positive for each, and the overall residual income is highest when both projects are accepted.

3.If the company had retained the $900,000 and invested it at 9%, the income would have been $81,000 ($900,000 0.09). However, the investment of the $900,000 in the two projects suggested by the Camping Division yields total incremental operating income of $93,000 ($55,000 + $38,000). This is a gain of $12,000 before taxes. Yes, the correct decision was made.

104

1.

After-Tax

Weighted

Percent

Cost

Cost

Common stock

0.500.1800.0900

10-year bonds

0.500.039*0.0195Weighted average cost of capital

0.1095*0.039 = 0.06 (0.06 0.35).

EVA = $210,000 (0.1095 $2,000,000) = ($9,000)

2.Year 1:

After-Tax

Weighted

Percent

Cost

Cost

Common stock

0.500.1500.0750

10-year bonds

0.500.0390.0195Weighted average cost of capital

0.0945EVA = $210,000 (0.0945 $2,000,000) = $21,000

Year 2:

After-Tax

Weighted

Percent

Cost

Cost

Common stock

0.500.1200.0600

10-year bonds

0.500.0390.0195Weighted average cost of capital

0.0795EVA = $210,000 (0.0795 $2,000,000) = $51,000

3.

After-Tax

Weighted

Percent

Cost

Cost

Common stock

0.800.1800.1440

10-year bonds

0.200.0390.0078Weighted average cost of capital

0.1518EVA = $750,000 (0.1518 $5,000,000) = ($9,000)

Year 1 (9% premium):

After-Tax

Weighted

Percent

Cost

Cost

Common stock

0.800.1500.1200

10-year bonds

0.200.0390.0078Weighted average cost of capital

0.1278EVA = $750,000 (0.1278 $5,000,000) = $111,000104Concluded

Year 2 (6% premium):

After-Tax

Weighted

Percent

Cost

Cost

Common stock

0.800.1200.0960

10-year bonds

0.200.0390.0078Weighted average cost of capital

0.1038EVA = $750,000 (0.1038 $5,000,000) = $231,000105

1.Whirlmore, Inc.

Income Statement (in thousands)

For the Year 20XX

Home-SupremeApartmentInternational

Total

Sales

$2,700$2,400$1,300$6,400

COGS

1,770

1,870

1,040

4,680

Gross profit

$930$530$260$1,720

Selling and admin. expense

640

180

100

920

Division profit

$290$350$160$800Income taxes (30%)

87

105

48

240

After-tax income

$203$245$112$5602.

After-Tax

Weighted

Percent

Cost

Cost

Common stock

0.800.1100.0880

Bonds

0.200.056*0.0112Weighted average cost of capital

0.0992*0.08(1 0.3) = 0.056.

3.

Home-SupremeApartmentInternational

Total

After-tax income

$203,000$245,000$112,000$560,000

Less cost of capital:

(0.0992 $2,100,000)

208,320

(0.0992 $500,000)

49,600

(0.0992 $400,000)

39,680 297,600EVA

$ (5,320)$195,400$ 72,320$262,400105Concluded

4.While EVA is positive for Whirlmore, Inc., as a whole, it is negative for the Home-Supreme Division. Therefore, even though the Home-Supreme Division has positive net income, it needs to increase net income or reduce the capital used to generate positive economic value added.

106

1.Maximum price

$ 2.80

Minimum price

1.15Difference

$ 1.65 The number of cases

100,000

Increased profit

$165,000Since the Glassware Division has idle capacity, the minimum price is the variable cost of $1.15 for the excess capacity. (The avoidable selling costs of $0.10 should not affect the minimum transfer price for the excess capacity because the Glassware Division will be worse off if the transfer price does not cover its variable manufacturing costs). Yes, the transfer should take place.

2.Eric might negotiate for a lower price. Jill would consider the $2.40 price, as her income would increase $125,000 [($2.40 $1.15) 100,000].

3.Full manufacturing cost is $1.85 ($1.15 + $0.70), so $1.85 would be the transfer price. The transfer could take place since $1.85 is between the minimum and maximum prices of the negotiating set.

107

1.The comparable uncontrolled price method should be used because a market price exists.

2.Market price

$25.00

Plus shipping, duties

2.75

Less marketing costs

(2.80)

Transfer price

$24.95108

1.The comparable uncontrolled price method should be used because a market price exists.

Market price

$0.95

Plus shipping, duties

0.05

Less marketing costs

( 0.06)

Transfer price

$0.942.The cost-plus method should be used because a market price does not exist, and the U.S. division is not going to resell the paint.

Manufacturing cost

$0.83

Plus shipping, duties

0.05

Transfer price

$0.88109

1.The resale price method should be used because a market price does not exist and the paint will be resold and not used in further manufacturing.

2.

Resale price= Transfer price +(0.50 Transfer price)

$18= 1.50 Transfer price

Transfer price= $18/1.50 = $12

1010

1.Pacific-Rim: $126,000 (0.12 $900,000) = $18,000

European: $1,350,000 (0.12 $9,000,000) = $270,000

Residual income is an absolute dollar measure, so it does not adjust for the relative sizes of the divisions.

2.Pacific-Rim: $18,000/$900,000 = 2%

European: $270,000/$9,000,000 = 3%

It is now possible to say the European Division is relatively more profitable than the Pacific-Rim Division.

3.Pacific-Rim: $126,000/$900,000 = 14%

European: $1,350,000/$9,000,000 = 15%

ROI can be used to compare relative divisional profitability.

1010Concluded

4.Pacific-Rim: 2% + 12% = 14%

European: 3% + 12% = 15%

The residual rate of return and the required rate of return will always sum to the ROI.

1011

1.

A

B

C

D

Revenue

$10,000$48,000$96,000$19,200*

Expenses

$8,000$36,000*$90,000$18,000*

Net Income

$2,000$12,000$6,000*$1,200*

Assets

$40,000$96,000*$48,000$9,600

Margin

20%*25%6.25%*6.25%

Turnover

0.25*0.502*2

ROI

5%*12.5%*12.5%*12.5%*

*Indicates calculated amounts.

2. As residual income = $2,000 (0.09 $40,000) = ($1,600)

Bs residual income = $12,000 (0.09 $96,000) = $3,360

Cs residual income = $6,000 (0.09 $48,000) = $1,680

Ds residual income = $1,200 (0.09 $9,600) = $336

1012

1.Net income = $1,000,000 $600,000 $100,000 = $300,000

Residual income = $300,000 (0.15)($1,500,000) = $75,000

2.ROI = $300,000/$1,500,000 = 0.20, or 20%

1013

If Casey accepts the new position, she will earn $56,000 (salary of $40,000 and bonus of $16,000) in Year 1. After two years, if Littons stock rises at the same rate as it has over the past five years, she will be able to exercise her stock option and realize a gain of the following:

Price of stock in two years ($12 1.15 1.15 10,000)

$158,700

Exercise price of stock

120,000

Gain

$ 38,700Casey will clearly be better off financially right away. Her salary plus bonus with Litton is $1,000 higher than her current salary. In addition, if the increase in net income for the Financial Services Division can be sustained, she stands to make considerably more through bonuses in the coming years. The stock option, exercisable in two years, also gives Casey the potential to make another $38,700.

On the down side, Caseys current salary is reasonably secure. The Litton position has a lower guaranteed salary and the risk of bonuses and option values which may not be realized. If the financial services industry experiences a downturn, Casey will suffer no matter how well she personally performs.

The final decision rests on Caseys assessment of the risk versus reward of the two positions. She should also consider the risk of remaining in her present position; that is, what are her prospects for making partner at the public accounting firm?

PROBLEMS

1014

1.Since the Transistor Division can sell all its transistors to the outside competitive market, the minimum transfer price is $3.40. The Systems Division can buy its transistors from the outside market at $3.40, so the maximum transfer price is $3.40.

2.Yes, since the minimum transfer price for the idle capacity is $1.90 ($2.65 less the $0.75 of allocated fixed overhead). The Division is better off if the transfer price is greater than $1.90 for the excess capacity.

3.The negotiated price of $11.00 provides profit for both the Board Division and the Systems Division. The Board Division realizes a profit of $1.85 per board ($11.00 $9.15). The Systems Division realizes a reduction in cost of $1.25 per board ($12.25 $11.00).

It should be noted that the $12.25 is not a true market price because this particular board is not sold externally. Thus, the Board Division is not necessarily foregoing profit by not selling externally at its regular markup.

1015

1.Reigis Steel Company

Unit Contribution Margin

(in thousands except for unit contribution margin)

For the Year Ended November 30, 2010Sales

$25,000

Less variable costs:

Cost of goods sold

$16,500

Selling expenses ($2,700 40%)

1,080 17,580Contribution margin

$ 7,420Unit contribution margin= $7,420/1,484 units

= $5.00 per unit2.a.ROI= Income before taxes/Average operating assets*

= $1,845,000/$15,375,000

= 12%

*Average operating assets= ($15,750,000 + 15,000,000)/2

= $15,375,000

Where November 30, 2009 operating assets = $15,750,000/1.05

1015Concluded

b.Residual income= $1,845,000 (0.11 $15,375,000)

= $1,845,000 $1,691,250

= $153,7503.The management of Reigis Steel would have been more likely to accept the contemplated capital acquisition if residual income were used as the performance measure because the investment would have increased both the divisions residual income and the management bonuses. Using residual income, management would accept all investments with a return higher than 11% as these investments would all increase the dollar value of residual income. When using ROI as a performance measure, Reigiss management is likely to reject any investment that would lower the overall ROI (12% in 2009), even though the return is higher than the required minimum, as this would lower bonuses.

4.Reigis must be able to control all items related to profits and investment if it is to be evaluated fairly as an investment center using either ROI or residual income as performance measures. Reigis must control all elements of the business except the cost of invested capital, that being controlled by Raddington Industries.

1016

1.Part 4CMModel 7ACCompanySales

$70,000*$550,000$620,000

Variable expenses

50,000 460,000 510,000

Contribution margin

$20,000$ 90,000$110,000*While all 10,000 units could be sold externally, currently none are.

2.The transfer price should be the market price of $12. This is the minimum price for the Components Division and the maximum price for the Small AC Division.

3.Unless the manager of the Small AC Division is able to increase the price of Model 7AC, he will discontinue production and will not purchase any of the component. (The cost of producing the window unit will increase from $52 to $57, a cost greater than the current selling price.)

4.All 10,000 units of Part 4CM will be sold externally at the market price of $12 per unit.

1016 Concluded

5.Sales

$120,000

Variable expenses

50,000

Contribution margin

$ 70,000

The contribution to profits increases by $20,000. The CEO made the correct decision.

1017

1.Raymond should not reduce the price charged to Brandi if he can sell all he produces at a price of $4.50 per pound. Brandi should buy externally, saving the company $50,000 (100,000 $0.50). The $50,000 savings belongs to the Donut Shop Division. There will be no effect on the Coffee Division.

2.Coffee Division:

Current profit:

950,000 ($4.50 $3.50) = $950,000

Profit with no internal transfers:

850,000 ($4.50 $3.50) = $850,000

Change in profit = $950,000 $850,000 = ($100,000)

Donut Shop Division:

Increase in profit:

($4.50 $4.00) 100,000 = $50,000

Effect on firm: ($100,000) + $50,000 = ($50,000)

3.Using the no transfer scenario as the point of reference, the minimum transfer price for the Coffee Division can be computed as follows (if internal transfer occurs, there will be 850,000 pounds sold externally and 100,000 sold internally):

Let P = Minimum transfer price

[850,000 ($4.50 $3.50)] + [100,000 (P $3.50)]= $850,000

$850,000 + 100,000P $350,000= $850,000

100,000P= $350,000

P= $3.50

The maximum transfer price is $3.50, the price that would be paid if no transfer occurs internally.

1017Concluded

For a transfer price of $3.50, the effect for each division and the firm is as follows:

Coffee Division:($3.50 $3.50)100,000 + ($4.50 $3.50)850,000 = $850,000

Change in profit: $850,000 $950,000 = ($100,000)

Donut Shop Division: $1 100,000 = $100,000 savings

Firm: No change

The outside bid has a direct benefit to the Donut Shop Division.

4.

Original Income

New Income

Sales:

External

$3,825,000

$3,825,000

Internal

450,000$4,275,000

350,000$4,175,000

Variable cost

1,900,000

1,900,000

Contribution margin

$2,375,000

$2,275,000

Fixed cost

1,500,000

1,500,000

Net income

$ 875,000

$775,000Original ROI = $875,000/$2,000,000 = 43.75%

New ROI = $775,000/$2,000,000 = 38.75%

The decrease in ROI will affect Raymonds evaluation as a manager and his chance for bonuses and promotions. Still, the transfer pricing negotiations have given him valuable information. He is now aware that an outside company is underpricing him on similar quality coffee; he needs to determine why (e.g., a more efficient cost structure) and whether this will also affect his own outside sales.

1018

1.$120

2.Minimum: $108

Maximum: $120

Actual: $114

3.($90 + $44)/2 = $67

Appliance Division:

Additional revenue ($67 2,000)

$134,000

Additional expenses ($44 2,000)

88,000Additional profit

$ 46,000

Manufactured Housing Division:

Reduction of costs ($90 $67) 2,000

46,000Total addition to profits

$ 92,0001019

1.The segment information prepared for public reporting purposes may not be appropriate for the evaluation of segment management performance because:

An allocation of common costs incurred for the benefit of more than one segment must be included for public reporting purposes.

Common costs are generally allocated on an arbitrary basis.

The segments identified for public reporting purposes may not coincide with actual management responsibilities.

This information does not distinguish between a segment that is a poor investment and the performance of a manager who has done well despite adverse circumstances.

2.If their performance is evaluated on the basis of the information in the annual financial report, Webster Corporations segment managers may become frustrated and dissatisfied because they would be held responsible for an earnings figure that includes the arbitrary allocation of common costs and costs traceable to but not controllable by them. Performance evaluation on this basis would be demotivating. As a result of this dissatisfaction, managers may seek employment elsewhere.

3.Webster Corporation should define responsibility centers that coincide with managers actual responsibilities rather than using the segment rules developed for public financial reporting. All reports should be prepared utilizing the contribution approach which would separate costs by behavior and assign costs to segments only if they could be controlled by the segment. The report should disclose contribution margin, contribution controllable by segment managers, and contribution by each segment after the allocation of common costs.

1020

1.$200, because it could purchase the motor externally for that price.

2.$195, because that is equal to variable cost; or $135 if labor is considered fixed (see answer to Requirement 3).

3.The environmental factor most important to this decision is the governmental prohibition against layoffs. This could turn direct labor into a strictly fixed cost. This particular prohibition is a serious one.

Some Spanish plants have been virtually closed for years, yet the firms must continue to pay the workers since the government has refused permission to lay off the workers.

1021

1.Fred turned down the proposed investment as the ROI from the investment is 13% ($156,000/$1,200,000) compared to the current ROI of 16% ($2,560,000/$16,000,000). If the iron is produced, then the divisions ROI would decrease to 15.79% ($2,716,000/$17,200,000).

2.The iron should have been manufactured since the companys income would increase $48,000 [$156,000 (9% $1,200,000)].

3.Yes. The project has a residual income of $48,000 and accepting it would have increased the divisions residual income.

4.Residual income encourages managers to invest in projects that increase a firms income, decreasing the likelihood that profitable investments will be turned down. ROI encourages managers to select those investments that provide the greatest return per dollar invested. ROI provides a relative mea- sure of performance, making comparisons among divisions possible.

5.Since ROI is the main performance measure, Fred was not willing to accept a profitable investment because it would decrease his divisions ROI. Facing a possible promotion, he chose to maintain the divisions high ROI rather than earn extra profits for the company. The decision was motivated by self-interest. Some may argue that the decision was encouraged by the companys reward system. This argument, however, is weak since it is virtually certain that the intent of higher management is to reward productive behavior, not manipulative behavior. From this perspective, the decision was wrong and, thus, unethical.

However, Fred might argue that the true objective of the firm is to encourage and reward high return on investment. He may be able to develop an acceptably high ROI project in the next eight to 10 months. Thus, not accepting the immediate project may give him the ability to invest in a more profitable project later on.

CYBER RESEARCH CASE

1022

Answers will vary.

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