Accounting for Decision Making and Control 9th Edition Zimmerman - Test Bank

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Using historical costs, which is true?

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Ur can increase its ROI by:

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Using historical costs, which is true?

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Which is true, when fixed asset costs are adjusted upward for inflation?

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

If Bones is operating below capacity, what is the minimum price that it should quote Biscuits per sack of bone meal to maximize GGP’s profits?

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

If Bones is at capacity and has sufficient outside customers for the containers, what is the minimum price that it should quote Biscuits per sack of bone meal to maximize GGP’s profits?

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

Should Biscuits buy bone meal from Bones at the price calculated in Q5-9?

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

Should GGP encourage an internal transaction for this order if Bones has outside customers for the bone meal, and, if so, at what price?

The following investment opportunities are available to an investment center manager:

Required:

a. If the investment manager is currently making a return on investment of 16 percent, which project(s) would the manager want to pursue?
b. If the cost of capital is 10 percent and the annual earnings approximate cash flows excluding finance charges, which project(s) should be chosen?
c. Suppose only one project can be chosen and the annual earnings approximate cash flows excluding finance charges. Which project should be chosen?

The Alpha Division of the Carlson Company manufactures product X at a variable cost of $40 per unit. Alpha Division’s fixed costs, which are sunk, are $20 per unit. The market price of X is $70 per unit. Beta Division of Carlson Company uses product X to make Y. The variable costs to convert X to Y are $20 per unit and the fixed costs, which are sunk, are $10 per unit. The product Y sells for $80 per unit.

Required:

a. What transfer price of X causes divisional managers to make decentralized decisions that maximize Carlson Company’s profit if each division is treated as a profit center?
b. Given the transfer price from part (a), what should the manager of the Beta Division do?
c. Suppose there is no market price for product X. What transfer price should be used for decentralized decision-making?
d. If there is no market for product X, is the operations of the Beta Division profitable?

Jefferson Company has two divisions: Jefferson Bottles and Jefferson Juice. Jefferson Bottles makes glass containers, which it sells to Jefferson Juice and other companies. Jefferson Bottles has a capacity of 10 million bottles a year. Jefferson Juice currently has a capacity of 3 million bottles of juice per year. Jefferson Bottles has a fixed cost of $100,000 per year and a variable cost of $0.01/bottle. Jefferson Bottles can currently sell all of its output at $0.03/bottle.

Required:

a. What should Jefferson Bottles charge Jefferson Juice for bottles so that both divisions will make appropriate decentralized planning decisions?
b. If Jefferson Bottles can only sell 5 million bottles to outside buyers, what should Jefferson Bottles charge Jefferson Juice for bottles so that both divisions will make appropriate decentralized planning decisions?

A chair manufacturer has two divisions: framing and upholstering. The framing costs are $100 per chair and the upholstering costs are $200 per chair. The company makes 5,000 chairs each year, which are sold for $500.

Required:

a. What is the profit of each division if the transfer price is $150?
b. What is the profit of each division if the transfer price is $200?

A soft drink company has three bottling plants throughout the country. Bottling occurs at the regional level because of the high cost of transporting bottled soft drinks. The parent company supplies each plant with the syrup. The bottling plants combine the syrup with carbonated soda to make and bottle the soft drinks. The bottled soft drinks are then sent to regional grocery stores.
The bottling plants are treated as costs centers. The managers of the bottling plants are evaluated based on minimizing the cost per soft drink bottled and delivered. Each bottling plant uses the same equipment, but some produce more bottles of soft drinks because of different demand. The costs and output for each bottling plant are:

Required:

a. Estimate the average cost per unit for each plant.
b. Why would the manager of plant A be unhappy with using the average cost as the performance measure?
c. What is an alternative performance measure that would make the manager of plant A happier?
d. Under what circumstances might the average cost be a better performance measure?

The Maple Way Golf Course is a private club that is owned by the members. It has the following managers and organizational structure:

Required:

Describe each of the managers in terms of being responsible for a cost, profit, or investment center and possible performance measures for each manager.

At a Stern-Stewart conference, one of the topics discussed was “taking EVA to the shop floor.” This session described “driving EVA analysis, decision making and incentives down through every level of an organization.” If you were attending this session, what questions would you ask the panelists?

The Eastern University Business School teaches some undergraduate business courses for students in the Eastern University College of Arts and Science (CAS). The 6,000 undergraduates generate 2,000 undergraduate student course enrollments in business courses per year. The B-school and CAS are treated as profit centers in that their budgets contain student tuition revenues as well as costs. The deans have discretion to set tuition and salaries and determine hiring as long as they operate with no deficit (revenues = expenses). Undergraduate tuition is $12,000 per year and each student takes eight courses per year. Average undergraduate financial aid amounts to 20% of gross tuition. The current transfer price rule is gross tuition per course less average financial aid.
This transfer price rule gives net tuition to the B-school as a revenue and deducts an equal amount from the CAS budget. The CAS dean argues that the current system is grossly unfair. CAS must provide costly services for undergraduates to maintain a top-rated undergraduate program. For example, career counseling, academic advising, sports programs, and the admissions office are costs that must be incurred if undergraduates are to enroll at Eastern. Therefore, the CAS dean argues, the average cost of these services per undergraduate student course enrollment should be deducted from the tuition transfer price. These undergraduate student services total $9.6 million per year.

Required:

a. Calculate the current revenue the B-school is receiving from undergraduate business courses. What will it be if the CAS dean’s proposal is adopted?
b. Discuss the pros and cons of the CAS dean’s proposal.
c. As special assistant to the B-school dean, prepare a response to the proposed tuition transfer pricing scheme.

Levis is a large manufacturer of office equipment, including copiers. Its electronics division is a cost center. Currently, electronics sells circuit boards to other divisions exclusively. Levis has a policy that internal transfers are to be priced at full cost (fixed + variable). Thirty percent of the cost of a board is considered fixed.
The electronics division is operating at 75 percent of capacity. Because there is excess capacity, electronics is seeking opportunities to sell boards to non-Levis firms. The electronics division policy on non-Levis sales states that each job must cover full cost and a minimum 10 percent profit. Electronics division management will be measured on its ability to make the minimum profit on any non-Levis contracts that are accepted.
Copy products is another Levis division. Copy products has recently reached an agreement with Siviy, a non-Levis firm, for the assembly of subsystems for a copier. Copy products has selected Siviy because of Siviy’s low labor cost. The subsystem Siviy will assemble requires circuit boards. Copy products has stipulated that Siviy must purchase the circuit boards from the electronics division because of electronics’ high quality and dependability.
Electronic products is anxious to accept this new work from copy products because it will increase electronic product’s workload by 15 percent.
In negotiating a contract price with Siviy, copy products needs to take into account the cost of the circuit boards from electronics. The financial analyst from copy products assumes that electronics will sell the circuit boards to Siviy at full cost (the same as the internal transfer price). Electronics is considering adding the minimum 10 percent profit margin to their full cost and transferring at that price to Siviy.
Copy products is preparing to negotiate its contract with Siviy. Develop and discuss at least three options that may be used in establishing the transfer price between the electronics division and Siviy. Discuss the advantages and disadvantages of each.

General Motors’s CFO, Michael Losh, converted GM’s performance measure for compensation from net income to ROA. In explaining the move), he said, “ROA was a logical next step because all those other measures generally have focused on the income statement. Moving to ROA means that we’re going to focus not only on the income statement, but on the balance sheet and effective utilization of the assets and liabilities that are on the balance sheet as well.
“ROA is a better measure for us than EVA. … EVA is simpler conceptually, because it automatically builds on growth, whereas with this approach we know that we’ve got to have growth as an overlying objective. … EVA is more comprehensive. And that has a certain appeal to me. But, given our situation, particularly in our North American operations, it just would not have been the right measure.
“ROA works for us and EVA doesn’t because our operations have to deal with those two different kinds of starting points. Within GM, in our North American operations, you’ve got a classic turnaround situation, and in our international operations, you’ve got a classic growth situation. You can apply ROA to both; you can’t apply EVA to both.”

Required:

a. Explain how ROA focuses on both the income statement and the balance sheet.
b. Explain why EVA is more “comprehensive” than ROA.
c. Do you agree with Losh’s statement that “you can apply ROA to both; you can’t apply EVA to both”? Explain.

PepsiCo, a major soft drink company, had a restaurant division consisting of Kentucky Fried Chicken, Taco Bell, and Pizza Hut. The only cola beverage these restaurants served was Pepsi. Assume that the major reason PepsiCo owned fast food restaurants is an attempt to increase its share of the cola market. Under this assumption, some Pizza Hut patrons who order a cola at the restaurant and are told they are drinking a Pepsi will switch and become Pepsi drinkers instead of Coke drinkers on other purchase occasions. However, studies have shown that some customers refuse to eat at restaurants unless they can get a Coke.
PepsiCo sells Pepsi Cola to non-PepsiCo restaurants at $0.53 per gallon. This is the market price of Pepsi-Cola. Pepsi-Cola’s variable manufacturing cost is $0.09 per gallon and its total (fixed and variable) manufacturing cost is $0.22 per gallon. PepsiCo produces Pepsi-Cola in numerous plants located around the world. Plant capacity can be added in small increments (e.g., a half-million gallons per year). The cost of additional capacity is approximately equal to the fixed costs per gallon of $0.13.

Required:

What transfer price should be set for Pepsi transferred from the soft drink division of PepsiCo to a PepsiCo restaurant such as Taco Bell? Justify your answer.

Sunstar sells a full line of small home kitchen appliances, including toasters, coffee makers, blenders, and bread machines. It is organized into a marketing division and a manufacturing division. The manufacturing division is composed of several plants, each a cost center, making one type of appliance. The toaster plant makes different models of toasters and toaster ovens. Most of the parts, such as the heating elements and racks for each toaster, are purchased externally, but a few are manufactured in the plant, including the sheet metal forming the body of the toaster. The toaster plant has a number of departments including sheet metal fabrication, purchasing, assembly, quality assurance, packaging, and shipping.
Each toaster model has a product manager who is responsible for manufacturing the product. Each product manager manages several similar models. Product managers, with the help of purchasing, ­negotiate prices and delivery schedules with external part vendors. Sunstar’s corporate headquarters sets all the toaster models’ selling prices and quarterly production quotas to maximize profits. Product managers’ compensation and promotions are based on lowering unit costs and meeting corporate headquarters’ production quota.
The product manager sets production schedule quotas for the product and is responsible for ensuring that the distribution division of Sunstar has the appropriate number of toasters at each distribution center. Product managers have discretion over outsourcing, production methods, and labor scheduling to manufacture the particular models under their control. For example, they do not have to produce the exact number of toasters set by corporate headquarters quarterly, but rather product managers have some discretion to produce more or fewer toasters as long as the distribution centers have enough inventory to meet demand.
The following data were collected for one particular toaster oven, model CVP-6907. These data are corporate forecasts for model CVP-6907 in regard to how prices and total manufacturing costs are expected to vary with the number of toasters manufactured (and sold) per day.

In addition to the manufacturing costs reported in the table, there are $10 of variable selling and distribution costs per toaster.

Required:

a. What daily production quantity would you expect the product manager for model CVP-6907 to set? Why?
b. Evaluate Sunstar’s performance evaluation system as it pertains to product managers. What behavior does it likely create among manufacturing product managers?
c. Describe the changes you would recommend Sunstar consider making in its performance evaluation system for manufacturing product managers.

Joan Chris is the Denver district manager of Stale-Mart, an old established chain of more than 100 department stores. Her district contains eight stores in the Denver metropolitan area. One of her stores, the Broadway store, is over 30 years old. Chris began working at the Broadway store as an assistant buyer when the store first opened, and she has fond memories of the store. The Broadway store remains profitable, in part because it is mostly fully depreciated, even though it is small, is in a location that is not seeing rising property values, and has had falling sales volume.
Stale-Mart owns neither the land nor the buildings that house its stores but rather leases them from developers. Lease payments are included in “operating income before depreciation.” Each store requires substantial leasehold improvements for interior decoration, display cases, and equipment. These expenditures are capitalized and depreciated as fixed assets by Stale-Mart. Leasehold improvements are depreciated using accelerated methods with estimated lives substantially shorter than the economic life of the store.
All eight stores report to Chris, and like all Stale-Mart district managers, 50 percent of her compensation is a bonus based on the average return on investment of the eight stores (total profits from the eight stores divided by the total eight-store investment). Investment in each store is the sum of inventories, receivables, and leasehold improvements, net of accumulated depreciation.
She is considering a proposal to open a store in the new upscale Horse Falls Mall three miles from the Broadway store. If the Horse Falls proposal is accepted, the Broadway store will be closed. Here are data for the two stores (in millions of dollars):

Assume that the forecasts for Horse Falls are accurate. Also assume that the Broadway store data are likely to persist for the next four years with little variation.
Stale-Mart finds itself losing market share to newer chains that have opened stores in growth areas of the cities in which they operate. The rate of return on Stale-Mart stock lags that of other firms in the retail department store industry. Its cost of capital is 20 percent.

Required:

a. Calculate the return on total investment and residual income for the Broadway and Horse Falls stores.
b. Chris expects to retire in five years. Do you expect her to accept the proposal to open the Horse Falls store and close the Broadway store? Explain why.
c. Offer a plausible hypothesis supported by facts in the problem that explains why Stale-Mart is losing market share and also explains the poor relative performance of its stock price. What changes at Stale-Mart would you suggest to correct the problem?

Serviflow manufactures products that move and measure various fluids, ranging from water to high-viscosity polymers, corrosive or abrasive chemicals, toxic substances, and other difficult pumping media. The Supply Division, a profit center, manufactures all products for the various marketing divisions, which also are profit centers. One of the marketing divisions, the Natural Gas Marketing Division (NGMD), designed and sells a liquid natural gas pressure regulating valve, NGM4010, which the Supply Division manufactures.
To produce one NGM4010, the Supply Division incurs a variable cost of $6, and NGMD incurs a variable cost of $14. The $6 and $14 variable costs per unit of NGM4010 are constant and do not vary with the number of units produced or sold. While both the Supply Division and NGMD have substantial fixed costs, for the purpose of this question, assume both divisions’ fixed costs are zero.
The following table depicts how the price of the NGM4010 to outside customers varies with the number of units sold each week. (That is, the external customers’ weekly demand curve for NGM4010 is given by the following formula: P 5 1000 2 10Q, where P is the final selling price and Q is the total number of units sold each week.)

Required:

a. If the senior managers in the corporate headquarters of Serviflow knew all the relevant information (the variable costs in the Supply Division and NGMD and the market demand curve for NGM4010), what profit maximizing final price would they set for NGM4010 and how many units would they tell the Supply Division to produce and NGMD to sell each week?
b. How much total profit does Serviflow generate each week based on the profit maximizing price-quantity decision made in part (a)?
c. Assume that Serviflow senior managers do not know all the relevant information to choose the profit maximizing price-quantity decision for NGM4010. Instead, they assign the decision rights to set the transfer price to the Supply Division. Assume the Supply Division knows how many units of NGM4010 NGMD will purchase as a function of the transfer price. The following table shows how NGMD’s purchase decision of NGM4010 depends on the transfer price set by the Supply Division.

(In other words, the Supply Division knows that NGMD’s demand curve for NGM4010 is T 5 986 2 20Q, where T is the transfer price and Q is the number of units of NGM4010 transferred from Supply to NGMD and sold by NGMD each week.) What transfer price will the Supply Division select to maximize the Supply Division’s profit on NGM4010?

d. If the Supply Division selects the transfer price to maximize its profits in part (c), how much profit will the Supply Division make each week, and how much profit will NGMD make each week?
e. Compare the level of firmwide profits calculated in part (b) with the sum of the Supply Division’s and NGMD’s profits calculated in part (d). Which one is larger (firm profits or Supply Division profits plus NGMD profits), and explain why.
f. Suppose corporate headquarters has all the information about customer demand and costs in the two divisions [the same assumption as in part (a)], but instead of telling the two divisions how many units to produce and transfer each week, they set the transfer price on NGM4010. What transfer price would corporate headquarters set in order to maximize firmwide profit?
g. What organizational problems are created if the transfer price for NGM4010 is set following your recommendation in part (f) above? Describe the dysfunctional incentives created by such a transfer pricing rule.

One drawback of decentralization is the reduction in head office control of local activities, which is often compensated for by increasing the number of reports sent to the head office. Very often, both head office and the local branch/division keep local records. Under decentralization, many activities are, in fact, duplicated.

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Using historical costs, which is true?

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Ur can increase its ROI by:

All of these strategies can be utilized to increase ROI. However, not all of these are necessarily beneficial to the parent company or the shareholders. Thus it is customary to supplement ROI performance measures with constraints and minimum performance or expenditure targets.

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Using historical costs, which is true?

Note that the magnitude (and, therefore, relative ranking) of residual income is critically dependent on the WACC. A lower WACC favors divisions with higher net assets (such as Babylon), whereas a high charge for the use of corporate funds favors divisions with lower net assets (such as Ur).

Both Ur and Babylon are investment centers.

*Net income is after tax but before interest

MMI’s weighted average cost of capital (WACC) is 11.5%. The MMI measures division performance based on the book value of net assets. The producer price index 15 years ago was 100, 116 five years ago, and currently is 125.

Which is true, when fixed asset costs are adjusted upward for inflation?

The trade-marked EVA formula tweaks the residual income approach. It utilizes a tax-adjusted WACC and is complex to administer. Where it is adopted in incentive plans, employees require special training to understand how their actions will increase their EVA score. On the other hand, all new incentive plans require extensive communications and training programs to be effective.

Division A’s sales of $500 are 66.7% bigger than C’s sales of $300.

Maximizing the firm’s after-tax tax profits is often a high priority in setting a transfer pricing policy. Where a firm has operations in different tax jurisdictions (e.g., New York and California; USA, England and Hong Kong), transfer prices attempt to shift profits to the tax jurisdiction with the lowest tax rate. It should be noted, however, that increasingly there are more regulatory constraints on firms’ abilities to use transfer prices to reduce taxes.

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

If Bones is operating below capacity, what is the minimum price that it should quote Biscuits per sack of bone meal to maximize GGP’s profits?

When below capacity, and the internal order does not lead to exceeding capacity, the minimum transfer price should recover Bones’ variable costs.

Of course, this price does not reward Bones for undertaking the order; it merely makes Bones no worse off.

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

If Bones is at capacity and has sufficient outside customers for the containers, what is the minimum price that it should quote Biscuits per sack of bone meal to maximize GGP’s profits?

When Bones has other customers for bone meal, the minimum price that makes GGP no worse off (i.e., indifferent), covers the variable costs of the internal transfer and the contribution margin foregone on the external sales.

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

Should Biscuits buy bone meal from Bones at the price calculated in Q5-9?

No. Biscuit’s transfer price from Q5-9 is $3.55 per lb. However, Biscuit can buy from an outside supplier for $3 per lb.

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $.05 per lbs) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 lbs sack; when sold to other firms, it is packed in 50lbs containers, costing $3 each. Bones prices the container product at $180. Biscuits just received an order for 800 cases of one of its specialty products, BisBone, and is contemplating purchasing bone meal from its sister division.

Should GGP encourage an internal transaction for this order if Bones has outside customers for the bone meal, and, if so, at what price?

If Bones is operating below capacity, there is a saving of $0.60 per case on an internal purchase, which leaves room for the two divisions to negotiate a price. However, when it is at capacity and there are outside customers ready to pay Bones’ regular price, GGP is worse off by 55 cents per pound not sold to third parties.

The following investment opportunities are available to an investment center manager:

Required:

a. If the investment manager is currently making a return on investment of 16 percent, which project(s) would the manager want to pursue?
b. If the cost of capital is 10 percent and the annual earnings approximate cash flows excluding finance charges, which project(s) should be chosen?
c. Suppose only one project can be chosen and the annual earnings approximate cash flows excluding finance charges. Which project should be chosen?

a. The ROI of the four projects are:

The manager would only want to accept projects that would raise the existing ROI above 16 percent. Only project B would raise the existing ROI.

b. All projects with an ROI greater than the cost of capital of 10 percent should be chosen. Therefore, projects A, B, and D should be chosen.
c. The project with the highest residual income should be chosen. The residual incomes of the four projects are:

Project D has the highest residual income and should be chosen.

The Alpha Division of the Carlson Company manufactures product X at a variable cost of $40 per unit. Alpha Division’s fixed costs, which are sunk, are $20 per unit. The market price of X is $70 per unit. Beta Division of Carlson Company uses product X to make Y. The variable costs to convert X to Y are $20 per unit and the fixed costs, which are sunk, are $10 per unit. The product Y sells for $80 per unit.

Required:

a. What transfer price of X causes divisional managers to make decentralized decisions that maximize Carlson Company’s profit if each division is treated as a profit center?
b. Given the transfer price from part (a), what should the manager of the Beta Division do?
c. Suppose there is no market price for product X. What transfer price should be used for decentralized decision-making?
d. If there is no market for product X, is the operations of the Beta Division profitable?

a. The transfer price should be equal to the opportunity cost of Alpha Division supplying X to the Beta Division, which is the market price of $70 per unit.
b. If the manager of the Beta Division must pay $70 per unit of X, the manager of Beta Division will not be able to generate a profit and should look for other opportunities rather than processing X.
c. If there is no market for X, the opportunity cost of supplying X is the variable cost of X or $40 per unit.
d. If the Beta Division only has to pay $40 per unit of X, then Beta can operate profitably by adding $20 in variable cost and selling product Y for $80 per unit.

Jefferson Company has two divisions: Jefferson Bottles and Jefferson Juice. Jefferson Bottles makes glass containers, which it sells to Jefferson Juice and other companies. Jefferson Bottles has a capacity of 10 million bottles a year. Jefferson Juice currently has a capacity of 3 million bottles of juice per year. Jefferson Bottles has a fixed cost of $100,000 per year and a variable cost of $0.01/bottle. Jefferson Bottles can currently sell all of its output at $0.03/bottle.

Required:

a. What should Jefferson Bottles charge Jefferson Juice for bottles so that both divisions will make appropriate decentralized planning decisions?
b. If Jefferson Bottles can only sell 5 million bottles to outside buyers, what should Jefferson Bottles charge Jefferson Juice for bottles so that both divisions will make appropriate decentralized planning decisions?

a. Jefferson Bottles should charge Jefferson Juice the opportunity cost of providing the bottles. The opportunity cost to Jefferson Bottles of selling to Jefferson Juice is the market price, or $0.03/bottle.
b. Jefferson Bottles can sell 5 million bottles it currently makes, but there is no apparent market for further bottles. If there were further demand, the company would be making more bottles because the bottles provide a positive contribution margin per unit. Therefore, the opportunity cost of making more bottles is the variable cost or $0.01/bottle, which should be used as the transfer price.

A chair manufacturer has two divisions: framing and upholstering. The framing costs are $100 per chair and the upholstering costs are $200 per chair. The company makes 5,000 chairs each year, which are sold for $500.

Required:

a. What is the profit of each division if the transfer price is $150?
b. What is the profit of each division if the transfer price is $200?

a. Profit of each division if the transfer price is $150/chair:

b. Profit of each division if the transfer price is $200/chair:

A soft drink company has three bottling plants throughout the country. Bottling occurs at the regional level because of the high cost of transporting bottled soft drinks. The parent company supplies each plant with the syrup. The bottling plants combine the syrup with carbonated soda to make and bottle the soft drinks. The bottled soft drinks are then sent to regional grocery stores.
The bottling plants are treated as costs centers. The managers of the bottling plants are evaluated based on minimizing the cost per soft drink bottled and delivered. Each bottling plant uses the same equipment, but some produce more bottles of soft drinks because of different demand. The costs and output for each bottling plant are:

Required:

a. Estimate the average cost per unit for each plant.
b. Why would the manager of plant A be unhappy with using the average cost as the performance measure?
c. What is an alternative performance measure that would make the manager of plant A happier?
d. Under what circumstances might the average cost be a better performance measure?

a. The average cost per unit of each plant is:

b. The manager of plant A would be unhappy with using the average cost as the performance measure because the lower output of plant A means that the fixed costs (which are the same for all firms) are spread over fewer units. If the managers of the bottling plants cannot control output, then they cannot control the average cost per unit.
c. The managers could be evaluated based on the variable cost per unit. In that case, the manager of plant A has the lowest variable cost per unit. The danger of using the variable cost per unit is that managers will claim that most of their costs are fixed not variable. Therefore, evaluating managers on both variable cost per unit and fixed costs is appropriate. Ideally, the performance measure should reflect controllable costs.
d. The average cost could be a good performance measure if the managers can control sales and output. By increasing sales and output, the managers can lower the average cost per unit and be rewarded accordingly.

The Maple Way Golf Course is a private club that is owned by the members. It has the following managers and organizational structure:

Required:

Describe each of the managers in terms of being responsible for a cost, profit, or investment center and possible performance measures for each manager.

Eric Olson is the general manager of the golf course, but probably has not been given the decision rights to expand the facilities. Therefore, Eric would be considered a profit center manager. Other than profit on the whole course, Eric could be evaluated based on member satisfaction, quality of facilities, and demand for new membership.
Jennifer Jones is responsible for maintaining the golf course. She has no direct control over revenue, so her position could be considered a cost center. But the quality of the course is an important factor in bringing in golfers. Therefore, revenue from the golf course could also be included in her performance measure. Other performance measures include the quality of the golf course, number of days the course is open, and membership satisfaction.
Edwin Moses is the manager of the restaurant, which has both revenues and costs and should be considered a profit center. Other than profit, performance measures could include diversity of menu, quality of the menu, and usage of the facility by members.
Mabel Smith is the head golf pro and responsible for the golf shop and golf lessons. She should be treated as a profit center because she controls both revenues and costs. Other than profit, she should be evaluated based on number of lessons given and satisfaction of members.
Wanda Itami is manager of the swimming pool and family recreational activities. Other than some swimming lessons, most of these activities are not revenue generating. Therefore, Wanda’s position would be treated as a cost center. In addition to costs, her performance measures would include time the pool is open and satisfaction of members.
Jake Reece manages the golf carts. Golfers are charged extra for golf carts. Jake probably also makes the decision on how many golf carts to have and is responsible for maintaining the golf carts. Therefore, Jake might be treated as an investment center or a profit center. The profit per golf cart or return on the investment in golf carts could be used as a performance measure. Customer satisfaction is also an important performance measure.

At a Stern-Stewart conference, one of the topics discussed was “taking EVA to the shop floor.” This session described “driving EVA analysis, decision making and incentives down through every level of an organization.” If you were attending this session, what questions would you ask the panelists?

An implicit assumption in “taking EVA to the shop floor” is that on average firms are overly centralized. Driving EVA, decision making, and incentives down is consistent with changing all three legs of the stool. However, the question arises as to why all firms should be decentralizing. This is the implicit assumption lurking in this discussion.
At any point in time, some firms may be overly centralized and others over decentralized. Without some technological or competitive shock to firms there is no good reason to believe that on average all firms are overly centralized and should decentralize by driving EVA down to the shop floor.

The Eastern University Business School teaches some undergraduate business courses for students in the Eastern University College of Arts and Science (CAS). The 6,000 undergraduates generate 2,000 undergraduate student course enrollments in business courses per year. The B-school and CAS are treated as profit centers in that their budgets contain student tuition revenues as well as costs. The deans have discretion to set tuition and salaries and determine hiring as long as they operate with no deficit (revenues = expenses). Undergraduate tuition is $12,000 per year and each student takes eight courses per year. Average undergraduate financial aid amounts to 20% of gross tuition. The current transfer price rule is gross tuition per course less average financial aid.
This transfer price rule gives net tuition to the B-school as a revenue and deducts an equal amount from the CAS budget. The CAS dean argues that the current system is grossly unfair. CAS must provide costly services for undergraduates to maintain a top-rated undergraduate program. For example, career counseling, academic advising, sports programs, and the admissions office are costs that must be incurred if undergraduates are to enroll at Eastern. Therefore, the CAS dean argues, the average cost of these services per undergraduate student course enrollment should be deducted from the tuition transfer price. These undergraduate student services total $9.6 million per year.

Required:

a. Calculate the current revenue the B-school is receiving from undergraduate business courses. What will it be if the CAS dean’s proposal is adopted?
b. Discuss the pros and cons of the CAS dean’s proposal.
c. As special assistant to the B-school dean, prepare a response to the proposed tuition transfer pricing scheme.

a.

b. The CAS proposal will increase the CAS budget by $400,000 and will reduce the number of courses the business school offers. By how many courses, we don’t know.
Ultimately the question comes down to what is the opportunity cost of providing the business course? Presumably, the business school does not have excess capacity among its teaching staff. The undergraduate courses will have to be staffed at some incremental cost to the business school. These staff require additional office space and support (e.g., secretarial, photocopying, computers, etc.). Therefore, the opportunity cost to the business school is these incremental costs to them. Unless they hire faculty of comparable quality to their existing faculty, there will be a brand-name loss of business school reputation.
The current scheme gives the business school the incentive to offer undergraduate business courses, which presumably increases the demand for the undergraduate degree. One advantage of the current system is it is fairly simple to administer. One problem with the CAS dean’s proposal is how does one determine the “etc.” For example, what prevents the CAS dean from classifying a math professor as spending 30 percent of her time advising students and thereby allocating 30 percent of her salary to “undergraduate student services” charged to the business school? How does one prevent the allocated costs from creeping up as the CAS dean reclassifies more and more expenses as “student services”?

c. Some possible arguing points include:

(i) Business school courses have a higher opportunity cost than undergraduate courses in the sense that B-School faculty have high salaries and hence a higher opportunity cost of time; the opportunity cost of B-School faculty teaching undergraduate courses is similarly higher. If Ph.D. students teach the undergraduate courses, they too have an opportunity cost of their time because teaching lengthens the time until they graduate and begin earning higher salaries.
(ii) Undergraduates taking a B-School course may use B-School services such as the computing center, placement services, business library, and executive seminars. This use reduces the amount of such services available to the MBA population and imposes an opportunity cost on the B-School.
(iii) Tuition at Eastern University can only be sustained at the higher level of $12,000 per year because undergraduates know that the undergraduate program is a back door way into “cheap” (to them) B-School courses.
(iv) Take the $9.6 million student services and split it into fixed and variable cost components. Allocate to the business school only its share of the variable cost component. But again, how will these “variable” costs be monitored to avoid their increasing in future years?

Levis is a large manufacturer of office equipment, including copiers. Its electronics division is a cost center. Currently, electronics sells circuit boards to other divisions exclusively. Levis has a policy that internal transfers are to be priced at full cost (fixed + variable). Thirty percent of the cost of a board is considered fixed.
The electronics division is operating at 75 percent of capacity. Because there is excess capacity, electronics is seeking opportunities to sell boards to non-Levis firms. The electronics division policy on non-Levis sales states that each job must cover full cost and a minimum 10 percent profit. Electronics division management will be measured on its ability to make the minimum profit on any non-Levis contracts that are accepted.
Copy products is another Levis division. Copy products has recently reached an agreement with Siviy, a non-Levis firm, for the assembly of subsystems for a copier. Copy products has selected Siviy because of Siviy’s low labor cost. The subsystem Siviy will assemble requires circuit boards. Copy products has stipulated that Siviy must purchase the circuit boards from the electronics division because of electronics’ high quality and dependability.
Electronic products is anxious to accept this new work from copy products because it will increase electronic product’s workload by 15 percent.
In negotiating a contract price with Siviy, copy products needs to take into account the cost of the circuit boards from electronics. The financial analyst from copy products assumes that electronics will sell the circuit boards to Siviy at full cost (the same as the internal transfer price). Electronics is considering adding the minimum 10 percent profit margin to their full cost and transferring at that price to Siviy.
Copy products is preparing to negotiate its contract with Siviy. Develop and discuss at least three options that may be used in establishing the transfer price between the electronics division and Siviy. Discuss the advantages and disadvantages of each.

This problem illustrates some complexities involved in transfer pricing when two internal divisions become involved.
In determining the appropriate selling price, the Electronics Division and the Copy Products Division must consider the following:

• The first question to raise is why the Electronics Division cares about the transfer price. Being a cost center, Electronics should be evaluated on costs, not profits. The first thing to investigate is whether the partitioning of decision rights and the performance evaluation systems are properly aligned.
• Taking the Siviy work raises volume in the Electronics division from 75 percent to 90 percent. Are marginal costs constant as output is increased? If not, then the price being quoted of allocated fixed costs plus variable cost is unlikely an accurate estimate of how costs actually will behave when this contract is added.
• There will be additional transaction costs incurred as a result of dealing with a non-Levis intermediary, such as billings, accounts receivable, transportation and shipping, etc.
• The stability of the work force within the Electronics Division must be considered. Will the added workload cause additional hiring or overtime or will it allow for better utilization of the existing work force? Without this added work, will Electronics be facing downsizing actions?
• There will be an increased need for management attention and additional overhead to negotiate and monitor such a small portion of the business. Perhaps the profit requirement exists to discourage internal Levis sales through a third party.

Three alternatives for negotiating a selling price to Siviy are:

• Transfer to Siviy at full cost plus transaction cost. This would ensure that no other Electronics customers would subsidize the sale of boards to Siviy. However, it is contrary to the current Electronics performance measurement system.
• Transfer as an internal sale to Copy Products at full cost. Copy Products may then consign the boards to Siviy for use in the sub-system. This allows Electronics to acquire the added workload without incurring the additional transaction cost. However, Copy Products would bear the transaction costs in managing the consigned material. Copy Products would also bear the responsibility for the added inventory dollars for the boards while at Siviy.
• Transfer at full cost plus profit. While this option would allow the Electronics Division to act in accordance with the standard transfer pricing policy, it may jeopardize the relationship between the two Levis divisions. It inflates the true cost of the board, which results in an inflated sub-system price from Siviy to Copy Products.

General Motors’s CFO, Michael Losh, converted GM’s performance measure for compensation from net income to ROA. In explaining the move), he said, “ROA was a logical next step because all those other measures generally have focused on the income statement. Moving to ROA means that we’re going to focus not only on the income statement, but on the balance sheet and effective utilization of the assets and liabilities that are on the balance sheet as well.
“ROA is a better measure for us than EVA. … EVA is simpler conceptually, because it automatically builds on growth, whereas with this approach we know that we’ve got to have growth as an overlying objective. … EVA is more comprehensive. And that has a certain appeal to me. But, given our situation, particularly in our North American operations, it just would not have been the right measure.
“ROA works for us and EVA doesn’t because our operations have to deal with those two different kinds of starting points. Within GM, in our North American operations, you’ve got a classic turnaround situation, and in our international operations, you’ve got a classic growth situation. You can apply ROA to both; you can’t apply EVA to both.”

Required:

a. Explain how ROA focuses on both the income statement and the balance sheet.
b. Explain why EVA is more “comprehensive” than ROA.
c. Do you agree with Losh’s statement that “you can apply ROA to both; you can’t apply EVA to both”? Explain.

a. ROA focuses on both statements because it is a ratio of net income (from the income statement) divided by total assets (from the balance sheet).
b. EVA is not more comprehensive than ROA. They both contain exactly the same inputs (net income and total assets). EVA also contains the weighted average cost of capital explicitly in the formula. But to implement ROA, each division’s ROA must be compared to its weighted average cost of capital (wacc). Just because two divisions have the same ROA does not mean they are performing the same if they have different wacc (because their risk factors differ).
c. Disagree. EVA and ROA can be applied to each case once the appropriate wacc is set. Both metrics are short-run to the extent that accounting earnings measure last year’s earnings; they do not capture future growth opportunities. For example, R&D expenditures reduce current accounting earnings, but are expected to produce future growth. Both EVA and ROA create incentives for managers to cut R&D spending to boost current ROA and EVA. However, these incentives are reduced if R&D is treated as a capital asset and not deducted from earnings. This adjustment can be made to accounting earnings and assets for both ROA and EVA. Finally, providing long-run incentives can be accomplished by the choice of performance rewards such as stock, options, and deferred compensation.

PepsiCo, a major soft drink company, had a restaurant division consisting of Kentucky Fried Chicken, Taco Bell, and Pizza Hut. The only cola beverage these restaurants served was Pepsi. Assume that the major reason PepsiCo owned fast food restaurants is an attempt to increase its share of the cola market. Under this assumption, some Pizza Hut patrons who order a cola at the restaurant and are told they are drinking a Pepsi will switch and become Pepsi drinkers instead of Coke drinkers on other purchase occasions. However, studies have shown that some customers refuse to eat at restaurants unless they can get a Coke.
PepsiCo sells Pepsi Cola to non-PepsiCo restaurants at $0.53 per gallon. This is the market price of Pepsi-Cola. Pepsi-Cola’s variable manufacturing cost is $0.09 per gallon and its total (fixed and variable) manufacturing cost is $0.22 per gallon. PepsiCo produces Pepsi-Cola in numerous plants located around the world. Plant capacity can be added in small increments (e.g., a half-million gallons per year). The cost of additional capacity is approximately equal to the fixed costs per gallon of $0.13.

Required:

What transfer price should be set for Pepsi transferred from the soft drink division of PepsiCo to a PepsiCo restaurant such as Taco Bell? Justify your answer.

This question addresses perhaps the thorniest issue in managerial accounting: choosing a transfer pricing method in the presence of divisional interdependencies. The following points should be covered in the answer:

• There are synergies (interdependencies) between the soft drink and food divisions that cause the firm to be more valuable with both divisions in the same firm than as two separate firms. These synergies involve the food division’s exclusive use of Pepsi in their restaurants which increases the market demand for Pepsi consumed outside of the restaurants and the restaurants lowering the average variable costs of Pepsi.
• The use of the market price for the transfer price is wrong as it does not capture the value of the interdependencies. At $0.53 per gallon, each store will set a high retail price and will sell too little Pepsi and there will be too few customers exposed to Pepsi.
• All transfer pricing methods have some imperfections. No method is without some problem. The importance of the problem varies from situation to situation, causing there to be no unambiguous, always preferred, best method.

• Given the data in the case, full cost of $0.22 has the fewest problems. Advantages of full cost include:

– Full cost is simple to compute and is verifiable because it is part of the audited accounting system
– Full cost does not require special studies to estimate the value of the interdependencies
– Full cost approximately equals the opportunity cost of producing an additional gallon if PepsiCo is at capacity (approximately equal to long-run marginal cost). But it misses the value to Pepsi of having its product sampled at restaurants.

Sunstar sells a full line of small home kitchen appliances, including toasters, coffee makers, blenders, and bread machines. It is organized into a marketing division and a manufacturing division. The manufacturing division is composed of several plants, each a cost center, making one type of appliance. The toaster plant makes different models of toasters and toaster ovens. Most of the parts, such as the heating elements and racks for each toaster, are purchased externally, but a few are manufactured in the plant, including the sheet metal forming the body of the toaster. The toaster plant has a number of departments including sheet metal fabrication, purchasing, assembly, quality assurance, packaging, and shipping.
Each toaster model has a product manager who is responsible for manufacturing the product. Each product manager manages several similar models. Product managers, with the help of purchasing, ­negotiate prices and delivery schedules with external part vendors. Sunstar’s corporate headquarters sets all the toaster models’ selling prices and quarterly production quotas to maximize profits. Product managers’ compensation and promotions are based on lowering unit costs and meeting corporate headquarters’ production quota.
The product manager sets production schedule quotas for the product and is responsible for ensuring that the distribution division of Sunstar has the appropriate number of toasters at each distribution center. Product managers have discretion over outsourcing, production methods, and labor scheduling to manufacture the particular models under their control. For example, they do not have to produce the exact number of toasters set by corporate headquarters quarterly, but rather product managers have some discretion to produce more or fewer toasters as long as the distribution centers have enough inventory to meet demand.
The following data were collected for one particular toaster oven, model CVP-6907. These data are corporate forecasts for model CVP-6907 in regard to how prices and total manufacturing costs are expected to vary with the number of toasters manufactured (and sold) per day.

In addition to the manufacturing costs reported in the table, there are $10 of variable selling and distribution costs per toaster.

Required:

a. What daily production quantity would you expect the product manager for model CVP-6907 to set? Why?
b. Evaluate Sunstar’s performance evaluation system as it pertains to product managers. What behavior does it likely create among manufacturing product managers?
c. Describe the changes you would recommend Sunstar consider making in its performance evaluation system for manufacturing product managers.

a. Product managers are evaluated and paid based on minimizing average unit costs. The following table computes the minimum average unit cost and total profits for model CVP-6907.

†Total cost equals total manufacturing cost plus variable selling and distribution cost.

From the above table we see that the product manager would like to produce 145 toasters per day as this quantity yields the lowest average cost per unit of $13.49.

b. Sunstar’s performance evaluation system has a number of advantages. It causes product managers to search out cost savings by negotiating lower prices with vendors and finding more efficient production techniques. However, it produces two dysfunctional behaviors.
First, it causes the product manager to produce more than the profit maximizing quantity of toasters. From the above table, we see that the profit maximizing quantity is 110 toasters per day. However, the unit cost minimizing output level is 145 toasters. So the product managers will be devising ways to produce more than forecasted sales. Year-end inventory is likely higher than expected. There is likely to be large number of toasters in transit to the distribution center at the end of the year and a large number of toasters still in the plant, either waiting for final inspection or packaging. Product managers will constantly be pushing for lower selling prices to increase the number they can manufacture.
The second incentive problem created by evaluating product managers based on minimizing average unit costs involves insuring product quality. Product managers can reduce costs by using thinner sheet metal and less expensive, lower-quality components.
c. Product managers should be evaluated based on the total cost of manufacturing a prespecified number of units each month. Instead of minimizing average cost, they should be evaluated based on the total cost for a fixed number of units. Alternatively, they can be given a fixed dollar amount and then evaluated on maximizing the number of units they manufacture for this fixed budget. In either case, Sunstar must closely monitor quality through an independent quality assurance department or by penalizing the product manager for units that are returned because they fail.
Suggesting that the product manager be evaluated as a profit center is not quite right because the product manager currently does not have the decision rights over pricing and distribution costs. Without these decision rights, the product manager’s performance measure (profits) and decision rights (production methods) are not consistent.

Joan Chris is the Denver district manager of Stale-Mart, an old established chain of more than 100 department stores. Her district contains eight stores in the Denver metropolitan area. One of her stores, the Broadway store, is over 30 years old. Chris began working at the Broadway store as an assistant buyer when the store first opened, and she has fond memories of the store. The Broadway store remains profitable, in part because it is mostly fully depreciated, even though it is small, is in a location that is not seeing rising property values, and has had falling sales volume.
Stale-Mart owns neither the land nor the buildings that house its stores but rather leases them from developers. Lease payments are included in “operating income before depreciation.” Each store requires substantial leasehold improvements for interior decoration, display cases, and equipment. These expenditures are capitalized and depreciated as fixed assets by Stale-Mart. Leasehold improvements are depreciated using accelerated methods with estimated lives substantially shorter than the economic life of the store.
All eight stores report to Chris, and like all Stale-Mart district managers, 50 percent of her compensation is a bonus based on the average return on investment of the eight stores (total profits from the eight stores divided by the total eight-store investment). Investment in each store is the sum of inventories, receivables, and leasehold improvements, net of accumulated depreciation.
She is considering a proposal to open a store in the new upscale Horse Falls Mall three miles from the Broadway store. If the Horse Falls proposal is accepted, the Broadway store will be closed. Here are data for the two stores (in millions of dollars):

Assume that the forecasts for Horse Falls are accurate. Also assume that the Broadway store data are likely to persist for the next four years with little variation.
Stale-Mart finds itself losing market share to newer chains that have opened stores in growth areas of the cities in which they operate. The rate of return on Stale-Mart stock lags that of other firms in the retail department store industry. Its cost of capital is 20 percent.

Required:

a. Calculate the return on total investment and residual income for the Broadway and Horse Falls stores.
b. Chris expects to retire in five years. Do you expect her to accept the proposal to open the Horse Falls store and close the Broadway store? Explain why.
c. Offer a plausible hypothesis supported by facts in the problem that explains why Stale-Mart is losing market share and also explains the poor relative performance of its stock price. What changes at Stale-Mart would you suggest to correct the problem?

a. Calculation of ROI and residual income:

b. I expect Ms. Chris to reject the proposal and keep the Broadway store open. She will do this to maximize her bonus compensation, not necessarily because of her emotional attachment to the Broadway store. From the calculations in part (a), the Broadway store has a higher ROI (28 percent) than the Horse Falls store (25 percent). Her bonus is based on ROI and opening the Horse Falls store lowers her average ROI across the eight stores.
c. Her decision to keep the Broadway store open will change if residual income is used to measure performance. Residual income of the Horse Falls store is higher than the residual income of the Broadway store.
Stale-Mart’s loss of market share and poor stock price performance is likely due to their unwillingness to open new stores in growing areas of cities and closing stores in declining areas of cities. The demographics of cities change over time and once profitable locations stagnate as affluent shoppers move residences to newer areas. Retailers must move with their customer base.
Stale-Mart does not appear to be doing this. The performance evaluation and reward systems encourage district managers to keep old stores open beyond the store’s prime. Once the leasehold improvements have been mostly depreciated the store’s accounting ROI then looks very good.

Stale-Mart has several options to correct this problem:

i. Remove the decision rights to open new stores from the district managers and give it to corporate managers who are compensated on share price appreciation. The problem with this option is that the district managers likely have better-specialized knowledge of their local markets than the corporate staff.
ii. Change the performance evaluation system of the district managers. Calculate the performance of each district manager based on operating income before depreciation. But then you have to control their incentive to over-invest in leasehold improvements. Alternatively, calculate depreciation on the straight-line method using longer lives. This reduces the penalty for opening new stores.
iii. Base bonuses on residual income, not ROI. If incentive plans are based on maximizing ROI, this creates incentives to under-invest or divest of projects that earn above their cost of capital but below the division’s average ROI. Residual income does not suffer from this problem.

Serviflow manufactures products that move and measure various fluids, ranging from water to high-viscosity polymers, corrosive or abrasive chemicals, toxic substances, and other difficult pumping media. The Supply Division, a profit center, manufactures all products for the various marketing divisions, which also are profit centers. One of the marketing divisions, the Natural Gas Marketing Division (NGMD), designed and sells a liquid natural gas pressure regulating valve, NGM4010, which the Supply Division manufactures.
To produce one NGM4010, the Supply Division incurs a variable cost of $6, and NGMD incurs a variable cost of $14. The $6 and $14 variable costs per unit of NGM4010 are constant and do not vary with the number of units produced or sold. While both the Supply Division and NGMD have substantial fixed costs, for the purpose of this question, assume both divisions’ fixed costs are zero.
The following table depicts how the price of the NGM4010 to outside customers varies with the number of units sold each week. (That is, the external customers’ weekly demand curve for NGM4010 is given by the following formula: P 5 1000 2 10Q, where P is the final selling price and Q is the total number of units sold each week.)

Required:

a. If the senior managers in the corporate headquarters of Serviflow knew all the relevant information (the variable costs in the Supply Division and NGMD and the market demand curve for NGM4010), what profit maximizing final price would they set for NGM4010 and how many units would they tell the Supply Division to produce and NGMD to sell each week?
b. How much total profit does Serviflow generate each week based on the profit maximizing price-quantity decision made in part (a)?
c. Assume that Serviflow senior managers do not know all the relevant information to choose the profit maximizing price-quantity decision for NGM4010. Instead, they assign the decision rights to set the transfer price to the Supply Division. Assume the Supply Division knows how many units of NGM4010 NGMD will purchase as a function of the transfer price. The following table shows how NGMD’s purchase decision of NGM4010 depends on the transfer price set by the Supply Division.

(In other words, the Supply Division knows that NGMD’s demand curve for NGM4010 is T 5 986 2 20Q, where T is the transfer price and Q is the number of units of NGM4010 transferred from Supply to NGMD and sold by NGMD each week.) What transfer price will the Supply Division select to maximize the Supply Division’s profit on NGM4010?

d. If the Supply Division selects the transfer price to maximize its profits in part (c), how much profit will the Supply Division make each week, and how much profit will NGMD make each week?
e. Compare the level of firmwide profits calculated in part (b) with the sum of the Supply Division’s and NGMD’s profits calculated in part (d). Which one is larger (firm profits or Supply Division profits plus NGMD profits), and explain why.
f. Suppose corporate headquarters has all the information about customer demand and costs in the two divisions [the same assumption as in part (a)], but instead of telling the two divisions how many units to produce and transfer each week, they set the transfer price on NGM4010. What transfer price would corporate headquarters set in order to maximize firmwide profit?
g. What organizational problems are created if the transfer price for NGM4010 is set following your recommendation in part (f) above? Describe the dysfunctional incentives created by such a transfer pricing rule.

a. Firm-wide profits are maximized by setting the price of NGM4010 at $510 and selling 49 units per week as calculated in the table below.

Instead of computing firm-wide profits from the table, since we know profits are maximized where marginal revenues equal marginal costs we can solve for the profit maximizing quantity using the following equations:

b. At a price of $510 and a weekly quantity of 49 units, Serviflow generates $24,010 of profits [$510 × 49 – 49($6 + $14)].
c. If the Supply Division knows NGMD’s demand curve for NGM4010 then it will set the transfer price at $496 units and NGMD will purchase and sell 24.5 units per week.

As in part (a), Supply maximizes its profits where

d. At a transfer price of $496 and 24.5 units transferred per week, NGMD and the Supply Division make the following profits:

e. If corporate headquarters has all the information and sets the output decision to sell 49 units Serviflow generates weekly profits of $24,010. Giving the Supply Division the decision rights to set the transfer price, total firm profits are only $18,007.50 per week or about 25 percent lower. The reason is that the Supply Division will set the transfer price to maximize its profits and then NGMD takes this transfer price as given to maximize its profits. The quantity of units that maximizes the Supply Division’s profits results in too few units being transferred. Only 24.5 units are transferred if Supply Division sets the transfer price, whereas 49 units are transferred if corporate knows all the relevant information. When each division maximizes its profits, firm-wide profits are lower and this is called the Double Marginalization Problem.
f. Corporate should set the transfer price at the Supply Division’s variable cost of  $6.
NGMD would then select

g. If Supply Division’s variable cost of $6 per unit is the transfer price, the Supply division does not make any money supplying NGM4010. In fact, if all of the Supply Division’s output is sold to other Serviflow divisions at Supply Division’s variable cost, the Supply Division reports a loss equal to its fixed costs. Evaluated as a profit center, the Supply Division appears to be losing money. To avoid losing money or to reduce the loss, the Supply Division will figure out ways to convert its fixed costs into variable costs, even if the total cost of production rises. In this way, the higher variable costs are passed on to marketing divisions.