Accounting for Decision Making and Control for the 9th Edition Solution – Test Bank

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Sample Questions Are Posted Below

Chapter 5

Responsibility Accounting and Transfer Pricing

P 5-1: Solution to Canadian Subsidiary (10 minutes)

[Problems with ROI]

Subsidiary net income is after payments to the debtholders and hence the calculation of return on net investment (which is equivalent to return on equity) is on a return-on-equity basis. Calculate net investment and residual income to equity in each year:

2015 2016 2017

Net income $14.0 $14.3 $14.4

÷ ROI 20% 22% 24%

Net investment = (A–L) = Net income ÷ ROI $70.0 $65.0 $60.0

L = Assets – net investment $55.0 $65.0 $75.0

Subsidiary Net income $14.0 $14.3 $14.4

less: Cost of capital on net investment (7.0) (6.5) (6.0)

Residual income $ 7.0 $ 7.8 $ 8.4

The calculation shows that residual income, like ROI, is rising. The subsidiary has been leveraging up — adding debt to its capital structure and reducing net investment.

Therefore, the improving ROI is the result of financing changes, not operating performance.

P 5-2: Solution to Phipps Electronics (15 minutes)

[International transfer pricing and taxes]

Transfer Pricing Methods

–––––––––––––––––––––––

Full Cost Variable Cost

Low Country Taxes:

Transfer Price $1,000 $ 700

-Cost (1,000) (1,000)

Taxable Income 0 (300)

Income Taxes (or refund) (30%) 0 ($ 90)

High Country Taxes:

Sales Price $1,200 $1,200

-Transfer Price (1,000) (700)

Taxable Income $ 200 $ 500

Income Taxes (40%) $ 80 $200

Import Duty (15% × transfer price) 150 105

Taxes in High Country $230 $305

Total Taxes $230 $215

Assuming Phipps has positive taxable income in Low Country against which to offset the loss of transferring the boards at variable cost, then the variable cost transfer pricing method minimizes the combined tax liability.

P 5-3: Solution to Sunder Properties (15 minutes)

[ROA creates under investment problems]

To calculate Sunder Properties’ ROA, the question arises as to whether the calculation should include or exclude interest. Since ROA is a measure of the return on total assets, not the return to equity investors, interest should be excluded from the calculation of the numerator. (Or equivalently, interest should be added back to Net income before taxes.) Below is the calculation of ROA.

Revenues		$86.50
Expenses
With interest	72.30
Interest	(2.60)
Expenses (excluding interest)		69.70
Net income before taxes		16.80
Divided by total assets		$64.00
ROA		26.25%

ROA Valley View:

Revenues		$16.60
Expenses
including interest	13.30
Interest	(.71)
Expenses (excluding interest)		(12.59)
Net income before taxes		4.01
÷ Total assets		$20.0
ROA		20.05%

Because the ROA of the new project (20.05%) is less than the firm’s ROA (26.25%), Sunder’s ROA will fall if the new project is accepted. Hence, management is expected to reject the new project.

The shareholders of Brighton Holdings will want the managers of Sunder Properties to purchase Valley View if it has a positive residual income.

Net income before taxes (excluding interest)		$4.01
Total Assets	$20.00
WACC	15%	3.00
Residual income		$1.01

Since residual income is positive, the shareholders will want to see the apartment complex be purchased.

Alternatively, since Valley View has a return on investment of 20.05% that exceeds Sunder’s weighted-average cost of capital of 15%, Valley View is a profitable acquisition.

Compensating the managers of Sunder Properties based on ROA gives them incentives to under-invest. We see in part (b) managers in Sunder reject the apartment complex because it lowers their overall average ROA, even though the apartment has a return in excess of its cost of capital (i.e., residual income is positive in part (c)). One suggestion is that Brighton Holdings compensate Sunder Properties’ management based on residual income, not ROA. By making this change, Sunder does not have the incentive to reject positive residual income projects.

P 5-4: Solution to Economic Earnings (15 minutes)

[Understanding the role of the capital charge and depreciation in EVA]

Weaknesses:

Like all accounting-based metrics, EE is short-run focused. Actions taken today that increase future cash flows do not show up in accounting-based performance measures until those cash flows are realized. If managers taking those actions have horizons shorter than when the cash flows are realized, then they have less incentive to take the actions.
Adding back depreciation creates an over-investment problem. The user is only charged for interest on the capital, not its decline in value. It’s like a bank only charging you interest and not principle.
EE double counts interest. Interest is deducted, as is a charge for all the capital. This double counts interest.

Strengths:

Like other accounting-based performance measures, EE is reasonably inexpensive and objective to compute. The accounting numbers are already being computed for taxes and external reporting and are audited.
Unlike stock price, accounting-based measures can be used to measure the performance of sub-units of the organization. In other words, accounting measures can be disagregated.

P 5-5: Solution to Performance Technologies (20 minutes)

[ROA, unlike residual income, creates under- and over-investment incentives]

The following table computes the ROA and residual income of Wilson’s existing assets and the two projects. This table is used to answer all parts of the question.

Since Zang is rewarded based on improving ROA, she will accept project A and reject B. Project A’s ROA of 14% is above her current ROA of 12%, and by choosing Project A, the combined ROA of the Wilson Division rises from 12% to 12.40%. Project B (with an ROA of 10%) will be rejected because it lowers her division’s combined ROA to 11.54%.

				Existing	Existing
	Existing			Portfolio	Portfolio
	Portfolio	Project	Project	& Project	& Project
	of projects	A	B	A Only	B Only
Total Assets	$100.00	$25.00	$30.00	$125.00	$130.00
EBI*	$12.00	$3.50	$3.00	$15.50	$15.00
ROA	12.00%	14.00%	10.00%	12.40%	11.54%

Cost of capital	11%	15%	9%

Residual income	$1.00	-$0.25	$0.30	$0.75	$1.30

*EBI: Earnings before interest

(All $ amounts in millions)

If residual income is used to measure divisional performance, project A is now rejected and project B accepted. Project A has a negative residual income of ($250,000) that lowers Zang’s RI from $1 million to $750,000. Project B has a positive residual income of $300,000 that increases Zang’s RI from $1 million to $1,300,000.

Zang changes her decisions because ROA ignores the project’s risk adjusted cost of capital. Use of ROA as a performance measure only involves increasing the division’s ROA and does not consider whether a project’s ROA is above or below its risk adjusted cost of capital.

As illustrated in this problem, ROA can induce incorrect investment decisions, whereas residual income does not. In particular, ROA can lead to over- and under-investment decisions. However, projects with a positive residual income have positive NPV, whereas projects with a negative residual income have a negative NPV. While not perfect, residual income is better than ROA as a performance measure because it does not produce these under/over investment incentives.

P 5-6: Solution to Metal Press (20 minutes)

[ROA under historical-cost and inflation-adjusted depreciation]

Book value and depreciation expense:

Historical Price-adjusted

Cost Historical Cost

Original cost $522,000 $522,000

Change in price index 1.19

Depreciable cost 522,000 621,180

Annual depreciation expense (÷12) 43,500 51,765

Accumulated depreciation (× 7) 304,500 362,355

Book value $217,500 $258,825

ROAs will fall because of two reasons:

(i) larger depreciation expense being subtracted from income reduces the numerator, and

(ii) larger asset values in the denominator.

Division managers have greater incentive to replace obsolete equipment under the price-level-adjusted method than under historical cost because the differential between the book value of the old equipment and the new equipment is smaller. Hence, the historical cost incentive to keep older equipment is reduced.

P 5-7: Solution to ICB, Intl. (20 minutes)

[Summary of key transfer pricing issues]

The following points summarize the important issues in transfer pricing:

Transfer pricing does not merely shift profits from one division to another, it affects overall firm profits by affecting the quantity of units transferred.

A transfer price of full cost plus profit causes the buying division to buy fewer units than if the transfer price were lower.

The ideal transfer price should be the resources forgone from making the transfer (opportunity cost).

Allowing manufacturing to make a profit means that the marketing divisions will buy and hence sell fewer units than if the transfer prices were set at opportunity cost, unless manufacturing can also sell at a profit outside.

If manufacturing has long-run excess capacity, it should transfer the conditioner at variable cost. If manufacturing does not have excess capacity, the transfer price should be at what it can sell the conditioner for in its next best use (market price).

If the corporate controller intervenes in this case, then future transfer pricing disputes will land on her desk. Her intervention in this case will likely change the process by which transfer prices are set. The current decentralized negotiation process will tend to become more centralized in the controller’s office.

P 5-8: Solution to Shop and Save (25 minutes)

[Transfer pricing using percentage of final selling price]

Advantages:

No gaming over the transfer price. It is objectively set by central management. The Bakery cannot game the system by substituting variable costs for fixed costs if a variable cost transfer pricing method was used for instance.
The transfer pricing policy is simple and easy to understand.
The Bakery has an incentive to produce efficiently since it cannot pass inefficiencies on to the stores through higher transfer prices if they were using a cost-based transfer price.

Disadvantages:

The optimum, firm-value maximizing transfer price is opportunity cost. With excess capacity, marginal (or variable) cost is the opportunity cost. There is no guarantee that 60 percent of the retail price is marginal cost. Moreover, it is unlikely that marginal cost is always 60 percent of the price across all fresh baked goods (breads, rolls, cakes, and pies).
The current pricing policy does not utilize any of the specialized knowledge of the local stores nor of the Bakery in determining the transfer price.
Decision rights over the transfer pricing of the baked goods are set centrally, but the Bakery is evaluated as a profit center. Hence, the performance evaluation and reward structure of the Bakery does not match the Bakery’s decision rights assignment.

They can continue to use the 60 percent of retail price as the transfer price of current bakery items but allow the stores and bakery to negotiate the transfer price of new bakery items. In this way the stores that have specialized knowledge of what consumers want and the stores that have specialized knowledge of recipes and current trends in baked goods can assemble this knowledge and negotiate over the transfer price.

Another suggestion is to allow the stores to purchase some fresh baked goods from local bakeries. This forces the bakery to become more competitive in terms of specialty baked goods at competitive prices.

Finally, S&S should prepare a market study of the wholesale prices of fresh baked goods in the region. If the wholesale price of most fresh baked goods is roughly 60 percent of the retail price, then the internal transfer price of 60 percent of the retail price is roughly the market price and hence is probably a good approximation of opportunity cost.

Other solutions include: decentralize the pricing decision to the Bakery/grocery stores or make the Bakery a cost center. However, before implementing either of these suggestions, one needs to ask: “Is the current system broken?”

P 5-9: Solution to Microelectronics (25 minutes)

[Simple transfer pricing]

As long as the Phone division is evaluated as a profit center and Microelectronics does not intervene somehow, the Phone Division will not purchase the circuit boards from the Circuit Board division because the Phone Division will lose money on each phone:

Selling price of phones $400

Transfer price of boards (market) $200

Other costs to complete phone 250 450

Incremental cash flow (loss) to Phone Division $(50)

Yes. Firm profits are higher assuming the excess capacity of 5,000 boards per month has no other use.

Selling price of phones $400

Incremental (variable) cost per board $130

Other costs to complete phone 250 380

Incremental cash flow (loss) $ 20

The transfer price must be set in such a way as to induce the two parties to make the transfer. In essence, the transfer price must give incentives to the Circuit Board Division to want to make the transfer and give incentives to the Phones Division to buy. In other words, the following two constraints must be satisfied:

Circuit Board Division: TP > $130 (variable cost)

Phones Division TP < $150 (selling price – costs to complete)

where: TP = transfer price

Therefore, any transfer price between $130 and $150 will induce the two divisions to make the transfer. However, $130 is best as it induces transfer even if the phone price declines $19.

There are three important assumptions.

(i) If the Circuit Board Division currently has 5,000 units of excess capacity (33 percent), why is it selling circuit boards externally at $200. Might it not be better to lower the price of the circuit boards to say $190 (depending on the price elasticity of demand) and use up the excess capacity this way rather than by producing boards for the Phones Division at the internal transfer price? That is, the decision to transfer the boards internally assumes the opportunity cost of the excess capacity is zero.

(ii) The answer in part (c) assumes that any price between $130 and $150 is equally useful. This assumes the Phones Division will not adjust its selling price (and thus number of phones sold) based on its marginal costs (including the transfer price).

(iii) Variable costs per board ($130) and per phone ($250) do not change with volume.

Other assumptions include:

There is a market for another 3,000 phones/month
After including fixed costs, the divisions are profitable.
Derived demand from additional phones does not drive down prices for circuit boards.
Creating an exception to the rule in this case does not lead to future transfer pricing disputes.

P 5-10: Solution to US Copiers (25 minutes)

[Transfer pricing and divisional interdependencies]

Two reasons why US Copiers manufactures both copiers and toner cartridges are: synergies in demand and/or production. Selling toner cartridges is a way to charge higher prices to consumers who use (and hence value) the copier more intensively than users who use the copier less intensively. It allows them to engage in a form of price discrimination. To the extent that most users of SCD copiers buy US Copiers’ toner cartridges at prices above marginal cost, US Copiers earns economic profits. Production synergies involve transaction cost savings from integrating the design of the cartridges and the copiers. It is likely that one firm can design both the cartridge and the copier at a lower cost than two separate firms trying to coordinate their design teams. Alternatively, since cartridges and copiers are highly specialized to each other, two separate firms have incentives to behave opportunistically in transferring the cartridges for inclusion in the copier. A single firm is likely to be better at controlling such opportunism than two separate firms.

You should consider the following issues:

(i) As long as TD can add capacity and produce cartridges at long-run marginal cost (LRMC) below price, then the correct transfer price should be LRMC.

(ii) Charging SCD market price of $35 will cause SCD to set a higher price on its copiers than if a transfer price less than $35 is charged. Thus, a lower transfer price causes more copiers to be sold and eventually more replacement toner cartridges to be sold.

(iii) Neither SCD nor TD should have the sole decision-making authority to price their own products. Rather, copiers and cartridges must be priced jointly. For example, when buying copiers, consumers consider both the copier’s and replacement toner prices. In setting the price of the copier, the SCD manager should consider the future stream of replacement toner sales. And the TD manager should consider the effect of toner prices on copier sales. However, focusing only on their own profits causes each divisional manager to ignore the effect of their pricing decision on the other manager’s cash flows. Hence, decentralizing the copier and toner cartridge prices to the respective managers is likely a bad idea.

P 5-11: Solution to Cogen (25 minutes)

[Full-cost versus variable cost transfer pricing]

If the transfer price is set at variable cost ($150,000), the Generator Division will buy seven turbines (see table) as this level maximizes the division’s profits.

			Generator’s	Var. Cost
			Variable	Transfer	Total	Generator’s
Quantity	Price (000)	Revenue	Cost	Price	Cost	Profits
1	$1,000	$1,000	$200	$150	$1750	($750)
2	950	$1,900	400	300	2100	(200)
3	900	$2,700	600	450	2450	250
4	850	$3,400	800	600	2800	600
5	800	$4,000	1000	750	3150	850
6	750	$4,500	1200	900	3500	1,000
7	700	$4,900	1400	1050	3850	1,050
8	650	$5,200	1600	1200	4200	1,000

The (average) full cost (000s) of a turbine is

Full cost = VC + FC ÷ 20

= $150 + $1800 ÷ 20

= $240

If the transfer price is set at full cost ($240,000), Generator will buy six turbines:

			Generator’s	Avg. Cost
			Variable	Transfer	Total	Generator’s
Quantity	Price (000)	Revenue	Cost	Price	Cost	Profits
1	$1,000	$1,000	$200	$240	$1840	($840)
2	950	$1,900	400	480	2280	(380)
3	900	$2,700	600	720	2720	(20)
4	850	$3,400	800	960	3160	240
5	800	$4,000	1000	1200	3600	400
6	750	$4,500	1200	1440	4040	460
7	700	$4,900	1400	1680	4480	420
8	650	$5,200	1600	1920	4920	280

Conventional wisdom argues that variable-cost transfer pricing yields the firm-profit maximizing solution. This is certainly the case as long as variable cost is reasonably easily observed and not subject to gaming. However, the Turbine Division has incentive to reclassify what are in reality fixed costs as variable costs and to convert activities that are now a fixed cost into a variable cost (by replacing contracts written in terms of fixed cash flows with contracts written so the cash outflows vary with units produced). Thus, full-cost transfer prices, being less subject to managerial discretion, might be preferred to variable-cost transfer prices, even though full-cost transfer prices result in fewer units being transferred and hence slightly lower overall profits.

P 5-12: Solution to Wegmans (25 minutes)

[Computing and analyzing differences in residual income among supermarket stores]

The following table computes the residual income for the three Wegmans stores:

(000s)	Virginia 3	Rochester 1	Median
Revenues	$59,300	$110,250	$70,000
Cost of goods sold	(41,510)	(74,970)	(48,300)
Store administration	(5,930)	(8,820)	(6,300)
Distribution center charges	(5,100)	(4,900)	(3,900)
Profits before capital charge	$6,760	$21,560	$11,500

Working capital	$1,100	$1,500	$1,300
Property, building, and fixtures	58,300	28,740	44,000
Total investment	$59,400	$30,240	$45,300
Capital charge (13%)	7,722	3,931	5,889
Residual income	($962)	$17,629	$5,611

Virginia 3’s negative residual income of nearly $1 million stands in stark contrast to Rochester 1’s $17.6 million and the Median’s $5.6 million residual incomes. On the surface, Virginia 3 is performing poorly relative to Rochester 3 and Median. However, there are a number of likely explanations for these differences:
1. Virginia 3 being relatively new in Virginia has not developed the same customer following and name recognition afforded long established Wegmans stores such as Rochester 1. Hence, Virginia 3 unlikely has the same volume and pricing advantages enjoyed by other Wegmans stores. From the following table we see that Virginia 3’s gross operating margin is 30% of sales, whereas Rochester 1’s margin is 32% of sales and the median store is 31% of sales.

(000s)	Virginia 3	Rochester 1	Median
Revenues	$59,300	$110,250	$70,000
Cost of goods sold	(41,510)	(74,970)	(48,300)
Gross margin	$17,790	$35,280	$21,700
Gross margin (% of sales)	30%	32%	31%

However, the lower gross margin in Virginia 3 only explains a relatively small difference in residual incomes among the three stores. A 1% or 2% higher margin would only increase Virginia 3’s residual income by $0.6 – $1.2 million.

Being a new store, Virginia 3’s construction costs are likely much higher than the older Rochester 1 and Median stores. Inflation and the likely higher cost of land in Virginia relative to upstate New York most likely explain the big differences in property, building and fixtures. In fact, the investment in property, building, and fixtures are twice as much in Virginia 3 than in Rochester 1 and over 130% higher than the median store. Without adjustment for inflation, residual income is lower for newer investments.

Wegmans expansion into Virginia is in the early stage, with only three stores served by one distribution center. With 80 stores and 10 distribution centers, the average Wegmans store bears roughly 1/8th the cost of the regional distribution center. Virginia 3 must bear roughly 1/3rd the cost of the regional distribution center. Compared to the median store that has more revenue ($70 million vs. $59.3 million), Virginia 3 has 30% more allocated distribution center costs ($5.93 million vs. $3.9 million).

P 5-13: Solution to Zee Spin Wedges (25 minutes)

[Setting the correct transfer price]

The firm-value-maximizing transfer price should be opportunity cost. If the Shaft division has excess capacity, then the opportunity cost of producing a shaft is only the variable manufacturing cost of the shaft ($11.48). If the shaft division does not have excess capacity, then by producing and selling the shaft internally to the Wedge division, Zee Spin foregoes selling the shaft to an external customer for $23 less the variable selling costs of $2.43, or $20.57. In other words, absent excess capacity, selling the shaft internally forces the firm to forego the incremental profits it could have earned from selling it externally. Therefore, the transfer price is either $11.48 or $$20.57 depending on whether the Shaft division has excess capacity.

Because the two profit center managers’ compensation depends on the transfer price of the shafts, they will argue about the transfer price. Three potential problems will arise.
The shaft division manager will always argue the Shaft division has no excess capacity in order to get the higher transfer price of $20.57. Or, the Shaft manager will actually plan production so there is no excess capacity to get the $20.57 transfer price.
The Shaft division manager will try to argue that some of the costs that are currently classified as “fixed” manufacturing costs should be reclassified as “variable” manufacturing costs so as to increase the variable cost and hence the transfer price if there is excess capacity.

The Shaft division manager will change the production process to convert fixed manufacturing costs to variable manufacturing costs, thereby raising the transfer price above $11.48. One way to do this is by outsourcing some of the current intermediate production processes.

P 5-14: Solution to Creative Learning Centers (25 minutes)

[Choosing among performance measures: operating income, ROI, and EVA]

The following table computes Ms. Schnelling’s performance on the existing Virginia preschools and the new schools using Operating income, ROI, and EVA:

	After Tax Operating Income	Total Investment	ROI	EVA
All 15 VA preschools	$1,811,250	$11,625,000	15.58%	$416,250
Best 3 Virginia performers
VA4	$184,230	$801,000	23.00%	$88,110
VA12	$156,030	$743,000	21.00%	$66,870
VA9	$151,000	$755,000	20.00%	$60,400
Worst 3 Virginia performers
VA2	$34,000	$680,000	5.00%	-$47,600
VA8	$14,200	$710,000	2.00%	-$71,000
VA5	-$23,700	$790,000	-3.00%	-$118,500

Potential New Virginia Preschools
NVA1	$132,000	$880,000	15.00%	$26,400
NVA2	$110,500	$850,000	13.00%	$8,500
NVA3	$79,200	$720,000	11.00%	-$7,200

If Ms. Schnelling is evaluated based on After tax operating income, she will close VA5 (the only existing school with negative After tax operating income) as this will increase her total After tax operating income. She will open all three new schools as they all have positive After tax operating income, and each one increases her total After tax operating income.

If Ms. Schnelling is evaluated based on ROI, she will close all three of her worst performing existing schools because each has an ROI below her average ROI. Moreover, she has an incentive to close other schools that have an ROI below her current average ROI of 15.58%. She will not open any of the three new schools as each has an ROI below her current average ROI. Opening any of them will cause her average ROI to fall. ROI causes an underinvestment problem in CLC because NVA1 and NVA2 both have ROIs in excess of CLC’s cost of capital and should be opened. Maximizing ROI causes her to reject these profitable new schools because they happen to have ROIs below Ms. Schnelling’s average ROI.

CLC should adopt EVA (i.e., residual income) as its performance measure. After tax operating income does not include the cost of capital invested in the school, and hence state managers like Ms. Schnelling view the cost of making the investment as free (except for the depreciation component of operating expenses). Hence, After tax operating income creates an over-investment problem. ROI implicitly incorporates the cost of investment by converting the performance measure to a return per dollar invested. But ROI creates both under- and over-investment incentives. She will reject (or close) any school that lowers her average ROI, even if the school yields a return above CLC’s cost of capital. ROI also can create an over-investment problem if a school’s ROI is above the manager’s average ROI but below CLC’s cost of capital.

EVA solves the over- and under-investment problems of After tax operating income and ROI by charging the state manager for the cost of the investment in each school. Under EVA Ms. Schnelling will close the three worst performing existing schools (and others that might have negative EVAs). And, she will only open NVA1 and NVA2 as they are generating After tax operating income in excess of the cost of capital invested in the schools.

P 5-15: Solution to Warm Boots (30 minutes)

[Poor incentives when managers are evaluated on minimizing average cost]

As the Manufacturing Division manager, I would choose the production level that minimizes average cost because that is how I am compensated. The table below computes average cost from total cost given in the problem.

Quantity	Total Cost	Average Cost
20	$645.00	$32.250
21	672.30	32.014
22	700.20	31.827
23	728.70	31.683
24	757.80	31.575
25	787.50	31.500
26	817.80	31.454
27	848.70	31.433
28	880.20	31.436
29	912.30	31.459
30	945.00	31.500
31	978.30	31.558
32	1012.20	31.631
33	1046.70	31.718
34	1081.80	31.818
35	1117.50	31.929

To maximize my bonus, I would choose to produce 27 boots per week as this is the minimum average cost.

As manager of the M&S Division of Warm Boots, and given that the Manufacturing Division level produces 27 pairs of boots per week at an average cost of $31.433, I would price the boots at $270 per pair and sell 23 pairs of boots per week as detailed below:


Quantity	Price	Revenue	Total Manufacturing Cost at Average Cost*	Profit at Average Cost
20	$300	$6,000.00	$628.667	$5,371.33
21	290	6,090.00	660.100	5,429.90
22	280	6,160.00	691.533	5,468.47
23	270	6,210.00	722.967	5,487.03
24	260	6,240.00	754.400	5,485.60
25	250	6,250.00	785.833	5,464.17
26	240	6,240.00	817.267	5,422.73
27	230	6,210.00	848.700	5,361.30
28	220	6,160.00	880.133	5,279.87
29	210	6,090.00	911.567	5,178.43
30	200	6,000.00	943.000	5,057.00
31	190	5,890.00	974.433	4,915.57
32	180	5,760.00	1005.867	4,754.13
33	170	5,610.00	1037.300	4,572.70
34	160	5,440.00	1068.733	4,371.27

* $31.433 x quantity

Firm profits are maximized by setting the price at $260 per pair and selling 24 pairs per week as shown below.

Quantity	Price	Total Cost	Revenue	Profits
20	$300	$645.00	$6,000.00	$5,355.00
21	290	672.30	6,090.00	5,417.70
22	280	700.20	6,160.00	5,459.80
23	270	728.70	6,210.00	5,481.30
24	260	757.80	6,240.00	5,482.20
25	250	787.50	6,250.00	5,462.50
26	240	817.80	6,240.00	5,422.20
27	230	848.70	6,210.00	5,361.30
28	220	880.20	6,160.00	5,279.80
29	210	912.30	6,090.00	5,177.70
30	200	945.00	6,000.00	5,055.00
31	190	978.30	5,890.00	4,911.70
32	180	1012.20	5,760.00	4,747.80
33	170	1046.70	5,610.00	4,563.30
34	160	1081.80	5,440.00	4,358.20
35	150	1117.50	5,250.00	4,132.50

By letting the Manufacturing Division manager set the production level to minimize average cost, he/she will produce too many units (27 pairs) to get the average cost down to $31.433. At this cost level, the M&S manager will maximize his/her division profits by selling only 23 pairs, resulting in an increase in inventory of 4 pairs per week.

The firm is not maximizing firm-wide profits because the decision as to how many units to produce should not in general be based on minimizing average cost. Stated differently, minimizing average costs is not the same as maximizing profits. This problem illustrates this general principle from economics.

P 5-16: Solution to University Lab Testing (30 minutes)

[Optimum transfer pricing schemes]

With excess capacity, performing one more test of Q796 does not prevent Lab Testing from performing a test for an outsider. Hence, the opportunity cost of one more test for an inside user is the variable cost of $22.05. Therefore, the University Hospital profit maximizing transfer price is $22.05 when Lab Testing has excess capacity. When an inside department is deciding to perform one Q796 test, the opportunity cost to the Hospital is $22.05.

If Lab Testing is reimbursed $22.05 for performing one more test, Joanna Wu incurs the variable cost of $22.05 and reports zero profits on this test. Notice, that the fixed costs of $25.93 do not affect the INCREMENTAL profits she generates because these fixed costs are FIXED, and by doing one more Q796 test, she only incurs the variable cost.

With no excess capacity, by performing one Q796 test, Joanna Wu forgoes doing an outside test (that is performed by another firm in the community). Thus, the opportunity cost to both the University Hospital and Lab Testing is $68.90, the revenue foregone from an outside health care provider. Thus, when Lab Testing has no excess capacity, the optimum transfer price (opportunity cost) is $68.90.

If Lab Testing is reimbursed $68.90 for performing one more test, Joanna Wu incurs the variable cost of $22.05 and reports profits of $46.85 on this test. Notice, that the fixed costs of $25.93 do not affect the INCREMENTAL profits she generates because these fixed costs are FIXED, and by doing one more Q796 test, she only incurs the variable cost.

The ideal transfer pricing policy is opportunity cost. Using this principle, if Lab Testing has excess capacity, the transfer price for one Q796 test is $22.05. Without excess capacity, the transfer price should be $68.90. But implementing this ideal transfer pricing scheme requires knowledge of whether Lab Testing has excess capacity at the time a test is performed. Joanna Wu has this specialized knowledge that varies over time, and possibly even within the same day. If Wu is given the decision rights to state whether excess capacity exists within her department with respect to Q796 tests, she has incentives to claim that no excess capacity exists in order to get the higher transfer price of $68.90. Even if she honestly reports whether she has excess capacity, it is very costly to communicate this information to physicians in real time so they can decide whether to order one more test or not. The administrative cost of implementing this two-tier transfer price is very expensive, not to mention the incentive problems of Wu mis-reporting the capacity of her lab. If her lab performs several hundred different tests, then the costs of implementing the ideal, two-tier transfer price for all her tests is exorbitant. An alternative transfer pricing scheme is to implement a full cost transfer price and charge internal users $47.98. While $47.98 is above variable cost of $22.05, it is still below the market price of $68.90. For each additional lab test, Wu generates $25.93 of profits (her fixed costs). Thus, full cost transfer pricing is a good compromise when one considers the costs of implementing and administering the transfer pricing policy. Another advantage of full cost transfer pricing is that it eliminates any incentives of Wu to convert fixed costs into variable costs. The disadvantages of full cost are that physicians will order too few tests when the price is $47.98 versus $22.05, and Wu has less incentive to be efficient as any cost increases get passed through to the University Hospital clinical units when the full cost gets recalculated based on the higher costs.

P 5-17: Solution to Beckett Automotive Group (30 minutes)

[Synergies and transfer pricing within an auto dealership]

By offering both new and used cars as well as service, Beckett is offering the customer convenience. Offering a bundled product consisting of a new car, trading in a used car, and service provides the customers one-stop shopping that lowers their transaction cost. When buying a new car, customers usually have a used car they no longer want. They could sell this car themselves privately through local ads, but this is a big inconvenience. Besides, there is a tax advantage to trading the old car. Sales tax is paid on the difference between the new and used car prices. If the used car is sold privately, the buyer pays more sales tax on the new car.

The current system gives the decision rights to negotiate the price of the trade-in to the Pre-owned Car manager. While this manager has the specialized knowledge of what the trade-in is worth, the manager does not have the incentive to take into account the potential lost profit on the new car if the customer rejects the trade-in price and walks away. For example, suppose the New Car sales person has talked the new car buyer into purchasing a car at a high price (and hence a large profit for Beckett). In this case, the Pre-Owned Car manager should be willing to take a lower profit on the trade-in. But this manager is not compensated for any part of the new car profits. In fact, if the new car purchase has a large enough profit built into the price, the Pre-Owned car manager should be willing to take a loss on the trade-in. This will only happen if the New Car sales person can talk the Pre-Owned Car manager into the deal, or if the New Car sales person goes to her manager, who goes to the owner of Beckett to convince the Pre-owned Car manager to take the deal. But this takes time, and the new car buyer may walk away.

Likewise, the New Car sales manager will not take into account the potential profit that Pre-owned Cars will make on the trade in when negotiating the price of the new car. If the New Car sales person knows that Pre-Owned Cars will make a large profit on the trade in, then New Cars should be willing to take a lower price on the new car to seal the total deal. The current system where each division is only rewarded on their own profits creates incentives for each manager to behave myopically.

One solution is to base part of the Pre-owned Car manager’s bonus on the New Car department’s profits. Suppose the Pre-owned Car manager’s bonus was based on say 70 percent of the profits in Pre-owned Cars and 30 percent of New Car profits. Then the Pre-owned car manager has some incentive to take a lower profit on the trade in if it means making the new car sale.

Beckett could install a transfer price scheme whereby New Cars profit is calculated as the difference between the selling price of the new car and its cost PLUS the difference between the Kelly Blue Book wholesale value of the trade in and the trade in allowance given to the customer buying the new car and trading in her old car. In this way, New Cars gets rewarded for both the sale of the new car and the estimated profit on the trade in. Pre Owned Cars’ profit is the difference between the price they receive when it sells the trade and the Kelly Blue Book wholesale price.

Another solution is to reorganize the firm so that both New and Pre-owned cars report to a single manager. In this way the profits from both the new car sale and the trade-in are captured within the same division.

P5-18: Solution to WBG (30 minutes)

[Practical problems with implementing optimum transfer pricing policies]

The proposed transfer pricing policy (“Use external market price of the transducers as the transfer price of transducers if and only if the Transducer Division is at capacity for the month, otherwise use variable cost as the transfer price”) best captures the opportunity cost of making and transferring transducers inside WBG. With no excess capacity, WBG foregoes selling the transducer externally if it transfers it inside to the Military or Commercial divisions. With excess capacity, the opportunity cost of making a transducer and transferring it to an internal division is just the out-of-pocket cost (variable cost). So to induce the Military and Commercial divisions to make the correct decision as to how many transducers to buy from the Transducer Division and how to price their final products, the two divisions should be confronted with WBG’s opportunity cost of the transducers.

Several problems arise in implementing this transfer pricing policy. Assuming that in some months the Transducer Division has excess capacity and in other months it does not, the transfer price varies monthly. This makes it difficult for the Military and Commercial divisions to set long term prices with their customers. Moreover, these two divisions’ profits will vary, imposing risk on the two divisions’ managers. The Transducer Division will always claim they have no excess capacity, allowing them to get a higher transfer price, and thereby report higher profits. Under the current full cost transfer price policy, the Military and Commercial divisions face a fairly constant transfer price each month, and hence can more easily establish a relatively constant long term price for their end products. Instead of bickering over the “correct” transfer price policy, now the divisions will bicker over whether the Transducer Division had excess capacity. Moreover, if the proposed policy is adopted, the Transducer Division will reduce its capacity to help ensure they always have no excess capacity, thereby leading to higher profits for the Transducer Division. In other words, the proposed transfer pricing policy can lead to an under investment problem in the Transducer Division.

Before adopting the proposed transfer pricing policy, WBG should collect the following data:

Collect data on the fraction of a transducer’s total cost that is fixed and its margin (market price less full cost). If the fixed cost is a relatively small percentage of the transducer’s total cost and the margin is relatively small, then full cost (the current policy), variable cost, and market price are approximately the same. Adopting the new policy will have little effect on the transfer price, and hence the new policy is probably not worth the headache of trying to determine if the Transducer Division was operating at capacity each month.

Collect data on the fraction of the total cost of the Military and Commercial Divisions’ final product cost is represented by the transducer. If the total cost of the transducer represents a small fraction of the final cost of the end product, then it probably doesn’t matter which transfer pricing policy is chosen because the transfer price will have a negligible effect on the pricing decisions made by the Military and Commercial Divisions.

Collect data on the price sensitivity of the Military and Commercial divisions’ customers (their price elasticity). Are these customers’ demands for WBG products with transducers extremely price sensitive? If they are, then adopting the new transfer pricing policy might cause us to lose customers we do not want to lose if the transducer’s transfer price is a fairly large fraction of the end product’s final cost.

P 5-19: Solution to CJ Equity Partners (30 minutes)

[Investment incentives and EVA, ROA, earnings]

The following table computes the performance of each operating company using residual income after taxes (or EVA).

	Jasco Tools	Miller Bottling	JanSan
Total assets	$20.1	$31.2	$16.3
After tax weighted-average cost of capital	0.14	0.12	0.10
After tax capital charge	$2.814	$3.744	$1.630

Residual income
Revenues	$38.600	$42.900	$21.200
Operating expenses	(33.600)	(36.800)	(18.200)
CM Equity management fee	(0.200)	(0.200)	(0.200)
Net operating profit before
capital charge and taxes	$4.800	$5.900	$2.800
Income taxes (40%)	(1.920)	(2.360)	(1.120)
Net income before capital charge	$2.880	$3.540	$1.680
Capital charge	(2.814)	(3.744)	(1.630)
Residual income	$0.066	$(0.204)	$0.050

Memo explaining the choice of performance measure:

Residual income is used to measure the performance of each of the operating companies because it provides the professional managers incentive to operate their company profitably, which includes using their assets efficiently. Each operating company is charged for the total assets in the company times each company’s risk adjusted, after tax cost of capital. This represents the opportunity cost to investors of assets invested in the company. Each operating company is charged for taxes to give them incentives to make tax-efficient decisions. Note: interest expense is not included in the calculation of residual income to avoid double counting the cost of debt financed assets. Using residual income gives each operating company’s professional manager incentives to use assets efficiently. Any asset (or project) that is not returning the company’s weighted-average cost of capital reduces firm value. The CJ Equity management fee is included as an expense because each operating company imposes costs on CJ Equity in the form of oversight and tax preparation.

The problem with the current performance measure (net income after taxes) is it creates an over investment problem. Using net income after taxes only charges the professional managers for the cost of assets financed with debt. Equity financed assets are “free.” ROA is not used as a performance measure because it creates incentives to under- (and in some cases to over-) invest in positive NPV projects.

Note: Some students might prepare a performance measure based on ROA, such as:

	Jasco Tools	Miller Bottling	JanSan
Total assets	$20.10	$31.20	$16.30
After tax weighted-average cost of capital	14%	12%	10%

Return on Assets (ROA)
Revenues	$38.60	$42.90	$21.20
Operating expenses	(33.60)	(36.80)	(18.20)
CM Equity management fee	(0.20)	(0.20)	(0.20)
Net Operating profit before taxes	$4.80	$5.90	$2.80
Income taxes (40%)	-1.92	-2.36	-1.12
Net Income after taxes	$2.88	$3.54	$1.68
ROA	14.33%	11.35%	10.31%

If students compute ROA, they should not deduct interest expense in calculating net income. ROA is a measure of return on total assets. Deducting interest expense to arrive at net income produces a return to the equity holders (i.e., after paying the debt holders). Hence, dividing net income (after deducting interest expense) by total assets produces inconsistent measures in the numerator and denominator. As noted before, residual income (or EVA) has the advantage over ROA of not creating an underinvestment problem.

P 5-20: Solution to R&D Inc. (35 minutes)

[Capitalizing versus expensing R&D in calculating EVA]

EVA if R&D is written off is:

Earnings before R&D expenditures $21.5

R&D expenditures 6.0

Earnings after expensing R&D $15.5

Total invested capital (excluding R&D assets) $100.0

Weighted average cost of capital 14%

Capital cost ($14.0)

EVA $ 1.5

R&D is capitalized and amortized over a three-year life:

The following table calculates the capitalization and amortization of R&D:

Year	Beginning R&D Book Value	R&D Expenditures	R&D Amortization	Ending R&D Book Value
1	$0.0	$6.0	$2.0	$4.0
2	4.0	6.0	4.0	6.0
3	6.0	6.0	6.0	6.0
4	6.0	6.0	6.0	6.0
5	6.0	6.0	6.0	6.0
6	6.0	6.0	6.0	6.0
7	6.0	6.0	6.0	6.0

Notice that after the second year, R&D Inc. is adding new R&D assets of $6.0 million and writing off R&D amortization of $6.0 million per year. The only difference is that the invested capital is larger by $6.0 million of R&D assets.

Earnings before R&D expenditures $21.50

Amortization of R&D assets 6.00

Earnings after R&D amortization $15.50

Total invested capital (including R&D assets) $106.00

Weighted average cost of capital 14%

Capital cost ($14.84)

EVA $ 0.66

Since the firm is spending a constant amount on R&D each year, capitalizing versus expensing R&D produce the same earnings after capitalization and amortization. Both methods charge earnings for $6 million. The only differential effect capitalization and amortization has is on the capital charge (14% × $6 million). Under R&D expensing, cutting R&D by $1 million gives the manager immediate savings of $1 million and thus $1 million more EVA. Under R&D capitalization/amortization, cutting R&D by $1 million translates into lower amortization this year of $333,333 ($1 million ÷ 3) plus a lower capital cost of $93,333 ($666,667 million ending book value x 14%), or a total savings this year of $426,666. Capitalization/amortization still gives the manager an incentive to under spend on R&D, but the incentive is smaller. Therefore, capitalization/amortization reduces the incentives of managers to cut R&D. (Note: the preceding calculations assume that the EVA capital charge of 14% is applied to the ending book value of the R&D asset. Slightly different numbers result if the 14% is applied to the average of the beginning and ending book values of the R&D asset, but the same conclusion obtains – capitalization/amortization reduces, but does not eliminate incentive of managers approaching retirement to under spend on R&D).

(Thanks to Heidi Tribunella for refining the solution.)

P 5-21: Solution to Flat Images (40 minutes)

[Other than variable cost transfer pricing reduces firm-wide profits]

At a transfer price of $4,800, Marketing will purchase 100 screens from Manufacturing and will make a profit of $50,000. See below:

Marketing Division Profit Maximizing Decision Given a Transfer Price of $4,800
No. of Screens	Selling Price	Revenue	Marketing’s Own Cost	Transfer Cost	Profit
50	$8000	$400,000	$160,000	$240,000	$0
75	7500	562,500	165,000	360,000	37,500
100	7000	700,000	170,000	480,000	50,000
125	6500	812,500	175,000	600,000	37,500
150	6000	900,000	180,000	720,000	0
175	5500	962,500	185,000	840,000	-62,500
200	5000	1,000,000	190,000	960,000	-150,000
225	4500	1,012,500	195,000	1,080,000	-262,500
250	4000	1,000,000	200,000	1,200,000	-400,000
275	3500	962,500	205,000	1,320,000	-562,500

At a transfer price of $4,800 per screen, Manufacturing makes a profit of:

Revenue from transfer (100 x $4,800) $480,000

Variable cost (100 x $800) (80,000)

Fixed cost (300,000)

Manufacturing’s profit $100,000

At a transfer price of $4,800, Flat Images is generating profit of:

Revenue from external sale (100 x $7,000) $700,000

Variable cost (100 x $1,000) (100,000)

Fixed cost ($150,000 + $300,000) (450,000)

Manufacturing’s profit $150,000

To maximize firm-wide profits Flat Image should manufacture and sell screens 200 screens. See below:

No. of Screens	Selling Price	Revenue	Total Cost	Profit
50	$8000	$ 400,000	$500,000	-$100,000
75	7500	562,500	525,000	37,500
100	7000	700,000	550,000	150,000
125	6500	812,500	575,000	237,500
150	6000	900,000	600,000	300,000
175	5500	962,500	625,000	337,500
200	5000	1,000,000	650,000	350,000
225	4500	1,012,500	675,000	337,500
250	4000	1,000,000	700,000	300,000
275	3500	962,500	725,000	237,500

The answers to (c) and (d) differ because the transfer price of $4,800 is above Manufacturing’s variable cost of $800. So Marketing buys only 100 screens from Manufacturing, which is less than the 200 screens that maximizes firm-wide profits. This is an example of the double-marginalization problem.

Flat Images should set the transfer price at Manufacturing’s variable cost of $800 to maximize firm-wide profits. At this transfer price, Marketing will purchase 200 screens per month.

No. of Screens	Revenue	Marketing’s Own Cost	Transfer Cost (@$800)	Total Cost	Profit
50	$400,000	$160,000	$40,000	$200,000	$200,000
75	562,500	165,000	60,000	225,000	337,500
100	700,000	170,000	80,000	250,000	350,000
125	812,500	175,000	100,000	275,000	537,500
150	900,000	180,000	120,000	300,000	600,000
175	962,500	185,000	140,000	325,000	637,500
200	1,000,000	190,000	160,000	350,000	650,000
225	1,012,500	195,000	180,000	375,000	637,500
250	1,000,000	200,000	200,000	400,000	600,000
275	962,500	205,000	220,000	425,000	537,500

P 5-22: Solution to Premier Brands (40 minutes)

[Over and under investment incentives from ROA and RONA]

The following table calculates the RONA of the two proposed acquisitions and also how Guttman’s total RONA changes if either brand is acquired. Here we see that Brand 1 lowers her combined RONA and so will be rejected while Brand 2 raises her RONA and will be accepted. However, since both brands yield RONAs in excess of Premier’s WACC, both should be accepted. This example illustrates that RONA (and ROA) create underinvestment incentives.

	Current	Brand	Brand	Current	Current
	Operations	1	2	& Brand 1	& Brand 2
Net income	$708	$67	$228	$775	$936
Total assets	6500	604	2044	7104	8544
Current liabilities	1300	82	498	1382	1798
Net assets	5200	522	1546	5722	6746
RONA	13.62%	12.84%	14.75%	13.54%	13.87%

If Premier’s WACC is 15.22 percent instead of 12.43 percent, Guttman’s decisions do not change. The bonus calculation is based on actual RONA achieved. Premier’s WACC does not enter into the bonus calculation. If the bonus was based on residual income (or EVA) the WACC becomes the hurdle rate that each acquisition must achieve.

As sole owner of Premier, I would want to acquire both brands as each one has a positive NPV. Again, this highlights that RONA (and ROA) can lead to an under investment problem.

As sole owner of Premier, I would acquire neither brand as each one has a negative NPV. In this situation RONA (and ROA) can lead to an over investment problem.

RONA, unlike ROA gives managers incentives to increase current liabilities, since this lowers net assets and raises RONA. In effect, RONA, unlike ROA, gives managers incentives to increase the amount of total assets financed by short term liabilities. Managers will do this by delaying payment to their trade creditors. However, since increasing the time to pay their creditors imposes costs on their suppliers, rational suppliers will look for means to recoup this cost by raising the price, reducing service, and so forth. In other words, there is no “free lunch.”

P5-23: Solution to Easton Electronics (45 minutes)

[Transfer pricing versus reorganization]

Easton’s objective is to maximize overall corporate profits. The company’s strategy is to offer its customers superior performance by providing completed products that meet or exceed the customer’s technical specifications and on time delivery schedules. By providing a complete box build unit, Easton is able to reduce the customer’s total contracting costs. Instead of having three separate contract manufacturers (box, circuit boards, and cables), Easton offers its customers one-stop shopping (including testing). Customers should be willing to pay a premium for this one-stop shopping (up to the point of their internal contracting costs of avoiding the costs and coordination of three separate suppliers and their testing costs). In addition to the premium pricing Easton receives for a complete box build, having a single source supplier makes it more costly for the customer to switch to another supplier because their switching costs are larger.

There are two questions Easton must address: how to bid the cable costs on box-build proposals and how to evaluate and reward the TT Cabling managers for cables supplied to the Irvine facility. While these two questions are related, they will be addressed separately.

Bidding on cables. Easton faces three alternative ways to bid on the cables: solicit price quotes from outside cable suppliers only, solicit bids from both outside cable suppliers and TT, or only get price quotes from TT Cabling. Soliciting bids from outside cable suppliers only is clearly inferior to the second alternative (get bids from both the outside and TT). TT might be able to supply the cables cheaper than outsiders. Likewise, the third alternative (only get bids from TT) is dominated by the second alternative because outsiders might provide cables cheaper than TT. Also, getting outside cable bids in addition to TT’s bid allows Easton to benchmark TT’s production efficiency. So Easton should get bids from both TT and outsiders when preparing its bid on box build proposals.

While the cost of cables is usually a small fraction of the total cost of complete box builds, if the cost of the cables is “too high,” at the margin the high cable costs could cause Irvine to lose the bid. Ceteris paribus, the lower Irvine bids the entire project, the more likely it will win the bid. (Remember: demand curves slope down.) The price TT charges Irvine for cables is the transfer price for the cables. The double marginalization problem in transfer pricing states that the internal selling division should not make a profit on the intermediate good transferred because this causes the selling division (Irvine in this case) to set too high a final price to the customer and to sell too few units (lose the bid). Following this rule, TT’s bid for the cables should only be its marginal cost. In the case of the SI cables, TT’s variable (marginal cost) is $1,000. Since all costs are variable in the long run, TT’s long-run cost is its fixed and variable cost, or $1,300 on the SI cables. The advantage of allowing TT to bid full cost (fixed plus variable) of $1,300 is that Easton management avoids having to monitor which of TT’s costs are fixed versus variable. If variable cost transfer pricing is used as the policy, then TT has incentives to reclassify fixed costs as variable.

Evaluating and rewarding TT Cabling. TT is currently treated as a profit center. As a profit center, TT has no incentive to bid and build cables at variable cost. TT has more incentive to bid cables on a full cost basis (if TT is not at capacity it recovers its fixed cost). TT is treated as a profit center because it was recently acquired. TT could be treated as a cost center in the same way board assembly, box build, and testing are evaluated and rewarded. Converting TT to a cost center eliminates the double marginalization problem, and hence removes the incentive for TT to charge a price to Irvine that recovers its costs and report a profit. Making TT a cost center allows it to focus on producing high quality cables on time at minimum cost. However, the marketing of TT cables to outsiders (not Easton box builds) would have to be handled through Easton’s current sales and marketing department. TT is currently marketing its cables to other companies and if TT retains this sales function, then TT should be retained as a profit center.

In summary, instead of focusing on determining the correct transfer price for TT cables supplied to Irvine, TT could be viewed as a cost center within Easton and focus on efficient cable production. However, the decision to keep TT as a profit center or convert it to a cost center depends on how the entire sales and marketing is best organized within Easton. In preparing bids for proposals that involve complete box builds, Irvine should solicit prices from outside cable producers and compare these prices to TT’s cost (both fixed and variable cost) of building the cables.

P5-24: Solution to Evergreen Nursery and Landscape (45 minutes)

[Transfer pricing]

The following table shows that the owner maximizes her profits by setting the price at $180 per tree and planting six trees per month.

Qty sold	Price per tree	Nursery VC	Landscape VC	Total FC	Total Rev	Firm Profits
2	$260	$20	$100	500	520	($100)
3	240	$30	$150	500	720	$40
4	220	$40	$200	500	880	$140
5	200	$50	$250	500	1000	$200
6	180	$60	$300	500	1080	$220
7	160	$70	$350	500	1120	$200
8	140	$80	$400	500	1120	$140
9	120	$90	$450	500	1080	$40

Setting the transfer price at Nursery’s variable cost of $10 per tree will cause Landscape to buy six trees from Nursery and plant them for $180 per tree, the same solution obtained in part (a) where the owner selects the price. The table below illustrates that this maximizes Landscapes’ profits.

Qty sold	Price/ tree	Landscape Revenue	Landscape VC	TP @ $10	Landscape FC	Landscape Profit
2	$260	$520	$100	$20	$290	$110
3	240	720	$150	30	290	$250
4	220	880	$200	40	290	$350
5	200	1000	$250	50	290	$410
6	180	1080	$300	60	290	$430
7	160	1120	$350	70	290	$410
8	140	1120	$400	80	290	$350
9	120	1080	$450	90	290	$250

However, since Nursery only receives its variable cost of $10 per tree, Nursery reports a loss of its fixed costs of $210. The sum of the two divisions’ profits ($430 and $210) is the firm’s total profit of $220 as in part (a).

At a transfer price of $75 per tree, Landscape will charge $220 per planted tree and will plant four trees per month to maximize its profits. The table below illustrates that Landscape maximizes its profit at this price-quantity relation when confronted with a $75 transfer price.

Qty sold	Price/ tree	Landscape Revenue	Landscape VC	Transfer cost	Landscape FC	Landscape Profit
2	260	520	100	150	290	($20)
3	240	720	150	225	290	$55
4	220	880	200	300	290	$90
5	200	1000	250	375	290	$85
6	180	1080	300	450	290	$40
7	160	1120	350	525	290	($45)
8	140	1120	400	600	290	($170)
9	120	1080	450	675	290	($335)

From part (c), Landscape buys four trees from Nursery at $75 per tree. Accordingly, Nursery’s profits are:

Revenue (4 @ $75) $300

Variable cost (4@ $10) (40)

Fixed cost (210)

Net income $50

Using variable cost as the transfer price results in the same firm-wide profits of $220 as if the owner made the pricing decision in Landscaping. In part (b), with a transfer price of $10, Landscape reports a profit $430 and Nursery reports a loss of $210, so total profits are again $220. If Nursery sets the transfer price at $75, Landscape buys and plants fewer trees and even though Nursery is now making a profit of $50, Landscape’s profits fall to $90. The combined profit of the entire firm is now $140.

P 5-25: Solution to Transfer Pricing Company (40 minutes)

[Full cost transfer pricing can be second best]

The following table calculates the profit maximizing price-quantity combination that corporate would set:

Quantity	Price	Variable Cost ($15+$5)	Profit
4	$420	$20	$1,600
5	400	20	1,900
6	380	20	2,160
7	360	20	2,380
8	340	20	2,560
9	320	20	2,700
10	300	20	2,800
11	280	20	2,860
12	260	20	2,880
13	240	20	2,860

The following table shows that Intermediate will select a transfer price of $270 to maximize its profits.

			Intermed
Transfer Price	Quantity Purchased	Intermed Revenue	Variable Cost	Intermed Profits
$220	7	$1,540	$105	$1,435
230	7	1,610	105	1,505
240	6	1,440	90	1,350
250	6	1,500	90	1,410
260	6	1,560	90	1,470
270	6	1,620	90	1,530
280	5	1,400	75	1,325
290	5	1,450	75	1,375

At a transfer price of $48, Final maximizes profits by purchasing 11 units of intermed as documented in the following table:


Quantity Transferred	Selling Price	Final’s Variable Cost	Transfer Price	Final’s Profit
4	$420	$5	$48	$1,468
5	400	5	48	1,735
6	380	5	48	1,962
7	360	5	48	2,149
8	340	5	48	2,296
9	320	5	48	2,403
10	300	5	48	2,470
11	280	5	48	2,497
12	260	5	48	2,484
13	240	5	48	2,431

For every unit of intermediate produced and transferred to Final, Intermediate’s profits rise by the amount of allocated fixed costs. Because these costs are fixed, producing more units of intermediate and selling them to Final causes Intermediate’s profits to rise by $33 ($48 – $15). Since Final will purchase 11 units, Final’s profits increase by 11 × $33, or $363.

Corporate should set the transfer price at full cost of $48 because this results in higher firm-wide profits than if Intermediate sets the transfer price at $270. If corporate knew Intermediate’s variable cost is $15 per unit, and corporate sets the transfer price at $15, Final would purchase 12 units. Using Intermediate’s full cost of $48 causes Final to purchase 11 units, one fewer than the firm-value-maximizing amount. While slightly less than the firm-value-maximizing transfer (11 vs. 12), full cost transfer pricing is far better than letting Intermediate set the transfer price at $270 where only six units are transferred. The following table shows that firm profits are larger at a transfer price of $48 than a transfer price of $270. And at a transfer price of $48, firm profits are only $20 below the firm-value maximizing transfer price of $15 ($2,860 vs. $2,880).

Transfer price = $48

Intermediate’s profits

Margin ($48 – $15) $33

Units transferred 11

Profits $363

Final’s profits

Margin ($280 – $48 – $5) $227

Units transferred 11

Profits $2,497

Total firm-wide profits $2,860

Transfer price = $270

Intermediate’s profits

Margin ($270 – $15) $255

Units transferred 6

Profits $1,530

Final’s profits

Margin ($380 – $270 – $5) $105

Units transferred 6

Profits $630

Total firm-wide profits $2,160

Transfer price = $15

Intermediate’s profits

Margin ($15 – $15) $0

Units transferred 12

Profits $0

Final’s profits

Margin ($260 – $15 – $5) $240

Units transferred 12

Profits $2,880

Total firm-wide profits $2,880

P 5-26: Solution to XBT Keyboards (45 minutes)

[Incentives to convert fixed costs to variable costs with variable cost transfer pricing]

This problem illustrates that managers who are receiving variable cost transfer prices have incentives to convert fixed costs into variable costs.

The current incremental cost of manufacturing 2.5 million keys internally are:

	Per Key
Materials ($3.00/50)	$0.06
Direct Labor – keys ($4.00/50)	0.08
Variable overhead ( × $4.00/50)	0.04
Injection molding ($10.00/50)	0.20
Average unit cost per key	$0.38

*$16 = sum of direct labor of keys and assembly ($4 + $12)

Therefore, if the keys are outsourced, instead of produced internally, the firm’s cash flows fall by $0.01 ($0.39 – $0.38) per key.

Ms. Litle will purchase the keys from the outside vendor in order to maximize division profits and her own compensation, even though the average incremental cost per unit ($0.38) is lower than the vendor’s price ($0.39). The reason Litle takes this firm-value decreasing action is to convert a fixed cost (injection molding lease), which is not part of the variable cost transfer price she receives for keyboards included with XBT PCs, into a variable cost.

XBT Keyboard Division’s pro forma income statement if manufacturing of all keys remains internal is:

XBT Keyboard Division

Pro Forma Income

(all keys fabricated internally)

Revenue:

External sales (150,000 @ $100)

Internal transfers (50,000 @ $60 × 1.2)

$15,000,000

3,600,000

$18,600,000

Costs:

Variable costs (200,000 @ $60)

Fixed Costs:

Key Injection molding (4 × $500,000)

Fixed overhead (200,000 @ $18)

$12,000,000

2,000,000

3,600,000

$17,600,000

Divisional Profits

$ 1,000,000

If the outside vendor is used to manufacture the keys for units transferred for use with the XBT PC, the Keyboard Division profits are:

XBT Keyboard Division

Pro Forma Income

(2.5 million keys purchased outside)

Revenue:

External sales (150,000 @ $100)

Internal transfers (50,000 @ $70.50* × 1.2)

$15,000,000

4,230,000

$19,230,000

Costs:

Variable Costs:

External sales (150,000 @ $60)

Internal transfers (50,000 @ $70.50)

Fixed Costs:

Key Injection molding (3 × $500,000)

Fixed overhead (200,000 @ $18)

$9,000,000

3,525,000

1,500,000

3,600,000

$17,625,000

Divisional Profits

$ 1,605,000

*Variable cost per keyboard with purchased keys:

Base $11.00

Key sockets 13.00

Connectors & cables 9.00

Direct labor – assembly 12.00

Variable overhead (× $12) 6.00

Keys ($0.39 × 50) 19.50

$70.50

Keyboard Division profits increase by $605,000 if 2.5 million keys are out-sourced. This $605,000 can be decomposed as follows:

Increase in divisional profits $605,000

Composed of:

Additional revenue from internal transfers on

Injection molding ($500,000 × 1.2) $600,000

Additional revenue from mark-up on higher

cost of vendor keys ([$0.39 – 0.38] × 2,500,000 × 20%) 5,000

$605,000

From this analysis, most of the additional divisional profits arise from converting a fixed cost ($500,000) into a variable cost, which increases the transfer price. But, an additional $5,000 arises because the division gets a 20 percent mark-up on the increased cost of keys supplied by the outside vendor.

As a large shareholder, in possession of all the facts, the firm would be better off by $25,000 (the extra cost of the purchased keys) if the external purchase was not made, assuming there are no other benefits from outside purchase.

Probably no major change in the accounting or organizational systems is warranted. Litle’s performance measure is higher when she cancels the lease and purchases the keys outside. If she is earning an above-market wage for her ability, other parts of her compensation can be adjusted. The only additional cash flow cost to XBT is the 1¢ additional cost per key on $2.5 million or $25,000 (before taxes). However, there are some offsetting benefits XBT receives for this $25,000. First, an external vendor now exists that can be used to benchmark the Keyboard Division’s internal cost and quality. Long-run variable cost for a keyboard is closer to $70.50 than the $60.00 because the $60.00 does not include the cost of injection molding which is variable in the long run. Therefore, the PC Division is being charged too little for keyboards at $60 and therefore might be underpricing its PCs.

P 5-27: Solution to Infantino Toyota (45 minutes)

[Calculating EVA and transfer pricing]

The residual incomes of the three departments are calculated in the following table:

	New Cars	Pre-owned Cars	Parts & Service	Total
% of land	50%	40%	10%	100%
% of building	30%	10%	60%	100%

Allocated land cost	$450,000	$360,000	$90,000	$900,000
Allocated building cost	3,600,000	1,200,000	7,200,000	12,000,000
Other assets	2,500,000	6,700,000	1,300,000	10,500,000
Total department assets	$6,550,000	$8,260,000	$8,590,000	$23,400,000
Capital charge (16%)	$1,048,000	$1,321,600	$1,374,400	$3,744,000
Department Income	$600,000	$1,725,000	$1,813,000	$4,138,000

Residual Income	$(448,000)	$403,400	$438,600	$394,000

It appears as though the new car department is losing money and the pre-owned and parts and service departments are making money. But this ignores the synergies/interdependencies among the departments (see part c).

The new car department appears to be losing money because most of the profit from transactions involving trade-ins gets assigned to the pre-owned car department when the trade-in allowance is used as the transfer price. Using the example in the problem, the new car department only makes $500 on the new car and the pre-owned car department makes $2,800 on the used car. But the used car department cannot make this profit unless the new car department sells a new car and takes a used car in trade, usually at a substantial discount from market. Infantino Toyota is selling a joint product consisting of new cars and a resale market for new car buyers’ used cars. New cars could show a profit if Infantino would give the new car department some of the profits made from selling the used car. For example, suppose the used car taken in trade has a fair market value of $9,200. The new car department gave the new car buyer $8,000 for his used car. The new car department should receive $1,200 of profit from this trade-in and when the used car department sells the used car for $10,800 it would show a profit of $1,600. That is, instead of using the trade-in allowance as the transfer price of the used car, the transfer price should be the fair market value of the used car. Also, the profits in the parts and service departments are due partially to the sales of cars made by the new and pre-owned car departments. Customers tend to bring their cars needing service back to the dealerships where they are purchased. There is no simple, obvious way to allocate the profits of the service department back to the new and used car department. Moreover, some new and used car customers choose where to purchase or not purchase their cars based on their past dealings with the service department. Providing high quality car service often generates new and used car sales.

Another problem in the way Infantino Toyota is calculating residual income is the cost assigned to the land. Infantino owns twenty acres of land in what has become a very valuable commercial area. The land was purchased 40 years ago for $900,000. Certainly, the value of the land has appreciated. Yet, the cost assigned to the three departments for their use of the land is only $144,000 (16% × $900,000). Suppose this land is now worth $5 million. Ms. Infantino is forgoing $800,000 (16% × $5 million) of income if she were to sell the land and invest it in similarly risky assets returning 16 percent a year. Viewed this way, she actually lost $406,000 ($800,000 – $394,000) before taxes by operating the dealership.

P 5-28: Solution to Wujo (45 minutes)

[Transfer pricing tradeoffs between incentives and taxes]

With a zero transfer price the profit maximizing price is €235 and WUK reports a profit of €12.225 million.

Price	Quantity (000)	Revenue	Variable cost	Fixed Cost	Transfer cost	Profit
270	130	35,100,000	9,100,000	15,000,000	0	11,000,000
265	135	35,775,000	9,450,000	15,000,000	0	11,325,000
260	140	36,400,000	9,800,000	15,000,000	0	11,600,000
255	145	36,975,000	10,150,000	15,000,000	0	11,825,000
250	150	37,500,000	10,500,000	15,000,000	0	12,000,000
245	155	37,975,000	10,850,000	15,000,000	0	12,125,000
240	160	38,400,000	11,200,000	15,000,000	0	12,200,000
235	165	38,775,000	11,550,000	15,000,000	0	12,225,000
230	170	39,100,000	11,900,000	15,000,000	0	12,200,000
225	175	39,375,000	12,250,000	15,000,000	0	12,125,000

With a transfer price of €50 per unit, the profit maximizing price is €260 and WUK reports a profit of €4.60 million.

Price	Quantity (000)	Revenue	Variable cost	Fixed cost	Transfer cost	Profit
270	130	35,100,000	9,100,000	15,000,000	6,500,000	4,500,000
265	135	35,775,000	9,450,000	15,000,000	6,750,000	4,575,000
260	140	36,400,000	9,800,000	15,000,000	7,000,000	4,600,000
255	145	36,975,000	10,150,000	15,000,000	7,250,000	4,575,000
250	150	37,500,000	10,500,000	15,000,000	7,500,000	4,500,000
245	155	37,975,000	10,850,000	15,000,000	7,750,000	4,375,000
240	160	38,400,000	11,200,000	15,000,000	8,000,000	4,200,000
235	165	38,775,000	11,550,000	15,000,000	8,250,000	3,975,000
230	170	39,100,000	11,900,000	15,000,000	8,500,000	3,700,000
225	175	39,375,000	12,250,000	15,000,000	8,750,000	3,375,000

Ignoring income taxes, the value maximizing transfer price is zero. A zero transfer price induces WUK to set a lower price (€235) and sell more units (165,000), than if the transfer price is €50. The WUK managers will treat the €50 transfer price as a variable cost. They will take this variable higher cost into effect when determining their profit maximizing price. The €50 royalty effectively shifts up WUK’s marginal cost curve causing them to sell fewer units at a higher price. But this royalty is not a real marginal cost to the firm. In effect, by charging a royalty of anything greater than zero results in the double marginalization problem discussed by economists.

The following table demonstrates that overall firm value is maximized (on an after tax basis) by charging WUK a royalty of €50 for each unit of EzPhoto sold.

	Transfer Price
	Zero	50
WUK profit before taxes	€12.225	€4.600
U.K. tax rate	0.330	0.330
WUK U.K. taxes	€4.034	€1.518

Wujo’s profit before taxes	€0.000	€7.000
Wujo’s PRC tax rate	0.150	0.150
Wujo PRC taxes	€0.000	€1.050
			Difference
Total revenue	€38.775	€36.400	€2.375
Variable cost	11.550	9.800	1.750
Operating margin	€27.225	€26.600	€0.625
WUK U.K. taxes	4.034	1.518	2.516
Wujo PRC taxes	0.000	1.050	-1.050
Fixed costs	15.000	15.000	0.000
Consolidated profits	€8.191	€9.032	-€0.841

Even though WUK sells 25,000 (165,000 – 140,000) fewer units of EzPhoto at a €50 transfer price, the combined taxes paid to the PRC and the U.K. are substantially lower. With a zero transfer price, its U.K. tax bill is €4.034 million. At a €50 transfer price, profits are shifted out of the high tax U.K. jurisdiction to the lower tax PRC jurisdiction, and the total tax liability (PRC plus U.K.) is only €2.568 million. The lower total taxes paid with a €50 transfer price more than makes up for the lower operating margin (€625,000) that results from WUK setting a higher price and selling fewer units. In fact, the combined net cash flows are higher by €841,000 with a €50 royalty. This example illustrates how tax considerations often “trump” internal incentives when it comes to setting transfer prices.

Clearly, if Wujo can set two different transfer prices, it would charge WUK a zero royalty internally to induce WUK to sell the profit maximizing number of EzPhotos, but the use the €50 transfer price on its PRC and U.K. tax returns. The following table calculates the combined cash flows after taxes.

	Wujo-PRC	WUK	Total
Profits before taxes		€12,225,000	€12,225,000
Units sold	165,000	165,000
Transfer price	€50	€50
Transfer revenue/cost	€8,250,000	€8,250,000
Income before tax	€8,250,000	€3,975,000
Tax rate	0.15	0.33
Income taxes	€1,237,500	€1,311,750	€2,549,250
Cash flow after taxes			€9,675,750

With a €50 transfer price used for both internal use and taxes, the total revenue is €4.6 million and a total tax liability of €2.568 million or net cash flows after taxes of €2.032 million. Clearly, Wujo would really like to use to separate transfer prices, a zero transfer price internally to motivate WUK to sell more units, and a €50 transfer price on its PRC and U.K. tax returns because this leads to much higher net cash flows after taxes (€7,643,750)

If the U.K. tax authorities audit WUK and find that WUK is using a €0 transfer price for internal purposes such as performance evaluation, they would challenge the use of the €50 transfer price used for taxes on the basis that the €50 transfer price being used for taxes serves no legitimate business purpose other than to minimize taxes. The only way WUK can justify its use of €50 as the transfer price for taxes is if they can show that this is normal business practice in the industry and that other software companies are using such a royalty rate in arms length transactions.

Case 5-1: Solution to Celtex (50 minutes)

[Transfer pricing dispute]

Cash flows:

Per Gal.

Buy Q47 Outside:

Out-of-pocket costs of Celtex to Meas $3.00

Buy Q47 Inside:

Out-of-pocket costs of Organic Chemical (80% of $1) $.80

Out-of-pocket costs of Synchem 1.75

Out-of-pocket costs of Celtex $2.55

Net Cash Outflow of buying from Meas $ .45

If Juris ends up buying from Meas, the net cash flow of Celtex is lower by $.45 for every gallon of Q47 purchased. Because there is excess capacity in the industry, the opportunity cost of capacity is zero. Fixed overhead costs will be incurred regardless of the decision to produce Q47.

(b) While it seems obvious that Debra Donak should somehow intervene and prevent this loss from occurring, the old maxim, “If it ain’t broke, don’t fix it” should be applied.

Celtex has been a successful chemical company. Its decentralized, senior management hands-off policy seems to be working. If Donak intervenes in the current dispute, she will be asked to intervene in future disputes. This will begin to unravel Celtex’s decentralization policy. Once Donak assumes the decision rights over pricing and external sourcing from her managers, internal managers will alter their behavior and ask Donak to intervene more often in the future.

The question is: are the cash flows forgone if Juris buys from Meas larger than the cash flows from weakening the high degree of decentralization? The current Synchem-Consumer Products ruckus appears inconsequential. This is a new start-up product for Consumer Products and is unlikely to be a large volume of business for Synchem. If this were a large cash flow item, Horigan would likely be acting differently towards his bid.

The real issue here is not the transfer pricing question and forcing or not forcing Horigan to lower his bid, but rather Horigan’s competence as a manager. Either Horigan knows what he is doing by bidding $3.20 or he doesn’t. Maybe he doesn’t want the business at anything less than $3.20 because he anticipates an upturn. If Horigan is not qualified to operate Synchem, Donak should replace him instead of intervening in the transfer pricing dispute that will likely undermine Celtex’s apparently successful decentralization policy. By intervening in this case, Donak changes the way decision rights are assigned in terms of setting transfer prices.

Case 5-2: Solution to Executive Inns (55 minutes)

[Depreciation as a commitment device and residual income]

Sarah will propose the expansion to Kathy because the net cash flows in years 1 – 10 are positive and she is not charged for the costs of the expansion. Thus, her compensation will increase.

Residual income is computed as:

Expected Net Cash Flows – Depreciation – 12% × Average Book Value of Investment

Using 12 percent as the cost of capital, the following table computes Ms. Adams’ annual expected residual income. She will use her expected cash flows, not the cash flow estimates she submits to justify the project because she wants an unbiased estimate of the effect of the decision to accept the project on her expected compensation.

Year	Expected Cash Flows	Straight Line Depreciation	End of Year Book Value	Average Book Value	Operating Profit After Depreciation	Residual Income
0	-$10		$10
1	2	$1.0	9.0	$9.5	$1.00	-$0.14
2	1.9	1.0	8.0	8.5	0.90	-0.12
3	1.8	1.0	7.0	7.5	0.80	-0.10
4	1.7	1.0	6.0	6.5	0.70	-0.08
5	1.6	1.0	5.0	5.5	0.60	-0.06
6	1.5	1.0	4.0	4.5	0.50	-0.04
7	1.4	1.0	3.0	3.5	0.40	-0.02
8	1.3	1.0	2.0	2.5	0.30	0.00
9	1.2	1.0	1.0	1.5	0.20	0.02
10	1.1	1.0	0.0	0.5	0.10	0.04

Sarah will not propose the expansion because the residual income is now negative in each of the first five years, before she expects to leave the firm.

If evaluated based on profits after depreciation, Sarah will now take the expansion project because net income is positive in each year.

She changes her decision in part (d) because she does not have to pay for the cost of capital invested in the project.

Case 5-3: Solution to Royal Resort and Casino (60 minutes)

[Synergies and transfer pricing]

a. Answering this question requires an understanding of the various niche strategies employed by the three separate firms and RRC. RRC caters to an upscale, high-income customer who wants luxurious surroundings, plush complimentary rooms, good food, and top-name entertainment. They want the convenience of “one-stop shopping” with all amenities in one location. By bundling gaming, lodging, and entertainment together, RRC lowers customers’ transaction costs, much like supermarkets and shopping centers. The high income RRC customer has a high opportunity cost of time and doesn’t want to waste time or have the weather-related inconvenience traveling to restaurants and shows. But this bundling niche strategy does not come for free – RRC must somehow provide incentives to its divisional managers to exploit the synergies.

Big Horseshoe Slots & Casino, Nell’s Lounge and Grill, and the Sunnyside Motel are separately owned, thus providing the owners with incentives to maximize their individual firms’ values. Loses in the marketplace quickly discipline inefficient owners. And neighboring business owners are unlikely to subsidize their unprofitable neighbors. The three separate businesses have fewer synergies among them, catering to a lower-income clientele that values less the one-stop services at RRC. If any synergies exist across the three separate firms such as parking or joint advertising, they can probably be captured via negotiations among the three owners.

Firms decentralize decision making authority in order to make better use of local knowledge. Firms are subdivided into divisions to solve free-rider problems by more closely tying pay to individual effort. To reduce the free-rider problem, the performance of each division is calculated as though the division was a free-standing firm. But this is a myth and it raises the central conundrum: If each division is truly free-standing in the sense that it has no synergies with other divisions, divest it. There is no reason the division should be under one corporate umbrella, shielded from the discipline of the market, and potentially subsidized by other divisions. However, if synergies exist, how should they be allocated, assigned, or accounted for in order that each decentralized division has incentive not to forego firm-value enhancing actions in the pursuit of myopic division profits? As illustrated in the context of the Royal Resort and Casino, an accounting system usually can not economically capture and report all the synergies.

One such interdependency is junkets. Entertainment and Hotel operations might appear to be unprofitable if they are not compensated for the complimentary food and lodging for the big gamblers. But how should such compensation across divisions be determined? Answering this question involves setting a transfer price the Hotel division receives and the Gaming division pays when one complimentary room is used for a junket guest.

As an example of another interdependency, consider a customer staying at another hotel who comes to RRC to see a show. Suppose this guest drops $50 in RRC slot machines, a synergy exists between Entertainment and Gaming. In designing a transfer price scheme, how much of this $50 should be credited to the Entertainment division because their show got this customer in the door? Gaming would prefer Entertainment set low prices for its shows to insure a large crowd of potential gamblers. It is probably prohibitively expensive to design and implement a transfer pricing system that perfectly captures this $50 transaction. Or, consider those gamblers, not staying at RRC who prefer to gamble at RRC. They think they are lucky at RRC, or prefer the atmosphere. These people stay to see shows and have meals. For these customers, some amount of their show and restaurant receipts should be transferred to Gaming to compensate Gaming for getting them to RRC. But again, estimating the magnitude of these transfers can be costly. Simply ignoring them does not create incentives for the division heads to take into account the consequences of their actions on the other divisions’ performance.

A number of mechanisms can be used to better capture synergies among divisions. These include:

use transfer prices,
award division managers shares in the firm,
tie divisional pay to firm-wide performance,
create groups and link pay to group-level performance,
link divisional pay to other divisions’ performance,
measure performance both objectively and subjectively,
use cost allocations to get divisional managers to cooperate,
reorganize.

Each of these is briefly discussed below.

Transfer pricing is a common method used to capture interdependencies among units. However, it has limitations as the following discussion illustrates. Suppose a room at RRC can be rented for $150 per night; it costs $25 to clean it and provide fresh linens. If Hotel does NOT have an empty room, the Hotel division foregoes $150 by providing a complimentary room to a Gaming junket guest. (The $25 cost of cleaning is incurred whether or not the guest is paying for the room.) By turning away a customer willing to pay for the room that is being provided complimentary to a junket guest, Gaming should pay Hotel the foregone room rental of $150. Had the room remained empty, the only cost the junket guest imposes on the Hotel division is the $25 cleaning cost. Therefore, the transfer price should be either $25 (had the room been empty) or $150 (if the room could have been rented). If Hotel, because it has the knowledge of whether or not they turned away a paying guest, has the authority to set the transfer price after each junket guest leaves, Hotel has incentives to lie about whether the room was rentable. Knowing that it will almost always be charged $150 for rooms, Gaming will tend not to invite gamblers unless they are expected to lose at least $150 per day. If Hotel has some empty rooms, it is best for Gaming to offer free lodging as long as the guest loses at least $25 to cover the cleaning cost.

The preceding transfer pricing rule does not capture the complexities of most real-world situations. Suppose the hotel is at capacity 40 percent of the time. Then, one possible transfer price is $75 (0.40 x $150 + 0.60 x $25). However, this transfer price does not take into account the variation in occupancy rates between weekdays and weekends, holidays, conventions, seasons, and the quality of the entertainment playing at RRC on that day. It can become very time consuming to develop a menu of transfer prices that incorporates most realities and yet not be dependent on privately-held information by one division.

Giving shares of the firm to divisional managers creates incentives for them to take actions to capture synergies across divisions. But additional company stock causes divisional managers to hold undiversifiable portfolios thereby increasing the amount of risk they bear. Moreover, small divisions, by definition, have little affect on firm-wide value and hence giving them stock creates little incentive to overcome the free-rider problem. Determining the optimum amount of stock to award divisional managers is tricky, but likely depends on the relative size of the division, the magnitude of the synergies, and the risk aversion of the managers.

To avoid the under-diversification problem associated with awarding company stock to divisional managers, some companies link pay to firm-wide accounting-based earnings rather than stock. In the long run, stock and earnings are about equally risky. But over short time periods, accounting earnings impose less risk on managers than does common stock. Stock returns are sensitive to market-wide factors such as interest rates, tax policy, foreign currency fluctuations, and so forth.[1] Firm-wide accounting earnings reduce risk, but still have free-rider problems.

To reduce free-rider problems, firms like Fiat with numerous profit and investment centers combine divisions with significant synergies into groups headed by a group-level manager. By tying the group-level manager’s pay to group-level performance, this manager has incentive to capture the synergies among divisions in his or her group. By not paying any divisional manager a bonus unless the group makes its target or by linking divisional managers’ pay directly to group performance reduces the divisional managers’ myopic behavior. However, adding group-level structures also has downsides. Another costly layer of management is created resulting in centralization of some decision making authority. This reduces the ability of divisions to respond quickly to unexpected events. While group-level structures better capture interactions among divisions within each group, they do not capture synergies among groups unless a super group-level structure is imposed on top of the group structure.

Instead of adding groups, divisional managers with significant synergies can link their pay to each other’s performance. For example, if two divisions have joint costs or joint benefits, each divisional manager’s pay can be based on say 70 percent of own division performance and 30 percent of the other division’s performance. Determining the “right” percentages is tricky. Eastman Chemical tried and abandoned this approach. When three or four divisions interact, the system becomes overly complicated.

Another method companies often use to give divisional managers incentives to cooperate to capture interdependencies is to combine both objective and subjective performance measures. For example, divisional EVA is an objective performance measure. Also rewarding managers through extra pay, non-pecuniary compensation, and promotions based on them being a “team” player as perceived by their superior is a subjective metric. “360˚ peer review” systems or basing some fraction of a manager’s bonus on the subjective evaluation of those who interact with the manager creates incentives to cooperate to capture synergies. Unfortunately, such systems also create incentives for managers to lobby for higher ratings from those providing the subjective evaluations.

Another often overlooked method for inducing cooperation among divisions is allocating corporate-level advertising and overhead. While some accountants argue that allocating corporate overhead is a tax on profitable divisions that can distort profitability, such allocations also have desirable incentive properties. For example suppose there are five divisions each with its own performance metric such as EVA. Corporate overhead is $100 million. If this overhead is allocated to the divisions based on the percentage of that division’s EVA to firm-wide EVA, then the divisions have incentives to cooperate. If one division’s EVA goes up so does the amount of overhead allocated to that division and the other divisions’ allocated corporate overhead goes down. Each division manager has incentive to increase the other divisions’ EVA so each manager’s own overhead goes down and EVA after allocated overhead increases. This type of allocation does not insulate each division’s cost allocation from the other divisions’ performance. In fact, if the synergies among divisions arise mainly from shared benefits such as brand-name capital, corporate overhead can be allocated based on divisional revenues instead of division profits or EVA. Chapters 7 and 8 discuss the incentive effects of cost allocations in greater detail.

Finally, if the synergies between two divisions become large, these two divisions can be combined into one EVA or profit center controlled by a single manager. However, as with all other possible “remedies,” reorganizing also has costs. In particular, local managers of the merged divisions no longer have profit responsibility for their organization.

[1] See R. Sloan, “Accounting Earnings and Top Executive Compensation,” Journal of Accounting and Economics(Jan./April/July 1993), pp. 55-100.

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