Accounting for Decision Making and Control Jerald Zimmerman 10e - Test Bank

Accounting for Decision Making and Control Jerald Zimmerman 10e – Test Bank

 

Instant Download – Complete Test Bank With Answers

 

 

Sample Questions Are Posted Below

 

Chapter 05 Test Bank – Static Key

 

Multiple Choice Questions

 

1. Each of the following responsibility centers and decision rights are correctly matched, except:

 

1. Cost center—input mix

 

1. Investment center—capital invested

 

1. Profit center—capital invested

 

1. Investment center—product mix

 

1. Profit center—input mix

 

Cost centers have decision rights for the input mix; profit centers for input mix, product mix, and selling prices; investment centers for input mix, product mix, selling prices and capital invested.

 

AACSB: Analytical Thinking

 

AACSB: Knowledge Application

 

Accessibility: Keyboard Navigation

 

Accessibility: Screen Reader Compatible

 

AICPA: BB Industry

 

AICPA: BB Resource Management

 

AICPA: FN Decision Making

 

Blooms: Understand

 

Difficulty: 2 Medium

 

Topic: Responsibility Accounting

 

 

2. Mesopotamian Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below:

 

	Ur			Babylon
Fixed assets, gross	$	2,500		$	4,000
Accumulated depreciation	$	1,500		$	1,200
Other assets	$	500		$	750
Liabilities	$	500		$	1,000
Sales	$	6,750		$	7,200
Net income after tax*	$	743		$	1,008
Average age of fixed assets (years)		15			5

 

*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?

 

1. Ur’s return on sales (net income percentage) is 14%

 

1. Ur’s return on net assets (RONA) is 74%

 

6. Babylon’s net asset turnover is 6.75

 

1. Babylon’s return on assets (ROA) is 40%

 

1. None of the choices are correct

 

	Ur				Babylon
Gross fixed assets	$	2,500			$	4,000
Accumulated depreciation	−$	1,500			−$	1,200
Net fixed assets	$	1,000			$	2,800
Other assets	$	500			$	750
Total assets	$	1,500			$	3,550
Liabilities	−$	500			−$	1,000
Net assets	$	1,000			$	2,550
RONA = Net income	$	743			$	1,008
Net assets	$	1,000			$	2,550
Return on net assets (historical)		74.3	%			39.5	%

 

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AICPA: FN Measurement

 

Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Investment Centers

 

3. Mesopotamian Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below:

 

	Ur			Babylon
Fixed assets, gross	$	2,500		$	4,000
Accumulated depreciation	$	1,500		$	1,200
Other assets	$	500		$	750
Liabilities	$	500		$	1,000
Sales	$	6,750		$	7,200
Net income after tax*	$	743		$	1,008
Average age of fixed assets (years)		15			5

 

*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:

 

1. increasing product contribution margin

 

1. increasing sales volume

 

1. reducing discretionary expenses

 

1. taking on debt

 

1. all of the choices are correct

 

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.

 

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AICPA: BB Industry

 

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Blooms: Remember

 

Difficulty: 1 Easy

 

Topic: Investment Centers

 

4. Mesopotamian Materials Inc. (MMI) has two decentralized divisions (Ur and Babylon) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below:

	Ur			Babylon
Fixed assets, gross	$	2,500		$	4,000
Accumulated depreciation	$	1,500		$	1,200
Other assets	$	500		$	750
Liabilities	$	500		$	1,000
Sales	$	6,750		$	7,200
Net income after tax*	$	743		$	1,008
Average age of fixed assets (years)		15			5

 

*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?

 

1. Babylon is a profit center

 

1. At a WACC of 5%, Ur’s residual income is lower than Babylon’s by $123

 

11. At the planned WACC (11.5%), Ur’s residual income is higher than Babylon’s by $87

 

1. At a WACC of 25%, Ur’s residual income is higher than Babylon’s by $123

 

1. None of the choices are correct

	Ur		Babylon		Diff
Net income after tax	$	743	$	1,008
Cost of capital (WACC @ 25% on net assets)	−$	250	−$	638
Residual income	$	493	$	370	$	123

 

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).

 

Because managers have decision making responsibility over the amount of resources invested in their divisions, both Ur and Babylon are investment centers.

 

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Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Investment Centers

 

Topic: Profit Centers

5. Honolulu Enterprises has two decentralized divisions (Coconut and Guava) that have decision making responsibility over the amount of resources invested in their divisions. Recent financial extracts for both divisions are presented below:

 

	Coconut			Guava
Fixed assets, gross	$	4,500		$	7,200
Accumulated depreciation	$	2,700		$	2,160
Other assets	$	900		$	1,350
Liabilities	$	900		$	1,800
Sales	$	12,150		$	12,960
Net income after tax*	$	1,330		$	1,810
Average age of fixed assets (years)		15			5

 

*Net income is after tax but before interest

 

Honolulu’s weighted average cost of capital (WACC) is 15% and the company uses residual income as a method to evaluate performance. Which of the following statements is correct?

 

1. Coconut’s ROI will be raised by divesting of a project with a 20% ROI but its RI will be lower.

 

3. Coconut’s RI will decrease by taking on a project with a $12 cost and net income before interest of $3.

 

1. Guava’s RI will increase by taking on a project with an $8 cost and net income before interest of $1.1.

 

1. Coconut’s RI is less than Guava’s RI.

 

1. None of the choices are correct

 

Coconut’s current ROI is 49.3% [$1,330 ÷ ($4,500 − $2,700 + $900)]. If Coconut divests of a project with a 20% ROI its current ROI will increase. But, since the project’s ROI exceeds the WACC, its RI will decrease. If Coconut takes on a project with a $12 cost and net income before interest of $3, its RI will increase by $1.2 ($12 × 0.15 = $1.8; $3 − $1.8 = $1.2). If Guava takes on a project with an $8 cost and net income before interest of $1.1, its RI will decrease by $.1 ($8 × 0.15 = $1.2; $1.1 − $1.2 = − $0.1. Coconut’s RI is $925 [($4,500 − $2,700 + $900) × 0.15] = $405; $1,330 − $405 = $925. Guava’s RI is $851.5 [($7,200 − $2,160 + $1,350) × 0.15] = $958.5; $1,810 − $958.5 = $851.5

 

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Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Investment Centers

 

6. Economic value added (EVA):

 

1. uses the same basic formula as return on investment (ROI)

 

1. ignores R&D spending

 

1. decreases a manager’s incentive to maximize firm value

 

1. is easy to administer

 

1. measures the total return after deducting the cost of all capital employed by the firm

 

The formula is based on the residual income, not ROI, approach. It utilizes a tax-adjusted WACC (for which advocate recommend adding back R&D spending) and is complex to administer. Where it is adopted in incentive plans, managers have increased incentives to maximize firm value. EVA measures the total return after deducting the cost of all capital.

 

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Blooms: Remember

 

Difficulty: 2 Medium

 

Topic: Economic Value Added (EVA®)

 

7. Given the following division performance indicators, which is true?

 

	Division
	A			B			C
Sales	$	500
Net profit	$	10		$	20
Net assets							$	80
Return on sales					6.0	%		4.0	%
Asset turnover		10			5
Return on assets								15.0	%

 

1. A’s return on assets is double that of B

 

1. C is the best division at managing its assets

 

66. A’s sales are 66.7% bigger than C’s

 

1. B would benefit least from a 10% increase in sales

 

1. All of the choices are correct

 

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

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

	Division
	A			B			C
Sales	$	500.0		$	333.3		$	300.0
Net profit	$	10.0		$	20.0		$	12.00
Net assets	$	50.0		$	66.7		$	80.0
Return on sales		2.0	%		6.0	%		4.0	%
Asset turnover		10.0			5.0			3.8
Return on assets		20.0	%		30.0	%		15.0	%
Return on sales = Net profit/Sales
Asset turnover = Sales/Net assets
Return on assets = Net profit/assets

 

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AICPA: BB Critical Thinking

 

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AICPA: FN Measurement

 

Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Investment Centers

 

8. Which is true of a firm’s transfer pricing policy?

 

1. Produces optimal results when set at the head office

 

1. Always promotes goal congruence

 

1. Leads to accurate measures of local performance

 

1. Is often designed to minimize tax expense

 

1. All of the choices are correct

 

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.

 

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Blooms: Remember

 

Difficulty: 1 Easy

 

Topic: Economics of Transfer Pricing

 

Topic: International Taxation

 

Topic: Transfer Pricing

 

9. Grammy Girl Products (GGP) has two divisions, Bones and Biscuits, both of which usually have independence in sourcing and pricing decisions. There is an unlimited supply of raw bones. Biscuits manufactures, amongst other items, a specialty product called BisBone. The BisBone formula requires 70% bone meal and 30% cereal per pound, plus a dollop of meat flavoring. BisBone is usually sold in 20-pound cases and processed bones in 5-pound packs. Cost and sales pricing data appears below.

 

	BisBone			Bones
Sales price, per case (pack)	$	100.00		$	20.00
Raw bones, per pound				$	1.50
Bone meal, per pound (external seller)	$	3.00
Cereals, per pound	$	0.50
Meat flavoring, per case	$	3.00
Processing, per pound	$	1.00		$	0.80
Packaging, per case (pack)	$	1.25		$	0.75
Overhead, per case (pack), 40% fixed	$	10.00		$	7.00

 

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $0.05 per pound) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 pound sack; when sold to other firms, it is packed in 50-pound 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?

 

1. $240

 

1. $239

 

251. $251.20

 

1. $296

 

1. None of the choices are correct

 

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

 

	Bone meal, 100 pound sack Internal sale
Raw bones		$	1.50
Grinding		$	0.05
Variable overhead, per pound		$	0.84
Cost per pound		$	2.39
Cost per 100 pound package		$	239.00
Bulk package		$	1.00
Minimum price, below capacity		$	240.00

 

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

 

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Accessibility: Keyboard Navigation

 

AICPA: BB Resource Management

 

AICPA: FN Measurement

 

Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

10. Grammy Girl Products (GGP) has two divisions, Bones and Biscuits, both of which usually have independence in sourcing and pricing decisions. There is an unlimited supply of raw bones. Biscuits manufactures, amongst other items, a specialty product called BisBone. The BisBone formula requires 70% bone meal and 30% cereal per pound, plus a dollop of meat flavoring. BisBone is usually sold in 20-pound cases and processed bones in 5-pound packs. Cost and sales pricing data appears below.

 

	BisBone			Bones
Sales price, per case (pack)	$	100.00		$	20.00
Raw bones, per pound				$	1.50
Bone meal, per pound (external seller)	$	3.00
Cereals, per pound	$	0.50
Meat flavoring, per case	$	3.00
Processing, per pound	$	1.00		$	0.80
Packaging, per case (pack)	$	1.25		$	0.75
Overhead, per case (pack), 40% fixed	$	10.00		$	7.00

 

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $0.05 per pound) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 pound sack; when sold to other firms, it is packed in 50-pound 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?

 

1. $245

 

1. $360

 

297. $297.50

 

1. $355

 

1. None of the choices are correct

 

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.

 

	Bone meal, 50 pound container External sale, short run
Sales price				$	180.00
Raw bones	$	1.50
Grinding	$	0.05
Variable overhead, per pound	$	0.84
Cost per pound	$	2.39
Cost per 50 pound	$	119.50
Bulk container	$	3.00
Total variable costs				−$	122.50
Contribution Margin (CM)				$	57.50
Min price = Total variable costs internal sale				$	240.00
+ CM foregone × 2				$	115.00
				$	355.00

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Difficulty: 3 Hard

Topic: Common Transfer Pricing Methods

 

11. Grammy Girl Products (GGP) has two divisions, Bones and Biscuits, both of which usually have independence in sourcing and pricing decisions. There is an unlimited supply of raw bones. Biscuits manufactures, amongst other items, a specialty product called BisBone. The BisBone formula requires 70% bone meal and 30% cereal per pound, plus a dollop of meat flavoring. BisBone is usually sold in 20-pound cases and processed bones in 5-pound packs. Cost and sales pricing data appears below.

 

	BisBone			Bones
Sales price, per case (pack)	$	100.00		$	20.00
Raw bones, per pound				$	1.50
Bone meal, per pound (external seller)	$	3.00
Cereals, per pound	$	0.50
Meat flavoring, per case	$	3.00
Processing, per pound	$	1.00		$	0.80
Packaging, per case (pack)	$	1.25		$	0.75
Overhead, per case (pack), 40% fixed	$	10.00		$	7.00

 

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $0.05 per pound) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 pound sack; when sold to other firms, it is packed in 50-pound 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 of $3.55 per pound?

 

1. Yes, because it is $0.55 per pound cheaper than its external supplier’s

 

1. No, because it is $0.55 per pound more costly than its external supplier’s

 

1. Yes, because it is $0.025 per pound cheaper than its external supplier’s

 

1. No, because it is $0.60 per pound more costly than its external supplier’s

 

1. None of the choices are correct

 

No. Biscuit’s transfer price from Q5-10 is $3.55 per pound. However, Biscuit can buy from an outside supplier for $3.00 per pound.

 

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AICPA: FN Decision Making

 

AICPA: FN Measurement

 

Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

12. Grammy Girl Products (GGP) has two divisions, Bones and Biscuits, both of which usually have independence in sourcing and pricing decisions. There is an unlimited supply of raw bones. Biscuits manufactures, amongst other items, a specialty product called BisBone. The BisBone formula requires 70% bone meal and 30% cereal per pound, plus a dollop of meat flavoring. BisBone is usually sold in 20-pound cases and processed bones in 5-pound packs. Cost and sales pricing data appears below.

 

	BisBone				Bones
Sales price, per case (pack)	$	100.00			$	20.00
Raw bones, per pound					$	1.50
Bone meal, per pound (external seller)	$	3.00
Cereals, per pound	$	0.50
Meat flavoring, per case	$	3.00
Processing, per pound	$	1.00			$	0.80
Packaging, per case (pack)	$	1.25			$	0.75
Overhead, per case (pack), 40% fixed	$	10.00			$	7.00

 

In lieu of its normal processing, Bones sometimes grinds raw bones into bone meal (grinding costs $0.05 per pound) When bone meal is sold to Biscuits, bulk packaging is used which costs $1 per 100 pound sack; when sold to other firms, it is packed in 50-pound 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?

 

1. No, because it will undermine the benefits of decentralization

 

2. Yes, at $2.70 per pound

 

1. No, because GGP will be worse off

 

1. Yes, at the external market price of $3 per pound

 

1. Yes, but at some other 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.

 

	Cases			Pounds per case			Total pounds
Total pounds in order		800			20			16,000
Proportion bone meal								70	%
Pounds of bone meal needed for order											11,200

 

 

	Outside			Bones			Per pound			Total
GGP cost if Biscuit buys from	$	3.00		$	2.40
Cost savings on an internal purchase							$	0.60
Bones’ foregone CM on external sale							$	1.15
Net loss							$	0.55		$	6,160

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Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

13. Bobo, Inc. manufactures small motors used in refrigerators, washing machines, and other household appliances in JuJu division. JuJu division is located in a country with a 30% income tax rate. JuJu transfers the motors to LaSalle division which is located in a country with a 40% income tax rate. The variable cost per motor is $560 and LaSalle sells each motor for $960. Bobo, Inc.’s full cost per motor is $800. Should the transfer be priced at variable cost or full cost, and why?

 

1. Variable cost because total firm net income is $400

 

1. Variable cost because total firm taxes will be minimized

 

1. Full cost because it leads to accurate measures of local performance by JuJu

 

1. Full cost because total firm net income is higher by $24 per motor

 

1. Either price will result in the same total net income for Bobo, Inc.

 

Maximizing the firm’s after-tax tax profits is often a high priority in setting a transfer pricing policy. If the transfer takes place at variable cost JuJu’s net income per motor is $0 and no taxes are paid by JuJu. LaSalle’s net income per motor is $400 and taxes of $160 are paid for a total Bobo, Inc. net income of $240. If the transfer takes place at full cost JuJu’s net income per motor is $240 and taxes of $72 are paid by JuJu. LaSalle’s net income per motor is $160 and taxes of $64 are paid for a total Bobo, Inc. net income of $264. The transfer price should be set at full cost.

 

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Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

Essay Questions

 

14. ROI and Residual Income

 

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

 

Project	Initial Investment			Annual Earnings
A	$	800,000		$	90,000
B		100,000			20,000
C		300,000			25,000
D		400,000			60,000

 

Required:

 

1. If the investment manager is currently making a return on investment of 16 percent, which project(s) would the manager want to pursue?

 

1. If the cost of capital is 10 percent and the annual earnings approximate cash flows excluding finance charges, which project(s) should be chosen?

 

1. Suppose only one project can be chosen and the annual earnings approximate cash flows excluding finance charges. Which project should be chosen?

 

Feedback:

1. The ROI of the four projects are:

 

A: $90,000/$800,000	=	11.25	%
B: $20,000/$100,000	=	20.00	%
C: $25,000/$300,000	=	8.33	%
D: $60,000/$400,000	=	15.00	%

 

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.

 

1. 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.

 

1. The project with the highest residual income should be chosen. The residual incomes of the four projects are:

 

A: $90,000 − (0.10) ($800,000)	=	$	10,000
B: $20,000 − (0.10) ($100,000)	=	$	10,000
C: $25,000 − (0.10) ($300,000)	=	$	(5,000	)
D: $60,000 − (0.10) ($400,000)	=	$	20,000

 

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

 

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Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

15. Transfer Prices

 

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:

 

1. 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?
2. Given the transfer price from part (a), what should the manager of the Beta Division do?

 

1. Suppose there is no market price for product X. What transfer price should be used for decentralized decision-making?

 

1. If there is no market for product X, is the operations of the Beta Division profitable?

 

Feedback:

1. 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.

 

1. 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.

 

1. If there is no market for X, the opportunity cost of supplying X is the variable cost of X or $40 per unit.

 

1. 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.

 

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Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

16. Transfer Prices and Capacity

 

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:

 

1. What should Jefferson Bottles charge Jefferson Juice for bottles so that both divisions will make appropriate decentralized planning decisions?

 

1. 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?

 

Feedback:

1. 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.
2. 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.

 

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Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

17. Transfer Prices and Divisional Profit

 

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:

 

1. What is the profit of each division if the transfer price is $150?

 

1. What is the profit of each division if the transfer price is $200?

 

Feedback:

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

 

	Framing			Upholstery
Revenues
($150/chair) (5,000 chairs)	$	750,000
($500/chair) (5,000 chairs)				$	2,500,000
Costs
($100/chair) (5,000 chairs)		500,000
($150 + $200/chair) (5,000 chairs)					1,750,000
Profit	$	250,000		$	750,000

 

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

 

	Framing			Upholstery
Revenues
($200/chair) (5,000 chairs)	$	1,000,000
($500/chair) (5,000 chairs)				$	2,500,000
Costs
($100/chair) (5,000 chairs)		500,000
($200 + $200/chair) (5,000 chairs)					2,000,000
Profit	$	500,000		$	500,000

 

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Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

18. Performance Measures for Cost Centers

 

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:

 

	A			B			C
Units Produced		10,000,000			20,000,000			30,000,000
Variable Costs	$	200,000		$	450,000		$	650,000
Fixed Costs	$	100,000		$	1,000,000		$	1,000,000

 

Required:

 

1. Estimate the average cost per unit for each plant.

 

1. Why would the manager of plant A be unhappy with using the average cost as the performance measure?

 

1. What is an alternative performance measure that would make the manager of plant A happier?

 

1. Under what circumstances might the average cost be a better performance measure?

 

Feedback:

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

 

Plant A: ($1,000,000 + $200,000)/10,000,000 units	=	$	0.1200/unit
Plant B: ($1,000,000 + $450,000)/20,000,000 units	=	$	0.0725/unit
Plant C: ($1,000,000 + $650,000)/30,000,000 units	=	$	0.0550/unit

 

1. 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.

 

1. 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.

 

1. 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.

 

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Difficulty: 3 Hard

 

Topic: Controllability Principle

 

Topic: Cost Centers

19. Responsibility Centers

 

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

 

Eric Olson:	General manager responsible for all the operations of the golf course and other facilities (swimming pool, restaurant, golf shop).
Jennifer Jones:	Manager of the golf course and responsible for its maintenance.
Edwin Moses:	Manager of the restaurant.
Mabel Smith:	Head golf professional and responsible for golf lessons, the golf shop, and reserving times for starting golfers on the course.
Wanda Itami:	Manager of the swimming pool and family recreational activities.
Jake Reece:	Manager of golf carts rented to golfers.

 

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.

 

Feedback:

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.

 

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Difficulty: 2 Medium

 

Topic: Cost Centers

 

Topic: Investment Centers

 

Topic: Profit Centers

 

Topic: Responsibility Accounting

 

20. Decision Rights Assignments and EVA

 

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?

 

Feedback:

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.

 

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Difficulty: 2 Medium

 

Topic: Economic Value Added (EVA®)

 

Topic: Recap

 

21. Transfer Pricing in Universities

 

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:

 

1. 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?

 

1. Discuss the pros and cons of the CAS dean’s proposal.

 

1. As special assistant to the B-school dean, prepare a response to the proposed tuition transfer pricing scheme.

 

Feedback:

Transfer price [$12,000/8 × (1 − 0.20)]	$	1,200
Number of undergraduate enrollments		2,000
Current tuition transfer to Business School	$	2,400,000
Total undergraduate course enrollments/year (6,000 × 8)	$	48,000
Undergraduate student services	$	9,600,000
Student services per course enrollment	$	200
Student services charged to Business School ($200 × 2,000)	$	400,000
Revised tuition transfer to Business School	$	2,000,000

 

1. 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”?

 

1. 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?

 

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Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

Topic: Economics of Transfer Pricing

 

Topic: Recap

 

Topic: Transfer Pricing

22. Transfer Prices and External Sourcing

 

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.

 

Feedback:

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.

 

 

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Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

Topic: Cost Centers

 

Topic: Economics of Transfer Pricing

 

Topic: Recap

 

Topic: Transfer Pricing

23. Comparing ROA and EVA

 

General Motors’ 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:

 

1. Explain how ROA focuses on both the income statement and the balance sheet.

 

1. Explain why EVA is more “comprehensive” than ROA.

 

1. Do you agree with Losh’s statement that “you can apply ROA to both; you can’t apply EVA to both”? Explain.

 

Feedback:

1. 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).

 

1. 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).

 

1. 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.

 

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Blooms: Understand

 

Difficulty: 2 Medium

 

Topic: Economic Value Added (EVA®)

 

Topic: Investment Centers

24. Transfer Pricing in the Presence of Divisional Interdependencies

 

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.

 

Feedback:

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.

 

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Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

Topic: Recap

 

Topic: Reorganization: The Solution if All Else Fails

 

Topic: Transfer Pricing

25. Dysfunctional Incentives Created by Minimizing Average Cost

 

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.

 

MODEL CVP-6907 Total Cost and Price by Quantity
Quantity	Manufacturing Cost				Price
100		$	1,450		$	120
105			1,496			116
110			1,545			112
115			1,596			108
120			1,650			104
125			1,706			100
130			1,765			96
135			1,826			92
140			1,890			88
145			1,956			84
150			2,025			80

 

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

 

Required:

 

1. What daily production quantity would you expect the product manager for model CVP-6907 to set? Why?

 

1. Evaluate Sunstar’s performance evaluation system as it pertains to product managers. What behavior does it likely create among manufacturing product managers?
2. Describe the changes you would recommend Sunstar consider making in its performance evaluation system for manufacturing product managers.

 

Feedback:

6907. 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.

 

Quantity	Total Mfg. Cost	Average Mfg. Cost	Price	Revenue	Total Cost†	Profits
100	1,450	14.50	120	12,000	2,450	9,550
105	1,496	14.25	116	12,180	2,546	9,634
110	1,545	14.05	112	12,320	2,645	9,675
115	1,596	13.88	108	12,420	2,746	9,674
120	1,650	13.75	104	12,480	2,850	9,630
125	1,706	13.65	100	12,500	2,956	9,544
130	1,765	13.58	96	12,480	3,065	9,415
135	1,826	13.53	92	12,420	3,176	9,244
140	1,890	13.50	88	12,320	3,290	9,030
145	1,956	13.49	84	12,180	3,406	8,774
150	2,025	13.50	80	12,000	3,525	8,475

 

†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.

 

1. 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.

 

1. Product managers should be evaluated based on the total cost of manufacturing a pre-specified 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.

 

AACSB: Analytical Thinking

 

AACSB: Communication

 

AACSB: Knowledge Application

 

Accessibility: Keyboard Navigation

 

AICPA: BB Resource Management

 

AICPA: FN Decision Making

 

AICPA: FN Measurement

 

Blooms: Apply

 

Blooms: Evaluate

 

Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

Topic: Cost Centers

 

Topic: Profit Centers

 

Topic: Recap

 

Topic: Reorganization: The Solution if All Else Fails

 

Topic: Transfer Pricing

 

26. Perverse Incentives from Accelerated Depreciation on ROI

 

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):

 

	Broadway (Actual)			Horse Falls (Forecast)
Average inventories and receivables during the year	$	2.100		$	2.900
Leasehold improvements, net of accumulated depreciation		0.900			4.600
Operating income before depreciation		1.050			3.300
Depreciation of leasehold improvements		0.210			1.415

 

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:

 

1. Calculate the return on total investment and residual income for the Broadway and Horse Falls stores.

 

1. 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.

 

1. 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?

 

Feedback:

1. Calculation of ROI and residual income:

	(Millions of dollars)
	Broadway (Actual)				Horse Falls (Forecast)
Operating income before depreciation	$	1.050				$	3.300
Depreciation		0.210					1.425
Net income	$	0.840				$	1.875
Investment:
Inventories and receivables	$	2.10				$	2.90
Fixed assets		0.90					4.60
Total investment	$	3.00				$	7.50
ROI		28	%				25	%
Net income	$	0.840				$	1.875
Less: Cost of capital (20%)		(0.600	)				1.500
Residual income		0.240				$	0.375

 

1. 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.

 

1. 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:

 

1. 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.

 

1. 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.

 

AACSB: Analytical Thinking

 

AACSB: Knowledge Application

 

Accessibility: Keyboard Navigation

 

AICPA: BB Critical Thinking

 

AICPA: BB Resource Management

 

AICPA: FN Decision Making

 

AICPA: FN Measurement

 

Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Investment Centers

27. Double Marginalization of Transfer Pricing

 

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.)

 

Quantity Purchased by the External Customer		Price Paid per Unit by the External Customer
20		$	800
22			780
24.5			755
26			740
30			700
40			600
45			550
49			510
50			500
60			400

 

Required:

 

1. 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?
2. How much total profit does Serviflow generate each week based on the profit maximizing price-quantity decision made in part (a)?

 

4010. 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.

 

Transfer Price			Units Purchased Weekly by NGMD
$	480		25.30
	490		24.80
	491		24.75
	492		24.70
	493		24.65
	494		24.60
	495		24.55
	496		24.50
	497		24.45
	498		24.40
	499		24.35
	500		24.30

 

(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?

 

1. 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?
2. 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.

 

4010. 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?

 

1. 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.

 

Feedback:

1. 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.

 

Quantity Sold	Price Paid By external customer			Total Revenues			Supply Div total cost				Mktg Div total cost				Servilow Total profit
20.0	$	800		$	16,000			$	120			$	280			$	15,600.00
22.0		780			17,160				132				308				16,720.00
24.5		755			18,497.50				147				343				18,007.50
26.0		740			19,240				156				364				18,720.00
30.0		700			21,000				180				420				20,400.00
40.0		600			24,000				240				560				23,200.00
45.0		550			24,750				270				630				23,850.00
49.0		510			24,990				294				686				24,010.00
50.0		500			25,000				300				700				24,000.00
60.0		400			24,000				360				840				22,800.00

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:

 

Revenue	=	(1,000 − 10Q)Q
	=	1,000Q − 10Q2
MR	=	1,000 − 20Q = MC = 20
20Q	=	980
Q	=	49

 

1. At a price of $510 and a weekly quantity of 49 units, Serviflow generates $24,010 of profits [$510 × 49 − 49($6+$14)].

 

24. 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.

Transfer Price			Units Purchased Weekly by NGMD		Supply Div total cost				Supply Div Profit
$	480		25.30		$	151.80			$	11,992.20
	490		24.80			148.80				12,003.20
	491		24.75			148.50				12,003.75
	492		24.70			148.20				12,004.20
	493		24.65			147.90				12,004.55
	494		24.60			147.60				12,004.80
	495		24.55			147.30				12,004.95
	496		24.50			147.00				12,005.00
	497		24.45			146.70				12,004.95
	498		24.40			146.40				12,004.80
	499		24.35			146.10				12,004.55
	500		24.30			145.80				12,004.20

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

MR	=	MC
Revenue	=	(986 − 20Q)Q = 986Q − 20Q2
MR	=	986 − 40Q = MC = 6
40Q	=	980
Q	=	24.5

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

	NGMD
Revenues (24.5 × $755)	$	18,497.50
Transfer cost (24.5 × 496)		(12,152.00	)
Variable cost (24.5 × $14)		(343.00	)
NGMD profits	$	6,002.50
Supply Division profits		12,005.00
Total firm profits	$	18,007.50

 

10. 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.

 

6. Corporate should set the transfer price at the Supply Division’s variable cost of $6.

 

NGMD would then select

 

T	=	986 − 20Q
$6	=	986 − 20Q
20Q	=	480
Q	=	49, which is the firm-wide profit maximizing quantity.

 

4010. 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.

 

AACSB: Analytical Thinking

 

AACSB: Communication

 

AACSB: Knowledge Application

 

Accessibility: Keyboard Navigation

 

AICPA: BB Resource Management

 

AICPA: FN Decision Making

 

AICPA: FN Measurement

 

Blooms: Apply

 

Difficulty: 3 Hard

 

Topic: Common Transfer Pricing Methods

 

Topic: Recap

 

Topic: Reorganization: The Solution if All Else Fails

 

Topic: Transfer Pricing

 

 

 

Chapter 05 Test Bank – Static Summary

 

Category	# of Questions
AACSB: Analytical Thinking	13
AACSB: Communication	6
AACSB: Knowledge Application	27
Accessibility: Keyboard Navigation	27
Accessibility: Screen Reader Compatible	10
AICPA: BB Critical Thinking	3
AICPA: BB Industry	3
AICPA: BB Resource Management	27
AICPA: FN Decision Making	16
AICPA: FN Measurement	26
Blooms: Apply	20
Blooms: Evaluate	1
Blooms: Remember	3
Blooms: Understand	4
Difficulty: 1 Easy	2
Difficulty: 2 Medium	5
Difficulty: 3 Hard	20
Topic: Common Transfer Pricing Methods	14
Topic: Controllability Principle	1
Topic: Cost Centers	4
Topic: Economic Value Added (EVA®)	3
Topic: Economics of Transfer Pricing	3
Topic: International Taxation	1
Topic: Investment Centers	8
Topic: Profit Centers	3
Topic: Recap	6
Topic: Reorganization: The Solution if All Else Fails	3
Topic: Responsibility Accounting	2
Topic: Transfer Pricing	6