Decentralization Responsibility Accounting by jennyyingdi

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									                   CHAPTER 10
               DECENTRALIZATION:
    RESPONSIBILITY ACCOUNTING, PERFORMANCE
       EVALUATION, AND TRANSFER PRICING
                     QUESTIONS FOR WRITING AND DISCUSSION

1. Decentralization is the delegation of               8. Residual income is the difference between
   decision-making authority to lower levels. In          operating income and the minimum dollar re-
   centralized decision making, decisions are             turn required on an investment. Residual in-
   made at the very top level, and lower-level            come encourages investment in all projects
   managers are responsible for implementing              that earn at least the minimum rate of return.
   these decisions. For decentralized decision
                                                       9. Both ROI and residual income encourage
   making, decisions are made and imple-
                                                          myopic behavior. This problem can be over-
   mented by lower-level managers.
                                                          come by using additional measures of
2. Reasons for decentralization include the fol-          performance that are long run in their orien-
   lowing: access to local information, cognitive         tation.
   limitations, more timely response, focusing
   of central management, exposure of seg-            10.   EVA is economic value added. It is the dif-
   ments to market forces, enhanced competi-                ference between after-tax operating income
   tion, training, and motivation.                          and the cost of the capital employed. EVA is
                                                            an absolute dollar amount, not a percentage
3. Knowledge of local conditions may be critical            rate of return like ROI. EVA differs from re-
   for decisions. Local managers are aware of               sidual income in its use of after-tax operating
   these conditions, whereas higher-level man-              income and the true cost of capital (rather
   agers may not be.                                        than a hurdle rate).
4. One cannot say without knowing the assets          11.   Owners may have difficulty in developing
   employed to earn the profits. In addition,               goal congruence with managers because
   knowledge of other factors may be important              managers may want to work less than the
   before a decision regarding relative perfor-
                                                            owner would like and because managers
   mance can be made.
                                                            may wish to use the company’s resources
5. Margin = Operating income/Sales, and                     for their own benefit. Properly structured in-
   Turnover = Sales/Average operating assets.               centive pay plans may be successful in
   By breaking ROI into margin and turnover,                overcoming these problems.
   more insight into why ROI may change from
   one period to the next is possible.                12.   A stock option is the right to purchase a
                                                            certain amount of stock at a fixed price. It
6. (1) ROI encourages managers to pay atten-                can encourage goal congruence by giving
   tion to the relationships among revenues,                managers an ownership stake in the firm,
   expenses, and investment. (2) ROI encour-                encouraging them to view operations from a
   ages cost efficiency. (3) ROI discourages                long-run perspective.
   excessive investment in operating assets.
   Increased profitability can be achieved (all       13.   A transfer price is the price charged for
   other things being equal) by increasing reve-            goods that are transferred from one division
   nues, decreasing expenses, or lowering in-               to another division of the same company.
   vestment.
                                                      14.   Transfer prices affect both the revenues of
7. ROI may discourage managers from invest-                 the transferring division and the costs of the
   ing in projects that would increase the profit-          buying division and, thus, the profits of both
   ability of the firm but decrease the division’s          divisions. A transfer price can affect the prof-
   ROI. It also may encourage managers to fo-               its of the firm because it can affect the out-
   cus on short-run profitability, and to take ac-          put decision of the buying division. If the
   tions that may harm long-run profitability.


                                                293
      price is set too high (low), then the output of     19.   Negotiated transfer prices allow both divi-
      the buying division may be too low (high).                sions to be made better off whenever oppor-
      Since the transfer price can affect firmwide              tunity costing signals that a transfer should
      profitability, upper management may be                    take place. Since both can be made better
      tempted to interfere with the autonomy of a               off, no interference from headquarters is
      division and dictate the price (rather than let-          needed or prompted. Moreover, the price
      ting the divisional manager make the pricing              emerging is necessarily a mutually satisfac-
      decision).                                                tory price. In effect, negotiated prices can
                                                                simultaneously satisfy the objectives of ac-
15.   The transfer pricing problem is finding a
                                                                curate performance evaluation, firmwide ef-
      transfer price that simultaneously satisfies
                                                                ficiency, and preservation of divisional au-
      three objectives: accurate performance
                                                                tonomy.
      evaluation, goal congruence, and preserva-
      tion of divisional autonomy.                              Disadvantages of negotiated transfer prices
                                                                include: (1) private information can be used
16.   The opportunity cost approach to transfer
                                                                for exploitation; (2) performance measures
      pricing identifies the minimum and maximum                are distorted by relative negotiating skills of
      transfer prices. The minimum transfer price               managers; and (3) negotiation can be costly.
      is the one that makes the transferring divi-
      sion no worse off, and the maximum transfer         20.   Full cost, full cost plus markup, and variable
      price is the one that makes the buying divi-              cost plus fixed fee. The major disadvantage
      sion no worse off.                                        is that cost-based transfer prices may not re-
                                                                flect the optimal outcome for the divisions
17.   Agree. At least one division will be made
                                                                and the firm. Specifically, it is possible for
      better off, and firm profits will increase.               the transfer price, using one of the costing
18.   Market price. Minimum price = Maximum                     approaches, to be less than the minimum
      price = Market price. Any other price would               price or greater than the maximum price.
      make at least one division worse off, and                 The prices, however, are simple to use and,
      firm profits may decrease if the price is not             in some cases, may reflect the outcome of a
      market price.                                             negotiated agreement.




                                                    294
                                   EXERCISES

10–1

1.   2004: $3,200,000/$20,000,000 = 16%
     2005: $2,800,000/$20,000,000 = 14%

2.   2004: Margin: $3,200,000/$64,000,000 = 5%
     2005: Margin: $2,800,000/$70,000,000 = 4%
     2004: Turnover: $64,000,000/$20,000,000 = 3.2
     2005: Turnover: $70,000,000/$20,000,000 = 3.5

3.   While the turnover ratio increased from 3.2 to 3.5, the margin dropped from
     5% to 4%.


10–2

1.   2004: $1,600,000/$10,000,000 = 16%
     2005: $1,200,000/$10,000,000 = 12%

2.   2004: Margin: $1,600,000/$32,000,000 = 5.0%
     2005: Margin: $1,200,000/$32,000,000 = 3.75%
     2004: Turnover: $32,000,000/$10,000,000 = 3.2
     2005: Turnover: $32,000,000/$10,000,000 = 3.2

3.   The Costume Jewelry Division’s ROI decreased by 4%, while the Cosmetics
     Division’s ROI decreased by 2%. Margin for both divisions decreased, but the
     Cosmetics Division was able to increase its turnover of operating assets.




                                     295
10–3

1.   MP3 Player:     ROI = $116,000/$800,000 = 14.5%
     Voice Recorder: ROI = $105,000/$750,000 = 14.0%

2.                           Add Only     Add Only    Add Both     Maintain
                            MP3 Player Voice Recorder Projects    Status Quo
     Operating income       $2,816,000   $2,805,000   $2,921,000  $2,700,000
     Avg. operating assets $18,800,000 $18,750,000 $19,550,000 $18,000,000
     ROI                         14.98%       14.96%       14.94%         15%
     The manager will maintain the status quo (no additional investment).


10–4

1.   MP3 Player:     RI = $116,000 – (0.12  $800,000) = $20,000
     Voice Recorder: RI = $105,000 – (0.12  $750,000) = $15,000

2.                     Add Only          Add Only       Add Both        Maintain
                      MP3 Player      Voice Recorder     Projects      Status Quo
     Operating income $2,816,000        $2,805,000      $2,921,000     $2,700,000
     Minimum income*   2,256,000         2,250,000       2,346,000       2,160,000
     ROI              $ 560,000         $ 555,000       $ 575,000      $ 540,000
     *Minimum income = Operating assets  Minimum required rate of return
     The manager will invest in both the MP3 player and the voice recorder.

3.   The company has increased profits by $35,000 before income taxes. Yes, the
     correct decision was made.




                                     296
10–5

1.                                                       After-Tax   Weighted
                                             Percent       Cost       Cost
     Common stock                             0.50         0.180      0.0900
     10-year bonds                            0.50         0.039*     0.0195
     Weighted average cost of capital                                 0.1095
     *0.039 = 0.06 – (0.06  0.35)
     EVA = $210,000 – (0.1095  $2,000,000) = ($9,000)

2.                                                       After-Tax   Weighted
                                             Percent       Cost       Cost
     Common stock                             0.50         0.150      0.0750
     10-year bonds                            0.50         0.039      0.0195
     Weighted average cost of capital                                 0.0945
     EVA = $210,000 – (0.0945  $2,000,000) = $21,000

     Year 2:
                                                         After-Tax   Weighted
                                             Percent       Cost       Cost
     Common stock                             0.50         0.120      0.0600
     10-year bonds                            0.50         0.039      0.0195
     Weighted average cost of capital                                 0.0795
     EVA = $210,000 – (0.0795  $2,000,000) = $51,000




                                     297
10–5 Concluded

3.                                                       After-Tax   Weighted
                                             Percent       Cost       Cost
     Common stock                             0.80         0.180      0.1440
     10-year bonds                            0.20         0.039      0.0078
     Weighted average cost of capital                                 0.1518
     EVA = $450,000 – (0.1518  $3,000,000) = ($5,400)

     Year 1 (9% premium):
                                                         After-Tax   Weighted
                                             Percent       Cost       Cost
     Common stock                             0.80         0.150      0.1200
     10-year bonds                            0.20         0.039      0.0078
     Weighted average cost of capital                                 0.1278
     EVA = $450,000 – (0.1278  $3,000,000) = $66,600

     Year 2 (6% premium):
                                                         After-Tax   Weighted
                                             Percent       Cost       Cost
     Common stock                             0.80         0.120      0.0960
     10-year bonds                            0.20         0.039      0.0078
     Weighted average cost of capital                                 0.1038
     EVA = $450,000 – (0.1038  $3,000,000) = $138,600




                                     298
10–6

1.                                        Franklin, Inc.
                                 Income Statement (in thousands)
                                       For the Year 20XX
                                                Residential    Commercial International      Total
     Sales ..................................... $1,620          $2,400      $1,000         $5,020
     Cost of goods sold ..............             1,215          1,710         600          3,525
     Gross profit ..........................      $ 405          $ 690        $ 400         $1,495
     Selling and admin. expense                       75            180         150            405
     Division profit ......................       $ 330          $ 510        $ 250         $1,090
     Income taxes (40%) .............                132            204         100            436
       After-tax operating income $ 198                          $ 306        $ 150         $ 654

2.                                                                         After-Tax    Weighted
                                                              Percent        Cost        Cost
     Common stock                                              0.80          0.110       0.0880
     Bonds                                                     0.20          0.048*      0.0096
     Weighted average cost of capital                                                    0.0976
     *0.08(1 – 0.4) = 0.048

3.
                                                Residential   Commercial International Total
     After-tax operating income . $198,000                     $306,000    $150,000   $654,000
     Less cost of capital:
        (0.0976  $2,100,000) ...... 204,960
        (0.0976  $500,000) .........                             48,800
        (0.0976  $400,000) .........                                          39,040      292,800
     EVA ....................................... $ (6,960)      $257,200     $110,960     $361,200

4.   While EVA is positive for Franklin, Inc., as a whole, it is negative for the Resi-
     dential Division. Therefore, even though the Residential Division has positive
     operating income after taxes, it needs to increase operating income after tax-
     es or reduce the capital used to generate positive economic value added.




                                                  299
10–7

1.   Maximum price                   $    2.70
     Minimum price                        1.15
     Difference                      $    1.55
      Number of boxes                150,000
         Increased profit            $ 232,500
     Since the Glass Division has idle capacity, the minimum price is variable cost
     of $1.25, less avoidable selling costs of $0.10. Yes, the transfer should take
     place.

2.   Erica might negotiate for a lower price. Neil would consider the $2.00 price,
     as his income would increase $127,500 [($2.00 – $1.15)  150,000].

3.   Full manufacturing cost is $1.75 ($1.25 + $0.50), so $1.75 would be the trans-
     fer price. The transfer could take place since $1.75 is between the minimum
     and maximum prices of the negotiating set.


10–8

1.   Green: $153,000 – (0.12  $900,000) = $45,000
     Red: $600,000 – (0.12  $4,000,000) = $120,000
     Residual income is an absolute dollar measure, so it does not adjust for the
     relative sizes of the divisions.

2.   Green: $45,000/$900,000 = 5%
     Red: $120,000/$4,000,000 = 3%
     It is now possible to say the Green Division is relatively more profitable than
     the Red Division.

3.   Green: $153,000/$900,000 = 17%
     Red: $600,000/$4,000,000 = 15%
     ROI can be used to compare relative divisional profitability.

4.   Green: 5% + 12% = 17%
     Red: 3% + 12% = 15%
     The residual rate of return and the required rate of return will always sum to
     the ROI.




                                         300
10–9

                              A               B             C            D
Revenue                    $10,000         $48,000       $96,000      $19,200*
Expenses                    $8,000         $36,000*      $90,000      $18,000*
Operating Income            $2,000         $12,000        $6,000*      $1,200*
Assets                     $40,000         $96,000*      $48,000       $9,600
Margin                          20%*            25%         6.25%*       6.25%
Turnover                      0.25*           0.50             2*           2
ROI                              5%*          12.5%*        12.5%*       12.5%*
*Indicates missing data.


10–10

A’s residual income = $2,000 – (0.11  $40,000) = ($2,400)

B’s residual income = $12,000 – (0.11  $96,000) = $1,440

C’s residual income = $6,000 – (0.11  $48,000) = $720

D’s residual income = $1,200 – (0.11  $9,600) = $144


10–11

1.   Operating income = $1,000,000 – $600,000 – $100,000 = $300,000
     Residual income = $300,000 – (0.15)($200,000) = $270,000

2.   ROI = $300,000/$200,000 = 1.5 or 150%




                                     301
                                    PROBLEMS

10–12

1.   Minimum transfer price = $3.40
     Maximum transfer price = $3.40
     Since a market price exists for the transistor used by the Systems Division,
     the minimum and maximum transfer prices are the same.

2.   Yes, since the variable cost of the transistor is $1.90 ($2.65 less the $0.75 of
     allocated fixed overhead).

3.   The negotiated price of $11.00 provides profit for both the Board Division and
     the Systems Division. The Board Division realizes a profit of $1.85 per board
     ($11.00 – $9.15). The Systems Division realizes a reduction in cost of $1.25
     per board ($12.25 – $11.00).
     It should be noted that the $12.25 is not a true market price because this par-
     ticular board is not sold externally. Thus, the Board Division is not necessari-
     ly foregoing profit by not selling externally at its regular markup.




                                      302
10–13

1.                                       Reigis Steel Division
                                Unit Contribution Margin (in thousands)
                                For the Year Ended November 30, 2005
     Sales .....................................................................             $25,000
     Less variable costs:
        Cost of goods sold .........................................               $16,500
        Selling expenses ($2,700  40%) ..................                           1,080    17,580
     Contribution margin ............................................                        $ 7,420
     Unit contribution margin = $7,420/1,484 units
                              = $5.00 per unit

2.   a. ROI = Income before taxes/Average operating assets*
            = $1,845,000/$15,375,000
            = 12%
          *Average operating assets = ($15,750,000 + $15,000,000)/2
                                    = $15,375,000
          Where November 30, 2004 operating assets = $15,750,000/1.05

     b. Residual income = $1,845,000 – (0.11  $15,375,000)
                        = $1,845,000 – $1,691,250
                        = $153,750

3.   The management of Reigis Steel would have been more likely to accept the
     contemplated capital acquisition if residual income were used as the perfor-
     mance measure because the investment would have increased both the divi-
     sion’s residual income and the management bonuses. Using residual income,
     management would accept all investments with a return higher than 11% as
     these investments would all increase the dollar value of residual income.
     When using ROI as a performance measure, Reigis’s management is likely to
     reject any investment that would lower the overall ROI (12% in 2005), even
     though the return is higher than the required minimum, as this would lower
     bonuses.

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




                                                         303
10–14

1.   The value of the option for each executive would be:
     Value of 20,000 shares on 12/1         $680,000
     Value of 20,000 shares on 4/1           300,000
        Value of option                     $380,000

2.   Advantages: Ownership of stock may encourage the executives to take a
     longer-term perspective, and it may make them conscious of the overuse of
     perquisites.
     Disadvantages: Often executives exercise the stock options and immediately
     sell the stock. In this case, the executives are not owners of the firm and have
     no more incentive to act like owners than they did before the options were
     exercised.


10–15

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

Price of stock in two years ($12  1.15  1.15  10,000)       $158,700
Exercise price of stock                                         120,000
   Gain                                                        $ 38,700

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

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

The final decision rests on Casey’s assessment of the risk versus reward of the
two positions. She should also consider the risk of remaining in her present posi-
tion; that is, what are her prospects for making partner at the professional ser-
vices firm?




                                      304
10–16

1.                              Component 4CM       Model 7AC        Company
     Sales                         $70,000*          $550,000        $620,000
     Variable expenses              50,000            460,000         510,000
     Contribution margin           $20,000           $ 90,000        $110,000
     *While all 10,000 units could be sold externally, currently none are.

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

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

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

5.   Sales                    $120,000
     Variable expenses          50,000
     Contribution margin      $ 70,000
     The contribution to profits increases by $40,000. The CEO made the wrong
     decision.




                                      305
10–17

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

2.   Coffee Division:
     Current profit:
       950,000  ($4.50 – $3.50) = $950,000
     Profit with no internal transfers:
        850,000  ($4.50 – $3.50) = $850,000
     Change in profit: $950,000 – $850,000 = ($100,000)

     Donut Shop Division:
     Increase in profit:
     ($4.50 – $4.00)  100,000 = $50,000
     Effect on firm: ($100,000) + $50,000 = ($50,000)

3.   Using the no-transfer scenario as the point of reference, the minimum trans-
     fer price for the Coffee Division can be computed as follows (if internal trans-
     fer occurs, there will be 850,000 pounds sold externally and 100,000 sold
     internally):
     Let P = Minimum transfer price
     [850,000  ($4.50 – $3.50)] + [100,000  (P – $3.50)]   = $850,000
                        $850,000 + 100,000P – $350,000       = $850,000
                                                100,000P     = $350,000
                                                        P    = $3.50
     The maximum transfer price is $3.50, the price that would be paid if no trans-
     fer occurs internally.




                                       306
10–17 Concluded

     For a transfer price of $3.50, the effect for each division and the firm is as fol-
     lows:
     Coffee: ($3.50 – $3.50)100,000 + ($4.50 – $3.50)850,000 = $850,000
             Change in profit: $850,000 – $950,000 = ($100,000)
     Donut Shop: $1  100,000 = $100,000 savings
     Firm: No change
     The outside bid has a direct benefit to the Donut Shop Division.

4.                                 Original Income                   New Income
     Sales:
       External              $3,825,000                        $3,825,000
       Internal                 450,000 $4,275,000                350,000 $4,175,000
     Variable cost                       1,900,000                         1,900,000
     Contribution margin                $2,375,000                        $2,275,000
     Fixed cost                          1,500,000                         1,500,000
     Operating income                   $ 875,000                         $ 775,000
     Original ROI = $875,000/$2,000,000 = 43.75%
     New ROI = $775,000/$2,000,000 = 38.75%
     The decrease in ROI will affect Raymond’s evaluation as a manager and his
     chance for bonuses and promotions. Still, the transfer pricing negotiations
     have given him valuable information. He is now aware that an outside com-
     pany is underpricing him on similar quality coffee; he needs to determine why
     (e.g., a more efficient cost structure) and whether this will also affect his own
     outside sales.




                                       307
10–18

1.   $120

2.   Minimum: $108
     Maximum: $120
     Actual: $114

3.   ($90 + $44.00)/2 = $67
     Appliance
     Additional revenue ($67  2,000)          $134,000
     Additional expenses ($44  2,000)           88,000
     Additional profit                         $ 46,000
     Manufactured Housing
     Reduction of costs ($90 – $67)  2,000       46,000
     Total addition to profits                  $ 92,000


10–19

1.   The segment information prepared for public reporting purposes may not be
     appropriate for the evaluation of segment management performance be-
     cause:
      An allocation of common costs incurred for the benefit of more than one
       segment must be included for public reporting purposes.
      Common costs are generally allocated on an arbitrary basis.
      The segments identified for public reporting purposes may not coincide
       with actual management responsibilities.
      This information does not distinguish between a segment that is a poor in-
       vestment and the performance of a manager who has done well despite
       adverse circumstances.




                                     308
10–19 Concluded

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

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


10–20

1.   a. Meyers Service Company 2004 bonus pool:
        Bonus pool = 10%  Income before taxes and bonus
                   = 0.10  $417,000
                   = $41,700

     b. Wellington Products, Inc., 2004 bonus pool:
        Bonus pool = 1%  (Revenue – Cost of product)
                   = 0.01  ($10,000,000 – $4,950,000)
                   = 0.01  ($5,050,000)
                   = $50,500




                                     309
10–20 Continued

2.   a. Two of the advantages and disadvantages to Renslen, Inc., of the bonus
        pool incentive plan at Meyers Service Company are as follows:
       Advantages:
       The management team will be motivated by the bonus plan as they have
       the opportunity to earn additional compensation if they work hard as a
       team and take some risks for the company.
       As management shares in the benefits of efficient operations, there is an
       incentive to control all costs (product costs as well as overhead costs)
       and to promote sales.
       Disadvantages:
       The plan may motivate management to increase the bottom line only and
       concentrate on the short term. The plan may encourage managers to sac-
       rifice quality for the sake of profits.
       Management may postpone necessary expenditures such as maintenance
       of assets or research and development in order to increase operating in-
       come.

     b. Two of the advantages and disadvantages to Renslen, Inc., of the bonus
        pool incentive plan at Wellington Products, Inc., are as follows:
       Advantages:
       The management team will be motivated by the bonus plan as each man-
       ager has the opportunity to earn additional compensation by working hard
       and taking some risks for the company.
       The managers will be encouraged to sell the most profitable mix of prod-
       ucts.
       Disadvantages:
       The plan omits accountability for all costs except production costs. There-
       fore, managers may feel no obligation to control the costs that are shown
       below the gross margin line.
       The plan may cause managers to focus all energies on maximizing current
       sales and production regardless of the impact this could have on the
       manufacturing plan.




                                    310
10–20 Concluded

3.   a. Having two different incentive plans for the two operating divisions could
        result in behavioral problems and may reduce teamwork/synergy between the
        two divisions if the managers of either division believe they are being
        treated unfairly.
        The management team at Meyers Service Company may believe that they
        have to work harder to achieve their bonuses as they are responsible for
        all costs and must achieve overall efficient operations to earn substantial
        bonuses.
        The management team at Wellington Products, Inc., may believe that they
        have less opportunity to affect the size of the bonuses they receive as only
        changes in sales and/or product costs will increase the gross margin.
        These perceptions of inequity could lead to decreased motivation that
        could result in decreased divisional performances.

     b. In order to justify having different incentive plans for the two divisions,
        Renslen, Inc., could argue that:
        The goals and products of the businesses are different (one is a service
        organization while the other is a manufacturing organization) and, there-
        fore, should be measured on different criteria. For example, the control of
        manufacturing costs and improved productivity may be the most important
        factors in maintaining Wellington’s competitiveness while it may be critical
        for Meyers to control all costs to maintain profitability.
        The plans were in place when the businesses were acquired and had
        proved satisfactory previously.




                                     311
10–21

1.   If Mason Industries continues to use return on investment as the sole meas-
     ure of division performance, JSC would be reluctant to acquire RLI because
     the combined return on investment would decrease.
     JSC return on investment = $2,000,000/$8,000,000 = 0.25
     RLI return on investment = $600,000/$3,200,000* = 0.1875
     Combined return on investment = $2,600,000/$11,200,000 = 0.232
     *Note that the asset cost used for RLI is the post-acquisition cost of
     $3,200,000, not the preacquisition value of assets.
     This would result in JSC managers either losing or having their bonuses lim-
     ited to 50 percent of the eligible amounts, which assumes management could
     provide convincing explanations for the decline in ROI.

2.   If Mason Industries could be persuaded to use residual income to measure
     performance, JSC would be more willing to acquire RLI because the residual
     income of the combined operation would be larger than the residual income
     for JSC alone.
     JSC residual income = $2,000,000 – ($8,000,000  0.15) = $800,000
     RLI residual income = $600,000 – ($3,200,000  0.15) = $120,000
     Combined residual income = $800,000 + $120,000 = $920,000

3.   The likely effect on the behavior of division managers whose performance is
     measured by:
     a. Return on investment includes considerations to: put off capital improve-
        ments or modernization to avoid capital expenditures; and shy away from
        profitable opportunities or investment that would yield more than the
        company’s cost of capital but which may lower overall ROI.

     b. Residual income includes considerations to: seek any opportunity or in-
        vestment that will earn more than the cost of capital target rate; and seek
        to reduce the level of assets employed in the business.




                                     312
10–22

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

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

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

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

5.   Since ROI is the main performance measure, Fred was not willing to accept a
     profitable investment because it would decrease his division’s ROI. Facing a
     possible promotion, he chose to maintain the division’s high ROI rather than
     earn extra profits for the company. The decision was motivated by self-
     interest. Some may argue that the decision was encouraged by the compa-
     ny’s reward system. This argument, however, is weak since it is virtually cer-
     tain that the intent of higher management is to reward productive behavior,
     not manipulative behavior. From this perspective, the decision was wrong
     and, thus, unethical.
     However, Fred might argue that the true objective of the firm is to encourage
     and reward high return on investment. He may be able to develop an accept-
     ably high ROI project in the next eight to ten months. Thus, not accepting the
     immediate project may give him the ability to invest in a more profitable pro-
     ject later on.




                                     313
10–23

1.   a. The positive and negative behavioral implications arising from employing
        a negotiated transfer pricing system for goods exchanged between divi-
        sions include the following:
        Positive:
        Both the buying and selling divisions have participated in the negotiations
        and are likely to believe they have agreed on the best deal possible.
        Negotiating and determining transfer prices will enhance the autonomy/
        independence of the divisions.
        Negative:
        The result of a negotiated transfer price between divisions may not be op-
        timal for the firm as a whole and therefore will not be goal congruent.
        The negotiating process may cause harsh feelings and conflicts between
        divisions.

     b. The behavioral problems which can arise from using actual full (absorp-
        tion) manufacturing costs as a transfer price include the following:
        Full-cost transfer pricing is not suitable for a decentralized structure
        where the autonomous divisions are measured on profitability, as the sell-
        ing unit is unable to realize a profit.
        This method can lead to decisions that are not goal congruent if the buy-
        ing unit decides to buy outside at a price less than the full cost of the sell-
        ing unit. If the selling unit is not operating at full capacity, it should reduce
        the transfer price to the market price if this would allow the recovery of
        variable costs plus a portion of the fixed costs. This price reduction would
        optimize overall company performance.




                                        314
10–23 Continued

2.   The behavioral problems that could arise if Lynsar Corporation decides to
     change its transfer pricing policy to one that would apply uniformly to all di-
     visions include the following:
     A change in policy may be interpreted by the divisional managers as an at-
     tempt to decrease their freedom to make decisions and reduce their autono-
     my. This perception could lead to reduced motivation.
     If managers lose control of transfer prices and, thus, some control over prof-
     itability, they will be unwilling to accept the change to uniform prices.
     Selling divisions will be motivated to sell outside if the transfer price is lower
     than market as this behavior is likely to increase profitability and bonuses.

3.   The likely behavior of both “buying” and “selling” divisional managers, for
     each of the following transfer pricing methods being considered by Lynsar
     Corporation, include the following:
     a. Standard full manufacturing costs plus markup
        The selling division will be motivated to control costs because any costs
        over standard cannot be passed on to the buying division and will reduce
        the profit of the selling division.
        The buying divisions may be pleased with this transfer price if the market
        price is higher. However, if the market price is lower and the buying divi-
        sions are forced to take the transfer price, the managers of the buying di-
        visions will be unhappy.

     b. Market selling price of the product being transferred
        This method creates a fair and equal chance for the buying and selling di-
        visions to make the most profit they can and should promote cost control,
        motivate divisional management, and optimize overall company perfor-
        mance. Since both parties are aware of the market price, there will be no
        distrust between the parties, and both should be willing to enter into the
        transaction.




                                       315
10–23 Concluded

   c. Outlay (out-of-pocket) costs incurred to the point of transfer plus oppor-
      tunity cost per unit
        This method is the same as market price when there is an established
        market price and the seller is at full capacity. At any level below full capac-
        ity, the transfer price is the outlay cost only (as there is no opportunity
        cost) which would approximate the variable costs of the goods being
        transferred.
        Both buyers and sellers should be willing to transfer under this method
        because the price is the best either party should be able to realize for the
        product under the circumstances. This method should promote overall
        goal congruence, motivate managers, and optimize overall company prof-
        its.


                             CYBER RESEARCH CASE

10–24

Answers will vary.




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