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									CHAPTER 10
Decentralization: Responsibility
Accounting, Performance Evaluation,
and Transfer Pricing

LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Define responsibility accounting, and describe the four types of responsibility centers.
2. Explain why firms choose to decentralize.
3. Compute and explain return on investment (ROI), residual income (RI), and economic value
   added (EVA).
4. Discuss methods of evaluating and rewarding managerial performance.
5. Explain the role of transfer pricing in a decentralized firm.
6. Discuss the methods of setting transfer prices.



CHAPTER REVIEW
This chapter describes how accounting information supports companies that decentralize in
decision-making authority. It begins with performance assessment of responsibility centers in
decentralized organizations. Next, the chapter discusses how to design management
compensation programs to reward managers for taking actions in the best interests of the firm.
Related transfer pricing issues and the methods of setting transfer prices are also examined.



CHAPTER REVIEW

I.    Responsibility Accounting           Learning Objective #1

      The responsibility accounting system has been developed to support the decentralized
      organizational structure with many responsibility centers where:
       A responsibility center is a segment of the business whose manager is accountable
        for only the activities of that center.
       Responsibility accounting is a system that measures the results of each responsibility
        center and compares those results with some measure of expected or budgeted
        outcome.


                                                 207
208                                                                                    Chapter 10


       A. Types of responsibility centers include:
           1. Cost centers—managers are responsible only for costs.
               Example: Production departments within the factory
           2. Revenue centers—managers are responsible only for sales.
               Example: A company’s marketing department
           3. Profit centers—managers are responsible for both revenues and costs.
               Example: A plant within a firm
           4. Investment centers—managers are responsible for revenues, costs, and
              investments.
               Example: A division within a firm
           Note that in a decentralized organization, some interdependencies usually exist. Thus,
           decisions made by the manager, such as transfer pricing, can affect other
           responsibility centers.
      B.   The Role of Information and Accountability
            Managers should be held accountable for outcomes in the areas in which they
             have the most knowledge and information available to them.

II.   Decentralization        Learning Objective #2

      A.   Decentralization is the practice of delegating decision-making authority to the lower
           levels.
           1. In centralized decision making:
               Decisions are made at the very top level of the organization.
               Lower-level managers are charged with implementation.
           2. In decentralized decision making:
               Managers at lower levels make and implement key decisions.
      B.   Reasons for Decentralization
           1. Have better access to local information
               Lower-level managers may have better quality information because they are
                ―closer to the action.‖
           2. Avoid cognitive limitations
               No one person has all of the expertise and training needed to process and use
                the information.
               Individuals with specialized skills will be needed.
           3. Allow more timely response
               Avoid delays caused by transmitting information to central management and
                waiting for the responses, and decrease the potential for miscommunication.
               Decentralization allows the local managers to both make and implement the
                decision.
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing           209

            4. Better focusing of central management
                 Top management is free to focus on strategic planning and decision making.
            5. Facilitate training and evaluation
                 Lower-level managers are given the opportunity to make decisions as well as
                  implement them.
            6. Provide motivation
                 Greater responsibility can produce more job satisfaction and motivate the local
                  manager.
            7. Enhance competition
                 Each decentralized division’s contribution to profit can be more easily measured.
                 Each division is exposed more directly to market forces.
       C.   The Units of Decentralization
            1. Decentralization is usually achieved by segmenting the company into divisions.
               Divisions may be differentiated by:
                a. Types of goods or services provided
                b. Types of customers served
                c. Geographic regions
            2. Decentralization creates the opportunity for control of the divisions through the use
               of responsibility accounting.
III.   Measuring the Performance of Investment Centers                      Learning Objective #3
       A.   Return on Investment
            1. Return on investment (ROI) measures profits earned per dollar of investment.
                a. It is the most common measure of performance for an investment center.
                                            Operating income
                                 ROI =
                                         Average operating assets

                                         Operating income            Sales
                                 ROI =                    ×
                                              Sales         Average operating assets

                                 ROI = Operating income margin × Operating asset turnover
                b. Operating income is earnings before interest and taxes.
                c. Operating assets are all assets acquired to generate operating income.
                     Includes cash, receivables, inventories, land, buildings, and equipment.
                                                       Beginning net book value + Ending net book value
                        Average operating assets =
                                                                              2
            2. Margin is the ratio of operating income to sales.
            3. Turnover shows how productively assets are being used to generate sales.
            4. Advantages of using ROI include:
                a. It encourages managers to pay careful attention to the relationships among sales,
                   expenses, and investments.
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              b. It encourages cost efficiency by focusing on reducing nonvalue-added activities
                 and/or improving productivity.
              c. It discourages excessive investment in operating assets and, thus, encourages
                 efficient investment.
           5. Disadvantages of the ROI measure include:
              a. It discourages managers from investing in projects that would increase the
                 profitability of the company as a whole but would decrease the divisional ROI
                 measure.
                  Managers would reject projects with an ROI less than a division’s current
                   ROI but higher than the firm’s cost of capital.
              b. It can encourage myopic behavior, in that managers may over emphasize
                 short-run results at the expense of the long-term profitability.
      B.   Residual Income
           1. Residual income (RI) is the difference between operating income and the minimum
              dollar return required on a company’s operating assets.
                    RI = Operating income – (Minimum rate of return × Operating assets)
           2. Advantage of residual income:
               A manager will accept any project that earns above the minimum rate of return
                because they will increase the company-wide profitability.
           3. Disadvantages of residual income:
              a. RI an absolute measure of return that makes it difficult to compare divisions of
                 different sizes.
                  Solution: Compute a residual return on investment.
                                                                     RI
                         Residual return on investment =
                                                           Average operating assets

              b. May encourage myopic behavior.
                  Same disadvantage as for ROI.
      C.   Economic Value Added
           1. Economic value added (EVA) is after-tax operating profit minus the total annual
              cost of capital.
                       EVA = After-tax operating income –
                             (Weighted average cost of capital × Total capital employed)
              a. EVA is a dollar figure rather than a percentage rate of return.
              b. EVA emphasizes after-tax operating profits and actual cost of capital.
              c. EVA uses the weighted average cost of capital, which is measured on an
                 after-tax basis.
                 Computation of the cost of capital employed involves the following steps:
                 (1) Determine the weighted average cost of capital as a percentage.
                      (a) Identify all sources of invested funds.
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing             211

                         (b) Multiply the proportion of capital from each source of financing by its
                             after-tax cost.
                               Interest expenses of debt financing are tax deductible. Thus,
                                       After-tax cost of capital for debt = Cost × (1 – Tax rate)
                               There are no tax adjustments for equity.
                                  Over time, stockholders receive an average return that is 6%
                                  higher than the return on long-term government bonds.
                    (2) Determine the total dollar amount of capital employed, including:
                          Buildings, land, and machinery.
                          Other investments meant to have a long-term payoff, such as
                           research and development, employee training, and so on.
                d. Positive EVA means that the firm creates wealth (value) by earning operating
                   profit over and above the cost of capital used.
                     EVA has a higher correlation with stock prices than other accounting
                      measures of return because it relates profit to the amount of resources
                      needed to achieve it.
            2. Behavioral Aspects of EVA
                a. EVA encourages managers to maintain a balanced emphasis on operating
                   income and capital employed. It helps lower-level management understand that
                   capital employed is not free.
                b. EVA can be improved by reducing capital usage.
      D.    Multiple Measures of Performance
             Modern managers use multiple measures of performance and include nonfinancial
              measures as well as financial measures.
                 ROI, residual income and EVA are financial performance measures.
                 Nonfinancial performance measures linked to long-run success factors include
                  market share, customer complaints, personnel turnover rates, and personnel
                  development.

IV.   Measuring and Rewarding the Performance of Managers                          Learning Objective #4

      Managers should be evaluated on the basis of factors under their control.
      A.    Incentive Pay for Managers—Encouraging Goal Congruence
            A well-structured incentive compensation plan encourages goal congruence between
            managers and owners, and between lower-level managers and top management. It
            should encourage managers to take risk, work hard, and not to abuse perquisites.
             Goal congruence is the alignment of low-level managers’ goals with those of top
              management, so that managers will act in the best interest of the firm.
             Perquisites are a type of fringe benefit received over and above salary.
      B.    Managerial Rewards
            Managerial rewards often include incentives tied to performance as follows:
212                                                                                      Chapter 10


           1. Cash Compensation
              a. Many companies use a combination of salary and bonuses to reward performance.
                 (1) Salaries can be kept fairly level.
                 (2) Bonuses can fluctuate with reported income, giving companies more flexibility.
              b. Income-based compensation can encourage dysfunctional behavior, such as
                 manipulating the timing of revenues and expenses.
              c. Profit-sharing plans pay employees a share of profits over and above their flat-
                 rate wages to provide an incentive for employees to work harder and smarter.
                  Profit-sharing plans make employees partial owners in the sense that they
                   receive a share of the profits.
           2. Stock-Based Compensation
              a. Issue stock to managers to make them part owners of the company.
                  Objective: To encourage goal congruence.
              b. Offer stock options to managers.
                  A stock option is the right to buy a certain number of shares of the
                   company’s stock at a particular price and after a set length of time.
                  Objective: To encourage managers to focus on long-term performance
                   improvement. If the stock price rises in the future, managers may exercise
                   the option, thus purchasing stock at a below-market price and realizing
                   gains.
                  A disadvantage of stock options is that the price of stock is influenced by
                   many factors out of a manager’s control.
           3. Issues to Consider in Structuring Income-Based Compensation
              a. Cash bonuses and stock options can encourage short-term orientation and
                 gaming behavior.
                  Gaming behavior occurs when managers increase short-term profit at the
                   expense of long-term profitability.
              b. Owners and managers are affected differently by risk.
                  Managers may prefer to take less risk than owners because they have so
                   much of their financial and human capital invested in the company.
                  Owners may prefer a more risk-taking attitude because of their ability to
                   diversify away some of the risk.
           4. Noncash Compensation
              a. Gives employees autonomy in the conduct of their daily business activities.
              b. Provides employees perquisites such as improvements in title, office location
                 and trappings, use of expense accounts, and so on.

V.    Transfer Pricing        Learning Objective #5

      A.   Transfer prices are the prices charged for goods produced by one division and
           transferred to another.
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing           213

            1. The transfer price charged affects the revenues of the transferring division and the
               costs of the receiving division.
            2. The transfer price also affects the managerial performance measures of both
               divisions.
      B.    The Transfer Pricing Problem
            1. A transfer pricing system should satisfy three objectives simultaneously:
                a. Provide accurate performance evaluation—no manager should benefit at the
                   expense of another manager.
                b. Encourage goal congruence—division managers are motivated to make
                   decisions that maximize firmwide profits.
                c. Maintain autonomy—central management should not interfere with the decision-
                   making freedom of divisional managers.
            2. The transfer pricing problem is the challenge to find a system that
               simultaneously satisfies the three objectives.
            3. The opportunity cost approach:
                a. Can be used to identify the appropriate transfer price because it helps
                   determine:
                    (1) The minimum transfer price (floor), which is the transfer price that would
                        leave the selling division no worse off if the good is sold to an internal
                        division.
                    (2) The maximum transfer price (ceiling), which is the transfer price that would
                        leave the buying division no worse off if an input is purchased from an internal
                        division.
                b. Helps ensure that the internal transfer does not decrease total divisional profits.
                     A good should be transferred internally whenever the opportunity cost
                      (minimum price) of the selling division is less than the opportunity cost
                      (maximum price) of the buying division.

VI.   Setting Transfer Prices              Learning Objective #6
      A.    Market Price
            1. If there is a perfectly competitive outside market for the good to be transferred, the
               correct transfer price is the market price.
                a. A perfectly competitive market implies that excess capacity does not exist.
                b. Limitation: Perfectly competitive markets rarely exist.
      B.    Negotiated Transfer Prices
            1. A negotiated transfer price is a practical alternative when market imperfections
               exist for the transferred good.
            2. A negotiated price is considered a good transfer price only if the opportunity cost rule
               is met. That is, the opportunity cost of the selling division is less than the
               opportunity cost of the buying division.
                 The minimum transfer price and the maximum transfer price set the limits of the
                  negotiation set.
214                                                                                         Chapter 10


           3. The transfer price can be negotiated from the market price when there are:
               Avoidable distribution costs such as selling, transportation, and collection
                expenses.
               Excess capacity in the selling division.
              Thus, the negotiated transfer price is set between the limits of:
               The minimum transfer price = Market price – Avoidable distribution costs
               The maximum transfer price = Market price


               Review textbook Exhibit 10-4, which compares income statements
                before and after negotiation of the transfer price. Notice how total
              profits of the firm increase and how the two divisions share that profit.


           4. When the selling division has no excess capacity:
               The minimum transfer price = Market price
               The maximum transfer price = Market price
               Note that the opportunity cost is zero.
           5. When the selling division has excess capacity:
               The minimum transfer price = Variable cost per unit
               The maximum transfer price = Market price
               Note that accepting an internal purchase order at a price above the minimum
                transfer price will provide positive contribution margin to the selling division.
           6. Disadvantages of negotiated transfer prices include:
              a. One division manager may possess ―private‖ information and, thus, can take
                 advantage of another division manager.
              b. Divisional performance measures may be distorted by the negotiating skills of
                 the managers.
                   This argument must be counterbalanced by the fact that negotiating skills
                    are also a desirable managerial skill.
              c. Negotiating takes considerable time and resources.
                   This argument must be counterbalanced by the fact that a mutually
                    satisfactory negotiated transfer price can produce increased profits for the
                    firm that outweighs the cost of negotiation.
           7. An advantage: Negotiating transfer prices may help departments achieve goal
              congruence, autonomy, and accurate performance evaluation.
      C.   Cost-Based Transfer Prices
           1. Full-cost transfer prices are the least desirable because they can provide perverse
              incentives and distorted performance measures.
           2. A full-cost-plus-markup approach is less perverse if the markup can be negotiated.
           3. Variable cost plus fixed fees can be useful if the fixed fee is negotiable.
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing      215

            4. Reasons to use cost-based transfer prices in spite of their disadvantages include:
                a. They are simple and objective.
                b. Transfers may have such a small impact on profits that the method of setting the
                   prices really does not matter.
                c. A full-cost formula may be what is agreed upon in negotiations.
216                                                                                     Chapter 10



KEY TERMS TEST
From the list that follows, select the term that best completes each statement and write it in the
space provided.

centralized decision making                          opportunity cost approach
cost center                                          perquisites
decentralization                                     profit center
decentralized decision making                        residual income
economic value added                                 responsibility accounting
effectiveness                                        responsibility center
efficiency                                           return on investment
investment center                                    revenue center
margin                                               stock option
maximum transfer price                               transfer price
minimum transfer price                               transfer pricing problem
myopic behavior                                      turnover
operating assets                                     weighted average cost of capital
operating income

 1. ___________________________ is earnings before interest and taxes.

 2. ___________________________ are those assets used to generate operating income.

 3. When the decisions are made and implemented by lower-level managers, there is
    _______________________________________________.

 4. To     compute     ____________________________________________________,              the
    proportionate share of each method of financing is multiplied by its percentage cost and
    summed.
 5. The ratio of operating income to average operating assets is the _______________
    _________________.
 6. The price that will make the buying division no worse off if an input is acquired internally is
    the _____________________________________; the price that will make the selling
    division no worse off from an internal sale of the product is the _______________
    ______________________.
 7. The granting of decision-making freedom to lower operating levels is called
    __________________________.

 8. _____________________________________ is finding a pricing system that simultaneously
    satisfies the objectives of accurate performance evaluation, goal congruence, and autonomy.
 9. __________________________ is an emphasis on short-run results at the expense of the
    long run.

10. ______________ is the ratio of sales to average operating assets.

11. The right to purchase a certain amount of stock at a fixed price is a(n) _________
    ___________.
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing         217

12. _________________ are a type of fringe benefit over and above the salary received by a
    manager.
13. The price charged for goods transferred from one division to another division is the
    _____________________.

14. When the decisions are made at the top level of the organization, there is
    ___________________________________________.

15. The difference between operating income and the minimum required dollar return on a
    company’s operating assets is called the _________________________.

16. _____________ is the ratio of net operating income to sales.

17. The method that helps determine the appropriate transfer price by identifying the minimum
    price a selling division would be willing to accept and the maximum price that a buying
    division would be willing to pay is the _________________________________________.
18. ___________________________________ is after-tax operating profit minus the total annual
    cost of capital.
19. A(n) _________________________________ is a segment of the business whose manager
    is accountable for specified sets of activities.
20. _______________________________________ is a system that measures the results of
    each responsibility center and compares those results with some measure of expected or
    budgeted outcome.

21. A responsibility center in which the manager has responsibility for incurring cost is a(n)
    ____________________________. If the responsibility is for both revenues and costs, it
    is a(n) ____________________________. If the responsibility is for revenues, costs, and
    investments, it is a(n) ____________________________. If the responsibility is only for
    sales, it is a(n) ____________________________.




MULTIPLE-CHOICE QUIZ
Complete each of the following statements by circling the letter of the best answer.

 1. A responsibility center that has responsibility for both its profits and the size of its operating
    assets is called a(n):
    a. cost center.
    b. expense center.
    c. investment center.
    d. profit center.
    e. revenue center.
218                                                                                    Chapter 10


 2. Which of the following is not normally considered an advantage to decentralization?
    a. Decisions will be made consistently throughout the company.
    b. Divisional managers have better access to local information.
    c. Top management can devote more time and energy to strategic planning.
    d. Lower-level managers may be motivated to perform better.
    e. Managers have greater opportunities for being trained and being evaluated.

 3. Which of the following is considered an appropriate tool to evaluate a profit center manager?
    a. economic value added
    b. profit variances
    c. residual income
    d. return on investment
    e. All of the above are appropriate tools.

 4. Which of the following is considered an appropriate tool to evaluate an investment center
    manager?
    a. economic value added
    b. residual income
    c. return on investment
    d. All of the above are appropriate tools.
    e. b and c only

 5. Return on investment is defined as:
    a. (Actual profits – Expected profits) / Expected profits.
    b. Operating income / Average operating assets.
    c. Operating income / Sales.
    d. Operating income margin / Operating asset turnover.
    e. Sales / Average operating assets.

 6. Economic value added (EVA) is defined as:
    a. After-tax operating income / Average operating assets.
    b. Operating income – (Minimum rate of return × Operating assets).
    c. After-tax operating income / Total capital employed.
    d. After-tax operating income – (Weighted average cost of capital × Total capital employed).
    e. Operating income – (Average cost of capital × Operating assets).

 7. Residual income is defined as:
    a. After-tax operating income / Average operating assets.
    b. Operating income – (Minimum rate of return × Operating assets).
    c. After-tax operating income / Total capital employed.
    d. After-tax operating income – (Weighted average cost of capital × Total capital employed).
    e. Operating income – (Average cost of capital × Operating assets).
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing   219

 8. Which of the following is not used as a transfer price?
    a. market price
    b. full cost plus a markup
    c. variable costs plus a markup
    d. market price less avoidable distribution costs
    e. All of the above can be used as transfer prices.
 9. XYZ Company has operating income of $100,000 on sales of $800,000 and a tax rate of 40%.
    Operating assets totaled $400,000. The minimum required rate of return was 15%. What is
    the residual income?
    a. 12.5%
    b. 25.0%
    c. $40,000
    d. $60,000
    e. none of the above
10. XYZ Company has operating income of $100,000 on sales of $800,000 and a tax rate of 40%.
    Operating assets totaled $400,000. The minimum required rate of return was 15%. What is
    the operating asset turnover?
    a. 12.5%
    b. 25.0%
    c. $40,000
    d. $60,000
    e. none of the above
11. Alpha Division of Acme Enterprises currently purchases a component needed in producing
    its product from an outside supplier for $20 each. Alpha has learned that Acme recently
    acquired Morgan Company, a competing supplier for this component. Morgan currently is
    operating at a 75% capacity level. Morgan currently sells the components it produces for $24
    on a variable cost of $15. What would be the minimum and maximum transfer price, assuming
    that the components needed by Alpha could be produced with Morgan’s excess capacity?
         Minimum      Maximum
     a.   $15         $20
     b.   $15         $24
     c.   $20         $24
     d.   $18         $20
     e. none of the above
12. Alpha Division of Acme Enterprises currently purchases a component needed in producing
    its product from an outside supplier for $20 each. Alpha has learned that Acme recently
    acquired Morgan Company, a competing supplier for this component. Morgan currently is
    operating at full capacity. Morgan currently sells the components it produces for $24 on a
    variable cost of $15. What would be the minimum and maximum transfer price?
         Minimum      Maximum
     a.   $15         $20
     b.   $15         $24
     c.   $18         $20
     d.   $24         $20
     e. none of the above
220                                                                                   Chapter 10



PRACTICE TEST

EXERCISE 1
ABC Division currently has an operating income of $3.5 million on average operating assets of
$21 million. ABC has two possible investment alternatives as follows:
                                                          Product One   Product Two
      Additional investment ...........................   $1,250,000     $750,000
      Additional operating income .................          200,000      175,000

Top management has made available $2.5 million of capital for ABC Division. Any funds not used
by ABC will be retained by headquarters. Top management has specified that a minimum rate of
return of 10% be earned on all investments.

Required:
1. Compute the ROI for each investment.




2. Compute the RI for each investment.




3. Compute the divisional ROI and RI for each of the following alternatives:
      a. No investment is made.




      b. Product One investment is made.




      c. Product Two investment is made.




      d. Both investments are made.
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing   221


EXERCISE 2
Acme Company earned an operating profit of $550,000 before taxes. Acme’s effective tax rate is
40%. Operating assets total $2.4 million; capital employed but not included in operating
assets (mainly R&D and personnel costs) is an additional $1.6 million. Acme’s capital structure
reveals 65% equity (yielding investors 12%), with the remaining capital being debt-paying 8%
interest.

Required:
Calculate Acme’s EVA.
222                                                                                  Chapter 10


EXERCISE 3
XYZ Division currently buys a component from outside suppliers for $10. Current needs of the
component total 10,000 units a month. MNO Division produces the component and would like to
supply XYZ if an appropriate price can be determined. The controller of MNO has calculated the
following costs of the component:
      Direct materials ................................................     $ 5.50
      Direct labor ......................................................     1.50
      Variable overhead ............................................          1.25
      Fixed overhead ................................................         3.75
         Total cost .....................................................   $12.00

MNO currently produces and sells 55,000 units each month to other companies at an average
selling price of $15. MNO has an overall capacity to produce 100,000 units per month.

Required:
1. What is the minimum transfer price for MNO Division?




2. What is the maximum transfer price for XYZ Division?




3. What is in the best interest for the overall company?
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing   223


EXERCISE 4
Coldco Division produces a product that Scottso Division is interested in purchasing. Scottso is
currently buying 15,000 units per year at $25 each from an outside company. Coldco has a plant
capacity of 100,000 units per year. The variable costs of the product are $15.

Required:
1. Assume that all of the product can be sold to external customers for $25 each. Scottso wants
   to buy 15,000 units per year. What should the transfer price be?




2. Assume that $2.50 in distribution and administrative costs can be avoided. Identify the
   maximum and minimum transfer prices.




3. Independent from the prior questions, assume that Coldco Division is operating at 80% of
   capacity. If Coldco supplies the product:
    a. How much will profits for the entire company increase?




    b. What will be the maximum and minimum transfer prices?
224                                                                                                 Chapter 10



“CAN YOU?” CHECKLIST
 Can you describe the advantages and disadvantages of decentralization?
 Can you define responsibility accounting? Can you describe the four types of responsibility
      centers?
 Can you compute return on investment, residual income, and economic value added? Can
      you explain how the measures differ and how they may affect a manager’s behavior?
 Can you describe both income-based and noncash compensation approaches?
 Can you explain the transfer pricing problem? Can you describe the opportunity cost approach
      to setting transfer prices?
 Can you explain the three common approaches to setting transfer prices?
       market prices
       negotiated prices
       cost-based prices




ANSWERS

KEY TERMS TEST
 1.   Operating income                                 12.   Perquisites
 2.   Operating assets                                 13.   transfer price
 3.   decentralized decision making                    14.   centralized decision making
 4.   weighted average cost of capital                 15.   residual income
 5.   return on investment                             16.   Margin
 6.   maximum transfer price, minimum transfer price   17.   opportunity cost approach
 7.   decentralization                                 18.   Economic value added
 8.   Transfer pricing problem                         19.   responsibility center
 9.   Myopic behavior                                  20.   Responsibility accounting
10.   Turnover                                         21.   cost center, profit center, investment center,
11.   stock option                                           revenue center
Decentralization: Responsibility Accounting, Performance Evaluation, and Transfer Pricing                           225

MULTIPLE-CHOICE QUIZ
 1.    c                                 5.    b
 2.    a                                 6.    d
 3.    b                                 7.    b
 4.    d                                 8.    e


 9. c      $100,000 – (15% × $400,000) = $100,000 – $60,000 = $40,000
10. e      Operating asset turnover = Sales / Average operating assets = $800,000 / $400,000 = 2.0
11. a      The minimum transfer price is Morgan’s variable cost of $15 (since there is excess capacity).
           The maximum transfer price is what Alpha currently pays, $20.
12. d      The minimum transfer price is Morgan’s selling price of $24 (since it has no excess capacity).
           The maximum transfer price is what Alpha currently pays, $20. In this case, the minimum is greater than the
           maximum.




PRACTICE TEST
EXERCISE 1 (ABC Division)
1. Product One ROI = $200,000 / $1,250,000 = 16%
   Product Two ROI = $175,000 / $750,000 = 23.33%
2. Product One RI = $200,000 – (0.10 × $1,250,000) = $200,000 – $125,000 = $75,000
   Product Two RI = $175,000 – (0.10 × $750,000) = $175,000 – $75,000 = $100,000
3. Note: All computations are presented in thousands.
      a. ROI = $3,500 / $21,000 = 16.67%
         RI = $3,500 – (0.10 × $21,000) = $3,500 – $2,100 = $1,400
      b. ROI = ($3,500 + $200) / ($21,000 + $1,250) = $3,700 / $22,250 = 16.63%
         RI = $3,700 – (0.10 × $22,250) = $3,700 – $2,225 = $1,475
      c. ROI = ($3,500 + $175) / ($21,000 + $750) = $3,675 / $21,750 = 16.90%
         RI = $3,675 – (0.10 × $21,750) = $3,675 – $2,175 = $1,500
      d. ROI = ($3,500 + $200 + $175) / ($21,000 + $1,250 + $750) = $3,875 / $23,000 = 16.85%
         RI = $3,875 – (0.10 × $23,000) = $3,875 – $2,300 = $1,575


EXERCISE 2 (Acme Company)
EVA = After-tax operating income – (Weighted average cost of capital × Total capital employed)
After-tax operating income = $550,000 × (1 – 0.4) = $550,000 × 0.6 = $330,000
Weighted average cost of capital:
                                                                    Percent   After-Tax Cost   Weighted Cost
       Equity ...................................................    0.65        0.120          0.0780
       Debt .....................................................    0.35        0.048          0.0168
       Weighted average cost of capital ........                                                0.0948
EVA = $330,000 – [.0948 × ($2,400,000 + $1,600,000)] = $330,000 – $379,200 = –$49,200


EXERCISE 3 (XYZ and MNO Divisions)
1. Minimum transfer price for MNO Division = Variable costs = $5.50 + $1.50 + $1.25 = $8.25
2. Maximum transfer price for XYZ Division = Current market price = $10.00
3. It is in the best interest of the company for MNO Division to supply the part.
226                                                                                                     Chapter 10


EXERCISE 4 (Coldco and Scottso Divisions)
1. Since Coldco is selling its full capacity, the transfer price should be the $25 market price.
2. Maximum transfer price: Scottso’s current price of $25
   Minimum transfer price: Coldco’s market price – Avoidable costs = $25.00 – $2.50 = $22.50
3. Coldco now has sufficient capacity to supply Scottso without taking sales away from outsiders.
   a. Outside purchase price – Internal variable cost = $25 – $15 = $10 per unit savings × 15,000 = $150,000
   b. Maximum transfer price: Scottso’s current price of $25
       Minimum transfer price: Coldco’s variable costs of $15

								
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