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11 Analysis of Decentralized Operations

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Learning Objectives

After studying Chapter 11, you will be able to:

• Describe the different types of responsibility centers.

• Discuss the advantages of decentralization.

• Evaluate a division manager’s performance using return on investment, residual income, and the economic value added approach.

• Explain performance evaluation systems in service organizations.

• Discuss the advantages and disadvantages of alternative transfer pricing methods.

• Understand transfer pricing issues in the international arena.

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Chapter Outline

11.1 Review of Responsibility Centers

11.2 Advantages of Decentralization

11.3 Measurement of Financial Performance Return on Investment Residual Income Economic Value Added Ethical Concerns Relating to Performance Measures

11.4 Performance Evaluation Systems in Service Organizations

11.5 Intracompany Transactions and Transfer Pricing Problems Desired Qualities of Transfer Prices and Policies Transfer Prices Evaluating Transfer Pricing Methods According to the Criteria

11.6 Maximizing International Profits: The Role of Transfer Prices Minimizing Worldwide Taxes Avoiding Financial Restrictions Gaining Host Country Approval

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Dividing the Profit Pie: Whose Is Whose?

Shagari Petroleum Company is a large Nigerian oil company headquartered in Lagos. The company has five operating divisions: Exploration & Production, Trading & Supply, Gas Processing, Refining, and Marketing & Distribution. Each division is responsible for generating a profit and for managing its investment in assets. Debates have raged among division managers about who earned what profits since, in many cases, “Your revenues are my costs.”

The Exploration & Production Division has the task of finding, developing, and producing oil and gas reserves. Oil produced is sold to the Trading & Supply Division or to outside customers, depending on who offers the best prices. Gas produced is sold to the Gas Processing Division, petrochemical companies, or pipeline companies.

The Trading & Supply Division is responsible for meeting the crude oil needs of the Refining Division. It purchases crude oil from the Exploration & Production Division and the open market. Crude oil not sold to Refining is marketed overseas.

Although the Gas Processing Division may purchase gas from other companies, 90% of its gas needs are met by the Exploration & Production Division. Processing results in liquid petroleum gas products such as ethane, propane, and butane. These products are sold to the Marketing & Distribution Division and to petrochemical companies.

The Refining Division has refineries in Kano, on the Niger River, and in Ibadan. The refineries have the capability to produce a full range of petroleum products. Finished products are sold either to the Marketing & Distribution Division or to an overseas wholesale market.

Marketing & Distribution sells to utilities and international resellers, plus industrial, governmental, commercial, and residential customers. It buys its products from the Refining and Gas Processing Divisions. If shortages occur, it may purchase from overseas wholesale markets. The division sells a wide range of products. It owns a barge fleet, tanker trucks, and some pipeline facilities for transporting the products. Other product shipments are contracted with shipping companies.

Since the divisions each generate profits and have tremendous investments in assets, Shagari Petroleum wants to develop an appropriate measure for evaluating the financial performance of the divisions and their managers. Also, a transfer price policy should value intracompany deals fairly.

One of the most striking characteristics of organizations over the past 30 years has been top management’s desire to grow and yet retain the advantages of smallness. Companies have decentralized operations to retain this element of smallness, to build “entrepreneurial spirit,” and to motivate division managers to act as the heads of their “own” companies.

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Section 11.1 Review of Responsibility Centers

In contrast to a centralized company in which decision making is largely done by top manage- ment, a decentralized company is one in which operating subunits (usually called divisions) are created with definite organizational boundaries, each with managers who have decision- making authority. Thus, responsibility for portions of the company’s profits can be traced to specific division managers. Even though the amount of authority granted to these managers varies among companies, the spirit of decentralization is clear—to divide a company into relatively self-contained divisions and allow them to operate in an autonomous fashion.

This chapter discusses two problem areas common to evaluating divisional performance. First, we discuss various evaluation measures and how these measures can be used. Then we discuss criteria, approaches, and problems associated with transfer prices for goods and services moving among divisions.

11.1 Review of Responsibility Centers Before discussing decentralization and performance measures, it is essential to review the types of responsibility centers first introduced in Chapter 7. A responsibility center is any organizational unit where control exists over costs or revenues. Managers of cost centers have control over the incurrence of cost but not over revenues. Cost centers are usually found at lower levels of an organization but may include entire plants or even entire parts of an organization, such as manufacturing or the controller’s office. In contrast, managers of profit centers have control over both costs and revenues. These managers are responsible for gen- erating revenues and for the costs incurred in generating those revenues.

In investment centers, managers control costs, revenues, and assets used in operations. The investment involves plants and equipment, receivables, inventories, and, in some cases, pay- ables traceable to the investment center’s operations. Companies or subsidiaries could be investment centers or profit centers, depending on whether the corporate headquarters gives investment responsibility to these levels. Investment responsibility is defined as authority to buy, sell, and use assets.

Top management’s intent often determines the type of responsibility center. In a large com- pany, a data processing center could be a cost center, either absorbing its own costs or allocat- ing its costs to users of the firm’s computer operations. As a profit center, it would be allowed to charge a rate for data processing services it provides to internal users and be expected to earn a profit on its operations. To create an investment center, the manager would be given responsibility to acquire equipment and update services from funds generated by its charges for services provided. Often, organizational structures create natural cost, profit, or invest- ment centers. But managerial intent is perhaps the most important factor in determining how a decentralized unit will be viewed and managed.

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Section 11.2 Advantages of Decentralization

11.2 Advantages of Decentralization Decentralization is the delegation of decision-making authority to lower management levels in an organization. The degree of decentralization depends on the amount of decision-making authority top management delegates to successively lower managerial levels. Advantages of decentralizing include:

1. Motivated managers. Managers who actively participate in decision making are more committed to working for the success of their divisions and are more willing to accept the consequences of their actions, whether positive or negative.

2. Faster decisions. In a decentralized organization, managers who are close to the decision point and familiar with the problems and situations are allowed to make the decisions. Consequently, decisions can be made faster without moving data up the organization and having a decision made by a manager far removed from the action.

3. Enhanced specialization. Delegating authority permits the various levels of man- agement to do those things each does best. For example, top management can concentrate on strategic planning and policy development; middle management on tactical decisions and management control; and lower management on operating decisions.

4. Defined span of control. As an organization increases in size, top management has more difficulty controlling the organization. Decentralizing the authority defines more narrowly the span of control for each manager and thus makes the control system more manageable.

5. Training. Experience in decision making at low management levels results in trained managers who can assume higher levels of responsibility when needed.

To realize the full benefits of these advantages, top management must address the following issues:

1. Competent people. Without competent people, the best policies break down; a lack of control reduces the efficiency and effectiveness of operations.

2. Measurement system. The same measurement system should be used for all divi- sions. Top management must develop policies that provide consistency in reporting periods, methods of reporting, and methods of data collection.

3. Clear corporate goals. Left to themselves, division managers may work for their own interests without consideration of benefits to the entire organization. Top manage- ment needs to focus all managers’ efforts on corporate goals through planning and incentive systems.

Formulating the best method for controlling and evaluating divisions is usually more complex than any other single control activity within a company. Motivation, control, and managerial behavior are broad topics and are far beyond the scope of this book.

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Section 11.3 Measurement of Financial Performance

11.3 Measurement of Financial Performance In previous chapters, planning and control methods were discussed. We apply these to cost, profit, and investment center evaluations. Cost controls used in cost centers are also relevant for profit and investment centers. Revenue and profit measurements used in profit centers are also applied to investment centers. Thus, we can build the following planning and control structure:

Centers

Cost Profit Investment

Expense budgeting X X X

Flexible budgets X X X

Plan versus actual expense comparisons X X X

Standard cost variances X X X

Revenue and profit budgeting X X

Plan versus actual controllable contribution margin X X

Plan versus actual direct contribution margin X X

Asset utilization and rate of return target setting X

Plan versus actual asset utilization comparisons X

Plan versus actual rates of return comparisons X

It is rare that financial measures alone can evaluate the performance of a responsibility cen- ter. Product or service quality, delivery reliability, market share, and responsiveness to cus- tomers are all nonfinancial measures critical to the overall success of a firm. Both financial and nonfinancial goals are often part of a manager’s business plan. We discuss in detail non- financial performance measures in the next chapter.

For profit and investment centers, selecting proper financial performance measures is not an easy task. The financial measures chosen:

• Send messages to all managers about what is important to the firm’s executive managers.

• Are often the basis for calculating incentive compensation, personnel evaluations, and promotion decisions.

• Influence the allocation of new capital and personnel resources.

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Section 11.3 Measurement of Financial Performance

Rate of return on investment is widely accepted as the primary measure of performance for investment centers.

Return on Investment Return on investment (ROI) is defined as a ratio:

Return on investment = Profit ÷ Investment

We can decompose this ratio into two elements for better control and evaluation:

Return on investment = (Profit ÷ Sales) × (Sales ÷ Investment )

The first term, Profit ÷ Sales, is return on sales (ROS) (sometimes called the profit margin). It measures the percentage of each sales dollar that is turned into profit. The second term, Sales ÷ Investment, is asset turnover, which measures the ability to generate sales from the assets a division employs.

Implementing the ROI concept raises a number of issues. Problems exist in defining the profit numerator as well as the investment denominator. Even then, divisions within a company may be dissimilar, creating “apples and oranges” comparisons.

The Numerator—Division Profit The choice of the profit figure is not simple. The first problem is how the profit number will be used. Will it be used to evaluate the division as an economic unit or to evaluate the divi- sion manager’s performance? A different profit is appropriate for each. Once the purpose is decided, the next problem is how to construct the best measure from several profit concepts commonly available. Assume that a division of Taratoot Financial Consulting reports the fol- lowing profit and loss data (all numbers in thousands):

Division revenues $1,000

Direct division costs:

Variable operating costs 700

Fixed division overhead—controllable at the division level 100

Fixed division overhead—noncontrollable at the division level 50

Indirect division costs:

Allocated (fixed) home office overhead 60

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Section 11.3 Measurement of Financial Performance

Four alternative income statements organize the data for different purposes.

Division Contribution

Margin

Division Controllable

Margin Segment Margin

Division Net Profit

Revenue $1,000 $1,000 $1,000 $1,000

Direct costs:

Variable costs 700 700 700 700

$300

Fixed controllable costs 100 100 100

$200

Fixed noncontrollable costs 50 50

$150

Indirect costs: 60

Allocated corporate overhead $90

Division Net Profit. The best profit measure for division performance may appear to be division net profit. However, the division net profit calculation includes allocated corporate overhead. An example of this cost would be the cost of operating the president’s office. Although each division benefits from these costs, they are not controllable at the division level nor traceable to specific divisions. Generally, division net profit is a poor indicator of a division’s performance. The main arguments for using division net profit are that the division manager is made aware of the entire firm’s operating costs and that these costs must be covered by the division’s earnings. Another argument is that the allocated corporate overhead costs stimulate division managers to pressure corporate managers to control their costs.

Corporate overhead expenses that are traceable to specific divisions should be assigned directly to those divisions. Allocated corporate overhead expenses are likely to be arbi- trary and open to question by the division managers. Often, division managers spend much time attempting to reduce their costs by getting top management to change the allocation procedure.

Segment Margin. Segment margin is defined as total division revenue less direct costs of the division. This concept avoids the main difficulty of division net profit since common costs of the firm are excluded. The segment margin is the most useful profit measure for comparing divisions’ performances, for resource allocation decisions, and for corporate planning purposes. All revenues and costs traceable to the divisions are included.

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Section 11.3 Measurement of Financial Performance

Often, corporate-level decision makers use the segment margin to indicate where additional investments should be made to generate the greatest incremental returns. Certainly, specific projects must justify themselves, as Chapter 10 demonstrates. But more attention will be paid to high-performing divisions.

Division Controllable Margin. Division controllable margin is defined as total division revenue less all costs that are directly traceable to the division and that are controllable by the division manager. Unlike the segment margin, costs that are not controllable by the division manager are not deducted. The division controllable margin is best for managerial performance measurement, because it reflects the division manager’s ability to execute assigned responsibilities. Any variances between actual and plan can be explained in terms of factors over which the division manager has control.

Sometimes direct costs are traceable to a division but cannot be controlled at that level. For instance, a division head’s salary is controllable only at a higher management level. Also, some division costs, such as long-term leases and depreciation, are from past investment decisions that may have been made by higher-level managers or previous division managers. These direct but noncontrollable costs should be excluded from the profit calculation for manage- rial evaluations. If this is not done, the division profit used for performance evaluation may be affected by actions outside the division or of prior managers.

Some factors in the division controllable margin may be difficult for the division manager to influence; for example, the materials prices may increase. Even though the price cannot be changed, perhaps alternate materials can be used or alternate sources of supply can be found. Problems of this nature may be difficult to solve, but they are part of the division manage- ment’s responsibility. Failure to solve such problems is different from being unable to take action due to lack of authority.

Division Contribution Margin. The division contribution margin is defined as total revenue less variable costs. Although contribution margin is useful in decision making, for performance evaluation its defect is obvious: Namely, direct and controllable fixed costs are excluded from the calculation. Variable costs do have an important role in intracompany pricing policies and decisions, which are discussed later in this chapter.

The Denominator—Investment If divisions are to be evaluated by ROI, it is necessary to measure the investment base. The investment base may be total direct assets, net direct assets, or net direct assets managed. Net direct assets would be traceable assets minus any traceable liabilities. Again, the distinc- tion between direct and controllability is important. Certain assets may be traced to a division but not be in service or usable by the division manager.

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Section 11.3 Measurement of Financial Performance

Since ROI is a measure for a period of time, which date during that period should be cho- sen to measure the amount of assets? Usually, a simple average of the beginning and ending amounts is used.

Asset Identification. The first task is to decide which assets to assign to each division. Many assets can be traced directly to a division. For example, much of a firm’s physical property can be traced to a particular division. A division may handle its own receivables and inventory and may even have jurisdiction over its own cash. But sometimes, these traceable assets are centrally administered and controlled. By proper account coding, it is possible to trace receivables and inventories to specific divisions. Cash, as a corporate asset, is rarely traceable to specific divisions.

For assets that are common to several divisions, no amount of coding, sorting, or classifying will enable tracing them to the divisions. An example of a common asset would be the admin- istrative offices used by two product divisions. Any basis of allocation would be arbitrary. As with home office expenses, avoiding these arbitrary allocations generally improves the analysis.

Asset Valuation. Once the assets have been identified with the divisions, the value of the assets must be determined. It may seem that the assets should be stated at some current value (e.g., replacement cost, original cost adjusted for price-level changes) rather than on a historical-cost basis. The obvious difficulty is measurement. How can replacement costs be determined? If a common-dollar base is desirable, which price-level index should be used? It is easier to raise questions than to give answers.

Preferred Relationships. Matching an income measure and an investment base is the next step. If the purpose is to evaluate the division itself, segment margin would be the natural match with net division direct assets, which are assets traceable to the specific division less traceable liabilities. To evaluate the division managers, controllable margin should be matched with net direct managed assets. Managed assets include the assets controlled by the division manager having the authority to acquire, use, and dispose of these assets.

Additional Problems With ROI Using the ROI concept as a means of evaluating performance raises some concerns about how effective ROI can be and about potential undesirable impacts that may arise from its use.

Comparability Among Divisions. One of the major concerns is that ROI comparisons should use the same definitions for the same purposes. Divisions being compared should have the same or similar accounting methods. The same depreciation method should apply

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to similar classes or categories of assets. Likewise, incorrect comparisons result when one division uses FIFO for inventories and another division uses LIFO. Also, each division being compared should have the same or similar policies for capitalizing or expensing costs. For instance, one division might expense tools whenever they are purchased. Another division might capitalize as assets the original tools plus any increments and expense replacement tools. It would be inappropriate to compare these two divisions on the basis of ROI without making appropriate adjustments.

Motivational Impact on Managers. From top management’s point of view, division managers should be working to achieve the overall objectives of the organization. This requires strategies, policies, techniques, and incentives to act as motivators for division managers. Goal congruence is the term often used to link each division manager’s goals with top management’s goals. Individual managers may have personal and organizational goals that differ from top management’s goals. When designing managerial performance criteria, senior management must carefully select measures to promote goal congruence. Thus, managers should be motivated to work for their own benefit while, at the same time, benefiting the whole organization.

ROI may sometimes promote decisions that are not goal congruent. For example, suppose that the Northern Division of Ellman’s Payroll Service is currently earning 25% ROI. The divi- sion manager may be reluctant to make additional investments at, perhaps, 20% because the average return of the division would drop. However, if new investments in other divisions of the company yield only 15%, company management may prefer that the investment with a yield of 20% be accepted. The high-earning manager may still be reluctant to lower the average ROI from 25% even though company management has set 15% as the base rate for comparison. Thus, the use of ROI might restrict additional investment to the detriment of company-wide profitability.

Improving ROI Since division managers are expected to improve ROI, they look to components they can con- trol. ROI can be improved in three direct ways: by increasing sales, by decreasing expenses, and by reducing the level of investment. To see how individual changes affect the ROI calculation, consider the following data for the Sports Division of Lindfield Entertainment Corporation:

Sales $2,500,000

Variable costs 1,500,000

Contribution margin $1,000,000

Fixed costs 600,000

Net income $400,000

Investment base $2,000,000

Return on sales 16.00% [$400,000 / $2,500,000]

Asset turnover 1.25 times [$2,500,000 / $2,000,000]

ROI 20.00% [$400,000 / $2,000,000]

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Increase Sales. Looking at ROI as a product of return on sales and asset turnover might give the impression that the sales figure is neutral, since it is the denominator in the return on sales and the numerator in asset turnover. However, suppose the Sports Division can increase ticket sales without increasing unit variable costs or fixed costs. The return on sales improves. This happens anytime the percentage increase in total expenses is less than the percentage increase in dollar sales. The increase in sales also improves the asset turnover as long as there is not a proportionate increase in assets. The objectives are to attain the highest level of net income from a given amount of sales and the highest level of sales from a given investment base.

Continuing the numerical example for the Sports Division, assume that ticket sales and total variable costs increase by 5% and that fixed costs and the investment base remain constant. ROI, return on sales, and asset turnover all increase, as follows:

Sales (105%) $2,625,000

Variable costs (105%) 1,575,000

Contribution margin $1,050,000

Fixed costs 600,000

Net income $ 450,000

Investment base $2,000,000

Return on sales 17.14% [$450,000 / $2,625,000]

Asset turnover 1.31 times [$2,625,000 / $2,000,000]

ROI 22.50% [$450,000 / $2,000,000]

Reduce Expenses. Often, the easiest path to improved ROI is to implement a cost reduction program (focusing on certain expense areas or across-the-board cuts). Reducing costs is usually the first approach managers take when facing a declining return on sales. A rather typical pattern has emerged. First, review the discretionary fixed costs, either individual cost items or programs representing a package of discretionary fixed costs, and find those that can be curtailed or eliminated quickly. Second, look for ways to make employees more efficient by eliminating duplication, nonvalue-adding time, or downtime and by increasing individual workloads. Third, review costs of resource inputs for operations and seek less costly choices.

Reduce Investment Base. Managers have traditionally sought to control sales and expenses. Their sensitivity to asset management, however, has not always been at the same high level. Managers, whose performances are evaluated using ROI, will find that trimming any excess investment can have a significant impact on the asset turnover and, therefore, on ROI. Reducing unnecessary investment often involves selling or writing off unused or unproductive assets. Recently, many companies have reduced investment in inventories, and also lowered nonvalue-added expenses, by changing to just-in-time inventory systems.

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Section 11.3 Measurement of Financial Performance

Referring to the original Sports Division data, assume that its managers are able to reduce the investment by 4% but still maintain the same level of sales and expenses. As a result, both the asset turnover and ROI increase:

Sales $2,500,000

Variable costs 1,500,000

Contribution margin $1,000,000

Fixed costs 600,000

Net income $400,000

Investment base $1,920,000

Return on sales 16.00% [$400,000 / $2,500,000]

Asset turnover 1.30 times [$2,500,000 / $1,920,000]

ROI 20.83% [$400,000 / $1,920,000]

If the eliminated investment is a depreciable asset, depreciation expense will also be reduced. This causes a compound reaction: profitability increases, return on sales increases, and ROI increases by improvement in both the return on sales and the asset turnover.

Contemporary Practice 11.1: ROI of College Education

“Snob appeal often plays a big role in the selection of a college by high school seniors and their families. . . . But what happens when you look at earnings per dollar spent to get an education? Before you spot a single Ivy League or big-name private school, public campuses grab 17 of PayScale’s first 18 spots. . . . Leading is Georgia Tech’s 13.9% return on investment. Next is the University of Virginia’s 13.3%.”

Source: Katzeff, P. (2011, May 27). Colleges with top investment returns on degree costs. Investors Business Daily. Retrieved from http://www.investors.com/NewsAndAnalysis/Article.aspx?id=573585&p=1

Residual Income The use of residual income has been proposed as an alternative to ROI. Residual income focuses attention on a dollar amount (instead of a ratio) and on a minimum expected return. The maximization of a dollar amount will tend to be in the best interest of both the division manager and the company as a whole.

In general, residual income is defined as the operating profit of a division less an assessed charge for the operating capital used by the division. It is the amount of profit over and above the profit that should be earned based on the division’s resources. The same measurement and valuation problems we encountered with ROI still apply to residual income. But motivational

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problems should be eased. Assume that, for Macquarie Moving Company, a division’s current controllable margin (before any assessed capital charge) is $250,000 and the relevant invest- ment is $1,000,000. The ROI, then, is 25%. Suppose top management wants division manage- ment to accept incremental investments so long as the return is greater than 15%. We refer to this rate as a minimum desired rate of return.

This minimum desired rate of return is then used to calculate an assessed charge for division investment funds. The residual income would be calculated as follows:

Division controllable margin (before imputed capital charge) $250,000

Less assessed capital charge (15% × $1,000,000) 150,000

Division residual income $100,000

The advantage of this evaluation measure is that the division manager is concerned with increasing a dollar amount (in this case, the $100,000) and is likely to accept incremental investments that have a yield of over 15%. The division manager’s behavior, then, is congru- ent with company-wide objectives. This would less likely be true with the ROI measure, since any incremental investment earning less than 25% pulls down the division’s current ROI.

A disadvantage with residual income arises when comparing the performance of divisions of different sizes. For example, a division with $50 million in assets should be expected to have a higher residual income than one with $2 million in assets.

The stage of growth and other risk factors influence the potential profits that a division can generate. Consequently, top management might select different minimum desired rates of return for each division to recognize the unique role each plays in the organization. For example, a start-up division may be more expensive to operate than a division in the mature stage—justifying a lower initial rate of return.

Economic Value Added In recent years, an approach quite similar to residual income has been developed to evaluate performance. Like residual income, the economic value added (EVA) approach deducts a min- imum rate of return (i.e., cost of capital × total capital) from the division’s profits, as follows:

EVA = Adjusted accounting profit − (Cost of capital × Total capital)

Hence, like residual income, the EVA measure is a dollar amount. ROI, in contrast, is a pure number (i.e., no unit of measure associated with it).

The adjusted accounting profit is an after-tax profit with some expenses, such as research and development, treated differently than is done for external reporting requirements. Managers often have incentives to reduce expenses by cutting amounts spent on items such as research and development, customer development costs, and employee training costs. To counteract this short-sighted inclination, these costs can be treated as assets that are amortized rather

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than as expenses, which would not be allowed for external reporting. The resulting profit number, the adjusted accounting profit, adds back these expenses to the accounting profit figure and therefore better reflects the division’s long-run profit potential. The total capital would also include these expenditures. Another frequent adjustment to total capital is the exclusion of current liabilities.

Whereas the capital charge in the residual income measure is usually based on the minimum desired rate of return, EVA uses the actual cost of capital. The EVA approach often determines the cost of capital differently than the traditional weighted average cost of capital calculation, which is a weighted average of the cost of debt and the cost of equity. EVA derives a cost of capital based on the industry and risk characteristics of the particular division.

Many large companies use the EVA approach and link EVA to incentive compensation. EVA is viewed as the amount that is added to shareholder wealth. When divisions are making investments that earn returns higher than the cost of capital, then the company’s sharehold- ers should earn a return in excess of their expectations, and the company’s stock price is likely to rise.

Ethical Concerns Relating to Performance Measures Division managers can increase short-run profits of divisions to the detriment of the com- pany as a whole. For example, it may be possible to delay maintenance costs. Such an action will increase short-run profits but adversely affect long-run profitability of the division and the company. Expenditures that engender employee loyalty, such as employee physical fit- ness programs, may be eliminated. By reducing training costs, the division manager may not develop long-run top management personnel.

Our earlier discussion that the use of ROI may not promote goal congruent behavior has ethi- cal implications also. A manager should consider whether it is ethical to reject an investment that would benefit the company even though it would reduce the manager’s average ROI.

Contemporary Practice 11.2: Conflicts of Interest With ROI

An experiment with individuals in graduate and executive education managerial accounting classes, who averaged about six years of full-time work experience, investigated investment decisions where the participants would be evaluated using ROI. In one setting, the investment under consideration would benefit the company but would reduce the current ROI of the participant. The study estimated that about 51% of the respondents would reject the investment. In another setting, a proposed asset replacement would benefit the company in the long-run but would lower the participant’s current ROI because the book value of assets is used in the denominator of ROI. The study estimated that about 38% of the respondents would reject the investment.

Source: Schneider, A. (2004, Summer). Ethical decision making on various managerial accounting issues. Journal of Applied Management Accounting Research, 2(2), 29–39.

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Section 11.5 Intracompany Transactions and Transfer Pricing Problems

11.4 Performance Evaluation Systems in Service Organizations

Service organizations, like manufacturers, also need evaluation systems. Evaluation criteria and measures can depend on whether the service organization is commercial or not-for-profit.

Profit-oriented operations have an incentive to be profitable. They may use ROI, residual income, or EVA, if an appropriate profit measure and an investment base are available. Obvi- ously, organizations such as CPA firms, law firms, insurance agencies, and consulting firms do not have large investment bases. Personnel is their prime resource. Furthermore, they often lease equipment, space, cars, and other operating assets. Using ROI, residual income, or EVA in these situations will not give a realistic measure of performance for the divisions within the organization. Return on revenue is a better measure and a greater management motivator than are ROI, residual income, and EVA.

Not-for-profit organizations are different because profits are not the prime interest of man- agers. Moreover, revenues are often unrelated to services performed; rather, they come from funding agencies. For example, a police department obtains its operating funds from the local government. The department’s mandate is to provide law enforcement services within the limits imposed by the operating funds. But how does one measure the level of services performed—by the number of cases investigated? by time spent on cases? by the number of arrests? Finding criteria for evaluating performance is not an easy task in not-for-profit settings.

11.5 Intracompany Transactions and Transfer Pricing Problems

In calculating division profit, problems arise when the divisions are not completely indepen- dent. If one division furnishes goods or services to another division, a transfer price must be set to determine the buying division’s cost and the selling division’s revenue.

The following list illustrates a variety of intracompany transactions:

1. A centralized accounting department serves all divisions of a company, and its costs are allocated to divisions based on the number of employees in each division.

2. One department provides repairs and maintenance for production departments’ equipment in a factory and bills for those services at an average actual cost per hour of service.

3. A Data Processing Services Division provides computer-based information systems services to all other divisions in the company and allocates costs on the basis of pre- determined prices for volumes of transactions and data handled.

4. Plant A produces components which are shipped to Plant B for assembly into an end product which is then transferred to the Sales Division for sale to outside custom- ers. Components and products are billed at a “full cost plus a profit” basis between Plants A and B and between Plant B and the Sales Division.

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5. Plant J sells strategic raw materials to a variety of customers, including Plant K in the same company. Managers negotiate a special price each year for the raw materials, depending on the supply and demand factors for each plant.

6. Division R sells an industrial product to a broad array of customers. Division S hap- pens to need the product and buys from the sister division at the prevailing market price because of the product’s high quality or the division’s delivery reliability.

This continuum of accounting approaches for intracompany dealings is shown in Figure 11.1. While not representing any numerical measuring scale, this line does illustrate the range of accounting techniques for intracompany transactions. At one end is pure (arbitrary) cost allo- cation. At the other end is pure market-driven pricing.

Figure 11.1: Continuum of accounting approaches for intracompany transactions

Usage-Based Cost Allocation

with a Predetermined Rate

Actual Cost Allocation Based

on Use

Arbitrary Cost Allocation Percentage

Cost Plus a Profit

Negotiated Price

Market Price

For the three boxes on the left side of the continuum, overhead or administrative costs are being roughly redistributed to other units using cost drivers, benefits received, or even arbi- trary rules. Commonly, service departments are transferring costs to producing departments. The two boxes labeled “Cost Plus a Profit” and “Negotiated Price” involve internal sales of goods and services where external markets do not exist or where company policies force the divisions to deal with each other internally. The box at the right end of the continuum repre- sents situations where external markets do exist and where market prices are used, in part or in total, as the exchange price. Buyers seek suppliers. Sellers seek customers. If an intracom- pany sale takes place, it is the best source for the buyer and a profitable sale for the seller and for the company as a whole.

Desired Qualities of Transfer Prices and Policies No one transfer pricing method will be best for all situations. A manager who has spent years supervising internal sales and purchases for a major company has said: “Perhaps the opti- mal policy is one that will produce the least amount of dysfunctional behavior or, at best, an amount that we can tolerate.” Hopefully, policies encourage positive behavior. But dysfunc- tional behavior, actions which hurt the firm’s results, can be frequent by-products.

Let us first outline the criteria for creating a transfer pricing system; second, discuss alterna- tive transfer prices; and third, identify the ability of each price to meet the criteria. Criteria for a transfer price can be reduced to four main elements:

1. Goal congruence. Will the transfer price encourage each manager to make decisions that will maximize profits for the firm as a whole? In decentralized

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organizations, perhaps one of the most difficult tasks is to get everyone to pull toward the common goal—the financial success of the whole firm. Success of each division will not guarantee the optimal success for the whole firm.

2. Performance evaluation. Will the transfer price allow corporate-level managers to measure the financial performance of division managers in a fair manner? How will power positions that certain divisions have over other divisions be neutralized? For instance, if one division sells its entire output to another division, the buyer can demand concessions from the seller that can cause the seller to appear unprofitable. If the two divisions are to remain independent, the pricing policy must allow the seller to get a reasonable price for its output.

3. Autonomy. Will the transfer price policy allow division managers to operate their divisions as if they were operating independent businesses? If a division manager must ask for approval from some higher level, the firm’s policies have diluted the autonomy of its managers. If autonomy is restricted greatly, the objectives of decen- tralization are defeated.

4. Administrative cost. Is the transfer pricing system easy and inexpensive to operate? As with all accounting costs, an incremental cost should generate a positive contribu- tion margin. Where internal transaction volume is large and complex, a more exten- sive internal pricing system is justified. Administrative costs also include waiting for decisions, hours spent haggling, and internal divisiveness.

These four criteria should be prioritized when forming transfer pricing policies. Different sit- uations will demand different transfer pricing policies and therefore different prioritizations.

Transfer Prices The most common transfer prices are:

1. Market price 2. Cost-based prices including:

a) Actual full cost b) Target or predetermined full cost c) Cost plus a profit d) Variable cost

3. Negotiated price 4. Dual prices

We will now examine each method with comparison to the transfer pricing criteria.

Market Price Market price is a price set between independent buyers and sellers. It is the amount one party is willing to pay and the other is willing to accept. Two contrasting conditions are typical:

1. A market price exists, and both buyer and seller have access to other sellers and buy- ers for the same products.

2. A market price is not readily available, but a pseudo-price is created either by using similar products or by getting outside bids for the same item.

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Market price meets more of the transfer pricing criteria than any other method. But finding a market price may be difficult since one may not exist. Examples include intermediate compo- nents, industrial supplies, and “make or buy” jobs. The buyer’s purchasing department may request bids from outside suppliers. If, because of company policy, the outside bidders are rarely considered seriously, the outside bidders will not play this game for long. Bidding is an expensive process. Some companies have a policy of considering outside vendors seriously and committing a certain percentage of business to these bidders to help keep the system viable.

Even if a market price exists, it may not be applicable. For instance, catalog prices may only vaguely relate to actual sales prices. Market prices may change often. Also, internal selling costs may be less than would be incurred if the products were sold to outsiders, and so the market price should be adjusted downward.

Despite the problems of finding a valid market price, managers generally agree that mar- ket prices are best for most transfer pricing situations. A market transfer price parallels the actual market conditions under which these divisions would operate if they were indepen- dent companies.

Goal Congruence. When excess capacity exists, market prices may not lead to goal congruence. For instance, Division A, which has excess capacity and a mixture of fixed and variable product costs ($50 per unit and $100 per unit, respectively), could benefit greatly from additional production volume. Division A sells its output on the market for $200 per unit. Division B is looking for a supplier for a part that Division A can easily provide. Division B asks for bids from a variety of suppliers. Company C, an unrelated firm, may be selected because it has bid $160 per unit. This price is well above Division A’s variable cost but below A’s market-price bid. Managers in A and B are making the best decisions for their respective divisions as they see it, but total company profit is hurt. The firm as a whole would be better off by $60 per unit ($160 − $100) if Division B purchased from Division A. But Division B would need to pay Division A a price $40 higher ($200 − $160), or Division A would have to accept a lower contribution margin ($160 − $100 = $60) than its regular business generates ($200 − $100 = $100).

Many believe that this is a small cost to incur if the individual division managers act in an aggressive, competitive style. What is lost from lack of goal congruence is gained in greater profits from highly motivated quasi-entrepreneurs. Depending on results in specific firms, this trade-off may or may not be justified.

Performance Evaluation and Autonomy. Market prices form an excellent performance indicator because they cannot be manipulated by the individuals who have an interest in profit calculations. A market price eliminates negotiations and squabbling over costs and definitions of fairness. If market power positions exist, they also exist in the general marketplace.

Where market prices are less clear and are either created or massaged, the pure advantage of market prices declines. In fact, as we move away from a true market price, the price becomes a negotiated price, which is discussed later.

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Administrative Cost. As part of normal buying and selling, the transfer price is determined almost costlessly. As we move away from a clear market price, costs increase. Negotiations are expensive in terms of consuming executive time, getting outside bids, and creating support data for negotiating positions.

Cost-Based Prices Unless market price is readily available, most transfer prices are based on production costs. Three issues stand out in cost-based transfer prices:

1. Actual cost versus a standard or budgeted cost 2. Cost only versus cost plus a profit 3. Full cost versus variable cost

Actual Cost Versus a Standard or Budgeted Cost. A primary problem with an actual full-cost transfer price is that it gives the selling division no incentive to control costs. All product costs are transferred to the buying division, “reimbursed” as revenue to the selling division. This can create a serious competitive problem for the vertically integrated firm that passes parts through numerous divisions before selling a product in a competitive market. Historically, this has been a problem for General Motors Corporation.

Moving to a standard or budgeted cost helps promote cost control but is not a perfect solution. If a budget or standard cost is used for cost control and also for transfer pricing, profit pres- sures may well subvert the cost system and damage its usefulness as a cost control device. Furthermore, who sets the standard? Is it a tight or lax standard?

Cost Only Versus Cost Plus a Profit. If cost only (actual cost, standard cost, full cost, or variable cost) is used as a transfer price, the selling unit cannot earn a profit. Full cost plus a profit percentage is a popular solution. Adding a percentage to cost for a profit creates a question: “What percentage?” Somehow 10% seems attractive and common. This is, however, an arbitrary choice. Perhaps a markup percentage can be calculated that will cover operating expenses and provide a target return on sales or assets. Even here, these prices fail to produce the kind of competitive environment that decentralization promotes.

Full Cost Versus Variable Cost. Another version of cost-based transfer pricing is variable cost. With variable-cost transfer prices, only variable production costs are transferred. These costs are generally materials, direct labor, and variable overhead. Variable cost has the major

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advantage of encouraging maximum profits for the entire firm when excess capacity exists. This will be illustrated later. The obvious problem is that the selling division must absorb all of its fixed costs. That division is now a loss division, nowhere near a profit center.

With these issues in mind, how well do cost-based transfer prices match with the evaluation criteria?

Goal Congruence. Full-cost transfer prices generally produce suboptimal profits for the firm as a whole. Variable-cost transfer prices generate an optimal firm-wide profit when the selling division has excess capacity. Otherwise, market prices yield optimal firm-wide profits. In general, the definition of the most goal-congruent transfer price is incremental costs plus any opportunity cost of transferring to the next division. Usually, incremental costs are the variable costs. The opportunity cost is the contribution margin earned from the best alternative use of the seller’s capacity. When there is no excess capacity, the incremental cost plus opportunity cost equals the market price. These relationships are summarized in Figure 11.2.

Figure 11.2: Goal-congruent transfer prices

Goal-Congruent

Transfer Price

Incremental

Cost

Opportunity Cost

of Transferring = +

Goal-Congruent

Transfer Price

If Seller has

Excess Capacity

Opportunity Cost

Equals Zero

Incremental

Cost

If Seller has

No Excess Capacity

Opportunity Cost

Exists

Market

Price

The following example highlights these concepts. Assume that Division A sells to Division B. The output of Division A is Product A, which can be sold to an outside market or to Division B to be processed further and sold as Product B. One unit of Product B uses one unit of Product A. In Division A, variable costs are $100 per unit, and Product A sells for $175. In Division B, additional variable costs are $200 per unit, and Product B sells for $350. This scenario is diagrammed in Figure 11.3. Arrows indicate costs flowing out of the divisions and revenues flowing into them.

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Suppose Division A has excess capacity. Thus, there is no opportunity cost of transferring to Division B, and the company would receive a contribution of $50 per unit ($350 − $200 − $100), assuming that these units do not increase total fixed costs. A full-cost transfer price, however, might not promote a transfer. If the fixed costs per unit for Products A and B totaled more than $50, Division B would not accept a transfer since its costs would be more than $350 per unit. Consequently, the full-cost transfer price is not goal congruent. Using a variable-cost transfer price, Division B would accept the units since now its total cost of $300 per unit is less than $350. The variable-cost transfer price is, therefore, goal congruent.

Now suppose that Division A has no excess capacity—all units produced can be sold to the outside market for $175. By selling outside instead of transferring to Division B, the company would receive a contribution of $75 per unit ($175 − $100) rather than just $50 ($350 − $200 − $100). A variable-cost transfer price, however, would not achieve this higher profit because Division B would readily accept transfers to earn $50 per unit. In contrast, a market price would be goal congruent. With a transfer price of $175, Division B’s costs would total $25 more than its revenue ($350 − $200 − $175), so it would not take any units from Division A.

We summarize these analyses using the preceding decision rule:

Excess capacity:

Goal congruent transfer price = Incremental cost + Opportunity cost = $100 + $0 = $100

No excess capacity:

Goal congruent transfer price = Incremental cost + Opportunity cost

= $100 + ($175 − $100) = $175

Figure 11.3: Diagram of example transaction possibilities

Division A Division B

Unit Variable Cost = $100 Unit Variable Cost = $200

Unit Selling Price = $175 Unit Selling Price = $350

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Performance Evaluation and Autonomy. Clearly, a variable-cost transfer price provides little help in performance evaluation if the division is considered to be a profit or investment center. Autonomy is also violated since close working relationships and much exchange of data are expected. When using full-cost transfer prices, an added profit percentage is necessary to get the seller to a profit position. It is difficult to support any cost-based approach as a strong performance evaluation method for profit centers. Cost-based transfer prices are best suited to cost centers.

Administrative Cost. Cost-based transfer prices are easy to obtain since they are outputs of the cost accounting system. Perhaps this is why, in spite of its weaknesses, cost-based transfer pricing is the most widely used transfer pricing approach.

Negotiated Price The use of negotiated transfer prices is often suggested as a compromise between mar- ket-based and cost-based transfer prices. Real advantages may exist in allowing two division managers to arrive at the transfer price through arm’s-length bargaining. The self-interests of the division managers may serve the company objectives. Negotiated prices are helpful when:

1. Cost savings occur from selling and buying internally 2. Additional internal sales fill previously unused capacity, allowing the buyer and seller

to share any incremental profit

As long as the negotiators have relatively equal power positions, negotiations can create a quasi-free market. Friction and bad feelings that may arise from centrally controlled transfer prices may be eliminated.

Goal Congruence. Often, the company as a whole benefits from the buying and selling divisions negotiating a price that is agreeable to both parties. Fairness is an issue that must be weighed. The firm as a whole will win if the divisions elect to enter negotiations freely.

Performance Evaluation and Autonomy. A negotiated price may be a suitable surrogate for a market price. A market atmosphere is created if buyers and sellers are free to go outside and if neither division has an unfair power position—such as a monopoly position for purchases or sales.

Negotiations can be between buyer and seller alone or involve the corporate office. If negotia- tions lead to arbitration by the corporate office or if corporate policies interfere with free nego- tiations, autonomy suffers. The corporate office has the delicate problem of keeping hands off and yet monitoring divisional dealings to prevent significant noncongruent behavior.

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Administrative Cost. Negotiations are often expensive, consume time of key executives, and may cause an internal unit to be created to handle these relationships. If intracompany sales are important to a division, its managers must put a high priority on these negotiations. Its sales and profit levels are at stake. In highly integrated companies, negotiation costs can be a major operating expense.

Dual Transfer Prices A dual transfer pricing system allows the selling division to “sell” at a real or synthetic mar- ket price (such as full cost plus a profit percentage). The transfer price to the buying division is usually the variable cost (plus perhaps identifiable opportunity costs). Use of dual transfer prices has been suggested as a way of creating a profit, and thus a positive motivation, in both the selling and buying divisions. Such a system, however, does expand the corporate office accounting task. Intracompany sales and duplicate profits have to be eliminated before total company profits can be determined.

Goal Congruence and Performance Evaluation. The advantages of a dual transfer price system rest on being able to evaluate performance of both units as profit centers and to encourage behavior that will benefit the firm as a whole. Thus, the dual system provides the buying division with incremental cost information and at the same time allows the selling division to show a profit. Such a system encourages the congruence of divisional goals with company-wide goals.

If the selling division has substantial fixed costs to cover, a danger does exist that the buying division will sell at cut-rate prices and fail to cover all fixed costs. Here, active corporate-level monitoring may be needed.

Autonomy and Administrative Cost. Costs and corporate interference are the practical considerations and the major obstacles to the use of dual transfer pricing systems. From an accounting point of view, each division records its own transactions, and the central office must monitor, record, and track intracompany dealings, a clear violation of autonomy. In financial statements for the combined company, accounts representing intracompany transactions are eliminated. For example, a selling division will record a sale and establish a receivable; a buying division will record a purchase and set up a payable. In eliminating the intracompany accounts, any intracompany profits in the buying division’s inventory will be adjusted out. The home office must have a special accounting system to track all transactions of a dual pricing system. These extra costs must be outweighed by the benefits of better performance evaluation and goal congruence.

Commonly, the dual transfer pricing system is an academic approach to solving transfer pric- ing conflicts. But occasionally, a real-world firm will put a dual pricing system in place. Given the right circumstances and intent of management, a dual system can generate the desired combination of benefits.

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Section 11.6 Maximizing International Profits: The Role of Transfer Prices

Evaluating Transfer Pricing Methods According to the Criteria Having discussed the transfer pricing criteria and the methods commonly used, an assess- ment of the relative strengths and weaknesses is as follows:

Goal Congruence

Performance Evaluation Autonomy

Administrative Cost

Market prices Strong Very Strong Very Strong Low, if available

Cost-based prices:

Actual cost Poor Poor Poor Very Low

Full cost plus profit Poor Average Average Low

Variable cost Strong Very Poor Poor Often Low

Negotiated prices Strong Strong Strong to Poor High

Dual prices Strong Strong Poor High

(Variable Cost) (Market Price)

Remember that specific cases can produce very different answers in each area. Clearly, no one transfer price serves all purposes. Managers must rank their priorities and select trans- fer pricing policies that fit the situation. Perhaps the goal really is to select a transfer pricing policy that creates the least disruption or adverse managerial behavior.

11.6 Maximizing International Profits: The Role of Transfer Prices

“Buy low, and sell high” is the proverbial route to profits. However, other factors determine how much profit is kept and how much is taxed or restricted in global business. Income taxes, import duties, and limits on repatriation of profits are major components in creating com- plex international financial management problems. In a truly global world, goods and cash should flow across borders without restriction and without tariffs being imposed. Also, tax rates would be the same in all countries with little inflation and minimal changes in currency exchange rates. Absent these ideals, the company’s controller must develop strategies to min- imize financial risks and to maximize profits and cash flow. Historically, transfer pricing has been used to manipulate profit levels internationally.

Because a transfer between subunits of a firm does not occur at arm’s length, manipulation of the transfer price can occur. Cost-based transfer prices can include, at management’s dis- cretion, more or fewer costs. Transfer prices for a multinational company are more complex because conditions differ in each country in which the company does business. Governments

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are concerned because transfer prices affect tax revenues. Companies are concerned because transfer prices affect direct cash flows for payments of goods, taxes, prices, and management performance evaluations.

Naturally, we want managers to make decisions that enhance company goal congruence. However, international transfer pricing goes beyond domestic needs to include:

• Minimization of worldwide income taxes and import duties • Avoidance of financial restrictions, including the movement of cash • Approvals from the host country

Assume that Firm A in Country A and Firm B in Country B are subsidiaries of the same holding company, Ellin International. The following cases could exist:

1. If income tax rates are high in Country A and low in Country B, use a low transfer price for sales from Firm A to Firm B. More profits will be shifted to Firm B, lowering total tax payments.

2. If import duties are high for imports into Country B, use a low transfer price for sales from Firm A to Firm B. Low duties are paid; profits are higher.

3. If Country B restricts cash withdrawals from the country or imposes a tax on divi- dends paid to the holding company, use a high transfer price on sales from Firm A to Firm B. This allows a greater cash outflow from Country B through payments for purchases.

When these simple cases are fused and more issues are added, situations quickly become complex, particularly when revenue-hungry governments are involved.

Minimizing Worldwide Taxes Manipulation opportunities in the transfer price setting process mean taxable profits can be shifted from a country with high income tax rates to a country with lower taxes. For example, assume that the tax rate in Brazil is 50%, while the tax rate in the United States is 35%. A U.S. subsidiary of a multinational company sells a product to its sister subsidiary in Brazil. If we assume that a normal transfer price is $16 per unit but that the transfer price for units going into Brazil is set at $20 per unit, the U.S. subsidiary’s profit will be higher by $4 per unit ($20 − $16), which is taxed at 35%. When the Brazilian subsidiary sells the units, its cost of goods is higher and profits are lower by $4 per unit. Therefore, $4 per unit is taxed at 35%, not 50%.

International taxation occurs when a domestic government imposes taxes on income or wealth generated within its boundaries by a company based in a foreign country. Also, taxes are levied on income earned by a domestic company from activities in foreign countries. A company is taxed in the foreign country and in the multinational’s home-base country. For

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example, Pharmacia & Upjohn is a U.S.-based pharmaceutical firm with extensive global opera- tions. It must comply with U.S. tax laws and tax laws of each country in which it does business.

International taxation has dramatic impacts on management decisions, such as where a com- pany should invest, what form of business organization is used, what products are produced where, how prices and transfer prices are set, which currency should be used to denominate transactions, and what financing should be used. A firm must have professional expertise on its staff or available to review its tax status and the impacts that changes in tax treaties, agree- ments, laws, and regulations will have.

Governments and taxpayers are equally aware of tax minimization strategies. Tax laws in each country reduce the management accountant’s flexibility. Even if we assume that they have a desire to be inherently fair, governments want to generate revenue, plug tax and cash-flow loopholes, get at least their share of tax revenues, promote specific types of economic growth, and perhaps build in subtle biases in favor of domestic firms.

The European Community (EC), General Agreement on Tariffs and Trade (GATT), North American Free Trade Agreement (NAFTA), and other bilateral and multilateral agreements have as their main themes encouraging free trade. While “free” means loosening many barri- ers, reducing or eliminating import duties and other cross-border taxes and fees is of major importance.

Avoiding Financial Restrictions Foreign governments often place financial restrictions on international subsidiaries operat- ing within their boundaries. Government restrictions are placed on the amount of cash that may leave the country and for management fees charged by the parent company. Thus, mov- ing profits and, therefore, “stuck” cash by high transfer prices can reduce those restricted profits and increase firm-wide liquidity and financial mobility.

Gaining Host Country Approval Governments are not naive. They are becoming sophisticated and aware of the results of using high or low transfer prices. Governments compare prices to arm’s-length sales prices elsewhere. Products are analyzed for content. Price controls may be based on the trans- ferred-in cost. For example, price increases may be limited by government regulators to cost increases. In the long run, companies find that transfer pricing policies which satisfy foreign authorities may be in the best interest of the company when compared to the greater profits that might be sacrificed. A foreign government’s requirements about domestic ownership, percentage of locally produced content, and approval for government sales can be significant factors in determining how an international market is entered and how a company will oper- ate there.

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asset turnover The ratio of sales divided by an investment base, which measures the efficiency of generating sales with the assets employed.

cost-based transfer prices Prices that are based on production costs and used to transfer goods or services from one subunit to another subunit of an organization.

decentralization The delegation of decision-making authority to lower managerial levels in an organization.

decentralized company A company in which operating subunits are created with definite organizational boundaries and in which managers have decision-making authority.

Summary & Resources

Chapter Summary Many companies have sought to increase their financial performance by organizing them- selves into an array of profit or investment centers. Decentralizing a company involves defin- ing boundaries for organizational units, called responsibility centers, and delegating decision- making authority to the managers of these centers. Such a structure motivates managers to work for the benefit of the company, provides for front-line decision making by those nearest the action, enhances specialization by letting managers do what they do best, and reduces the span of control for management.

A control system is necessary if management wants to motivate its division managers and to evaluate performance. Measurements of expected performance level and of actual perfor- mance are the two essential ingredients for a control system. Since decentralized companies frequently place investment authority at the divisional level, performance measures should relate profitability to the amount of investment. Return on investment, residual income, and economic value added are approaches to divisional financial performance evaluation. Prob- lems exist in defining both profit and investment. Possible profit definitions include segment margins and controllable margins. Possible investment definitions include net direct assets and managed assets.

Divisions within a company do not operate in isolation from one another; rather, they fre- quently do business as buyer and seller. Any time intracompany transactions occur, a transfer price must be attached to the transaction. Criteria of goal congruence, performance evaluation, autonomy, and administrative cost are developed to measure the strengths and weaknesses of each type of transfer price. Transfer prices can be market based, cost based, negotiated, or dual. No one method meets all criteria. Each has strengths and weaknesses depending on the importance of intracompany dealings and the priorities of management. Transfer pricing of goods and services moving among units of the same company and across borders takes on a meaning different from that of domestic transfer pricing.

Key Terms

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division contribution margin The excess of revenues over variable costs.

division controllable margin The excess of revenues over variable costs and other costs controlled by the division manager.

division net profit The excess of revenues over variable costs, direct fixed costs, and any costs allocated to the division.

dual transfer pricing system Pricing systems that use a full-cost plus price or a market price for the selling subunit and use variable cost plus opportunity costs for the buying subunit.

economic value added (EVA) A measure of divisional performance that deducts a capital charge from an adjusted accounting profit.

full-cost transfer price A price based on full manufactured cost of the product or service and used by the seller and buyer as the transaction value.

goal congruence A condition under which managers work to achieve their own objec- tives and, at the same time, accomplish the objectives of the organization.

international taxation Occurs when a domestic government imposes taxes on income or wealth generated within its boundaries by a company based in a foreign country.

investment base The amount of invest- ment uniquely devoted to support a particu- lar divisional operation.

market price A price agreed upon by inde- pendent buyers and sellers.

minimum desired rate of return The imputed capital charge used in computing residual income, as selected by top manage- ment, for determining the division’s mini- mum acceptable return.

negotiated transfer prices Prices agreed to by both the buying and selling subunits of an organization to transfer goods or services between the two subunits.

residual income The operating profit of a division less an imputed charge for the oper- ating capital used by the division.

return on investment (ROI) The ratio of profit divided by investment.

return on sales (ROS) The ratio of profit divided by sales.

segment margin The excess of revenues over variable costs and all fixed costs trace- able to the division.

transfer price The value a company attaches to goods or services furnished by one division to another division within the company.

variable-cost transfer prices Prices based on variable costs of the products or services transferred from the seller to the buyer and used by the seller and buyer as the transac- tion value.

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Problem for Review A division of Field’s Office Rentals follows a pricing policy whereby normal activity is used as a basis for pricing. That is, prices are set on the basis of long-run annual volume predictions and market conditions. They are then rarely changed, except for notable changes in wage rates or supplies prices. The division controller, David Mazel, has provided the following data:

Supplies, wages, and other variable costs $5,000 per unit per year

Fixed overhead $30,000,000 per year

Desired rate of return on invested capital 20%

Normal annual rental volume 40,000 units

Invested capital $90,000,000

Required:

1. What net income percentage based on revenues is needed to attain the desired rate of return?

2. What rate of return on invested capital will be earned at a rental volume of 35,000 units?

3. If rentals were to drop to 35,000 units, by what percentage must each of the follow- ing variables change from the normal level of 40,000 units to achieve the 20% rate of return? a. Rental price b. Fixed overhead c. Return on revenues percentage d. Invested capital

Solution:

1. Net income = Investment base × Return on investment = $90,000,000 × 20% = $18,000,000

To solve for the net income percentage, first find revenues necessary to earn the $18,000,000 net income:

Net income $18,000,000

Plus:

Variable cost (40,000 × $5,000) 200,000,000

Fixed cost 30,000,000

Revenues $248,000,000

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Note: The rental price is $6,200 per unit ($248,000,000 ÷ 40,000 units). This value is needed later in the solution.

Net income percentage = Net income ÷ Revenues = $18,000,000 ÷ $248,000,000 = 7.26%

2. Sales volume drops to 35,000 units:

Revenues (35,000 × $6,200) $217,000,000

Less: Variable cost (35,000 × $5,000) – 175,000,000

Contribution margin 42,000,000

Less: Fixed cost – 30,000,000

Net income $12,000,000

Return on investment = Net income ÷ Investment base = $12,000,000 ÷ $90,000,000 = 13.33%

3. First, format the income statement for the normal volume of 40,000 units, with dol- lars and percentages:

Revenues (40,000 × $6,200) $248,000,000 100.00%

Less: Variable cost (40,000 × $5,000) − 200,000,000 80.65%

Contribution margin $48,000,000 19.35%

Less: Fixed cost − 30,000,000 12.10%

Net income $18,000,000 7.25%

Remember that this net income provides a 20% rate of return.

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Assume drop in volume to 35,000 units:

a. Change in rental price:

Net income $18,000,000

Plus:

Variable cost (35,000 × $5,000) 175,000,000

Fixed cost 30,000,000

Revenues $223,000,000

Divided by volume in units ÷ 35,000

New rental price per unit $6,371

This represents an increase of 2.76% over the original rental price of $6,200 per unit.

b. Change in fixed overhead:

Revenues (35,000 × $6,200) $217,000,000

Less: Variable cost (35,000 × $5,000) − 175,000,000

Contribution margin $42,000,000

Less net income − 18,000,000

New fixed overhead $24,000,000

This represents a decrease in fixed overhead of 20% over the original fixed over- head of $30,000,000.

c. Change in return on revenues percentage:

Dividing the revenues figure of $223,000,000, from Part (a), into the net income figure of $18,000,000 gives a return on revenues percentage of 8.07. This repre- sents an increase of 11.16% over the original return on revenues percentage of 7.26 ($18,000,000 ÷ $248,000,000).

d. Change in invested capital:

New investment base = Net income (from Part 2) ÷ ROI = $12,000,000 ÷ .20 = $60,000,000

This represents a decrease in investment base of 33.33% over the original invest- ment base of $90,000,000.

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Questions for Review and Discussion

1. What are the advantages of decentralization? What are the primary problems of decentralization?

2. How is performance generally measured in a cost center? In a profit center? In an investment center?

3. What are some problems in using division profit as an evaluation measure? 4. Identify and explain allocation problems involved in determining a profit measure

and the investment base for calculating ROI. 5. List the components of the ROI equation, tell how they are related, and identify an

action a manager can take regarding each component to improve ROI. 6. Identify the major factors necessary in conceptually defining profit centers for pro-

moting decentralization in an organization. 7. Identify four criteria that are useful in evaluating transfer prices for intracompany

transactions. 8. If a market-based transfer price can be determined, why is such a price usually con-

sidered the best one to use? 9. Briefly describe a dual transfer price. What are the advantages and disadvantages of

implementing such a pricing system? 10. What is the disadvantage of negotiated transfer prices when no intermediate market

exists for the producing division? 11. If a full-cost transfer price does not produce an optimal profit for the firm, why is it

so popular? 12. Why is an international transfer price often not the result of an arm’s-length

transaction?

Exercises

11-1. Profit Measures. The following data are from the Personal Injury Division of a law firm, Ezor & Associates:

Question:

Calculate division contribution margin, division controllable margin, segment margin, and division net profit.

Revenues $95,000

Division variable cost 48,000

Allocated home office overhead 7,000

Fixed overhead traceable to division ($5,000 is controllable, and $15,000 is not controllable)

20,000

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11-2. Comparison of ROI and Residual Income. The Electricity Division of Terrapin Utilities reported operating income of $2,400,000 per year based on an investment of $12,000,000. The company is considering the use of ROI or residual income as an evaluation measure. At the present time, the division manager, Julie Evanamy, is faced with a decision on an incremental investment of $4,000,000 which will increase annual operating income by $700,000 per year.

Question:

Provide calculations showing the difference between the two performance measures, and explain the possible advantage of using residual income assuming that a 15% ROI is consid- ered minimally acceptable.

11-3. ROI and Residual Income. Puffino Life & Casualty is a large insurance company headquartered in Milan, Italy, and has 14 divisions. The company has a 15% mini- mum desired rate of return. Its Residential Insurance Division has an investment base of 700,000 euros. During the current year, this division earned a residual income of 90,000 euros and had a return on sales of 8%.

Questions:

1. Compute the division’s ROI for the current year. 2. Compute the division’s asset turnover for the current year.

11-4. Investment Decision and Ethics. Minsk Brothers is a securities brokerage firm with four autonomous divisions. ROI is used to evaluate each division. Cash bonuses are given to division managers who have the highest ROI figures at year-end. The firm’s minimum desired rate of return is 15%. The Southeast Division’s projected operating results for this year are as follows:

Revenues $5,000,000

Variable expenses 3,000,000

Contribution margin 2,000,000

Direct fixed expenses 1,600,000

Segment margin 400,000

The Southeast Division has $1,200,000 of total direct assets. Early this year, Donald Malcolm, the manager of the Southeast Division, was presented with the following investment proposal:

Additional direct assets required $500,000

Additional revenues anticipated $1,000,000

Additional variable expenses 60% of revenues

Additional fixed expenses $300,000

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Questions:

1. Would Donald Malcolm be likely to accept the proposed investment? Explain with supporting computations.

2. Discuss the ethical issues that Donald Malcolm would face.

11-5. ROI and Residual Income. Shomovic Podiatry Clinic (“Time wounds all heels”) provides the following information:

Cost of assets $800,000

Annual profit before depreciation expense $480,000

Desired rate of return 14%

Annual depreciation expense $40,000

For purposes of determining ROI and residual income, the clinic uses the book value of assets at the beginning of a year.

Questions:

1. Compute ROI for the third year. 2. Compute residual income for the seventh year.

11-6. Economic Value Added. Michael Siegel & Associates is an engineering firm with four divisions, each of which has a cost of capital of 15%. One of its divisions, Civil Engineering, had an EVA of $5 million in 2010. This division had total capital of $20 million, which included an addition of $2 million in research and development costs.

Question:

Determine the adjusted accounting profit for the Civil Engineering Division.

11-7. Decision Based on a Transfer Price. The following information is available for Division A of Copeland Corporation:

Selling price to outside customers $31

Variable cost per unit $20

Fixed cost per unit (based on capacity) $4.25

Capacity in units 17,000

Division B would like to purchase 5,000 units each year from Division A. Division A has enough excess capacity to handle all of Division B’s needs. Division B now purchases from an outside supplier at a price of $28 and insists that it should be charged that same price by Division A.

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Question:

If Division A refuses to accept the $28 price for transfers to Division B, what effect would this have on the annual profit of Copeland Corporation?

11-8. Transfer Prices and Decision Making. Division 1 of Joel Marks & Company pro- duces 100,000 units of a product with a variable cost of $5 per unit and a fixed cost of $3 (based on $300,000 allocated to 100,000 units). These units can be sold in an intermediate market for $1,000,000 ($10 per unit) or transferred to Division 2 for additional processing and sold in a finished market. The selling price of the fully processed units is $14, and the additional processing cost in Division 2 is $1.50 per unit. The fixed costs in Division 2 total $100,000. At this time, excess capacity exists in Division 2 if the units are not transferred.

Question:

Should the 100,000 units be sold by Division 1 or processed further and sold by Division 2? Would a transfer price based on either market price or variable cost be likely to lead to the right decision? Explain.

11-9. Transfer Pricing Problem. Jennie Corporation has a production division that is cur- rently manufacturing 120,000 units but has a capacity of 180,000 units. The variable cost of the product is $22 per unit, and the total fixed cost is $720,000 or $6 per unit based on current production.

The Sales Division of the Jennie Corporation offers to buy 40,000 units from the Production Division at $21 per unit. The Production Division manager, Willie Green, refuses the order because the price is below variable cost. The Sales Division man- ager, Adele Herman, argues that the order should be accepted since by taking the order the Production Division manager can lower the fixed cost per unit from $6 to $4.50. (Output will increase to 160,000 units.) This decrease of $1.50 in fixed cost per unit will more than offset the $1 difference between the variable cost and the transfer price.

Questions:

1. If you were the Production Division manager, would you accept the Sales Division manager’s argument? Why, or why not? (Assume that the 120,000 units currently being produced sell for $30 per unit in the external market.)

2. From the viewpoint of Jennie Corporation, should the order be accepted if the man- ager of the Sales Division intends to sell each unit to the outside market for $27 after incurring an additional processing cost of $2.25 per unit? Explain.

11-10. Transfer Prices and Income Statements. Dora Company has two divisions, M and S. Division M manufactures a product, and Division S sells it. The intermediate market is competitive. But the product can be processed further and sold or stored for later processing and sale. Once the product is manufactured, some of it is sold by

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Division M, and some is transferred to Division S, which decides whether to hold or to process and sell the product. The following information pertains to the current year:

Division M manufacturing cost for 1,200,000 units $7,200,000

Of the 1,200,000 units produced:

Sold by M in intermediate market—600,000 units 6,000,000

Held by S for later sale—200,000 units (no additional processing work done on these units in Division S)

2,000,000

Processed by S and sold—400,000 units 7,200,000

Intermediate market value of 600,000 units when transferred to S 6,000,000

Total additional processing costs of S 1,300,000

Assume no beginning inventories.

Questions:

1. Prepare an income statement for the whole firm. 2. Prepare a separate income statement for each division using a cost-based transfer

price. 3. Prepare a separate income statement for each division using a market-value transfer

price.

11-11. Transfer Pricing Problem. The tailor shop in Sons of the Desert, a men’s clothing store, is set up as an autonomous unit. The transfer price for tailoring services is based on variable cost, which is estimated at $12 per hour. The store manager, How- ard Newman, feels that the Suit and Sport Coat Department is currently using too much tailor time and that this department could cut down on hours used by taking more care in fitting the garments. Newman has decided to double the hourly tailor rate even though this new rate will be no reflection of the real variable cost. The idea is simply to provide an incentive to the Suit and Sport Coat Department to conserve on tailor time.

Questions:

1. What possible disadvantages do you see in the store manager’s action? Do you agree or disagree with this means of stressing the need to conserve tailor time? Why?

2. Would it make any difference if the various selling departments were not required to use the tailor shop and were allowed to take their work to some outside tailor shop? Explain.

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11-12. Transfer Pricing. Koch Enterprises is an import company that purchases men’s shirts in the Far East and sells them in the United States. The company’s Acquisi- tion Division sells to over 200 retail and wholesale establishments. In addition, Koch supplies its own Wholesale Division, which also purchases merchandise from other vendors. The following July data pertain to Koch’s Acquisition Division:

Selling price to outside retailers and wholesalers $12

Variable cost per shirt $5

Total fixed costs $7,000

Capacity (number of shirts) 16,000

Currently, the Acquisition Division is selling all it can purchase to outside retailers and wholesalers. If it sells to the Wholesale Division, $0.75 can be avoided in vari- able cost per shirt. The Wholesale Division is currently purchasing from an outside supplier at $11.50 per shirt.

Questions:

1. From the point of view of the Acquisition Division, any sales to the Wholesale Divi- sion should have a price of at least how much?

2. Use the same facts as in Part (1) except that the Acquisition Division can sell only 10,000 shirts to outside retailers and wholesalers. How would your answer to Part (1) change?

11-13. Allocation of Cost or Transfer Price. Adler Furniture Leasing has several operating divisions that are largely autonomous as far as decision making is concerned. The central corporate office consists mainly of the president and immediate staff. The annual cost is $1,000,000, and this cost is fixed. In calculating division profit, this cost is allocated to divisions on the basis of sales. The current allocation rate is $0.04 per sales dollar based on the company-wide normal sales volume of $25,000,000 per year. David Stuart, the company controller, does not consider this to be a transfer price because he feels that the divisions are not really buying anything. In Stuart’s view, the charge is a method of allocating cost that should be absorbed by the divi- sions when they calculate their annual net income.

Question:

Do you agree with Mr. Stuart? In what sense is the charge a transfer price? Could the charge affect the decision of a division manager considering a new product with a variable cost of $5.50 and a selling price of $8? Explain.

11-14. Profit Centers and Transfer Prices. Dave Silverman Automobile Dealership is installing a responsibility accounting system with three profit centers: Parts and Ser- vice, New Vehicles, and Used Vehicles. The department managers were told to run their shops as if they were in business for themselves. However, interdepartmental dealings frequently occur. For example:

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a. The Parts and Service Department prepares new cars for final delivery and repairs used cars prior to resale.

b. The Used Vehicle Department’s major source of inventory is cars traded in as partial payment for new cars.

Question:

The owner of the dealership, Dave Silverman, has asked you to outline criteria for a company policy statement on transfer pricing, together with specific rules to be applied to the common examples cited. He has told you that clarity is of paramount importance because your criteria will be relied on for settling transfer-pricing disputes.

11-15. International Transfer Pricing Problem. Meisels Company is a Swiss subsidiary of a German company. In a normal month, Meisels produces 100,000 units of prod- uct with a variable cost of SFr12 per unit and fixed costs of SFr8 per unit (based on SFr800,000 of fixed costs allocated to production). These units can be sold in Swit- zerland for SFr26 per unit or transferred to the German subsidiary for additional processing and sold in a processed form. The selling price processed is 34 euros. The cost to complete the additional processing is 6 euros per unit. The fixed cost of pro- cessing is 300,000 euros. The current exchange rate between francs and euros is one Swiss franc to 0.90 euros. If the product is not transferred, the German subsidiary would have excess capacity.

Questions:

1. Should the Swiss production be transferred to the German subsidiary or sold locally? Explain your answer.

2. Explain how a transfer price could be used to move cash from Switzerland to Ger- many, assuming Switzerland does not like to see money leave the country.

Problems 11-16. Capital Budgeting and ROI. Wartell, Inc. has a division that performs telemarketing

services for clients throughout the United States. The income statement of this divi- sion is as follows:

Revenues $17,000,000

Less: Division costs:

Variable cost $12,000,000

Fixed cost 4,000,000 16,000,000

Segment margin $1,000,000

Less: Allocated central office overhead 500,000

Net income $500,000

Investment allocated to division $5,000,000

ROI 10%

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The management is disturbed about the low ROI. The corporate treasurer, Doreen Burton, indicates that the company can earn at least 20% on investment funds from any number of other projects. Furthermore, Burton points out that the investment is actually understated because the facility carried at a cost of $5,000,000 could be disposed of for about $8,000,000.

An investigation reveals that 50% of the division’s fixed cost of $4,000,000 cannot be eliminated even if the division is sold. The allocated central office overhead is a pro- rata share of operating the corporate offices, and sale of the division would not affect this cost either.

Questions:

1. Assuming that an expenditure of $1,000,000 annually would maintain the facility in good operating condition for at least 10 years, should the division be sold? Explain.

2. If not, does a better way of reporting the ROI exist that would alert management to consider selling if volume begins to decline? Describe.

11-17. ROI and Residual Income. Ben Hirsch Properties, Inc. has three divisions. Division managers are given bonuses based on ROI figures. Last year’s operating results for the Apartment Division, which had $12,000,000 in assets, were:

Revenues $60,000,000

Less: Variable expenses 42,000,000

Contribution margin $18,000,000

Less: Fixed expenses 14,000,000

Operating profit $ 4,000,000

The company had an overall ROI last year of 17%. The Apartment Division has an opportunity to add another building, which would require an additional asset invest- ment of $3,500,000. Revenues and costs relating to the new investment would be:

Revenues $11,000,000

Variable expenses 70% of revenues

Fixed expenses $2,500,000

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Questions:

1. As manager of the Apartment Division, would you accept or reject the new invest- ment? Explain, providing appropriate computations.

2. As president of the company, would you want the Apartment Division to accept or reject the new investment? Explain.

3. Suppose the company views an ROI of 13% as being the minimum that should be earned by any division, and the company evaluates performance by the residual income approach. Under these conditions, as manager of the Apartment Division, would you accept or reject the new investment? Explain, providing appropriate computations.

11-18. Transfer Pricing and Purchasing Decisions. Fernhoff Corporation, manufacturer of specialized trailers for over-the-road and container shipping, is decentralized, with each product line operating as a divisional profit center. Each division head is delegated full authority on all decisions involving sales of divisional output both to outsiders and to other divisions of Fernhoff. The International Shipping Division (ISD) has always purchased its requirements for a particular trailer platform subas- sembly from the Highway Division (HD). However, when informed that the HD was increasing its price to $300, ISD management decided to purchase the subassembly from an outside supplier.

ISD can purchase a similar subassembly from a reliable supplier for $260 per unit plus an annual die maintenance charge of $20,000. HD insists that owing to the recent installation of some highly specialized equipment, which has resulted in high depreciation charges, it would not be able to make an adequate profit on its invest- ment unless it charged $300. In fact, the ISD business was part of the justification for buying the new equipment. HD’s management appealed to Vivian Sweetwood, the company’s CEO, for support in its dispute with ISD and supplied the following operating data:

ISD’s annual purchases of subassembly 2,000 units

HD’s variable costs per unit of subassembly $220

HD’s fixed costs per unit of subassembly $65

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Questions:

1. Assume that no alternative use for HD’s internal facilities exists. Determine whether the company as a whole will benefit if ISD purchases the subassembly from the out- side supplier.

2. Assume that HD’s internal facilities would not otherwise be idle. By using the capac- ity needed to produce the 2,000 units for ISD for other production, HD can earn $40,000 in contribution margin. Should ISD purchase from the outsider? Explain.

3. If the outside supplier drops the price by another $20 per unit, would your answer to either Part 1 or 2 change? If so, why?

11-19. Transfer Pricing and Bids. The Jay Division of Cinnamon Corporation expects the following results for the coming year on sales to outsiders:

Sales (100,000 units) $600,000

Variable cost of sales $300,000

Fixed cost of sales 200,000 500,000

Profit $100,000

Yesterday, Pete Morris, the manager of the Ray Division, requested a bid from Jay for 30,000 units. Ray would perform additional work on each unit at a cost of $4 per unit and sell the end product for $9 per unit. Jay can make only 120,000 units per year and would have to forgo some regular sales if the Ray business is accepted. Ray has an outside bid of $4.50 per unit.

Questions:

1. What is the minimum bid Jay should make to Ray, and what transfer pricing goal is being optimized?

2. What is the maximum bid Jay should make to Ray, and what transfer pricing goal is being optimized?

3. If Ray buys from the outside supplier, does Cinnamon gain or lose and by how much?

11-20. Transfer Pricing and Divisional Income Statements. Michael Carter & Company has two divisions. Division 1 is responsible for slaughtering and cutting the unpro- cessed meat. Division 2 processes meat such as hams, bacon, and so forth. Division 2 can buy meat from Division 1 or from outside suppliers. Division 1 can sell at the market price all the unprocessed meat that it can produce. The current year’s income statement for the company is as follows:

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The ending inventory of $200,000 is valued at the product cost incurred in Division 1. This inventory is as yet unprocessed. The market value unprocessed is $300,000. The sales for the year can be broken down as follows:

Sales $2,600,000

Cost of goods sold:

Beginning inventory $0

Plus: Processing costs:

Livestock costs, Division 1 $600,000

Labor, Division 1 400,000

Overhead, Division 1 500,000

Processing supplies, Division 2 200,000

Labor, Division 2 300,000

Overhead, Division 2 100,000

Cost of goods available for sale $2,100,000

Less ending inventory cost:

Division 1 $0

Division 2 200,000 200,000 1,900,000

Gross margin $700,000

Operating expenses:

Sales & administrative, Division 1 $ 120,000

Sales & administrative, Division 2 100,000

Central office overhead 100,000 $320,000

Income before income tax $380,000

Division 1 (to outsiders) $600,000

Division 2 2,000,000

$2,600,000

The market value of the unprocessed meat actually transferred from Division 1 to Division 2 (exclusive of the ending inventory) was $1,800,000.

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Questions:

1. Prepare divisional income statements that might be used to evaluate the perfor- mance of the two division managers.

2. Explain the transfer pricing policy you have used in preparing the statements. 3. Can you see any conflict in the policy you have used if this same transfer price is to

be used for decision making? Explain.

11-21. Transfer Price Based on Full Cost. The Ohio Division of Dessler Company produces a large metal frame, which is sold to the Pennsylvania Division. Pennsylvania Divi- sion uses these frames in constructing metal lathes, which are sold to machine tool manufacturers. In Ohio Division, the frames are produced in a stamping process and are then run through a finishing process in which they are trimmed and polished before being shipped to the Pennsylvania Division.

The current estimate of the variable cost of materials and labor to produce a frame in the stamping process is $120 per frame. Fixed overhead associated with this process in the Ohio Division is $700,000 per year. Current production is 50,000 frames, which is full capacity for both the stamping and the trimming and polishing processes.

The variable cost of labor in the trimming and polishing process is $12 per frame since labor in this process is paid on a piece-rate basis. (No additional materials are required.) The fixed overhead in this process is $300,000 per year and is largely due to equipment depreciation and related costs. The machines have almost no salvage value because of their special-purpose design.

The transfer price to the Pennsylvania Division is a full-cost transfer price and is calculated by prorating the current fixed cost in each process over the 50,000 frames being produced. The price is quoted for each process and is presented to the man- ager as follows:

Stamping process:

Materials and labor cost per unit $120

Fixed overhead cost per unit ($700,000 ÷ 50,000 units) 14 $134

Trimming and polishing process:

Labor cost per unit $ 12

Fixed overhead cost per unit ($300,000 ÷ 50,000 units) 6 18

Total cost per unit $152

An outside company, Seide Industries, has offered to rent to Pennsylvania Division machinery that would perform the trimming and polishing process. The rental cost of the machinery is $200,000 per year. With the new machinery, the labor cost per frame would remain at $12. The Pennsylvania Division manager, Irving Stone, sees

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the possibility of obtaining the frames from the Ohio Division for $134 by eliminat- ing the $18 cost of trimming and polishing and of performing these processes in the Pennsylvania Division. An analysis is as follows:

New process:

Machine rental cost per year $200,000

Labor cost ($12 × 50,000 units) 600,000

Total Pennsylvania Division trimming and polishing costs $800,000

Current process:

50,000 units at $18 per unit (portion of the Ohio Division transfer price attributable to trimming and polishing process)

$900 000

Irving Stone has approached the vice president of operations for approval to acquire the new machinery.

Questions:

1. As the vice president, how would you advise Irving Stone? 2. Could the transfer pricing system be improved and, if so, how?

11-22. Transfer Pricing and Decision Making. Summit Security Services (SSS) has three operating divisions. The Central Division installs high-tech security systems for corporate clients throughout the country. Two other divisions, Electronics and Com- munications, produce components for the various security systems. One particular system requires one unit from Electronics and one unit from Communications. Data for this security system follow:

Selling price (Central Division) $8,000

Variable costs:

Electronics Division $2,000

Communications Division 1,400

Central Division 800

Total variable costs $4,200

Current volume 10,000 systems

The Electronics and Communications Divisions charge the Central Division $2,500 and $1,800, respectively, for each unit. The Central Division manager, Emily Kaplan, has been approached by an outside supplier who has offered to sell, for $2,300 per unit, the component now produced by the Electronics Division.

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Questions:

1. Prepare partial income statements, down to contribution margin, for each of the three divisions based on current operations.

2. Determine whether the outside supplier’s offer should be accepted. If the Electronics Division meets the price offered by the outside supplier, Central will continue to buy from Electronics. Answer from the point of view of what’s best for SSS.

3. Suppose that Electronics can sell its entire annual output of 10,000 units at a price of $3,000 if it performs additional work on the component. The additional work will add $500 to the unit variable cost, whereas fixed costs will be unaffected. The capac- ity of the Electronics Division is 10,000 units. Determine the incremental contribu- tion margin to SSS if Central is allowed to buy from the outside supplier.

11-23. Transfer Pricing in a Multinational Company. Zanitsky Farming Company has two units: the Mexican Division produces grain, and the U.S. Division sells the grain. As soon as the grain is produced, it is placed in storage areas until sold by the U.S. Divi- sion. A transfer price is used to charge the U.S. Division and to recognize the Mexican Division as a profit center.

During the year, three grain crops of 1,900,000 bushels each were produced. All three have now been sold, although some were held in inventory for various periods of time. The market prices (in pesos) at production time were M$10 per bushel for the first crop (M$1 = $0.34), M$12 per bushel for the second (M$1 = $0.35), and M$8 per bushel for the third (M$1 = $0.33). No beginning inventories were on hand. The Mexican producer uses a transfer price equal to the market price in pesos.

The results for the period are:

Total company revenues (5,700,000 bushels) $22,300,000

Costs:

Producing division (M$1 = $0.33):

Labor and materials $13,200,000

Division overhead 5,610,000

Selling division:

Labor 900,000

Division overhead 900,000

The company president, Barry Heifitz, is pleased with the total profit (stated in U.S. dollars) generated by the two divisions. He wants to determine whether the price speculation activities of the selling division are earning a profit.

Questions:

1. Prepare divisional income statements for each division, using the currency of the country where each operates. Which division is more profitable?

2. Would you use the market price or the cost for the transfer price? Explain.

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Case: Kinsman Corporation

Kinsman Corporation, headquartered in Cleveland, is a highly diversified company organized into autonomous divisions along product lines. The autonomy permits division managers a significant amount of authority in operating their divisions. Each manager is responsible for sales, cost of operations, acquisition of division assets, management of accounts receivable and inventories, and use of existing facilities. Cash management is centralized at the corporate home office. Divisions are permitted cash for their normal operating needs, but all excess cash is transferred to the corporate home office in Cleveland.

Division managers are responsible for presenting requests for capital expenditures (to acquire assets, expand existing facilities, or make any other long-term investment) to corporate management for approval. Once the proposals are analyzed and evaluated, corporate management decides whether to commit funds to the requests.

Kinsman Corporation adopted an ROI measure several years ago. The measure uses division direct profit and an investment base composed of fixed assets employed plus accounts receivable and inventories. ROI is used to evaluate the performance of each division, and it is the primary factor in assessing salary increases each year. Also, changes in the ROI from year to year affect the amount of the annual bonus.

ROI has grown over the years for each division. However, the company’s overall ROI has declined in recent years. Cash balances are increasing at the corporate level, and investments in marketable securities are growing. Idle cash and marketable securities do not earn as good a rate of return as division capital investments.

Two of Kinsman Corporation divisions—the Apparel Division and the Sports Gear Division— operate retail stores throughout the United States. The following data (with 000s omitted) show the operating results for these divisions for the last three years:

Apparel Division Sports Gear Division

2017 2018 2019 2017 2018 2019

Estimated industry sales $10,000 $11,000 $12,100 $5,000 $6,250 $7,500

Division sales $1,200 $1,380 $1,587 $500 $650 $780

Division direct costs:

Variable costs $360 $396 $467 $160 $182 $203

Discretionary fixed costs 480 490 500 180 210 240

Committed fixed costs 250 300 375 150 215 260

Total division direct costs $ 1,090 $ 1,186 $ 1,342 $ 490 $ 607 $ 703

Division net profit $110 $194 $245 $10 $43 $77

Investment base $1,100 $1,200 $1,300 $125 $195 $280

ROI 10.00% 16.17% 18.85% 8.00% 22.05% 27.50%

(continued)

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Summary & Resources

Case: Kinsman Corporation (continued)

The managers of both divisions were promoted to their positions in 2017. Irene Henry had been assistant division manager of the Apparel Division for six years prior to her appointment as manager of that division. The Sports Gear Division was created in 2015. Arnold Phillips had served as assistant manager of the Toy Division for four years prior to becoming manager of the Sports Gear Division, when the latter position suddenly became available in late 2016.

Questions:

1. In general, is ROI an appropriate measure of performance? Explain. 2. Explain how an overemphasis on ROI can result in a declining corporate ROI and in

increasing cash and marketable securities. 3. Describe specific actions that might have caused this increase in 2019 divisional ROI

while the corporate ROI declined. 4. Assuming the minimum desired rate of return is 12% for Apparel and 15% for

Sports Gear, compute the residual income and the residual income as a percentage of the investment base for each division for each year.

5. Which division manager (Henry or Phillips) do you judge as the better manager? What are your reasons?

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