Evaluating Performance and Non value- Added Costs in a Doctor's Office

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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.

11 Analysis of Decentralized Operations

jaochainoi/iStock/Thinkstock

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Dividing the Pro�it Pie: Whose Is Whose?

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

The Exploration & Production Division has the task of �inding, 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 Re�ining Division. It purchases crude oil from the Exploration & Production Division and the open market. Crude oil not sold to Re�ining 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 Re�ining Division has re�ineries in Kano, on the Niger River, and in Ibadan. The re�ineries 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 Re�ining 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 �leet, tanker trucks, and some pipeline facilities for transporting the products. Other product shipments are contracted with shipping companies.

Since the divisions each generate pro�its and have tremendous investments in assets, Shagari Petroleum wants to develop an appropriate measure for evaluating the �inancial 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.

In contrast to a centralized company in which decision making is largely done by top management, a decentralized company is one in which operating subunits (usually called divisions) are created with

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de�inite organizational boundaries, each with managers who have decision-making authority. Thus, responsibility for portions of the company’s pro�its can be traced to speci�ic 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.

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11.1 Review of Responsibility Centers Before discussing decentralization and performance measures, it is essential to review the types of responsibility centers �irst 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 of�ice. In contrast, managers of pro�it centers have control over both costs and revenues. These managers are responsible for generating 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, payables traceable to the investment center’s operations. Companies or subsidiaries could be investment centers or pro�it centers, depending on whether the corporate headquarters gives investment responsibility to these levels. Investment responsibility is de�ined as authority to buy, sell, and use assets.

Top management’s intent often determines the type of responsibility center. In a large company, a data processing center could be a cost center, either absorbing its own costs or allocating its costs to users of the �irm’s computer operations. As a pro�it center, it would be allowed to charge a rate for data processing services it provides to internal users and be expected to earn a pro�it 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, pro�it, or investment 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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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 management 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. De�ined span of control. As an organization increases in size, top management has more dif�iculty controlling the organization. Decentralizing the authority de�ines 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 bene�its 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 ef�iciency and effectiveness of operations.

2. Measurement system. The same measurement system should be used for all divisions. 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 bene�its to the entire organization. Top management 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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11.3 Measurement of Financial Performance In previous chapters, planning and control methods were discussed. We apply these to cost, pro�it, and investment center evaluations. Cost controls used in cost centers are also relevant for pro�it and investment centers. Revenue and pro�it measurements used in pro�it centers are also applied to investment centers. Thus, we can build the following planning and control structure:

Centers

Cost Pro�it 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 pro�it 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 �inancial measures alone can evaluate the performance of a responsibility center. Product or service quality, delivery reliability, market share, and responsiveness to customers are all non�inancial measures critical to the overall success of a �irm. Both �inancial and non�inancial goals are often part of a manager’s business plan. We discuss in detail non�inancial performance measures in the next chapter.

For pro�it and investment centers, selecting proper �inancial performance measures is not an easy task. The �inancial measures chosen:

Send messages to all managers about what is important to the �irm’s executive managers. Are often the basis for calculating incentive compensation, personnel evaluations, and promotion decisions. In�luence the allocation of new capital and personnel resources.

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 de�ined as a ratio:

Return on investment = Pro�it ÷ Investment

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

Return on investment = (Pro�it ÷ Sales) × (Sales ÷ Investment )

The �irst term, Pro�it ÷ Sales, is return on sales (ROS) (sometimes called the pro�it margin). It measures the percentage of each sales dollar that is turned into pro�it. 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 de�ining the pro�it numerator as well as the investment denominator. Even then, divisions within a company may be dissimilar, creating “apples and oranges” comparisons.

The Numerator—Division Pro�it The choice of the pro�it �igure is not simple. The �irst problem is how the pro�it number will be used. Will it be used to evaluate the division as an economic unit or to evaluate the division manager’s performance? A different pro�it is appropriate for each. Once the purpose is decided, the next problem is how to construct the best measure from several pro�it concepts commonly available. Assume that a division of Taratoot Financial Consulting reports the following pro�it 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 (�ixed) home of�ice overhead 60

Four alternative income statements organize the data for different purposes.

Division Contribution Margin

Division Controllable Margin

Segment Margin

Division Net Pro�it

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

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Division Contribution Margin

Division Controllable Margin

Segment Margin

Division Net Pro�it

Indirect costs: 60

Allocated corporate overhead

$90

Division Net Pro�it. The best pro�it measure for division performance may appear to be division net pro�it. However, the division net pro�it calculation includes allocated corporate overhead. An example of this cost would be the cost of operating the president’s of�ice. Although each division bene�its from these costs, they are not controllable at the division level nor traceable to speci�ic divisions. Generally, division net pro�it is a poor indicator of a division’s performance. The main arguments for using division net pro�it are that the division manager is made aware of the entire �irm’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 speci�ic divisions should be assigned directly to those divisions. Allocated corporate overhead expenses are likely to be arbitrary 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 de�ined as total division revenue less direct costs of the division. This concept avoids the main dif�iculty of division net pro�it since common costs of the �irm are excluded. The segment margin is the most useful pro�it measure for comparing divisions’ performances, for resource allocation decisions, and for corporate planning purposes. All revenues and costs traceable to the divisions are included.

Often, corporate-level decision makers use the segment margin to indicate where additional investments should be made to generate the greatest incremental returns. Certainly, speci�ic 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 de�ined 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 re�lects 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 pro�it calculation for managerial evaluations. If this is not done, the division pro�it 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 dif�icult for the division manager to in�luence; 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 dif�icult to solve, but they are part of the division management’s responsibility. Failure to solve such problems is different from being unable to take action due to lack of authority.

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Division Contribution Margin. The division contribution margin is de�ined 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 �ixed 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 distinction 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.

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

Asset Identi�ication. The �irst 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 �irm’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 speci�ic divisions. Cash, as a corporate asset, is rarely traceable to speci�ic 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 administrative of�ices used by two product divisions. Any basis of allocation would be arbitrary. As with home of�ice expenses, avoiding these arbitrary allocations generally improves the analysis.

Asset Valuation. Once the assets have been identi�ied 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 dif�iculty 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 speci�ic 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 de�initions for the same purposes. Divisions being compared should have the same or similar accounting methods. The same depreciation method should apply to similar classes or categories of

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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 bene�it while, at the same time, bene�iting 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 division 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 pro�itability.

Improving ROI Since division managers are expected to improve ROI, they look to components they can control. 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 Lind�ield 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]

Increase Sales. Looking at ROI as a product of return on sales and asset turnover might give the impression that the sales �igure 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 �ixed costs. The return on sales improves. This happens anytime the

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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 �ixed 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 �irst approach managers take when facing a declining return on sales. A rather typical pattern has emerged. First, review the discretionary �ixed costs, either individual cost items or programs representing a package of discretionary �ixed costs, and �ind those that can be curtailed or eliminated quickly. Second, look for ways to make employees more ef�icient 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 �ind that trimming any excess investment can have a signi�icant 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. 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

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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: pro�itability 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 �irst 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/etfs-and-funds/mutual-funds/colleges-with-top-investment-returns-on-degree-costs/ (http://www.investors.com/etfs-and-funds/mutual-funds/colleges-with-top-investment-returns-on-degree-costs/)

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 de�ined as the operating pro�it of a division less an assessed charge for the operating capital used by the division. It is the amount of pro�it over and above the pro�it 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 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 investment is $1,000,000. The ROI, then, is 25%. Suppose top management wants division management 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

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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 congruent 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 in�luence the potential pro�its 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 minimum rate of return (i.e., cost of capital × total capital) from the division’s pro�its, as follows:

EVA = Adjusted accounting pro�it − (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 pro�it is an after-tax pro�it 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 than as expenses, which would not be allowed for external reporting. The resulting pro�it number, the adjusted accounting pro�it, adds back these expenses to the accounting pro�it �igure and therefore better re�lects the division’s long-run pro�it 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 shareholders should earn a return in excess of their expectations, and the company’s stock price is likely to rise.

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Ethical Concerns Relating to Performance Measures

Division managers can increase short-run pro�its of divisions to the detriment of the company as a whole. For example, it may be possible to delay maintenance costs. Such an action will increase short-run pro�its but adversely affect long-run pro�itability of the division and the company. Expenditures that engender employee loyalty, such as employee physical �itness 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 ethical implications also. A manager should consider whether it is ethical to reject an investment that would bene�it the company even though it would reduce the manager’s average ROI.

Contemporary Practice 11.2: Con�licts 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 bene�it 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 bene�it 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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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-pro�it.

Pro�it-oriented operations have an incentive to be pro�itable. They may use ROI, residual income, or EVA, if an appropriate pro�it measure and an investment base are available. Obviously, organizations such as CPA �irms, law �irms, insurance agencies, and consulting �irms 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-pro�it organizations are different because pro�its are not the prime interest of managers. 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-pro�it settings.

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11.5 Intracompany Transactions and Transfer Pricing Problems In calculating division pro�it, problems arise when the divisions are not completely independent. 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 predetermined 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 customers. Components and products are billed at a “full cost plus a pro�it” basis between Plants A and B and between Plant B and the Sales Division.

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 happens 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 allocation. At the other end is pure market-driven pricing.

Figure 11.1: Continuum of accounting approaches for intracompany transactions

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, bene�its received, or even arbitrary rules. Commonly, service departments are transferring costs to producing departments. The two boxes labeled “Cost Plus a Pro�it” 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 represents situations where external markets do exist and where market

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prices are used, in part or in total, as the exchange price. Buyers seek suppliers. Sellers seek customers. If an intracompany sale takes place, it is the best source for the buyer and a pro�itable 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 optimal 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 dysfunctional behavior, actions which hurt the �irm’s results, can be frequent by-products.

Let us �irst outline the criteria for creating a transfer pricing system; second, discuss alternative 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 pro�its for the �irm as a whole? In decentralized organizations, perhaps one of the most dif�icult tasks is to get everyone to pull toward the common goal—the �inancial success of the whole �irm. Success of each division will not guarantee the optimal success for the whole �irm.

2. Performance evaluation. Will the transfer price allow corporate-level managers to measure the �inancial 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 unpro�itable. 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 �irm’s policies have diluted the autonomy of its managers. If autonomy is restricted greatly, the objectives of decentralization 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 contribution margin. Where internal transaction volume is large and complex, a more extensive internal pricing system is justi�ied. 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 situations 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 pro�it

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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 buyers 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.

Market price meets more of the transfer pricing criteria than any other method. But �inding a market price may be dif�icult since one may not exist. Examples include intermediate components, 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 �inding a valid market price, managers generally agree that market 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 independent 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 �ixed and variable product costs ($50 per unit and $100 per unit, respectively), could bene�it 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 �irm, 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 pro�it is hurt. The �irm 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 pro�its from highly motivated quasi-entrepreneurs. Depending on results in speci�ic �irms, this trade-off may or may not be justi�ied.

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Performance Evaluation and Autonomy. Market prices form an excellent performance indicator because they cannot be manipulated by the individuals who have an interest in pro�it calculations. A market price eliminates negotiations and squabbling over costs and de�initions 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.

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 pro�it 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 �irm 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, pro�it pressures 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 Pro�it. If cost only (actual cost, standard cost, full cost, or variable cost) is used as a transfer price, the selling unit cannot earn a pro�it. Full cost plus a pro�it percentage is a popular solution. Adding a percentage to cost for a pro�it 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 advantage of encouraging maximum pro�its for the entire �irm when excess capacity exists. This will be illustrated later. The obvious problem is that the selling division must absorb all of its �ixed costs. That division is now a loss division, nowhere near a pro�it center.

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

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Goal Congruence. Full-cost transfer prices generally produce suboptimal pro�its for the �irm as a whole. Variable-cost transfer prices generate an optimal �irm-wide pro�it when the selling division has excess capacity. Otherwise, market prices yield optimal �irm-wide pro�its. In general, the de�inition 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

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 �lowing out of the divisions and revenues �lowing into them.

Figure 11.3: Diagram of example transaction possibilities

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 �ixed costs. A full-cost transfer price, however, might not promote a transfer. If the �ixed costs per unit for Products A and B totaled more than $50, Division B would not

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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 pro�it 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

Performance Evaluation and Autonomy. Clearly, a variable-cost transfer price provides little help in performance evaluation if the division is considered to be a pro�it 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 pro�it percentage is necessary to get the seller to a pro�it position. It is dif�icult to support any cost-based approach as a strong performance evaluation method for pro�it 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 market-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 �ill previously unused capacity, allowing the buyer and seller to share

any incremental pro�it

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.

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Goal Congruence. Often, the company as a whole bene�its from the buying and selling divisions negotiating a price that is agreeable to both parties. Fairness is an issue that must be weighed. The �irm 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 of�ice. If negotiations lead to arbitration by the corporate of�ice or if corporate policies interfere with free negotiations, autonomy suffers. The corporate of�ice has the delicate problem of keeping hands off and yet monitoring divisional dealings to prevent signi�icant noncongruent behavior.

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 pro�it 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 market price (such as full cost plus a pro�it percentage). The transfer price to the buying division is usually the variable cost (plus perhaps identi�iable opportunity costs). Use of dual transfer prices has been suggested as a way of creating a pro�it, and thus a positive motivation, in both the selling and buying divisions. Such a system, however, does expand the corporate of�ice accounting task. Intracompany sales and duplicate pro�its have to be eliminated before total company pro�its 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 pro�it centers and to encourage behavior that will bene�it the �irm 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 pro�it. Such a system encourages the congruence of divisional goals with company-wide goals.

If the selling division has substantial �ixed costs to cover, a danger does exist that the buying division will sell at cut-rate prices and fail to cover all �ixed 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 of�ice must monitor, record, and track intracompany dealings, a clear violation of autonomy. In �inancial 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 pro�its in the buying division’s inventory will be adjusted out. The home of�ice must have a special accounting system to track all transactions of a dual pricing system. These extra costs must be outweighed by the bene�its of better performance evaluation and goal congruence.

Commonly, the dual transfer pricing system is an academic approach to solving transfer pricing con�licts. But occasionally, a real-world �irm will put a dual pricing system in place. Given the right circumstances

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and intent of management, a dual system can generate the desired combination of bene�its.

Evaluating Transfer Pricing Methods According to the Criteria

Having discussed the transfer pricing criteria and the methods commonly used, an assessment 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 pro�it

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

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11.6 Maximizing International Pro�its: The Role of Transfer Prices “Buy low, and sell high” is the proverbial route to pro�its. However, other factors determine how much pro�it is kept and how much is taxed or restricted in global business. Income taxes, import duties, and limits on repatriation of pro�its are major components in creating complex international �inancial management problems. In a truly global world, goods and cash should �low across borders without restriction and without tariffs being imposed. Also, tax rates would be the same in all countries with little in�lation and minimal changes in currency exchange rates. Absent these ideals, the company’s controller must develop strategies to minimize �inancial risks and to maximize pro�its and cash �low. Historically, transfer pricing has been used to manipulate pro�it levels internationally.

Because a transfer between subunits of a �irm does not occur at arm’s length, manipulation of the transfer price can occur. Cost-based transfer prices can include, at management’s discretion, 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 are concerned because transfer prices affect tax revenues. Companies are concerned because transfer prices affect direct cash �lows 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 �inancial 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 pro�its 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; pro�its are higher.

3. If Country B restricts cash withdrawals from the country or imposes a tax on dividends paid to the holding company, use a high transfer price on sales from Firm A to Firm B. This allows a greater cash out�low 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 pro�its 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 pro�it 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 pro�its are lower by $4 per unit. Therefore, $4 per unit is taxed at 35%, not 50%.

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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 example, Pharmacia & Upjohn is a U.S.-based pharmaceutical �irm with extensive global operations. 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 company 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 �inancing should be used. A �irm must have professional expertise on its staff or available to review its tax status and the impacts that changes in tax treaties, agreements, 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 �lexibility. Even if we assume that they have a desire to be inherently fair, governments want to generate revenue, plug tax and cash-�low loopholes, get at least their share of tax revenues, promote speci�ic types of economic growth, and perhaps build in subtle biases in favor of domestic �irms.

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 barriers, reducing or eliminating import duties and other cross-border taxes and fees is of major importance.

Avoiding Financial Restrictions

Foreign governments often place �inancial restrictions on international subsidiaries operating 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, moving pro�its and, therefore, “stuck” cash by high transfer prices can reduce those restricted pro�its and increase �irm-wide liquidity and �inancial 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 transferred-in cost. For example, price increases may be limited by government regulators to cost increases. In the long run, companies �ind that transfer pricing policies which satisfy foreign authorities may be in the best interest of the company when compared to the greater pro�its that might be sacri�iced. A foreign government’s requirements about domestic ownership, percentage of locally produced content, and approval for government sales can be signi�icant factors in determining how an international market is entered and how a company will operate there.

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Summary & Resources

Chapter Summary Many companies have sought to increase their �inancial performance by organizing themselves into an array of pro�it or investment centers. Decentralizing a company involves de�ining 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 bene�it 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 performance are the two essential ingredients for a control system. Since decentralized companies frequently place investment authority at the divisional level, performance measures should relate pro�itability to the amount of investment. Return on investment, residual income, and economic value added are approaches to divisional �inancial performance evaluation. Problems exist in de�ining both pro�it and investment. Possible pro�it de�initions include segment margins and controllable margins. Possible investment de�initions include net direct assets and managed assets.

Divisions within a company do not operate in isolation from one another; rather, they frequently 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

asset turnover The ratio of sales divided by an investment base, which measures the ef�iciency 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 de�inite organizational boundaries and in which managers have decision-making authority.

division contribution margin The excess of revenues over variable costs.

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

division net pro�it The excess of revenues over variable costs, direct �ixed 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 pro�it.

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 objectives 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 investment uniquely devoted to support a particular divisional operation.

market price A price agreed upon by independent buyers and sellers.

minimum desired rate of return The imputed capital charge used in computing residual income, as selected by top management, for determining the division’s minimum 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 pro�it of a division less an imputed charge for the operating capital used by the division.

return on investment (ROI) The ratio of pro�it divided by investment.

return on sales (ROS) The ratio of pro�it divided by sales.

segment margin The excess of revenues over variable costs and all �ixed costs traceable to the division.

transfer price

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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 transaction value.

Problem for Review A division of Field’s Of�ice 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

Questions:

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 following 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, �irst �ind 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 dollars 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.

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

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

b. Change in �ixed 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 �ixed overhead $24,000,000

This represents a decrease in �ixed overhead of 20% over the original �ixed overhead of $30,000,000.

c. Change in return on revenues percentage:

Dividing the revenues �igure of $223,000,000, from Part (a), into the net income �igure of $18,000,000 gives a return on revenues percentage of 8.07. This represents 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 investment base of $90,000,000.

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 pro�it center? In an investment

center? 3. What are some problems in using division pro�it as an evaluation measure? 4. Identify and explain allocation problems involved in determining a pro�it 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 de�ining pro�it centers for promoting

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 considered the

best one to use? 9. Brie�ly describe a dual transfer price. What are the advantages and disadvantages of

implementing such a pricing system?

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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 pro�it for the �irm, 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. Pro�it Measures. The following data are from the Personal Injury Division of a law �irm, Ezor & Associates:

Revenues $95,000

Division variable cost 48,000

Allocated home of�ice overhead 7,000

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

20,000

Question:

Calculate division contribution margin, division controllable margin, segment margin, and division net pro�it.

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 considered minimally acceptable.

11-3. ROI and Residual Income. Puf�ino Life & Casualty is a large insurance company headquartered in Milan, Italy, and has 14 divisions. The company has a 15% minimum 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 �irm with four autonomous divisions. ROI is used to evaluate each division. Cash bonuses are given to division managers who have the highest ROI �igures at year-end. The �irm’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

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Variable expenses 3,000,000

Contribution margin 2,000,000

Direct �ixed 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 �ixed expenses $300,000

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 pro�it 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 �irm 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 pro�it for the Civil Engineering Division.

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

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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.

Question:

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

11-8. Transfer Prices and Decision Making. Division 1 of Joel Marks & Company produces 100,000 units of a product with a variable cost of $5 per unit and a �ixed 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 �inished 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 �ixed 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 currently 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 �ixed 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 manager, Adele Herman, argues that the order should be accepted since by taking the order the Production Division manager can lower the �ixed cost per unit from $6 to $4.50. (Output will increase to 160,000 units.) This decrease of $1.50 in �ixed 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 manager 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

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can be processed further and sold or stored for later processing and sale. Once the product is manufactured, some of it is sold by 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 �irm. 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, Howard 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 �itting the garments. Newman has decided to double the hourly tailor rate even though this new rate will be no re�lection 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.

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 Acquisition 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 �ixed costs $7,000

Capacity (number of shirts) 16,000

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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 variable 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 Division 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 of�ice consists mainly of the president and immediate staff. The annual cost is $1,000,000, and this cost is �ixed. In calculating division pro�it, 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 divisions 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. Pro�it Centers and Transfer Prices. Dave Silverman Automobile Dealership is installing a responsibility accounting system with three pro�it centers: Parts and Service, 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:

a. The Parts and Service Department prepares new cars for �inal 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 speci�ic 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 product with a variable cost of SFr12 per unit and �ixed costs of SFr8 per unit (based on SFr800,000 of �ixed costs allocated to production). These units can be sold in Switzerland 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 �ixed cost of processing 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.

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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 Germany, 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 division 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 of�ice overhead 500,000

Net income $500,000

Investment allocated to division $5,000,000

ROI 10%

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 �ixed cost of $4,000,000 cannot be eliminated even if the division is sold. The allocated central of�ice overhead is a pro-rata share of operating the corporate of�ices, 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 �igures. 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

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Less: Fixed expenses 14,000,000

Operating pro�it $ 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 investment 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

Questions:

1. As manager of the Apartment Division, would you accept or reject the new investment? 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 pro�it 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 subassembly 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 pro�it on its investment unless it charged $300. In fact, the ISD business was part of the justi�ication 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 �ixed costs per unit of subassembly $65

Questions:

1. Assume that no alternative use for HD’s internal facilities exists. Determine whether the company as a whole will bene�it if ISD purchases the subassembly from the outside supplier.

2. Assume that HD’s internal facilities would not otherwise be idle. By using the capacity needed to produce the 2,000 units for ISD for other production, HD can earn $40,000 in contribution

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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

Pro�it $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 unprocessed 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:

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:

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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 of�ice overhead 100,000 $320,000

Income before income tax $380,000

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:

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.

Questions:

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

2. Explain the transfer pricing policy you have used in preparing the statements. 3. Can you see any con�lict 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 Division 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 �inishing 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 �ixed 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 �ixed cost in each process over the 50,000 frames being produced. The price is quoted for

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each process and is presented to the manager 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 the possibility of obtaining the frames from the Ohio Division for $134 by eliminating 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 Communications, 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

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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.

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 �ixed costs will be unaffected. The capacity of the Electronics Division is 10,000 units. Determine the incremental contribution 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. Division. A transfer price is used to charge the U.S. Division and to recognize the Mexican Division as a pro�it 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 �irst 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 Hei�itz, is pleased with the total pro�it (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 pro�it.

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Questions:

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

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

Case: Kinsman Corporation

Kinsman Corporation, headquartered in Cleveland, is a highly diversi�ied company organized into autonomous divisions along product lines. The autonomy permits division managers a signi�icant 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 of�ice. Divisions are permitted cash for their normal operating needs, but all excess cash is transferred to the corporate home of�ice 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 pro�it and an investment base composed of �ixed 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 �ixed costs 480 490 500 180 210 240

Committed �ixed costs 250 300 375 150 215 260

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Apparel Division Sports Gear Division

2017 2018 2019 2017 2018 2019

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

Division net pro�it $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%

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 speci�ic 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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Learning Objectives

After studying Chapter 12, you will be able to:

Explain relationships among the costs of quality categories.

Understand the concepts of target costing and kaizen costing.

Distinguish between value-added and nonvalue-added activities.

Describe various types of non�inancial performance measures.

Identify non�inancial performance measures for multinational companies.

Comprehend the elements of a balanced scorecard.

Describe benchmarking techniques to improve productivity and quality.

12 Costs of Quality and Other CostManagement Issues

jacoblund/iStock/Thinkstock

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Explain strategies to enhance productivity such as downsizing and business process reengineering.

TQM and the Need to Measure Quality Costs

Pete Moss, considered the ace troubleshooter for DeKalb Fertilizer Company, was sent to its Georgia regional of�ice by “Big Dan” DeLion, president of DeKalb, about 15 months ago. What he found was “big trouble.” The region was losing about $400,000 per month—mostly from waste, low productivity, and customer warranty claims. Revenues were declining, and too many customers were unhappy. This was Spring 2018, long after Total Quality Management (TQM) was a cliché and a norm in most �irms. Yes, DeKalb had a TQM program that “Big Dan” had announced in late 2019. Signs had been posted about quality being “No. 1.” A consulting �irm had conducted seminars for workers, statistical control charts were maintained, and managers had increased inspections. Faster response to warranty claims had been implemented through a costly system to guarantee a 24-hour response to any customer problem.

Yet, productivity declined, scrap was up, and warranty costs soared. Workers saw the TQM program as a management project. Managers blamed much of the problem on the lack of union cooperation and of employee concern. No speci�ic quality goals were set. Everyone lacked a sense of urgency. Pete’s arrival brought a sudden change: meetings with line workers quickly pointed to key production problems, warranty claims were grouped to identify failure causes, landscape designers and on-site supervisors were brought together to analyze failures, and certain changes were made “overnight.” A goal of cutting scrap by 50% in three months was set.

At every step, the same question came up: “What’s this costing us?” Pete, knowing that this question was key at other plants, sought out Rose Bush, the plant cost accountant. Rose was in the middle of an ABC study and had begun to de�ine new activity centers and cost drivers. While not an easy task, Rose was able to modify her system rather quickly to identify quality costs: which, where, and how much. Pete and Rose became allies, promoting each other’s views to managers and employees alike. Within two months, Rose gave Pete a 2019 costs of quality analysis. These costs totaled a surprising 15% of revenues. Of this, little was spent on prevention, about 30% was spent on appraisal, nearly 45% went to �ixing internal failures, and the rest were external failure costs. Lost revenues because of bad product weren’t captured or estimated. In addition to many non�inancial quality measures, the quality cost reports helped Pete measure the impact of his recovery program.

Pete is now gone, off to another problem plant. The Georgia plant is now at breakeven. But the quality job is just now paying dividends. Rose’s latest costs of quality report shows total costs still high at 12% of revenues. But, the cost composition had changed already: 30% prevention, 30% appraisal, 25% internal failure, and 15% external failure. The target for 2021 was 10% of revenues with percentages of 40, 40, 15, and 5, respectively. Long-term goals are 6% of revenues and a percentage mix of 70, 20, 10, and 0, respectively. Incidentally, revenues are rebounding.

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In the last decade, the competitive environment has forced a changed and improved focus on every business. Heightened customer service expectations, development of integrated systems, demands for cost reductions, advances in information technology, access to international markets, and speed of competitor reactions have all increased the demands on managerial accountants for relevant and timely data for decisions. This chapter examines a set of the more important areas of change in managerial accounting. These topics are heavily in�luenced by international competitors, particularly the Japanese. Product quality and process improvement have allowed Japanese automakers, electronics �irms, and other consumer goods producers to capture major shares of international markets. Disciplined and team-oriented approaches brought market and �inancial success. Soon others, particularly U.S. �irms, began to adopt and adapt similar concepts and strategies. JIT, quality circles, and continuous improvement programs are examples.

In this chapter, we focus on several of these topics that have strong managerial accounting rami�ications. Speci�ically, measuring and monitoring quality costs are major parts of any total quality management program. Team approaches to design, costing, production planning, and process improvement have yielded huge dividends. These approaches have focused on linking customer needs to the design process, on identifying and eliminating any activity that does not add value to the product, and on organizing planning and control activities that truly measure performance. Many more topics could be included and more pages added on a weekly basis. Old accounting tools are redesigned, some are abandoned, and new concepts are tried and tested. The pace of change is exciting.

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12.1 Costs of Quality “Quality is free” is a favorite saying of many who argue for efforts to improve quality. It may be dif�icult to accept the concept that spending more on quality improvement efforts will lower costs. But the facts tell an exciting story:

Increased training of workers will reduce scrap and rework costs. Higher-quality products and services improve customer satisfaction and generate higher sales. Narrower control limits force improved processes and greater utilization of capacity. With reduced waste, more product can be generated with the same equipment and workers. “Designing in” quality prevents production problems and the need for engineering changes to create “�ixes.” An error of $1 in design can easily cause $10 in production problems. Empowering employees through quality circles and other participation techniques to give them control over quality-related production decisions increases total commitment. Employee satisfaction from eliminating rework, downtime, and scrap increases productivity and further commitment to improvement, particularly if the bene�its are shared with the employees.

These results reduce quality costs and, therefore, product costs. Quality efforts come in many forms and names, including:

Total quality management (TQM)—an integrated effort of training, process controls, incentives, employee empowerment, product engineering and design, supplier involvement, and customer satisfaction measurement to achieve quality goals. Statistical quality control—the use of statistical techniques on processes to measure, monitor, and evaluate performance based on goals, control ranges, and performance percentages. Continuous improvement programs—efforts to establish quality targets that represent improvement over current performance through worker involvement in evaluation processes. Quality control through the guidance of quality experts—speci�ic approaches to quality management promoted by internationally recognized leaders such as Deming, Juran, Crosby, and Taguchi.

All of these focus on management commitment to bringing about a change in attitude and changes in processes.

Methods vary, but all emphasize heavy management commitment to change. One Michigan �irm’s management, tired of customer complaints and nagging productivity problems, introduced an array of techniques to impress employees and managers with the need to work toward zero defects in its output. Every work station was made responsible for approving the quality of its work before sending it to the next station. When defects were detected, the entire line was halted, horns sounded, the problem diagnosed, and responsibility for the solution identi�ied. The initial result was that very little was shipped from that plant for nearly two weeks because of the nearly constant stoppage of the line. But within two months, productivity was above any prior period and continued to rise. The costs of the early stoppages were nearly fatal to the �irm, but the payoffs are substantial both internally and to customers, many of whom are automotive related and are using vendor certi�ication programs to promote quality, delivery, and cost goals, and to eliminate nonperforming suppliers.

Cost Categories

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Four categories of costs are commonly identi�ied. These categories are related and can be considered tradeoffs for each other. They, along with examples, are:

Prevention costs are incurred to prevent the production of products or services that do not meet speci�ications. As these costs increase, failure costs should decrease. These costs, often spent prior to production, include:

Job training Quality training

Supplier evaluation and approvals Preventive maintenance

Development of speci�ications and standards Promotion of quality

Employee quality circle teams New equipment to reduce waste

Design and process engineering

Appraisal costs are incurred to monitor and inspect production. These costs are intended to detect products or services that do not meet speci�ication during the production process. As these costs increase, failure costs should decrease. Included are:

Inspections of materials Quality control activities

Inspections during production Production testing

Inspections of �inished products Statistical quality control

Line personnel’s self-checking activities Calibration of test equipment

Internal auditing activities

Internal failure costs are incurred after defective or substandard product or service is detected but before it leaves the plant. These costs increase as the number of defective units detected increases. Included are:

Rework, retesting, and rescheduling Scrap

Lost production Downtime

Lost contribution margin on defective units* Increased inventory

* These items are measurable only by making estimates of external impacts and are rarely part of a costs of quality accounting report. They are the most subjective of all quality costs yet, perhaps, the most important in a strategic sense.

External failure costs are incurred when the defective product or service gets to the customer. These costs increase as customers �ind defective units and reject them. These costs include two important groups: costs of handling customer complaints and costs of future lost sales because of poor quality and customer dissatisfaction. Included are:

Repairs Logistics of returned units

Warranties (estimated and actual) Processing recall programs

Contribution margin on replacement units

Lost contribution margin from damaged product reputation*

Liability claims Complaint departments

Lost contribution margin from price reductions*

Product service departments

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* These items are measurable only by making estimates of external impacts and are rarely part of a costs of quality accounting report. They are the most subjective of all quality costs yet, perhaps, the most important in a strategic sense.

While these lists seem straightforward, much judgment goes into the typical quality cost analysis. If a person’s duties are part production and part inspection, what percentage should be considered to be quality costs? Each �irm must decide on its own de�initions. Also, as time passes, processes change, greater understanding of quality issues evolves, and accounting systems change. One danger behind this discussion is that an impression is created that cost measurement is precise and easily performed. Activity-based costing, special studies, and improved charts of accounts have certainly detailed the trail of costs.

Traditionally, these costs have been buried in other cost categories. Prevention costs are “lost” in administrative overhead. Appraisal costs are spread among the many locations. Internal failure costs show up in ef�iciency and quantity variances and allowances for “normal scrap.” External failure costs are selling and administrative costs or not captured at all. In many �irms, it takes a major effort to identify, measure, and track these costs with reasonable accuracy.

Prevention and appraisal costs are considered tradeoffs to internal and external failure costs. Thus, stronger training programs are viewed as important costs that help reduce internal and external failure costs. Also, a stronger appraisal program should reduce both internal and external failure costs. Yet, in the long run, spending on prevention costs may allow a company to reduce both failure costs and appraisal costs. Better-trained employees will produce much higher-quality products that require less testing and inspecting, a result of producing few if any defective units. Implicitly, failure costs fall to near- zero levels.

Diagramming Costs of Quality

Figure 12.1 illustrates the interaction of the four costs of quality categories. The horizontal, or x-axis, re�lects either a decreasing defect rate or an increasing quality assurance rate. As can be seen, an optimal cost level can be drawn. The presumption is that increased prevention and appraisal spending will lower failure costs (internal plus external). We must be careful not to oversimplify the relationships here. For example:

The optimal spending level can be drawn but can rarely be measured accurately. Also, this optimal level of spending implies that we should be satis�ied with this level of quality (defects). This static drawing of the four cost categories re�lects general trends but implies that they are equally important and are of approximately equal size. Rarely is this the case. The cost curves imply that cost functions can be de�ined quantitatively to allow these costs to be plotted at various levels of quality assurance. While cost relationships do exist, they are dif�icult to quantify accurately. Too often, managers assume that by merely spending money on quality prevention and appraisal activities their quality goals can be achieved. Some TQM programs have been successful and sustainable; many others have achieved neither their quality nor cost reduction goals.

Figure 12.1: Costs of quality

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Any manager or managerial accountant who advocates �inding the optimal spending and failure cost level and operating at that level fails to understand the interrelationships that exist. For example, prevention costs (i.e., training, education, and quality-enhancing investments) are in effect current investments in future defect reductions. More spending on training and vendor certi�ication programs, for example, should reduce internal and external failure rates in the future. A highly trained workforce should reduce the need for inspections in the future.

As an of�beat example of this idea, compare the teenage driver accident rate in the United States with Japan. In the U.S., most teenagers take a short driver’s training course with very limited coverage of driving laws, driver etiquette, and hands-on skill development. In Japan, compulsory driver education courses cost approximately $5,000 per person because of the amount of training required. Car accidents do occur but at a much lower level as compared to U.S. experiences. (To test the idea, survey your current class. Odds are that well over half of your fellow students have had an auto accident before they reached 20 years of age.) Japan has traded accident costs for training costs. Other social impacts must be considered; for example, many persons might not drive because they cannot afford the $5,000.

As a numerical example of Figure 12.1, assume that 100,000 units are produced with six possible levels of spending on prevention and appraisal efforts. The contribution margin is $10 per unit. Of the defects, 60% is detected internally; and 40% is discovered externally. All defects must be reworked at a cost of $8 per unit. External failures cause a loss of future sales at a ratio of three units of lost sales for each external defect found, or $30 of lost contribution margin for each external defective unit. All dollar and unit amounts are in thousands (adapted from Godfrey & Pasewark, 1988, p. 72).

Defect Rates

Prevention Costs

Appraisal Costs

Rework Costs Lost Contribution Margin

Units Costs Units Costs Total Quality

Costs

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Defect Rates

Prevention Costs

Appraisal Costs

Rework Costs Lost Contribution Margin

Units Costs Units Costs Total Quality

Costs

5.00% $100 $100 $8 × 5.0

$40 $30 × 2.0

$60 $300

3.50 120 80 8 × 3.5 28 30 × 1.4 42 270

2.25 140 65 8 × 2.25

18 30 × 0.9 27 250

1.25 160 55 8 × 1.25

10 30 × 0.5 15 240

0.50 190 50 8 × 0.5 4 30 × 0.2 6 250

0.10 240 48 8 × 0.1 0.80 30 × 0.04

1.20 290

To explain these numbers, the �irst row assumes that 5% of the 100,000 units produced is defective. Also, we are now spending $100,000 each on prevention and appraisal costs. It will cost $8 per unit to rework the 5,000 defective, units or $40,000. Lost contribution margin is found by taking the external failures (40% × 5,000 units) times the contribution margin of three lost units (3 × $10)—a lost sales cost of $60,000 in contribution margin. The total costs of quality are $300,000.

Based on these numbers, the managerial accountant would recommend that the current optimal cost level is $240,000. This assumes that we can quantify the relationship between higher prevention costs and lower defective percentages. It also assumes that appraisal costs can be reduced accordingly. Internal and external discovery rates for defective units and lost sales �igures are clearly estimates. Contribution margins and rework costs are reasonably solid data. This, however, is a static picture of quality costs. As time passes, these relationships will change, resulting in a new optimal spending pattern.

Continuous Improvement

Can any �irm be satis�ied with a static quality level? No! Markets are demanding higher and higher quality assurance levels. Japanese auto quality levels of the 1980s well exceeded U.S. capabilities. U.S. �irms now exceed those levels, but Japanese carmakers have moved to still higher levels. Competition demands continuous improvement.

Prior to the implementation of a TQM program, appraisal costs and combined failure costs will likely be very high. For example, the mix of quality costs at the start of a major quality effort in a machine manufacturer was:

Prevention costs 4.5%

Appraisal costs 41.7

Internal failure costs 53.4

External failure costs    .4 (excluding lost sales estimates)

Total costs of quality 100.0%

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Total costs were approximately 8% of total sales. As part of management efforts to get employee “buy in,” �igures were presented to show the impact on employee pro�it sharing if the percentage decreased to 6%.

As time passes, Figure 12.1 will be revised to re�lect improvements in quality and changed cost relationships. Movement will be toward higher quality assurance and lower defect levels. Cost patterns will shift from failure to prevention. Even appraisal costs may decrease as more con�idence is gained in the production processes. Figure 12.2 incorporates a sequence of Figure 12.1 diagrams and re�lects this change in patterns over a series of years.

Figure 12.2: Annual shifts in the total costs of quality line

A line linking minimum cost points should always be shifting downward and to the right. Whether the company is ever at the exact optimal point each year or month is questionable. But aggressive TQM programs have produced results following this pattern. As an illustration of the shifting cost patterns, a set of summarized biannual data from a �ilm studio appears in Figure 12.3. The data are in millions and include an approximate 10% increase in sales each year. De�initions of what costs belong in each category rests with company personnel.

Figure 12.3: Shifting patterns of costs of quality over time

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Notice that, at the start of the total quality management program, internal failure is the highest percentage category; two years later, appraisal costs are the highest percentage; and �inally, prevention costs become the highest percentage. Of particular note is the steadily declining percentage of quality costs to sales. While signi�icant reductions in these percentages are rather consistent, company management feels that the TQM program training effort is approaching a steady state. The forecast for 2021 shows a further dramatic decline in the costs to sales percentage and in total quality costs. These challenges have been met in the past, but the 2021 goal is particularly rigorous. Managerial and employee efforts will determine the result.

Sources of Costs of Quality Data—ABC and Customer Inputs

Most traditional costing systems will �ind it dif�icult, if not impossible, to collect the type of data needed for the preceding analyses. ABC has been a timely innovation. Activity centers that focus on quality issues (i.e., training, rework and scrap, inspections, and quality assurance program costs) can separate these activities and the resources they consume. Cost drivers can help identify relationships between failure costs and their causes. Thus, ABC increases the ability to identify quality costs, focuses attention on costly activities, and even helps recognize cause-and-effect linkages.

Many companies must extend even ABC data to capture more quality costs. This might include account analysis, discussed in Chapter 6. With certain costs, allocations may be needed, which introduce dif�iculties when measuring improvement. As improvements occur, costs must be reallocated, often introducing arbitrariness.

The tough measurement is still lost sales, part of external failure. Numerous �irms have made customer satisfaction surveys important and routine parts of their marketing, service, and product planning and design functions. Quality councils have included both suppliers and customers to add critical external views of internal quality levels and efforts. In the past, lost sales estimates were only vague guesses, but greater articulation of customer and potential customer inputs can push this �igure toward a more valid estimate.

Service Applications

While TQM programs are often linked to manufacturing and its quality, service organizations also �ind quality just as critical to customer satisfaction and to their long-term survival. The same categories of costs of quality apply to all organizations. Xerox, for example, has developed signi�icant quality programs for its manufacturing, sales, and service activities. Training to increase service employee competence, to improve interactions with customers, and to raise the quality of services provided is similar to

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manufacturing tradeoffs. The focus is more heavily on customer satisfaction since providing the service, in many cases, is at the customer contact point. Lost sales, service reputation, and attributes such as “friendliness” are dif�icult to measure in a �inancial context. Yet, measuring costs of improving and sustaining quality and of eliminating service failures is critical. Hospitals, for example, have an obvious need for high levels of quality control activities. Monitoring quality costs, while important, becomes secondary to the need for assuring extremely high levels of operating quality regardless of cost. Yet, because of huge increases in health care costs, national health care policies will require measuring and analyzing operating costs, including costs of quality.

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12.2 Cost Management in Design and Production Stages Companies have traditionally emphasized cost management in the product production phase, while neglecting the design and development stages. Managers now recognize that most of the costs incurred in the production stage are, in fact, determined in the design and development stages. Accordingly, many companies are adopting target costing, a system initiated in Japan, to manage costs in the design and development stages for new (or redesigned) products. Another Japanese system known as kaizen costing is used to manage costs in the product manufacturing stage.

Target Costing

Historically, U.S. manufacturers have set their pricing strategies by adding required pro�it margins to the costs of already designed products. Target costing reverses this process. After a target selling price and a target pro�it are established, an allowable cost consistent with these targets is obtained for the product. The company then designs the product based on the allowable (target) cost. Figure 12.4 compares the target costing approach to the traditional approach.

Figure 12.4: Target costing compared to the traditional approach

In target costing, the process begins with a general plan to produce a product based on marketing research. This marketing research also suggests a target selling price by estimating what consumers will pay for the product. The company then determines the amount of pro�it that would be expected by management for this product. From this target price and target pro�it, a target cost is obtained:

Target cost = Target selling price – Target pro�it

This overall target cost is then decomposed into speci�ic cost elements for materials, subassemblies, direct labor, various manufacturing overhead categories, and various nonmanufacturing categories such

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as distribution and customer service. Finally, the design department establishes a blueprint according to the target cost for each element.

As an example of the target costing approach, suppose that Lylatove Sleepwear is considering the production of a new line of pajamas. Based on preliminary market research, management has decided that each pair of pajamas should be priced at $20. Furthermore, management believes that the pro�it margin should be 12% of sales revenue. Hence, the target pro�it would be $2.40 (0.12 × $20). The target cost, therefore, would be $17.60 ($20 – $2.40).

Kaizen Costing

Kaizen costing is a system to support cost reduction beyond the design and development stages. “Kaizen” is a Japanese word that refers to “continuous accumulations of small betterment activities rather than innovative improvement” (Monden & Hamada, 1991, p. 17). Innovative improvements are usually introduced in the design and development stages. In kaizen costing, the actual cost for the previous period becomes the kaizen cost target for the current period. To promote continuous improvement, these kaizen cost targets must be reduced in each successive period. For instance, suppose a company’s shipping costs are $10,000 for 2020 and that its kaizen cost reduction targets are 3% per year for the next two years. So, for 2021, its kaizen cost target would be $9,700 (.97 × $10,000), and for 2022, it would be $9,409 (.97 × $9,700).

These techniques have allowed many Japanese �irms to overcome the effects of the increased value of the yen in international markets. Lower costs and improved products have offset less competitive yen exchange rates.

To achieve cost reduction, many companies are adopting an activity-based management (ABM) approach. ABM is an outgrowth of activity-based costing (ABC) that emphasizes management of activities through ABC, activity analysis, and performance measurement. We discussed ABC in Chapter 4; the latter topics are discussed in the following sections.

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12.3 Activity Analysis Companies are monitoring their activities to assess which activities add value to the customer, which, in turn, should add pro�it to the company. This technique is referred to as activity analysis. An emphasis on activities can help identify nonvalue-added costs and eliminate the activities that cause them. Any resource-using activity that does not add value is often called waste. Having value implies that a consumer would be willing to pay for the results of the activity. A key goal of production managers is to eliminate waste and, thereby, to have an ef�icient and productive operation.

Time is perhaps the most valuable resource. Study of nonvalue-added time in operations takes �ive forms: process time, inspection time, move time, wait time, and storage time.

Process time is the time during which a product is undergoing conversion activities that transform raw materials into �inished products. Although most people view process time as the sum of many value- added activities, the presence of inef�iciency or other nonproductive activities represents nonvalue- added time. Managers must continually review processes to catch inef�iciencies that can creep in over time.

Just-in-time (JIT) production concepts are fundamental building blocks for reducing process time. Many companies have physically reorganized their factories to encourage faster process time. Figure 12.5 compares a JIT layout to a traditional factory layout. The traditional plant has large inventories, much materials movement within the plant, and a mixing of fabricating and assembly tasks. The JIT plant produces only when parts and products are needed, carries low amounts of inventories, has a north-to- south �low of production, and organizes production around product families (similar production requirements). The implication is that greater output can be achieved with the same equipment, people, and space—waste is reduced.

Figure 12.5: Traditional factory versus just-in-time factory layouts

Inspection time is the amount of time spent ensuring that the product is of high quality. Typically, materials and components are inspected upon arrival. Then inspection occurs at various points during and at the conclusion of the production process. It is dif�icult to determine whether inspection

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procedures result in nonvalue-added costs without detailed knowledge of the production technology and inspection procedures. However, many companies are striving to reduce the costs of maintaining product quality and are working virtually to eliminate the costs of reworking defective products. Consequently, zero defects and total quality control programs sensitize employees to the need for eliminating spoiled and defective units. The argument is that quality is built into and not inspected into the product. Unless otherwise stated, we presume that inspection is a nonvalue-added activity.

Move time is the time spent moving raw materials, work in process, or �inished products between operations within the plant. This includes the activities associated with receiving materials, moving them into storage, moving materials and components to the �irst production operation, moving partially completed products from one work center to the next, and moving the completed product to the �inished goods storage area to await shipping. Many companies refer to these activities as materials-handling operations. Move time is a nonvalue-added activity. A certain amount of move time is necessary in any production process, but proper sequencing of operations and tasks and implementing automation technologies can signi�icantly reduce move time. Figure 12.5 illustrates the importance of an ef�icient �low through the factory to minimize materials movement.

Wait time is the amount of time that materials or work in process spend waiting for the next operation. This includes the time that materials, components, and partially completed products remain in queues immediately preceding an operation and in holding areas located near each department waiting for the next production operation. Wait time potentially represents a signi�icant nonvalue-added cost. A company’s working capital is tied up in work in process, and space is unnecessarily wasted on numerous production queues and holding areas. Even in the simple diagrams in Figure 12.5, we see that space released from having inventory wait for the next production step can be used to expand production. The ultimate goal of the JIT philosophy is to eliminate wait time completely. Companies using JIT systems have proven that remarkable reductions in in-process inventories can be made. For example, a car assembly plant producing 70 cars per hour may have less than one hour’s supply of car seats in the plant at any time. When a car begins its two-hour trip along an assembly line, an electronic message is received in a supplier’s seating plant to trigger assembly of that car’s seats. The seats are built and delivered to the car assembly line minutes before the car arrives at the seat installation point.

Storage time is the time during which �inished products are held in stock before shipment to customers. It includes the time products spend in storage and the time spent packaging the products for shipment. Traditionally, companies have stored large inventories of �inished products to avoid stockouts. Similar to waiting time, storage time ties up a company’s working capital in inventories and requires large amounts of space devoted to storage activities. While not applicable to all manufacturing operations, produce-to- order is a goal—manufacture products only after a sales order is received. Improvements in order entry systems and shortened lead times in production scheduling can give the appearance of a produce-to- order operation.

The time required for an average unit to go from the beginning of the production process to completion and shipment is often referred to as throughput time. This time is equal to productive processing time plus nonvalue-added time. More speci�ically, it is the sum of all �ive activities previously discussed: process time, inspection time, move time, wait time, and storage time. Suppose that the manufacturing of a particular cellphone began at 9 a.m. It spent two hours on the various assembly lines and another 15 minutes of inspection. In addition, there were three moves between assembly lines and two moves involving storage areas, all totaling 20 minutes. The phone spent a total of 30 minutes waiting at four different work stations before work was initiated in those areas. Before shipment to the customer, the

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phone was stored in the warehouse for three hours. The throughput time amounts to 6.08 hours (2 + .25 + .33 + .5 + 3).

Contemporary Practice 12.1: Activity Analysis at Caterpillar’s Marketing & Product Support Division (MPSD)

The activity-based management process starts by “searching for low- and no-value activities within each of�ice process to eliminate or signi�icantly reduce the cost of these activities. It ends by identifying the supply source for each of�ice process. For MPSD, this meant examining the core competencies of its global operations, deciding what to keep doing internally and what to source from outside vendors. . . . Because Caterpillar has locations around the world, MPSD was able to address the services it provided to both internal (other Caterpillar divisions) and external (dealers and customers) organizations to leverage the global footprint by taking ABM-optimized processes and sourcing them where it made the most sense to provide each service.”

Source: DeFreitas, D.G., Gillett, J.W. & Fink, R.L. (2013, January). Getting lean and mean with Caterpillar with ABM. Strategic Finance, 24–33.

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12.4 Non�inancial Performance Measures As changes occur in the operating environment, traditional measures of performance are being reexamined. New measures are being adopted to better �it the concepts of activity-based management. In addition, accountants are measuring performance in new areas of operations, areas that have normally been outside of the accountants’ domain or are new because of needs that innovative and automated environments create. This section gives a glimpse of some of the critical changes taking place.

Accountants have traditionally focused on �inancial measures of performance, such as variations from budgeted or standard costs. Such measures are still important, but a broader evaluation including non�inancial measures is necessary. For example, physical measures such as throughput time, value- added labor ratio, and defective product rates are playing greater roles in helping managers achieve high-quality and competitive operations. Let’s look at some non�inancial performance measures that are commonly being used.

Measures of Manufacturing Productivity

Increasing pressure from global competition has caused many companies to focus on better measures of productivity. Traditionally, accountants have associated productivity with variances calculated for quantity, ef�iciency, mix, yield, and capacity. The goal was cost minimization. Other productivity measures commonly used were nothing more than quantities of output divided by quantities of input. Today, we are looking for more detailed, meaningful measures. Activity-based costing can pinpoint high-cost activities. Engineers can design for greater production ef�iciency and defect elimination. For example, a machine manufacturer might determine the number of machines produced per day per employee. A car assembly operation might ascertain the square footage required per day per car. An electrical generating plant might keep track of the tons of coal required to generate a thousand kilowatt-hours of electricity. The measures are oriented toward speci�ic activities and evaluate management control over these activities.

Manufacturing cycle ef�iciency (MCE) is a measure of the amount of throughput time that consists of process time. It is the following ratio:

Remember that throughput time is the sum of process time, inspection time, wait time, move time, and storage time. Assuming that inspection time is nonvalue-added time, then MCE measures the portion of throughput time which is value-added time. The goal is to have MCE as high as possible, with 100% as the theoretical ideal.

Another widely used productivity measure is the �irst-pass yield. This measures the percentage of nondefective items that have gone through the production process one time only (i.e., without needing any rework).

Computer-integrated manufacturing (CIM) is an attempt to optimize the entire plant’s production by planning which departments will produce which parts and products, in what order, and when. Formerly, each department’s ef�iciency was measured, and keeping all departments running at full speed was the goal. Now in CIM, certain departments may be idled until their resources are needed. This is “pull

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through” production and part of the JIT philosophy. Produce only what is needed immediately. Performance measures must therefore evaluate a unit based on its production assignment, not necessarily its capacity. Responsibility for productivity is now moved to higher management levels and away from the individual activity center or cost center manager.

Productivity of Labor

The total labor expended for the bene�it of a product or service is segregated into direct and indirect labor. Direct labor is all labor that can be speci�ically identi�ied with a product or service in an economically feasible manner. Value-added direct labor is that portion of direct labor that changes raw materials into a �inished product or service that is delivered to a customer. For example, value-added direct labor fabricates, assembles, and �inishes products. Nonvalue-added direct labor moves, inspects, stores, examines, or otherwise handles the products without adding customer value. Indirect labor is labor that is not readily traced to a product or service. Indirect workers supervise, repair, manage, purchase, inspect, record, advise, or otherwise support the direct workers. Traditionally, indirect workers are considered nonvalue-added labor. In labor-intensive activities, one measure of performance for labor is the value-added labor ratio or ratio of value-added time to total time:

The ratio also may be computed in terms of number of employees or payroll. One goal is to reduce the number of supervisors, managers, clerical staff, accountants, engineers, inspectors, and all others that are nonvalue-added workers. This is part of empowering workers to work as teams and to assume responsibility for production.

In many operations, direct labor is being replaced by automated equipment, and indirect labor now includes technicians needed to program, set up, and maintain the equipment. Often, the distinction between direct and indirect labor is blurred or eliminated. Team approaches to production (work units or product family cells as shown in Figure 12.5), guaranteed wage labor contracts, and broader job classi�ications have further eroded the importance of direct labor as a cost group. A labor-related performance measure that does not distinguish between direct and indirect labor is the percentage of total labor cost in the total product cost, called the labor content percentage:

The goals are to reduce this percentage and to increase the productivity of all labor dollars.

Product Quality

Earlier in this chapter, we discussed �inancial measures of product quality. Costs of quality enable us to aggregate various aspects of quality by using a common unit of measure—dollars. Furthermore, costs of quality allow us to assess the impact of quality on the company’s pro�its. However, knowing the costs of quality does not enable us to pinpoint speci�ic sources of quality problems. To diagnose and correct speci�ic problems relating to quality, we need a variety of non�inancial measures of quality.

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Four categories of non�inancial measures are helpful in assessing and maintaining quality. The �irst, customer acceptance measures, focuses on the extent to which a company’s customers perceive its product to be of high quality. It includes such measures as counts of customer complaints, warranty claims, incidence of failures at customer locations, products returned, and repeat sales.

Design quality assesses how well a product has been designed. Frequency of engineering change orders is an important measure of design quality. Other measures include the number of parts in the product and the percentage of common versus unique parts. Since simplicity is desirable; the fewer the number of parts and the higher the percentage of common parts, the better the design quality.

In-process quality measures look at product quality during production. Rework, defects, and scrap measures are used to keep these items to a minimum. Products are also selected for testing at random, or statistically sampled during the various stages of production. Defect rates are measured, and corrective actions speci�ied.

A fourth area of quality measurement relates to purchased materials and parts. Pressure is on purchasing agents to acquire high-quality inputs to meet materials requirements at low costs and on a timely basis. Common vendor performance measures include percentage of defects in the delivery (in terms of dollars as well as number of items), percentage of orders �illed, and percentage of orders delivered on time. Many companies are now computing an overall rating of suppliers based on the quality of their materials, delivery performance, and customer service. Also, waste, scrap, and defects occurring during production that are traceable to materials are identi�ied with speci�ic suppliers. A growing number of companies now have vendor certi�ication programs, where managers may purchase from only those vendors who have met the company’s quality standards.

Inventory Reduction

Inventory investments, ordering costs, and carrying costs often include signi�icant amounts of nonvalue- added costs. To remain price competitive, effort is necessary to reduce or eliminate inventories. Many companies use an approach called economic order quantity, which utilizes a mathematical formula to minimize the total costs of ordering and storing inventories. The JIT philosophy focuses on keeping inventories at low or zero levels for materials and parts at every stage of production. Therefore, inventory control measures are used to minimize nonvalue-added costs. Such measures may include average inventory values, average time various categories of materials are held or inventories are standing in a production operation, and inventory turnovers (cost of goods sold divided by average inventory). Measures like manufacturing cycle ef�iciency also relate to inventory reduction because nonprocessing time—inspection, move, wait, and storage times—is much of the reason why inventories exist.

Machine Maintenance

If our efforts to reduce inventories are successful, we shift our focus to the company’s capability of producing goods quickly. We must keep production equipment and machinery operating. Therefore, performance measures will look at unscheduled machine downtime, equipment repair time, tooling turnaround time, engineering change time, machine availability, and adherence to maintenance schedules. Some companies even make a distinction between bottleneck and nonbottleneck machinery. A bottleneck operation is one that limits the production capacity of the entire facility. It is vital that the machinery in bottleneck operations be available 100% of the time, excluding time for routine required

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maintenance. Managing bottleneck operations has received considerable attention in recent years and has become a central component of a management philosophy known as the Theory of Constraints. This philosophy emphasizes planning around constraining factors and working to relax the constraints.

Delivery Performance

As a �inal point, assume that we have done a super job of reducing many nonvalue-added activities and eliminating others. Still, we are not successful until quality products are delivered on time and at the right place to the customer. This is especially important for customers who have JIT systems.

Some companies have a goal of �illing 100% of their orders on time. Common measures of delivery performance include the percentage of orders �illed, the percentage of on-time deliveries, and the average time between the receipt of a customer order and the delivery of the goods. Monitoring customer backorders also tells how many orders were not �illed from stock or on time and how long a customer had to wait for an order. A desirable piece of information often impossible to measure is business lost because of delivery failure. Many managers believe that the “competitive ballgame” is won or lost with product quality and delivery performance.

In Figure 12.6, we summarize the non�inancial performance measures previously discussed.

Figure 12.6: Summary of non�inancial performance measures

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12.5 Non�inancial Measures for the Multinational Company Multinational companies are increasingly using non�inancial performance measures in evaluations. Common ones for international operating units are:

1. Increasing market share and market size 2. Relationship with host country government 3. Quality assurance 4. Productivity improvement 5. Customer development 6. Innovation 7. Cooperation with other company units and the parent 8. Environment compliance 9. Employee training and development

10. Employee safety 11. Labor turnover 12. Community service

Notice that for some of these measures a company will have dif�iculty attaching numerical values. These measures are very important in comparing performances, particularly over time and against planned target levels.

The implication is that the corporate of�ice is in close touch with the international operation, can assess budget and planning targets astutely, and can link successful performance in the local environment with global economic goals of the corporation.

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12.6 Balanced Scorecard Many companies are integrating �inancial and non�inancial performance measures into a tool that has become known as a balanced scorecard. Historically, companies’ operational and management control systems have been built around short-term �inancial measures that have not been linked to long-term strategic objectives. A balanced scorecard attempts to overcome this de�iciency by using a set of performance measures that serve to link a company’s long-term strategy with its short-term actions. The scorecard communicates the long-term strategy to all levels of the organization so that both departmental and individual objectives are aligned with the company’s goals.

Typically, a balanced scorecard consists of the following four categories of performance measures:

Financial—measures that describe economic consequences and are of most interest to shareholders. Customer—measures that relate to the customer’s perspective and to the market segment in which the company competes. Internal business process—measures that describe the internal processes (i.e., the means) needed to provide value for customers and shareholders. Learning and growth—measures that de�ine the capabilities needed to create long-term growth and innovation.

A balanced scorecard is not simply a collection of performance measures. These measures are derived from the company’s mission, strategy, and objectives and represent a balance among the four measurement perspectives. In the �inancial category, the strategic themes often include revenue enhancement, cost minimization, and asset utilization. Examples of these �inancial measures, as well as measures for the other three categories in the balanced scorecard, can be found in Figure 12.7. Strategic themes for the customer category often include market share growth, customer retention, customer acquisition, and customer satisfaction. In the internal business process category, the strategic objectives relate to increasing the ef�iciency and effectiveness of operations. The objectives for the learning and growth category relate to the ability to innovate and improve.

Figure 12.7: Examples of measures in a balanced scorecard

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The frequency of measurement varies depending on the type of performance measure. For instance, operating measures such as machine downtime or percentage of orders �illed may be measured daily. Other operating measures such as manufacturing cycle ef�iciency or amount of rework may be measured weekly. Yet others such as inventory turnovers and number of warranty claims may be measured quarterly. Some measures such as economic value added (EVA) and number of new products introduced may be measured annually. Generally, non�inancial measures are reported more frequently than �inancial measures.

As a result of introducing the balanced scorecard, some companies have reduced their emphasis on short-term incentive compensation systems. Instead, they are linking bonuses to balanced scorecard measures. One particular oil company decided to base 60% of its executive bonuses on the achievement of targets relating to four �inancial factors: return on capital, pro�itability, cash �low, and operating cost. The remaining 40% is based on indicators of customer satisfaction, dealer satisfaction, employee satisfaction, and environmental responsibility (Kaplan & Norton, 1996).

Contemporary Practice 12.2: Balanced Scorecard at Store24

“Store24 is a privately held convenience store retailer in New England. . . . Store24 used a balanced scorecard-based performance measurement system. The company collected information on a variety of performance measures at various levels of the organization and at various frequencies. Management collected store-level �inancial performance metrics quarterly. It monitored store-level customer measures less frequently.”

Source: Campbell, D., Datar, S.M., Kulp, S.L., & Nayayanan, V.G. (2015). Testing strategy with multiple performance measures: Evidence from a balanced scorecard at Store24. Journal of Management Accounting Research, 27(2), 39–65.

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12.7 Benchmarking To improve both quality and productivity, many companies are turning to benchmarking. This technique identi�ies activities as standards (“benchmarks”) by which similar activities should be judged. Simply put, it is a process of �inding better practices. Benchmarking can be done with internal sources—other parts of the company—or with other companies, including competitors. The external candidates are often obtained by examining lists of companies cited in trade and business journals for excellence in their business practices.

Aside from trade and business publications, performance benchmarks can be gathered from electronic databases, professional conferences and trade conventions, commissioned studies, and site visits to companies. Benchmarking utilizes both �inancial and non�inancial performance measures. But this information says nothing about the changes needed to improve quality and ef�iciency. Therefore, those doing the benchmarking must also obtain an understanding of these “best practices” so that they can implement them in their own organizations.

To promote ethical benchmarking, the International Benchmarking Clearinghouse and the Strategic Planning Institute Council on Benchmarking have adopted a common Code of Conduct. These rules of conduct cover such areas as:

Legal matters (e.g., collusion to restrain trade) Integrity Con�identiality Proper use of information and names Contacting policies Preparation for benchmarking

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12.8 Strategies to Enhance Productivity To achieve gains in productivity, many companies have turned to various strategies in recent years. Two of these strategies are downsizing and business process reengineering.

Downsizing

For many companies, particularly in service industries, a major portion of costs are labor-related costs. These include not only the wages and salaries of employees but also fringe bene�its and overhead costs to support labor such as telephone expenses and of�ice space. Thus, when companies look to reduce costs and improve ef�iciency, a prime candidate becomes the reduction of their work force. This phenomenon, sometimes referred to as downsizing, can involve outsourcing one or more functions, consolidating certain functions, initiating across-the-board cuts in personnel, or eliminating business segments such as product lines or geographical territories.

While downsizing may reduce costs and improve ef�iciency in the short run, it can harm the company’s long-run competitiveness and well-being. Remaining employees sometimes become overburdened, making more mistakes and declining in productivity. Morale suffers. Employees fear for their jobs, and company commitment takes a back seat to personal interests. Therefore, if downsizing is deemed necessary, it must be done with extreme care.

Often, downsizing is accompanied by fundamentally changing the way a company operates. This strategy is called business process reengineering.

Business Process Reengineering

A business process is a series of activities that are linked to perform a speci�ic objective. Business processes include both manufacturing as well as nonmanufacturing processes such as purchasing materials or handling customer inquiries and complaints. Business process reengineering (BPR) refers to changes made in management, organizational structure, and work practices to achieve signi�icant improvements in quality, cost, speed, and service. BPR is not merely a marginal changing of processes; rather, it involves major restructuring of organizational forms, management procedures, job descriptions, work �lows, control systems, and organizational cultures.

One of the main principles of BPR is to organize work around processes and outcomes rather than around tasks and departments. Instead of having a specialist for each separate task, one person or group is responsible for an entire process. This has led to the replacement of functional departments like sales and production with interdisciplinary teams that focus on performing an entire process. For instance, at IBM Credit Corporation, the credit approval process formerly involved �ive different individuals. Credit requests were forwarded to someone to check the applicant’s credit, then to another person to set the interest rate, and so on. IBM Credit reengineered this process so that one individual, called a deal structurer, completely processes an application.

Ethical Considerations

Enhancing productivity via downsizing or business process reengineering can be traumatic for individuals in the organization. Therefore, management must be careful to conduct these changes in an ethical manner. A key consideration should be to communicate the changes in an honest way. Decisions

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as to who gets terminated and how it is done can be subject to serious abuses. Those whose job duties are changed should be properly informed about new expectations and should be trained adequately for their new roles.

Major downsizing or business process reengineering can sometimes affect entire communities. Such is often the case with plant closings. Should management consider the impact of a plant closing on the welfare of the surrounding community? Many people believe that there is an ethical responsibility to do so.

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Summary & Resources

Chapter Summary The focus on quality has caused the analysis of the costs of quality to become an important managerial task. These costs are broken into four components: prevention, appraisal, internal failure, and external failure. Often it is dif�icult to de�ine these costs clearly. The goal is to reduce total quality costs. Often this is done by increasing prevention and appraisal costs to reduce or nearly eliminate failure costs. ABC systems have aided the measurement and reporting of these costs signi�icantly. Quality costs and documentation are the management accountant’s responsibility.

Recognizing that most costs of production are determined when products are developed and designed, many companies are turning to a technique known as target costing. After a target selling price and a target pro�it are established, a target cost is obtained for the product. The company then designs the product based on the target cost. To promote continuous improvement in the manufacturing stage, kaizen cost targets are reduced in each successive period.

Activity analysis involves reviewing activities and eliminating those that do not add value to the product. Throughput time is composed of process time, inspection time, move time, wait time, and storage time. The most common place to look for nonvalue-added activities is in inspection, move, wait, and storage time.

Traditional measures of performance are being reexamined. New measures are being adopted to better �it the concepts of activity-based management. These are largely non�inancial measures relating to manufacturing productivity, labor productivity, product quality, inventory reduction, machine maintenance, and delivery performance. Many companies are beginning to integrate non�inancial measures with �inancial measures into a balanced scorecard. Companies are also benchmarking their performance against best practices from other organizations. To achieve gains in productivity, many companies have turned to strategies such as downsizing and business process reengineering.

Key Terms

activity analysis Monitoring activities to assess which activities add value to the customer, which, in turn, should add pro�it to the company.

appraisal costs Costs of quality that are incurred to monitor and inspect production.

balanced scorecard A tool that integrates �inancial and non�inancial performance measures.

benchmarking Comparing operations, costs, and productivity with world-class performers.

business process reengineering (BPR) Changes made in management, organizational structure, and work practices to achieve signi�icant improvements in quality, cost, speed, and service.

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continuous improvement programs Efforts to establish quality targets that represent improvement over current performance through worker involvement in evaluation processes.

downsizing Removing entire layers of management to make the organization “lean and mean.”

economic order quantity A technique that utilizes a mathematical formula to minimize the total costs of ordering and storing inventories.

external failure costs Costs of quality that are incurred when the defective product or service gets to the customer.

�irst-pass yield The percentage of good product that passes through the production process without needing rework.

inspection time The amount of time spent ensuring that the product is of high quality.

internal failure costs Costs of quality that are incurred after defective products or services are detected but before they reach the customer.

kaizen costing A system to support cost reduction after the design and development stages. The actual cost for the latest period becomes the kaizen cost target for the current period.

labor content percentage Total labor costs expressed as a percentage of total product costs.

manufacturing cycle ef�iciency (MCE) A measure of what part of throughput time consists of process time.

move time The time spent moving raw materials, work in process, or �inished goods between operations.

prevention costs Costs of quality that are incurred to prevent the production of products or services that do not meet speci�ications.

process time The time during which the product is undergoing the conversion activities that transform raw materials into �inished products.

statistical quality control The use of statistical techniques on processes to measure, monitor, and evaluate performance based on goals, control ranges, and performance percentages.

storage time

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The time during which materials, partially completed products, or �inished products are held in stock before further processing or shipment to customers.

Theory of Constraints A philosophy that emphasizes planning around constraining factors and working to relax the constraints.

throughput time The time it takes for an average unit to go from the beginning of the production process to completion and shipment.

total quality management (TQM) An integrated effort of training, process controls, incentives, employee empowerment, product engineering and design, supplier involvement, and customer satisfaction measurement to achieve quality goals.

value-added labor ratio The ratio of value-added time to total time.

wait time The amount of time that materials or work in process spend waiting for the next operation.

Problem for Review The following accounts were listed among the chart of accounts for Arbiser Machine Tooling:

Warranty Repairs Supplier Training and Certi�ication Programs Cost Accounting Salaries Engineering Design Reviews Customer Returns and Allowances Scrap Depreciation on Machinery Final Product Testing Rework Time Planned Machine Maintenance Emergency Machine Repairs Purchased Materials Inspection Direct Labor

Question:

Classify these accounts according to the appropriate costs of quality category: prevention, appraisal, internal failure, or external failure. Not all accounts will be included.

Solution:

Prevention costs:

Supplier Training and Certi�ication Programs Engineering Design Reviews

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Planned Machine Maintenance

Appraisal costs:

Final Product Testing Purchased Materials Inspection

Internal failure costs:

Scrap Rework Time Emergency Machine Repairs

External failure costs:

Warranty Repairs Customer Returns and Allowances

Cost Accounting Salaries, Depreciation on Machinery, and Direct Labor may include elements of quality costs, but they are not normally considered costs of quality accounts. If quality costs are included in these accounts, they should be segregated by creating new expense accounts to track these costs directly.

Questions for Review and Discussion 1. Identify four categories of costs of quality. Give an example of each. 2. Greg Orian, Controller of Calendar Creators, sees the four categories of costs of quality as

substitutions for each other. Explain why he might believe this. 3. Why might the task of measuring, reporting, and analyzing costs of quality be dif�icult? Can these

costs be easily benchmarked across �irms? Explain. 4. Discuss the possible linkage between monitoring quality by measuring quality costs and by using

non�inancial measures of quality performance. Comment on which is most important. 5. For most �irms, is it possible to eliminate failures and, therefore, failure costs? Is it possible to

push total quality costs to zero? Explain. 6. How is target costing different from the traditional approach of setting costs and prices? 7. What is meant by the term “nonvalue-added costs?” Provide three examples. 8. Explain the value-added labor ratio. 9. Why are non�inancial measures of quality needed in addition to costs of quality?

10. Describe the four types of non�inancial measures related to product quality. 11. What are the common external sources for obtaining performance benchmarks? 12. Explain business process reengineering.

Exercises 12-1. Costs of Quality Categories. The following accounts and their costs are from Kessler Textiles.

Customer design veri�ication $ 5,000

Machine testing after machine setup 10,000

Employee training 40,000

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Raw materials testing 12,000

Scrap loss net of scrap sales 30,000

Materials reprocessing 28,000

Customer complaints and returns 40,000

Final product testing 20,000

In-process inspection 45,000

Routine machine maintenance 25,000

Nonroutine machine repairs 50,000

Discounts for missed delivery dates 33,000

Price reductions for product quality downgrades 68,000

Idle labor—downtime due to machine repairs 37,000

Questions:

1. Classify these costs by the four costs of quality categories. 2. If sales were $4,600,000, show the costs of quality as a percentage of sales for each category and

in total.

12-2. Costs of Quality Trends. Haber & Blass, an architectural �irm, recently studied its costs over the past three years. The partners of the �irm have been promoting total quality management programs to its clients for years. They �inally decided to apply the same concepts to their own business. After much discussion, they adopted certain de�initions of quality costs and began to monitor them. They did acknowledge that internal failure costs also included costs of nonvalue-added activities that were not technically failure costs. Now, three years later, they show the following data as highly summarized results of their efforts.

2019 2020 2021

1st Half 2nd Half 1st Half 2nd Half 1st Half 2nd Half

Prevention costs $ 5,000 $ 20,000 $ 50,000 $ 60,000 $ 50,000 $ 55,000

Appraisal costs 40,000 60,000 65,000 70,000 72,000 70,000

Internal failure costs 120,000 130,000 120,000 123,000 110,000 105,000

External failure costs 43,000 30,000 25,000 26,000 18,000 15,000

Client billings have gone up modestly over the three years, perhaps 20% in total.

Questions:

1. For each cost category and each time period, determine its percentage of total costs for that time period.

2. Comment on the changes over the three-year time period and the results of the three-year effort.

12-3. Analysis of Quality Costs. Goldin Realtors has reported the following data for 2020:

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Prevention costs $374,000

Appraisal costs 615,600

Internal failure costs 651,400

External failure costs 27,100

Question:

Comment on the following thoughts:

a. Prevention and appraisal spending has eliminated nearly all customer quality problems. b. More should be spent on prevention to even the spending among the three internal cost

categories. c. A goal of reducing costs in each category by 10% (or by some speci�ic dollar amount) should be

set in next year’s pro�it plan. d. A good job has been accomplished if the sum of the four costs as a percentage of sales declines

somewhat.

12-4. Classifying Costs of Quality. Paul Miller, controller of Meta Medical, has reviewed the costs of quality records for the past year. Meta Medical provides calibration and maintenance services for sophisticated medical equipment in the Midwest. Training, testing, and service calls are major costs that seem to grow each year. Miller is trying to measure possible ways of reducing the total costs of quality as part of a review of all processes and activities within the �irm. He assembled the following costs.

Parts warranty, including replacement labor $ 92,000

Emergency trips to service client machines 86,000

Rental of substitute equipment to cover client downtime 43,000

Training of repair technicians (time and travel) 196,000

Inspection of �inished repairs 45,000

Testing and certi�ications of calibration equipment 15,000

Development of client testing processes and diagnostics 31,500

Miller is aware of two contracts that were cancelled this past year because of client complaints about poor service response. These contracts totaled $60,000.

Questions:

1. Classify these costs according to prevention, appraisal, internal failure, and external failure. 2. Comment on the dif�iculty that Paul Miller likely has in analyzing these and other costs that might

be costs of quality.

12-5. Target Costing. Janet Harris, general manager of Banks Bus Service, is considering adding a new route. Based on preliminary market research, she has decided that the fare should be $3.50.

Question:

If the company’s pro�it margin is 20% of revenues, what should the target cost be?

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12-6. Kaizen Costing. In 2019, Heights High School incurred the following costs in its athletic department:

Event Cost per Event

Track meet $600

Swim meet 950

Soccer game 820

Water polo match 980

The school has recently begun a system of kaizen costing. Accordingly, the principal, Janet Orr, has asked Jim Nasium, the head of the athletic department, to reduce costs by 2% each year for the foreseeable future.

Question:

Assume that Jim Nasium reduces costs according to the plans set by Janet Orr. Compute the projected kaizen cost targets in 2023 for each of the preceding events.

12-7. Value-Added and Nonvalue-Added Activities. Loretta Love Clothiers manufactures denim jeans in a process that passes through three departments. The output of each department is immediately transferred to the next department to await further work. Output from the last department in the process represents the completed product, which goes to �inished goods inventory to await shipping. Speci�ically, dyed denim cloth bales are released from the storeroom (materials inventory) and moved to the Cutting Department where the fabric is cut to patterns. The cut pieces are sorted into sets of jeans. Any miscut pieces are scrapped. The sets move to the Stitch and Form Department where the pieces are sewn together. Thread, zippers, and snaps are added during this process to make the completed jeans. The jeans are sent to the Inspection and Finishing Department. Inspection makes certain that jeans meet quality standards; spoiled and defective jeans are removed from the process. Spoiled jeans go to the scrap pile. Inspectors must determine the extent of defect in those jeans considered defective. If the defect can easily be corrected, the jeans go back into the process where the work will be done. If the defect cannot be corrected, the jeans are treated as seconds and are sold unlabeled in factory outlets and discount stores. Those jeans successfully passing inspection move to the labeling tables where brand labels are stitched on each pair of jeans. The completed jeans move to the warehouse where they become part of the �inished goods inventory.

Questions:

1. Identify the activities in the denim jeans production process that fall into process time, inspection time, move time, wait time, and storage time.

2. List the activities in the denim jeans production process that are candidates for nonvalue-added activities.

12-8. Value-Added Labor. Natasha Company produces air pumps in a small factory about 30 kilometers south of Moscow, Russia. The company employs eleven people with nine direct and two indirect laborers. The plant manager, Boris Badinov, describes the tasks of the nine direct workers as follows:

a. Three fabricators who cut and grind metal parts from raw steel, aluminum, and brass b. One parts inspector who examines and approves parts produced c. One warehouse stocker who keeps parts in inventory and �ills bins used by assembly workers

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d. One molder who makes vinyl seals and plastic �ittings by using an injection molder e. Two assemblers who assemble parts into product f. One product inspector who approves the �inal product

Questions:

1. Categorize each of the nine workers as a value-added or nonvalue-added worker. 2. Compute the value-added labor ratio.

12-9. Nonvalue-Added Costs in a Doctor’s Of�ice. Dr. Steve Rosenthal has his own medical practice. He specializes in the treatment of diabetics. His staff consists of a receptionist, two nurses, a lab technician, and a dietitian. As patients enter the outer of�ice, they check in with the receptionist. The patient then waits until called by a nurse. When called, the patient moves from the waiting room to the inner of�ices. The patient must weigh in and is then assigned a room for the rest of the work and conferences. The nurse assigning the patient to a room gathers all the personal data for updating the medical records, such as insulin dosage, medication, illnesses since last visit, and so forth. The nurse also takes an initial blood sample for blood sugar testing and performs a blood pressure test. The patient then waits until the doctor comes in. After the doctor’s conference, the nurse returns to take more blood samples, depending on what is ordered by the doctor. The patient then waits until the dietitian comes to review eating habits and talk about how to improve meal planning and weight control. The patient returns to the receptionist to pay for the of�ice visit and to schedule the next visit.

Questions:

1. Identify the activities in the doctor’s of�ice that fall into process time, inspection time, move time, wait time, and storage time.

2. List the activities in the doctor’s of�ice that are candidates for nonvalue-added activities. Explain why you classify them as nonvalue-added activities.

12-10. Downsizing, Kaizen Costing, and Ethics. Biltmore Insurance Corporation instituted kaizen costing in 2019 for all of its divisions. During 2018, the Claims Division incurred costs of $5.6 million. Seeking to dramatically reduce costs, the manager of the Claims Division, Gail Norman, thought about cutting $200,000 in payroll costs for 2019 by eliminating all part-time claims adjuster positions. However, she soon realized that her kaizen cost target for 2020 would then be $5.4 million. Therefore, she decided to institute her reforms much more slowly and, consequently, reduced payroll costs by only $40,000 during 2019.

Question:

Discuss the ethical dimension of Gail Norman’s dilemma.

12-11. Balanced Scorecard. Nemeth’s Pizza Shops (“Seven days without pizza makes one weak”) operates in 55 locations throughout Pennsylvania and Maryland. The CEO, Eddie Berger, wants to institute a performance measurement system based on a balanced scorecard. The following measures are being considered:

a. Percentage of pizzas delivered on time i. Number of customer complaints

b. Percentage of sales growth j. Number of pizzas per labor hour

c. Pounds of pizza scrapped k. Hours of community volunteer work

d. Production cost per pizza l. Return on invested capital

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e. Packaging materials cost per month m. Cost per delivery

f. Percentage of repeating customers n. Throughput time

g. Employee turnover percentages o. Suggestions per employee

h. Response time to customer inquiries p. Safety incident index

Question:

Classify the performance measures into the four categories contained in a balanced scorecard.

Problems 12-12. Trends in Quality Costs. Kal Held Properties sells time sharing for its condominiums in Florida. Michael Leader, the controller, has just �inished a study of its quality costs. Based on recent accounting reports, quality costs for the 2018 �iscal year are as follows:

Prevention costs $100,000

Appraisal costs 300,000

Internal failure costs 400,000

External failure costs (including lost sales) 300,000

These costs are 11% of sales. The �irm plans to implement a program called “TQM Victory” to reduce quality costs in total and as a percentage of sales. Sales are expected to expand by 10% per year. By 2020, it expects to spend $300,000 on prevention costs by substantially expanding employee training. Improved inspection efforts will add $100,000 to appraisal costs. By 2020, each failure cost category will be reduced by 10%.

By 2022, continued efforts will hold prevention and appraisal costs constant; but external failure costs are expected to drop to 1% of sales. Internal failure costs will drop 30% from 2020 levels.

By 2024 (the target year of the TQM effort), prevention costs should fall to $200,000; appraisal costs could be cut in half from 2020 levels. Internal failure costs should drop another 40% from their 2022 levels. And, external failure costs are targeted to be no higher than 0.3% of sales.

Questions:

1. What are total quality costs targeted to be in 2024? 2. Can the �irm get to a 4% of sales target by 2024? Explain. 3. Comment on at least three key assumptions you see from the data provided.

12-13. Analyzing Quality Costs Over Time. Management of Spero Software Services (SSS) has recently implemented a TQM program to eliminate a serious level of “program bugs” that has plagued its recent product releases. The following activities and their costs were taken from SSS’s records. The data are for 2018 (the year prior to the TQM program) and 2020 (the year after the start of the TQM program).

2018 2020

Design documentation standards development $ 0 $100,000

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2018 2020

Software testing—prerelease 50,000 140,000

Documentation of customer training process 0 20,000

Documentation of changes to software 5,000 20,000

Customer training 100,000 130,000

Software testing—customer site 130,000 80,000

Telephone “on-line” customer problem support 90,000 60,000

Software corrections and redesign 50,000 20,000

Field “troubleshooting” for customer support 140,000 80,000

Costs of contract cancellations 180,000 30,000

Revenues lost due to delivery date delays 0 120,000

Training for systems designers/programmers 100,000 250,000

Training for sales staff 10,000 80,000

Questions:

1. Categorize the costs of quality for both years. 2. Evaluate the two years. Develop a scenario to explain the major differences in costs between the

two years. In other words, what happened? 3. If 2018 showed an operating loss and 2020 showed a small operating pro�it, would this change

your scenario in Part 2 or con�irm it? Explain.

12-14. Business Process Reengineering. Fishwrap, Inc. owns a chain of 20 similar-sized newspapers. A decentralized purchasing system is used, whereby each newspaper obtains its own newsprint. On average for all newspapers, 70% of the newsprint is delivered on time.

The following average cost data per newspaper have been obtained for the past year:

Costs of newsprint $980,000

Purchasing Department salary costs 240,000

Other Purchasing Department costs 125,000

Of the above newsprint, an average of $7,200 turned out to be defective.

Because of the decentralized purchasing system, Fishwrap has been unable to take advantage of quantity discounts. Therefore, the company reengineered the purchasing process by introducing a corporate Purchasing Department. Each newspaper continued to purchase its own newsprint from approved vendors. However, the corporate controller, Diane Green, began to track the purchases of all 20 newspapers and used that data to negotiate quantity discounts and resolve problems with vendors. The on-time delivery rate improved to 85%. The defect rate (in terms of dollars) decreased by 60%. The average quantity discount amounted to 2.8% of newsprint cost. After reengineering, the average salary and other purchasing costs for the local departments decreased from $365,000 to $190,000. The annual costs of the centralized Purchasing Department are $1,800,000.

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Question:

Evaluate whether reengineering the purchasing process was worthwhile.

12-15. Non�inancial Performance Measures. Jagoda Hair Products manufactures a wide range of shampoos and conditioners. The company has the reputation for delivering high-quality products on time. Each month the CFO, Ricky Kaplan, issues a production ef�iciency report. The data compiled on these reports for the third quarter are as follows:

July August September

Manufacturing cycle ef�iciency 94% 96% 92%

Total setup time (hours) 62 60 58

Overtime hours 70 73 76

Power consumption in kilowatt-hours (000s omitted) 802 832 838

Machine downtime (hours) 15 10 20

Number of unscheduled machine maintenance calls 0 0 1

Inventory value/Sales revenue 4% 4% 5%

Number of defective units received in raw materials orders 2 1 0

Number of defective units—in-process 35 40 55

Number of defective units—�inished goods 18 12 24

Percentage of customer orders �illed 100% 100% 100%

Percentage of on-time orders delivered 99% 98% 94%

Number of products returned by customers 0 0 1

Question:

Categorize each of the preceding non�inancial performance measures as one of the following:

a. Manufacturing productivity b. Product quality c. Delivery performance d. Inventory control e. Machine maintenance

12-16. Cost of Breakage and Defective Customer Service. Bangkok Trucking Co. hauls goods throughout Thailand. The company guarantees arrival at the designated place within an agreed two-hour period. Penalty for late arrival is 10% off the shipping rate. The penalty for being a day late is 20% off shipping rates. Each additional day costs an additional 20%. The following portion of shipments will arrive late:

More than 2 hours but less than 1 day late 3%

1 day late 2%

2 days late 1%

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Breakage of shipped goods results in additional costs related to replacing the goods, reshipping them to their destination, and the disruption of the customer’s business. The company follows the policy of paying replacement costs on all broken goods, refunding shipping charges on damaged shipments, and paying a 30% surcharge on the replacement cost for business interruption. Approximately 1% of goods shipped (in sales value) will be damaged in shipment.

During July, Bangkok Trucking expects to make 642 shipments with total revenues (before breakage and slow service costs) amounting to 6,420,000 baht. The average shipment is expected to have an 8,000 baht replacement cost. The variable costs are 70% of the billed shipping rate. Fixed costs are 900,000 baht per month.

Questions:

1. Prepare an estimate of the penalties, or revenues lost, from late shipments during July. 2. Prepare an estimate of the costs of shipments with breakage payments. 3. Assume the company can make systems changes and implement training programs that will

reduce the late shipments to: More than 2 hours but less than 1 day late 2%

1 day late 1%

More than 1 day 0%

The percentage of goods shipped that would be damaged would be cut in half. How much could the company afford to pay for such changes and programs?

12-17. Non�inancial Measures of Product Quality. Howard Pen Company manufactures expensive calligraphy pens in two of its Ohio plants. One plant is located in Cleveland, and the other is in Columbus. The pens produced are similar but not identical. Moe Howard, the president, wishes to evaluate the quality of production in each plant. He has asked the two plant managers, Larry Fine of Cleveland and Jerome (Curly) Howard of Columbus, to provide certain performance measures for the most recent year. After he threatened to tear out their tonsils, he received the following data from his two plant managers:

Cleveland Plant Columbus Plant

Number of pens produced and sold 20,000 20,000

Number of parts in each pen 7 5

Number of unique parts in each pen 3 1

Percentage of pens returned by customers 2% 5%

Dollar amount of scrap $250 $370

Percentage of defects in parts received 3% 4%

Dollar percentage of defects in parts received 3.5% 3.2%

Number of warranty claims 22 39

Amount of pens that needed rework 950 1,400

Question:

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Provide an analysis of product quality performance for the two plants.

12-18. Non�inancial Performance Measures. Robert Newman Associates manufactures transducers in one of its plants. The number produced and sold between 2019 and 2021 has remained steady. Speci�ic performance data for these three years are provided by the plant’s general manager, Howie Lee, as follows:

2019 2020 2021

Time from customer order to delivery 3 weeks 2.5 weeks 2.2 weeks

Number of failures at customer locations 76 88 91

Transducers produced per day per employee 25.6 29.1 30.6

Number of returned transducers 111 114 142

Manufacturing cycle ef�iciency 80% 89% 90%

Costs of scrap $1,897 $1,995 $2,066

Percentage of customer orders �illed 85% 89% 91%

Average time inventories are held 20 days 26 days 28 days

First-pass yield 77% 72% 68%

Unscheduled machine downtime 10 hrs. 9.5 hrs. 8.5 hrs.

Number of engineering change orders 5 3 2

Costs of rework $8,144 $8,993 $9,857

Percentage of defects in delivered components 1.5% 1.9% 2.2%

Questions:

1. Did product quality improve from 2019 to 2021? Explain. 2. Did manufacturing productivity improve from 2019 to 2021? Explain. 3. Did inventory control improve from 2019 to 2021? Explain. 4. Did delivery performance improve from 2019 to 2021? Explain.

Case: Murray’s Donut Heaven

Murray’s Donut Heaven manufactures donuts that are available fresh every day at several stores throughout Memphis. Donuts left over at the end of the day are packaged and sold at a reduced price as day-old donuts. Donuts not sold by the end of the second day are contributed to the local food bank. The production process consists of the following steps:

a. Ingredients such as �lour, sugar, and cooking oil are received, inspected, and placed in the storeroom until requisitioned by production.

b. Upon requisition, the ingredients are transported from the storeroom to the production area and staged at the mixing area.

c. Ingredients are blended into a dough mixture in 40-pound batches by six heavy-duty mixers.

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d. The dough is rolled on large boards and left to rise in a holding area. e. When the dough is ready, the boards are moved to the cutting machines; and the donuts

are cut. Leftovers from each cutting are accumulated, re-rolled on another board, and processed through the cutting machine. At the end of the production day, leftovers and unprocessed dough on boards are thrown into the trash.

f. The cut donuts and donut holes are placed on wire trays and taken to the cooking area, where the trays are stacked until ready for cooking.

g. The cooks empty the trays into large vats of hot cooking oil where the donuts and donut holes are, in effect, fried in a sea of oil.

h. The cooked products are removed from the vats and placed on drying pads that absorb the excess oil from the donuts. While the product is drying, it is inspected. Misshaped donuts are removed and set aside for disposal. What the crew doesn’t eat is thrown out at the end of the production shift.

i. After drying, the products are placed on large square boards and moved to the �inishing area where they will be coated with glaze, icing, powdered sugar, coconut, candy chips, etc.

j. After the coating settles or dries, whichever is the case, the donuts are placed in boxes of four dozen each. Donut holes are packed in boxes with 100 donut holes per box. The boxes are moved to the shipping area to await the trucks that will deliver them to the various retail outlets.

k. Each morning the delivery trucks return the unsold donuts delivered the previous day. (For some reason donut holes are always sold out.) The day-old donuts are repackaged in plastic bags. Each bag contains one dozen donuts and is marked “day-old.” The packages are then returned to the retail outlets. On the second day, any unsold packages are returned to the shipping area. At the end of the day, these packages are delivered to the food bank.

Questions:

1. Identify the activities in the donut production process that fall into process time, inspection time, move time, wait time, and storage time.

2. List the activities in the donut production process that are candidates for nonvalue-added activities. Explain your rationale.