Chapter 14 - Answer

CHAPTER 11

MANAGEMENT ACCOUNTING - Solutions Manual

Chapter 14 Responsibility Accounting and Transfer PricingResponsibility Accounting and Transfer Pricing Chapter 14

CHAPTER 14RESPONSIBILITY ACCOUNTING AND

TRANSFER PRICINGI.Questions1.Cost centers are evaluated by means of performance reports. Profit centers are evaluated by means of contribution income statements (including cost center performance reports), in terms of meeting sales and cost objectives. Investment centers are evaluated by means of the rate of return which they are able to generate on invested assets.

2.Overall profitability can be improved (1) by increasing sales, (2) by reducing expenses, or (3) by reducing assets.

3.ROI may lead to dysfunctional decisions in that divisional managers may reject otherwise profitable investment opportunities simply because they would reduce the divisions overall ROI figure. The residual income approach overcomes this problem by establishing a minimum rate of return which the company wants to earn on its operating assets, thereby motivating the manager to accept all investment opportunities promising a return in excess of this minimum figure.

4.A cost center manager has control over cost, but not revenue or investment funds. A profit center manager, by contrast, has control over both cost and revenue. An investment center manager has control over cost and revenue and investment funds.5. The term transfer price means the price charged for a transfer of goods or services between units of the same organization, such as two departments or divisions. Transfer prices are needed for performance evaluation purposes.

6. The use of market price for transfer purposes will create the actual conditions under which the transferring and receiving units would be operating if they were completely separate, autonomous companies. It is generally felt that the creation of such conditions provides managerial incentive, and leads to greater overall efficiency in operations.

7. Negotiated transfer prices should be used (1) when the volume involved is large enough to justify quantity discounts, (2) when selling and/or administrative expenses are less on intracompany sales, (3) when idle capacity exists, and (4) when no clear-cut market price exists (such as a sister division being the only supplier of a good or service).

8. Suboptimization can result if transfer prices are set in a way that benefits a particular division, but works to the disadvantage of the company as a whole. An example would be a transfer between divisions when no transfers should be made (e.g., where a better overall contribution margin could be generated by selling at an intermediate stage, rather than transferring to the next division). Suboptimization can also result if transfer pricing is so inflexible that one division buys from the outside when there is substantial idle capacity to produce the item internally. If divisional managers are given full autonomy in setting, accepting, and rejecting transfer prices, then either of these situations can be created, through selfishness, desire to look good, pettiness, or bickering.

II.ExercisesExercise 1 (Evaluation of a Profit Center)

No. Although Department 3 does not cover all of the cost allocated to it. It contributes P21,000 to the total operations over and above its direct costs. Without Department 3, the company would earn P21,000 less as compared with the original over-all income of P47,000.

Department

124Total

RevenueP132,000P168,000P98,000P398,000

Direct cost of department 82,000 108,000 61,000 251,000

Contribution of the departmentP 50,000P 60,000P37,000P147,000

Allocated cost 121,000

Net incomeP 26,000

With the discontinuance of Department 3, the revenue and direct cost of the department are eliminated, but there is no reduction in the total allocated cost.

Exercise 2 (Evaluation of an Investment Center)Requirement 1ROIRI

Operating assetsP400,000P400,000

Operating incomeP100,000P100,000

ROI (P100,000 ( P400,000)25%

Minimum required income

(16% x P400,000)P64,000

RI (P100,000 - P64,000)P36,000

Requirement 2The manager of the Cling Division would not accept this project under the ROI approach since the division is already earning 25%. Accepting this project would reduce the present divisional performance, as shown below:

PresentNew ProjectOverall

Operating assetsP400,000P60,000P460,000

Operating incomeP100,000P12,000*P112,000

ROI25%20%24.35%

* P60,000 x 20% = P12,000

Under the RI approach, on the other hand, the manager would accept this project since the new project provides a higher return than the minimum required rate of return (20 percent vs. 16 percent). The new project would increase the overall divisional residual income, as shown below:

PresentNew ProjectOverall

Operating assetsP400,000P60,000P460,000

Operating incomeP100,000P12,000P112,000

Minimum required return at 16% 64,000 9,600* 73,600

RIP 36,000P 2,400 P 38,400

* P60,000 x 16% = P9,600

Exercise 3 (ROI, Comparison of Three Divisions)Requirement 1

Division XDivision YDivision Z

ROI:P10,000P40,000P12,600P70,000P 28,800P180,000

Requirement 2Division X would reject this investment opportunity since the addition would lower the present divisional ROI. Divisions Y and Z would accept it because they would look better in terms of their divisional ROI.

Exercise 4 (ROI, RI, Comparisons of Two Divisions)

Requirement 1

Division A :

Division B :

Requirement 2

Division ADivision B

Average operating assets (a)

P3,000,000P10,000,000

Net operating income

P 630,000P 1,800,000

Minimum required return on average operating assets - 16% x (a)

480,000 1,600,000

Residual income

P 150,000P 200,000

Requirement 3

No, Division B is simply larger than Division A and for this reason one would expect that it would have a greater amount of residual income. As stated in the text, residual income cant be used to compare the performance of divisions of different sizes. Larger divisions will almost always look better, not necessarily because of better management but because of the larger peso figures involved. In fact, in the case above, Division B does not appear to be as well managed as Division A. Note from Part (2) that Division B has only an 18 percent ROI as compared to 21 percent for Division A.

Exercise 5 (Evaluation of a Cost Center)(1)Controllable Costs by supervisor of Department 10 are as follows:

a.Supplies, Department 10

b.Repairs and Maintenance, Department 10

c.Labor Cost, Department 10

(2)Direct Costs of Department 10 are

a.Salary, supervisor of Department 10

b.Supplies, Department 10

c.Repairs and Maintenance, Department 10

d.Labor Cost, Department 10

(3) Costs allocated to Factory Department are:

a.Factory, heat and light

b.Depreciation, factory

c.Factory insurance

d.Salary of factory superintendent

(4)Costs which do not pertain to factory operations are:

a.Sales salaries and commissions

b.General office salaries

Exercise 6 (Evaluating New Investments Using Return on Investment (ROI) and Residual Income)Requirement 1

Computation of ROIDivision A:

Division B:

Division C:

Requirement 2Division ADivision BDivision C

Average operating assets

P1,500,000P5,000,000P2,000,000

Required rate of return

15% 18% 12%

Required operating income

P225,000P 900,000P 240,000

Actual operating income

P300,000P 900,000P 180,000

Required operating income (above)

225,000 900,000 240,000

Residual income

P 75,000P 0P(60,000)

Requirement 3a. and b.Division ADivision BDivision C

Return on investment (ROI)

20%18%9%

Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would

RejectRejectAccept

Minimum required return for computing residual income

15%18%12%

Therefore, if the division is presented with an investment opportunity yielding 17%, it probably would

AcceptRejectAccept

If performance is being measured by ROI, both Division A and Division B probably would reject the 17% investment opportunity. The reason is that these companies are presently earning a return greater than 17%; thus, the new investment would reduce the overall rate of return and place the divisional managers in a less favorable light. Division C probably would accept the 17% investment opportunity, since its acceptance would increase the Divisions overall rate of return.

If performance is being measured by residual income, both Division A and Division C probably would accept the 17% investment opportunity. The 17% rate of return promised by the new investment is greater than their required rates of return of 15% and 12%, respectively, and would therefore add to the total amount of their residual income. Division B would reject the opportunity, since the 17% return on the new investment is less than Bs 18% required rate of return.Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company)

Requirement 1

Division ADivision BTotal Company

Sales

P3,500,0001P2,400,0002P5,200,0003

Less expenses:

Added by the division

2,600,0001,200,0003,800,000

Transfer price paid

700,000

Total expenses

2,600,0001,900,000 3,800,000


P 900,000P500,000P1,400,000

120,000 units P175 per unit = P3,500,000.

24,000 units P600 per unit = P2,400,000.

3Division A outside sales (16,000 units P175 per unit)

P2,800,000

Division B outside sales (4,000 units P600 per unit)

2,400,000

Total outside sales

P5,200,000

Observe that the P700,000 in intracompany sales has been eliminated.

Requirement 2

Division A should transfer the 1,000 additional units to Division B. Note that Division Bs processing adds P425 to each units selling price (Bs P600 selling price, less As P175 selling price = P425 increase), but it adds only P300 in cost. Therefore, each tube transferred to Division B ultimately yields P125 more in contribution margin (P425 P300 = P125) to the company than can be obtained from selling to outside customers. Thus, the company as a whole will be better off if Division A transfers the 1,000 additional tubes to Division B.Exercise 8 (Transfer Pricing Situations)

Requirement 1

The lowest acceptable transfer price from the perspective of the selling division is given by the following formula:

.

There is no idle capacity, so each of the 20,000 units transferred from Division X to Division Y reduces sales to outsiders by one unit. The contribution margin per unit on outside sales is P20 (= P50 P30).

The buying division, Division Y, can purchase a similar unit from an outside supplier for P47. Therefore, Division Y would be unwilling to pay more than P47 per unit. Transfer price ( Cost of buying from outside supplier = P47The requirements of the two divisions are incompatible and no transfer will take place.Requirement 2

In this case, Division X has enough idle capacity to satisfy Division Ys demand. Therefore, there are no lost sales and the lowest acceptable price as far as the selling division is concerned is the variable cost of P20 per unit.

The buying division, Division Y, can purchase a similar unit from an outside supplier for P34. Therefore, Division Y would be unwilling to pay more than P34 per unit. Transfer price ( Cost of buying from outside supplier = P34In this case, the requirements of the two divisions are compatible and a transfer will hopefully take place at a transfer price within the range:P20 ( Transfer price ( P34

Exercise 9 (Transfer Pricing: Decision Making)

Requirement 1

Division As purchase decision from the overall firm perspective:Purchase costs from outside10,000 x P150 = P1,500,000

Less: Savings of Divisions Bs variable costs10,000 x P140= 1,400,000Net Cost (Benefit) for A to buy outside

P 100,000

Assuming Division B has no outside sales, Division A should buy inside from Division B for the benefit of the entire firm.Requirement 2

As above, but in addition, if Division A buys outside, Division B saves an additional P200,000.Purchase costs from outside10,000 x P150 = P1,500,000

Less: Savings in variable costs10,000 x P140= 1,400,000Less: Savings of B material assignment

200,000Net Cost (Benefit) for A to buy outside

P (100,000)

The additional savings in Division B means that now Division A should buy outside.Requirement 3

Assuming the outside price drops from P150 to P130:Purchase costs from outside10,000 x P130 = P1,300,000

Less: Savings in variable costs10,000 x P140= 1,400,000Net Cost (Benefit) for A to buy outside

P (100,000)

Division A should buy outside.

Exercise 10 (Compute the Return on Investment (ROI))

Requirement (1)

Requirement (2)

Requirement (3)

ROI = Margin x Turnover

=30% x 0.5 = 15%

Exercise 11 (Residual Income)


P2,200,000


P400,000

Minimum required return: 16% (a)

352,000

Residual income

P48,000

III.Problems

Problem 1 (Evaluation of Profit Centers)

Requirement (a)Jadlow Manufacturing Corporation

Income Statement

For the Year Ended December 31, 2005TotalProduct SProduct T

SalesP5,100,000P2,700,000P2,400,000

Less: Variable Costs 3,330,000 1,890,000 1,440,000

Contribution MarginP1,770,000P 810,000P 960,000

Less: Controllable fixed expenses 501,000 66,000 435,000

Contribution to the recovery of non-controllable fixed expensesP1,269,000P 744,000P 525,000

Requirement (b)The complaint of the manager of Product T is justified on the ground that his product line shows a positive contribution margin and therefore, contributes to the recovery of non-controllable fixed expenses. This observation is, of course, made under the assumption that the preceding years figures (which are not given) were less favorable than the current year.

Problem 2 (Evaluation of Profit Centers)

Requirement 1Product

ABC

Incremental salesP71,000P46,000P117,000

Less: Incremental costs 42,000 15,000 96,000

Net incomeP29,000P31,000P 21,000

Product B seems to offer the best profit potential.

Requirement 2

The sunk costs are:

Depreciation of equipmentP 6,400

Operating cost of the equipment 4,600

Total

P11,000

Requirement 3

Opportunity cost of selling Product B is

From Product AP29,000

From Product C 21,000

Total

P50,000

Problem 3 (Evaluation of Performance)

Ranjie Tool Company

Performance Report

For the Year 2005Budgeted Labor Hours4,000

Actual Labor Hours 4,200

Cost-Volume FormulaActual 4,200 Hours Budget Based on 4,200 HoursVariance U (F)

Variable Overhead Costs:

UtilitiesP0.80 per hourP 3,600P 3,360P240

Supplies 1.807,4007,560(160)

Indirect labor 1.20

5,300 5,040 260

TotalP3.80P16,300P15,960P340

Fixed Overhead Costs:

UtilitiesP 1,600P 1,600-

Supplies2,2002,200-

Depreciation6,0006,000-

Indirect labor5,4005,400-

Insurance 1,200 1,200 -

TotalP16,400P16,400 -

Total Factory Overhead CostsP32,700P32,360P340

Problem 4 (Evaluation of Performance)

Requirement 1

Performance Report for the Production Manager

Actual

Cost Flexible Budget CostVariance

(U) or (F)

Controllable costs:

Direct materialP24,000P20,000P4,000 (U)

Direct labor48,00050,0002,000 (F)

Supplies4,0006,0002,000 (F)

Maintenance 3,000 4,000 1,000 (F)

TotalP79,000P80,000P1,000 (F)

The cost of raw materials rose significantly, possibly because of (1) deficient machinery due to the cutback in maintenance expenditures and/or (2) to the lower labor cost, possibly due to the use of less-skilled workers. Supplies decreased, indicating possible inadequacies for next periods production run.

Requirement 2

Performance Report for the Vice President

Actual

Cost Flexible Budget CostVariance

(U) or (F)

Controllable costs:

Marketing divisionP104,000P102,000 P2,000 (U)

Production division79,00080,0001,000 (F)

Personnel division72,00076,0004,000 (F)

Other costs 68,800 70,000 1,200 (F)

TotalP323,800P328,000P4,200 (F)

The marketing division is behind its cost allotment. The personnel division came in somewhat under its budgeted costs. Perhaps there has been a cutback in hiring, indicating possible reduction in future production.

Problem 5 (Target Sales Price; Return on Investment)Requirement 1

Return on investment=Operating income / Investment

20%=X / P800,000

Target Operating Income=P160,000

Target revenues, calculated as follows:

Fixed overhead

P200,000

Variable costs1,500,000 x P300450,000

Desired operating income

160,000

Revenues

P810,000

The selling price per units is P540 = P810,000 / 1,500

Requirement 2

Data are in thousands.Units1,5002,0001,000

RevenuesP810P1,080P540

Variable costs450600300

Fixed costs 200 200200

Total costs650800500

Operating incomeP160P280P 40

Return on investment20%35%5%

= P160 / P800= P280 / P800= P40 / P800

Note how the change in income follows the change in revenues, as predicted by operating leverage. Operating leverage multiplied times the percentage change in sales gives the percentage change in income. Thus, the greater the operating leverage ratio, the larger the effect on income and ROI of a given percentage change in sales. This exercise provides an opportunity to review the relationship between volume and profit. See the illustration below:

Operating leverage = contribution margin / operating income

= (P810 P450) / P160 = 2.25 % change in income=operating leverage x % change in revenues

=2.25 x 33.33% = 75%

% change in income

If volume goes to 2,000 units: (P280 P160) / P160 = 75%

If volume goes to 1,000 units: (P160 P40) / P160 = 75%

% change in ROI

If volume goes to 2,000 units: (35% - 20%) / 20% = 75%

If volume goes to 1,000 units: (20% - 5%) / 20% = 75%

Problem 6 (Contrasting Return on Investment (ROI) and Residual Income)

Requirement 1

ROI computations:

Pasig:

Quezon:Requirement 2PasigQuezon


P3,000,000P10,000,000


P 630,000P1,800,000

Minimum required return on average operating assets16% (a)

480,000P 1,600,000

Residual income

P150,000P 200,000

Requirement 3

No, the Quezon Division is simply larger than the Pasig Division and for this reason one would expect that it would have a greater amount of residual income. Residual income cant be used to compare the performance of divisions of different sizes. Larger divisions will almost always look better, not necessarily because of better management but because of the larger peso figures involved. In fact, in the case above, Quezon does not appear to be as well managed as Pasig. Note from Part (1) that Quezon has only an 18% ROI as compared to 21% for Pasig.Problem 7 (Transfer Pricing)Requirement 1Since the Valve Division has idle capacity, it does not have to give up any outside sales to take on the Pump Divisions business. Applying the formula for the lowest acceptable transfer price from the viewpoint of the selling division, we get:

The Pump Division would be unwilling to pay more than P29, the price it is currently paying an outside supplier for its valves. Therefore, the transfer price must fall within the range:P16 ( Transfer price ( P29

Requirement 2

Since the Valve Division is selling all of the valves that it can produce on the outside market, it would have to give up some of these outside sales to take on the Pump Divisions business. Thus, the Valve Division has an opportunity cost, which is the total contribution margin on lost sales:

Since the Pump Division can purchase valves from an outside supplier at only P29 per unit, no transfers will be made between the two divisions.

Requirement 3

Applying the formula for the lowest acceptable price from the viewpoint of the selling division, we get:

In this case, the transfer price must fall within the range:

P27 ( Transfer price ( P29

Problem 8 (Transfer Pricing)

To produce the 20,000 special valves, the Valve Division will have to give up sales of 30,000 regular valves to outside customers. Applying the formula for the lowest acceptable price from the viewpoint of the selling division, we get:

Problem 9 (Effects of Changes in Sales, Expenses, and Assets in ROI)

1.

2.

3.

ROI = Margin x Turnover

=10% x 2.5 = 25%

Problem 10 (Transfer Pricing Basics)

Requirement (1)

a.The lowest acceptable transfer price from the perspective of the selling division, the Electrical Division, is given by the following formula:

Because there is enough idle capacity to fill the entire order from the Motor Division, there are no lost outside sales. And because the variable cost per unit is P21, the lowest acceptable transfer price as far as the selling division is concerned is also P21.

b.The Motor Division can buy a similar transformer from an outside supplier for P38. Therefore, the Motor Division would be unwilling to pay more than P38 per transformer.

Transfer price: Cost from buying from outside supplier = P38

c.Combining the requirements of both the selling division and the buying division, the acceptable range of transfer prices in this situation is:P21 : Transfer price : P38

Assuming that the managers understand their own businesses and that they are cooperative, they should be able to agree on a transfer price within this range and the transfer should take place.

d.From the standpoint of the entire company, the transfer should take place. The cost of the transformers transferred is only P21 and the company saves the P38 cost of the transformers purchased from the outside supplier.

Requirement (2)

a.Each of the 10,000 units transferred to the Motor Division must displace a sale to an outsider at a price of P40. Therefore, the selling division would demand a transfer price of at least P40. This can also be computed using the formula for the lowest acceptable transfer price as follows:

b.As before, the Motor Division would be unwilling to pay more than P38 per transformer.

c.The requirements of the selling and buying divisions in this instance are incompatible. The selling division must have a price of at least P40 whereas the buying division will not pay more than P38. An agreement to transfer the transformers is extremely unlikely.

d.From the standpoint of the entire company, the transfer should not take place. By transferring a transformer internally, the company gives up revenue of P40 and saves P38, for a loss of P2.

Problem 11 (Transfer Pricing with an Outside Market)

Requirement (1)

The lowest acceptable transfer price from the perspective of the selling division is given by the following formula:

The Tuner Division has no idle capacity, so transfers from the Tuner Division to the Assembly Division would cut directly into normal sales of tuners to outsiders. The costs are the same whether a tuner is transferred internally or sold to outsiders, so the only relevant cost is the lost revenue of P200 per tuner that could be sold to outsiders. This is confirmed below:

Therefore, the Tuner Division will refuse to transfer at a price less than P200 per tuner.

The Assembly Division can buy tuners from an outside supplier for P200, less a 10% quantity discount of P20, or P180 per tuner. Therefore, the Division would be unwilling to pay more than P180 per tuner. Transfer price : Cost of buying from outside supplier = P180

The requirements of the two divisions are incompatible. The Assembly Division wont pay more than P180 and the Tuner Division will not accept less than P200. Thus, there can be no mutually agreeable transfer price and no transfer will take place.

Requirement (2)

The price being paid to the outside supplier, net of the quantity discount, is only P180. If the Tuner Division meets this price, then profits in the Tuner Division and in the company as a whole will drop by P600,000 per year:

Lost revenue per tuner

P200

Outside suppliers price

P180

Loss in contribution margin per tuner

P20

Number of tuners per year

30,000

Total loss in profits

P600,000

Profits in the Assembly Division will remain unchanged, since it will be paying the same price internally as it is now paying externally.

Requirement (3)

The Tuner Division has idle capacity, so transfers from the Tuner Division to the Assembly Division do not cut into normal sales of tuners to outsiders. In this case, the minimum price as far as the Assembly Division is concerned is the variable cost per tuner of P11. This is confirmed in the following calculation:

The Assembly Division can buy tuners from an outside supplier for P180 each and would be unwilling to pay more than that in an internal transfer. If the managers understand their own businesses and are cooperative, they should agree to a transfer and should settle on a transfer price within the range:P110 : Transfer price : P180

Requirement (4)

Yes, P160 is a bona fide outside price. Even though P160 is less than the Tuner Divisions P170 full cost per unit, it is within the range given in Part 3 and therefore will provide some contribution to the Tuner Division.

If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in potential profits:

Price per tuner

P160

Variable costs

110

Contribution margin per tuner

P50

30,000 tuners P50 per tuner = P1,500,000 potential increased profits

This P1,500,000 in potential profits applies to the Tuner Division and to the company as a whole.

Requirement (5)

No, the Assembly Division should probably be free to go outside and get the best price it can. Even though this would result in lower profits for the company as a whole, the buying division should probably not be forced to purchase inside if better prices are available outside.

Requirement (6)

The Tuner Division will have an increase in profits:

Selling price

P200

Variable costs

110

Contribution margin per tuner

P90

30,000 tuners P90 per tuner = P2,700,000 increased profits

The Assembly Division will have a decrease in profits:

Inside purchase price

P200

Outside purchase price

160

Increased cost per tuner

P40

30,000 tuners P40 per tuner = P1,200,000 decreased profits

The company as a whole will have an increase in profits:

Increased contribution margin in the Tuner Division

P90

Decreased contribution margin in the Assembly Division

40

Increased contribution margin per tuner

P50

30,000 tuners P50 per tuner = P1,500,000 increased profits

So long as the selling division has idle capacity and the transfer price is greater than the selling divisions variable costs, profits in the company as a whole will increase if internal transfers are made. However, there is a question of fairness as to how these profits should be split between the selling and buying divisions. The inflexibility of management in this situation damages the profits of the Assembly Division and greatly enhances the profits of the Tuner Division.

Problem 12 (Transfer Pricing; Divisional Performance)

Requirement (1)

The Electronics Division is presently operating at capacity; therefore, any sales of the KK8 circuit board to the Clock Division will require that the Electronics Division give up an equal number of sales to outside customers. Using the transfer pricing formula, we get a minimum transfer price of:

Thus, the Electronics Division should not supply the circuit board to the Clock Division for P90 each. The Electronics Division must give up revenues of P125.00 on each circuit board that it sells internally. Since management performance in the Electronics Division is measured by ROI and dollar profits, selling the circuit boards to the Clock Division for P9 would adversely affect these performance measurements.

Requirement (2)

The key is to realize that the P100 in fixed overhead and administrative costs contained in the Clock Divisions P697.50 cost per timing device is not relevant. There is no indication that winning this contract would actually affect any of the fixed costs. If these costs would be incurred regardless of whether or not the Clock Division gets the oven timing device contract, they should be ignored when determining the effects of the contract on the companys profits. Another key is that the variable cost of the Electronics Division is not relevant either. Whether the circuit boards are used in the timing devices or sold to outsiders, the production costs of the circuit boards would be the same. The only difference between the two alternatives is the revenue on outside sales that is given up when the circuit boards are transferred within the company.

Selling price of the timing devices

P700.00

Less:

The cost of the circuit boards used in the timing devices (i.e. the lost revenue from sale of circuit boards to outsiders)

P125.00

Variable costs of the Clock Division excluding the circuit board (P300.00 + P207.50)

507.50632.50

Net positive effect on the companys profit

P67.50

Therefore, the company as a whole would be better off by P67.50 for each timing device that is sold to the oven manufacturer.

Requirement (3)

As shown in part (1) above, the Electronics Division would insist on a transfer price of at least P125.00 for the circuit board. Would the Clock Division make any money at this price? Again, the fixed costs are not relevant in this decision since they would not be affected. Once this is realized, it is evident that the Clock Division would be ahead by P67.50 per timing device if it accepts the P125.00 transfer price.

Selling price of the timing devices

P700.00

Less:

Purchased parts (from outside vendors)

P300.00

Circuit board KK8 (assumed transfer price)

125.00

Other variable costs

207.50632.50

Clock Division contribution margin

P67.50

In fact, since the contribution margin is P62.50, any transfer price within the range of P125.00 to P192.50 (= P125.00 + P67.50) will improve the profits of both divisions. So yes, the managers should be able to agree on a transfer price.

Requirement (4)

It is in the best interests of the company and of the divisions to come to an agreement concerning the transfer price. As demonstrated in part (3) above, any transfer price within the range P125.00 to P192.50 would improve the profits of both divisions. What happens if the two managers do not come to an agreement?

In this case, top management knows that there should be a transfer and could step in and force a transfer at some price within the acceptable range. However, such an action, if done on a frequent basis, would undermine the autonomy of the managers and turn decentralization into a sham.

Our advice to top management would be to ask the two managers to meet to discuss the transfer pricing decision. Top management should not dictate a course of action or what is to happen in the meeting, but should carefully observe what happens in the meeting. If there is no agreement, it is important to know why. There are at least three possible reasons. First, the managers may have better information than the top managers and refuse to transfer for very good reasons. Second, the managers may be uncooperative and unwilling to deal with each other even if it results in lower profits for the company and for themselves. Third, the managers may not be able to correctly analyze the situation and may not understand what is actually in their own best interests. For example, the manager of the Clock Division may believe that the fixed overhead and administrative cost of P100 per timing device really does have to be covered in order to avoid a loss.

If the refusal to come to an agreement is the result of uncooperative attitudes or an inability to correctly analyze the situation, top management can take some positive steps that are completely consistent with decentralization. If the problem is uncooperative attitudes, there are many training companies that would be happy to put on a short course in team building for the company. If the problem is that the managers are unable to correctly analyze the alternatives, they can be sent to executive training courses that emphasize economics and managerial accounting.

IV.Multiple Choice Questions1. C11. E21. C31. B

2. D12. D22. B32. D

3. A13. C23. A33. D

4. A14. C24. D34. D

5. C15. B25. B35. C

6. A16. C26. A36. D

7. D17. B27. A37. B

8. A18. A28. B38. D

9. C19. B29. D39. B

10. A20. A30. A40. D

= 16%

= 18%

= 25%

Sales

Average Operating Assets

Net Operating income

Sales

= ROI

X

P9,000,000

P3,000,000

= ROI

X

P630,000

P9,000,000

7%

= 21%

3

X

X

P1,800,000

P20,000,000

P20,000,000

P10,000,000

= ROI

9%

X

2

= 18%

ROI=

P300,000

P6,000,000

x

P6,000,000

P1,500,000

= 5% x 4 = 20%

= 9% x 2 = 18%

P10,000,000

P5,000,000

x

P900,000

P10,000,000

ROI=

= 2.25% x 4 = 9%

P8,000,000

P2,000,000

x

P180,000

P8,000,000

ROI=

Transfer price (

P20 +

P0

20,000

=P20

Variable cost per unit

Total contribution margin

on lost sales

Number of units transferred

+

Transfer price (

P28 + P20 = P48

P20 x 20,000

20,000

(P30 P2) +

Transfer price (

Transfer price =

ROI=


Sales

x

Sales


P630,000

P9,000,000

P9,000,000

P3,000,000

x

= 7% x 3 = 21%

= 9% x 2 = 18%

P20,000,000

P10,000,000

x

P1,800,000

P20,000,000



on lost sales


+

Transfer price (

=P16

P0

10,000

P16 +

Transfer price (

=P16 + P14 = P30

(P30 P16) x 10,000

10,000

P16 +

Transfer price (



on lost sales


+

Transfer price (

=P13 + P14 = P27

(P30 P16) x 10,000

10,000

(P16 P3) +

Transfer price (



on lost sales


+

Transfer price (

=P20 + P21 = P41

(P30 P16) x 30,000

20,000

P20 +

Transfer price (



on lost sales


+

Transfer price (


Sales

Margin =

=

P5,400,000

P18,000,000

= 30%

Sales


Turnover =

P18,000,000

P36,000,000

=

= 0.5

= 2.5

=

P8,000,000

P3,200,000

Turnover =

Sales


= 10%

=

P800,000

P8,000,000

Margin =


Sales


on lost sales


+

Variable cost

per unit

Transfer price =

Transfer price = P21 +

P0

10,000

= P21

= P21 + (P40 P21) = P40

(P40 P21) x 10,000

10,000


Transfer price =

Variable cost

per unit

+


on lost sales


= P110 + (P200 P110) = P200

(P200 P110) x 30,000

30,000


= P110

P0

30,000


Transfer price =

Variable cost

per unit

+


on lost sales


= P82.50 + (P125.00 P82.50)

= P82.50 + P42.50

Transfer price =

Transfer price =

Transfer price =

= P125.00

14-114-2614-25

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Chapter 14 - Answer