206 Chapter 5

variable-cost transfer pricing approximates the opportunity cost ofproducing one more unitwhen excess capacity exists, it is rarely used in practice. Market-based and full-cost trans­fer pricing methods are the most prevalent; each is used roughly 40 percent of the time.r?While we do not know exactly why variable costing is used infrequently, we can speculateon some plausible reasons. Full-cost transfer pricing approximates the costs of adding fixedcapacity (in the absence of inflation and productivity changes). Also, with variable-costtransfer pricing it is difficult to separate fixed and variable costs. Finally, as discussed ear­lier, variable costing gives the selling division significant discretion in altering the transferprice by reclassifying fixed costs as variable costs.

The trade-offbetween decision making and control discussed in Chapter 1 also appliesto transfer prices. The transfer price that most accurately measures the opportunity cost tothe firm of transferring one more unit inside the firm may not be the transfer pricingmethod that gives internal managers the incentive to maximize firm value. For example, ifthe transfer pricing method that most accurately measures the opportunity cost of trans­ferred units also requires managers producing these units to reveal privately held and hard­to-verify data of their costs, then these managers have considerable discretion over thetransfer prices . If these transfer prices are important in rewarding managers, the producingmanagers can distort the transfer price to their benefit. Alternatively, a transfer pricingscheme that measures opportunity cost less accurately but more objectively might producea higher firm value than a transfer pricing scheme that more closely approximates oppor­tunity costs.

Managers often have authority for external sourcing. The ability to buy/sell outside isan important control device on the transfer pricing scheme . No matter how the internaltransfer price is set, the ability to go outside limits the monopoly profits that can be earnedby one responsibility center at the expense of another.

Changing transfer-pricing methods does more than shift income among responsibilitycenters. The level of the firm's output changes, as does firmwide profitability. The transferprice not only changes how the total profit pie is divided among responsibility centers; italso affects the size of the pie.

Finally, transfer pricing is more ubiquitous in organizations than many managers real­ize. Most organizations recharge inside users for information technology, telecommunica­tions, janitorial service, maintenance, and so forth. In effect, these recharge schemes, basedon cost allocations, are cost-based transfer prices. Since much of management accountingand cost accounting deals with cost allocations, many of the same issues that apply to trans­fer pricing also arise in later chapters.

Q5-7 What are the two main reasons for transfer pricing withinfirms?

Q5-8 Name four alternative methods for determining transferprices.

Q5-9 Is the choice of transfer pricing methods a zero-sum game?

22 R Tang, "Transfer Pricing in the 1990s," Management Accounting, February 1992, pp. 22-26; R Benke Jr.and J Edwards , Transfer Pricing: Techniques and Uses (New York: National Association ofAccountants, 1980);D Keegan, Transfer Pricing Practices ofAmerican Industry (Price Waterhouse, March 31, 1984); R F Vancil,Decentralization: ManagerialAmbiguity by Design (Homewood, IL: Dow Jones-Irwin, 1979), p. 114.

c. Summary

Responsibility Accounting and Transfer Pricing 207

Besides making operating decisions that involve pricing, marketing , and financing, managers mustalso ensure that employees perform tasks that add value to the firm. Chapter 4 described the generalagency problem and how the firm 's organizational architecture can provide incentives for self­interested employees to take value-adding actions. In particular, the organizational architecture, whichconsists of the three legs of the stool (the performance evaluation system, the performance reward sys­tem, and the partitioning of decision rights), helps align employees' and owners' interests. Accountingsystems are an integral part of the firm's organizational architecture. This chapter described two cen­tral ways in which accounting systems are used: responsibility accounting and transfer pricing.

In responsibility accounting, decision rights within the firm are partitioned to cost, profit, andinvestment centers. Cost centers usually have decision rights over the mix of inputs used to producethe product or service. Cost centers are then evaluated based on the ability of the center to maximizeoutput for a given cost or to minimize cost for a predetermined amount of output. Profit centers havedecision rights over input mix and pricing and are evaluated based on profits. Investment centers haveall the decision rights of profit centers plus the rights over how much capital is invested in the center.They are evaluated based on either return on investment or residual income.

Accounting is also often used in transfer pricing. Whenever goods or services are transferredacross responsibility centers and the performance of these centers is measured, a transfer price for thetransferred item must be calculated. Market prices, cost-based transfer prices, or negotiated transferprices are used. Cost-based transfer prices include both variable costs and full costs (variable plusfixed costs). Each transfer pricing scheme has pros and cons that depend on the particular circum­stances of the firm. Hence, each firm must determine the transfer pricing scheme that is best for itssituation. In general, no transfer pricing scheme, just as no particular organizational architecture, isbest for all firms or even best for a single firm over time. In transfer pricing schemes, as in other in­ternal accounting methods, a trade-off exists between decision making and control. Transfer priceschemes that are best for decision making are not always the best for control and vice versa.

Chapter 6 describes another example of how accounting systems are used to reduce agencyproblems: budgeting systems.

Self-Study ProblemsSelf-Study Problem 1: Tam Burger

In the past five years, Tam Burger has expanded to more than 200 stores, 80 percent of which arefranchised. Two of the company-operated units, Northside and Southside, are among the fastest­growing stores. Both are considering expanding their menus to include pizza. Purchase and installa­tion of the necessary equipment costs $180,000 per store. The current investment in the Northsidestore totals $890,000. Store revenues are $1,100,500 and expenses are $924,420. Expansion of theNorthside's menu should increase profits by $30,600. The current investment in the Southside storetotals $1,740,000. The store's revenues are $1,760,800 and expenses are $1,496,680. Adding pizza toSouthside's menu should increase its profits by $30,600.

Tam Burger evaluates its managers based on return on investment. Managers of individual storeshave decision rights over the pizza expansion.

Required:

a. Calculate the return on investment for both stores before pizza is added, for the pizzaproject only, and for the stores after expansion.

b. Assuming a 14 percent cost of capital, calculate residual income for both stores before andafter the potential expansion.

c. Will the Tam Burger stores choose to expand? How would the answer change if the storeswere franchised units?

Solution:

Chapter 5

c. The two units currently have different ROls. The smaller Northside store is earning anROI ofjust under 20 percent, while the larger Southside store is earning an ROI ofjustover 15 percent. Since the project's ROI is 17 percent, adding the project to the Northsidestore lowers its average ROI; adding the project to the Southside store raises its averageROI. The Northside manager will avoid adding pizza to the menu, since the store's ROIwould drop as a result. The Southside manager, however, will want to add pizza since thestore's ROI would subsequently rise.

$1,760,8001,496,680

$ 264,1201,740,000

15.18%

$ 30,600180,000

17.00°;6

$ 294,7201,920,000

15.35%

SouthsideNorthside

$1,100,500924,420

$ 176,080890,000

19.78%

$ 30,600180,000

17.00%

$ 206,6801,070,000

19.32°;6

ROI

ROI of Pizza OnlyIncreased profits from pizza-7- Expansion cost

ROI of project

ROI before PizzaRevenueExpenses

Net income-7- Assets

ROI after PizzaTotal income-7- Total assets

Total ROI

b. Residual income before and after the pizza expansion:

Northside Southside

Cost of capital 14.00% 14.00°;6

Residual Income before PizzaNet income $176,080 $264,120Less: Assets X 14% (124,600) (243,600)

Residual income $ 51,480 $ 20,520

Residual Income of Pizza OnlyIncreased profits from pizza $ 30,600 $ 30,600Less: 14% X Expansion cost (25,200) (25,200)

Residual income $ 5,400 $ 5,400

Residual Income after PizzaNet income $206,680 $294,720Less: 14% X Assets (149,800) (268,800)

Residual income $ 56,880 $ 25,920

a. Return on investment before and after the pizza expansion:

208

Solution:

Required:

Self-Study Problem 2: BioScience

209

$100,00050,000

$150,00010,000

$ 15.003.00

$ 18.00

Depreciation per month ($12 million -7- 120 months)Other fixed costs

Total fixed costs-7- Capacity per month (pounds)

Fixed costs per unit of capacity (pound)Variable costs per pound

Full cost per pound

a. The following table indicates that BioScience generates incremental cash flow of $13 forevery pound ofMK-23 it transfers to Home Life to be converted to Tomato Safe, assumingit does not forgo selling this pound of MK-23 directly to farmers for $30 per pound.

Responsibility Accounting and Transfer Pricing

Tomato beetles, a major pest to the tomato crop, are now being controlled by toxic pesticides. Thefirm BioScience invested $5 million in R&D over the last five years to produce a genetically engi­neered, patented microbe, MK-23, which controls tomato beetles in an environmentally safe way.BioScience built a plant with capacity to produce 10,000 pounds ofMK-23 per month. The plant cost$12 million and has a 10-year life. MK-23 has a variable cost of $3 per pound. Fixed costs are$50,000 per month for such costs as plant management, insurance, taxes, and security. Plant depreci­ation is not included in the $50,000 fixed cost.

The following table summarizes the full cost of producing MK-23:

a. Should the internal transfer be allowed?

b. What happens if the transfer price is set at full cost, $18? What happens if the transferprice is set at variable cost, $3?

c. After deciding to use variable cost as the transfer price, new farm orders for 2,000 poundsof MK-23 at $30 per pound per month are received. Suppose plants come only in fixedsizes of 10,000-pound capacities of $12 million each. Analyze the various options facingBioScience.

d. What is the opportunity cost of the excess capacity prior to producing MK-23 for Tomato­Safe?

e. What happened to the $5 million R&D costs incurred to invent MK-23?

If the stores were franchised units, both owners would definitely expand. The ROI ofthe project is higher than the cost of capital. This ensures a positive residual income for theproject. As long as the residual income is positive, any franchise owner would jump at theopportunity. Franchise owners would not care if the store's ROI dropped as long as theresidual income increased.

MK-23 is sold for $30 per pound. BioScience is currently selling 8,000 pounds per month totomato farmers.

Another division of BioScience, Home Life, wants to secure 1,000 pounds per month ofMK-23that it will process further into a consumer product, Tomato Safe, for gardeners. Home Life is willingto pay an internal transfer price of $5 per pound. Home Life will incur an additional $4 of variablecost per pound of MK-23 in packaging and reducing the potency of MK-23 to make Tomato Safemore appropriate for home gardeners. Tomato Safe will sell for $20 per pound ofMK-23.

Chapter 5

Contribution Margins for MK-23 and Tomato Safe

MK-23 Tomato Safe

Selling price $30.00 $20.00Variable costs

Manufacturing MK-23 3.00 3.00Additional processing 4.00

--Contribution margin $27.00 $13.00

--- --

$54,00013,000

$41,000

2,000 X $271,000 X $13

Contribution from new orderContribution forgone from Tomato Safe

Additional contribution

Clearly, if BioScience has excess capacity of 2,000 pounds of MK-23 production permonth , then transferring 1,000 pounds ofMK-23 enhances overall firm profits.

b. If a full-cost transfer price of $18 per pound is charged for MK-23 , Home Life will notaccept the transfer because its total cost of $22 ($18 transfer price plus $4 for furtherprocessing) is above the market price of $20. If the firm has unused capacity, thentransferring at full cost causes it to forgo selling Tomato Safe and receiving $13 per poundfor its unused capacity. Transferring at variable cost ($3) allows Tomato Safe to beproduced. In the case where the firm has unused excess capacity, full-cost transfer pricingleads to the wrong decision.

If variable-cost transfer pricing is used, each month 1,000 pounds ofMK-23 aretransferred to Home Life.

c. After receiving new farm orders for 2,000 pounds ofMK-23, management has threeoptions. First, it can fill 1,000 pounds of the 2,000-pound order, because this is all thecapacity available after transferring 1,000 pounds to Home Life. Second, management cancancel the 1,000 pounds transferred for Tomato Safe and fill all 2,000 pounds of the newfarm order. Or third, management can build a new plant to increase capacity. Canceling the1,OOO-pound transfer to Home Life and using this production capacity to fill the new farmorders increases BioScience's cash flows:

Every additional pound ofMK-23 sold to farmers instead of converted to Tomato Safecontributes $14 (or $27 - $13) to BioScience's cash flows, assuming the firm does nothave enough capacity to meet demand in the farm market. The third option of addingcapacity to meet both farm and home demand is not profitable. Each pound, including newcapacity for MK-23, costs $18, and Tomato Safe cannot recover these costs. Therefore,full-cost transfer pricing includes the cost of adding additional capacity.

The managers of Home Life will object to canceling the internal transfer because theirdivisional profits will fall. They will most likely construct reasons that such a decision willadversely affect their other products. Undoing the decision to transfer MK-23 will requiresenior managers' time and patience. Thus, influence costs are likely to be generated. Ingeneral , internal transfers tend to be permanent and difficult to change.

d. Prior to accepting the internal transfer ofMK-23 to produce Tomato Safe, BioScience has2,000 pounds of unused capacity. If the demand for MK-23 is growing, then eitherconsuming this capacity with an internal transfer causes the firm to forgo the contributionmargin on lost sales of MK-23 or else the firm has to add capacity. The decision topermanently consume fixed capacity should not be based on the short-run incremental costof the transfer unless it is highly likely that the internal transfer is the only long-run use ofthe unused capacity. Full-cost transfer pricing includes an estimate of the cost of adding

210

ProblemsP 5-1: Canadian Subsidiary

Required:

Analyze the effect of full-cost and variable-cost transfer pricing methods on Phipps' cash flows.

P 5-3: Sunder Properties

The following data summarize the operating performance of your company's wholly owned Canadiansubsidiary for 2009 to 2011. The cost of capital for this subsidiary is 10 percent.

211

$14.4135

24%

2011

$14.3130

22%

2010

($000,000)

$86.50(72.30)$14.20

$14.0125

20%

2009

Sunder Properties(Last Fiscal Year)

(Millions)

*Includes interest expense of $2.6 million .

RevenuesExpenses *Net income before taxes

capacity and reveals the past (historical) cost of a unit of capacity. A new unit of capacitywill cost more than historical cost if there has been construction cost inflation. However, aunit of capacity can cost less than the historic cost if adding a second plant createsproductivity enhancements or synergies.

e. These R&D costs were not included in the manufacturing costs ofMK-23. Theaccounting system writes these costs off when incurred. The firm has an unrecordedbut real economic asset, the patent on MK-23. The profit of$12 per pound ofMK-23($30 - $18) represents the firm's return on this investment.

Responsibility Accounting and Transfer Pricing

Subsidiary net incomeTotal assets in subsidiaryReturn on net investment* in subsidiary

*Net investment is calculated as total assets less all liabilities.

Required:

Critically evaluate the performance of this subsidiary.

Phipps manufactures circuit boards in Division Low in a country with a 30 percent income tax rateand transfers them to Division High in a country with a 40 percent income tax. An import duty of15 percent of the transfer price is paid on all imported products. The import duty is not deductible incomputing taxable income. The circuit boards' full cost is $1,000 and variable cost is $700; they aresold by Division High for $1,200. The tax authorities in both countries allow firms to use either vari­able cost or full cost as the transfer price.

Brighton Holdings owns private companies and hires professional managers to run its companies.One company in Brighton Holdings' portfolio is Sunder Properties. Sunder owns and operates apart­ment complexes, and has the following operating statement.

c

P 5-2: Phipps Electronics

Suppose the client has total assets of $6,000 and a risk-adjusted weighted-average cost of capital(WACC) of 25 percent. Then this client's EE is calculated as follows:

P 5-4: Economic Earnings

A large consulting firm is looking to' expand the services currently offered its clients . The firm hasdeveloped a new performance metric called "Economic Earnings," or EE for short. The performancemetric is argued to be a better measure of both divisional performance and firmwide performance,and hence "a more rational platform for compensating employees and managers." The consultingfirm is seeking to convince clients they should replace their current metrics, such as accounting netincome , ROA, EVA, and so forth, with EE.

EE starts with traditional accounting net income but then makes a series of adjustments. The pri­mary adjustment is to add back depreciation and then subtract a required return .on invested capital.The consultants argue for adding accounting depreciation back because it is a sunk cost. It does notrepresent a current cash flow. For example, suppose a client has accounting net income calculated as:

Chapter 5

$16.60$13.30$20.00

$5,700(2,000)

$3,700(900)(700)(500)

$1,600(640)

$ 960

*Includes interest expense of$0.71.

RevenuesExpenses*Total assets of new apartment

RevenuesCost of goods sold

Gross marginDepreciationSelling, general, otherInterest

Earnings before taxesIncome taxes (40%)

Net income

Client's TraditionalIncome Statement

a. Calculate Sunder's ROA last year.

b. Sunder management is considering purchasing a new apartment complex called ValleyView that has the following operating characteristics (millions $):

Will the managers of Sunder Properties purchase Valley View?

c. If they had the same information about Valley View as Sunder's management, would theshareholders of Brighton Holdings accept or reject the acquisition ofValley View inpart (b)?

d. What advice would you offer the management team of Brighton Holdings?

Brighton Holdings estimates Sunder Properties' before-tax weighted average cost of capitalto be 15 percent. Brighton Holdings rewards managers of their operating companies based on theoperating company's before-tax return on assets. (The higher the operating company's before-taxROA, the more Sunder managers are paid.) Sunder Properties' total assets at the end of last fiscal yearare $64 million.

Required:

212

P 5-6: Metal Press

P 5-5: Discretionary Cost Centers

23 C Horngren and G Foster, Cost Accounting: A Managerial Emphasis, 6th ed. (Englewood Cliffs, NJ:Prentice Hall, 1987), p. 378.

213

$ 960900

(1,500)

$ 360

$6,00025°A>

$1,500

Client's Economic Earnings

Net incomeDepreciationCapital charge*

Economic earnings

*Total assetsWACC

Capital charge

Responsibility Accounting and Transfer Pricing

Required:

Critically evaluate EE as a performance measure. What are its strengths and weaknesses?

Discretionary costs are defined as "costs that (1) arise from periodic (usually yearly) appropriationdecisions regarding the maximum amounts to be incurred and (2) have no well-specified function re­lating inputs (as measured by the costs) and outputs (as measured by revenue or other objectives suchas students' knowledge or patients' health). Examples include advertising, public relations, executivetraining, teaching, research, health care, and management consulting services. The most noteworthyaspect of discretionary costs is that one is seldom confident that the 'correct' amount is beingspent."23

Discretionary cost centers are those parts of the organization that have large discretionary costs.Such subunits of the organization tend to 'have a high percentage of their costs in human resourcesperforming nonrepetitive and nonroutine functions whose principal output is information-/service­oriented. The value of the output from discretionary cost centers is difficult to determine, as is thequality. Examples of discretionary cost centers include R&D, legal, public relations, and internal con­sulting organizations.

Max Jarvis, corporate controller for a midsize steel company, has just attended a seminar ondiscretionary cost centers. He decides to adopt this approach in budgeting and controlling severalcorporate headquarters departments, including market research and environmental protection. Thesedepartments are currently cost centers.

Required:

a. How do discretionary cost centers differ from cost centers and profit centers?

b. What changes do you expect Max Jarvis's adoption of discretionary cost centers toproduce?

Your firm uses return on assets (ROA) to evaluate investment centers and is considering changing thevaluation basis of assets from historical cost to current value. When the historical cost of the asset isupdated, a price index is used to approximate replacement value. For example, a metal fabricationpress, which bends and shapes metal, was bought seven years ago for $522,000. The company willadd 19 percent to this cost, representing the change in the wholesale price index over the seven years.This new, higher cost figure is depreciated using the straight-line method over the same 12-year as­sumed life (no salvage value).

(

P 5-8: Shop and Save

214

P 5-7: IC8, IntI.

Chapter 5

Required:

a. Calculate depreciation expense and book value of the metal press under both historical costand price-level-adjusted historical cost.

b. In general, what is the effect on ROA of changing valuation bases from historical cost tocurrent values?

c. The manager of the investment center with the metal press is considering replacing itbecause it is becoming obsolete. Will the manager's incentives to replace the metal presschange if the firm shifts from historical cost valuation to the proposed price-level-adjustedhistorical cost valuation?

ICB has four manufacturing divisions, each producing a particular type of cosmetic or beauty aid.These products are then transferred to five marketing divisions, each covering a particular geographicregion. Manufacturing and marketing -divisions are free to negotiate among themselves the transferprices for products transferred internally. The manufacturing division that produces all the hair careproducts wants a particular hair conditioner it developed and produces for Asian markets priced at fullcost plus a 5 percent profit markup, which amounts to $105 per case.

The South American marketing division believes it can sell this conditioner in South Americaafter redesigning the labels. However, most South American currencies have weakened against thedollar, putting further pressure on the prices of U.S.-produced products. The South Americanmarketing division estimates it can make money on the hair conditioner only if it can buy it frommanufacturing at $85 per case.

Manufacturing claims that it cannot make a profit at $85 per case. Moreover, the other ICBmarketing divisions that are paying around $105 per case will likely want to renegotiate the $105transfer price if South America marketing buys it for $85.

You work for the corporate controller of ICB, IntI. She has asked you to write a short, nontech­nical memo to her that spells out the key points she should consider in her upcoming meeting withthe two division heads regarding transfer pricing. You are not being asked to recommend a particulartransfer price, but rather to list the important issues the controller should be aware of for the meeting.

Shop and Save (S&S) is a large grocery chain with 350 supermarkets. Twenty-eight S&S stores arelocated within the Detroit metropolitan region and serviced by the S&S Detroit Bakery, a large cen­tral bakery producing all of the fresh-baked goods (breads, rolls, donuts, cakes, and pies) sold in the28 individual S&S stores in the Detroit region. Besides selling S&S baked goods, the stores also sellother nationally branded commercial baked goods both in the baked goods section of the store and inthe frozen section as well. But all freshly baked items sold in the 28 S&S stores come from the S&SDetroit Bakery. Each store orders all the baked goods from the S&S Detroit Bakery the day before.The S&S Detroit Bakery also is a profit center and sells only to the 28 Detroit S&S stores. Each storepays the bakery 60 percent of the retail selling price. So, for example, if a store manager orders fromthe bakery a loaf of whole grain bread that has a retail price of $5.00, that store is charged $3.00(60% X $5.00) and the Detroit Bakery records revenues of $3.00.

Each store manager is evaluated and compensated as a profit center and has some decision rightsover the particular items stocked in each store. But roughly 85 percent of all SKUs (stock keepingunits) carried by each store and the retail price of each SKU are dictated centrally by the S&S DetroitRegional headquarters, which oversees both the 28 stores and the bakery. Each store manager hasdecision rights over the quantity of the various baked goods ordered from the S&S Detroit Bakery.The retail price of each freshly baked item produced by the S&S Detroit Bakery and sold in the gro­cery stores is set by the Detroit Regional headquarters, not the individual grocery stores or the S&SDetroit Bakery.

The manager of the Detroit Bakery complains that the reason her central bakery loses moneyis that the 60 percent rate is too low to cover her costs. The individual grocery store managers com­plain that the quality and variety of fresh baked goods they receive from the S&S Detroit Bakery arenot competitive with high-end private specialty bake shops in the Detroit area.

Required:

Required:

P 5-9: Microelectronics

215Responsibility Accounting and Transfer Pricing

a. Why does us Copiers manufacture both copiers and toner cartridges? Why don't separatefirms specialize in either copiers or toner cartridges like Intel specializes in makingcomputer chips and Gateway specializes in assembling and selling PCs?

b. You work for the president of SCD. Write a memo to your boss identifying the salientissues she should raise in discussing the price SCD should pay TD for toner cartridgesincluded in SCD copiers.

a. Will the phone division purchase the circuit boards from the circuit board division? (Showcalculations.)

b. Suppose the circuit board division is currently manufacturing and selling externally 10,000circuit boards per month and has capacity to manufacture 15,000 boards. From thestandpoint of Microelectronics, should 3,000 additional boards be manufactured andtransferred internally?

c. Discuss what transfer price should be set for (b).

d. List the three most important assumptions underlying your analysis in (b) and (c).

Required:

a. Evaluate the advantages and disadvantages of the S&S policy of each S&S grocery storepaying the S&S Detroit Bakery 60 percent of the retail price of the bakery item.

b. Suggest ways that S&S can improve the relationship between its grocery stores and itscentral bakery.

Microelectronics is a large electronics firm with multiple divisions. The circuit board division man­ufactures circuit boards, which it sells externally and internally. The phone division assembles cellu­lar phones and sells them to external customers. Both divisions are evaluated as profit centers. Thefirm has the policy of transferring all internal products at market prices.

The selling price of cellular phones is $400, and the external market price for the cellular phonecircuit board is $200. The outlay cost for the phone division to complete a phone (not including thecost of the circuit board) is $250. The variable cost of the circuit board is $130.

US Copiers manufactures a full line of copiers including desktop models. The Small Copier Division(SCD) manufactures desktop copiers and sells them in the United States. A typical model has a retailprice of less than $500. An integral part in the copier is the toner cartridge that contains the blackpowder used to create the image on the paper. The toner cartridge can be used for about 10,000 pagesand must then be replaced. The typical owner of an SCD copier purchases four replacement car­tridges over the life of the copier.

SCD buys the initial toner cartridges provided with the copier from the Toner Division (TD) ofUS Copiers. TD sells subsequent replacement cartridges to distributors that sell them to U.s. retailstores. Toner cartridges sell to the end consumer for $50. TD sells the cartridges to distributors forabout 70 percent of the final retail price paid by the consumer. The Toner Division manager arguesthat the market price to TD of $35 (700/0 X $50) is the price SCD should pay to TD for each tonercartridge transferred.

Cogen's Turbine Division manufactures gas-powered turbines for generating electric power and hotwater for heating systems. Turbine's variable cost per unit is $150,000 and its fixed cost is $1.8 mil­lion per month. It has excess capacity. Cogen's Generator Division buys gas turbines from Cogen'sTurbine Division and incorporates them into electric steam generating units. Both divisional man­agers are evaluated and rewarded as profit centers.

P 5-10: US Copiers

P 5-11: Cogen

P 5-12: University Lab Testing

Chapter 5

The predetermined rate paid by the outsiders (non-University Hospital health care providers) for thistest (Q796) is $68.90.

$22.05

25.93

$47.98

$800750700650

Price ($000)

$8.9013.15

$17.202.056.68

5678

Quantity

Cost Structure for Q796

$1,000950900850

Price ($000)

1234

Quantity

a. If the transfer price of turbines is set at Turbine's variable cost ($150,000), how manyturbines will the Generator Division purchase to maximize its profits?

b. The Turbine Division expects to sell a total of 20 turbines a month, which includes bothexternal and internal sales. Calculate the (average) full cost of a turbine (fixed cost plusvariable cost) at this level of sales.

c. If the transfer price of turbines is set at Turbine's (average) full cost calculated in (b), howmany turbines will the Generator Division purchase?

d. Should Cogen use a variable-cost transfer price or a full-cost transfer price to transferturbines between the Turbine and Generator divisions? Why?

Variable CostsChemical & suppliesLabor

Fixed CostsEquipmentSupervision & administrationOccupancy

Total Cost

The Generator Division has variable cost of $200,000 per completed unit, excluding the cost ofthe turbine, and fixed cost of $1.4 million per month. The Generator Division faces the followingmonthly demand schedule for its complete generating unit (turbine and generator):

Required:

Joanna Wu manages the University Lab Testing department within the University Hospital. LabTesting, a profit center, performs most of the standard medical tests (such as blood tests) for otheruniversity clinical care units as well as for outside health care providers (independent hospitals, clin­ics, and physician groups). These outside health care providers are charged a price for each lab testusing a predetermined rate schedule. University Hospital health care providers reimburse UniversityLab Testing using a transfer price formula. Roughly 70 percent of all Lab Testing procedures are per­formed for University Hospital units and the remainder for outside health care providers. Other labtesting firms in the community perform many of the same tests as Lab Testing. Lab Testing operatesat about 85 percent capacity, on average. But when Lab Testing is operating at 100 percent of capac­ity it must refuse outside work and even sends some inside- (University Hospital-) generated speci­mens to other community testing labs.

A standard blood test (code Q796) performed by Lab Testing has the following cost structure:

216

P 5-13: Beckett Automotive Group

A large corporation has a manufacturing division with 40 parts departments and 20 assembly depart­ments. The parts departments manufacture most of the parts for the products, and the assemblydepartments assemble the parts (some of which are purchased outside the firm) into final products.

Required:

a. Describe some of the synergies that exist within Beckett. In other words, why does Beckettconsist of three departments (New Cars, Pre-owned Cars, and Service) as opposed to justselling new cars, or just selling used cars, or just providing service?

b. What potential conflicts of interest exist between the New Cars and Pre-owned Carsdepartment managers? For example, describe how in pursuing their own self-interest, themanager of New Cars or Pre-owned Cars will behave in a way that harms the othermanager.

c. Suggest two alternative mechanisms to reduce the conflicts of interest you described inpart (b).

P 5-14: Assembly and Parts Departments

217Responsibility Accounting and Transfer Pricing

Required:

a. Suppose Lab Testing has excess capacity. What transfer price maximizes UniversityHospital's profits?

b. Using the transfer price you chose in part (a), how much profit does Joanna Wu generate forher department if she performs one more Q796 test for an internal University Hospital user?

c. Suppose Lab Testing has no excess capacity. What transfer price maximizes UniversityHospital's profits?

d. Using the transfer price you chose in part (c), how much profit does Joanna Wu generate forher department if she performs one more Q796 test for an internal University Hospital user?

e. What transfer pricing policy should University Hospital implement regarding otherUniversity Hospital clinical care units reimbursing Lab Testing for Q796 blood tests? Besure to describe the logic (and any administrative problems that you considered) underlyingyour proposed transfer pricing policy for Q796.

Beckett is a large car dealership that sells several different automobile manufacturers new cars(Toyota, Ford, Lexus, and Subaru). Beckett also consists of a Pre-owned Cars Department and a largeservice department. Beckett is organized into three profit centers: New Cars, Pre-owned Cars, andService. Each profit center has a manager who is paid a fixed salary plus a bonus based on the netincome generated in his or her profit center.

When customers buy new cars, they first negotiate a price with a new car salesperson. Once theyhave agreed on a price for the new car, if the customer has a used car to trade in, the Pre-owned CarsDepartment manager gives the customer a price for the trade in. If the customer agrees with the trade­in price offered by Pre-owned Cars, the customer pays the difference between the price of the new carand the trade-in price.

Suppose a customer buys a new car for $47,000 that has a dealer cost of$46,200. The same cus­tomer receives and accepts $11,000 for the trade-in of her used car and pays the balance of $36,000in cash (ignoring taxes and license). In this case, New Cars shows a profit of $800 (before any com­mission to the salesperson). If the customer does not accept the trade-in value, she does not purchasethe new car from Beckett.

Once the deal is struck, the trade-in is then either sold by Pre-owned Cars to another customerat retail or is taken to auction where it is sold at wholesale. Continuing the above example, supposethe customer accepts $11,000 as the trade-in for her used car. The Pre-owned Cars Department cansell it on its used car lot for $15,000 at retail or sell it at auction for $12,000. If the trade-in is sold for$15,000, Pre-owned Cars would have a profit of $4,000 ($15,000 - $11,000). Ifit is sold at auction,Pre-owned Cars reports a profit of$I,OOO ($12,000 - $11,000).

P 5-15: U.S. Pump Systems

218 Chapter 5

About 70 percent of the manufacturing operation occurs in one geographic location, and the remain­der is in plants around the world. Several hundred different final products, some in very large unit vol­umes, are produced, involving thousands of different parts. The final products range from inexpensiveconsumer goods (selling price $50) to very expensive business products (selling price $500,000).

The marketing division forecasts sales six months in advance. These forecasts then become man­ufacturing's production quotas. As soon as manufacturing produces the product, it is turned over tomarketing for either shipment or storage.

Manufacturing's production quotas are "exploded" into parts requirements and the parts depart­ments begin producing parts for use by assembly. In order for assembly to meet its production quotaon final products, every part in the product must be on hand for assembly. Not having a spring cost­ing $0.0001 is just as costly to the assembly department as not having a motor costing $500; both shutdown the assembly line.

If a part is not available, the assembly department tries to assemble another product, often bycoercing a parts department to alter its schedule to produce parts for the alternative product assembly.

Assembly and parts departments are evaluated as cost centers. Parts departments are evaluatedon being able to produce parts cheaper than last year while meeting quality standards. They must alsomeet their production quotas and schedules. Parts departments that continually force assembly linesto shut down because of parts shortages impose significant costs on assembly lines. Assembly de­partments are evaluated based on (1) their labor costs to assemble products versus budgeted laborcosts and (2) their production quotas.

In order to minimize average costs, parts departments try to manufacture all the units of a par­ticular part required for a six-month period at once. The major discretionary fixed cost per part issetup time. That is, when the machine is being converted from producing one part to another, no out­put is produced. Setup time is often half a day. Therefore, to reduce average unit costs, parts are pro­duced in large lot sizes. As soon as parts are produced, they are sent to the assembly departments.Parts departments carry no inventories of final parts, only raw materials.

There is no transfer price for parts. There is no need for a transfer price because assembly andparts departments are evaluated as cost centers. One senior manager feels that considerable squabblingover transfer prices could be avoided by focusing on departmental costs that are under the control ofthe department managers. A modification is being proposed that would charge each department a hold­ing cost for inventory on hand (12 percent cost of inventory). That is, each assembly department cur­rently charged for its direct labor, overhead, and factory burden will also be charged 12 percent of allparts inventories. Assembly managers think this is unfair because they have no control over when andhow many parts the parts departments produce. Assembly departments would like to get all the partsfor one month's assembly instead of having to hold a six-month inventory of parts.

The parts department managers argue that the inventory holding cost charged to assemblydepartments is fair because assembly departments are always screaming for more inventory as safetystocks to their assembly lines, and this inventory holding charge will force assembly departments tobear the costs they are imposing on the firm by demanding large inventories. Parts department man­agers argue that it is inefficient to produce in one-month lot sizes.

Required:

Critically evaluate the existing management control system. Describe the strengths and weaknessesof the current and proposed systems. What dysfunctional behaviors exist in the current and proposedsystems?

U.S. Pump is a multidivisional firm that manufactures and installs chemical piping and pump sys­tems. The valve division makes a single standardized valve. The valve division and the installation di­vision are currently involved in a transfer pricing dispute. Last year, half of the valve division's outputwas sold to the installation division for $40 and the remaining half was sold to outsiders for $60.

The existing transfer price has been set at $40 per pump through a process of negotiationbetween the two divisions, with the involvement of senior management. The installation division hasreceived a bid from an outside valve manufacturer to supply it with an equivalent valve for $35 each.

P 5-16: CJ Equity Partners

Analyze the situation and recommend a course of action. What should installation division man­agers do? What should valve division managers do? What should U.S. Pump's senior managers do?

The manager of the valve division has argued that ifit is forced to meet the external price of$35,it will lose money on selling internally.

The operating data for last year for the valve division are as follows:

219

10%$0.200

85$0.800

40%$18.200$21.200

$16.3

JanSan

$1,200,000(600,000)(135,000)

$ 465,000

To Outside

12%$0.200

120$1.800

40%$36.800$42.900

$31.2

MillerBottling

20,000 @ $60$800,000(600,000)(135,000)

$ 65,000

JascoTools

14%$0.200

84$1.600

40%$33.600$38.600

$20.1

VALVE DIVISIONOperating Statement

Last Year

To Installation Division

20,000 @ $4020,000 @ $30

Responsibility Accounting and Transfer Pricing

SalesVariable costsAllocated fixed costs

Gross margin

* Not included in the operating expenses of the three companies.

CJ Equity Partners is a privately held firm that buys small family-owned firms, installs professionalmanagers to run the firms, and then sells them 3-5 years later, often for a substantial profit. CJ Eq­uity is owned by four partners who raise capital from wealthy investors and invest this money in un­related firms. Their aim is to provide a 15 percent rate of return on their investors' capital after payingthe partners of CJ Equity a management fee. CJ Equity currently owns three operating companies: atool and die company (Jasco Tools), a chemical bottling company (Miller Bottling), and a janitorialsupply company (JanSan). The professional managers running these three companies are paid a fixedsalary and bonus based on the performance of their company. Currently, CJ Equity is measuring andrewarding its three professional managers based on the net income after taxes of their individual com­panies. The following table summarizes the current year's operations of each of the three companies(all dollar amounts in millions):

Weighted average cost of capitalCJ Equity management fee*Number of employeesInterest expense*Income tax rateOperating expensesRevenuesTotal assets

CJ Equity charges each of the three operating companies an annual management fee of$200,000for managing the companies, including filing the various tax returns. The weighted average cost ofcapital represents CJ Equity's estimate of the risk-adjusted, after-tax rate of return of similar compa­nies in each operating company's industry.

You have been hired by CJ Equity as a consultant to recommend whether CJ Equity shouldchange the way it measures the performance of the three companies (net income after taxes), whichis then used to compute the professional managers' bonuses.

P 5-17: Sunstar Appliances

MODEL CVP-6907Total Cost and Price

by Quantity

Quantity Manufacturing Cost Price

100 $1,450 $120

/105 1,496 116110 1,545 112115 1,596 108120 1,650 104125 1,706 100130 1,765 96135 1,826 92140 1,890 88145 1,956 84150 2,025 80

220 Chapter 5

Required:

a. Design and prepare a performance report for the three operating companies that youbelieve best measures each operating company's performance and which will be used incomputing the three professional managers' bonuses. In other words, using yourperformance measure, compute the performance of each of the three operatingcompanies.

b. Write a short memo explaining why you believe the performance measure you chose inpart (a) best measures the performance of the three professional managers .

Sunstar sells a full line of small home kitchen appliances, including toasters, coffee makers, blenders,and bread machines. It is organized into a marketing division and a manufacturing division. The man­ufacturing division is composed of several plants, each a cost center, making one type of appliance.The toaster plant makes several different models of toasters and toaster ovens. Most of the parts, suchas the heating elements and racks for each toaster, are purchased externally, but a few are manufac­tured in the plant , including the sheet metal forming the body of the toaster. The toaster plant has anumber of departments including sheet metal fabrication, purchasing, assembly, quality assurance,packaging, and shipping.

Each toaster model has a product manager who is responsible for manufacturing the product.Each product manager manages several similar models. Product managers, with the help ofpurchas­ing, negotiate prices and delivery schedules with external part vendors. Sunstar's corporate head­quarters sets all the toaster models' selling prices and quarterly production quotas to maximizeprofits. Product managers' compensation and promotions are based on lowering unit costs and meet­ing corporate headquarters ' production quota.

The product manager sets production schedule quotas for the product and is responsible for en­suring that the distribution division of Sunstar has the appropriate number of toasters at each distrib­ution center. Product managers have discretion over outsourcing, production methods, and laborscheduling to manufacture the particular models under their control. For example, they do not haveto produce the exact number of toasters set by corporate headquarters quarterly, but rather productmanagers have some discretion to produce more or fewer toasters as long as the distribution centershave enough inventory to meet demand .

The following data were collected for one particular toaster oven, model CVP-6907. These dataare corporate forecasts for model CVP-6907 in regard to how prices and total manufacturing costs areexpected to vary with the number of toasters manufactured (and sold) per day.