Solution manual cost accounting 12e by horngren ch 22

To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 22 MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING, AND MULTINATIONAL CONSIDERATIONS 22-1 A management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout an organization and to guide the behavior of its managers and employees The goal of the system is to improve the collective decisions within an organization 22-2 To be effective, management control systems should be (a) closely aligned to an organization's strategies and goals, (b) designed to fit the organization's structure and the decision-making responsibility of individual managers, and (c) able to motivate managers and employees to put in effort to attain selected goals desired by top management 22-3 Motivation combines goal congruence and effort Motivation is the desire to attain a selected goal specified by top management (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort aspect) 22-4 The chapter cites five benefits of decentralization: Creates greater responsiveness to local needs Leads to gains from faster decision making Increases motivation of subunit managers Assets management development and learning Sharpens the focus of subunit managers The chapter cites four costs of decentralization: Leads to suboptimal decision making Focuses managers’ attention on the subunit rather than the company as a whole Increases costs of gathering information Results in duplication of activities 22-5 No Organizations typically compare the benefits and costs of decentralization on a function-by-function basis For example, companies with highly decentralized operating divisions frequently have centralized income tax strategies 22-6 No A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization The two segments can be cost centers, profit centers, or investment centers For example, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an example of transfer pricing 22-7 The three general methods for determining transfer prices are: Market-based transfer prices Cost-based transfer prices Negotiated transfer prices 22-1 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-8 Transfer prices should have the following properties They should promote goal congruence, be useful for evaluating subunit performance, motivate management effort, and preserve a high level of subunit autonomy in decision making 22-9 No, the chapter illustration demonstrates how division operating incomes differ dramatically under the variable costs, full costs, and market price methods of transfer pricing 22-10 Transferring products or services at market prices generally leads to optimal decisions when (a) the market for the intermediate product market is perfectly competitive, (b) interdependencies of subunits are minimal, and (c) there are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally 22-11 One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal decisions for the company as a whole An example of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally This situation often arises where full-cost-based transfer prices are used This situation can make the fixed costs of the supplying division appear to be variable costs of the purchasing division Another limitation is that the supplying division may not have sufficient incentives to control costs if the full-cost-based transfer price uses actual costs rather than standard costs The purchasing division sources externally if market prices are lower than full costs From the viewpoint of the company as a whole, the purchasing division should source from outside only if market prices are less than variable costs of production, not full costs of production 22-12 Reasons why a dual-pricing approach to transfer pricing is not widely used in practice include: In this approach, the manager of the supplying division uses a cost-based method to record revenues and does not have sufficient incentives to control costs This approach does not provide clear signals to division managers about the level of decentralization top management wants This approach tends to insulate managers from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division It leads to problems in computing the taxable income of subunits located in different tax jurisdictions 22-13 Disagree Cost and price information are often useful starting points in the negotiation process Costs, particularly variable costs of the selling division, serve as a ―floor‖ below which the selling division would be unwilling to sell Prices that the buying division would pay to purchase products from the outside market serves as a ―ceiling‖ above which the buying division would be unwilling to buy The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices But the negotiated price will generally fall between the variable costs-based floor and the market price-based ceiling 22-2 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-14 Yes The general transfer-pricing guideline specifies that the minimum transfer price equals the incremental cost per unit incurred up to the point of transfer plus the opportunity cost per unit to the supplying division When the supplying division has idle capacity, its opportunity cost per unit is zero; when the supplying division has no idle capacity, its opportunity cost per unit is positive Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not 22-15 Alternative transfer-pricing methods can result in sizable differences in the reported operating income of divisions in different income tax jurisdictions If these jurisdictions have different tax rates or deductions, the net income of the company as a whole can be affected by the choice of the transfer-pricing method 22-16 (15min.) Management control systems, balanced scorecard Durham produces and sells furniture of unique design and outstanding quality Clearly, it is pursuing a product-differentiation strategy, and its balanced-scorecard-based management control system should reflect that strategy and measure and communicate the degree to which the organization meets its strategic goals Some possible financial and non-financial measures are: Financial measures (for financial perspective): Profit margins, stock price, net income, return on investment, cash flow from operations, design costs as a percentage of sales Non-financial measures: market share in the high-end furniture segment, customer repeat purchases, number of mentions of Durham furniture in design and architecture magazines (customer perspective), recognized quality certifications, number of innovative designs, (internal business process perspective), ability to attract and keep the best designers, employee satisfaction, employee pride in Durham’s identity (learning-and-growth perspective) 22-3 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-17 (25 min.) Decentralization, responsibility centers The manufacturing plants in the Manufacturing Division are cost centers Senior management determines the manufacturing schedule based on the quantity of each type of lighting product specified by the sales and marketing division and detailed studies of the time and cost to manufacture each type of product Manufacturing managers are accountable only for costs They are evaluated based on achieving target output within budgeted costs 2a If manufacturing and marketing managers were to directly negotiate the prices for manufacturing various products, Quinn should evaluate manufacturing plant managers as profit centers—revenues received from marketing minus the costs incurred to produce and sell output 2b Quinn Corporation would be better off decentralizing its marketing and manufacturing decisions and evaluating each division as a profit center Decentralization would encourage plant managers to increase total output to achieve the greatest profitability, and motivate plant managers to cut their costs to increase margins Manufacturing managers would be motivated to design their operations according to the criteria that meet the marketing managers’ approval, thereby improving cooperation between manufacturing and marketing Under Quinn’s existing system, manufacturing managers have every incentive not to improve Manufacturing managers’ incentives are to get as high a cost target as possible so that they can produce output within budgeted costs Any significant improvements could result in the target costs being lowered for the next year, increasing the possibility of not achieving budgeted costs By the same line of reasoning, manufacturing managers would also try to limit their production so that production quotas would not be increased in the future Decentralizing manufacturing and marketing decisions overcomes these problems 22-4 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-18 (15 min.) Decentralization, goal congruence, responsibility centers The environmental-management group appears to be decentralized because its managers have considerable freedom to make decisions They can choose which projects to work on and which projects to reject Top management will adjust the size of the environmental-management group to match the demand for the group’s services by operating divisions The environmental-management group is a cost center The group is required to charge the operating divisions for environmental services at cost and not at market prices that would help earn the group a profit The benefits of structuring the environmental-management group in this way are: a The operating managers have incentives to carefully weigh and conduct cost-benefit analyses before requesting the environmental group’s services b The operating managers have an incentive to follow the work and the progress made by the environmental team c The environmental group has incentives to fulfill the contract, to a good job in terms of cost, time, and quality, and to satisfy the operating division to continue to get business The problems in structuring the environmental-management group in this way are: a The contract requires extensive internal negotiations in terms of cost, time, and technical specifications b The environmental group needs to continuously ―sell‖ its services to the operating division, and this could potentially result in loss of morale c Experimental projects that have long-term potential may not be undertaken because operating division managers may be reluctant to undertake projects that are costly and uncertain, whose benefits will be realized only well after they have left the division To the extent that the focus of the environmental-management group is on short-run projects demanded by the operating divisions, the current structure leads to goal congruence and motivation Goal congruence is achieved because both operating divisions and the environmental-management group are motivated to work toward the organizational goals of reducing pollution and improving the environment The operating divisions will be motivated to use the services of the environmental-management group to achieve the environmental goals set for them by top management The environmental-management group will be motivated to deliver high-quality services in a cost-effective way to continue to create a demand for their services The one issue that top management needs to guard against is that experimental projects with long-term potential that are costly and uncertain may not be undertaken under the current structure Top management may want to set up a committee to study and propose such long-run projects for consideration and funding by corporate management 22-5 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-19 (35 min.) Multinational transfer pricing, effect of alternative transfer-pricing methods, global income tax minimization This is a three-country, three-division transfer-pricing problem with three alternative transfer-pricing methods Summary data in U.S dollars are: China Plant Variable costs: Fixed costs: South Korea Plant Variable costs: Fixed costs: U.S Plant Variable costs: Fixed costs: 1,000 Yuan ÷ Yuan per $ = $125 per subunit 1,800 Yuan ÷ Yuan per $ = $225 per subunit 360,000 Won ÷ 1,200 Won per $ = $300 per unit 480,000 Won ÷ 1,200 Won per $ = $400 per unit = $100 per unit = $200 per unit Market prices for private-label sale alternatives: China Plant: 3,600 Yuan ÷ Yuan per $ = $450 per subunit South Korea Plant: 1,560,000 Won ÷ 1,200 Won per $ = $1,300 per unit The transfer prices under each method are: a Market price • China to South Korea = $450 per subunit • South Korea to U.S Plant = $1,300 per unit b 200% of full costs • China to South Korea 2.0 ($125 + $225) = $700 per subunit • South Korea to U.S Plant 2.0 ($700 + $300 + $400) = $2,800 per unit c 300% of variable costs • China to South Korea 3.0 $125 = $375 per subunit • South Korea to U.S Plant 3.0 ($375 + $300) = $2,025 per unit 22-6 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Method A Internal Transfers at Market Price China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 40% Division net income per unit South Korea Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 20% Division net income per unit United States Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 30% Division net income per unit Method B Internal Transfers at 200% of Full Costs Method C Internal Transfers at 300% of Variable Costs $ 450 $ 700 $ 375 125 225 350 100 40 $ 60 125 225 350 350 140 $ 210 125 225 350 25 10 $ 15 $1,300 $2,800 $2,025 450 300 400 1,150 150 30 $ 120 700 300 400 1,400 1,400 280 $1,120 375 300 400 1,075 950 190 $ 760 $3,200 $3,200 $3,200 1,300 100 200 1,600 1,600 480 $1,120 2,800 100 200 3,100 100 30 $ 70 2,025 100 200 2,325 875 262.5 $ 612.5 Division net income: Market Price China Division South Korea Division U.S Division User Friendly Computer, Inc $ 60 120 1,120 $1,300 200% of Full Costs $ 210 1,120 70 $1,400 300% of Variable Cost $ 15.00 760.00 612.50 $1,387.50 User Friendly will maximize its net income by using 200% of full costs as the transfer-price This is because Method B sources the largest proportion of income in Korea, the country with the lowest income tax rate 22-7 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-20 (30 min.) Transfer-pricing methods, goal congruence Alternative 1: Sell as raw lumber for $200 per 100 board feet: Revenue Variable costs Contribution margin $200 100 $100 per 100 board feet Alternative 2: Sell as finished lumber for $275 per 100 board feet: Revenue Variable costs: Raw lumber Finished lumber Contribution margin $275 $100 125 225 $ 50 per 100 board feet British Columbia Lumber will maximize its total contribution margin by selling lumber in its raw form An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, $275 – $200 Incremental costs Incremental loss $ 75 125 $ (50) per 100 board feet Transfer price at 110% of variable costs: = $100 + ($100 0.10) = $110 per 100 board feet Sell as Raw Lumber Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income Sell as Finished Lumber $200 100 $100 $110 100 $ 10 $ — $275 110 125 $ 40 $ The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is the action preferred by the company as a whole The Finished Lumber Division will maximize division operating income by selling finished lumber, which is contrary to the action preferred by the company as a whole 22-8 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Transfer price at market price = $200 per 100 board feet Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income Sell as Raw Lumber Sell as Finished Lumber $200 100 $100 $200 100 $100 $ $275 200 125 $ (50) — — $ Since the Raw Lumber Division will be indifferent between selling the lumber in raw or finished form, it would be willing to maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole The Finished Lumber Division will maximize division operating income by not further processing raw lumber and this is preferred by the company as a whole Thus, transfer at market price will result in division actions that are also in the best interest of the company as a whole 22-9 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-21 (30 min.) Effect of alternative transfer-pricing methods on division operating income Method A Internal Transfers at Market Prices Mining Division Revenues: $90, $661 400,000 units Costs: Division variable costs: $522 400,000 units Division fixed costs: $83 400,000 units Total division costs Division operating income Metals Division Revenues: $150 400,000 units Costs: Transferred-in costs: $90, $66 400,000 units Division variable costs: $364 400,000 units Division fixed costs: $155 400,000 units Total division costs Division operating income Method B Internal Transfers at 110% of Full Costs $36,000,000 $26,400,000 20,800,000 20,800,000 3,200,000 24,000,000 $12,000,000 3,200,000 24,000,000 $ 2,400,000 $60,000,000 $60,000,000 36,000,000 26,400,000 14,400,000 14,400,000 6,000,000 56,400,000 $ 3,600,000 6,000,000 46,800,000 $13,200,000 $66 = Full manufacturing cost per unit in the Mining Division, $60 110% Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor + 75% of manufacturing overhead = $12 + $16 + (75% $32) = $52 Fixed cost per unit = 25% of manufacturing overhead = 25% $32 = $8 Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40% of manufacturing overhead = $6 + $20 + (40% $25) = $36 Fixed cost per unit in Metals Division = 60% of manufacturing overhead = 60% $25 = $15 22-10 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Consider the optimal transfer prices that can be set to minimize taxes (for Anita and its subsidiaries) (a) for transfers from Anita to the Brazilian subsidiary and (b) for transfers from Anita to the Swiss subsidiary a Transfers from Anita to the Brazilian subsidiary should ―allocate‖ as much of the operating income to Anita as possible, since the tax rate in the United States is lower than in Brazil for this transaction Therefore, these transfers should be priced at the highest allowable transfer price of $700,000 to minimize overall company taxes Taxes paid: Anita, 0.40 ($700,000 – $500,000) Brazilian subsidiary, 0.60 ($1,000,000 – $700,000 – $200,000) Total taxes paid by Anita Corporation and its subsidiaries on transfers to Brazil $ 80,000 60,000 $140,000 After-tax operating income: Anita, ($700,000 – $500,000) – $80,000 Brazilian subsidiary ($1,000,000 – $700,000 – $200,000) – $60,000 Total after-tax operating income for Anita Corporation and its subsidiaries on transfers to Brazil $120,000 40,000 $160,000 b Transfers from Anita to the Swiss subsidiary should ―allocate‖ as little of the operating income to Anita as possible, since the tax rate in the United States is higher than in Switzerland for this transaction Therefore, these transfers should be priced at the lowest allowable transfer price of $500,000 to minimize overall company taxes Taxes paid: Anita, 0.40 ($500,000 – $500,000) Swiss subsidiary, 0.15 ($950,000 – $500,000 – $250,000) Total taxes paid by Anita Corporation and its subsidiaries on transfers to Switzerland After-tax operating income: Anita, ($500,000 – $500,000) – $0 Swiss subsidiary ($950,000 – $500,000 – $250,000) – $30,000 Total net income for Anita Corporation and its subsidiaries on transfers to Switzerland $ 30,000 $30,000 $ 170,000 $170,000 From the viewpoint of Anita Corporation and its subsidiaries together, overall after-tax operating income is maximized if the machine is transferred to the Swiss subsidiary (after-tax operating income of $170,000 versus after-tax operating income of $160,000 if the machine is transferred to the Brazilian subsidiary) Note that the corporation and its subsidiaries trade off the lower overall before-tax operating income achieved by transferring to the Swiss subsidiary with the lower taxes that result from such a transfer Thus, (a) the equipment should be manufactured by Anita, and (b) it should be transferred to the Swiss subsidiary at a price of $500,000 22-33 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com As in requirement 2, the Brazilian subsidiary would be willing to bid up the price to $800,000, while the Swiss subsidiary would be willing to pay only up to $700,000 Anita Corporation, acting autonomously, would like to maximize its own after-tax operating income by transferring the machine at as high a transfer price as possible As in requirement 2, the price would end up being at least $700,000 Since the taxing authorities will not allow prices above $700,000, the transfer price will be $700,000 At this transfer price, the Swiss subsidiary makes zero operating income and will not be interested in the machine As a result, Anita Corporation will sell the machine to the Brazilian subsidiary at a price of $700,000 The answer is not the same as in requirement 3, because, acting autonomously, the objective of each manager is to maximize after-tax operating income of his or her own company rather than after-tax operating income of Anita Corporation and its subsidiaries as a whole Goal congruence is not achieved in this setting Can the company induce the managers to take the right actions without infringing on their autonomy? This outcome is probably not going to be easy One possibility might be to implement a dual-pricing scheme in which the machine is transferred at cost ($500,000), but under which Anita Corporation is credited with after-tax operating income earned on the machine by the subsidiary it ships the machine to (in this example, $170,000 of net income earned by the Swiss subsidiary) A negative feature of this arrangement is that the $170,000 of after-tax operating income will be ―double counted‖ and recognized on the books of both Anita Corporation and the Swiss subsidiary Another possibility might be to evaluate the managers on the basis of overall after-tax operating income of Anita Corporation and its subsidiaries This approach will induce a more global perspective, but at the cost of inducing a larger noncontrollable element in each manager’s performance measure 22-34 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-34 (30 min.) Transfer pricing, goal congruence See column (1) of Solution Exhibit 22-34 The net cost of the in-house option is $230,000 See columns (2a) and (2b) of Solution Exhibit 22-34 As the calculations show, if Johnson Corporation offers a price of $38 per tape player, Orsilo Corporation should purchase the tape players from Johnson; this will result in an incremental net cost of $210,000 (column 2a) If Johnson Corporation offers a price of $45 per tape player, Orsilo Corporation should manufacture the tape players in-house; this will result in an incremental net cost of $230,000 (column 2b) SOLUTION EXHIBIT 22-34 Transfer 10,000 tape players to Assembly Sell 2,000 in outside market at $35 each (1) Incremental cost of Cassette Division supplying 10,000 tape players to Assembly Division $25 10,000; 0; 0; Incremental costs of buying 10,000 tape players from Johnson $0; $38 10,000; $40 10,000; $45 10,000 Revenue from selling tape players in outside market $35 2,000; 12,000; 12,000; 12,000 Incremental costs of manufacturing tape players for sale in outside market $25 2,000; 12,000; 12,000; 12,000 Revenue from supplying head mechanism to Johnson $20 0; 10,000; 10,000; 10,000 Incremental costs of supplying head mechanism to Johnson $15 0; 10,000; 10,000; 10,000 Net costs Buy 10,000 tape players from Johnson at $38 Sell 12,000 tape players in outside market at $35 each (2a) $(250,000) $ (380,000) 70,000 420,000 (50,000) (300,000) 200,000 $(230,000) (150,000) $(210,000) Buy 10,000 tape players from Johnson at $40 Sell 12,000 tape players in outside market at $35 each (2x) $ Buy 10,000 tape players from Johnson at $45 Sell 12,000 tape players in outside market at $35 each (2b) $ (400,000) (450,000) 420,000 420,000 (300,000) (300,000) 200,000 200,000 (150,000) $(230,000) (150,000) $(280,000) Comparing columns (1) and (2a), at a price of $38 per tape player from Johnson, the net cost of $210,000 is less than the net cost of $230,000 to Orsilo Corporation if it made the tape players in-house So, Orsilo Corporation should outsource to Johnson Comparing columns (1) and (2b), at a price of $45 per tape player from Johnson, the net cost of $280,000 is greater than the net cost of $230,000 to Orsilo Corporation if it made the tape players in-house Therefore, Orsilo Corporation should reject Johnson’s offer Now consider column (2x) of Solution Exhibit 22-34 It shows that at a price of $40 per tape player from Johnson, the net cost is exactly $230,000, the same as the net cost to Orsilo 22-35 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Corporation of manufacturing in-house (column 1) Thus, for prices between $38 and $40, Orsilo will prefer to purchase from Johnson For prices greater than $40 (and up to $45), Orsilo will prefer to manufacture in-house The Cassette Division can manufacture at most 12,000 tape players and it is currently operating at capacity The incremental costs of manufacturing a tape player are $25 per unit The opportunity cost of manufacturing tape players for the Assembly Division is (1) the contribution margin of $10 (selling price, $35 minus incremental costs $25) that the Cassette Division would forgo by not selling tape players in the outside market plus (2) the contribution margin of $5 (selling price, $20 minus incremental costs, $15) that the Cassette Division would forgo by not being able to sell the head mechanism to external suppliers of tape players such as Johnson (recall that the Cassette division can produce as many head mechanisms as demanded by external suppliers, but their demand will fall if the Cassette Division supplies the Assembly Division with tape players) Thus, the total opportunity cost to the Cassette Division of supplying tape players to Assembly is $10 + $5 = $15 per unit Using the general guideline, Incremental cost per Minimum transfer = tape player up to the price per tape player point of transfer Opportunity cost per tape player to the selling division = $25 + $15 = $40 Thus, the minimum transfer price that the Cassette Division will accept for each tape player is $40 Note that at a price of $40, Orsilo is indifferent between manufacturing tape players inhouse or purchasing them from an external supplier 4a The transfer price is set to $40 + $1 = $41 and Johnson is offering the tape players for $40.50 each Now, for an outside price per tape player below $41, the Assembly Division would prefer to purchase from outside; above it, the Assembly Division would prefer to purchase from the Cassette Division So, the Assembly division will buy from Johnson at $40.50 each and the Cassette Division will be forced to sell its output on the outside market 4b But for Orsilo, as seen from requirements and 2, an outside price of $40.50, which is greater than the $40 cut-off price, makes inhouse manufacture the optimal choice So, a mandated transfer price of $41 causes the division managers to make choices that are suboptimal for Orsilo 4c When selling prices are uncertain, the transfer price should be set at the minimum acceptable transfer price It is only if the price charged by the external supplier falls below $40 that Orsilo Corporation as a whole is better off purchasing from the outside market Setting the transfer price at $40 per unit achieves goal congruence The Cassette division will be willing to sell to the Assembly Division, and the Assembly Division will be willing to buy in-house and this would be optimal for Orsilo, too 22-36 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-35 (40 50 min.) Transfer pricing, utilization of capacity Super-chip Selling price $60 Direct material cost per unit Direct manufacturing labor cost per unit 28 Contribution margin per unit $30 Contribution margin per hour ($30 2; $4 0.5) $15 Okay-chip $12 $ $ Because the contribution margin per hour is higher for Super-chip than for Okay-chip, CIC should produce and sell as many Super-chips as it can and use the remaining available capacity to produce Okay-chip The total demand for Super-chips is 15,000 units, which would take 30,000 hours (15,000 hours per unit) CIC should use its remaining capacity of 20,000 hours (50,000 – 30,000) to produce 40,000 Okay-chips (20,000 0.5) Options for manufacturing process-control unit: Using Using Circuit Board Super-chip Selling price $132 $132 Direct material cost per unit 60 Direct manufacturing labor cost per unit (Super-chip) 28 Direct manufacturing labor cost per unit (process-control unit) 50 60 Contribution margin per unit $ 22 $ 42 Overall Company Viewpoint Alternative 1: No Transfer of Super-chips: Sell 15,000 Super-chips at contribution margin per unit of $30 Transfer Super-chips Sell 40,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 Control units at contribution margin per unit of $22 Total contribution margin 22-37 $450,000 160,000 110,000 $720,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Alternative 2: Transfer 5,000 Super-chips to Process-Control Division These Super-chips would require 10,000 hours to manufacture, leaving only 10,000 hours for the manufacture of 20,000 Okay-chips (10,000 0.5): Sell 15,000 Super-chips at contribution margin per unit of $30 Transfer 5,000 Super-chips to Process-Control Division Sell 20,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 Control units at contribution margin per unit of $42 Total contribution margin $450,000 80,000 210,000 $740,000 CIC is better off transferring 5,000 Super-chips to the Process-Control Division For each Super-chip that is transferred, two hours of time (labor capacity) are given up in the Semiconductor Division, and, in those two hours, four Okay-chips could be produced, each contributing $4 Minimum transfer price = per Super - chip = = Incrementa l cost Opportunity cost per unit for per unit to + the Semiconductor Division the point of transfer $30 + $16 $46 per unit If the selling price for the process-control unit were firm at $132, the Process-Control Division would accept any transfer price up to $50 ($60 price of circuit board $10 incremental labor cost if Super-chip used) However, consider what happens if the transfer price of Super-chip is set at, say, $49, and the price of the control unit drops to $108 From CIC’s viewpoint: Using Circuit Board Selling price $108 Direct material cost per unit 60 Direct manufacturing labor cost per unit 50 Contribution margin per unit $ –2 Using Using Super-chip $108 49 60 $ –1 Process-Control Division will not produce any control units From the company’s viewpoint, the contribution margin on the control unit if the Super-chip is used is: Selling price Direct material cost per unit Direct manufacturing labor cost per unit (Super-chip) Direct manufacturing labor cost per unit (process-control unit) Contribution margin per unit 22-38 $108 28 60 $ 18 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com The contribution margin per unit from producing Super-chips for the process-control unit exceeds the contribution margin of $16 from producing Okay-chips, each yielding a contribution margin of $4 per unit Therefore, the Semiconductor Division should transfer 5,000 Super-chips as the following calculations show: Alternative 1—No transfer (and, therefore, no sales of process-control units): Sell 15,000 Super-chips at contribution margin per unit of $30 Sell 40,000 Okay-chips at contribution margin per unit of $4 $450,000 160,000 $610,000 Alternative 2—Transfer 5,000 Super-chips: Sell 15,000 Super-chips at contribution margin per unit of $30 Sell 20,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 control units at contribution margin per unit of $18 $450,000 80,000 90,000 $620,000 So, if the price for the control unit is uncertain, the transfer price must be set at the minimum acceptable transfer price of $46 For a transfer of any amount between and 10,000 Super-chips (which require hours each to produce), the opportunity cost is the production of Okay-chips (which require ½ hour each) In this range, the relevant costs are equal to the transfer price of $46 established in part If more than 10,000 Super-chips are transferred, the opportunity cost becomes the sale of Super-chips on the outside market Now the minimum transfer price per Super-chip becomes: Incremental Opportunit y cost per Super - cost per Super chip up to the + chip to the = $30 + ($60 – $30) = $60, the market price point of Semiconduc tor transfer Division At this transfer price, it is cheaper for the Process-Control Division to buy the circuit board for $60, since $10 of additional direct manufacturing labor cost is saved The Semiconductor Division should at most transfer 10,000 Super-chips: Internal Demand 0–10,000 10,000–25,000 Transfer Price $46 60 22-39 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 22-36 (20 min.) Ethics, transfer pricing The contribution margin for 10,000 units of R47 if variable costs are $14 and $16 per unit, respectively, are as follows: Variable Variable Costs of Costs of $14 per Unit $16 per Unit Transfer price at 200% of variable costs Variable cost per unit Contribution margin per unit Contribution margin for 10,000 units $14 10,000; $16 10,000 $ $ 28 14 14 $140,000 $ $ 32 16 16 $160,000 In assessing the situation, the specific ―Standards of Ethical Conduct for Management Accountants,‖ described in Chapter that the management accountant should consider are listed below Competence Clear reports using relevant and reliable information should be prepared Reports prepared on the basis of incorrectly identifying variable costs would violate the management accountant’s responsibility to competence It is unethical for Lasker to suggest that Tanner should change the variable cost numbers that were prepared for costing product R47 and, hence, the transfer price for R47 The methodology to calculate variable costs has been in place for some time at Durham Industries The company could certainly re-evaluate this methodology but Tanner cannot so on his own Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict Increasing the variable costs allocated to R47 will increase the transfer price and as a result, the revenues of the Belmont Division If they changed the method of determining variable costs, Lasker and Tanner would appear to favor the Belmont Division (that manufactures R47) over the Alston Division (that uses R47) This action could be viewed as violating the responsibility for integrity The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information In this regard, both Lasker’s and Tanner’s behavior (if Tanner agrees to increase variable costs) could be viewed as unethical Objectivity The ―Standards of Ethical Conduct for Management Accountants‖ require that information should be fairly and objectively communicated and that all relevant information should be disclosed From a management accountant’s standpoint, increasing the variable costs of a product to earn higher revenue for a division, in violation of company policy, clearly violates both these precepts For the various reasons cited above, the behavior of Lasker and Tanner (if he goes along with Lasker’s wishes) is unethical 22-40 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Tanner should indicate to Lasker that the variable costs of R47 are indeed appropriate, given that the methods for computing variable costs and fixed costs have been in place for some time If Lasker still insists on making the changes and increasing the variable costs of making R47, Tanner should raise the matter with Lasker’s superior If, after taking all these steps, there is continued pressure to increase the variable cost component, Tanner should consider resigning from the company and not engage in unethical behavior Some students may raise the issue of whether variable cost transfer pricing is appropriate in this context The problem does not provide enough details for a complete discussion of this issue Management may well conclude that the transfer price should not be set as a multiple of variable costs But that is a management decision The management accountant should not unilaterally use methods of calculating variable costs that are in direct violation of accepted past practice 22-37 (40–50 min.) Goal congruence, income taxes, different market conditions Selling price Savings in purchase cost per unit by making engines in-house Manufacturing cost per unit: Direct materials Direct manufacturing labor Variable manufacturing overhead Total costs of manufacturing Contribution margin per unit from New Engine Net savings in cost per unit by making existing engine in-house New Engine $375 $400 $100 40 25 $125 50 25 165 $210 If the order for the new engine is accepted, San Ramon earns a contribution margin of $210 2,000 units In this case, Engine Division will be in a position to supply only 2,000 units to Assembly, and Assembly will have to purchase 1,200 engines from outside The incremental cost of buying engines from outside is $200 1,200 Net benefit from accepting order 22-41 Existing Engine Used by Assembly 200 $200 $420,000 240,000 $180,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com An alternative approach is to compare relevant costs of the accept order and reject order alternatives: Accept Order Contribution margin from selling 2,000 units of new engine, $210 2,000 Incremental cost of making and transferring 2,000 units or 3,200 units of old engines, $200 2,000; $200 3,200 Incremental costs of purchasing 1,200 units from outside, $400 1,200 Reject Order $(420,000) 400,000 $640,000 480,000 $460,000 $640,000 San Ramon Corporation should: a make 2,000 units of the new engine in the Engine Division b make 2,000 units of the existing engine for the Assembly Division c have the Assembly Division purchase 1,200 existing engines from the outside market The options facing the Engine Division manager are (a) to sell 2,000 units of the special order engine and make 2,000 units for the Assembly Division, or (b) to make 3,200 units for the Assembly Division The contribution margin per unit from accepting the special order is $210 per unit Let the transfer price be $X Then, we want to find X such that ($210 2,000) + ($X – $200) 2,000 ($X – $200) (3,200 – 2,000) $X – $200 X = ($X – $200) 3,200 = $420,000 $420 ,000 = = $350 1,200 = $550 For transfer prices below $550, the Engine Division gets more by selling 2,000 units outside and transferring 2,000 units to Assembly Division It will not transfer more than 2,000 units to Assembly even though the transfer price is greater than the variable costs of manufacturing the existing engine, $200 plus the contribution margin per unit from accepting the special order of $210 equal to $410 ($500, say) Why? Because by transferring an additional 1,200 units (say), it will have to give up $420,000 ($210 2,000) of contribution margin by not accepting the special order The Engine Division manager would be willing to transfer 2,000 units for which it has capacity (after fulfilling the outside order) to the Assembly Division provided the transfer price covers the Engine Division's variable costs So, the range of transfer price that will induce the Engine Division manager to implement the optimal solution in requirement is: TP $200 for the first 2,000 units TP $550 for the next 1,200 units 22-42 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com The Assembly Division manager would be willing to buy from the Engine Division so long as the transfer price is less than or equal to the price at which the Assembly Division can buy the engines on the outside market TP $400 It will not buy the engines from the Engine Division if TP > $400 The range of TP that will result in both managers favoring the optimal actions in requirement is TPs that satisfy the respective constraints described above $200 TP $400 for the first 2,000 units TP = $550 for the next 1,200 units This transfer-pricing scheme will induce both managers to transfer 2,000 units between the Engine and Assembly Divisions, but no more Because the Assembly Division manager is willing to pay no more than $400 per unit and the Engine Division manager is unwilling to transfer unless the transfer price is above $550, no transfers will occur beyond the first 2,000 units 3a are: The full manufacturing cost per unit of the engines transferred to the Assembly Division Direct materials cost per unit Direct manufacturing labor cost per unit Variable manufacturing overhead cost per unit Fixed manufacturing overhead cost per unit $520,000 $260,000 2,000 engines since the engines transferred to the Assembly Division use up half the Engine Division's capacity Total manufacturing cost per unit $125 50 25 130 $330 b A transfer price of $330 is in the optimal range identified in requirement 2, and so will achieve the optimal actions of selling 2,000 engines to the outside party and transferring 2,000 engines to the Assembly Division as identified in requirement The transfer price for the next 1,200 units should be set at $550 so that the Assembly Division will prefer to purchase engines at $400 per unit from the outside market The transfer price for the next 1,200 units should not be set at the full manufacturing cost of $330 per unit because the Assembly Division will then want to buy the engines internally This is not in the best interest of San Ramon Corporation as a whole c One advantage of full cost transfer pricing is that it is useful for the firm’s long-run pricing decisions One disadvantage of full cost transfer pricing is that costs that are fixed for the corporation as a whole look like variable costs from the viewpoint of the Assembly Division manager This is because, by choosing not to have a unit transferred from the 22-43 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Engine Division, the Assembly Division manager would appear to save both the variable and fixed costs of the engine This could lead to suboptimal decisions 4a To minimize taxes, San Ramon should transfer the engines at the highest price it can, the market price of $400 The Engine Division would pay no taxes on any income that it would report By setting the transfer price as high as possible, the Assembly Division would minimize the income it would report and the taxes it would pay b Yes, as in part 3b, the transfer price of $400 for the first 2,000 engines is also within the range identified in requirement and so will achieve the outcome desired in requirement (sell 2,000 engines under the outside offer and transfer 2,000 engines to the Assembly Division) San Ramon should use a transfer price of $400 for the first 2,000 units and $550 for the next 1,200 units when transferring engines from the Engine Division to the Assembly Division This transfer price minimizes tax payments for the San Ramon Corporation as a whole and also achieves goal congruence That is, at the transfer prices indicated, both Divisions will be content with the following arrangement: a The Engine Division will make 2,000 engines for outside customers and 2,000 engines for the Assembly Division b The Assembly Division will take 2,000 engines from the Engine Division and 1,200 engines from the outside market Of course, the Assembly Division manager would like to negotiate a price lower than $400 (but greater than $200) for the first 2,000 engines from the Engine Division, but this would increase San Ramon's tax payments At a transfer price of $400, San Ramon can still evaluate each division's performance on the basis of division operating income because the transfer price of $400 approximates the market prices for the engines transferred from the Engine Division to the Assembly Division Market-based transfer prices give top management a reasonably good picture of the contributions of the individual divisions to overall companywide profitability 22-44 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 22 Case The Information Systems Corporation case can only be discussed using the textbook case writeup The case questions challenge students to apply the concepts learned in the chapter to a specific business situation INFORMATION SYSTEMS CORPORATION: Transfer Prices and Goal Congruence You may wish to begin the class discussion by asking the first assignment question, ―Why you suppose this plant’s costs are higher than competitors’ market prices?‖ The most obvious reason is the current idle capacity Because most costs are fixed, the full cost per unit increases as capacity utilization declines While this explanation explains a large portion of the current problem, it does not explain why the plant’s costs were higher than competitors’ prices when the plant was operating at capacity (a few years ago) There are three explanations for the latter problem First, the competitors in the industry employ ―forward pricing.‖ This term, also known as ―experience curve pricing‖ or ―volume pricing,‖ refers to a practice of estimating the average cost to be incurred over several years and pricing the product to earn a profit relative to the projected average cost In the early periods of production of a new product, this approach means pricing the product below the actual manufacturing cost The second explanation is more subtle Note that for several years, the semiconductor division was the company’s only source of RAMs There was no competition Without competition there was no strong pressure to be cost effective and unnecessary costs had crept into the process Third, students may argue that the non-U.S suppliers of RAMs were dumping their products––selling RAMs in the U.S at a price below the market value in the country of its creation U.S semiconductor manufacturers have charged nonU.S competition with dumping There are a number of possible alternatives for establishing an appropriate transfer price for interdivisional transfers: a Some of these are based upon cost and would continue to have many of the problems already identified by management b However, since there is an existing external market for much of the site’s output, a market-based price may be appropriate for the plant’s standard output c The remaining unique proprietary production could be transferred at some ―negotiated‖ market price to maintain a consistent set of measurements throughout the site Furthermore, use of a market-based price is more in keeping with the concept of profit center responsibility as practiced in most decentralized companies An income statement can easily be created that would allow management to measure its results against the competition rather than relying solely on measurements that compare actual results to plans or to prior periods 22-45 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Students are likely to make arguments in support of each of the three alternatives identified in requirement Student comments should make the following points: a Some discussion of the general guideline described in Chapter 22 The case facts appear to describe a competitive market for RAMs and idle capacity at the plant The minimum transfer price in this case is the incremental (variable) cost per unit at the plant In the short run, Information Systems Corporation (ISC) as a whole benefits if the variable cost per unit at the plant is less than the market price and the purchasing divisions purchase RAMs from the plant rather than from external suppliers This outcome will be achieved if the transfer price is set between the plant’s variable cost per unit and the market price b Using the current full cost per unit (which is greater than the market price) as the transfer price appears to be a poor choice This approach will lead purchasing divisions to buy RAMs from external suppliers Purchasing from external suppliers would be suboptimal from the viewpoint of ISC as a whole if the incremental (variable) cost per unit of making RAMs in-house is less than the market price Furthermore, ISC will be unable to evaluate the profitability of the semiconductor division Is the division worth keeping or should it be shut down and all RAMs be purchased from external suppliers? c Some discussion of using market prices as transfer prices The advantage of transferring at market prices is that buying divisions will be willing to buy from the semiconductor division Management can then evaluate the division’s competitiveness over a period of time If the division cannot recover all its costs, ISC may be better off shutting down the division and buying all RAMs from external suppliers The industry practice for pricing semiconductors is forward pricing based on average cost per unit over a period of years With such a pricing scheme, there might be a period of loss in the initial years that will be recouped with profits in the future The average price should permit a gradual recovery of initial start-up costs Thus, the ―buyer‖ immediately benefits from the projected improvements and also has a sense of commitment from the site that the published price will prevail over a period of time Using market prices will also result in variable profit markups, depending on the uniqueness of the product Market prices will yield greater margins on unique items and lower margins on the higher volume, standard products Naturally, this approach will provide a more attractive base business to support future activities Using market prices as transfer prices is problematic if the market prices represent temporary ―distress prices.‖ Students who believe that low prices arose as a result of ―dumping‖ activities by foreign companies may argue that these low prices are unlikely to continue This is a reasonable argument though most of the evidence suggests that low RAM prices are more the result of learning curve effects, long-term excess capacity, technological advances, and forward pricing rather than dumping Consequently, low market prices for RAMs are likely to prevail over a long period of time On balance, it appears that market prices are the best choice of transfer price for RAMs at ISC 22-46 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com What the Firm Actually Did The site controller recommended that the site adopt a market-based interdivisional transfer price for its production This transfer price would enable the ―buying‖ product managers to view the site like the semiconductor industry In keeping with this strategy, the site would commit to its prices, monitor their competitiveness, have variable markups by product, and offer flexible terms and conditions These terms and conditions included minimum order quantities to assist in stabilizing production and bringing about further cost improvements Three types of price categories were established: Prices for functionally substitutable products are based upon competitive product prices, as long as a profit can be achieved over the lifetime of the product This forward pricing technique enabled the site to take advantage of technology learning curve effects and optimize capacity Unique products have a price developed on a cost-plus approach, but, once again, they are forward priced over the life of the product Finally, products which are hybrids between being functionally substitutable and unique, are priced with both techniques and are subject to negotiation To accommodate these changes, the accounting system was modified to model the consumption of the site’s production throughout the corporation by major product The percentage of interdivisional profit for each product was developed by the site accounting organization and eventually eliminated by the corporate accounting consolidation staff, based upon shipment information provided by the site each month As ―buyers,‖ product managers saw only the established transfer price in their costs and income statements The resulting model was highly complex and required considerable programming and systems effort to make it usable Nevertheless, the model was installed, reviewed with the appropriate state tax authorities and external auditors, and implemented within a year after the decision to adopt the market-based transfer price The site management has adopted the new measurements and has moved aggressively to compete for its ―lost‖ marketplace 22-47 ... suppliers Relevant costs if purchased from Division A: Incremental (outlay) costs if purchased from Division A Opportunity costs if purchased from Division A Total relevant costs if purchased from Division... methods Summary data in U.S dollars are: China Plant Variable costs: Fixed costs: South Korea Plant Variable costs: Fixed costs: U.S Plant Variable costs: Fixed costs: 1,000 Yuan ÷ Yuan per $ = $125... variable costs: $ 522 400,000 units Division fixed costs: $83 400,000 units Total division costs Division operating income Metals Division Revenues: $150 400,000 units Costs: Transferred-in costs: