HOW DO TRANSFER PRICES AFFECT DECENTRALIZED COMPANIES?
5. How do transfer prices affect decentralized companies?
■
■ The transfer price is the transaction amount of one unit of goods when the transaction occurs between divisions within the same company.
■
■ Transfer prices should be set to achieve goal congruence.
■
■ Market-based transfer prices are appropriate when the selling division is operating at capacity.
■
■ Cost-based transfer prices are appropriate when the selling division is operating below capacity.
■
■ The transfer price negotiable range is the variable cost to the market price.
> Check Your Understanding 24-1
Check your understanding of the chapter by completing this problem and then looking at the solution. Use this practice to help identify which sections of the chapter you need to study more.
The balanced scorecard gives performance perspective from four different viewpoints.
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Requirements
1. Each of the following describes a key performance indicator. Determine which of the balanced scorecard perspectives is being addressed (financial, customer, internal business, or learning and growth) (See Learning Objective 2):
a. Employee turnover b. Earnings per share
c. Percentage of on-time deliveries d. Revenue growth rate
e. Percentage of defects discovered during manufacturing f. Number of warranty claims
g. New product development time h. Number of repeat customers
i. Number of employee suggestions implemented
2. Read the following company initiatives, and determine which of the balanced scorecard perspectives is being addressed (financial, customer, internal business, or learning and growth) (See Learning Objective 2):
a. Purchasing efficient production equipment b. Providing employee training
c. Updating retail store lighting
d. Paying quarterly dividends to stockholders e. Updating the company’s information system
> Solution
Requirement 1
a. Learning and growth b. Financial
c. Customer d. Financial e. Internal business f. Internal business g. Internal business h. Customer
i. Learning and growth Requirement 2
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Check your understanding of the chapter by completing this problem and then looking at the solution. Use this practice to help identify which sections of the chapter you need to study more.
Swift Company has three divisions and expects each division to earn a 16% target rate of return. The company had the following results last year:
Division Profit margin ratio Asset turnover ratio ROI
1 7.2% 2.737 19.7%
2 11.7% 1.584 18.5%
Division 3 reported the following data:
Operating income $ 1,450,000 Average total assets 16,100,000 Net sales revenue 26,500,000
Requirements
1. Compute Division 3’s profit margin ratio, asset turnover ratio, and ROI. Round your results to three decimal places. Interpret the results in relation to the other two divi- sions. (See Learning Objective 4)
2. Compute and interpret Division 3’s RI. (See Learning Objective 4)
3. What can you conclude based on the financial performance KPIs? (See Learning Objective 4)
> Check Your Understanding 24-2
> Solution
Requirement 1
Division 3’s
profit margin ratio = Operating income
Net sales revenue = +1,450,000
+26,500,000 = 0.055 = 5.5, Division 3’s
asset turnover ratio = Net sales revenue
Average total assets = +26,500,000
+16,100,000 = 1.646 Division 3’s ROI = Profit margin ratio * Asset turnover ratio
= 5.5,* 1.646 = 9.1,
Division 3 is far from meeting top management’s expectations. Its ROI is only 9.1%. The profit margin ratio of 5.5% is significantly lower than the other two divisions. Addition- ally, the asset turnover ratio (1.646) is much lower than Division 1’s but slightly higher than Division 2’s. This means that Division 3 is not generating sales from its average total assets as efficiently as Division 1 but it is more efficient than Division 2. Division management needs to consider ways to increase the efficiency with which it uses divisional average total assets and increase profitability.
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Requirement 2
RI = Operating income - (Target rate of return * Average total assets)
= +1,450,000 - (16, * +16,100,000)
= +1,450,000 - +2,576,000
= +(1,126,000)
The negative RI confirms the ROI results: The division is not meeting management’s target rate of return.
Requirement 3
Both investment center financial performance KPIs (ROI and RI) point to the same conclusion: Division 3 is not meeting financial expectations. Either top management’s and stakeholders’ expectations are unrealistic or the division is not currently performing up to par. Recall, however, that financial performance measures tend to be lag indicators—
measuring the results of decisions made in the past. The division’s manager may cur- rently be implementing new initiatives to improve the division’s future profitability. Lead indicators should be used to project whether such initiatives are pointing the division in the right direction.
> Key Terms
Asset Turnover Ratio (p. 1341) Balanced Scorecard (p. 1331) Centralized Company (p. 1325) Controllable Cost (p. 1334)
Cost-Based Transfer Price (p. 1348) Cost Center (p. 1327)
Decentralized Company (p. 1325) Goal Congruence (p. 1326) Investment Center (p. 1328)
Key Performance Indicator (KPI) (p. 1331)
Lag Indicator (p. 1331) Lead Indicator (p. 1331)
Market-Based Transfer Price (p. 1347) Operational Performance
Measure (p. 1331) Opportunity Cost (p. 1347) Performance Evaluation System
(p. 1330)
Profit Center (p. 1327) Profit Margin Ratio (p. 1341) Residual Income (RI) (p. 1343) Responsibility Accounting
System (p. 1327)
Responsibility Center (p. 1327) Responsibility Report (p. 1334) Return on Investment (ROI) (p. 1340) Revenue Center (p. 1327)
Transfer Price (p. 1346)
> Quick Check
1. Which is not one of the potential advantages of decentralization?
a. Improves motivation and retention b. Supports use of expert knowledge c. Improves customer relations d. Increases goal congruence
Learning Objective 1
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3. Which of the following is not a goal of performance evaluation systems?
a. Promoting goal congruence and coordination b. Communicating expectations
c. Providing feedback
d. Reprimanding unit managers
4. Which of the following balanced scorecard perspectives essentially asks, “Can we continue to improve and create value?”
a. Customer
b. Learning and growth
c. Financial d. Internal business 5. The performance evaluation of a cost center is typically based on its
a. sales volume variance.
b. ROI.
c. static budget variance.
d. flexible budget variance.
The following data apply to questions 6 through 9.
Assume the Residential Division of Kipper Faucets had the following results last year:
Net sales revenue $ 4,160,000
Operating income 1,040,000
Average total assets 5,200,000
Management’s target rate of return 18%
6. What is the division’s profit margin ratio?
a. 400%
b. 20%
c. 25%
d. 80%
7. What is the division’s asset turnover ratio?
a. 0.20 b. 0.80
c. 1.25 d. 0.25 8. What is the division’s ROI?
a. 20%
b. 25%
c. 500%
d. 80%
9. What is the division’s RI?
a. $(140,000) b. $104,000
c. $140,000 d. $(104,000)
10. Penn Company has a division that manufactures a component that sells for $50 and has variable costs of $25 and fixed costs of $10. Another division wants to purchase the component. What is the minimum transfer price if the division is operating at capacity?
a. $10 b. $25
c. $35 d. $50 Check your answers at the end of the chapter.
Learning Objective 2
Learning Objective 2
Learning Objective 3
Learning Objective 4
Learning Objective 4
Learning Objective 4
Learning Objective 4
Learning Objective 5
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ASSESS YOUR PROGRESS
> Review Questions
1. Explain the difference between a centralized company and a decentralized company.
2. List the advantages of decentralization.
3. List the disadvantages of decentralization.
4. What is goal congruence?
5. Usually, which outweighs the other in decentralization—advantages or disadvantages?
6. What is the purpose of a responsibility accounting system?
7. What is a responsibility center?
8. List the four types of responsibility centers, and briefly describe each.
9. What is a performance evaluation system?
10. What are the goals of a performance evaluation system?
11. Explain the difference between a lag indicator and a lead indicator.
12. How is the use of a balanced scorecard as a performance evaluation system helpful to companies?
13. What is a key performance indicator?
14. What are the four perspectives of the balanced scorecard? Briefly describe each.
15. Explain the difference between a controllable and a noncontrollable cost.
16. What is the typical focus of responsibility reports for cost centers, revenue centers, and profit centers?
17. What are two key performance indicators used to evaluate investment centers?
18. Describe the two ways ROI can be calculated.
19. What does ROI measure?
20. What is the biggest disadvantage of using ROI to evaluate investment centers?
21. How is RI calculated?
22. What does RI measure?
23. What is the biggest advantage of using RI to evaluate investment centers?
24. What are some limitations of financial performance measures?
25. What is a transfer price?
26. Explain the difference between market-based transfer prices and cost-based transfer prices.
27. How does capacity affect transfer pricing decisions?
> Short Exercises
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Requirements
1. Explain why companies decentralize. Describe some typical methods of decentralization.
2. List the four most common types of responsibility centers, and describe their responsibilities.
S24-2 Classifying responsibility centers
Each of the following managers works for a national chain of hotels and has been given certain decision-making authority. Classify each of the managers according to the type of responsibility center he or she probably manages.
a. Manager of the Central Reservation Office
b. Managers of various corporate-owned hotel locations
c. Managers of the Northeast and Southeast Corporate Divisions d. Manager of the Housekeeping Department at one hotel e. Manager of the complimentary breakfast buffet at one hotel
S24-3 Explaining why companies use performance evaluation systems
Well-designed performance evaluation systems accomplish many goals. Consider the following actions, and state which goal is being achieved by the action:
a. Comparing targets to actual results
b. Providing subunit managers with performance targets c. Comparing actual results with industry standards
d. Providing bonuses to subunit managers who achieve performance targets e. Aligning subunit performance targets with company strategy
f. Comparing actual results of competitors g. Taking corrective actions
h. Using the adage “you get what you measure” when designing the performance evaluation system
S24-4 Describing the balanced scorecard and identifying key performance indicators for each perspective
Consider the following key performance indicators, and classify each according to the balanced scorecard perspective it addresses. Choose from financial perspective, customer perspective, internal business perspective, or learning and growth perspective.
a. Number of employee suggestions implemented b. Revenue growth
c. Number of on-time deliveries
d. Percentage of sales force with access to real-time inventory levels e. Customer satisfaction ratings
f. Number of defects found during manufacturing g. Number of warranty claims
h. Return on investment i. Variable cost per unit
Learning Objective 1
Learning Objective 2
Learning Objective 2
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j. Percentage of market share
k. Number of hours of employee training l. Number of new products developed
m. Yield rate (number of units produced per hour) n. Average repair time
o. Employee satisfaction p. Number of repeat customers
S24-5 Using performance reports to evaluate cost, revenue, and profit centers Management by exception is a term often used in performance evaluation. Describe management by exception and how it is used in the evaluation of cost, revenue, and profit centers.
S24-6 Evaluating investment centers
Consider the following data, and determine which of the corporate divisions is more profitable. Explain your reasoning.
Domestic International Operating income $ 10,000,000 $ 11,000,000 Average total assets 24,000,000 32,000,000
S24-7 Using ROI and RI to evaluate investment centers
XTreme Sports Company makes snowboards, downhill skis, cross-country skis, skateboards, surfboards, and inline skates. The company has found it beneficial to split operations into two divisions based on the climate required for the sport: Snow Sports and Non-snow Sports. The following divisional information is available for the past year:
Net Sales Revenue
Operating Income
Average Total
Assets ROI
Snow Sports $ 5,500,000 $ 990,000 $ 4,100,000 24.1%
Non-snow Sports 8,500,000 1,530,000 6,100,000 25.1%
XTreme’s management has specified a 13% target rate of return. Calculate each divi- sion’s profit margin ratio. Interpret your results.
Note: Short Exercise S24-7 must be completed before attempting Short Exercise S24-8.
S24-8 Using ROI and RI to evaluate investment centers Refer to the information in Short Exercise S24-7.
Requirements
Learning Objective 3
Learning Objective 4
Learning Objective 4
Learning Objective 4
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Note: Short Exercise S24-7 must be completed before attempting Short Exercise S24-9.
S24-9 Using ROI and RI to evaluate investment centers
Refer to the information in Short Exercise S24-7. Compute each division’s RI.
Interpret your results. Are your results consistent with each division’s ROI?
S24-10 Transfer pricing
Henderson Company manufactures electronics. The Calculator Division (an invest- ment center) manufactures handheld calculators. The division can purchase the bat- teries used in the calculators from the Battery Division (another investment center) or from an outside vendor. The cost to purchase batteries from the outside vendor is $5.
The transfer price to purchase from the Battery Division is $6. The Battery Division also sells to outside customers. The sales price is $6, and the variable cost is $3. The Battery Division has excess capacity.
Requirements
1. Should the Calculator Division purchase from the Battery Division or the outside vendor?
2. If Henderson Company allows division managers to negotiate transfer prices, what is the maximum transfer price the manager of the Calculator Division should consider?
3. What is the minimum transfer price the manager of the Battery Division should consider?
4. Does your answer to Requirement 3 change if the Battery Division is operating at capacity?
Learning Objective 4
Learning Objective 5
> Exercises
E24-11 Identifying responsibility centers after decentralization
Grandpa Jim’s Cookie Company sells homemade cookies made with organic ingredi- ents. His sales are strictly Web based. The business is taking off more than Grandpa Jim ever expected, with orders coming from across the country from both consumers and corporate event planners. Grandpa decides to decentralize and hires a full-time baker who will manage production and product costs and a Web site designer/sales manager who will focus on increasing sales through the Web site. Grandpa Jim can no longer handle the business on his own, so he hires a business manager to work with the other employees to ensure the company is best utilizing its assets to produce profit.
Grandpa will then have time to focus on new product development.
Now that Grandpa Jim’s Cookie Company has decentralized, identify the type of responsibility center that each manager is managing.
E24-12 Explaining why companies use performance evaluation systems Financial performance is measured in many ways.
Requirements
1. Explain the difference between lag and lead indicators.
2. The following is a list of financial measures. Indicate whether each is a lag or a lead indicator:
a. Income statement shows net income of $100,000 b. Listing of next week’s orders of $50,000
Learning Objective 1
Learning Objective 2
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c. Trend showing that average hits on the redesigned Web site are increasing at 5%
per week
d. Price sheet from vendor reflecting that cost per pound of sugar for the next month is $2
e. Contract signed last month with large retail store that guarantees a minimum shelf space for Grandpa’s Overloaded Chocolate Cookies for the next year E24-13 Explaining why companies use performance evaluation systems
Well-designed performance evaluation systems accomplish many goals. Describe the potential benefits performance evaluation systems offer.
E24-14 Describing the balanced scorecard and identifying key performance indicators for each perspective
Consider the following key performance indicators, and classify each indicator accord- ing to the balanced scorecard perspective it addresses. Choose from the financial perspective, customer perspective, internal business perspective, and the learning and growth perspective.
Learning Objective 2
Learning Objective 2
a. Number of customer complaints
b. Number of information system upgrades completed c. Residual income
d. New product development time e. Employee turnover rate
f. Percentage of products with online help manuals g. Customer retention
h. Percentage of compensation based on performance i. Percentage of orders filled each week
j. Gross margin growth k. Number of new patents l. Employee satisfaction ratings
m. Manufacturing cycle time (average length of production process)
n. Earnings growth
o. Average machine setup time p. Number of new customers q. Employee promotion rate r. Cash flow from operations s. Customer satisfaction ratings t. Machine downtime
u. Finished products per day per employee
v. Percentage of employees with access to upgraded system w. Wait time per order prior to start of production
E24-15 Using responsibility reports to evaluate cost, revenue, and profit centers
One subunit of Harris Sports Company had the following financial results last month:
Learning Objective 3 1. Direct Materials 8.11% U
Harris—Subunit X
Actual Results
Flexible Budget
Flexible Budget Variance (F or U)
% Variance (F or U) Direct Materials $ 28,000 $ 25,900
Direct Labor 13,000 13,800
Indirect Labor 26,400 23,100
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Requirements
1. Complete the performance evaluation report for this subunit. Enter the variance percent as a percentage of the budgeted amount rounded to two decimal places.
2. Based on the data presented, what type of responsibility center is this subunit?
3. Which items should be investigated if part of management’s decision criteria is to investigate all variances exceeding $2,500 or 10%?
4. Should only unfavorable variances be investigated? Explain.
E24-16 Using responsibility reports to evaluate cost, revenue, and profit centers
The accountant for a subunit of Speed Sports Company went on vacation before completing the subunit’s monthly responsibility report. This is as far as she got:
Learning Objective 3
Speed—Subunit X Revenue by Product
Actual Results
Flexible Budget Variance
Flexible Budget
Sales Volume Variance
Static Budget
Downhill-RI $ 321,000 (a) (b) $ 17,000 F $ 295,000
Downhill-RII 151,000 (c) $ 161,000 (d) 145,000
Cross-EXI 285,000 $ 3,000 U 288,000 (e) 303,000
Cross-EXII 259,000 (f) 255,000 16,500 U 271,500
Snow-LXI 425,000 2,000 F (g) (h) 404,000
Total $ 1,441,000 (i) (j) (k) $ 1,418,500
Requirements
1. Complete the responsibility report for this subunit.
2. Based on the data presented, what type of responsibility center is this subunit?
3. Which items should be investigated if part of management’s decision criteria is to investigate all variances exceeding $12,000?
E24-17 Using ROI and RI to evaluate investment centers
Zims, a national manufacturer of lawn-mowing and snow-blowing equipment, segments its business according to customer type: professional and residential. The following divisional information was available for the past year:
Net Sales Revenue Operating Income Average Total Assets
Residential $ 550,000 $ 65,280 $ 192,000
Professional 1,090,000 164,820 402,000
Management has a 26% target rate of return for each division.
Requirements
1. Calculate each division’s ROI. Round all of your answers to four decimal places.
2. Calculate each division’s profit margin ratio. Interpret your results.
3. Calculate each division’s asset turnover ratio. Interpret your results.
4. Use the expanded ROI formula to confirm your results from Requirement 1. What can you conclude?
Learning Objective 4 1. Residential’s ROI 34.00%
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Note: Exercise E24-17 must be completed before attempting Exercise E24-18.
E24-18 Using ROI and RI to evaluate investment centers
Refer to the data in Exercise E24-17. Calculate each division’s RI. Interpret your results.
E24-19 Determining transfer pricing
The Watkins Company is decentralized, and divisions are considered investment centers. Watkins specializes in sports equipment, and one division manufactures netting that is used for basketball hoops, soccer goals, and other sports equipment. The Net- ting Division reports the following information for a heavy-duty basketball hoop net:
Sales Price per Unit $ 18 Variable Cost per Unit 6 Contribution Margin per Unit $ 12
The Basketball Equipment Division can purchase a similar heavy-duty net from an outside vendor for $15.
Requirements
1. Determine the negotiable range for the transfer price.
2. What is the minimum transfer price the Netting Division should consider if operating at capacity? Below capacity?
3. What is the maximum transfer price the Basketball Equipment Division should consider?
Learning Objective 4
Professional’s RI $60,300 Learning Objective 5
> Problems Group A
P24-20A Integrating decentralization and performance evaluation systems One subunit of Racer Sports Company had the following financial results last month:
Subunit X Actual Results Flexible Budget
Flexible Budget Variance (F or U)
% Variance (F or U) Net Sales Revenue $ 476,000 $ 451,000
Variable Expenses 261,000 251,000
Contribution Margin 215,000 200,000
Traceable Fixed Expenses 40,000 26,000 Divisional Segment Margin $ 175,000 $ 174,000
Requirements
1. Complete the performance evaluation report for this subunit (round to two decimal places).
Learning Objectives 1, 2, 3 1. Sales $25,000 F
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5. Is it possible that the variances are due to a higher-than-expected sales volume?
Explain.
6. Will management place equal weight on each of the variances exceeding $8,000?
Explain.
7. Which balanced scorecard perspective is being addressed through this
performance report? In your opinion, is this performance report a lead or a lag indicator? Explain.
8. List one key performance indicator for the three other balanced scorecard perspectives. Make sure to indicate which perspective is being addressed by the indicators you list.
P24-21A Using ROI and RI to evaluate investment centers
Consider the following condensed financial statements of Forever Free, Inc. The company’s target rate of return is 40%.
Learning Objective 4 3. Asset turnover ratio 7.00
Cost of Goods Sold Net Sales Revenue
Gross Profit Operating Expenses
1,300,000 950,000 350,000 (27,000) 323,000 2,200,000
$ 3,500,000
Operating Income Interest Expense
Other Income and (Expenses):
Income Before Income Tax Expense Income Tax Expense
Net Income
FOREVER FREE, INC.
Income Statement
For the Year Ended December 31, 2018
113,050
$ 209,950
FOREVER FREE, INC.
Comparative Balance Sheet As of December 31, 2018 and 2017
Assets
2018 2017
Cash
Accounts Receivable Supplies
Property, Plant, and Equipment, net Patents, net
Total Assets
Accounts Payable Short-term Notes Payable Long-term Notes Payable Common Stock, no Par Retained Earnings
Total Liabilities and Stockholders’ Equity
Liabilities and Stockholders’ Equity
$ 52,000
400 229,800 119,000
$ 419,000 17,800
$ 64,000
1,000 331,800 135,000
$ 581,000 49,200
136,000 42,000
$ 17,000 $ 19,000
184,000 114,500 232,000 242,000
12,000 1,500
$ 581,000 $ 419,000
Requirements
1. Calculate the company’s ROI. Round all of your answers to four decimal places.
2. Calculate the company’s profit margin ratio. Interpret your results.
3. Calculate the company’s asset turnover ratio. Interpret your results.
4. Use the expanded ROI formula to confirm your results from Requirement 1.
Interpret your results.
5. Calculate the company’s RI. Interpret your results.