Solutions Manual
to accompany
MANAGERIAL
ACCOUNTING
Ronald W. Hilton
Cornell University
David E. Platt
University of Texas at Austin
13-1
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Contents
Preface iii
Chapter 8 Variable Costing and the Costs of Quality and Sustainability 8-1
Chapter 15 Target Costing and Cost Analysis for Pricing Decisions 15-1
ii
13-2
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Preface
The best way for most students to learn managerial accounting is to read the text and then
solve a representative sample of the review questions, exercises, problems and cases at the
end of each chapter. These end-of-chapter materials span a wide range of topics, types of
organizations, and levels of difficulty. The topic of each exercise, problem, and case is
indicated in the text. The estimated amount of time required is shown in the solutions
manual. The Solutions Manual also includes a brief discussion of the points raised in the
Focus on Ethics features, which appear at the end of most chapters in the text. We
gratefully acknowledge Liesl Folks and Yinian Hou for their very able assistance in preparing
discussion points for the text’s Focus on Ethics features.
Several exercises and problems in each chapter (excluding chapter 1) include an optional
requirement entitled Build a Spreadsheet , which is highlighted in the text in red. Here
students are instructed to build an Excel spreadsheet that will solve one or more of the
requirements in the exercise or problem. There are several alternatives for instructors with
regard to assigning these optional Build a Spreadsheet requirements.
(2) Assign the optional Build a Spreadsheet requirement in addition to the manual
computational requirements. Under this approach, the student would solve several
of the problem’s requirements twice, once manually and then a second time in the
context of the Excel spreadsheet.
(3) Assign the optional Build a Spreadsheet requirement instead of the manual
computational requirements that the optional Excel spreadsheet solves.
The electronic version of this solutions manual includes links to Excel spreadsheets that
solve these optional spreadsheet requirements.
We have found that students’ Excel skills vary widely. Consequently, the time that students
will need to build each Excel spreadsheet will vary considerably as well. For this reason, the
suggested solution times given for each exercise and problem do not include the time
required to build the optional Excel spreadsheet.
13-3
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
CHAPTER 13
Investment Centers and Transfer Pricing
13-5
income income sales revenue
Return on investment (ROI)
invested capital sales revenue invested capital
13-6 A division's ROI can be improved by improving the sales margin, by improving
the capital turnover, or by some combination of the two. The manager of the
Automobile Division of an insurance company could improve the sales margin
by increasing the profit margin on each insurance policy sold. As a result,
every sales dollar would generate more income. The capital turnover could be
improved by increasing sales of insurance policies while keeping invested
capital fixed, or by decreasing the invested assets required to generate the
same sales revenue.
13-4
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
The imputed interest rate is used in calculating residual income, but it is not
used in computing ROI. The imputed interest rate reflects the firm's minimum
required rate of return on invested capital.
13-8 The chief disadvantage of ROI is that for an investment that earns a rate of
return greater than the company's cost of raising capital, the manager in
charge of deciding about that investment may have an incentive to reject it if
the investment would result in reducing the manager's ROI. The residual-
income measure eliminates this disadvantage by including in the residual-
income calculation the imputed interest rate, which reflects the firm's cost of
capital. Any project that earns a return greater than the imputed interest rate
will show a positive residual income.
13-9 The rise in ROI or residual income across time results from the fact that
periodic depreciation charges reduce the book value of the asset, which is
generally used in determining the investment base to use in the ROI or
residual-income calculation. This phenomenon can have a serious effect on the
incentives of investment-center managers. Investment centers with old assets
will show higher ROIs than investment centers with relatively new assets. This
result can discourage investment-center managers from investing in new
equipment. If this behavioral tendency persists for a long time, a division's
assets can become obsolete, making the division uncompetitive.
13-10 The economic value added (EVA) is defined as follows:
13-5
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-11 a. Total assets: Includes all divisional assets. This measure of invested capital
is appropriate if the division manager has considerable authority in making
decisions about all of the division's assets, including nonproductive assets.
b. Total productive assets: Excludes assets that are not in service, such as
construction in progress. This measure is appropriate when a division
manager is directed by top management to keep nonproductive assets,
such as vacant land or construction in progress.
c. Total assets less current liabilities: All divisional assets minus current
liabilities. This measure is appropriate when the division manager is
allowed to secure short-term bank loans and other short-term credit. This
approach encourages investment-center managers to minimize resources
tied up in assets and maximize the use of short-term credit to finance
operations.
13-12 The use of gross book value instead of net book value to measure a division's
invested capital eliminates the problem of an artificially increasing ROI or
residual income across time. Also, the usual methods of computing
depreciation, such as straight-line or declining-balance methods, are arbitrary.
As a result, some managers prefer not to allow these depreciation charges to
affect ROI or residual-income calculations.
13-16 During periods of inflation, historical-cost asset values soon cease to reflect
the cost of replacing those assets. Therefore, some accountants argue that
13-6
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-19 The goal in setting transfer prices is to establish incentives for autonomous
division managers to make decisions that support the overall goals of the
organization. Transfer prices should be chosen so that each division manager,
when striving to maximize his or her own division's profit, makes the decision
that maximizes the company's profit.
13-20 Four methods by which transfer prices may be set are as follows:
(a) Transfer price = additional outlay costs incurred because goods are
transferred + opportunity costs to the organization because of the transfer.
(c) Transfer prices may be set on the basis of negotiations among the division
managers.
(d) Transfer prices may be based on the cost of producing the goods or
services to be transferred.
13-21 When the transferring division has excess capacity, the opportunity cost of
producing a unit for transfer is zero.
13-7
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-8
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
SOLUTIONS TO EXERCISES
EXERCISE 13-24 (10 MINUTES)
income $10,000,000
Sales margin = sales revenue = $125,000,0
00 = 8%
sales revenue $125,000,0
00
Capital turnover = invested capital = $50,000,000 = 2.5
income $10,000,00
0
Return on = invested capital = $50,000,00
0 = 20%
investment
There are an infinite number of ways to improve the division's ROI to 25 percent. Here
are two of them:
Since sales revenue remains unchanged, this implies a cost reduction of $2,500,000
at the same volume.
= 8% 3.125 = 25%
Since sales revenue remains unchanged, this implies that the firm can divest itself
of some productive assets without affecting sales volume.
13-9
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
income income
2. ROI = 20% = invested capital = £ 50,000
Income = 20% £50,000 = £10,000
Income = sales revenue – expenses = £10,000
Income = £100,000 – expenses = £10,000
Expenses = £90,000
Therefore, expenses must be reduced to £90,000 in order to raise the firm's ROI to
20 percent.
income £ 10,000
= 10%
3. Sales margin = sales revenue = £ 100,000
13-10
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Students will need to decide how to determine the income and the invested assets
to use in both calculations. The discussion in the text will serve as a guide in this
regard.
= 20%
13-11
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
3. In the electronic version of the solutions manual, press the CTRL key and click on
the following link: 10E - BUILD A SPREADSHEET 13-29.XLS
Memorandum
Date: Today
From: I. M. Student
When ROI is calculated on the basis of net book value, it will typically increase over
time. The net book value of the bundle of assets declines over time as depreciation is
recorded. The income generated by the bundle of assets often will remain constant or
increase over time. The result is a steady increase in the ROI, as income remains
constant (or increases) and book value declines.
This effect will not exist (or at least will not be as pronounced) if the firm continues to
invest in new assets at a roughly steady rate across time.
13-12
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
1. The same employee is responsible for keeping the inventory records and taking the
physical inventory count. In addition, when the records and the count do not agree,
the employee changes the count, rather than investigating the reasons for the
discrepancy. This leaves open the possibility that the employee would steal inventory
and conceal the theft by altering both the records and the count. Even without any
dishonesty by the employee, this system is not designed to control inventory since it
does not encourage resolution of discrepancies between the records and the count.
(a) Assign two different employees the responsibilities for the inventory records and
the physical count. With this arrangement, collusion would be required for theft to
be concealed.
(b) Require that discrepancies between the inventory records and the physical count
be investigated and resolved when possible.
13-13
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-14
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
After-Tax Economic
Operating Total Assets Current Value
Income Liabilities Added
Division (in millions) (in millions) (in millions) WACC (in millions)
Real Estate
$30(1.40) $150 $9 .114 = $1.926
1. outlay opportunity
Transfer price = cost + cost
= $450* + $120 † = $570
outlay opportunity
Transfer price = cost + cost
= $450 + 0 = $450
13-15
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
1. The Assembly Division's manager is likely to reject the special offer because the
Assembly Division's incremental cost on the special order exceeds the division's
incremental revenue:
2. The Assembly Division manager's likely decision to reject the special order is not in
the best interests of the company as a whole, since the company's incremental
revenue on the special order exceeds the company ' s incremental cost:
3. The transfer price could be set in accordance with the general rule, as follows:
outlay opportunity
Transfer price = cost + cost
= $590 + 0*
= $590
*Opportunity cost is zero, since the Fabrication Division has excess capacity.
Now the Assembly Division manager will have an incentive to accept the special
order since the Assembly Division's incremental revenue on the special order
exceeds the incremental cost. The incremental revenue is still $1,000 per unit, but
the incremental cost drops to $890 per unit ($590 transfer price + $300 variable cost
incurred in the Assembly Division).
13-16
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
SOLUTIONS TO PROBLEMS
PROBLEM 13-36 (25 MINUTES)
The answer to the question as to which division is the most successful depends on the
firm's cost of capital. To see this, compute the residual income for each division using
various imputed interest rates.
Division I Division II
Divisional profit.......................................................... $2,700,000 $600,000
Less: Imputed interest charge:
I: $18,000,000 14%..................................... 2,520,000
II: $ 3,000,000 14%..................................... ________ 420,000
Residual income......................................................... $ 180,000 $180,000
If the firm's cost of capital is 10 percent, then Division I has a higher residual income
than Division II. With a cost of capital of 15 percent, Division II has a higher residual
income. At a 14 percent cost of capital, both divisions have the same residual income.
This scenario illustrates one of the advantages of residual income over ROI. Since the
residual income calculation includes an imputed interest charge reflecting the firm's cost
of capital, it gives a more complete picture of divisional performance.
13-17
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Explanatory notes:
a income $400,000
Sales margin = = = 20%
sales revenue $2,000,000
c
ROI = sales margin capital turnover = 20% 2 = 40%
d
Residual income = income – (imputed interest rate)(invested capital)
= $400,000 – (10%)($1,000,000) = $300,000
income
e
Sales margin = sales revenue
$80,000
25% = sales revenue
sales revenue
f
Capital turnover = invested capital
$320,000
= invested capital
13-18
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
income
j
ROI = invested capital = 24%
Therefore, income = (24%)(invested capital)
Residual = income – (imputed interest rate)(invested capital)
income
= $280,000
Substituting from above for income:
(24%)(invested capital) – (10%)(invested capital) = $280,000
Therefore, (14%)(invested capital) = $280,000
So, invested capital = $2,000,000
income
k
ROI =
invested capital
income
24% = $2,000,000
l
income
Sales margin =
sales revenue
$480,000
30% = sales revenue
13-19
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
(a) Increase income, while keeping invested capital the same. Suppose income
increases to $9,000,000. The new ROI is:
income $9,000,000
ROI 90%
invested capital $10,000,000
(b) Decrease invested capital, while keeping income the same. Suppose invested
capital decreases to $9,600,000. The new ROI is:
income $8,000,000
ROI 83.3% (rounded )
invested capital $9,600,000
(c) Increase income and decrease invested capital. Suppose income increases to
$8,400,000 and invested capital decreases to $9,600,000. The new ROI is:
income $8,400,000
ROI 87.5%
invested capital $9,600,000
13-20
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
This problem is similar to Problem 13-36, except that here students are given a hint in
answering the question about which division is the most successful by requiring the
calculation of residual income for three different imputed interest rates. If the firm's cost
of capital is 12 percent, then Division I has a higher residual income than Division II.
With a cost of capital of 15 percent or 18 percent, Division II has a higher residual
income.
Division I Division II
Divisional profit.......................................................... $2,700,000 $600,000
Less: Imputed interest charge:
I: $18,000,000 12%..................................... 2,160,000
II: ....................................$ 3,000,000 12% 360,000
Residual income........................................................ $ 540,000 $240,000
Division I Division II
Divisional profit............................................................ $2,700,000 $600,000
Less: Imputed interest charge:
I: $18,000,000 15%...................................... 2,700,000
II: ......................................$ 3,000,000 15% 450,000
Residual income.......................................................... $ $150,000
0
13-21
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
The imputed interest rate r, at which the two divisions’ residual income is the same,
is 14 percent, computed as follows:
13-22
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Sales $500,000
revenue…………………………………….
Less: Variable costs ($500,000 x 75%) $375,000
……...
Fixed 100,000 475,000
costs………………………………..
Income………………………………………… $ 25,000
…..
2. Divisional management will likely be against the acquisition because ROI will
be lowered from 25% to 19.40%. Since bonuses are awarded on the basis of
ROI, the acquisition will result in less compensation.
Sales $200,000
revenue……………………………………..
Less: Variable costs ($200,000 x 60%) $120,000
……....
Fixed costs 70,000 190,000
………………………………..
13-23
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Income………………………………………… $ 10,000
…...
13-24
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
4. Yes, the divisional ROI would increase to 23.30%. However, the absence of
the upgrade could lead to long-run problems, with customers being confused
(and perhaps turned-off) by two different retail environments—the retail
environment they have come to expect with other Megatronics outlets and that
of the newly acquired, non-upgraded competitor.
Divisional $25,000
profit………………………………………………
Less: Imputed interest charge ($100,000 x 15%) 15,000
……..
Residual $10,000
income……………………………………………..
Yes, management most likely will change its attitude. Residual income will
increase by $7,000 ($17,000 - $10,000) as a result of the acquisition.
13-26
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
ROI
ROI Based
Based Average on
Income Income Average on Gross Gross
Before Annual Net of Net Net Book Book
Year Depreciatio Depreciatio Depreciatio Book Book Value Value
n n n Value* Value †
1 $150,000 $200,000 $(50,000) $400,00 — $500,00 —
0 0
2 150,000 120,000 30,000 240,000 12.5% 500,000 6.0%
3 150,000 72,000 78,000 144,000 54.2% 500,000 15.6%
4 150,000 54,000 96,000 81,000 118.5% 500,000 19.2%
5 150,000 54,000 96,000 27,000 355.6% 500,000 19.2%
*Average net book value is the average of the beginning and ending balances for the year in
net book value. In Year 1, for example, the average net book value is:
$500,000 $300,000
$400,000
2
†
ROI rounded to the nearest tenth of 1 percent.
1. This table differs from Exhibit 13-3 in that ROI rises even more steeply across time
than it does in Exhibit 13-3. With straight-line depreciation, ROI rises from 11.1
percent in Year 1 to 100 percent in Year 5. Under the accelerated depreciation
schedule used here, we have a loss in Year 1 and then ROI rises from 12.5 percent
in Year 2 to 355.6 percent in Year 5.
13-27
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
*Average net book value is the average of the beginning and ending balances for the year in net book value.
†
Imputed interest charge is 10 percent of the average book value, either net or gross.
Notice in the table that residual income, computed on the basis of net book value,
increases over the life of the asset. This effect is similar to the one demonstrated for
ROI.
It is not very meaningful to compute residual income on the basis of gross book
value. Notice that this asset shows a zero residual income for all five years when the
calculation is based on gross book value.
13-28
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
2. Strategy (a): Income will be reduced to $450,000 because of the loss, and
invested capital will fall to $8,910,000 from the disposal. ROI = $450,000 ÷
$8,910,000, or 5.05%. This strategy should be rejected, since it further hurts
Washburn’s performance.
Strategy (b): In terms of ROI, this strategy neither hurts nor helps. The
acceleration of overdue receivables increases cash and decreases accounts
receivable, producing no effect on invested capital. Of course, it is possible that
the newly acquired cash could be invested in something that would provide a
positive return for the firm.
13-29
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
From the preceding calculations, both investments appear attractive given the
current state of affairs (i.e., the Hardware Division’s current ROI of 6%).
However, if Washburn desires to maximize ROI, he would be advised to acquire
only Anderson Manufacturing.
Current +
Current + Anderson +
Current Anderson Palm Beach
Income……………… $ $ $
. 540,000 1,440,000* 2,010,000**
Invested capital…… 9,000,00 16,500,00 23,625,000
0 0
ROI………………… 6% 8.73% 8.51%
…
13-30
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
A f te r - a x M a rk e t C o s t f M a r k e t
c os t f
d e bt v a l u e q u i t y v a l u e o f
eightd-W ofdebt capitl equity
averg capitl
c o s t f M a rk e t M a rk e t
c a p it l v a l u e v a l u e
o f d e b t o f e q u i ty
The following calculation shows that the company’s WACC is 9.72 percent.
13-31
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-32
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
3. The EVA analysis reveals that the Atlantic Division is in trouble. Its substantial
negative EVA merits the immediate attention of the management team.
13-33
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
cost of CCLS’s equity capital is 14 percent. Moreover, the market value of the
company’s equity is $180 million. The following calculation shows that Cape Cod
Lobster Shacks’ WACC is 10.56 percent.
After-Tax Economic
Operating Total Assets Current Value
Income Liabilities Added
Division (in millions) (in millions) (in millions) WACC (in millions)
3. In the electronic version of the solutions manual, press the CTRL key and click on
the following link: 10E - BUILD A SPREADSHEET 13-45.XLS
13-35
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
2. Although Tampa is receiving a $50 “price break” on each unit purchased from
Birmingham, the $1,500 transfer price would probably be deemed too high. The
reason: Tampa will lose $40 on each satellite positioning system produced and
sold.
Sales $2,800
revenue…………………………………..
Less: Variable manufacturing $1,340
costs……….
Transfer price paid to 1,500 2,840
Birmingham…
Income (loss) $ (40)
……………………………………
4. MTI would benefit more if it sells the diode reducer externally. Observe that the
transfer price is ignored in this evaluation—one that looks at the firm as a whole.
Put simply, Birmingham would record the transfer price as revenue whereas
Tampa would record the transfer price as a cost, thereby creating a “wash” on the
part of the overall entity.
Produce Diode;
Produce Transfer; Sell
Diode; Sell Positioning System
Externally
13-37
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-38
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
The Glass Division manager has an incentive to reject the special order
because the Glass Division's reported net income would be reduced by $402 for
every window in the order.
f. One can raise an ethical issue here to the effect that a division manager should
always strive to act in the best interests of the whole company, even if that
action seemingly conflicts with the division’s best interests. In complex transfer
pricing situations, however, it is not always as clear what the company’s optimal
action is as it is in this rather simple scenario.
3. The use of a transfer price based on the Frame Division's full cost has caused a
cost that is a fixed cost for the entire company to be viewed as a variable cost in the
Glass Division. This distortion of the firm's true cost behavior has resulted in an
incentive for a dysfunctional decision by the Glass Division manager.
13-39
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
1. Among the reasons transfer prices based on total actual costs are not appropriate
as a divisional performance measure are the following:
They provide little incentive for the selling division to control manufacturing
costs, because all costs incurred will be passed on to the buying division.
They often lead to suboptimal decisions for the company as a whole, because
they can obscure cost behavior. Costs that are fixed for the company as a
whole can be made to appear variable to the division buying the transferred
goods.
2. Using the market price as the transfer price, the contribution margin for both the
Mining Division and the Metals Division is calculated as follows:
Mining Metals
Division Division
Note: the $150 variable selling cost that the Mining Division would incur for sales on the
open market should not be included, because this is an internal transfer.
13-40
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
3. If RIRC instituted the use of a negotiated transfer price that also permitted the
divisions to buy and sell on the open market, the price range for toldine that would
be acceptable to both divisions would be determined as follows.
The Mining Division would like to sell to the Metals Division for the same price it
can obtain on the outside market, $2,700 per unit. However, Mining would be
willing to sell the toldine for $2,550 per unit, because the $150 variable selling
cost would be avoided.
The Metals Division would like to continue paying the bargain price of $1,980 per
unit. However, if Mining does not sell to Metals, Metals would be forced to pay
$2,700 on the open market. Therefore, Metals would be satisfied to receive a
price concession from Mining equal to the costs that Mining would avoid by selling
internally. Therefore, a negotiated transfer price for toldine between $2,550 and
$2,700 would be acceptable to both divisions and benefits the company as a
whole.
*Outlay cost = direct material + direct labor + variable overhead [see requirement
(2)]
**Opportunity cost = forgone contribution margin from outside sale on open
market
= $1,188 contribution margin from internal sale calculated in
requirement (2), less the additional $150 variable selling
cost incurred for an external sale
Therefore, the general rule yields a minimum acceptable transfer price to the
Mining Division of $2,550, which is consistent with the conclusion in requirement
(3).
13-41
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Benefit the Metals Division by providing toldine at a lower cost than that of its
competitors.
13-42
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
1. If the transfer price is set equal to the U.S. variable manufacturing cost, Delta
Telecom will make $98.40 per circuit board:
U.S. operation:
Sales revenue (transfer price) $
……………………………... 390.00
Less: Variable manufacturing 390.0
cost……………………….. 0
Contribution $
margin…………………………………………. --
German operation:
Sales $1,080.0
revenue…………………………………… 0
Less: Transfer $390.00
price…………………………….
Shipping 60.0
fees……………………………. 0
Additional processing costs………….. 345.00
Import duties ($390.00 x 10%) 39.0 834.0
………… 0 0
Income before $
tax………………………………. 246.00
Less: Income tax expense ($246.00 x 147.6
60%).. 0
Income after $
tax………………………………… 98.40
2. If the transfer price is set equal to the U.S. market price, Delta will make $117.60
per circuit board: $72.00 + $45.60 = $117.60. The U.S. market price is therefore
more attractive as a transfer price than the U.S. variable manufacturing cost.
U.S. operation:
Sales $
revenue…………………………………………………. 510.00
Less: Variable manufacturing 390.0
cost……………………….. 0
Income before $
tax……………………………………………. 120.00
Less: Income tax expense ($120.00 x 40%) 48.0
……………… 0
13-43
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Income after $
tax………………………………………………. 72.00
German operation:
Sales $1,080.0
revenue…………………………………… 0
Less: Transfer $510.00
price…………………………….
Shipping 60.0
fees……………………………. 0
Additional processing costs………….. 345.00
Import duties ($510.00 x 10%) 51.0 966.0
………… 0 0
Income before $ 114.00
tax……………………………….
Less: Income tax expense ($114.00 x 68.4
60%).. 0
Income after $
tax………………………………… 45.60
13-44
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
3. (a) The head of the German division should be a team player; however, when
the
circuit board can be obtained locally for $465, it is difficult to get excited
about doing business with the U.S. operation. Courtesy of the shipping fee
and import duty, both of which can be avoided, it is advantageous to
purchase in Germany. Even if the lower of the two transfer prices is
adopted, the German division would be better off to acquire the circuit
board at home ($465 vs. $390 + $60 + $39 = $489).
(b) Yes. Delta will make $180.00 per circuit board ($72.00 + $108.00) if no
transfer takes place and all circuit boards are sold in the U.S.
U.S. operation:
Sales $
revenue………………………………………………. 510.00
Less: Variable manufacturing cost…………………….. 390.0
0
Income before $
tax………………………………………….. 120.00
Less: Income tax expense ($120.00 x 40%) 48.0
…………… 0
Income after $
tax……………………………………………. 72.00
German operation:
Sales $1,080.0
revenue………………………………….. 0
Less: Purchase price…………………………. $465.0
0
Additional processing costs………… 345.0 810.0
0 0
Income before $
tax……………………………... 270.00
Less: Income tax expense ($270.00 x 162.0
60%).. 0
Income after $
tax………………………………... 108.00
4. When tax rates differ, companies should strive to generate less income in high
tax-rate countries, and vice versa. When alternatives are available, this can be
accomplished by a careful determination of the transfer price.
13-45
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
5. In the electronic version of the solutions manual, press the CTRL key and click on
the following link: 10E - BUILD A SPREADSHEET 13-49.XLS
13-46
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
SOLUTIONS TO CASES
1. If New Age Industries continues to use return on investment as the sole measure of
division performance, Fun Times Entertainment Corporation (FTEC) would be
reluctant to acquire Recreational Leasing, Inc. (RLI), because the post-acquisition
combined ROI would decrease.
Return on Investment
FTEC RLI Combined
Operating income..........................................$1,000,000 $ 300,000 $
1,300,000
Total assets................................................... 4,000,000 1,500,000 5,500,000
Return on investment (income/assets)............ 25% 20% 23.6%*
*Rounded.
The result would be that FTEC's management would either lose their bonuses or
have their bonuses limited to 50 percent of the eligible amounts. The assumption is
that management could provide convincing explanations for the decline in return on
investment.
2. Residual income is the profit earned that exceeds an amount charged for funds
committed to a business unit. The amount charged for funds is equal to an imputed
interest rate multiplied by the business unit's invested capital.
Residual Income
FTEC RLI Combined
Total assets............................................ $4,000,000 $1,600,000* $5,600,000
Income................................................... $1,000,000 $ 300,000 $1,300,000
Less: Imputed interest charge
(assets 15%).................................... 600,000 240,000 840,000
Residual income..................................... $ 400,000 $ $ 460,000
60,000
13-47
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-48
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Shy away from profitable opportunities or investments that would yield more
than the company's cost of capital but that could lower ROI.
13-49
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
1. Diagram of scenario:
Alternative 1:
Transfer the Alternative 2:
Low- High- Buy the
HDP
Density Density Control Pack
Panels Panels
(LDP) (HDP) Imported TCH-320
Control Tachometer
Pack
Outside Outside
Market Market
Outside
Market
2. First, compute the unit contribution margin of an LDP and an HDP as follows:
LDP HDP
Price.......................................................................... $28 $ 115
Less: Variable cost:
Unskilled labor.................................................. $5 $5
Skilled labor...................................................... 5 30
Raw material..................................................... 3 8
Purchased components..................................... 5 15
Variable overhead............................................. 4 12
Total variable cost............................................. 22 70
Unit contribution margin............................................. $ 6 $ 45
13-50
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Second, compute the unit contribution margin of Volkmar's TCH-320 under each of its
alternatives, as follows:
TCH-320 TCH-320
Using Using
Imported an
Control Pack HDP
Price.................................................... $275.00 $275.00
Less: Variable cost:
Unskilled labor............................. $ 4.50 $ 4.50
Skilled labor................................ 51.00 85.00
Raw material............................... 10.50 5.00
Purchased components................ 150.00 5.00
Variable overhead........................ 12.00 12.00
Variable cost of manufacturing -0- 70.00
HDP
Variable cost of transporting HDP. -0- 4.50
Total variable cost........................ 228.00 186.00
Unit contribution margin........................ $ 47.00 $ 89.00
Difference
is $42.
From the perspective of the entire company, the scarce resource that will limit overall
company profit is the limited skilled labor time available in the Hudson Bay Division. The
question, then, is how can the company as a whole best use the limited skilled labor time
available at Hudson Bay? The division has two products: LDP and HDP. One can view
these as three products, though, in the sense that the HDP units can be produced either
for outside sale or for transfer to the Volkmar Tachometer Division.
13-51
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
What is the unit contribution to covering the overall company's fixed cost and profit from
each of these three products? The calculations above show that the unit contribution
margin of an LDP is $6, and the unit contribution of an HDP sold externally is $45.
Moreover, the unit contribution to the overall company of an HDP produced for transfer is
$42, which is the increase in the unit contribution margin of the TCH-320 when it is
manufactured with the HDP instead of the imported control pack. To summarize:
Unit Contribution to
Covering the Company's
Hudson Bay's Product Fixed Cost and Profit
HDP sold externally $45
HDP transferred 42
internally
LDP 6
The analysis of these three products' contribution margins (to General Instrumentation
as a whole) has not gone far enough, because the products do not require the same
amount of the scarce resource, skilled labor time. The important question is how much
one hour of limited skilled labor at Hudson Bay spent on each of the three products will
contribute toward the overall firm's fixed cost and profit.
13-52
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
This analysis shows that from the perspective of the entire company, Hudson Bay's best
use of its limited skilled labor resource is to produce HDPs for external sale, up to the
maximum demand of 6,000 units per year. The second best use of Hudson Bay's limited
skilled labor is to produce HDPs for internal transfer, up to the maximum number of units
needed by the Volkmar Tachometer Division. This number is 10,000 HDPs, since that is
the demand for Volkmar's TCH-320. Hudson Bay's least profitable product is the LDP.
Therefore, from the perspective of General Instrumentation as a whole, the Hudson Bay
Division should use its limited skilled labor time as follows:
The final answer to requirement (2) is that all of the required 10,000 TCH-320
tachometers should be manufactured using the HDP unit from the Hudson Bay
Division.
4. Hudson Bay's minimum acceptable transfer price is given by the general transfer-
pricing rule, as follows:
13-53
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Explanatory notes:
(a) The outlay cost is equal to the variable cost of manufacturing an HDP.
(b) The opportunity cost is equal to the forgone contribution margin on the LDP
units that Hudson Bay will be unable to produce because it is manufacturing
an HDP for transfer. In the 1.5 hours of skilled labor time required to produce
an HDP for transfer, Hudson Bay could manufacture six LDPs, since each
LDP requires only .25 hours. Thus, the forgone contribution margin is $36 (6
units $6 unit contribution margin).
5. The maximum transfer price that the Volkmar Tachometer Division would find
acceptable is $112, computed as follows:
If Volkmar's management must pay $112 for an HDP, it will be indifferent between
using the HDP and the imported control pack. If the transfer price is lower than
$112, the Volkmar Tachometer Division will be better off with the HDP. At a transfer
price in excess of $112, Volkmar's management will prefer the control pack.
6. The transfer is in the overall company's best interest. Thus, any transfer price in the
interior of the range $106 to $112 will provide the proper incentives to the
management of each division to agree to a transfer. For example, a transfer price of
$109 would split the range evenly, and make each division better off by making the
transfer.
13-54
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
1. Yes, Air Comfort Division should institute the 5% price reduction on its air
conditioner units because net income would increase by $264,000. Supporting
calculations follow:
Before 5% After 5%
Price Reduction Price Reduction
Total
Per Total Per Total Difference
Unit (in thousands) Unit (in thousands) (in thousands)
$80 $12,000 $76
Sales revenue 0 0 $13,224 .0 $1,224 .0
Variable costs:
$14 $ 2,100 $14
Compressor 0 0 $ 2,436.0 $ 336.0
Other direct material 74 1,110 74 1,287.6 177.6
60 900 60
Direct labor 1,044.0 144.0
90 1,350 90
Variable overhead 1,566.0 216.0
3 540 3
Variable selling 6 6 626 .4 86 .4
Total variable $40 $ 6,000 $40
costs 0 0 $ 6,960 .0 $ 960 .0
$40 $ 6,000 $36
Contribution margin 0 0 $ 6,264 .0 $ 264 .0
Summarized presentation:
2. No, the Compressor Division should not sell all 17,400 units to the Air Comfort
Division for $100 each. If the Compressor Division does sell all 17,400 units to Air
Comfort, Compressor will only be able to sell 57,600 units to outside customers
instead of 64,000 units due to the capacity restrictions. This would decrease the
13-55
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
13-56
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
Solution:
3. Yes, it would be in the best interests of Continental Industries for the Compressor
Division to sell the units to the Air Comfort Division at $100 each. The net
advantage to Continental Industries is $625,000 as shown in the following
analysis. The net advantage is the result of the cost savings from purchasing the
compressor unit internally and the contribution margin lost from the 6,400 units
that the Compressor Division otherwise would sell to outside customers.
13-57
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13 - Investment Centers and Transfer Pricing
4. As the answers to requirements (2) and (3) show, $100 is not a goal-congruent
transfer price. Although a transfer is in the best interests of Continental Industries
as a whole, a transfer of $100 will not be perceived by the Compressor Division’s
management as in that division’s best interests.
13-58
Copyright © 2015 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.