MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 14

RESPONSIBILITY ACCOUNTING AND

TRANSFER PRICING

I. Questions
1. Cost centers are evaluated by means of performance reports. Profit
centers are evaluated by means of contribution income statements
(including cost center performance reports), in terms of meeting sales
and cost objectives. Investment centers are evaluated by means of the
rate of return which they are able to generate on invested assets.
2. Overall profitability can be improved (1) by increasing sales, (2) by
reducing expenses, or (3) by reducing assets.
3. ROI may lead to dysfunctional decisions in that divisional managers may
reject otherwise profitable investment opportunities simply because they
would reduce the divisions overall ROI figure. The residual income
approach overcomes this problem by establishing a minimum rate of
return which the company wants to earn on its operating assets, thereby
motivating the manager to accept all investment opportunities promising
a return in excess of this minimum figure.
4. A cost center manager has control over cost, but not revenue or
investment funds. A profit center manager, by contrast, has control over
both cost and revenue. An investment center manager has control over
cost and revenue and investment funds.
5. The term transfer price means the price charged for a transfer of goods
or services between units of the same organization, such as two
departments or divisions. Transfer prices are needed for performance
evaluation purposes.
6. The use of market price for transfer purposes will create the actual
conditions under which the transferring and receiving units would be
operating if they were completely separate, autonomous companies. It is
generally felt that the creation of such conditions provides managerial
incentive, and leads to greater overall efficiency in operations.

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7. Negotiated transfer prices should be used (1) when the volume involved
is large enough to justify quantity discounts, (2) when selling and/or
administrative expenses are less on intracompany sales, (3) when idle
capacity exists, and (4) when no clear-cut market price exists (such as a
sister division being the only supplier of a good or service).
8. Suboptimization can result if transfer prices are set in a way that benefits
a particular division, but works to the disadvantage of the company as a
whole. An example would be a transfer between divisions when no
transfers should be made (e.g., where a better overall contribution
margin could be generated by selling at an intermediate stage, rather
than transferring to the next division). Suboptimization can also result if
transfer pricing is so inflexible that one division buys from the outside
when there is substantial idle capacity to produce the item internally. If
divisional managers are given full autonomy in setting, accepting, and
rejecting transfer prices, then either of these situations can be created,
through selfishness, desire to look good, pettiness, or bickering.

II. Exercises

Exercise 1 (Evaluation of a Profit Center)

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

Department
1 2 4 Total
Revenue P132,000 P168,000 P98,000 P398,000
Direct cost of department 82,000 108,000 61,000 251,000
Contribution of the
department P 50,000 P 60,000 P37,000 P147,000
Allocated cost 121,000
Net income P 26,000

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

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Exercise 2 (Evaluation of an Investment Center)

Requirement 1
ROI RI
Operating assets P400,000 P400,000
Operating income P100,000 P100,000
ROI (P100,000 P400,000) 25%
Minimum required income
(16% x P400,000) P64,000
RI (P100,000 - P64,000) P36,000

Requirement 2

The manager of the Cling Division would not accept this project under the
ROI approach since the division is already earning 25%. Accepting this
project would reduce the present divisional performance, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000* P112,000
ROI 25% 20% 24.35%
* P60,000 x 20% = P12,000

Under the RI approach, on the other hand, the manager would accept this
project since the new project provides a higher return than the minimum
required rate of return (20 percent vs. 16 percent). The new project would
increase the overall divisional residual income, as shown below:
Present New Project Overall
Operating assets P400,000 P60,000 P460,000
Operating income P100,000 P12,000 P112,000
Minimum required
return at 16% 64,000 9,600* 73,600
RI P 36,000 P 2,400 P 38,400
* P60,000 x 16% = P9,600

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Exercise 3 (ROI, Comparison of Three Divisions)

Requirement 1

Division X Division Y Division Z

ROI: P10,000 P12,600 P 28,800
= 25% = 18% = 16%
P40,000 P70,000 P180,000

Requirement 2

Division X would reject this investment opportunity since the addition

would lower the present divisional ROI. Divisions Y and Z would accept it
because they would look better in terms of their divisional ROI.

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

Requirement 1

Net Operating income X Sales = ROI

Sales Average Operating Assets

P630,000 P9,000,000
Division A : X = ROI
P9,000,000 P3,000,000

7% X 3 = 21%

P1,800,000 P20,000,000
Division B : X = ROI
P20,000,000 P10,000,000

9% X 2 = 18%

Requirement 2

Division A Division B
Average operating assets (a) ........ P3,000,000 P10,000,000
Net operating income................... P 630,000 P 1,800,000
Minimum required return on average
operating assets - 16% x (a) .... 480,000 1,600,000
Residual income........................... P 150,000 P 200,000

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Requirement 3

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

Exercise 5 (Evaluation of a Cost Center)

(1) Controllable Costs by supervisor of Department 10 are as follows:

a. Supplies, Department 10
b. Repairs and Maintenance, Department 10
c. Labor Cost, Department 10

(2) Direct Costs of Department 10 are

a. Salary, supervisor of Department 10
b. Supplies, Department 10
c. Repairs and Maintenance, Department 10
d. Labor Cost, Department 10

(3) Costs allocated to Factory Department are:

a. Factory, heat and light
b. Depreciation, factory
c. Factory insurance
d. Salary of factory superintendent

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

a. Sales salaries and commissions
b. General office salaries

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Exercise 6 (Evaluating New Investments Using Return on Investment

(ROI) and Residual Income)

Requirement 1

Computation of ROI

Division A:
P300,000 P6,000,000
ROI = x = 5% x 4 = 20%
P6,000,000 P1,500,000

Division B:
P900,000 P10,000,000
ROI = x = 9% x 2 = 18%
P10,000,000 P5,000,000

Division C:

P180,000 P8,000,000
ROI = x = 2.25% x 4 = 9%
P8,000,000 P2,000,000

Requirement 2

Division A Division B Division C

Average operating assets................................P1,500,000 P5,000,000 P2,000,000
Required rate of return................................ 15% 18% 12%
Required operating income................................P 225,000 P 900,000 P 240,000
Actual operating income................................ P 300,000 P 900,000 P 180,000
Required operating income (above) ................................
225,000 900,000 240,000
Residual income ................................................................
P 75,000 P 0 P (60,000)

Requirement 3

a. and b. Division A Division B Division C

Return on investment (ROI) ................................
20% 18% 9%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ................................Reject Reject Accept

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Minimum required return for

computing residual income................................
15% 18% 12%
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would ................................Accept Reject Accept

If performance is being measured by ROI, both Division A and Division B

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

If performance is being measured by residual income, both Division A and

Division C probably would accept the 17% investment opportunity. The
17% rate of return promised by the new investment is greater than their
required rates of return of 15% and 12%, respectively, and would therefore
add to the total amount of their residual income. Division B would reject the
opportunity, since the 17% return on the new investment is less than Bs
18% required rate of return.

Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company)

Requirement 1
Division A Division B Total Company
Sales P3,500,000 1 P2,400,000 2
P5,200,000 3

Less expenses:
Added by the division................................
2,600,000 1,200,000 3,800,000
Transfer price paid................................
700,000
Total expenses................................
2,600,000 1,900,000 3,800,000
Net operating income................................
P 900,000 P 500,000 P1,400,000
1
20,000 units P175 per unit = P3,500,000.
2
4,000 units P600 per unit = P2,400,000.
3
Division A outside sales (16,000 units P175 per unit) ................................ P2,800,000
Division B outside sales (4,000 units P600 per unit)................................ 2,400,000
Total outside sales ................................................................................................
P5,200,000

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

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Requirement 2

Division A should transfer the 1,000 additional units to Division B. Note

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

Exercise 8 (Transfer Pricing Situations)

Requirement 1

The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred
.
There is no idle capacity, so each of the 20,000 units transferred from
Division X to Division Y reduces sales to outsiders by one unit. The
contribution margin per unit on outside sales is P20 (= P50 P30).
P20 x 20,000
Transfer price (P30 P2) +
20,000
Transfer price = P28 + P20 = P48

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P47. Therefore, Division Y would be unwilling to pay more
than P47 per unit.

Transfer price Cost of buying from outside supplier = P47

The requirements of the two divisions are incompatible and no transfer will
take place.

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Requirement 2

In this case, Division X has enough idle capacity to satisfy Division Ys

demand. Therefore, there are no lost sales and the lowest acceptable price
as far as the selling division is concerned is the variable cost of P20 per unit.
P0
Transfer price P20 +
20,000
= P20

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P34. Therefore, Division Y would be unwilling to pay more
than P34 per unit.

Transfer price Cost of buying from outside supplier = P34

In this case, the requirements of the two divisions are compatible and a
transfer will hopefully take place at a transfer price within the range:

P20 Transfer price P34

Exercise 9 (Transfer Pricing: Decision Making)

Requirement 1

Division As purchase decision from the overall firm perspective:

Purchase costs from outside 10,000 x P150 = P1,500,000

Less: Savings of Divisions Bs variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P 100,000

Assuming Division B has no outside sales, Division A should buy inside

from Division B for the benefit of the entire firm.

Requirement 2

As above, but in addition, if Division A buys outside, Division B saves an

additional P200,000.

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Purchase costs from outside 10,000 x P150 = P1,500,000

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Less: Savings of B material assignment 200,000
Net Cost (Benefit) for A to buy outside P (100,000)

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

Requirement 3

Assuming the outside price drops from P150 to P130:

Purchase costs from outside 10,000 x P130 = P1,300,000

Less: Savings in variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside P (100,000)

Division A should buy outside.

III. Problems

Problem 1 (Evaluation of Profit Centers)

Requirement (a)

Jadlow Manufacturing Corporation

Income Statement
For the Year Ended December 31, 2005

Total Product S Product T

Sales P5,100,000 P2,700,000 P2,400,000
Less: Variable Costs 3,330,000 1,890,000 1,440,000
Contribution Margin P1,770,000 P 810,000 P 960,000
Less: Controllable fixed
expenses 501,000 66,000 435,000
Contribution to the recovery
of non-controllable fixed
expenses P1,269,000 P 744,000 P 525,000

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Requirement (b)

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

Problem 2 (Evaluation of Profit Centers)

Requirement 1
Product
A B C
Incremental sales P71,000 P46,000 P117,000
Less: Incremental costs 42,000 15,000 96,000
Net income P29,000 P31,000 P 21,000

Product B seems to offer the best profit potential.

Requirement 2
The sunk costs are:
Depreciation of equipment P 6,400
Operating cost of the equipment 4,600
Total P11,000

Requirement 3
Opportunity cost of selling Product B is
From Product A P29,000
From Product C 21,000
Total P50,000

Problem 3 (Evaluation of Performance)

Ranjie Tool Company

Performance Report
For the Year 2005
Budgeted Labor Hours 4,000
Actual Labor Hours 4,200
Budget

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Actual Based on
Cost-Volume 4,200 4,200 Variance
Formula Hours Hours U (F)
Variable Overhead Costs:
Utilities P0.80 per hour P 3,600 P 3,360 P240
Supplies 1.80 7,400 7,560 (160)
Indirect labor 1.20 5,300 5,040 260
Total P3.80 P16,300 P15,960 P340
Fixed Overhead Costs:
Utilities P 1,600 P 1,600 -
Supplies 2,200 2,200 -
Depreciation 6,000 6,000 -
Indirect labor 5,400 5,400 -
Insurance 1,200 1,200 -
Total P16,400 P16,400 -
Total Factory Overhead Costs P32,700 P32,360 P340

Problem 4 (Evaluation of Performance)

Requirement 1

Performance Report for the Production Manager

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Direct material P24,000 P20,000 P4,000 (U)
Direct labor 48,000 50,000 2,000 (F)
Supplies 4,000 6,000 2,000 (F)
Maintenance 3,000 4,000 1,000 (F)
Total P79,000 P80,000 P1,000 (F)

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

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Requirement 2

Performance Report for the Vice President

Actual Flexible Variance
Cost Budget Cost (U) or (F)
Controllable costs:
Marketing division P104,000 P102,000 P2,000 (U)
Production division 79,000 80,000 1,000 (F)
Personnel division 72,000 76,000 4,000 (F)
Other costs 68,800 70,000 1,200 (F)
Total P323,800 P328,000 P4,200 (F)

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

Problem 5 (Target Sales Price; Return on Investment)

Requirement 1

Return on investment = Operating income / Investment

20% = X / P800,000
Target Operating Income = P160,000

Target revenues, calculated as follows:

Fixed overhead P200,000

Variable costs 1,500,000 x P300 450,000
Desired operating income 160,000
Revenues P810,000

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

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Requirement 2

Data are in thousands.

Units 1,500 2,000 1,000

Revenues P810 P1,080 P540

Variable costs 450 600 300

Fixed costs 200 200 200
Total costs 650 800 500

Operating income P160 P280 P 40

Return on investment 20% 35% 5%
= P160 / P800 = P280 / P800 = P40 / P800

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

Operating leverage = contribution margin / operating income

= (P810 P450) / P160 = 2.25

% change in income = operating leverage x % change in revenues

= 2.25 x 33.33% = 75%

% change in income
If volume goes to 2,000 units: (P280 P160) / P160 = 75%
If volume goes to 1,000 units: (P160 P40) / P160 = 75%

% change in ROI
If volume goes to 2,000 units: (35% - 20%) / 20% = 75%
If volume goes to 1,000 units: (20% - 5%) / 20% = 75%

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

Income)

Requirement 1

ROI computations:

Net operating income Sales

ROI = x
Sales Average operating assets

Pasig: P630,000 P9,000,000

x = 7% x 3 = 21%
P9,000,000 P3,000,000

P1,800,000 P20,000,000
Quezon: x = 9% x 2 = 18%
P20,000,000 P10,000,000

Requirement 2

Pasig Quezon
Average operating assets (a) ................................
P3,000,000 P10,000,000
Net operating income ................................ P 630,000 P 1,800,000
Minimum required return on average
operating assets16% (a) ................................ 480,000 P 1,600,000
Residual income................................................................
P 150,000 P 200,000

Requirement 3

No, the Quezon Division is simply larger than the Pasig Division and for this
reason one would expect that it would have a greater amount of residual
income. Residual income cant be used to compare the performance of
divisions of different sizes. Larger divisions will almost always look better,
not necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Quezon does not appear to be as
well managed as Pasig. Note from Part (1) that Quezon has only an 18%
ROI as compared to 21% for Pasig.

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Problem 7 (Transfer Pricing)

Requirement 1

Since the Valve Division has idle capacity, it does not have to give up any
outside sales to take on the Pump Divisions business. Applying the formula
for the lowest acceptable transfer price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable on lost sales
Transfer price cost per unit +
Number of units transferred

P0
Transfer price P16 +
10,000
= P16

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

P16 Transfer price P29

Requirement 2

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

(P30 P16) x 10,000

Transfer price P16 +
10,000

= P16 + P14 = P30

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

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Requirement 3

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

Total contribution margin

Variable on lost sales
Transfer price cost per unit
+
Number of units transferred

(P30 P16) x 10,000

Transfer price (P16 P3) +
10,000

= P13 + P14 = P27

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

P27 Transfer price P29

Problem 8 (Transfer Pricing)

To produce the 20,000 special valves, the Valve Division will have to give
up sales of 30,000 regular valves to outside customers. Applying the
formula for the lowest acceptable price from the viewpoint of the selling
division, we get:
Total contribution margin
Variable on lost sales
Transfer price cost per unit
+
Number of units transferred

(P30 P16) x 30,000

Transfer price P20 +
20,000

= P20 + P21 = P41

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IV. Multiple Choice Questions

1. C 11. E 21. C 31. B

2. D 12. D 22. B 32. D
3. A 13. C 23. A 33. D
4. A 14. C 24. D 34. D
5. C 15. B 25. B 35. C
6. A 16. C 26. A 36. D
7. D 17. B 27. A 37. B
8. A 18. A 28. B 38. D
9. C 19. B 29. D 39. B
10. A 20. A 30. A 40. D

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