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CHAPTER 13

RESPONSIBILITY ACCOUNTING, SUPPORT DEPARTMENT


ALLOCATIONS, AND TRANSFER PRICING

QUESTIONS

1. Four potential advantages of decentralization are:


Better executed executive training and development
Higher level of job satisfaction for employees
Effectiveness and speed of decision making by local managers with intimate
knowledge of problems
Reduced management oversight time through use of management by
exception principle
Three potential disadvantages of decentralization are:
Suboptimization by plant or outlet managers
Possibility of organizational disruption if top management has difficulty in
relinquishing control or communicating to subordinates
Potentially high costs of incorrect decisions by subordinates
Functions that may be handled centrally:
Capital project approval
(1) Major costs for long-term commitments
(2) Specialized knowledge
(3) Need for coordination in the selection and funding of major projects
Cash management
(1) Cash and investment funds are managed more efficiently if they are
pooled.
(2) When funds are needed, tradition and good business dictate that they are
acquired at the firm level and allocated to segments as needed.
(3) Cash is the most vulnerable asset and merits tight central control.
Inventory control
Inventory, being a near-cash asset, is subject to theft and misappropriation. Its
control is also crucial to efficient and effective production, delivery and
customer relations.
Evaluation of divisional profitability
Top management must reward or penalize division managers as a matter of
appropriate organizational hierarchical prerogatives.

2. The two basic functions of responsibility reports are to


provide operational managers with information needed for planning,
controlling, and decision making for their areas of responsibility and
assist top managers in evaluating how well operational managers fulfilled their
responsibilities to the organization.
359
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It is sometimes appropriate for a company to prepare a single responsibility report


for a division. However, many companies prepare two different responsibility
reports for a division: one report, which is used to evaluate a managers
performance, shows only the costs controllable by that manager; the second report
shows all costs incurred by and assigned to the division so that a notion of the
total performance of the division can be gained. If total cost information can be
subdivided into controllable and noncontrollable costs for the division manager,
then one report can effectively accomplish both purposes.

3. Suboptimization is a condition in which individual managers work to achieve


results that are in their own and their segments best interests to the detriment of
the overall company. Top managers must guard against such behavior by
subordinates when authority is delegated to them in a decentralized setting.
Suboptimization results from segment managers motivation to appear successful
and gain rewards and recognition. Sometimes, this motivation overrides the
companys best interests.

4. Support department costs may be allocated to revenue-producing departments for


a variety of reasons. The most common reasons are to encourage managers to use
support areas in the most cost-beneficial manner, make performance comparisons
with independent organizations, determine the full cost of production to make fair
and acceptable pricing decisions, and support decision making. (These are all
enumerated in Exhibit 13.7.) Such allocations are not always useful from a
decision-making standpoint because they assign costs that are uncontrollable by a
department to that department.
In addition to allocating support department costs to obtain a full cost of products
or other cost objects, there are behavioral consequences associated with allocating
support department costs. Generally, managers become more sensitive to the
assistance provided by the support area, which leads managers to use such
resources in a more cost-beneficial way and to recommend cost control
improvements to the support department. However, such cost allocations may
cause dysfunctional behavior if the manager of the revenue-producing area
perceives the cost allocation to be unfair.

5. The four criteria (benefits received, causation, equity, and ability-to-bear) are all
relevant to making support department allocations and should, theoretically, be
applied equally. However, it is often not practical to apply the equity criterion
because it is too difficult to achieve agreement on what is fair. Ability-to-bear is
often not used because it may result in unrealistic or profit-detrimental actions.
Therefore, most support department allocations are based on the benefits-received
and causation criteria.

6. The direct method is the simplest method of allocation and does not take into
consideration the assistance provided among support departments. Thus, the direct
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Chapter 13 361

method is the only method that does not allocate a support departments costs to
other support departments.
The step method does take into consideration assistance provided between support
departments, but does so sequentially based on a benefits-provided ranking.
Because of the necessity to rank benefits, all support department interaction is not
accounted for using the step method. This method is more difficult than the direct
method, but less difficult than the algebraic method.
The algebraic method, unlike the other methods, recognizes reciprocal (give-and-
take) exchanges of assistance among the support departments by providing a set of
simultaneous equations to solve for the effects of such exchanges. However, this
method is very difficult to use without the aid of a computer when more than two
or three departments are involved. If formulae are correct, the algebraic method
provides the most accurate measure of the usage of assistance among departments.
The only similarity among the methods is their ultimate objective: the assignment
of support department costs to revenue-producing areas.

7. The added costs are an artifact of the cross-allocation process of solving


simultaneous equations. These fictional costs are ignored in the revenue-
producing areas for the purpose of developing an overhead application rate.

8. Transfer prices are internally set and agreed on prices with which a selling
division transfers goods or services to a buying division. The objectives are goal
congruence, autonomy, motivation toward effectiveness and efficiency,
practicality, and credibility as a basis for performance evaluation.
In negotiating transfer prices among segment managers, the managers are
expected to work together (1) to make choices that will maximize the efficiency
and effectiveness of their respective divisions and (2) to contribute to overall
company performance. For example, when it is in the companys best interest for
a buying division to purchase goods or services internally from a selling division,
segment managers are expected to agree on a price to encourage such purchases.
If top management has properly trained, motivated, and evaluated segment
managers, the transfer price can be a device to promote such goal congruence.
In contrast, sometimes segment managers become myopic in their zeal to
maximize the apparent performance of their own divisions. For example,
sometimes buying segment managers will choose to buy externally at a price
lower than the transfer price because such purchases makes the division look
better even though analysis would reveal that the whole company would do better
if the acquisitions were made internally. This example illustrates the concept of
suboptimization.

9. The biggest problem involves how the term cost is defined. A cost can be
defined as any of the following: incremental or variable; absorption (product costs
only); or absorption plus some portion of the segments nonproduction costs
(selling and administrative). An amount for estimated opportunity costs for use of
the facilities can be added to any of the above. In some cases, arguments can be
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Chapter 13 362

made for reducing absorption costs by estimated savings in production or


distribution costs on internal sales.
Another problem is that if actual costs include inefficiencies, the transfer prices
set on the basis of such inefficiencies may lead to incorrect management
decisions.

Problems of using market-based transfer prices include:


the possibility that no objective price can be found because the product has no
exact counterpart in the market;
market price ignores any production or distribution savings on internally
transferred goods; and
the possibility that current prices are temporarily not representative of a long-
run price.

10.
Type of Center Recommended Type of Transfer Price & Usage
Cost-Selling Segment Cost-based: consistent with the objective of this
type of center, this use is a way of allocating the
centers cost to other centers.
Cost-Buying Preferably cost-based: consistent with the objective
Segment of this type of center, however, depending on the
selling segments demands, the transfer price could
be at any point between the lower limit
(incremental costs plus opportunity cost of
facilities) and the upper limit (lowest market price
the buying segment would have to pay externally);
goods or services received by the center are carried
at the transfer price for internal reporting purposes.
Revenue-Selling Market price: revenue from transfers of goods or
Segment services is recorded at the transfer price for internal
reporting purposes.
Revenue-Buying Transfer prices for goods or services should be
Segment between the lower and upper limits with the lower
limit giving this segment the greatest gross margin
on its internal sales; whichever transfer price is
chosen will be the cost of goods or services
purchased for this segment for internal reporting.
Profit or Investment- Transfer prices should be set between the lower and
Selling Segment upper limits; since these types of centers are
supposed to earn a profit, their managers will try to
negotiate a price closer to the upper limit;
whichever price is set becomes the revenue measure
for internal sales for internal reporting purposes.

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Profit or Investment- Transfer prices should fall between lower and upper
Buying Segment limits with managers of these segments arguing for
prices closer to the lower limits to afford their
segments the highest gross margin; whichever price
is set becomes the cost of goods or services
acquired by the center for internal reporting
purposes.

11. Dual pricing exists when the selling division is permitted to record one transfer
price (higher) and the buying division to record another (lower). This practice is
intended to minimize suboptimization and create goal-congruent incentives for
both divisions.

12. Support departments can use transfer prices when (1) user departments of the
support department have significant control over the quantity and quality of
assistance provided and (2) a reasonable surrogate measure of assistance benefits
provided to users exists. In such circumstances, transfer prices can be an effective
way of promoting a more efficient use of resources and of reassigning support
department costs. Setting the transfer price depends on the nature of the (1)
support department (cost or profit center) and (2) assistance itself (whether it can
be acquired externally, is recurring and uniform, and is expensive).
Advantages of transfer prices over allocation include:
motivation of user departments to suggest improvements and monitor usage;
inclusion of costs in user departments performance report (if user department
controls the amount of assistance it buys);
potential to generate suggestions for services more beneficial to users;
the fact that the rationale for the transfer prices must be provided to the buying
department; and
transformation of a support department from cost center to profit center;
provides additional performance measures for the center and its manager.

13. In a multinational setting, transfer prices can affect the profits and inventory
values reported in multiple countries as well as the taxes paid to various
jurisdictions. As such, managers must be more aware of setting prices, within
legal and ethical limits, to minimize income taxes and tariffs. Also, in a
multinational setting, there would be various taxing authorities with which to
come to agreements on advance purchase agreementsshould the company
decide to enter into those.

14. Any companys green agenda must be a global undertaking; activities in one
segment may create costs and benefits for part or all of an organization. Such
interactions impact the function, asset, and risk profile of an MNE and, thus,
modify intraorganizational transactions or create new value interactions that must
be considered from a transfer pricing perspective.
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An important impact of the green agenda is the incorporation of environmental


costs that have previously been avoided or undervalued by some companies.
Substantive pollution and waste costs that once were included in public
expenditures or ignored are now being passed along to companies. In a cap-and-
trade environment, companies are given a specified pollution limit (the cap) for
carbon and other emissions; pollution above that limit is only legally allowed if
the offending company buys another companys surplus creditscreating an
organizational cost for emissions.
The active markets in emissions credits provide a selling/buying value for them.
However, these values can be variable and volatile because cap-and-trade schemes
are localized, and as with any market, prices may change because of prevalence or
absence of activity and new markets can emerge.

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Intraorganizational sharing of carbon or emissions credits requires an appropriate


pricing mechanism for a companys transfer pricing policy and will create
challenges and opportunities in identifying an arms-length price. Additionally,
the transfer pricing policy must accommodate price fluctuations, differing regional
market values, and different values in various parts of the business so that value
can be optimized for tax purposes.
PricewaterhouseCoopers, Transfer Pricing and the Green Agenda (2008), pp. 12;
http://www.pwc.com/en_GX/gx/tax-management-
strategy/pdf/pwc_tax_transfer_pricing_and _the_green_agenda.pdf (last accessed
12/30/11).

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EXERCISES

15. a. C
b. D
c. C
d. D
e. C
f. C
g. C
h. D
i. D
j. C
k. D
l. D
m. C
n. D

16. a. A
b. N
c. A
d. A
e. A
f. D
g. D
h. A
i. N (authority can be delegated, but not responsibility)
j. A

17. Each student will have a different answer; however, some important
considerations follow.
Centralized model: all IT functions (strategy and planning, application
development and maintenance, and operations) report directly to a senior
executive. All assets (hardware, software, human resources and the budget) are
controlled by this organization.
Advantages of Centralization:
Hardware and software can be obtained with the largest economies of scale
(often resulting in a 10 to 15 percent cost savings).
Redundant functions, such as multiple help desk support groups, are
eliminated.
Organizational communications are simpler.
Activities are more aligned with overall company strategies.
A unified presence is provided to customers and suppliers.
Disadvantages of Centralization:
If operated as a cost center, ITs enormous budget is often a point of
contention.

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If costs are allocated back to other areas, managers in those areas may believe
they are being overcharged.
A very effective decision and resource allocation process is needed since each
business unit can have different or conflicting IT needs.
IT outages could cause an entire company to be crippled.
The key to a centralized organizations success is its ability to be responsive. If
the big, centralized operation can be responsive to the needs of the business, then
that approach can make sense. When companies decide to move away from
decentralization back to centralized functions, the most common reasons are
usually cost savings and ability to manage the function more effectively.
Decentralized model: created when companies adopt specific client/server
architectures or occurred during a merger because separateness was often the
quickest way to solve the problem of integrating disparate hardware and software
infrastructures.
Advantages of Decentralization:
The ability to integrate disparities after a merger is improved.
Managers have their choice of hardware and software acquisition.
Managers have the ability to allocate IT resources.
There is a perception of faster, more flexible responses to change.
Disadvantages of Decentralization:
There will be higher total hardware and software costs for the organization.
There will be duplication of support needs.
There is the possibility of incompatibility of systems.
There can be a lack of accountability for problems.
Other important information:
Type and size of company
Level of geographical dispersion
Management characteristics
Employee levels of motivation and responsiveness

18. Each student will have a different answer. No solution is provided.

19. a. P
b. R
c. I
d. R or P
e. I
f. C
g. R or P
h. R or P
i. R or P
j. R or P
k. C
l. R (or revenue and limited cost)
m. C or P (if recoveries were assigned to the unit)
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20. Each student will have a different answer. However, following are some of the
units that may be included.
Cost centers: Career services, campus security, financial aid, information
technology, custodial, human resources, and accounting
Profit centers: Athletics, bookstore, residence halls, cafeterias, international
programs, university newspaper/radio station, and community workshops

21. a. The EM group is centralized.


b. The EM group is probably a profit center; however, it could be an investment
center if its manager has control over the groups asset base.
c. Having the operating divisions solicit and pay for the EM group projects could
mean that fewer projects are generated than would be likely if the EM group
initiated the project work; fewer EM projects would mean fewer costs and
higher profits. Requiring the EM group to charge a market-based price for
services could mean that different divisions, because of their operating locales,
are charged different amounts for the same projects. Additionally, whereas a
market price allows the EM group to show profitability, such a price is more
onerous to the operating divisions than a cost-based price would beleading
to a lowered likelihood of usage because of reduced profitability.

22. Each student will have a different answer; however some important considerations
follow.
a. In multiple-doctor medical practices, setting up the recordkeeping system to
reflect each doctor as his/her own profit center will give insight into the
expenses each doctor is absorbing against revenue directly generated by
him/her. The data generated from this exercise give management another tool
in evaluating performance for salary adjustments, bonuses, and promotions.
b. The typical software accounting packages used by medical practices are
Peachtree, QuickBooks and Creative Solutions.
c. Some directly traceable costs include salary, malpractice insurance, fringe
benefits, conferences and seminars, vehicle expense, meals and entertainment,
patient refunds, insurance refunds, travel and lodging, licenses, supplies and
vaccines that are used by a specialist, and dues and fees.
d. Indirect expenses include building rent, depreciation, equipment lease
payments, interest expense, legal and accounting fees, office supplies, medical
waste disposal, pension expense, utilities, and staff salaries, taxes and fringe
benefits. Allocations bases would include gross revenues generated by doctor,
percent of cash receipts generated by doctor, percent of patients seen by
doctor, percent of occupancy space used by doctor, or equal allocation among
all doctors.

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Chapter 13 369

23. ASP ASV BSP ASV BSP BSV


$38 473,000 $39 473,000 $39 460,000
$17,974,000 $18,447,000 $17,940,000
$473,000 U $507,000 F
Sales Price Variance Sales Volume Variance
$34,000 F
Total Revenue Variance
Because the company sold units at a lower than planned price, $473,000 less
revenue was generated. However, the decrease in selling price was offset by the
fact that 13,000 more units were sold than were budgeted. The net result of these
two differences created a $34,000 favorable revenue variance.

24. ASP ASV BSP ASV BSP BSV


$0.68 682,000 $0.70 682,000 $0.70 675,000
$463,760 $477,400 $472,500
$13,640 U $4,900 F
Sales Price Variance Sales Volume Variance
$8,740 U
Total Revenue Variance
The company sold 7,000 units more than budget but sold those units at $0.02 less
than the budgeted selling price, creating an unfavorable $13,640 sales price
variance. However, since 7,000 more than budgeted were sold, a $4,900 favorable
sales volume variance occurred. The combination of these two factors created the
$8,740 revenue shortfall.

25. a. 30 1.3 = 39 seminars in 2013; 39 $4,200 = $163,800


b. ASP ASV BSP ASV BSP BSV
$3,675* 42 $4,000 42 $4,000 39
$154,350 $168,000 $156,000
$13,650 U $12,000 F
Sales Price Variance Sales Volume Variance
$1,650 U
Total Revenue Variance
*$154,350 42 = $3,675 per seminar
c. Yi did not achieve his expected revenue because, although he gave three more
seminars than he budgeted, the average price he received for each seminar was
only $3,675 rather than the budgeted $4,000.

26. a. From HR to Fabricating [(0.35 0.80) $630,000] $275,625


From Admin. to Fabricating [(0.50 0.90) $450,000] 250,000
Total $525,625
b. From HR to Finishing [(0.45 0.80) $630,000] $354,375
From Admin. to Finishing [(0.40 0.90) $450,000] 200,000
Total $554,375
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Chapter 13 370

27. Checking:
Administration (0.30 0.80) $540,000 $ 202,500
Human resources (0.30 0.80) $360,000 135,000
Accounting (0.40 0.80) $300,000 150,000
Direct costs 630,000
$1,117,500
Savings:
Administration (0.40 0.80) $540,000 $270,000
Human resources (0.20 0.80) $360,000 90,000
Accounting (0.20 0.80) $300,000 75,000
Direct costs 337,500
$772,500
Loans:
Administration (0.10 0.80) $540,000 $ 67,500
Human resources (0.30 0.80) $360,000 135,000
Accounting (0.20 0.80) $300,000 75,000
Direct costs 675,000
$952,500

28. Administration ($540,000)


Human resources ($540,000 0.10) $ 54,000
Accounting ($540,000 0.10) 54,000
Checking ($540,000 0.30) 162,000
Savings ($540,000 0.40) 216,000
Loans ($540,000 0.10) 54,000
$540,000
Human resources ($360,000 + $54,000 = $414,000)
Accounting $414,000 (0.10 0.90) $ 46,000
Checking $414,000 (0.30 0.90) 138,000
Savings $414,000 (0.20 0.90) 92,000
Loans $414,000 (0.30 0.90) 138,000
$414,000
Accounting ($300,000 + $54,000 + $46,000 = $400,000)
Checking $400,000 (0.40 0.80) $200,000
Savings $400,000 (0.20 0.80) 100,000
Loans $400,000 (0.20 0.80) 100,000
$400,000
Checking: $630,000 + $162,000 + $138,000 + $200,000 = $1,130,000
Savings: $337,500 + $216,000 + $ 92,000 + $100,000 = $ 745,500
Loans: $675,000 + $ 54,000 + $138,000 + $100,000 = $ 967,000

29. a. Human resources ($360,000)


Administration ($360,000 0.10) $ 36,000
Maintenance ($360,000 0.15) 54,000
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Chapter 13 371

Assembly ($360,000 0.40) 144,000


Finishing ($360,000 0.35) 126,000
$360,000
Administration ($558,000 + $36,000 = $594,000)
Maintenance $594,000 (0.10 0.90) $ 66,000
Assembly $594,000 (0.50 0.90) 330,000
Finishing $594,000 (0.30 0.90) 198,000
$594,000
Maintenance ($170,000 + $54,000 + $66,000 = $290,000)
Assembly $290,000 (0.45 0.80) $163,125
Finishing $290,000 (0.35 0.80) 126,875
$290,000
b. Assembly:
(0.40 $360,000) + [(0.5 0.9) $594,000] + [(0.45 0.8) $290,000] =
$144,000 + $330,000 + $163,125 = $637,125
Finishing:
(0.35 $360,000) + [(0.3 0.9) $594,000] + [(0.35 0.8) $290,000] =
$126,000 + $198,000 + $126,875 = $450,875
c. The cost allocation is affected by the order in which costs are assigned
because the cost allocated from a particular service department depends on the
amount of cost allocated to that service department from other service
departments. The amount of costs allocated from other service departments
depends on the benefits-provided ranking.

30. Admin. HR Acctg.


Administration 0.10 0.10
Human resources 0.10 0.10
Accounting 0.10 0.10
Checking 0.30 0.30 0.40
Savings 0.40 0.20 0.20
Loans 0.10 0.30 0.20
(A) Administration = $540,000 + 0.10B + 0.10C
(B) Human resources = $360,000 + 0.10A + 0.10C
(C) Accounting = $300,000 + 0.10A + 0.10B
B = $360,000 + 0.10($540,000 + 0.10B + 0.10C) + 0.10C
C = $300,000 + 0.10($540,000 + 0.10B + 0.10C) + 0.10B
B = $360,000 + $54,000 + 0.01B + 0.01C + 0.10C
B = $414,000 + 0.01B + 0.11C
0.99B = $414,000 + 0.11C
C = $300,000 + $54,000 + 0.01B + 0.01C + 0.10B
C = $354,000 + 0.11B + 0.01C
0.99C = $354,000 + 0.11B

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Chapter 13 372

C = $357,576 + 0.1111B
0.99B = $414,000 + 0.11($357,576 + 0.1111B)
0.99B = $414,000 + $39,333 + 0.0122B
0.9778B = $453,333
B = $463,625
C = $357,576 + 0.1111($463,625)
= $357,578 + 51,509
= $409,085
A = $540,000 + 0.10($463,625) + 0.10($409,085)
= $540,000 + $46,362.50 + $40,908.50
= $627,271
Admin. HR Acctg. Check. Sav. Loans
Direct costs $ 540,000 $ 360,000 $ 300,000 $ 630,000 $337,500 $675,000
Admin. (627,271) 62,727 62,727 188,181 250,908 62,727
HR 46,363 (463,625) 46,363 139,088 92,725 139,088
Acctg. 40,909 40,909 (409,085) 163,634 81,817 81,817
Total costs $ 0 $ 0 $ 0 $1,120,903 $762,950 $958,632

Note: The Administration, Human Resources, and Accounting columns do not


sum to $0 because of rounding.

31. S1 = $170,000 + 0.40S2 + 0.20S3


S2 = $360,000 + 0.10S1 + 0.30S3
S3 = $600,000 + 0.20S1 + 0.30S2
Substitute S3 into the equations for S1 and S2:
(1) S1 = $170,000 + 0.40S2 + 0.20($600,000 + 0.20S1 + 0.30S2)
(2) S2 = $360,000 + 0.10S1 + 0.30($600,000 + 0.20S1 + 0.30S2)
Simplifying:
(1) S1 = $170,000 + 0.40S2 + $120,000 + 0.04S1 + 0.06S2
0.96S1 = $290,000 + 0.46S2
S1 = $302,083 + 0.48S2
(2) S2 = $360,000 + 0.10S1 + $180,000 + 0.06S1 + 0.09S2
0.91S2 = $540,000 + 0.16S1
S2 = $593,407 + 0.18S1
Substitute S2 into the equation for S1:
S1 = $302,083 + 0.48($593,407 + 0.18S1)
S1 = $302,083 + $284,835 + 0.09S1
0.91 S1 = $586,918
S1 = $644,965
Substitute S1 ($644,965) into the original S2 and S3 equations:
(1) S2 = $360,000 + 0.10($644,965) + 0.30S3
(2) S3 = $600,000 + 0.20($644,965) + 0.30S2
Simplifying:
(1) S2 = $360,000 + $64,497 + 0.30S3
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S2 = $424,497 + 0.30S3
(2) S3 = $600,000 + $128,993 + 0.30S2
S3 = $728,993 + 0.30S2

Substitute S3 into the equation for S2:


S2 = $424,497 + 0.30($728,993 + 0.30S2)
S2 = $424,497 + $218,698 + 0.09S2
0.91S2 = $643,195
S2 = $706,808
Substitute S1 and S2 into the original equations and solve for S3:
S3 = $600,000 + 0.20($644,965) + 0.30($706,808)
S3 = $600,000 + $128,993 + $212,042
S3 = $941,035
Allocate the service department costs to the other departments:
S1 S2 S3 RP1 RP2
Direct costs $ 170,000 $ 360,000 $ 600,000
S1 (644,965) 64,497 128,993 $193,490 $257,986
S2 282,723 (706,808) 212,042 141,362 70,681
S3 188,207 282,311 (941,035) 376,414 94,104
To RP $ (4,035)* $ 0 $ 0 $711,266 $422,771
*off due to rounding

32. a. D
b. A
c. D
d. A
e. D
f. A
g. A
h. D
i. N
j. A
k. A
l. D

33. a. $3 1.80 = $5.40


b. ($3 + $2) = $5; $5 1.30 = $6.50
c. $10
d. Sales (40,000 $55) $ 2,200,000
Internal cost (25,000 $32) $800,000
External cost (15,000 $47) 705,000 (1,505,000)
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Chapter 13 374

$ 695,000
Operating profit = 15,000 $15 = $225,000

34. a. External purchase cost (30,000 $4.50) $ 135,000


Internal cost [(30,000 $4.00) + $0 opportunity cost] (120,000)
Advantage of purchasing internally $ 15,000

b. External purchase cost (30,000 $4.50) $ 135,000


Internal cost [($30,000 $4.00) + $25,000 opportunity cost] (145,000)
Disadvantage of purchasing internally $ (10,000)
c. Should the Assembly Divisions external suppliers raise prices in the future,
purchasing costs would increase for Squish. A question arises as to what
happened to the fixed costs being incurred by the Production Division. Were
all costs eliminated when the division was closed? If not, some or all of the
Production Divisions monthly fixed costs of $30,000 would still have to be
paid by Squishreducing the $25,000 of rental income. If some of the fixed
costs were personnel costs, there may be a community issue of increasing
unemployment or the possibility of terminating long-term, more senior-aged
employees (age discrimination?).

35. a. Upper limit is the best external price = $112.50


Lower limit is variable production cost = $54 + Any opportunity cost
b. Minimum price is current selling price = $162

36. a. (1) Variable production cost $40.00


Variable selling cost 16.00
Total variable cost $56.00 per unit
(2) Variable production cost $40.00
FOH ($1,800,000 1,200,000) 1.50
Full production cost $41.50 per unit
(3) Variable production cost $40.00
Fixed selling [$2,400,000 (0.25 1,200,000)] 8.00
Total variable production + necessary selling $48.00 per unit
(4) Market price $67.00 per unit
b. The highest price Elba should choose to sell the units for $63 per unit since no
advertising costs would need to be paid relative to internal sales.
37. a. Lower limit is the incremental variable cost ($9.00 + $11.40 + $4.80) +
Opportunity cost of $43.80 per unit lost CM = $69.00
(Lost CM = $72.00 $9.00 $11.40 $4.80 $3.00 = $43.80)

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This is the normal selling price less the normal variable costs excluding the
$3.00 variable selling expense.
b. Under these conditions, Peyvandi Co. could accept any price that at least
covers variable production costs: DM $9.00 + DL $11.40 + VOH $4.80 =
$25.20
c. $2,606,250 1.25 = $2,085,000 for 50,000 units = $41.70 per unit DM $9.00
+ DL $11.40 + VOH $4.80 + FOH $16.50 = $41.70
$1,575,000 1.25 = $1,260,000 for 50,000 units = $25.20 per unit DM $9.00
+ DL $11.40 + VOH $4.80 = $25.20
Joe Dhir was defining cost as variable cost, while Peyvandi Co. was defining
cost as absorption cost.

38. a. The rapid increase in food costs has created a significant difference between
the historical cost of items and the replacement cost of items. Because
transfers between stores are made at historical costs, the transferring store
loses in the transaction because it must replace the transferred item at
replacement cost. This situation creates an incentive for stores to misrepresent
the actual inventories on hand when transfers are requested by sister stores.
b. The transfer pricing policy could be changed to allow transfers to take place at
replacement cost rather than historical cost. Such a change would remove the
disincentive of the existing policy.

39. a. $665,000 700,000 minutes = $0.95 per minute

b. $665,000 1,000,000 minutes = $0.665 per minute


c. Expected: 730,000 $0.95 = $693,500
Total variance = $689,400 $693,500 = $4,100 F
Theoretical: 730,000 $0.665 = $485,450
Total variance = $689,400 $485,450 = $203,950 U
The variance could have been caused by volume of activity being above the
expected level or by operating costs exceeding the expected level. More
information is needed to determine the actual causes.

40. Each student will have a different answer. No solution is provided. One recent case
that could be discussed involved GlaxoSmithKline, which settled a transfer pricing
dispute with the U.S. Internal Revenue Service in September 2006 for $3+ billion
and, as of early 2007, was preparing for litigation in the United Kingdom. The
companys 2006 annual report indicated the problem was related to the years 1994
and forward. See http://www.irs.gov/newsroom/article/0,,id=162359,00.html (last
accessed 1/2/12). Another case involved computer chip company Xilinx
(http://www.taxgirl.com/landmark-transfer-pricing-case-is-it-a-different-world/).
Also see http://ustransferpricing.com/decisions.html.

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Chapter 13 376

PROBLEMS

41. a. The ethical problems are created when short-run gains can be maximized by
doing what is unethical rather than what is ethical. This situation is created by
the companys incentive system. By narrowly focusing performance
evaluation on profit-related measures, the firm is ignoring other important
critical success factors. By measuring achievement across a broader set of
critical success factors, the company could induce the managers to behave in a
more ethically acceptable manner. The managers are merely reacting, albeit in
an ethically questionable way, to the incentives that have been put in place by
the company.
b. By refocusing the performance evaluation measures on a broader set of critical
success factors, top managers can induce lower managers to behave more
ethically. Top managers need to develop performance measures that are more
long term; focus on customer satisfaction, product quality, and social
responsibility; and provide managerial training in ethical behavior.
(CMA adapted)

42. a. The primary cause of the trend was the availability of new technology that
was supposed to enhance communications such as wireless phones, notebook
computers, and handheld monitoring devices.
b. One of the major problems is still communications because the patients entire
medical team still needs to collaborate and interact. The decentralized stations
created a problem in that they often replaced the centralized stations, so nurses
and physicians had to meet in hallways for discussions often within the
hearing range of a patient who was not the patient being discussed, which
could create ethical dilemmas . . . and increasing the noise level that could
disturb a patients rest and ability to recover. Additionally, the decentralized
stations distanced the nurses from their colleagues, which limited the ability to
share professional expertise with one another as well as engage in the
socialization that is important to job enhancement and development of a
team perspective. The isolation made it hard to help out in emergencies or
even to know if a nurses station on the same floor might be short-handed. To
adjust the situation, hospitals are now reconfiguring floor layouts to have
decentralized stations as well as centralized stations; the latter tend to be
designed as data centers for a variety of equipment, interactive communication
stations, medicine-storage facilities, supply intake operations, and lounge
areas. Combining the decentralized and centralized concepts retain the patient
benefit of close contact, but eliminate the noise and overhearing possibilities
as well as encourage nurse interactions and promote team spirit.

43. a. The report is not in accordance with the concept of responsibility accounting,
in which each managers performance is judged by how well he/she manages
those items directly under his/her control. Responsibility accounting does not
recognize the allocation of common costs to segments. While including the
corporate costs may be useful in calling attention to these activities,
differences between budgeted and actual for these items are beyond the
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Chapter 13 377

control of the Machining Department supervisor and are not properly


chargeable to him/her. Thus, corporate costs should not be included in the
report.
The report compares actual performance to a static budget. A static budget
fails to distinguish between the supervisors production control and cost
control responsibilities. Cost control is involved with seeing that output is
produced at the least possible cost, consistent with quality standards. All
dollar amounts in the report deal with cost control and tell nothing about how
well variable costs were controlled during the month. Budget costs are based
on a 3,000 units-per-month activity level, whereas actual costs were incurred
at an activity level of 3,185 units per month. The report should use a flexible
budget because it can be tailored for any level of activity within a relevant
range. This would result in the meaningful comparison of the actual cost of
producing 3,185 units with the budgeted cost of producing 3,185 units.
Without additional information, it cannot be known which of the fixed
manufacturing OH items are controllable at the department level. Only the
costs over which the department has control should be included in the report.
Also, inclusion of the FOH costs indicates that they are a necessary part of the
manufacturing activity, which may not be true.
b. Machining Department
Performance Report
For the Month Ended October 31, 2013
BUDGET ACTUAL VARIANCE
Units 3,185 3,185 0
Controllable costs
Var. mfg. costs
DM $ 9.00 $28,665 $ 8.80 $28,028 $0.20 $ 637 F
DL 9.50 30,258 9.45 30,098 0.05 160 F
VOH 11.10 35,354 11.00 35,035 0.10 319 F
Total $29.60 $94,277 $29.25 $93,161 $0.35 $1,116 F
Noncontrollable costs
Indirect labor $ 3,300 $ 3,334 $ (34) U
Depreciation 1,500 1,500 0
Taxes 300 300 0
Insurance 240 240 0
Other 930 1,027 (97) U
Total fixed OH $ 6,270 $ 6,401 $ (131) U
Total mfg. costs $100,547 $99,562 $ 985 F
c. Review favorable unit and component variances to determine if realistic
budgets were set. Note that all of the controllable manufacturing cost
variances were favorable. The only variance exceeding 5 percent was the
small $97 variance for the other category, and perhaps this should be
analyzed.
(CMA
adapted)
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Chapter 13 378

44. a. The most significant problem is that variances have been computed by
comparing a static budget to actual expenses. To evaluate cost control,
variances should be computed by comparing a flexible budget at the actual
activity level to actual costs. Also, the performance evaluation does not
contain auxiliary performance measures such as measures of customer service,
win/loss records, etc.

b. Flexible
Budget Actual Variance
Activity # of cases 2,970 2,970
Variable costs
Professional labor $2,970,000 $2,820,000 $150,000 F
Travel 148,500 120,000 28,500 F
Supplies 297,000 270,000 27,000 F
Fixed costs
Professional labor 1,200,000 1,215,000 15,000 U
Facilities 750,000 795,000 45,000 U
Insurance 240,000 234,000 6,000 F
Total $5,605,500 $5,454,000 $151,500 F
c. The variances that are most likely to be investigated are the ones that are
material and may be attributed to controllable factors. The most significant
variances are for those for professional labor (5 percent under the flexible
budget), travel (19 percent under the flexible budget), facilities (6 percent over
the flexible budget), and supplies (9 percent under the flexible budget).

45. a. Budget Actual Variance


Direct labor $ 375,000 $300,000 $ 75,000 F
Repairs 75,000 80,000 5,000 U
Maintenance 450,000 325,000 125,000 F
Indirect labor 75,000 77,500 2,500 U
Power 150,000 157,500 7,500 U
Totals $1,125,000 $940,000 $185,000 F
b. Although the bottom line is positive, questions need to be asked about the
extremely favorable variances existing in the direct labor and maintenance
categories. Were less experienced (and, thus, lower paid) workers used during
the period, and if so, how was production quality? Was the decrease in
maintenance spending appropriate, or will it cause machine failures in future
periods?
c. Promotion decisions should be deferred until the answers to the questions
posed in (b) can be answered in depth.
d. It is possible that many, if not all, of the costs shown on the responsibility
report are not under Rigeras control. The costs of direct and indirect labor
may be related to labor union contracts or rate renegotiations; repairs and

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Chapter 13 379

maintenance may be related to the costs of supplies or machinery failures; and


power may be related to utility company rate adjustments.

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Chapter 13 380

46. a. Revenues ($900 100) $ 90,000


Variable costs:
Meals ($10 9 106) $ 9,540
Lodging ($75 3 106) 23,850
Supplies ($10 106) 1,060 (34,450)
Contribution margin $ 55,550
Direct fixed costs:
Speakers ($2,500 each) $15,000
Rent on facilities 3,600
Advertising 4,000 (22,600)
Segment margin $ 32,950
Allocated fixed costs (0.25 $90,000) (22,500)
Net operating income $ 10,450
b. Revenues ($850 120) $102,000
Variable costs:
Meals ($10 9 1.15 126) $13,041
Lodging ($75 3 126) 28,350
Supplies ($10 126) 1,260 (42,651)
Contribution margin $ 59,349
Direct fixed costs:
Speakers ($2,950 6) $17,700
Rent on facilities 4,200
Advertising 4,900 (26,800)
Segment margin $ 32,549
Allocated fixed costs (0.25 $102,000) (25,500)
Net operating income $ 7,049
c. ASP ASV BSP ASV BSP BSV
$850 120 $900 120 $900 100
$102,000 $108,000 $90,000
$6,000 U $18,000 F
Sales Price Variance Sales Volume Variance
$12,000 F
Total Revenue Variance

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Chapter 13 381

Original Flexible
Budget Budget Actual Variance
Revenues $ 90,000 $108,000 $102,000 $ 6,000 U
Variable costs:
Meals $ 9,540 $ 11,340 $ 13,041 (1,701) U
Lodging 23,850 28,350 28,350 (0)
Supplies 1,060 1,260 1,260 (0)
Contribution margin $ 55,550 $ 67,050 $ 59,349
Direct fixed costs:
Speakers (15,000) (15,000) (17,700) (2,700) U
Rent on facilities (3,600) (3,600) (4,200) (600) U
Advertising (4,000) (4,000) (4,900) (900) U
Segment margin $ 32,950 $ 44,450 $ 32,549
Allocated fixed costs (22,500) (27,000) (25,500) (1,500) F
Net operating income $ 10,450 $ 17,450 $ 7,049 $(10,401) U

By far, given that revenues exceeded the budget, the two biggest contributors
to the seminars decreased profitability were the failure to include the
speakers airfare in the original budget and the failure to include the gratuity
on the meals. Also contributing to the reduced profitability were higher than
expected fixed costs for rent and advertising. However, the flexible budget
shows that variable costs were budgeted correctly per participant, with the
exception of the gratuity.

47. a. CRM is typically defined as the process of finding, getting, and retaining
customers. CRM is also defined as tracking customer behavior to develop
marketing and relationship-building programs that bond consumers to a brand
often by development of software systems to provide one-on-one contact
between the marketing business and their customer. CRM is the core of any
customer-focused business strategy and includes the people, processes, and
technology associated with sales, marketing, and service.
b. Each student will have a different answer. No solution is provided.
c. Each student will have a different answer. No solution is provided. However,
contact centers that are engaged in answering customer questions and
providing help services will typically be cost centers; those that have been
designed to engage in product sales will typically be profit centers.
d. Each student will have a different answer. No solution is provided. However,
contact center costs could be allocated to revenue-producing areas based on
number of people, time spent on services related to a particular product,
dollars of revenues, etc.
e. Each student will have a different answer. No solution is provided. However,
the following measurements may be useful:
Average time to answer calls
Percent of calls abandoned
Percent of calls that needed to be referred to another representative
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Chapter 13 382

Average number of issues handled per call


Average call-handling time
Employee turnover
Number of caller complaints; number of caller complaints per
employee
Number of instances of reported identity theft

48. a. Viewing child-care facilities as a cost center could create a negative


perspective of such operations from the companys standpoint. As such, the
company might try to control or reduce the costs of the child-care facilities by
engaging in one or more of the following actions:
Hiring less-qualified, lower-paid staff personnel
Reducing janitorial and/or maintenance activities
Limiting the number of staff to less-than-necessary
Purchasing low-quality equipment, toys, etc. that could be potentially
harmful to the children
Setting heating/air conditioning thermostats too high or too low to save on
electrical/gas costs
Providing unhealthy or low quality food and snacks

b. Each student will have a different answer. No solution is provided. However,


it should be pointed out that desiring a particular rate of return on the facilities
can also create some problems because the facilities may no longer be seen as
an employee benefit but, instead, a way for the company to increase its bottom
line. Such a perspective could also lead to some of the same actions discussed
in (a) or employees could continually find their charges increasing because the
company did not seek to control costs since they would be passed along in the
form of increased charges. It would probably be most beneficial to the
employees for the company to attempt to break even on the child-care facility
rather than view it as a profit enhancer.
Another possibility is for the company to allocate the cost of the facility to
revenue-producing departments. Such an action, however, might be difficult
because of the difficulty in finding a reasonable allocation base. For example,
number of employees is not appropriate because all employees do not have
children nor would all those having children choose the use the child-care
facilities.
c. Each student will have a different answer. No solution is provided.

49. a. Footballs: $1,200,000 $60 = 20,000 units


Shoulder pads: $1,800,000 $45 = 40,000 units

b. Sales volume variance = $60 (21,000 20,000) = $60,000 F


c. Actual volume = 40,000 ($360,000 $45) = 40,000 8,000 = 32,000
Actual price = $1,680,000 32,000 = $52.50
Sales price variance = 32,000 ($52.50 $45) = 32,000 $7.50 = $240,000 F
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Chapter 13 383

d. Total sales price variance ($63,000 U + $240,000 F) $177,000 F


Total sales volume variance ($60,000 F + $360,000 U) 300,000 U
Total sales variance $123,000 U
Budgeted revenue exceeded actual revenue by $123,000 for two reasons. First,
footballs were sold at a lower price than budgeted, and second, too few
shoulder pads were sold. These negative effects were partially offset by (1) a
higher price for shoulder pads and (2) a higher-than-planned sales volume of
footballs.

50. a. Actual sales volumes


HD radio tuners: $195,500 $115 = 1,700 units
Satellite radios: $141,400 $70 = 2,020 units
MP3 car decks: $228,250 $55 = 4,150 units
Sales price variances
HD radio tuners: 1,700 ($120 $115) = $ 8,500 U
Satellite radios: 2,020 ($68 $70) = 4,040 F
MP3 car decks: 4,150 ($60 $55) = 20,750 U
Total $25,210 U
b. Sales volume variances
HD radio tuners: $120 (1,600 1,700) = $ 12,000 F
Satellite radios: $68 (2,100 2,020) = 5,440 U
MP3 car decks: $60 (1,050 4,150) = 186,000 F
Total $192,560 F
c. Overall, the sales price variance was $25,210 unfavorable and, approximately
82 percent of this was caused by negative price variance of the MPS car decks.
These results could be attributed to short-term economic pressures or
marketing tactics used by Taub. Assuming the results reflect a rational
strategy, Taub may have accepted lower prices to increase the overall volume
of saleswhich is indicated by the high volume of MP3 car deck sales. The
results could also indicate a trend that more customers are opting to purchase
MP3 car decks because they prefer to listen to the music they have selected
rather than someone elses choices as would be the case with either of the
other music options.
d. By telling Taub that her performance would only be evaluated on three
specific products, she would tend to ignore other products in her area, which
could have been more appropriate to customers needs. Taub might also not
have understood whether she was being evaluated on the basis of volume or
revenue. If she believed that the company was concerned about the volume of
product sales, Taub can point to the fact that volumes for two of the three
products were higher than budgeted, which could have been forced by
reducing selling prices.

51. a. Actual sales price = $235,000 5,000 = $47


Budgeted sales price = $300,000 6,000 = $50

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Chapter 13 384

ASP ASV BSP ASV BSP BSV


$47 5,000 $50 5,000 $50 6,000
$235,000 $250,000 $300,000
$15,000 U $50,000 U
Sales Price Variance Sales Volume Variance

b. The budgeted contribution margin was $120,000 6,000 or $20 per unit.
Since the companys sales volume was 1,000 units less than budgeted, the
total impact on the companys contribution margin would be a reduction of
$20,000 from what was budgeted.
c. To isolate the effect on operating income of an increase or decrease in market
share, the company must know its budgeted and actual market shares, the
actual size of the market share for November 2013, and the budgeted
weighted- average unit contribution margin. These computations may help
Folsoms managers determine whether the decline in sales was due to a loss of
competitiveness or a shrinkage of the overall market.
d. Performance evaluation would be limited, because in most instances,
managers are also responsible for managing some costs in their centers. In
Folsoms case, evaluation of the control over variable and fixed costs goes
beyond the sales price and sales volume variances.

52. Assets # of Hours of


Employed % Employees % Operation %
Surgery $3,948,500 53 20 20 24,850 35
In-patient 2,458,500 33 36 36 28,400 40
Out-patient 1,043,000 14 44 44 17,750 25
$7,450,000 100 71,000

Administration costs:
Surgery: $5,400,000 0.53 = $2,862,000
In-patient: $5,400,000 0.33 = $1,782,000
Out-patient: $5,400,000 0.14 = $756,000
Public relations cost:
Surgery: $1,100,000 0.20 = $220,000
In-patient: $1,100,000 0.36 = $396,000
Out-patient: $1,100,000 0.44 = $484,000
Maintenance and janitorial cost:
Surgery: $1,700,000 0.35 = $595,000
In-patient: $1,700,000 0.40 = $680,000
Out-patient: $1,700,000 0.25 = $425,000
Surgery In-Patient Out-Patient
Administration $2,862,000 $1,782,000 $ 756,000
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Chapter 13 385

Public Relations 220,000 396,000 484,000


Maintenance 595,000 680,000 425,000
Total $3,677,000 $2,858,000 $1,665,000

53. a. Administration: 45 + 210 + 18 = 273


Commercial = 45 273 = 16%; 0.16 $1,500,000 = $240,000
Residential = 210 273 = 77%; 0.77 $1,500,000 = $1,155,000
Property Mgmt. = 18 273 = 7%; 0.07 $1,500,000 = $105,000

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Chapter 13 386

Accounting = $900,000 + $1,440,000 + $540,000 = $2,880,000


Commercial = $900,000 $2,880,000 = 31%; 0.31 $990,000 = $306,900
Residential = $1,440,000 $2,880,000 = 50%; 0.50 $990,000 = $495,000
Property Mgmt. = $540,000 $2,880,000 = 19%; 0.19 $990,000 =
$188,100
Promotion: $10,000,000 + $18,000,000 + $2,000,000 = $30,000,000
Commercial = $10,000,000 $30,000,000 = 33%; 0.33 $720,000 = $237,600
Residential = $18,000,000 $30,000,000 = 60%; 0.60 $720,000 = $432,000
Property Mgmt. = $2,000,000 $30,000,000 = 7%; 0.07 $720,000 =
$50,400
b. Comm. Res. Prop. Mgmt.
Revenue $ 10,000,000 $18,000,000
$2,000,000
Direct costs (10,490,000) (9,179,000) (398,400)
Allocated costs:
Administration (240,000) (1,155,000) (105,000)
Accounting (306,900) (495,000) (188,100)
Promotion (237,600) (432,000) (50,400)
Operating income $ (1,274,500) $ 6,739,000 $1,258,100

54. a. Administration costs ($1,500,000)


Base Allocation
Accounting 15 300 $ 75,000
Promotion 12 300 60,000
Commercial 45 300 225,000
Residential 210 300 1,050,000
Property Mgmt. 18 300 90,000
Total (rounded) $1,500,000

Accounting costs ($990,000 + $75,000 = $1,065,000)


Base Allocation
Promotion $720,000 $3,600,000 $ 213,000
Commercial $900,000 $3,600,000 266,250
Residential $1,440,000 $3,600,000 426,000
Property Mgmt. $540,000 $3,600,000 159,750
Total (rounded) $1,065,000
Promotion ($720,000 + $60,000 + $213,000 = $993,000)
Base Allocation
Commercial $10,000,000 $30,000,000 $331,000
Residential $18,000,000 $30,000,000 595,800
Property Mgmt. $2,000,000 $30,000,000 66,200
$993,000
Summary of allocations:
Commercial: $225,000 + $266,250 + $331,000 = $822,250
Residential: $1,050,000 + $426,000 + $595,800 = $2,071,800
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Chapter 13 387

Property Mgmt.: $90,000 + $159,750 + $66,200 = $315,950

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Chapter 13 388

b. Commercial Residential Property Mgmt.


Revenues $ 10,000,000 $18,000,000 $2,000,000
Direct costs (10,490,000) (9,179,000) (398,400)
Indirect costs (822,250) (2,071,800) (315,950)
Income $ (1,312,250) $ 6,749,200 $1,285,650
The Property Management Department is the most profitable with a return on
revenues of 64.3 percent.

55. a. Personnel: 72 + 48 = 120


Residential = 72 120 = 60%; 0.60 $140,000 = $84,000
Commercial = 48 120 = 40%; 0.40 $140,000 = $56,000
Administration: $480,000 + $800,000 = $1,280,000
Residential = $480,000 $1,280,000 = 37.5%; 0.375 $180,000 = $67,500
Commercial = $800,000 $1,280,000 = 62.5%; 0.625 $180,000 = $112,500
Total support costs allocated to Residential = $84,000 + $67,500 = $151,500
Total support costs allocated to Commercial = $56,000 + $112,500 =
$168,500
b. # of Empl. % Direct Costs %
Administration 30 20%
Residential 72 48% $480,000 37.5%
Commercial 48 32% 800,000 62.5%
150
Personnel = $140,000 of costs
Administration = 0.20 $140,000 = $28,000
Residential = 0.48 $140,000 = $67,200
Commercial = 0.32 $140,000 = $44,800
Administration = $180,000 + $28,000 = $208,000 of costs
Residential = 0.375 $208,000 = $78,000
Commercial = 0.625 $208,000 = $130,000
Total support costs allocated to Residential = $67,200 + $78,000 = $145,200
Total support costs allocated to Commercial = $44,800 + $130,000 =
$174,800
c. (1) Direct Method
Residential = $480,000 + $151,500 = $631,500; $631,500 60,000 =
$10.53
Commercial = $800,000 + $168,500 = $968,500; $968,500 570,000
= $1.70
(2) Step Method
Residential = $480,000 + $145,200 = $625,200; $625,200 60,000 =
$10.42
Commercial = $800,000 + $174,800 = $974,800; $974,800 570,000
= $1.71

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Chapter 13 389

56. ADMINISTRATION EDITORIAL


Department Base % Base %
Admin. (A) N/A N/A 5 11.11
Editorial (E) $ 75,000 6.25 N/A N/A
College Texts 600,000 50.00 25 55.56
Prof. Pubs. 525,000 43.75 15 33.33
Total $1,200,000 100.00 45 100.00 rounded
A = $225,000 + 0.1111E
E = $175,000 + 0.0625A
A = $225,000 + 0.1111($175,000 + 0.0625A)
A = $225,000 + $19,443 + 0.0069A
0.9931A = $244,443
A = $246,141
E = $175,000 + 0.0625($246,141)
E = $175,000 + $15,384
E = $190,384
College
Dept. Admin. Edit. Texts Prof. Pubs.
Direct costs $ 225,000 $ 175,000 $2,250,000 $ 950,000
Admin. (246,141) 15,384 123,071 107,687
Edit. 21,152 (190,384) 105,777 63,455
Total $ 0 $ 0 $2,478,848 $1,121,142

Note: The Administration column does not sum to zero because of rounding.

57. a. Assets Employed % # of Employees %


Adv. $ 381,200 29 6 32
Cir. 935,150 71 13 68
$1,316,350 100% 19 100%
Adv. Cir.
Admin. (0.29 $390,750; 0.71 $390,750) $113,318 $277,433
H. Res. (0.32 $246,350; 0.68 $246,350) 78,832 167,518
$192,150 $444,951
b. Adv.: $478,900 + $192,150 = $ 671,050
Cir.: $676,300 + $444,951 = 1,121,251
$1,792,301 (off due to rounding)
c. Admin. ($390,750):
Base Allocation
H. Res. $145,850 $1,462,200 $ 38,976
Adv. $381,200 $1,462,200 101,870
Cir. $935,150 $1,462,200 249,904
$390,750
H. Res. ($246,350 + $38,976) = $285,326:
Base Allocation
Adv. 6 19 $ 90,103
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Chapter 13 390

Cir. 13 19 195,223
$285,326

d. Adv.: $478,900 + $101,870 + $90,103 = $ 670,873


Cir.: $676,300 + $249,904 + $195,223 = 1,121,427
$1,792,300

e. ADMIN. H. RES.
Department Base % Base %
Admin. (A) N/A N/A 5 21
H. Res. (H) $ 145,850 10 N/A N/A
Adv. 381,200 26 6 25
Cir. 935,150 64 13 54
$1,462,200 24
A = $390,750 + 0.21H
H = $246,350 + 0.10A
A = $390,750 + 0.21($246,350 + 0.10A)
= $390,750 + $51,733.50 + 0.021A
0.979A = $442,483.50
A = $451,975
H = $246,350 + 0.10($451,975)
= $246,350 + $45,197.50
= $291,548
Admin. H. Res. Advertising Circulation
Direct costs $ 390,750 $ 246,350 $478,900 $ 676,300
Admin. (451,975) 45,198 117,514 289,264
H. Res. 61,225 (291,548) 72,887 157,436
$ 0 $ 0 $669,301 $1,123,000

58. a. Administrative Costs ($2,130): (000s omitted)


Base Allocation
Legal/Acctg. 40 800 $ 106.50
Maint./Eng. 60 800 159.75
Proc. 400 800 1,065.00
Finish. 300 800 798.75
$2,130.00
Legal/Acctg. ($1,680 + $106.50 = $1,786.50):
Base Allocation
Maint./Eng. 400 4,000 $ 178.65
Proc. 1,600 4,000 714.60
Finish. 2,000 4,000 893.25
$1,786.50
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Chapter 13 391

Maint./Eng. ($2,370 + $159.75 + $178.65 = $2,708.40):


Base Allocation
Proc. 136 340 $1,083.36
Finish. 204 340 1,625.04
$2,708.40
Summary of allocation:
Proc.: $1,065 + $714.60 + $1,083.36 + $7,520 = $10,382.96
Finish.: $798.75 + $893.25 + $1,625.04 + $7,200 = $10,517.04

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Chapter 13 392

Factory overhead rates:


Proc.: $10,382.96 400 = $25.96 per direct labor hour
Finish.: $10,517.04 300 = $35.06 per direct labor hour
b. Floor Space % # of Employees % # of Hours %
Proc. 1,600 44 400 57 136 40
Finish. 2,000 56 300 43 204 60
3,600 700 340
Proc. Finish.
Admin. $1,214 $ 916
Legal/Acctg. 739 941
Maint./Eng. 948 1,422
Total $2,901 $3,279
Factory overhead rates:
Proc.: ($7,520 + $2,901) 400 = $26.05 per direct labor hour
Finish.: ($7,200 + $3,279) 300 = $34.93 per direct labor hour
c. ADMIN. LEGAL/ACCTG. MAINT./ENG.
Department Base % Base % Base %
Admin. (A) N/A N/A 800 16.67 30 7.32
Legal/Acctg. (L) 40 5.00 N/A N/A 40 9.76
Maint./Eng. (M) 60 7.50 400 8.33 N/A N/A
Proc. 400 50.00 1,600 33.33 136 33.17
Finish. 300 37.50 2,000 41.67 204 49.76
800 4,800 410
A = $2,130 + 0.17L + 0.07M
L = $1,680 + 0.05A + 0.10M
M = $2,370 + 0.075A + 0.08L
A = $2,130 + 0.17($1,680 + 0.05A + 0.10M) + 0.07M
A = $2,130 + $285.60 + 0.0085A + 0.087M
0.9915A = $2,415.60 + 0.087M
A = $2,436 + 0.088M
M = $2,370 + 0.075A + 0.08($1,680 + 0.05A + 0.10M)
M = $2,370 + 0.075A + $134.40 + 0.004A + 0.008M
0.992M = $2,504.40 + 0.079A
M = $2,525 + 0.0796A
Substituting M:
A = $2,436 + 0.088($2,525 + 0.0796A)
A = $2,436 + $222.20 + 0.007A
0.993A = $2,658.20
A = $2,677
M = $2,525 + 0.0796($2,677)
= $2,525 + $213.09
= $2,738
L = $1,680 + 0.05($2,677) + 0.10($2,738)
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Chapter 13 393

= $1,680 + $133.85 + $273.80


= $2,088
Admin. L/A M/E Proc. Fin.
Direct costs $ 2,130 $ 1,680 $ 2,370 $ 7,520 $ 7,200
Admin. (2,677) 134 201 1,339 1,004
Legal/Acctg. 355 (2,088) 167 689 877
Maint./Eng. 192 274 (2,738) 904 1,369
$ 0 $ 0 $ 0 $10,452 $10,450

Factory overhead rates:


Proc: $10,452 400 = $26.13 per direct labor hour
Finish: $10,450 300 = $34.83 per direct labor hour

59. Allocation of computer services costs should be made on an hours used basis to
permit a more efficient use of company resources. The charging basis should
encourage users to take advantage of the Computer Systems Departments
services but not permit the Computer Systems Department to pass on its
inefficiencies. For instance, a standard hourly usage rate should be developed
based on past experience, adjusted for efficiency considerations. Divisions would
be charged the standard rate for the hours of recorded usage.
(CMA adapted)

60. a. Case 1 upper limit = $70


Case 1 lower limit = [$32 + $12 + $4 + ($6 $1)] + (Lost CM of $26) = $79
Lost CM = $80 ($32 + $12 + $4 + $6) = $26
Case 2 upper limit = $57
Case 2 lower limit = [$22 + $10 + $3 + ($3 $1)] + (Lost CM of $27) = $64
Lost CM = $65 ($22 + $10 + $3 + $3) = $27
Interpretation: When, as in both cases in this problem, the lower limit exceeds
the upper limit, the intracompany transfers should not be made because the
company will be worse off.
b. Selling price = Variable cost + $12
Case 1 selling price = [$32 + $12 + $4 + ($6 $1)] + $12 = $65
Case 2 selling price = [$22 + $10 + $3 + ($3 $1)] + $12 = $49
c. Dual transfer prices for Case 1: Speakers selling price [from (b)] = $65 Sound
Systems purchase price = ($70 $12) = $58
Speakers Division manager should demonstrate that the whole company will
be worse off if this is done based on the answer to (a):
Contribution margin lost by Speaker Division $ 26
Savings to Sound System by purchasing
below the external purchase price ($70 $58) (12)
Loss to company per unit transferred $ 14

61. a. Current external selling price, $10,464


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Chapter 13 394

Selling Divisionfair value since most are produced and sold at this price
externally.
Buying Divisionprice is higher than outside vendor price so this would
make its performance report appear worse than by buying externally.
Total variable production cost ($4,200) + 20% = $5,040
Selling Divisioncontributes minimally to covering fixed costs, and
therefore, no profit is shown from these sales as opposed to external sales.
There is little incentive to sell internally if the selling division can sell all its
output externally.
Buying Divisionless than external purchase price, therefore it is more
beneficial to the bottom line of Ludmilla Company.
Total product ($6,000) cost + 20% = $7,200
Selling Divisioncovers some but not all costs for this division, therefore
incentive to sell internally isnt there if Engine Division can sell its output
externally.
Buying Divisionpurchase price below external so better for margin in this
division.
Bid price from external supplier ($9,280)
Selling Divisionallows for some profit which is an incentive to sell
internally unless it can sell all its output externally.
Buying Divisionno incentive to buy internally since it costs the same as to
buy from an external supplier.
b. Upper limit = $9,280
Lower limit = costs of $4,800 + Contribution margin of $5,664 = $10,464
Since the lower limit exceeds the upper limit, the company would be better off
not making the internal transfers.

62. a. Roll-Em-On SkyWheels


A/R (SW Div.) 640,000 Inventory 640,000
Intraco. Sales 640,000 A/P (REO Div.) 640,000
Worldly Travelers
Intraco. CGS 368,000
Finished Goods 368,000
[4,000 ($40 + $12 + $16 + $24) = 4,000 $92]

b. Variable cost = $40 + $12 + $16 + $8 = $76; $76 + (0.15)($92) = $89.80


Total transfer cost = 4,000 $89.80 = $359,200
Roll-Em-On SkyWheels
A/R (SW Div.) 359,200 Inventory 359,200
Intraco. Sales 359,200 A/P (REO Div.) 359,200
Worldly Travelers
Intraco. CGS 368,000
Finished Goods 368,000
[4,000 ($40 + $12 + $16 + $24) = 4,000 $92]
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Chapter 13 395

c. Roll-Em-On SkyWheels
A/R (SW Div.) 272,000 Inventory 272,000
Intraco. Sales in A/P (REO Div.) 272,000
Excess of
Assigned Cost 368,000
Intraco. Sales 640,000

Worldly Travelers
Intraco. CGS 368,000
Finished Goods 368,000
d. Roll-Em-On SkyWheels
A/R (SW Div.) 368,000 Inventory 368,000
Intraco. Sales 368,000 A/P (REO Div.) 368,000
Worldly Travelers.
Intraco. CGS 368,000
Finished Goods 368,000

63. a. Plain Cookies Decorated Cookies Company Total


Sales
To outsiders $ 6,000 $ 3,200 $ 9,200
To other division 0 0
Variable costs:
Cookies (1,500) (1,600) (3,100)
Other costs _ (600) (600)
_
Contribution margin $ 4,500 $ 1,000 $ 5,500
Fixed costs (300) (500) (800)
Segment margin $ 4,200 $ 500 $ 4,700
Bonus (10%) (420) (50) (470)
Operating income $ 3,780 $ 450 $ 4,230
b. Since the Plain Cookies Division currently has excess capacity, the lowest
transfer price should be its variable cost plus the opportunity cost. With excess
capacity, opportunity cost is $0. The lowest transfer price is $0.50 per cookie.
Since the manager of the Decorated Cookies Division would buy from outside
vendors at a price in excess of the market price of $2 per cookie, the highest
transfer price would be $2.
c. Transfer price of $0.50 per cookie
Plain Cookies Decorated Cookies Company Total
Sales
To outsiders $ 6,000 $3,200 $ 9,200
To other division 400 0
Variable costs:
Cookies (1,500) (400) (1,500)
Other costs (400) (600) (1,000)
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Chapter 13 396

Contribution margin $ 4,500 $2,200 $ 6,700


Fixed costs (300) (500) (800)
Segment margin $ 4,200 $1,700 $ 5,900
Bonus (10%) (420) (170) (590)
Operating income $ 3,780 $1,530 $ 5,310
Note: The intracompany revenue of $400 and intracompany cost of $400 have
been eliminated in the company total income statement.
Daviss bonus increases by $120 because of the $1,200 cost savings from
buying cookies from Plain Cookies Division rather than from outside
suppliers (savings of $1.50 per cookie 800 decorated cookies).
Cookie Delights segment margin increases by the same $1,200.
Lindens bonus remains that same because the Plain Cookies Division
makes no additional money on the transfer of cookies to the Decorated
Cookies Division.

Transfer price of $2.00 per cookie


Plain Cookies Decorated Cookies Company Total
Sales
To outsiders $ 6,000 $ 3,200 $ 9,200
To other division 1,600 0
Variable costs:
Cookies (1,500) (1,600) (1,500)
Other costs (400) (600) (1,000)
Contribution margin $ 5,700 $ 1,000 $ 6,700
Fixed costs (300) (500) (800)
Segment margin $ 5,400 $ 500 $ 5,900
Bonus (10%) (540) (50) (590)
Operating income $ 4,860 $ 450 $ 5,310
Note: The intracompany revenue of $1,600 and intracompany cost of $1,600
have been eliminated in the company total income statement.
Daviss bonus remains at $50 because there is no cost savings from buying
cookies from Plain Cookies Division rather than from outside suppliers.
Cookie Delights segment margin still increases by $1,200 because the
companys cost per cookie is $0.50 rather than $2.00.
Lindens bonus increases by $120, which is 10 percent of the $1,200 profit
his division makes on selling plain cookies to Decorated Cookies Division
for $1,200 more than they cost to make.
d. The computations show that Cookie Delight Company is better off at any
value between the lowest transfer price of $0.50 and the highest transfer price
of $2 because of the companys cost savings from making the cookies that the
Decorated Cookies Division uses rather than buying them from the outside.
However, because of the bonus structure, Linden would prefer the $2 transfer
price while Davis would prefer the $0.50 transfer price. The optimum solution
is to encourage the division managers to negotiate an acceptable transfer price.

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Chapter 13 397

A negotiated transfer price of $1.25 would encourage both division managers


to transfer internally and create goal congruence in the company.
64. a. To maximize short-run contribution margin, the Alberton Division should
accept the contract from New London Company. This conclusion is supported
by the following calculations.
(1) Alberton transfer to Summerside:
Transfer price (1,500 $1,500) $ 2,250,000
Variable cost
Purch. from OLeary (1,500 $600) $900,000
Process by Alberton (1,500 $500) 750,000 (1,650,000)
Contribution Margin $ 600,000

(2) Alberton accepts New London contract:


Selling price (1,750 $1,250) $ 2,187,500
Variable cost
Purch. from OLeary (1,750 $500) $875,000
Process by Alberton (1,750 $400) 700,000 (1,575,000)
Contribution Margin $ 612,500
Conclusion:
Contribution margin from New London contract $ 612,500
Contribution margin from Summerside sale (600,000)
Difference in favor of New London contract $ 12,500
b. Alberton Divisions decision to accept the contract from New London
Company is in the companys best interest because the decision increases the
companys overall contribution margin. This conclusion is supported by the
following calculations.
Revenues and cost savings to Charlottetown Inc:
Sale: Alberton to New London (1,750 $1,250) $2,187,500
Sale: OLeary to Montague (1,500 $400) 600,000
Cost savings (variable costs avoided by not
not accepting the Summerside order)
OLearys savings (1,500 $300) 450,000
Albertons savings (1,500 $500) 750,000 $ 3,987,500
Expenditures incurred by Charlottetown Inc.
Variable costs incurred for New London order
Alberton (1,750 $400) $ 700,000
OLeary (1,750 $250) 437,500
Variable cost incurred for purchase
Summerside from Montague (1,500 $1,500) 2,250,000
Montague from OLeary (1,500 $200) 300,000 (3,687,500)
Positive contribution margin $ 300,000

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Chapter 13 398

(CMA adapted)

65. a. Total EDP hours used = 1,220 + 650 + 190 = 2,060


Transfer price revenue = 2,060 $80 = $164,800
Actual variable EDP costs = $181,280 = $88 transfer price
Total EDP hours used 2,060
The $80 transfer price is inadequate because the EDP Department is left with a
loss (for internal evaluation purposes) of ($181,280 $164,800) or $16,480.

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Chapter 13 399

b. and c. Allocate administration costs of $900,000 and fixed EDP costs of


$600,000:
Lit. FP LC Total
Administration ($900,000)
(10/18, 5/18, 3/18) $ 500,000 $ 250,000 $150,000 $ 900,000
EDP-Fixed ($600,000)
(80/345,240/345,
25/345) 139,130 417,392 43,478 600,000
Total allocated $ 639,130 $ 667,392 $193,478 $1,500,000
Transfer costs 97,600 52,000 15,200 164,800
Direct costs 400,000 510,000 680,000 1,590,000
Total $1,136,730 $1,229,392 $888,678 $3,254,800

66. To achieve CarryOn!s goals, the division manager should purchase the materials
needed at the lowest price available to CarryOn! Division at the present time. The
three possible prices are as follows:
Koenigs price $8.00
HIDEs price 9.00
Thompsons price 7.00
CarryOn! Division should purchase from Thompson.
For CarryOn! Division to achieve the overall company goals, the following
analysis is required to compare the costs of the three bidders:
Koenigs price $8.00
HIDEs price:
Sales price Profit margin = $9.00 (0.40 $9.00) 5.40
Thompsons price $ 7.00
However, the profit margin of Barrows Chemical
should be deducted = $7.00 (0.30 $2.00) (0.60) 6.40
From Eekaydos standpoint, the relevant costs for this decision are the variable
costs per square foot if there is available capacity and no additional fixed costs
would be incurred. For any division to achieve the overall company goals to
maximize profit, variable organizational costs must be minimized. In this case,
CarryOn! must choose the best price available to it. HIDE should consider
lowering its price to meet Thomsons competition.
(CMA adapted)

67. a. Regular selling price $26.00


Regular selling price less variable selling and distribution
expenses ($26.00 $2.40) $23.60
Standard manufacturing cost plus 15%
($12.80 + $4.80) 1.15 $20.24
Standard variable manufacturing cost plus 20%
($12.80 1.20) $15.36

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Chapter 13 400

b. Currently, Gondorf Division management should be positive to each of these


prices in decreasing order because the division apparently has unused
capacity. As an investment center, the manager of Gondorf Division is likely
to be evaluated based on return on investment, and since each of these prices
exceeds divisional variable costs, any of the prices will increase Gondorfs
ROI.
If, at some point, all existing capacity of Gondorf Division is being used, the
divisions manager would want the intercompany transfer price to generate the
same amount of profit as outside business to maximize division ROI.
c. Negotiation between the two divisions is the best method to settle on a transfer
price. The company is highly decentralized, and each of the following four
conditions necessary for negotiated transfer prices exist:
An outside market exists that provides both parties with an alternative.
Both parties have access to market price information.
Both parties are free to buy and sell outside the company.
Top management supports the continuation of the decentralized
management concept.
d. No, corporate management should not become involved in this controversy.
Because the decision has been made to operate the divisions as investment
centers, top management must believe that such an organizational structure
will maximize long-term profits. Imposing corporate restrictions will
adversely affect the current management evaluation system because
investment center managers would no longer have complete control of their
units profits. Also, the addition of corporate restrictions could have a negative
impact on division management who are accustomed to an autonomous
working environment.
(CMA adapted)

68. a. The main advantage that I-O-WoW might have is a cost advantage. It is likely,
because the division sells mainly internally, that the division incurs lower
marketing and promotion costs than other divisions. By selling mainly
internally, the division has no requirement to maintain the same marketing
capability as other divisions that sell their products externally. In addition, the
division may reap substantial savings on distribution costs because it does not
have to ship most of its output to other customer locations.
b. Because the division sells mainly internally, it would be possible to make the
I-O-WoW Division a cost center. Then, output of the division could be
transferred to other internal divisions at full or variable cost. The other logical
alternative is to allow the internal buying divisions to negotiate with I-O-
WoW for discounts from the usual market price so that the buying divisions
share in the cost savings.

69. Each student will have a different answer. No solution is provided. URL
is http://www.ey.com/GL/en/Services/Tax/International-Tax/Transfer-Pricing-and
-Tax-Effective-Supply-Chain-Management/2011-Transfer-pricing-reference-guide
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accessible website, in whole or in part.
Chapter 13 401

(Should this link not be accessible, type in Ernst & Young 2011 Transfer Pricing
Reference Guide into search engine.)

70. Each student will have a different answer. No solution is provided.

71. Each student will have a different answer. No solution is provided. However, the
following may be helpful in the discussion.
Excerpted from Transfer Pricing in a Recession: What Companies Should
Consider (PricewaterhouseCoopers, 2009)
With rising unemployment comes reduced personal income taxes, and with
reduced corporate profits come reduced corporate revenue. The global tax base
has decreased and probably will continue to shrink. Even in a recession, a
discussion by any politician of increased taxes is risky. More money is needed to
keep funding current programs, and while taxes of many varieties may increase, a
less controversial option is for the Internal Revenue Service to collect more
revenue through increased enforcement and other means. Globally, taxing
authorities will increase their efforts to collect taxes needed to fuel their
governments spending.
A substantial increase in tax audits, including those focused on transfer pricing, is
expected. In addition to the increased number of audits expected globally, the
difficulty and complexity of such audits are expected to increase as taxing
authorities continue to become more sophisticated and open to sharing taxpayer
information. Issues that may have been overlooked before will be reconsidered.
Settlement positions arrived at in the past may no longer be accepted. All
possibilities are on the table.
In such uncertain economic times, how should multinational companies approach
defending past transfer pricing policies including those established under advance
pricing agreements during robust economic times? How should companies
prepare to go forward regarding their transfer pricing options? In addition to
ensuring they have adequately documented their transfer pricing to defend
historical positions, companies also must consider ways to optimize current and
future transfer pricing positions. This includes evaluating current transfer prices
under current structures as well as opportunities to modify current organizational
and tax structures. Multinational companies abilities to develop and sustain tax-
efficient structures (alongside required supply chain modifications) will have
significant implications for their abilities to reduce costs and remain competitive.
From David D. Stewart, Transfer Pricing Practitioners Find Challenges,
Opportunities in Economic Climate, Worldwide Tax Daily (May 22, 2009): Steve
Hasson with PwCs U.K. transfer pricing group discussed difficulties related to
pricing using comparables and adjusting to the current environment with existing
arrangements. Hasson noted that the data being used for determining comparables
are historic and lagged, resulting in a data set that does not reflect the current
economic environment. In short, what it means is that the data you are relying on
is drawn from boom years, and you probably dont want to benchmark your

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accessible website, in whole or in part.
Chapter 13 402

pricing against that position or indeed you may not be able to, Hasson said. This
whole question of comparability has gotten a whole lot harder, he added.
According to Greg Ossi, a principal with PwCs transfer pricing group, companies
with a current APA will face challenges in the current environment, but
companies in negotiations for APAs could find opportunities. For companies
with current APAs, Ossi said that while it is unlikely tax authorities would be
willing to renegotiate the agreement based only on a decline in sales, it may be
possible to seek an extension of a current APA with renegotiated terms for the
remainder. For companies considering or in negotiations for an APA, Ossi
explained that the IRSs APA office is open to a range of techniques and
refinements employed in a new agreement. Among the techniques Ossi
suggested were using different pricing over several periods to reflect the current
downturn and expected recovery, shortening the APA term, or including special
critical assumptions in the agreement. I would characterize this as a work in
process at the APA office, Andrus said. They are clearly working on figuring it
out, but I dont think there is a fixed menu of things that they are willing to do in
any case or in every case thats carved in stone at this point.

72. Each student will have a different answer. No solution is provided. However, the
following may be helpful in the discussion: New OECD Project on the Pricing of
Intangibles, A World in Transition (March 2011); http://www.kpmg.com/Global/
en/IssuesAndInsights/ArticlesPublications/Documents/world-in-transition.pdf, p.
28ff (accessed 1/2/12).

2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly
accessible website, in whole or in part.