Chapter 10-Solutions-Hansen 6e-doc PDF

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CHAPTER 10DECENTRALIZATION:RESPONSIBILITY ACCOUNTING, PERFORMANCEEVALUATION, AND TRANSFER PRICINGQUESTIONS FOR WRITING AND DISCUSSION Decentralization is the delegation of decision-making authority to lower levels. In centralized decision making, decisions are made at the very top level, and lower-l...

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CHAPTER 10 DECENTRALIZATION: RESPONSIBILITY ACCOUNTING, PERFORMANCE EVALUATION, AND TRANSFER PRICING QUESTIONS FOR WRITING AND DISCUSSION 1. Decentralization is the delegation of decision-making authority to lower levels. In centralized decision making, decisions are made at the very top level, and lower-level managers are responsible for implementing these decisions. For decentralized decision making, decisions are made and implemented by lower-level managers.

required on an investment. Residual income encourages investment in all projects that earn at least the minimum rate of return. 8. EVA is economic value added. It is the difference between after-tax income and the cost of the capital employed. EVA is an absolute dollar amount, not a percentage rate of return like ROI. EVA differs from residual income in EVA’s use of after-tax income and the true cost of capital (rather than a hurdle rate).

2. Reasons for decentralization include the following: access to local information, more timely response, focusing of central management, exposure of segments to market forces, enhanced competition, training, and motivation.

9. A stock option is the right to purchase a certain amount of stock at a fixed price. It can encourage goal congruence by giving managers an ownership stake in the firm, encouraging them to view operations from a long-run perspective.

3. Knowledge of local conditions may be critical for decisions; local managers are aware of these conditions, whereas higherlevel managers may not be. This can lead to more informative decision making. 4. Margin = Net income/Sales, and Turnover = Sales/Average operating assets. By breaking ROI into margin and turnover, more insight into why ROI may change from one period to the next is possible. 5. Three advantages of ROI include: (1) ROI encourages managers to pay attention to the relationships among sales, expenses, and investment. (2) ROI encourages cost efficiency. (3) ROI discourages excessive investment in operating assets. Increased profitability can be achieved (all other things being equal) by increasing revenues, decreasing expenses, or lowering investment. 6. Two disadvantages of ROI are: (1) ROI may discourage managers from investing in projects that would increase the profitability of the firm but decrease the division’s ROI. (2) It also may encourage managers to focus on short-run profitability and to take actions that may harm long-run profitability. 7. Residual income is the difference between net income and the minimum dollar return

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10.

A transfer price is the price charged for goods that are transferred from one division to another division of the same company.

11.

The transfer pricing problem is finding a transfer price that simultaneously satisfies three objectives: accurate performance evaluation, goal congruence, and preservation of divisional autonomy.

12.

Agree. Because at least one division will be made better off and firm profits will increase.

13.

If a perfectly competitive outside market exists, the transfer price should be market price. Minimum price = maximum price = market price. Any other price would make at least one division worse off, and firm profits may decrease if the price is not market price.

14.

Full cost, full cost plus, variable cost plus. The major disadvantage is that cost-based transfer prices may not reflect the optimal outcome for the divisions and the firm. Specifically, it is possible for the transfer price, using one of the costing approaches, to be less than the minimum price or greater

income tax purposes. The four acceptable methods are the comparable uncontrolled price method, the resale price method, the cost-plus method, and any method jointly acceptable to the IRS and the company.

than the maximum price. The prices, however, are simple to use and, in some cases, may reflect the outcome of a negotiated agreement. 15.

Internal Revenue Code Section 482 outlines the transfer pricing methods acceptable for

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EXERCISES 10–1 1.

Sporting Goods Division ROI: Year 1: $2,800,000/$20,000,000 = 14% Year 2: $3,000,000/$20,000,000 = 15% Sporting Goods Division Margin: Year 1: $2,800,000/$70,000,000 = 4.0% Year 2: $3,000,000/$75,000,000 = 4.0% Sporting Goods Division Turnover: Year 1: Turnover: $70,000,000/$20,000,000 = 3.5 Year 2: Turnover: $75,000,000/$20,000,000 = 3.75

2.

Camping Division ROI: Year 1: $1,200,000/$10,000,000 = 12% Year 2: $1,000,000/$10,000,000 = 10% Camping Division Margin: Year 1: $1,200,000/$24,000,000 = 5.0% Year 2: $1,000,000/$25,000,000 = 4.0% Camping Division Turnover: Year 1: Turnover: $24,000,000/$10,000,000 = 2.4 Year 2: Turnover: $25,000,000/$10,000,000 = 2.5

3.

ROI for the Sporting Goods Division increased from 14% to 15%. This increase is due entirely to the increase in turnover from 3.5 to 3.75. (Margin for this division stayed the same from Year 1 to Year 2.) The Camping Division, on the other hand, experienced a drop in ROI from 12% to 10%. Margin in this division decreased from 5% to 4%, and the small increase in turnover (from 2.4 to 2.5) was not enough to overcome the margin decline.

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10–2 1.

Ever-Tent ROI = $55,000/$500,000 = 11.0% KiddieKamp ROI = $38,000/$400,000 = 9.5%

2.

Add Only Add Only Add Both Maintain Ever-Tent KiddieKamp Projects Status Quo Operating income... $ 1,055,000 $ 1,038,000 $ 1,093,000 $ 1,000,000 Operating assets.... 10,500,000 10,400,000 10,900,000 10,000,000 ROI............................ 10.05% 9.98% 10.03% 10% The manager will invest only in the Ever-Tent since that alternative has the highest ROI.

10–3 1.

Ever-Tent residual income = $55,000 – (0.09 × $500,000) = $10,000 KiddieKamp residual income = $38,000 – (0.09 × $400,000) = $2,000

2. Operating income... Minimum income*... Residual income.....

Add Only Ever-Tent $1,055,000 945,000 $ 110,000

Add Only KiddieKamp $ 1,038,000 936,000 $ 102,000

Add Both Projects $1,093,000 981,000 $ 112,000

Maintain Status Quo $1,000,000 900,000 $ 100,000

*Minimum income = Operating assets × Minimum required rate of return. The manager will invest in both the Ever-Tent and the KiddieKamp because residual income is positive for each, and the overall residual income is highest when both projects are accepted. 3.

If the company had retained the $900,000 and invested it at 9%, the income would have been $81,000 ($900,000 × 0.09). However, the investment of the $900,000 in the two projects suggested by the Camping Division yields total incremental operating income of $93,000 ($55,000 + $38,000). This is a gain of $12,000 before taxes. Yes, the correct decision was made.

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10–4 1.

After-Tax Percent Cost Common stock................................... 0.50 0.180 10-year bonds..................................... 0.50 0.039* Weighted average cost of capital.......................................................

Weighted Cost 0.0900 0.0195 0.1095

*0.039 = 0.06 – (0.06 × 0.35). EVA = $210,000 – (0.1095 × $2,000,000) = ($9,000) 2.

Year 1: After-Tax Percent Cost Common stock.................................... 0.50 0.150 10-year bonds..................................... 0.50 0.039 Weighted average cost of capital.......................................................

Weighted Cost 0.0750 0.0195 0.0945

EVA = $210,000 – (0.0945 × $2,000,000) = $21,000 Year 2: After-Tax Percent Cost Common stock.................................... 0.50 0.120 10-year bonds..................................... 0.50 0.039 Weighted average cost of capital.......................................................

Weighted Cost 0.0600 0.0195 0.0795

EVA = $210,000 – (0.0795 × $2,000,000) = $51,000 3.

After-Tax Percent Cost Common stock.................................... 0.80 0.180 10-year bonds..................................... 0.20 0.039 Weighted average cost of capital.......................................................

Weighted Cost 0.1440 0.0078 0.1518

EVA = $750 ,000 – (0.1518 × $ 5,000,000) = ($ 9,000) Year 1 (9% premium): After-Tax Percent Cost Common stock.................................... 0.80 0.150 10-year bonds..................................... 0.20 0.039 Weighted average cost of capital....................................................... EVA = $750 ,000 – (0.1278 × $ 5,000,000) = $111,000

10–4

Concluded

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Weighted Cost 0.1200 0.0078 0.1278

Year 2 (6% premium): After-Tax Percent Cost Common stock.................................... 0.80 0.120 10-year bonds..................................... 0.20 0.039 Weighted average cost of capital.......................................................

Weighted Cost 0.0960 0.0078 0.1038

EVA = $750 ,000 – (0.1038 × $ 5,000,000) = $231,000

10–5 1.

Whirlmore, Inc. Income Statement (in thousands) For the Year 20XX

Sales.................................... COGS................................... Gross profit.................... Selling and admin. expense Division profit................ Income taxes (30%)............ After-tax income............ 2.

Home-Supreme Apartment $2,700 $2,400 1,770 1,870 $ 930 $ 530 640 180 $ 290 $ 350 87 105 $ 203 $ 245

International $1,300 1,040 $ 260 100 $ 160 48 $ 112

After-Tax Percent Cost Common stock.................................. 0.80 0.110 Bonds................................................. 0.20 0.056* Weighted average cost of capital.......................................................

Total $ 6,400 4,680 $ 1,720 920 $ 800 240 $ 560 Weighted Cost 0.0880 0.0112 0.0992

*0.08(1 – 0.3) = 0.056. 3. After-tax income.............. 560,000 Less cost of capital: (0.0992 × $2,100,000) (0.0992 × $500,000)... (0.0992 × $400,000)... EVA..................................$

Home-Supreme $ 203,000

Apartment $245,000

International $ 112,000

Total $

208,320 49,600 (5,320) $

195,400$

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39,680 72,320 $

297,600 262,400

10–5 4.

Concluded

While EVA is positive for Whirlmore, Inc., as a whole, it is negative for the Home-Supreme Division. Therefore, even though the Home-Supreme Division has positive net income, it needs to increase net income or reduce the capital used to generate positive economic value added.

10–6 1.

Maximum price....................... Minimum price........................ Difference................................ × The number of cases.......... Increased profit...............

$

2.80 1.15 $ 1.65 ×100,000 $ 165,000

Since the Glassware Division has idle capacity, the minimum price is the variable cost of $1.15 for the excess capacity. (The avoidable selling costs of $0.10 should not affect the minimum transfer price for the excess capacity because the Glassware Division will be worse off if the transfer price does not cover its variable manufacturing costs). Yes, the transfer should take place. 2.

Eric might negotiate for a lower price. Jill would consider the $2.40 price, as her income would increase $ 125,000 [($2.40 – $ 1.15) × 100,000].

3.

Full manufacturing cost is $1.85 ($1.15 + $0.70), so $ 1.85 would be the transfer price. The transfer could take place since $ 1.85 is between the minimum and maximum prices of the negotiating set.

10–7 1.

The comparable uncontrolled price method should be used because a market price exists.

2.

Market price......................... Plus shipping, duties.......... Less marketing costs......... Transfer price...............

$25.00 2.75 (2.80) $ 24.95

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10–8 1.

The comparable uncontrolled price method should be used because a market price exists. Market price......................... Plus shipping, duties.......... Less marketing costs......... Transfer price...............

2.

$ 0.95 0.05 ( 0.06) $ 0.94

The cost-plus method should be used because a market price does not exist, and the U.S. division is not going to resell the paint. Manufacturing cost............. Plus shipping, duties.......... Transfer price...............

$ 0.83 0.05 $ 0.88

10–9 1. 2.

The resale price method should be used because a market price does not exist and the paint will be resold and not used in further manufacturing. Resale price = Transfer price +(0.50 × Transfer price) $18 = 1.50 × Transfer price Transfer price = $18/1.50 = $12

10–10 1.

Pacific-Rim: $126,000 – (0.12 × $900,000) = $18,000 European: $1,350,000 – (0.12 × $9,000,000) = $270,000 Residual income is an absolute dollar measure, so it does not adjust for the relative sizes of the divisions.

2.

Pacific-Rim: $18,000/$900,000 = 2% European: $270,000/$9,000,000 = 3% It is now possible to say the European Division is relatively more profitable than the Pacific-Rim Division.

3.

Pacific-Rim: $126,000/$900,000 = 14% European: $1,350,000/$9,000,000 = 15% ROI can be used to compare relative divisional profitability.

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10–10 4.

Concluded

Pacific-Rim: 2% + 12% = 14% European: 3% + 12% = 15% The residual rate of return and the required rate of return will always sum to the ROI.

10–11 1. Revenue............... Expenses............. Net Income.......... Assets.................. Margin.................. Turnover.............. ROI.......................

A $10,000 $8,000 $2,000 $40,000 20%* 0.25* 5%*

B $48,000 $36,000* $12,000 $96,000* 25% 0.50 12.5%*

C $96,000 $90,000 $6,000* $48,000 6.25%* 2* 12.5%*

*Indicates calculated amounts. 2. A’s residual income = $2,000 – (0.09 × $40,000) = ($1,600) B’s residual income = $12,000 – (0.09 × $96,000) = $3,360 C’s residual income = $6,000 – (0.09 × $48,000) = $1,680 D’s residual income = $1,200 – (0.09 × $9,600) = $336

10–12 1.

Net income = $1,000,000 – $600,000 – $100,000 = $300,000 Residual income = $300,000 – (0.15)($1,500,000) = $75,000

2.

ROI = $300,000/$1,500,000 = 0.20, or 20%

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D $19,200* $18,000* $1,200* $9,600 6.25% 2 12.5%*

10–13 If Casey accepts the new position, she will earn $56,000 (salary of $40,000 and bonus of $16,000) in Year 1. After two years, if Litton’s stock rises at the same rate as it has over the past five years, she will be able to exercise her stock option and realize a gain of the following: Price of stock in two years ($12 × 1.15 × 1.15 × 10,000)............... $158,700 Exercise price of stock..................................................................... 120,000 Gain............................................................................................. $ 38,700 Casey will clearly be better off financially right away. Her salary plus bonus with Litton is $1,000 higher than her current salary. In addition, if the increase in net income for the Financial Services Division can be sustained, she stands to make considerably more through bonuses in the coming years. The stock option, exercisable in two years, also gives Casey the potential to make another $38,700. On the down side, Casey’s current salary is reasonably secure. The Litton position has a lower guaranteed salary and the risk of bonuses and option values which may not be realized. If the financial services industry experiences a downturn, Casey will suffer no matter how well she personally performs. The final decision rests on Casey’s assessment of the risk versus reward of the two positions. She should also consider the risk of remaining in her present position; that is, what are her prospects for making partner at the public accounting firm?

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PROBLEMS 10–14 1.

Since the Transistor Division can sell all its transistors to the outside competitive market, the minimum transfer price is $3.40. The Systems Division can buy its transistors from the outside market at $3.40, so the maximum transfer price is $3.40.

2.

Yes, since the minimum transfer price for the idle capacity is $1.90 ($2.65 less the $0.75 of allocated fixed overhead). The Division is better off if the transfer price is greater than $1.90 for the excess capacity.

3.

The negotiated price of $11.00 provides profit for both the Board Division and the Systems Division. The Board Division realizes a profit of $1.85 per board ($11.00 – $9.15). The Systems Division realizes a reduction in cost of $1.25 per board ($12.25 – $11.00). It should be noted that the $12.25 is not a true market price because this particular board is not sold externally. Thus, the Board Division is not necessarily foregoing profit by not selling externally at its regular markup.

10–15 1.

Reigis Steel Company Unit Contribution Margin (in thousands except for unit contribution margin) For the Year Ended November 30, 2010 Sales................................................................. Less variable costs: Cost of goods sold................................. Selling expenses ($2,700 × 40%)........... Contribution margin.......................................

$25,000 $16,500 1,080

17,580 $ 7,420

Unit contribution margin = $7,420/1,484 units = $5.00 per unit 2.

a.

ROI = Income before taxes/Average operating assets* = $1,845,000/$15,375,000 = 12% *Average operating assets = ($15,750,000 + 15,000,000)/2 = $15,375,000 Where November 30, 2009 operating assets = $15,750,000/1.05

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10–15 Concluded b.

Residual income = $1,845,000 – (0.11 × $15,375,000) = $1,845,000 – $1,691,250 = $153,750

3.

The management of Reigis Steel would have been more likely to accept the contemplated capital acquisition if residual income were used as the performance measure because the investment would have increased both the division’s residual income and the management bonuses. Using residual income, management would accept all investments with a return higher than 11% as these investments would all increase the dollar value of residual income. When using ROI as a performance measure, Reigis’s management is likely to reject any investment that would lower the overall ROI (12% in 2009), even though the return is higher than the required minimum, as this would lower bonuses.

4.

Reigis must be able to control all items related to profits and investment if it is to be evaluated fairly as an investment center using either ROI or residual income as performance measures. Reigis must control all elements of the business except the cost of invested capital, that being controlled by Raddington Industries.

10–16 1. Sales..................................... Variable expenses............... Contribution margin......

Part 4CM $70,000* 50,000 $ 20,000

Model 7AC $550,000 460,000 $ 90,000

Company $620,000 510,000 $110,000

*While all 10,000 units could be sold externally, currently none are. 2.

The transfer price should be the market price of $12. This is the minimum price for the Components Division and the maximum price for the Small AC Division.

3.

Unless the manager of the Small AC Division is able to increase the price of Model 7AC, he will discontinue production and will not purchase any of th...