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

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 assist top managers in evaluating how well operational managers fulfilled their responsibilities to the organization.

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   manager’s 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 company’s best interests. 4. Support department costs may be allocated to revenue­producing departments for a variety of reasons. The most common reasons are to encourage managers to use support areas in the most cost­beneficial 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 decision­making 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   cost­beneficial   way   and   to   recommend   cost   control improvements   to   the   support   department.   However,   such   cost   allocations   may cause   dysfunctional   behavior   if   the   manager   of   the   revenue­producing   area perceives the cost allocation to be unfair. 5. The four criteria (benefits received, causation, equity, and ability­to­bear) 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. Ability­to­bear is often not used because it may result in unrealistic or profit­detrimental actions. Therefore, most support department allocations are based on the benefits­received and causation criteria. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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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 method is the only method that does not allocate a support department’s costs to other support departments.

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The step method does take into consideration assistance provided between support departments,   but   does   so   sequentially   based   on   a   benefits­provided   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 (give­and­ 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 revenue­producing areas. 7. The   added   costs   are  an artifact of  the   cross­allocation   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 company’s 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   segment’s   nonproduction   costs © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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(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 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 market­based 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 Cost­Selling Segment Cost­based:   consistent   with   the   objective   of   this type of center, this use is a way of allocating the center’s cost to other centers. Cost­Buying  Segment

Preferably cost­based: consistent with the objective of this type of center, however, depending on the selling segment’s 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.

Revenue­Selling Segment

Market  price:   revenue  from  transfers   of goods  or services is recorded at the transfer price for internal reporting purposes.

Revenue­Buying Segment

Transfer   prices   for   goods   or   services   should   be 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; © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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whichever price is set becomes the revenue measure for internal sales for internal reporting purposes. 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  goal­congruent  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 department’s 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   agreements—should   the   company decide to enter into those. 14. Any company’s green agenda must be a global undertaking; activities in one segment may create costs and benefits for part or all of an organization. Such © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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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. 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-andtrade 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 company’s surplus credits––creating 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.

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

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Intraorganizational sharing of carbon or emissions credits requires an appropriate pricing mechanism for a company’s transfer pricing policy and will create challenges and opportunities in identifying an arm’s-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.   1–2; http://www.pwc.com/en_GX/gx/tax­management­strategy/pdf/pwc_tax_transfer_pricing_and _the_green_agenda.pdf (last accessed 12/30/11).

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

D C D C C C D D C D D C D

16. a. b. c. d. e. f. g. h. i. j.

A N A A A D D A N (authority can be delegated, but not responsibility) A 

C

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, IT’s enormous budget is often a point of contention.  If costs are allocated back to other areas, managers in those areas may believe they are being overcharged. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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 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 organization’s 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. b. c. d. e. f. g. h. i. j. k. l. m.

P R I R or P I C R or P R or P R or P R or P C  R (or revenue and limited cost) 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 group’s 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 market­based 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 cost­based price would be—leading 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 multiple­doctor 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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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 $0.68  682,000 $463,760

 BSP  ASV $0.70  682,000 $477,400

BSP  BSV $0.70  675,000 $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   $3,675*  42      $154,350

BSP  ASV $4,000  42 $168,000

BSP  BSV $4,000  39 $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]  From Admin. to Fabricating [(0.50 ÷ 0.90) × $450,000] Total b. From HR to Finishing [(0.45 ÷ 0.80) × $630,000]  From Admin. to Finishing [(0.40 ÷ 0.90) × $450,000] 

$275,625    250,000 $525,625 $354,375     200,000

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Total

$554,375

27. Checking: Administration (0.30 ÷ 0.80) × $540,000 Human resources (0.30 ÷ 0.80) × $360,000 Accounting (0.40 ÷ 0.80) × $300,000 Direct costs Savings: Administration (0.40 ÷ 0.80) × $540,000 Human resources (0.20 ÷ 0.80) × $360,000 Accounting (0.20 ÷ 0.80) × $300,000 Direct costs Loans: Administration (0.10 ÷ 0.80) × $540,000 Human resources (0.30 ÷ 0.80) × $360,000 Accounting (0.20 ÷ 0.80) × $300,000 Direct costs 28. Administration ($540,000) Human resources Accounting Checking Savings Loans

($540,000 × 0.10) ($540,000 × 0.10) ($540,000 × 0.30) ($540,000 × 0.40) ($540,000 × 0.10)

Human resources ($360,000 + $54,000 = $414,000) Accounting $414,000 × (0.10 ÷ 0.90) Checking $414,000 × (0.30 ÷ 0.90) Savings $414,000 × (0.20 ÷ 0.90) Loans $414,000 × (0.30 ÷ 0.90) Accounting ($300,000 + $54,000 + $46,000 = $400,000) Checking $400,000 × (0.40 ÷ 0.80) Savings $400,000 × (0.20 ÷ 0.80) Loans $400,000 × (0.20 ÷ 0.80) Checking: Savings: Loans:

$   202,500 135,000 150,000           630,000  $1,117,500 $270,000 90,000 75,000       337,500  $772,500 $  67,500 135,000 75,000       675,000  $952,500

$  54,000 54,000 162,000 216,000       54,000 $540,000 $  46,000 138,000 92,000   138,000    $414,000 $200,000 100,000   100,000    $400,000

$630,000 + $162,000 + $138,000 + $200,000 = $1,130,000 $337,500 + $216,000 + $  92,000 + $100,000 = $   745,500 $675,000 + $  54,000 + $138,000 + $100,000 = $   967,000

29. a. Human resources ($360,000) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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Administration Maintenance Assembly Finishing

($360,000 × 0.10) ($360,000 × 0.15) ($360,000 × 0.40) ($360,000 × 0.35)

$  36,000 54,000 144,000   126,000    $360,000

Administration ($558,000 + $36,000 = $594,000) Maintenance $594,000 × (0.10 ÷ 0.90) Assembly $594,000 × (0.50 ÷ 0.90) Finishing $594,000 × (0.30 ÷ 0.90) Maintenance ($170,000 + $54,000 + $66,000 = $290,000) Assembly $290,000 × (0.45 ÷ 0.80) Finishing $290,000 × (0.35 ÷ 0.80)

$  66,000 330,000   198,000    $594,000 $163,125   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 benefits­provided ranking. 30. Administration Human resources Accounting Checking Savings Loans

Admin. — 0.10 0.10 0.30 0.40 0.10

HR 0.10 — 0.10 0.30 0.20 0.30

Acctg. 0.10 0.10 — 0.40 0.20 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 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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C = $354,000 + 0.11B + 0.01C  0.99C = $354,000 + 0.11B 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 Direct costs Admin.  HR  Acctg.  Total costs 

   Admin. $ 540,000  (627,271)    46,363        40,909 $            0

  HR $ 360,000 62,727   (463,625)        40,909 $            0

     Acctg. $ 300,000 62,727 46,363      (409,085) $            0

  Check. $   630,000 188,181 139,088        163,634 $1,120,903

Sav. Loans $337,500  $675,000 250,908 62,727 92,725 139,088       81,817          81,817 $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 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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Simplifying: (1) S2 = $360,000 + $64,497 + 0.30S3 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 Direct costs $  170,000 $  360,000 $ 600,000 S1     (644,965)   64,497 128,993 S2   282,723          (706,808) 212,042 S3         188,207            282,311      (941,035) To RP   $    (4,035)*   $            0 $            0

   RP1

RP2

$193,490 $257,986 141,362 70,681   376,414          94,104 $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 

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d. Sales (40,000 × $55) Internal cost (25,000 × $32) External cost (15,000 × $47)

$ 2,200,000 $800,000   705,000   (1,505,000)     $    695,000

Operating profit = 15,000 × $15 = $225,000 34. a. External purchase cost (30,000 × $4.50) Internal cost [(30,000 × $4.00) + $0 opportunity cost] Advantage of purchasing internally

$ 135,000         (120,000) $   15,000

b. External purchase cost (30,000 × $4.50) Internal cost [($30,000 × $4.00) + $25,000 opportunity cost] Disadvantage of purchasing internally

$ 135,000   (145,000) $  (10,000)

c. Should the Assembly Division’s 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 Division’s monthly fixed costs of $30,000 would still have to be paid by Squish—reducing 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 long­term, more senior­aged 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 Variable selling cost Total variable cost

$40.00   16.00        $56.00 per unit

(2)

Variable production cost FOH ($1,800,000 ÷ 1,200,000) Full production cost

$40.00       1.50     $41.50 per unit

(3)

Variable production cost Fixed selling [$2,400,000 ÷ (0.25 × 1,200,000)] Total variable production + necessary selling

$40.00          8.00     $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.

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

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

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accessed   1/2/12).   Another   case   involved   computer   chip   company   Xilinx (http://www.taxgirl.com/landmark­transfer­pricing­case­is­it­a­different­world/). Also see http://ustransferpricing.com/decisions.html.

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121

PROBLEMS 41. a. The ethical problems are created when short­run gains can be maximized by doing what is unethical rather than what is ethical. This situation is created by the   company’s   incentive   system.   By   narrowly   focusing   performance evaluation   on  profit­related   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 patient’s 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 patient’s   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 short­handed. 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,   medicine­storage   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 manager’s 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 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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may   be   useful   in   calling   attention   to   these   activities,   differences   between budgeted and actual for these items are beyond the 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   supervisor’s   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 units­per­month 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 Depreciation Taxes Insurance Other Total fixed OH Total mfg. costs

$    3,300 1,500 300 240            930 $    6,270 $100,547

$  3,334 1,500 300 240       1,027 $  6,401 $99,562

              $   (34) U                      0                      0                      0                        (97) U       $ (131) U              $  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. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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                        (CMA adapted)

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.

Activity # of cases Variable costs Professional labor Travel Supplies Fixed costs Professional labor Facilities Insurance Total

  Flexible    Budget 2,970 

    Actual 2,970

  Variance

$2,970,000 148,500  297,000 

$2,820,000 120,000 270,000

 $150,000 F      28,500 F      27,000 F

1,200,000  1,215,000 750,000  795,000        240,000        234,000 $5,605,500 $5,454,000

15,000 U 45,000 U            6,000 F  $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. Direct labor Repairs Maintenance Indirect labor Power Totals

Budget $   375,000 75,000 450,000 75,000        150,000 $1,125,000

Actual $300,000 80,000 325,000 77,500   157,500    $940,000

Variance $   75,000 F 5,000 U        125,000 F 2,500 U         7,500 U      $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 Rigera’s control. The costs of direct and indirect labor may   be  related   to  labor  union   contracts   or  rate   renegotiations;   repairs  and © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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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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46. a. Revenues ($900  100) Variable costs: Meals ($10  9  106) Lodging ($75  3  106) Supplies ($10  106) Contribution margin

$  90,000 $  9,540 23,850      1,060

Direct fixed costs: Speakers ($2,500 each) Rent on facilities Advertising Segment margin Allocated fixed costs (0.25  $90,000) Net operating income b. Revenues ($850  120) Variable costs: Meals ($10  9  1.15  126) Lodging ($75  3  126) Supplies ($10  126) Contribution margin Direct fixed costs: Speakers ($2,950  6) Rent on facilities Advertising Segment margin Allocated fixed costs (0.25  $102,000) Net operating income c. 

ASP  ASV $850  120 $102,000

BSP  ASV $900  120 $108,000

$15,000 3,600         4,000

       (34,450) $  55,550

     (22,600) $  32,950      (22,500) $  10,450 $102,000

$13,041    28,350          1,260

 $17,700      4,200          4,900

        (42,651) $  59,349

       (26,800) $  32,549        (25,500) $    7,049 BSP  BSV $900  100 $90,000

$6,000 U Sales Price Variance

$18,000 F Sales Volume Variance $12,000 F Total Revenue Variance

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

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Revenues Variable costs: Meals Lodging Supplies Contribution margin Direct fixed costs: Speakers Rent on facilities Advertising Segment margin Allocated fixed costs Net operating income

Original   Flexible    Budget  Budget $ 90,000 $108,000

  Actual $102,000

$   9,540 23,850        1,060 $ 55,550

$  13,041 28,350         1,260 $  59,349

$  11,340 28,350         1,260 $  67,050

  (15,000)   (15,000)     (17,700)     (3,600)     (3,600)       (4,200)         (4,000)       (4,000)           (4,900) $ 32,950   $  44,450 $  32,549    (22,500)      (27,000)   (25,500)    $ 10,450   $  17,450 $    7,049

  Variance   $   6,000 U (1,701) U (0)  (0) (2,700) U (600) U  (900) U          (1,500) F $(10,401) U

By far, given that revenues exceeded the budget, the two biggest contributors to   the   seminar’s   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 relationship­building programs that bond consumers to a brand often   by   development   of   software   systems   to   provide   one­on­one   contact between the marketing business and their customer. CRM is the core of any customer­focused 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 revenue­producing 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

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

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     

127

Percent of calls that needed to be referred to another representative Average number of issues handled per call Average call­handling time Employee turnover Number   of   caller   complaints;   number   of   caller   complaints   per employee Number of instances of reported identity theft

48. a. Viewing   child­care   facilities   as   a   cost   center   could   create   a   negative perspective of such operations from the company’s standpoint. As such, the company might try to control or reduce the costs of the child­care facilities by engaging in one or more of the following actions:     

Hiring less­qualified, lower­paid staff personnel Reducing janitorial and/or maintenance activities Limiting the number of staff to less­than­necessary Purchasing   low­quality   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 child­care facility rather than view it as a profit enhancer. Another possibility is for the company to allocate the cost of the facility to revenue­producing 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 child­care 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 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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Actual price = $1,680,000 ÷ 32,000 = $52.50 Sales price variance = 32,000  ($52.50 – $45) = 32,000  $7.50 = $240,000 F 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 higher­than­planned sales volume of footballs. 50. a. Actual sales volumes HD radio tuners: Satellite radios: MP3 car decks:

$195,500 ÷ $115 = 1,700 units $141,400 ÷ $70 = 2,020 units $228,250 ÷ $55 = 4,150 units

Sales price variances HD radio tuners: 1,700  ($120 – $115)  Satellite radios: 2,020  ($68 – $70)  MP3 car decks:  4,150  ($60 – $55)  Total b. Sales volume variances HD radio tuners: $120  (1,600 – 1,700)  Satellite radios:  $68  (2,100 – 2,020)  MP3 car decks:  $60  (1,050 – 4,150)  Total 

= $  8,500 U  =     4,040 F =   20,750 U    $25,210 U  = $  12,000 F    =       5,440 U    =   186,000 F          $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 short­term 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 sales—which 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 else’s “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. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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51. a. Actual sales price = $235,000 ÷ 5,000 = $47 Budgeted sales price = $300,000 ÷ 6,000 = $50 ASP  ASV $47  5,000 $235,000

BSP  ASV $50  5,000 $250,000

$15,000 U Sales Price Variance

BSP  BSV $50  6,000 $300,000

$50,000 U   Sales Volume Variance

b. The   budgeted   contribution   margin   was   $120,000   ÷   6,000   or   $20   per   unit. Since the company’s sales volume was 1,000 units less than budgeted, the total impact on the company’s 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 Folsom’s 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 Folsom’s case, evaluation of the control over variable and fixed costs goes beyond the sales price and sales volume variances.     52. Surgery In­patient Out­patient

Assets Employed $3,948,500 2,458,500   1,043,000    $7,450,000

% 53 33 14

# of Employees 20 36   44    100

% 20 36 44

Hours of Operation 24,850 28,400 17,750 71,000

% 35 40 25

Administration costs: Surgery: $5,400,000  0.53 = $2,862,000 In­patient: $5,400,000  0.33 = $1,782,000 Out­patient: $5,400,000  0.14 = $756,000 Public relations cost: Surgery: $1,100,000  0.20 = $220,000 In­patient: $1,100,000  0.36 = $396,000 Out­patient: $1,100,000  0.44 = $484,000 Maintenance and janitorial cost: Surgery: $1,700,000  0.35 = $595,000 In­patient: $1,700,000  0.40 = $680,000 Out­patient: $1,700,000  0.25 = $425,000 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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Administration Public Relations Maintenance Total

  Surgery $2,862,000 220,000        595,000 $3,677,000

In­Patient $1,782,000 396,000        680,000 $2,858,000

Out­Patient $   756,000 484,000        425,000 $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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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.

Revenue Direct costs Allocated costs: Administration Accounting Promotion Operating income

Comm. Res. $ 10,000,000 $18,000,000 (10,490,000) (9,179,000)

Prop. Mgmt. $2,000,000 (398,400)

(240,000) (1,155,000) (306,900) (495,000)        (237,600)        (432,000) $  (1,274,500)   $  6,739,000

(105,000) (188,100)       (50,400) $1,258,100

   54. a. Administration costs ($1,500,000)             Base Accounting  15 ÷ 300 Promotion  12 ÷ 300 Commercial  45 ÷ 300 Residential  210 ÷ 300 Property Mgmt.  18 ÷ 300 Total (rounded)

Allocation $     75,000 60,000 225,000 1,050,000          90,000 $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 Property Mgmt.: $90,000 + $159,750 + $66,200 = $315,950 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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b.

133

  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. Administration Residential Commercial

# of Empl. 30 72       48

% 20% 48% 32%

Direct Costs

%

$480,000 800,000

37.5% 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 56. Department

ADMINISTRATION Base %

  EDITORIAL Base %

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Admin. (A) Editorial (E) College Texts Prof. Pubs. Total

N/A  $     75,000  600,000         525,000  $1,200,000

     N/A 6.25 50.00   43.75    100.00

5 11.11 N/A   N/A 25 55.56 15   33.33    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 Dept. Direct costs Admin. Edit. Total

Admin.      Edit. $ 225,000 $ 175,000 (246,141) 15,384        21,152          (190,384) $            0 $            0

College Texts  Prof. Pubs. $2,250,000 $   950,000 123,071 107,687        105,777          63,455 $2,478,848 $1,121,142

Note: The Administration column does not sum to zero because of rounding. 57. a. Adv. Cir.

Assets Employed % $   381,200 29        935,150       71 $1,316,350           100%

Admin. (0.29 × $390,750; 0.71 × $390,750) H. Res. (0.32 × $246,350; 0.68 × $246,350) b. Adv.: $478,900 + $192,150 =  Cir.: $676,300 + $444,951 =  c.

# of Employees % 6  32 13          68 19                  100%      Adv.       Cir. $113,318 $277,433          78,832   167,518    $192,150 $444,951

$   671,050   1,121,251    $1,792,301 (off due to rounding)

Admin. ($390,750):               Base H. Res. $145,850 ÷ $1,462,200 Adv. $381,200 ÷ $1,462,200 Cir. $935,150 ÷ $1,462,200

   Allocation $  38,976 101,870       249,904 $390,750

H. Res. ($246,350 + $38,976) = $285,326:       Base                    Allocation Adv. 6 ÷ 19 $  90,103 Cir. 13 ÷ 19   195,223    © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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$285,326 d. Adv.: $478,900 + $101,870 + $90,103 = Cir.: $676,300 + $249,904 + $195,223 =

e.   Department  Admin. (A)  H. Res. (H)  Adv.  Cir.

$   670,873   1,121,427      $1,792,300

ADMIN. Base % N/A N/A $   145,850 10 381,200 26        935,150 64 $1,462,200

     H. RES. Base % 5 21 N/A N/A 6 25 13 54 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 Direct costs Admin. H. Res.

  Admin. H. Res. $ 390,750 $ 246,350      (451,975) 45,198              61,225       (291,548) $            0 $            0

Advertising $478,900 117,514       72,887 $669,301

Circulation $   676,300 289,264        157,436 $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 ÷ 1,065.00 800 Finish.  300 ÷        798.75  800 $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  © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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$1,786.50 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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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. Proc. Finish.

Floor Space 1,600 2,000 3,600

Admin. Legal/Acctg. Maint./Eng. Total

 % # of Employees 44 400 56 300 700    Proc. $1,214 739        948 $2,901

  % # of Hours 57 136 43 204 340

 % 40 60

Finish. $   916 941   1,422    $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.

Department Admin. (A) Legal/Acctg. (L) Maint./Eng. (M) Proc. Finish.

ADMIN. Base % N/A N/A 40 5.00 60 7.50 400 50.00 300 37.50 800

LEGAL/ACCTG. Base % 800 16.67 N/A N/A 400 8.33 1,600 33.33 2,000 41.67 4,800

MAINT./ENG.  Base       % 7.32 30  9.76 40  N/A N/A  33.17 136  49.76 204  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 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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L = $1,680 + 0.05($2,677) + 0.10($2,738) = $1,680 + $133.85 + $273.80 = $2,088   Admin.     L/A    M/E     Proc. Direct costs $  2,130 $  1,680 $  2,370 $  7,520 Admin.     (2,677) 134 201 1,339 Legal/Acctg. 355      (2,088) 167 689 Maint./Eng.          192          274         (2,738)          904 $         0 $         0 $         0 $10,452

 Fin. $  7,200 1,004 877       1,369 $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   Department’s 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: Speaker’s selling price [from (b)] = $65 Sound System’s purchase price = ($70 – $12) = $58 Speaker’s 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 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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61. a. Current external selling price, $10,464 Selling Division—fair value since most are produced and sold at this price externally. Buying Division—price 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   Division—contributes   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   Division—less   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   Division—covers   some   but   not   all   costs   for   this   division,   therefore incentive   to   sell   internally   isn’t   there   if   Engine   Division   can   sell   its   output externally. Buying Division—purchase price below external so better for margin in this division. Bid price from external supplier ($9,280) Selling   Division—allows   for   some   profit   which   is   an   incentive   to   sell internally unless it can sell all its output externally. Buying Division—no 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. Roll­Em­On A/R (SW Div.) 640,000 Intraco. Sales

SkyWheels Inventory 640,000 640,000 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 Roll­Em­On A/R (SW Div.)  359,200 Intraco. Sales 

359,200

Worldly Travelers  Intraco. CGS 368,000 Finished Goods

 368,000

SkyWheels Inventory 359,200 A/P (REO Div.) 359,200

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[4,000  ($40 + $12 + $16 + $24) = 4,000  $92]

c. Roll­Em­On  A/R (SW Div.) Intraco. Sales in  Excess of  Assigned Cost Intraco. Sales

SkyWheels  Inventory 272,000 A/P (REO Div.) 272,000

272,000 368,000 640,000

Worldly Travelers Intraco. CGS  368,000 Finished Goods 368,000 d.  Roll­Em­On A/R (SW Div.) 368,000 Intraco. Sales

SkyWheels Inventory 368,000 368,000       A/P (REO Div.) 368,000

Worldly Travelers. Intraco. CGS 368,000       Finished Goods 368,000 Plain Cookies  Decorated Cookies

63. a. Sales To outsiders To other division Variable costs: Cookies Other costs Contribution margin Fixed costs Segment margin Bonus (10%) Operating income

$ 6,000 0

$ 3,200

      (1,500)              (1,600)                                         (600) $ 4,500  $ 1,000               (300)                     (500) $ 4,200 $    500              (420)                       (50) $ 3,780 $    450

Company Total $ 9,200 0

                    (3,100)                            (600) $ 5,500                            (800) $ 4,700                             (470) $ 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) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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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. 

 

Davis’s 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 Delight’s segment margin increases by the same $1,200. Linden’s   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.   

d.

Davis’s bonus remains at $50 because there is no cost savings from buying cookies from Plain Cookies Division rather than from outside suppliers. Cookie Delight’s  segment  margin still  increases  by $1,200 because the company’s cost per cookie is $0.50 rather than $2.00. Linden’s 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.

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   company’s   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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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   short­run   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) Variable cost Purch. from O’Leary (1,500  $600) Process by Alberton (1,500  $500) Contribution Margin

(2) Alberton accepts New London contract: Selling price (1,750  $1,250) Variable cost Purch. from O’Leary (1,750 × $500) Process by Alberton (1,750  $400) Contribution Margin

$ 2,250,000 $900,000   750,000   

$ 2,187,500 $875,000   700,000   

Conclusion: Contribution margin from New London contract Contribution margin from Summerside sale Difference in favor of New London contract b.

   (1,650,000) $    600,000

   (1,575,000) $    612,500   $   612,500          (600,000)  $     12,500

Alberton Division’s decision to accept the contract from New London Company is in the company’s best interest because the decision increases the company’s 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) Sale: O’Leary to Montague (1,500 × $400) Cost savings (variable costs avoided by not not accepting the Summerside order) O’Leary’s savings (1,500 × $300) Alberton’s savings (1,500 × $500) Expenditures incurred by Charlottetown Inc. Variable costs incurred for New London order Alberton (1,750 × $400) O’Leary (1,750 × $250) Variable cost incurred for purchase Summerside from Montague (1,500 × $1,500)  Montague from O’Leary (1,500 × $200) Positive contribution margin

$2,187,500 600,000 450,000       750,000 

$ 3,987,500

$  700,000 437,500 2,250,000         300,000     (3,687,500) $    300,000       (CMA adapted)

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65. a. Total EDP hours used = 1,220 + 650 + 190 = 2,060 Transfer price revenue = 2,060 × $80 = $164,800 Actual variable EDP costs = Total EDP hours used

$181,280 2,060

= $88 transfer price

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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b. and c.

Allocate   administration   costs   of   $900,000   and   fixed   EDP   costs   of $600,000: Lit.

Administration ($900,000) (10/18, 5/18, 3/18) EDP­Fixed ($600,000) (80/345,240/345, 25/345)  Total allocated Transfer costs Direct costs Total

$   500,000

FP

LC

Total

$   250,000

$150,000

$   900,000

       139,130        417,392       43,478         600,000 $   639,130 $   667,392 $193,478 $1,500,000 97,600 52,000 15,200 164,800        400,000        510,000   680,000      1,590,000    $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: Koenig’s price $8.00 HIDE’s price 9.00 Thompson’s 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: Koenig’s price HIDE’s price: Sales price – Profit margin = $9.00 – (0.40 × $9.00) Thompson’s price However, the profit margin of Barrows Chemical should be deducted = $7.00 – (0.30 × $2.00)

$8.00 $ 7.00   (0.60)   

5.40 6.40

From Eekaydo’s 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 Thomson’s competition.          (CMA adapted) 67. a. Regular selling price Regular  selling  price  less  variable  selling  and distribution expenses ($26.00 – $2.40) Standard manufacturing cost plus 15%  ($12.80 + $4.80) × 1.15 Standard variable manufacturing cost plus 20% ($12.80 × 1.20)

$26.00 $23.60 $20.24 $15.36

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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 Gondorf’s ROI. If, at some point, all existing capacity of Gondorf Division is being used, the division’s 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   long­term   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 I­O­WoW 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 I­O­WoW   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   I­O­ 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/International­Tax/Transfer­Pricing­and ­Tax­Effective­Supply­Chain­Management/2011­Transfer­pricing­reference­guide © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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(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   tax­efficient   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 PwC’s 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   don’t   want   to   benchmark   your © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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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 PwC’s transfer pricing group, companies with   a   current   APA   will   face   challenges   in   the   current   environment,   but companies   in   negotiations   for   APA’s   could   find   opportunities.   For   companies with current APA’s, 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   IRS’s   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 don’t think there is a fixed menu of things that they are willing to do in any case or in every case that’s 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.

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