Exam 19: Strategic Performance Measurement: Investment Centers and Transfer Pricing

Assume two divisions of a company, P (producing) and B (buying), that are treated as investment centers for performance evaluation purposes. As the management accountant, you've been asked to provide input to the determination of the appropriate transfer price for an exchange of product between these two divisions. In case #1, Division P is experiencing a capacity constraint, while in case #2 it is assumed that Division P has excess capacity. The incremental production cost incurred by Division P, to the point of transfer, is $80.00 per unit. Division P can sell its output externally for $120.00 per unit, less a sales commission charge of $5.00 per unit. Currently, Division B is purchasing the product from an external supplier at $120.00 per unit, plus a $3.00 transportation charge per unit. Required: 1. Assume that Division P has limited capacity. Thus, for each unit it sells internally, it loses the opportunity to sell that unit externally. Use the general transfer pricing rule to determine the minimum transfer price for internal transfers of units, that Division P would charge Division B. From the standpoint of Division P, why is the figure you calculated considered an acceptable transfer price? 2. What is the maximum transfer price that Division B would be willing to pay per unit on any internal transfers? 3. If top management of the company allows the managers of Divisions P and B to negotiate a transfer price, what is the likely range of possible transfer prices? 4. Assume now that Division P has excess capacity. Use the general transfer pricing rule to determine the minimum transfer price that Division P would be willing to accept from Division B for any internal transfers. Would this transfer price motivate the correct economic decision (internal versus external transfer) from the standpoint of the company as a whole? Explain. 5. Given the situation described above in (4), would top management of the company want the transfer to take place internally? Why? (Show calculations, if appropriate.) How could top management ensure that an internal transfer would take place?

The major operating divisions of Grey Company are organized as investment centers for performance evaluation purposes. The division managers are evaluated, in part, on the basis of the change in the return on investment (ROI) of their units. Operating results for the Division A for the coming year, 2019, based on its existing assets are budgeted as follows: Sales \ 5,000,000 Less variable costs Contribution margin 2,500,000 Less fixed expenses Operating income \ 700,000 Operating assets for the Division A are currently $3,600,000. For 2019, the division can add a new product line for an investment of $600,000. The new product line is expected to generate sales of $1,600,000 and will incur fixed expenses of $600,000 annually. Variable costs of the new product are expected to average 60% of the selling price. Required: 1. What is the effect on ROI of accepting the new product line? 2. If the company's required rate of return is 6% and residual income is used to evaluate managers, would this encourage the division to accept the new product line? Explain and show computations.

Selected data from Chering Division's accounting records revealed the following: Sales \ 825,000 Average investment \ 440,000 Net operating income \ 66,000 Minimum rate of return (divisional cost of capital) 14\% Chering Division's residual income (RI) is:

Because the full-cost method of transfer pricing includes fixed cost, it can:

The following questions pertain to the process of transfer pricing. Required: 1. Define the term transfer price. 2. What are the three general alternatives for setting domestic transfer prices? 3. What is meant by the term dual pricing, as used within the context of the transfer pricing decision? Give one example of dual pricing. 4. What criteria can be used to judge a particular transfer pricing alternative? (Hint: think about the different objectives of transfer pricing, including objectives in an international setting.) 5. What is meant by the term "advance pricing agreement" (APA)? What is the essential purpose of an APA?

A measure of the manager's ability to control expenses and increase revenues to improve profitability is:

Parkside Inc. has three divisions (Entertainment, Plastics, and Video Card), each of which is considered an investment center for performance evaluation purposes. The Entertainment Division manufactures video arcade equipment using products produced by the other two divisions, as follows: 1. The Entertainment Division purchases plastic components from the Plastics Division that are considered unique (i.e., they are made exclusively for the Entertainment Division). In addition, the Plastics Division makes less-complex plastic components that it sells externally, to other producers. 2. The Entertainment Division purchases, for each unit it produces, a video card from Parkside's Video Card Division, which also sells this video card externally (to other producers). The per-unit manufacturing costs associated with each of the above two items, as incurred by the Plastic Components Division and the Video Card Division, respectively, are: Plastic Components Video Cards Direct material \ 1.25 \ 2.40 Direct labor 2.35 3.00 Variable overhead 1.00 1.50 Fixed overhead 0.40 2.25 Total cost \5 .00 \9 .15 The Plastics Division sells its commercial products at full cost plus a 25% markup and believes the proprietary plastic component made for the Entertainment Division would sell for $6.25/unit on the open market. The market price of the video card used by the Entertainment Division is $10.98/unit. A per-unit transfer price from the Video Cards Division to the Entertainment Division at full cost, $9.15, would:

Firms with high operating leverage tend to have:

The historical cost of an asset less its accumulated depreciation is:

Selected data from Division A of Green Company are as follows: Sales \ 500,000 Average investment \ 300,000 Operating income \ 60,000 Minimum rate of return 15\% Division A's return on investment (ROI) is:

One approach to measuring the short-term financial performance of a business unit considered an investment center is return on investment (ROI). ROI is expressed as operating income of the investment center:

Which of the following is not a criticism of using return on investment (ROI) for divisional performance evaluation?

Pearl Inc.has the following financial results for 2019 for its three regional divisions: Estimated Current Cost Region Operating Income NBV GBV Replacement Cost Liquidation Value Northeast \ 50,000 \ 100,000 \ 150,000 \ 750,000 \ 500,000 Midwest \ 80,000 \ 300,000 \ 400,000 \ 500,000 300,000 Southeast \ 90,000 \ 400,000 \ 500,000 \ 900,000 950,000 Required: Calculate return on investment (ROI), asset turnover (AT), and return on sales (ROS) for each division for 2019. The sales in the Northeast, Midwest, and Southeast regions are $700,000, $800,000, and $990,000, respectively. Calculate ROI and AT for each of the four measures of investment (i.e., NBV (net book value), GBV (gross book value), Replacement Cost, and Liquidation Value). Round all answers except ROI to 2 decimal places (e.g., 0.12522 becomes 12.52%); round ROI to whole percentage amounts, e.g., 0.1998 becomes 20%.

Brown's Mill has two operating units, each of which is considered an investment center for evaluation purposes. The Cutting Division of the mill prepares timber at its sawmills. Afterwards, the Assembly Division prepares the cut lumber into finished wood, to be sold to furniture manufacturers. During the most recent year, the Cutting Division produced 120,000 cords of wood, at a total cost of $1,320,000. The entire output was transferred to the Assembly Division, where additional costs of $6 per cord were incurred. The 1,200,000 board-feet of finished wood were then sold in the open market for $5,000,000. Required: 1. Determine the operating income for each division if the transfer price from the Cutting Division to the Assembly Division is set at full production cost, $11 per cord. 2. Determine the operating income for each division if the transfer price is set at $9 per cord. 3. Since the Cutting Division sells all of its output internally, does the manager care about what price is charged? Why? Should the Cutting Division in this case be considered a cost center or a(n) profit/investment center?

Residual income (RI) may be a better measure for performance evaluation of an investment center manager than return on investment (ROI) because:

Return on Investment (ROI), though widely used, is subject to which one of the following limitations?

The basic objective of the residual income (RI) approach to divisional performance measurement and evaluation is to have a division maximize its:

The Division A of Standard Products is planning its 2019 operating budget. Average operating assets of $1,500,000 will be used during in the division during the year and per-unit selling prices are expected to average $100. Variable costs of the division are budgeted at $400,000, while fixed costs are set at $250,000. The company's required rate of return for purposes of calculating residual income (RI) is 18%. Required: 1. Compute the sales volume (in units) necessary for Division A to achieve a 20% ROI in 2019. 2. The division manager receives a bonus of 50% of residual income (RI). What is her anticipated bonus for 2019 for the division manager, assuming she achieves the 20% ROI target specified in part (1)?

Assume two divisions, P (producing) and B (buying) of a company are both treated as investment centers for performance evaluation purposes. Division B requires 1,000 units of product that it can either purchase externally on the open market for $13.50 per unit, or obtain internally from Division P. The incremental (i.e., out-of-pocket) costs to Division P are estimated at $12.00 per unit. Because of spot shortages of this product in the open market, it is sometimes possible for Division P to sell at a price higher than the normal market price. Such is currently the case: Division P has an offer to sell 1,000 units at a gross selling price of $15.50 per unit. In addition to the normal incremental production costs, Division P would have to pay a $0.50 sales commission cost for each unit sold externally. Required: 1. If Division B purchased the units externally, would the firm as a whole benefit or lose (in terms of a short-term financial impact)? Show calculations. 2. Apply the general transfer pricing model to this situation. What is the minimum transfer price indicated for each of the 1,000 units in question? Show calculations. 3. What is the likely consequence, from a decision standpoint, if the transfer price is set at the amount stipulated by the general transfer pricing rule?

Michael Cianci, manager of Division C of the FX Corporation, is considering a new investment for his division. The division currently has an investment base (i.e., assets) of $4,000,000, and operating income of approximately $600,000 per year. The new investment of $500,000 supports corporate strategy and is expected to increase operating income by $50,000 next year, an acceptable level of return from the standpoint of the corporation as a whole. Required: 1. What is the current return on investment (ROI) for Division C? 2. What will be the ROI of the division if the new investment is undertaken? 3. Suppose the manager's compensation consists of a salary plus a bonus proportional to divisional ROI. Would the manager's compensation be higher with, or without, the new investment? 4. Suggest changes to corporate management that will better align performance evaluation and compensation with corporate goals.