Chapter 12 Controller Ship

8/8/2019 Chapter 12 Controller Ship

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Copyright 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

11th EditionChapter 12


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Segment Reporting andDecentralization

Chapter Twelve


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Decentralization in Organizations

Benefits of

DecentralizationTop management

freed to concentrateon strategy.

Top managementfreed to concentrate

on strategy.

Lower-level managersgain experience indecision-making.

Lower-level managersgain experience indecision-making.

Decision-makingauthority leads tojob satisfaction.

Decision-makingauthority leads tojob satisfaction.

Lower-level decisionoften based on

better information.

Lower-level decisionoften based onbetter information.

Lower level managerscan respond quickly

to customers.

Lower level managerscan respond quickly

to customers.


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Decentralization in Organizations

Disadvantages of

Decentralization

Lower-level managersmay make decisionswithout seeing the

big picture.

Lower-level managersmay make decisions

without seeing thebig picture.

May be a lack ofcoordination among

autonomousmanagers.

May be a lack ofcoordination among

autonomousmanagers.

Lower-level managers

objectives may notbe those of theorganization.

Lower-level managers

objectives may notbe those of theorganization. May be difficult to

spread innovative ideasin the organization.

May be difficult tospread innovative ideas

in the organization.


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Cost, Profit, and Investments Centers

Responsibility

Center

Responsibility

Center

CostCenter

CostCenter

ProfitCenter

ProfitCenter

InvestmentCenter

InvestmentCenter

Cost, profit,

and investmentcenters areallknown asresponsibility

centers.


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Cost Center

A segment whosemanager has control

over costs,

but not over revenuesor investment funds.


7/92Copyright 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin


Profit Center

A segment whosemanager has controloverbothcosts and

revenues,

but no control overinvestment funds.

Revenues

Sales

Interest

Other

Costs

Mfg. costs

Commissions

Salaries

Other




Investment Center

A segment whosemanager has controlover costs, revenues,

and investments inoperating assets.

Corporate Headquarters



Responsibility Centers

S a l t y S nP r o d u c t

B o t t l i nM a n a

W a r e hM a n a

D i s t r i bM a n a

B e v e r aP r o d u c t

C o n f e cP r o d u c t

O p e r a t i oV i c e P r e s

F i n a n c eC h i e f F I n a n

L e g a lG e n e r a l C

P e r s o n nV i c e P r e s

S u p e r i o r F o oC o r p o r a t e H e

P r e s i d e n t a

Cost

Centers

InvestmentCenters

Superior Foods Corporation provides an example of thevarious kinds of responsibility centers that exist in an

organization.






W a r e hM a n a









P r e s i d e n t a


organization.

Profit

Centers






W a r e hM a n a









P r e s i d e n t a

Cost

Centers


organization.



Decentralization and Segment Reporting

Asegmentsegmentis any partor activity of an

organization about

which a managerseeks cost, revenue,

or profit data. A

segment can be . . .

Quick MartQuick Mart

An Individual Store

A Sales Territory

A Service Center



Superior Foods: Geographic Regions

E a s t

$ 7 5 , 0 0 0

O r e g o$ 4 5 , 0 0 0

W a s h i n$ 5 0 , 0 0 0

C a l i f o r $ 1 2 0 , 0 0

M o u n t a i$ 8 5 , 0 0 0

W e s t

$ 3 0 0 , 0 0

M i d w e

$ 5 5 , 0 0 0

S o u t h

$ 7 0 , 0 0 0

S u p e r i o r F o o d$ 5 0 0 , 0 0 0 , 0

Superior Foods Corporation could segment its businessby geographic regions.


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Keys to Segmented Income Statements

There are two keys to buildingsegmented income statements:

A contribution format should be used because itseparates fixed from variable costs and it

enables the calculation of a contribution margin.

Traceable fixed costs should be separated from

common fixed costs to enable the calculation ofa segment margin.



Identifying Traceable Fixed Costs

Traceable costsarise because of the existence of aparticular segment and would disappear over time if the

segment itself disappeared.

No computerNo computerdivision means . . .division means . . .

No computerNo computerdivision manager.division manager.



Identifying Common Fixed Costs

Common costsarise because of the overalloperation of the company and would not disappear

if any particular segment were eliminated.

No computerNo computerdivision but . . .division but . . .

We still have aWe still have acompany president.company president.

T bl C t C B C



Traceable Costs Can Become CommonCosts

It is important to realize that the traceablefixed costs of one segment may be a

common fixed cost of another segment.

For example, the landing feepaid to land an airplane at an

airport is traceable to the

particular flight, but it is nottraceable to first-class,

business-class, andeconomy-class passengers.



Segment Margin

The segment marginsegment margin, which is computed by subtractingthe traceable fixed costs of a segment from its

contribution margin, is the best gaugebest gaugeof the long-runprofitability of a segment.

TimeTime

Pro

fit

s

Pro

fit

s



Traceable and Common Costs

FixedCosts

TraceableTraceable CommonCommon

Dont allocateDont allocate

common costs tocommon costs to

segments.segments.



Activity-Based Costing

9-inch 12-inch 18-inch Tota l

W a re house sq. ft. 1,000 4,000 5,000 10,000

Le a se price pe r sq. ft. 4$ 4$ 4$ 4$

Tota l le a se cost 4,000$ 16,000$ 20,000$ 40,000$

Pipe Products

Activity-based costing can help identify how costsshared by more than one segment are traceable to

individual segments.Assume that three products, 9-inch, 12-inch, and 18-inch pipe, share 10,000

square feet of warehousing space, which is leased at a price of $4 per squarefoot.

If the 9-inch, 12-inch, and 18-inch pipes occupy 1,000, 4,000, and 5,000 squarefeet, respectively, then ABC can be used to trace the warehousing costs to the

three products as shown.



Levels of Segmented Statements

Lets look more closely at the TelevisionDivisions income statement.

Lets look more closely at the TelevisionDivisions income statement.

Webber, Inc. has two divisions.

C o m p u t e r T e l e v i s i o n

W e b b e r ,




Our approach to segment reporting uses thecontribution format.

Income Statement

Contribution Margin Format

Television Division

Sales 300,000$

Variable COGS 120,000

Other variable costs 30,000

Total variable costs 150,000Contribution margin 150,000

Traceable fixed costs 90,000

Division margin 60,000$

Cost of goodssold consists of

variablemanufacturing

costs.

Cost of goodssold consists of

variablemanufacturing

costs.

Fixed andvariable costsare listed in

separatesections.

Fixed andvariable costsare listed in

separatesections.


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Segment marginis Televisions

contributionto profits.

Segment marginis Televisions

contributionto profits.

Our approach to segment reporting uses thecontribution format.

Income Statement

Contribution Margin Format

Television Division

Sales 300,000$

Variable COGS 120,000

Other variable costs 30,000

Total variable costs 150,000Contribution margin 150,000

Traceable fixed costs 90,000

Division margin 60,000$

Contribution margin

is computed bytaking sales minus

variable costs.

Contribution margin

is computed bytaking sales minus

variable costs.


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Income Statement

Company Television Computer

Sales 500,000$ 300,000$ 200,000$

Variable costs 230,000 150,000 80,000

CM 270,000 150,000 120,000Traceable FC 170,000 90,000 80,000

Division margin 100,000 60,000$ 40,000$

Common costs

Net operatingincome


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Income Statement

Company Television Computer

Sales 500,000$ 300,000$ 200,000$

Variable costs 230,000 150,000 80,000

CM 270,000 150,000 120,000Traceable FC 170,000 90,000 80,000

Division margin 100,000 60,000$ 40,000$

Common costs 25,000

Net operatingincome 75,000$

Common costs should not

be allocated to thedivisions. These costs

would remain even if oneof the divisions were

eliminated.

Common costs should not

be allocated to thedivisions. These costs

would remain even if oneof the divisions were

eliminated.


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Traceable Costs Can Become Common Costs

As previously mentioned, fixed costs that aretraceable to one segment can become commonif the company is divided intosmallersmallersegments.

Lets see how this works

using the Webber Inc.example!


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ProductProduct

LinesLines

Webbers Television Division

Regular Big Screen

Television

Division


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We obtained the following information fromthe Regular and Big Screen segments.

Income StatementTelevision

Division Regular Big Screen

Sales 200,000$ 100,000$

Variable costs 95,000 55,000

CM 105,000 45,000Traceable FC 45,000 35,000

Product line margin 60,000$ 10,000$

Common costs

Divisional margin


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Income StatementTelevision

Division Regular Big Screen

Sales 300,000$ 200,000$ 100,000$

Variable costs 150,000 95,000 55,000

CM 150,000 105,000 45,000Traceable FC 80,000 45,000 35,000

Product line margin 70,000 60,000$ 10,000$

Common costs 10,000

Divisional margin 60,000$


Fixed costs directly tracedto the Television Division

$80,000 + $10,000 = $90,000

Fixed costs directly tracedto the Television Division

$80,000 + $10,000 = $90,000


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External Reports

The Financial Accounting Standards Board now requiresthat companies in the United States include segmented

financial data in their annual reports.

1. Companies must report segmentedresults to shareholders using the samemethods that are used for internalsegmented reports.

2. Since the contribution approach to

segment reporting does not complywith GAAP, it is likely that somemanagers will choose to constructtheir segmented financial statementsusing the absorption approach tocomply with GAAP.


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Omission of Costs

Costs assigned to a segment should include allcosts attributable to that segment from thecompanys entirevalue chainvalue chain.

Product CustomerR&D Design Manufacturing Marketing Distribution Service

Business FunctionsBusiness Functions

Making Up TheMaking Up The

Value ChainValue Chain

Inappropriate Methods of Allocating Costs Among


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Inappropriate Methods of Allocating Costs AmongSegments

Segment1

Segment3

Segment4

Inappropriateallocation base

Segment2

Failure to tracecosts directly


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Common Costs and Segments

Segment1

Segment3

Segment4

Segment2

Common costs should not be arbitrarily allocated to segmentsbased on the rationale that someone has to cover the

common costs for two reasons:

1. This practice may make a profitable business segment appearto be unprofitable.

2. Allocating common fixed costs forces managers to be heldaccountable for costs they cannot control.


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Income StatementHaglund's

Lakeshore Bar Restaurant

Sales 800,000$ 100,000$ 700,000$

Variable costs 310,000 60,000 250,000CM 490,000 40,000 450,000

Traceable FC 246,000 26,000 220,000

Segment margin 244,000 14,000$ 230,000$

Common costs 200,000

Profit 44,000$

Allocations of Common Costs

Assume that Haglunds Lakeshore prepared thesegmented income statement as shown.


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Quick Check

How much of the common fixed cost of $200,000can be avoided by eliminating the bar?

a. None of it.

b. Some of it.c. All of it.


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Quick Check

How much of the common fixed cost of $200,000can be avoided by eliminating the bar?

a. None of it.

b. Some of it.c. All of it.

A common fixed cost cannot beeliminated by dropping one of

the segments.


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Quick Check

Suppose square feet is used as the basis forallocating the common fixed cost of $200,000. Howmuch would be allocated to the bar if the baroccupies 1,000 square feet and the restaurant9,000 square feet?

a. $20,000

b. $30,000

c. $40,000

d. $50,000

Q i k Ch k


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Quick Check

Suppose square feet is used as the basis forallocating the common fixed cost of $200,000. Howmuch would be allocated to the bar if the baroccupies 1,000 square feet and the restaurant9,000 square feet?

a. $20,000

b. $30,000

c. $40,000

d. $50,000

The bar would be allocated

1/10 of the cost or $20,000.

Q i k Ch k


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Quick Check

If Haglunds allocates its commoncosts to the bar and the restaurant,what would be the reported profit of

each segment?


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Income StatementHaglund's


Sales 800,000$ 100,000$ 700,000$

Variable costs 310,000 60,000 250,000

CM 490,000 40,000 450,000Traceable FC 246,000 26,000 220,000

Segment margin 244,000 14,000 230,000

Common costs 200,000 20,000 180,000

Profit 44,000$ (6,000)$ 50,000$

Allocations of Common Costs

Hurray, now everything adds up!!!

Q i k Ch k


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Quick Check

Should the bar be eliminated?

a. Yes

b. No

Q i k Ch k


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Should the bar be eliminated?

a. Yes

b. No

Quick Check

Income Statement

Haglund's


Sales 700,000$ 700,000$

Variable costs 250,000 250,000CM 450,000 450,000

Traceable FC 220,000 220,000

Segment margin 230,000 230,000

Common costs 200,000 200,000

Profit 30,000$ 30,000$

The profit was $44,000 beforeeliminating the bar. If we eliminate

the bar, profit drops to $30,000!

R t I t t (ROI) F l


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Return on Investment (ROI) Formula

ROI =ROI = Net operating incomeNet operating incomeAverage operating assetsAverage operating assets

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Cash, accounts receivable, inventory,plant and equipment, and other

productive assets.

Income before interestand taxes (EBIT)

Income before interestand taxes (EBIT)

N t B k V l G C t


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Net Book Value vs. Gross Cost

Most companies use the net book value ofdepreciable assets to calculate average

operating assets.

Acquisition cost

Less: Accumulated depreciation

Net book value

R t I t t (ROI) F l


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Return on Investment (ROI) Formula

ROI =ROI =Net operating incomeNet operating income

Average operating assetsAverage operating assets

Margin =Margin =Net operating incomeNet operating incomeSalesSales

Turnover =Turnover =SalesSales

Average operating assetAverage operating asset

ROI =ROI =MarginMargin TurnoverTurnover

I i ROI


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Increasing ROI

There are three ways to increase ROI . . .There are three ways to increase ROI . . .

IncreaseIncrease

SalesSales

ReduceReduce

ExpensesExpensesReduceReduce

AssetsAssets

I i ROI A E l


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Increasing ROI An Example

Regal Company reports the following:Regal Company reports the following: Net operating income $ 30,000Net operating income $ 30,000

Average operating assets $ 200,000Average operating assets $ 200,000

Sales $ 500,000Sales $ 500,000Operating expenses $ 470,000Operating expenses $ 470,000

ROI =ROI =MarginMargin TurnoverTurnoverNet operating income

SalesSales

Average operating assetsROI =

What is Regal Companys ROI?

I i ROI A E l


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Increasing ROI An Example

$30,000$500,000

$500,000$200,000

ROI =

6%6% 2.5 = 15%2.5 = 15%ROI =


SalesSales



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Increasing Sales Without an Increase in


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Increasing Sales Without an Increase inOperating Assets

$42,000$600,000

$600,000$200,000

ROI =

7%7% 3.0 = 21%3.0 = 21%ROI =

ROI increased from 15% to 21%.ROI increased from 15% to 21%.


SalesSales


Decreasing Operating Expenses with no


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Decreasing Operating Expenses with noChange in Sales or Operating Assets

Assume that Regals manager was able to reduceoperating expenses by $10,000 withoutaffecting sales or operating assets. This would

increase net operating income to $40,000.

Lets calculate the new ROI.Lets calculate the new ROI.

Regal Company reports the following:Regal Company reports the following:

Net operating income $ 40,000Net operating income $ 40,000


Sales $ 500,000Sales $ 500,000

Operating expenses $ 460,000Operating expenses $ 460,000

Decreasing Operating Expenses with no


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Decreasing Operating Expenses with noChange in Sales or Operating Assets

$40,000$500,000

$500,000$200,000

ROI =

8%8% 2.5 = 20%2.5 = 20%ROI =

ROI increased from 15% to 20%.ROI increased from 15% to 20%.


SalesSales


Decreasing Operating Assets with no


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Decreasing Operating Assets with noChange in Sales or Operating Expenses

Assume that Regals manager was able to reduceinventories by $20,000 using just-in-timetechniques without affecting sales or operating

expenses.





Sales $ 500,000Sales $ 500,000


Decreasing Operating Assets with no


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Decreasing Operating Assets with noChange in Sales or Operating Expenses

$30,000$500,000

$500,000$180,000

ROI =

6%6% 2.77 = 16.7%2.77 = 16.7%ROI =

ROI increased from 15% to 16.7%.ROI increased from 15% to 16.7%.


SalesSales


Investing in Operating Assets to


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Investing in Operating Assets toIncrease Sales

Assume that Regals manager invests in a$30,000 piece of equipment that increasessales by $35,000 while increasing operating

expenses by $15,000.





Sales $ 535,000Sales $ 535,000


Investing in Operating Assets to


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est g Ope at g ssets toIncrease Sales

$50,000$535,000

$535,000$230,000

ROI =

9.35%9.35% 2.33 = 21.8%2.33 = 21.8%ROI =

ROI increased from 15% to 21.8%.ROI increased from 15% to 21.8%.


SalesSales


ROI and the Balanced Scorecard


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ROI and the Balanced Scorecard

It may not be obvious to managers how to increase sales,decrease costs, and decrease investments in a way that is

consistent with the companys strategy. A well constructedbalanced scorecard can provide managers with a road map that

indicates how the company intends to increase ROI.

Which internal businessprocess should be

improved?

Which customers shouldbe targeted and how will

they be attracted and

retained at a profit?

Criticisms of ROI


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Criticisms of ROI

In the absence of the balancedscorecard, management may

not know how to increase ROI.

Managers often inherit manycommitted costs over whichthey have no control.

Managers evaluated on ROI

may reject profitableinvestment opportunities.

Residual Income - Another Measure of


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Performance

Net operating incomeabove some minimum

return on operatingassets

Calculating Residual Income


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Calculating Residual Income

Residual

income=

Net

operating

income

-

Average

operating

assets

Minimum

required rate of

return( )This computation differs from ROI.

ROI measures net operating income earned relativeto the investment in average operating assets.

Residual income measures net operating incomeearned less the minimum required return on average

operating assets.

Residual Income An Example


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The Retail Division of Zepher, Inc. has averageoperating assets of $100,000 and is required toearn a return of 20% on these assets.

In the current period the division earns $30,000.

Lets calculate residual income.Lets calculate residual income.



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Operating assets 100,000$

Required rate of return 20%

Minimum required return 20,000$

Actua l incom e 30,000$

Minim um required return (20,000)

Re sidua l incom e 10,000$

Motivation and Residual Income


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Motivation and Residual Income

Residual income encourages managers toResidual income encourages managers tomake profitable investments that wouldmake profitable investments that would

be rejected by managers using ROI.be rejected by managers using ROI.

Quick Check


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Quick Check

Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of

$300,000. The required rate of return for thecompany is 15%. What is the divisions ROI?

a. 25%

b. 5%c. 15%

d. 20%

Quick Check


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Quick Check

Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of

$300,000. The required rate of return for thecompany is 15%. What is the divisions ROI?

a. 25%

b. 5%c. 15%

d. 20%

ROI = NOI/Average operating assets

= $60,000/$300,000 = 20%

Quick Check


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Quick Check

Redmond Awnings, a division of Wrapup Corp., hasa net operating income of $60,000 and averageoperating assets of $300,000. If the manager of thedivision is evaluated based on ROI, will she want to

make an investment of $100,000 that wouldgenerate additional net operating income of$18,000 per year?

a. Yesb. No

Quick Check


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Quick Check

Redmond Awnings, a division of Wrapup Corp., hasa net operating income of $60,000 and averageoperating assets of $300,000. If the manager of thedivision is evaluated based on ROI, will she want to

make an investment of $100,000 that wouldgenerate additional net operating income of$18,000 per year?

a. Yesb. NoROI = $78,000/$400,000 = 19.5%

This lowers the divisions ROI from

20.0% down to 19.5%.

Quick Check


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Quick Check

The companys required rate of return is 15%.Would the company want the manager of theRedmond Awnings division to make an investmentof $100,000 that would generate additional net

operating income of $18,000 per year?

a. Yes

b. No

Quick Check


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Quick Check

The companys required rate of return is 15%.Would the company want the manager of theRedmond Awnings division to make an investmentof $100,000 that would generate additional net

operating income of $18,000 per year?

a. Yes

b. No ROI = $18,000/$100,000 = 18%

The return on the investment exceedsthe minimum required rate of return.

Quick Check


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Quick Check

Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of$300,000. The required rate of return for thecompany is 15%. What is the divisionsresidual income?

a. $240,000

b. $ 45,000c. $ 15,000

d. $ 51,000

Quick Check


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Quick Check

Redmond Awnings, a division of WrapupCorp., has a net operating income of$60,000 and average operating assets of$300,000. The required rate of return for thecompany is 15%. What is the divisionsresidual income?

a. $240,000

b. $ 45,000c. $ 15,000

d. $ 51,000

Net operating income $60,000Required return (15% of $300,000) $45,000

Residual income $15,000

Quick Check


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Quick Check

If the manager of the Redmond Awnings division isevaluated based on residual income, will she wantto make an investment of $100,000 that wouldgenerate additional net operating income of

$18,000 per year?

a. Yes

b. No

Quick Check


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Quick Check

If the manager of the Redmond Awnings division isevaluated based on residual income, will she wantto make an investment of $100,000 that wouldgenerate additional net operating income of

$18,000 per year?

a. Yes

b. No Net operating income $78,000

Required return (15% of $400,000) $60,000

Residual income $18,000This is an increase of $3,000 in the residual

income.

Divisional Comparisons and ResidualI


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Income

The residualincome approach

has one major

disadvantage.

It cannot be used tocompare

performance ofdivisions ofdifferent sizes.

Zepher, Inc. - Continued


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Zepher, Inc. Continued

Retail Wholesale

Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%

Minimum required return 20,000$ 200,000$

Retail Wholesale

Actual income 30,000$ 220,000$Minimum required return (20,000) (200,000)

Residual income 10,000$ 20,000$

Recall the followinginformation for the RetailDivision of Zepher, Inc.

Assume the followinginformation for the Wholesale

Division of Zepher, Inc.

Zepher, Inc. - Continued


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ep e , c Co t ued

Retail Wholesale

Operating assets 100,000$ 1,000,000$Required rate of return 20% 20%

Minimum required return 20,000$ 200,000$

Retail Wholesale

Actual income 30,000$ 220,000$Minimum required return (20,000) (200,000)

Residual income 10,000$ 20,000$

The residual income numbers suggest that the Wholesale Division outperformed

the Retail Division because its residual income is $10,000 higher. However, theRetail Division earned an ROI of 30% compared to an ROI of 22% for the

Wholesale Division. The Wholesale Divisions residual income is larger than theRetail Division simply because it is a bigger division.


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Transfer Pricing

Appendix 12A

Key Concepts/Definitions


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y p

A transfer price is the pricecharged when one segment ofa company provides goods orservices to another segment of

the company.

The fundamental objective in

setting transfer prices is tomotivate managers to act in thebest interests of the overall

company.

Three Primary Approaches


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y pp

There are three primaryapproaches to setting

transfer prices:

1. Negotiated transfer prices

2. Transfers at the cost to theselling division

3. Transfers at market price

Negotiated Transfer Prices


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g

A negotiated transfer price results from discussionsbetween the selling and buying divisions.

Advantages of negotiated transfer prices:

1. They preserve the autonomy of thedivisions, which is consistent withthe spirit of decentralization.

2. The managers negotiating thetransfer price are likely to have muchbetter information about the potentialcosts and benefits of the transferthan others in the company.

Upper limit isdetermined by thebuying division.

Lower limit isdetermined by theselling division.

Range of AcceptableTransfer Prices

Harris and Louder An Example


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p

Imperial Beverages:

Ginger beer production capactiy per month 10,000 barrels

Variable cost per barrel of ginger beer 8 per barrel

Fixed costs per month 70,000

Selling price of Imperial Beverages ginger be

on the outside market 20 per barrel

Pizza Maven:

Purchase price of regular brand of ginger beer 18 per barrel

Monthly comsumption of ginger beer 2,000 barrels

Assume the information as shown with respectto Imperial Beverages and Pizza Maven (bothcompanies are owned by Harris and Louder).



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p

The selling divisions (Imperial Beverages) lowest acceptable transferprice is calculated as:

Variable cost Total contribution margin on lost sales

per unit Number of units transferredTransfer Price +

Transfer Price Cost of buying from outside supplier

The buying divisions (Pizza Maven) highest acceptable transfer price iscalculated as:

Lets calculate the lowest and highest acceptabletransfer prices under three scenarios.

Transfer Price Profit to be earned per unit sold (not including the transfer price)

If an outside supplier does not exist, the highest acceptable transfer priceis calculated as:



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p

If Imperial Beverages has sufficient idle capacity (3,000 barrels) to satisfyPizza Mavens demands (2,000 barrels) without sacrificing sales to other

customers, then the lowest and highest possible transfer prices arecomputed as follows:

02,000

= 8Transfer Price +8Selling divisions lowest possible transfer price:

Transfer Price Cost of buying from outside supplier = 18Buying divisions highest possible transfer price:

Therefore, the range of acceptabletransfer price is 8 18.



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p

If Imperial Beverages has no idle capacity (0 barrels) and must sacrifice othercustomer orders (2,000 barrels) to meet Pizza Mavens demands (2,000

barrels), then the lowest and highest possible transfer prices are computedas follows:

( 20 - 8) 2,0002,000

= 20Tra nsfe r P r i +8

Selling divisions lowest possible transfer price:


Therefore, there is no range ofacceptable transfer prices.



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p

If Imperial Beverages has some idle capacity (1,000 barrels) and mustsacrifice other customer orders (1,000 barrels) to meet Pizza Mavens

demands (2,000 barrels), then the lowest and highest possible transfer pricesare computed as follows:


Therefore, the range of acceptabletransfer price is 14 18.

Selling divisions lowest possible transfer price:

( 20 - 8) 1,0002,000

= 14Tra nsfe r P r i +8

Evaluation of Negotiated TransferPrices


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Prices

If a transfer within a company would result in

higher overall profits for the company, there isalways a range of transfer prices within whichboth the selling and buying divisions would

have higher profits if they agree to thetransfer.

If managers are pitted against each otherrather than against their past performance orreasonable benchmarks, a noncooperative

atmosphere is almost guaranteed.

Given the disputes that often accompany thenegotiation process, most companies rely onsome other means of setting transfer prices.

Transfers at the Cost to the SellingDivision


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Division

Many companies set transfer prices at eitherthe variable cost or full (absorption) cost

incurred by the selling division.

Drawbacks of this approach include:1. Using full cost as a transfer

price and can lead tosuboptimization.

2. The selling division will nevershow a profit on any internaltransfer.

3. Cost-based transfer prices donot provide incentives to control

costs.

Transfers at Market Price


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A market price (i.e., the price charged for anitem on the open market) is often regarded as

the best approach to the transfer pricingproblem.

1. A market price approach worksbest when the product or serviceis sold in its present form tooutside customers and the

selling division has no idlecapacity.

2. A market price approach doesnot work well when the sellingdivision has idle capacity.

Divisional Autonomy andSuboptimization


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Suboptimization

The principles ofdecentralization suggestthat companies should

grant managers autonomyto set transfer prices and

to decide whether to sellinternally or externally,

even is this mayoccasionally result in

suboptimal decisions.This way top management

allows subordinates tocontrol their own destiny.

International Aspects of TransferPricing


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Pricing

Transfer PricingObjectives

Domestic Greater divisional autonomy Greater motivation for managers Better performance evaluation Better goal congruence

International Less taxes, duties, and tariffs Less foreign exchange risks Better competitive position Better governmental relations

End of Chapter 12


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Chapter 12 Controller Ship

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