CHAPTER 10

DECENTRALIZATION:
RESPONSIBILITY ACCOUNTING, PERFORMANCE
EVALUATION, AND TRANSFER PRICING
QUESTIONS FOR WRITING AND DISCUSSION

1. Decentralization is the delegation of required on an investment. Residual income

decision-making authority to lower levels. In encourages investment in all projects that
centralized decision making, decisions are earn at least the minimum rate of return.
made at the very top level, and lower-level
8. EVA is economic value added. It is the
managers are responsible for implementing
difference between after-tax income and the
these decisions. For decentralized decision
cost of the capital employed. EVA is an
making, decisions are made and
absolute dollar amount, not a percentage
implemented by lower-level managers.
rate of return like ROI. EVA differs from
2. Reasons for decentralization include the residual income in EVA’s use of after-tax
following: access to local information, more income and the true cost of capital (rather
timely response, focusing of central than a hurdle rate).
management, exposure of segments to
9. A stock option is the right to purchase a
market forces, enhanced competition,
certain amount of stock at a fixed price. It
training, and motivation.
can encourage goal congruence by giving
3. Knowledge of local conditions may be managers an ownership stake in the firm,
critical for decisions; local managers are encouraging them to view operations from a
aware of these conditions, whereas higher- long-run perspective.
level managers may not be. This can lead to
more informative decision making. 10. A transfer price is the price charged for
goods that are transferred from one division
4. Margin = Net income/Sales, and Turnover = to another division of the same company.
Sales/Average operating assets. By
breaking ROI into margin and turnover, 11. The transfer pricing problem is finding a
more insight into why ROI may change from transfer price that simultaneously satisfies
one period to the next is possible. three objectives: accurate performance
evaluation, goal congruence, and
5. Three advantages of ROI include: (1) ROI preservation of divisional autonomy.
encourages managers to pay attention to
the relationships among sales, expenses, 12. Agree. Because at least one division will be
and investment. (2) ROI encourages cost made better off and firm profits will
efficiency. (3) ROI discourages excessive increase.
investment in operating assets. Increased 13. If a perfectly competitive outside market
profitability can be achieved (all other things exists, the transfer price should be market
being equal) by increasing revenues,
price. Minimum price = maximum price =
decreasing expenses, or lowering
market price. Any other price would make at
investment.
least one division worse off, and firm profits
6. Two disadvantages of ROI are: (1) ROI may may decrease if the price is not market
discourage managers from investing in proj- price.
ects that would increase the profitability of
the firm but decrease the division’s ROI. (2) 14. Full cost, full cost plus, variable cost plus.
It also may encourage managers to focus on The major disadvantage is that cost-based
short-run profitability and to take actions transfer prices may not reflect the optimal
that may harm long-run profitability. outcome for the divisions and the firm.
Specifically, it is possible for the transfer
7. Residual income is the difference between price, using one of the costing approaches,
net income and the minimum dollar return to be less than the minimum price or greater

210
 than the maximum price. The prices, income tax purposes. The four acceptable
however, are simple to use and, in some methods are the comparable uncontrolled
cases, may reflect the outcome of a price method, the resale price method, the
negotiated agreement. cost-plus method, and any method jointly
acceptable to the IRS and the company.
15. Internal Revenue Code Section 482 outlines
the transfer pricing methods acceptable for

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 EXERCISES

10–1
1. Sporting Goods Division ROI:
Year 1: $2,800,000/$20,000,000 = 14%
Year 2: $3,000,000/$20,000,000 = 15%
Sporting Goods Division Margin:
Year 1: $2,800,000/$70,000,000 = 4.0%
Year 2: $3,000,000/$75,000,000 = 4.0%
Sporting Goods Division Turnover:
Year 1: Turnover: $70,000,000/$20,000,000 = 3.5
Year 2: Turnover: $75,000,000/$20,000,000 = 3.75

2. Camping Division ROI:

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

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

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10–2
1. Ever-Tent ROI = $55,000/$500,000
= 11.0%
KiddieKamp ROI = $38,000/$400,000
= 9.5%

2. Add Only Add Only Add Both Maintain

Ever-Tent KiddieKamp Projects Status Quo
Operating income... $ 1,055,000 $ 1,038,000 $ 1,093,000 $ 1,000,000
Operating assets.... 10,500,000 10,400,000 10,900,000 10,000,000
ROI............................ 10.05% 9.98% 10.03% 10%

The manager will invest only in the Ever-Tent since that alternative has the
highest ROI.

10–3
1. Ever-Tent residual income = $55,000 – (0.09 × $500,000)
= $10,000
KiddieKamp residual income = $38,000 – (0.09 × $400,000)
= $2,000

2. Add Only Add Only Add Both Maintain

Ever-Tent KiddieKamp Projects Status Quo
Operating income... $1,055,000 $ 1,038,000 $1,093,000 $1,000,000
Minimum income*... 945,000 936,000 981,000 900,000
Residual income..... $ 110,000 $ 102,000 $ 112,000 $ 100,000

*Minimum income = Operating assets × Minimum required rate of return.

The manager will invest in both the Ever-Tent and the KiddieKamp because
residual income is positive for each, and the overall residual income is
highest when both projects are accepted.

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

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10–4
1. After-Tax Weighted
Percent Cost Cost
Common stock................................... 0.50 0.180 0.0900
10-year bonds..................................... 0.50 0.039* 0.0195
Weighted average cost of capital....................................................... 0.1095
*0.039 = 0.06 – (0.06 × 0.35).
EVA = $210,000 – (0.1095 × $2,000,000) = ($9,000)

2. Year 1:
After-Tax Weighted
Percent Cost Cost
Common stock.................................... 0.50 0.150 0.0750
10-year bonds..................................... 0.50 0.039 0.0195
Weighted average cost of capital....................................................... 0.0945
EVA = $210,000 – (0.0945 × $2,000,000) = $21,000

Year 2:
After-Tax Weighted
Percent Cost Cost
Common stock.................................... 0.50 0.120 0.0600
10-year bonds..................................... 0.50 0.039 0.0195
Weighted average cost of capital....................................................... 0.0795
EVA = $210,000 – (0.0795 × $2,000,000) = $51,000

3. After-Tax Weighted
Percent Cost Cost
Common stock.................................... 0.80 0.180 0.1440
10-year bonds..................................... 0.20 0.039 0.0078
Weighted average cost of capital....................................................... 0.1518
EVA = $750,000 – (0.1518 × $5,000,000) = ($9,000)

Year 1 (9% premium):

After-Tax Weighted
Percent Cost Cost
Common stock.................................... 0.80 0.150 0.1200
10-year bonds..................................... 0.20 0.039 0.0078
Weighted average cost of capital....................................................... 0.1278
EVA = $750,000 – (0.1278 × $5,000,000) = $111,000

10–4 Concluded

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 Year 2 (6% premium):
After-Tax Weighted
Percent Cost Cost
Common stock.................................... 0.80 0.120 0.0960
10-year bonds..................................... 0.20 0.039 0.0078
Weighted average cost of capital....................................................... 0.1038
EVA = $750,000 – (0.1038 × $5,000,000) = $231,000

10–5
1. Whirlmore, Inc.
Income Statement (in thousands)
For the Year 20XX
Home-Supreme Apartment International Total
Sales.................................... $2,700 $ 2,400 $1,300 $ 6,400
COGS................................... 1,770 1,870 1,040 4,680
Gross profit.................... $ 930 $ 530 $ 260 $ 1,720
Selling and admin. expense 640 180 100 920
Division profit................ $ 290 $ 350 $ 160 $ 800
Income taxes (30%)............ 87 105 48 240
After-tax income............ $ 203 $ 245 $ 112 $ 560

2. After-Tax Weighted
Percent Cost Cost
Common stock.................................. 0.80 0.110 0.0880
Bonds................................................. 0.20 0.056* 0.0112
Weighted average cost of capital....................................................... 0.0992
*0.08(1 – 0.3) = 0.056.

3.
Home-Supreme Apartment International Total
After-tax income.............. $ 203,000 $245,000 $ 112,000 $
560,000
Less cost of capital:
(0.0992 × $2,100,000) 208,320
(0.0992 × $500,000)... 49,600
(0.0992 × $400,000)... 39,680 297,600
EVA..................................$ (5,320) $ 195,400$ 72,320 $ 262,400

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10–5 Concluded
4. While EVA is positive for Whirlmore, Inc., as a whole, it is negative for the
Home-Supreme Division. Therefore, even though the Home-Supreme Division
has positive net income, it needs to increase net income or reduce the capital
used to generate positive economic value added.

10–6

1. Maximum price....................... $ 2.80

Minimum price........................ 1.15
Difference................................ $ 1.65
× The number of cases.......... ×100,000
Increased profit............... $ 165,000

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

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

3. Full manufacturing cost is $1.85 ($1.15 + $0.70), so $1.85 would be the

transfer price. The transfer could take place since $1.85 is between the
minimum and maximum prices of the negotiating set.

10–7
1. The comparable uncontrolled price method should be used because a market
price exists.

2. Market price......................... $25.00

Plus shipping, duties.......... 2.75
Less marketing costs......... (2.80)
Transfer price............... $ 24.95

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10–8
1. The comparable uncontrolled price method should be used because a market
price exists.

Market price......................... $ 0.95

Plus shipping, duties.......... 0.05
Less marketing costs......... ( 0.06)
Transfer price............... $ 0.94

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

Manufacturing cost............. $ 0.83

Plus shipping, duties.......... 0.05
Transfer price............... $ 0.88

10–9
1. The resale price method should be used because a market price does not
exist and the paint will be resold and not used in further manufacturing.

2. Resale price = Transfer price +(0.50 × Transfer price)

$18 = 1.50 × Transfer price
Transfer price = $18/1.50 = $12

10–10
1. Pacific-Rim: $126,000 – (0.12 × $900,000) = $18,000
European: $1,350,000 – (0.12 × $9,000,000) = $270,000
Residual income is an absolute dollar measure, so it does not adjust for the
relative sizes of the divisions.

2. Pacific-Rim: $18,000/$900,000 = 2%
European: $270,000/$9,000,000 = 3%

It is now possible to say the European Division is relatively more profitable

than the Pacific-Rim Division.

3. Pacific-Rim: $126,000/$900,000 = 14%

European: $1,350,000/$9,000,000 = 15%
ROI can be used to compare relative divisional profitability.

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10–10 Concluded
4. Pacific-Rim: 2% + 12% = 14%
European: 3% + 12% = 15%
The residual rate of return and the required rate of return will always sum to
the ROI.

10–11
1.
A B C D
Revenue............... $10,000 $48,000 $96,000 $19,200*
Expenses............. $8,000 $36,000* $90,000 $18,000*
Net Income.......... $2,000 $12,000 $6,000* $1,200*
Assets.................. $40,000 $96,000* $48,000 $9,600
Margin.................. 20%* 25% 6.25%* 6.25%
Turnover.............. 0.25* 0.50 2* 2
ROI....................... 5%* 12.5%* 12.5%* 12.5%*
*Indicates calculated amounts.

2. A’s residual income = $2,000 – (0.09 × $40,000) = ($1,600)

B’s residual income = $12,000 – (0.09 × $96,000) = $3,360

C’s residual income = $6,000 – (0.09 × $48,000) = $1,680

D’s residual income = $1,200 – (0.09 × $9,600) = $336

10–12
1. Net income = $1,000,000 – $600,000 – $100,000 = $300,000
Residual income = $300,000 – (0.15)($1,500,000) = $75,000

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

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10–13

If Casey accepts the new position, she will earn $56,000 (salary of $40,000 and
bonus of $16,000) in Year 1. After two years, if Litton’s stock rises at the same
rate as it has over the past five years, she will be able to exercise her stock
option and realize a gain of the following:

Price of stock in two years ($12 × 1.15 × 1.15 × 10,000)............... $158,700

Exercise price of stock..................................................................... 120,000
Gain............................................................................................. $ 38,700
Casey will clearly be better off financially right away. Her salary plus bonus with
Litton is $1,000 higher than her current salary. In addition, if the increase in net
income for the Financial Services Division can be sustained, she stands to make
considerably more through bonuses in the coming years. The stock option,
exercisable in two years, also gives Casey the potential to make another $38,700.
On the down side, Casey’s current salary is reasonably secure. The Litton
position has a lower guaranteed salary and the risk of bonuses and option values
which may not be realized. If the financial services industry experiences a
downturn, Casey will suffer no matter how well she personally performs.

The final decision rests on Casey’s assessment of the risk versus reward of the
two positions. She should also consider the risk of remaining in her present
position; that is, what are her prospects for making partner at the public
accounting firm?

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 PROBLEMS

10–14
1. Since the Transistor Division can sell all its transistors to the outside
competitive market, the minimum transfer price is $3.40. The Systems
Division can buy its transistors from the outside market at $3.40, so the
maximum transfer price is $3.40.
2. Yes, since the minimum transfer price for the idle capacity is $1.90 ($2.65 less
the $0.75 of allocated fixed overhead). The Division is better off if the transfer
price is greater than $1.90 for the excess capacity.

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

10–15
1. Reigis Steel Company
Unit Contribution Margin
(in thousands except for unit contribution margin)
For the Year Ended November 30, 2010
Sales................................................................. $25,000
Less variable costs:
Cost of goods sold................................. $16,500
Selling expenses ($2,700 × 40%)........... 1,080 17,580
Contribution margin....................................... $ 7,420
Unit contribution margin = $7,420/1,484 units
= $5.00 per unit

2. a. ROI = Income before taxes/Average operating assets*

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

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10–15 Concluded
b. Residual income = $1,845,000 – (0.11 × $15,375,000)
= $1,845,000 – $1,691,250
= $153,750

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

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

10–16
1. Part 4CM Model 7AC Company
Sales..................................... $70,000* $550,000 $620,000
Variable expenses............... 50,000 460,000 510,000
Contribution margin...... $ 20,000 $ 90,000 $110,000
*While all 10,000 units could be sold externally, currently none are.

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

3. Unless the manager of the Small AC Division is able to increase the price of
Model 7AC, he will discontinue production and will not purchase any of the
component. (The cost of producing the window unit will increase from $52 to
$57, a cost greater than the current selling price.)

4. All 10,000 units of Part 4CM will be sold externally at the market price of $12
per unit.

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10–16 Concluded
5. Sales......................................... $120,000
Variable expenses................... 50,000
Contribution margin.......... $ 70,000
The contribution to profits increases by $20,000. The CEO made the correct
decision.

10–17
1. Raymond should not reduce the price charged to Brandi if he can sell all he
produces at a price of $4.50 per pound. Brandi should buy externally, saving
the company $50,000 (100,000 × $0.50). The $50,000 savings belongs to the
Donut Shop Division. There will be no effect on the Coffee Division.

2. Coffee Division:
Current profit:
950,000 × ($4.50 – $3.50) = $950,000
Profit with no internal transfers:
850,000 × ($4.50 – $3.50) = $850,000
Change in profit = $950,000 – $850,000 = ($100,000)
Donut Shop Division:
Increase in profit:
($4.50 – $4.00) × 100,000 = $50,000
Effect on firm: ($100,000) + $50,000 = ($50,000)

3. Using the no transfer scenario as the point of reference, the minimum

transfer price for the Coffee Division can be computed as follows (if internal
transfer occurs, there will be 850,000 pounds sold externally and 100,000
sold internally):
Let P = Minimum transfer price
[850,000 × ($4.50 – $3.50)] + [100,000 × (P – $3.50)] = $850,000
$850,000 + 100,000P – $350,000 = $850,000
100,000P = $350,000
P = $3.50
The maximum transfer price is $3.50, the price that would be paid if no
transfer occurs internally.

222
10–17 Concluded

For a transfer price of $3.50, the effect for each division and the firm is as
follows:
Coffee Division: ($3.50 – $3.50)100,000 + ($4.50 – $3.50)850,000 = $850,000
Change in profit: $850,000 – $950,000 = ($100,000)
Donut Shop Division: $1 × 100,000 = $100,000 savings
Firm: No change
The outside bid has a direct benefit to the Donut Shop Division.

4. Original Income New Income

Sales:
External..................... $3,825,000 $ 3,825,000
Internal...................... 450,000 $4,275,000 350,000 $ 4,175,000
Variable cost.................. 1,900,000 1,900,000
Contribution margin $2,375,000 $ 2,275,000
Fixed cost...................... 1,500,000 1,500,000
Net income............... $ 875,000 $ 775,000
Original ROI = $875,000/$2,000,000 = 43.75%
New ROI = $775,000/$2,000,000 = 38.75%
The decrease in ROI will affect Raymond’s evaluation as a manager and his
chance for bonuses and promotions. Still, the transfer pricing negotiations
have given him valuable information. He is now aware that an outside
company is underpricing him on similar quality coffee; he needs to determine
why (e.g., a more efficient cost structure) and whether this will also affect his
own outside sales.

223
10–18
1. $120

2. Minimum: $108
Maximum: $120
Actual: $114

3. ($90 + $44)/2 = $67

Appliance Division:
Additional revenue ($67 × 2,000)............................. $134,000
Additional expenses ($44 × 2,000)........................... 88,000
Additional profit......................................................... $ 46,000
Manufactured Housing Division:
Reduction of costs ($90 – $67) × 2,000................... 46,000
Total addition to profits............................................ $ 92,000

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10–19
1. The segment information prepared for public reporting purposes may not be
appropriate for the evaluation of segment management performance
because:
 An allocation of common costs incurred for the benefit of more than one
segment must be included for public reporting purposes.
 Common costs are generally allocated on an arbitrary basis.
 The segments identified for public reporting purposes may not coincide
with actual management responsibilities.
 This information does not distinguish between a segment that is a poor
investment and the performance of a manager who has done well despite
adverse circumstances.

2. If their performance is evaluated on the basis of the information in the annual

financial report, Webster Corporation’s segment managers may become
frustrated and dissatisfied because they would be held responsible for an
earnings figure that includes the arbitrary allocation of common costs and
costs traceable to but not controllable by them. Performance evaluation on
this basis would be demotivating. As a result of this dissatisfaction,
managers may seek employment elsewhere.

3. Webster Corporation should define responsibility centers that coincide with

managers’ actual responsibilities rather than using the segment rules
developed for public financial reporting. All reports should be prepared
utilizing the contribution approach which would separate costs by behavior
and assign costs to segments only if they could be controlled by the
segment. The report should disclose contribution margin, contribution
controllable by segment managers, and contribution by each segment after
the allocation of common costs.

10–20
1. $200, because it could purchase the motor externally for that price.

2. $195, because that is equal to variable cost; or $135 if labor is considered

fixed (see answer to Requirement 3).

3. The environmental factor most important to this decision is the governmental

prohibition against layoffs. This could turn direct labor into a strictly fixed
cost. This particular prohibition is a serious one.
Some Spanish plants have been virtually closed for years, yet the firms must
continue to pay the workers since the government has refused permission to
lay off the workers.
10–21

225
1. Fred turned down the proposed investment as the ROI from the investment is
13% ($156,000/$1,200,000) compared to the current ROI of 16%
($2,560,000/$16,000,000). If the iron is produced, then the division’s ROI
would decrease to 15.79% ($2,716,000/$17,200,000).

2. The iron should have been manufactured since the company’s income would
increase $48,000 [$156,000 – (9% × $1,200,000)].

3. Yes. The project has a residual income of $48,000 and accepting it would
have increased the division’s residual income.

4. Residual income encourages managers to invest in projects that increase a

firm’s income, decreasing the likelihood that profitable investments will be
turned down. ROI encourages managers to select those investments that
provide the greatest return per dollar invested. ROI provides a relative mea-
sure of performance, making comparisons among divisions possible.

5. Since ROI is the main performance measure, Fred was not willing to accept a
profitable investment because it would decrease his division’s ROI. Facing a
possible promotion, he chose to maintain the division’s high ROI rather than
earn extra profits for the company. The decision was motivated by self-
interest. Some may argue that the decision was encouraged by the
company’s reward system. This argument, however, is weak since it is
virtually certain that the intent of higher management is to reward productive
behavior, not manipulative behavior. From this perspective, the decision was
wrong and, thus, unethical.
However, Fred might argue that the true objective of the firm is to encourage
and reward high return on investment. He may be able to develop an
acceptably high ROI project in the next eight to 10 months. Thus, not
accepting the immediate project may give him the ability to invest in a more
profitable project later on.

CYBER RESEARCH CASE

10–22
Answers will vary.

226