Responsibility

Accounting Systems
CHAPTER 11

Managerial
Accounting
Seventeenth edition

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw Hill.
 Decentralization in
Organizations: Benefits
Benefits of
Top management freed to
Decentralization concentrate on strategy.

Lower-level decisions often

based on better information.
Lower-level managers can
respond quickly to
customers.
Lower-level managers gain
experience in decision making.

Decision-making authority
leads to job satisfaction.

© McGraw Hill 11-2

 Decentralization in
Organizations: Disadvantages
Disadvantages of
Decentralization

Lower-level managers may make decisions

without seeing the “big picture.”

May be a lack of coordination among

autonomous managers.
Lower-level managers’ objectives may not be those of
the organization.

May be difficult to spread innovative

ideas in the organization.
© McGraw Hill 11-3
 Responsibility Accounting
Managers are held responsible for those items
—and only those items—that the manager can
actually control to a significant extent.

A responsibility center is used for any part of

an organization whose manager has control
over and is accountable for cost, profit, or
investments.

© McGraw Hill 11-4

 Cost Center

A segment whose manager has control

over costs but not over revenues or
investment funds.

© McGraw Hill 11-5

 Profit Center
Revenues
Sales
A segment whose manager Interest
has control over both costs Other
and revenues
but no control over Costs
investment funds. Mfg. costs
Commissions
Salaries
Other

© McGraw Hill 11-6

 Investment Center

A segment whose manager has control

over costs, revenues, and investments
in operating assets.

© McGraw Hill 11-7

 Learning Objective 1

Compute return on investment (ROI) and

show how changes in sales, expenses, and
assets affect ROI.

© McGraw Hill 11-8

 Return on Investment (ROI)
Formula
Income before interest
and taxes (EBIT)

Net operating income

ROI =
Average operating assets

Cash, accounts receivable, inventory,

plant and equipment, and other
productive assets.

© McGraw Hill 11-9

 Net Book Value versus Gross
Cost
Most companies use the net book value of
depreciable assets to calculate average operating
assets.

Acquisition cost
Less: Accumulated depreciation
Net book value .

© McGraw Hill 11-10

 Understanding ROI
Net operating income
ROI 
Average operating assets

Net operating income

Margin 
Sales

Sales
Turnover 
Average operating assets

ROI Margin  Turnover

© McGraw Hill 11-11

 Increasing ROI: An Example
Regal Company reports the following:
Net operating income $ 30,000
Average operating assets $200,000
Sales $500,000
Operating expenses $470,000

What is Regal Company’s ROI?

ROI Margin ×Turnover

Net operating income Sales

ROI  
Sales Average operating assets
© McGraw Hill 11-12
 Increasing ROI – An Example:
Solution

ROI Margin Turnover

Net operating income Sales

ROI  
Sales Average operating assets

$30,000 $500,000
ROI  
$500,000 $200,000

ROI 6%  2.5 15%

© McGraw Hill 11-13

 Investing in Operating Assets to
Increase Sales – An Example
Assume that Regal’s manager invests in a $30,000
piece of equipment that increases sales by $35,000
while increasing operating expenses by $15,000.

Regal Company reports the following:

Net operating income $ 50,000
Average operating assets $230,000
Sales $535,000
Operating expenses $485,000

Let’s calculate the new ROI.

© McGraw Hill 11-14
 Investing in Operating Assets to
Increase Sales – An Example: Solution
ROI Margin Turnover
Net operating income Sales
ROI  
Sales Average operating assets

$50, 000 $535, 000

ROI  
$535, 000 $230, 000

ROI 9.35%  2.33 21.8%

ROI increased from 15% to 21.8%.

© McGraw Hill 11-15

 Criticisms of ROI
In the absence of the balanced
scorecard, management may
not know how to increase ROI.

Managers often inherit many

committed costs over which
they have no control.

Managers evaluated on ROI

may reject profitable
investment opportunities.
© McGraw Hill 11-16
 Learning Objective 2

Compute residual income and

understand its strengths and
weaknesses.

© McGraw Hill 11-17

 Residual Income – Another
Measure of Performance

Residual income is net operating

income above some minimum return
on operating assets.

© McGraw Hill 11-18

 Calculating Residual Income
Residual Net  Average Minimum 
 
income  operating   operating  required rate of 
income  assets return 
 

This computation differs from ROI.

ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on
average operating assets.
© McGraw Hill 11-19
 Residual Income – An
Example
The Retail Division of Zephyr, Inc. has average
operating assets of $100,000 and is required
to earn a return of 20% on these assets.
In the current period, the division earns
$30,000.

Let’s calculate residual income.

© McGraw Hill 11-20

 Residual Income – An Example:
Solution

Operating assets $100,000

Required rate of return × 20%
Minimum required return $ 20,000

Actual income $ 30,000

Minimum required return (20,000)
Residual income $ 10,000

© McGraw Hill 11-21

 Motivation and Residual
Income

Residual income encourages managers to make

profitable investments that would be rejected by
managers using ROI.

© McGraw Hill 11-22

 Quick Check 1
Redmond Awnings, a division of Wrap-Up Corp., has a net
operating income of $60,000 and average operating assets
of $300,000. The required rate of return for the company is
15%. What is the division’s ROI?
a. 25%.
b. 5%.
c. 15%.
d. 20%.

© McGraw Hill 11-23

 Quick Check 1a
Redmond Awnings, a division of Wrap-Up Corp., has a net
operating income of $60,000 and average operating assets
of $300,000. The required rate of return for the company is
15%. What is the division’s ROI?
a. 25%.
b. 5%.
c. 15%.
d. Answer: 20%.

ROI = NOI/Average operating assets

= $60,000/$300,000 = 20%
© McGraw Hill 11-24
 Quick Check 2
Redmond Awnings, a division of Wrap-Up Corp., has a net
operating income of $60,000 and average operating assets
of $300,000. If the manager of the division is evaluated
based on ROI, will she want to make an investment of
$100,000 that would generate additional net operating
income of $18,000 per year?
a. Yes.
b. No.

© McGraw Hill 11-25

 Quick Check 2a
Redmond Awnings, a division of Wrap-Up Corp., has a net
operating income of $60,000 and average operating assets
of $300,000. If the manager of the division is evaluated
based on ROI, will she want to make an investment of
$100,000 that would generate additional net operating
income of $18,000 per year?
a. Yes.
b. Answer: No.

ROI = $78,000/$400,000 = 19.5%

This lowers the division’s ROI from 20.0% to 19.5%.
© McGraw Hill 11-26
 Quick Check 3
The company’s required rate of return is 15%. Would the
company want the manager of the Redmond Awnings
Division to make an investment of $100,000 that would
generate additional net operating income of $18,000 per
year?
a. Yes.
b. No.

© McGraw Hill 11-27

 Quick Check 3a
The company’s required rate of return is 15%. Would the
company want the manager of the Redmond Awnings
Division to make an investment of $100,000 that would
generate additional net operating income of $18,000 per
year?
a. Answer: Yes.
b. No.

ROI = $18,000/$100,000 = 18%

The return on the investment exceeds the minimum
required rate of return.
© McGraw Hill 11-28
 Quick Check 4
Redmond Awnings, a division of Wrap-Up Corp., has a net
operating income of $60,000 and average operating assets of
$300,000. The required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000.
b. $45,000.
c. $15,000.
d. $51,000.

© McGraw Hill 11-29

 Quick Check 4a
Redmond Awnings, a division of Wrap-Up Corp., has a net
operating income of $60,000 and average operating assets of
$300,000. The required rate of return for the company is 15%.
What is the division’s residual income?
a. $240,000.
b. $45,000.
c. Answer: $15,000.
d. $51,000.

Net operating income $ 60,000

Required return (15% of $300,000) (45,000)
Residual income $ 15,000

© McGraw Hill 11-30

 Quick Check 5
If the manager of the Redmond Awnings Division is
evaluated based on residual income, will she want to make
an investment of $100,000 that would generate additional
net operating income of $18,000 per year?
a. Yes.
b. No.

© McGraw Hill 11-31

 Quick Check 5a
If the manager of the Redmond Awnings Division is
evaluated based on residual income, will she want to make
an investment of $100,000 that would generate additional
net operating income of $18,000 per year?
a. Answer: Yes.
b. No.
Net operating income $ 78,000
Required return (15% of $400,000) (60,000)
Residual income $ 18,000

Yields an increase of $3,000 in the residual income.

© McGraw Hill 11-32

 Learning Objective 3

Determine the range, if any, within which

a negotiated transfer price should fall.

© McGraw Hill 11-33

 Key Concepts/Definitions
A transfer price is the price
charged when one segment of a
company provides goods or
services to another segment of
the company.

The fundamental objective in

setting transfer prices is to
motivate managers to act in
the best interests of the
overall company.

© McGraw Hill 11-34

 Three Primary Approaches
There are three primary approaches to setting
transfer prices:
1. Negotiated transfer prices;
2. Set transfer prices at cost using either variable
cost or full (absorption) cost; and
3. Transfers at market price.

© McGraw Hill 11-35

 Negotiated Transfer Prices
A negotiated transfer price results from discussions
between the selling and buying divisions.

Advantages of negotiated transfer prices:

1. They preserve the autonomy of the
divisions, which is consistent with the
spirit of decentralization.
2. The managers negotiating the transfer
price are likely to have much better
information about the potential costs
and benefits of the transfer than others
in the company.

© McGraw Hill 11-36

 Grocery Storehouse 1

Assume the information as shown with respect to

West Coast Plantations and Grocery Mart (both
companies are owned by Grocery Storehouse).
West Coast Plantations:
Naval orange harvest capacity per month 10,000 crates
Variable cost per crate of naval oranges $10 per crate
Fixed costs per month $100,000
Selling price of navel oranges on the outside market $25 per crate
Grocery Mart:
Purchase price of current naval oranges $20 per crate
Monthly sales of naval oranges 1,000 crates

© McGraw Hill 11-37

 Grocery Storehouse 2

The selling division’s (West Coast Plantations) lowest acceptable

transfer price is calculated as:
Total contribution margin on lost sales
Transfer price Variable cost per unit 
Number of units transferred
Let’s calculate the lowest and highest acceptable transfer
prices under three scenarios.
The buying division’s (Grocery Mart) highest acceptable transfer price
is calculated as:
Transfer price ≤ Cost of buying from outside supplier
If an outside supplier does not exist, the highest acceptable transfer
price is calculated as:
Transfer price ≤ Profit to be earned per unit sold (not including the transfer price)

© McGraw Hill 11-38

 Grocery Storehouse 3

If West Coast Plantations has sufficient idle capacity (3,000 crates) to

satisfy Grocery Mart’s demands (1,000 crates), without sacrificing sales
to other customers, then the lowest and highest possible transfer
prices are computed as follows:

Selling division’s lowest possible transfer price:

$
Transfer price  $10  $10
1, 000

Buying division’s highest possible transfer price:

Transfer price ≤ Cost of buying from outside supplier = $20

Therefore, the range of acceptable transfer prices is $10 − $20.

© McGraw Hill 11-39

 Grocery Storehouse 4

If West Coast Plantations has no idle capacity (0 crates) and must

sacrifice other customer orders (1,000 crates) to meet Grocery Mart’s
demands (1,000 crates), then the lowest and highest possible transfer
prices are computed as follows:

Selling division’s lowest possible transfer price:

($25  $10) 1, 000
Transfer price  $10  $25
1, 000

Buying division’s highest possible transfer price:

Transfer price ≤ Cost of buying from outside supplier = $20

Therefore, there is no range of acceptable transfer prices.

© McGraw Hill 11-40

 Grocery Storehouse 5

If West Coast Plantations has some idle capacity (500 crates) and must
sacrifice other customer orders (500 crates) to meet Grocery Mart’s
demands (1,000 crates), then the lowest and highest possible transfer
prices are computed as follows:

Selling division’s lowest possible transfer price:

($25  $10) 500
Transfer price  $10  $17.50
1, 000
Buying division’s highest possible transfer price:

Transfer price ≤ Cost of buying from outside supplier = $20

Therefore, the range of acceptable transfer prices is
$17.50 − $20.00.

© McGraw Hill 11-41

 Evaluation of Negotiated
Transfer Prices
If a transfer within a company would result in
higher overall profits for the company, there
is always a range of transfer prices within
which both the selling and buying divisions
would have higher profits if they agree to the
transfer.
If managers are pitted against each other rather
than against their past performance or reasonable
benchmarks, a noncooperative atmosphere is
almost guaranteed.

Given the disputes that often accompany the

negotiation process, most companies rely on
some other means of setting transfer prices.

© McGraw Hill 11-42

 Transfers at the Cost to the
Selling Division
Many companies set transfer prices at either the
variable cost or full (absorption) cost incurred by
the selling division.
Drawbacks of this approach include:
1. Using full cost as a transfer price can lead to
suboptimization.
2. The selling division will never show a profit
on any internal transfer.
3. Cost-based transfer prices do not provide
incentives to control costs.

© McGraw Hill 11-43

 Transfers at Market Price
A market price (i.e., the price charged for an item on the
open market) is often regarded as the best approach to the
transfer pricing problem.

1. A market price approach works best when the

product or service is sold in its present form to
outside customers and the selling division has
no idle capacity.
2. A market price approach does not work well
when the selling division has idle capacity.

© McGraw Hill 11-44

 Learning Objective 4

Charge operating departments for

services provided by service
departments.

© McGraw Hill 11-45

 Operating versus Service
Departments

Operating Departments
• Carry out central purposes of organization.

Service Departments
• Do not directly engage in operating activities.

© McGraw Hill 11-46

 Reasons for Charging Service
Department Costs
Service department costs are charged to operating
departments for a variety of reasons including:

To encourage operating To provide operating

departments to wisely use departments with more
service department complete cost data for
resources. making decisions.

To help measure the To create an incentive for

profitability of operating service departments to
departments. operate efficiently.

© McGraw Hill 11-47

 Charging Costs by Behavior 1

Variable and fixed service

department costs
should be charged to
operating departments
separately.

© McGraw Hill 11-48

 Charging Costs by Behavior 2

Variable service department

costs should be charged to
consuming departments
according to whatever activity
(or cost driver) causes the
incurrence of the cost.

© McGraw Hill 11-49

 Charging Costs by Behavior 3

Charge fixed service department costs to consuming

departments in predetermined lump-sum amounts that are
based on the consuming department’s peak-period or long-
run average servicing needs.
• Are based on amounts of capacity each consuming
department requires.
• Should not vary from period to period.

© McGraw Hill 11-50

 Should Actual or Budgeted
Costs Be Charged?

Budgeted variable and fixed

service department costs
should be charged to operating
departments.

© McGraw Hill 11-51

 Sipco – An Example
Sipco has a maintenance department and two operating
departments: Cutting and Assembly. Variable maintenance
costs are budgeted at $0.60 per machine hour. Fixed
maintenance costs are budgeted at $200,000 per year.
Data relating to the current year are:

Percent of
Peak-Period
Operating Capacity Hours
Departments Required Planned Hours Used
Cutting 60% 75,000 80,000
Assembly 40% 50,000 40,000
Total hours 100% 125,000 120,000

Allocate maintenance costs to the two operating departments.

© McGraw Hill 11-52
 Sipco – End of the Year 1

Actual hours

Cutting Assembly
Department Department
Variable cost allocation:
$0.60 × 80,000 hours $ 48,000
$0.60 × 40,000 hours $ 24,000
Fixed cost allocation:

. .

Total allocated cost . .

© McGraw Hill 11-53

 Sipco – End of the Year 2

Cutting Assembly
Department Department
Variable cost allocation:
$0.60 × 80,000 hours $ 48,000
$0.60 × 40,000 hours $ 24,000
Fixed cost allocation:
60% × $200,000 120,000
40% × $200,000 80,000
Total allocated cost $168,000 $104,000

60% × $200,000: Percent of peak-period capacity

© McGraw Hill 11-54

 Quick Check 1
Foster City has an ambulance service that is used by the
two public hospitals in the city. Variable ambulance costs
are budgeted at $4.20 per mile. Fixed ambulance costs are
budgeted at $120,000 per year. Data relating to the current
year are:
Percent of
Peak-Period
Capacity Miles Miles
Hospitals Required Planned Used
Mercy 45% 15,000 16,000
Northside 55% 17,000 17,500
Total 100% 32,000 33,500

© McGraw Hill 11-55

 Quick Check 1a
How much ambulance service cost will be allocated to Mercy
Hospital at the end of the year?
a. $121,200.
b. $254,400.
c. $139,500.
d. $117,000.

© McGraw Hill 11-56

 Quick Check 1b
How much ambulance service cost will be allocated to Mercy
Hospital at the end of the year?
a. Answer: $121,200.
b. $254,400.
c. $139,500.
d. $117,000.
Mercy Northside
Variable cost allocation:
$4.20 × 16,000 miles $ 67,200
$4.20 × 17,500 miles $ 73,500
Fixed cost allocation:
45% × $120,000 54,000
55% × $120,000 66,000
Total allocated cost $121,200 $139,500

© McGraw Hill 11-57

 Pitfalls in Allocating Fixed Costs
1

Allocating fixed
costs using a variable
allocation base that
fluctuates period to
period.
Fixed costs
allocated to one
department are
heavily influenced by
what happens in
other departments.

© McGraw Hill 11-58

 Pitfalls in Allocating Fixed Costs
2

Using sales
dollars as an
allocation base.

Sales of one department

influence the service
department costs
allocated to other
departments.

© McGraw Hill 11-59

 Autos R Us – An Example

Autos R Us has one service department and three

sales departments: New Cars, Used Cars, and Car
Parts. The service department costs total $80,000
for both years in the example. Contrary to good
practice, Autos R Us allocates the service
department costs based on sales.

© McGraw Hill 11-60

 Autos R Us – First-Year
Allocation
Department Department Department of
of New of Used Parts Total

Sales by department $1,500,000 $900,000 $600,000 $3,000,000

Percentage of total
sales 50% 30% 20% 100%
Allocation of service
department costs $40,000 $24,000 $16,000 $80,000

$1,500,000 ÷ $3,000,000
50% of $80,000

In the next year, the manager of the New Cars Department

increases sales by $500,000. Sales in the other departments
are unchanged. Let’s allocate the $80,000 service
department cost for the second year given the sales
increase.
© McGraw Hill 11-61
 Autos R Us – Second-Year
Allocation
Department of Department of Department of
New Used Parts Total

Sales by department $2,000,000 $900,000 $600,000 $3,500,000

Percentage of total
57% 26% 17% 100%
sales
Allocation of service
$45,714 $20,571 $13,715 $80,000
department costs

$2,000,000 ÷ $3,500,000
57% of $80,000

If you were the manager of the New Cars Department, you

would likely complain about the increased service
department costs allocated to your department.
© McGraw Hill 11-62
 End of Chapter 11

© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw Hill.