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11.4 The limitations of market-based transfer prices exist when the market
price does not reflect the opportunity cost of the goods and services, for
example if idle capacity is present. Also, temporary short-run fluctuations
in market prices could lead to suboptimal long-run decisions. But the key
limitation is that market prices are often not readily available.
11.6 Companies often use prices other than market prices for interdivisional
transfers because (1) market prices may not be available, (2) market
prices can lead to suboptimal behavior when the supplier division has idle
capacity, or (3) the company is not otherwise indifferent between internal
and external buying.
11.7 The disadvantages of a negotiated transfer price system are that a great
deal of management effort may be used on the negotiating process and
that the negotiated price may be based more upon the manager's ability
to negotiate rather than other factors.
11-1 Solutions
11.8 This occurs when the benefits of an action to one division are more than
offset by harmful effects to another division. For example, the sale of a
critical component by one division to outside customers rather than to
another division may be harmful to the company as a whole if the second
division cannot obtain the component from other sources.
11.10 The use of the term "price" suggests an exchange of cash or promise to
pay cash. Divisions seldom actually exchange cash.
11.11 The Internal Revenue Service (IRS) disputed the transfer price because it
was not adjusted down in the face of decreasing demand for the product.
This caused the U.S. subsidiary to report lower profits and hence pay less
taxes than they would using the market price. For this reason, the IRS
wanted the transfer price lowered to what the IRS considered to be a
market price.
11.14 The economic basis for transfer pricing systems is that as long as the
transfer price is greater than the opportunity cost of the selling division
and less than the opportunity cost of the buying division, a transfer will be
encouraged.
Solutions 11-2
11.16 This statement may be correct depending on how ROI is calculated. If
assets are stated at acquisition cost and depreciable assets are stated net
of accumulated depreciation, then the statement is correct. The assets of
divisions with newer assets will be stated at more recent higher costs,
assuming inflation, and at a higher proportion of their acquisition costs.
With a larger denominator, the ROI of new divisions will be lower than for
older divisions, other things being the same.
11.17 ROI measures scale the division accounting profit by the investment
required, which facilitates comparison between divisions of various sizes.
Also, managers would have incentives to maximize accounting measures
of profit without regard to the investment required. (Use of economic
profits would not have this problem, of course.)
11.18 If the return on a specific project is greater than the company's cost of
capital, but has an accounting ROI that is lower than the division's ROI, a
division manager would have an incentive to avoid that project even
though it meets the company's cost of capital requirements. This is
because it would lower the division’s ROI, which is weighted according to
investment and return.
11.19 By maximizing economic value added, managers will accept all projects
above the minimum acceptable rate of return.
11.20 According to the general rule when the selling division is below capacity
the transfer price should be set at the differential cost. The buying
division will then choose the least costly alternative between internal or
external purchasing, which will also be the least costly for the company.
Setting the transfer price higher can lead to the incorrect decisions for the
company as a whole.
11-3 Solutions
11.21 (Transfer pricing.)
a. b.
Market-Based Negotiated
Transfer Price Transfer Price
New York New Jersey New York New Jersey
Division Division Division Division
Sales............................ $ 600,000a $1,500,000 $ 470,000c $1,500,000
Costs of Goods Sold..... (440,000) (840,000)b (440,000) (710,000)d
Selling and Adminis-
trative Expenses........ (120,000) (200,000) (120,000) (200,000)
Operating Profit............ $ 40,000 $ 460,000 $ (90,000) $ 590,000
Total Company............. $500,000 $500,000
a$600,000 = $.40 X 1,500,000 gallons.
b$840,000 = ($.40 X 1,300,000 gallons) + $320,000.
c$470,000 = ($.40 X 200,000 gallons) + ($.30 X 1,300,000 gallons).
d$710,000 = ($.30 X 1,300,000 gallons) + $320,000.
c. Although the company has the same total profit, the statement is
incorrect if the type of transfer price used has an effect on the
decisions of people in either division. For example, the use of a cost-
based transfer price may provide no incentive for divisions to control
costs because they will always have zero net income. Managers may
choose not to sell to other divisions at a loss to their divisions, forcing
the buying divisions to go outside the company.
Solutions 11-4
11.22 (Return on investment computations.)
All amounts in thousands of dollars (000 omitted).
a. Miami Division: $500/$4,000= 12.5%;
Now subtract each of the above allocations from $500 and divide by
each division’s divisional investment. For Miami, for example:
Miami: ($500 - $120)/$4,000 = 9.5%
Kansas City: 7.0%
Seattle: 5.33%
Now subtract each of the above allocations from $500 and divide by
each division’s divisional investment. For Miami, for example:
Miami: ($500 - $180)/$4,000 = 8.0%
Kansas City: 7.0%
Seattle: 6.33%
Now subtract each of the above allocations from $500 and divide by
each division’s divisional investment. For Miami, for example:
Miami: ($500 - $225)/$4,000 = 6.88%
Kansas City: 7.6%
Seattle: 6.58%
:
11-5 Solutions
11.23 (ROI computations with a capital charge.)
Solutions 11-6
a. Toronto Division: $800,000/$4,000,000= 20%
Phoenix Division: $1,200,000/$7,500,000 = 16%
11-7 Solutions
a. U.S. Division: $3,000,000/$20,000,000 = 15%
Australian Division: $4,000,000/$50,000,000 = 8%
Solutions 11-8
11.26 (Comparing profit margin and ROI as performance measures.)
8% = 5.88% X 1.36
a. Using the profit margin percentage, the ranking of the districts is New
Orleans, Denver, and then Chicago.
b. Using ROI, the ranking of districts is Denver, New Orleans, and then
Chicago.
11-9 Solutions
11.27 (Profit margin and investment turnover ratio computations.)
= X
12% = 6% X 2.0
Solutions 11-10
11.29 (Transfer pricing [CPA adapted].)
It would cost the company $45,000 if Pre-Fab purchased units from the
outside supplier for $230 each. This $45,000 is the difference between
the price paid for the units from an outside supplier ($230) and the
differential cost of producing in the Hardware Division ($200) times the
1,500 units in the order. The fixed costs are sunk and, therefore, do not
enter into the decision. Both the company and Hardware would be
$45,000 worse off if Pre-Fab purchased from an outsider. Pre-Fab would
not be affected whether paying $230 per unit to hardware or to an
outsider. If management enforced the $260 transfer price and insisted
that Pre-Fab purchase the units from Hardware, then the overall company
profits would not be affected by the transfer price increase. However,
Hardware would gain $45,000 while Pre-Fab would lose $45,000
compared to the current situation.
a. Total
Auditors Consultants Accounting
(Buyers) (Sellers) Firm
Buy Services Internally Pay $200 Receive $ 200 Pays $ 0
Pay 70 Pays 70
Pays $ 70
b. Total
Auditors Consultants Accounting
(Buyers) (Sellers) Firm
Buy Services Internally Pay $200 Receive $200 Pays $ 0
Pay 70 Pays 70
Pays $ 70
11-11 Solutions
11.31 ( ROI and EVA using the internet.)
a. Return on Investment:
c. The manager of the Asia Division is doing the best job based on ROI
because it has the highest return. The Asia Division manager is also
doing best with EVA of $10,400. Although Europe has the next
highest EVA, it is earned with substantially more assets ($175,000
versus $150,000) and more capital employed ($160,000 versus
$140,000) than the U.S. Coupled with the fact that the U.S. has a
slightly higher ROI, the U.S. probably earns the overall second place
as to divisional performance.
Solutions 11-12
11.33 (Keller Company; transfer pricing.)
11-13 Solutions
11. 34. Transfer pricing, with taxes
a. Use $7 million
transfer price
Asian European
Revenue $7,000,000 $30,000,000
Third-party costs (6,000,000) ( 8,000,000)
Transferred goods costs _________ ( 7,000,000)
Taxable income $1,000,000 $15,000,000
Tax rate x 40% x 70%
Tax liability $400,000 $10,500,000
Solutions 11-14
11.35 (Biases in ROI computations.)
11-15 Solutions
accumulated depreciation or even stated at current replacement cost
in new condition.
Solutions 11-16
11.36 (Issues in designing ROI measures.)
6. What is the basis for the transfer price set for central engineering
services? Does this represent a market price for the services in
Brazil? If not, the foreign division should probably have the flexibility
to purchase the services locally.
11-17 Solutions
11.37 (ROI and residual income.)
c. If the ROI for a division decreases then the ROI for the company will also
decrease, holding everything else constant.
d. (2) and the manager might choose either (3) or (4). Using ROI to measure
performance, the manager of Shellfish has incentives not to purchase Shrimp
because that purchase will lower Shellfish’s ROI. Using residual income, the
Shellfish manager would be indifferent about the purchase because the
purchase would not affect Shellfish’s residual income. In our experience,
managers are risk averse. The manager of Shellfish would not purchase
Shrimp if risk averse because there is likely a 50% probability that the residual
income will be negative instead of zero.
Solutions 11-18
11.38. (ROI and EVA)
b. Division A has the higher ROI, implying that it uses its assets more
efficiently. Division A is also generating more economic profit than
Division B even though it is smaller. If the ROI numbers are recomputed
using EVA’s measure of investment (assets – current liabilities) then the
new ROI numbers are the following: A--$42,000/$140,000 = 30%; B--
$63,000/$330,000 = 19.09%. Division A’s ROI is greater than Division
B’s ROI. Division A wins.
11-19 Solutions
25,200 in
requirement a.
ROI would drop, while EVA would increase a little. Using the ROI
performance measure creates a conflict for the manager. Taking
the project would be good for company value because it has a
positive NPV, but the manager would look worse because divisional
ROI would decrease.
Solutions 11-20
11.39 (ROI and EVA)
b. Division X has the higher ROI, implying that it uses its assets more
efficiently. However, Division Z is also generating more economic profit
than Division X because it is larger. If one could invest in only one or the
other division, then the investor would choose Division Z because it
generates more economic value than Division X.
11-21 Solutions
requirement a.
ROI would drop. EVA would decrease very little. Using the ROI
performance measure creates a conflict for the manager. Taking
the project would be good for company value because it has a
positive NPV, but the manager would look worse because divisional
ROI would decrease. Using EVA, the division’s performance would
look worse, but not by as much.
Solutions 11-22
11.40 (Evaluating profit impact of alternative transfer price [CMA adapted].)
Revenue............. $10,000
Cost.................... 7,200
Profit................ $ 2,800
Revenue............. $63,900
Cost.................... 58,400 ($48,400 + $10,000)
Profit.................. $ 5,500
Revenue............. $63,900
Cost.................... 55,600 ($48,400 + $7,200)
$ 8,300
b.
(1) Yes. Bottle Division:
Volume
Cases........................................... 2,000 4,000 6,000
Revenue...................................... $ 4,000 $ 7,000 $10,000
Cost............................................. 3,200 5,200 7,200
Profit............................................ $ 800 $ 1,800 $ 2,800
Volume
Cases........................................ 2,000 4,000 6,000
Revenue.................................... $25,000 $45,600 $63,900
Costa......................................... 20,400 39,400 58,400
Profit......................................... $ 4,600 $ 6,200 $ 5,500
Volume
Cases........................................ 2,000 4,000 6,000
Revenue.................................... $25,000 $45,600 $63,900
Costb......................................... 19,600 37,600 55,600
Profit......................................... $ 5,400 $ 8,000 $ 8,300
11-23 Solutions
$58,400 = $48,400 + $10,000.
Solutions 11-24
11.41 (Impact of division performance measures on management incentives.)
Reject Accept
New Project New Project
Division A
Income from:
Existing Assets (.40 X $60,000).............. $24,000 $24,000
New Project (.30 X $30,000)................... --- 9,000
(1) Net Income................................................ $24,000 $33,000
Assets Employed:
Existing Assets................................... $60,000 $60,000
New Project's Assets.......................... --- 30,000
(2) Total Assets............................................... $60,000 $90,000
Rate of Return on Investment (1)/(2)......... 40.0% 36.7%
Net Income................................................ $24,000 $33,000
Less Minimum Acceptable Return on
Invested Assets [= .20 X (2)]................. 12,000 18,000
Income in Excess of Company Minimum. . . $12,000 $15,000
Division B
Income from:
Existing Assets (.25 X $60,000).............. $15,000 $15,000
New Project (.30 X $30,000)................... --- 9,000
(1) Net Income................................................ $15,000 $24,000
Assets Employed:
Existing Assets................................... $60,000 $60,000
New Project's Assets.......................... --- 30,000
(2) Total Assets............................................... $60,000 $90,000
Rate of Return on Investment (1)/(2)......... 25.0% 26.7%
Net Income................................................ $15,000 $24,000
Less Minimum Acceptable Return on
Invested Assets [= .20 X (2)]................. 12,000 18,000
Income in Excess of Company Minimum. . . $ 3,000 $ 6,000
11-25 Solutions
11.41 continued.
Solutions 11-26
11.42 (Diversified Electronics; capital investment analysis and decentralized
performance measurement—a comprehensive case.)
a. Ralph Browning's new product proposal was rejected because its ROI
was less than 15 percent after tax.
Project ROI =
= [$230,000 (1.0.40)]/$1,000,000
= 13.8%.
11-27 Solutions
11.42 a. continued.
Project Year 0 1 2 3 4 5 6 7 8
Investment
(1) Land $ (200,000) $400,000
PV Factors (15%) 1.000 .86957 .75614 .65752 .57175 .49718 .43233 .37594 .32690
PV of Cash Flows $(1,000,000) $227,827 $242,116 $197,506 $177,207 $167,198 $137,862 $131,868 $230,741
Solutions 11-28
11.42 continued.
11-29 Solutions
11.42 continued.
Solutions 11-30
11.43 (Custom Freight Systems (A); transfer pricing.)
a. The Logistics Division should accept the bid from the Forwarders
Division. Custom Freight Systems is $72 better off if the Logistics
division uses the Forwarders division for this contract.
Air
Cargo Forwarders Logistics
Division Division Division
Sales........................................... $ 155 $ 210 -0-
Variable Costs:
($155 X 60%)......................... 93
($175 – $155)........................ 20
(from Air Cargo Division)....... 155
(from Forwarders Division).... $ 210
Operating Profit/(Cost)............... $ 62 $ 35 $ (210)
Opportunity
Cost of
Differential + Transferring = Transfer
Outlay Cost Internally Price
If the seller (the division
supplying the goods or ser-
vices) has idle capacity......... $175 + $ 0 = $175
11-31 Solutions
11.43 continued.
• Tell the Logistics and Forwarders divisions that the transfer price
will be between differential cost of $113 (which is the sum of the
Air Cargo variable cost of $93 and the added variable cost for
Forwarders of $20) and the lowest outside market price of $185
and allow them to negotiate the profit.
Solutions 11-32
11.44 (Custom Freight Systems (B); transfer pricing.)
Similar to Case A, the Logistics Division should accept the bid from the
Forwarders Division. However, if we eliminate the Forwarders Division
from the bidding process, the bid from World should be accepted.
Emphasize that even though World’s bid is $10 per hundred higher than
United’s, the overall cost to Custom Freight Systems is lower because
other divisions of Custom Freight Systems are included in the bid.
Air
Cargo Forwarders Logistics
Division
Division
Division
Sales........................................... $ 155 $ 210 -0-
Variable Costs:
($155 X 60%)......................... 93
($175 – $155)........................ 20
(from Air Cargo Division)....... 155
(from Forwarders Division).... $ 210
Operating Profit/(Cost)............... $ 62 $ 35 $ (210)
Air
Cargo Forwarders Logistics
Division
Division
Division
Sales........................................... $ 155 $ -0- -0-
Variable Costs: 93 $ 195
Operating Profit/(Cost)............... $ 62 $ -0- $ (195)
11-33 Solutions