Ch5 45-60

P 5-17: Sunstar Appliances

MODEL CVP-6907Total Cost and Price

by Quantity

Quantity Manufacturing Cost Price

100 $1,450 $120

/105 1,496 116110 1,545 112115 1,596 108120 1,650 104125 1,706 100130 1,765 96135 1,826 92140 1,890 88145 1,956 84150 2,025 80

220 Chapter 5

Required:

a. Design and prepare a performance report for the three operating companies that youbelieve best measures each operating company's performance and which will be used incomputing the three professional managers' bonuses. In other words, using yourperformance measure, compute the performance of each of the three operatingcompanies.

b. Write a short memo explaining why you believe the performance measure you chose inpart (a) best measures the performance of the three professional managers .

Sunstar sells a full line of small home kitchen appliances, including toasters, coffee makers, blenders,and bread machines. It is organized into a marketing division and a manufacturing division. The man­ufacturing division is composed of several plants, each a cost center, making one type of appliance.The toaster plant makes several different models of toasters and toaster ovens. Most of the parts, suchas the heating elements and racks for each toaster, are purchased externally, but a few are manufac­tured in the plant , including the sheet metal forming the body of the toaster. The toaster plant has anumber of departments including sheet metal fabrication, purchasing, assembly, quality assurance,packaging, and shipping.

Each toaster model has a product manager who is responsible for manufacturing the product.Each product manager manages several similar models. Product managers, with the help ofpurchas­ing, negotiate prices and delivery schedules with external part vendors. Sunstar's corporate head­quarters sets all the toaster models' selling prices and quarterly production quotas to maximizeprofits. Product managers' compensation and promotions are based on lowering unit costs and meet­ing corporate headquarters ' production quota.

The product manager sets production schedule quotas for the product and is responsible for en­suring that the distribution division of Sunstar has the appropriate number of toasters at each distrib­ution center. Product managers have discretion over outsourcing, production methods, and laborscheduling to manufacture the particular models under their control. For example, they do not haveto produce the exact number of toasters set by corporate headquarters quarterly, but rather productmanagers have some discretion to produce more or fewer toasters as long as the distribution centershave enough inventory to meet demand .

The following data were collected for one particular toaster oven, model CVP-6907. These dataare corporate forecasts for model CVP-6907 in regard to how prices and total manufacturing costs areexpected to vary with the number of toasters manufactured (and sold) per day.

Required:

P 5-18: Stale-Mart

a. Calculate the return on total investment and residual income for the Broadway and HorseFalls stores.

221

4.6003.3001.425

$2.900

Horse Falls(Forecast)

0.9001.0500.210

$2.100

Broadway(Actual)

Responsibility Accounting and Transfer Pricing

Joan ,Chris is the Denver district manager of Stale-Mart, an old established chain of more than 100department stores. Her district contains eight stores in the Denver metropolitan area. One of herstores, the Broadway store, is over 30 years old. Chris began working at the Broadway store as anassistant buyer when the store first opened, and she has fond memories of the store. The Broadwaystore remains profitable, in part because it is mostly fully depreciated, even though it is small, is in alocation that is not seeing rising property values, and has had falling sales volume.

Stale-Mart owns neither the land nor the buildings that house its stores but rather leases themfrom developers. Lease payments are included in "operating income before depreciation." Each storerequires substantial leasehold improvements for interior decoration, display cases, and equipment.These expenditures are capitalized and depreciated as fixed assets by Stale-Mart. Leasehold im­provements are depreciated using accelerated methods with estimated lives substantially shorter thanthe economic life of the store.

All eight stores report to Chris, and, like all Stale-Mart district managers, 50 percent of her com­pensation is a bonus based on the average return on investment of the eight stores (total profits fromthe eight stores divided by the total eight-store investment). Investment in each store is the sum ofinventories, receivables, and leasehold improvements, net of accumulated depreciation.

She is considering a proposal to open a store in the new upscale Horse Falls Mall three milesfrom the Broadway store. If the Horse Falls proposal is accepted, the Broadway store will be closed.Here are data for the two stores (in millions of dollars):

In addition to the manufacturing costs reported in the table, there are $10 of variable selling anddistribution costs per toaster.

Required:

a. What daily production quantity would you expect the product manager for model CVP­6907 to set? Why?

b. Evaluate Sunstar's performance evaluation system as it pertains to product managers . Whatbehavior does it likely create among manufacturing product managers?

c. Describe the changes you would recommend Sunstar consider making in its performanceevaluation system for manufacturing product managers.

Average inventories and receivables during the yearLeasehold improvements, net of accumulated

depreciationOperating income before depreciationDepreciation of leasehold improvements

Assume that the forecasts for Horse Falls are accurate. Also assume that the Broadway store dataare likely to persist for the next four years with little variation .

Stale-Mart finds itself losing market share to newer chains that have opened stores in growthareas of the cities in which they operate. The rate of return on Stale-Mart stock lags that of other firmsin the retail department store industry. Its cost of capital is 20 percent.

P 5-20: Flat Images

Chapter 5

b. Chris expects to retire in five years. Do you expect her to accept the proposal to open theHorse Falls store and close the Broadway store? Explain why.

c. Offer a plausible hypothesis supported by facts in the problem that explains why Stale­Mart is losing market share and also explains the poor relative performance of its stockprice. What changes at Stale-Mart would you suggest to correct the problem?

$21.5$0.0$6.0

$100.014%

$150,000$200

Marketing

$300,000$800

Manufacturing

Earnings before R&D expendituresInterest expenseR&D expendituresTotal invested capital (excluding R&D assets)Weighted average cost of capital

Fixed cost (per month)Variable cost per screen

a. R&D Inc. writes off R&D expenditures as an operating expense. Calculate R&D Inc.'sEVA for the current year.

b. R&D Inc. decides to capitalize R&D and amortize it over three years. R&D expendituresfor the last three years have been $6.0 million per year. Calculate R&D Inc.'s EVA for thecurrent year after capitalizing the current year and previous years' R&D and amortizing thecapitalized R&D balance.

c. In the specific case of R&D Inc., how does capitalizing and amortizing R&D expendituresinstead of expensing R&D affect the incentive for managers approaching retirement tounderspend on R&D at R&D Inc.

Assume the tax rate is zero.

R&D Inc. has the following financial data for the current year (millions):

Required:

Flat Images develops and manufactures large , state-of-the-art flat-panel television screens that con­sumer electronic companies purchase and incorporate into a complete TV unit by adding the case,mounting brackets, tuner, amplifier, other electronics, and speakers. Flat Images has just introduceda new high-resolution, high-definition 60-inch screen. Flat Images is composed of two profit centers:Manufacturing and Marketing. Manufacturing produces sets that are sold internally to Marketing.Each profit center has the following cost structure:

Note that Marketing's fixed cost of $150 ,000 and variable cost of $200 per screen do not contain anytransfer price from Manufacturing. The numbers in the preceding table consist only of their owncosts, not any costs transferred from the other department.

The selling price that Marketing receives for each 60-inch screen depends on the number ofscreens sold that month, according to the following table .l"

222

P 5-19: R&D Inc.

24 An equivalent way to express the price-quantity relation in the table is P = $9,000 - 20Q , where P = priceand Q= quantity.

P 5-21: Premier Brands

Premier Brands buys and manages consumer personal products brands such as cosmetics, hair care,and personal hygiene. Premier management purchases underperforming brands and redesigns theirmarketing strategy and brand equity positioning, and then promotes the repositioned brand to themega-retail chains (Wal-Mart and Kmart) . Each product line manager is evaluated and rewardedbased on return on net assets (RONA). RONA is calculated as net income divided by net assets wherenet assets is total assets invested in the product line less current liabilities in the product line (RONA =

Net income / [Total assets - Current liabilities D. For every 1 percent of RONA (or fraction thereof)in excess of 12 percent of the product line returns, the product line manager receives a bonus of$250,000. So, if a manager's RONA is 13.68 percent, his or her bonus is $420,000 ([13.68% ­12.00%] X 100 X $250,000). Premier's weighted average cost of capital (WACC) is 12.43 percent.

Amy Guttman, one of Premier's three product line managers, manages a portfolio of four brandsin the hair care business. These four brands currently generate net income of $708,000, requiring $6.5million of total assets and $1.3 million ofcurrent liabilities. Guttman is evaluating two possible brandacquisitions: Brand 1 and Brand 2. The following table summarizes the salient information abouteach brand (thousands).

Required:

a. Suppose that Manufacturing sets a transfer price for each screen at $4,800. How manyscreens will Marketing purchase to maximize Marketing's profits (after Marketing paysManufacturing $4,800 per screen) and how much profit will Marketing make?

b. At a transfer price of $4,800 per screen, and assuming Marketing buys the number ofscreens you calculated in part (a), how much profit is Manufacturing reporting?

c. At an internal transfer price of $4,800, and assuming Marketing purchases the number ofscreens you calculate in part (a), what is Flat Images' profit?

d. Given the cost structures of Manufacturing and Marketing, and the price-quantity relationgiven in the problem, how many 60-inch screens should Flat Image manufacture and sellto maximize firmwide profits?

e. If (c) and (d) are the same, explain why they are the same. If they are different, explainwhy they are different.

f What transfer price should Flat Images set to maximize firmwide profits? (Give aquantitative number.)

223

Price

$8,0007,5007,0006,5006,0005,5005,0004,5004,0003,500

5075

100125150175200225250275

Quantity

Brand 1 Brand 2

Current liabilities $ 82 $ 498Net assets 522 1,546Net income 67 228Total assets 604 2,044

Responsibility Accounting and Transfer Pricing

Chapter 5

Required:

When it started the U.S. operation, Hochstedt invested 8.12 million ($5.8 X 1.4) euros when theexchange rate was 1.4 euros per U.S. dollar ($1 = €1.4). The exchange rate over the current year hasbeen constant at $1 = €1.57.

This table summarizes the operations of the U.S. subsidiary for the current calendar year:

$6.0

$6.0

€8.4

$14 million$ 8 million

€6.2 million

Equity of parent

Total equity

2.4

3.1

$6.0

$0.5

$3.00.6

HOCHSTEDT U.S. SUBSIDIARYBalance Sheet

Current Year (Millions)

HOCHSTEDT U.s. SUBSIDIARYCurrent-Year Operations

U.S. salesU.S. expenses (including depreciation)Imports from parent sold in the year

Current assets

a. Given Premier's incentive plan, will Amy Guttman acquire Brand 1 and/or Brand 2, orneither? Justify your answer with supporting calculations.

b. Suppose that Premier's WACC is 15.22 percent instead of 12.43 percent, and the bonussystem remains as described in the problem. How do Amy's decisions in part (a) change?Explain your answer.

c. Given the facts as stated in the problem, if you were the sole owner of Premier Products,would you acquire Brand 1 and/or Brand 2, or neither? Justify your answer with supportingcalculations.

d. Given the facts as stated in the problem except that Premier's WACC is 15.22 percentinstead of 12.43 percent, if you were the sole owner of Premier Products, would you acquireBrand 1 and/or Brand 2, or neither? Justify your answer with supporting calculations.

e. Why do some companies use RONA instead ofROA (net income/total assets)? In otherwords, describe how the incentives generated by using RONA differ from the incentivesfrom using ROA.

Hochstedt is a German firm with a wholly owned U.S. subsidiary. The parent firm manufactures andexports products from Germany to its U.S. subsidiary for sale in the United States. Hochstedt also haswholly owned subsidiaries in 14 other countries. The firm has a 35 percent cost of capital requirementon its foreign subsidiaries. Hochstedt invested $5.8 million in the U.S. operation three years ago. Theinvestment consisted of land, buildings, equipment, and working capital. Today, the book value of theinvestment (original cost less accumulated depreciation) is $6 million. Here is the balance sheet forthe U.S. subsidiary:

Buildings and equipmentCostAccumulated depreciation

Land

Total assets

Current investment in U.S. subsidiary stated in euros at the exchange rate at thetime of the investment of 1.4 euros per dollar($6 X 1.4€/$)

224

P 5-22: Hochstedt

P 5-23: Savannah Products

P 5-24: Westinghouse Electric Supply Contract

25 Cited in M Dugan and W Hughes , "Why Not Disclose Supply Commitments?" Management Accounting,July 1991, pp. 34-36.

225Responsibility Accounting and Transfer Pricing

Savannah Products, a small integrated wood and lumber products company with substantial timberholdings, has two divisions: Forest and Lumber. Forest Division manages the timber holdings, main­tains the land, and plants and harvests trees. It acquired its various forests over the last 50 years; itstotal asset value as stated on Savannah's balance sheet is $2.2 billion. Most of the timber the ForestDivision harvests is sold internally to the Lumber Division. Any harvested timber not sold to theLumber Division can be sold externally. Last year, the Forest Division sold 200 million board feet oftimber to external customers at $4.50 per board foot. A boardfoot is a standard unit of measure in thetimber business. Forest Division sold another 800 million board feet of timber to the Lumber Divi­sion. The Forest Division's operating expenses last year totaled $2 billion.

The Lumber Division only purchases timber from the Forest Division. The purchase price iscomputed as Lumber's share of Forest's operating expenses where the share is based on Lumber'sfraction of Forest's total board feet harvested. Lumber takes the timber from Forest, cuts it intolumber, and sells it to distributors. Lumber's total revenues, other operating expenses, and assets are$7.6 billion, $3.5 billion, and $2.7 billion, respectively. Lumber's operating expenses of $3.5 billiondo not include its pro rata share of Forest's operating expenses.

Savannah Products uses economic value added (EVA) to evaluate and reward the performanceof the senior managers in the two divisions. The risk-adjusted weighted-average cost of capital for theForest and Lumber Divisions is 15 percent and 20 percent, respectively.

Required:

a. Calculate the EVA of the Forest and Lumber Divisions.

b. Based on your calculations in (a), identify the most profitable division.

c. Do the calculations in (a) correctly identify the most profitable division? Explain why orwhy not.

d. What changes would you recommend Savannah Products make in its performancemeasurement scheme?

The U.S. subsidiary imported from the parent €6.2 million of product that it sold for $14 million. Itincurred expenses in the United States of $8 million. Ignore taxes.

Required:

a. Senior management of Hochstedt are interested in comparing the profitability of itsvarious foreign wholly owned subsidiaries. Prepare a performance report for the U.S.subsidiary for the current year.

b. List and discuss some of the issues that management must address in designing a measureof performance for its foreign subsidiaries.

Westinghouse Electric Corporation has entered into a number of long-term contractual agree­ments to sell up to 80 million tons of uranium to utility companies to encourage nuclear reactorconstruction and to secure sales of uranium. The contracts are optional to the purchasers at afixed price. The average contract price is approximately $9.50 per pound, and the current mar­ket price is $8.00 per pound . We cannot reasonably estimate the amount of purchases that willbe made under these agreements because of the optional nature of the contracts."

To induce utilities to award contracts to Westinghouse Electric to build nuclear reactors, Westing­house contracted to supply uranium to these utilities at an average price of $9.50 per pound over a20-year period. In 1966, Westinghouse disclosed in its annual report,

P 5-25: XBT Keyboards

Chapter 5

Required:

28.00

$88.00

$60.00

$10.0018.00

$ 3.0011.0013.009.004.00

12.008.00

Cost Data per XBT Keyboard

Variable CostsMaterials

Plastic for keysBaseKey socketsConnectors and cablesDirect labor, keysDirect labor, assemblyVariable overhead*

Fixed Costs"Key injection moldingFixed overhead

Unit manufacturing cost

a. How should the performance of the uranium supply division be measured?

b. Public utilities, including those with nuclear power generating plants, are regulated by statecommissions. State regulatory commissions set the utilities' prices for electricity based oncost plus a "fair return on capital." Cost is based on transactions prices. Given the facts inthe problem, how should managers of public utilities with Westinghouse Electric uraniumcontracts behave, in light of the difference between the contract price of $9.50 per poundof uranium and the current market price of $44.50?

By 1976, the market price of uranium was over $40 per pound. Westinghouse was unable to meetits commitments to deliver uranium and was faced with a potential loss of $2.275 billion, which wasover six times the company's net income in 1976. In 1976 , a new manager of the Westinghouse ura­nium supply division (USD) was hired. This division is responsible for the acquisition and sales ofuranium to utilities, both those that have Westinghouse reactors and those with competitor reactors.USD purchases raw uranium in world markets and then processes it into nuclear reactor fuel cells.This division is evaluated as a profit center. The new manager argues that because a number of long­term supply agreements were signed before he joined Westinghouse, USD 's revenues on these oldcontracts should be measured using the current market price rather than the original contract price.

The keyboard division ofXBT, a personal computer manufacturing firm, fabricates 50-key keyboardsfor both XBT and non-XBT computers. Keyboards for XBT machines are included as part ofthe XBT personal computer and are also sold separately. The keyboard division is a profit center.Keyboards included as part of the XBT PCs are transferred to the PC division at variable cost ($60)plus a 20 percent markup. The same keyboard, when sold separately (as a replacement part) or soldfor non-XBT machines, is priced at $100. Projected sales are 50,000 keyboards transferred to the PCdivision (included as part of the XBT PC) and 150,000 keyboards sold externally.

The keys for the keyboard are fabricated by XBT on leased plastic injection-molding machinesand then placed in purchased key sockets. These keys and sockets are assembled into a base, and con­nectors and cables are attached. Ten million keys are molded each year on four machines to meet theprojected demand of200,000 keyboards. Molding machines are leased for $500,000 per year per ma­chine; maximum practical capacity is 2.5 million keys per machine per year. The variable overheadaccount includes all of the variable factory overhead costs for both key manufacturing and assembly.Studies have shown that variable overhead is more highly correlated with direct labor dollars than anyother volume measure.

226

*Based on direct labor dollars .

tAt projected production of 200,000 keyboards.

P 5-26: Infantino Saab

Pre-owned Parts &New Cars Cars Service Total

Percent of land 50% 40% 10% 100%Percent of building 30% 10% 60% 100%Department Income $600,000 $1,725,000 $1,813,000 $4,138,000Other net assets $2,500,000 $6,700,000 $1,300,000 $10,500,000

Sara Litle, manager of the keyboard division, is considering a proposal to buy some keysfrom an outside vendor instead of fabricating them inside XBT. These keys (which do not include thesockets) will be used in the keyboards included with XBT PCs but not in keyboards sold separatelyor sold to non-XBT computer manufacturers. The lease on one of XBT's key injection-moldingmachines is about to expire and the capacity it provides can be easily shifted to the outside vendor.

The outside vendor will produce keys for $0.39 per key and will guarantee capacity of at least2.5 million keys per year. Litle is compensated based on the profits of the keyboard division. She isconsidering returning one of the injection-molding machines when its lease expires and purchasingkeys from the outside vendor.

227Responsibility Accounting and Transfer Pricing

Infantino Saab is a car dealership that has been in business for 40 years at the same 20-acre locationselling and servicing new and "pre-owned" (used) Saabs. Two years ago Infantino Saab replaced itsaging showroom and service center with a new, state-of-the-art facility. When Ms. Infantino's fatherstarted the dealership, the business was on the outskirts of town. Now with city sprawl, the dealershipis located on a busy commercial street surrounded by other dealerships, restaurants, and shoppingcenters.

The market for new cars is very competitive because many buyers shop on the Internet beforevisiting new car dealers. Once customers decide to purchase a new car from a dealer, they usuallytrade in their used car to avoid the hassle of selling the car themselves, and hence these new car buy­ers are willing to accept lower prices from car dealers for their trade-ins. Also, pre-owned cars havehigher margins because there is less competition for used cars, as each used car differs in terms ofmileage, condition, and options. Suppose a new car is sold for $45,000 ($500 over dealer cost) andthe buyer receives a trade-in allowance on his old car of $8,000 and pays the difference in cash. Thatused car is then sold for $10,800. The dealer makes $500 on the new car and $2,800 on the used car.Infantino also offers parts and service for the new and pre-owned cars it sells.

Infantino Saab is organized into three departments: New Cars, Pre-owned Cars, and Service. Allthree share the same building and lot where the new and used cars are displayed. Ms. Infantino com­pensates her three department heads based on residual income. After careful analysis by her financialmanager, they determine that all three departments should be charged for the capital invested in theirdepartments at 16 percent.

The new building cost $12 million and the land cost $900,000. The following table summarizesthe land and building utilization by each department, each department's net income, and other netassets invested in each department:

Required:

a. How much will XBT save per key if it outsources the 2.5 million keys rather thanproducing them internally?

b. What decision do you expect Sara Litle to make? Explain why.

c. If you were a large shareholder of XBT and knew all the facts, would you make the samedecision as Litle? Explain.

d. What changes in XBT's accounting system and/or organizational structure would yousuggest, given the facts of the case? Explain why.

P 5-27: University Medical Lab

228 Chapter 5

For example, the new car department occupies 50 percent of the land and 30 percent of the building.It had net income of $600,000 and other net assets of $2,500,000. Other net assets consist of all in­ventories and receivables (net of external financing) invested in the department. For example, the newcar department has a substantial inventory ofnew cars. But this new car inventory is mostly financedby short-term bank loans. The new car department pays interest on these loans, which is deducted(and hence included) in the new car department's net income of $600,000. Each department's incomeconsists of all revenues and expenses directly traceable to that department, including interest on anydebt used to finance the department's inventory. Income taxes are not included in each department'snet income reported in the table. Infantino Saab uses the trade-in allowance ofused cars taken in tradeas the transfer price of used cars in calculating the net incomes of the new and pre-owned cardepartments.

Required:

a. Calculate the residual income of each of the three divisions of Infantino Saab.

b. Discuss the relative profitability of the three departments. Which is making the mostmoney and which is making the least amount of money?

c. Discuss whether the residual incomes of the three departments capture the trueprofitability of each department. What problems do you see in the way Ms. Infantino isevaluating the performance of the three department managers and of Infantino Saab as awhole?

The University has a medical school that operates a large teaching hospital. Other smaller hospitalsin the region are independent of University Hospital in the sense that they are owned and operated byunaffiliated not-for-profit corporations.

University Hospital has a Medical Laboratory Department (MLD) that provides a wide rangeof medical tests including hematology, biopsies, electron microscopy, immunology, toxicology, andvirology. Few of the other independent hospitals in the region have the scale to provide the samecomprehensive range of tests that MLD provides. Consequently, other hospitals rely on MLD forsome of their lab tests.

For quality assurance and billing purposes, MLD tracks how much time laboratory techniciansspend on each test performed. Based on these time sheets and the salaries of the technicians, 70 per­cent of MLD's lab technician salary expense (direct labor cost) is incurred performing lab tests forpatients at University Hospital. The remaining 30 percent of MLD's lab technician direct labor costis incurred performing tests for patients at the other nonaffiliated hospitals. Direct labor cost consistsof the salaries and benefits of the lab technicians while they are performing test procedures."

MLD charges other departments at University Hospital the variable cost of performing the testswhere variable cost is the actual direct labor cost of the lab technician (salary and benefits) plus di­rect materials. Direct materials (laboratory materials, supplies, chemicals, and other consumables) are40 percent of direct labor. So, if the direct labor of a lab technician for a particular test is $120, theUniversity Hospital department requesting the test is charged $168 ($120 + 40% X $120).

The reason for charging University Hospital departments requesting lab work only the variable(direct) cost of the tests is to keep the cost of lab work down. The vast majority of patients at Univer­sity Hospital have HMO or other third-party insurance providers that pay University Hospital for

26 Suppose a technician who is paid $25 per hour and has benefits of 30 percent of her salary works 8 hoursone particular day-6 hours performing tests and the other 2 hours in training. Then the direct labor cost of thislab technician is $195 (6 hours X $25 X 1.3) and the other $65 (2 hours X $25 X 1.3) is charged to FixedOverhead.

Fixed overhead cost of $900,000 consists of supervision and administrative costs , occupancycosts, depreciation and leases of equipment, training, and so forth.

MEDICAL LABORATORY DEPARTMENTUniversity Hospital

Expenses(Most Recent Fiscal Year)

Wujo is a Shanghai company that designs high-end software to enhance and edit digital images. Itssoftware, EzPhoto, is more powerful and easier to use than Adobe Photoshop, but sells at a muchlower price. Currently, EzPhoto is written in Chinese for the Chinese market, but Wujo is entering theEnglish-speaking market. This requires a substantial investment to convert EzPhoto to English. Wujohas established a U.K. wholly owned subsidiary (Wujo U.K., or WUK for short) to sell EzPhoto toNorth American and European consumers-professional and serious amateur photographers. The

229

$1,400,000560,000900,000

Direct laborDirect materials & suppliesFixed overhead cost

Responsibility Accounting and Transfer Pricing

Required:

a. Based on the existing pricing arrangements for inside and outside users , prepare an incomestatement for MLD for the most recent fiscal year.

b. Given the income statement you prepared in part (a), discuss the financial condition ofMLD and the reasons for MLD's financial condition for the last fiscal year.

c. The manager of MLD believes that University Hospital departments sending specimens tohis department for testing are not paying their fair share of the costs of his departmentunder the current pricing arrangement. The MLD manager is proposing that inside users ofMLD be charged the full cost that his department incurs to provide testing services (directlabor plus direct material plus fixed overhead). The manager proposes that since MLD'sfixed costs are $900,000 and the direct labor costs are $1,400,000, then for every $1 ofdirect labor cost in each lab test, that lab test (for inside University Hospital departments)should be charged $0.6429 ($900,000/$1,400,000) of fixed overhead (in addition to thedirect material charge of $0.40 and the direct labor charge of $1). The pricing of lab testsfor outside users will not change. Prepare an income statement for MLD for the mostrecent fiscal year assuming the MLD manager's proposal is accepted .

d. Explain briefly why the net income figures computed in parts (a) and (c) differ.

e. Describe the likely consequences for MLD if its manager's suggestion described inpart (c) is implemented.

providing care to their clients. Before University Hospital can get reimbursed from these third-partyproviders , the insurance provider must preapprove the treatment plan (including lab tests). If theHospital does not get permission, the insurance provider might deny the charge. Since insuranceproviders base their approval decisions to some extent on the estimated cost of the treatment (includ­ing lab work), the Hospital wants to reduce the cost of lab tests to encourage the performance ofadequate test procedures.

Outside, unaffiliated hospitals are charged 200 percent of the direct cost of performing a test.So, if an outside (unaffiliated) hospital sends a specimen to MLD and requests a test that has a directlabor cost of$120, it is charged $336 ([$120 + 40% X $120] X 2).

The following table lists the expenses incurred by MLD in the most recent fiscal year.

P 5-28: Wujo

230 Chapter 5

following table displays the various combinations of prices and quantities it expects to sell EzPhototo English-speaking users:

Price Quantity(euros) (000)

270 130265 135260 140255 145250 150245 155240 160235 165230 170225 175

For example, at a price of €270 it expects to sell 130,000 units of EzPhoto, or at €225 it can sell175,000 units. To enter this market WUK must spend €15 million to convert EzPhoto from Chineseto English, advertise EzPhoto, establish a Web site where purchasers can download EzPhoto , and hirean administrative staff to market and maintain the Web site. For each English version ofEzPhoto sold,WUK expects to incur costs of €70 for sales commissions paid to third parties who market EzPhoto(e.g., Amazon, ZDNet.com, and Buy.com) and technical support for customers purchasing EzPhoto.EzPhoto will be distributed only via the WUK Web site. There are no packaging or CD-ROM costs.

WUK is evaluated and its managers compensated based on reported WUK profits. Wujo China,the parent company, is considering charging WUK a transfer price (actually a royalty) for each unitof EzPhoto WUK sells.

Required:

a. IfWujo China does not charge WUK a royalty for each unit of EzPhoto WUK sells (i.e.,the transfer price is zero), what price-quantity combination will WUK select and howmuch profit will WUK make?

b. IfWujo China charges WUK a royalty of €50 for each unit of EzPhoto WUK sells (i.e., thetransfer price is €50), what price-quantity combination will WUK select and how muchprofit will WUK make?

c. Ignoring any income taxes, what is the firm-value maximizing royalty (either zero euros or€50) that Wujo should charge WUK for each unit of EzPhoto WUK sells? Explain youranswer.

d. Wujo (the parent) has to pay income taxes to the People's Republic of China (PRC) at therate of 15 percent on any royalty payments it receives from WUK, while WUK faces aU.K. tax rate of33 percent on profits of EzPhoto. Note that WUK's taxable income iscalculated after deducting any transfer price (royalties) paid to Wujo. What is the firm­value maximizing royalty (either zero euros or €50) that Wujo should charge WUK foreach unit of EzPhoto WUK sells? Whichever transfer price Wujo charges WUK (zero or€50), that transfer price is used to (1) measure and reward WUK managers , and (2)calculate income taxes in the PRC and the U.K. Provide a detailed explanation supportedby calculations justifying your answer.

e. Suppose that Wujo is able to use a different transfer price for determining WUK's profits(and hence the compensation paid to WUK management) than it uses for calculatingincome taxes on its PRC and U.K. tax returns. What transfer prices should Wujo use forcalculating WUK's net income in determining WUK's managers' bonuses and for use onits two tax returns? The same transfer price has to be used on the two tax returns , but thistransfer price need not be the same transfer price used for calculating WUK 's income formanagement bonuses.

Required:

a. Calculate ROJ and residual income (1) before any corporate overhead allocations and(2) after corporate overhead allocations for each division.

Senior management is in the process of evaluating the relative performance ofeach division. TheNetherlands division generates the most profits and has the largest investment of assets, as indicatedby the following table:

231

€406€14

Total

€131€68.0%

US.

€195€48.0%

Netherlands

€80€48.0%

Australia

SWAN SYSTEMSMiscellaneous Operating Data ,

Last Fiscal Year(Millions of Euros)

SWAN SYSTEMSSummary of Operations, Last Fiscal Year

(Millions of Euros)

Australia Netherlands US. Total

Sales €50 €55 €75 €180Divisional expenses 38 33 58 129

-- -- -- --Net income €12 €22 €17 € 51

-- -- -- --

Responsibility Accounting and Transfer Pricing

f Why might you expect Wujo will be unable to implement the two transfer prices youpropose in (e)?

*Allocated based on divisional sales revenue.

Divisional net assetsAllocated corporate overhead*Cost of capital

Swan Systems developed and manufactures residential water filtration units that are installed undersinks. The filtration unit removes chlorine and other chemicals from drinking water. This Dutch com­pany has successfully expanded sales of its units in the European market for the past 12 years. Swanstarted a U.S. manufacturing and marketing division six years ago and an Australian manufacturingand marketing division three years ago. Here are summary operating data for the last fiscal year:

After careful consideration, senior management decided to examine the relative performance ofthe three divisions using several alternative measures of performance: ROJ (return on investment asmeasured by net assets, or total assets less liabilities), residual income (net income less the cost ofcapital times net assets), and both of these measures after allocated corporate overhead is subtractedfrom divisional income. The cost of capital in each division was estimated to be 8 percent. (Assumethis 8 percent estimate is accurate.)

There was much debate about whether corporate overhead should be allocated to the divisionsand subtracted from divisional income. It was decided to allocate back to each division that portionof corporate overhead that is incurred to support and manage the division. The allocated corporateoverhead items include worldwide marketing, legal expenses, and accounting and administration.Sales revenue was chosen as the allocation base because it is simple and best represents the cause­and-effect relation between the divisions and the generation of corporate overhead.

P 5-29: Swan Systems

Required:

Will the resources of the Creative Design Group be efficiently utilized under the new plan? Why?What are the merits and demerits of the existing plan? Is the proposed plan better than the existingone? Why or why not?

CasesCase 5-1: Troy Industrial Designs

Susan Willard, the CEO ofTroy Industrial Designs (TID) , has called a meeting to evaluate the presentmethod of charging the two offices at Washington and Rochester for the shared services of theCreative Design Group (CDG). She wants to discuss the present transfer price system and suggest abetter one.

TID is a reputable firm in the industrial design sector. It bids for design contracts from differentfirms. When a bid is accepted, TID either makes prototypes based on the client's blueprints, designsnew products out of existing designs , or draws designs for a product the client has in mind. TIDcharges clients a fixed figure upon completion of the job and 1 percent of sales accruing to the clientevery year for the first seven years for the use ofTID designs.

The two offices ofTID are independently run by different managers and are both profit centers .Each manager assigns account executives to individual accounts. The account executives are paid afixed salary, but a large part oftheir compensation is their bonus, which is based on the revenues accru­ing from the jobs they manage. Once receiving a job, each account executive informs George Scott, thehead of CDG. They meet with the client and discuss the details of the job, including specifications,requirements, and expected completion time. The client is consulted when the account executivereceives the preliminary design. As soon as the job for a client is finished, the account executive makesa detailed report explaining the work done, the number of designers employed for the job, the numberof hours worked on it, the amount billed to the client, and any follow-up needed. Designing is a one-timejob, and additional follow-up is rarely required. Account executives are responsible for any follow-upon the jobs done by them. If the client comes back with another project, it is treated as a separate job.

TID centralized the design departments of the two offices to take advantage of the specializedknowledge of the designers. Though CDG is only five years old, it employs the best talent and usesthe latest technology. This has had a positive impact on customers, and because of this, TID hasgrown rapidly in the past few years. The two offices have a lot of confidence in the Creative DesignGroup and use it for all their design needs. The rapid growth has caused top management to rethinkthe transfer pricing procedures and other organizational aspects of the business.

CDG is totally responsible for the designing part of the job. It interacts with the client only at thedesign stage; all other aspects of the job are done by the appropriate account executive. CDG worksin small teams, each led by a supervisor who reports to Scott daily. Scott is evaluated on the excessof revenues collected from the two offices over the costs ofhis department. The transfer price chargedto each office is decided before the designing job is taken by CDG. Before the client is brought in forthe discussion, the account executive and Scott decide what fees CDG will charge the office for theservices. Revenues for CDG come from the predetermined fees charged to the two offices.

Willard suggests that CDG should provide its services free of charge. Under this proposal, Scottwould receive a fixed salary and a bonus based on overall firm profits (i.e. , a percentage of the com­bined profits of the two offices). She thinks that as the cost of the department is finally consolidatedwith the costs of the firm, there should be no transfer prices for the department. Removal of the trans­fer price will help reduce the work of the accounting department and streamline the department tocope with the firm's rapid growth. Willard says that the firm is committed to designing the best prod­ucts and that transfer prices really do not matter.

232 Chapter 5

b. Discuss the differences among the various performance measures.

c. Based on the data presented in the case, evaluate the relative performance of the threeoperating divisions. Which division do you think performed the best and which performedthe worst?

Case 5-3: Executive Inn

Required:

a. Calculate the incremental cash flows to Celtex if the consumer products division obtainsQ47 from Synchem versus Meas Chemicals.

b. What advice would you give Debra Donak?

233Responsibility Accounting and Transfer Pricing

Celtex is a large and very successful decentralized specialty chemical producer organized into fiveindependent investment centers. Each of the five investment centers is free to buy products either in­side or outside the firm and is judged based on residual income. Most of each division's sales are toexternal customers. Celtex has the general reputation of being one of the top two or three companiesin each of its markets.

Don Horigan, president of the synthetic chemicals (Synchem) division, and Paul Juris, presidentof the consumer products division, are embroiled in a dispute. It all began two years ago when Jurisasked Horigan to modify a synthetic chemical for a new household cleaner. In return, Synchem wouldbe reimbursed for out-of-pocket costs. After Synchem spent considerable time perfecting the chemi­cal, Juris solicited competitive bids from Horigan and some outside firms and awarded the contractto an outside firm that was the low bidder. This angered Horigan, who expected his bid to receivespecial consideration because he developed the new chemical at cost and the outside vendors tookadvantage of his R&D.

The current conflict involves Synchem's production of chemical Q47, a standard product, forconsumer products. Because ofan economic slowdown, all synthetic chemical producers have excesscapacity. Synchem was asked to bid on supplying Q47 for the consumer products division. Consumerproducts is moving into a new, experimental product line, and Q47 is one of the key ingredients.While the order is small relative to Synchem's total business , the price of Q47 is very important in de­termining the profitability of the experimental line. Horigan bid $3.20 per gallon. Meas Chemicals,an outside firm, bid $3.00. Juris is angry because he knows that Horigan 's bid contains a substantialamount of fixed overhead and profit. Synchem buys the base raw material, Q4, from the organicchemicals division of Celtex for $1.00 per gallon. The organic chemical division 's out-of-pocket costs(i.e. , variable costs) are 80 percent of the selling price. Synchem then further processes Q4 into Q47and incurs additional variable costs of $1.75 per gallon. Synchem's fixed manufacturing overheadadds another $0.30 per gallon.

Horigan argues that he has $3.05 of cost in each gallon of Q47. If he turned around and soldthe product for anything less than $3.20, he would be undermining his recent attempts to get hissalespeople to stop cutting their bids and start quoting full-cost prices . Horigan has been trying toenhance the quality of the business he is getting, and he fears that if he is forced to make Q47 forconsumer products, all of his effort the last few months will be for naught. He argues that he alreadygave away the store once to consumer products and he won't do it again. He asks, "How can seniormanagers expect me to return a positive residual income if I am forced to put in bids that don'trecover full cost?"

Juris, in a chance meeting at the airport with Debra Donak, senior vice president of Celtex ,described the situation and asked Donak to intervene. Juris believed Horigan was trying to get evenafter their earlier clash. Juris argued that the success of his new product venture depended on beingable to secure a stable, high-quality supply of Q47 at low cost.

Sarah Adams manages Executive Inn of Toronto, a 200-room facility that rents furnished suites to ex­ecutives by the month. The market is for people relocating to Toronto and waiting for permanenthousing. Adams's compensation contains a fixed component and a bonus based on the net cash flowsfrom operations. She seeks to maximize her compensation. Adams likes her job and has learned a lot,but she expects to be working for a financial institution within five years.

Adams's occupancy rate is running at 98 percent, and she is considering a $10 million expansionof the present building to add more rental units. She has very good private knowledge of the future

Case 5-2: Celtex

234 Chapter 5

cash flows. In year 1, they will be $2 million and will decline $100,000 a year. The following tablesummarizes the expansion's cash flows:

Net Cash Net CashFlow Flow

Year (Millions) Year (Millions)

0 $(10.0) 6 1.51 2.0 7 1.42 1.9 8 1.33 1.8 9 1.24 1.7 10 1.15 1.6

Based on the preceding data, Adams prepares a discounted cash flow analysis of the addition, whichis contained in the following report:

Net Cash PresentFlow Discount Value of

Year (Millions) Factor Cash Flow

0 $(10.0) 1.000 $(10.00)1 '2.0 0.893 1.792 1.9 0.797 1.513 1.8 0.712 1.284 1.7 0.636 1.085 1.6 0.567 0.916 1.5 0.507 0.767 1.4 0.452 0.638 1.3 0.404 0.539 1.2 0.361 0.43

10 1.1 0.322 0.35

Total $ (0.73)

The discount factors are based on a weighted-average cost of capital of 12 percent, which accu­rately reflects the inn's nondiversifiable risk.

Adams's boss, Kathy Judson, manages the Inn Division of Comfort Inc., which has 15 proper­ties located around North America including Executive Inn ofToronto. Judson does not have the de­tailed knowledge of the Toronto hotel/rental market as Adams does. Her general knowledge is not asdetailed or as accurate as Adams's. (For the following questions, ignore taxes.)

Required:

a. The Inn Division of Comfort Inc. has a very crude accounting system that does not assignthe depreciation of particular inns to individual managers. As a result, Adams's annual netcash flow statement is based on the operating revenues less operating expenses. Neither thecost of expansion nor depreciation on expanding her inn is charged to her operating

Case 5-4: Royal Resort and Casino

Royal Resort and Casino (RRC), a publicly traded company, caters to affluent customers seeking plushsurroundings, high-quality food and entertainment, and all the "glitz" associated with the best resortsand casinos. RRC consists of three divisions: hotel, gaming, and entertainment. The hotel divisionmanages the reservation system and lodging operations. Gaming consists of operations, security, andjunkets. Junkets offers complimentary air fare and lodging and entertainment at RRC for customersknown to wager large sums. The entertainment division consists of restaurants, lounges, catering, andshows. It books lounge shows and top-name entertainment in the theater. Although many of those peo­ple attending the shows and eating in the restaurants stay at RRC, customers staying at other hotels andcasinos in the area also frequent RRC's shows, restaurants, and gaming operations. The following tabledisaggregates RRC's total EVA of $12 million into an EVA for each division:

Judson realizes that Adams's Projected cash flows are most likely optimistic, but she doesnot know how optimistic or even whether or not the project is a positive net present valueproject. She decides to change Adams's performance measure used in computing herbonus. Adams's compensation will be based on residual income (EVA). Judson alsochanges the accounting system to track asset expansion and depreciation on the expansion.Adams's profits from operations will now be charged for straight-line depreciation of theexpansion using a 10-year life (assume a zero salvage value). Calculate Adams's expectedresidual income from the expansion for each of the next 10 years.

c. Based on your calculations in (b), will Adams propose the expansion project? Explain why.

d. Instead of using residual income as Adams's performance measure in (b), Judson uses netcash flows from operations less straight-line depreciation. Will Adams seek to undertakethe expansion? Explain why.

e. Reconcile any differences in your answers for (c) and (d).

235

Net Cash PresentFlow Discount Value of

Year (Millions) Factor Cash Flow

0 $(10.0) 1.000 $(10.00)1 2.0 0.893 1.792 1.9 0.797 1.513 1.9 0.712 1.354 1.8 0.636 1.145 1.8 0.567 1.026 1.8 0.507 0.917 1.8 0.452 0.818 1.8 0.404 0.739 1.7 0.361 0.61

10 1.7 0.322 0.55--

Net present value $0.42--

statement. Given the facts provided so far, what decision do you expect her to makeregarding building the $10 million addition? Explain why.

b. Adams prepares the following report for Judson to justify the expansion project:

Responsibility Accounting and Transfer Pricing