MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 14
RESPONSIBILITY ACCOUNTING AND
TRANSFER PRICING
I.

Questions
1. Cost centers are evaluated by means of performance reports. Profit
centers are evaluated by means of contribution income statements
(including cost center performance reports), in terms of meeting sales and
cost objectives. Investment centers are evaluated by means of the rate of
return which they are able to generate on invested assets.
2. Overall profitability can be improved (1) by increasing sales, (2) by
reducing expenses, or (3) by reducing assets.
3. ROI may lead to dysfunctional decisions in that divisional managers may
reject otherwise profitable investment opportunities simply because they
would reduce the divisions overall ROI figure. The residual income
approach overcomes this problem by establishing a minimum rate of
return which the company wants to earn on its operating assets, thereby
motivating the manager to accept all investment opportunities promising a
return in excess of this minimum figure.
4. A cost center manager has control over cost, but not revenue or investment
funds. A profit center manager, by contrast, has control over both cost
and revenue. An investment center manager has control over cost and
revenue and investment funds.
5. The term transfer price means the price charged for a transfer of goods or
services between units of the same organization, such as two departments
or divisions. Transfer prices are needed for performance evaluation
purposes.
6. The use of market price for transfer purposes will create the actual
conditions under which the transferring and receiving units would be
operating if they were completely separate, autonomous companies. It is
generally felt that the creation of such conditions provides managerial
incentive, and leads to greater overall efficiency in operations.
7. Negotiated transfer prices should be used (1) when the volume involved is
large enough to justify quantity discounts, (2) when selling and/or
administrative expenses are less on intracompany sales, (3) when idle
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capacity exists, and (4) when no clear-cut market price exists (such as a
sister division being the only supplier of a good or service).
8. Suboptimization can result if transfer prices are set in a way that benefits
a particular division, but works to the disadvantage of the company as a
whole. An example would be a transfer between divisions when no
transfers should be made (e.g., where a better overall contribution margin
could be generated by selling at an intermediate stage, rather than
transferring to the next division). Suboptimization can also result if
transfer pricing is so inflexible that one division buys from the outside
when there is substantial idle capacity to produce the item internally. If
divisional managers are given full autonomy in setting, accepting, and
rejecting transfer prices, then either of these situations can be created,
through selfishness, desire to look good, pettiness, or bickering.
II. Exercises
Exercise 1 (Evaluation of a Profit Center)
No. Although Department 3 does not cover all of the cost allocated to it. It
contributes P21,000 to the total operations over and above its direct costs.
Without Department 3, the company would earn P21,000 less as compared
with the original over-all income of P47,000.

Revenue
Direct cost of department
Contribution of the
department
Allocated cost
Net income

Department
1
2
4
Total
P132,000 P168,000 P98,000 P398,000
82,000
108,000
61,000
251,000
P 50,000

P 60,000

P37,000 P147,000
121,000
P 26,000

With the discontinuance of Department 3, the revenue and direct cost of the
department are eliminated, but there is no reduction in the total allocated cost.
Exercise 2 (Evaluation of an Investment Center)
Requirement 1
ROI
P400,000

Operating assets
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RI
P400,000

Responsibility Accounting and Transfer Pricing Chapter 14

Operating income
ROI (P100,000 P400,000)
Minimum required income
(16% x P400,000)
RI (P100,000 - P64,000)

P100,000
25%

P100,000
P64,000
P36,000

Requirement 2
The manager of the Cling Division would not accept this project under the
ROI approach since the division is already earning 25%. Accepting this
project would reduce the present divisional performance, as shown below:
Operating assets
Operating income
ROI

Present
P400,000
P100,000
25%

New Project
P60,000
P12,000*
20%

Overall
P460,000
P112,000
24.35%

* P60,000 x 20% = P12,000

Under the RI approach, on the other hand, the manager would accept this
project since the new project provides a higher return than the minimum
required rate of return (20 percent vs. 16 percent). The new project would
increase the overall divisional residual income, as shown below:
Operating assets
Operating income
Minimum required
return at 16%
RI

Present
P400,000
P100,000

New Project
P60,000
P12,000

Overall
P460,000
P112,000

64,000
P 36,000

9,600*
P 2,400

73,600
P 38,400

* P60,000 x 16% = P9,600

Exercise 3 (ROI, Comparison of Three Divisions)

Requirement 1
ROI:

Division X
Division Y
Division Z
P10,000
P12,600
P 28,800
= 25%
= 18%
= 16%
P40,000
P70,000
P180,000
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Requirement 2
Division X would reject this investment opportunity since the addition would
lower the present divisional ROI. Divisions Y and Z would accept it because
they would look better in terms of their divisional ROI.
Exercise 4 (ROI, RI, Comparisons of Two Divisions)
Requirement 1
Net Operating income X
Sales
Division A :

Division B :

Sales
Average Operating Assets

P630,000
P9,000,000 X P9,000,000
P3,000,000
X
7%
3
P1,800,000 X
P20,000,000
X

9%

= ROI

= ROI
= 21%

P20,000,000
P10,000,000 = ROI
2

= 18%

Requirement 2
Average operating assets (a)..........
Net operating income....................
Minimum required return on average
operating assets - 16% x (a).....
Residual income............................

Division A
P3,000,000
P 630,000

Division B
P10,000,000
P 1,800,000

480,000
P 150,000

1,600,000
200,000

Requirement 3
No, Division B is simply larger than Division A and for this reason one would
expect that it would have a greater amount of residual income. As stated in
the text, residual income cant be used to compare the performance of
divisions of different sizes. Larger divisions will almost always look better,
not necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Division B does not appear to be
as well managed as Division A. Note from Part (2) that Division B has only
an 18 percent ROI as compared to 21 percent for Division A.
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Exercise 5 (Evaluation of a Cost Center)

(1) Controllable Costs by supervisor of Department 10 are as follows:
a. Supplies, Department 10
b. Repairs and Maintenance, Department 10
c. Labor Cost, Department 10
(2) Direct Costs of Department 10 are
a. Salary, supervisor of Department 10
b. Supplies, Department 10
c. Repairs and Maintenance, Department 10
d. Labor Cost, Department 10
(3) Costs allocated to Factory Department are:
a. Factory, heat and light
b. Depreciation, factory
c. Factory insurance
d. Salary of factory superintendent
(4) Costs which do not pertain to factory operations are:
a. Sales salaries and commissions
b. General office salaries

Exercise 6 (Evaluating New Investments Using Return on Investment

(ROI) and Residual Income)
Requirement 1
Computation of ROI
Division A:
ROI

P300,000
P6,000,000

P6,000,000
P1,500,000

= 5% x 4 = 20%

P900,000
P10,000,000

P10,000,000
P5,000,000

= 9% x 2 = 18%

Division B:
ROI

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Division C:
ROI

P180,000
P8,000,000

P8,000,000
P2,000,000

= 2.25% x 4 = 9%

Requirement 2
Average operating assets
Required rate of return
Required operating income
Actual operating income
Required operating income (above)
Residual income

Division A
P1,500,000

15%
P 225,000
P 300,000
225,000
P 75,000

Division B
P5,000,000

18%
P 900,000
P 900,000
900,000
P
0

Division C
P2,000,000

12%
P 240,000
P 180,000
240,000
P (60,000)

Division A
20%

Division B
18%

Division C
9%

Reject

Reject

Accept

15%

18%

12%

Accept

Reject

Accept

Requirement 3
a. and b.
Return on investment (ROI)
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would
Minimum required return for
computing residual income
Therefore, if the division is
presented with an investment
opportunity yielding 17%, it
probably would

If performance is being measured by ROI, both Division A and Division B

probably would reject the 17% investment opportunity. The reason is that
these companies are presently earning a return greater than 17%; thus, the
new investment would reduce the overall rate of return and place the divisional
managers in a less favorable light. Division C probably would accept the
17% investment opportunity, since its acceptance would increase the
Divisions overall rate of return.
If performance is being measured by residual income, both Division A and
Division C probably would accept the 17% investment opportunity. The 17%
rate of return promised by the new investment is greater than their required
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Responsibility Accounting and Transfer Pricing Chapter 14

rates of return of 15% and 12%, respectively, and would therefore add to the
total amount of their residual income. Division B would reject the
opportunity, since the 17% return on the new investment is less than Bs 18%
required rate of return.
Exercise 7 (Transfer Pricing from Viewpoint of the Entire Company)
Requirement 1
Sales
Less expenses:
Added by the division
Transfer price paid
Total expenses
Net operating income
1
2
3

Division A
P3,500,000

2,600,000

2,600,000
P 900,000

Division B
P2,400,000
1,200,000
700,000
1,900,000
P 500,000

Total Company
P5,200,000

3,800,000

3,800,000
P1,400,000

20,000 units P175 per unit = P3,500,000.

4,000 units P600 per unit = P2,400,000.
Division A outside sales (16,000 units P175 per unit)......................................................
P2,800,000
Division B outside sales (4,000 units P600 per unit)........................................................
2,400,000
Total outside sales..................................................................................................................
P5,200,000

Observe that the P700,000 in intracompany sales has been eliminated.

Requirement 2
Division A should transfer the 1,000 additional units to Division B. Note that
Division Bs processing adds P425 to each units selling price (Bs P600
selling price, less As P175 selling price = P425 increase), but it adds only
P300 in cost. Therefore, each tube transferred to Division B ultimately yields
P125 more in contribution margin (P425 P300 = P125) to the company than
can be obtained from selling to outside customers. Thus, the company as a
whole will be better off if Division A transfers the 1,000 additional tubes to
Division B.
Exercise 8 (Transfer Pricing Situations)
Requirement 1
The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
on lost sales
Variable cost
+
Transfer price
Number of units transferred
per unit
.
There is no idle capacity, so each of the 20,000 units transferred from Division
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Chapter 14 Responsibility Accounting and Transfer Pricing

X to Division Y reduces sales to outsiders by one unit. The contribution

margin per unit on outside sales is P20 (= P50 P30).
P20 x 20,000
Transfer price (P30 P2) +
20,000
Transfer price

P28 + P20

= P48

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P47. Therefore, Division Y would be unwilling to pay more than
P47 per unit.
Transfer price Cost of buying from outside supplier = P47
The requirements of the two divisions are incompatible and no transfer will
take place.

Requirement 2
In this case, Division X has enough idle capacity to satisfy Division Ys
demand. Therefore, there are no lost sales and the lowest acceptable price as
far as the selling division is concerned is the variable cost of P20 per unit.
Transfer price

P20 +

P0
20,000

P20

The buying division, Division Y, can purchase a similar unit from an outside
supplier for P34. Therefore, Division Y would be unwilling to pay more than
P34 per unit.
Transfer price Cost of buying from outside supplier = P34
In this case, the requirements of the two divisions are compatible and a
transfer will hopefully take place at a transfer price within the range:
P20 Transfer price P34
Exercise 9 (Transfer Pricing: Decision Making)
Requirement 1
Division As purchase decision from the overall firm perspective:
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Responsibility Accounting and Transfer Pricing Chapter 14

Purchase costs from outside

10,000 x P150 = P1,500,000
Less: Savings of Divisions Bs variable costs 10,000 x P140 = 1,400,000
Net Cost (Benefit) for A to buy outside
P 100,000
Assuming Division B has no outside sales, Division A should buy inside from
Division B for the benefit of the entire firm.
Requirement 2
As above, but in addition, if Division A buys outside, Division B saves an
additional P200,000.

Purchase costs from outside

Less: Savings in variable costs
Less: Savings of B material assignment
Net Cost (Benefit) for A to buy outside

10,000 x P150 = P1,500,000

10,000 x P140 = 1,400,000
200,000
P (100,000)

The additional savings in Division B means that now Division A should buy
outside.
Requirement 3
Assuming the outside price drops from P150 to P130:
Purchase costs from outside
Less: Savings in variable costs
Net Cost (Benefit) for A to buy outside

10,000 x P130 = P1,300,000

10,000 x P140 = 1,400,000
P (100,000)

Division A should buy outside.

III. Problems
Problem 1 (Evaluation of Profit Centers)
Requirement (a)
Jadlow Manufacturing Corporation
Income Statement
For the Year Ended December 31, 2005
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Sales
Less: Variable Costs
Contribution Margin
Less: Controllable fixed
expenses
Contribution to the recovery
of non-controllable fixed
expenses

Total
P5,100,000
3,330,000
P1,770,000

Product S
P2,700,000
1,890,000
P 810,000

Product T
P2,400,000
1,440,000
P 960,000

501,000

66,000

435,000

P1,269,000

P 744,000

P 525,000

Requirement (b)
The complaint of the manager of Product T is justified on the ground that his
product line shows a positive contribution margin and therefore, contributes to
the recovery of non-controllable fixed expenses. This observation is, of
course, made under the assumption that the preceding years figures (which
are not given) were less favorable than the current year.
Problem 2 (Evaluation of Profit Centers)
Requirement 1
Incremental sales
Less: Incremental costs
Net income

A
P71,000
42,000
P29,000

Product
B
P46,000
15,000
P31,000

C
P117,000
96,000
P 21,000

Product B seems to offer the best profit potential.

Requirement 2
The sunk costs are:
Depreciation of equipment
Operating cost of the equipment
Total

P 6,400
4,600
P11,000

Requirement 3
Opportunity cost of selling Product B is
From Product A
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Responsibility Accounting and Transfer Pricing Chapter 14

From Product C
Total

21,000
P50,000

Problem 3 (Evaluation of Performance)

Ranjie Tool Company
Performance Report
For the Year 2005
Budgeted Labor Hours
Actual Labor Hours

4,000
4,200

Budget
Based on
4,200
Hours

Variance
U (F)

P 3,600
7,400
5,300
P16,300

P 3,360
7,560
5,040
P15,960

P240
(160)
260
P340

P 1,600
2,200
6,000
5,400
1,200
P16,400
P32,700

P 1,600
2,200
6,000
5,400
1,200
P16,400
P32,360

Actual
4,200
Hours

Cost-Volume
Formula
Variable Overhead Costs:
Utilities
P0.80 per hour
Supplies
1.80
Indirect labor
1.20
Total
P3.80
Fixed Overhead Costs:
Utilities
Supplies
Depreciation
Indirect labor
Insurance
Total
Total Factory Overhead Costs

Problem 4 (Evaluation of Performance)

Requirement 1
Performance Report for the Production Manager

Controllable costs:
Direct material
Direct labor
Supplies
Maintenance
Total

Actual
Cost

Flexible
Budget Cost

Variance
(U) or (F)

P24,000
48,000
4,000
3,000
P79,000

P20,000
50,000
6,000
4,000
P80,000

P4,000 (U)
2,000 (F)
2,000 (F)
1,000 (F)
P1,000 (F)

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The cost of raw materials rose significantly, possibly because of (1) deficient
machinery due to the cutback in maintenance expenditures and/or (2) to the
lower labor cost, possibly due to the use of less-skilled workers. Supplies
decreased, indicating possible inadequacies for next periods production run.

Requirement 2
Performance Report for the Vice President
Actual
Cost
Controllable costs:
Marketing division
Production division
Personnel division
Other costs
Total

P104,000
79,000
72,000
68,800
P323,800

Flexible
Budget Cost

Variance
(U) or (F)

P102,000
80,000
76,000
70,000
P328,000

P2,000 (U)
1,000 (F)
4,000 (F)
1,200 (F)
P4,200 (F)

The marketing division is behind its cost allotment. The personnel division
came in somewhat under its budgeted costs. Perhaps there has been a cutback
in hiring, indicating possible reduction in future production.
Problem 5 (Target Sales Price; Return on Investment)
Requirement 1
Return on investment = Operating income / Investment
20% = X / P800,000
Target Operating Income = P160,000
Target revenues, calculated as follows:
Fixed overhead
Variable costs
Desired operating income
Revenues

1,500,000 x P300

The selling price per units is P540 = P810,000 / 1,500

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P200,000
450,000
160,000
P810,000

Responsibility Accounting and Transfer Pricing Chapter 14

Requirement 2
Data are in thousands.
Units
Revenues

1,500
P810

2,000
P1,080

1,000
P540

450
200
650

600
200
800

300
200
500

P160
20%
= P160 / P800

P280
35%
= P280 / P800

P 40
5%
= P40 / P800

Variable costs
Fixed costs
Total costs
Operating income
Return on investment

Note how the change in income follows the change in revenues, as predicted
by operating leverage. Operating leverage multiplied times the percentage
change in sales gives the percentage change in income. Thus, the greater the
operating leverage ratio, the larger the effect on income and ROI of a given
percentage change in sales. This exercise provides an opportunity to review
the relationship between volume and profit. See the illustration below:
Operating leverage = contribution margin / operating income
= (P810 P450) / P160 = 2.25
% change in income =
=

operating leverage x % change in revenues

2.25 x 33.33% = 75%

% change in income
If volume goes to 2,000 units: (P280 P160) / P160 = 75%
If volume goes to 1,000 units: (P160 P40) / P160 = 75%
% change in ROI
If volume goes to 2,000 units: (35% - 20%) / 20% = 75%
If volume goes to 1,000 units: (20% - 5%) / 20% = 75%
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Problem 6 (Contrasting Return on Investment (ROI) and Residual

Income)
Requirement 1
ROI computations:
ROI

Net operating income

Sales

Sales
Average operating assets

Pasig:

P630,000
P9,000,000

P9,000,000
P3,000,000

= 7% x 3 = 21%

Quezon:

P1,800,000
P20,000,000

P20,000,000
P10,000,000

= 9% x 2 = 18%

Requirement 2
Average operating assets (a)
Net operating income
Minimum required return on average
operating assets16% (a)
Residual income

Pasig
P3,000,000
P 630,000

Quezon
P10,000,000
P1,800,000

480,000
P 150,000

P 1,600,000
P 200,000

Requirement 3
No, the Quezon Division is simply larger than the Pasig Division and for this
reason one would expect that it would have a greater amount of residual
income. Residual income cant be used to compare the performance of
divisions of different sizes. Larger divisions will almost always look better,
not necessarily because of better management but because of the larger peso
figures involved. In fact, in the case above, Quezon does not appear to be as
well managed as Pasig. Note from Part (1) that Quezon has only an 18% ROI
as compared to 21% for Pasig.

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Problem 7 (Transfer Pricing)

Requirement 1
Since the Valve Division has idle capacity, it does not have to give up any
outside sales to take on the Pump Divisions business. Applying the formula
for the lowest acceptable transfer price from the viewpoint of the selling
division, we get:

Transfer price

Variable cost
+
per unit

Transfer price

P16 +

Total contribution margin

on lost sales
Number of units transferred
P0
10,000

P16

The Pump Division would be unwilling to pay more than P29, the price it is
currently paying an outside supplier for its valves. Therefore, the transfer
price must fall within the range:
P16 Transfer price P29
Requirement 2
Since the Valve Division is selling all of the valves that it can produce on the
outside market, it would have to give up some of these outside sales to take on
the Pump Divisions business. Thus, the Valve Division has an opportunity
cost, which is the total contribution margin on lost sales:

Transfer price

Variable cost
+
per unit

Transfer price

Total contribution margin

on lost sales
Number of units transferred
(P30 P16) x 10,000
10,000

P16 +

P16 + P14

P30

Since the Pump Division can purchase valves from an outside supplier at only
P29 per unit, no transfers will be made between the two divisions.
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Chapter 14 Responsibility Accounting and Transfer Pricing

Requirement 3
Applying the formula for the lowest acceptable price from the viewpoint of the
selling division, we get:

Transfer price

Variable cost
+
per unit

Transfer price

Total contribution margin

on lost sales
Number of units transferred

(P16 P3) +

P13 + P14

(P30 P16) x 10,000

10,000

P27

In this case, the transfer price must fall within the range:
P27 Transfer price P29
Problem 8 (Transfer Pricing)
To produce the 20,000 special valves, the Valve Division will have to give up
sales of 30,000 regular valves to outside customers. Applying the formula for
the lowest acceptable price from the viewpoint of the selling division, we get:

Transfer price

Variable cost
+
per unit

Transfer price

Total contribution margin

on lost sales
Number of units transferred
(P30 P16) x 30,000
20,000

P20 +

P20 + P21

IV. Multiple Choice Questions

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Responsibility Accounting and Transfer Pricing Chapter 14

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

C
D
A
A
C
A
D
A
C
A

11.
12.
13.
14.
15.
16.
17.
18.
19.
20.

E
D
C
C
B
C
B
A
B
A

21.
22.
23.
24.
25.
26.
27.
28.
29.
30.

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C
B
A
D
B
A
A
B
D
A

31.
32.
33.
34.
35.
36.
37.
38.
39.
40.

B
D
D
D
C
D
B
D
B
D