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CHAPTER 10
SEGMENTED REPORTING, INVESTMENT CENTER
EVALUATION, AND TRANSFER PRICING
QUESTIONS FOR WRITING AND DISCUSSION
1. In centralized decision making, decisions
are made at the very top level, and lower-
level managers are responsible for imple-
menting these decisions. For decentralized
decision making, decisions are made and
implemented by lower-level managers.
2. Decentralization is the delegation of deci-
sion-making authority to lower levels.
3. Reasons for decentralization include access
to local information, cognitive limitations,
more timely responses, focusing of central
management, training, and motivation.
4. The only difference is the way in which fixed
overhead costs are assigned. Under varia-
ble costing, fixed overhead is a period cost;
under absorption costing, it is a product
cost.
5. Absorption-costing income is greater be-
cause some of the period’s fixed overhead is
placed in inventory and not recognized on
the absorption-costing income statement.
6. Absorption costing. Variable costing would
recognize only the period’s fixed overhead
as an expense. The additional fixed over-
head expense must have come from inven-
tory.
7. Variable costing does not distort product
performance by allocating common fixed
costs. It allows managers to identify the con-
tributions individual segments are making
toward coverage of fixed costs.
8. Variable costing allows managers to identify
what the costs ought to be for various levels
of activity. By knowing what the costs ought
to be for the actual level of activity, meaning-
ful comparisons can be made to the costs
that actually occurred.
9. A direct fixed cost is traceable to a particular
cost object. A common fixed cost is common
to several cost objects. The distinction is im-
portant because direct fixed costs will vanish
if the cost object is eliminated but common
fixed costs will not.
10. Contribution margin is the amount available
to cover fixed expenses and provide for prof-
it. Segment margin is the amount available
to cover common fixed expenses and pro-
vide for profit for a segment. Contribution
margin is the difference between revenues
and variable expenses. Segment margin is
contribution margin less direct fixed ex-
penses for a segment.
11. Absorption-costing income can increase
from one period to the next if more is pro-
duced than what is sold. Even though the
fixed costs may not have changed, the fixed
costs recognized on the income statement
can change (because of inventory changes).
12. Different customer groups cause different
activities and costs. Understanding what ac-
tivities are unique to the various customer
groups can help the firm determine custom-
er profitability and also help it set different
prices for the customer groups.
13. Margin = Operating income/Sales, and
Turnover = Sales/Average operating assets.
By breaking ROI into margin and turnover,
more information is available to assess per-
formance. Knowledge of margin and turno-
ver gives more insight into why the ROI may
change from one period to the next.
14. ROI (1) encourages managers to pay atten-
tion to the relationships among sales, ex-
penses, and investment, (2) encourages
cost efficiency, and (3) discourages exces-
sive investment in operating assets. In-
creased profitability can be achieved (all
else being equal) by increasing revenues,
decreasing expenses, or lowering invest-
ment.
15. ROI may discourage managers from invest-
ing in projects that would increase the profit-
ability of the firm but decrease the division’s
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ROI. It also may encourage myopic behavior
by encouraging managers to make deci-
sions that are profitable in the short run but
harmful in the long run (e.g., cutting re-
search and development costs).
16. EVA is the difference between after-tax
operating income and the total annual cost
of capital.
17. Owners may have difficulty developing goal
congruence with managers because man-
agers may not want to work as hard as the
owner would like and because managers
may wish to use the company’s resources
for their own benefit. Properly structured in-
centive pay plans may be successful in
overcoming these problems.
18. A transfer price is the price charged for
goods that are transferred from one division
to another.
19. Transfer prices impact the revenues of the
transferring division and the costs of the
buying division and, thus, the profits of both
divisions. A transfer price can affect the prof-
its of the firm because it can affect the out-
put decision of the buying division. If the
price is set too high (low), then the output of
the buying division may be too low (high).
Since the transfer price can affect firmwide
profitability, higher management may be
tempted to interfere with the autonomy of a
division and dictate the price (rather than let-
ting the divisional manager make the pricing
decision).
20. The opportunity cost approach to transfer
pricing identifies the minimum and maximum
transfer prices. The minimum transfer price
is the one that makes the transferring divi-
sion no worse off, and the maximum transfer
price is the one that makes the buying divi-
sion no worse off.
21. Agree. At least one division will be made
better off, and firm profits will increase.
22. Market price. Minimum price = Maximum
price = Market price. Any other price would
make at least one division worse off, and
firm profits may decrease if the price is not
market price.
23. Negotiated transfer prices allow both divi-
sions to be made better off whenever oppor-
tunity costing signals that a transfer should
take place. Because both can be made bet-
ter off, no interference from headquarters is
needed. Moreover, the price emerging is
necessarily a mutually satisfactory price. In
effect, negotiated prices can simultaneously
satisfy the objectives of accurate perfor-
mance evaluation, firmwide efficiency, and
preservation of divisional autonomy. Disad-
vantages of negotiated transfer prices are
that (1) private information can be used for
exploitation, (2) performance measures are
distorted by relative negotiating skills of
managers, and (3) it is costly.
24. Three cost-based transfer prices are full
cost, full cost plus markup, and variable cost
plus fixed fee. Disadvantages are that prices
may not reflect the optimal outcome for the
divisions and for the firm. Specifically, it is
possible for the transfer price using one of
the costing approaches to be less than the
minimum price and greater than the maxi-
mum price. The prices, however, are simple
to use and, in some cases, may reflect the
outcome of a negotiated agreement.
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EXERCISES
10-1
Cost center – Total cost
Profit center – Operating income
Revenue Center – Sales
Investment center – Return on Investment
10–2
1. Total Cost Per Unit
Direct materials $ 120,600 $ 6.03
Direct labor 90,000 4.50
Variable overhead 26,400 1.32
Fixed overhead 68,000 3.40
Total $ 305,000 $ 15.25
Cost of ending inventory = $15.25 × 650 = $9,912.50
2. Total Cost Per Unit
Direct materials $ 120,600 $ 6.03
Direct labor 90,000 4.50
Variable overhead 26,400 1.32
Total $ 237,000 $ 11.85
Cost of ending inventory = $11.85 × 650 = $7,702.50
3. Since absorption costing is required for external reporting, the amount re-
ported would be $9,912.50.
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10–3
1. Fixed overhead rate = $107,500/25,000 = $4.30 per unit
The difference is computed as follows:
Fixed overhead rate(Production – Sales)
$4.30(25,000 – 23,000) = $8,600
2. a. Lextel, Inc.
Variable-Costing Income Statement
For the Year Ended December 31, 2008
Sales (23,000 × $26) …………………………………. $ 598,000
Less variable expenses:
Cost of goods sold (23,000 × $12.80) …… $ 294,400
Selling (23,000
× $4) ……………………………. 92,000 386,400
Contribution margin ………………………………… $ 211,600
Less fixed expenses:
Overhead ……………………………………………. $ 107,500
Selling and administrative …………………… 26,800 134,300
Operating income ……………………………………. $ 77,300
b. Lextel, Inc.
Absorption-Costing Income Statement
For the Year Ended December 31, 2008
Sales …………………………………………………………………………. $ 598,000
Less: Cost of goods sold (23,000 × $17.10) …………………. 393,300
Gross margin …………………………………………………………….. $ 204,700
Less: Selling and administrative expenses …………………. 118,800
Operating income ………………………………………………….. $ 85,900
10–4
1. Cocino Company
Product-Line Income Statements
Blenders
Coffee Makers Total
Sales $ 2,200,000 $ 1,125,000 $ 3,325,000
Less: Variable cost of goods sold 2,000,000 1,075,000 3,075,000
Contribution margin $ 200,000 $ 50,000 $ 250,000
Less: Direct fixed expenses 90,000 45,000 135,000
Product margin $ 110,000 $ 5,000 $ 115,000
Less: Common fixed expenses 115,000
Net income $ 0
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2. If the coffee-maker line is dropped, profits will decrease by $5,000, the prod-
uct margin. If the blender line is dropped, profits will decrease by $110,000.
3. Blenders
Coffee Makers Total
Sales $ 2,405,000 $ 1,125,000 $ 3,530,000
Less: Variable cost of goods sold 2,200,000 1,075,000 3,275,000
Contribution margin $ 205,000 $ 50,000 $ 255,000
Less: Direct fixed expenses 90,000 45,000 135,000
Product margin $ 115,000 $ 5,000 $ 120,000
Less: Common fixed expenses 115,000
Operating income $ 5,000
Profits increase by $5,000. Alternatively,
Increased profit = ($20.50 – $20.00) × 10,000 = $5,000
10–5
1. Absorption costing:
Direct materials $1.20
Direct labor 0.75
Variable overhead 0.65
Fixed overhead 3.10
Unit cost $5.70
Cost of ending inventory = $5.70 × 200 = $1,140
2. Variable costing:
Direct materials $1.20
Direct labor 0.75
Variable overhead 0.65
Unit cost $2.60
Cost of ending inventory = $2.60 × 200 = $520
3. Selling price $ 7.50
Less:
Variable cost of goods sold (2.60)
Commission (0.75)
Contribution margin per unit $ 4.15
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4. Sales ($7.50 × 17,600) …………………………. $ 132,000
Less:
Variable cost of goods sold ……………. $45,760
Commissions ………………………………… 13,200 58,960
Contribution margin ……………………………. $ 73,040
Less fixed expenses:
Fixed overhead ……………………………… $27,900
Fixed administrative ………………………. 23,000 50,900
Net income …………………………………………. $ 22,140
Variable costing should be used, since the fixed costs will not increase as
production and sales increase.
10–6
1. Operating income = Sales – Expenses = $50,000 − $48,000 = $2,000
2. Margin = Operating income/Sales
= $2,000/$50,000 = 0.04
Turnover = Sales/Operating assets
= $50,000/$10,000 = 5
3. ROI = Margin × Turnover = 0.04 × 5 = 0.20, or 20%
10–7
1. Average operating assets = ($78,650 + $81,350)/2 = $80,000
2. Margin = Operating income/Sales
= $7,200/$240,000 = 0.03
Turnover = Sales/Operating assets
= $240,000/$80,000 = 3.0
ROI = Margin × Turnover = 0.03 × 3.0 = 0.09, or 9.0%
10–8
1. a. ROI of division without radio = $480,000/$8,000,000 = 0.06
b. ROI of the radio project = $270,000/$1,500,000 = 0.18
c. ROI of division with radio = $750,000/$9,500,000 = 0.0789
2. Yes, Cheryl will decide to invest in the project, since overall division ROI will
increase.
10–9
1. After-tax cost of mortgage bonds = (1 – 0.3)(0.08) = 0.056
2. Cost of common stock = 0.06 + 0.06 = 0.12
3. Dollar After-Tax Weighted
Amount
Percent × Cost = Cost
Mortgage bonds $1,300,000 0.65 0.056 0.0364
Common stock 700,000 0.35 0.120 0.0420
Total $2,000,000
Weighted average cost of capital 0.0784
4. Cost of capital = $1,500,000 × 0.0784 = $117,600
5. After-tax operating income $115,000
Less: Cost of capital 117,600
EVA $ (2,600)
Because EVA is negative, Schipper is destroying wealth.
