Chapter 13 – Investment Centers and Transfer Pricing
13-1
CHAPTER 13
Investment Centers and Transfer Pricing
ANSWERS TO REVIEW QUESTIONS
13-1 The managerial accountant’s primary objective in designing a responsibility-
13-2 Goal congruence means a meshing of objectives, in which the managers throughout
an organization strive to achieve goals that are consistent with the goals set by top
13-3 Under the management-by-objectives (MBO) philosophy, managers participate in
setting goals that they then strive to achieve. These goals may be expressed in
13-4 An investment center is a responsibility-accounting center, the manager of which is
held accountable not only for the investment center’s profit but also for the capital
13-6 A division’s ROI can be improved by improving the sales margin, by improving the
capital turnover, or by some combination of the two. The manager of the Automobile
Chapter 13 – Investment Centers and Transfer Pricing
13-2
13-7 Example of the calculation of residual income: Suppose an investment center’s profit
is $100,000, invested capital is $800,000, and the imputed interest rate is 12 percent:
13-8 The chief disadvantage of ROI is that for an investment that earns a rate of return
greater than the company’s cost of raising capital, the manager in charge of deciding
13-9 The rise in ROI or residual income across time results from the fact that periodic
depreciation charges reduce the book value of the asset, which is generally used in
determining the investment base to use in the ROI or residual-income calculation.
13–10 The economic value added (EVA) is defined as follows:
−−=
capital
ofcost
average–Weighted
sliabilitiecurrent
scenter’
Investment
assets total
scenter’
Investment
income operating
tax–after
scenter’ Investment
added
value
Economic
13-3
13–11 a. Total assets: Includes all divisional assets. This measure of invested capital is
13–12 The use of gross book value instead of net book value to measure a division’s
invested capital eliminates the problem of an artificially increasing ROI or residual
13–13 It is important to make a distinction between an investment center and its manager,
because in evaluating the manager’s performance, only revenues and costs that the
13–14 Pay for performance is a one-time cash payment to an investment-center manager as
13–15 An alternative to using ROI or residual income to evaluate a division is to look at its
income and invested capital separately. Actual divisional profit for a period of time is
Chapter 13 – Investment Centers and Transfer Pricing
13-4
13–16 During periods of inflation, historical-cost asset values soon cease to reflect the cost
of replacing those assets. Therefore, some accountants argue that investment-center
13–17 Examples of nonfinancial measures that could be used to evaluate a division of an
insurance company include the following: (1) new policies issued and insurance
13–18 Nonfinancial information is useful in measuring investment-center performance
because it gives top management insight into the summary financial measures such
13–19 The goal in setting transfer prices is to establish incentives for autonomous division
managers to make decisions that support the overall goals of the organization.
13–20 Four methods by which transfer prices may be set are as follows:
(a) Transfer price = additional outlay costs incurred because goods are transferred +
13–21 When the transferring division has excess capacity, the opportunity cost of
producing a unit for transfer is zero.
Chapter 13 – Investment Centers and Transfer Pricing
13-5
13–22 The management of a multinational company has an incentive to set transfer prices
so as to minimize the income reported for divisions in countries with relatively high
13–23 Multinational firms may be charged import duties, or tariffs, on goods transferred
between divisions in different countries. These duties often are based on the
Chapter 13 – Investment Centers and Transfer Pricing
13-6
SOLUTIONS TO EXERCISES
EXERCISE 13-24 (10 MINUTES)
Sales margin
=
=
=
=
2.5
=
=
=
20%
income
=
0$10,000,00
=
8%
EXERCISE 13-25 (15 MINUTES)
There are an infinite number of ways to improve the division’s ROI to 25 percent. Here are
two of them:
1.
Improve the sales margin to 10 percent by increasing income to $12,500,000:
ROI
=
sales margin capital turnover
2.
Improve the turnover to 3.125 by decreasing average invested capital to $40,000,000:
ROI
=
sales margin capital turnover
13-7
EXERCISE 13-26 (5 MINUTES)
=
$4,500,000
EXERCISE 13-27 (15 MINUTES)
1.
Sales margin
=
revenue sales
income
=
6,000,000
*300,000
=
5%
*Income = £300,000 = £6,000,000 – £3,300,000 – £2,400,000
capital invested
3,000,000
capital invested
income
3,000,000
300,000
£
£
£
£
2.
ROI = 15%
=
capital invested
income
=
3,000,000
income
=
sales revenue – expenses = £450,000
=
£6,000,000 – expenses = £450,000
=
£5,550,000
3.
Sales margin
=
revenue sales
income
=
7.5%
6,000,000
450,000 =
£
£
£
£
£
13-8
EXERCISE 13-28 (30 MINUTES)
1. Students’ calculation of return on investment and residual income will depend on the
2. Some companies’ annual reports include a calculation and discussion of ROI in the
EXERCISE 13-29 (30 MINUTES)
1.
Average investment in productive assets:
Balance on 12/31/x1 ……………………………………………………………………………
$25,200,000
Balance on 1/1/x1 ($25,200,000 1.05)…………………………………………………
24,000,000
Beginning balance plus ending balance ………………………………………………
$49,200,000
Average balance ($49,200,000 2) ………………………………………………………
a.
ROI
=
assets productive average
taxesincome before operations from income
=
b.
Income from operations before income taxes ……………………………….
$ 4,920,000
Less: imputed interest charge:
Average productive assets …………………………………
Imputed interest charge …………………………………………………………..
Residual income ………………………………………………………………………….
$ 1,230,000
Chapter 13 – Investment Centers and Transfer Pricing
13-9
EXERCISE 13-29 (CONTINUED)
2.
Yes, Fairmont’s management probably would have accepted the investment if residual
income were used. The investment opportunity would have lowered Fairmont’s 20×1
EXERCISE 13-30 (15 MINUTES)
Memorandum
Date:
Today
To:
President, Suncoast Food Centers
From:
I. M. Student
Subject:
Behavior of ROI over time
13–10
EXERCISE 13-31 (10 MINUTES)
1.
The same employee is responsible for keeping the inventory records and taking the
physical inventory count. In addition, when the records and the count do not agree, the
2.
The internal control system could be strengthened in two ways:
(a)
Assign two different employees the responsibilities for the inventory records and
EXERCISE 13-32 (15 MINUTES)
The weighted-average cost of capital (WACC) is defined as follows:
value
Market
equity
ofCost
value
Market
debt of
cost tax–After
+
Chapter 13 – Investment Centers and Transfer Pricing
13–11
EXERCISE 13-33 (20 MINUTES)
The economic value added (EVA) is defined as follows:
For Golden Gate Construction Associates, we have the following calculations of each
division’s EVA.
Division
After-Tax
Operating
Income
(in millions)
Total Assets
(in millions)
Current
Liabilities
(in millions)
WACC
Economic
Value
Added
(in millions)
EXERCISE 13-34 (10 MINUTES)
1.
Transfer price
=
outlay
cost
+
opportunity
cost
=
$450* + $120† = $570
*Outlay cost = unit variable production cost
=
forgone contribution margin
=
2.
If the Fabrication Division has excess capacity, there is no opportunity cost associated
with a transfer. Therefore:
=
Chapter 13 – Investment Centers and Transfer Pricing
13–12
EXERCISE 13-35 (25 MINUTES)
1.
The Assembly Division’s manager is likely to reject the special offer because the
Assembly Division’s incremental cost on the special order exceeds the division’s
incremental revenue:
Incremental revenue per unit in special order …………………..
$700
Transfer price ……………………………………………………………
Additional variable cost ……………………………………………..
Total incremental cost …………………………………………………….
Loss per unit in special order ………………………………………….
Incremental cost to Assembly Division per unit
2.
The Assembly Division manager’s likely decision to reject the special order is not in the
best interests of the company as a whole, since the company’s incremental revenue on
the special order exceeds the company‘s incremental cost:
Incremental revenue per unit in special order …………………
$700
Incremental cost to company per unit in special order:
Unit variable cost incurred in Fabrication Division ………
Unit variable cost incurred in Assembly Division ………..
Total unit variable cost ………………………………………………….
Profit per unit in special order ……………………………………….
$100
3.
The transfer price could be set in accordance with the general rule, as follows:
Transfer price
=
outlay
cost
+
opportunity
cost
=
=
$450
*Opportunity cost is zero, since the Fabrication Division has excess capacity.
incremental cost. The incremental revenue is still $700 per unit, but the incremental
Assembly Division).
Chapter 13 – Investment Centers and Transfer Pricing
13–13
SOLUTIONS TO PROBLEMS
PROBLEM 13-36 (25 MINUTES)
The answer to the question as to which division is the most successful depends on the
firm’s cost of capital. To see this, compute the residual income for each division using
various imputed interest rates.
(a)
Imputed interest rate of 10%:
Division I
Division II
Divisional profit …………………………………………………………..
$2,700,000
$600,000
Less: Imputed interest charge:
(b)
Imputed interest rate of 14%:
Division I
Division II
Divisional profit …………………………………………………………..
$2,700,000
$600,000
Less: Imputed interest charge:
(c)
Imputed interest rate of 15%:
Divisional profit …………………………………………………………..
$2,700,000
$600,000
Less: Imputed interest charge:
If the firm’s cost of capital is 10 percent, then Division I has a higher residual income than
Division II. With a cost of capital of 15 percent, Division II has a higher residual income. At a
Chapter 13 – Investment Centers and Transfer Pricing
13–14
PROBLEM 13-37 (45 MINUTES)
Division I
Division II
Division III
Sales revenue …………………………………………………
$40,000,000
$8,000,000e
$3,200,000l
Income …………………………………………………………..
$ 8,000,000
$ 1,600,000
$ 800,000k
Average investment ………………………………………..
$10,000,000
$4,000,000j
Sales margin …………………………………………………
Capital turnover ……………………………………………..
ROI ………………………………………………………………..
Explanatory notes:
20%
0$40,000,00
$8,000,000
revenue sales
income
margin Sales
a===
= $8,000,000 – (8%)($10,000,000) = $7,200,000
Therefore, sales revenue = $8,000,000
fCapital turnover
=
capital invested
revenue sales
=
Therefore, invested capital = $8,000,000
13–15
PROBLEM 13-37 (CONTINUED)
hResidual income
=
income – (imputed interest rate)(invested capital)
=
$1,600,000 – (8%)($8,000,000)
=
$960,000
Therefore, capital turnover = .8
jROI
=
capital invested
income
=
20%
Therefore, income = (20%)(invested capital)
=
$480,000
Substituting from above for income:
(20%)(invested capital) – (8%)(invested capital) = $480,000
Therefore, (12%)(invested capital) = $480,000
kROI
=
capital invested
income
Therefore, sales revenue = $3,200,000
income
Chapter 13 – Investment Centers and Transfer Pricing
13–16
PROBLEM 13-38 (20 MINUTES)
1.
Three ways to increase Division I’s ROI:
(a)
Increase income, while keeping invested capital the same. Suppose income
increases to $9,000,000. The new ROI is:
(b)
Decrease invested capital, while keeping income the same. Suppose invested
capital decreases to $9,600,000. The new ROI is:
(c)
Increase income and decrease invested capital. Suppose income increases to
$8,400,000 and invested capital decreases to $9,600,000. The new ROI is:
=
25%
Chapter 13 – Investment Centers and Transfer Pricing
13–17
PROBLEM 13-39 (25 MINUTES)
This problem is similar to Problem 13-36, except that here students are given a hint in
answering the question about which division is the most successful by requiring the
calculation of residual income for three different imputed interest rates. If the firm’s cost of
capital is 12 percent, then Division I has a higher residual income than Division II. With a
cost of capital of 15 percent or 18 percent, Division II has a higher residual income.
1.
Imputed interest rate of 12%
Division I
Division II
Divisional profit …………………………………………………………..
$2,700,000
$600,000
Less: Imputed interest charge:
2.
Imputed interest rate of 15%
Division I
Division II
Divisional profit …………………………………………………………….
$2,700,000
$600,000
Less: Imputed interest charge:
PROBLEM 13-39 (CONTINUED)
3.
Imputed interest rate of 18%
Division I
Division II
Divisional profit …………………………………………………………….
$2,700,000
$600,000
Less: Imputed interest charge:
The imputed interest rate r, at which the two divisions’ residual income is the same, is
14 percent, computed as follows:
Division II’s residual
income
=
Division I’s residual income
=
$2,700,000 – (r)($18,000,000)
=
$2,100,000
=
$2,100,000/$15,000,000
=
14%
13–19
PROBLEM 13-40 (35 MINUTES)
1. Current ROI of the Western Division:
Sales revenue……………………………………
$4,200,000
Less: Variable costs ($4,200,000 x 70%)……
$2,940,000
$ 185,000
ROI = Income ÷ invested capital
Western Division’s ROI if competitor is acquired:
Sales revenue ($4,200,000 + $2,600,000)…….
$6,800,000
$ 260,000
ROI = Income ÷ invested capital
2. Divisional management will likely be against the acquisition because ROI will be
3. An examination of the competitor’s financial statistics reveals the following:
Sales revenue……………………………………..
$2,600,000
Less: Variable costs ($2,600,000 x 65%)……..
$1,690,000
835,000
$ 75,000
ROI = Income ÷ invested capital
Chapter 13 – Investment Centers and Transfer Pricing
13–20
PROBLEM 13-40 (CONTINUED)
Corporate management would probably favor the acquisition. Megatronics has been
4. Yes, the divisional ROI would increase to 21.01%. However, the absence of the
upgrade could lead to long-run problems, with customers being confused (and
perhaps turned-off) by two different retail environments—the retail environment they
have come to expect with other Megatronics outlets and that of the newly acquired,
non-upgraded competitor.
5. Current residual income of the Western Division: