MANAGEMENT ACCOUNTING - 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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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.

Exercise 10 (Compute the Return on Investment (ROI))
Requirement (1)
Margin =
=

Net operating income

Sales
P5,400,000
P18,000,000
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= 30%

Chapter 14 Responsibility Accounting and Transfer Pricing

Requirement (2)
Sales
Average operating assets

Turnover =
=

P18,000,000
P36,000,000

= 0.5

Requirement (3)
ROI

Margin x Turnover

30% x 0.5 = 15%

Exercise 11 (Residual Income)

Average operating assets (a)..............................................
Net operating income........................................................
Minimum required return: 16% (a)................................
Residual income................................................................

P2,200,000
P400,000
352,000
P 48,000

III. Problems
Problem 1 (Evaluation of Profit Centers)
Requirement (a)
Jadlow Manufacturing Corporation
Income Statement
For the Year Ended December 31, 2005
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)
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Responsibility Accounting and Transfer Pricing Chapter 14

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
From Product C
Total
Problem 3 (Evaluation of Performance)
Ranjie Tool Company
Performance Report
For the Year 2005
Budgeted Labor Hours
Actual Labor Hours

4,000
4,200
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P29,000
21,000
P50,000

Chapter 14 Responsibility Accounting and Transfer Pricing

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

P340

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)

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:
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Flexible
Budget Cost

Variance
(U) or (F)

Responsibility Accounting and Transfer Pricing Chapter 14

Marketing division
P104,000
P102,000
P2,000 (U)
Production division
79,000
80,000
1,000 (F)
Personnel division
72,000
76,000
4,000 (F)
Other costs
68,800
70,000
1,200 (F)
Total
P323,800
P328,000
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

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

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

Requirement 2
Data are in thousands.
Units
Revenues
Variable costs
Fixed costs
Total costs
Operating income
Return on investment

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

Note how the change in income follows the change in revenues, as predicted
by operating leverage. Operating leverage multiplied times the percentage
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Chapter 14 Responsibility Accounting and Transfer Pricing

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%
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
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Responsibility Accounting and Transfer Pricing Chapter 14

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.
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

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Chapter 14 Responsibility Accounting and Transfer Pricing

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:
Variable cost
+
per unit

Transfer price

Total contribution margin

on lost sales
Number of units transferred

Transfer price

(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.
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)

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Responsibility Accounting and Transfer Pricing Chapter 14

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:
Variable cost
+
per unit

Transfer price

Transfer price

Total contribution margin

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

P20 +

P20 + P21

P41

Problem 9 (Effects of Changes in Sales, Expenses, and Assets in ROI)

1.

Net operating income

Sales

Margin =
=

2.

P800,000
P8,000,000

= 10%

Sales
Average operating assets

Turnover =
=

P8,000,000
P3,200,000

= 2.5

3.
ROI

Margin x Turnover

10% x 2.5 = 25%

Problem 10 (Transfer Pricing Basics)

Requirement (1)
a. The lowest acceptable transfer price from the perspective of the selling
division, the Electrical Division, is given by the following formula:

Transfer price =

Variable cost
per unit

Total contribution margin

on lost sales
Number of units transferred

Because there is enough idle capacity to fill the entire order from the
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Motor Division, there are no lost outside sales. And because the variable
cost per unit is P21, the lowest acceptable transfer price as far as the
selling division is concerned is also P21.
Transfer price = P21 +

P0
10,000

= P21

b. The Motor Division can buy a similar transformer from an outside

supplier for P38. Therefore, the Motor Division would be unwilling to pay
more than P38 per transformer.
Transfer price: Cost from buying from outside supplier = P38
c. Combining the requirements of both the selling division and the buying
division, the acceptable range of transfer prices in this situation is:
P21 : Transfer price : P38
Assuming that the managers understand their own businesses and that they
are cooperative, they should be able to agree on a transfer price within this
range and the transfer should take place.
d. From the standpoint of the entire company, the transfer should take place.
The cost of the transformers transferred is only P21 and the company
saves the P38 cost of the transformers purchased from the outside
supplier.
Requirement (2)
a. Each of the 10,000 units transferred to the Motor Division must displace a
sale to an outsider at a price of P40. Therefore, the selling division would
demand a transfer price of at least P40. This can also be computed using
the formula for the lowest acceptable transfer price as follows:
(P40 P21) x 10,000
Transfer price = P21 +
10,000
= P21 + (P40 P21) = P40
b. As before, the Motor Division would be unwilling to pay more than P38
per transformer.
c. The requirements of the selling and buying divisions in this instance are
incompatible. The selling division must have a price of at least P40
whereas the buying division will not pay more than P38. An agreement to
transfer the transformers is extremely unlikely.
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Responsibility Accounting and Transfer Pricing Chapter 14

d. From the standpoint of the entire company, the transfer should not take
place. By transferring a transformer internally, the company gives up
revenue of P40 and saves P38, for a loss of P2.
Problem 11 (Transfer Pricing with an Outside Market)
Requirement (1)
The lowest acceptable transfer price from the perspective of the selling
division is given by the following formula:
Total contribution margin
Variable cost +
on lost sales
Transfer price =
per unit
Number of units transferred
The Tuner Division has no idle capacity, so transfers from the Tuner Division
to the Assembly Division would cut directly into normal sales of tuners to
outsiders. The costs are the same whether a tuner is transferred internally or
sold to outsiders, so the only relevant cost is the lost revenue of P200 per tuner
that could be sold to outsiders. This is confirmed below:
Transfer price = P110 +

(P200 P110) x 30,000

30,000

= P110 + (P200 P110) = P200

Therefore, the Tuner Division will refuse to transfer at a price less than P200
per tuner.
The Assembly Division can buy tuners from an outside supplier for P200, less
a 10% quantity discount of P20, or P180 per tuner. Therefore, the Division
would be unwilling to pay more than P180 per tuner.
Transfer price : Cost of buying from outside supplier = P180
The requirements of the two divisions are incompatible. The Assembly
Division wont pay more than P180 and the Tuner Division will not accept
less than P200. Thus, there can be no mutually agreeable transfer price and no
transfer will take place.
Requirement (2)
The price being paid to the outside supplier, net of the quantity discount, is
only P180. If the Tuner Division meets this price, then profits in the Tuner
Division and in the company as a whole will drop by P600,000 per year:
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Chapter 14 Responsibility Accounting and Transfer Pricing

Lost revenue per tuner.......................................................

Outside suppliers price.....................................................
Loss in contribution margin per tuner................................
Number of tuners per year.................................................
Total loss in profits............................................................

P200
P180
P20
30,000
P600,000

Profits in the Assembly Division will remain unchanged, since it will be

paying the same price internally as it is now paying externally.
Requirement (3)
The Tuner Division has idle capacity, so transfers from the Tuner Division to
the Assembly Division do not cut into normal sales of tuners to outsiders. In
this case, the minimum price as far as the Assembly Division is concerned is
the variable cost per tuner of P11. This is confirmed in the following
calculation:
P0
Transfer price = P110 +
= P110
30,000
The Assembly Division can buy tuners from an outside supplier for P180 each
and would be unwilling to pay more than that in an internal transfer. If the
managers understand their own businesses and are cooperative, they should
agree to a transfer and should settle on a transfer price within the range:
P110 : Transfer price : P180

Requirement (4)
Yes, P160 is a bona fide outside price. Even though P160 is less than the
Tuner Divisions P170 full cost per unit, it is within the range given in Part
3 and therefore will provide some contribution to the Tuner Division.
If the Tuner Division does not meet the P160 price, it will lose P1,500,000 in
potential profits:
Price per tuner.................................................. P160
Variable costs................................................... 110
Contribution margin per tuner........................... P 50
30,000 tuners P50 per tuner = P1,500,000 potential increased profits
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Responsibility Accounting and Transfer Pricing Chapter 14

This P1,500,000 in potential profits applies to the Tuner Division and to the
company as a whole.
Requirement (5)
No, the Assembly Division should probably be free to go outside and get the
best price it can. Even though this would result in lower profits for the
company as a whole, the buying division should probably not be forced to
purchase inside if better prices are available outside.
Requirement (6)
The Tuner Division will have an increase in profits:
Selling price...................................................... P200
Variable costs................................................... 110
Contribution margin per tuner........................... P 90
30,000 tuners P90 per tuner = P2,700,000 increased profits

The Assembly Division will have a decrease in profits:

Inside purchase price........................................ P200
Outside purchase price..................................... 160
Increased cost per tuner.................................... P 40
30,000 tuners P40 per tuner = P1,200,000 decreased profits
The company as a whole will have an increase in profits:
Increased contribution margin in the Tuner Division............................................
P 90
Decreased contribution margin in the Assembly Division.....................................
40
Increased contribution margin per tuner...............................................................
P 50
30,000 tuners P50 per tuner = P1,500,000 increased profits
So long as the selling division has idle capacity and the transfer price is
greater than the selling divisions variable costs, profits in the company as a
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Chapter 14 Responsibility Accounting and Transfer Pricing

whole will increase if internal transfers are made. However, there is a question
of fairness as to how these profits should be split between the selling and
buying divisions. The inflexibility of management in this situation damages the
profits of the Assembly Division and greatly enhances the profits of the Tuner
Division.
Problem 12 (Transfer Pricing; Divisional Performance)
Requirement (1)
The Electronics Division is presently operating at capacity; therefore, any
sales of the KK8 circuit board to the Clock Division will require that the
Electronics Division give up an equal number of sales to outside customers.
Using the transfer pricing formula, we get a minimum transfer price of:
Total contribution margin
on lost sales
Number of units transferred

Transfer price =

Variable cost
per unit

Transfer price =

P82.50 + (P125.00 P82.50)

Transfer price =

P82.50 + P42.50

Transfer price = P125.00

Thus, the Electronics Division should not supply the circuit board to the Clock
Division for P90 each. The Electronics Division must give up revenues of
P125.00 on each circuit board that it sells internally. Since management
performance in the Electronics Division is measured by ROI and dollar
profits, selling the circuit boards to the Clock Division for P9 would adversely
affect these performance measurements.
Requirement (2)
The key is to realize that the P100 in fixed overhead and administrative costs
contained in the Clock Divisions P697.50 cost per timing device is not
relevant. There is no indication that winning this contract would actually affect
any of the fixed costs. If these costs would be incurred regardless of whether
or not the Clock Division gets the oven timing device contract, they should be
ignored when determining the effects of the contract on the companys profits.
Another key is that the variable cost of the Electronics Division is not relevant
either. Whether the circuit boards are used in the timing devices or sold to
outsiders, the production costs of the circuit boards would be the same. The
only difference between the two alternatives is the revenue on outside sales
that is given up when the circuit boards are transferred within the company.
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Responsibility Accounting and Transfer Pricing Chapter 14

Selling price of the timing devices.................................................................

P700.00
Less:
The cost of the circuit boards used in the timing devices
(i.e. the lost revenue from sale of circuit boards to
outsiders)...............................................................................................
P125.00
Variable costs of the Clock Division excluding the circuit
board (P300.00 + P207.50)...................................................................
507.50 632.50
Net positive effect on the companys profit....................................................
P 67.50
Therefore, the company as a whole would be better off by P67.50 for each
timing device that is sold to the oven manufacturer.
Requirement (3)
As shown in part (1) above, the Electronics Division would insist on a transfer
price of at least P125.00 for the circuit board. Would the Clock Division make
any money at this price? Again, the fixed costs are not relevant in this decision
since they would not be affected. Once this is realized, it is evident that the
Clock Division would be ahead by P67.50 per timing device if it accepts the
P125.00 transfer price.
Selling price of the timing devices................................................................
P700.00
Less:
Purchased parts (from outside vendors)....................................................
P300.00
Circuit board KK8 (assumed transfer price).............................................
125.00
Other variable costs.................................................................................
207.50 632.50
Clock Division contribution margin..............................................................
P 67.50
In fact, since the contribution margin is P62.50, any transfer price within the
range of P125.00 to P192.50 (= P125.00 + P67.50) will improve the profits of
both divisions. So yes, the managers should be able to agree on a transfer
price.
Requirement (4)
It is in the best interests of the company and of the divisions to come to an
agreement concerning the transfer price. As demonstrated in part (3) above,
any transfer price within the range P125.00 to P192.50 would improve the
profits of both divisions. What happens if the two managers do not come to an
agreement?
In this case, top management knows that there should be a transfer and could
step in and force a transfer at some price within the acceptable range.
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Chapter 14 Responsibility Accounting and Transfer Pricing

However, such an action, if done on a frequent basis, would undermine the

autonomy of the managers and turn decentralization into a sham.
Our advice to top management would be to ask the two managers to meet to
discuss the transfer pricing decision. Top management should not dictate a
course of action or what is to happen in the meeting, but should carefully
observe what happens in the meeting. If there is no agreement, it is important
to know why. There are at least three possible reasons. First, the managers
may have better information than the top managers and refuse to transfer for
very good reasons. Second, the managers may be uncooperative and unwilling
to deal with each other even if it results in lower profits for the company and
for themselves. Third, the managers may not be able to correctly analyze the
situation and may not understand what is actually in their own best interests.
For example, the manager of the Clock Division may believe that the fixed
overhead and administrative cost of P100 per timing device really does have to
be covered in order to avoid a loss.
If the refusal to come to an agreement is the result of uncooperative attitudes
or an inability to correctly analyze the situation, top management can take
some positive steps that are completely consistent with decentralization. If the
problem is uncooperative attitudes, there are many training companies that
would be happy to put on a short course in team building for the company. If
the problem is that the managers are unable to correctly analyze the
alternatives, they can be sent to executive training courses that emphasize
economics and managerial accounting.
IV. Multiple Choice Questions
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