Solution manual cost and managerial accounting by barfield 3rd responsibility accounting and transfer pricing in decentralized organizations

Type of Center Recommended Type of Transfer Price & UsageCost-Selling Cost-based: consistent with objective of Segment this type of center; this use is a way of allocating the center's c

Chapter 18

Responsibility Accounting and Transfer Pricing in Decentralized OrganizationsQuestions

1 The extent to which decision-making responsibility is distributed

throughout an organization determines whether a firm is centrally or decentrally organized Decentralization refers to the end of the continuum where decision making is widely dispersed; centralization refers to the end of the continuum where decision making is made only

by top management

Exhibit 18-1 reflects criteria that help to determine whether a

company should be decentralized These characteristics are:

* Mature in age

* Large size

* Product development in a growth stage

* Rapid firm growth rate

* Low expected impact on profits of incorrect decisions

* High confidence in subordinates' abilities

* Less rigorous historical degree of top management control

2 Even companies that are thought to be highly decentralized for most

functions will often perform some functions centrally Some functions which may be better handled centrally are:

* Capital project approval

* Cash management

* Inventory control

* Evaluation of division profitability

Thus, most firms are neither purely centralized nor purely

decentralized; rather, they have decision making activities that fit

in both categories

219

3 Four potential advantages of decentralization are:

* Executive training and development

* Job satisfaction

* Effectiveness and speed of decision making by local

managers with intimate knowledge of problems

* "Management by exception principle" frees top management time

Three potential disadvantages of decentralization are:

4 Functions that are better

handled centrally Reasons

* Capital project approval 1) Major costs for long-term commitments

2) Specialized knowledge

3) Need for coordination in the selection and funding of major projects

* Cash management 1) Cash and investment funds are managed more efficiently

if they are pooled

2) When funds are needed,

tradition and good business dictate that they are

acquired at the firm level and allocated to segments as

and misappropriation Its

control is also crucial to efficient and effective

production, delivery and

or-5 The process of implementing or utilizing a decentralized

organizational structure can cause costs to be incurred The following are potential costs of decentralization:

* a more expensive control system is required

These costs can be minimized through effective training and,

if decentralization is to be effective, should be less than the benefits derived from the use of such a structure

6 Decentralization is the degree to which decision-making

authority is delegated downward in an organization Accountingreports should be prepared to reflect how managers of

significant segments of the organization perform relative to the authority delegated to them The responsibility accountingsystem must be kept in sufficient detail to permit segment reporting

7 The two basic functions of responsibility reports are to:

* Provide operational managers with information needed for planning, controlling, and decision making for their areas

of responsibility

* Assist top managers in evaluating how well operational

managers fulfilled their responsibilities to the

organization

8 It is sometimes appropriate for a company to prepare a single

responsibility report for a division However, many companies prepare two different responsibility reports for a division: one report, which is used to evaluate a manager's performance,shows only the costs controllable by that manager; the other responsibility report shows all costs incurred by and assigned

to the division so that a notion of the total performance of the division can be gained If the latter report can be

subdivided into controllable and noncontrollable costs of the division manager, then one report can effectively accomplish both purposes

9 Total amounts for actual costs, budgeted costs, and variances

of lower organizational levels are successively consolidated

in the performance reports of progressively higher-level

managers who are responsible for the results of the level segments Thus, the report for the higher-level manager includes the direct costs of his/her segment and the total costs incurred by lower-level segments which report to that manager

lower-10 The goal of measuring performance is to objectively capture

achievement of the organization's goals To achieve goals, firms identify critical success factors Some critical

success factors are more easily measured in nonmonetary units rather than monetary units Examples of such factors include:customer satisfaction, throughput, and product quality

11 The four types of responsibility centers are cost, revenue,

profit, and investment centers Cost centers focus primarily

on costs Revenue centers focus primarily on revenues Profit centers focus on both revenues and costs Investment centers focus on both profits and the investment base that is utilized

to generate those profits

12 While salaries are not the primary focus of a revenue center

report, they may, nonetheless, be included if the revenue center manager has significant control over labor rates and/orlabor schedules

13 Suboptimization is a condition whereby individual managers

work to achieve results that are in their own best interests and that of their segments to the detriment of the overall company Top managers must guard against such behavior of subordinates when authority is delegated to them in a

decentralized setting Suboptimization results from segment managers’ motivation to appear successful and gain rewards andrecognition Sometimes, this motivation overrides the best interests of the company

14 Service departments are internal departments that provide

goods/services to other internal departments Service

departments typically provide few, if any, services to

external constituents Examples of service departments

include training, personnel, accounting, electronic data

processing, and legal services Service departments are

distinguished from operating departments in that service

departments do not directly make products for external buyers,but instead, serve those departments that produce goods and services that are sold to external consumers

15 Service department costs may be allocated to revenue-producing

departments for a variety of reasons Several of the more common reasons include the following: to encourage managers

to use support areas in the most cost-beneficial manner; to make performance comparisons with independent organizations;

to determine the full cost of production to make fair and acceptable pricing decisions; and to support decision making (These are all enumerated in Exhibit 18-6.) Such allocations are not always useful from a decision-making standpoint

because the allocations bring costs that are uncontrollable by

a department into that department

16 In addition to allocating service department costs to obtain a

full cost of products or other cost objects, there are

behavioral consequences associated with allocating service department costs Generally, managers become more sensitive

to the support provided by the service area, which leads them

to utilize this resource in a more cost-beneficial way and to recommend cost control improvements to the service department.However, such cost allocations can cause dysfunctional

behavior if the manager of the revenue-producing area

perceives the cost allocation to be unfair

17 The four criteria (benefits received, causation, equity, and

ability to bear) are all relevant to making service departmentallocations and should, theoretically, be applied equally However, it is often not practical to apply the equity

criterion because it is too difficult to achieve agreement on what is fair Ability to bear is often not used because it results in unrealistic or profit-detrimental actions

Therefore, most service department allocations are based on the benefits-received and causation criteria

18 The direct method is the only method that does not allocate a

service department's costs to other service departments The step method does make such an allocation, but does so

sequentially based on a benefits-provided ranking The

algebraic method, unlike the other methods, recognizes

reciprocal (give-and-take) exchanges of services among the service departments by providing a set of simultaneous

equations to solve for the effects of such interchanges

The only similarity among the methods is their ultimate objective - the assignment of service department costs to revenue-producing areas

19 The direct method of allocating service department costs is

the simplest method of allocation It does not take into consideration services exchanged among service departments,however The step method does take into consideration

services used between service departments, but only after a benefits-provided ranking order has been established Because

of the necessity to rank services, all service department interaction is not accounted for using the step method This method is more difficult than the direct method, but less difficult than the algebraic method The algebraic method of allocating service department costs considers the

interrelationships of all departments through the use of

simultaneous equations This method is very difficult to use without the aid of a computer, however, when more than two orthree departments are involved The algebraic method does provide the best measure of the usage of costs among

departments

20 A benefits-provided ranking is necessary under the step method

of allocating service department costs because, once costs areassigned out of an area, they cannot be reassigned to that area The method requires the allocation process to begin withthe area that provides the most service to all other areas andend with the area that provides most of its services only to revenue-producing departments In this manner, some, but not all, service interrelationships are considered Such a

ranking is not necessary in the algebraic method because all interrelationships among departments are considered

21 The added costs are fictional and are caused by the

cross-allocation process of solving simultaneous equations These fictional costs are ignored in the revenue-producing areas for the purpose of developing an overhead application rate

22 Computer technology has reduced the burden of making the

calculations that are required to solve simultaneous

equations The computer handles such calculations at very low cost and a high level of precision

23 Transfer prices are internally set (agreed on) prices with

which a “selling” division transfers goods or services to a

“buying” division The objectives are goal congruence,

autonomy, motivation toward effectiveness and efficiency, practicality, and credibility as a basis for performance

evaluation

24 Type of Center Recommended Type of Transfer Price & Usage

Cost-Selling Cost-based: consistent with objective of Segment this type of center; this use is a way of allocating the center's cost to other

centers

Cost-Buying Preferably cost based: consistent with Segment this type of center; however, depending on the demands of the selling segments, the transfer price could be anywhere between the lower limit (incremental costs plus opportunity cost of facilities) and the upper limit (lowest market price the buy-

ing segment would have to pay externally);

the services or materials received by the center will be carried at the transfer price at their cost for internal reporting purposes

Revenue-Selling Market price: consistent with this type of Segment center; revenue from transfers of goods or services is recorded at the transfer price for internal reporting purposes

Revenue-Buying Goods or services transfer prices should Segment be between the lower and upper limits with the lower limit giving this segment the greatest gross margin on its internal sales; whatever transfer price is

chosen is the cost of goods or services purchased for this segment for internal reporting

Profit or Transfer prices should be set between the Investment lower and upper limits; since these typesCenters-Selling of centers are supposed to earn a profit, Segment their managers will try to negotiate a price closer to the upper limit; whatever price is set becomes the revenue measure for internal sales for internal reporting purposes

Profit or Transfer prices should fall between lowerInvestment and upper limits with managers of these Centers-Buying segments arguing for prices closer to the Segment lower limits to afford their segments the highest gross margin; whatever price is

set becomes the cost of goods or servicesacquired by the center for internal re-porting purposes

25 In negotiating transfer prices among segment managers, the

managers are expected to work together to (1) make choices that will maximize the efficiency and effectiveness of their respective divisions and (2) to contribute to overall company performance For example, when it is in the best interest of the whole company for a buying division to purchase goods or services internally from a selling division, segment managers are expected to agree on a price to encourage this If top management has properly trained, motivated, and evaluated these segment managers, the transfer price can be a device to promote such goal congruence

In contrast, sometimes segment managers become myopic in their zeal to maximize the apparent performance of their own divisions For example, sometimes a buying segment manager will choose to buy externally at a price lower than the

transfer price because it makes his division look better even though analysis would reveal that the whole company would do better were the acquisitions made internally This is an

example of suboptimization

26 The upper limit is the lowest external market price for the

product because this measures the amount for which the buying segment could acquire the product The lower limit is the sum

of the incremental costs of producing the product plus the opportunity cost of the facilities used; this is what the selling segment sacrificed to make the product

27 Standard cost has the advantage of being known or agreed on in

advance and of being a measure of efficient production Actualcost may vary widely from month to month because of large changes in production volume, seasonal variations, and

efficiencies

28 The biggest problem involves the definition and what is

included in the term "cost." Cost can mean any of the

following: incremental or variable; absorption (product costs only); and absorption plus some portion of the segment's

nonproduction costs (selling and administrative) An amount for estimated opportunity costs for use of the facilities can

be added to any of the above In some cases, arguments can be made for reducing absorption costs by estimated savings in production or distribution costs on internal sales

Another problem is that if actual costs include inefficiencies, the transfer prices set on the basis of such inefficiencies may lead to incorrect management decisions

29 Problems of using market-based transfer prices include

* the possibility that no objective market price is known

because the product has no exact counterpart in the market;

* market price ignores any production or distribution savings

on internally transferred goods; and

* current prices being temporarily nonrepresentative of a long-run price

30 Negotiation can create teamwork and generate creative

solutions that better the whole company It can, in contrast, create an unhealthy adversarial climate in which fierce

competition can lead to suboptimization This creates a

potential for exerting top management leadership to promote the former situation

31 Dual pricing occurs when the selling division is permitted to

record one transfer price (higher) and the buying division to record another (lower) This practice is intended to minimize suboptimization and create goal-congruent incentives for both divisions

32 Where (1) user departments have significant control over the

quantity and quality of services used and (2) there is a

reasonable surrogate measure of service benefits provided to users, transfer prices can be an effective way of promoting proper use of resources and of reassigning service department costs Setting the transfer price depends on (1) the nature ofthe service center (cost or profit center) and (2) the nature

of the service itself (can it be acquired externally, is it recurring and uniform, and is it expensive?)

Advantages of transfer prices over allocation include

* Motivation of user departments to suggest improvements and monitor usage;

* Inclusion of costs in user department's performance report (if user department controls the amount of service it

"buys");

* Promotion of services more beneficial to users;

* Requires that transfer prices be justified; and

* Transforms a service department from cost center to profit center and this provides more performance measures

33 Transfer pricing arrangements can be costly in terms of

suboptimization Also, the process of setting transfer pricesmay be expensive when considering the time and effort that is involved in the buying and selling division Lastly, the use

of transfer pricing may be optimal in maintaining goal

congruence but be very costly for multinational firms that areunable to use intraorganizational transfers to control their income tax liabilities

34 Because transfer prices between multinational units of a

company can affect profits and inventory values reported in two different countries, managers are cognizant of setting prices, within legal and ethical limits, to minimize income taxes and tariffs

35 Student answers will vary No solution provided

39 a From Personnel to Fabricating: (0.45 ÷ 0.85) × $70,000

= $37,059 From Maintenance to Fabricating: (0.60 ÷ 0.90) × $50,000

= $33,333

b From Personnel to Finishing: (0.40 ÷ 0.85) × $70,000

= $32,941From Maintenance to Finishing: (0.30 ÷ 0.90) × $50,000

= $16,667

40 Checking:

Administration (.30÷0.80) × $90,000 $ 33,750 Personnel (.30÷0.80) × $60,000 22,500 Accounting (.40÷0.80) × $90,000 45,000

$191,250Savings:

Administration (.40÷0.80) × $90,000 $ 45,000

Personnel (.20÷0.80) × $60,000 15,000 Accounting (.20÷0.80) × $90,000 22,500 Direct costs 75,000

$157,500Loans:

Administration (.10÷0.80) × $90,000 $ 11,250

Personnel (.30÷0.80) × $60,000 22,500

Accounting (.20÷0.80) × $90,000 22,500 Direct costs 150,000

$206,250

41 Administration Costs ($90,000)

Personnel ($90,000 × 0.10) $ 9,000 Accounting ($90,000 × 0.10) 9,000 Checking ($90,000 × 0.30) 27,000 Savings ($90,000 × 0.40) 36,000 Loans ($90,000 × 0.10) 9,000

$90,000Personnel Costs ($60,000 + $9,000)

Accounting [$69,000 × (0.10÷.90)] $ 7,667

Checking [$69,000 × (0.30÷.90)] 23,000 Savings [$69,000 × (0.20÷.90)] 15,333 Loans [$69,000 × (0.30÷.90)] 23,000

$69,000 Accounting Costs ($90,000 + $9,000 + $7,667)

Checking [$106,667 × (0.40÷.80)] $53,334 Savings [$106,667 × (0.20÷.80)] 26,667 Loans [$106,667 × (0.20÷.80)] 26,667

$106,668 (rounded)

Checking = $90,000 + $27,000 + $23,000 + $53,334 = $193,334Savings: $75,000 + $36,000 + 15,333 + $26,667 = $153,000Loans: $150,000 + $9,000 + $23,000 + $26,667 = $208,667

42 a Personnel Costs ($60,000)

Administration($60,000 × 0.15) $ 9,000 Maintenance ($60,000 × 0.10) 6,000 Stamping ($60,000 × 0.45) 27,000 Assembly ($60,000 × 0.30) 18,000

$60,000Administration Costs ($90,000 + $9,000)

Maintenance [$99,000 × (.15÷0.90)] $16,500

Stamping [$99,000 × (.50÷0.90)] 55,000 Assembly [$99,000 × (.25÷0.90)] 27,500

$99,000Maintenance Costs ($40,000 + $6,000 + $16,500)

Stamping [$62,500 × (.50÷0.85)] $36,765 Assembly [$62,500 × (.35÷0.85)] 25,735

$62,500

b Stamping: $27,000 + $55,000 + $36,765 = $118,765

Assembly: $18,000 + $27,500 + $25,735 = $ 71,235

c The cost allocation is affected by the order in which

costs are assigned because the cost allocated from aparticular service department depends on the amount of cost allocated to that service department from other service departments; the amount of costs allocated from other service departments depends on the benefits-

Note: The Personnel and Accounting columns do not actually sum

to $0 because of rounding

Administration Personnel

Department Base % Base %

Admin (A) n/a n/a 10 11.11

Pers (P) $ 75,000 6.25 n/a n/a

Note: The Administration column does not actually sum to zero

because of rounding

45 a The upper limit is the best external price = $15.00

The lower limit is variable production cost = $7.20 +opportunity cost

b Minimum price is regular price = $21.75

46 a Lower limit is the variable cost ($1.50 + $1.90 + $0.80)

+ $7.30 lost CM = $11.50; this is the normal sellingprice less the normal variable costs excluding the $0.50 variable selling expense

b Under these conditions, Goodbrake Division could accept

any price that at least covers variable production costs:

DM $1.50 + DL $1.90 + VOH $0.80 = $4.20