RESPONSIBILITY ACCOUNTING AND TRANSFER PRICING

P 5-1: Solution to Canadian Subsidiary (10 minutes)

[Problems with ROI]

Subsidiary net income is after payments to the debtholders and hence the calculation of return on net investment (which is equivalent to return on equity) is on a return-on-equity basis. Calculate net investment and residual income to equity in each year:

2015 2016 2017

Net income $14.0 $14.3 $14.4

÷ ROI 20% 22% 24%

Net investment = (A–L) = Net income ÷ ROI $70.0 $65.0 $60.0

L = Assets – net investment $55.0 $65.0 $75.0

Subsidiary Net income $14.0 $14.3 $14.4

less: Cost of capital on net investment (7.0) (6.5) (6.0)

Residual income $ 7.0 $ 7.8 $ 8.4

The calculation shows that residual income, like ROI, is rising. The subsidiary has been leveraging up — adding debt to its capital structure and reducing net investment.

Therefore, the improving ROI is the result of financing changes, not operating performance.

P 5-2: Solution to Phipps Electronics (15 minutes)

[International transfer pricing and taxes]

Transfer Pricing Methods

–––––––––––––––––––––––

Full Cost Variable Cost

Low Country Taxes:

Transfer Price $1,000 $ 700

-Cost (1,000) (1,000)

Taxable Income 0 (300)

Income Taxes (or refund) (30%) 0 ($ 90)

High Country Taxes:

Sales Price $1,200 $1,200

-Transfer Price (1,000) (700)

Taxable Income $ 200 $ 500

Income Taxes (40%) $ 80 $200

Import Duty (15% × transfer price) 150 105

Taxes in High Country $230 $305

Total Taxes $230 $215

Assuming Phipps has positive taxable income in Low Country against which to offset the loss of transferring the boards at variable cost, then the variable cost transfer pricing method minimizes the combined tax liability.

P 5-3: Solution to Sunder Properties (15 minutes)

[ROA creates under investment problems]

a. To calculate Sunder Properties’ ROA, the question arises as to whether the calculation should include or exclude interest. Since ROA is a measure of the return on total assets, not the return to equity investors, interest should be excluded from the calculation of the numerator. (Or equivalently, interest should be added back to Net income before taxes.) Below is the calculation of ROA.

Revenues

$86.50
Expenses

With interest

72.30

Interest

(2.60)

Expenses (excluding interest)

69.70
Net income before taxes

16.80
Divided by total assets

$64.00
ROA

26.25%

b. ROA Valley View:

Revenues

$16.60
Expenses

including interest

13.30

Interest

(.71)

Expenses (excluding interest)

(12.59)
Net income before taxes

4.01
÷ Total assets

$20.0
ROA

20.05%

Because the ROA of the new project (20.05%) is less than the firm’s ROA (26.25%), Sunder’s ROA will fall if the new project is accepted. Hence, management is expected to reject the new project.

c. The shareholders of Brighton Holdings will want the managers of Sunder Properties to purchase Valley View if it has a positive residual income.

Net income before taxes (excluding interest)

$4.01
Total Assets
$20.00

WACC

15%

3.00
Residual income

$1.01

Since residual income is positive, the shareholders will want to see the apartment complex be purchased.

Alternatively, since Valley View has a return on investment of 20.05% that exceeds Sunder’s weighted-average cost of capital of 15%, Valley View is a profitable acquisition.

d. Compensating the managers of Sunder Properties based on ROA gives them incentives to under-invest. We see in part (b) managers in Sunder reject the apartment complex because it lowers their overall average ROA, even though the apartment has a return in excess of its cost of capital (i.e., residual income is positive in part (c)). One suggestion is that Brighton Holdings compensate Sunder Properties’ management based on residual income, not ROA. By making this change, Sunder does not have the incentive to reject positive residual income projects.

P 5-4: Solution to Economic Earnings (15 minutes)

[Understanding the role of the capital charge and depreciation in EVA]

Weaknesses:

•Like all accounting-based metrics, EE is short-run focused. Actions taken today that increase future cash flows do not show up in accounting-based performance measures until those cash flows are realized. If managers taking those actions have horizons shorter than when the cash flows are realized, then they have less incentive to take the actions.

• Adding back depreciation creates an over-investment problem. The user is only charged for interest on the capital, not its decline in value. It’s like a bank only charging you interest and not principle.

• EE double counts interest. Interest is deducted, as is a charge for all the capital. This double counts interest.

Strengths:

• Like other accounting-based performance measures, EE is reasonably inexpensive and objective to compute. The accounting numbers are already being computed for taxes and external reporting and are audited.

• Unlike stock price, accounting-based measures can be used to measure the performance of sub-units of the organization. In other words, accounting measures can be disagregated.

P 5-5: Solution to Performance Technologies (20 minutes)

[ROA, unlike residual income, creates under- and over-investment incentives]

a. The following table computes the ROA and residual income of Wilson’s existing assets and the two projects. This table is used to answer all parts of the question.

Since Zang is rewarded based on improving ROA, she will accept project A and reject B. Project A’s ROA of 14% is above her current ROA of 12%, and by choosing Project A, the combined ROA of the Wilson Division rises from 12% to 12.40%. Project B (with an ROA of 10%) will be rejected because it lowers her division’s combined ROA to 11.54%.

Existing

Portfolio

Project

& Project

of projects

A Only

B Only

Total Assets

$100.00

$25.00

$30.00

$125.00

$130.00

EBI*

$12.00

$3.50

$3.00

$15.50

$15.00

ROA

12.00%

14.00%

10.00%

12.40%

11.54%

Cost of capital

11%

15%

Residual income

$1.00

-$0.25

$0.30

$0.75

$1.30

*EBI: Earnings before interest

(All $ amounts in millions)

b. If residual income is used to measure divisional performance, project A is now rejected and project B accepted. Project A has a negative residual income of ($250,000) that lowers Zang’s RI from $1 million to $750,000. Project B has a positive residual income of $300,000 that increases Zang’s RI from $1 million to $1,300,000.

c. Zang changes her decisions because ROA ignores the project’s risk adjusted cost of capital. Use of ROA as a performance measure only involves increasing the division’s ROA and does not consider whether a project’s ROA is above or below its risk adjusted cost of capital.

d. As illustrated in this problem, ROA can induce incorrect investment decisions, whereas residual income does not. In particular, ROA can lead to over- and under-investment decisions. However, projects with a positive residual income have positive NPV, whereas projects with a negative residual income have a negative NPV. While not perfect, residual income is better than ROA as a performance measure because it does not produce these under/over investment incentives.

P 5-6: Solution to Metal Press (20 minutes)

[ROA under historical-cost and inflation-adjusted depreciation]

a. Book value and depreciation expense:

Historical Price-adjusted

Cost Historical Cost

Original cost $522,000 $522,000

Change in price index 1.19

Depreciable cost 522,000 621,180

Annual depreciation expense (÷12) 43,500 51,765

Accumulated depreciation (× 7) 304,500 362,355

Book value $217,500 $258,825

b. ROAs will fall because of two reasons:

(i) larger depreciation expense being subtracted from income reduces the numerator, and

(ii) larger asset values in the denominator.

c. Division managers have greater incentive to replace obsolete equipment under the price-level-adjusted method than under historical cost because the differential between the book value of the old equipment and the new equipment is smaller. Hence, the historical cost incentive to keep older equipment is reduced.

P 5-7: Solution to ICB, Intl. (20 minutes)

[Summary of key transfer pricing issues]

The following points summarize the important issues in transfer pricing:

• Transfer pricing does not merely shift profits from one division to another, it affects overall firm profits by affecting the quantity of units transferred.

• A transfer price of full cost plus profit causes the buying division to buy fewer units than if the transfer price were lower.

• The ideal transfer price should be the resources forgone from making the transfer (opportunity cost).

• Allowing manufacturing to make a profit means that the marketing divisions will buy and hence sell fewer units than if the transfer prices were set at opportunity cost, unless manufacturing can also sell at a profit outside.

• If manufacturing has long-run excess capacity, it should transfer the conditioner at variable cost. If manufacturing does not have excess capacity, the transfer price should be at what it can sell the conditioner for in its next best use (market price).

• If the corporate controller intervenes in this case, then future transfer pricing disputes will land on her desk. Her intervention in this case will likely change the process by which transfer prices are set. The current decentralized negotiation process will tend to become more centralized in the controller’s office.

P 5-8: Solution to Shop and Save (25 minutes)

[Transfer pricing using percentage of final selling price]

a. Advantages:

No gaming over the transfer price. It is objectively set by central management. The Bakery cannot game the system by substituting variable costs for fixed costs if a variable cost transfer pricing method was used for instance.

The transfer pricing policy is simple and easy to understand.

The Bakery has an incentive to produce efficiently since it cannot pass inefficiencies on to the stores through higher transfer prices if they were using a cost-based transfer price.

Disadvantages:

The optimum, firm-value maximizing transfer price is opportunity cost. With excess capacity, marginal (or variable) cost is the opportunity cost. There is no guarantee that 60 percent of the retail price is marginal cost. Moreover, it is unlikely that marginal cost is always 60 percent of the price across all fresh baked goods (breads, rolls, cakes, and pies).

The current pricing policy does not utilize any of the specialized knowledge of the local stores nor of the Bakery in determining the transfer price.

Decision rights over the transfer pricing of the baked goods are set centrally, but the Bakery is evaluated as a profit center. Hence, the performance evaluation and reward structure of the Bakery does not match the Bakery’s decision rights assignment.

b. They can continue to use the 60 percent of retail price as the transfer price of current bakery items but allow the stores and bakery to negotiate the transfer price of new bakery items. In this way the stores that have specialized knowledge of what consumers want and the stores that have specialized knowledge of recipes and current trends in baked goods can assemble this knowledge and negotiate over the transfer price.

Another suggestion is to allow the stores to purchase some fresh baked goods from local bakeries. This forces the bakery to become more competitive in terms of specialty baked goods at competitive prices.

Finally, S&S should prepare a market study of the wholesale prices of fresh baked goods in the region. If the wholesale price of most fresh baked goods is roughly 60 percent of the retail price, then the internal transfer price of 60 percent of the retail price is roughly the market price and hence is probably a good approximation of opportunity cost.

Other solutions include: decentralize the pricing decision to the Bakery/grocery stores or make the Bakery a cost center. However, before implementing either of these suggestions, one needs to ask: “Is the current system broken?”

P 5-9: Solution to Microelectronics (25 minutes)

[Simple transfer pricing]

a. As long as the Phone division is evaluated as a profit center and Microelectronics does not intervene somehow, the Phone Division will not purchase the circuit boards from the Circuit Board division because the Phone Division will lose money on each phone:

Selling price of phones $400

Transfer price of boards (market) $200

Other costs to complete phone 250 450

Incremental cash flow (loss) to Phone Division $(50)

b. Yes. Firm profits are higher assuming the excess capacity of 5,000 boards per month has no other use.

Selling price of phones $400

Incremental (variable) cost per board $130

Other costs to complete phone 250 380

Incremental cash flow (loss) $ 20

c. The transfer price must be set in such a way as to induce the two parties to make the transfer. In essence, the transfer price must give incentives to the Circuit Board Division to want to make the transfer and give incentives to the Phones Division to buy. In other words, the following two constraints must be satisfied:

Circuit Board Division: TP > $130 (variable cost)

Phones Division TP < $150 (selling price – costs to complete)

where: TP = transfer price

Therefore, any transfer price between $130 and $150 will induce the two divisions to make the transfer. However, $130 is best as it induces transfer even if the phone price declines $19.

d. There are three important assumptions.

(i) If the Circuit Board Division currently has 5,000 units of excess capacity (33 percent), why is it selling circuit boards externally at $200. Might it not be better to lower the price of the circuit boards to say $190 (depending on the price elasticity of demand) and use up the excess capacity this way rather than by producing boards for the Phones Division at the internal transfer price? That is, the decision to transfer the boards internally assumes the opportunity cost of the excess capacity is zero.

(ii) The answer in part (c) assumes that any price between $130 and $150 is equally useful. This assumes the Phones Division will not adjust its selling price (and thus number of phones sold) based on its marginal costs (including the transfer price).

(iii) Variable costs per board ($130) and per phone ($250) do not change with volume.

Other assumptions include:

• There is a market for another 3,000 phones/month

• After including fixed costs, the divisions are profitable.

• Derived demand from additional phones does not drive down prices for circuit boards.

• Creating an exception to the rule in this case does not lead to future transfer pricing disputes.

P 5-10: Solution to US Copiers (25 minutes)

[Transfer pricing and divisional interdependencies]

a. Two reasons why US Copiers manufactures both copiers and toner cartridges are: synergies in demand and/or production. Selling toner cartridges is a way to charge higher prices to consumers who use (and hence value) the copier more intensively than users who use the copier less intensively. It allows them to engage in a form of price discrimination. To the extent that most users of SCD copiers buy US Copiers’ toner cartridges at prices above marginal cost, US Copiers earns economic profits. Production synergies involve transaction cost savings from integrating the design of the cartridges and the copiers. It is likely that one firm can design both the cartridge and the copier at a lower cost than two separate firms trying to coordinate their design teams. Alternatively, since cartridges and copiers are highly specialized to each other, two separate firms have incentives to behave opportunistically in transferring the cartridges for inclusion in the copier. A single firm is likely to be better at controlling such opportunism than two separate firms.

b. You should consider the following issues:

(i) As long as TD can add capacity and produce cartridges at long-run marginal cost (LRMC) below price, then the correct transfer price should be LRMC.

(ii) Charging SCD market price of $35 will cause SCD to set a higher price on its copiers than if a transfer price less than $35 is charged. Thus, a lower transfer price causes more copiers to be sold and eventually more replacement toner cartridges to be sold.

(iii) Neither SCD nor TD should have the sole decision-making authority to price their own products. Rather, copiers and cartridges must be priced jointly. For example, when buying copiers, consumers consider both the copier’s and replacement toner prices. In setting the price of the copier, the SCD manager should consider the future stream of replacement toner sales. And the TD manager should consider the effect of toner prices on copier sales. However, focusing only on their own profits causes each divisional manager to ignore the effect of their pricing decision on the other manager’s cash flows. Hence, decentralizing the copier and toner cartridge prices to the respective managers is likely a bad idea.

P 5-11: Solution to Cogen (25 minutes)

[Full-cost versus variable cost transfer pricing]

a. If the transfer price is set at variable cost ($150,000), the Generator Division will buy seven turbines (see table) as this level maximizes the division’s profits.

Generator’s

Var. Cost

Variable

Transfer

Total

Generator’s

Quantity

Price (000)

Revenue

Cost

Price

Cost

Profits

$1,000

$200
$150

$1750

($750)

950

$1,900

400
300

2100

(200)

900

$2,700

600
450

2450

250

850

$3,400

800
600

2800

600

800

$4,000

1000
750

3150

850

750

$4,500

1200
900

3500

1,000

700

$4,900

1400
1050

3850

1,050

650

$5,200

1600
1200

4200

1,000

b. The (average) full cost (000s) of a turbine is

Full cost = VC + FC ÷ 20

= $150 + $1800 ÷ 20

= $240

c. If the transfer price is set at full cost ($240,000), Generator will buy six turbines:

Generator’s

Avg. Cost

Variable

Transfer

Total

Generator’s

Quantity

Price (000)

Revenue

Cost

Price

Cost

Profits

$1,000

$200
$240

$1840

($840)

950

$1,900

400
480

2280

(380)

900

$2,700

600
720

2720

(20)

850

$3,400

800
960

3160

240

800

$4,000

1000
1200

3600

400

750

$4,500

1200
1440

4040

460

700

$4,900

1400
1680

4480

420

650

$5,200

1600
1920

4920

280

d. Conventional wisdom argues that variable-cost transfer pricing yields the firm-profit maximizing solution. This is certainly the case as long as variable cost is reasonably easily observed and not subject to gaming. However, the Turbine Division has incentive to reclassify what are in reality fixed costs as variable costs and to convert activities that are now a fixed cost into a variable cost (by replacing contracts written in terms of fixed cash flows with contracts written so the cash outflows vary with units produced). Thus, full-cost transfer prices, being less subject to managerial discretion, might be preferred to variable-cost transfer prices, even though full-cost transfer prices result in fewer units being transferred and hence slightly lower overall profits.

P 5-12: Solution to Wegmans (25 minutes)

[Computing and analyzing differences in residual income among supermarket stores]

a. The following table computes the residual income for the three Wegmans stores:

(000s)

Virginia 3

Rochester 1

Median

Revenues

$59,300

$110,250

$70,000

Cost of goods sold

(41,510)

(74,970)

(48,300)

Store administration

(5,930)

(8,820)

(6,300)

Distribution center charges

(5,100)

(4,900)

(3,900)

Profits before capital charge

$6,760

$21,560

$11,500

Working capital

$1,100

$1,500

$1,300

Property, building, and fixtures

58,300

28,740

44,000

Total investment

$59,400

$30,240

$45,300

Capital charge (13%)

7,722

3,931

5,889

Residual income

($962)

$17,629

$5,611

Virginia 3’s negative residual income of nearly $1 million stands in stark contrast to Rochester 1’s $17.6 million and the Median’s $5.6 million residual incomes. On the surface, Virginia 3 is performing poorly relative to Rochester 3 and Median. However, there are a number of likely explanations for these differences:

Virginia 3 being relatively new in Virginia has not developed the same customer following and name recognition afforded long established Wegmans stores such as Rochester 1. Hence, Virginia 3 unlikely has the same volume and pricing advantages enjoyed by other Wegmans stores. From the following table we see that Virginia 3’s gross operating margin is 30% of sales, whereas Rochester 1’s margin is 32% of sales and the median store is 31% of sales.

(000s)

Virginia 3
Rochester 1
Median
Revenues

$59,300

$110,250

$70,000

Cost of goods sold

(41,510)

(74,970)

(48,300)

Gross margin

$17,790

$35,280

$21,700

Gross margin (% of sales)

30%

32%

31%

However, the lower gross margin in Virginia 3 only explains a relatively small difference in residual incomes among the three stores. A 1% or 2% higher margin would only increase Virginia 3’s residual income by $0.6 – $1.2 million.