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MA 15e_IE PPT_Ch10.pptx
1.
Evaluating Decentralized Operations Chapter 10
2.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objectives (slide 1 of 2) • Obj. 1: Describe the advantages and disadvantages of decentralized operations. • Obj. 2: Prepare a responsibility accounting report for a cost center. • Obj. 3: Prepare responsibility accounting reports for a profit center. • Obj. 4: Compute and interpret the return on investment and residual income for an investment center.
3.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objectives (slide 2 of 2) • Obj. 5: Describe and illustrate how the market price, negotiated price, and cost price approaches to transfer pricing may be used by decentralized segments of a business. • Obj. 6: Describe and illustrate the use of profit margin, investment turnover, and R O I in evaluating whether a company should expand through franchised or owner-operated stores.
4.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Centralized and Decentralized Operations
5.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Advantages of Decentralization (slide 1 of 2) • For large companies, it is difficult for top management to: o Maintain daily contact with all operations o Maintain operating expertise in all product lines and services • In such cases, delegating authority to managers closest to the operations usually results in better decisions.
6.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Advantages of Decentralization (slide 2 of 2) • Decentralized operations provide excellent training for managers. • Delegating responsibility allows managers to develop managerial experience early in their careers. o This helps a company retain managers, some of whom may be later promoted to top management positions. • Managers of decentralized operations often work closely with customers. o As a result of this, they tend to identify with customers and, thus, are often more creative in suggesting operating and product improvements.
7.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Disadvantages of Decentralization Decisions made by one manager may negatively affect the profits of the company. Assets and expenses may be duplicated across divisions.
8.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Advantages and Disadvantages of Decentralized Operations
9.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting • In a decentralized business, accounting assists managers in evaluating and controlling their areas of responsibility, called responsibility centers. o Responsibility accounting is the process of measuring and reporting operating data by responsibility center. o Three types of responsibility centers are as follows: Cost centers, which have responsibility over costs Profit centers, which have responsibility over revenues and costs Investment centers, which have responsibility over revenues, costs, and investment in assets
10.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Cost Centers (slide 1 of 3) • A cost center manager has responsibility for controlling costs. o However, a cost center manager does not make decisions concerning sales or the amount of fixed assets invested in the center. • Cost centers may vary in size from a small department to an entire manufacturing plant. • Cost centers may exist within other cost centers.
11.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Centers in a University
12.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Cost Centers (slide 2 of 3) • Responsibility accounting for cost centers focuses on the controlling and reporting of costs. • Budget performance reports that report budgeted and actual costs are normally prepared for each cost center.
13.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting Reports for Cost Centers (slide 3 of 3)
14.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Cost Center Responsibility Measures (slide 1 of 2) • Delinco Tech Inc. manufactures corrosion-resistant water pumps and fluid meters. Its Commercial Products Division is organized as a cost center. The division’s budget for the month ended July 31 is as follows (in thousands): Materials $140,000 Factory wages 77,000 Supervisor salaries 15,500 Utilities 8,700 Depreciation of plant equipment 9,000 Maintenance 3,200 Insurance 750 Property taxes 800 Total $254,950
15.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Cost Center Responsibility Measures (slide 2 of 2) • During July, actual costs incurred in the Commercial Products Division were as follows: • Prepare a budget performance report for the director of the Commercial Products Division for July. Materials $152,000 Factory wages 77,800 Supervisor salaries 15,500 Utilities 8,560 Depreciation of plant equipment 9,000 Maintenance 3,025 Insurance 750 Property taxes 820 Total $267,455
16.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Cost Center Responsibility Measures Solution
17.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Profit Centers (slide 1 of 3) • A profit center manager has the responsibility and authority for making decisions that affect both revenues as well as costs and profits. o Profit centers may be divisions, departments, or products. o The manager does not make decisions concerning the fixed assets invested in the center.
18.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Profit Centers (slide 2 of 3) • Responsibility accounting for profit centers focuses on reporting revenues, expenses, and operating income. o Thus, responsibility accounting reports for profit centers take the form of income statements.
19.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Profit Centers (slide 3 of 3) • The profit center income statement should include only revenues and expenses that are controlled by the manager. o Controllable revenues are revenues earned by the profit center. o Controllable expenses are costs that can be influenced (controlled) by the decisions of the profit center managers.
20.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 1 of 9) • The controllable expenses of profit centers include direct operating expenses such as sales salaries and utility expenses. • A profit center may incur expenses provided by internal centralized service departments.
21.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 2 of 9) • Service department charges are indirect expenses to a profit center. o They are similar to the expenses that would be incurred if the profit center purchased the services from outside the company. • A profit center manager has control over service department expenses if the manager is free to choose how much service is used. o In such cases, service department allocations are assigned to profit centers based on the usage of the service by each profit center.
22.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 3 of 9) • Nova Entertainment Group (N E G), a diversified entertainment company, has two operating divisions organized as profit centers.
23.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 4 of 9) • The revenues and direct operating expenses for the two divisions are shown below. o The operating expenses consist of direct expenses, such as the wages and salaries of a division’s employees. Theme Park Division Movie Production Division Revenues $6,000,000 $2,500,000 Operating expenses $2,495,000 $ 405,000
24.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 5 of 9) • N E G’s service departments and the expenses they incurred for the year ended December 31, 20Y8, are as follows: Purchasing $400,000 Payroll Accounting 255,000 Legal 250,000 Total $905,000
25.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 6 of 9) • A cost driver for each service department is used to allocate service department expenses to the Theme Park and Movie Production divisions. o The cost driver for each service department is a measure of the services performed. For N E G, the service department cost drivers are as follows: Department Cost Driver Purchasing Number of purchase requisitions Payroll Accounting Number of payroll checks Legal Number of billed hours
26.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 7 of 9) • The use of services by the Theme Park and Movie Production divisions is as follows:
27.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 8 of 9) • The rates at which allocated are charged to each division are called support department charge rates. These rates are computed as follows: o N E G’s service department charges are computed as follows: Support Department Expense Support Department Allocation Rate = Total Support Department Usage $400,000 Purchasing Allocation Rate = = $10 per purchase requisition 40,000 purchase requisitions $255,000 Payroll Allocation Rate = = $17 per payroll check 15,000 payroll checks $ Legal Allocation Rate = 250,000 = $250 per hr. 1,000 billed hrs.
28.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges (slide 9 of 9) • The services used by each division are multiplied by the service department allocation rates to determine the service department allocations for each division, computed as follows: Support Department Allocation = Service Usage × Support Department Allocation Rate
29.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Service Department Charges to N E G Divisions
30.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Profit Center Reporting • In evaluating the profit center manager, operating income should be compared over time to a budget. • However, it should not be compared across profit centers because the profit centers are usually different in terms of size, products, and customers.
31.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Divisional Income Statements—N E G
32.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Profit Center Responsibility Reporting (slide 1 of 2) • Johnson Company has two divisions, East and West, that operate as profit centers. Sales, cost of goods sold, and selling expenses for the two divisions for the year ended December 31 are as follows: • In addition, the company has two support departments, Legal and Tech Support. • The support department expenses for the year ended December 31 are as follows: East Division ($) West Division ($) Sales $3,000,000 $8,000,000 Cost of goods sold 1,650,000 4,200,000 Selling expenses 850,000 1,850,000 Legal Department Tech Support Department $350,000 $250,000
33.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Profit Center Responsibility Reporting (slide 2 of 2) • The Legal Department costs are allocated to user divisions based on the number of hours of service, and the Tech Support Department costs are allocated to user divisions based on the number of computers. • The usage of service by the two divisions is as follows: • Prepare income statements for the year ended December 31, showing operating income for the two divisions. o Use two column headings: East and West. Legal Tech Support East Division 500 hours 80 computers West Division 1,500 hours 120 computers Total 2,000 hours 200 computers
34.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Profit Center Responsibility Reporting Solution
35.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Investment Centers (slide 1 of 2) • An investment center manager has the responsibility and the authority to make decisions that affect not only costs and revenues but also the assets invested in the center. • Investment centers are often used in diversified companies organized by divisions. o In such cases, the divisional manager has authority similar to that of a chief operating officer or president of a company.
36.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Responsibility Accounting for Investment Centers (slide 2 of 2) • Because investment center managers have responsibility for revenues and expenses, operating income is part of investment center reporting. • In addition, because the manager has responsibility for the assets invested in the center, the following two additional measures of performance are used: o Return on investment o Residual income
37.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Divisional Income Statements—DataLink Inc.
38.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 1 of 14) • Because investment center managers control the amount of assets invested in their centers, they should be evaluated on the use of these assets. • One measure that considers the amount of assets invested in an investment center is the return on investment (R O I) or return on assets. • The return on investment (R O I) is computed as follows: Operating Income Return on Investment (ROI) = Invested Assets
39.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 2 of 14) • The return on investment is useful because the three factors subject to control by divisional managers (revenues, expenses, and invested assets) are considered. o The higher the return on investment, the better the division is using its assets to generate income. • In effect, the return on investment measures the income (return) on each dollar invested. o As a result, the return on investment can be used as a common basis for comparing divisions with each other.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 3 of 14) • The invested assets of DataLink’s three divisions are as follows: Invested Assets Northern Division $350,000 Central Division 700,000 Southern Division 500,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 4 of 14) • Using the operating income for each division in slide 37, the return on investment for each division is computed as follows: o Northern Division: o Central Division: o Southern Division: Operating Income $70,000 Return on Investment = = = 20% Invested Assets $350,000 Operating Income $84,000 Return on Investment = = = 12% Invested Assets $700,000 Operating Income $75,000 Return on Investment = = = 15% Invested Assets $500,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 5 of 14) • To analyze differences in the return on investment across divisions, the DuPont formula for the return on investment is often used. • The DuPont formula views the return on investment as the product of two factors. o Profit margin, which is the ratio of operating income to sales o Investment turnover, which is the ratio of sales to invested assets
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 6 of 14) • Using the DuPont formula, the return on investment is expressed as follows: Return on Investment = Profit Margin × Investment Turnover Operating Income Sales Return on Investment = × Sales Invested Assets
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 7 of 14) • The DuPont formula is useful in evaluating divisions. o This is because the profit margin and the investment turnover reflect the following underlying operating relationships of each division: Profit margin indicates operating profitability by computing the profit earned on each sales dollar. – If a division’s profit margin increases, and all other factors remain the same, the division’s return on investment will increase. Investment turnover indicates operating efficiency by computing the number of sales dollars generated by each dollar of invested assets. – If a division’s investment turnover increases, and all other factors remain the same, the division’s return on investment will increase.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 8 of 14) The return on investment, profit margin, and investment turnover operate in relationship to one another. More income can be earned by either increasing the investment turnover, increasing the profit margin, or both.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 9 of 14) • Using the DuPont formula yields the same return on investment for each of DataLink’s divisions, computed as follows: o Northern Division: o Central Division: o Southern Division: Operating Income Sales Return on Investment = × Sales Invested Assets $70,000 $560,000 Return on Investment = × = 12.5% × 1.6 = 20% $560,000 $350,000 $84,000 $672,000 Return on Investment = × = 12.5% × 0.96 = 12% $672,000 $700,000 $75,000 $750,000 Return on Investment = × = 10% × 1.5 = 15% $750,000 $500,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 10 of 14) • To increase the return on investment, the profit margin and investment turnover for a division may be analyzed. • Assume that the revenues of the Northern Division could be increased by $56,000 through increasing operating expenses, such as advertising, to $385,000.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 11 of 14) o The Northern Division’s operating income will increase from $70,000 to $77,000, computed as follows: o The return on investment for the Northern Division, using the DuPont formula, is recomputed as follows: Revenues ($560,000 + $56,000) $ 616,000 Operating expenses (385,000) Operating income before support department allocations $ 231,000 Support department allocations (154,000) Operating income $ 77,000 $77,000 $616,000 Return on Investment = × = 12.5% × 1.76 = 22% $616,000 $350,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 12 of 14) • The return on investment is also useful in deciding where to invest additional assets or expand operations. o For example, DataLink should give priority to expanding operations in the Northern Division because it earns the highest return on investment. In other words, an investment in the Northern Division will return 20 cents (20%) on each dollar invested. In contrast, investments in the Central and Southern divisions will earn only 12 cents and 15 cents, respectively, per dollar invested.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 13 of 14) • A disadvantage of the return on investment as a performance measure is that it may lead divisional managers to reject new investments that could be profitable for the company as a whole.
51.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Return on Investment (slide 14 of 14) • Assume the following returns on investment for the Northern Division of DataLink: o If the manager of the Northern Division invests in the new project, the Northern Division’s overall return on investment will decrease from 20% due to averaging. Thus, the division manager might decide to reject the project, even though the new project’s expected return of 14% exceeds DataLink’s minimum acceptable return of 10%. Current return on investment 20% Minimum acceptable return on investment set by top management 10% Expected return on investment for new project 14%
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income (slide 1 of 5) • Residual income is useful in overcoming some of the disadvantages of the return on investment. • Residual income is the excess of operating income over a minimum acceptable operating income. o The minimum acceptable operating income is computed by multiplying the company minimum return on investment by the invested assets. The minimum rate is set by top management, based on such factors as the cost of financing.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income (slide 2 of 5)
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income—DataLink, Inc.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income (slide 3 of 5) • The major advantage of residual income as a performance measure is that it considers the minimum acceptable return on investment, invested assets, and the operating income for each division. o In doing so, residual income encourages division managers to maximize operating income in excess of the minimum. This provides an incentive to accept any project that is expected to have a return on investment in excess of the minimum.
56.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income (slide 4 of 5) • Assume the following returns on investment for the Northern Division of DataLink: o If the manager of the Northern Division is evaluated on new projects using only the return on investment, the division manager might decide to reject the new project. This is because investing in the new project will decrease Northern’s current return on investment of 20%. – While this helps the division maintain its high R O I, it hurts the company as a whole as the expected return on investment of 14% exceeds DataLink’s minimum acceptable of return on investment of 10%. Current return on investment 20% Minimum acceptable return on investment set by top management 10% Expected return on investment for new project 14%
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Residual Income (slide 5 of 5) o In contrast, if the manager of the Northern Division is evaluated using residual income, the new project would probably be accepted. This is because the new project will increase the Northern Division’s residual income. – In this way, residual income supports both divisional and overall company objectives.
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Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Investment Center Performance Measures • Yummy Foods Company is a diversified company with three divisions organized as investment centers. Condensed data taken from the records of the three divisions for the year ended December 31 are as follows: a. Using the DuPont formula for return on investment, compute the profit margin, investment turnover, and return on investment for each division. b. Determine the residual income for each division, assuming a minimum acceptable return on investment is 14%. Snack Goods Canned Foods Frozen Foods Revenues $ 784,000 $ 940,800 $1,050,000 Operating expenses (470,400) (700,000) (562,500) Operating income before support department allocations $ 313,600 $ 240,800 $ 487,500 Support department allocations (219,520) (99,680) (382,500) Operating income $ 94,080 $ 141,120 $ 105,000 Invested assets $ 448,000 $ 940,800 $ 750,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Investment Center Performance Measures Solution (Slide 1 of 2)
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Investment Center Performance Measures Solution (Slide 2 of 2)
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Transfer Pricing (slide 1 of 2)
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Transfer Pricing (slide 2 of 2) • The objective of setting a transfer price is to motivate managers to behave in a manner that will increase the overall company income. • Transfer prices can be set as low as the variable cost per unit or as high as the market price. o Often, transfer prices are negotiated at some point between the two.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Commonly Used Transfer Prices
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Income Statements— No Transfers Between Divisions
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Market Price Approach (slide 1 of 3) • Using the market price approach, the transfer price is the price at which the product or service transferred could be sold to outside buyers. • If an outside market exists for the product or service transferred, the current market price may be a proper transfer price. Transfer Price = Market Price
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Market Price Approach (slide 2 of 3) • Assume that materials used by Wilson in producing snack food in the Western Division are currently purchased from an outside supplier at $20 per unit. o The same materials are produced by the Eastern Division. o The Eastern Division is operating at full capacity of 50,000 units and can sell all it produces to either the Western Division or to outside buyers.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Market Price Approach (slide 3 of 3) • A transfer price of $20 per unit (the market price) has no effect on the Eastern Division’s income or total company income. o The Eastern Division will earn revenues of $20 per unit on all its production and sales, regardless of who buys its product. o The Western Division will pay $20 per unit for materials (the market price). • In this situation, the use of the market price as the transfer price is proper.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 1 of 11) • If unused or excess capacity exists in the supplying division (the Eastern Division) and the transfer price is equal to the market price, total company profit may not be maximized. o This is because the manager of the Western Division will be indifferent toward purchasing materials from the Eastern Division or from outside suppliers. In both cases the Western Division manager pays $20 per unit (the market price). Therefore, the Western Division may purchase the materials from outside suppliers.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 2 of 11) • If the Western Division purchases the materials from the Eastern Division, the difference between the market price of $20 and the variable costs of the Eastern Division of $10 per unit can cover fixed costs and contribute to overall company profits. o Thus, the Western Division manager should be encouraged to purchase the materials from the Eastern Division.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 3 of 11) • The negotiated price approach allows the managers to agree (negotiate) among themselves on a transfer price. • The only constraint is that the transfer price be less than the market price but greater than the supplying division’s variable costs per unit, as follows: Variable Costs per Unit < Transfer Price < Market Price
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 4 of 11) • Assume that instead of a capacity of 50,000 units, the Eastern Division’s capacity is 70,000 units. • In addition, assume that the Eastern Division can continue to sell only 50,000 units to outside buyers.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 5 of 11) • A transfer price less than $20 would encourage the manager of the Western Division to purchase from the Eastern Division. o This is because the Western Division is currently purchasing its materials from outside suppliers at a cost of $20 per unit. Thus, its materials cost would decrease, and its operating income would increase.
73.
© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 6 of 11) • At the same time, a transfer price above the Eastern Division’s variable costs per unit of $10 would encourage the manager of the Eastern Division to supply materials to the Western Division. o In doing so, the Eastern Division’s operating income would also increase.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Income Statements—Negotiated Transfer Price
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 7 of 11) • The increase of $100,000 in the Eastern Division’s income can also be computed as follows: • The increase of $100,000 in the Western Division’s income can also be computed as follows: Increase in Eastern (Supplying) Division's Operating Income = (Transfer Price – Variable Cost per Unit) × Units Transferred = ($15 – $10) 20,000 units = $100,000 Increase in Western (Purchasing) Division's Operating Income = (Market Price – Transfer Price) × Units Transferred = ($20 – $15) 20,000 units = $100,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 8 of 11) • Comparing the exhibits in slides 65 and 75 shows that Wilson’s operating income increased by $200,000. • Any negotiated transfer price between $10 and $20 is acceptable, as shown in the following formula: Variable Costs per Unit < Transfer Price < Market Price $10 < Transfer Price < $20
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 9 of 11) • Any transfer price within this range will increase the overall operating income for Wilson by $200,000. o The increases in the Eastern and Western divisions’ operating income will vary depending on the transfer price. • A transfer price of $16 would increase the Eastern Division’s operating income by $120,000, computed as follows: Increase in Eastern (Supplying) Division's Operating Income = (Transfer Price – Variable Cost per Unit) × Units Transferred = ($16 – $10) 20,000 units = $120,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 10 of 11) • A transfer price of $16 would increase the Western Division’s operating income by $80,000, computed as follows: • With a transfer price of $16, Wilson Company’s operating income still increases by $200,000. o This amount consists of the Eastern Division’s increase of $120,000 and the Western Division’s increase of $80,000. Increase in Western (Purchasing) Division's Operating Income = (Market Price – Transfer Price) × Units Transferred = ($20 – $16) 20,000 units = $80,000
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Negotiated Price Approach (slide 11 of 11) • A negotiated price provides each division manager with an incentive to negotiate the transfer of materials. • At the same time, the overall company’s operating income will also increase. • However, the negotiated approach only applies when the supplying division has excess capacity.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Transfer Pricing • The materials used by the South Division of Eagle Company are currently purchased from outside suppliers at $30 per unit. These same materials are produced by Eagle’s North Division. Operating income assuming no transfers between divisions is $1,200,000 for the North Division and $1,360,000 for the South Division. • The North Division has unused capacity and can produce the materials needed by the South Division at a variable cost of $15 per unit. The two divisions have recently negotiated a transfer price of $22 per unit for 30,000 units. • Based on the agreed upon transfer price, with no reduction in the North Division’s current sales: a. How much would the North Division’s operating income increase? b. How much would the South Division’s operating income increase? c. How much would Eagle Company’s operating income increase?
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Check Up Corner Transfer Pricing Solution
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Price Approach (slide 1 of 3) • Under the cost price approach, cost is used to set transfer prices. • A variety of costs may be used in this approach, including: o Total product cost per unit Direct materials, direct labor, and factory overhead are included in the transfer price. o Variable product cost per unit The fixed factory overhead cost is excluded from the transfer price.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Price Approach (slide 2 of 3) • Actual costs or standard (budgeted) costs may be used in applying the cost price approach. o If actual costs are used, inefficiencies of the producing (supplying) division are transferred to the purchasing division. Thus, there is little incentive for the producing (supplying) division to control costs. – Most companies use standard costs in the cost price approach. – In this way, differences between actual and standard costs remain with the producing (supplying) division for cost control purposes.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Cost Price Approach (slide 3 of 3) • The cost price approach is most often used when the responsibility centers are organized as cost centers. • When the responsibility centers are organized as profit or investment centers, the cost price approach is normally not used.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Franchise Operations (slide 1 of 7) • A franchise is the right or license granted to an individual or group to market a company’s goods or services. • The franchisor is the entity that provides the franchise, while the franchisee is the entity that pays for the franchise. • The franchise fee is often expressed as a percent of revenues earned by the franchisee. • In addition, the franchisee invests in the property and equipment to deliver the franchised product or service.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Franchise Operations (slide 2 of 7) • The franchisor often provides support in start-up, advertising, management development, business systems, and supplier relationships. o The benefits to a franchisee are instant access to a recognized brand, established customer base, and working business systems. o The main benefit to the franchisor is an ability to expand the brand without investing significantly in property and equipment.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Franchise Operations (slide 3 of 7) • From the franchisor’s perspective the return on investment for franchised operations should be increased by the low investment. o The DuPont formula should show a healthy profit margin combined with a high investment turnover. • Assume that Hilton Worldwide Holdings, Inc. (HLT), has both company-operated and franchised hotel operations. o In a recent year, Hilton had 141 company-operated hotels and 4,781 franchised hotels around the world.
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Franchise Operations (slide 4 of 7) • Segment disclosures with some assumptions regarding owned and franchised operations are as follows, in millions: *Assume all the general and administrative expenses support franchised operations, since less than 3% of hotel properties are company-operated. ** Total property, plant, and equipment is $8,930. Assume 10% of total property, plant, and equipment support administrative (franchised) operations, while the remaining 90% consist of owned hotel properties. Company-Operated Franchised Revenues $ 4,126 $ 1,701 Operating expenses $ 3,100 $ 0 General and administrative expenses* $ 0 $ 616 Property, plant, and equipment** $ 8,037 $ 893
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Franchise Operations (slide 5 of 7) • The return on investment (R O I) using the DuPont formula for both segments is as follows: o Company-Operated Hotels: Return on Investment = Profit Margin × Investment Turnover Operating Income Revenues Return on Investment = × Revenues Invested Assets 1 1 $1,026 $4,126 Return on Investment = × $4,126 $8,037 = 24.9% × 0.51 = 12.7% (rounded) $4,126 – $3,100
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Franchise Operations (slide 6 of 7) o Franchised Hotels: • Under these assumptions, franchised hotels provide a superior R O I compared to company- operated hotels. 2 2 $1,085 $1,701 Return on Investment = × $1,701 $893 = 63.8% × 1.90 = 121.2% (rounded) $1,701 – $616
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© 2020 Cengage
Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Franchise Operations (slide 7 of 7) • The superior performance is caused by both a stronger profit margin and a higher investment turnover. • The R O I will often favor franchised operations in this way. o This is likely the reason for Hilton’s decision to emphasize franchised operations.
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