DECENTRALIZED OPERATIONS

Sherry Smith is the president/CEO of Tiller Components. She founded the firm and has led it to become an industry leader in the area of automobile manufacturing components and parts. The company has plants in over 35 areas across the country. Smith is finding that she cannot manage and stay on track with things the way she was able to in the past.

Discuss the decision-making approaches (centralized and decentralized) that you might use if you were the CEO of Tiller Components and how this would affect the different local and regional managers.

What activities would be conducted centrally and which would you decentralize?

How would the shifts in this method of decision-making and management that you suggest impact the company overall?

Further, how can the use of analytical tools assist Smith with better understanding how each of her divisions and segments are performing?

Directions:

Discuss the concepts, principles, and theories from your textbook. Cite your textbooks and cite any other sources if appropriate.

Support your submission with course material concepts, principles, and theories from the textbook and at least three scholarly, peer-reviewed journal articles

Your initial post should address all components of the question with a 500 word limit.

Chapter 10
Evaluating
Decentralized
Operations
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.
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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.
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Centralized and Decentralized Operations
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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.
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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.
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Disadvantages of Decentralization
Decisions made by one manager may
negatively affect the profits of the company.
Assets and expenses may be duplicated
across divisions.
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Advantages and Disadvantages
of Decentralized Operations
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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
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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.
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Cost Centers in a University
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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.
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Responsibility Accounting Reports for
Cost Centers (slide 3 of 3)
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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
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Check Up Corner
•
Cost Center Responsibility
Measures (slide 2 of 2)
During July, actual costs incurred in the Commercial Products Division were as
follows:
Materials
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
•
$152,000
$267,455
Prepare a budget performance report for the director of the Commercial Products
Division for July.
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Check Up Corner
Cost Center Responsibility
Measures Solution
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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.
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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.
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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.
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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.
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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.
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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.
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Service Department Charges
(slide 4 of 9)
• The revenues and direct operating expenses for
the two divisions are shown below.
Theme Park
Division
Movie Production
Division
Revenues
$6,000,000
$2,500,000
Operating expenses
$2,495,000
$ 405,000
o The operating expenses consist of direct expenses,
such as the wages and salaries of a division’s
employees.
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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
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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
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Service Department Charges
(slide 7 of 9)
• The use of services by the Theme Park and
Movie Production divisions is as follows:
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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:
Support Department Allocation Rate =
Support Department Expense
Total Support Department Usage
o N E G’s service department charges are computed as
follows:
Purchasing Allocation Rate =
Payroll Allocation Rate =
Legal Allocation Rate =
$400,000
= $10 per purchase requisition
40,000 purchase requisitions
$255,000
= $17 per payroll check
15,000 payroll checks
$250,000
= $250 per hr.
1,000 billed hrs.
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Service Department Charges
(slide 9 of 9)
• The services used by each division are
multiplied by the service department allocation
rates to determine the service department
allocations for each division, computed as
follows:
Support Department Allocation = Service Usage × Support Department Allocation Rate
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Service Department Charges to N E G
Divisions
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Profit Center Reporting
• In evaluating the profit center manager,
operating income should be compared over time
to a budget.
• However, it should not be compared across
profit centers because the profit centers are
usually different in terms of size, products, and
customers.
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Divisional Income Statements—N E G
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Check Up Corner
•
•
•
Profit Center Responsibility
Reporting (slide 1 of 2)
Johnson Company has two divisions, East and West, that operate as profit centers.
Sales, cost of goods sold, and selling expenses for the two divisions for the year
ended December 31 are as follows:
East Division ($)
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
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:
Legal Department
Tech Support
Department
$350,000
$250,000
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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:
Legal
Tech Support
East Division
500 hours
80 computers
West Division
1,500 hours
120 computers
Total
2,000 hours
200 computers
Prepare income statements for the year ended December 31, showing operating
income for the two divisions.
o
Use two column headings: East and West.
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Check Up Corner
Profit Center Responsibility
Reporting Solution
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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.
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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
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Divisional Income Statements—DataLink Inc.
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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:
Return on Investment (ROI) =
Operating Income
Invested Assets
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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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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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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:
Return on Investment =
o
Operating Income
$70,000
=
= 20%
Invested Assets
$350,000
Central Division:
Return on Investment =
o
Operating Income
$84,000
=
= 12%
Invested Assets
$700,000
Southern Division:
Return on Investment =
Operating Income
$75,000
=
= 15%
Invested Assets
$500,000
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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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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
Return on Investment =
Operating Income
Sales
×
Sales
Invested Assets
© 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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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.
© 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:
Return on Investment =
o
Operating Income
Sales
×
Sales
Invested Assets
Northern Division:
$70,000
$560,000
×
= 12.5% × 1.6 = 20%
$560,000
$350,000
Return on Investment =
o
Central Division:
Return on Investment =
o
$84,000
$672,000
×
= 12.5% × 0.96 = 12%
$672,000
$700,000
Southern Division:
Return on Investment =
$75,000
$750,000
×
= 10% × 1.5 = 15%
$750,000
$500,000
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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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Return on Investment
(slide 11 of 14)
o
o
The Northern Division’s operating income will increase
from $70,000 to $77,000, computed 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
The return on investment for the Northern Division, using
the DuPont formula, is recomputed as follows:
Return on Investment =
$77,000
$616,000
×
= 12.5% × 1.76 = 22%
$616,000
$350,000
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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.
© 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.
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Return on Investment
(slide 14 of 14)
• Assume the following returns on investment for
the Northern Division of DataLink:
Current return on investment
20%
Minimum acceptable return on investment set
by top management
10%
Expected return on investment for new project
14%
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%.
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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.
© 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 2 of 5)
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Residual Income—DataLink, Inc.
© 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.
© 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:
Current return on investment
20%
Minimum acceptable return on investment set by top management
10%
Expected return on investment for new project
14%
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%.
© 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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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:
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
a. Using the DuPont formula for return on investment, compute the profit margin, investment
b.
turnover, and return on investment for each division.
Determine the residual income for each division, assuming a minimum acceptable return on
investment is 14%.
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Check Up Corner
Investment Center Performance
Measures Solution (Slide 1 of 2)
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Check Up Corner
Investment Center Performance
Measures Solution (Slide 2 of 2)
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Transfer Pricing
(slide 1 of 2)
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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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Commonly Used Transfer Prices
© 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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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
© 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.
© 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.
© 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.
© 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.
© 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 © 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. © 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. © 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. © 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 © 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: Increase in Eastern (Supplying) Division's Operating Income = (Transfer Price – Variable Cost per Unit) × Units Transferred = ($15 – $10)  20,000 units = $100,000 • The increase of $100,000 in the Western Division’s income can also be computed as follows: Increase in Western (Purchasing) Division's Operating Income = (Market Price – Transfer Price) × Units Transferred = ($20 – $15)  20,000 units = $100,000 © 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 © 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 © 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: Increase in Western (Purchasing) Division's Operating Income = (Market Price – Transfer Price) × Units Transferred = ($20 – $16)  20,000 units = $80,000 • 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. © 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. © 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. b. c. How much would the North Division’s operating income increase? How much would the South Division’s operating income increase? How much would Eagle Company’s operating income increase? © 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 © 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. © 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. © 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. © 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. © 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. © 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. © 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: 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 *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. © 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: Return on Investment = Profit Margin × Investment Turnover Return on Investment = Operating Income Revenues × Revenues Invested Assets o Company-Operated Hotels: $1,0261 $4,126 Return on Investment = × $4,126 $8,037 = 24.9% × 0.51 = 12.7% (rounded) 1 $4,126 – $3,100 © 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: $1,0852 $1,701 Return on Investment = × $1,701 $893 = 63.8% × 1.90 = 121.2% (rounded) 2 $1,701 – $616 • Under these assumptions, franchised hotels provide a superior R O I compared to companyoperated hotels. © 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. © 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.