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2015-02-12
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Chapter 11
Financial
Control
QUESTIONS
11-1 Financial control is the formal evaluation of some financial facet of an organization or a
responsibility center to assess organization and management performance. Financial control
uses financial numbers, such as costs or expenses, as broad indices of performance or
measures of the resources used by a process or organizational unit. Financial control may
involve comparing actual financial numbers with targets from a standard or budget to derive
variances.
11-2 Internal financial control is the application of financial control tools to evaluate
organization units. The resulting information is used inside the organization and is not
provided to outsiders. External financial control is the application of financial control tools by
outside analysts to evaluate various aspects of organization performance.
11-3 Decentralization is the delegation of decision-making authority from people at higher
levels in the organization to front line decision makers of the organization.
11-4 Control refers to the systems and tools that an organization uses to motivate
decentralized decision makers to pursue the organization’s goals.
11-5 A responsibility center is an organizational unit for which a manager is held accountable.
The manager is asked to run the center to achieve the objectives of the larger organization.
11-6 A cost center is a responsibility unit that is evaluated based on its ability to control costs
relative to some standard. Revenues or investment level are not controlled.
11-7 A revenue center is assigned the responsibility to achieve, within its own operating
guidelines, a target level of revenues. Managers in a revenue center do not control costs or the
level of investment.
11-8 Organizations use profit centers when profit center employees have the ability and
responsibility to control significant levels of revenues and costs of the products or services
they deliver.
11-9 An investment center is a responsibility unit that is evaluated based on its return on
investment. The managers and other employees control revenues, costs, and the level of
investment.
11-10 The controllability principle requires that people should only be held accountable for
results that they can control. The manager of a responsibility center should be assigned
responsibility for the revenues, costs, or investments controlled by responsibility center
personnel.
11-11 Responsibility centers participate in developing the goods and services that the
organization supplies to its customers, sharing the use of many common resources in this
process. In most organizations, many revenues and costs are jointly earned or incurred.
11-12 A segment margin is the difference between the revenues and costs that are deemed to
be directly controllable by a responsibility center. It is therefore an important summary
performance measure for each responsibility center.
11-13 A soft number is a number that is based on conventional accounting assumptions but
relies on subjective revenue and cost allocation assumptions over which there can be
legitimate disagreement. Because soft numbers result from subjective interpretation, they are
neither right nor wrong.
11-14 A transfer price is the price at which a good or service is deemed to have been
transferred between two responsibility centers within an organization. The transfer price is
treated as revenue in the supplying division and as a cost in the receiving division. The
transfer price is a fiction created for control purposes and does not affect external reporting.
11-15 The four bases for setting transfer prices are market, cost, negotiated, and
administered.
11-16 Organizations earn revenues by selling goods and services to customers. When
organizations use control systems that require revenue numbers for responsibility centers, the
revenue earned from the sale to the final customer must be divided among the contributing
responsibility centers. This process is necessary to prepare responsibility center income
statements, and in turn, evaluate the center’s performance.
11-17 Organizations use many types of resources to make goods and services. When
organizations use control systems that require cost numbers for responsibility centers, the
costs of the resources that are used by two or more responsibility centers must be divided
between or among those responsibility centers. This process is necessary to prepare
responsibility center income statements, and in turn, evaluate the center’s performance.
11-18 Return on investment is a measure of accounting income (typically, operating income)
divided by a measure of the investment in the assets used to earn that income.
11-19 All other things being equal, as efficiency (the ratio of income to sales) increases
(decreases), return on investment increases (decreases).
11-20 All other things being equal, as productivity (the ratio of sales to investment) increases
(decreases), return on investment increases (decreases).
11-21 Residual income is the difference between reported accounting income and the
required return on the investment (economic cost of investment) used to earn that income.
11-22 Economic value added (EVA) is a refinement of the residual income idea. The EVA
computation adjusts reported accounting income and asset levels for what many consider the
biasing effects on current results of the financial accounting doctrine of conservatism. For
example, GAAP requires the immediate expensing of research and development costs; yet,
when shareholder value analysis income is computed, research and development costs are
capitalized and expensed over a certain time period, such as five years.
11-23 Whole Foods states, “ We use EVA extensively for capital investment decisions,
including evaluating new store real estate decisions and store remodeling proposals. We only
invest in projects that we believe will add long-term value to the Company. The EVA decisionmaking model also enhances operating decisions in stores. Our emphasis is on EVA
improvement …”
( http://www.wholefoodsmarket.com/company/eva.php, accessed January 12, 2011) . As
mentioned in Chapter 11, Quaker Foods & Beverages, a food manufacturer, used EVA to
support its decision in June 1992 to cease trade loading , which is the food industry’s practice
of using promotions to obtain orders for a two- or three-month supply of food from customers.
Trade loading causes quarterly peaks in production and sales that, in turn, require huge
investments in assets, including the inventory itself, warehouses, and distribution centers.
11-24 Financial control alone may be an ineffective control scorecard for three reasons. First,
it focuses on financial measures that do not measure the organization’s other important
attributes, such as product quality and customer service. Second, financial control measures
the financial effect of the overall level of performance achieved on the critical success factors,
and it ignores the performance achieved on the individual critical success factors. Third,
financial control is usually oriented to short-term profit performance.
EXERCISES
11-25 Decentralization creates the need to ensure that the decentralized decision makers are
pursuing the organization’s stated goals and are coordinated as they make their independent
decisions.
11-26 Examples of organization units that might be responsibility centers in a university
include: A school or college, a department within a school or college, maintenance, the
computing center, a dormitory residence, the registrar’s office, a sports program, and the
alumni office.
11-27 Examples of cost centers are: A maintenance department in a factory, a computer
department in an insurance company, and a personnel office in a government. What these
responsibility centers have in common is that they do not deal directly with the organization’s
primary customer. Therefore, they have no direct effect on revenues. They also do not control
investment levels.
11-28 Examples of revenue centers are: The sporting goods department in a large department
store where the corporation’s purchasing group makes all stocking decisions, the counter
department in a fast food restaurant, and the sales office in an insurance company. What these
responsibility centers have in common is that they all deal with customers and have little
control over the major cost of the product that they are selling to the customer. They also do
not control investment levels.
11-29 The manager of a large department store may have little control over stock, prices, and
advertising but controls many of the other facets of performance. How customers are treated
and how displays are arranged will affect sales. How staffing is done and service functions
performed within the store will affect its total costs. However, the main determinants of
investment—building costs and inventory, are likely not controllable by the manager.
Therefore, it is likely that the store should be evaluated as a profit center rather than as an
investment center. The maintenance department is likely to meet the conditions of a cost
center—it sells nothing to outside customers and only has a vague and indeterminable effect
on sales. A single department within a store is likely to be treated as a revenue center since the
manager of that department is likely to have a minimal effect on the department’s costs.
11-30 Although many people assume that a foreign subsidiary will meet the conditions to be
treated as an investment center, the classification is not automatic. As with divisions within a
company, the key is the discretion that the subsidiary’s management has over prices, product
selection, product development, costs, and investment levels.
11-31 Responsibility centers might include cooking operations, ordering operations, counter
and customer service operations, and maintenance. All responsibility centers interact in terms
of providing customers with low costs, quality, and service.
11-32 The manager of the cinema does not control the movie that is playing, the advertising
that is done for the movie, the cost of the products sold at the snack bar (these would likely be
purchased by a central agency, which would also make the decision about what products to
sell), and the wages that are paid to employees (this would likely be determined by a collective
agreement between the union representing all the employees at all the cinemas and the parent
company). The manager and her staff would control how customers are treated (which might
affect revenues), the scheduling of staff (which would affect total staff costs and service), the
amount of waste and pilferage in the snack bar, and the organization of ticket and snack bar
sales (which might affect total sales).
11-33 There are two generic problems in this setting. Are the revenues reported for this
division independent of the revenues reported for the other divisions? For example: Are there
interactions that require transfer pricing or do sales in renovations affect sales in other
departments? If these interactions exist, it is difficult to interpret the revenue, and therefore
the profits, reported by each division as the contribution by that division to corporate profits.
Similarly, if there are cost interactions (for example, the divisions use the same expensive
equipment and cost allocations are used to assign the cost of that equipment to the divisions)
then it is difficult to interpret the costs reported for a division, and therefore its profits, with
any certainty.
11-34 The response to this question will reflect the degree of autonomy the respondent feels
that the center manager has. It is likely that the fitness center manager must follow head office
policy concerning the wages paid, but the center manager will control the number of hours
worked by casual employees. If the chain’s policy is to build identical buildings with identical
equipment, then the depreciation on the building and equipment is not controllable by the
center manager.
The manager should be held accountable for controllable costs and should not be held
accountable for costs that (1) were determined or incurred by someone else and (2) cannot be
changed. The reason for distinguishing between controllable and uncontrollable costs is to
identify which costs the manager should be held accountable for. The controllability principle
asserts that the manager should only be held accountable for controllable costs.
11-35 The controllability principle asserts that the manager of a responsibility center should
be assigned responsibility only for the revenues, costs, or investments controlled by
responsibility center personnel. Revenues, costs and investments that people outside the
responsibility center control should be excluded from the accounting assessment of that
center’s performance. For example the manager of a production line in a factory should be
evaluated based on labor and machine hours used and not on labor cost and machine cost
because labor wage rates and machine costs were determined elsewhere in the organization.
In this case, invoking the controllability principle will have a desirable effect if the manager
perceives the performance measurement process as fairer, thereby increasing his or her
satisfaction.
Suspending the controllability principle is desirable if there is a reasonable expectation that
this will cause the employee to find a means of controlling the previously uncontrollable event
and that the employee will feel that being asked to control the event is reasonable. For
example, as described in the textbook, a dairy faced the problem of developing performance
standards in an environment of continuously rising costs. Because the costs of raw materials,
which were between 60% and 90% of the final costs of the various products, were market
determined and, therefore, thought to be beyond the control of the various product managers,
people argued that evaluation of the managers should depend on their ability to control the
quantity of raw materials used rather than the cost.
The dairy’s senior management announced, however, that it planned to evaluate managers on
their ability to control total costs. The managers quickly discovered that one way to control
raw materials costs was to make judicious use of long-term fixed price contracts for raw
materials. These contracts soon led to declining raw materials costs. Moreover, the company
could project product costs several quarters into the future, thereby achieving lower costs and
stability in planning and product pricing.
Thus, managers, even when they cannot control costs entirely, can take steps to influence final
product costs. When more costs or even revenues are included in performance measures,
managers are more motivated to find actions that can influence incurred costs or generated
revenues.
11-36 Division C has sufficient excess capacity to supply the 200,000 units of C82 to Division
D, so neither Division C nor McCann Company will incur an opportunity cost if the transfer
takes place. The incremental cost for Division C to manufacture the C82 for Division D is
200,000 × ($20 + $12 + $8) = $8,000,000. If Division D purchases these units from the outside
market, it will spend 200,000 × $50 = $10,000,000 and both Division D and the McCann
Company will be $2,000,000 (= $8,000,000 − $10,000,000) worse off. For Division C, the
transfer price should at least cover variable costs of $40. For Division D, the transfer price
should be less than $50. So to induce an internal transfer, the transfer price should be between
$40 and $50.
11-37 When transfer prices are used for internal purposes they are generally intended to
motivate the decision maker to act in the organization’s interest. However, when transfer
prices are used for international transfer pricing, managers have an incentive to choose
transfer prices to minimize the organization’s total tax liability by locating most of its profit in
the lower-tax country. The objectives for internal purposes and international tax purposes are
often conflicting. Tax authorities are well aware of the tax incentives, and therefore examine
international transfer pricing policies of companies conducting business under the authorities’
jurisdiction. The 1995 Organization for Economic Co-operation and Development (OECD)
guidelines (Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
(Paris: OECD, 1995)) indicate that whenever possible, transfer prices should reflect market or
economic circumstances. If an organization’s domestic transfer pricing system has been
designed to reflect economic considerations, then its international transfer pricing system
should be the same. Moreover, using one system for domestic transfer pricing and a different
system for international transfer pricing is likely to trigger investigation by taxing authorities.
11-38 Transfer prices can be based on market prices, based on costs, negotiated, or set by
some arbitrator or administrative rule. There are market prices for raw logs. However, the
number of logs that this company buys in these markets would likely be small compared to the
number of logs that are processed internally. The transfer price could be based on the costs of
maintaining the forests and logging costs. However, logs suitable for a sawmill are more
valuable than logs suitable for a pulp mill, and cost-based transfer pricing would not reflect
this. If a reliable market price is available, it can be used as the transfer price.
The real issue here is the benefit to the organization of treating the logging and
finishing divisions (the saw mills and the pulp mills) as profit centers. If company
success is determined by having the appropriate supply of trees at the
appropriate time, those criteria might be a more useful basis for control than
financial controls organized around profit centers.
11-39 Assuming that the finished products are prepared especially for this fishing products
company, there are likely limited market prices for raw fish and semi-processed fish, but little
outside market opportunity to sell finished products. Therefore, while transfers between
harvesting and processing might be based on market prices or costs, transfers between
processing and selling would have to be based on costs. One approach used by a fishing
company in this situation is a dual pricing system where the selling division is paid the net
realizable value of the product and pays the accumulated cost to date. Another fishing
company in this situation treats each unit as a cost center and evaluates the contribution that
each unit makes to product quality and timeliness of product availability.
11-40 A market price is an independent valuation of the transferred good or service.
Therefore, the market price is an excellent way of identifying where value is added in the
organization. However, finding the exact market price of the transferred product may be
difficult because the market price will often reflect many product facets that may not be
identically replicated in the product being transferred. In order to use a market price the
organization must ensure that the transferred product is exactly the same as the product for
which a market price is observed.
11-41 Numbers that accountants report to outsiders in financial statements are hard in the
sense that they result from the application of strict rules . In a given situation, there is some,
but limited, opportunity for discretion in determining a number’s value. Therefore, people
tend to think of accounting numbers as hard in the sense that two accountants faced with the
same situation would likely come up with numbers that are quite close together. For internal
financial control, however, many accounting numbers, such as profits and costs, result from
applying subjective rules such as transfer prices and cost allocations. These subjective rules
create the possibility of large differences resulting from the application of different
assumptions. The idea of a soft number was likely developed to warn people that these
internal accounting numbers have very different properties than the accounting numbers that
are reported to outsiders.
11- 4 2 One possibility is to assign building costs to the departments based on the floor space
that each occupies, on the assumption that the building size is the cost driver for building
costs.
11-43 (a) Return on investment is division income divided by historical cost of investments,
and residual income is division income minus 10% of historical cost of investments.
Division Historical
Division
Return on Investment
Residual Income
Cost of Investments
Operating Income
X
$560,000
$66,500
11.88%
$10,500
Y
532,000
64,400
12.11%
11,200
Z
350,000
43,120
12.32%
8,120
(b)
Division Net Book Value of
Investments
Division
Return on
Investment
Residual
Income
X
$280,000
$66,500
23.75%
$38,500
Y
266,000
64,400
24.21%
37,800
Z
175,000
43,120
24.64%
25,620
Operating
Income
(c) Return on investment and residual income do not necessarily produce the same rankings,
as seen in part (a), where Division Z has the highest return on investment but Division Y has
the highest residual income. Part (a) also illustrates that smaller divisions (for example,
Division Z) will look less favorable than larger divisions (Divisions X and Y) under residual
income. Note, however that Division X is the larger division in terms of investments but has
lower residual income than Division Y. The results in (b) show that, as in part (a), Division Z
has the largest return on investment, but now Division X now has the largest residual income.
Only the measurement of the value of the investment is different between parts (a) and (b),
illustrating that the measurement choice changes not only the return on investment and
residual income measures, but also potentially changes the relative rankings across divisions.
(d) Managers will only find it attractive to invest in new, more costly equipment if the
investment brings a large enough increase in income to offset the reduction in return on
investment or residual income associated with the new investment.
11-44 (a) Return on investment is division income divided by investment. Sales margin is
division income divided by sales, and turnover is sales divided by investment. Moreover,
return on investment = (sales margin) turnover.
Division Investment Division
Sales
Operating
Income
Return on
Investment
Sales
Margin
Turnover
E
$575,000
$75,000
$500,000 13.04%
15.00%
86.96%
F
700,000
91,000
542,000
13.00%
16.79%
77.43%
G
1,000,000
176,000
763,000
17.60%
23.07%
76.30%
(b) Divisions E and F have nearly identical return on investment, but E has higher turnover,
indicating that E generates more sales per dollar of investment, while F has a slightly higher
sales margin. Division G has the highest return on investment and sales margin, but the
division’s turnover is the lowest of the three divisions. Division E has the highest turnover.
(c)
Division E
Division F
Division G
Operating income
$75,000
$91,000
$176,000
Cost of capital:
46,000
56,000
80,000
$29,000
$35,000
$96,000
8% × division investment
Residual income
11-45 (a) The new return-on-sales ratio will be 0.8 × 1.2 = 0.96. The turnover will be 2.0 ×
0.8 = 1.6. Therefore, the r eturn on investment will be 0.96 1.6 = 1.536. The previous return
on investment was 0.8 × 2 = 1.6. Therefore, the percentage change is (1.536 – 1.6)/1.6 = –4%.
(b) Let x = the desired increase in the return-on sales ratio to achieve a 10% increase in
return on investment
R eturn on investment = ( return on sales )
( investment turnover).
1.1 × 1.6 = [ (1 + x ) × 0.8] × (2.0 × 0.8)
x = 0.375
Equivalently, the desired percentage increase is 37.5%.
11-46 (a) R eturn on investment = income/investment
= ($420,000/$1,400,000) = 30%
(b)
Division income
$420,000
Cost of capital:
140,000
10% × division investment
Residual income
$280,000
11-47 The response is problematic and reflects the respondent’s image of different
businesses. One industry that relies on a low ratio of profits to sales and a high ratio of sales to
assets is the grocery store business. One industry that relies on a high ratio of profits to sales
and a low ratio of sales to assets is the quality jewelry business. The business strategy in a
grocery business is to promote sales based on low costs. The business strategy in the quality
jewelry business is to promote a high price based on the nature of the merchandise.
11-48 Recall that the productivity ratio is output divided by input. Consider processing a side
of beef. The input is the weight of the side of beef. If the output measure is simply the weight of
the final products produced from the side of beef, it makes no difference how the side of beef is
processed—if it is all turned into hamburger, the productivity ratio will be the same. However,
if the output measure is the value of the products produced from the side of beef, then the
productivity ratio will assess the skill used to turn the side of beef into finished products. In
general, whenever skill is involved in turning raw materials into finished products, the
organization should consider using the value of the output in the numerator of the
productivity measure and base the evaluation of the process on the value of the output
produced relative to the potential given the quality of the inputs.
11-49 Residual income
income – required return on investment
Residual income = $1,000,000 – ($20,000,000
11-50
0.08) = –$600,000.
Golfing
Ski
Tennis
Football
Line
Line
Line
Line
Income
$3,500,000
$7,800,000
$2,600,000
$1,700,000
Investment
$35,000,000
$50,000,000
$45,000,000
$23,000,000
@ 10%
$3,500,000
$5,000,000
$4,500,000
$2,300,000
Residual income
$0
$2,800,000
($1,900,000)
($600,000)
Required return
Based on this analysis, the golfing line is marginally acceptable and the tennis lines and
football lines are unacceptable. It is only the ski line that appears to be providing a return that
would justify the investment level. These results must be interpreted with caution. The
accountant must determine whether there are revenue and cost allocation assumptions
underlying the reported income figures that could cause the reported results to be quite
different than if other assumptions were used. There should be a determination of whether
this is an unusual year or an average year. If the income numbers seem hard and the results
typical of an average year’s operations, this company must improve its performance in the
tennis and football lines substantially or think seriously of abandoning them.
PROBLEMS
11-51 One interpretation, with reasoning, is given for each of the following items. Other
interpretations are possible but should be provided with appropriate reasoning.
(a) The role is to minimize the cost of the tests while performing them properly (quality) and
when they are required (service). This is a cost center since the responsibility unit does not
affect demand.
(b) The role is to provide profits to the store by providing customers with the
services (food and how it is presented) and controlling the costs associated with
providing those services. This is a profit center since the responsibility unit can
affect sales and costs but is unlikely to affect the investment level significantly.
(c) The role is to provide a range and quality of services that meet customer requirements
while controlling costs. This is probably a cost center since the responsibility unit does not
affect revenues. However, in this setting the company might treat this group as a profit center
and allow users to buy computing services outside if they wish.
(d) The role is to minimize the cost of the maintenance services provided while performing
them properly (quality) and when they are required (service). This is a cost center since the
responsibility unit does not affect demand.
(e) The role is to minimize the cost of the customer services provided while performing them
properly (quality) and when they are required (service). This is a cost center since the
responsibility unit likely has an indeterminable effect on demand.
(f) The role is to minimize the cost of warehousing services provided while performing them
properly (quality) and when they are required (service). This is a cost center since the
responsibility unit likely has an indeterminable effect on demand.
(g) The role is to provide a reasonable return on investment to the parent by providing
customers with desired products and controlling the costs associated with providing those
goods. This is at a minimum a profit center since the responsibility unit can affect sales and
costs, and is an investment center if the publishing company can affect the investment level
significantly.
11-52 One of the first questions to ask is whether there is any purpose served by allocating
factory building depreciation space to the individual cost centers. If there is none, then there is
no point in allocating these costs—cost allocation takes time and inevitably causes
controversies. For example, some accounting systems allocate these costs in proportion to
other costs, such as labor wages. There is no point served by allocations such as these.
One purpose of allocating these costs might be to motivate the cost center managers to use
less floor space for storing work in process. (That is, to motivate them to work toward using
just-in-time manufacturing.) In this case, you might allocate the factory depreciation costs
using floor space occupied by each organization unit. In summary, the method used to allocate
these costs should serve some desired decision-making purpose or motivate some desired
behavior.
11-53 (a) This question is intended to explore the respondent’s understanding of controllable
and uncontrollable cost. The example provided should be unambiguous with an explanation of
why the item is controllable or uncontrollable. It is useful to discuss suggestions in a class
format because some costs that appear to be uncontrollable to some people may seem
controllable to other people. For example, some people will argue that absenteeism costs are
uncontrollable while others will argue that they are controllable through proper human
resource practices.
(b) The idea is that by insisting that someone be held accountable for a cost, that person will
be motivated to discover a way to control that cost. This results in making costs that were
formerly thought to be uncontrollable controllable. For example, one might try to change a
spot market transaction, where the cost is variable, into a contractual transaction where the
cost is fixed.
1154
(a)
Product
Line
1
2
3
Total
Revenue
$7,160,000
$1,900,000
$4,200,000
$13,260,000
Variable costs
4,296,000
950,000
1,680,000
6,926,000
Contribution
margin
2,864,000
950,000
2,520,000
6,334,000
Other costs
859,200
237,500
693,000
1,789,700
Segment margin
2,004,800
712,500
1,827,000
4,544,300
costs
349,000
156,000
698,000
1,203,000
Income
$1,655,800
$556,500
$1,129,000
$3,341,300
Allocated
avoidable
Unallocated costs
801,300
Company profit
$2,540,000
(b) The common interpretation is that the segment margin is the stand-alone
profit of each segment, or the financial effect on the organization if the segment
is eliminated after the fixed capacity used by the segment is either redeployed or sold off.
Beyond issues relating to the allocation of joint costs and revenues, the major
problem with this interpretation is the effects that the segments have on each
other. For example, in a financial institution, the need for checking accounts may
draw customers to the institution; if the financial institution does not offer
checking accounts, customers may take all their business elsewhere. As another
example, consider the role of a restaurant in a large hotel. On the surface,
restaurants are money losers. However, eliminating a restaurant would likely have
a negative effect on room occupancy, particularly if the hotel is a convention
hotel. This question provides an opportunity to discuss these interpretational issues
and possible interdivisional externalities in organizations.
11-55 Such a search should locate many useful illustrations. As of February 2010, a PDF file
on RadioShack® Corporation’s decision to close some underperforming stores was available
at http://media.corporateir.net/media_files/NYS/RSH/presentations/bearstearns/bear_sterns_pres.pdf . The report
discusses the corporation’s plans to take a more proactive approach to closing stores and
managing slow-moving inventory, and discusses use of gross margin per square foot of shelf
space to evaluate the performance of its inventory. The corporation also describes various
measures to control costs, including closing several distribution centers.
11-56 Transfer prices based on market prices invite, and in many cases are designed to invite,
comparisons with the costs of outside suppliers. Given cost, reliability, and quality
comparisons, many organizations are abandoning self-supply and relying on outside experts.
(This phenomenon is sometimes called hollowing-out.) Governments all over the world are
now using this tool to evaluate and improve or eliminate, internal operations. In fact, in New
Zealand , government agencies are required to sell their services to the government as if they
were independent outside suppliers.
The key is that the services must be comparable . Not only must cost comparisons be made,
but also quality and service comparisons must be made. If the outside supplier meets, or
exceeds, the potential of the insider supplier and there are no security issues (for example, the
government cannot rely on an outside printer to print classified government documents or
contract with a gang of hooligans to provide security services), then the outsider supplier
should be used.
11-57 (a) Most commentators on transfer price state flatly that, if a market price is available,
that is the price the organization should use to price internal transfers. In this case the amount
of $650 appears to be a legitimate market price since the commodity is well specified and the
purchaser is willing to sign a long-term contract. Therefore, it is inappropriate to argue in this
setting that the $650 is not a legitimate market price. If the organization wishes to maintain
the credibility, the motivational effect, and the economic insights of transfer pricing, it must
allow the selling division a price of $625 (which is the net realizable value of selling outside)
for the boards.
(b) At the moment, the value-added by the programming division, which is
apparently $75 ($700 – $625), is less than the cost of adding this value ($100).
There are only three alternatives in this situation. First, the programming division
can investigate whether the current price of $700 is too low. Second, the
programming division can try to improve its efficiency so that its programming
costs are less than $75 per unit. Third, the programming division can go out of
business.
Motivationally, it would appear most desirable to require that the programming division pay
$625 per board. The resulting losses would force the programming division to choose one, or
several, improvement alternatives. Setting a transfer price that ignores this situation and
allows the programming division to continue to show a profit would create only disincentives
for appropriate action in this setting.
11-58 (a)
(b)
(c) Because the overall ROI is higher without the new investment, Michelle’s compensation
will be much higher if she does not undertake the new investment. Therefore, the
compensation scheme does not provide incentives for a manager to undertake an investment
that would benefit the corporation.
(d) A variety of changes are possible. For example, the manager could receive a flat bonus
upon achieving a target ROI or target residual income. Another alternative is to base the
manager’s compensation on a combination of financial and nonfinancial measures. Currentperiod actions that decrease the current period’s financial performance may be creating future
value. Such actions include investments in research and development, employee training, new
distribution channels, and customer service. Conversely, companies that decrease their
investments in these activities may show good current-period financial performance but they
will have likely diminished future value. Therefore, a mixture of financial and non-financial
measures can provide information about the current period’s success in generating both
current financial performance and growth options for the future.
11-59 (a)
Net Book Value (The franchise cost is fully amortized.)
= 29,997%
Historical Cost
= 58.71%
(b) Net Book Value (The franchise cost is fully amortized.)
Economic value added = Income – Required return on investment
Economic value added = $3,000,000 – ($10,001
15%) = $2,998,499.85
Historical Cost
Economic value added = Income – Required return on investment
Economic value added = $3,000,000 – ($5,110,000
15%) = $2,233,500.
11-60 In this setting, economic value added requires that the bank can compute the revenue,
costs, assets, and asset values associated with each product line. This will require allocations
of revenues, costs and assets in a bank where many revenues are jointly earned and many
costs are jointly incurred. A remaining problem concerns the valuation of assets.
For example, consider the profitability associated with the provision of safety
deposit boxes. The bank would need to determine the revenues associated with
these boxes, which is straightforward if the boxes are billed separately but can be
complicated if the boxes are part of larger customer service packages sold to
customers. (For example, the customer might pay a monthly fee that includes a
credit card, a checking account, a safety deposit box and direct payment
privileges.) The bank would need to determine the costs associated with these
boxes.
Out-of-pocket costs such as purchasing and maintenance costs on the boxes are
straightforward. However, other costs are more problematic. Such costs include cost of space
for the boxes in the vault, which is also used to store money and records, and the time of bank
staff devoted to safety deposit box activities, when the staff are also engaged in other activities.
Finally, the cost of long-term facilities, such as the vault and bank itself, needs to be evaluated
to determine the investment base for the residual income calculation.
11-61 This is a terrible idea. Economic value added analysis is useful to identify the economic
benefits of an existing investment—it is not intended to assess a manager’s ability to manage
that investment. For example, a manager might be doing a good job managing the investment
in an asset that should be liquidated. Unless the manager controls both the investment and the
management of the investment, the two functions should be evaluated separately. The
investment should be evaluated using economic value added, and the manager should be
evaluated using budgets or benchmarking the manager’s performance to comparable
organizations.
11-62 No. The reported results might be soft numbers resting on subjective allocations.
Moreover, there may be a high degree of interaction between the manufacturing business and
installing business. If the product has an excellent reputation, installation sales might fall if
another manufacturer’s product is substituted. Finally, the current period’s results might be
unusually low. The company owner needs more investigation and data before making the
decision.
11-63 Note : The solution below draws on net present value analysis, which is covered in other
courses but not in this book.
(a)
Strathcona Paper
Year
Outflow
Savings
Depreciation
0
50,000,000
0
0
1
0
16,000,000
10,000,000
2
0
16,000,000
10,000,000
3
0
16,000,000
10,000,000
4
0
16,000,000
10,000,000
5
0
16,000,000
10,000,000
Year
Taxes
NCF
PV
0
0
(50,000,000)
(50,000,000)
1
2,100,000
13,900,000
12,410,714
2
2,100,000
13,900,000
11,080,995
3
2,100,000
13,900,000
9,893,745
4
2,100,000
13,900,000
8,833,701
5
2,100,000
13,900,000
7,887,233
Net present value
$106,388
Since the net present value of this project is positive, from the point of view of the company, it
should be accepted.
(b) The manager is evaluated based on the after-tax return on investment of assets managed.
The current investment base is $50,000,000 and the current net income after taxes is
$7,000,000, which yields a return on investment of 14% = $7,000,000 $50,000,000.
With the new investment in the first year, income after taxes will increase to $10,900,000 =
($7,000,000 + $16,000,000 – $10,000,000 – $2,100,000) and the new investment level will
increase to $90,000,000 = ($50,000,000 + $50,000,000 – $10,000,000). Therefore, the return
on investment for the first year of operations with the new trucks will be 12.1% = $10,900,000
$90,000,000.
Therefore, evaluated by the first year of operations, the manager would prefer not to make
this investment. However, the return on investment numbers for years 2 through 5 inclusive
are 13.6%, 15.6%, 18.2%, and 21.8%, respectively. Note that each year the income level will
remain the same while the investment level will be $80,000,000 in year 2, $70,000,000 in year
3, $60,000,000 in year 4, and $50,000,000 in year 5. Therefore, the manager’s attitude about
this investment will reflect how long the manager expects to remain in her current position.
(c) The after-tax residual income currently is $1,000,000 = [$7,000,000 ($50,000,000
12%)]. The after-tax residual income in the first year after the investment in the new trucks is
$100,000 = [$10,900,000 ($90,000,000 12%)]. If evaluated by the first year of operations,
the manager would not make the investment. The residual income numbers in years 2 through
5 are: $1,300,000, $2,500,000, $3,700,000, and $4,900,000. Therefore, the manager’s attitude
about this investment will reflect how long the manager expects to remain in his current
position.
11-64 The following are suggestions; individual responses may vary depending on what
performance the respondent deems critical to the organization’s success.
(a) Rate of adding or losing customers, contribution per customer, and cost of installation—an
important item not assessed by this financial control system is why customers are signing up
or leaving the company.
(b) Contribution per performance, other costs and revenues, and committed costs—an
important item not assessed by this financial control system is the type of program that
audiences find attractive.
(c) Contribution per unit, cost of developing new recipes and incorporating feedback on
existing recipes, and committed costs—an important item not assessed by this financial
control system is the rate of new product innovation.
(d) Cost per unit of work, number of clients, and services per client—an important item not
assessed by this financial control system is the degree of client satisfaction with the services
being offered by this agency.
(e) Percent available time used, profit contribution per job, and selling and administrative
support costs—an important item not assessed by this financial control system is the degree
of employee preparation for new tools and ideas that customers might demand in the future.
(f) Design cost per line, contribution per unit, and profit per line—an important item not
assessed by this financial control system is the training, future potential and public image of
the organization’s design group.
11-65 Software writers are highly skilled and creative. Many organizations believe that to
attract and keep this type of person, they have to give them freedom to exercise their skill and
creativity. However, unlimited freedom can lead to products that do not meet customers’
requirements. Moreover, in a large project the activities of independent writers must be
coordinated to achieve the project’s overall objectives. Therefore, many people believe that
the organization should control and coordinate the activities of these independent agents as
they create. The example provided for an organic organization should be clearly one where
there are relatively few rules and where decision makers are free to make decisions.
Governments are mechanistic because they believe this is how they can ensure accountability
to the legislative authority for the expenditures that they undertake and so that they will not
do anything unless it has been authorized by the legislative body. Most people believe that
governments should be less mechanistic. The legislative body should delegate the authority to
public servants to meet the spirit of the legislation without tying them down with burdensome
rules and procedures. The example provided for a mechanistic organization should be clearly
on where there are many rules and decision-making responsibilities are highly constrained.
11-66 The key in this question is to identify how many performance measures can motivate
organization units to behave in ways that are inconsistent with the good of the whole
organization. The most interesting examples are highly integrated organizations where
success depends on cooperation between the units. Examples include: A courier, any
organization using just-in-time, and an operating team in a hospital. The response should
explore why organizations tend to use measures of individual performance and the
undesirable behavior they promote.
11-67 Organizations use the functional approach to organization design to capture the
economies of scale due to specialization in task and information. The problem is coordinating
a functional organization where functional experts make decisions about their own function
without regard to the contribution by other functional areas. One approach to improving this
process is to create a team of functional experts who are focused on the product or project
rather than their function. In this context, information between functions is exchanged quickly
and the functional perspective is adapted to focus on the specific product needs. This matrix,
or team approach, to product design results in more effective and lower cost designs that are
completed in much shorter periods than the functional approach to product design. This is the
approach that Ford Motor Corporation exploited to design the Taurus automobile and is called
concurrent design.
11-68 (a) The regional offices meet all the criteria to be managed as investment centers. They
control sales, costs, and the level of investment.
(b) The corporate office performs two, virtually unrelated, functions—administration and
ordering. The ordering activity is service-oriented. The idea is to get the required product at
the lowest long-run cost. This suggests a cost center organization but how to choose a
reasonable target level of costs is a difficult issue here.
(c) While financial control systems that do mesh promote consistency of purpose and view,
the financial control systems do not have to mesh. The key is whether the operational
activities related to ordering at the corporate office mesh with the regional requirements. This
cannot be promoted or controlled using a financial tool. Performance measures will have to be
established that assess the center’s ability to find the products required by the regions and
supply them when the regions require them and at attractive prices.
11-69 (a) The issue turns on the respondent’s view of the role of accountability in
organizations. If the respondent believes that individuals can be motivated to improve the
organization’s performance without holding them specifically accountable for certain facets of
performance, then the issue of controllable and uncontrollable can be avoided. However, if the
respondent believes that people must be held accountable for something to make them
interested in improving performance, then the issue of controllable versus uncontrollable
must be addressed.
(b) The organization would likely move to team rather than individual measures of
performance. All members of the team would be expected to deal with opportunities to
improve performance. Therefore the question of whether any one item is controllable or not
by an individual would disappear and be replaced by questions about group performance.
11-70 The major issue in choosing a transfer price is motivating the managers of the two
divisions to behave in a way that makes the organization’s profits as large as possible.
For existing home kits, the manager of the sales division will want to buy home kits as long as
the sales division can realize a profit on selling the home kits to the final customers. Therefore,
the transfer price must not exceed $35,000, which is the selling price of $40,000 less the
selling division’s cost of $5,000 per home.
The manager of the manufacturing division will want to sell existing home kits as long as the
manufacturing division can realize a profit on selling the homes to the selling division.
Therefore, the transfer price must exceed $30,000 ($33,000 1.1) , which is the variable cost
of making the home kits.
Therefore, any transfer price between $30,000 and $35,000 for the existing homes will cause
the manufacturing division to make, and the selling division to buy and sell, all the home kits
that the manufacturing division is capable of making.
Turning to the proposal to make cottage kits, recall that the manufacturing division is
currently operating at capacity and will therefore have to give up production of home kits in
order to manufacture cottage kits. From the company’s perspective, t he company’s
contribution margin per home kit is $5,000 = ($40,000 – $30,000 $5,000). Let P = the price
at which the company is indifferent (with respect to profit) between selling all home kits or all
cottage kits. Home kits require 10 machine hours (mh) per unit and cottage kits require 13 mh
per unit, and 5,000 mh are available per year. Assuming that the selling cost of the cottage kit
is the same as the selling cost of the home kit ($5,000 per unit), equating the total contribution
margins for the two options requires the following:
(5,000 mh
13 mh per cottage) × (P – $30,000 – $3,000 – $5,000) =
(5,000 mh
10 mh per home) × ( $40,000 – $30,000
$5,000)
Thus, P – $38,000 = ( $5,000
10 mh per home) × (13 mh per cottage), so
P = $38,000 + $6,500 = $44,500.
Note that $6,500 is the opportunity cost of producing and selling a cottage kit instead of a
home kit. This opportunity cost is the $500 of contribution margin per mh for home kits,
multiplied by the 13 mh required per cottage kit. (If one wishes to take into account only
production in whole numbers, then 5,000 13 = 384.62 will have to rounded down to 384,
and the necessary price will be approximately $44,511.)
The analysis from the manufacturing division’s point of view is similar.
Let TP = the transfer price for cottage kits at which the division is indifferent between
transferring home kits at variable cost plus 10% ($30,000 + $3,000) or cottage kits at TP per
unit. Assuming production of either all home kits or all cottage kits and equating the total
contribution margins for the two options requires the following:
(5,000 mh 13 mh per cottage) × (TP – $30,000 – $3,000) =
(5,000 mh
10 mh per home) × ($33,000
$30,000)
TP – $33,000 = ( $3,000/10 mh per home) × (13 mh per cottage), so
TP = $33,000 + $3,900 = $36,900.
This transfer price incorporates the original variable cost of $30,000, the incremental
manufacturing cost of $3,000, and the $3,900 opportunity cost to the manufacturing division
for making a cottage kit instead of a home kit, given the existing transfer price for home kits.
Thus, the manufacturing division will not be willing to accept a transfer price less than
$36,900 per cottage kit. Assuming a selling price per cottage kit of $44,500, the selling division
will not be willing to pay more than $39,500 ($44,500 – $5000). Therefore, a transfer price
between $36,900 and $39,500 should induce both managers to be willing to engage in the
transfer.
11-71 This question explores some of the practical problems of using the return on
investment criterion to evaluate on-going investments in fixed assets. The return on
investment tool was originally designed to evaluate new investments rather than on-going
investments. In the case of new investments, there is no confusion about the investment
amount. When this tool is used to evaluate on-going investments important valuation
problems have to be resolved.
If the original notion of return on investment is applied to evaluate on-going investments, the
philosophy would be to assume that in each period the organization makes a reinvestment
decision. Therefore, the amount implicitly reinvested is the net realizable value (disposable
value) of the investment. In a situation where there are multiple uses of the resource, the
relevant net realizable value is the highest value. Therefore the return would be the income,
plus the change in the net realizable value of the asset during the year, divided by the net
realizable value of the asset at the end of the year.
(a) In this case we do not know the change in the net realizable value of the property during
the year. Therefore we could compute the return on investment as 7.43% = [$130,000
($2,000,000 – $250,000)], which is net profit divided by selling price less disposal costs (the
highest realizable value for the land).
(b) The first question to resolve is whether the current results are typical. The second
question to resolve is the basis that will be used to make this decision. If the basis is purely
financial and if the company requires a return on investment greater than 7.43%, the asset
should be put to its most profitable use, which would be to demolish the building and sell the
land, netting $1,750,000.
CASES
11-72 (a) Shellie is likely to focus her efforts on layout design, the product line that shows
the highest reported profit. With the information provided up to this point, one can conjecture
that Shellie may be undercharging for layout design because there is great demand for
Shellie’s layout design services, but no other lawn and garden businesses in the city are
attempting to compete for the layout design business. If Shellie is undercharging for layout
design and thereby not adequately covering associated costs, profits will continue to
deteriorate.
(b)
Shellie’s Lawn and Garden
Resource Use Information
Trucks and
Cost
Capacity
Rate
Used
Allocation
Unused
$50,000
800
$62.50
600
$37,500
$12,500
37,500
1,500
25.00
1,200
30,000
7,500
150,000
400
375.00
400
150,000
0
87,500
700
125.00
500
62,500
25,000
related costs
Lawn mowing
equipment
Layout design
equipment
Other
maintenance
equipment
$325,000
$280,000
$45,000
(c)
Shellie’s Lawn and Garden
Product Line Income
Statements
Lawn
Mowing
Layout
Design
Other
Maintenance
Total
Revenues
$287,500
$218,750
$312,500
$818,750
Direct costs
156,250
70,000
181,250
407,500
Margin
131,250
148,750
131,250
411,250
Own
30,000
150,000
62,500
242,500
Trucks
12,500
12,500
12,500
37,500
Cost of unused own
7,500
0
25,000
32,500
$81,250
–$13,750
$31,250
$98,750
Cost of used capacity
capacity
Product line profit
Cost of unused shared
12,500
capacity (trucks)
General business
50,000
costs
Organization profit
$36,250
Note that the product line profit numbers do not include the $50,000 of general business
costs and the $12,500 of costs of unused truck capacity, since there is no practical way of
allocating these costs to any one of the three lines of business. They must be covered by the
margins created by each of the three business lines.
(d) Based on the exhibits in part s (b) and (c) , cutting back on lawn mowing and other
maintenance is undesirable if capacity stays the same. Both these product lines have unused
capacity. The layout design business is draining profits. The prices charged for layout do not
reflect the costs of the associated specialized equipment, confirming the conjecture in part (a)
that Shellie’s low prices are generating demand and discouraging competition. Shellie can
raise prices on the layout design business and try to increase volume in the lawn mowing and
other maintenance business, to use available capacity.
11-73 (a) This is an organization where the activities of all the elements of the system must
work together and be very highly integrated. This is a setting where basing rewards on
individual measures of performance can be very dysfunctional. Since the investment center
approach requires that the costs, profit, and investment levels of each responsibility center be
computed, it would seem, on the surface at least, that this is not the type of organization where
an investment center approach can be properly used.
(b) The existing performance measurement system should be expanded beyond financial
control to include measures of performance that reflect what customers require. Performance
measures relating to on-time performance, sorting error rates, and customer complaints
should be developed. These measures could be used not only as bases for rewards, but also to
focus attention on problems relating to customer service, service failures, and cost control.
Similarly, issues important to other stakeholders, such as employee training, relations with
suppliers, and community relations are important performance measures to assess.
(c) The organization should consider eliminating the investment center approach.
The existing responsibility centers could be organized as cost centers and the
performance measurement system expanded along the lines suggested in part (b).
Each responsibility unit manager could contract with the other managers and the
process controller to deliver cost, quality, and customer service results. Unit
members could be rewarded based on their ability to meet cost, customer service,
and quality targets of their unit and the profit of the overall operation. The
performance measurement system could also reflect the requirements of the
organization by other stakeholders (such as public safety considerations in the
operation of the courier trucks) if they are deemed controllable by the
responsibility center managers. The current financial system is distracting the
organization’s attention by focusing on allocation issues rather than customer
service issues.
11-74 (a) This is a situation where historical and political issues, combined with
an inappropriate delegation of organization responsibilities to organization units,
created a problem that caused customer and safety concerns and organization
frictions. Given the structure and the division of responsibilities, the event
described in the case was virtually certain to occur at some point in time.
Moreover, the bureaucracy and inability to handle priority calls relating to citizen
safety issues exacerbated the underlying organization problem. There are at least
five problems here: A poor organization design, a poor division of responsibilities
among the organization units, a bureaucratic structure within each department that
requires approval by specific individuals and makes no provision for replacements
when individuals are unavailable, a lack of initiative that is widespread, and no
provision to provide an emergency response group that cuts across departmental lines.
(b) Within the existing structure this incident could have been avoided by creating a multidepartment team to handle emergency and safety prob lems that cut across departmental
lines.
(c) The city manager should accept the blame for what happened and ensure the public that:
Steps will be taken to ensure that this event will not happen again, that these steps will be
taken promptly, and that the manager will report back to the public within 2 weeks with the
change proposal.
(d) The city must be reorganized so that related activities fall under the same department.
The cost focus of each department might be replaced by a focus on accomplishing service
objectives, within the constraint of not overspending. Response teams, consisting of members
from appropriate departments should be organized to deal with predictable emergency and
safety incidents. These teams should be ready to respond to situations without requiring time
for approval and scheduling.
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