Electronic Presentation by Douglas Cloud Pepperdine University Survey of Accounting Electronic Presentation by Douglas Cloud Pepperdine University Carl S.Warren

Task Force Clip Art included in this electronic presentation is used with the permission of New Vision Technology of Nepean Ontario, Canada.

Chapter 14 Differential Analysis and Product Pricing

After studying this chapter, you should be able to: Learning Objectives 1. List and explain the advantages and disadvantages of decentralized operations. 2. Prepare a responsibility accounting report for a cost center. 3. Prepare responsibility accounting reports for a profit center. After studying this chapter, you should be able to: Continued

Learning Objectives 4. Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center. 5. Explain how the market price, negotiated price, and cost price approaches to transfer pricing can be used by decentralized segments of a business.

Learning Objective 1 List and explain the advantages and disadvantages of decentralized operations.

Advantages of Decentralized Operations 1. Lower-level managers can react more quickly to problems or changes in operations. 2. Lower-level managers are closer and more responsive to the customer’s needs. 3. The operation provides a better training ground for managers. 4. Delegation improves employee morale. 5. Top managemjent is free to devote time to strategic planning.

Disadvantages of Decentralized Operations 1. Assets and operating costs are duplicated (e.g., each division has its own administrative staff). 2. Managers may pursue their own goals, instead of company goals.

Learning Objective 2 Prepare a responsibility accounting report for a cost center.

Responsibility Centers Cost Centers Managers are held accountable for controlling costs. Managers are held accountable for costs and making decisions that impact revenues favorably. Managers are held accountable for costs and revenues and are also held accountable for the efficient use of assets. Profit Centers Investment Centers

Cost Center Responsibility Accounting Budget Performance Report Vice-President, Production For the Month Ended October 31, 2004 Over Under Budget Actual Budget Budget Administration $ 19,500 $ 19,700 $ 200 Plant A 467,475 470,330 2,855 Plant B 395,225 394,300 $925 $882,200 $884,330 $3,550 $925 Each of the line items above will be supported by a cost center report.

Cost Center Responsibility Accounting Budget Performance Report Vice-President, Production For the Month Ended October 31, 2004 Over Under Budget Actual Budget Budget Administration $ 19,500 $ 19,700 $ 200 Plant A 467,475 470,330 2,855 Plant B 395,225 394,300 $925 $882,200 $884,330 $3,550 $925 This is supported by a cost center report for Plant A.

Cost Center Responsibility Accounting Budget Performance Report Manager, Plant A For the Month Ended October 31, 2004 Over Under Budget Actual Budget Budget Administration $ 17,500 $ 17,350 $150 Department 1 109,725 111,280 $1,555 Department 2 190,500 192,600 2,100 Department 3 149,750 149,100 650 $467,475 $470,330 $3,655 $800 This is shown on the production report.

Cost Center Responsibility Accounting Budget Performance Report Manager, Plant A For the Month Ended October 31, 2004 Over Under Budget Actual Budget Budget Administration $ 17,500 $ 17,350 $150 Department 1 109,725 111,280 $1,555 Department 2 190,500 192,600 2,100 Department 3 149,750 149,100 650 $467,475 $470,330 $3,655 $800 This is supported by a cost center report for Department 1.

Cost Center Responsibility Accounting Budget Performance Report Supervisor, Department 1—Plant A For the Month Ended October 31, 2004 Over Under Budget Actual Budget Budget Factory wages $ 58,100 $ 58,000 $150 Materials 32,500 34,225 $1,725 Supervisory salaries 6,400 6,400 Power and light 5,750 5,690 650 Depreciation 4,000 4,000 Maintenance 2,000 1,990 10 Insurance, taxes 975 975 $109,725 $111,280 $1,725 $170 This is shown on Plant A’s report.

Learning Objective 3 Prepare responsibility accounting reports for a profit center.

Profit Center Responsibility Accounting Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2004 Theme Movie Park Production Division Division Revenues $6,000,000 $2,500,000 Operating expenses 2,495,000 405,000 Income from operations $3,505,000 $2,095,000 Income from operations before service department charges.

Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2004 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 These costs are charged to the divisions based on the activity base of the service department.

Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2004 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 25,000 purchase requisitions x $10 per requisition = $250,000 15,000 purchase requisitions x $10 per requisition = $150,000

Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2004 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 12,000 payroll checks x $17 per check = $204,000 3,000 payroll checks x $17 per check = $51,000

Service Department Charges to Profit Centers Nova Entertainment Group Service Department Charges to NEG Divisions For the Year Ended December 31, 2004 Theme Movie Park Production Service Department Division Division Purchasing $250,000 $150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total charges $479,000 $426,000 100 hours x $250 per hour = $25,000 900 hours x $250 per hour = $225,000

Profit Center Responsibility Accounting Nova Entertainment Group Divisional Income Statements For the Year Ended December 31, 2004 Theme Movie Park Production Revenues $6,000,000 $2,500,000 Operating expenses 2,495,000 405,000 Income from operations before service department charges $3,505,000 $2,095,000 Less service dept. charges: Purchasing $ 250,000 $ 150,000 Payroll accounting 204,000 51,000 Legal 25,000 225,000 Total service dept. charges $ 479,000 $ 426,000 Income from operations $3,026,000 $1,669,000

Learning Objective 4 Compute and interpret the rate of return on investment, the residual income, and the balanced scorecard for an investment center.

Investment Center Responsibility Accounting DataLink Inc. Divisional Income Statements For the Year Ended December 31, 2004 Northern Central Southern Division Division Division Revenues $560,000 $672,000 $750,000 Operating expenses 336,000 470,400 562,500 Income from operations before service dept. charges $224,000 $201,600 $187,500 Service department charges 154,000 117,600 112,500 Income from operations $ 70,000 $ 84,000 $ 75,000 Invested assets $350,000 $700,000 $500,000 Rate of return on investment 20% 12% 15%

Investment Center Responsibility Accounting Northern Central Southern Division Division Division Profit Margin Income from operations $ 70,000 $ 84,000 $ 75,000 Revenues (Sales) $560,000 $672,000 $750,000 Profit margin 12.5% 12.5% 10.0% Invested assets $350,000 $700,000 $500,000 Investment turnover 1.6 .96 1.5 Rate of return on investment 20% 12% 15% Investment Turnover Rate of Return (ROI)

Rate of Return on Investment DataLink Inc. Divisional Income Statements For the Year Ended December 31, 2004 Northern Central Southern Division Division Division Profit margin 12.5% 12.5% 10.0% Investment turnover x 1.6 x .96 x 1.5 Rate of return on investment 20% 12% 15%

Divisional Income Statements For the Year Ended December 31, 2004 Residual Income DataLink Inc. Divisional Income Statements For the Year Ended December 31, 2004 Northern Central Southern Division Division Division Income from operations $ 70,000 $ 84,000 $ 75,000 Invested assets $350,000 $700,000 $500,000 Minimum desired return 10.0% 10.0% 10.0% Minimum desired income $ 35,000 $ 70,000 $ 50,000 Residual income $ 35,000 $ 14,000 $ 20,000 How can Northern Division have the highest residual income when they have the lowest income from operations?

Learning Objective 5 Explain how the market price, negotiated price, and cost price approaches to transfer pricing can be used by decentralized segments of a business.

Benefits of Transfer Pricing 1. Divisions can be evaluated as profit or investment centers. 2. Divisions are forced to control costs and operate competitively. 3. If divisions are permitted to buy component parts wherever they can find the best price (either internally or externally), transfer pricing will allow a company to maximize its profits.

Commonly Used Transfer Prices 1. Market price approach sets the price at which the product transferred could be sold to outside buyers. 2. Negotiated price approach allows decentralized managers to agree (negotiate) among themselves. 3. Cost price approach uses a variety of cost concepts for setting the transfer price. Commonly Used Transfer Prices Variable Cost per Unit $10 Full Cost per Unit $13 Market Price per Unit $20 Negotiated Price

Transfer Pricing—Negotiated Price Approach Assumptions 1. Division M produces a product with a variable cost of $10 per unit. Division M has unused capacity. 2. Division N purchases 20,000 units of the same product at $20 per unit from an outside source. Variable Cost per Unit $10 Market Price per Unit $20 Negotiated Price If the division managers agree on a price of $18 per unit, how much will each division’s income increase? How much for the overall company? Division M Division N

Chapter 14 The End