Responsibility Accounting and Performance Evaluation

Responsibility Accounting and Performance Evaluation
Chapter 24 Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall
Decentralization What is decentralization? Splitting a company into different segments such as departments and divisions with the segment managers making planning and controlling decisions for their segments. Decentralization involves splitting a company into different segments such as departments and divisions with the segment managers making planning and controlling decisions for their segments. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Advantages of Decentralization
Frees top management time Supports use of expert knowledge Improves customer relations Provides training Improves motivation and retention The advantages of decentralization include: (1) frees top management time, (2) supports use of expert knowledge, (3) improves customer relations, (4) provides training, and (5) improves motivation and retention. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Disadvantages of Decentralization
Duplication of costs Problems achieving goal congruence. Goal congruence means aligning the goals of business segment managers and other subordinates with the goals of top management. Disadvantages of decentralization include: (1) duplication of costs and (2) problems achieving goal congruence. Goal congruence means aligning the goals of business segment managers and other subordinates with the goals of top management. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Center
A part of the organization for which a manager has decision-making authority and accountability for the results of those decisions. Responsibility centers are a part of the organization for which a manager has decision-making authority and accountability for the results of those decisions. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Types of Responsibility Centers
Cost Center—A responsibility center whose manager is only responsible for controlling costs. Revenue Center—A responsibility center whose manager is only responsible for generating revenue. A Cost Center is a responsibility center whose manager is only responsible for controlling costs. A Revenue Center is a responsibility center whose manager is only responsible for generating revenue. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Types of Responsibility Centers
Profit Center—A responsibility center whose manager is responsible for generating revenue, controlling costs, and producing profits. Investment Center—A responsibility center whose manager is responsible for generating profits and efficiently managing the center’s assets. A Profit Center is a responsibility center whose manager is responsible for generating revenue, controlling costs, and producing profits. An Investment Center is a responsibility center whose manager is responsible for generating profits and efficiently managing the center’s invested capital, or assets. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Reports
Responsibility Center Manager’s Responsibility Responsibility Report Cost Center Controlling costs Compare actual costs to budgeted costs Revenue Center Generating revenues Compare actual revenues to budgeted revenues Profit Center Generating revenues, controlling costs, producing profits Compare actual revenues to budgeted revenues; compare actual costs to budgeted costs Investment Center Producing profits and managing center’s invested capital Compare actual profits to budgeted profits; measures return on investment and residual income This chart summarizes the different types of responsibility centers, the information reported on the responsibility report and the manager’s responsibility for each responsibility center. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise The menswear department of a department store, which is responsible for buying and selling merchandise, is a(n) _______. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise The menswear department of a department store, which is responsible for buying and selling merchandise, is a(n) profit center. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Managers of cost and revenue centers are at _______ levels of the organization than are managers of profit and investment centers. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Managers of cost and revenue centers are at lower levels of the organization than are managers of profit and investment centers. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Performance Evaluation System
A system that provides top management with a framework for maintaining control over the entire organization. A Performance Evaluation System provides top management with a framework for maintaining control over the entire organization. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Goals of Performance Evaluation Systems
Promote goal congruence and coordination Communicating expectations Motivating segment managers Providing feedback Benchmarking Goals of Performance Evaluation Systems include: (1) promote goal congruence and coordination, (2) communicating expectations, (3) motivating segment managers, (4) providing feedback, and (5) benchmarking. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Limitations of Financial Performance Measurement
Financial Performance Measures are lag indicators. Lag indicators reveal past performance. Managers need lead indicators as well. Financial Performance Measures have a short-term focus. Managers should have a long-term focus as well. Financial Performance Measures have two limitations. First, financial performance measures are lag indicators; they measure past performance. Managers need lead indicators as well as lag indicators. Second, financial performance measures have a short-term focus. Managers should also have a long-run focus. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Balanced Scorecard The performance evaluation system that requires management to consider both financial performance measures and operational performance measures when judging the performance of a company and its subunits. The Balanced Scorecard requires managers to consider financial performance measures and nonfinancial performance measures when evaluating the performance of a company. Besides looking at financial measures such as net income and sales revenue, the balanced scorecard requires managers to also examine other aspects of the company, such as customer satisfaction, employee turnover, number of new product developed, etc. The balanced scorecard has four different perspectives that include: (1) financial, (2) customer, (3) internal business and (4) learning and growth. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Different Perspectives From Balanced Scorecard
Financial Perspective Customer Perspective Internal Business Perspective Learning and Growth Perspective To evaluate a company, the balanced scorecard requires managers to look at four different perspectives: (1) financial, (2) customer, (3) internal business and (4) learning and growth. Each perspective examines a different perspective about the company. It is no longer adequate to examine only financial measures when evaluating a company’s performance. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Key Performance Indicator
A summary measure that helps managers assess whether the company is achieving its goals. Key performance indicators are used to evaluate the different perspectives in the balanced scorecard. The term “key performance indicators” was developed by the founders of the balanced scorecard. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Balanced Scorecard Perspective Key Performance Indicators Financial Net income Sales revenue growth Gross margin growth Cash flow Return on investment Residual income To evaluate the financial perspective of a company, several measures or key performance indicators are given. Most of these indicators are familiar to accountants. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Balanced Scorecard Perspective Key Performance Indicators Customer Customer satisfaction ratings Percentage of market share Increase in number of customers Number of repeat customers Number of customer complaints Rate of on-time deliveries Percentage of sales returns To evaluate the customer perspective of the balanced scorecard, several measures are given. Customer satisfaction ratings are at the top of the list. Most of the KPIs deal with some aspect of customers. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Balanced Scorecard Perspective Key Performance Indicators Internal Business Number of new products developed New-product development time Manufacturing cycle time Defect rate Number of units produced per hour Number of warranty claims received Average repair time Average wait time for a customer service representative To evaluate the internal business perspective of the balanced scorecard, several measures are given. The indicators deal with new products, the manufacturing process and post-sale customer service. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Balanced Scorecard Perspective Key Performance Indicators Learning & Growth Hours of employee training Number of cross-trained employees Percentage of computer downtime Percentage of processes with real-time feedback on quality, cycle time and cost Employee satisfaction Employee turnover Number of employee suggestions implemented To evaluate the Learning and Growth perspective of the balanced scorecard, several measures are given that relate to employees, such as employee turnover, employee satisfaction and employee training. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of repeat customers Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of repeat customers—Customer Perspective Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of repeat customers--Customer Perspective Employee turnover Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of repeat customers--Customer Perspective Employee turnover--Learning & Growth Perspective Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of repeat customers--Customer Perspective Employee turnover--Learning & Growth Revenue growth Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of repeat customers--Customer Perspective Employee turnover--Learning & Growth Revenue growth--Financial Perspective Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of on-time deliveries Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of on-time deliveries--Customer Perspective Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of on-time deliveries--Customer Perspective Number of defects found during manufacturing process Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Classify each key performance indicator according to the balanced scorecard perspective it addresses. Number of on-time deliveries--Customer Perspective Number of defects found during manufacturing process--Internal Business Perspective Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Reports
Responsibility reports are completed for the manager of each business segment. Responsibility accounting attempts to associate costs with the manager who has control over each cost. Responsibility reports are used to evaluate the performance of a manager. Only costs controllable by the manager are included. Performance reports are prepared for each segment of a business. Performance reports include all the expenses the segment manager may or may not be able to control. For example, allocated corporate costs will be included in the performance report, but they are not controlled by the segment manager. Responsibility reports are also prepared for each segment of a business. Responsibility reports only include expenses that the manager has control over because these reports are used to evaluate the performance of the segment manager. If a segment manager cannot control the cost, they are not included in the responsibility report. For example, allocated corporate costs will not be included in the responsibility report. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Controllable Cost A controllable cost is a cost that a manager has the power to influence by his or her decisions. Upper level management has control over more costs than lower level management. Lower level managers have responsibility for a limited amount of costs. A controllable cost is a cost that a segment manager has the power to influence by his or her decisions. For example, the cost of the legal department at the corporate headquarters is not a controllable cost for the manager of a department store. On the other hand, the wages of the employees working at the department store will be considered a controllable cost. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Reports for Cost Centers
Focuses on costs or expenses. Focuses on the flexible budget variance for each cost. The flexible budget variance highlights differences caused by changes in costs, not by changes in sales or production volume. Responsibility reports for cost centers report variances for costs because the responsibility centers are only responsible for costs. So, it makes sense that only variances for costs are reported. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Report for Cost Center: Example
Actual Results Flexible Budget Flexible Budget Variance Wages $15,500 $15,000 $500 U Supplies $1,850 $2,000 $150 F Other Expenses $1,900 $100 F Total $19,250 $19,000 $250 U The flexible budget variance is the difference between the actual cost and the flexible budget cost for each cost examined. The flexible budget cost is the standard cost per unit times the actual number of units sold. The actual cost is the actual cost per unit times the actual number of units sold. The variance is favorable when actual costs are less than flexible budget costs. In the example, this is the case for supplies. The variance is unfavorable when actual costs exceed flexible budget costs. In this example, this is the case for wages and other expenses. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Management by Exception
Used to determine which variances in the responsibility report should be investigated. Variances are investigated if they exceed a certain dollar amount or a certain percentage. For example, variances over $1,000 should be investigated. Responsibility reports reveal the variances for costs, revenues, and profit figures. The question that remains is whether all the variances should be investigated. Usually, only material variances are investigated to find out why they exist. Materiality cutoffs based on dollar amounts are usually used. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Flexible Budget Variance
If Variances Over $1,000 should be investigated, which variances should be investigated? None in the table below. Actual Results Flexible Budget Flexible Budget Variance Wages $15,500 $15,000 $500 U Supplies $1,850 $2,000 $150 F Other Expenses $1,900 $100 F Total $19,250 $19,000 $250 U Since all the flexible budget variances are less than $1,000, none of the variances should be investigated. The interpretation is that the variances are not significant or material enough to warrant further study. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Reports for Revenue Centers
Focuses on revenues. Focuses on flexible budget variance and sales volume variance for revenue. The sales volume variance is due to volume differences—selling more or fewer units than planned. The flexible budget variance is due to differences in the sales price—selling units for a higher or lower price than planned. Since revenue centers focus on revenues only, responsibility reports for revenue centers also focus on revenues. Variances are calculated for revenues. The sales volume variance reveals the effect of sales volume differences on revenues. The sales volume variance looks at the number of units actually sold versus the number of units expected to be sold. The flexible budget variance looks at differences in the sales price. The flexible budget variance takes the difference between the number of units actually sold times the actual selling price and the number of units actually sold times the budgeted selling price. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Report for Revenue Center: Example
Actual Results Flexible Budget Variance Flexible Budget Sales Volume Variance Static Budget Number of units sold 90 10 F 80 Sales Revenue $47,250 $2,250 F $45,000 $5,000 F $40,000 Responsibility reports for revenue centers report a flexible budget variance and a sales volume variance for sales revenue. If the actual sales price exceeds the budgeted sales price, the flexible budget variance is favorable. If the actual amount of units sold exceeds the budgeted amount of units to be sold under the static budget, the sales volume variance is favorable. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Flexible Budget Variance
If Variances Over $1,000 should be investigated, which variances should be investigated? Both variances. Actual Results Flexible Budget Variance Flexible Budget Sales Volume Variance Static Budget Number of units sold 90 10 F 80 Sales Revenue $47,250 $2,250 F $45,000 $5,000 F $40,000 Since the flexible budget variance and the sales volume variance exceed $1,000, both variances should be investigated. We would want to determine the causes for the variances. In the case of the flexible budget variance, we know that the actual sales price exceeds the budgeted sales price. We would want to know the reasons for this. In the case of the sales volume variance, we know that the actual number of units sold exceeds the budgeted number of units sold. Again, we want to know the reasons for this. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Reports for Profit Centers
Focuses on revenues, costs and contribution margin. Focus on flexible budget variances for revenues, expenses and contribution margin. Since profit centers report revenues, expenses and measures of profit such as contribution margin, variances are computed for revenues, expenses and measures of profit. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Responsibility Report for Profit Center: Example
Actual Results Flexible Budget Flexible Budget Variance Sales Revenue $5,243,600 $5,000,000 $243,600 F Variable Expenses $4,183,500 $4,000,000 $183,500 U Contribution Margin $1,060,100 $1,000,000 $60,100 F Since the report is for a profit center that is responsible for revenues, expenses and contribution margin, we see all these elements reported and flexible budget variances for revenue, expenses and contribution margin. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Match the responsibility center to the correct responsibility report. 14. Cost center is matched to what type of responsibility report? Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Match the responsibility center to the correct responsibility report. 14. Cost center is matched to: Responsibility report that includes flexible budget variance for costs. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Match the responsibility center to the correct responsibility report. 15. Revenue center is matched to what type of responsibility report? Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Match the responsibility center to the correct responsibility report. 15. Revenue center is matched to: Responsibility report that includes flexible budget variance and sales volume variance for revenues. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Match the responsibility center to the correct responsibility report. 16. Profit center is matched to what type of responsibility report? Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Match the responsibility center to the correct responsibility report. 16. Profit center is matched to: Responsibility report that includes flexible budget variances for revenues and costs. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Evaluation of Investment Centers
The evaluation of investment centers must evaluate two factors: (1) the amount of operating income the center is generating (2) the efficiency in the use of the center’s assets. Managers of investment centers are responsible for generating income and managing the center’s assets. As a result, to evaluate investment centers, we must consider these two factors. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Evaluation of Investment Centers
Performance measures should include: (1) operating income of investment center and (2) total assets of investment center. Two commonly used performance measures are: (1) return on investment and (2) residual income. When evaluating investment centers, two commonly used performance measures are return on investment and residual income. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Return On Investment Return On Investment = Operating Income Average Total Assets The ratio, Return on Investment, is a simple ratio that takes operating income divided by average total assets. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Example of Return on Investment
Division 1 Division 2 Operating Income $450,000 $975,800 Average Total Assets $2,500,000 $6,500,000 Net Sales $7,500,000 $5,243,600 Return on Investment $450,000/$2,500,000 $975,800/$6,500,000 18% 15% In this example, Division 1 has the higher return on investment. This is not expected when you look at the actual figures for operating income and average total assets individually. For example, Division 2 actually has more operating income than Division 1. Division 2 actually has more total assets than Division 1. But when you look at both operating income and average total assets at the same time, Division 1 is outperforming Division 2. That is, Division 1 is producing more operating income than Division 2 when you consider the amount of total assets that Division 1 has. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Example of Return on Investment
Division 1 has the higher Return on Investment. Division 1 is outperforming Division 2 based on Return on Investment. This is not expected because: Division 1 has less operating income than Division 2. Division 1 has less average total assets than Division 2. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Drawback of Return On Investment
Evaluating division managers solely on Return on Investment gives them an incentive to adopt only projects that maintain or increase their Return on Investment. Projects that decrease a segment’s Return on Investment may be acceptable to the company as a whole. As a result, goal congruence is not achieved. A problem with the use of return on investment is that it does not lead to goal congruence between segment managers and the company as a whole. When using return on investment, managers are trying to maintain or increase their return on investment. A new project may decrease a single manager’s return on investment for the segment but increase the return on investment for the company as a whole. The manager will reject the new project whereas the company CEO would advocate that the project should be accepted. Goal congruence is not achieved using return on investment as the performance measure. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Residual Income Considers operating income and average total assets Achieves goal congruence better than Return On Investment Residual income is another measure of performance. Like return on investment, it considers operating income and average total assets. However, residual income achieves goal congruence better than return on investment. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Residual Income Residual Income = minus Operating Income
Minimum Acceptable Operating Income (Target Rate of Return x Avg. Total Assets) Operating Income The calculation for residual income is operating income minus the minimum acceptable operating income. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Residual Income: Example
Division 1 Division 2 Operating Income $450,000 $975,800 Target Rate of Return 16% Average Total Assets $2,500,000 $6,500,000 Residual Income $450,000 – (16% x $2,500,000) = $50,000 $975,800 – (16% x $6,500,000) = $(64,200) Residual income is calculated for two divisions. Division 1 has residual income of $50,000, which is a positive number. Division 2 has residual income of $(64,200), which is a negative number. Division 1 is outperforming Division 2. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Padgett Company has complied the following data: What is the profit margin ratio? Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% What is the profit margin ratio? Profit margin ratio = Operating income / Net sales = $60,000/$1,000,000 = 0.06 Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% What is the asset turnover ratio? Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% What is the asset turnover ratio? Asset turnover ratio = Net sales/Average total assets = $1,000,000/$400,000 = 2.5 Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% What is the return on investment? Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% What is the return on investment? Return on Investment = Operating income / Average total assets = $60,000/$400,000 = 0.15 = 15% Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% What is the residual income? Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Net sales $1,000,000 Operating income $60,000 Average total assets $400,000 Target rate of return 12% What is the residual income? Residual income = Operating income –(Average total assets x Target rate of return) = $60,000 – ($400,000 x 12%) = $12,000 Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

What is the Transfer Price?
The transaction amount for one unit of goods when the transaction occurs between divisions within the same company. The price Division A charges Division B for a sale of units to Division B. Division A and Division B are two divisions within a company. Division A is going to sell some units to Division B. Division A is going to charge Division B a certain amount called the transfer price. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Setting the Transfer Price
The Transfer Price can be in a range that extends from: Variable Cost to Outside Market Price The minimum Transfer Price is the Variable Cost per unit. The maximum Transfer Price is the Outside Market Price. When setting the transfer price, division managers usually consider two factors: (1) the variable cost to make the unit transferred and (2) the market price they could get if they sold the unit outside the company. The transfer price can be in the range from variable cost per unit to the outside market price per unit. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Example Sales price per unit(outside company) $100 Variable cost per unit $60 Fixed cost per unit $20 Contribution margin per unit $40 Range for Transfer Price $60 to $100 The range for the transfer price is the variable cost of $60 per unit to the outside sales price of $100 per unit. The transfer price can be $60 to $100. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

More Rules for Setting Transfer Prices
If the selling division is operating at capacity, use the outside sales price. If the selling division has excess capacity, the variable cost is the minimum and the outside sales price is the maximum. If the selling division is operating at capacity, then the units to be sold internally are in high demand and the division manager should charge the market price. If the selling division has excess capacity, then the minimum transfer price should be the total variable cost per unit and the maximum transfer price should be the market price, or the outside sales price. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Example Sales price per unit(outside company) $100 Variable cost per unit $60 Fixed cost per unit $20 Contribution margin per unit $40 Transfer Price if Operating at Capacity Transfer Price if Excess Capacity $60 to $100 If the selling division is operating at capacity, the transfer price should equal the outside sales price of $100. If the selling division has excess capacity, the minimum transfer price is the variable cost per unit of $60 and the maximum transfer price is the outside sales price of $100 per unit. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

Try It! Exercise Sheffield Company manufactures power tools. The Electric Drill Division can purchase motors for the drill from the Motor Division or an outside vendor. The outside vendor cost is $20. The Motor Division also sells to outside customers, and sells the motors for $25 to outside customers. The variable cost for a motor is $15. The Motor Division has excess capacity. Copyright © 2014 Pearson Education, Inc. Publishing as Prentice Hall

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