Agenda Today

1
Agenda Today

• Review some chapter 12 ideas
• Outline transfer pricing issues
• Go over EVA case Outsource, Inc.

2
Profit Centers

• Responsibility elements
• Sales prices
• Sales volumes
• Sales mix
• Promotional activities
• Other terms of sale

3
Profit Centers (Cont.)

• Direct cost elements
• Production activity costs
• Order-getting costs
• Order-filling costs
• Marketing expenses
• Support activity costs
• Costs associated with other terms of sale

4
Profit Centers (Cont.)

• Other possible responsibility elements
• Receivables
• Inventories
• Plant equipment
• Examples?

5
Investment Centers

• Profit centers with additional responsibility
  elements
• Investment in current operating assets
• Investment in plant equipment

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Investment Centers

• Challenges
• Allocation of common assets
• Cash
• Receivables
• Warehouse space
• Transportation resources
• Valuation of investment
• Inflation and currency effects

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Invest.Centers (Cont.)

• Examples
• Lazarus store in City Center Mall
• Marysville Honda plant
• EDS processing centers

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Divisions

• Divisions are investment centers whose managers
  have the broad decision-making authority
  associated with decentralized management systems
• Divisions may have a variety of legal forms
  (corporations, unincorporated, etc.)

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Divisions

• Divisions vary greatly in size
• Financial controls dominate since the
  decision-making is decentralized

10
Transfer Pricing

• A transfer price is the price at which a product
  or service is transferred from one entity to
  another entity within the same firm. Typically
  when products are moved from one cost center to
  another within a manufacturing system, the
  transfer price is the cumulative cost of the
  product to date.

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Transfer Pricing

• In a standard cost system, when products are
  transferred out of a cost center, they are
  transferred at their standard cost. The
  difference between the standard cost credited
  (received) for the product transferred, and the
  cost of the resources that are allowed by the
  standards for the production achieved, are the
  cost variances.

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Manufacturing Process 1
Inputs
Outputs at Standard Cost
Materials
Manufacturing Process 1
Labor
Manufacturing Process 2
Support
Support
Difference between cost of inputs and standard
cost of outputs variances
13
Support Service

• When a support service is charged to other
  entities at a predetermined price, that amounts
  to a transfer price. If the transfer price is a
  budgeted cost, as in the previous slides, the
  difference between the budgeted prices of the
  services provided to others, and the cost of
  resources used by the entity, are cost variances.

14
Services in General

• When a service is provided to other entities in
  the same firm at a predetermined price, that
  amounts to a transfer price. If the transfer
  price were a budgeted cost, then like the
  previous slides, the difference between the
  budgeted cost of the services provided and the
  cost of resources actually used to provide those
  services would be cost variances.

15
Therefore,

• we have dealt with transfer prices in the context
  of cost centers. The transfers between cost
  centers can be made at budgeted, standard, or
  actual cost. The objective of a cost center is
  to create a positive difference between the
  actual costs incurred and the budgeted cost
  allowance for the output levels achieved.

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Revenue Centers

• In the case of revenue centers, we are tracking
  revenues by responsibility center, where the
  emphasis in on generating revenues. Normally,
  there are no transfers involved with revenue
  centers.

17
Profit Investment Centers

• Profit centers and investment centers have profit
  responsibility--usually in the form of the
  control of both revenues and costs. Therefore,
  transferring goods and services out of a profit
  center at cost is inconsistent with the idea of
  having profit responsibility. Normally, for true
  profit centers, there should be a meaningful
  profit component.

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Pricing Goods and Services

• In a market economy, prices determine economic
  activity. Prices determine what resources are
  offered, and how they are used to produce which
  products and services. Activities cease when
  they are no longer economic but persist when
  they are economic. Economic activity is the
  result of independent decisions made based on
  available prices.

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Pricing Goods and Services

• Large, decentralized organizations simulate
  market economies by allowing internal (transfer)
  prices to guide intra-firm economic activity.
  Ideally, managers would be free to price
  transfers of goods and services at a mutually
  agreed upon price, as in a market economy.
  Divisions would buy from the best sources and
  sell to maximize their own profitability.

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Decentralization Purposes

• Decentralize managerial responsibilities to local
  managers.
• Provide managerial incentives to operating
  executives
• Isolate economic efficiency by responsible entity

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Decentralization Purposes

• Distribute overall profitability among
  contributing entities
• Distribute overall profitability among taxing
  entities

22
Transfer Pricing Methods

• Transfer pricing methods that include a profit
  element include
• Marginal cost (economic theory)
• Administered prices
• Cost-plus prices
• Negotiated prices
• Market prices

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Transfer Price Internal Price
Corporate Entity
Primary or inter-mediate producer
Transfer price
Intermediate Producer or Distributor
Final price
External Customer
24
Note!!

• The selling divisions price is the buying
  divisions cost for divisional performance
  measurement purposes.
• Production mix and volume decisions are
  incremental analysis-type decisions in a
  multi-entity context.

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Three Perspectives

• The total firm
• Selling division
• Purchasing division

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Artic Delights

• Total Per Unit
• Sales 17,500 1.75
• Variable cost 10,000 1.00
• Contribution margin 7,500 .75
• Machine rental cost 6,000 .60
• Income from operations 1,500 .15

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Sandwich Stands

• We do not know the ultimate sales price to final
  customers, but price increases are not at issue.
• 1. Sandwich stands should buy from Artic Delights
  so long as the purchase price paid by the stand
  exceeds the variable cost of producing ice cream.

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Artic Delights

• 2. Artic delights should produce so long as the
  purchase price is above variable cost of 1 per
  gallon.
• Do companies ever produce for less than variable
  cost?
• How would one analyze a situation like that?
• 3. If stands can but ice cream for 1.50, Artic
  Delights will have to drop its price.

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Artic Delights

• 4. How does the transfer price affect the
  profitability of (a) Artic Delights excluding the
  stands, (b) each Sandwich stands, and (c) Artic
  Delights and its stands.
• (a) The higher the transfer price, the higher
  the profits of Artic Delights, excluding the
  stands. The lower the price, the lower the
  income from operations.

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Artic Delights

• 4 (b). The higher the transfer price, the lower
  the income of each stand, and the lower the
  compensation of each manager. The lower the
  transfer price, the higher the income of each
  stand and the higher the compensation of each
  manager.

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Artic Delights

• 4 (c). When the stands are included with the
  results of Artic Delights, profitability is
  reduced to the extent that transfer prices are
  lower and the managers earn a higher return.
  This is a real problem in terms of balancing
  compensation and incentives.

32
EFG Company

• Division S (Supplying)
• Subassemblies
• Price 260
• Variable cost 200
• Contribution margin 60
• Widgets
• Price 150
• Variable cost 125
• Contribution margin 25

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EFG Company

• Division P (Purchasing)
• Product B
• Price 400
• Variable cost 160
• Contribution margin 240
• Gadget
• Price 180
• Variable cost 150
• Contribution margin 30

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EFG Company

• Case A
• Maximum external sales
• Division S - 1,600 subassemblies
• (capacity 2,000 units)
• Division P - 500 Gadgets
• (capacity 1,000 units)

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EFG - Case A

• Division S Production
• 1,600 subassemblies for external sale
• 400 subassemblies for Div. P
• Division P Production
• 400 units of Product B
• 500 Gadgets

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EFG - Case B

• Case B
• Maximum external sales
• Division S - 1,600 subassemblies
• - 200 widgets
• (capacity 2,000 units)
• Division P - 600 Gadgets
• (capacity 1,000 units)

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EFG - Case B

• Division S Production 1,600 subassemblies for
  external sale 400 subassemblies for
  Div. PDivision P Production 400 units of
  Product B 600 Gadgets

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EFG - Case C

• Case C
• Maximum external sales
• Division S - 1,500 subassemblies
• - 200 widgets
• - 600 subs to P
• (capacity 2,000 units)

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EFG Case C (Div. S)

• Division S Production 1,500 subassemblies for
  external sale 500 subassemblies for Div.
  P 0 Widgets

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EFG Case D (Div. S)

• Case D
• Maximum external sales
• Division S - 1,500 subassemblies
• - 300 widgets
• - 600 subs to P for 220
• (capacity 2,000 units)

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EFG Case D (Div. S)

• Division S Production 1,500 subassemblies for
  external sale 200 subassemblies for Div.
  P 300 Widgets for external sale
• Subassemblies to outside get 60
• Widgets get 25
• Subassemblies get 20 (at TP of 220)

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EFG Overview

• The key issue is to set a transfer price that
  takes advantage of excess capacity when it
  exists. The fact that one cannot earn the market
  price may be more of a temporary problem than a
  measure of ones inefficiency.
• Generally 200 lt price lt 240, but this depends
  on the other markets.

43
Evaluation Questions

• Were any of the calculators like the ones for
  learning curves and the internal rate of return
  of any benefit?
• Would calculators be useful for such topics as
  standard cost systems, etc.
• Looking back, were the graded problems/cases
  useful in terms of getting together to work on
  homework?
• Would you recommend quizzes again?

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Evaluation Questions

• Was having some MC questions available to study
  useful?
• Was the web page helpful?
• If yes, what would make it more helpful?

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Final Examination Discussion

• Content
• Preparation
• Presentation
• Grading

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Quiz Discussion?
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