Skip to Content
OpenStax Logo
Principles of Accounting, Volume 2: Managerial Accounting

9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers

Principles of Accounting, Volume 2: Managerial Accounting9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
Buy book
  1. Preface
  2. 1 Accounting as a Tool for Managers
    1. Why It Matters
    2. 1.1 Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
    3. 1.2 Distinguish between Financial and Managerial Accounting
    4. 1.3 Explain the Primary Roles and Skills Required of Managerial Accountants
    5. 1.4 Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards
    6. 1.5 Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Thought Provokers
  3. 2 Building Blocks of Managerial Accounting
    1. Why It Matters
    2. 2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations
    3. 2.2 Identify and Apply Basic Cost Behavior Patterns
    4. 2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Cost-Volume-Profit Analysis
    1. Why It Matters
    2. 3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin
    3. 3.2 Calculate a Break-Even Point in Units and Dollars
    4. 3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations
    5. 3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations
    6. 3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  5. 4 Job Order Costing
    1. Why It Matters
    2. 4.1 Distinguish between Job Order Costing and Process Costing
    3. 4.2 Describe and Identify the Three Major Components of Product Costs under Job Order Costing
    4. 4.3 Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts
    5. 4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
    6. 4.5 Compute the Cost of a Job Using Job Order Costing
    7. 4.6 Determine and Dispose of Underapplied or Overapplied Overhead
    8. 4.7 Prepare Journal Entries for a Job Order Cost System
    9. 4.8 Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment
    10. Key Terms
    11. Summary
    12. Multiple Choice
    13. Questions
    14. Exercise Set A
    15. Exercise Set B
    16. Problem Set A
    17. Problem Set B
    18. Thought Provokers
  6. 5 Process Costing
    1. Why It Matters
    2. 5.1 Compare and Contrast Job Order Costing and Process Costing
    3. 5.2 Explain and Identify Conversion Costs
    4. 5.3 Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage
    5. 5.4 Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage
    6. 5.5 Prepare Journal Entries for a Process Costing System
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  7. 6 Activity-Based, Variable, and Absorption Costing
    1. Why It Matters
    2. 6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
    3. 6.2 Describe and Identify Cost Drivers
    4. 6.3 Calculate Activity-Based Product Costs
    5. 6.4 Compare and Contrast Traditional and Activity-Based Costing Systems
    6. 6.5 Compare and Contrast Variable and Absorption Costing
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  8. 7 Budgeting
    1. Why It Matters
    2. 7.1 Describe How and Why Managers Use Budgets
    3. 7.2 Prepare Operating Budgets
    4. 7.3 Prepare Financial Budgets
    5. 7.4 Prepare Flexible Budgets
    6. 7.5 Explain How Budgets Are Used to Evaluate Goals
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Standard Costs and Variances
    1. Why It Matters
    2. 8.1 Explain How and Why a Standard Cost Is Developed
    3. 8.2 Compute and Evaluate Materials Variances
    4. 8.3 Compute and Evaluate Labor Variances
    5. 8.4 Compute and Evaluate Overhead Variances
    6. 8.5 Describe How Companies Use Variance Analysis
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  10. 9 Responsibility Accounting and Decentralization
    1. Why It Matters
    2. 9.1 Differentiate between Centralized and Decentralized Management
    3. 9.2 Describe How Decision-Making Differs between Centralized and Decentralized Environments
    4. 9.3 Describe the Types of Responsibility Centers
    5. 9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  11. 10 Short-Term Decision Making
    1. Why It Matters
    2. 10.1 Identify Relevant Information for Decision-Making
    3. 10.2 Evaluate and Determine Whether to Accept or Reject a Special Order
    4. 10.3 Evaluate and Determine Whether to Make or Buy a Component
    5. 10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product
    6. 10.5 Evaluate and Determine Whether to Sell or Process Further
    7. 10.6 Evaluate and Determine How to Make Decisions When Resources Are Constrained
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  12. 11 Capital Budgeting Decisions
    1. Why It Matters
    2. 11.1 Describe Capital Investment Decisions and How They Are Applied
    3. 11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
    4. 11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities
    5. 11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
    6. 11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Balanced Scorecard and Other Performance Measures
    1. Why It Matters
    2. 12.1 Explain the Importance of Performance Measurement
    3. 12.2 Identify the Characteristics of an Effective Performance Measure
    4. 12.3 Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added
    5. 12.4 Describe the Balanced Scorecard and Explain How It Is Used
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  14. 13 Sustainability Reporting
    1. Why It Matters
    2. 13.1 Describe Sustainability and the Way It Creates Business Value
    3. 13.2 Identify User Needs for Information
    4. 13.3 Discuss Examples of Major Sustainability Initiatives
    5. 13.4 Future Issues in Sustainability
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Thought Provokers
  15. Financial Statement Analysis
  16. Time Value of Money
  17. Suggested Resources
  18. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
  19. Index

Organizations incur various types of costs using decentralization and responsibility accounting, and they need to determine how the costs relate to particular segments of the organization within the responsibility accounting framework. One way to categorize costs is based on the level of autonomy the organization (or responsibility center manager) has over the costs. Controllable costs are costs that a company or manager can influence. Examples of controllable costs include the wages paid to employees of the company, the cost of training provided to employees, and the cost of maintaining buildings and equipment. As it relates to controllable costs, managers have a fair amount of discretion. While managers may choose to reduce controllable costs like the examples listed, the long-term implications of reducing certain controllable costs must be considered. For example, suppose a manager chooses to reduce the costs of maintaining buildings and equipment. While the manager would achieve the short-term goal of reducing expenses, it is important to also consider the long-term implications of those decisions. Often, deferring routine maintenance costs leads to a greater expense in the long-term because once the building or equipment ultimately needs repairs, the repairs will likely be more extensive, expensive, and time-consuming compared to investments in routine maintenance.

Think It Through

The Frequency of Maintenance

If you own your own vehicle, you may have been advised (maybe all too often) to have your vehicle maintained through routine oil changes, inspections, and other safety-related checks. With advancements in technology in both car manufacturing and motor oil technology, the recommended mileage intervals between oil changes has increased significantly. If you ask some of your family members how often to change the oil in your vehicle, you might get a wide range of answers—including both time-based and mileage-based recommendations. It is not uncommon to hear that oil should be changed every three months or 3,000 miles. An article from the Edmunds.com website devoted to automobiles suggests automobile manufacturers are extending the recommended intervals between oil changes to up to 15,000 miles.

Do you know what the recommendation is for changing the oil in the vehicle you drive? Why do you think the recommendations have increased from the traditional 3,000 miles to longer intervals? How might a business apply these concepts to the concept of maintaining and upgrading equipment? If you were the accountant for a business, what factors would you recommend management consider when making the decisions on how frequently to maintain equipment and how big of a priority should equipment maintenance be?

The goal of responsibility center accounting is to evaluate managers only on the decisions over which they have control. While many of the costs that managers will encounter are controllable, other costs are uncontrollable and originate from within the organization. Uncontrollable costs are those costs that the organization or manager has little or no ability to influence (in the short-term, at least) and therefore should not be incorporated into the analysis of either the manager or the segment’s performance. Examples of uncontrollable costs include the cost of electricity the company uses, the cost per gallon of fuel for a company’s delivery trucks, and the amount of real estate taxes charged by the municipalities in which the company operates. While there are some long-term ways that companies can influence these costs, the examples listed are generally considered uncontrollable.

One category of uncontrollable costs is allocated costs. These are costs that are often allocated (or charged) to the segments within the organization based on some allocation formula or process, such as the costs of receiving support from corporate headquarters. These costs cannot be controlled by the responsibility center manager and thus should not be considered when that manager is being evaluated. Costs relevant to decision-making and financial performance evaluation will be further explored in Short-Term Decision-Making.

Effects of Decisions on Performance Evaluation of Responsibility Centers

Suppose, as the manager of the maintenance department of a major airline, you become aware of a training session that is available to your mechanics. The disadvantages are that the training will require the mechanics to miss an entire week of work and the associated costs (travel, lodging, training session) are high. The advantage is that, as a result of the training, the time during which the planes are grounded for repairs will significantly decrease. What factors would influence your decision regarding whether or not to send mechanics to school? Considering the fact that each mechanic would miss an entire week of work, what factors would you consider in determining how many mechanics to send? Do these factors align with or conflict with what is best for the company or you as the department manager? Is there a way to quantify the investment in the training compared to the benefit of quicker repairs for the airplanes?

Scenarios such as this are common for managers of the various responsibility centers—cost, discretionary cost, revenue, profit, and investment centers. Managers must be well-versed at using both financial and nonfinancial information to make decisions such as these in order to do what is best for the organization.

Ethical Considerations

Pro-Stakeholder Culture Opens Business Opportunities

The use of pro-stakeholder decision-making by managers in their responsibility centers allows managers to determine alternatives that are both profitable and follow stakeholders’ ethics-related demands. In an essay in Business Horizons, Michael Hitt and Jamie Collins explain that companies with a pro-stakeholder culture should better understand the multiple ethical demands of those stakeholders. They also argue that this understanding should “provide these firms with an advantage in recognizing economic opportunities associated with such concerns.”6 The identification of these opportunities can make a manager’s decisions more profitable in the long run.

Hitt and Collins go on to argue that “as products and services may be developed in response to consumers’ desires, stakeholders’ ethical expectations can, in fact, represent latent signals on emerging economic opportunities.”7 Providing managers the ability to identify alternatives based upon stakeholders’ desires and demands gives them a broader decision-making platform that allows for decisions that are in the best interest of the organization.

Often one of the most challenging decisions a manager must make relates to transfer pricing, which is the pricing process put into place when one segment of a business “sells” goods to another segment of the same business. In order to understand the significance of transfer pricing, recall that the primary goal of a responsibility center manager is to manage costs and make decisions that contribute to the success of the company. In addition, often the financial performance of the segment impacts the manager’s compensation, through bonuses and raises, which are likely tied to the financial performance of the segment. Therefore, the decisions made by the manager will affect both the manager and the company.

Application of Transfer Pricing

Transfer pricing can affect goal congruence—alignment between the goals of the segment or responsibility center, or even an individual manager, with the strategic goals of the organization. Recall what you’ve learned regarding segments of the business. Often, segments will be arranged by the type of product produced or service offered. Segments often sell products to external customers. For example, assume a soft drink company has a segment—called the blending department—dedicated to producing various types of soft drinks. The company may have an external customer to which it sells unique soft drink flavors that the customer will bottle under a different brand name (perhaps a store brand like Kroger or Meijer). The segment may also produce soft drinks for another segment within its own company—the bottling department, for example—for further processing and ultimate sale to external customers. When the internal transfer occurs between the blending segment and the bottling segment, the transaction will be structured as a sale for the blending segment and as a purchase for the bottling department. To facilitate the transaction, the company will establish a transfer price, even though the transaction is internal because each segment is responsible for its own profits and costs.

Figure 9.12 shows a graphical representation of the transfer pricing structure for the soft drink company used in the example.

Transer Pricing Structure. Blending Department External sales, $25,000, Internal sales, $75,000, Total sales, $100,000. Bottling Department Sales $225,000 less Ingredient Costs, ($75,000). There is an arrow from the $75,000 Internal sales in the Blending Department to the ($75,000) Ingredient Costs of the Bottling Department.
Figure 9.12 Transfer Pricing. The sale for the Blending Department is the purchase for the Bottling Department. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Notice that the blending department has two categories of customers—external and internal. External customers purchase the soft drink mixtures and bottle the drinks under a different label, such as a store brand. Internally, the blending department “sells” the soft drink mixtures to the bottling department. Notice the “sale” by the blending department (a positive amount) and the “purchase” by the bottling department (a negative amount) net out to zero. This transaction does not impact the overall financial performance of the organization and allows the responsibility center managers to analyze the financial performance of the segment just as if these were transactions involving outside entities.

What issues might this scenario cause as it relates to goal congruence—that is, meeting the goals of the corporation as a whole as well as meeting the goals of the individual managers?

In situations where the selling division, in this case the blending division, has excess capacity—meaning they can produce more than they currently sell—and ignoring goal congruence issues, the selling division would sell its products internally for variable cost. If there is no excess capacity, though, the opportunity cost of the contribution margin given up by taking internal sales instead of external sales would need to be considered. Let’s look at each of these general situations individually.

In the case of excess capacity, the selling division has the ability to produce the goods to sell internally with only variable costs increasing. Thus, it seems logical to make transfer price the same as the variable costs—but is it? Reflecting back on the concept of responsibility centers, the idea is to allow management to have decision-making authority and to evaluate and reward management based on how well they make decisions that lead to increased profitability for their segment. These managers are often rewarded with bonuses or other forms of compensation based on how well they reach certain profitability measures. Does selling goods at variable cost increase the profitability for the selling division? The answer, of course, is no. Thus, why would a manager, who is rewarded based on profitability, sell goods at variable cost? Obviously, the manager would prefer not to sell at variable cost and would rather sell the goods at some amount above variable cost and thus contribute to the segment’s profitability. What should the transfer price be? There are various options for choosing a transfer price.

Concepts In Practice

Transfer Pricing with Overseas Segments

An inherent assumption in transfer pricing is that the divisions of a company are located in the same country. While implementing a transfer pricing framework can be complex for a business located entirely in the United States, transfer pricing becomes even more complex when any of the divisions are located outside of the United States.

Companies with overseas transactions involving transfer pricing must pay particular attention to ensure compliance with the tax, foreign currency exchange rate fluctuations, and other regulations in the countries in which they operate.

This can be expensive and difficult for companies to manage. While many firms use their own employees to manage the process, the Big Four accounting firms, for example, offer expertise in transfer pricing setup and regulatory compliance. This short video from Deloitte on transfer pricing provides more information about this valuable service that accountants provide.

Available Transfer Pricing Approaches

There are three primary transfer pricing approaches: market-based prices, cost-based prices, or negotiated prices.

Market Price Approach

With the market price approach, the transfer price paid by the purchaser is the price the seller would use for an outside customer. Market-based prices are consistent with the responsibility accounting concepts of profit and investment centers, as managers of these units are evaluated based on purchasing and selling goods and services at market prices. Market-based transfer pricing is very common in a situation in which the seller is operating at full capacity.

The benefit of using a market price approach is that the company will need to stay familiar with market prices. This will likely occur naturally because the company will also have outside sales. A potential disadvantage of this approach is that conflicts might arise when there are discrepancies between the current market price and the market price the company sets for transfer prices. Firms should decide at what point and how frequently to update the transfer prices used in a market approach.

For example, assume a company adopts a market approach for transfer prices. As time goes by, the market price will likely change—it will either increase or decrease. When this occurs, the firm must decide if and when to update transfer prices. If current market prices are higher than the market price the company uses, the selling division will be happy because the price earned for intersegment (transfer) sales will increase while inputs (costs) to provide the goods or services remain the same. An increase in the transfer price will, in turn, increase the profit margins of the selling division. The opposite is true for the purchasing division. If the market transfer price increases to match the current market price, the costs (cost of goods sold, in particular) will increase. Without a corresponding increase in the prices charged to its customers or an offset through cost reductions, the profit margins of the purchasing division will decrease. This situation could cause conflict between divisions within same company, an unenviable situation for management as one manager is pleased with the transfer price situation and the other is not. Both managers desire to improve the profits of their respective divisions, but in this situation, the purchasing division may feel they are giving up profits that are then being realized by the selling division due the increase in the market price of the goods and the use of a market-based transfer price.

Cost Approach

When the transfer price uses a cost approach, the price may be based on either total variable cost, full cost, or a cost-plus scenario. In the variable cost scenario, as mentioned previously, the transfer of the goods would take place at the total of all variable costs incurred to produce the product. In a full-cost scenario, the goods would be transferred at the variable cost plus the fixed cost per unit associated with making that product. With a cost-plus transfer price, the goods would be transferred at either the variable cost or the full-cost plus a predetermined markup percentage. For example, assume the variable cost to produce a product is $10 and the full cost is $12. If the company uses a cost-plus methodology to calculate the transfer price with a 30% mark-up, the transfer price would be $13 ($10 × 130%) based on just the variable cost or $15.60 ($12 × 130%) based on the full cost. When using the full cost as a basis for applying markup, it is important to understand that the cost structure may include costs that are irrelevant to establishing a transfer price (for example, costs unrelated to producing the actual product to be transferred, such as the fixed cost of the plant supervisor’s salary, which will exist whether the product is transferred internally or externally), which may unnecessarily influence decisions.

The benefit of using a cost approach is that the company will invest effort into determining the actual costs involved in making a product or providing another service. The selling division should be able to justify to the purchasing division the cost that will be charged, which likely includes a profit margin, based on what the division would earn on a sale to an outside customer. At the same time, a deeper understanding of what drives the costs within a division provides an opportunity to identify activities that add unnecessary costs. Companies can, in turn, work to increase efficiency and eliminate unnecessary activity and bring down the cost. In essence, the selling division has to justify the costs it is charging the purchasing division.

Negotiated Price Approach

Somewhere in between a transfer price based on cost and one based on market is a negotiated price approach in which the company allows the buying segment and the selling segment to negotiate the transfer price. This is common in situations in which there is no external market. When an external price exists and is used as a starting point for establishing the transfer price, the organization must be aware of differences in specific costs between the source of the external price and its own organization. For example, a price from an external source may include a higher profit margin than the profit margin targeted by a company pursuing a cost leadership strategy. In this case, the external price should be reduced to account for such differences.

However, one disadvantage of using a negotiated price system is the possibility of creating a situation in which competition exists between a department and an outside vendor (as occurs when it is cheaper for a department to purchase from an outside vendor rather than another department in the organization) or, worse yet, between departments of the same organization. It is paramount that, when selecting a transfer pricing methodology, the goals of the particular departments involved align with the overall strategic goals of the organization. A transfer pricing structure is not intended to facilitate competition between departments within the same company. Rather, a transfer pricing system should be viewed as a tool to help the company remain competitive in the marketplace and improve a company’s overall profit margin.

Other Transfer Pricing Issues

The three approaches to transfer pricing assume that the selling department has excess capacity to produce additional products to sell internally. What happens if the selling department does not have excess capacity—in other words, if the selling department can sell all that it produces to external customers? If an internal department wants to purchase goods from the selling department, what would be an appropriate selling price? In this case, the transfer price must take into consideration the opportunity cost of the contribution margin that would be lost from having to forego external sales in order to meet internal sales.

Suppose in the previous example that the blending department is at full capacity but the bottling department wants to purchase some of its soft drink blends internally. Assume the variable cost to produce one unit of soft drink is $10, the fixed cost per unit is $2, and the market price for selling one unit is $18. What would be an appropriate transfer price in this situation? Since the blending department does not have the capacity to meet external sales plus internal sales, in order to accept the internal sales order, the blending department would have to lose sales to external customers. The contribution margin per unit is $8 ($18 − $10). Thus, $8 per unit would be given up for each external unit that is sold internally.

Looking only at costs, the blending department would be indifferent between an external sale of $18 and an internal sale of $18 ($10 variable cost + $8 contribution margin). Obviously, there are other issues that need to be considered in these situations, such as the effect on external customers if demand cannot be met. Overall, if there is no excess capacity, the transfer price should take into consideration the opportunity cost lost from taking internal sales over external sales.

In addition to the possibility of losing opportunity costs, there are additional transfer pricing issues. Recall that decentralized organizations delegate decision-making authority throughout the organization. A well-designed transfer pricing policy can contribute not only to the segment manager’s profits but to overall corporate profits in situations where the transfer price is lower than the external price. However, when a transfer pricing system is used to facilitate transactions between departments, an ill-designed policy is likely to lead to disputes between departments. It is possible the departments view each other as competition rather than strategic partners. When this occurs, it is important for upper-level management to establish a process that allows managers to resolve disagreements in a way that aligns with organizational, rather than departmental, goals.

Transfer pricing systems become even more complicated when departments are located in different countries. The transfer price in an international setting must also account for differences in currencies and fluctuating exchange rate as well as differences in regulations such as tariffs and duties, taxes, and other regulations.

Transfer Pricing Example

Regal Paper has two divisions. The Paper Division produces copy paper, wrapping paper, and paper used on the outside of cardboard displays placed in grocery, office, and department stores. The Box Division produces cardboard boxes sold at Christmas, cardboard boxes purchased by manufacturers for packaging their goods, and cardboard displays for stores, particularly seasonal displays. Both divisions are profit centers, and each manager is evaluated and rewarded based on his division’s profitability. The Box Division has approached the Paper Division to buy paper needed to cover cardboard displays that have been ordered by several major snack food manufacturers for the upcoming Superbowl game. The Box Division has been buying the display coverings from an external seller for $12.50 per unit. Currently, the Paper Division has excess capacity and can fill the order for the 500,000 display coverings that the Box Division is requesting.

The cost to the Paper Division to produce one display covering is as follows:

Variable cost per unit $8, Fixed cost per unit $1, Selling price to external customers $12, Price at which Box Division can buy externally $12.50.

What would be the transfer price per unit under each of the following scenarios?

  1. Market-based transfer price. This transfer price is the same as the selling price to external customers, which is $12.
  2. Cost-based transfer price. This transfer price is the same as the variable costs per unit, which is $8.
  3. Full-cost–based transfer price. This transfer price is the same as the variable costs plus the fixed cost per unit, which is $9.
  4. Cost plus assuming 20% mark-up. This marks up the cost-based transfer price by 20%, which is $8 × 120%, or $9.60.
  5. Full-cost plus assuming 20% mark-up. This marks up the full-cost–based transfer price by 20%, which is $9 × 120%, or $10.80.
  6. Range of negotiated transfer price. The negotiated transfer price should be between the lowest and highest possible prices: $8–12
  7. What if Paper had no excess capacity? If the Paper Division had no excess capacity, the transfer price would be the cost plus the contribution margin, which is $8 + $4, or $12.
  8. Which transfer price is best? If there is excess capacity, then typically a negotiated transfer price is best, as it allows the managers who are evaluated on that decision to have input into the decision and does not take away their autonomy. Table 9.1 shows the per-unit effect on income of each of the transfer pricing options on each division. Remember, the effects provided here cannot necessarily be generalized, as there are two critical factors: whether or not the selling department is at capacity and the price at which the purchasing department could buy the goods externally, which in this case is $0.50 more per unit than the market price of the paper being sold by the Paper Division.
Per-Unit Effect on Division Income of Various Transfer Pricing Methodologies
Transfer Pricing Method Paper Division Box Division
Market $4 per unit increase in income
($12 SP − $8 VC)
$0.50 per unit increase in income
($12.50 − $12 SP)
Cost $0 per unit increase in income
($8 SP − $8 VC)
$4.50 per unit increase in income
($12.50 − $8)
Full-cost $1 per unit increase in income
($9 SP − $8 VC)
$3.50 per unit increase in income
($12.50 − $9)
Cost-Plus (20%) $1.60 per unit increase in income
($9.60 SP − $8 VC)
$2.90 per unit increase in income
($12.50 − $9.60)
Full-cost Plus (20%) $2.80 per unit increase in income
($10.80 SP − $8VC)
$1.70 per unit increase in income
($12.50 − $10.80)
Negotiated ($0 − $12) Increase to income between $0 and $4 per unit Increase to income between $0.50 and $4.50
No Excess Capacity $4 per unit increase in income
($12 SP − $8 VC)
$0.50 per unit increase in income
($12.50 − $12 SP)
SP = selling price; VC = variable cost
Table 9.1

As you can see, the transfer price can significantly affect the profitability of the division. It is easy to see which transfer prices most benefit the seller and which most benefit the buyer. Thus, as previously mentioned, a negotiated transfer price is often the best resolution to determining a transfer price.

Think It Through

Comparing Transfer Pricing and Outsourcing

Assume you are the President of a manufacturing firm that has a division that transfers products to other divisions within the company. The other divisions have recently complained that the transfer price charged to the departments has increased significantly over the past several quarters. They are frustrated because performance evaluations and bonuses are linked to the profitability of their respective departments.

During a recent management meeting, a cost accountant suggests the company can solve this issue by transferring production to another supplier that has a lower cost of production due to lower labor costs. In addition to solving the conflict between departments, the company’s overall profitability will increase because of the substantial cost savings.

Evaluate this scenario and explain how you would respond as the company’s President. Consider the perspectives of various stakeholders in this situation.

Footnotes

  • 6 Michael Hitt and Jamie Collins “Business Ethics, Strategic Decision Making, and Firm Performance.” Business Horizons 50, no. 5 (February 2007): 353–357.
  • 7 Michael Hitt and Jamie Collins “Business Ethics, Strategic Decision Making, and Firm Performance.” Business Horizons 50, no. 5 (February 2007): 353–357.
Citation/Attribution

Want to cite, share, or modify this book? This book is Creative Commons Attribution-NonCommercial-ShareAlike License 4.0 and you must attribute OpenStax.

Attribution information
  • If you are redistributing all or part of this book in a print format, then you must include on every physical page the following attribution:
    Access for free at https://openstax.org/books/principles-managerial-accounting/pages/1-why-it-matters
  • If you are redistributing all or part of this book in a digital format, then you must include on every digital page view the following attribution:
    Access for free at https://openstax.org/books/principles-managerial-accounting/pages/1-why-it-matters
Citation information

© Feb 14, 2019 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License 4.0 license. The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.