FNEC-2600 Lecture Notes - Transfer Pricing, Variable Cost, Investment
15 May 2018
School
Department
Course
Professor
Managerial accounting
test four study guide
Multiple Choice Topics: (12 Questions, 36
Points)
1. Transfer pricing: Amount charged for transferring goods or rendering services on an intra-company
(between segments) basis. The price has no impact on pre-tax income for the company as a whole, but transfer prices
must be established when evaluating responsibility centers. Intra-company interactions an become very complex,
because of the changing of tax jurisdictions. E&Y tax could hire E&Y consulting, for example. In general, just a multiple
choice question on the test.
• Approaches to Establishing Transfer Prices:
1. Cost or Cost-plus Approach – Costs used can be variable or total product costs and are generally based on
standard, not actual costs. That keeps costs of inefficiencies within the selling division. The variable cost is the
best option when the selling division is organized as a cost center and has excess capacity. This ensures the
buying division does not go outside the company.
2. Market Price Approach – Price is based on cost incurred if the buying division goes outside the company to
acquire the product or service. This is the best option if the selling division has no excess capacity and it has a
positive impact on company profits without penalizing either the buying or selling division.
C. Negotiated Price Approach – Can be used if excess capacity exists within the selling division or if selling costs can
be avoided due to the intra-opa tasatio. The floo pie ould e the poduts aiale ost ith
ceiling equaling the market price. This method is most commonly practiced when both divisions are organized as
profit centers. The selling division has to have an incentive to sell (they have no incentive selling if using a cost
approach) and the buying division must have an incentive buy in-house (so the price must be below market to
keep their costs at a iiu. The idea is to aiize opa pofits hile aiizig eah etes
performance results.
Transfer Pricing Can Lead to:
1. Cost centers to be evaluated using some of the same methods (ROI or Segment Margins) as profit and investment
centers. Forces cost centers to become more efficient.
2. Multi-national corporations to shift income from higher-tax countries to lower-tax countries. The same could be
said for state to state transactions.
1. Can do so legally, but if you do so illegally, there are serious consequences.
3. Issues regarding establishment of a market price for a product or service when no readily available market price
exists for that product or service (e.g. royalties, commission sharing among multi-national offices).
2. Understand the different types of responsibility centers
Responsibility Centers – Unit/Segment that is held accountable for budgeted costs and/or revenues.
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A. Cost Center – only incurs costs. Usually includes production departments or service departments. Evaluation
often involves variance analysis. One tool could be variances we just did in the previous section.
B. Revenue Center – only responsible for sales. Variance analysis and budget variances are often used for
evaluation.
C. Profit Center – incurs costs and generates revenues. Examples might include individual departments within a
retail store or individual stores or offices of a company. Evaluated by segmented income statements using
variable costing.
D. Investment Center – incurs costs and generates revenues with the use of investment funds available. These
segments control or influence investment decisions pertaining to plant expansion and entry into new market
areas. The primary basis for evaluation is Return on Investment (ROI). Residual Income and Economic Value
Added (EVA) are also used for evaluation.
3. Understand the methods used to evaluate investment centers
Primary performance measure is Return on Investment (ROI)
• ROI has two components:
• Profit Margin Ratio = Operating Income / Revenues
• Asset Turnover Ratio = Revenues / Average Operating Assets
Thus, ROI can be expressed in its expanded version:
Profit Margin x Asset Turnover
(Operating Income / Revenues) x (Revenues / Ave. Operating Assets)
OR, cancel out revenues and you left with ROI in its basic form:
Operating Income / Average Operating Assets
On the test, probably ask about a decision and its impact on ROI. If you produce more units than you sold,
what's the impact on ROI? That's not a formula, but if you understand, the answer is that it would reduce
your ROI. Costs are hidden in ending inventory if you produce more than you sell, and inventory is part of
operating assets.
• Advantages of ROI
1. Forces a focus on the relationship among sales, expenses, and investment
2. Forces a focus on cost efficiency (non-value added activities)
3. Forces a focus on operating asset efficiency
• Weakness in ROI
• If a iestet ete is opeatig ith a highe ‘OI tha the opas oeall ‘OI, the iestet ete a
reject a project that could impoe the opas oeall ‘OI. ‘esidual ioe a the e used istead of ‘OI.
• Focus can be placed on short-term results
Strengths and weaknesses are usually part of multiple choice on the test. Have to be careful about how you use
ROI because it can cause people to make poor decisions. Managers turning down opportunities because it would
initially drop ROI; can discourage equipment investment.
Residual Income – amount of operating profit earned above a minimum rate of return on assets = Operating Inc. – (Min. rate
of return x Ave. Operating Assets)
• Advantage: Any project with a positive residual income will be accepted, which benefits the company as a whole
• Disadvantage: Focus can be placed on short-term results
• Similar to another standard. Are we getting at least a 12% return on investment, or whatever that standard is. As
long as you can generate an operating income that exceeds the result of that product, you can take on the
project/idea. This helps to combat the weakness of ROI.
Economic Value Added (EVA®) – developed by Stern Stewart & Co. and based on the concept that all capital has a cost and
that earning more than the cost of capital creates value for shareholders.
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After-Tax Operating Inc. – (Cost of Capital x Total Capital Employed) = EVA
You will have to determine total capital employed. See below.
Cost of Capital = Weighted Ave. Cost of Capital (WACC), which is a complex function of the capital structure
(proportion of debt and equity on the balance sheet), the stock's volatility measured by its beta and the market
risk. Small changes in these inputs can result in big changes in the final WACC calculation.
EVA is a non-GAAP financial measure. Different companies calculate it differently. Very similar to residual income.
Differences between Residual Income and EVA:
• EVA considers taxes whereas Residual Income uses income before tax.
• The iiu ate of etu used i ‘esidual Ioe is estalished gt., heeas EVA uses a speifi ost of
apital alled WACC.
• Residual Income uses avg. operating assets, whereas EVA backs out non-interest bearing liabilities such as
accounts payable & wages payable, so Total Capital Employed = interest bearing liabilities + total equity.
or Total Capital Employed = Total assets – non-interest bearing liabilities.
4. Cost/Revenue terminology used in differential analysis; be able to
define and/or identify different types of costs/revenues.
Terminology:
Differential Analysis (The Decision-Making Model)– Effect of alternative courses of action on relevant revenues and costs. In
other words: a financial comparison between alternatives.
Relevant Revenues or Relevant Costs – Future Revenues or costs that change under different courses of action.
For example, if labor costs are $1,200 under alternative (A) and $1,400 under
alternative (B), then labor is a relevant cost when evaluating these alternatives.
Differential Revenues or Differential Costs – The amount of the change in a
revenue or cost because an alternative action is taken.
From the example above, the differential labor cost is $200 ($1,400 from
alternative (B) vs. $1,200 from alternative (A)).
Differential Income or Loss – is equal to the Differential Revenues minus the
Differential Costs.
Sunk Costs – Past costs incurred or future costs that cannot be avoided. Sunk costs are not relevant to a decision and are
NOT considered when comparing two alternatives.
For example, if you are considering outsourcing your payroll department,
and your company had spent $2 million on a new system two years ago,
human nature tells us to keep providing the service in house since so much
money was spent on the system. The fact is, that $2 million has already
been spent and must be accounted for regardless of the decision, so DO
NOT CONSIDER the $2 million as relevant.
Opportunity Costs – profit/benefit lost or foregone as a result of selecting one alternative over another. Opportunity costs
are always relevant but often hard to measure. If they can be measured, they should be included in the analysis even though
they are not considered accounting costs (i.e. recorded).
Joint Costs – costs incurred up to the point where a product can be sold as is or processed further, producing another product
(petroleum industry, coffee industry)
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