Segment Reporting and the

Contribution Approach
7

The issue of "Segment Reporting" and "the Contribution Approach" is

the implication of the managerial philosophy like "Decentralization
Divisionalization". Segment reporting is one way to measure
performance in a divisionalized organization, where as "contribution
approach" is a way of segment reporting. Thus this unit covers some of
fundamental issues. To cover most of the issues, this unit will include the
following lessons:
Decentralized organizations;
Segment Reporting and Profitability Analysis (Contribution Approach);
Transfer Pricing; and
IAS relating to Segment Reporting;
School of Business

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Lesson 1 : Decentralizaed Organizations

The content of this lesson will be a repetition of a unit of management
course. Before going to discuss the role of management accountants in
decentralized organizations, it will be wise to recapitulate related
important issues of decentralization.
After completing this lesson, you are expected to be able to:
 Explain various concepts relating to decentralization;
 Identify various advantages and disadvantages of decentralization;
 Explain the concept of delegation of authority and its advantages;
and
 Explain the concept of divisionalization.
The concept of 'decentralization' is very much related to some concepts
of management like (i) power; (ii) authority, (iii) line; (iv) staff and (v)
delegation. It is better to explain these terms in brief.
Authority
[Jerry M. Rosenberg]
(i) Authority "describes the relationship in an organization between
positions and expectations of members. It also specifies behavior
necessary for company effectiveness and is a cost of organizational
membership."
(ii) Authority is "the power possessed by an individual for making Authority is the power
decisions and carrying them out." possessed by an
individual for making
[Heinz Weihrich & Harold Koontz] decisions and
carrying them out.
(iii) "Authority in organization is the right in a position (and through it,
the right of the person occupying the position) to exercise discretion in
making decisions affecting others. It is, of course, one type of power."
Power
[Rosenberg]
"The ability to control others in an organization, utilizing personal
presentation and other personal characteristics, various approaches for
reward and punishment, position title, and level of competence and
experience."
[Weihrich & Koontz]
Power, a much
"Power, a much broader term than authority, is the ability of individuals broader term than
or groups to induce or influence the beliefs or actions of other persons or authority, is the ability
groups." of individuals or
groups to induce or
Bases of Power: influence the beliefs
or actions of other
(a) Legitimate Power: It arises from positions and derives from our persons or groups.
cultural system of rights, obligations and duties whereby a position is
accepted by people as being legitimate.

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(b) Expert Power: This is the power of knowledge. Physicians, lawyers

and university professors may have considerable influence on others
because they are respected for their special knowledge. Power may
further exist as referent power, that is, influence that people or groups
may exercise because people believe in them and their ideas.
(c) Reward Power: Power may arise from the ability of some persons to
grant rewards.
(d) Coercive Power: It is the power to punish.
Authority arises from the power of position or legitimate power.
Line and Staff Authority Relationship
[Rosenberg]

A part of the
Line and staff authority:
organization a part of the organization identified as those having the right to decide
identified as those
having the right to
and to order others to perform activities (line) and those having the right
decide and to order to plan, recommend, advice or assist but not to order others to perform
others to perform activities (staff).
activities (line).
Line authority:
authority that is exerted downward i.e. over subordinates in an
organization.
Staff:
employees who advise and assist line managers and employees but are
not directly engaged in the production of the final good or service.
Staff function:
service, advisory, or otherwise supportive activities performed by staff
units in line and staff organizations.
The nature of line and staff relationship:
Line authority is that relationship in which a supervisor exercises direct
supervision over a subordinate- an authority relationship in direct line or
step.
"The nature of the staff relationship is advisory. The functions of people
in a pure staff capacity is to investigate, research and give advice to line
managers."
Scalar Principle:
"The clearer the line authority from the ultimate management position in
an enterprise to every subordinate position, the clearer will be the
responsibility for decision making and the more effective will be the
organization communication."
Functional Authority:
It is "the right that is delegated to an individual or a department to
control specific processes, practices, policies or other matters relating to
activities undertaken per persons in other departments."

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Decentralization and Centralization

Decentralization
[Rosenberg]
Decentralization is "a situation in which decisions tend to be made at A situation in which
lower levels in a firm or at the country operating levels rather than head decisions tend to be
quarters." made at lower levels
in a firm or at the
[Koontz] country operating
levels rather than
Decentralization is the tendency to disperse decision making authority in head quarters.
an organization structure. It is a fundamental aspect of delegation; to the
extent that authority is not delegated, it centralized."

Complete Complete
Centralization Decentralization

Degree of delegation

Authority delegated

Authority not delegated

The degree to which formal authority is delegated by managers

throughout the organization runs along a continuum from
decentralization to centralization.
Centralization
[Koontz]
a. Centralization of Performance: It pertains to geographic
concentration; it characterizes a company operating in a single location.
b. Departmental Centralization: It refers to concentration of specialist
activities, generally, in one department.
c. Centralization as an aspect of management: It is the tendency to
restrict delegation of decision making. A high degree of authority is held
at or near the top by managers in the organizational hierarely.
Advantages of Decentralization
[Weihrich & Koontz]
(i) Relieves top management of some burden of decision making and
forces upper-level managers to let go.
(ii) Encourages decision-making and assumption of authority and
responsibility.
(iii) Gives managers more freedom and independence in decision
making.

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(iv) Promotes establishment and use of broad controls which may

increase motivation.
(v) Makes comparison of performance of different organizational units
possible.
(vi) Facilitates setting up of profit centers.
(vii) Facilitates product diversification.
(viii) Promotes development of general managers.
(ix) Aids in adaptation to fast changing environment.
Limitations of Decentralization
[Welhrich & Koontz]
(1) Makes it more difficult to have a uniform policy.
(2) Increases complexity of coordination of decentralized organizational
units.
(3) May result in loss of some control by upper-level managers.
(4) May be limited by inadequate control techniques.
(5) May be constrained by inadequate planning and control systems.
(6) Can be limited by the availability of qualified managers.
(7) Involves considerable expenses for training managers.
(8) May be limited by external forces (national labor union given mental
control, tax policies).
(9) May not be favored by economies of scale of some operations.
Centralization is preferable for the following reasons:
(a) Specialized skills, talents, and technology are sometimes neither
affordable nor practical in multiple locations.
(b) Decentralized locations usually mean an increase in overheads and
staff. Coordination of products, money and control also add to the
cost of decentralized locations.
(c) Recent improvements in communication technology facilitate the
movement of money, credit information, transportation and data
processing from a central location.
Delegation of Authority:
Rosenberg

Delegation is the Delegation is the process by which authority is distributed downward in

process by which the organization.
authority is
distributed downward [Stoner et al.]
in the organization. Delegation is the assignment to another person of formal authority
(legitimate power) and accountability for carrying out specific activities.

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Advantages of Delegation:
Delegation has the following advantages:
(i) The more tasks managers are able to delegate, the more
responsibilities they have to seek and accept increased
responsibilities from higher level managers.
(ii) Delegation causes employees to accept accountability and exercise
judgment. This not only helps train them, but also improves their
self confidence and willingness to take initiative.
(iii) It frequently leads to better decisions because employees; closest
to where the action is, are likely to have a clear view of the facts.
(iv) Effective delegation also speeds up decision making.
Divisionalization
This section is based on the thoughts of David Solomons. According to
him, it is not wise to use “Decentralization” and “Divisionalization” as
synonyms. The devolution of authority to make decisions, which is the
essence of decentralization is often carried out in businesses which are
not divisionalized. Divisionalization adds to decentralization, the concept
of delegation of profit responsibility. According to this concept, a
division is defined as:
“a company unit headed by a man fully responsible for the
profitability of its operations, including planning, production,
financial and accounting activities and who usually, although not
always, has his own sales force. The division may be a unit of
the parent company or it may be a wholly or partially owned
subsidiary.”
Divisional Organizations and Functional Organizations
Functional Organizations: [J.M. Rosenberg]
Originated by F.W. Taylor, “a functional organization, currently, refers
A functional
to a type of organizations in which the direction and management of organization,
work is divided according to specialized functions or duties, rather than currently, refers to a
pure line or staff areas of specialization.” Functional organizations are type of organizations
based on the principle of functional departmentation which means in which the direction
and management of
grouping of activities into subunits based on the primary functions of the
work is divided
organization, such as engineering, production, purchasing, personnel and according to
marketing. Here, no department is responsible for the entire work of specialized functions
buying of raw materials, conversion of raw materials into finished or duties.
products and selling finished products to consumers.
Divisional Organizations:
Divisional organizations are organizations with autonomous units.
Responsibility of performance rests with division or section managers
who operate the divisions as if they were separate from the parent
organization.
Reasons for Divisionalization
David Solomons suggested the following reasons for divisionalizaiton:

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(i) A divisional structure makes diversification relatively easy for a

desiring company to combine diversity with unity.
(ii) “A great improvement is behind to result in any firm when the
creative talents of responsible individuals are encouraged to
develop a climate of individual responsibility, authority and
dignity a climate that is made possible by decentralization of
decision-making.
(iii) ‘Since the principal objective of divisional management is the
long-run maximization of the division’s contribution to the
profitability of the corporations as a whole, there is a ready
available measure of divisional success in the form of profit
contribution.’
(iv) Divisional operations provide a first-rate training ground for the
development of company’s future senior management.
The remaining lessons of this unit will be devoted to issues relating to
measurement of contributions by independent divisions and other related
issues.

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Lesson-2: Segment Reporting and Profitability

Analysis (Contribution Approach)
Divisionalized / Decentralized organizations have added responsibility of
measuring the performance of organizational units enjoying delegated
authority. This lesson is designed to cover the issue of measuring
divisional performance and reporting.
After completing this lesson, you are expected to be able to:
 Identify three business practices that hinder proper cost assignment;
 Prepare a segmented income statement using the contribution format;
 Explain the difference between traceable fixed costs and common
fixed cost; and
 Explain how to determine customer profitability.
Segment Report and Profitability Analysis [Contribution Approach]
At period end, aggregated income statements are prepared to measure the
amount of profit earned or losses incurred by organizations during a
particular accounting year. This aggregated income statement may
satisfy the external users. But the top management of a divisionalized
firm may not be satisfied with this summarized statement. Internal
management may need such statements which can help identify bad/good
performing segments so that it can take appropriate steps for
improvement.
Various Concepts
Segment:
A segment can be defined as any part or activity of an organization about
which a manager seeks costs, revenue or profit data. (Garrison)
Segment reporting:
‘An analysis of sales, profit or assets by line of business or by
geographical area. This analysis is required to be disclosed for reportable
segments by certain enterprises. (Rosenberg).
Segment revenue:
‘Revenue reported in the enterprises income statement that is directly
attributable to a segment or can be reasonably allocated to it.
Segment expense:
‘Expenses resulting from the operating activities of a segment that are
directly attributable to the segment or can reasonably be allocated to it.
Segment results:
Difference between segment revenues and segment expenses.
Common costs:
The costs that are borne by all the output of a process, or those costs
shared by a number of departments. Common costs are those associated

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with the corporate headquarters building. Common costs relate to overall

operating activities in a company, a common costs can’t be traced to a
particulars segment.
Traceable Costs: [Kohler]
“Any cost whose original transaction character is maintained or can be
followed after its transfer or allocation to another account.”
Traceable costs are costs which can be identified with any product or
department.
Value-chain: [Horngren]
‘The value chain is the set of business functions that adds value to the
products or services of an organization. These functions are as follows:
a. Research and Development
b. Design of products, services or processes
c. Production
d. Marketing [Informing the society about the product]
e. Distribution [Delivering the product]
f. Customer Service
g. Support Functions [MIS & Accounting]
Product Life Cycle: [Horngren]
‘Product life cycle refers to the various stages through which a product
passes from conception and development through introduction into the
market through maturation and finally, withdrawal from the market.’
Stages of Product Life Cycle Nature of Sales
Product Development No sales
Introduction to market Sales Growth
Mature Market Stable Sales Level
Phase-out of products Low sales --------> No sales
Cross-Subsidization: [Garrison]
Cross-subsidization or cost distortion occurs when costs are improperly
assigned among either products or company segments. Cross-
subsidization can occur in two ways: first, when companies fail to trace
costs directly to segments or products in those situations where it is
feasible to do so; and second, when companies use inappropriate bases to
allocate costs.
Segment Performance Measurement:
Segments are “responsibility centers for which a separate measure of
revenues and costs is obtained.” Therefore, controllable costs of a
segment must be determined. Comparatively, it is easy to identify the
revenues of a segment.

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Uncontrollable Costs: An uncontrollable cost is ‘any cost that cannot be

affected by the management of a responsibility center within a given
time span’.
Controllable Costs: Controllable costs include all costs that are
influenced by a manager’s decision and actions. Reporting controllable
costs provides evidence about a managers’ performance. Costs that are
completely uncontrollable tell nothing about a manager’s decisions and
actions, because nothing a manager does will affect the cost. Naturally,
such costs should be ignored in evaluating the performance of a segment.
Hindrances to Proper Cost Assignment:
For proper segment reporting, costs must be analysed and assigned to
segments as reasonably as possible. More specifically, all attributable
costs should be assigned to segments. Naturally, questions arise about the
allocation of common costs not attributable to segments. Traditionally,
common costs are allocated to products/segments/customers based on
certain methods. Most of these accounting methods are inappropriate and
result in distorted costs. Unfortunately, three business practices are in use
that greatly hinder proper cost assignment. These three practices are (i)
omission of some costs in the assignment process, (ii) the use of
improper methods for allocating costs among segments, and (iii)
assignment of costs to segments that are really common costs of the
entire organization (Garrison and Noreen).
Two Approaches of Segment Reporting:
There are two approaches available for segment reporting. These are:
(a) Horngren’s Approach
(b) Garrison’s Approach
Let us explain these approaches quoting two examples from those texts.
Horngren’s Approach:
Baleycorng Inc.
Contribution Approach: (Model Income Statement
by Segments in Tk.‘000)
Breakdown Breakdown of west Division Breakdown W.D. Meat only
Particulars Company East West Not Grousing Produce Meats Not Store Store
as a whole Division Division allocated allocated 1 2
Tk. Tk. Tk. Tk. Tk. Tk. Tk. Tk. Tk. Tk.
Net Sales 4,000 1,500 2,500 - 1300 300 900 - 600 300
Variable cost of 3,000 1,100 1,900 1,000 230 670 450 220
Merchandise sold
Variable Operating Exp. 260 100 160 100 10 50 35 15
Total Variable cost 3,260 1,200 2,060 1,100 240 720 485 235
(a) Contribution Margin 740 300 440 200 60 180 115 65
Less fixed costs 260 100 160 20 40 10 90 30 35 25
controllable by
segments managers

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(b) Contribution 480 200 280 (20) 160 50 90 (30) 80 40

Controllable by
segment managers
Less fixed costs 200 90 110 20 40 10 40 10 22 8
controllable by other
(c) Contribution by 280 110 170 (40) 120 40 50 (40) 58 32
segments
Less Uncontrollable 100
costs
(d) Income before income 180
taxes
Special features:
(i) Contribution Margin: Net Sales – Total Variable Costs
(ii) Contribution Controllable
by segment manages: Contribution Margin – Fixed Costs controllable by segment management
(iii) Segment Contribution: Contribution controllable by segment manager – Fixed costs controllable by others.

Garrison’s Approach:
Soft Solutions, Inc.
Segmented Income Statement
[Contribution Format]

Total Company Segments

Particulars Business Consumer
Product Product
Division Division
Tk. Tk. Tk.
Sales 500,000 3,00,000 200,000
Less Variable expenses:
Variable cost of goods sold 180,000 1,20,000 60,000
Other variable expenses 50,000 30,000 20,000
Total Variable Expenses 230,000 1,50,000 80,000
Contribution Margin 270,000 1,50,000 1,20,000
Less Traceable Fixed Expenses 170,000 90,000 80,000
Divisional Segment Margin 100,000 60,000 40,000
Less Common Fixed Expenses 85,000
Net Income 15,000 - -

Statement of Product Line Segment Margin

Consumer Segments
Product Clip Art Computer
Division Games
Tk. Tk. Tk.
Sales 200,000 75,000 125,000

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Less Variable expenses:

Variable cost of goods sold 60,000 20,000 40,000
Other variable expenses 20,000 5,000 15,000
Total Variable Expenses 80,000 25,000 55,000
Contribution Margin 120,000 50,000 70,000
Less Traceable Fixed Expenses 70,000 30,000 40,000
Product Line Segment Margin 50,000 20,000 30,000
Less Common Fixed Expenses 10,000
Divisional Segment Margin 40,000 - -

Statement of Channel Segment Margin

Computer Segments
Games Retails Stores Catalog Sales
Tk. Tk. Tk.
Sales 1,25,000 1,00,000 25,000
Less Variable expenses:
Variable cost of goods 40,000 32,000 8,000
sold
Other variable expenses 15,000 5,000 10,000
Total Variable Expenses 55,000 37,000 18,000
Contribution Margin 70,000 63,000 7,000
Less Traceable Fixed 25,000 15,000 10,000
Expenses
Territorial Segment Margin 45,000 48,000 (3,000)
Less Common Fixed 15,000
Expenses
Product line Segment Margin 30,000 - -
Special Features:
(i) Contribution Margin: Sales – Total Variable Expenses
(ii) Product Line Segment Margin:
Contribution Margin – Traceable Fixed Expenses to product Line
(iii) Territorial Segment Margin:
Contribution Margin – Traceable Fixed Expenses to territorial segment

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Example # 1
The most recent monthly income statement for Reston Company is given
below:
Reston Company
Income Statement
For the Month Ended May 31, 2007
Sales Tk.900,000 100%
Less Variable expenses 408,000 45.3%
Contribution margin 492,000 54.7%
Less fixed expenses 465,000 51.7%
Net Income 27,000 3.0%

Management is disappointed with the company’s performance and is

wondering what can be done to improve profits. By examining sales and
cost records, you have determined the following:
(a) The company is divided into two sales territories-Central and
Eastern. The Central territory recorded Tk.4,00,000 in sales and
Tk.2,08,000 in variable expenses during May. The remaining sales
and variable expenses were recorded in the Eastern territory. Fixed
expenses of Tk.1,60,000 and Tk.1,30,000 are traceable to the Central
and Eastern Territories respectively. The rest of the fixed expenses
are common to two territories.
(b) The company sells two products-Awls and Pows. Sales of Awls and
Pows totaled Tk.1,00,000 and Tk.3,00,000 respectively, in the
central Territory during May. Variable expenses are 25% of the
selling price for Awls and 61% for Pows. Cost records show that
Tk.60,000 of the Central Territory’s fixed expenses are traceable to
Awls and Tk.54,000 to Pows, with the remainder common to the two
products.
Prepare a segment income statement
Solution:
[Garrison Format]
Reston Company
Segmented Income Statement
For May 31, 2007
Particulars Total Segments
Company Central Eastern
Tk. Tk. Tk.
Sales 9,00,000 4,00,000 5,00,000
Less: Variable Expenses 4,08,000 2,08,000 2,00,000
Contribution Margin 4,92,000 1,92,000 3,00,000
Less: Traceable Fixed Costs 2,90,000 1,60,000 1,30,000

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Divisional Segment Margin 2,02,000 32,000 1,70,000

Less: Common Fixed Costs 1,75,000
Net Income 27,000

Reston Company: Central Division

Product Line Segment Margin Statement
For May, 2007
Particulars Central Segments
Division as Awls Pows
a whole
Tk. Tk. Tk.
Sales 400,000 100,000 300,000
Less Variable Expenses 208,000 25,000 183,000
Contribution Margin 192,000 75,000 117,000
Less Traceable Fixed Expenses 114,000 60,000 54,000
Product Line Segment Margin 78,000 15,000 63,000
Less Common Fixed Costs 46,000
Divisional Segment Margin 32,000

Horngren’s Approach:
Reston Company
Segment Income Statement
For May, 2007
Breakdowns Breakdown of Central
Particulars Company Central Eastern Not Awls Pows
as a Division Division Allocated
whole
Tk. Tk. Tk. Tk. Tk. Tk.
Sales 900,000 4,00,000 500,000 - 1,00,000 300,000
Less Variable Expenses 408,000 2,08,000 200,000 - 25,000 1,83,000
(a) Contribution Margin 492,000 1,92,000 300,000 - 75,000 1,77,000
Less Fixed Costs Controlled 290,000 1,60,000 130,000 46,000 60,000 54,000
by segments
(b) Contribution Controllable 202,000 32,000 170,000 (46,000) 15,000 63,000
by segment managers
Less Uncontrollable Fixed 175,000
costs
Net Income 27,000

Customers’ Profitability Analysis:

While customers are clearly important to profit, some are more profitable
than others. Companies that assess the profitability of various customer
groups can accurately target their markets and increase profits. The first
step in determining customer profitability is to identify the customers.
The second step is to determine which customers add value to the
company. Once customer groups are identified, the second step is to
determine which customer groups are the most profitable, work to keep
the existing customers in those groups and add more of them.

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Example # 2
Oline Company manufactures and distributes carpentry tools. Production
of the tools is in the mature portion of the product life cycle. Oline has a
sales force of 20. Sales people are paid a commission of 7 percent of
sales plus expenses of Tk.35 per day for days spent on the road away
from home, plus Tk. 0.30 per mile. They deliver products in addition to
making the sales, and each sales person is required a truck suitable for
making deliveries.
Sales Tk.13,00,000
Cost of Goods sold 4,50,000
On average, a sales person travels 6,000 miles per quarter and spends 38
days on the road. The fixed marketing and administrative expenses total
Tk.400,000 per quarter.
Required:
(i) Prepare an income statement for Oline Company for the next
quarter.
(ii) Suppose that a large hardware chain, Mega Hard Ware Inc. wants
Oline Company to sell 80% of total output to the chain. The tools
will be imprinted with the super tool brand, requiring Oline to
purchase new equipment, use somewhat different materials and
reconfigure the production line. Olines industrial engineers
estimate that cost of goods sold for the Super Tool line would
increase by 15 percent. No sales commission would be incurred,
and Mega hardware would link Oline to its EDI system. This
would require an annual cost of Tk.100,000 on the part of Oline.
Mega Hardware would pay shipping. As a result, the sales force
would shrink by 80%. Should Oline accept Mega Hardware’s
offer? Support your answer with appropriate calculation.
Solution: (i)
Oline Company
Income Statement
For the Next Quarter
Sales Tk.13,00,000
Less Cost of Goods sold: 450, 000
Gross Profit Tk.8,50,000
Less Operating Expenses:
Fixed Marketing & Administration Expenses: Tk.400,000
Variable selling & distribution expenses:
Commission: @ 7% Tk.91,000
Traveling expenses 6000  .3  20 36,000
Per day Tk. 35  38  20 = 26,600
5,53,600
Net Income: Tk.2,96,400

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Solution: (ii) Evaluation of the offer by Megahardware

Oline Company
Income Statement
for the next quarter
Sales Tk.13,00,000
Less Cost of Goods sold: Tk.450,000  1.15 5,17,500
Gross Profit Tk.7,82,500
Less Operating Expenses:
Fixed Marketing & Administration Tk.425,000
Expenses:
Variable selling & Administrative expenses: 30,720
Tk.1,53,600  .2
4,55,720
Net Income: Tk.3,26,780
Oline should accept Mega Hardware’s offer as the net income during the
next quarter will go up by Tk.30,380 (Tk.3,26,780 – Tk.296,400).

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Lesson-3: Transfer Pricing

In a decenralized environment, when goods and services are transferred
from one antonomous unit to another, the pricing of transferred goods
and services may create problems between sending units and receiving
units regarding the price to be charged, because profit increase of a unit
on account of this will be a loss to another unit. So, there should be some
way to resolve this issue.
After completing this lesson, you are expected to be able to:
 Grasp the various types of transfer prices;
 Explain the importance of transfer price, and
 Explain the transfer price in a multi-national setting.
Transfer Pricing
[Penguin Dictionary of Accounting]
“The notional or real price charged by one part of a company (or group
of companies) to another part when goods or services are transferred. In
the context of multi-national organizations, the manipulation of transfer
prices is designed to enable profit to be moved from higher tax to low tax
countries.”
[Rosenberg]
“Transfer price is the price charged by one segment of an organization
Transfer price is the
price charged by one for a product or service it supplies to another part of the same part.
segment of an Transfer cost is the cost that a department accepts for items supplied by
organization for a other departments.”
product or service it
supplie to another The meaning of ‘transfer price’ is very simple. Transfer prices are the
part of the same part. prices charged for goods produced by one division and transferred to
another division. The price charged affects the revenues of transferring
divisions and the costs of the receiving division. As a result, the
profitability, return on investment and managerial performance
evaluation of both divisions are affected.
The Impact of Transfer Pricing on Income
Under normal situation, a price used for transferring goods and services
from one division to another division will affect the performance of both
the divisions involved, but the performance of the firm as a whole may
remain unaffected.
Example # 1
ABC Inc.
A Division C Division
Transferring Division Receiving Division
Division-A produces parts and Division C purchases pars from A
transfers to C for a transfer price of at a transfer price of Tk.50 per unit
Tk.50 per unit. and uses in production of final
product.

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Transfer Price = Tk.50 per unit Transfer Price = Tk.50 per unit
 Revenue to A  Cost to C
 Increases net income  Decreases net income
 Increases ROI  Decreases ROI
Transfer Price Revenue = Transfer Price Cost
Zero Impact on ABC Inc.
While the actual transfer price nets out for the company as a whole,
transfer pricing can affect the level of profits earned by the company as a
whole, if it affects divisional behavior. Divisions, acting independently,
may set transfer prices that maximize divisional profits but adversely
affect firm wide profit.
Extension of the Last Example:
A Division C Division
Transferring Division Receiving Division
Transfer Price : Tk.50 per unit Transfer Cost : Tk.50 per unit
Variable Cost : Tk.35 per unit Outside Cost : Tk.45 per unit
Contribution : Tk.15 per unit Decision to buy from outside
Decision : No transfer Savings: Tk.5 per unit
Loss of profit : Tk.15 per unit Net Income increases
ABC Inc. as a Whole will lose Tk.10.00 per unit
[Internal cost Tk.35 < External Cost Tk.45]
The Transfer Pricing Problem:
A transfer pricing system should satisfy the following three objectives:
(i) Accurate Performance Evaluation: This means that no one division
managers should benefit at the expense of another.
(ii) Goal congruence: This means that divisional managers should select
actions that maximize firm wide profits.
(iii) Preservation of Divisional Autonomy: Central management should
not interfere with the decision-making freedom of divisional managers.
The transfer pricing problem concerns finding a system that
simultaneously satisfies all the above mentioned objectives. One can
evaluate the degree to which a transfer price satisfies the objectives of a
transfer pricing system by considering the opportunity cost of goods
transferred. The opportunity cost approach is compatible with the
objectives of performance evaluation, goal congruence and autonomy.
The opportunity cost approach identifies the following:
(i) The minimum transfer price: [Floor price] It is the transfer price that
would leave the selling division no worse off if the goods are sold to an
interested internal division.
(ii) The maximum transfer price: [Ceiling price] It is the transfer price
that would leave the buying division no worse off if an input is
purchased from an internal division.

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The opportunity cost rule signals when it is possible to increase firm

wide profits throughs internal transfer.
Types of Transfer Prices
Inter-divisional transfers may follow any of the following prices:
(a) Market Price
(b) Negotiated Transfer Prices
(c) Cost-Based Transfer Prices:
(i) Full-cost transfer price
(ii) Full-cost plus markup
(iii) Variable cost plus fixed fee
Market Price as a Transfer price
Competitive market price is generally regarded as the best approach to
the transfer-pricing problem. It dovetails with the profit center concept
and makes profit-based performance evaluation feasible at many levels
of an organization. To the extent the transfer prices reflect actual market
conditions divisional operating results provide an excellent basis for
evaluating managerial performance.
The following guidelines should be followed when using market prices
to control transfers between divisions: [Garrison]
(a) The buying division must purchase internally so long as the
selling division meets all bonafide outside prices and wants to
sell internally.
(b) If the selling division does not meet all bonafide outside prices,
then the buying division is free to purchase outside.
(c) The selling division must be free to reject internal business if it
prefers to sell outside.
(d) An impartial board must be established to help settle
disagreements between divisions over transfer prices.
Transfers at Market Price
Well-defined Intermediate Market
An intermediate market means that a market exists in which an item can
be sold immediately and in its present form to outside customers.
Transfer Price = Variable Costs + Lost Contribution margin on outside
sales.
Transfers at Market Price:
Price charges in the intermediate market
(a) Selling division at full capacity: Transfer Price = Variable costs +
Lost Contribution per unit on outside sales
(b) Selling Division with idle capacity: “Under idle capacity situation,
so long as the selling division receives a price greater than its variable

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costs, all parties will benefit by keeping business inside the company
rather than having the buying division go outside.” Otherwise, there will
be “sub-optimization” which means that the overall level of profitability
will be less than the segment or the company is capable of earning.
Negotiated Transfer Price
Perfectly competitive markets rarely exist. When imperfection exists to When imperfection
the market for the intermediate products, market price may no longer be exists to the market
suitable. In such situations, negotiated transfer prices may be practical for the intermediate
alternatives. A negotiated transfer price is one agreed on between the products, a negotiated
transfer price is one
buying and selling divisions that reflects unusual or mitigating situations. agreed on between the
In the absence of intermediate market the negotiated transfer price is the buying and selling
only alternative. divisions that reflects
unusual or mitigating
Disadvantages of Negotiated transfer prices: situations.
Negotiated transfer prices have three disadvantages that are commonly
mentioned below:
(i) One divisional manager possessing private information, may
take advantage of another divisional manager.
(ii) Performance measures may be distorted by the negotiating
skills of managers.
(iii) Negotiations can consume considerable time and resources.
Advantages of Negotiated Transfer prices:
Being time consuming, negotiated transfer prices offer some hope of
complying with the three criteria of good congruence, autonomy, and
accurate performance evaluation. If negotiation helps ensure goal
congruence, the temptation for central management is diminished
considerably.
Finally, if negotiation skills of managers are comparable or if the firm
views these skills as an important managerial skill, concerns about
motivation and accurate performance measures are avoided.
Cost-Based Transfer Prices
Many firms make transfers between divisions on a basis of the
accumulated cost of the goods being transferred thus ignoring any profit
element to the selling division. There may be three forms of cost-based
transfer prices- (i) Full cost, (ii) Full costs plus markups and (iii)
Variable cost plus fixed fee. In all three cases, to avoid passing on the
inefficiencies of one division to another, standard costs should be used to
determine the transfer price.
Full Cost Transfer pricing:
Full cost = Direct material + Direct Labour + Factory Overhead.
It is simple. But it is the least desirable type of transfer pricing. It can
provide perverse incentives and distort performance measures. Managers
will not be interested in transferring at full cost.

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Full Cost Plus Markup:

Full cost plus markup suffers from virtually the same problems as full
cost. It may be the result of negotiations.
Variable Cost Plus Fixed Fee:
Like full cost plus markup, variable cost plus fixed fee can be a useful
transfer pricing approach provided that the fixed fee is, negotiable. This
method has one advantage over full cost plus markup: if the selling
division is operating below capacity, variable cost is its opportunity cost.
Assuming that the fixed fee is negotiable, the variable cost approach can
be equivalent to negotiated transfer pricing. Negotiation with full
consideration of opportunity costs is preferred.
Example # 1
A company has two divisions, A and B. The division A is currently
operating at full capacity. It has been asked to supply its product to
division B. Division A sells its product to its regular customers for Tk.30
each. Division B (currently operating at 50% capacity) is willing to pay
Tk.20 each for the component produced by division A (This represents
the full absorption cost per component at division A).
The components will be used by division B in supplementing its main
product to conform to the need of special order.
As per the contract terms of sales, the buyer calls for reimbursement of
full cost to division B plus 10%.
Division A has a variable cost of Tk.17 per component. The cost per unit
of division B subsequent to the buying part from division A is estimated
as follows:
Taka
Purchased parts – outside vendors 90
Purchased part from division A 20
Other variable costs 50
Fixed overheads and administration 40
Full costs: Tk.200
The company uses return on investment in the measurement of division
and divisional manager’s performance.
Required:
(i) As a manager of division A, would you recommend sales of
your output to division B at the stipulated price of Tk.20?
(ii) Would it be in the over-all interest of the company for division
A to sell its output to division B?
(iii) Suggest an alternative transfer price and show how could it
lead to goal congruence.

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Solution:
(i) Division A is running at capacity.
Selling Price to outside customer : Tk.30
Variable cost per component : Tk.17
Performance measure : ROI
Offer Price : Tk.20
As a manager of divisional I will not accept the transfer price of Tk.20
per component. This will reduce per unit profit by Tk.10 and also the
division’s ROI.
(ii) Decision Analysis: [Whether to transfer from division A to Division
B]
Sold externally Transfer to B
Selling Price: Tk.30 Tk.220
Less relevant costs:
For Part-A 17 17
For outside part – 90
Other variable cost – 50
Total relevant costs 17 157
Contribution per component 13 63
In the overall interest of the company, division A should sell to division
B. Profit per component will go up by Tk.50 (Tk.63 – Tk.13).
(iii) As long as division’s performance is measured by ROI, suggested
alternative should not affect the profit of a division, which is running at
capacity. It will not be wise to suggest an alternative, which will reduce
the project and ROI of a selling division which is running at capacity.
First suggested transfer price will be:
Variable costs + Lost contribution margin on outside sale
= Tk.17 + 13 = Tk.30
This will on the other, hand increased the cost of the receiving division,
the selling price as per contract and also the profit.
Division - B
Present Suggested
Purchased Part: Outside Tk.90.00 Tk.90.00
Purchased Part Division-A 20.00 30.00
Other Variable Cost 50.00 50.00
Fixed overhead & Administrative 40.00 40.00
costs
200.00 210.00
Profit @ 10% 20.00 21.00
Selling Price Tk.220.00 Tk.231.00

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Profit per unit will go up by Tk.1 in division B and at the same time the
profit and division – A will remain unchanged.
Example # 2
The Components Division produces a part that is used by the Goods
Division. The cost of manufacturing the part is given below:
Tk.
Direct Materials : 10.00 per unit
Direct Labour : 2.00 ”
Variable Overhead : 3.00 ”
Fixed Overhead : 5.00 ”
Total Costs : 20.00 ”
Fixed cost is based on a practical volume at 200,000 parts.
Other costs incurred by the Components Division are as follows:
Tk.
Fixed Selling and Administrative 5,00,000
Variable SellingTk.1 / unit
The part usually sells for between Tk.28 and Tk.30 in the external
market. Currently, the Components Division is selling it to external
customers for Tk.29. The division is capable of producing 2,00,000 units
of the part per year; however, because of a week economy, only 1,50,000
parts are expected to be sold during the year. The variable selling
expenses are avoidable if the part is sold internally.
The Goods Division has been buying the same part from an external
supplier for Tk.28. It expects to use 50,000 units of the part during the
coming year. The manager of the Goods Division has offered to buy
50,000 units from the components division for Tk.18 per unit.
Required:
(i) Determine the minimum transfer price that the Components
Division would accept.
(ii) Determine the maximum transfer price that the manager of the
goods division would pay.
(iii) Should an internal transfer take place? Why? If you were
manager of the components division would you sell the 50,000
components for Tk.18 each? Explain.
(iv) Suppose, that the average operating assets of the components
division total Tk.100 lakhs, compute the ROI for the coming
year, assuming that the 50,000 units are transferred to the
Goods division at Tk.21 each.

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Solution:
(i) Existence of unutilized capacity of 50,000 units.
Minimum transfer price per unit.
Variable cost per unit : Tk.15.00
Direct Materials : Tk.10.00
Direct Labour : 2.00
Variable Overhead : 3.00
Tk.15.00

(ii) Maximum transfer price : Tk.28.00

[Cost of external source]

(iii) Yes, there should be internal transfer.

Components division will gain:
(Tk.18–15)×50,000 = Tk.150,000
Goods division will gain: (Tk.28-Tk.18) 50,000 = 500,000
Corporation will gain: Tk.650,000

(iv) Component Divisions’ ROI

Total Contribution: (Tk.29-Tk.15) 150,000 = Tk.21,00,000
(Tk.21 – Tk.15) 50,000 = 300,000
Tk.24,00,000
Less Fixed Expenses:
Fixed Production Overhead : Tk.10,00,000
Fixed Selling & Administrative : 5,00,000
Variable selling : 1,50,000 16,50,000
Net Income: Tk.7,50,000

Net Income Tk.750,000 × 100

ROI : --------------------------- = --------------------------
Operating Assets Tk.100,00,000

= 7.5%
International Aspect of Transfer Pricing:
The creation of foreign subsidiaries and bases of operation for cross
border flow of services, trademarks, funding and technology is having a
significant impact on the issue of transfer pricing in today’s international
business scenario. The objectives of multi-national transfer pricing are
different from domestic transfer pricing.

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Transfer pricing
objectives

Domestic International

 Greater divisional autonomy  Less taxes, duties and tariffs

 Greater motivation for managers  Less foreign exchange risk
 Better performance evaluation  Better competitive position
 Better goal congruence  Better governmental relations.

In case of domestic transfer pricing, divisional performance, divisional

autonomy are important along with overall performance of the enterprise.
But in a multinational setting, overall performance of the enterprise is
sensitive to the geographic, political, and economic circumstances in
which they are operating and set transfer prices in such a way as to
optimize total company performance.
Example # 3
An item produced by Division A in a country with a 25% income tax rate
is transferred to Division B in a country with a 50% income tax rate. In
addition, an import duty equal to 20% of the price of the item is assessed.
Suppose the full unit cost of the item is Tk.100 and the variable cost is
Tk.60. If tax authorities allow either variable or full-cost transfer prices,
which should be chosen? Assume that import duties are not deductible
for tax purpose.
Solution:
Effect of Transferring at Tk.100 instead of at Tk.60
Income of Division A is Tk.40 higher:
Therefore, A pays 25% of Tk.40 more income tax. Tk.(10.00)
Income of Division B is Tk.40 lower:
Therefore B pay 50% of Tk.40 less income tax. Tk.20.00
Import duty of Division is 20% of Tk.40 = Tk.8 higher Tk.(8.00)
Net savings from transferring at Tk.100 instead of Tk.60 Tk.2.00

Example # 4
Suppose that Division A buys a product from Division B. The divisions
are in different countries. The tax rate in Division A’s country is 20%
and Division B’s country 60%. Both use the same currency to prepare
income statement. Some data about the two divisions are as follows:
Division A:
Selling price of division A’s product Tk.100
Variable cost, excluding transfer price Tk.20
Tax rate 20%

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Division B:
Variable cost of Division B’s product Tk.30
Tax rate 60%
Assume, Division B transfers 1000 units to Division A at Tk.30 and
Tk.60.
Solution:
Transfer at Tk.60 instead of Tk.30:
Tax of Division B will go up:
60% of (Tk.60-Tk.30) = Tk.(18.00)
Tax of Division A will go down:
20% of (Tk.60-Tk.30) = 6.00
Total tax burden will go up by (per unit) Tk.(12.00)
It is better to transfer at Tk.30 per unit.

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Lesson-4: IAS Relating to Segment Reporting

Segment reporting is an issue of concern of internal management in a
divisionalized organization. Management in a divisionalized firm has to
compare the performance of various autonomons divisions. But the
objectives of segment reporting under IAS # 14 of the IASC are some
what different. This standard has been designed for external reporting.
The requirement of this standard may not be necessary for internal
management. Still, it is better to have some knowledge of the standard.
After completing this lesson, you are expected to be able to:
 To explain the objective of designing this standard;
 To explain various concepts used in this standard;
 To explain the requirements of this standard; and
 To give a format of external segment reporting.
Reporting Financial Information by Segment
Traditionally, business is operated in a single industry segment or within
a very small number of such groupings. During that time it was not
difficult to understand and use financial statements. But during mid-to
late 60s, the trend toward conglomerates became noticeable. Even in
Bangladesh, now we have different groups of industries. Different types
of businesses are assembled under one management. Naturally,
shareholders will be interested to know the performance of each unit
under the group management.
The International Accounting Standard Committee first issued IAS # 14
(Reporting Financial Information by Segment) in March, 1981.
Subsequently, the IASC significantly revised this standard in 1997. This
standard became effective after July 1, 1998.
Objective of the Standard
The objective of presenting information by segment is to provide users of
financial statements with information on the relative (i) size, (ii) profit
contribution and (iii) growth trend of different industries and different
geographical areas in which diversified enterprise operates to enable
them to make more informed judgments about the enterprise as a whole.
These data are needed to measure the risk of investing in such firms.
Scope of This Standard
This standard will be applicable to:
(a) Enterprises engaged in different industries in different
geographical areas;
(b) Enterprises whose securities are publicity traded.
Terms used in this Standard
Industry Segments:
Industry segments are the distinguishable components of an enterprise
each engaged in providing a different product or service, or a different

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group of related products or services, primarily to customers outside the

enterprise.
Geographical Segments:
Geographical segments are the distinguishable components of an
enterprise engaged in operations in individual countries or group of
countries within particular geographical areas as may be determined to
be appropriate in an enterprise’s particular circumstances.
Segment Revenue:
Segment revenue is revenue that is directly attributable to a segment, or
the relevant portion of revenue that can be allocated on a reasonable
basis to a segment and that is derived from transactions with parties
outside the enterprise and from other segments of the same enterprise.
Segment Expense:
Segment expense is expense that is directly attributable to a segment or
the relevant portion of an expense that can be allocated on a reasonable
basis to the segments.
Segment Assets:
Segment assets are the resources employed in generating segment
operating results. Such assets include all tangible and intangible assets
that can be identified with a particular segment. Assets shared by two or
more segments may be allocated between or among those segments on a
reasonable basis is available.
Inter-segment Pricing:
Inter-segment sales and other operating inter-segment revenues cannot
always be determined on an arm’s length basis. For this reasons
disclosure of the amount of such revenues and an explanation of the
inter-segment pricing basis (such as “fair market value”, cost, or market
price less a discount is useful.
Information Reported:
For each reported industry and geographical segment, the following
financial information should be disclosed:
(i) Sales or other operating revenues, distinguishing between
revenue derived from customers outside the enterprise and
revenue derived from other segments;
(ii) Segment results;
(iii) Segment assets employed, expressed either in money amounts
or as percentages of the consolidated totals; and
(iv) the basis of inter-segment pricing.
Segment Result:
The measure of the profitability of a segment is disclosed as the segment
result. The segment result is the difference between segment revenue and
segment expense and generally reflects operating profit. Where revenues
and expenses are not directly attributable to a segment but a reasonable
basis for allocation exists, they may be allocated these to on that basis.

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Example # 1
Comprehensive example of segment reporting under revised IAS 14
To illustrate the expansion of reporting requirements under the new
standard, revised IAS 14, a comprehensive illustration is given below.
The facts assumed are as follows as these would have been presented in
conformity with the original IAS 14:
(All amount in Tk. millions)
Electronic components Mechanical components
Net sales
2005 345.0 228.6
2006 378.5 219.8
Operating profit
2005 29.6 13.2
2006 36.0 8.5
Capital expenditures
2005 12.1 3.5
2006 21.4 2.5
Identifiable assets
2005 122.9 128.4
2006 140.2 118.5
Depreciation and amortization
1999 13.7 15.9
2000 17.5 13.6

Unallocated (corporate) assets totaled Tk.7.6 million in 2005 and Tk.8.1

million in 2006. Unallocated corporate expenses equaled Tk.3.4 million
in 2005 and Tk.4.5 million in 2006. Intersement sales, which are made at
cost, are not material in amount. Operating profit by segment is defined
as third-party sales less operating expenses; corporate overhead and
financing cost are excluded from segment expenses.
Revenue by geographic area is summarized below:
(All amount in Tk. millions)
Western Europe Eastern Europe Middle East
Net sales
2005 348.8 113.4 111.7
2006 366.3 133.4 98.6
Operating profit
2005 22.7 8.6 11.5
2006 20.6 13.9 10.0

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Identifiable assets
2005 178.4 63.2 9.7
2006 183.3 69.5 5.9

Western Europe includes primarily Germany and France, with a

relatively small amount of activity in Belgium and the Netherlands.
Eastern Europe includes Hungary, Poland, Slovakia and the Czech
Republic. The Middle East is principally Lebanon and Syria, with a
small level of activity in Egypt and Saudi Arabia. Sales in the Middle
East are made almost entirely to after-market suppliers, whereas
revenues derived from European markets are predominantly from
original equipment manufacturers of automobiles and construction
equipment. Approximately 12% and 14% of sales in Western Europe, for
2005 and 2006, respectively, were made to after-market suppliers, for
Eastern European sales, the corresponding percentages were 19% and
23% for 2005 and 2006, respectively.
It is assumed that management has determined that the primary reporting
format should be by business segment; the secondary reporting format,
therefore, will be geographical segment. What follows is the set of
required disclosures to conform with revised IAS 14:
Note: Segment information
Management has determined that the primary determinant of its decision
making is the major products offered by the company, with lesser
attention being based on geographical location of its customers.
Accordingly, the primary disclosures, below, are based on business
segment, alternatively, electronic or mechanical components, with the
following secondary disclosures based on geographic location of
customers.
(All amounts in Tk. millions)
Electronic Mechanical
components components
Net sales
2005-In total 345.0 228.6
2005-To external customers 336.3 228.6
2005-Intersegment sales 8.7 0.0
2006-In total 378.5 219.8
2006-To external customers 371.0 219.5
2006-Intersegment sales 7.5 .3
Operating profit
2005 29.6 13.2
2006 36.0 8.5
Interest and dividend income
2005-Interest income 1.2 .2
2005-Dividend income .1 0

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2006-Interest income 1.1 .3

2006-Dividend income 0 0
Interest expense
2005 1.5 1.1
2006 1.2 1.0
Identifiable assets, at net carrying amounts
2005 122.9 128.4
2006 140.2 118.5
Segment liabilities
2005 62.3 43.4
2006 59.6 40.1
Contingent liabilities related to contractual disputes
2005 2.5 1.0
2006 4.4 1.2
Capital expenditures
2005 12.1 3.5
2006 21.4 2.5
Depreciation and amortization
2005 13.7 15.9
2006 17.5 13.6
Nonrecurring items
2005-Revenue from government contract 6.7 0
2006-Gain from settlement of patent suit 2.3 0
Equity in income of investee
2005 2.2 0
2006 .5 0
Investment in equity method investee
2005 5.6 0
2006 6.9 0

Segment information is reconciled to corresponding enterprise totals in

the following section:
Net sales
2005 To external customers
Electronic components 336.3
Mechanical components 228.6
Enterprise total sales 564.9

2006-To external customers

Electronic components 371.0
Mechanical components 219.5
Enterprise total sales 590.5

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Operating profit
2005
Electronic components 29.6
Mechanical components 13.2
Less: Unallocated corporate expenses (3.4)
Enterprise total operating profit 39.4

2006
Electronic components 36.0
Mechanical components 8.5
Less: Unallocated corporate expenses (4.5)
Enterprise total operating profit 40.0
Identifiable assets, at net carrying amounts
2005
Electronic components 122.9
Mechanical components 128.4
Unallocated corporate assets 7.6
Enterprise total assets 258.9

2006
Electronic components 140.2
Mechanical components 118.5
Unallocated corporate e assets 8.1
Enterprise total assets 266.8
Segment liabilities
2005
Electronic components 62.3
Mechanical components 43.4
Enterprise total liabilities 105.7
2006
Electronic components 59.6
Mechanical components 40.1
Enterprise total liabilities 99.7
Revenue by geographic area is summarized below (based on location of
customers.)
(All amounts in Tk. millions)
Western Europe Eastern Europe Middle East
Net sales
2005 348.8 113.4 111.7
2006 366.3 133.4 98.6

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Identifiable assets
2005 178.4 63.2 9.7
2006 183.3 69.5 5.9
Capital
expenditures
2005 8.2 4.4 3.0
2006 12.5 5.5 5.9

Western Europe includes primarily Germany and France, with a

relatively small amount of activity in Belgium and the Netherlands.
Eastern Europe includes Hungary, Poland, Slovakia and the Czech
Republic. The Middle East is principally Lebanon and Syria, with a
small level of activity in Egypt and Saudi Arabia. Sales in the Middle
East are made almost entirely to after-market suppliers, whereas
revenues derived from European markets are predominantly from
original equipment manufacturers of automobiles and construction
equipment. Approximately 12% and 14% of sales in Western Europe, for
2005 and 2006, respectively, were made to after-market suppliers, for
Eastern European sales, the corresponding percentages were 19% and
23% for 2005 and 2006, respectively.

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Self Assessment Questions

(A) True or False
1. Indicate which statement is true and which statement is false by using
“T” and “F” respectively.
(i) Power is a much broader term than authority.
(ii) Authority is the power possessed by an individual for making
decisions and carrying them out.
(iii) An accountant is a line authority.
(iv) A staff has the authority to take decision.
(v) Scalar principle tells that the clearer the line authority, the clearer
will be the responsibility and the more effective will be
communication.
(vi) Decentralization is the goal whereas delegation is the means.
(vii) Decentralization is nothing but one form of divisionalization.
(viii) Cross-subsidization is the result of improperly assignment of joint
costs among products.
(ix) Contribution margin is always equal segment margin.
(x) Multi-national transfer-pricing is not a clash of interest between a
subsidiary and its parent company.

(B) Multiple Choice

2. Select the correct answer for the following multiple choice
questions:
(i) Which approach to transfer pricing uses the price at which the
product or service transferred could be sold to outside buyers?
(a) Cost price approach
(b) Negotiated approach
(c) Market price approach
(d) None of the above.

(ii) Which of the following statements regarding transfer pricing is

false?
(a) When idle capacity exists, there is no opportunity cost to
producing intermediate products for another division.
(b) Market-based transfer prices should be reduced by any costs
avoided by selling internally rather than externally.
(c) No contribution margin is generated by the transferring
division when variable cost-based transfer prices are used.
(d) The goal of transfer pricing is to provide segment managers
with incentive to maximize the profits of their divisions.

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(iii) In theory, the optimal method for establishing a transfer price is

(a) Flexible budget costs
(b) Incremental cost
(c) Market price
(d) Budgeted cost with or without a markup
(e) Actual cost with or without a markup.

(iv) Transfer pricing should encourage goal congruence and managerial

effort. In a decentralized organization, it should also encourage
autonomous decision making. Managerial effort is -
(a) The desire and the commitment to achieve a specific goal
(b) The sharing of goals by supervisors and subordinates
(c) The extent to which individuals have the authority to make
decisions.
(d) The extent of the attempt to accomplish a specific goal.

(v) A limitation of transfer prices based on actual cost is that they

(a) Charge inefficiencies to the departments that is transferring
the goods.
(b) Can lead to sub optimal decisions for the company as a
whole.
(c) Must be adjusted by some markup.
(d) Lack clarity and administrative convenience.

(vi) Which is not the limitation of decentralization?

(a) It makes it more difficult to have uniform policy.
(b) It may result in loss of some control by upper-level
managers.
(c) It facilitates product diversification.
(d) It may be limited by inadequate control techniques.

(vii) Which one is not the advantage of decentralization?

(a) It encourages decision making and assumption of authority
and responsibility.
(b) It promotes development of general managers.
(c) It involves considerable amount of expenses for training
managers.
(d) It aids in adoption to fast changing environment.

(viii) Which of the following does not support centralization?

(a) Specialized skills, talents, and technology are sometimes
neither affordable nor practical in multiple locations.
(b) Coordination of products, money and control also add to the
cost.
(c) Recent improvements in communication technology
facilitate the movement of money, credit information,
transportation and data processing.
(d) There is a need of environment which gives manages more
freedom and independence in decision making.

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(ix) Which benefit cannot be achieved by delegation?

(a) It can speed up decision making.
(b) It causes employees to accept accountability and exercise
judgment.
(c) It frequently leads to better decisions because employees,
closest to where the action is, are likely to have a clearer
view of the fact.
(d) The more tasks managers are able to delegate, the lesser
responsibilities they have to seek.

(x) Which situation is not feasible?

(a) No sales during product development stage.
(b) Sales growth during product introduction stage.
(c) Sales decrease during mature stage.
(d) Low sales to no-sales during phase-out stage.

(C) Short Questions:

1. Differentiate between.
(a) Power and Authority.
(b) Centralization and Decentralization
(c) Decentralization and Divisionalization
(d) Delegation and Decentralization
(e) Staff authority and Line authority.

2. What is decentralization? What are its advantages and

disadvantages?
3. What is delegation of authority? Discuss its advantages.
4. Differentiate between “Divisional Organizations” and “Functional
Organizations”, What are the reasons for divisionalization?
5. What is segment? What is segment reporting? Discuss two
approaches of segment reporting.
6. What is transfer pricing? Explain the impact of transfer price on
sending department and receiving department.
7. What are the various problems created by transfer prices? What are
the various types of transfer prices?
8. What is negotiated transfer price? What are its advantages and
disadvantages?
9. What are the contents of IAS 14? Do you think that a management
accountant should be concerned about the contents?
10. What does segment margin mean?

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Problems
1. The most recent monthly income statement for Reston Company is
given below:
RESTON COMPANY
Income Statement
For the Month Ended May 31
Sales Tk.900,000 100.0%
Less variable expenses 408,000 45.3
Contribution margin 492,000 54.7
Less fixed expenses 465,000 51.7
Net operating income Tk.27,000 3.0%

Management is disappointed with the company’s performance and is

wondering what can be done to improve profits. By examining sales and
cost records, you have determined the following:
(a) The company is divided into two sales territories-Central and
Eastern. The Central Territory recorded Tk.400,000 in sales
and Tk.208,000 in variable expenses during May. The
remaining sales and variable expenses were recorded in the
eastern Territory. Fixed expenses of Tk.160,000 and
Tk.130,000 are traceable to the Central and Eastern Territories,
respectively. The rest of the fixed expenses are common to the
two territories.
(b) The company sells two products- Awls and Pows, Sales of
Awls and Pows totaled Tk.100,000 and Tk.300,000,
respectively, in the Central territory during May. Variable
expenses are 25% of the selling price for Awls and 61% for
Pows. Cost records show that Tk.60,000 of the Central
Territory’s fixed expenses are traceable to Awls and Tk.54,000
to Pows, with the remainder common to the two products.
Required:
(i) Prepare segmented income statements, first showing the total
company broken down between sales territories and then showing
the Central Territory broken down by product line. Show both
Amount and Percent columns for the company in total and for each
segment. Round percentage computations to one decimal place.
(ii) Look at the statement you have prepared showing the total
company segmented by sales territory. What points revealed by
this statement should be brought to the attention of management?
(iii) Look at the statement you have prepared showing the Central
Territory segmented by product lines. What points revealed by this
statement should be brought to the attention of management?

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2. Vega Foods, Inc., has recently purchased a small mill that it

intends to operate as one of its subsidiaries. The newly acquired
mill has three products that it offers for sale-wheat cereal, pancake
mix. and flour. Each product sells for Tk.10 per package.
Materials, labor and other variable production costs are Tk.3.00 per
bag of wheat cereal Tk.4.20 per bag of pancake mix. and Tk.1.80
per bag of flour. Sales commissions are 10% of sales for any
product. All other costs are fixed.
The mill’s income statement for the most recent month is given below:
Product Line
Wheat Pancake
Total Company Cereal Mix Flour
Sales Tk.600,000 100.0% Tk.200,000 Tk.300,000 Tk.100,000
Less expenses
Materials, labor, and other 204,000 34.0 60,000 126,000 18,000
Sales commissions 60,000 10.0 20,000 30,000 10,000
Advertising 123,000 20.5 48,000 60,000 15,000
Salaries 66,000 11.0 34,000 21,000 11,000
Equipment depreciation 30,000 5.0 10,000 15,000 5,000
Warehouse rent 12,000 2.0 4,000 6,000 2,000
General administration 90,000 15.0 30,000 30,000 30,000
Total expenses 585,000 97.5 206,000 288,000 91,000
Net operating income (loss) Tk.15,000 2.5% Tk.(6,000) Tk.12,000 Tk.9,000

The following additional information is available about the company:

(a) The same equipment is used to mill and package all three products.
In the above income statement, equipment depreciation has been
allocated on the basis of sales dollars. An analysis of the use of the
equipment indicates that it is used 40% of the time to make wheat
cereal, 50% of the time to make pancake mix, and 10% of the time
to make flour.
(b) All three products are stored in the same warehouse. In the above
income statement, the warehouse rent has been allocated on the
basis of sales Taka. The warehouse contains 24,000 square feet of
space, of which 8,000 square feet are used for wheat cereal, 14,000
square feet are used for pancake mix, and 2,000 square feet are
used for flour. The warehouse space costs the company Tk.0.50
per square foot to rent.
(c) The general administration costs relate to the administration of the
company as a whole. In the above income statement, these costs
have been divided equally among the three product lines.
(d) All other costs are traceable to the product lines.

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Vega Foods management is anxious to improve the mill’s 2.5% margin

on sales.
Required:
(i) Prepare a new segmented income statement for the month, using
the contribution approach. Show both Amount and Percent
columns for the company as a whole and for each product line.
Adjust the allocation of equipment depreciation and warehouse
rent as indicated by the additional information provided.
(ii) After seeing the income statement in the main body of the
problem, management has decided to eliminate the wheat cereal,
since it is not returning a profit, and to focus all available resources
on promoting the pancake mix.
(a) Based on the statement you have prepared, do you agree with
the decision to eliminate the wheat cereal? Explain.
(b) Based on the statement you have prepared, do you agree with
the decision to focus all available resources on promoting the
pancake mix? Explain (You may assume that an ample market
is available for all three products)
(iii) What additional points would you bring to the attention of
management that might help to improve profits?
3. Brabant NV is a wholesale distributor of Dutch cheeses that it sells
throughout the country. Unfortunately, the company’s profits have
been declining, which has caused considerable concern. To help
understand the condition of the company, the managing director of
the company has requested that the monthly income statement be
segmented by sales territory. Accordingly, the company’s
accounting department has prepared the following statement for
March, the most recent month.
Sales Territory
Dhaka Rajshahi Chittagong
Sales Tk.300,000 Tk.800,000 Tk.700,000
Less territorial expenses (traceable):
Cost of goods sold 93,000 240,000 315,000
Salaries 54,000 56,000 112,000
Insurance 9,000 16,000 14,000
Advertising 105,000 240,000 245,000
Depreciation 21,000 32,000 28,000
Shipping 15,000 32,000 42,000
Total territorial expenses 297,000 616,000 756,000
Territorial income (loss) before
corporate expenses 3,000 184,000 (56,000)
Less corporate expenses:
Advertising (general) 15,000 40,000 35,000
General administrative 20,000 20,000 20,000

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Total corporate expenses 35,000 60,000 55,000

Net operating income (loss) (Tk.32,000) (Tk.124,000) Tk.(111,000)

Cost of goods sold and shipping expenses are both variable; other costs
are all fixed. Brabant NV purchases cheeses at auction and from farmers’
cooperatives and it distributes them in the three territories listed above.
Each of the three sales territories has its own manager and sales staff.
The cheeses vary widely in profitability; some have a high margin and
some have a low margin. (Certain cheese, after having been aged for
long periods, are the most expensive and carry the highest margins).
Required:
(i) List any disadvantages or weaknesses that you see to the statement
format illustrated above.
(ii) Explain the basis that is apparently being used to allocate the
corporate expenses to the territories. Do you agree with these
allocations? Explain.
(iii) Prepare a new segmented income statement for May using the
contribution approach. Show a Total column as well as data for
each territory. Include percentages on your statement for all
columns. Carry percentages to one decimal place.
(iv) Analyze the statement that you prepared in (3) above. What points
that might help to improve the company’s performance would you
be particularly anxious to bring to the attention of management?

4. Padma Group, is organized into two divisions. The company’s

segmented for last month is given below:
Total Divisions
Company Cloth Leather
Sales Tk.3,500,000 Tk.2,000,000 Tk.1,500,000
Less variable expenses 1,721,000 960,000 761,000
Contribution margin 1,779,000 1,040,000 739,000
Less traceable fixed expenses:
Advertising 612,000 300,000 312,000
Administration 427,000 210,000 217,000
Depreciation 229,000 115,000 114,000
Total traceable fixed expenses 1,268,000 625,000 643,000
Divisional segment margin 511,000 Tk.415,000 Tk.96,000
Less common fixed expenses 390,000
Net operating income Tk.121,000

Top management can’t understand why the Leather Division has such a
low segment margin when its sales are only 25% less than sales in the

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Cloth Division. As one step in isolating the problem, management has

directed that the Leather Division be further segmented into product
lines. The following information is available on the product lines in the
Leather Division:
Leather Division Product Lines
Garments Shoes Handbags
Sales Tk.500,000 Tk.700,000 Tk.300,000
Traceable fixed expenses:
Advertising 80,000 112,000 120,000
Administration 30,000 35,000 42,000
Depreciation 25,000 56,000 33,000
Variable expenses as a percentage 65% 40% 52%
of sales

Analysis shows that Tk.110,000 of the Leather Division’s administration

expenses are common to the product lines.
Required:
(i) Prepare a segmented income statement for the Leather Division
with segments defined as product lines. Use the contribution
approach. Show both Amount and Percent columns for the division
in total and for each product line. Carry percentage figures to one
decimal place.
(ii) Management is surprised by the handbag product line’s poor
showing and would like to have the product line segmented by
market. The following information is available about the markets
in which the handbag line is sold:
Handbag Markets
Domestic Foreign
Sales Tk.200,000 Tk.100,000
Traceable fixed expenses:
Advertising 40,000 80,000
Variable expenses as a percentage of sales 43% 70%

All of handbag product line’s administration expenses and depreciation

are common to the markets in which the product is sold. Prepare a
segmented income statement for the handbag product line with segments
defined as markets. Again use the contribution approach and show both
Amount and Percent columns.
(iii) Refer to the statement prepared in (i) above. The sales manager
wants to run a special promotional campaign on one of the product
lines over the next month. A marketing study indicates that such a
campaign would increase sales of the garment product line by
Tk.200,000 or sales of the shoes product line by Tk.145,000. The
campaign would cost Tk.30,000. Show computations to determine
which product line should be chosen.

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5. “Rats! We’re still in the red.” said Jana Andrews, executive vice
president of the Ashland Company. “I know,” said Steve Clark, the
controller, “Just look at this income statement for March. We’ve
got to forget about Districts A and B and focus on District C.” The
statement to which Mr. Clark was referring is shown below:
Total Districts
Company A B C
Sales @ Tk.20 per unit Tk.1,000,000 Tk.300,000 Tk.500,000 Tk.200,000
Less cost of goods sold @ Tk.9 per 450,000 135,000 225,000 90,000
unit
Gross margin 550,000 165,000 275,000 110,000
Less operating expenses:
Marketing expenses:
Shipping 51,250 11,250 25,000 15,000
Warehouse rent 80,000 24,000 40,000 16,000
Sales commissions 60,000 18,000 30,000 12,000
Sales salaries 30,000 12,000 10,000 8,000
District advertising 75,000 20,000 25,000 30,000
National advertising* 115,000 34,500 57,500 23,000
Total marketing expenses 411,250 119,750 187,500 104,000
Administrative expenses:
District management salaries 40,000 12,000 15,000 13,000
Central office administrative
expenses* 100,000 30,000 50,000 20,000
Total administrative expenses 140,000 42,000 65,000 33,000
Total operating expenses 551,250 161,750 252,500 137,000
Net operating income (loss) Tk.(1,250) Tk.3,250 Tk.22,500 Tk.(27,000)

* Allocated on the basis of sales Taka.

The company is a retail organization that sells a single product. The
product is sold in three districts, as shown above. Additional information
on the company follows:
(a) The sales and administrative offices are centrally located being
about the same distance from each district.
(b) Each district specifies on the sales order what shipping method is
to be used (by truck, rail, or air). All goods are shipped from a
central warehouse. Shipping is a variable cost, and it is traceable to
the districts; differences in amounts above are reflective of the
difference shipping methods used.
(c) All salespersons are paid a base salary of Tk.2,000 per month, plus
a commission of 6% of sales. There are 6 salespersons in District
A, 5 in District B, and 4 in District C.
(d) Each district manager must arrange his or her own district’s
advertising program. The national advertising is provided by the
central office.

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(e) The variable costs of processing orders, which have been included
in the “Central office administrative expenses” above, amount to
Tk.25,000. During March, District A had 3,000 orders. District B
had 1,500 orders, and District C had 500 orders. The remainder of
the “Central office administrative expenses” are fixed and relate to
general administrative assistance provided to all parts of the
organization.
(f) The warehouse contains 160,000 square feet of storage space.
District A uses 60,000 square feet, District B uses 80,000 square
feet, and District C uses 20,000 square feet.
Required:
(i) Garth Hansen, the president, has asked that the company’s income
statement be redone using the contribution format, which he heard
about at a recent industry convention. Prepare the income
statement as requested by Mr. Hansen. Show both an Amount and
a Percent column for the company in total and for each district,
(carry computations to one decimal place.)
(ii) Compute the contribution margin per order for each district. What
problems does this computation suggest?
(iii) The manager of District B would like to spend an extra Tk.25,000
next month in a special promotional campaign. If sales increase by
Tk.100,000 as a result, would the expenditure be justified? No
additional warehouse space would be required.
(iv) Analyze the data in the statement you prepared in (i) above. What
points should be brought to the attention of management?

6. Benson Company makes bicycles. Components are made in

various divisions and transferred to the Omaha Division for
assemble into final products. The Omaha Division can also buy
components from external suppliers. The wheels are made in the
Lincon Division which also sells wheels to external customers. All
divisions are profit center and managers are free to negotiate
transfer pries. Prices and costs for the Lincon and Omaha division
are:
Lincon Division
Sales price to external customers : 1200
Internal transfer price ?
Costs:
Variable costs per wheel 800
Total fixed costs 32,000,000
Budgeted production 64,000 wheels
Omaha Division
Sales price to external customers: 16,000

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Costs:
Wheels per cycle ?
Other components, per bicycle 8,000
Total fixed costs 64,000,000
Budgeted production 16,000 bicycles

Fixed costs in both divisions will be unaffected by the transfer of wheels

from Lincon to Omaha.
Required:
(i) Computer the maximum price per wheel the Omaha Division
would be willing to pay to buy wheels from the Lincon
Division.
(ii) Computer the maximum transfer price per wheel at which
the Lincon Division would be willing to produce and sell
wheels to the Omaha Division. Assume that Lincon has
excess capacity.

7. Globe Enterprise Inc. has production and marketing divisions

throughout the world. One particular product is produced in Japan,
where the income tax rate is 30% and transferred to a marketing
division in Sweden, where the income tax rate is 60%, Assume that
Sweden places an income tax of 10% on the product and that
import duties are not tax deductible for income tax purposes.
The variable cost of the product is Tk.200 and the full cost is
Tk.400. Suppose the company can select a transfer price any where
the variable and full cost.
(a) What transfer price should Global Enterprise use to
minimize taxes? Explain why this is the tax-minimizing
transfer price.
(b) Compute the amount of taxes saved by using the transfer
price in requirement (a) instead of the transfer price that
would result in the highest taxes.

8. The Grand Rapid Division of National Woodcrest purchases

lumber, which it uses to fabricate tables, chair and other wood
furniture. Most of the lumber is purchased from Northwood’s Mill,
also a division of National Woodcraft. Both the ‘Grand Rapids
Division and Northwood Mill are profit centers.
The Grand Rapids Division proposes to produce a new shaker-
style chair that will sell for Tk.9200. The manager is exploring the
possibility of purchasing the required lumber from Northeroods
Mill. Production of 800 chairs is planned using capacity in the
Grand Rapids Division that is currently idle.

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The Grand Rapids Division can purchase the lumber from an

outside supplier for Tk.7200. National Woodcraft has a policy that
internal transfers are priced at finally allocated cost.
Assume the following costs for the production of one chair and the
lumber required for the chair:
Northwoods Mill Grand Rapids Division
Variable Cost: Tk.4,800 Variable Cost:
Allocated fixed costs: 2,200 Lumber from
Fully allocated cost: Tk.7,000 Northwoods Mill Tk.7000
Grand Rapids
Division Variable cost
Manufacturing Tk.2100
Selling 600 2700
Total variable cost: Tk.9700

Required:
(i) Assume that the Northwoods Mill has idle capacity and therefore
would incur no additional fixed costs to produce the required
lumber. Would the Grand Rapids division manager buy the lumber
for the chair from the Northwoods Mill, given the existing transfer-
pricing policy? Why or why not? Would the company as a whole
benefit if the manager decides to buy from the Northwoods Mill?
Explain.
(ii) Assume that there is no idle capacity at the Northwoods Mill and
the lumber required for one chair can be sold to outside customer
for Tk.7200. Would the company as a whole benefit if the manager
decides to buy? Explain.

9. Malone’s Medical Instruments, Inc. produces a variety of medical

products at its plant in Seattle. The company has sales divisions
worldwide. One of their sales divisions is located in Oslo, Norway.
Assume that the U.S. income tax rate is 34%, the Norwegian rate is
60% and a 15% import duly is imposed on medical supplies
brought into Norway.
One product produced in Seattle and shipped to Norway is a heart
monitor. The variable cost of production is Tk.30,000 per unit and
the fully allocated cost is Tk.55,000 per unit.

Required:
(i) Suppose the Norwegian and U.S. governments allow either the
variable cost or fully-allocated costs to be used as a transfer
price. Which price should Malone’s Medical Instruments
choose to minimize the total of income taxes and import
duties? Compute the amount the company saves if it uses your
suggested transfer price instead of the alternative. Assume
import duties are not deductible for tax purposes.

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(ii) Suppose the Norwegian parliament passed a law decreasing

the income tax rate to 50% and increasing the duty on heart
monitors to 20%. Repeat the requirement (i) using these new
facts.

10. Pella Company has several independent divisions. The company’s

Compressor Division produces a high-quality compressor that is
sold to various users. The division’s income statement for the most
recent month, in which 500 compressors were sold, is given below:
Total Unit
Sales Tk.12,500,000 Tk.25,000
Less cost of goods sold 7,500,000 15,000
Gross margin 5,000,000 10,000
Less selling and administrative expenses 3,000,000 6,000
Divisional net operating income Tk.2,000,000 Tk.4,000

As shown above, it costs the division Tk.15,000 to produce a

compressor. This figure consists of the following costs:
Direct materials Tk.5,000
Direct labour 6,000
Manufacturing overhead (50% fixed) 4,000
Total cost Tk.15,000

The division has fixed selling and administrative expenses of

Tk.2,500,000 per month and variable selling and administrative expenses
of Tk.1,000 per compressor.
Another division of Pella Company, the Home Products Division uses
compressors as a component part of air-conditioning systems that it
installs. The Home Products Division asked the Compressor Division to
sell it 40 compressors each month of a somewhat different design. The
Compressor Division has estimated the following cost for each of the
new compressors:
Direct materials Tk.6,000
Direct labour 9,000
Manufacturing overhead (two-thirds fixed) 7,500
Total cost Tk.22,500

In order to produce the new compressors, the Compressor Division

would have to reduce production of its present compressors by 100 units
per month. However all variable selling and administrative expenses
could be avoided on the intracompany business. Total fixed overhead
costs would not change. Assume direct labor is a variable cost.

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Required:
(i) Determine the lowest acceptable transfer price from the
perspective of the Compressor Division for the new
compressor.
(ii) Suppose the Home Products Division has found an outside
supplier that will provide the new compressors for only
Tk.35,000 each. If the Compressor Division meets this price
what will be the effect on the profits of the company as a
whole?

11. Damico Company’s Board Division manufactures an electronic

control board that is widely used in high-end DVD players. The
cost per control board is as follows:
Variable cost per board Tk.1,200
Fixed cost per board 300*
Total cost per board Tk.1,500
* Based on a capacity of 800,000 boards per year.
Part of the Board Division’s output is sold to outside manufacturers of
DVD players and part is sold to Damico Company’s Consumer products
Division which produces a DVD player under the Damico name. The
Board Division charges a selling price of Tk.1,900 per control board for
all sales both internally and externally.
The costs revenue and net operating income associated with the
Consumer Products Division’s DVD player are given below:
Selling price per player Tk.5,800
Less variable costs per player:
Cost of the control board Tk.1,900
Variable cost of other parts 2,300
Total variable costs 4,200
Contribution margin 1,600
Less fixed costs per player 850*
Net operating income per player Tk. 750
* Based on a capacity of 200,000 DVD players per year.
The Consumer Products Division has an order from an overseas
distributor for 5,000 DVD players. The distributor wants to pay only
Tk.4,000 per DVD player.
Required:
(i) Assume that the Consumer Products Division has enough idle
capacity to fill the 5,000 unit order. Is the division likely to accept
the Tk.4,000 price or to reject it? Explain.
(ii) Assume that both the Board Division and the Consumer Products
Division have idle capacity. Under these conditions, would

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rejecting the Tk.4,000 price be an advantage to the company as a

whole or would it result in the loss of potential profits? Show
computations to support your answer.
(iii) Assume that the Board Division is operating at capacity and could
sell all of its control boards to outside manufacturers of DVD
players. Assume, however that the Consumer products Division
has enough idle capacity to fill to 5,000-unit order. Under these
conditions compute the Taka advantage or disadvantage to the
Consumer Product s Division of accepting the order at the
Tk.4,000 price.
(iv) What conclusions do you draw concerning the use of market price
as a transfer price in intracompany transactions?

12. Ideal Products. Inc. has just purchased a small company that
specializes in he manufacture of electronic tuners that are used as a
component part to TV sets. Ideal Products. Inc. is a decentralized
company and it will treat the newly acquired company as an
autonomous division with full profit responsibility. The new
division called the Tuner Division has the following revenue and
costs associated with each tuner that it manufactures and sells:
Selling price Tk.2,000
Less expenses:
Variable Tk.1,100
Fixed (based on a capacity of 100,000
tuners per year) 6,00 1,700
Net operating income Tk.300

Ideal Products also has an Assembly Division that assembles TV sets.

This division in currently purchasing 30,000 tuners per year from an
overseas supplier at a cost of Tk.2000 per tuner less a 10% quantity
discount. The president of Ideal Products is anxious to have the
Assembly Division begin purchasing is tuners from the newly acquired
Tuner Division in order to “keep the profits within the profits within the
corporate family.”
Required:
For (i) through (ii) below assume that the Tuner Division can sell all of
its output to outside TV manufacturers at the normal Tk.2,000 price.
(i) Are the managers of the Tuner and Assembly Divisions likely to
voluntarily agree to a transfer price for 30,000 tuners each year?
Why or why not?
(ii) If the Tuner Division meets the price that the Assembly Division is
currently paying to its overseas supplier and sells 30,000 tuners to
the assembly Division each year what will be the effect on the
profits of the Tuner Division the Assembly Division and the
company as a whole?

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For (iii) through (vi) below assume that the Tuner Division is currently
selling only 60,000 tuners each year to outside TV manufacturers at the
stated Tk.2,000 price.
(iii). Are the managers of the Tuner and Assembly Divisions likely to
voluntarily agree to a transfer price for 30,000 tuners each year?
Why or why not?
(iv) Suppose that the Assembly Division’s overseas supplier drops its
price (net the quantity discount) to only Tk.1,600 per tuner. Should
the Tuner Division meet this price? Explain. If the Tuner Division
does not meet this price, what will be the effect on the profits of
the company as a whole?
(v) Refer to (iv) above. If the Tuner Division refuses to meet the
Tk.1,600 price should the Assembly Division be required to
purchase from the Tuner Division at a higher price for the good of
the company as a whole? Explain.
(vi) Refer to (vi) above. Assume that due to inflexible management
policies the Assembly Division is required to purchase 30,000
tuners each year from the Tuner Division at Tk.2,000 per tuner.
What will be the effect on the profits of the company as whole?

13. In case 1-3 below, assume the Division A has a product that can be
sold either to Division B of the same company or to outside
customers. The managers of both divisions are evaluated based on
their own division’s return on investment (ROI). The managers are
free to decide if they will participate in any internal transfers. All
transfer prices are negotiated. Treat each case independently.
Case
1 2 3 4
Division A:
Capacity in units 50,000 300,000 100,000 200,000
Number of units now being sold to outside 50,000 300,000 75,000 200,000
customers
Selling price per unit on the outside Tk.10,000 Tk.4,000 Tk.6,000 Tk.4,500
market
Variable costs per unit Tk.6,300 Tk.1,900 Tk.3,500 Tk.3,000
Fixed costs per unit (based on capacity) Tk.2,500 Tk.800 Tk.1,700 Tk.600
Division B:
Number of units needed annually 10,000 70,000 20,000 60,000
Purchase price now being paid to an Tk.9,200 Tk.3,900 Tk.6,000* ---
outside supplier

* Before any quantity discount.

Required:
(i) Refer to case I above. A study has indicated that Division A can
avoid Tk.500 per unit in variable costs on any sales to Division B.

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Will the managers agree to a transfer and if so, within what range
will the transfer price be? Explain.
(ii) Refer to case 2 above. Assume that Division A can avoid Tk.400
per unit in variable costs on any sales to Division B.
(a) Would you expect any disagreement between the two
divisional managers over what the transfer price should be?
Explain.
(b) Assume that Division A offers to sell 70,000 units to
Division B for Tk.3,800 per unit and that Division B refuses
this price. What will be the loss in potential profits for the
company as a whole?
(iii) Refer to case 3 above Assume that Division B is now receiving a
5% quantity discount from the outside supplier.
(a) Will the managers agree to a transfer? If so, within what
range will the transfer price be?
(b) Assume that Division B offers to purchase 20,000 units from
Division A at Tk.5,200 per unit. If Division A accepts this
price would you expect its ROI to increase decrease or
remain unchanged? Why?
(iv) Refer to case 4 above. Assume that Division B wants Division A to
provide it with 60,000 units of a different product from the one that
Division A is now producing. The new product would require
Tk.2,500 per unit in variable costs and would required that
Division A cut back production of its present product by 30,000
units annually. What is the lowest acceptable transfer price from
Division A’s perspective?

14. The Film Division of the Photo life, produces 35 mm film that can
be sold externally or internally to photo life’s school Photography
Division. Sales and cost data per roll of 35 mm film follow:
Unit selling price : Tk.295
Unit variable costs : 140
Unit product fixed cost : 120
Practical capacity 5,00,000 units
[Unit product fixed costs has been calculated as follows:
Tk.60000000 ÷ 5,00,000 = Tk.120]
During the coming year, the Film Division expects to sell 3,50,000
rolls of this film. The School Photography division currently plans
to buy 1,50,000 rolls of the film on the outside market for Tk.295
each. Anita Mathur, manager of the Film Division, has approached
Kazal, manager of the school photography division and offered to
sell the 150,000 rolls for Tk..294 each. Anita explains to Kazal that
she can avoid selling cost of Tk.2 per film roll and that she would
split the savings by offering a Tk.1 discount on the usual price.

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Required:
(i) What is the minimum transfer price that the Film Division
would be willing to accept? What is the maximum transfer
price that the School Photography division would be willing
to pay? Should an internal transfer take place? What would
be the benefit or loss to the firm as a whole if the internal
transfer takes place?
(ii) Suppose Kajal knows that the Film Division has idle
capacity. Do you think that she would agree to the transfer
price of Tk.294. Suppose she counters with an offer of
Tk.285. If you were Anita Mathur would you be interested in
this price? Explain with supporting computations.
(iii) Suppose that Photolife’s policy is that all internal transfers
take place at full manufacturing cost. What would the
transfer price be? Would the transfer take place?

15. Pfizer Industries is a vertically integrated firm with several

divisions that operate as decentralized profit centers. Pfizer System
Division manufactures scientific instruments and uses the products
of two other divisions. The Board Division manufactures printed
circuit boards (PCB). One PCB model is made exclusively for the
Systems Division using proprietary designs, while less complex
models are sold in outside markets. The products of the Transistor
Division are sold in a well developed competitive market:
however, one transistor model is used by the Systems Division.
The cost per unit of the products used by the System Division
follow:
PCB Transistor
Taka Taka
Direct Materials 2,500 800
Direct Labour 4,500 1,000
Variable overhead 2,000 500
Fixed overhead 800 750
Total Cost 9,800 3,050

The board division sells its commercial products at full cost plus a 25
percent markup and believes the proprietary board made for the System
Division would sell for Tk.12,250 per unit on the open market. The
market price of the transistor used by the System Division is Tk.3,700
per unit.
Required:
(i) What is the minimum price for the Transistor Division? What is
the maximum transfer price of the transistor for the System
Division?

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 Bangladesh Open University

(ii) Assume the Systems Division is able to purchase a large quantity

of transistors from an outsource at Tk.2900 per unit. Further
assume that the Transistor Division has excess capacity. Can the
Transistor Division meet this price?
(iii) The Board and Systems Divisions have negotiated a transfer price
of Tk.11,000 per printed circuit board. Discuss the impact this
price will have on each division.

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