Quiz 5: Responsibility Accounting and Transfer Pricing

Business

Transfer Price Transfer price is the price which is charged by the internal department of an entity from one another. This price is generally less than the market price. Sometimes prices charged between two related parties are also termed as transfer price. Setting a transfer price is always difficult as it involves a contradiction in the two departments of an entity. Opportunity Cost It is the income foregone which could have earned if the current task has not opted. Since an opportunity of income is forgiven it is termed as opportunity cost. A famous person once said, "no coming of money is equivalent to going of money". This refers to that the income you have forgiven is now a cost which should be recovered from the adopted task. If it is not recovered then there is ultimately loss of the amount not recovered.a Calculate the excess cash flow of the product is purchased from M using MS Excel as follows: img The result of above is as follows: img Hence if the company purchases from m instead of S then it will have to spend extra $0.45 for every gallon. It is to be noted that the opportunity cost of the plant is 0 and fixed overheads cannot be eliminated.b.In the present case, the S department wants to charge some profit and fixed overheads from the experimental department of C but this cost is more than the market cost of $3. If the experimental department buys from outside then he needs to pay $0.45 extra because the fixed overheads will continue to incur. The company follows decentralization and therefore decisions regarding the transfer price are made by the manger. Since purchasing from outside costs more it is obvious that the purchase from S department is beneficial for the company. But to execute the transfer price should be such which is not more than the market price of the product. It is advised that the corporate manager should not intervene in between because it will harm the very basic purpose of the decentralization instead the corporate manager should remove the S department's manager if his actions are not beneficial to the company as a whole.

Net Income: The resultant amount after reducing all expenses of the company weather direct or indirect for the period from all revenues is termed as net income.Cost of Capital: It refers to the margin of profit which is lost on a particular source of investment by the entity i.e. the amount of income that the entity might have earned on the same amount of investment if that particular investment was being invested in some better source of investment. The factor of risk in both the investment sources will be same.Subsidiary Company A subsidiary company is a company in which the major shareholding is held by some other company which is called the parent company. There may be one parent company or may even be multiple parent company. Such parent company is involved in major management decisions of it subsidiary. In the present case, C Company is the wholly owned subsidiary of Y Company and C Company earned net income of $14,000,000 in 2009, $14,300,000 in 2010 and $14,400,000 in 2011 and return on investment in subsidiary for three years are 20%, 22%, and 24% respectively. Prepare a schedule to compute the net investment and residual income of C Company using MS Excel, which will be shown as follows: img The result of above will be as follows: img The net investment of subsidiary company is reduced from $70 million to $60 million and it also makes a change in its capital structure by increasing debt funds and reducing equity funds. The net income of subsidiary also have an increasing trend and due to a decrease in net investments of the company the return on investment get improved but this improvisation does not have any effect of operating performance of the company.

Residual income Residual income is another method used to determine performance of division. It subtracts the opportunity cost of capital employed from divisional performance. Residual income is therefore excess of earnings earned over the cost of capital. Formula to calculate residual income img a.In given case A would propose the addition of building $10 million because net cash flow for years 1-10 is positive with expansion and A would not be charged for expansion of building. This expansion would increase her compensation. b.Use the below formula to calculate residual income img The cost of capital used would be 12% and A would be using expected cash flow calculated by her rather than cash flow estimate used by her to justify the project as she would not want biased estimate of the project on her decision to accept project. Calculate residual income for each year as shown below img Following shows the working img c.Based on residual value A would not propose expansion. This is because the residual value is negative and lower which would reduce her compensation amount. d.If A's compensation is dependent on operating profit after depreciation then she would accept the project expansion as operating profit after depreciation for each year is positive.e.The difference in part (c) and (d) is that in part (c) 12% cost of capital is considered for which A needs to pay while in (d) A need not pay for the cost of capital and thus operating profit after depreciation for each year is positive.

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