CH 19

Chapter 19
Strategic Performance Measurement: Investment Centers and

Transfer Pricing
Multiple Choice Questions
1. Under the notion of controllability, it is most appropriate for top management to

evaluate the profitability of an investment center in terms of:
A. Profits generated in relation to the amount of capital invested in the unit.

B. Returns expressed as a percentage.
C. Profits expressed in absolute terms.
D. Operating profit generated.
E. Returns expressed in actual dollar amounts.
2. Which of the following is the most appropriate and comprehensive short-term

financial-performance indicator for an investment center that is a division of a larger
business entity?
A. Residual income (RI).

B. Operating income, pre-tax.
C. Return on equity (ROE).
D. Operating income, after-tax.
E. Return on sales (ROS).
3. The conventional return on investment (ROI) performance measure calculates "profit"

and "investment" based on:
A. American Accounting Association (AAA) recommendations.

B. U.S. Generally Accepted Accounting Principles (GAAP).
C. The American Institute of Certified Public Accountants (AICPA) regulations.
D. The legal and business professions' practices.
E. Requirements specified by the U.S. Securities and Exchange Commission (SEC).
4. Return on investment (ROI) is the result of multiplying:
A. Return by average investment.

B. Profit by average operating assets.
C. Return on sales (ROS) by asset turnover (AT).
D. Return on assets (ROA) by asset turnover (AT).
E. Margin on sales by return on assets (ROA).
19-1
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McGraw-Hill Education.
5. Determination of the useful life of an asset and choice of a depreciation method will
affect all of the following except:
A. The amount of operating income earned by an investment center for any given
period.
B. The investment base for purposes of calculating ROI.
C. Amount of depreciation expense recorded for any given period.
D. Net book value (NBV) of an asset as of any point in time.
E. The opportunity cost of lost sales on alternative projects.
6. The choice of valuation method for inventories would normally not affect which
item(s) used in calculating Return on Investment (ROI)?
A. The valuation of fixed assets (e.g., Plant, Property, and Equipment) used by an
investment center.
B. The amount of operating income earned by an investment center in a given
period.
C. Both the investment base and the level of operating income reported by an
investment center.
D. The estimated value of current assets of a business entity, such as an investment
center.
E. The return on sales (ROS) of an investment center for the period.
7. As a general rule, leased assets should be included as part of the calculation of

"investment" (for calculating ROI and residual income) since they represent assets
used:
A. As collateral to borrow funds.

B. To generate operating income.
C. To offset current operating expenses.
D. To reduce taxes.
E. To estimate earnings per share for a given period.
8. Firms with high operating leverage tend to have:
A. High asset turnover and high return on sales.

B. Low asset turnover and low return on sales.
C. Low asset turnover and high return on sales.
D. High asset turnover and low return on sales.
E. Decreased levels of short-term fixed costs.
19-2
9. Which one of the following is an advantage of both Return on Investment (ROI) and
Residual Income (RI)?
A. They both measure all elements important for measuring short-term financial
performance of investment centers: revenues, costs, and investment.
B. They are both very widely used in practice today.
C. They both can use the minimum rate of return to adjust for differences in risk
across different investment centers.
D. They are both comparable to interest rates and to rates of return on alternate
investments.
E. They can both use a different minimum rate of return for different types of assets
used by an investment center.
10. When investments in facilities are shared by different subunits in a firm, allocation of
the cost of these common facilities to sharing units should be determined by:
A. Reference to Generally Accepted Accounting Principles (GAAP).

B. Relative sales dollars generated by the various units.
C. The relative amount of use of the facilities, or demand for the facilities, by the
various investment centers in the organization.
D. Special techniques prescribed by the American Institute of Certified Public
Accountants (AICPA).
E. Some measure of current value (e.g., replacement cost).
11. The difference between the historical cost and the net book value (NBV) of a plant
asset is the:
A. Residual value of the asset.

B. Depreciation expense for the current period.
C. An estimate of the remaining useful life of the asset.
D. Accumulated depreciation expense on the asset.
E. Estimated replacement cost of the asset.
12. Use of net book value (NBV) in valuing investment in operating plant assets for
investment centers, in contrast to using an estimate current value, will:
A. Have no appreciable effect on ROI in most situations.

B. Have no appreciable effect on plant asset book value.
C. Have no appreciable effect on operating income reported by the investment
centers.
D. Usually understate ROI.
E. Usually overstate ROI.
19-3
13. The use of gross book value (GBV) for measuring the level of investment in
depreciable assets (for purposes of calculating return on investment, ROI) is preferred
by those who value the objectivity of:
A. An historical cost number.

B. The depreciation process.
C. Price-level adjusted data.
D. The cost-allocation process.
E. Current-cost information.
14. The use of replacement cost of assets for purposes of calculating return on
investment (ROI) has the advantage of:
A. Historical accuracy.
B. Being a relevant measure of the level of investment in a continuing business.
C. Objectivity.
D. Consistency with generally accepted accounting principles (GAAP).
E. Avoiding the need for developing estimates of current cost.
15. A primary limitation of return on investment (ROI) as a performance-evaluation

metric for investment centers is that ROI:
A. Is a long-term, not short-term, performance indicator.

B. Understates the level of "investment" for organizations operating in the so-called
knowledge-based economy.
C. Excludes the level of investment from the performance metric.
D. Cannot handle current-value estimates of assets.
E. Is not a relative performance indicator.
16. Return on investment (ROI) encourages business unitssuch as investment centers

to invest only in projects that earn:
A. A rate of return greater than borrowing costs.

B. An amount greater than the amount of EVA currently being generated.
C. A rate of return greater than the amount of residual income currently being
earned.
D. A rate of return less than the unit's current ROI.
E. A rate of return higher than the unit's current ROI.
19-4
17. Because residual income (RI) is a dollar amount, in contrast to a percentage (as is
return on investment, ROI), RI:
A. Allows, through different discount rates, adjustment for differing levels of risk
across investment centers within an organization.
B. Cannot be used to evaluate the financial performance of a given investment center
over time.
C. Is less useful than ROI for performance-evaluation purposes.
D. Allows for differing investment amounts for different investment centers.
E. Is less useful to stockholders of the company.
18. Since residual income (RI) is not a percentage, it is not very useful for:
A. Comparing business units of significantly different size.

B. Evaluating the performance of subunits with high ROIs.
C. Motivating goal-congruent behavior on the part of divisional managers.
D. Evaluating the short-term financial performance of small divisions.
E. Evaluating the short-term financial performance of larger divisions.
19. In contrast to residual income (RI), economic value added (EVA) uses in its
calculation:
A. The firm's cost of capital rather than its minimum rate of return.
B. A measure (or estimate) of economic, not accounting, income.
C. A required rate of return in estimating the amount of profit generated.
D. Values determined by using conventional accounting policies (i.e., GAAP).
E. Accounting, not economic, measures of income and investment.
20. Put simply, transfer pricing is a management tool for assigning a "price" to internally
transferred goods (or services) in order to simulate the marketplace, thus
encouraging mangers to make decisions that are in the best interest of the:
A. Operating managers.
B. Producing (i.e., selling) unit within the firm.
C. Firm as a whole.
D. Manager of the buying (i.e., purchasing) unit.
E. Operating units in the short run, and the firm in the long-run.
21. Because the full-cost method of transfer pricing includes fixed cost, it can:
A. Pass strict accounting requirements for determining transfer prices.

B. Pass current income tax requirements in the U.S. for determining transfer prices.
C. Establish consistency across state and national borders.
D. Violate OECD agreements.
E. Cause sub-optimal short-term decision making.
19-5
22. Use of the market-price method (when such prices exist) satisfies a key objective of
transfer pricing, namely:
A. Objectivity.
B. Selectivity.
C. Usability.
D. Transportability.
E. Reliability.
23. A key standard in international transfer pricing is:
A. Consistency.
B. Reliability.
C. The arm's-length standard.
D. Open marketability.
E. Translatability.
24. The biggest problem with cost-based transfer prices is:
A. The fact that their use may result in sub-optimal decisions from the standpoint of
the organization as a whole.
B. Too much negotiation is involved in determining the transfer price.
C. Data unavailability.
D. They are difficult to put into place.
E. They may lead to goal congruence within the firm.
25. If after-tax income of Grey Division, adjusted for economic value, is 15% of sales,
capital employed is $5,000,000 (adjusted for equity-equivalents), the divisional cost
of capital (discount rate) is 8%, and sales are $12,000,000, then Economic Value
Added (EVA) is:
A. $1,800,000
B. $400,000
C. $1,400,000
D. $3,200,000
E. Undeterminable given the information provided.
26. A measure of the manager's ability to control expenses and increase revenues to
improve profitability is:
A. Residual income (RI) divided by level of invested capital.

B. Return on equity (ROE).
C. Return on investment (ROI).
D. Return on sales (ROS).
E. Asset turnover (AT).
19-6
27. A measure of the manager's ability to produce increased sales from a given level of
investment is:

28. The historical cost of an asset less its accumulated depreciation is:
A. Net book value (NBV).

D. A rough measure of current replacement cost of the asset.
E. An estimate of liquidation value of the asset.
29. Replacement cost of a division's assets will most probably be greater than:
A. Gross book value (GBV) of the assets.

B. Historical cost of the assets.
C. Liquidation value of the assets.
D. Price-level adjusted cost of the assets.
E. Current cost of the assets.
30. Which one of the following is not a limitation shared by residual income (RI) and
return on investment (ROI) divisional performance measures?
A. They are both short-term performance indicators.

B. They both may fail to capture significant value-creating activities of the
organization.
C. They are both subject to short-term manipulation on the part of divisional
managers.
D. Both are subject to a number of measurement issues that complicate their use in
practice.
E. They both relate, in percentage terms, earnings to the level of investment in each
division.
31. The estimated cost to replicate assets of an investment center at the current level of
service and functionality of these assets is defined as:
A. Gross book value.

B. Historical cost, plus accumulated depreciation to date.
C. Liquidation value.
D. Replacement cost.
E. Price-level adjusted original cost.
19-7
32. The estimated price that could be received for the sale of divisional assets is referred
to as:
A. Gross book value (GBV), plus accumulated depreciation to date.

B. Gross book value (GBV).
C. Price-level adjusted cost.
E. Liquidation value.
33. A dollar amount equal to the operating income of a division less a charge for the level
of investment in the division is called:
A. Operating profit after tax.

B. Return on investment (ROI).
C. Earnings from continuing operations.
D. Return on equity (ROE).
E. Residual income (RI).
34. A division's after-tax cash operating income less depreciation and less an imputed
cost of capital is called its:
A. After-tax operating income.

B. Income from continuing operations.
C. Return on sales (ROS).
D. Economic value added (EVA).
35. Return on Investment (ROI), though widely used, is subject to which one of the
following limitations?
A. ROI cannot incorporate differences in risk across different divisions.

B. ROI ignores the amount of capital invested in a division.
C. ROI may not capture value-creation for firms operating in capital-intensive
industries.
D. ROI may motivate managers to take suboptimal decisions from the standpoint of
the organization as a whole.
E. ROI cannot be used to judge the performance of units of different size.
36. All of the following are possible transfer pricing methods used in practice except:
A. Market price.
B. Variable cost.
C. Fixed cost.
D. Full cost.
E. Negotiated price.
19-8
37. Which one of the following establishes an "arm's-length price" by using the sales
prices of similar products made by unrelated firms?
A. Wholesale-price method.
B. Retail-price method.
C. Related-products method.
D. Cost-plus method.
E. Comparable-price method.
38. Which one of the following transfer pricing alternatives is based on determining an
appropriate markup, where the markup is based on gross profits of unrelated firms
selling similar products?
B. Resale-price method.
C. Net-price method.
39. Which one of the following determines the transfer price based on the seller's costs,
plus a gross profit percentage determined from comparison of sales of the seller to
those of unrelated parties?
19-9
40. Consider the following data for three divisions of a company, X, Y, and Z:
Div
isio Y Z
X
nal
:
$ $ $
1, 9 4,
8 0 8
Sal 0 0 0
es 0, , 0,
0 0 0
0 0 0
0 0 0
1
Op 2 2
0
era 5 4
8
ting 2, 0,
,
Inc 0 0
0
om 0 0
0
e 0 0
0
Inv 5 3,
6
est 4 0
3
me 0 0
0,
nt , 0,
0
in 0 0
0
ass 0 0
0
ets 0 0
The return on investment (ROI) for Division X is:
A. 8.0%.
B. 12.0%.
C. 20.0%.
D. 25.0%.
E. 40.0%.
19-10
19-11
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
8 08
S
0 00
al
0,0
es
,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
es 0 00
t , ,0
m 0 00
19-12
e
nt ,
in 0 00
as 0 00
se 0
ts
The return on investment (ROI) for Division Y is:
A. 8.0%.
B. 12.0%.
C. 20.0%.
D. 25.0%.
E. 40.0%.
19-13
19-14
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
8 08
S
0 00
al
0,0
es
,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
es 0 00
t , ,0
m 0 00
19-15
e
nt ,
in 0 00
as 0 00
se 0
ts
The return on investment (ROI) for Division Z is:
A. 8.0%.
B. 12.0%.
C. 20.0%.
D. 25.0%.
E. 40.0%.
19-16
Div
isio Y Z
X
nal
:
$ $ $
1, 9 4,
8 0 8
Sal 0 0 0
es 0, , 0,
0 0 0
0 0 0
0 0 0
1
Op 2 2
0
era 5 4
8
ting 2, 0,
,
Inc 0 0
0
om 0 0
0
e 0 0
0
Inv 5 3,
6
est 4 0
3
me 0 0
0,
nt , 0,
0
in 0 0
0
ass 0 0
0
ets 0 0
The return on sales (ROS) for Division X is:
A. 5.0%.
B. 8.0%.
C. 12.0%.
D. 14.0%.
E. 20.0%.
19-17
19-18
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
8 08
S
0 00
al
0,0
es
,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
es 0 00
t , ,0
m 0 00
19-19
e
nt ,
in 0 00
as 0 00
se 0
ts
The return on sales (ROS) for Division Y is:
A. 5.0%.
B. 8.0%.
C. 12.0%.
D. 14.0%.
E. 20.0%.
19-20
19-21
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
8 08
S
0 00
al
0,0
es
,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
es 0 00
t , ,0
m 0 00
19-22
e
nt ,
in 0 00
as 0 00
se 0
ts
The return on sales (ROS) for Division Z is:
A. 5.0%.
B. 8.0%.
C. 12.0%.
D. 14.0%.
E. 20.0%.
19-23
Div
isio Y Z
X
nal
:
$ $ $
1, 9 4,
8 0 8
Sal 0 0 0
es 0, , 0,
0 0 0
0 0 0
0 0 0
1
Op 2 2
0
era 5 4
8
ting 2, 0,
,
Inc 0 0
0
om 0 0
0
e 0 0
0
Inv 5 3,
6
est 4 0
3
me 0 0
0,
nt , 0,
0
in 0 0
0
ass 0 0
0
ets 0 0
The asset turnover (AT) for Division X is (rounded):
A. 1.43.
B. 1.60.
C. 1.67.
D. 2.86.
E. 3.33.
19-24
19-25
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
8 08
S
0 00
al
0,0
es
,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
es 0 00
t , ,0
m 0 00
19-26
e
nt ,
in 0 00
as 0 00
se 0
ts
The asset turnover (AT) for Division Y is calculated to be (rounded):
A. 1.43.
B. 1.60.
C. 1.67.
D. 2.86.
E. 3.33.
19-27
19-28
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
8 08
S
0 00
al
0,0
es
,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
es 0 00
t , ,0
m 0 00
19-29
e
nt ,
in 0 00
as 0 00
se 0
ts
The asset turnover (AT) for Division Z is:
A. 1.43.
B. 1.60.
C. 1.67.
D. 2.86.
E. 3.33.
49. Consider the following data from two divisions of a company, P and Q:
Divisional
Sales
Operating Income
Investment
If the minimum rate of return is 11%, what is Division P's residual income (RI)?
A. $160,000.
B. $1,040,000.
C. $1,060,000.
D. $1,434,000.
E. $3,934,000.
19-30
Divisional
Sales
Operating Income
Investment
If the minimum rate of return is 11%, what is Division Q's residual income (RI)?
A. $147,500.
B. $490,000.
C. $752,000.
D. $950,000.
E. $1,049,500.
Divisional
Sales
Operating Income
Investment
If both divisions were presented with an opportunity to invest in a project that is
estimated to achieve an ROI of 15%, what will the units likely decide?
A. Division P will invest; Division Q will not invest.

B. Division P will invest; Division Q will be indifferent.
C. Division P will not invest; Division Q will invest.
D. Division P will be indifferent; Division Q will not invest.
E. Neither unit will invest in the projects.
19-31
52. Selected data from Chering Division's accounting records revealed the following:
$825,00
Sales
$440,00
Average investment
Net operating income $66,000

Minimum rate of return (divisional cost of
14%
capital)
Chering Division's return on investment (ROI) is:
A. 6.0%.
B. 8.0%.
C. 14.0%.
D. 15.0%.
E. 20.0%.
Sales $825,000
Average investment $440,000
Minimum rate of return (divisional cost of capital) 14%
Chering Division's return on sales (ROS) is:
A. 6.0%.
B. 8.0%.
C. 14.0%.
D. 15.0%.
E. 20.0%.
19-32
$825,00
Sales
$440,00
Average investment

14%
capital)
Chering Division's asset turnover (AT) is calculated to be:
A. 1.070.
B. 1.625.
C. 1.875.
D. 4.270.
E. 12.500.
$825,00
Sales
$440,00
Average investment

14%
capital)
Chering Division's residual income (RI) is:
A. $4,400.
B. $8,800.
C. $9,240.
D. $22,380.
E. $49,500.
19-33
$825,00
Sales
$440,00
Average investment

14%
capital)
If the minimum rate of return (i.e., cost of capital) was 13%, Chering Division's
residual income (RI) would calculate to be:
A. $4,400.
B. $8,800.
C. $9,240.
D. $22,380.
E. $49,500.
57. An investment center's return on investment (ROI) is affected by a change in:
Asset Turnover Return on Sales

(A) Yes
(B) Yes
(C) No
(D) No
(E) Yes Not likely
A. Option A
B. Option B
C. Option C
D. Option D
E. Option E
19-34
58. The return on investment (ROI) ratio measures:
A. The rate of return on average shareholders' equity.

B. Only earnings as a percent of sales.
C. The combined effect of both asset turnover (AT) and return on sales (ROS).
D. Asset turnover (AT) and earnings as a percent of sales, correcting for the effects of
differing depreciation methods.
E. Operating income less a charge for divisional investment (assets).
59. Return on investment (ROI) is a term often used to express income earned on capital
invested in a division (investment center). A division's ROI would increase if:
A. Sales increased by the same dollar amount as expenses and total assets
increased.
B. Sales remained the same and expenses were reduced by the same dollar amount
that total assets increased.
C. Sales decreased by the same dollar amount that expenses increased.
D. Sales and expenses increased by the same percentage that total assets increased.
E. Net profit margin on sales increased by the same percentage that total assets
increased.
60. Residual income (RI) is:
A. Contribution margin of an investment center, less the imputed interest on the

invested capital used by the center.
B. Operating income of an investment center divided by average total assets.
C. Another name for Economic Value Added (EVA)
D. Operating income of an investment center, less the imputed interest on the capital
used by the center.
E. Operating income of an investment center, plus the imputed interest on the capital
used by the center.
61. The following results pertain to an investment center.
Sales $1,500,000
Variable costs 800,000
Traceable fixed costs 100,000
Average investment 1,000,000
Divisional cost of capital (discount rate) 10%
How much is the residual income (RI) for this investment center?
A. $100,000.
B. $500,000.
C. $600,000.
D. $700,000.
E. $800,000.
19-35
Sales $1,500,000
How much is the return on investment (ROI) for this investment center?
A. 5%.
B. 50%.
C. 60%.
D. 70%.
E. 75%.
63. Residual income (RI) may be a better measure for performance evaluation of an
investment center than return on investment (ROI) is because:
A. Problems associated with measuring the asset base are eliminated.

B. Desirable investment decisions will not be discouraged by high-rate-of-return
divisions.
C. Only the gross book value (GBV) of assets needs to be calculated.
D. Returns do not increase as assets are depreciated.
E. The arguments over the appropriate discount rate to use in the calculations are
eliminated.
64. Given a competitive outside market for identical intermediate goods, what is
generally considered the best transfer price, assuming all relevant information is
readily available?
A. Average cost of production.

B. Average cost of production, plus average production department allocated profit.
C. Market price of the intermediate goods.
D. Market price of the intermediate goods, less average production department
allocated profit.
E. Full cost, plus a mark-up for profit.
65. Transfer prices based on actual costs of the selling division as opposed to standard
costs incurred by that division:
A. Are preferred by the purchasing division.

B. Mat fail to provide the selling division with an incentive to control costs.
C. Often encourage the selling division to control costs.
D. Are required by international financial reporting standards.
E. Often encourage the purchasing division to control costs.
19-36
66. The primary limitation of a full-cost based transfer pricing system is that:
A. The supplying and purchasing divisions are more likely to make decisions that are
inconsistent with the goals of the organization as a whole.
B. There will be little incentive on the part of the supplying manager to supply goods
and services efficiently.
C. Managers may spend too much time negotiating the transfer price.
D. Managers may find that the transfer price is difficult to compute.
E. Such transfer prices are not currently allowed for federal income tax purposes.
67. A company has two divisions, X and Y, each operated as an investment center. X
charges Y $55 per unit for each unit transferred to Y. Other data are:
Xs variable cost per unit $40

Xs fixed costs $100,000
Xs annual sales to Y 5,000 units
Xs sales to outsiders 10,000 units
X is planning to raise its transfer price to $65 per unit. Division Y can purchase units
at $50 each from outsiders, but doing so would idle X's facilities now committed to
producing units for Y. Division X cannot increase its sales to outsiders. From the
perspective of the short-term profit position of the company as a whole, from which
source should Division Y acquire the units?
A. Outside vendors.
B. Division X, but only at the variable cost per unit.
C. Division X, but only until fixed costs are covered, then should purchase from
outside vendors.
D. Division X, in spite of the increased transfer price.
E. It is not possible to tell without additional information.
68. Division A, which is operating at capacity, produces a component that it currently

sells in a competitive market for $25 per unit. At the current level of production, the
fixed cost of producing this component is $8 per unit and the variable cost is $10 per
unit. Division B would like to purchase this component from Division A. The price that
Division A should charge Division Y for this component is:
A. $10 per unit.

B. $18 per unit.
C. $20 per unit.
D. $25 per unit.
E. $35 per unit.
19-37
69. A company established a branch to sell automobile seat covers. The company
purchases these covers and stores them in a warehouse. The covers are then shipped
from the warehouse to both the home office and the new branch, FOB (Free On
Board) destination. Home office management is responsible for setting the transfer
price of the covers charged to the branch. Per-unit costs of the covers are:
$60.
purchase price
00
$2.5
shipping cost to warehouse
0
$3.0 handling cost, including $1 allocated
0 administrative overhead
$3.5
shipping cost to branch, paid by home office
0
According to the general transfer-pricing formula given in the text, the minimum
transfer price that home office should charge the branch is:
A. $62.50.
B. $63.50.
C. $66.00.
D. $68.00.
E. $69.00.
70. Selected data from Division A of Green Company are as follows:
Sales
Average investment
Operating income
Minimum rate of return
Division A's return on investment (ROI) is:
A. 1.8%.
B. 7.5%.
C. 12.0%.
D. 20.0%.
E. 48.0%.
19-38
Sales
Average investment
Operating income
Division A's return on sales (ROS) is:
A. 1.8%.
B. 7.5%.
C. 12.0%.
D. 20.0%.
E. 48.0%.
Sales
Average investment
Operating income
Division A's asset turnover (AT) is (rounded to two decimal places):
A. 0.72.
B. 1.00.
C. 1.58.
D. 1.67.
E. 2.08.
Sales
Average investment
Operating income
Division A's residual income (RI) is:
A. $15,000.
B. $24,000.
C. $30,000.
D. $36,000.
E. $54,000.
19-39
Sales
Average investment
Operating income
If the minimum rate of return was 10%, Division A's residual income (RI) would be:
A. $15,000.
B. $24,000.
C. $30,000.
D. $36,000.
E. $45,000.
75. In the context of transfer pricing, dual pricing is:
A. Never used when numerous conflicts exist between two units.

B. The simultaneous use of two or more transfer pricing methods.
C. The use of two or more transfer pricing methods by the buyer only.
D. Not recommended because of negative behavioral consequences.
E. Not recommended because it conflicts with current income tax requirements.
76. Expropriation occurs when the government in which a foreign company's investment
assets are located:
A. Takes ownership and control of those assets.

B. Charges additional taxes for the use of those assets.
C. Uses domestic currency to purchase those assets.
D. Uses foreign currency to purchase those assets.
E. Does not allow transnational transfers of currency.
77. One advantage of the return on investment (ROI) metric is that it:
A. Can use the minimum rate of return to adjust for differences in risk.
B. Can use a different minimum rate of return for different types of assets.
C. Eliminates goal congruency problems, particularly for better-performing divisions.
D. Requires disclosure under current international financial reporting standards.
E. Can be compared to interest rates and to rates of return on alternative
investments.
19-40
78. One approach to measuring the short-term financial performance of a business unit
considered an investment center is return on investment (ROI). ROI is expressed as
operating income of the investment center:
A. Divided by the current year's capital expenditures plus cost of capital.

B. Minus imputed interest charged for the use of invested capital by the investment
center.
C. Divided by fixed assets.
D. Divided by total assets used by the investment center.
E. Minus the asset turnover (AT) of the investment center.
79. The two approaches for estimating Economic Value Added (EVA) are:
A. The operating approach and the capital approach.

B. The financing approach and the operating approach.
C. The discounted approach and the financing approach.
D. The operating approach and the discounted approach.
E. The residual income approach and the operating-income approach.
80. A fully-owned subsidiary of a multinational company reports its return on investment

(ROI) periodically during the year. This unit of the company, for performance-
evaluation purposes, is likely considered a(n):
A. Profit center.
B. Revenue center.
C. Cost center.
D. Operating center.
E. Investment center.
81. A primary goal of transfer pricing is to:
A. Agree on a price for external sales.

B. Obtain a high transfer price for the purchasing unit.
C. Obtain a high transfer price for the selling unit.
D. Motivate decision-makers to act in the best interests of the organization.
E. Minimize recordkeeping costs.
82. All of the following are true of market-based transfer prices except:
A. They generally motivate the correct economic decision.

B. They can be determined for all goods and services transferred internally.
C. They may lead to goods and services purchased externally by the purchasing unit.
D. To the extent they exist, they are objective.
E. They provide an independent valuation for internal transfers.
19-41
83. All of the following are true of cost-based transfer prices except:
A. They generally promote optimal decision-making from the standpoint of the

organization as a whole.
B. They may be based either on actual costs or standard (i.e., budgeted) costs.
C. Their use may not provide proper motivation for cost control on the part of the
producing division.
D. They may not provide proper guidance when opportunity costs exist.
E. Generally speaking, such cost data are readily available.
84. The greatest advantage of using a negotiated transfer price is:
A. It is generally the most efficient method of determining transfer prices.

B. This may be the most practical approach when conflicts exist between selling and
buying divisions.
C. The method produces transfer prices that are acceptable under international
financial reporting standards.
D. Tax problems are avoided because the method is considered "arm's-length."
E. It is required for federal income tax purposes.
85. The most likely result of using a negotiated transfer price is that:
A. The resulting decision reflects purely economic considerations.

B. More than the optimum number of units will be transferred between divisions.
C. Fewer than the optimum number of units will be transferred between divisions.
D. It takes away from the buying and selling units the ultimate responsibility for
determining the transfer price.
E. The end result might reflect the relative bargaining skills of the negotiating
managers.
86. All of the following represent a way of calculating ROI (return on investment) for a
division except:
A. (Operating income sales) (sales investment).

B. Operating income divisional investment.
C. Return on sales (ROS) Inventory turnover.
D. Operating income divisional assets.
87. The primary limitation of using Economic Value Added (EVA) to evaluate the
financial performance of investment centers is:
A. Complexity of the calculation.

B. Dysfunctional long-term investment decisions that can be motivated by focusing
on EVA.
C. Failure to include a measure of invested capital.
D. Inability to use EVA to benchmark against competitor organizations.
E. Inability to align managerial incentives with ownership interests.
19-42
88. EVA (economic value added):
A. Is another name for return on investment (ROI).

B. Is generally synonymous with residual income (RI).
C. Encourages investment center managers to accept new investments that have an
ROI greater than the existing ROI of the center.
D. Of $100,000 for an investment center indicates that the investment center earned
$100,000 of after-tax profit for the company as a whole.
E. Of $100,000 for an investment center indicates that the invest center's economic
profit for the period was $100,000.
89. Which of the following specifications for calculating EVA is correct?
A. EVA = accounting income investment.

B. EVA = economic profit equity equivalents.
C. EVA = NOPAT investment, where NOPAT = net operating profit after (cash)
taxes.
D. EVA = NOPAT - Imputed charge on EVA capital, where NOPAT = net operating
profit after (cash) taxes.
E. EVA = reported operating profit, after tax - imputed charge on average
investment in the subunit.
90. Which of the following statements regarding the calculation of Economic Value Added
(EVA) is not true?
A. Adjusted accounting data are used to estimate EVA.

B. The operating approach and the financing approach lead to identical estimates of
EVA.
C. EVA NOPAT represents after-tax cash operating income, after depreciation.
D. EVA NOPAT represents after-tax cash operating income, before depreciation.
E. The divisional cost of capital (minimum rate of return) is used to impute a charge
on capital invested in the division during the period.
91. A segment of an organization is referred to as an investment center if it has:
A. Authority to make decisions affecting the major determinants of profit, including

the power to choose its markets and sources of supply.
B. Authority to make decisions affecting the major determinants of profit, including
the power to choose its markets and sources of supply and significant control over
the amount of invested capital.
C. Authority to make decisions over the most significant costs of operations, including
the power to choose sources of supply.
D. Authority to provide specialized support to other units within the organization.
E. Responsibility for developing markets for and selling the output of the
organization.
19-43
92. A company currently earning a profit can increase its return on investment (ROI) by:
A. Increasing sales revenue and operating expenses by the same dollar amount.
B. Decreasing sales revenues and operating expenses by the same percentage.
C. Increasing investment and operating expenses by the same dollar amount.
D. Increasing sales revenues and operating expenses by the same percentage.
E. Decreasing investment and sales by the same percentage.
93. Which one of the following statements pertaining to the return on investment (ROI)
as a performance measure is incorrect?
A. When average age of assets differs substantially across segments of a business,

the use of ROI may not be appropriate.
B. ROI relies on financial measures that are capable of being independently verified
while other forms of performance measures are subject to manipulation.
C. The use of ROI may lead managers to reject capital investment projects that can
be justified using discounted cash flow (DCF) decision models.
D. The use of ROI can make it undesirable for a skillful manager to take on trouble-
shooting assignments such as those involving turning around unprofitable
divisions.
E. The use of ROI can lead managers to emphasize the ROI of a division over the
profitability of the parent organization.
94. The basic objective of the residual income (RI) approach to performance
measurement of a business unit considered an investment center is to have the
investment center maximize its:
A. Return on investment.
B. Imputed interest rate charge.
C. Cash flows.
D. Cash flows in excess of a desired minimum amount.
E. Operating income in excess of a desired minimum dollar return.
95. Under the notion of controllability, it is appropriate to evaluate the profitability of

each investment center based on each center's:
A. Operating income before tax.

B. Operating income after tax.
D. Profit earned in relation to the amount of capital invested in the subunit.
E. Return on equity (ROE).
19-44
96. Compared to return on investment (ROI), residual income (RI) may be a better
measure of the financial performance of an investment center because:
A. Problems associated with measuring the investment base are eliminated.

B. Of the fact that desirable investment opportunities will not be neglected by
divisions currently earning high rates of return.
C. Only the gross book value of assets needs to be calculated.
E. The arguments over the implicit cost of capital (discount rate) are largely
eliminated.
97. A primary characteristic of a negotiated transfer price is that it:
A. Takes away the ultimate responsibility of the resulting transfer price from the two
parties.
B. Decreases sub-unit (i.e., divisional) autonomy.
C. Can be costly and time-consuming to implement.
D. Generally results in transferring more than the optimum number of units between
the buying and selling divisions of the organization.
E. Provides performance indicators that are independent of the negotiating skills of
divisional managers.
98. Return on investment (ROI) can be directly increased by:
A. Increasing sales.
B. Increasing the minimum desired rate of return (i.e., divisional cost of capital).
C. Decreasing operating assets.
D. Decreasing operating income.
E. Decreasing asset turnover (AT).
99. The major criticism of using return on investment (ROI) for evaluating the financial
performance of business units considered investment centers is that ROI:
A. Gives managers of profitable business units an incentive to reject some projects

that would benefit the organization as a whole.
B. Is not easily understood by managers.
C. Usually uses a blended rate of capital as the required rate of return.
D. Has a long-term (strategic) focus and therefore is not useful in terms of evaluating
short-term performance.
E. Favors large units (investment centers).
19-45
100 Assume that an organization's weighted-average cost of capital (minimum rate of
. return) is 8% and that Division A currently has a 12% return on investment (ROI). The
manager of Department A, who is evaluated on the basis of divisional ROI, would
most likely accept an investment that is expected to return:
A. More than 8%.

B. More than 12%.
C. More than 8% but less than 12%.
D. Less than 12%.
E. Impossible to tell without further information.
101 Economic value added (EVA) for a division:

.
A. Encourages divisional mangers to accept only new capital projects (i.e., long-term
investments) with a return on investment (ROI) that exceeds the current ROI.
B. Of $50,000 indicates that the division earned $50,000 for the company.
C. Of $10,000 indicates that the division's actual earnings (adjusted for bias effects of
accounting conservatism) exceed the division's imputed capital charge by
$10,000.
D. Is considered appropriate for evaluating the financial performance of profit but not
investment centers.
E. Has the added benefit of being usable for income tax determination purposes.
102 An appropriate transfer price between two divisions of The Stark Company can be
. determined from the following data:
Fabricating Division:
Market price of the subassembly
Variable cost of the subassembly
Excess capacity (in units)
Assembly Division:
Number of units needed
What is the natural bargaining range for the two divisions?
A. Between $20 and $50.

B. Between $50 and $70.
C. Any amount less than $50.
D. $50 is the only acceptable price.
E. $20 is the only acceptable price.
19-46
103 Decentralized firms can delegate authority and yet retain control and monitor
. managers' performances by structuring the organization into so-called "responsibility
centers." Which one of the following business segments/responsibility centers is most
like an independent business?
A. Revenue center.
B. Profit center.
C. Cost center.
D. Profit and loss center.
104 Which one of the following statements pertaining to the return on investment (ROI)
. as a divisional performance measure is incorrect?
A. When the average age of assets differs substantially across divisions of a business
the use of ROI may not be appropriate.
B. ROI relies on financial measures that are capable of being independently verified
while other forms of performance measures are subject to manipulation.
C. The use of ROI may lead managers to reject capital investment projects that can
be justified using discounted cash flow (DCF) models.
divisions.
E. The use of ROI can lead managers to emphasize the ROI of his/her division over
the profitability of the organization as a whole.
105 Managerial performance can be measured in various ways, including return on

. investment (ROI) and residual income (RI). A good reason for using RI rather than ROI
is:
A. RI can be computed without regard to identifying an investment base.

B. Goal congruence is more likely to be promoted by using RI.
C. RI is well understood and often used and discussed in the financial press.
D. ROI does not take into consideration both the asset turnover (AT) ratio and the
return-on-sales (ROS) percentage.
E. An imputed interest rate (minimum rate of return) does not have to be specified.
106 Return on investment (ROI), residual income (RI), and Economic Value Added (EVA)
. all have in common which one of the following characteristics?
A. They all lead to goal-congruency problems when used to evaluate subunit

performance.
B. They all incorporate nonfinancial performance measures into the metric.
C. They all rely on the use of data used in the preparation of financial statements (for
external reporting).
D. They are all relative (rather than absolute) performance indicators.
E. They all incorporate in the financial performance metric some measure of
investment.
19-47
107 The basic objective of the residual income (RI) approach to divisional performance
. measurement and evaluation is to have a division maximize its:
A. Return on investment (ROI) rate.

C. Cash flows, after taxes.
E. Operating income in excess of an imputed charge for capital invested in the
division.
108 Which of the following items would most likely not be incorporated into the
. calculation of a division's investment base when using the residual income (RI) or the
return on investment (ROI) approach for performance measurement and evaluation?
A. Fixed assets used in divisional operations.

B. Land being held by the division as a site for a new plant in the future.
C. Division inventories when division management exercises control over the
inventory levels.
D. Division accounts payable when division management exercises control over the
amount of short-term credit utilized.
E. Division accounts receivable with division management exercises control over
credit policy and credit terms.
109 Which of the following is a true about return on investment (ROI)?

.
A. It is generally used to evaluate the short-term financial performance of profit

centers.
B. Its use can motivate suboptimal decision making on the part of subunit managers.
C. It is defined as the difference between some measure of "profit" and an imputed
charge for use of assets by the subunit whose performance is being evaluated.
D. When inflation is low, it approximates the amount of economic income that a
subunit generates.
E. It generally cannot be used to compare the financial performance of one unit in an
organization to other units in that organization.
110 Residual income (RI) may be a better measure for performance evaluation of an
. investment center manager than is the return on investment (ROI) metric because:

B. Desirable investment decisions will not likely be neglected by high-return divisions
of the company.
E. Arguments over the implicit cost of capital are eliminated.
19-48
111 Which of the following is not a criticism of using return on investment (ROI) for
. divisional performance evaluation?
A. ROI may not capture and reflect value creation in the "new economy."
B. ROI does not take into consideration the amount of capital invested in the division
whose performance is being evaluated.
C. The ROI metric has a short-term focus/orientation.
D. ROI fails to capture broader elements of "performance," beyond financial
performance.
E. There is a disconnect between models used for the analysis of long-term capital
investment projects and subsequent evaluation of the financial results of those
projects using ROI.
112 Listed below is selected financial information for the Western Division of the Henzel
. Company for last year:
Account Amount (thousands)

Average working capital $625
General and administrative expenses 75
Net sales 4,000
Average plant and equipment 1,775
Cost of goods sold 3,525
If Henzel treats the Western Division as an investment center for performance

evaluation purposes, what is the before-tax return on investment (ROI) for last year?
(Round your answer to two decimal places.)
A. 34.68%.
B. 26.76%.
C. 22.54%.
D. 19.79%.
E. 16.67%.
19-49
113 James Webb is the general manager of the Industrial Product Division, and his
. performance is measured using the residual income (RI) method. Webb is reviewing
the followed forecasted information for his division for the coming year:
Category Amount (thousands)

Current assets (e.g., inventory) $1,800
Revenue 30,000
Plant and equipment (net book value) 17,200
If the imputed interest charge (i.e., divisional cost of capital) is 15% and Webb wants
to achieve an RI target of $2 million, what will costs have to be in order to achieve
the target?
A. $9,000,000.
B. $10,800,000.
C. $23,620,000.
D. $25,150,000.
E. $25,690,000.
19-50
114 Parkside Inc. has three divisions (Entertainment, Plastics, and Video Card), each of
. which is considered an investment center for performance-evaluation purposes. The
Entertainment Division manufactures video arcade equipment using products
produced by the other two divisions, as follows:
1. The Entertainment Division purchases plastic components from the Plastics

Division that are considered unique (i.e., they are made exclusively for the
Entertainment Division). In addition, the Plastics Division makes less-complex plastic
components that it sells externally, to other producers.
2. The Entertainment Division purchases, for each unit it produces, a video card from
Parkside's Video Card Division, which also sells this video card externally (to other
producers).
The per-unit manufacturing costs associated with each of the above two items, as
incurred by the Plastic Components Division and the Video Card Division,
respectively, are:
19-51
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19-52
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The Plastics Division sells its commercial products at full cost plus a 25% markup
and believes the proprietary plastic component made for the Entertainment Division
would sell for $6.25/unit on the open market. The market price of the video card used
by the Entertainment Division is $10.98/unit. A per-unit transfer price from the Video
Cards Division to the Entertainment Division at full cost, $9.15, would:
A. Allow evaluation of both divisions on a competitive basis.

B. Satisfy the Video Cards Division profit desire by allowing recovery of opportunity
costs.
C. Demotivate the Entertainment Division and cause mediocre performance.
D. Provide no profit incentive for the Video Cards Division to control or reduce costs.
E. Encourage the Entertainment Division to purchase video cards from an outside
source.
19-53

producers).
respectively, are:
19-54
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19-55
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c
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t
Assume that the Entertainment Division is able to purchase a large quantity of video
cards from an outside source at $8.70/unit. The Video Cards Division, having excess
capacity, agrees to lower its transfer price to $8.70/unit. This action would likely:
A. Optimize the profit goals of the Entertainment Division while subverting the profit
goals of Parkside Inc.
B. Allow evaluation of both divisions on the same basis.
C. Subvert the profit goals of the Video Cards Division while optimizing the profit
goals of the Entertainment Division.
D. Cause mediocre behavior in the Video Cards Division as lost opportunity costs
increase.
E. Optimize the overall profit goals of Parkside Inc.
19-56

producers).
respectively, are:
19-57
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19-58
d
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c
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t
Assume that the Plastics Division has excess capacity and it has negotiated a
transfer price of $5.60 per plastic component with the Entertainment Division. This
price will likely:
A. Cause the Plastics Division to reduce the number of commercial plastic

components it manufactures.
B. Motivate both divisions because estimated profits will be shared.
C. Encourage the Entertainment Division to seek an outside source for plastic
components.
D. Demotivate the Plastics Division, causing mediocre performance.
E. Motivate the Plastics Division to increase the portion of its manufacturing devoted
to the Entertainment Division.
Essay Questions
19-59
117 Alice and Jon Harrison operate two full-service dry cleaning outlets in the St. Louis
. metropolitan area. One of the outlets generates over $800,000 revenue per year and
has more than a million dollar investment in state-of-the-art equipment. The other
outlet is older, generates $20,000 revenue per month, and has 20-25 year-old
equipment currently worth approximately $85,000. Both outlets are profitable with
growing market bases. (The ratio between operating income and sales for each unit,
based on historical-cost accounting numbers, is roughly the same.) Managers at each
location are currently paid a base salary, and receive a year-end bonus which is five
percent of total operating profit produced by both outlets combined. Alice has just
finished a workshop on investment center performance evaluation, and wants to
change the evaluation and reward structure, hoping to motivate the two managers to
produce greater revenue and profit.
Required:
What type of evaluation mechanisms should she propose for the two managers?
118 Ellie Jackson is upset by the new transfer pricing system recently implemented at
. Monson Company. As manager of the first of three sequential production
departments, she can't see the value of a transfer pricing system for her
department. "We can't sell what we produce to any outside buyer. And we're never
pushed for capacity, so I don't think transfer pricing will do anything but make my life
more complicated." You are Ellie's boss.
Required:
Explain how transfer pricing can help Ellie evaluate her department's operations and
allow you to more effectively evaluate her management abilities.
19-60
119 Consider the following data for three divisions of a company, X, Y, and Z:
.
Divisional X Y Z
Sales $2,200,000 $1,100,000 $5,800,000
Operating income 330,000 143,000 580,000
Investment (assets) 750,000 572,000 2,900,000
Required:
Calculate return on investment (ROI), return on sales (ROS), and asset turnover (AT)
for each division. Round your answers to two decimal places where appropriate.
120 Selected data from an investment center's accounting records reveal the following:
.
Sales $700,000
Operating income $50,000
Minimum rate of return 12%
Required:
1. Calculate return on investment (ROI) for this investment center (show separately
the two major components of the ROI calculation). Round all computations to two
decimal places.
2. Calculate residual income (RI) for this investment center.
19-61
121 Accounting records from Division A, Alpha Manufacturing Company indicate the
. following:
$1,5
Divisional
00,0
Sales
00
$1,0
Average
00,0
Investment
00
Divisional $16
operating 9,50
income 0
Minimum
Rate of 14%
Return
Required:
1. Compute the return on sales (ROS) for Division A. (Round answer to one decimal
point.)
2. Compute the asset turnover (AT) for Division A.
3. Compute return on investment (ROI) for this division, using answers to parts (1)
and (2). (Round answer to two decimal points.)
4. Compute residual income (RI) for Division A.
5. Describe how Alpha Manufacturing would determine whether or not to invest in
any particular project in the future.
19-62
122 When the Bronx Company formed three divisions a year ago, the president told the
. division managers an annual bonus would be given to the most profitable division.
The bonus would be based on either the return on investment (ROI) or residual
income (RI) of the division. Investment, for both calculations, is to be measured using
either gross book value (GBV) or net book value (NBV) of divisional assets. The
following data are available:
Divisio Gross Book Value Operating

n (GBV) Income
A $500,000 $53,500
B $480,000 $52,000
C $300,000 $33,300
All the assets are long-lived assets that were purchased 15 years ago and have 15
years of useful life remaining. A zero terminal (disposal) value is predicted. Bronx's
minimum rate of return (cost of capital) used for computing RI, for all three divisions,
is 10%.
Required:
Which method for computing profitability would each manager likely choose? Show
supporting calculations. Round percentage answers to 2 decimal places (e.g.,
0.12344 = 12.34%). Where applicable, assume straight-line depreciation.
19-63
123 T-shirts R Us Inc. operates two divisions that each manufactures t-shirts for
. universities. Each division has its own manufacturing facility. The historical-cost
accounting system reports the following financial data for 2016.
Atlantic Coast Division

Condensed Income Statement Data
(000s)
Revenues $600
Operating Costs 470
Operating Income $130
Big-10 Division
(000s)
Revenues $600
Operating Costs 400
T-shirts R Us Inc. estimates the useful life of each manufacturing facility to be 15
years. The company uses straight line depreciation, with a depreciation charge of
$70,000 per year for each division and no salvage value at the end of 15 years. The
manufacturing facility is the only long-lived asset of either division. Current assets
are $300,000 in each division. At the end of 2016 the Atlantic Coast Division is 4
years old and the Big-10 Division is 6 years old. An index of construction costs,
replacement cost, and liquidation values for manufacturing facilities used in the
production of t-shirts for the 7-year period that T-shirts R Us Inc. has been operating,
are as follows:
19-64
Liquidation Value
Replacement Atlantic
Year Cost Index Cost Coast
2010 80 $1,000,000 $800,000
2011 82 1,000,000 800,000
2012 84 1,100,000 700,000
2013 89 1,150,000 700,000
2014 94 1,200,000 800,000
2015 96 1,250,000 900,000
2016 100 1,300,000 1,000,000
Required:
Round answers to 2 decimal places where appropriate.
1. Compute return on investment (ROI) for each division using net book value (NBV).
Interpret the results.
2. Compute return on investment (ROI) for each division, incorporating current-cost
estimates as follows, using:
(a) Gross book values (GBV) under historical cost;

(b) GBV at historical cost restated to current cost using the index of construction
costs;
(c) NBV of long-lived assets restated at current cost using the index of construction
costs (the facility was constructed the year before the first year of use);
(d) Current replacement cost; and
(e) Current liquidation value.
3. Which of the measures calculated in (2) above would you choose for (a)
performance evaluation of each division manager, and (b) deciding which division is
most profitable for the overall firm? What are the strategic advantages and
disadvantages to the firm of each measure for both (a) and (b)?
19-65
124 Domi Products, a multi-divisional manufacturing company, measures performance
. and awards bonuses to division managers based upon divisional operating income.
Under the current bonus plan, common company-wide operating expenses are
allocated evenly to all five of its divisions. For example, if rent were $50,000, each
division would be charged $10,000. In planning next year's budget, corporate
management has requested that the division managers recommend how common
expenses should be distributed to the divisions. The division managers met and
jointly developed an incentive plan that would more equitably distribute common
expenses on the basis of resources used and that would measure each division
manager's performance based on return on assets (ROI), with divisional bonuses
based on a target ROI. They jointly presented their recommendation to corporate
management.
Required:
1. Describe at least three problems that Domi Products could encounter when using
return on investment (ROI) as the basis of performance measurement.
2a. Define the residual income (RI) approach to segment performance
measurement.
2b. Determine if Domi Products should implement this approach instead of the ROI
approach.
3. Discuss the behavioral implications of the division managers' involvement in the
corporate budgeting process, and the decision to more equitably allocate common
costs.
19-66
12 Eikelberry, Inc. has the following financial results for 2016 for its three regional
5. divisions:
Gross
Net Book Replacem
Book
Region Income Value
Value
FINANCIAL
DATA
North Atlantic $45,000 $225,000 $450,600
Mid Atlantic 33,000 289,000 310,000
South Atlantic 22,000 115,000 166,000
Required:
Calculate return on investment (ROI), asset turnover (AT), and return on sales (ROS)
for each of the three divisions for 2016. The sales in the North, Mid and South Atlantic
regions are $2,350,000, $1,450,000, and $500,000, respectively. Calculate ROI and
asset turnover (AT) for each of the four measures of investment (i.e., for each of four
possible denominators in determining ROI and AT). Round all answers except ROI to 2
decimal places, e.g., round 0.12487 to 12.49%. Round ROI to whole percentage
amounts, e.g., 0.1998 to 20%.
19-67
126 Edwards Inc. manufactures electronics. It consists of several divisions classified as
. investment centers for performance-evaluation purposes. Division A desires to
purchase materials from Division B at a price of $85 per unit. Division B can produce
25,000 units at full capacity, and is currently operating at 90% capacity with a
variable cost of $80 per unit. Division B currently sells only to outside customers who
pay $115 per unit. Division A pays an outside company $110 per unit. If purchased
from Division B, B's variable costs per unit would be $10 less because the division
would save on marketing expenses for these internal transfers. Division A requires
10,000 units.
Required:
1. How would Division B selling to Division A affect Division A's purchasing costs?
2. How would intercompany sales affect Division B?
3. What solution would be best for Edwards Inc., assuming Division B has the ability
to operate at full capacity?
19-68
127 Max Ltd. produces kitchen tools, and operates several divisions as investment
. centers. Division M produces a product that it sells to other companies for $16 per
unit. It is currently operating at its full capacity of 45,000 units per year. Variable
manufacturing cost is $9 per unit, and variable marketing cost is $3 per unit. The
company wishes to create a new division, Division N, to produce an innovative new
tool that requires the use of Division B's product (or one very similar). Division N will
produce 30,000 units per year. Currently, Division N can purchase a product
equivalent to Division M's from Company X for $15 per unit. However, Max Ltd. is
considering transferring the necessary product from Division M.
Required:
1. Assume the transfer price is $12 per unit:
a. How would this price affect the purchasing costs of Division N?

b. How would this price affect the profits of Division M?
c. How would this price affect Max Ltd. as a whole?
2. What if the transfer price was $13 per unit?
19-69
128 Pearl Inc. has the following financial results for 2016 for its three regional divisions:
.
Historical Cost Estimated Current Cos
Operating Income Replacement Co

Region NBV GBV
Northeast $50,000 $100,000 $150,000
Midwest $80,000 $300,000 $400,000
Southeast $90,000 $400,000 $500,000
Required:
for each division for 2016. The sales in the Northeast, Midwest, and Southeast
regions are $700,000, $800,000, and $990,000, respectively. Calculate ROI and AT
for each of the four measures of investment (i.e., NBV (net book value), GBV (gross
book value), Replacement Cost, and Liquidation Value). Round all answers except ROI
to 2 decimal places (e.g., 0.12522 becomes 12.52%); round ROI to whole percentage
amounts, e.g., 0.1998 becomes 20%.
19-70
129 Selected data from one of the investment centers from Jones Company are as
. follows:
Sales
Average divisional assets
Divisional operating income
Required:
1. Calculate return on investment (ROI), including each of the two component

measures of ROI.
2. Calculate residual income (RI).
130 Brown's Mill has two operating units, each of which is considered an investment
. center for evaluation purposes. The Cutting Division of the mill prepares timber at its
sawmills. Afterwards, the Assembly Division prepares the cut lumber into finished
wood, to be sold to furniture manufacturers. During the most recent year, the Cutting
Division produced 120,000 cords of wood, at a total cost of $1,320,000. The entire
output was transferred to the Assembly Division, where additional costs of $6 per
cord were incurred. The 1,200,000 board-feet of finished wood were then sold in the
open market for $5,000,000.
Required:
1. Determine the operating income for each division if the transfer price from the
Cutting Division to the Assembly Division is set at full production cost, $11 per cord.
2. Determine the operating income for each division if the transfer price is set at $9
per cord.
3. Since the Cutting Division sells all of its output internally, does the manager care
about what price is charged? Why? Should the Cutting Division in this case be
considered a cost center or a(n) profit/investment center?
19-71
131 Simmons Bedding Company manufactures an array of bedding-related products,
. including pillows. The Cover Division of Simmons makes covers, while the Assembly
Division of the company produces finished pillows. The covers can be sold separately
for $10.00 a piece, while the pillows sell for $12.00 per unit. For performance-
evaluation purposes, these two divisions are treated as investment centers. Financial
results from the most recent accounting period are as follows:
Assembl
Cover
y
Division
Division
$6,000,0 $1,500,0
Traceable manufacturing costs
00 00
$4,000,0 $7,200,0
External sales
00 00
Market value of output transferred from Cover Division to the

$6,000,0
Assembly Division
00
Required:
1. What is the operating income for each of the two divisions and for the company
as a whole? (Use market value as the transfer price.)
2. Do you think each of the two divisional managers is happy with this transfer-
pricing method? Explain.
19-72
132 The manager of the processing division of XYZ Corporation is considering the
. purchase of new equipment, which would modernize an aging plant. Currently, the
division has an asset base of $8,000,000 and net operating income of $1,200,000.
The new equipment is expected to cost $1,000,000; it supports the corporate
strategy of competing on the basis of quality and customer response time (CRT). The
new investment is also expected to increase operating income by $100,000 next
year, which is an acceptable return on investment (ROI) from the standpoint of
corporate management.
Required:
1. What is the current ROI for the processing division of XYZ Corporation? (Show
calculations.)
2. What will be the divisional ROI if the new investment is undertaken?
3. Suppose that the compensation contract for the manager of the processing
division consists of a base salary plus a bonus that is proportional to the ROI earned
by the division. Is this manager's total compensation higher with or without the new
investment? (Show calculations.)
4. What changes to the divisional manager's compensation contract might corporate
management make that would better align divisional manager's compensation (and
performance evaluation) with overall corporate goals?
133 The following questions pertain to the process of transfer pricing.

.
1. Define the term "transfer price."
2. What the three general alternatives for setting domestic transfer prices?
3. What is meant by the term "dual pricing," as used within the context of the
transfer pricing decision? Give one example of "dual pricing."
4. What criteria can be used to judge a particular transfer pricing alternative? (Hint:
think about the different objectives of transfer pricing, including objectives in an
international setting.)
5. What is meant by the term "advance pricing agreement" (APA)? What is the
essential purpose of an APA?
19-73
134 The text presents what it calls a "general transfer-pricing" rule that can be used to
. help set an appropriate transfer price. The following questions pertain to this general
rule.
Required:
1. Present, in equation form, the general transfer-pricing rule presented in the

chapter. Briefly describe the elements of the model.
2. In what sense is the model presented in the chapter a general transfer-pricing
rule?
3. Evaluate the general transfer-pricing rule in light of the objectives for transfer
pricing that are presented in the chapter.
4. What are some of the major implementation issues associated with applying the
general transfer-pricing rule in practice?
135 What special problems and opportunities arise in setting transfer prices in an
. international setting (i.e., for transfers between subunits that operate in different
countries)? Hint: In terms of special problems, make sure you reference OECD
requirements and practical implementation alternatives for general OECD
requirements.)
136 What are the principal advantages and disadvantages of using cost-based transfer
. prices? (Give a short explanation of each item you list.)
19-74
137 The text notes that there are various objectives of transfer pricing. This raises the
. possibility of using multiple transfer pricing alternatives. For example, an
organization could use one transfer pricing alternative for domestic transfers and
another alternative for transnational transfers.
Required:
1. Provide a reason why an organization might choose a particular transfer pricing

alternative for domestic transfers and a different transfer pricing alternative for
international transfers.
2. Provide a reason why an organization may not want to use two different transfer
pricing systems, one for domestic transfers and another for international transfers.
138 As noted in the text (Chapter 19), the use of market price can be used to set the
. transfer price associated with interdivisional transfers of goods and services.
Required:
1. What are the primary advantages of using market price as the transfer price?
2. What are the primary disadvantages of using market price as the transfer price?
19-75
139 Assume the following facts regarding a product that Division P can sell internally (to
. Division B) or externally on the open market. Incremental (i.e., out-of-pocket) cost to
Division P for each unit produced = $12. External purchase price, to be paid by
Division B = $13.50. Total units needed (annually) by Division B = 1,000.
Required:
1. Assume that there are no alternative uses for Division P's facilities. Determine
whether the company as a whole will benefit if Division B purchases the product
externally. At what amount should the transfer price be set such that each divisional
manager, acting in the best interest of his or her own division, take actions that are
in the best interest of the company as a whole?
2. Assume that Division P's facilities would not otherwise be idle if it didn't produce
the product for Division B. By not producing the product for Division B, the freed-up
facilities would be used to generate a net cash benefit of $1,800. Should Division B
purchase from suppliers? (Show calculations.)
3. Assume that for the foreseeable future there are no alternative uses for Division
P's facilities, and that the outside supplier's cost to Division B drops by $2. Under this
circumstance, should Division B purchase externally? At what amount should the
transfer price be set such that each divisional manager, acting in the best interest of
his or her division, would take actions that are in the best interest of the company as
a whole?
19-76
140 Assume two divisions, P (producing) and B (buying) of a company are both treated as
. investment centers for performance-evaluation purposes. Division B requires 1,000
units of product that it can either purchase externally on the open market for $13.50
per unit, or obtain internally from Division P. The incremental (i.e., out-of-pocket)
costs to Division P are estimated at $12.00 per unit. Because of spot shortages of
this product in the open market, it is sometimes possible for Division P to sell at a
price higher than the normal market price. Such is currently the case: Division P has
an offer to sell 1,000 units at a gross selling price of $15.50 per unit. In addition to
the normal incremental production costs, Division P would have to pay a $0.50 sales
commission cost for each unit sold externally.
Required:
1. If Division B purchased the units externally, would the firm as a whole benefit or
lose (in terms of a short-term financial impact)? Show calculations.
2. Apply the general transfer-pricing model to this situation. What is the minimum
transfer price indicated for each of the 1,000 units in question? Show calculations.
3. What is the likely consequence, from a decision standpoint, if the transfer price is
set at the amount stipulated by the general transfer-pricing rule?
19-77
141 Assume two divisions of a company, P (producing) and B (buying), that are treated as
. investment centers for performance-evaluation purposes. As the management
accountant, you've been asked to provide input to the determination of the
appropriate transfer price for an exchange of product between these two divisions. In
case #1, Division P is experiencing a capacity constraint, while in case #2 it is
assumed that Division P has excess capacity. The incremental production cost
incurred by Division P, to the point of transfer, is $80.00 per unit. Division P can sell
its output externally for $120.00 per unit, less a sales commission charge of $5.00
per unit. Currently, Division B is purchasing the product from an external supplier at
$120.00 per unit, plus a $3.00 transportation charge per unit.
Required:
1. Assume that Division P has limited capacity. Thus, for each unit it sells internally, it
loses the opportunity to sell that unit externally. Use the general transfer-pricing rule
to determine the minimum transfer price for internal transfers of units, that Division
P would charge Division B. From the standpoint of Division P, why is the figure you
calculated considered an acceptable transfer price?
2. What is the maximum transfer price that Division B would be willing to pay per
unit on any internal transfers?
3. If top management of the company allows the managers of Divisions P and B to
negotiate a transfer price, what is the likely range of possible transfer prices?
4. Assume now that Division P has excess capacity. Use the general transfer-pricing
rule to determine the minimum transfer price that Division P would be willing to
accept from Division B for any internal transfers. Would this transfer price motivate
the correct economic decision (internal versus external transfer) from the standpoint
of the company as a whole? Explain.
5. Given the situation described above in (4), would top management of the
company want the transfer to take place internally? Why? (Show calculations, if
appropriate.) How could top management ensure that an internal transfer would take
place?
19-78
142 This question deals with summary financial performance indicators for investment
. centers.
Required:
1. Discuss the similarities between ROI, residual income (RI), and EVA.
2. In what sense is EVA similar to and in what sense is it distinct from residual
income (RI)?
3. Present the equation for calculating EVA and provide a brief discussion of the
elements that go into the calculation of EVA.
4. What are the two approaches that can be used to estimate the two major
components of EVA? Which of these two approaches is superior?
143 A fellow student of yours who has just completed a course in management
. accounting recently made the following comment to you regarding the establishment
of transfer prices for transnational transfers of goods and services within the same
company: "In the process of preparing consolidated financial statements, all profit
and loss attributable to internal transfers of goods and services are removed. The
amount of profit a company reports is therefore affected only by transactions with
external parties. Therefore, the subject of transfer pricing may be important for
motivational purposes or some other managerial objective, but the choice of a
transfer pricing system has no effect on the bottom line, even when transfers are
made between units of a company operating in different countries."
Required:
Critically analyze and respond to the above assertion.
19-79
144 Michael Cianci, manager of Division C of the FX Corporation, is considering a new
. investment for his division. The division currently has an investment base (i.e.,
assets) of $4,000,000, and operating income of approximately $600,000 per year.
The new investment of $500,000 supports corporate strategy and is expected to
increase operating income by $50,000 next year, an acceptable level of return from
the standpoint of the corporation as a whole.
Required:
1. What is the current return on investment (ROI) for Division C?

2. What will be the ROI of the division if the new investment is undertaken?
3. Suppose the manager's compensation consists of a salary plus a bonus
proportional to divisional ROI. Would the manager's compensation be higher with, or
without, the new investment?
4. Suggest changes to corporate management that will better align performance
evaluation and compensation with corporate goals.
145 This question pertains to the use of market-based transfer prices.

.
Required:
What is the primary advantage and what is the primary difficulty in using market-
based transfer prices?
19-80
146 Pacific Mill consists of two operating divisions, a Cutting division and the Assembly
. division. The Cutting division prepares cords of timber at its sawmills, while the
Assembly division prepares the cut cords of lumber into board-feet of finished wood
(which is sold to various furniture manufacturers). During the most recent year the
Cutting division prepared 60,000 cords of wood at a cost of $1,320,000. All of this
lumber was transferred to the Assembly division, where incremental costs of $12 per
cord were added. Pacific Mill sold the 600,000 board-feet of finished wood for
$5,000,000.
Required:
1. What would the operating income for each of the two divisions be if the transfer
price from Cutting to Assembly was set at the cord cost of $22 per cord? (Show
calculations.)
price is set at $18 per cord? (Show calculations.)
3. Since Cutting transfers all of its output internally (to Assembly), does the manager
of Cutting care what price is selected? Why? Should Cutting be treated as a cost
center under the circumstances (rather than a profit center or investment center)?
Explain.
147 This question pertains to factors affecting the setting of transfer prices in an
. international setting.
Required:
What are the primary factors affecting the setting of transfer prices between
divisions of a company that operates in different countries?
19-81
148 The microprocessor division of Zenith Systems Company sells a computer module to
. the company's Assembly Division, which puts together the finished product (viz.,
guidance systems). The Microprocessor Division is currently working at capacity. The
computer module costs $10,000 to manufacture, and it can be sold externally to
companies for approximately $13,500 per unit.
Required:
1. Use the general transfer pricing rule to compute a transfer price for the computer
module.
2. Explain the underlying logic of the general transfer pricing rule discussed in the
chapter.
149 The Division A of Standard Products is planning its 2016 operating budget. Average
. operating assets of $1,500,000 will be used during in the division during the year and
per-unit selling prices are expected to average $100. Variable costs of the division
are budgeted at $400,000, while fixed costs are set at $250,000. The company's
required rate of return for purposes of calculating residual income (RI) is 18%.
Required:
1. Compute the sales volume (in units) necessary for Division A to achieve a 20% ROI
in 2016.
2. The division manager receives a bonus of 50% of residual income (RI). What is his
anticipated bonus for 2016 for the division manager, assuming she achieves the 20%
ROI target specified in part (1)? below.
19-82
150 The major operating divisions of Grey Company are organized as investment centers
. for performance-evaluation purposes. The division managers are evaluated, in part,
on the basis of the change in the return on investment (ROI) of their units. Operating
results for the Division A for the coming year, 2016, based on its existing assets are
budgeted as follows:
Sales
Less variable costs
Contribution margin
Less fixed expenses
Operating income
Operating assets for the Division A are currently $3,600,000. For 2016, the division
can add a new product line for an investment of $600,000. The new product line is
expected to generate sales of $1,600,000 and will incur fixed expenses of $600,000
annually. Variable costs of the new product are expected to average 60% of the
selling price.
Required:
1. What is the effect on ROI of accepting the new product line?

2. If the company's required rate of return is 6% and residual income is used to
evaluate managers, would this encourage the division to accept the new product
line? Explain and show computations.
19-83
151 Meridian Investments has three divisions (A, B, C) organized for performance-
. evaluation purposes as investment centers. Each division's required rate of return for
purposes of calculating residual income (RI) is 15%. Budgeted operating results for
2016 for each of the three divisions are as follows:
Division Operating income Investment

A $15,000,000 $100,000,000
B $25,000,000 $125,000,000
C $11,000,000 $50,000,000
The company is planning an expansion, which will require each division to increase
its investments by $25,000,000 and its operating income by $4,500,000.
Required:
1. Compute the current ROI for each division.

2. Compute the current residual income (RI) for each division.
3. Rank the divisions according to their current ROIs and in terms of their residual
incomes.
4. Determine the effects after adding the new project to each division's ROI and
residual income (RI).
5. Assuming the managers are evaluated on either ROI or residual income (RI).
Which divisions are pleased with the expansion and which ones are unhappy? Explain
briefly.
19-84
Chapter 19 Strategic Performance Measurement: Investment
Centers and Transfer Pricing Answer Key
Multiple Choice Questions
1. Under the notion of controllability, it is most appropriate for top management to

evaluate the profitability of an investment center in terms of:
A. Profits generated in relation to the amount of capital invested in the unit.

B. Returns expressed as a percentage.
C. Profits expressed in absolute terms.
D. Operating profit generated.
E. Returns expressed in actual dollar amounts.
AACSB: Reflective Thinking

AICPA: BB Critical Thinking
AICPA: FN Measurement
Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 19-01 Explain the use and limitations of return on investment (ROI) for evaluating the
short-term financial performance of investment centers.
Topic: Financial Performance
Topic: Return on Investment
2. Which of the following is the most appropriate and comprehensive short-term

financial-performance indicator for an investment center that is a division of a
larger business entity?
A. Residual income (RI).

B. Operating income, pre-tax.
C. Return on equity (ROE).
D. Operating income, after-tax.
E. Return on sales (ROS).

Blooms: Remember
Difficulty: 2 Medium
Learning Objective: 19-02 Explain the use and limitations of residual income (RI) for evaluating the short-term
financial performance of investment centers.
Topic: Residual Income
19-85
3. The conventional return on investment (ROI) performance measure calculates
"profit" and "investment" based on:
A. American Accounting Association (AAA) recommendations.

B. U.S. Generally Accepted Accounting Principles (GAAP).
C. The American Institute of Certified Public Accountants (AICPA) regulations.
D. The legal and business professions' practices.
E. Requirements specified by the U.S. Securities and Exchange Commission (SEC).

Blooms: Remember
4. Return on investment (ROI) is the result of multiplying:
A. Return by average investment.

B. Profit by average operating assets.
C. Return on sales (ROS) by asset turnover (AT).
D. Return on assets (ROA) by asset turnover (AT).
E. Margin on sales by return on assets (ROA).

Blooms: Remember
Difficulty: 1 Easy
5. Determination of the useful life of an asset and choice of a depreciation method

will affect all of the following except:
A. The amount of operating income earned by an investment center for any given
period.
B. The investment base for purposes of calculating ROI.
C. Amount of depreciation expense recorded for any given period.
D. Net book value (NBV) of an asset as of any point in time.
E. The opportunity cost of lost sales on alternative projects.
AACSB: Analytical Thinking

Blooms: Analyze
Difficulty: 1 Easy
19-86
6. The choice of valuation method for inventories would normally not affect which
item(s) used in calculating Return on Investment (ROI)?
A. The valuation of fixed assets (e.g., Plant, Property, and Equipment) used by an
investment center.
B. The amount of operating income earned by an investment center in a given
period.
C. Both the investment base and the level of operating income reported by an
investment center.
D. The estimated value of current assets of a business entity, such as an
investment center.
E. The return on sales (ROS) of an investment center for the period.

Blooms: Analyze
Difficulty: 1 Easy
7. As a general rule, leased assets should be included as part of the calculation of

"investment" (for calculating ROI and residual income) since they represent assets
used:
A. As collateral to borrow funds.

B. To generate operating income.
C. To offset current operating expenses.
D. To reduce taxes.
E. To estimate earnings per share for a given period.

Blooms: Understand
8. Firms with high operating leverage tend to have:
A. High asset turnover and high return on sales.

B. Low asset turnover and low return on sales.
C. Low asset turnover and high return on sales.
D. High asset turnover and low return on sales.
E. Decreased levels of short-term fixed costs.

19-87
Blooms: Analyze
Difficulty: 3 Hard
9. Which one of the following is an advantage of both Return on Investment (ROI) and
Residual Income (RI)?
A. They both measure all elements important for measuring short-term financial
performance of investment centers: revenues, costs, and investment.
B. They are both very widely used in practice today.
C. They both can use the minimum rate of return to adjust for differences in risk
across different investment centers.
D. They are both comparable to interest rates and to rates of return on alternate
investments.
E. They can both use a different minimum rate of return for different types of
assets used by an investment center.

Blooms: Understand
10. When investments in facilities are shared by different subunits in a firm, allocation
of the cost of these common facilities to sharing units should be determined by:
A. Reference to Generally Accepted Accounting Principles (GAAP).

B. Relative sales dollars generated by the various units.
C. The relative amount of use of the facilities, or demand for the facilities, by the
various investment centers in the organization.
D. Special techniques prescribed by the American Institute of Certified Public
Accountants (AICPA).
E. Some measure of current value (e.g., replacement cost).

Blooms: Understand
19-88
11. The difference between the historical cost and the net book value (NBV) of a plant
asset is the:
A. Residual value of the asset.

B. Depreciation expense for the current period.
C. An estimate of the remaining useful life of the asset.
D. Accumulated depreciation expense on the asset.
E. Estimated replacement cost of the asset.

Blooms: Remember
Difficulty: 1 Easy
12. Use of net book value (NBV) in valuing investment in operating plant assets for
investment centers, in contrast to using an estimate current value, will:
A. Have no appreciable effect on ROI in most situations.

B. Have no appreciable effect on plant asset book value.
C. Have no appreciable effect on operating income reported by the investment
centers.
D. Usually understate ROI.
E. Usually overstate ROI.

Blooms: Analyze
13. The use of gross book value (GBV) for measuring the level of investment in
depreciable assets (for purposes of calculating return on investment, ROI) is
preferred by those who value the objectivity of:
A. An historical cost number.

B. The depreciation process.
C. Price-level adjusted data.
D. The cost-allocation process.
E. Current-cost information.

Blooms: Understand
Difficulty: 1 Easy
19-89
14. The use of replacement cost of assets for purposes of calculating return on
investment (ROI) has the advantage of:
A. Historical accuracy.
B. Being a relevant measure of the level of investment in a continuing business.
C. Objectivity.
D. Consistency with generally accepted accounting principles (GAAP).
E. Avoiding the need for developing estimates of current cost.

Blooms: Understand
15. A primary limitation of return on investment (ROI) as a performance-evaluation

metric for investment centers is that ROI:
A. Is a long-term, not short-term, performance indicator.

B. Understates the level of "investment" for organizations operating in the so-
called knowledge-based economy.
C. Excludes the level of investment from the performance metric.
D. Cannot handle current-value estimates of assets.
E. Is not a relative performance indicator.

Blooms: Analyze
Difficulty: 3 Hard
16. Return on investment (ROI) encourages business unitssuch as investment

centers to invest only in projects that earn:
A. A rate of return greater than borrowing costs.

B. An amount greater than the amount of EVA currently being generated.
C. A rate of return greater than the amount of residual income currently being
earned.
D. A rate of return less than the unit's current ROI.
E. A rate of return higher than the unit's current ROI.

19-90
Blooms: Remember
Difficulty: 1 Easy
17. Because residual income (RI) is a dollar amount, in contrast to a percentage (as is
return on investment, ROI), RI:
A. Allows, through different discount rates, adjustment for differing levels of risk
across investment centers within an organization.
B. Cannot be used to evaluate the financial performance of a given investment
center over time.
C. Is less useful than ROI for performance-evaluation purposes.
D. Allows for differing investment amounts for different investment centers.
E. Is less useful to stockholders of the company.

Blooms: Understand
18. Since residual income (RI) is not a percentage, it is not very useful for:
A. Comparing business units of significantly different size.

B. Evaluating the performance of subunits with high ROIs.
C. Motivating goal-congruent behavior on the part of divisional managers.
D. Evaluating the short-term financial performance of small divisions.
E. Evaluating the short-term financial performance of larger divisions.

Blooms: Understand
19-91
19. In contrast to residual income (RI), economic value added (EVA) uses in its
calculation:
A. The firm's cost of capital rather than its minimum rate of return.
B. A measure (or estimate) of economic, not accounting, income.
C. A required rate of return in estimating the amount of profit generated.
D. Values determined by using conventional accounting policies (i.e., GAAP).
E. Accounting, not economic, measures of income and investment.

Blooms: Remember
Learning Objective: 19-03 Explain the use and limitations of economic value added (EVA) for evaluating the
shortterm financial performance of investment centers.
Topic: Economic Value Added
20. Put simply, transfer pricing is a management tool for assigning a "price" to
internally transferred goods (or services) in order to simulate the marketplace,
thus encouraging mangers to make decisions that are in the best interest of the:
A. Operating managers.
B. Producing (i.e., selling) unit within the firm.
C. Firm as a whole.
D. Manager of the buying (i.e., purchasing) unit.
E. Operating units in the short run, and the firm in the long-run.

Blooms: Understand
Learning Objective: 19-04 Explain the objectives of transfer pricing, and describe the advantages and
disadvantages of various transfer-pricing alternatives.
Topic: Transfer Pricing
21. Because the full-cost method of transfer pricing includes fixed cost, it can:
A. Pass strict accounting requirements for determining transfer prices.

B. Pass current income tax requirements in the U.S. for determining transfer
prices.
C. Establish consistency across state and national borders.
D. Violate OECD agreements.
E. Cause sub-optimal short-term decision making.

Blooms: Understand
19-92
22. Use of the market-price method (when such prices exist) satisfies a key objective
of transfer pricing, namely:
A. Objectivity.
B. Selectivity.
C. Usability.
D. Transportability.
E. Reliability.

Blooms: Remember
Difficulty: 1 Easy
23. A key standard in international transfer pricing is:
A. Consistency.
B. Reliability.
C. The arm's-length standard.
D. Open marketability.
E. Translatability.
AACSB: Diversity
AICPA: BB Global
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 19-05 Discuss important international issues that arise in transfer pricing.
24. The biggest problem with cost-based transfer prices is:
A. The fact that their use may result in sub-optimal decisions from the standpoint
of the organization as a whole.
B. Too much negotiation is involved in determining the transfer price.
C. Data unavailability.
D. They are difficult to put into place.
E. They may lead to goal congruence within the firm.

Blooms: Understand
Difficulty: 1 Easy
19-93
25. If after-tax income of Grey Division, adjusted for economic value, is 15% of sales,
capital employed is $5,000,000 (adjusted for equity-equivalents), the divisional
cost of capital (discount rate) is 8%, and sales are $12,000,000, then Economic
Value Added (EVA) is:
A. $1,800,000
B. $400,000
C. $1,400,000
D. $3,200,000
E. Undeterminable given the information provided.
1. NOPAT = [0.15 sales] = 0.15 $12,000,000 = $1,800,000

2. EVA = $1,800,000 - (0.08 $5,000,000) = $1,800,000 - $400,000 =
$1,400,000
AACSB: Knowledge Application

Blooms: Apply
Difficulty: 1 Easy
26. A measure of the manager's ability to control expenses and increase revenues to
improve profitability is:


Blooms: Remember
Difficulty: 1 Easy
19-94
27. A measure of the manager's ability to produce increased sales from a given level
of investment is:


Blooms: Remember
Difficulty: 1 Easy
28. The historical cost of an asset less its accumulated depreciation is:
A. Net book value (NBV).

D. A rough measure of current replacement cost of the asset.
E. An estimate of liquidation value of the asset.

Blooms: Remember
Difficulty: 1 Easy
29. Replacement cost of a division's assets will most probably be greater than:
A. Gross book value (GBV) of the assets.

B. Historical cost of the assets.
C. Liquidation value of the assets.
D. Price-level adjusted cost of the assets.
E. Current cost of the assets.

Blooms: Analyze
19-95
30. Which one of the following is not a limitation shared by residual income (RI) and
return on investment (ROI) divisional performance measures?
A. They are both short-term performance indicators.

B. They both may fail to capture significant value-creating activities of the
organization.
C. They are both subject to short-term manipulation on the part of divisional
managers.
D. Both are subject to a number of measurement issues that complicate their use
in practice.
E. They both relate, in percentage terms, earnings to the level of investment in
each division.

Blooms: Analyze
31. The estimated cost to replicate assets of an investment center at the current level
of service and functionality of these assets is defined as:
A. Gross book value.

B. Historical cost, plus accumulated depreciation to date.
C. Liquidation value.
E. Price-level adjusted original cost.

Blooms: Remember
Difficulty: 1 Easy
32. The estimated price that could be received for the sale of divisional assets is
referred to as:
A. Gross book value (GBV), plus accumulated depreciation to date.

B. Gross book value (GBV).
C. Price-level adjusted cost.
E. Liquidation value.
19-96
Blooms: Remember
Difficulty: 1 Easy
33. A dollar amount equal to the operating income of a division less a charge for the
level of investment in the division is called:
A. Operating profit after tax.

B. Return on investment (ROI).
C. Earnings from continuing operations.
D. Return on equity (ROE).

Blooms: Remember
Difficulty: 1 Easy
34. A division's after-tax cash operating income less depreciation and less an imputed
cost of capital is called its:
A. After-tax operating income.

B. Income from continuing operations.
D. Economic value added (EVA).

Blooms: Remember
Difficulty: 1 Easy
19-97
35. Return on Investment (ROI), though widely used, is subject to which one of the
following limitations?
A. ROI cannot incorporate differences in risk across different divisions.

B. ROI ignores the amount of capital invested in a division.
C. ROI may not capture value-creation for firms operating in capital-intensive
industries.
D. ROI may motivate managers to take suboptimal decisions from the standpoint
of the organization as a whole.
E. ROI cannot be used to judge the performance of units of different size.

Blooms: Understand
36. All of the following are possible transfer pricing methods used in practice except:
A. Market price.
B. Variable cost.
C. Fixed cost.
D. Full cost.
E. Negotiated price.

Blooms: Remember
Difficulty: 1 Easy
37. Which one of the following establishes an "arm's-length price" by using the sales
prices of similar products made by unrelated firms?
B. Retail-price method.
C. Related-products method.
AACSB: Diversity
AICPA: BB Global
Blooms: Remember
Difficulty: 1 Easy
Text Feature: International
19-98
38. Which one of the following transfer pricing alternatives is based on determining an
appropriate markup, where the markup is based on gross profits of unrelated firms
selling similar products?
AACSB: Diversity
AICPA: BB Global
Blooms: Remember
39. Which one of the following determines the transfer price based on the seller's
costs, plus a gross profit percentage determined from comparison of sales of the
seller to those of unrelated parties?

Blooms: Remember
Difficulty: 1 Easy
19-99
Div
isi YZ
X
on
al:
$ $
1 $ 4
, 9 ,
8 0 8
Sal 0 0 0
es 0 , 0
, 0 ,
0 0 0
0 0 0
0 0
Op 2 1 2
era 5 0 4
tin 2 8 0
g , , ,
Inc 0 0 0
om 0 0 0
e 0 0 0
3
Inv 6 5 ,
est 3 4 0
me 0 0 0
nt , , 0
in 0 0 ,
ass 0 0 0
ets 0 0 0
0
The return on investment (ROI) for Division X is:
A. 8.0%.
B. 12.0%.
C. 20.0%.
D. 25.0%.
E. 40.0%.
ROI = Operating income Investment = $252,000 $630,000 = 40.0%

Blooms: Apply
Difficulty: 1 Easy
19-100
19-101
19-102
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
S 8 08
al 0 00
e 0,0
s ,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
e 0 00
st , , 0
m 0 00
19-103
e
nt
,
in
0 00
a
0 00
ss
0
et
s
The return on investment (ROI) for Division Y is:
A. 8.0%.
B. 12.0%.
C. 20.0%.
D. 25.0%.
E. 40.0%.
ROI = Operating income Investment = $108,000 $540,000 = 20.0%

Blooms: Apply
Difficulty: 1 Easy
19-104
19-105
19-106
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
S 8 08
al 0 00
e 0,0
s ,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
e 0 00
st , , 0
m 0 00
19-107
e
nt
,
in
0 00
a
0 00
ss
0
et
s
The return on investment (ROI) for Division Z is:
A. 8.0%.
B. 12.0%.
C. 20.0%.
D. 25.0%.
E. 40.0%.
ROI = Operating income Investment = $240,000 $3,000,000 = 8.0%

Blooms: Apply
Difficulty: 1 Easy
19-108
Div
isi YZ
X
on
al:
$ $
1 $ 4
, 9 ,
8 0 8
Sal 0 0 0
es 0 , 0
, 0 ,
0 0 0
0 0 0
0 0
Op 2 1 2
era 5 0 4
tin 2 8 0
g , , ,
Inc 0 0 0
om 0 0 0
e 0 0 0
3
Inv 6 5 ,
est 3 4 0
me 0 0 0
nt , , 0
in 0 0 ,
ass 0 0 0
ets 0 0 0
0
The return on sales (ROS) for Division X is:
A. 5.0%.
B. 8.0%.
C. 12.0%.
D. 14.0%.
E. 20.0%.
ROS = Operating income Sales = $252,000 $1,800,000 = 14.0%

Blooms: Apply
Difficulty: 1 Easy
19-109
19-110
19-111
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
S 8 08
al 0 00
e 0,0
s ,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
e 0 00
st , , 0
m 0 00
19-112
e
nt
,
in
0 00
a
0 00
ss
0
et
s
The return on sales (ROS) for Division Y is:
A. 5.0%.
B. 8.0%.
C. 12.0%.
D. 14.0%.
E. 20.0%.
ROS = Operating income Sales = $108,000 $900,000 = 12.0%

Blooms: Apply
Difficulty: 1 Easy
19-113
19-114
19-115
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
S 8 08
al 0 00
e 0,0
s ,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
e 0 00
st , , 0
m 0 00
19-116
e
nt
,
in
0 00
a
0 00
ss
0
et
s
The return on sales (ROS) for Division Z is:
A. 5.0%.
B. 8.0%.
C. 12.0%.
D. 14.0%.
E. 20.0%.
ROS = Operating income Sales = $240,000 $4,800,000 = 5.0%

Blooms: Apply
Difficulty: 1 Easy
19-117
Div
isi YZ
X
on
al:
$ $
1 $ 4
, 9 ,
8 0 8
Sal 0 0 0
es 0 , 0
, 0 ,
0 0 0
0 0 0
0 0
Op 2 1 2
era 5 0 4
tin 2 8 0
g , , ,
Inc 0 0 0
om 0 0 0
e 0 0 0
3
Inv 6 5 ,
est 3 4 0
me 0 0 0
nt , , 0
in 0 0 ,
ass 0 0 0
ets 0 0 0
0
The asset turnover (AT) for Division X is (rounded):
A. 1.43.
B. 1.60.
C. 1.67.
D. 2.86.
E. 3.33.
Asset Turnover (AT) = Sales Investment = $1,800,000 $630,000 = 2.86

Blooms: Apply
Difficulty: 1 Easy
19-118
19-119
19-120
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
S 8 08
al 0 00
e 0,0
s ,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
e 0 00
st , , 0
m 0 00
19-121
e
nt
,
in
0 00
a
0 00
ss
0
et
s
The asset turnover (AT) for Division Y is calculated to be (rounded):
A. 1.43.
B. 1.60.
C. 1.67.
D. 2.86.
E. 3.33.
Asset Turnover (AT) = Sales Investment = $900,000 $540,000 = 1.67

Blooms: Apply
Difficulty: 1 Easy
19-122
19-123
19-124
D
iv
is
YZ
io X
n
al
:
$ $
1 $4
,9,
S 8 08
al 0 00
e 0,0
s ,0,
0 00
0 00
0 0
O
p
er 2 12
at 5 04
in 2 80
g ,, ,
In 0 00
c 0 00
o 0 00
m
e
In 6 53
v 34 ,
e 0 00
st , , 0
m 0 00
19-125
e
nt
,
in
0 00
a
0 00
ss
0
et
s
The asset turnover (AT) for Division Z is:
A. 1.43.
B. 1.60.
C. 1.67.
D. 2.86.
E. 3.33.
Asset Turnover (AT) = Sales Investment = $4,800,000 $3,000,000 = 1.60

Blooms: Apply
Difficulty: 1 Easy
19-126
Divisional
Sales
Operating Income
Investment
If the minimum rate of return is 11%, what is Division P's residual income (RI)?
A. $160,000.
B. $1,040,000.
C. $1,060,000.
D. $1,434,000.
E. $3,934,000.
Residual Income = Operating Income - Imputed Capital Charge = $600,000 - (0.11

$4,000,000) = $600,000 - $440,000 = $160,000

Blooms: Apply
Difficulty: 1 Easy
19-127
Divisional
Sales
Operating Income
Investment
If the minimum rate of return is 11%, what is Division Q's residual income (RI)?
A. $147,500.
B. $490,000.
C. $752,000.
D. $950,000.
E. $1,049,500.
Residual Income = Operating Income - Imputed Capital Charge = $450,000 - (0.11

$2,750,000) = $450,000 - $302,500 = $147,500

Blooms: Apply
Difficulty: 1 Easy
19-128
Divisional
Sales
Operating Income
Investment
If both divisions were presented with an opportunity to invest in a project that is
estimated to achieve an ROI of 15%, what will the units likely decide?
A. Division P will invest; Division Q will not invest.

B. Division P will invest; Division Q will be indifferent.
C. Division P will not invest; Division Q will invest.
D. Division P will be indifferent; Division Q will not invest.
E. Neither unit will invest in the projects.
Current ROI for Division P: $600,000 $4,000,000 = 15%

Current ROI for Division Q: $450,000 $2,750,000 = 16%

AICPA: FN Decision Making
Blooms: Analyze
Difficulty: 3 Hard
Text Feature: Strategy
19-129
$825,00
Sales
$440,00
Average investment

14%
capital)
Chering Division's return on investment (ROI) is:
A. 6.0%.
B. 8.0%.
C. 14.0%.
D. 15.0%.
E. 20.0%.
ROI = Net Operating Income Average Investment = $66,000 $440,000 =

15.0%

Blooms: Apply
Difficulty: 1 Easy
19-130
Sales $825,000
Minimum rate of return (divisional cost of capital) 14%
Chering Division's return on sales (ROS) is:
A. 6.0%.
B. 8.0%.
C. 14.0%.
D. 15.0%.
E. 20.0%.
Return on Sales (ROS) = Net Operating Income Sales = $66,000 $825,000 =

8.0%

Blooms: Apply
Difficulty: 1 Easy
19-131
$825,00
Sales
$440,00
Average investment

14%
capital)
Chering Division's asset turnover (AT) is calculated to be:
A. 1.070.
B. 1.625.
C. 1.875.
D. 4.270.
E. 12.500.
Asset Turnover (AT) = Sales Average Investment = $825,000 $440,000 =

1.875

Blooms: Apply
Difficulty: 1 Easy
19-132
$825,00
Sales
$440,00
Average investment

14%
capital)
Chering Division's residual income (RI) is:
A. $4,400.
B. $8,800.
C. $9,240.
D. $22,380.
E. $49,500.
Residual Income (RI) = Net Operating Income - Imputed Capital Charge = $4,400
= $66,000 - (0.14 $440,000) = $66,000 - $61,600 = $4,400

Blooms: Apply
Difficulty: 1 Easy
19-133
$825,00
Sales
$440,00
Average investment

14%
capital)
If the minimum rate of return (i.e., cost of capital) was 13%, Chering Division's
residual income (RI) would calculate to be:
A. $4,400.
B. $8,800.
C. $9,240.
D. $22,380.
E. $49,500.
Residual Income (RI) = Net Operating Income - Imputed Capital Charge = Net
Operating Income - (Average Investment cost of capital) = $66,000 - ($440,000
0.13) = $66,000 - $57,200 = $8,800

Blooms: Apply
Difficulty: 1 Easy
19-134
57. An investment center's return on investment (ROI) is affected by a change in:
Asset Turnover Return on Sales

(A) Yes
(B) Yes
(C) No
(D) No
(E) Yes Not likely
A. Option A
B. Option B
C. Option C
D. Option D
E. Option E

Blooms: Understand
Difficulty: 1 Easy
58. The return on investment (ROI) ratio measures:
A. The rate of return on average shareholders' equity.

B. Only earnings as a percent of sales.
C. The combined effect of both asset turnover (AT) and return on sales (ROS).
D. Asset turnover (AT) and earnings as a percent of sales, correcting for the effects
of differing depreciation methods.
E. Operating income less a charge for divisional investment (assets).

Blooms: Remember
Difficulty: 1 Easy
19-135
59. Return on investment (ROI) is a term often used to express income earned on
capital invested in a division (investment center). A division's ROI would increase
if:
A. Sales increased by the same dollar amount as expenses and total assets
increased.
B. Sales remained the same and expenses were reduced by the same dollar
amount that total assets increased.
C. Sales decreased by the same dollar amount that expenses increased.
D. Sales and expenses increased by the same percentage that total assets
increased.
E. Net profit margin on sales increased by the same percentage that total assets
increased.

Blooms: Analyze
Difficulty: 3 Hard
60. Residual income (RI) is:
A. Contribution margin of an investment center, less the imputed interest on the

invested capital used by the center.
B. Operating income of an investment center divided by average total assets.
C. Another name for Economic Value Added (EVA)
D. Operating income of an investment center, less the imputed interest on the
capital used by the center.
E. Operating income of an investment center, plus the imputed interest on the
capital used by the center.

Blooms: Understand
19-136
Sales $1,500,000
How much is the residual income (RI) for this investment center?
A. $100,000.
B. $500,000.
C. $600,000.
D. $700,000.
E. $800,000.
Residual Income (RI) = Divisional Operating Income - Imputed Capital Charge on

Divisional Investment = Divisional Operating Income - (Average Investment cost
of capital) = ($1,500,000 - $800,000 - $100,000) - (0.10 $1,000,000) =
$600,000 - $100,000 = $500,000

Blooms: Apply
Difficulty: 1 Easy
19-137
Sales $1,500,000
How much is the return on investment (ROI) for this investment center?
A. 5%.
B. 50%.
C. 60%.
D. 70%.
E. 75%.
ROI = Divisional Operating Income Average Investment in the Division =

$600,000 $1,000,000 = 60%

Blooms: Apply
Difficulty: 1 Easy
investment center than return on investment (ROI) is because:

B. Desirable investment decisions will not be discouraged by high-rate-of-return
divisions.
E. The arguments over the appropriate discount rate to use in the calculations are
eliminated.

Blooms: Analyze
19-138
64. Given a competitive outside market for identical intermediate goods, what is
generally considered the best transfer price, assuming all relevant information is
readily available?
A. Average cost of production.

B. Average cost of production, plus average production department allocated
profit.
C. Market price of the intermediate goods.
D. Market price of the intermediate goods, less average production department
allocated profit.
E. Full cost, plus a mark-up for profit.

Blooms: Understand
65. Transfer prices based on actual costs of the selling division as opposed to standard
costs incurred by that division:
A. Are preferred by the purchasing division.

B. Mat fail to provide the selling division with an incentive to control costs.
C. Often encourage the selling division to control costs.
D. Are required by international financial reporting standards.
E. Often encourage the purchasing division to control costs.

Blooms: Understand
66. The primary limitation of a full-cost based transfer pricing system is that:
A. The supplying and purchasing divisions are more likely to make decisions that
are inconsistent with the goals of the organization as a whole.
B. There will be little incentive on the part of the supplying manager to supply
goods and services efficiently.
C. Managers may spend too much time negotiating the transfer price.
D. Managers may find that the transfer price is difficult to compute.
E. Such transfer prices are not currently allowed for federal income tax purposes.

Blooms: Understand
19-139
Difficulty: 3 Hard
67. A company has two divisions, X and Y, each operated as an investment center. X
charges Y $55 per unit for each unit transferred to Y. Other data are:
Xs variable cost per unit $40

Xs fixed costs $100,000
Xs annual sales to Y 5,000 units
Xs sales to outsiders 10,000 units
X is planning to raise its transfer price to $65 per unit. Division Y can purchase
units at $50 each from outsiders, but doing so would idle X's facilities now
committed to producing units for Y. Division X cannot increase its sales to
outsiders. From the perspective of the short-term profit position of the company as
a whole, from which source should Division Y acquire the units?
A. Outside vendors.
B. Division X, but only at the variable cost per unit.
C. Division X, but only until fixed costs are covered, then should purchase from
outside vendors.
D. Division X, in spite of the increased transfer price.
E. It is not possible to tell without additional information.
Incremental cost of the producing division, X (including opportunity costs of $0) <
external purchase price paid by Y, but X is overpricing the unit by asking for
excess over market price.

Blooms: Analyze
Difficulty: 3 Hard
19-140
68. Division A, which is operating at capacity, produces a component that it currently
sells in a competitive market for $25 per unit. At the current level of production,
the fixed cost of producing this component is $8 per unit and the variable cost is
$10 per unit. Division B would like to purchase this component from Division A. The
price that Division A should charge Division Y for this component is:
A. $10 per unit.

B. $18 per unit.
C. $20 per unit.
D. $25 per unit.
E. $35 per unit.
Generally speaking, when external market prices exist, their use results in an
optimal transfer price from the standpoint of the organization as a whole, in terms
of the transfer-pricing objectives listed in Part Two of Chapter 19.

Blooms: Apply
19-141
69. A company established a branch to sell automobile seat covers. The company
purchases these covers and stores them in a warehouse. The covers are then
shipped from the warehouse to both the home office and the new branch, FOB
(Free On Board) destination. Home office management is responsible for setting
the transfer price of the covers charged to the branch. Per-unit costs of the covers
are:
$60.
purchase price
00
$2.5
shipping cost to warehouse
0
$3.0 handling cost, including $1 allocated
0 administrative overhead
$3.5
shipping cost to branch, paid by home office
0
According to the general transfer-pricing formula given in the text, the minimum
transfer price that home office should charge the branch is:
A. $62.50.
B. $63.50.
C. $66.00.
D. $68.00.
E. $69.00.
Minimum Transfer Price = Incremental Cost = Out-of-Pocket Cost + Opportunity

Cost = $68.00 = [$60.00 + $2.50 + $3.50 + ($3.00 - $1.00)] + $0; notewhile not
asked, the maximum amount to be charged would be the external market price (if
such existed).

Blooms: Apply
19-142
Sales
Average investment
Operating income
Division A's return on investment (ROI) is:
A. 1.8%.
B. 7.5%.
C. 12.0%.
D. 20.0%.
E. 48.0%.
Divisional ROI = Divisional Operating Income Average Divisional Investment =

$60,000 $300,000 = 20.0%

Blooms: Apply
Difficulty: 1 Easy
Sales
Average investment
Operating income
Division A's return on sales (ROS) is:
A. 1.8%.
B. 7.5%.
C. 12.0%.
D. 20.0%.
E. 48.0%.
Return on Sales (ROS) = Divisional Operating Income Sales = $60,000

$500,000 = 12.0%

19-143
Blooms: Apply
Difficulty: 1 Easy
Sales
Average investment
Operating income
Division A's asset turnover (AT) is (rounded to two decimal places):
A. 0.72.
B. 1.00.
C. 1.58.
D. 1.67.
E. 2.08.
Asset Turnover (AT) = Sales Average Divisional Investment = $500,000

$300,000 = 1.67

Blooms: Apply
Difficulty: 1 Easy
19-144
Sales
Average investment
Operating income
Division A's residual income (RI) is:
A. $15,000.
B. $24,000.
C. $30,000.
D. $36,000.
E. $54,000.
Residual Income (RI) = Divisional Operating Income - Imputed Charge on Divisional

Investment = Divisional Operating Income - (divisional cost of capital Divisional
Investment) = $60,000 - (0.15 $300,000) = $60,000 - $45,000 = $15,000

Blooms: Apply
Difficulty: 1 Easy
19-145
Sales
Average investment
Operating income
If the minimum rate of return was 10%, Division A's residual income (RI) would be:
A. $15,000.
B. $24,000.
C. $30,000.
D. $36,000.
E. $45,000.
Residual Income (RI) = Divisional Operating Income - Imputed Charge on Divisional

Investment = Divisional Operating Income - (divisional cost of capital Divisional
Investment) = $60,000 - (0.10 $300,000) = $60,000 - $30,000 = $30,000

Blooms: Apply
Difficulty: 1 Easy
75. In the context of transfer pricing, dual pricing is:
A. Never used when numerous conflicts exist between two units.

B. The simultaneous use of two or more transfer pricing methods.
C. The use of two or more transfer pricing methods by the buyer only.
D. Not recommended because of negative behavioral consequences.
E. Not recommended because it conflicts with current income tax requirements.

Blooms: Remember
Difficulty: 1 Easy
19-146
76. Expropriation occurs when the government in which a foreign company's
investment assets are located:
A. Takes ownership and control of those assets.

B. Charges additional taxes for the use of those assets.
C. Uses domestic currency to purchase those assets.
D. Uses foreign currency to purchase those assets.
E. Does not allow transnational transfers of currency.
AACSB: Diversity
AICPA: BB Global
AICPA: BB Legal
Blooms: Remember
Difficulty: 1 Easy
77. One advantage of the return on investment (ROI) metric is that it:
A. Can use the minimum rate of return to adjust for differences in risk.
B. Can use a different minimum rate of return for different types of assets.
C. Eliminates goal congruency problems, particularly for better-performing
divisions.
D. Requires disclosure under current international financial reporting standards.
E. Can be compared to interest rates and to rates of return on alternative
investments.

Blooms: Understand
78. One approach to measuring the short-term financial performance of a business

unit considered an investment center is return on investment (ROI). ROI is
expressed as operating income of the investment center:
A. Divided by the current year's capital expenditures plus cost of capital.

B. Minus imputed interest charged for the use of invested capital by the
investment center.
C. Divided by fixed assets.
D. Divided by total assets used by the investment center.
E. Minus the asset turnover (AT) of the investment center.

Blooms: Remember
19-147
79. The two approaches for estimating Economic Value Added (EVA) are:
A. The operating approach and the capital approach.

B. The financing approach and the operating approach.
C. The discounted approach and the financing approach.
D. The operating approach and the discounted approach.
E. The residual income approach and the operating-income approach.

Blooms: Remember
Difficulty: 1 Easy
80. A fully-owned subsidiary of a multinational company reports its return on

investment (ROI) periodically during the year. This unit of the company, for
performance-evaluation purposes, is likely considered a(n):
A. Profit center.
B. Revenue center.
C. Cost center.
D. Operating center.

Blooms: Understand
Difficulty: 1 Easy
81. A primary goal of transfer pricing is to:
A. Agree on a price for external sales.

B. Obtain a high transfer price for the purchasing unit.
C. Obtain a high transfer price for the selling unit.
D. Motivate decision-makers to act in the best interests of the organization.
E. Minimize recordkeeping costs.

Blooms: Remember
19-148
Difficulty: 1 Easy
82. All of the following are true of market-based transfer prices except:
A. They generally motivate the correct economic decision.

B. They can be determined for all goods and services transferred internally.
C. They may lead to goods and services purchased externally by the purchasing
unit.
D. To the extent they exist, they are objective.
E. They provide an independent valuation for internal transfers.

Blooms: Remember
83. All of the following are true of cost-based transfer prices except:
A. They generally promote optimal decision-making from the standpoint of the

organization as a whole.
B. They may be based either on actual costs or standard (i.e., budgeted) costs.
C. Their use may not provide proper motivation for cost control on the part of the
producing division.
D. They may not provide proper guidance when opportunity costs exist.
E. Generally speaking, such cost data are readily available.

Blooms: Understand
84. The greatest advantage of using a negotiated transfer price is:
A. It is generally the most efficient method of determining transfer prices.

B. This may be the most practical approach when conflicts exist between selling
and buying divisions.
C. The method produces transfer prices that are acceptable under international
financial reporting standards.
D. Tax problems are avoided because the method is considered "arm's-length."
E. It is required for federal income tax purposes.

19-149
Blooms: Understand
Difficulty: 1 Easy
85. The most likely result of using a negotiated transfer price is that:
A. The resulting decision reflects purely economic considerations.

B. More than the optimum number of units will be transferred between divisions.
C. Fewer than the optimum number of units will be transferred between divisions.
D. It takes away from the buying and selling units the ultimate responsibility for
determining the transfer price.
E. The end result might reflect the relative bargaining skills of the negotiating
managers.

Blooms: Understand
86. All of the following represent a way of calculating ROI (return on investment) for a
division except:
A. (Operating income sales) (sales investment).

B. Operating income divisional investment.
C. Return on sales (ROS) Inventory turnover.
D. Operating income divisional assets.

Blooms: Remember
Difficulty: 1 Easy
19-150
87. The primary limitation of using Economic Value Added (EVA) to evaluate the
financial performance of investment centers is:
A. Complexity of the calculation.

B. Dysfunctional long-term investment decisions that can be motivated by
focusing on EVA.
C. Failure to include a measure of invested capital.
D. Inability to use EVA to benchmark against competitor organizations.
E. Inability to align managerial incentives with ownership interests.

Blooms: Understand
88. EVA (economic value added):
A. Is another name for return on investment (ROI).

B. Is generally synonymous with residual income (RI).
C. Encourages investment center managers to accept new investments that have
an ROI greater than the existing ROI of the center.
D. Of $100,000 for an investment center indicates that the investment center
earned $100,000 of after-tax profit for the company as a whole.
E. Of $100,000 for an investment center indicates that the invest center's
economic profit for the period was $100,000.

Blooms: Analyze
89. Which of the following specifications for calculating EVA is correct?
A. EVA = accounting income investment.

B. EVA = economic profit equity equivalents.
C. EVA = NOPAT investment, where NOPAT = net operating profit after (cash)
taxes.
D. EVA = NOPAT - Imputed charge on EVA capital, where NOPAT = net
operating profit after (cash) taxes.
E. EVA = reported operating profit, after tax - imputed charge on average
investment in the subunit.

19-151
Blooms: Remember
90. Which of the following statements regarding the calculation of Economic Value
Added (EVA) is not true?
A. Adjusted accounting data are used to estimate EVA.

B. The operating approach and the financing approach lead to identical estimates
of EVA.
C. EVA NOPAT represents after-tax cash operating income, after depreciation.
D. EVA NOPAT represents after-tax cash operating income, before depreciation.
E. The divisional cost of capital (minimum rate of return) is used to impute a
charge on capital invested in the division during the period.

Blooms: Remember
91. A segment of an organization is referred to as an investment center if it has:
A. Authority to make decisions affecting the major determinants of profit, including

the power to choose its markets and sources of supply.
B. Authority to make decisions affecting the major determinants of profit, including
the power to choose its markets and sources of supply and significant control
over the amount of invested capital.
C. Authority to make decisions over the most significant costs of operations,
including the power to choose sources of supply.
D. Authority to provide specialized support to other units within the organization.
E. Responsibility for developing markets for and selling the output of the
organization.

Blooms: Understand
19-152
92. A company currently earning a profit can increase its return on investment (ROI)
by:
A. Increasing sales revenue and operating expenses by the same dollar amount.
B. Decreasing sales revenues and operating expenses by the same percentage.
C. Increasing investment and operating expenses by the same dollar amount.
D. Increasing sales revenues and operating expenses by the same percentage.
E. Decreasing investment and sales by the same percentage.

Blooms: Analyze
as a performance measure is incorrect?
A. When average age of assets differs substantially across segments of a

business, the use of ROI may not be appropriate.
B. ROI relies on financial measures that are capable of being independently
verified while other forms of performance measures are subject to
manipulation.
C. The use of ROI may lead managers to reject capital investment projects that
can be justified using discounted cash flow (DCF) decision models.
divisions.
E. The use of ROI can lead managers to emphasize the ROI of a division over the
profitability of the parent organization.

Blooms: Analyze
19-153
94. The basic objective of the residual income (RI) approach to performance
measurement of a business unit considered an investment center is to have the
investment center maximize its:
A. Return on investment.
C. Cash flows.
E. Operating income in excess of a desired minimum dollar return.

Blooms: Remember
Difficulty: 1 Easy
95. Under the notion of controllability, it is appropriate to evaluate the profitability of

each investment center based on each center's:
A. Operating income before tax.

B. Operating income after tax.
D. Profit earned in relation to the amount of capital invested in the subunit.
E. Return on equity (ROE).

Blooms: Understand
Difficulty: 1 Easy
96. Compared to return on investment (ROI), residual income (RI) may be a better
measure of the financial performance of an investment center because:
A. Problems associated with measuring the investment base are eliminated.

B. Of the fact that desirable investment opportunities will not be neglected by
divisions currently earning high rates of return.
C. Only the gross book value of assets needs to be calculated.
E. The arguments over the implicit cost of capital (discount rate) are largely
eliminated.

Blooms: Analyze
Difficulty: 1 Easy
19-154
97. A primary characteristic of a negotiated transfer price is that it:
A. Takes away the ultimate responsibility of the resulting transfer price from the
two parties.
B. Decreases sub-unit (i.e., divisional) autonomy.
C. Can be costly and time-consuming to implement.
D. Generally results in transferring more than the optimum number of units
between the buying and selling divisions of the organization.
E. Provides performance indicators that are independent of the negotiating skills
of divisional managers.

Blooms: Understand
98. Return on investment (ROI) can be directly increased by:
A. Increasing sales.
B. Increasing the minimum desired rate of return (i.e., divisional cost of capital).
C. Decreasing operating assets.
D. Decreasing operating income.
E. Decreasing asset turnover (AT).

Blooms: Analyze
19-155
99. The major criticism of using return on investment (ROI) for evaluating the financial
performance of business units considered investment centers is that ROI:
A. Gives managers of profitable business units an incentive to reject some projects

that would benefit the organization as a whole.
B. Is not easily understood by managers.
C. Usually uses a blended rate of capital as the required rate of return.
D. Has a long-term (strategic) focus and therefore is not useful in terms of
evaluating short-term performance.
E. Favors large units (investment centers).

Blooms: Understand
100. Assume that an organization's weighted-average cost of capital (minimum rate of

return) is 8% and that Division A currently has a 12% return on investment (ROI).
The manager of Department A, who is evaluated on the basis of divisional ROI,
would most likely accept an investment that is expected to return:
A. More than 8%.

B. More than 12%.
C. More than 8% but less than 12%.
D. Less than 12%.
E. Impossible to tell without further information.

Blooms: Understand
Difficulty: 1 Easy
19-156
101. Economic value added (EVA) for a division:
A. Encourages divisional mangers to accept only new capital projects (i.e., long-
term investments) with a return on investment (ROI) that exceeds the current
ROI.
B. Of $50,000 indicates that the division earned $50,000 for the company.
C. Of $10,000 indicates that the division's actual earnings (adjusted for bias
effects of accounting conservatism) exceed the division's imputed capital
charge by $10,000.
D. Is considered appropriate for evaluating the financial performance of profit but
not investment centers.
E. Has the added benefit of being usable for income tax determination purposes.

Blooms: Analyze
102. An appropriate transfer price between two divisions of The Stark Company can be
determined from the following data:
Fabricating Division:
Market price of the subassembly
Variable cost of the subassembly
Excess capacity (in units)
Assembly Division:
Number of units needed
What is the natural bargaining range for the two divisions?
A. Between $20 and $50.

B. Between $50 and $70.
C. Any amount less than $50.
D. $50 is the only acceptable price.
E. $20 is the only acceptable price.
The minimum transfer price acceptable to the Fabricating Division (according to

the general transfer-pricing rule) = out-of-pocket cost + opportunity cost, in this
case $20 (i.e., $20 + $0). The maximum price the Assembly Division would be
willing to pay would be the external market price, $50. Thus, the transfer price
range would likely be between $20/unit and $50/unit.

Blooms: Apply
19-157
Difficulty: 1 Easy
103. Decentralized firms can delegate authority and yet retain control and monitor
managers' performances by structuring the organization into so-called
"responsibility centers." Which one of the following business
segments/responsibility centers is most like an independent business?
A. Revenue center.
B. Profit center.
C. Cost center.
D. Profit and loss center.

Blooms: Understand
Difficulty: 1 Easy
as a divisional performance measure is incorrect?
A. When the average age of assets differs substantially across divisions of a

business the use of ROI may not be appropriate.
B. ROI relies on financial measures that are capable of being independently
verified while other forms of performance measures are subject to
manipulation.
C. The use of ROI may lead managers to reject capital investment projects that
can be justified using discounted cash flow (DCF) models.
divisions.
E. The use of ROI can lead managers to emphasize the ROI of his/her division over
the profitability of the organization as a whole.

Blooms: Analyze
Difficulty: 3 Hard
19-158
105. Managerial performance can be measured in various ways, including return on
investment (ROI) and residual income (RI). A good reason for using RI rather than
ROI is:
A. RI can be computed without regard to identifying an investment base.

B. Goal congruence is more likely to be promoted by using RI.
C. RI is well understood and often used and discussed in the financial press.
D. ROI does not take into consideration both the asset turnover (AT) ratio and the
return-on-sales (ROS) percentage.
E. An imputed interest rate (minimum rate of return) does not have to be
specified.

Blooms: Understand
Difficulty: 1 Easy
106. Return on investment (ROI), residual income (RI), and Economic Value Added
(EVA) all have in common which one of the following characteristics?
A. They all lead to goal-congruency problems when used to evaluate subunit

performance.
B. They all incorporate nonfinancial performance measures into the metric.
C. They all rely on the use of data used in the preparation of financial statements
(for external reporting).
D. They are all relative (rather than absolute) performance indicators.
E. They all incorporate in the financial performance metric some measure of
investment.

Blooms: Understand
19-159
107. The basic objective of the residual income (RI) approach to divisional performance
measurement and evaluation is to have a division maximize its:
A. Return on investment (ROI) rate.

C. Cash flows, after taxes.
E. Operating income in excess of an imputed charge for capital invested in the
division.

Blooms: Understand
Difficulty: 1 Easy
108. Which of the following items would most likely not be incorporated into the
calculation of a division's investment base when using the residual income (RI) or
the return on investment (ROI) approach for performance measurement and
evaluation?
A. Fixed assets used in divisional operations.

B. Land being held by the division as a site for a new plant in the future.
C. Division inventories when division management exercises control over the
inventory levels.
D. Division accounts payable when division management exercises control over
the amount of short-term credit utilized.
E. Division accounts receivable with division management exercises control over
credit policy and credit terms.

Blooms: Understand
Difficulty: 1 Easy
19-160
109. Which of the following is a true about return on investment (ROI)?
A. It is generally used to evaluate the short-term financial performance of profit

centers.
B. Its use can motivate suboptimal decision making on the part of subunit
managers.
C. It is defined as the difference between some measure of "profit" and an
imputed charge for use of assets by the subunit whose performance is being
evaluated.
D. When inflation is low, it approximates the amount of economic income that a
subunit generates.
E. It generally cannot be used to compare the financial performance of one unit in
an organization to other units in that organization.

Blooms: Understand
investment center manager than is the return on investment (ROI) metric
because:

B. Desirable investment decisions will not likely be neglected by high-return
divisions of the company.
E. Arguments over the implicit cost of capital are eliminated.

Blooms: Understand
19-161
111. Which of the following is not a criticism of using return on investment (ROI) for
divisional performance evaluation?
A. ROI may not capture and reflect value creation in the "new economy."
B. ROI does not take into consideration the amount of capital invested in the
division whose performance is being evaluated.
C. The ROI metric has a short-term focus/orientation.
D. ROI fails to capture broader elements of "performance," beyond financial
performance.
E. There is a disconnect between models used for the analysis of long-term capital
investment projects and subsequent evaluation of the financial results of those
projects using ROI.

Blooms: Understand
112. Listed below is selected financial information for the Western Division of the
Henzel Company for last year:
Account Amount (thousands)

Average working capital $625
General and administrative expenses 75
Net sales 4,000
Average plant and equipment 1,775
Cost of goods sold 3,525
If Henzel treats the Western Division as an investment center for performance

evaluation purposes, what is the before-tax return on investment (ROI) for last
year? (Round your answer to two decimal places.)
A. 34.68%.
B. 26.76%.
C. 22.54%.
D. 19.79%.
E. 16.67%.
ROI = divisional operating income average operating assets = ($4,000 - $3,525 -

$75) ($625 + $1,775) = $400 $2,400 = 16.67%.

Blooms: Apply
19-162
113. James Webb is the general manager of the Industrial Product Division, and his
performance is measured using the residual income (RI) method. Webb is
reviewing the followed forecasted information for his division for the coming year:
Category Amount (thousands)

Current assets (e.g., inventory) $1,800
Revenue 30,000
Plant and equipment (net book value) 17,200
If the imputed interest charge (i.e., divisional cost of capital) is 15% and Webb
wants to achieve an RI target of $2 million, what will costs have to be in order to
achieve the target?
A. $9,000,000.
B. $10,800,000.
C. $23,620,000.
D. $25,150,000.
E. $25,690,000.
Let X = budgeted costs (to achieve profit target). Then, $2,000,000 =

[$30,000,000 - X] - [0.15 ($1,800,000 + $17,200,000)]; $2,000,000 =
[$30,000,000 - X] - $2,850,000. Thus, X = $25,150,000.

Blooms: Apply
19-163
19-164
114. Parkside Inc. has three divisions (Entertainment, Plastics, and Video Card), each of
which is considered an investment center for performance-evaluation purposes.
The Entertainment Division manufactures video arcade equipment using products

Entertainment Division). In addition, the Plastics Division makes less-complex
plastic components that it sells externally, to other producers.
2. The Entertainment Division purchases, for each unit it produces, a video card
from Parkside's Video Card Division, which also sells this video card externally (to
other producers).
respectively, are:
19-165
P
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19-166
d
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c
o
s
t
The Plastics Division sells its commercial products at full cost plus a 25% markup
and believes the proprietary plastic component made for the Entertainment
Division would sell for $6.25/unit on the open market. The market price of the
video card used by the Entertainment Division is $10.98/unit. A per-unit transfer
price from the Video Cards Division to the Entertainment Division at full cost,
$9.15, would:
A. Allow evaluation of both divisions on a competitive basis.

B. Satisfy the Video Cards Division profit desire by allowing recovery of
opportunity costs.
C. Demotivate the Entertainment Division and cause mediocre performance.
D. Provide no profit incentive for the Video Cards Division to control or reduce
costs.
E. Encourage the Entertainment Division to purchase video cards from an outside
source.

Blooms: Apply
19-167
19-168

other producers).
respectively, are:
19-169
P
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19-170
d
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c
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t
Assume that the Entertainment Division is able to purchase a large quantity of

video cards from an outside source at $8.70/unit. The Video Cards Division, having
excess capacity, agrees to lower its transfer price to $8.70/unit. This action would
likely:
A. Optimize the profit goals of the Entertainment Division while subverting the
profit goals of Parkside Inc.
B. Allow evaluation of both divisions on the same basis.
C. Subvert the profit goals of the Video Cards Division while optimizing the profit
goals of the Entertainment Division.
D. Cause mediocre behavior in the Video Cards Division as lost opportunity costs
increase.
E. Optimize the overall profit goals of Parkside Inc.

Blooms: Apply
19-171
19-172

other producers).
respectively, are:
19-173
P
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19-174
d
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c
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s
t
Assume that the Plastics Division has excess capacity and it has negotiated a
transfer price of $5.60 per plastic component with the Entertainment Division. This
price will likely:
A. Cause the Plastics Division to reduce the number of commercial plastic

components it manufactures.
B. Motivate both divisions because estimated profits will be shared.
C. Encourage the Entertainment Division to seek an outside source for plastic
components.
D. Demotivate the Plastics Division, causing mediocre performance.
E. Motivate the Plastics Division to increase the portion of its manufacturing
devoted to the Entertainment Division.

Blooms: Analyze
Essay Questions
19-175
117. Alice and Jon Harrison operate two full-service dry cleaning outlets in the St. Louis
metropolitan area. One of the outlets generates over $800,000 revenue per year
and has more than a million dollar investment in state-of-the-art equipment. The
other outlet is older, generates $20,000 revenue per month, and has 20-25 year-
old equipment currently worth approximately $85,000. Both outlets are profitable
with growing market bases. (The ratio between operating income and sales for
each unit, based on historical-cost accounting numbers, is roughly the same.)
Managers at each location are currently paid a base salary, and receive a year-end
bonus which is five percent of total operating profit produced by both outlets
combined. Alice has just finished a workshop on investment center performance
evaluation, and wants to change the evaluation and reward structure, hoping to
motivate the two managers to produce greater revenue and profit.
Required:
What type of evaluation mechanisms should she propose for the two managers?
(Note: The primary purpose of this problem is to force the student to confront a
situation in which no single measure, whether ROI, RI, or EVA, will produce
consistent performance-evaluation "signals" across all business units.)
There is significant difference between the two investment centers in revenue and
asset size (i.e., level of investment). In addition, the assets of the two outlets are
very different in age and book value. Return on investment (ROI) has the
advantage over residual income (RI) of being reported as a percentage, which
allows for comparison of units of different size. A more difficult problem is the
dramatic difference in the age of the two outlets' asset bases. Use of gross book
value (GBV) or net book value (NBV) for both units would distort comparative
results; current market value would be a more appropriate measure of invested
capital (assets) for each division. Because this is a smaller firm, the use of
economic value added (EVA) as the performance metric may not be cost-
justified. Since the two units are so different, consideration should be given to
using separate evaluation techniques for each outlet. The disadvantage of
separate outlet evaluation techniques is that the firm's overall performance-
evaluation measure cannot be consistent with at least one of the two outlets.
Finally, there is the entire issue of limitations of short-run financial performance
indicators, and the need for a balanced view of "performance" by expanding the
analysis to include relevant nonfinancial-performance indicators.

AACSB: Communication
Blooms: Analyze
Text Feature: Service
19-176
118. Ellie Jackson is upset by the new transfer pricing system recently implemented at
Monson Company. As manager of the first of three sequential production
departments, she can't see the value of a transfer pricing system for her
department. "We can't sell what we produce to any outside buyer. And we're never
pushed for capacity, so I don't think transfer pricing will do anything but make my
life more complicated." You are Ellie's boss.
Required:
Explain how transfer pricing can help Ellie evaluate her department's operations
and allow you to more effectively evaluate her management abilities.
Transfer pricing is an attempt to create an internal marketplace to allow for the

financial-performance evaluation of both profit centers and investment centers. In
a highly decentralized firm, transfer pricing can be used to promote sub-unit
actions that benefit the organization as a whole, that is, that lead to better
decision-making. Even though Ellie has no real control over "prices," her
department can assist the two successive departments to focus on better asset
allocation within the firm. Consideration of the "profit" generated by each
department can improve the equity of rewards for managers of all three
production departments, and hopefully, provide a motivational tool for the same
managers.

Blooms: Analyze
Difficulty: 1 Easy
19-177
19-178
Divisional X Y Z
$2,200,00 $1,100,00 $5,800,00
Sales
0 0 0
Operating income 330,000 143,000 580,000
Investment
750,000 572,000 2,900,000
(assets)
Required:
Calculate return on investment (ROI), return on sales (ROS), and asset turnover
(AT) for each division. Round your answers to two decimal places where
appropriate.
19-179
Division X:
Operating
$330,000
income
750,00
Investment
0
ROI 44%
Division Y:
Operating
$143,000
income
572,00
Investment
0
ROI 25%
Division Z:
Operating
$580,000
income
2,900,00
Investment
0
ROI 20%
Division X:
Operating
$330,000
Income
2,200,00
Sales
0
ROS 15%
Division Y:
Operating
$143,000
Income
1,100,00
Sales
0
ROS 13%
Division Z: 19-180
Blooms: Apply
120. Selected data from an investment center's accounting records reveal the following:
Sales $700,000
Minimum rate of return 12%
Required:
1. Calculate return on investment (ROI) for this investment center (show

separately the two major components of the ROI calculation). Round all
computations to two decimal places.
2. Calculate residual income (RI) for this investment center.
1. Return on Sales = Investment center operating income

(ROS) center sales
= $50,000 $700,000 = 0.07
Asset turnover (AT) = Investment center sales Average
= $700,000 $350,000 = 2.00 times
ROI = Return on Sales(ROS) Asset Turno
= 7% 2 = 14.00%
= Operating income - (Average investe
2. RI
minimum rate of return)
= $50,000 -($350,000 0.12) = $8,00
Blooms: Apply
Difficulty: 1 Easy
19-181
19-182
121. Accounting records from Division A, Alpha Manufacturing Company indicate the
following:
$1,5
Divisional
00,0
Sales
00
$1,0
Average
00,0
Investment
00
Divisional $16
operating 9,50
income 0
Minimum
Rate of 14%
Return
Required:
1. Compute the return on sales (ROS) for Division A. (Round answer to one
decimal point.)
2. Compute the asset turnover (AT) for Division A.
3. Compute return on investment (ROI) for this division, using answers to parts (1)
and (2). (Round answer to two decimal points.)
4. Compute residual income (RI) for Division A.
5. Describe how Alpha Manufacturing would determine whether or not to invest in
any particular project in the future.
1. ROS = Operating income Sales = $169,500 $1,500,000 = 0.113 (or,

11.3%).
2. Asset Turnover (AT) = Sales Average Investment = $1,500,000 $1,000,000
= 1.5 times.
3. ROI = ROS AT = 0.113 1.5 = 0.1695 (or, 16.95%).
4. RI = Operating income - Imputed charge on divisional assets (investment) =
$169,500 - (0.14 $1,000,000) = $169,500 - $140,000 = $29,500.
5. If the estimated ROI for the new project is greater than the current rate of return
(16.95%), Alpha Division would be wise to invest. For any rate of return lower than
the current ROI, Alpha would not benefit from the new project: the incremental
investment, even if justified in an economic sense (i.e., even if the projected rate
of return on the new project exceeds the 14% minimum rate of return), would
decrease divisional ROIunless the rate of return on the new project > 16.95%.

19-183
Blooms: Apply
Difficulty: 1 Easy
19-184
19-185
122. When the Bronx Company formed three divisions a year ago, the president told the
division managers an annual bonus would be given to the most profitable division.
The bonus would be based on either the return on investment (ROI) or residual
income (RI) of the division. Investment, for both calculations, is to be measured
using either gross book value (GBV) or net book value (NBV) of divisional assets.
The following data are available:
Divisio Gross Book Value Operating

n (GBV) Income
A $500,000 $53,500
B $480,000 $52,000
C $300,000 $33,300
All the assets are long-lived assets that were purchased 15 years ago and have 15
years of useful life remaining. A zero terminal (disposal) value is predicted. Bronx's
minimum rate of return (cost of capital) used for computing RI, for all three
divisions, is 10%.
Required:
Which method for computing profitability would each manager likely choose?
Show supporting calculations. Round percentage answers to 2 decimal places
(e.g., 0.12344 = 12.34%). Where applicable, assume straight-line depreciation.
19-186
M
a
Metho
n
d
a
Likely
g
Chosen
er
of
RI
A based
on NBV
RI
B based
on GBV
ROI
based
on
C
either
GBV or
NBV
Calculations: The manager's preferred performance-evaluation measure is shown
in bold.
19-187
Return on Investment (ROI) Calculation
Operating Income GBV of Operating Incom
Division
Assets NBV of Assets*
A $53,500 $500,000 = 10.70% $53,500 $250,
B $52,000 $480,000 = 10.83% $52,000 $240,
C $33,300 $300,000 = 11.10% $33,300 $150,
Residual Income (RI) Calculations
Operating Income Imputed Operating Incom
Division Capital Charge (based on Capital Charge
10% of GBV of Assets) of Average NBV
A $53,500 -$50,000 = $3,500 $53,500 -$25,000
B $52,000 -$48,000 = $4,000 $52,000 -$24,000
C $33,300 -$30,000 = $3,300 $33,300 -$15,000
*Average net book value (NBV) is one half of gross book value (GBV): all assets
were purchased 15 years ago and have 15 years of useful life remaining.

Blooms: Apply
19-188
19-189
123. T-shirts R Us Inc. operates two divisions that each manufactures t-shirts for
universities. Each division has its own manufacturing facility. The historical-cost
accounting system reports the following financial data for 2016.
Atlantic Coast Division

(000s)
Revenues $600
Operating Costs 470
Big-10 Division
(000s)
Revenues $600
Operating Costs 400
T-shirts R Us Inc. estimates the useful life of each manufacturing facility to be 15
years. The company uses straight line depreciation, with a depreciation charge of
$70,000 per year for each division and no salvage value at the end of 15 years.
The manufacturing facility is the only long-lived asset of either division. Current
assets are $300,000 in each division. At the end of 2016 the Atlantic Coast Division
is 4 years old and the Big-10 Division is 6 years old. An index of construction costs,
replacement cost, and liquidation values for manufacturing facilities used in the
production of t-shirts for the 7-year period that T-shirts R Us Inc. has been
operating, are as follows:
19-190
Liquidation Value
Replacement Atlantic
Year Cost Index Cost Coast
2010 80 $1,000,000 $800,000
2011 82 1,000,000 800,000
2012 84 1,100,000 700,000
2013 89 1,150,000 700,000
2014 94 1,200,000 800,000
2015 96 1,250,000 900,000
2016 100 1,300,000 1,000,000
Required:
Round answers to 2 decimal places where appropriate.
1. Compute return on investment (ROI) for each division using net book value
(NBV). Interpret the results.
2. Compute return on investment (ROI) for each division, incorporating current-
cost estimates as follows, using:
(a) Gross book values (GBV) under historical cost;

(b) GBV at historical cost restated to current cost using the index of construction
costs;
(c) NBV of long-lived assets restated at current cost using the index of
construction costs (the facility was constructed the year before the first year of
use);
(d) Current replacement cost; and
(e) Current liquidation value.
3. Which of the measures calculated in (2) above would you choose for (a)
performance evaluation of each division manager, and (b) deciding which division
is most profitable for the overall firm? What are the strategic advantages and
disadvantages to the firm of each measure for both (a) and (b)?
1. ROI based on NBV of Assets (Note: $300 other (current) assets added to all
computations to achieve total asset base):
Atlantic Coast (ACC): $70/year (given) 11 years remaining useful life (given) =
$770;
ROIACC: $130 ($770 + $300) = 12.15%.
Big-10: $70/year (given) 9 years remaining useful life (given) = $630
ROIBig 10: $200 ($630 + $300) = 21.51%.
Thus, the Big-10 Division is more profitable than the ACC Division under NBV-
19-191
based ROI.
2a. Gross Book Value (GBV) of Fixed Assets:
ACC: $70/year 15 years = $1,050 (Depreciation/year useful life, in years)

ROIACC: $130 ($1,050 + $300) = 9.63%
Big-10: Gross Book Value (GBV) of Fixed Assets: $70/year 15 years = $1,050
(Depreciation/year useful life, in years)
ROIBig-10: $200 ($1,050 + $300) = 14.81%
2b. ROI based on Price-Level Adjusted Gross Book Value (GBV): (GBV at historical
cost) (construction cost index in 2016 Construction cost in year of
construction)
GBVACC: $1,050 (100 84) = $1,250

ROIACC: $130 ($1,250 + $300) = 8.39%
GBVBig 10: $1,050 (100 80) = $1,312.50
ROIBig 10: $200 ($1,312.50 + $300) = 12.40%
2c. ROI based on price-level adjusted NPV: (NBV at historical cost) (construction
cost index in 2016 Construction cost in year of construction)
ACC: $1,070 (100 84) = $1,273.30

ROIACC: $130 ($1,273.30 + $300) = 8.26%
Big 10: $930 (100 80) = $1,162.50
ROIBig-10: $200 ($1,162.50 + $300) = 13.68%
2d. ROI Based on Current Replacement Cost:
ROIACC: $130 ($1,300 + $300) = 8.13%

ROIBig-Ten: $200 ($1,300 + $300) = 12.5%
2e. ROI Based on Current Liquidation Value:
ROIACC: $130 ($1,000 + $300) = 10%

ROIBig-10: $200 ($500 + $300) = 25%
3a. The best (i.e., most sensible or revealing) measure for evaluating the manager
is replacement cost, as it corresponds to the "going-concern" value of the
investment. The objective is to identify a measure of investment that fairly reflects
the productive capacity of the assets. Often, NBV falls much faster than the
productive capability of the assets, and thus, the ROI with the older assets
overstates the profitability of the unit. The use of GBV or current cost can help
reduce the bias favoring divisions with older assets. It is superior to NBV and GBV,
which are not related to the current value of the investment. While the GBV of the
investment is superior to NBV (since it is not biased by the age of the assets), a
direct measure of current value such as replacement cost is preferable. Liquidation
value is not used because the divisions are not for sale, nor is sale of either
division currently contemplated. The advantages of the replacement cost measure
are fairness, since it avoids the age bias issues associated with the NBV measure,
and motivation, since it reflects the current value of the asset and therefore what
investment value the manager has to work with. The use of a construction cost
index is a further improvement on GBV, and is useful when a reasonably
meaningful measure of replacement cost is not available because, for example,
19-192
the assets are very specialized and replacement costs would be extremely high.
3b. The evaluation of the division should use replacement cost for the same
reasons as explained in (a) above. The only difference here is when either division
might be sold or relocated, in which case the liquidation value is relevant. Top
management can also look at the liquidation value ROI as a direct measure of
whether the business or division should be sold: the division should earn a
favorable return on liquidation value, and if not, then management should consider
liquidation.

Blooms: Apply
Blooms: Evaluate
Difficulty: 3 Hard
19-193
124. Domi Products, a multi-divisional manufacturing company, measures performance
and awards bonuses to division managers based upon divisional operating income.
Under the current bonus plan, common company-wide operating expenses are
allocated evenly to all five of its divisions. For example, if rent were $50,000, each
division would be charged $10,000. In planning next year's budget, corporate
management has requested that the division managers recommend how common
expenses should be distributed to the divisions. The division managers met and
jointly developed an incentive plan that would more equitably distribute common
expenses on the basis of resources used and that would measure each division
manager's performance based on return on assets (ROI), with divisional bonuses
based on a target ROI. They jointly presented their recommendation to corporate
management.
Required:
1. Describe at least three problems that Domi Products could encounter when
using return on investment (ROI) as the basis of performance measurement.
2a. Define the residual income (RI) approach to segment performance
measurement.
2b. Determine if Domi Products should implement this approach instead of the
ROI approach.
3. Discuss the behavioral implications of the division managers' involvement in
the corporate budgeting process, and the decision to more equitably allocate
common costs.
1. At least three problems that Domi Products could encounter when using return
on investment (ROI) as the basis of performance measurement include difficulty in
determining the appropriate investment value; book value may not be very useful,
since the rate of return artificially increases as assets are depreciated possibly
rejecting profitable projects unit managers delaying replacement of old and
inefficient assets unless current replacement cost is used as the asset value. A
new asset increases the asset base and thus, decreases ROI resulting in a
disincentive to invest and then negative, long-term consequences.
2a. Residual income (RI) is defined as the division's operating income after
deducting a charge for imputed interest. Imputed interest is equal to the asset
used by the division multiplied by the firm's cost of capital.
2b. RI should be adopted as it reveals the firm's true cost of capital to managers,
and avoids some of the problems with ROI. However, it has the same problems as
ROI in terms of the problems in the measurement of income and investment.
3. The beneficial behavioral implications of division managers participating in the
corporate budgeting process include:
a. goals being more realistic and acceptable and, therefore, the evaluation
process is perceived as fair
b. improvement in communication, coordination, and group cohesion
c. a sense of commitment and willingness to be held accountable for the budget
Blooms: Evaluate
19-194
19-195
19-196
12 Eikelberry, Inc. has the following financial results for 2016 for its three regional
5. divisions:
Gross
Net Book Replacem
Book
Region Income Value
Value
FINANCIAL
DATA
North Atlantic $45,000 $225,000 $450,600
Mid Atlantic 33,000 289,000 310,000
South Atlantic 22,000 115,000 166,000
Required:
for each of the three divisions for 2016. The sales in the North, Mid and South Atlantic
regions are $2,350,000, $1,450,000, and $500,000, respectively. Calculate ROI and
asset turnover (AT) for each of the four measures of investment (i.e., for each of four
possible denominators in determining ROI and AT). Round all answers except ROI to 2
decimal places, e.g., round 0.12487 to 12.49%. Round ROI to whole percentage
amounts, e.g., 0.1998 to 20%.
19-197
Measure of
Investment
ROI NBV GBV RC LV
North Atlantic 20% 10% 5% 13%
Mid Atlantic 11% 11% 9% 7%
South Atlantic 19% 13% 3% 2%
Asset Turnover (AT)
North Atlantic 10.44 5.22 2.37 6.71
Mid Atlantic 5.02 4.68 3.82 3.26
South Atlantic 4.35 3.01 0.77 0.51
Return on Sales
(ROS)
North Atlantic 1.91%
Mid Atlantic 2.28%
South Atlantic 4.40%
Blooms: Apply
19-198
126. Edwards Inc. manufactures electronics. It consists of several divisions classified as
investment centers for performance-evaluation purposes. Division A desires to
purchase materials from Division B at a price of $85 per unit. Division B can
produce 25,000 units at full capacity, and is currently operating at 90% capacity
with a variable cost of $80 per unit. Division B currently sells only to outside
customers who pay $115 per unit. Division A pays an outside company $110 per
unit. If purchased from Division B, B's variable costs per unit would be $10 less
because the division would save on marketing expenses for these internal
transfers. Division A requires 10,000 units.
Required:
1. How would Division B selling to Division A affect Division A's purchasing costs?
2. How would intercompany sales affect Division B?
3. What solution would be best for Edwards Inc., assuming Division B has the
ability to operate at full capacity?
1. Division A: It currently costs this division $1,100,000 (i.e., 10,000 units

$110/unit) to purchase externally. It would cost $850,000 (10,000 units $85/unit)
to purchase from Division B. Therefore, if purchases were made internally, Division
A would save $250,000 (i.e., $1,100,000 - $850,000).
2. Selling to Division A would mean that Division B would not be able to sell 7,500
[10,000 - (0.1 25,000)] units to outside customers. Division B's contribution
margin for sales to outsiders is $35 per unit (i.e., $110 - $85) and its contribution
margin for sales to Division A is $15 per unit (i.e., $85 - $70). Therefore, Division B
would lose $150,000 [($35 7,500) - ($15 7,500)] if it sold 10,000 units to
Division A.
3. Edwards Inc. Edwards Inc. would save $100,000 ($150,000 - $250,000) if
Division B sold 10,000 units to Division A. The best solution would be for Division B
to sell 2,500 units to Division A @ $70/unit, and A can outsource the additional
7,500 units.

Blooms: Apply
Blooms: Evaluate
Difficulty: 1 Easy
19-199
127. Max Ltd. produces kitchen tools, and operates several divisions as investment
centers. Division M produces a product that it sells to other companies for $16 per
unit. It is currently operating at its full capacity of 45,000 units per year. Variable
manufacturing cost is $9 per unit, and variable marketing cost is $3 per unit. The
company wishes to create a new division, Division N, to produce an innovative new
tool that requires the use of Division B's product (or one very similar). Division N
will produce 30,000 units per year. Currently, Division N can purchase a product
equivalent to Division M's from Company X for $15 per unit. However, Max Ltd. is
considering transferring the necessary product from Division M.
Required:
1. Assume the transfer price is $12 per unit:
a. How would this price affect the purchasing costs of Division N?

b. How would this price affect the profits of Division M?
c. How would this price affect Max Ltd. as a whole?
2. What if the transfer price was $13 per unit?
1. a. Division N needs 30,000 units. Outsourced, this would cost $450,000 annually
($15/unit 30,000 units/year). Purchased from Division M, this would amount to
an annual cost of $360,000 ($12/unit 30,000 units/year). Therefore, transferring
internally would save Division N $90,000/year (i.e., $450,000 - $360,000).
b. Division M is operating at capacity, generating a contribution of $4 per unit ($16
- $9 - $3) sold to outside customers. This means that, based on external sales,
Division M is generating an annual contribution margin of $180,000 ($4/unit
45,000 units/year). If 30,000 of the 45,000 units are transferred to Division N, then
Division M on these units would have a margin of only $3 per unit, which we
reduce total contribution margin (and operating income) by $30,000 per year (i.e.,
30,000 units/year $1/unit).
c. As a whole, the company would save $60,000 ($90,000 - $30,000) if transfer
pricing @ $12 per unit was used.
2. Purchased from Division M, this would cost $390,000. Transferring would still
save Division N $60,000. At $13, the new transfer profit margin would be $4 per
unit. This is the same as the profit margin for selling to outside customers, so
Division M would be indifferent about selling to outside customers versus
transferring to Division N. As a whole, setting the transfer price @ $13 per unit
would save Max Ltd. $60,000.

Blooms: Apply
19-200
128. Pearl Inc. has the following financial results for 2016 for its three regional divisions:
Historical Cost Estimated Current Cos
Operating Income Replacement Co

Region NBV GBV
Northeast $50,000 $100,000 $150,000
Midwest $80,000 $300,000 $400,000
Southeast $90,000 $400,000 $500,000
Required:
Calculate return on investment (ROI), asset turnover (AT), and return on sales
(ROS) for each division for 2016. The sales in the Northeast, Midwest, and
Southeast regions are $700,000, $800,000, and $990,000, respectively. Calculate
ROI and AT for each of the four measures of investment (i.e., NBV (net book value),
GBV (gross book value), Replacement Cost, and Liquidation Value). Round all
answers except ROI to 2 decimal places (e.g., 0.12522 becomes 12.52%); round
ROI to whole percentage amounts, e.g., 0.1998 becomes 20%.
Measure of Investment
ROI NBV GBV
Northeast 50% 33%
Midwest 27% 20%
Southeast 23% 18%
Asset Turnover (AT)
Northeast 7.00 4.67
Midwest 2.67 2.00
Southeast 2.48 1.98
Return on Sales (ROS)
Northeast 7.14 7.07
Midwest 10.11 10.00
Southeast 9.27 9.09

Blooms: Apply
19-201
129. Selected data from one of the investment centers from Jones Company are as
follows:
Sales
Average divisional assets
Divisional operating income
Required:
1. Calculate return on investment (ROI), including each of the two component

measures of ROI.
2. Calculate residual income (RI).
(1) Return on Sales (ROS) = Investment center operating income Investment center sales
= $40,000 $400,000 = 10%
Asset turnover (AT) = Investment center sales Average divisional assets
= $400,000 $320,000 = 1.25 times
ROI = ROS AT
= 10% 1.25 times = 12.5%
(2) RI = Investment center operating income - (Average invested capital minimu
= $40,000 - ($320,000 0.11) = $4,800

Blooms: Apply
Difficulty: 1 Easy
19-202
19-203
130. Brown's Mill has two operating units, each of which is considered an investment
center for evaluation purposes. The Cutting Division of the mill prepares timber at
its sawmills. Afterwards, the Assembly Division prepares the cut lumber into
finished wood, to be sold to furniture manufacturers. During the most recent year,
the Cutting Division produced 120,000 cords of wood, at a total cost of
$1,320,000. The entire output was transferred to the Assembly Division, where
additional costs of $6 per cord were incurred. The 1,200,000 board-feet of finished
wood were then sold in the open market for $5,000,000.
Required:
1. Determine the operating income for each division if the transfer price from the
Cutting Division to the Assembly Division is set at full production cost, $11 per
cord.
2. Determine the operating income for each division if the transfer price is set at
$9 per cord.
3. Since the Cutting Division sells all of its output internally, does the manager
care about what price is charged? Why? Should the Cutting Division in this case be
considered a cost center or a(n) profit/investment center?
1. Transfer price set at full manufacturing cost per unit $11 per cord:
Revenue
Costs:
Direct
Transferred-In
Total cost
Operating income
2. Transfer price set at $9 per cord:
Revenue
Costs:
Direct
Transferred-In
Total cost
Operating income
3. As indicated by the calculations presented above in (a) and (b), the manager of
the Cutting Division probably cares very much whether the division is treated as a
cost center or a profit (or investment) center for performance-evaluation purposes.
If the Cutting Division has the option or opportunity of selling outside, then there
are reasons why it should be considered a profit or investment center. On the other
hand, if we envision that the Cutting Division will remain a captive supplier of the
Assembly Division, then it should probably be evaluated as a cost center, in which
19-204
case the issue of transfer pricing is not important from its perspective. Note that to
be considered a profit or an investment center, there is a presumption that the
manager of the division exercises control over costs incurred and revenues
generated (and, in the case of an investment center, level of investment in the
division). It does not appear that such control exists in the current situation.

Blooms: Analyze
Blooms: Apply
19-205
19-206
131. Simmons Bedding Company manufactures an array of bedding-related products,
including pillows. The Cover Division of Simmons makes covers, while the
Assembly Division of the company produces finished pillows. The covers can be
sold separately for $10.00 a piece, while the pillows sell for $12.00 per unit. For
performance-evaluation purposes, these two divisions are treated as investment
centers. Financial results from the most recent accounting period are as follows:
Assemb
Cover
ly
Divisio
Divisio
n
n
$6,000, $1,500,
Traceable manufacturing costs
000 000
$4,000, $7,200,
External sales
000 000
Market value of output transferred from Cover Division to the

$6,000,
Assembly Division
000
Required:
1. What is the operating income for each of the two divisions and for the company
as a whole? (Use market value as the transfer price.)
2. Do you think each of the two divisional managers is happy with this transfer-
pricing method? Explain.
1.
Item
Revenue:
Internal sales
External sales
Costs:
Traceable to the division
Transferred in costs
Total costs
Operating income (loss)
2. As reflected above, the manager of the Assembly Division is probably not

happy with the transfer-pricing method chosen. This is because the use of market
prices results in his/her division showing an operating loss for the period. This
manager would probably argue that the transfer price should be set at something
less than market price, a situation that may be tenable if there are cost savings
(transportation, sales commissions, etc.) associated with internal transfers. In
general, the use of market price as the transfer price is desirable in terms of the
objectives presented at the beginning of Part Two of Chapter 19. In this case, the
use of market prices signals the need for the Assembly Division manager to either
19-207
increase the selling price of its product or to reduce its own costs, or both.

Blooms: Analyze
Blooms: Apply
19-208
19-209
132. The manager of the processing division of XYZ Corporation is considering the
purchase of new equipment, which would modernize an aging plant. Currently, the
division has an asset base of $8,000,000 and net operating income of $1,200,000.
The new equipment is expected to cost $1,000,000; it supports the corporate
strategy of competing on the basis of quality and customer response time (CRT).
The new investment is also expected to increase operating income by $100,000
next year, which is an acceptable return on investment (ROI) from the standpoint
of corporate management.
Required:
1. What is the current ROI for the processing division of XYZ Corporation? (Show
calculations.)
2. What will be the divisional ROI if the new investment is undertaken?
3. Suppose that the compensation contract for the manager of the processing
division consists of a base salary plus a bonus that is proportional to the ROI
earned by the division. Is this manager's total compensation higher with or without
the new investment? (Show calculations.)
4. What changes to the divisional manager's compensation contract might
corporate management make that would better align divisional manager's
compensation (and performance evaluation) with overall corporate goals?
1. ROI = divisional operating income divisional assets = $1,200,000

$8,000,000 = 15%.
2. ROI = divisional operating income divisional assets = ($1,200,000 +
$100,000) ($8,000,000 + $1,000,000) = $1,300,000 $9,000,000 = 14.44%.
3. The overall divisional ROI will decrease if the new investment is undertaken,
even though from the standpoint of corporate management the new investment is
desirable. Because the overall ROI is higher without the new investment, the
divisional manager's compensation will be much higher if he/she does not
undertake the new investment. Therefore, the compensation scheme does not
provide incentives for a manager to undertake an investment that would benefit
the corporation. This is a classic example of a goal congruency problem.
4. There are several options for achieving a better alignment between corporate
goals and the incentive system used to reward divisional managers of this
corporation. One possibility is that divisional performance be assessed using an
absolute metric, such as residual income (RI). As long as a new investment adds to
RI, the divisional manager would be motivated to make the new investment.
Another possibility is to use Economic Value Added (EVA). Similar to RI, EVA is
an absolute, not relative, performance metric. Another possibility is to give
divisional managers a flat bonus upon achieving a target ROI or target residual
income (RI), which could be lower than the existing ROI or level of RI. Still another
alternative is to base the manager's compensation on a combination of financial
and nonfinancial measures. Current-period actions that decrease the current
period's financial performance may be creating future value. Such actions include
investments in research and development, employee training, new distribution
channels, and customer service. Conversely, companies that decrease their
investments in these activities may show good current-period financial
performance but they will have likely diminished future value. Therefore, a mixture
of financial and non-financial measures can provide information about the current
period's success in generating both current financial performance and growth
options for the future. This would be particularly important for investments, such
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as the current case, that support the overall strategy of the organization.

Blooms: Apply
Blooms: Evaluate
19-211
133. The following questions pertain to the process of transfer pricing.
1. Define the term "transfer price."

2. What the three general alternatives for setting domestic transfer prices?
3. What is meant by the term "dual pricing," as used within the context of the
transfer pricing decision? Give one example of "dual pricing."
4. What criteria can be used to judge a particular transfer pricing alternative?
(Hint: think about the different objectives of transfer pricing, including objectives in
an international setting.)
5. What is meant by the term "advance pricing agreement" (APA)? What is the
essential purpose of an APA?
1. A transfer price is the amount assigned (or charged) for intra-organizational

transfers of goods or services. That is, it is the price one subunit of an organization
charges for a product or service supplied to another subunit of the same
organization. Note that the subunits can be cost centers, profit centers, or
investment centers.
2. The three general alternatives for setting domestic transfer prices are as
follows: cost (either variable cost or full cost, either standard cost or actual cost),
market price, and negotiated price.
3. There is no strict requirement that the same transfer price be used by both the
buying unit and the selling subunit for a given transaction. When two separate
transfer prices are used for an internal transfer (one for the buying unit, the other
for the selling unit), dual pricing is used. For example, on a given internal
transaction, the buying unit might be charged standard full cost, while the selling
unit might use the external market price to record the transaction. (Note that when
consolidated financial statements are prepared, the income effect of all internal
transfers is removed as part of the consolidation process.)
4. The chapter identifies the following primary objectives for transfer pricing: (a)
managerial motivation, (b) goal congruency (i.e., consistency between goals of top
management and decisions made by managers), and (c) performance evaluation
(i.e., the transfer price mechanism should be useful for rewarding managers for
their effort and skill, and the effectiveness of the decisions they make). Students
should also specifically mention tax planning from an international perspective.
Students may indicate the following additional objectives: (a) autonomy (i.e.,
extent to which a particular transfer price preserves a high level of subunit
autonomy in decision-making), and (b) administrative ease/implementation costs.
5. Advance pricing agreements (APAs) are pre-transaction agreements between
the IRS and taxpayer regarding the acceptability of a particular transfer-pricing
alternative. The primary objective of APAs is to resolve transfer pricing disputes in
a timely manner and to avoid costly (and time-consuming) litigation.
AACSB: Diversity
AICPA: BB Global
Blooms: Understand
19-212
19-213
19-214
134. The text presents what it calls a "general transfer-pricing" rule that can be used to
help set an appropriate transfer price. The following questions pertain to this
general rule.
Required:
1. Present, in equation form, the general transfer-pricing rule presented in the

chapter. Briefly describe the elements of the model.
2. In what sense is the model presented in the chapter a general transfer-pricing
rule?
3. Evaluate the general transfer-pricing rule in light of the objectives for transfer
pricing that are presented in the chapter.
4. What are some of the major implementation issues associated with applying
the general transfer-pricing rule in practice?
1. Minimum transfer price = incremental ("out-of-pocket") cost of the producing

division, up to the point of transfer + opportunity cost to the selling division by
making an internal transfer. This rule establishes the "floor" or minimum transfer
price from the standpoint of the selling division. If the transfer price were less than
the amount indicated by the general rule, the selling division would have no
motivation to sell at that amount. That is, the selling division, at a minimum, would
want the internal transfer price set so as to cover the selling division's incremental
costs (needed to get the product to the point of transfer) plus compensation for
any opportunity cost associated with making an internal transfer rather than an
external sale.
2. The general transfer-pricing rule is equivalent to the rule discussed in Chapter
11 for determining relevant costs for decision-making. One specification of
relevant cost is the sum of out-of-pocket costs plus opportunity costs (if any). The
resulting cost information can be used to address a number of decision problems,
including acceptance of a special sales order, short-term pricing decisions, and the
equipment-replacement decision. We see from the above equation that the
minimum transfer price can similarly be defined as the sum of out-of-pocket cost
(of the producing division, up to the point of transfer) plus any opportunity costs
incurred by the selling division. Thus, the general transfer-pricing rule can be
related to material students were exposed to in an earlier chapter in the text.
Finally, the point can be made that the price indicated by application of the
general rule is but one input to the ultimate transfer pricing decision.
3. As stated in the text, a particular transfer pricing alternative can be evaluated
on the basis of: (a) whether the resulting transfer price is useful for evaluating
divisional performance, (b) whether it facilitates goal congruence, (c) the extent to
which it motivates management effort, and (d) extent to which the transfer pricing
alternative maintains divisional autonomy. The application of a decision rule, such
as the transfer price specified by application of the general transfer-pricing rule,
infringes on divisional autonomy, and therefore may have negative motivational
(behavioral) consequences. On the other dimensions, the use of the general
transfer-pricing rule seems to perform well. Thus, the best way to think about the
general transfer-pricing rule is that it is but one piece of information relevant to
the determination of an appropriate transfer price.
4. The text suggests two practical issues that may arise in attempting to
implement the general transfer-pricing rule. One, estimating opportunity costs
may be a difficult taskby definition, such costs are not based on an actual
market exchange. A variation of this argument is that a comparable product, sold
on an external market, may not exist. (This would occur, for example, with
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intermediate products, components, or subassemblies.) Two, unless the product in
question is a commodity-type product, economic theory suggests that selling price
is partly a function of quantity sold. In this context, selling price, and therefore the
transfer price, is partly a function of the amount of internal versus external sales
by the producing division. Such an interaction complicates attempts to estimate an
opportunity cost associated with internal transfers of goods and services. In these
cases, the organization either needs to use an alternative transfer pricing method
or accept the uncertainties associated with the process of estimating opportunity
costs.
Blooms: Understand
Difficulty: 3 Hard
19-216
135. What special problems and opportunities arise in setting transfer prices in an
international setting (i.e., for transfers between subunits that operate in different
countries)? Hint: In terms of special problems, make sure you reference OECD
requirements and practical implementation alternatives for general OECD
requirements.)
Opportunities: Alternative transfer-pricing methods can result in sizable differences

in the reported operating income of divisions in different income tax jurisdictions.
If these jurisdictions have different tax rates or deductions, the net income of the
company as a whole can be affected by the choice of the transfer-pricing method.
In addition, net cash flow (world-wide) of the organization is affected by total
customs charges paid across territories and jurisdictions. Such charges are
typically based on cost, which is represented by the transfer price. In short, there
are significant tax-planning opportunities associated with the setting of transfer
prices in an international setting.
Problems/Issues: As indicated in the text, most countries today accept the OECD's
model treaty, which calls for transfer prices to be adjusted using the "arm's-
length" standard, that is, to a price that unrelated parties would have set.
Basically, this treaty seeks to limit the tax-planning opportunities of organizations
doing business in an international setting. The arm's-length standard calls for
setting transfer prices to reflect the price that unrelated parties acting
independently would have set. This standard is applied in practice by using one of
the following three approaches:
1. Comparable prices methodthe "arm's-length" transfer price is defined as the

sales price of similar products made and sold by unrelated firms, that is, firms in
which there is no common ownership interest.
2. Resale price methodthe "arm's-length" transfer price is used for distributors
and marketing units when little value is added and significant manufacturing
operations exist. The transfer price is based on an appropriate markup using gross
profits of unrelated firms selling similar products.
3. Cost-plus methodunder this approach, the "arm's-length" transfer price is
based on the selling unit's cost plus a gross profit percentage determined by
comparing the selling unit's sales to those of unrelated parties or to unrelated
parties' sales to those of other unrelated parties.
AACSB: Diversity
AICPA: BB Global
Blooms: Understand
19-217
136. What are the principal advantages and disadvantages of using cost-based transfer
prices? (Give a short explanation of each item you list.)
Advantages
1. Managers of the various subunits have an intuitive understanding of "cost."

2. Cost information may be readily available, because such data are needed for
financial reporting purposes (and tax purposes).
3. Related to #2 above, the use of some form of "cost" as the transfer price might
be administratively the least costly alternative.
4. Variable cost information may facilitate optimal short-run decision-making.
5. Full cost information may facilitate optimal long-run decision-making (that is,
they may provide optimal signals to subunit managers for making sourcing
decisions).
Disadvantages
1. Full-cost transfer prices can lead to suboptimal decisions from the standpoint of
the organization as a whole. For example, full costs may not motivate an internal
transaction when it would be beneficial, firm-wide, for this to happen. (That is, the
buying division inappropriately treats as a variable cost the full cost of the selling
division. Normally, the buying division should purchase internally when the
producing unit's incremental costs are less than the external market price.)
2. Unless standard costs are used, cost-based transfer prices may not engender
cost control on the part of the producing (selling) subunit, since cost incurred is
simply passed on to the buying unit.
3. From the standpoint of the producing (selling) unit, the use of cost as the
transfer price does not allow any profit on the transaction. (To the extent that only
a minor portion of the selling unit's output is consumed internally, this may not be
a major problem.)
Blooms: Understand
19-218
137. The text notes that there are various objectives of transfer pricing. This raises the
possibility of using multiple transfer pricing alternatives. For example, an
organization could use one transfer pricing alternative for domestic transfers and
another alternative for transnational transfers.
Required:
1. Provide a reason why an organization might choose a particular transfer pricing

alternative for domestic transfers and a different transfer pricing alternative for
international transfers.
2. Provide a reason why an organization may not want to use two different transfer
pricing systems, one for domestic transfers and another for international
transfers.
1. For domestic transfers, the organization might choose a transfer pricing

alternative that, in its opinion, best reflects the performance of its managers or
that achieves goal congruence (i.e., one that causes managers to act in the best
interest of the organization as a whole). For transnational transfers of goods and
services within the organization, top management may choose a transfer pricing
system (or alternative) that minimizes the organization's world-wide tax liability.
This is done by pursuing the following strategy: as much as possible, locating most
of its profit in the lower-tax country.
2. The main point of this question is that the objectives for domestic versus
international transfers can be conflicting. However, international authorities are
aware of tax-related incentives and therefore examine international transfer
pricing policies of companies carefully, particularly in light of the amount of taxes
at stake. OECD (Organization for Economic Co-operation and Development)
guidelines* indicate that whenever possible, transfer prices should reflect market
or economic circumstances. If the domestic transfer pricing system was designed
to reflect economic considerations, then that system may meet OECD
requirements for transnational transfers. Looked at perhaps from a defensive
posture, using one system for domestic transfer pricing and a different system for
international transfer pricing is likely to trigger investigation by taxing authorities.
For this reason, an organization may choose to use the same system for both
domestic and international transfers.
*Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,

Paris: OECD, 1995.
AACSB: Diversity
AICPA: BB Global
Blooms: Understand
19-219
138. As noted in the text (Chapter 19), the use of market price can be used to set the
transfer price associated with interdivisional transfers of goods and services.
Required:
1. What are the primary advantages of using market price as the transfer price?
2. What are the primary disadvantages of using market price as the transfer price?
1. Primary Advantages
a. The use of market prices helps preserve divisional autonomythe resulting

profit statements for both the buying and the selling divisions approximate what
would have occurred if all transactions were with external, independent entities.
b. The use of market price provides an incentive for the selling (producing)
division to be competitive with outside suppliers.
c. For determining the transfer price for international transfers, the use of market
prices meets the "arm's-length" standard.
d. Transferring products or services at market prices generally (but not always)
leads to optimal decisions from a short-term financial perspective. This is to the
extent that:
(a) the market for the intermediate product market is perfectly competitive
(b) interdependencies of subunits are minimal, and
(c) there are no additional costs or benefits to the company as a whole from
buying or selling in the external market instead of transacting internally.
2. Primary Disadvantages
a. There may not be an established market (e.g., the product is a subassembly,

component, or intermediate product), in which case there is no external market
price
b. Market price for all but commodity-type products is partly a function of selling
price, but it is selling price (market price) that you are trying to determine. Hence,
there appears to be some circularity of reasoning.
c. For certain short-run decisions, the use of an external market price may not
motivate the correct economic decision. (Specifically, when the selling division's
opportunity costs are zero and its incremental costs are less than the external
market price, the organization as a whole will benefit if the transfer takes place
internally. However, the use of an external market price may not motivate this
economically desirable transfer.)
Blooms: Understand
19-220
19-221
139. Assume the following facts regarding a product that Division P can sell internally
(to Division B) or externally on the open market. Incremental (i.e., out-of-pocket)
cost to Division P for each unit produced = $12. External purchase price, to be paid
by Division B = $13.50. Total units needed (annually) by Division B = 1,000.
Required:
1. Assume that there are no alternative uses for Division P's facilities. Determine
whether the company as a whole will benefit if Division B purchases the product
externally. At what amount should the transfer price be set such that each
divisional manager, acting in the best interest of his or her own division, take
actions that are in the best interest of the company as a whole?
2. Assume that Division P's facilities would not otherwise be idle if it didn't
produce the product for Division B. By not producing the product for Division B, the
freed-up facilities would be used to generate a net cash benefit of $1,800. Should
Division B purchase from suppliers? (Show calculations.)
3. Assume that for the foreseeable future there are no alternative uses for Division
P's facilities, and that the outside supplier's cost to Division B drops by $2. Under
this circumstance, should Division B purchase externally? At what amount should
the transfer price be set such that each divisional manager, acting in the best
interest of his or her division, would take actions that are in the best interest of the
company as a whole?
1. The company as a whole will not benefit if Division B purchases from external
suppliers:
Purchase costs paid by Division B to external suppliers = 1,000 units $13.50/unit =
Deduct: Avoidable costs, Division P output: 1,000 units $12.00/unit =
Net cost (benefit) to company as a whole as a result of purchasing from external suppliers
Any transfer price between $12.00 and $13.50 per unit will achieve goal
congruence. That is, at any of these transfer prices the divisional managers, acting
in their own best interests, will take actions that are in the best interests of the
company as a whole (in terms of maximizing short-term operating income for the
firm).
2. The company as a whole will benefit if Division B purchases from the external
supplier:
Amount paid to the external supplier = 1,000 units $13.50/unit =

Less: Division Ps avoidable costs = 1,000 units $12.00/unit =
Incremental benefit from freed-up facilities, Division P =
Net cost (benefit) to company as a whole as a result of purchasing from the external supplier
Therefore, Division B should purchase the product from the external supplier. This
action would help the firm as a whole to maximize short-term operating profit.
19-222
3. The company as a whole will benefit if Division B purchases from an external
supplier:
Purchase cost paid by Division B to the external supplier: 1,000 units $11.50/unit
Less: Avoidable costs, Division P output: 1,000 units $12.00/unit

Net cost (benefit) to company as a whole if Division B purchases externally
The three requirements are summarized below (in thousands):
(1) (2) (3)

Purchase costs paid $13.50 $13.50 $11.50
to external suppliers
Relevant costs if B
purchases internally
(from P) :
Incremental (outlay) 12.00 12.00 12.00
costs, Division P
Opportunity costs if 1.80
purchased from
Division P
Total relevant costs 12.00 13.80 12.00
if purchased from
Division P
Per-unit advantage $1.50 ($0.30) ($0.50)
(disadvantage) to
company as a whole
as a result of
purchasing internally
Goal congruence would be achieved if the transfer price is set equal to the total
relevant costs of purchasing from Division P (i.e., the sum of out-of-pocket costs
+ opportunity costs [if any]).

Blooms: Apply
19-223
140. Assume two divisions, P (producing) and B (buying) of a company are both treated
as investment centers for performance-evaluation purposes. Division B requires
1,000 units of product that it can either purchase externally on the open market
for $13.50 per unit, or obtain internally from Division P. The incremental (i.e., out-
of-pocket) costs to Division P are estimated at $12.00 per unit. Because of spot
shortages of this product in the open market, it is sometimes possible for Division
P to sell at a price higher than the normal market price. Such is currently the case:
Division P has an offer to sell 1,000 units at a gross selling price of $15.50 per unit.
In addition to the normal incremental production costs, Division P would have to
pay a $0.50 sales commission cost for each unit sold externally.
Required:
1. If Division B purchased the units externally, would the firm as a whole benefit or
lose (in terms of a short-term financial impact)? Show calculations.
2. Apply the general transfer-pricing model to this situation. What is the minimum
transfer price indicated for each of the 1,000 units in question? Show calculations.
3. What is the likely consequence, from a decision standpoint, if the transfer price
is set at the amount stipulated by the general transfer-pricing rule?
1. If Division B purchases the units externally, then the firm as a whole would
benefit by $1,500, which is the net effect of two offsetting factors:
(a) the firm's operating income would decrease by $1,500 because of the extra
amount paid by Division B for the units it needs (that is, $1,500 = [$12.00/unit -
$13.50/unit] 1,000 units); and
(b) the firm's operating income would increase by the $3,000 contribution margin
that Division P would realize on the external sales (i.e., $3,000 = [$15.50 - $12.00
- $0.50]/unit 1,000 units).
In short, there is a positive net short-term financial benefit of having Division P sell
its entire output externally.
2. General transfer-pricing rule: minimum transfer price/unit = incremental cost of
Division P, to the point of transfer + opportunity cost (if any) for any internal
transfers, expressed on a per-unit basis. Incremental (out-of-pocket) production
cost to point of transfer = $12.00 per unit (given). Opportunity cost of making an
internal transfer = ($15.50 - $12.00 - $0.50) per unit = $3.00. Therefore, minimum
transfer price = $12.00 (out-of-pocket cost) + $3.00 (opportunity cost) = $15.00
per unit.
3. As implied by the above calculations, the producing (selling) division would be
indifferent between selling internally versus externally if the transfer price is set at
$15.00 per unit. At this price, the buying division will likely purchase externally (at
a premium of $1.50 per unit over the producing division's incremental production
costs), and the producing division will also sell externally (achieving a $3.00 per
unit premium). As shown by requirement (1) above, the net short-term financial
impact on the company as a whole is + $1.50 per unit.

Blooms: Analyze
Blooms: Apply
19-224
19-225
19-226
141. Assume two divisions of a company, P (producing) and B (buying), that are treated
as investment centers for performance-evaluation purposes. As the management
accountant, you've been asked to provide input to the determination of the
appropriate transfer price for an exchange of product between these two divisions.
In case #1, Division P is experiencing a capacity constraint, while in case #2 it is
assumed that Division P has excess capacity. The incremental production cost
incurred by Division P, to the point of transfer, is $80.00 per unit. Division P can
sell its output externally for $120.00 per unit, less a sales commission charge of
$5.00 per unit. Currently, Division B is purchasing the product from an external
supplier at $120.00 per unit, plus a $3.00 transportation charge per unit.
Required:
1. Assume that Division P has limited capacity. Thus, for each unit it sells
internally, it loses the opportunity to sell that unit externally. Use the general
transfer-pricing rule to determine the minimum transfer price for internal transfers
of units, that Division P would charge Division B. From the standpoint of Division P,
why is the figure you calculated considered an acceptable transfer price?
2. What is the maximum transfer price that Division B would be willing to pay per
unit on any internal transfers?
3. If top management of the company allows the managers of Divisions P and B to
negotiate a transfer price, what is the likely range of possible transfer prices?
4. Assume now that Division P has excess capacity. Use the general transfer-
pricing rule to determine the minimum transfer price that Division P would be
willing to accept from Division B for any internal transfers. Would this transfer price
motivate the correct economic decision (internal versus external transfer) from the
standpoint of the company as a whole? Explain.
5. Given the situation described above in (4), would top management of the
company want the transfer to take place internally? Why? (Show calculations, if
appropriate.) How could top management ensure that an internal transfer would
take place?
1. Minimum selling price to Division B = incremental costs incurred by Division P,

up to the point of transfer + opportunity cost on any external sales foregone
(expressed per unit of internal transfer) = $80.00 + [$120.00 - $5.00 - $80.00] =
$115.00 per unit. Note that at an internal transfer price of $115.00 per unit, the
producing division (Division P) would be indifferent between selling internally and
selling to an external party.
2. The maximum transfer price that Division B would be willing to offer Division B
is its own total cost for purchasing externally, $123 per unit (i.e., $120 plus $3 per
unit).
3. The likely range of possible transfer prices is $115.00 to $123.00 per unit. The
general transfer-pricing rule provides the floor or minimum likely transfer price
while the external market price (above in [2]) establishes the ceiling. Thus, there is
likely an $8.00 per unit range that would be subject to negotiation between the
two divisional managers.
4. If the producing division has excess capacity, then by definition its opportunity
cost for internal transfers is $0. Thus, based on the original data, the general
transfer-pricing rule provides a minimum transfer price of $80.00 per unit, that is,
the incremental cost incurred by the producing division to the point of transfer. At
a transfer price of $80.00 per unit, the producing division would realize zero profit
on any internal transfers. Thus, the divisional manager may not be motivated to
produce/sell at this transfer price. Also, setting the transfer price at this amount
19-227
complicates top management's effort to evaluate the short-term financial
performance of Division P. If top management allows the divisional managers to
negotiate a transfer price, then the likely range is from $80.00 (minimum) to
$123.00 (maximum).
5. From the point of view of the top management of the company, all of the
producing division's output should be transferred internally to the buying division.
All such transfers would avoid the $3 per unit transportation cost that is incurred
by the buying division when it purchases units from the outside; such transfers
would also save the $5 sales commission cost the SD would incur to sell each
screen on the outside market. It would be possible at this point that top
management could dictate the transfer price, which would, in effect, force an
internal transfer. However, the downside of this approach (which maximizes short-
term financial performance for the company as a whole), is that it decreases
divisional autonomy.

Blooms: Analyze
Blooms: Apply
19-228
19-229
142. This question deals with summary financial performance indicators for investment
centers.
Required:
1. Discuss the similarities between ROI, residual income (RI), and EVA.
2. In what sense is EVA similar to and in what sense is it distinct from residual
income (RI)?
3. Present the equation for calculating EVA and provide a brief discussion of the
elements that go into the calculation of EVA.
4. What are the two approaches that can be used to estimate the two major
components of EVA? Which of these two approaches is superior?
1. ROI, RI, and EVA have the following in common:
(a) they are all summary financial-performance indicatorsas such, each can be
included as a high-level objective in, say, the balanced scorecard (BSC) of an
organization;
(b) each is appropriate for assessing the financial performance of investment
centers because each incorporates the level of investment in the performance
metric;
(c) each is limited in the sense of assessing only short-run financial performance;
and
(d) because they are short-term financial-performance indicators, each can be
manipulated by managersat least to some extent.
2. Both EVA and residual income (RI) are absolute performance indicators. That
is, they represent dollars of earnings (in some form). As such, there use tends to
avoid negative behavioral effects associated with the use of a relative
performance indicator, such as ROI. (By relative performance indicator, we mean
"ratio.") Further, both EVA and residual income (RI) impute a charge for use of
divisional assets (investment in the unit). Thus, it is not until there is a "return of
capital" that a "return on capital" is indicated. Finally, both RI and EVA, because
they are absolute performance metrics, have an inherent bias toward larger
divisions. EVA and residual income (RI) look similar, on the surface. However,
there is a significant difference between the two. RI uses conventional accounting
data, for both "operating income" and "investment." As such, the metric is subject
to the same limitations as those associated with such data. EVA, on the other
hand, attempts to approximate "economic earnings." Thus, both the income figure
and the level of invested capital are adjusted to remove what proponents of EVA
consider to be "accounting distortions." In fact, Stern Stewart in the classic book
on EVA shows approximately 160 such adjustments that can be made to
reported accounting data when calculating EVA for a given company.
3. EVA = NOPAT - (k average invested capital), where NOPAT = after-tax cash
operating earnings, after depreciation = "total pool of cash funds available to the
suppliers of capital" = revenues - cash operating costs - depreciation - cash taxes
on operating income, k = an appropriate discount rate (such as the weighted-
average cost of capital, WACC), and "invested capital" = "economic capital" = cash
contributed by suppliers of funds to the business (or business unit).
4. EVA NOPAT and EVA capital can be estimated using one of two approaches:
operating approach and financing approach. These two approaches lead to
equivalent estimates of EVA NOPAT and EVA capital. The approach chosen for
19-230
use is a matter of personal preference.

Blooms: Understand
Difficulty: 3 Hard
143. A fellow student of yours who has just completed a course in management
accounting recently made the following comment to you regarding the
establishment of transfer prices for transnational transfers of goods and services
within the same company: "In the process of preparing consolidated financial
statements, all profit and loss attributable to internal transfers of goods and
services are removed. The amount of profit a company reports is therefore
affected only by transactions with external parties. Therefore, the subject of
transfer pricing may be important for motivational purposes or some other
managerial objective, but the choice of a transfer pricing system has no effect on
the bottom line, even when transfers are made between units of a company
operating in different countries."
Required:
Critically analyze and respond to the above assertion.
The above comment may have some validity if there were no income tax effects
associated with transnational exchanges of goods and services, or if the tax rates
were relatively equal across tax jurisdictions (which they are not). However, the
existence of income tax differentials and import duties in the real world provides
opportunities for tax planning and therefore optimization of after-tax earnings and
cash flows. That is, alternative transfer pricing methods can result in sizable
differences in the reported operating income of divisions in different income tax
jurisdictions. If these jurisdictions have different tax rates or deductions, the net
income of the company as a whole can be affected by the choice of the transfer
pricing method. The above comment can also be challenged because it ignores
incentive or other decision effects associated with income tax differentials. (In
technical terms, the argument assumes a static analysis.) For example, to the
extent that a company is able to achieve reductions in worldwide taxes (and
duties) it may be able to lower its selling price. Depending on the price elasticity of
demand for the product (or service) in question, this reduction in selling price
could affect total sales, thereby affecting in a positive way the bottom line
worldwide income of the organization.

AACSB: Diversity
AICPA: BB Global
19-231
Blooms: Analyze
Difficulty: 1 Easy
144. Michael Cianci, manager of Division C of the FX Corporation, is considering a new

investment for his division. The division currently has an investment base (i.e.,
assets) of $4,000,000, and operating income of approximately $600,000 per year.
The new investment of $500,000 supports corporate strategy and is expected to
increase operating income by $50,000 next year, an acceptable level of return
from the standpoint of the corporation as a whole.
Required:
1. What is the current return on investment (ROI) for Division C?

2. What will be the ROI of the division if the new investment is undertaken?
3. Suppose the manager's compensation consists of a salary plus a bonus
proportional to divisional ROI. Would the manager's compensation be higher with,
or without, the new investment?
4. Suggest changes to corporate management that will better align performance
evaluation and compensation with corporate goals.
1. ROI = Operating Income Investment = $600,000 $4,000,000 = 15.00%

2. ROI = Operating Income Investment = $650,000 $4,500,000 = 14.44%
3. Because the overall ROI is higher without the new investment, Michael's
compensation will be much higher if he does not undertake the new investment.
Therefore, the compensation scheme does not provide incentives for a manager to
undertake an investment that would benefit the corporation as a whole.
4. A variety of changes would be possible. For example, the manager could receive
a flat bonus upon achieving a target ROI or target residual income. Another
alternative is to base the manager's compensation on a combination of financial
and nonfinancial measures. Current-period actions that decrease the current
period's financial performance may be creating future value. Such actions include
investments in research and development, employee training, new distribution
channels, and customer service. Conversely, companies that decrease their
investments in these activities may show good current-period financial
performance but they will have likely diminished future value. Therefore, a mixture
of financial and non-financial measures can provide information about the current
period's success in generating both current financial performance and growth
options for the future.

Blooms: Analyze
Blooms: Apply
19-232
145. This question pertains to the use of market-based transfer prices.
Required:
What is the primary advantage and what is the primary difficulty in using market-
based transfer prices?
A market price is an independent valuation of the transferred good or service.

Therefore, the market price is an excellent way of identifying where value is added
in the organization. However, finding the exact market price of the transferred
product may be difficult because the market price will often reflect many product
facets that may not be identically replicated in the product being transferred. In
order to use a market price the organization must ensure that the transferred
product is exactly the same as the product for which a market price is observed.
Blooms: Understand
Difficulty: 1 Easy
19-233
19-234
146. Pacific Mill consists of two operating divisions, a Cutting division and the Assembly
division. The Cutting division prepares cords of timber at its sawmills, while the
Assembly division prepares the cut cords of lumber into board-feet of finished
wood (which is sold to various furniture manufacturers). During the most recent
year the Cutting division prepared 60,000 cords of wood at a cost of $1,320,000.
All of this lumber was transferred to the Assembly division, where incremental
costs of $12 per cord were added. Pacific Mill sold the 600,000 board-feet of
finished wood for $5,000,000.
Required:
price from Cutting to Assembly was set at the cord cost of $22 per cord? (Show
calculations.)
price is set at $18 per cord? (Show calculations.)
3. Since Cutting transfers all of its output internally (to Assembly), does the
manager of Cutting care what price is selected? Why? Should Cutting be treated as
a cost center under the circumstances (rather than a profit center or investment
center)? Explain.
1.
Cutting Assembly
Revenue $1,320,000 * $5,000,000
Operating Costs:
Direct $1,320,000 * $720,000 **
Transferred Costs N/A $1,320,000
Operating Profit $0 $2,960,000
*$22/cord 60,000 cords = $1,320,000

**$12/cord 60,000 cords = $720,000
2.
Cutting Assembly
Revenue $1,080,000 * $5,000,000
Operating Costs:
Direct $1,320,000 *** $720,000 **
Transferred Costs N/A $1,080,000
Operating Profit ($240,000) $3,200,000
*$18/cord 60,000 cords = $1,320,000

**$12/cord 60,000 cords = $720,000
***$22/cord 60,000 cords = $1,320,000
3. The manager of the Cutting Division would care about the transfer price if
19-235
his/her division was treated as either a profit center or an investment center for
performance evaluation purposes. In this particular case, it would seem as if the
Cutting Division should probably be treated as a cost centerit is, in essence, a
captive supplier to the Assembly Division. We do not know whether the Cutting
Division could sell its output on the open market. In the absence of this
information, we should probably assume that it cannot. For both reasons,
therefore, the Cutting Division should probably be treated as a cost center, and not
concern itself about the "profit" it pretends to make by selling to the Assembly
Division of the company.

Blooms: Analyze
Blooms: Apply
19-236
147. This question pertains to factors affecting the setting of transfer prices in an
international setting.
Required:
What are the primary factors affecting the setting of transfer prices between
divisions of a company that operates in different countries?
There are two primary considerations affecting the setting of transfer prices in an
international setting: inter-country differences in income tax rates, and the effect
of import duties.
Differences in Income Tax Rates: Companies with divisions operating in different

countries, and engaging in inter-divisional transfers of goods and services, can
improve its worldwide after-tax earnings by appropriate tax planning. This
assumes: (a) that the income-tax rates differ between countries (as we know they
do), and (b) that the company as a whole does not violate, in setting its transfer
prices, local income-tax laws or provisions in GATT (General Agreement on Tariffs
and Trade).
Suppose a company based in, say, the U.S. has a division in, say, Asia. A U.S.
division produces a subassembly, which is then transferred to the Asian division for
assembly and sale of the final product. Assume that the income tax rate of the
company's U.S. division is greater than the rate in the Asian division's country. In
this scenario, corporate management has an incentive to set a low transfer price
for the subassembly. This, in turn, will result in lower taxable income for the
company's U.S. division, and higher taxable income for the Asian division. Under
the assumption that the tax rate is lower for the Asian division, this "shifting of
profits" (via the transfer pricing mechanism) has helped the company minimize its
total (i.e., worldwide) income tax payments. Note, however, that tax laws vary
among countries with regard to flexibility in setting a transfer price.
Import Duties: A second major consideration associated with setting international

transfer prices has to do with import duties (or tariffs). These assessments are
levied on an importer, and are generally based on the reported value of the goods
being imported. Consider the preceding example of a company with divisions in
both the U.S. and in Asia. If the Asian country imposes an import duty on goods
transferred in from the U.S. division to the Asian division, then the company has an
incentive to set a relatively low transfer price on any inter-divisional transfers of
goods or services. By doing this, the company as a whole would minimize the duty
levied and in so doing will help maximize overall profit of the company. Note that,
as in the case above, countries sometimes pass laws that limit a multination
company's flexibility in setting transfer prices for the purpose of minimizing import
duties.
AACSB: Diversity
AICPA: BB Global
Blooms: Understand
19-237
148. The microprocessor division of Zenith Systems Company sells a computer module
to the company's Assembly Division, which puts together the finished product
(viz., guidance systems). The Microprocessor Division is currently working at
capacity. The computer module costs $10,000 to manufacture, and it can be sold
externally to companies for approximately $13,500 per unit.
Required:
1. Use the general transfer pricing rule to compute a transfer price for the
computer module.
2. Explain the underlying logic of the general transfer pricing rule discussed in the
chapter.
1. Minimum transfer price = Incremental Cost + Opportunity Cost (if any)

= $10,000 + ($13,500 - $10,000) = $13,500
2. The general transfer price model is based on the "relevant cost" model
presented in Chapter 11 of the text (Decision-Making). That is, for short-run
decisions, relevant costs can be defined as the sum of incremental (i.e., "out-of-
pocket" costs) plus opportunity costs (if any). When applied to a "special sales
order" decision, this rule establishes the floor below which a company would not
accept a special sales order. That is, if the selling price were set at the sum of
incremental cost plus opportunity cost, the seller would be indifferent between
accepting and rejecting the special sales order. The same logic can be applied in
the context of setting transfer prices. Application of the general model provides a
minimum selling price. It is optimal from the standpoint of the company as a whole
because it generally motivates an internal transfer which such a transfer is
economically desirable. (This is because the incremental costs of the producing
unit are generally less than an external price.) One issue with the general model is
that it may not provide sufficient incentive to the selling division of the company
especially if the selling division's opportunity costs are zero (i.e., it has excess
capacity). That is, the application of the model provides the floor or minimum
transfer price. Therefore, to provide appropriate incentives for the selling division
to sell internally, it may be appropriate to add some type of profit mark-up on any
internal transfers. Thus, the actual transfer price might be defined as the sum of
the amount represented by the general transfer-pricing model plus a reasonable
markup.
Blooms: Apply
19-238
149. The Division A of Standard Products is planning its 2016 operating budget. Average
operating assets of $1,500,000 will be used during in the division during the year
and per-unit selling prices are expected to average $100. Variable costs of the
division are budgeted at $400,000, while fixed costs are set at $250,000. The
company's required rate of return for purposes of calculating residual income (RI)
is 18%.
Required:
1. Compute the sales volume (in units) necessary for Division A to achieve a 20%
ROI in 2016.
2. The division manager receives a bonus of 50% of residual income (RI). What is
his anticipated bonus for 2016 for the division manager, assuming she achieves
the 20% ROI target specified in part (1)? below.
1. ROI = Operating income Average operating assets

20% (given) = Operating income $1,500,000 (given)
Therefore, target operating income = 0.20 $1,500,000 = $300,000
Required sales volume ($):
Sales revenue
Less: Variable costs
Less: Fixed costs
Targeted operating income
Therefore, required sales revenue (X) = $950,000.
Required sales volume (in units) = $950,000 $100/unit (given) = 9,500 units
2. Predicted bonus, 2016:
Asset base (given)

Minimum rate of return (given)
Required operating income
Target operating income (part 1)
Required operating income (above)
Residual income
Bonus = Residual income (above) 0.50 (given) = $30,000 0.50 = $15,000

19-239
Blooms: Apply
19-240
19-241
150. The major operating divisions of Grey Company are organized as investment
centers for performance-evaluation purposes. The division managers are
evaluated, in part, on the basis of the change in the return on investment (ROI) of
their units. Operating results for the Division A for the coming year, 2016, based
on its existing assets are budgeted as follows:
Sales
Less variable costs
Contribution margin
Less fixed expenses
Operating income
Operating assets for the Division A are currently $3,600,000. For 2016, the
division can add a new product line for an investment of $600,000. The new
product line is expected to generate sales of $1,600,000 and will incur fixed
expenses of $600,000 annually. Variable costs of the new product are expected to
average 60% of the selling price.
Required:
1. What is the effect on ROI of accepting the new product line?

2. If the company's required rate of return is 6% and residual income is used to
evaluate managers, would this encourage the division to accept the new product
line? Explain and show computations.
1. Effect of the proposed investment on reported ROI for Division A:
New investment:
Sales $1,600,000
Variable costs $960,000
Fixed costs 600,000 1,560,000
Current Divisional ROI = Operating income Operating assets = $700,000
$3,600,000 = 0.194
ROI associated with proposed investment = $40,000 (above) $600,000 (given)
= 0.067
Divisional ROI after new investment = $740,000 $4,200,000 = 0.176
Accepting the new product line will reduce the division's ROI. This would make the
manager reluctant to make the investment.
2. Motivation to invest (i.e., goal-congruency issue):
19-242
$600,00
Proposed new investment
0

Minimum required rate of return
0.06
Required annual profit associated with $36,00
proposed investment 0
Projected division operating income, after
$40,000
new investment
Required amount of operating income 36,00
(above) 0
Excess of projected income over required $4,00
amount = RI 0
The manager would likely accept the investment because residual income (RI) is
increased by $4,000.

Blooms: Analyze
Blooms: Apply
Difficulty: 1 Easy
19-243
19-244
151. Meridian Investments has three divisions (A, B, C) organized for performance-
evaluation purposes as investment centers. Each division's required rate of return
for purposes of calculating residual income (RI) is 15%. Budgeted operating results
for 2016 for each of the three divisions are as follows:
Division Operating income Investment

A $15,000,000 $100,000,000
B $25,000,000 $125,000,000
C $11,000,000 $50,000,000
The company is planning an expansion, which will require each division to

increase its investments by $25,000,000 and its operating income by $4,500,000.
Required:
1. Compute the current ROI for each division.

2. Compute the current residual income (RI) for each division.
3. Rank the divisions according to their current ROIs and in terms of their residual
incomes.
4. Determine the effects after adding the new project to each division's ROI and
residual income (RI).
5. Assuming the managers are evaluated on either ROI or residual income (RI).
Which divisions are pleased with the expansion and which ones are unhappy?
Explain briefly.
1. Division A ROI = $15,000,000 $100,000,000 = 0.15

Division B ROI = $25,000,000 $125,000,000 = 0.20
Division C ROI = $11,000,000 $50,000,000 = 0.22
2. Division A RI = $15,000,000 - ($100,000,000 0.15) = $0
Division B RI = $25,000,000 - ($125,000,000 0.15) = $6,250,000
Division C RI = $11,000,000 - ($50,000,000 0.15) = $3,500,000
3. Divisional Rank Based on ROI:
1. C
2. B
3. A
Divisional Rank Based on RI:
1. B
2. C
3. A
4. Division ANew ROI = $19,500,000 $125,000,000 = 0.156

Division BNew ROI = $29,500,000 $150,000,000 = 0.197
Division CNew ROI = $15,500,000 $75,000,000 = 0.207
Division ANew RI = $19,500,000 - ($125,000,000 0.15) = $750,000

19-245
Division BNew RI = $29,500,000 - ($150,000,000 0.15) = $7,000,000
Division CNew RI = $15,500,000 - ($75,000,000 0.15) = $4,250,000
5. All three divisional managers would likely be pleased if RI were used because
residual incomes increase with the expansion. However, it would be difficult to
evaluate each division on a comparative basis because each division's investment
base (i.e., amount of operating assets) is different.
If divisional ROI were used to evaluate performance, then only the manager of
Division A would likely be pleased with the new investment: Division A is the only
division whose ROI would increase. In the case of additional investments that are
required by corporate management, residual income (RI) may be the best to use
for evaluating each manager individually, but not collectively.

Blooms: Analyze
Blooms: Apply
19-246

CH 19

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CH 19

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Chapter 19

Strategic Performance Measurement: Investment Centers and

Multiple Choice Questions

1. Under the notion of controllability, it is most appropriate for top management to

A. Profits generated in relation to the amount of capital invested in the unit.

2. Which of the following is the most appropriate and comprehensive short-term

A. Residual income (RI).

3. The conventional return on investment (ROI) performance measure calculates "profit"

A. American Accounting Association (AAA) recommendations.

4. Return on investment (ROI) is the result of multiplying:

A. Return by average investment.

7. As a general rule, leased assets should be included as part of the calculation of

A. As collateral to borrow funds.

8. Firms with high operating leverage tend to have:

A. High asset turnover and high return on sales.

A. Reference to Generally Accepted Accounting Principles (GAAP).

A. Residual value of the asset.

A. Have no appreciable effect on ROI in most situations.

A. An historical cost number.

15. A primary limitation of return on investment (ROI) as a performance-evaluation

A. Is a long-term, not short-term, performance indicator.

16. Return on investment (ROI) encourages business unitssuch as investment centers

A. A rate of return greater than borrowing costs.

A. Comparing business units of significantly different size.

A. Pass strict accounting requirements for determining transfer prices.

23. A key standard in international transfer pricing is:

24. The biggest problem with cost-based transfer prices is:

A. Residual income (RI) divided by level of invested capital.

A. Residual income (RI) divided by level of invested capital.

A. Net book value (NBV).

A. Gross book value (GBV) of the assets.

A. They are both short-term performance indicators.

A. Gross book value.

A. Gross book value (GBV), plus accumulated depreciation to date.

A. Operating profit after tax.

A. After-tax operating income.

A. ROI cannot incorporate differences in risk across different divisions.

The return on investment (ROI) for Division X is:

The return on sales (ROS) for Division X is:

The asset turnover (AT) for Division X is (rounded):

A. Division P will invest; Division Q will not invest.

Net operating income $66,000

Chering Division's return on sales (ROS) is:

Net operating income $66,000

Net operating income $66,000

Net operating income $66,000

57. An investment center's return on investment (ROI) is affected by a change in:

Asset Turnover Return on Sales

A. The rate of return on average shareholders' equity.

60. Residual income (RI) is:

A. Contribution margin of an investment center, less the imputed interest on the

61. The following results pertain to an investment center.

A. Problems associated with measuring the asset base are eliminated.

A. Average cost of production.

A. Are preferred by the purchasing division.

Xs variable cost per unit $40

68. Division A, which is operating at capacity, produces a component that it currently

A. $10 per unit.

70. Selected data from Division A of Green Company are as follows:

Division A's return on investment (ROI) is:

Division A's return on sales (ROS) is:

72. Selected data from Division A of Green Company are as follows:

Division A's asset turnover (AT) is (rounded to two decimal places):