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Chapter 17 - Divisional Performance Evaluation
Chapter 17
Divisional Performance Evaluation
Essay Questions
1. The CEO of Always Round Tires has decided to open a battery division. He thinks that
batteries would sell well with tires at their outlets and that Always Round's quality reputation
will be transferred to the batteries. Should he set up the new division as a Revenue Center, as
a Profit Center, or as an Investment Center? Why?
Answer: The new division should be set up as a profit center. Batteries are a separate product
from tires and therefore the division's profitability can be easily measured and rewarded. A
revenue center with pricing authority would set a price lower than the profit-maximizing price
which would reduce the value of the firm. The CEO should be aware that incentives at the
retail level will need to support both tire sales and battery sales. In addition, he should take
steps to guard against double markups in transfer pricing from the battery division to the retail
outlets.
Difficulty: 03 Hard
Blooms: Analyze
AACSB: Analytic
Topic: Measuring Divisional Performance
2. Always Round Tire's new division, Start-up Batteries, finds that its total cost curve, TC =
300 + 2Q + 2Q2 and its demand curve, P = 130 – 2Q.
If the division is operated as an independent profit center, what will be the price and quantity
sold each day? Will the division make a profit?
If the division is operated purely as a revenue center, how many batteries will they sell each
day?
If the division is operated as a cost center and told to produce 20 batteries per day, what would
be the cost per battery?
Answer: Using a calculus approach, marginal cost is the first derivative of TC: MC = 2 + 4Q.
From the demand curve, we know that MR = 130 – 4Q. Setting MR=MC and solving for Q
yields the profit maximizing output of Q = 16 batteries per day. To sell this quantity of
batteries, the price should be $98 per battery. The resulting total cost will be $844 per day and
total revenue $1,568, yielding a profit.
If the division operates as a Revenue Center, it will maximize total revenue. Assuming it has
pricing authority, the division will choose a price and output accordingly. Maximum total
revenue occurs at an output where MR = 0, or 130 −4Q = 0, or Q=32.5 batteries.
If the division operates as a cost center with a target of Q = 20, TC = 300 + 2(20) + 2(20)2 =
1
$1,140. The cost per battery is $1,140/20 = $57.
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
3. Measuring the success of a divisional Investment Center is closely tied to understanding

whether or not the division meets profit expectations. To understand profits, two alternatives
are proposed for tracking profitability: ROA and EVA. From the point of view of an
economist, why is EVA usually preferred?
Answer: ROA is accounting net income divided by total assets. The problem with ROA is that
assets are not measured at market value, and accounting net income excludes some increases
in economic value. EVA uses the opportunity cost of capital and more accurately measures
true economic cost of assets. EVA also estimates the economic profits of the firm.
Difficulty: 02 Medium
Blooms: Understand
AACSB: Reflective Thinking
4. What are the measures of performance for investment centers? How do they work?
Answer: There are two commonly used measures of performance for investment centers:
accounting return on investment and residual income. ROA (return on assets) is the ratio of
accounting net income generated by the investment center divided by total assets invested in
the investment center. Residual income captures business-unit performance by subtracting the
opportunity cost of capital employed from the profits of the business unit.
Blooms: Understand
2
5. Clearly, an economist would like to see a profit center implement a system that most
closely approximates the rule of profit maximization, MR = MC, in building a system of
prices for other divisions. What are the pluses and minuses of allowing a division to engage in
this type of activity?
Answer: MR = MC will drive a division to its most efficient production level, all else
constant. However, this ignores possible linkages between divisions. For example, if a higher
MR for an upstream division yields a higher MC for a downstream division, as in some
transfer pricing scenarios, the value of the firm will decrease. One solution is to centrally
control transfer prices to minimize negative impacts of an upstream division on a downstream
division.
Difficulty: 03 Hard
Blooms: Analyze
AACSB: Analytic
Topic: Transfer Pricing
6. What is transfer pricing?
Answer: Whenever business units transfer goods or services among themselves, measuring
their performance requires that a transfer price be established for the goods and services
exchanged. The rule which is employed for this purpose is called the transfer-pricing rule
which states that the optimal transfer price for a good is its opportunity cost— it is the value
forgone by not using the product transferred in its next best alternative use.
Blooms: Understand
3
7. What are the common transfer pricing methods?
Answer: There are four different methods for setting transfer prices: market price, marginal
production cost, full cost, and negotiated pricing. The market-price method tells us that the
product should be transferred at the external market price. If market prices are not available,
then marginal product cost method tells us that MC of the unit transferred is an effective
transfer price. Sometimes, MC is difficult to obtain. Hence, firms use full-cost method, which
tells us that the transfer price must equal all costs, fixed plus variable. Negotiated price is the
price that the different units arrive at after negotiation.
Blooms: Understand
8. The accounting department had a plumbing problem and they called the maintenance
department to fix this. After the job was done, the maintenance department sent the
accounting department a bill for services rendered. Does this make sense? After all they are
all a part of the same company?
Answer: No, this is not strange. These are called charge-backs. The maintenance department
sent its workers to the accounting department instead of working elsewhere for actual
payment. So their opportunity cost has to be borne by the accounting department.
Difficulty: 03 Hard
Blooms: Analyze
AACSB: Analytic
9. Economists often remark that accounting data are purely historical and at an aggregate level
and do not provide information on incremental changes. So why is it the key data source for
decision control and important in decision management?
Answer: Accounting data are useful for measuring actual performance of managers. Because
it is historical, it is not likely to be misrepresented and more likely to reflect actual
performance. However, it is less useful for decision management. Accounting data are at too
aggregate a level and therefore, not useful for decisions regarding incremental changes.
Nevertheless, accounting data can provide a framework for forecasting future consequences
of proposed decisions. Examining historical data for cause and effect relationships can help
understand these relationships and therefore, help make projections about future performance.
4
Difficulty: 03 Hard
Blooms: Analyze
AACSB: Analytic
Topic: Internal Accounting System and Performance Evaluation
Multiple Choice Questions
10. A cost center can be asked to achieve one of two typical objectives. A cost center can
either minimize costs for a given output or it can:
A. maximize revenue for a given price.
B. maximize output for a given budget.
C. maximize returns for a given budget.
D. minimize output for a given budget.
Answer: B
Difficulty: 01 Easy
Blooms: Remember
11. Cost center managers are evaluated on their efficiency in using an input-mix to:
A. produce a stipulated level of output.
B. generate a stipulated amount of revenue.
C. produce a pre-decided level of net profit.
D. generate a certain amount of return on investment.
Answer: A
Blooms: Understand
12. Profit center managers are allocated decision rights for:

A. input mix, product mix, and selling prices.
B. selling prices and capital expenditures.
C. product mix and selling price only.
D. input mix and product mix only.
5
Answer: A
Difficulty: 01 Easy
Blooms: Remember
13. Refer to Figure 17.1 What output matches MR = MC?
A. 5 units
B. 6 units
C. 7 units
D. 8 units
Answer: C
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
6
14. Refer to Figure 17.1. What is the output level where the average cost is at its minimum?
A. 6 units
B. 7 units
C. 8 units
D. 9 units
Answer: D
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
7
15. Refer to Figure 17.1. Which of these will hold true if the manager is given a budget of
$155?
A. She should produce 6 units of output because profits are maximized.

B. She should produce 8 units of output to maximize output for the budget.
C. She should try to produce 9 units of output because average costs are minimized.
D. She should lobby her boss for more money.
Answer: B
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
8
16. A manager in an investment center is offered a potential investment that would have an
ROA of 15 percent. After the investment, it would make up 20 percent of his total portfolio.
Currently, he makes 20 percent on his portfolio, though the company requires only 12 percent.
Which of the following is true?
A. He will make the investment since it is 3 percent greater than the company's required
return.
B. He will make the investment because a larger portfolio is always better than a smaller
portfolio.
C. He will not make the investment because the company prefers 12 percent.
D. He will not make the investment because it lowers his overall return to 19 percent.
Answer: D
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
17. Consider a particular division that earns an after-tax profit of $40 million and has total
assets worth $120 million. The residual income of the division is ______ if its required cost of
capital is 20%.
A. $16 million
B. $40 million
C. $24 million
D. $8 million
Answer: A
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
9
18. If a company division is operated as a revenue center and its demand curve is P = 200 –
2Q, how many units should it produce per day?
A. 0
B. 25
C. 50
D. 100
Answer: C
Difficulty: 03 Hard
Blooms: Apply
AACSB: Analytic
19.Which of these is a commonly used measure of performance for investment centers?

A. Residual income
B. Total assets
C. Total income
D. Variable cost
Answer: A
Difficulty: 01 Easy
Blooms: Remember
20. Transfer price refers to the price at which:

A. goods are transferred from one location to another.
B. services are transferred overseas for a cheaper rate.
C. goods are sold to loyal customers without shipping and delivery cost.
D. goods and services are transferred within a business.
Answer: D
Difficulty: 01 Easy
Blooms: Remember
10
21. One of the problems of transfer prices comes from the successive impact of the prices as
the product moves downstream toward the consumer. At each step, the transfer price becomes
the ______ for the next part of the company.
A. market price
B. total cost
C. marginal cost
D. negotiated price
Answer: C
Blooms: Understand
22. If a corporation operates two divisions that supply one another, and each division is
located in a different country, then transfer prices are:
A. set to allocate profit to the low tax rate country.
B. set to allocate all costs to the low tax rate country.
C. set to allocate profit to the high tax rate country.
D. not allowed between most countries.
Answer: A
Blooms: Understand
23. If each division of a company with a monopoly niche is allowed to set its transfer price at
the profit-maximizing level for the next division as the product flows toward the consumer
(assuming no external market for the product), then prices will:
A. be higher and profits lower than with non-divisional organization.
B. be lower and profits higher than with a non-divisional organization.
C. be the same and profits will be the same as with a non-divisional organization.
D. match the competitive benchmark and profits will be zero.
Answer: A
Blooms: Understand
11
24. If there exists an external market for an intermediate good produced by a company, then
an easy way to set a transfer price would be to use a:
A. market-based transfer price.
B. marginal-cost transfer price.
C. full-cost transfer price.
D. monopoly transfer price.
Answer: A
Blooms: Understand
25. If a company adds up all the costs of producing an intermediate product – direct labor,
materials, and overhead – to establish a transfer price, then it is using a:
A. market-based transfer price.
B. marginal-cost transfer price.
C. full-cost transfer price.
D. monopoly transfer prices.
Answer: C
Blooms: Understand
26. Holmstrom and Tirole note "The economist's first instinct is to set transfer price equal to
marginal cost." However, a distinct plurality of companies uses the full-cost method. That is
because:
A. most companies do not employ economists.
B. it is simple and has a low cost of implementation.
C. it is identical to using a marginal cost approach to transfer prices.
D. the results are much better in the field with full-cost method.
Answer: B
Blooms: Understand
12
27. Full-cost transfer-pricing creates an incentive for:
A. distribution to be inefficient.
B. distribution to be over-efficient.
C. manufacturing to be over-efficient.
D. manufacturing to be less efficient.
Answer: D
Difficulty: 01 Easy
Blooms: Remember
28. Full-cost transfer-pricing frequently:

A. understates the opportunity costs of external transfers.
B. overstates the opportunity costs of external transfers.
C. understates the opportunity costs of internal transfers.
D. overstates the opportunity costs of internal transfers.
Answer: D
Difficulty: 01 Easy
Blooms: Remember
29. Marginal-cost transfer-pricing creates incentives for manufacturing to distort MC:

A. upward and then downward.
B. downward and then upward.
C. downward.
D. upward.
Answer: D
Difficulty: 01 Easy
Blooms: Remember
13
30. Which one of the following is not a method used to set transfer prices?
A. Market price method
B. Marginal production cost method
C. Negotiated pricing method
D. Opportunity cost method
Answer: D
Difficulty: 01 Easy
Blooms: Remember
31. The basic incentive problem associated with internal transfers is that:
A. divisional managers have private information about opportunity costs.
B. divisional managers have only public information about opportunity costs.
C. senior management have private information about opportunity costs.
D. senior management make all information about opportunity costs public.
Answer: A
Difficulty: 01 Easy
Blooms: Remember
32. You can manufacture a product in the US and transfer it to Europe. If the marginal cost
(MC) is $3 per unit, and the market price in Europe is $5 per unit, should the product be
manufactured?
A. No, because the net receipt of $5 is larger than the MC in the US.
B. Yes, because the gross receipt of $3 is larger than the MC in the US.
C. No, because the net receipt of $3 is the same as the MC in the US.
D. Yes, because the net receipts in Europe will exceed the MC in the US.
Answer: D
Blooms: Understand
14
334. The choice of transfer-pricing method:
A. merely reallocates total company profits among its smaller units.
B. does nothing to profits of sub-units.
C. merely reallocates total company profits among its bigger units.
D. affects the firm's total profits.
Answer: D
Difficulty: 01 Easy
Blooms: Remember
34=. If a company has two profit centers where one supplies the other with necessary
ingredients to a company product, and if the relationship between two centers is clearly
inimical to company success, then:
A. it is time to use the market-based transfer price system.
B. it is time to implement a marginal cost based transfer system.
C. the company should change its management control system.
D. the company should probably reorganize.
Answer: D
Blooms: Understand
35. In terms of using accounting data to build an effective management control system, what
is the nirvana fallacy?
A. It is the tendency to use market-based transfer prices.
B. It is the system of using accounting data for both decision management and decision
control.
C. It is the tendency to use cost centers rather than profit centers as the core of business
structure.
D. It is the belief that a perfect control system can be invented that will stop all fraud.
Answer: D
Difficulty: 01 Easy
Blooms: Remember
15
36. In general, the use of accounting-based performance analysis is more effective in:
A. decision management.
B. decision control.
C. audit review of failed enterprises.
D. residual income.
Answer: B
Difficulty: 01 Easy
Blooms: Remember
37. In the Celtex case study, Leo Garcia, President of the synthetic chemical division,
regularly fails to sell his products to and through the consumer products division. This is
because:
A. there is a market-based alternative to his products that are cheaper.
B. Celtex has a faulty organizational structure that regularly cheats Garcia.
C. the head of the consumer products division does not understand the difference between
price and value.
D. Garcia produces inferior products.
Answer: A
Blooms: Understand
38. The accounting-based performance analysis:

A. provides aggregate level data that is insufficient for decision making.
B. is completely under the control of the operating managers.
C. is a true reflector of a particular management center’s functioning.
D. provides inexpensive information on opportunity costs.
Answer: A
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Chapter 17 - Divisional Performance Evaluation

3. Measuring the success of a divisional Investment Center is closely tied to understanding

6. What is transfer pricing?

7. What are the common transfer pricing methods?

Multiple Choice Questions

12. Profit center managers are allocated decision rights for:

13. Refer to Figure 17.1 What output matches MR = MC?

A. She should produce 6 units of output because profits are maximized.

19.Which of these is a commonly used measure of performance for investment centers?

20. Transfer price refers to the price at which:

28. Full-cost transfer-pricing frequently:

29. Marginal-cost transfer-pricing creates incentives for manufacturing to distort MC:

38. The accounting-based performance analysis:

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