1. Explain what is responsibility accounting? Describe how is it related to an organizations structure?

2. Explain what is a financial responsibility center? Distinguish between the four types of financial responsibility centers.

3. Explain what is a transfer price?

4. Explain what are the common methods for setting a transfer price?

5. If Melanies point is valid, perhaps Mark should transfer rooms to her. For the Kokopelli Resort, calculate what the transfer price for rooms using the different methods described in case requirement 4 should be. Compare what the effect is of each transfer price on divisional profits.

6. Explain what the difference is, if any, between cost assignments and transfer prices?

7. If you were Rachana, appraise which transfer price would you recommend to Stuart? Debate which criteria you would use in evaluating the alternative transfer pricing methods? If you dont believe transfer pricing is appropriate in this context, present arguments for keeping the financial reporting as it is? 8. Appraise whether golf course should remain as a responsibility center reporting to Stuart? If not, prepare recommendations to Stuart about the golf course? 9. Appraise whether the spa be closed? Prepare recommendations for Stuart regarding the spa? Propose suggestions, if any, for improving the financial performance of the spa?

KOKOPELLI RESORT: A CASE STUDY OF TRANSFER PRICING IN A SERVICE INDUSTRY CONTEXT Keywords: transfer pricing; responsibility centers; performance measurement; decentralization; service industry; hospitality I. CASE About a month ago, Stuart Tyler, President and Chief Executive Officer (CEO) was sitting with his Chief Financial Officer (CFO), Rachana Patel. Stuart had been CEO of the Kokopelli Resort for the past four years, having replaced the prior CEO who was fired after EBITDA had fallen nearly 50%. During his tenure, Stuart hasn't seen much growth in revenues, but EBITDA has increased 29%. The Board of Directors, wanting to get back to the record revenues and EBITDA of a decade ago, has been putting pressure onto Stuart. That led to last month's meeting between Stuart and Rachana. Sitting in one of the restaurants of the 740-room hotel, Stuart said: "We started out as a mid-size hotel in Scottsdale, steadily expanding to where we are today. The problem I have is that our annual income statements are an outgrowth of what we used more than 40 years ago. Back then we were a 180-room hotel. But we've expanded over the years, adding two new buildings for hotel rooms, added an event center 20 years ago and, more recently, added a golf course and spa. Our income statement treats the organization as a hotel with multiple departments. But I think of us as a multi-divisional company, and each line of business should be evaluated on its own merits. Can you put together a new income statement that better reflects the performance of our various divisions?" Stuart felt that he needed to better understand how the different managers were performing Currently, Stuart can be thought of as an investment center manager. He has eight senior managers reporting to him (see Figure 1 for the organization chart). The managers of the Hotel, Events and Food & Beverage, Golf and Spa divisions were treated as profit center managers, while his other direct reports are cost center managers. The accounting department has followed the industry practice of preparing income statement in accordance with the Uniform System of Accounts for the Lodging Industry (USALI). Income statements for the past three years are shown in Table 1. Background The Kokopelli Resort was developed in the 1970s when Scottsdale, Arizona was a small , upscale suburb of Phoenix. Scottsdale has grown into a large suburban city (population 250,000) with multiple high-end resorts, golf courses, spa centers, a thriving business center and numerous high-end retail centers. Phoenix-Mesa-Scottsdale, with a population of nearly 5 million, is the 11" largest metropolitan area in the United States. With a large, international airport (136h busiest with 22 million passengers), Scottsdale area resorts host golf tournaments, business meetings and group events, in addition to normal business travel and tourism. For many years, hotels were simply buildings for accommodating transient guests. The food and beverage (F&B) outlets were there to feed guests. But serving the events market (corporate meetings, sales meetings, weddings, professional conferences, etc.), shifted their customer base. Many of the new customers required that the Kokopelli provide better facilities with bundled services (direct billing, bidding on the event and meeting space along with hotel rooms and banquets). Stuart felt that a new incentive compensation plan, along with a new reporting format, might be what's needed to get the performance being sought by the Kokopelli Board of Directors. The Complaint Late last week Rachana distributed her proposed Divisional Income Statement. See Table 2. This statement summarized and reorganized what was on the current statement. She listed five separate areas of responsibility: Hotel, Events, Golf, Spa and Other. The first four were the profit centers, but the last category was a collection of items that Rachana wasn't sure about. She felt that she'd need more input from Stuart and the other members of the senior executive team to refine the new income statement. Today, in the monthly executive team meeting, Melanie expressed some concerns over the new format. She spoke up: "Stuart, I think this new approach is a good idea. But I think we need to make some improvements. I don't think this statement accurately reflects my contribution to the organization. Last year I booked more than 40 major events, with an average attendance of 300 persons, staying an average of 5 nights. These numbers suggest that my hard work brought in more than 60,000 room-nights. The marketing, sales, negotiations and successful executions have made us a leader in the events business in the Valley of the Sun. Mark gets all of the credit for those room rentals but - and I hate to say this - he hasn't done anything to capture that incremental business. Now if you look at Mark's business, he rented about 169,000 rooms last year. If he didn't have the customers I brought, his revenues would have dropped more than $13.4 million. But since his marginal costs are low, most of that would have fallen to his bottom line. His gross margin and EBITDA would have dropped about $10 million." Stuart recognized right away that Melanie had a valid point. He needs to recognize and award her for doing a good job - for working hard and making the right decisions. It was clear that the proposed income statement, while an improvement, wasn't quite there yet. Stuart had taken a management accounting course and had heard of transfer pricing. While the examples he'd seen were all in a manufacturing setting, he didn't see why Mark couldn't sell rooms to Melanie. But was he wrong? Stuart asked Rachana to look into this further and come to the executive committee next month with a revised income statement that will incorporate a transfer price that the two managers (Mark and Melanie) could agree upon. Stuart also had two other concerns. Recently, the executive committee had thought about closing the golf course and spa. The land around the hotel is valuable and the Board of Directors asked Stuart to look into selling the land to a local developer who would turn the land into a shopping center. The Executive Committee did a study and found that most golf patrons were attending events. Apparently, the golf course was a major selling point for events and Melanie feared that her event events business would drop 20-40% if the golf course were to go away. For this reason, the Board decided to keep the golf course. But Stuart wondered if Bob Nasr, GM of the golf course should remain as a profit center reporting to him. Stuart's second concern was whether the spa should be closed. It has not done well and last year the division lost more than $100,000. Neither Mark nor Melanie felt that closing the spa would have an effect on the performance of their profit centers. TABLET Income Statements Panel A: Rentals and Revenues Room Nights Available Room Rentals 2019 269,272 169,467 2018 269,068 184,747 2017 221,796 160,741 Transient Revenue Group Revenue Rooms Other Total Rooms $ 14,321,446 21,598,944 1,944,550 $ 37,864,940 $ 12,708,218 22,340,493 1,652.437 $36,701,148 $ 10,433,763 19,438,393 2,917,357 $ 32,789,513 $9,828,486 885,872 20,088,864 450,419 409,588 1,366,164 4,325,106 2,425,543 $ 39,780,042 $9,865,115 957,647 21,702,607 522,204 306,037 1,404,299 4,074,827 6,338,279 $ 45,171,015 Outlets $ 10,078,543 In-room Dining 790,987 Banquet/Catering 20,686,606 Mini Bar and Other 451,317 Meeting Room Rental 478,228 Other 1,123,051 Audio/Visual Rentals 4,389,131 Service Charges 2,430,491 Total Food & Beverage $ 40,428,354 Golf-Retail (Merchandise) $ 1,643,452 Golf - Other 178,572 Spa - Treatments 1,539,723 Spa - Retail 169,678 Spa - Other 183,100 Garage/Parking 647,526 Telecom 704,558 Laundry Other 403,033 Total Other Operated Departments $5,469,642 Rentals & Other Income $1,916,199 Cancellation Penalties TOTAL REVENUES $ 85,679,135 $ 1,514,476 178,302 1,835,534 192,736 153,572 529,893 677,019 63,485 399,671 $ 5,544,688 $1,190,850 397,234 $ 1,591,175 186,227 1,955,865 230,233 100,454 667,948 718,223 77,198 2,000,592 $ 7,527,915 $2,528,751 314,476 0 0 $ 83,613,962 $ 88,331,670 Proposed Divisional Income Statement (in millions of $) Revenue Expense Gross Margin Hotel $37.865 8.470 $ 29.395 Events/F&B $ 40.428 20.787 $ 19.642 Golf $ 1.822 0 $ 1.822 Spa $ 1.893 1.346 $ 0.546 Other $ 3.671 2.514 $1.157 Total $ 85.679 33.116 $ 52.563 Allocated Costs Administration $ 2.910 Marketing 3.090 Utilities 1.461 Maintenance 2.128 Management Fee 1.136 Other Fixed Costs 2.684 Total Allocation $13.410 $ 3.107 3.299 1.560 2.272 1.213 2.866 $ 14.317 $0.140 0.149 0.070 0.102 0.055 0.129 $ 0.645 $ 0.145 0.154 0.073 0.106 0.057 0.134 $ 0.670 $0.282 0.300 0.142 0.206 0.110 0.260 $1.300 $6.586 6.992 3.305 4.815 2.570 6.074 $ 30.343 EBITDA $15.986 $ 5.325 $ 1.177 $(0.124) $(0.143) $ 22.220 KOKOPELLI RESORT: A CASE STUDY OF TRANSFER PRICING IN A SERVICE INDUSTRY CONTEXT Keywords: transfer pricing; responsibility centers; performance measurement; decentralization; service industry; hospitality I. CASE About a month ago, Stuart Tyler, President and Chief Executive Officer (CEO) was sitting with his Chief Financial Officer (CFO), Rachana Patel. Stuart had been CEO of the Kokopelli Resort for the past four years, having replaced the prior CEO who was fired after EBITDA had fallen nearly 50%. During his tenure, Stuart hasn't seen much growth in revenues, but EBITDA has increased 29%. The Board of Directors, wanting to get back to the record revenues and EBITDA of a decade ago, has been putting pressure onto Stuart. That led to last month's meeting between Stuart and Rachana. Sitting in one of the restaurants of the 740-room hotel, Stuart said: "We started out as a mid-size hotel in Scottsdale, steadily expanding to where we are today. The problem I have is that our annual income statements are an outgrowth of what we used more than 40 years ago. Back then we were a 180-room hotel. But we've expanded over the years, adding two new buildings for hotel rooms, added an event center 20 years ago and, more recently, added a golf course and spa. Our income statement treats the organization as a hotel with multiple departments. But I think of us as a multi-divisional company, and each line of business should be evaluated on its own merits. Can you put together a new income statement that better reflects the performance of our various divisions?" Stuart felt that he needed to better understand how the different managers were performing Currently, Stuart can be thought of as an investment center manager. He has eight senior managers reporting to him (see Figure 1 for the organization chart). The managers of the Hotel, Events and Food & Beverage, Golf and Spa divisions were treated as profit center managers, while his other direct reports are cost center managers. The accounting department has followed the industry practice of preparing income statement in accordance with the Uniform System of Accounts for the Lodging Industry (USALI). Income statements for the past three years are shown in Table 1. Background The Kokopelli Resort was developed in the 1970s when Scottsdale, Arizona was a small , upscale suburb of Phoenix. Scottsdale has grown into a large suburban city (population 250,000) with multiple high-end resorts, golf courses, spa centers, a thriving business center and numerous high-end retail centers. Phoenix-Mesa-Scottsdale, with a population of nearly 5 million, is the 11" largest metropolitan area in the United States. With a large, international airport (136h busiest with 22 million passengers), Scottsdale area resorts host golf tournaments, business meetings and group events, in addition to normal business travel and tourism. For many years, hotels were simply buildings for accommodating transient guests. The food and beverage (F&B) outlets were there to feed guests. But serving the events market (corporate meetings, sales meetings, weddings, professional conferences, etc.), shifted their customer base. Many of the new customers required that the Kokopelli provide better facilities with bundled services (direct billing, bidding on the event and meeting space along with hotel rooms and banquets). Stuart felt that a new incentive compensation plan, along with a new reporting format, might be what's needed to get the performance being sought by the Kokopelli Board of Directors. The Complaint Late last week Rachana distributed her proposed Divisional Income Statement. See Table 2. This statement summarized and reorganized what was on the current statement. She listed five separate areas of responsibility: Hotel, Events, Golf, Spa and Other. The first four were the profit centers, but the last category was a collection of items that Rachana wasn't sure about. She felt that she'd need more input from Stuart and the other members of the senior executive team to refine the new income statement. Today, in the monthly executive team meeting, Melanie expressed some concerns over the new format. She spoke up: "Stuart, I think this new approach is a good idea. But I think we need to make some improvements. I don't think this statement accurately reflects my contribution to the organization. Last year I booked more than 40 major events, with an average attendance of 300 persons, staying an average of 5 nights. These numbers suggest that my hard work brought in more than 60,000 room-nights. The marketing, sales, negotiations and successful executions have made us a leader in the events business in the Valley of the Sun. Mark gets all of the credit for those room rentals but - and I hate to say this - he hasn't done anything to capture that incremental business. Now if you look at Mark's business, he rented about 169,000 rooms last year. If he didn't have the customers I brought, his revenues would have dropped more than $13.4 million. But since his marginal costs are low, most of that would have fallen to his bottom line. His gross margin and EBITDA would have dropped about $10 million." Stuart recognized right away that Melanie had a valid point. He needs to recognize and award her for doing a good job - for working hard and making the right decisions. It was clear that the proposed income statement, while an improvement, wasn't quite there yet. Stuart had taken a management accounting course and had heard of transfer pricing. While the examples he'd seen were all in a manufacturing setting, he didn't see why Mark couldn't sell rooms to Melanie. But was he wrong? Stuart asked Rachana to look into this further and come to the executive committee next month with a revised income statement that will incorporate a transfer price that the two managers (Mark and Melanie) could agree upon. Stuart also had two other concerns. Recently, the executive committee had thought about closing the golf course and spa. The land around the hotel is valuable and the Board of Directors asked Stuart to look into selling the land to a local developer who would turn the land into a shopping center. The Executive Committee did a study and found that most golf patrons were attending events. Apparently, the golf course was a major selling point for events and Melanie feared that her event events business would drop 20-40% if the golf course were to go away. For this reason, the Board decided to keep the golf course. But Stuart wondered if Bob Nasr, GM of the golf course should remain as a profit center reporting to him. Stuart's second concern was whether the spa should be closed. It has not done well and last year the division lost more than $100,000. Neither Mark nor Melanie felt that closing the spa would have an effect on the performance of their profit centers. TABLET Income Statements Panel A: Rentals and Revenues Room Nights Available Room Rentals 2019 269,272 169,467 2018 269,068 184,747 2017 221,796 160,741 Transient Revenue Group Revenue Rooms Other Total Rooms $ 14,321,446 21,598,944 1,944,550 $ 37,864,940 $ 12,708,218 22,340,493 1,652.437 $36,701,148 $ 10,433,763 19,438,393 2,917,357 $ 32,789,513 $9,828,486 885,872 20,088,864 450,419 409,588 1,366,164 4,325,106 2,425,543 $ 39,780,042 $9,865,115 957,647 21,702,607 522,204 306,037 1,404,299 4,074,827 6,338,279 $ 45,171,015 Outlets $ 10,078,543 In-room Dining 790,987 Banquet/Catering 20,686,606 Mini Bar and Other 451,317 Meeting Room Rental 478,228 Other 1,123,051 Audio/Visual Rentals 4,389,131 Service Charges 2,430,491 Total Food & Beverage $ 40,428,354 Golf-Retail (Merchandise) $ 1,643,452 Golf - Other 178,572 Spa - Treatments 1,539,723 Spa - Retail 169,678 Spa - Other 183,100 Garage/Parking 647,526 Telecom 704,558 Laundry Other 403,033 Total Other Operated Departments $5,469,642 Rentals & Other Income $1,916,199 Cancellation Penalties TOTAL REVENUES $ 85,679,135 $ 1,514,476 178,302 1,835,534 192,736 153,572 529,893 677,019 63,485 399,671 $ 5,544,688 $1,190,850 397,234 $ 1,591,175 186,227 1,955,865 230,233 100,454 667,948 718,223 77,198 2,000,592 $ 7,527,915 $2,528,751 314,476 0 0 $ 83,613,962 $ 88,331,670 Proposed Divisional Income Statement (in millions of $) Revenue Expense Gross Margin Hotel $37.865 8.470 $ 29.395 Events/F&B $ 40.428 20.787 $ 19.642 Golf $ 1.822 0 $ 1.822 Spa $ 1.893 1.346 $ 0.546 Other $ 3.671 2.514 $1.157 Total $ 85.679 33.116 $ 52.563 Allocated Costs Administration $ 2.910 Marketing 3.090 Utilities 1.461 Maintenance 2.128 Management Fee 1.136 Other Fixed Costs 2.684 Total Allocation $13.410 $ 3.107 3.299 1.560 2.272 1.213 2.866 $ 14.317 $0.140 0.149 0.070 0.102 0.055 0.129 $ 0.645 $ 0.145 0.154 0.073 0.106 0.057 0.134 $ 0.670 $0.282 0.300 0.142 0.206 0.110 0.260 $1.300 $6.586 6.992 3.305 4.815 2.570 6.074 $ 30.343 EBITDA $15.986 $ 5.325 $ 1.177 $(0.124) $(0.143) $ 22.220