Kinney ● Raiborn Cost Accounting: Foundations and Evolutions, 8e © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 13: Responsibility Accounting, Support Department Allocations, and Transfer Pricing

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives Which factors determine whether a firm should be decentralized or centralized? How are decentralization and responsibility accounting related? What are the four primary types of responsibility centers, and what distinguishes them from each other? How are revenue variances computed? Why and how are support department costs allocated to operating departments? What types of transfer prices are used in organizations, and why are such prices used? What difficulties can be encountered by multinational companies using transfer prices?

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Organizational Structure Centralization  Top management retains the major portion of authority Decentralization  Top management delegates decision- making authority to subunit managers

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Decentralization Continuum (slide 1 of 2) Age of firmYoung Mature Size of firmSmallLarge Stage of product developmentStableGrowth Growth rateSlowRapid Impact on profits of incorrect decisionsHighLow Management ’ s confidence in subordinates LowHigh Degree of controlTightModerate/loose Factor Centralized Decentralized

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Geographic diversity Local Widespread Cost of communications LowHigh Ability to resolve conflictsEasyDifficult Level of employee motivation LowModerate to high Level of organizational flexibilityLowHigh Response time to changesSlowRapid Factor Centralized Decentralized Decentralization Continuum (slide 2 of 2)

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Advantages and Disadvantages of Decentralization Advantages  Personnel Train and screen aspiring managers Develop leadership qualities, problem-solving abilities, and decision- making skills Compare managers’ results Increase job satisfaction and job enrichment  Effective means of achieving organizational goals  Reduces decision-making time  Allows management by exception Disadvantages  Lack of goal congruence  Suboptimization Pursuing the subunit manager’s goals instead of the company’s goals  Requires more effective communication skills  Managers must relinquish control  Expensive Train managers in decision- making skills Absorb cost of poor decisions Requires a sophisticated planning and reporting system

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Accounting Reporting system  Provides information about subunits  Allows management to measure subunit performance Consistent with  Standard costing  Activity-based costing Monetary and nonmonetary Adjusted for the planning, controlling, and decision- making needs of each unit manager Separates costs as controllable or noncontrollable by the unit manager Managers delegate decision-making authority but retain responsibility for outcomes.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Report Budgeted Costs Actual Costs Variance Itemized Costs Controllable Noncontrollable Nonmonetary items DEPARTMENTMANAGER

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Nonmonetary Measures Capacity measures Target ROI Desired/actual market share Throughput Defects Backorders Complaints On-time delivery Manufacturing cycle efficiency Reduction of non-value- added time Employee suggestions received/implemented Unplanned production interruptions Schedule changes Engineering changes Safety violations Absenteeism

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Control Process Steps Prepare a plan using budgets and standards and use it to communicate output expectations and delegate authority Use responsibility accounting system to record and summarize data for each organizational unit Monitor the differences between planned and actual data at scheduled intervals Exert influence in response to significant differences Continue comparing data and responding and then begin the process again

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Reporting Upward flow of information  From operations to top management Unit level reports are detailed Upper-level reports are summarized Encourages management by exception  Major deviations are highlighted

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Reporting System Dept R Costs Itemized Total for Dept Dept Q Costs Itemized Total for Dept Division A Dept Q Totals Dept R Totals Total for Division Division B Dept X Totals Dept Y Totals Total for Division To CEO Division A Total Division B Total Total for Company Department data are reported to the Division Division data are reported to the CEO

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Disadvantages of Responsibility Accounting Disadvantages of responsibility accounting include  Important details may not be visible at upper management levels  Managers might “promote” their unit while “blaming” their competitor units  Departmental interdependencies might not be visible

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Centers Responsibility accounting systems identify, measure, and report on activities in responsibility centers  Cost center  Revenue center  Profit center  Investment center

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost Centers Authority to incur costs Evaluated on how well costs are controlled Revenues  Do not exist Example: equipment maintenance center  Exist but are not under manager’s control Example: community libraries  Exist but cannot be measured Example: R&D center Focus on variances outside acceptable range

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Revenue Centers Responsible for generating revenue  No control of selling price or costs Example: Individual sales departments in retail stores  Revenue and Limited Cost Center Some involvement in planning and controlling costs

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Profit Centers Responsible for generating revenues — set selling prices Responsible for controlling expenses — allowed to purchase at most economical price Goal is to maximize the center’s profit Independent units  Examples: Bank branches Educational divisions 18-wheelers Evaluate on profit variance

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Investment Centers Responsible for generating revenues and planning and controlling expenses Responsible for plant assets Goal is maximize rate of return on assets Evaluate on rate of return on assets and other performance measures Example: Divisions or subsidiaries

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Responsibility Centers To control cost center performance, management may:  Assign costs incurred in cost centers to revenue- producing areas through service department cost allocation  “Create” revenue through a system of internal charges (charge-backs) for the center’s tangible or intangible output used by other company units

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Department Cost Allocation Service departments provide functional tasks for other internal units  Purchasing  Maintenance  Engineering  Security  Warehousing Administrative departments provide management activities for the organization  Human resources  Accounting  Legal  Insurance

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Allocating Service Costs: Full Cost Objective Reasons for:  Cost recovery  Awareness of support costs  “Fair share” of costs  Regulations for some pricing instances Reasons against:  Managers cannot control costs  Arbitrary costs not useful in decision making  Confuses costing and pricing issues

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Allocating Service Costs: Motivation for Managers Objective Reasons for:  Awareness of support costs in production managers  Relates unit’s profit to total company profits  Reflects usage of services  Encourages cost control  Encourages usage of certain services Reasons against:  Distorts profits with subjective allocations  Managers cannot control costs  Not material to profits  Creates interdivisional ill will  Not cost beneficial

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Allocating Service Costs: Compare Alternate Courses of Action Objective Reasons for:  Relevant information helps compare alternatives  Provides best cost estimates when comparing alternatives Reasons against:  Unnecessary if costs do not change among alternatives  Arbitrary allocations distort cash flow and profits for alternatives

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Allocation Bases for Service Department Costs Rational and systematic base  Benefit received by revenue-producing department  Causal relationship  Fairness or equity of the allocations  Ability of revenue-producing department to bear the allocated cost Methods  Direct method  Step method Benefits-provided ranking  Algebraic method Simultaneous equations

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Revenue 1 2 A B C $ Step 1 $ Step 2 Assigns costs straight to revenue-producing areas Does not recognize service provided to other service departments Direct Method

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Revenue 1 2 A B C $ Step 2 $ Step 1 Partially recognizes relationships among service departments Does not recognize the two-way exchange of services between service departments Service Method

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Revenue 1 2 A B C $ $ At the same time Recognizes all interrelationships among departments Provides the best allocation information Algebraic Method

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Service Cost Allocation Allocated service department costs are included in the overhead application rate for the revenue-producing areas Service department costs are allocated to products or jobs through normal overhead assignment procedures

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transfer Pricing Internal charges for the exchange of goods or services within the organization Promote goal congruence Make performance evaluation among segments more comparable Transform a cost center into a pseudo-profit center Encourages managers to be entrepreneurial Advantages  Encourage development of beneficial services  Promote cost consciousness of services provided  Promote making a service department a profit center Transfer prices are for internal use only. They are eliminated on external financial reports.

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Setting the Transfer Price Maximum—no higher than the lowest market price Minimum—no less than the sum of  Selling segment’s incremental costs plus  The opportunity cost of the facilities used Ease of determining the transfer price Managers should understand how to compute and evaluate the transfer price

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost-Based Transfer Prices Definition of cost  Variable cost vs. absorption cost  Actual vs. standard Standard cost is superior to actual cost  Actual costs vary according to season and production volume  Standard costs are stable measures of production costs  Variances are attributed to selling division

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Market-Based Transfer Prices Objective, arm’s-length measure Potential problems when the market determines the transfer price  No exact counterpart in the external market  Ignores internal cost savings  Market price varies Current depressed price vs. long-run market price  Different prices, discounts, and credit terms for different buyers

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Negotiated Transfer Prices Below market purchase price Above the incremental and opportunity costs of the selling unit If negotiation fails  Managers can purchase on the market  Arbitration by top management

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Dual Pricing Seller transfers at market or negotiated price Buyer records transfer at cost-based amount Eliminates need to divide profits artificially Provides relevant information for decision making and performance evaluation Requires internal reconciliation

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Advantages and Disadvantages of Transfer Pricing Systems Advantages  Permit evaluation of segment performance  Allow for rational acquisition of goods and services between corporate divisions  Provide flexibility to respond to changes  Encourage and reward goal congruence Disadvantages  May cause disagreement among managers  Adds costs and takes time  May not work for all departments  May cause underutilization or overutilization of services  May cause dysfunctional organizational behavior  Causes a need for year-end entries to eliminate transfer prices

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Multinational Transfer Pricing Differences in  Tax systems  Customs duties  Freight and insurance costs  Import/export regulations  Foreign-exchange controls Develop guidelines that are followed on a consistent basis Set transfer prices that reflect an arm’s-length transaction Be prepared for transfer pricing audits Consider Advance Pricing Agreements—binding contracts between a company and taxing authorities that set an acceptable transfer pricing methodology

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transfer Pricing Audit

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Multinational Transfer Pricing Objectives Internal  Better goal congruence  Better performance evaluations  More motivated managers  Better cash management External  Less taxes and tariffs  Less foreign exchange risks  Better competitive positions  Better relations with government

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Questions What are some advantages and disadvantages of decentralization? What are the four types of responsibility centers? Why are transfer prices used?

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Potential Ethical Issues Managers who make decisions to benefit themselves but not always the firm Burying important details in responsibility reports Allocating costs using “ability-to-bear” criterion Shifting support department costs to inappropriate departments Not allowing managers to buy or sell externally in a transfer pricing situation Using transfer pricing to shift costs to low- or no-tax locations