Chapter 5 – Responsibility Accounting and Transfer Pricing

What is a Responsibility Center? It is any part, segment, or subunit of a business that needs control. It is headed by a manager who is “responsible” for its activities. – production – service

Responsibility Centers Often tied to “control” of the organizational unit Organizational unit manager often has the authority to make decisions on behalf of the organizational unit Unit often held accountable for decisions made by the organizational unit manager

Controllability It is the degree of influence that a specific manager has over costs, revenues, or other items in question. Responsibility accounting focuses on information and knowledge, not control. A responsibility accounting system could exclude all uncontrollable costs from a manager’s performance report. In practice, controllability is difficult to pinpoint.

Responsibility Centers Cost/expense centers Responsible for incurring costs/expenses; not accountable for generating revenues Often measured by comparing actual costs to standard costs Revenue centers Responsible for generating revenues, regardless of costs Often measured by comparing actual revenues to budgeted or forecasted revenues Profit centers Responsible for both revenues and costs Measures include profitability measures Investment centers Responsible for revenues, costs, and assets used to generate profits. Measured by return on investment and other measures

Cost and Expense Centers Two main types Engineered The right or proper amount of costs can be estimated with reasonable reliability Ex: manufacturing, warehousing, distribution, accounts payable, payroll, company cafeteria Often measured by variance analysis Discretionary No such right or proper estimate of cost is feasible Ex: research and development, marketing, public relations, legal, administrative and support departments Often measured by goals accomplished

Profit Centers Advantages: Quality of decisions may improve (due to more visibility for the division) Speed of decisions is often quicker Profit center managers can often be more creative and entrepreneurial Good training ground for corporate management Good to have information on the profitability of each business segment Have an incentive to be more responsive to market changes

Disadvantages of Profit Centers Decentralized decision-making results in some loss of control Quality of decisions may be reduced (due to inexperience) Transfer prices must be dealt with May have to allocate common costs May have to allocate joint revenues Competition among units can cause goal incongruence Additional costs imposed due to divisionalization Lack of competent managers May be short-term oriented with managers leaving after short-term gains Loss of synergy

Conditions for Delegating Profit Responsibility Manager has access to relevant information needed Some responsibility centers are clearly profit centers while others clearly are not. Managers must decide on the centers in between Management must decide when the benefits of giving profit responsibility outweigh the disadvantages

Other Units Functioning as Profit Centers Functional units – whether to treat as profit centers depends on how much manager can influence the bottom line of the unit Marketing Along with sales, charge standard cost of products sold Manufacturing Give credit for sales price less budgeted marketing costs This allows manufacturing to accept rush orders that will please the customer This allows manufacturing to treat quality as an important marketing item Give market prices for transfer pricing

Other Units functioning as Profit Centers Functional units Service and Support units Maintenance, information systems, legal departments, public relations, etc. Charge for their services Amount to charge may be lower outside the company in which case business units may want to get these services outside the company

Measuring Profitability Measure of management performance How well the manager is doing Should be separate from how well the profit center is doing Measure of economic performance How well the profit center is doing

Types of Profitability Measures Contribution margin Revenues and variable costs Problem: Managers can often control the efficiency of some fixed costs Direct profit Revenues, variable costs, fixed profit center costs Problem: not allocating corporate costs makes profit center think corporate headquarters services are free. Controllable profit Revenues, variable costs, fixed profit center costs, corporate charges directly related to profit center Problem: Data cannot be compared to outside companies for benchmarking purposes

Types of Profitability Measures Income before taxes Revenues and all costs including common corporate costs but not taxes Problem: Some costs included in measurement that profit center manager cannot control If allocated, use budgeted instead of actual corporate costs Plus: Profit center manager may put pressure on corporate headquarters to be more efficient Plus: Data more comparable to outside companies/divisions Goal congruence is often better in long-run Net income All revenues and all costs, even common corporate costs Problem: Profit centers often do not control tax planning Big problem internationally due to different tax rates

Investment Centers Investment centers are the highest level of responsibility centers. These centers control expenses, revenues, AND the assets used to generate profits. Obviously, one would expect that investment centers with more assets would generate greater profits.

Performance Measures for Investment Centers Return on investment (ROI) A ratio which allows comparison Measured as the return generated from accounting income for a particular investment Simple to understand, easy to calculate Residual Income (RI) Dollar amount of income remaining after capital charge for assets; not a ratio More complex to understand and calculate Theoretically superior to ROI

Return on Investment ROI = Income Assets employed Varies based on what is included in the numerator and denominator Often operating income and assets Sometimes income and assets limited to what is controllable by managers Short-term oriented measure Can be manipulated by managers

Residual Income Net operating income - % minimum return on average operating assets Dollar figure developed to compare to other divisions and companies Allows firms to invest in projects that are below their ROI

Economic Value Added Stern Stewart & Co. introduced the formal concept of EVA® over 10 years ago. They define EVA as “an estimate of true economic profit or the amount by which earnings exceed the required minimum rate of return that shareholders could get by investing in other securities of comparable risk.”

Economic Value Added (EVA) EVA = ROIC – [WACC x AIC] ROIC = Return on invested capital (operating profit minus cash taxes paid = NOPAT) WACC = after-tax weighted average cost of capital AIC = average invested capital = total assets - current liabilities

Capital Charge This can be the weighted average cost of capital for the entire company or something else Company can use a cost of capital derived on different rates for working capital and long-term financing sources Company can use different capital charges for each business unit due to: Different risks Different financing sources Other objectives

Economic Valued Added Complexities: Determining what to include in operating income. Determining the company’s cost of capital Determining the average invested capital LIFO inventory adjustments to income and assets Deferred taxes must be adjusted to true taxes paid. Goodwill amortization is often added back to income and assets. Research and Development expenses – often added back to income and included in assets. They are then amortized over a designated period (3 yrs., 5 yrs., etc.)

Economic Valued Added Positive EVA requires that a company earn a return on its assets that exceeds the cost of capital. It is an actual monetary amount of value added. It measures changes in value for a period

Economic Valued Added A 1993 Fortune Magazine determined that EVA correlated better with stock performance than EPS. A Stern Stewart study showed that companies that implemented EVA in the 1990s outperformed their competitors by an average of 8.3% each year over the five years following adoption and created total excess shareholder wealth of $116 billion.

Economic Valued Added A Stern Stewart study showed that tying bonuses to EVA led to significantly higher returns for shareholders. The EVA-bonus payers generated total shareholder returns of 64.5% over the five years ending June 2002, compared with 16.1% for EVA measurement companies and 7.2% for peer companies. The S&P 500 returns 19.7% over the 5 years. A separate academic study demonstrated that substantial improvements in EBITDA and operating margins, faster asset turns and stronger cash flow generation were the drivers of the superior stock market performance.

Transfer Prices An internal transaction price to account for the transfer of goods or services between divisions of the same firm. Very important to set correct transfer prices Impacts performance evaluations of divisions and resource allocations Distortions impact managers willingness to do business with sister divisions

Figure 8-1

Objectives Provide relevant information Induce goal congruent decisions Help measure the economic performance of each division Be simple to understand and easy to administer

Transfer Pricing Using Market Data – optimum price External market prices Must have an outside market Specialized goods Must be able to determine “market price” Reflects opportunity cost Objective and simple Divisions appear as stand alone businesses with market transfer prices; can be evaluated as such

Transfer Pricing Operating at full capacity Market price is best Company wide income is only maximized when market price is charged If buying division can get a lower price outside, they should take it. Operating at less than full capacity Other prices can be considered to optimize company wide income

Transfer Pricing Using Internal Cost Data What is “internal cost”? Should just variable or incremental costs be used? This is the lowest accounting-based transfer price. Standard costs often used so inefficiencies are not passed on to other divisions Buying division often very happy with these lower prices Selling division - no profit thus not motivated to sell to sister division and may provide poor service

Figure 8-2

Transfer Pricing Using Internal Cost Data Variable costs If selling division is operating at full capacity, company may lose overall profitability Buying division may underprice finished products due to lower transfer price paid Should fixed costs (full cost) be included? Standard costs often used Simple Allows recovery of full costs Inaccuracies of cost allocations passed on

Transfer Pricing Using Internal Cost Data Full costs Fixed costs of selling division become variable costs of buying division which may impact some decisions Still no profit

Transfer Pricing Using Internal Cost Data Should a profit markup be included? If so, how much? Should return on investment percentage be used? Two-step pricing Standard variable costs assigned on a transaction basis Fixed costs and return on investment assigned monthly Shared profits Outside profits shared when final sale is made Problem with how profits are “shared” – equally, 40/60, 30/70, etc.

Transfer Pricing Two sets of transfer prices Market-based price for selling division Standard cost for buying division Can include separate charges for variable and fixed costs Problems can occur if buying division charges too low prices because all costs not charged to them Bookkeeping more complex but everybody is happy Masks problems of overall company profitability Divisions may look profitable when overall company is not doing well Can be used when there is a lot of friction between business units

Transfer Pricing Negotiated Prices Often reflect fairness Process is time-consuming Political Negotiation often part of line management Managers cannot blame poor profits on “arbitrary” transfer prices if they determined them Arbitration committees often set up when parties cannot agree to a price

Source: Horngren, Cost Accounting, 2009

Transfer Pricing International Implications Taxes and tariffs Establish market position Cash flows Foreign exchange risks Establish better governmental relationships

Corporate Services Transfer prices must be determined for corporate services used by sister divisions Corporate services: research and development, information technology, human resources, maintenance, legal services Must departments accept these in-house services or are they allowed to get outside help? If so, the departments can often control the amount of services used but not their efficiency.

Corporate Services Standard variable costs are often used to entice departments to use the service Standard variable costs plus fixed costs – represents long-run full costs Market price – department must feel the service is worth the market cost or they will not use the in-house service which could be bad for the company If the internal departments do not want to use the in-house corporate services, this could signal an area to outsource

Problems/Cases P5-12 – University Lab Testing P5-17 – Stale-Mart Savannah Products (On S-Drive) ALL DUE WEDNESDAY, FEBRUARY 11