Chapter 14 Responsibility Accounting and Transfer Pricing in Decentralized Operations

1. When are decentralized operations appropriate? 2. How does responsibility accounting relate to decentralization? 3. What are the differences among the four types of responsibility centers? C14 Learning Objectives

4. What is suboptimization and what are its effects? 5. How and why are transfer prices for products used in organizations? C14 Continuing... Learning Objectives

6. What are the differences among the various definitions of product cost? 7. How and why are transfer prices for services used in organizations? C14 Continuing... Learning Objectives

Centralization Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title The majority of authority is retained by top management.

Decentralization Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Name Title Top management delegates decision making to subordinate managers.

Completely Centralized

Completely Decentralized

Continuum of Authority in Organizational Structure Age of firmYoung >Mature Size of firmSmall >Large Stage of product developmentStable >Growth Growth rate of firmSlow > Rapid Expected impact of incorrect decisions on profitsHigh > Low Pure Factor CentralizationDecentralization

Continuum of Authority in Organizational Structure Top management’s confidence in subordinatesLow >High Historical degree of control in firmTight > Moderate Use of technologyLow >High Rate of change in the firm’s marketSlow >Rapid Pure Factor CentralizationDecentralization

Advantages of Decentralization Helps top management recognize and develop managerial talent Allows managerial performance to be comparatively evaluated Often leads to greater job satisfaction

Continuing... Advantages of Decentralization Makes the accomplishment of organizational goals and objectives easier –Reduction in decision-making time –Minimization of difficulties resulting from attempts to communicate problems and instructions through an organizational chain of command –Quicker perceptions of environmental changes Allows the use of management by exception

Disadvantages of Decentralization May result in a lack of goal congruence or suboptimization Requires more effective communication abilities May create personnel difficulties upon introduction –Employees asked to do too much too soon –Some managers have difficulty relinquishing control

Continuing... Disadvantages of Decentralization Can be extremely expensive –Training lower-level managers –Potential cost of poor decisions –Duplication of activities –Developing and operating sophisticated planning and reporting system Requires accepting inappropriate decisions as it is a training ground

Responsibility Accounting Systems Responsibility accounting refers to an accounting system that provides information to top management about the performance of organizational subunits. One purpose of a responsibility accounting system is to “secure control at the point where costs are incurred instead of assigning them all to products and processes remote from the point of incurrences.”

Control Procedures Control procedures are implemented for the following three reasons: Managers attempt to cause actual operating results to conform to planned results (effectiveness) Managers attempt to cause, at a minimum, the standard output to be produced from the actual input costs incurred (efficiency) Managers need to ensure, to the extent possible, a reasonable utilization of plant and equipment

Responsibility Report Assists each successively higher level of management in evaluating performance of subordinate managers and their respective organizational units Contains monetary and nonmonetary information Separates costs into those controlled by unit managers and those not controlled by unit managers

Basic Steps in a Control Process Compare Monitor Plan Gather actual data Managerial influence

Manager’s Performance Report

Production Vice-President’s Performance Report

President’s Performance Report

Nonmonetary Information for Responsibility Reports Departmental/divisional throughput Number of defects (by product, product line, supplier) Number of orders backlogged (by date, quantity, cost, and selling price) Number of customer complaints (by type and product); method of complaint resolution Percentage of orders delivered on time

Nonmonetary Information for Responsibility Reports Manufacturing (or service) cycle efficiency Percentage of reduction of non-value-added time from previous reporting period (broken down by idle time, storage time, quality control time) Number of employee suggestions considered significant and practical Number of employee suggestions implemented Number of unplanned production interruptions

Nonmonetary Information for Responsibility Reports Number of schedule changes Number of engineering change orders; percentage change from previous period Number of safety violations; percentage change from previous period Number of days of employee absences; percentage change from previous period

Responsibility Center Cost center Revenue center Profit center Investment center Classification of center based on manager’s scope of authority and type of financial responsibility

Profit Center Master Budget

Critical Success Factors Examples are: Quality Customer service Efficiency Cost control Responsiveness to change Critical success factors are those items that are so important that, without them, the organization would cease to exist.

Suboptimization Top management must be aware that suboptimization can occur and develop ways to avoid it Primary way to limit suboptimization is by communicating corporate goals Suboptimization exists when individual managers pursue goals and objectives that are in their own and/or their segments’ particular interests rather than in the company’s best interests.

Transfer Price General rules to set price for internal use: –The maximum price should be no greater than the lowest market price at which the buying segment can acquire the goods or services externally. –The minimum price should be no less than the sum of the selling segment’s incremental production costs plus the opportunity cost of the facilities used. A transfer price is an internal charge established for the exchange of goods or services between organizational units of the same company.

Cost-Based Transfer Prices Absorption cost –Does not produce same amount of income that would be generated if transferring division sold goods externally From Exhibit 14-11: DM + DL + VOH + FOH = $160 + $48 + $72 +$78 = $358

Continuing... Cost-Based Transfer Prices Variable cost – production or total? –May have motivation problem for selling department From Exhibit 14-11: Production: DM + DL + VOH = $160 + $48 + $72 = $280 Total: Variable Production Cost + Variable S & A = $280 + $8 = $288

Cost-Based Transfer Prices Actual cost –Inefficiencies in production may not be corrected Standard cost –“Buyer” could pay more than actual cost for goods

Market-Based Transfer Prices Advantages –Both seller and buyer should accept Problems –Product may not be sold in open market –Internal cost savings may exist –External market may temporarily be high or low –Determination of “right” market price may be difficult

Negotiated Transfer Prices Normally below external sales price Above unit’s incremental costs, including opportunity cost Managers must have authority to go outside the company if negotiations fail

Dual Pricing Different prices for seller and for buyer Profit for seller and minimal cost to buyer Managers to have most relevant information for decision making and performance evaluation

Transfer Pricing in Multinational Settings Extremely difficult to set –Tax systems –Customs duties –Freight and insurance costs –Import/export regulations –Foreign exchange controls –Internal and external objectives of transfer differ May use different transfer prices for different countries; make certain of legality.