CHAPTER FIVE Responsibility Accounting and Transfer Pricing

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-2 Outline of Chapter 5 Responsibility Accounting and Transfer Pricing  Responsibility Accounting  Transfer Pricing

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-3 Responsibility Accounting Characteristics of responsibility centers are:  Knowledge of the centers’ managers is difficult to acquire, maintain, or analyze at higher levels  Decision rights are specified for each center  Performance measurement is obtained from internal accounting system (Recall organizational architecture concepts in Chapter 4.) Types of responsibility centers: cost, profit, investment. See Table 5-1.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-4 Cost Center - Design Knowledge:  Central manager knows optimal production quantity and budget  Cost center manager knows how to optimally mix inputs Decision rights:  Cost center manager chooses quantity and quality of inputs used in cost center (labor, material, supplies) Measurement:  Minimize total cost for a fixed output  Maximize output for a fixed budget

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-5 Cost Center - Problems  Minimizing average costs does not necessarily maximize profits. Cost centers have an incentive to produce more units to spread fixed costs over a large number of units.  Quality of products produced by cost center must be monitored.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-6 Profit Center - Design Knowledge:  Profit center managers’ knowledge of product mix, demand, and pricing is difficult to transfer to central management Decision rights:  Can chose input mix, product mix, and selling prices  Given fixed capital budget Measurement:  Actual profits  Actual profits compared to budget

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-7 Profit Center - Problems  Setting appropriate transfer prices on goods and services transferred within the firm  How to allocate corporate overhead costs to responsibility centers  Profit centers that focus only on their own profits often ignore how their actions affect other responsibility centers

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-8 Investment Centers Knowledge:  Investment center manager has knowledge of investment opportunities and operating decisions Decision rights:  Ratify and monitor decisions of cost and profit centers  Decide amount of capital invested or disposed Measurement:  Return on Investment (ROI)  Residual Income (RI)  Economic Value Added (EVA)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-9 Return on Investment Return on Investment (ROI) = Accounting net income for an investment center  Total assets invested in that investment center DuPont formula separates ROI into two components: ROI= Sales turnover  Return on sales ROI= (Sales  Total Investment)  (Net Income  Sales) ROI increases with smaller investments and larger profit margins. Focusing on ROI can cause underinvestment. See Self Study Problem 1, part a.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Residual Income Residual income (RI) = Accounting net income of investment center  (Required rate of return  Capital invested in that center)  RI is determined with financial accounting measurements of net income and capital  Each investment center could be assigned a different required rate of return depending on its risk  RI can be increased by increasing income or decreasing investment See Self Study Problem 1, part b.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Economic Value Added EVA is a refinement of residual income that uses economic measures of income and capital rather than financial accounting measures. Economic value added (EVA) = Adjusted accounting net income of investment center  (Weighted average cost of capital  Capital invested in that center) Examples of EVA adjustments to accounting:  Research and development (R&D) is amortized over 5 years for EVA, but expensed immediately for financial accounting.  Unamortized R&D is included in capital for EVA, but treated is treated as an expired cost (zero value) for financial accounting.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Economic Value Added  EVA can be increased by three basic methods: –Increase the efficiency of existing operations, and thus the spread between the investment return and the firm’s weighted average cost of capital –Increase the amount of capital invested in projects with positive spreads between investment return and the firm’s weighted average cost of capital –Withdraw capital from operations where the investment return is less than the firm’s weighted average cost of capital

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Investment Center - Problems  Disputes over how to measure income and capital.  Difficult to compare investment centers of different sizes.  Firm’s central management must monitor product quality and market niches of investment centers to reduce possibility for self-interested investment center to damage firm’s reputation.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Controllability Principle Controllability Principle:  Hold center managers responsible for only those costs and decisions for which they have authority Drawbacks of controllability principle:  If managers suffer no consequences from events outside their direct control, they have no incentive to take actions that can affect the consequences of uncontrollable events (such as storms, corporate income taxes, etc.)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Transfer Pricing - Defined Transfer Price defined: the internal price (or cost allocation) charged by one segment of a firm for a product or service supplied to another segment of the same firm Examples of transfer prices:  Internal charge paid by final assembly division for components produced by other divisions  Service fees to operating departments for telecommunications, maintenance, and services by support services departments  Cost allocations for central administrative services (general overhead allocation)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Transfer Pricing and Firm Value Transfer prices have multiple effects on firm value: Performance measurement:  Reallocate total company profits among business segments  Influence decision making by purchasing, production, marketing, and investment managers Rewards and punishments:  Compensation for divisional managers Partitioning decision rights:  Disputes over determining transfer prices

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Ideal Transfer Pricing Ideal transfer price would be  Opportunity cost, or the value forgone by not using the transferred product in its next best alternative use  Opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Transfer Pricing Methods  External market price –If external markets are comparable  Variable cost of production –Exclude fixed costs which are unavoidable  Full-cost of production –Average fixed and variable cost  Negotiated prices –Depends on bargaining power of divisions See Self-Study Problem 2.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Transfer Pricing Implementation  Disputes over transfer pricing occur frequently because transfer prices influence performance evaluation of managers  Internal accounting data are often used to set transfer prices, even when external market prices are available  Classifying costs as fixed or variable can influence transfer prices determined by internal accounting data  To reduce transfer pricing disputes, firms may reorganize by combining interdependent segments or spinning off some segments as separate firms

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Transfer Pricing for International Taxation When products or services of a multinational firm are transferred between segments located in countries with different tax rates, the firm attempts to set a transfer price that minimizes total income tax liability. Segment in higher tax country: Reduce taxable income in that country by charging high prices on imports and low prices on exports. Segment in lower tax country: Increase taxable income in that country by charging low prices on imports and high prices on exports. Government tax regulators try to reduce transfer pricing manipulation.