1. Responsibility Accounting and Transfer Pricing
Chapter Five
Responsibility Accounting and Transfer Pricing
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3. Today’s Objectives
Familiarize ourselves with the types of responsibility centers,
Understand accounting diagnostic measures employed to measure performance of responsibility centers,
Note the assumptions and issues inherent in these measures.
Explore transfer pricing and its role in the above.
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4. First: Agency Theory and Self-interested Behavior
Fundamental assumption of economics:
Individuals act in their own self-interest to maximize utility.
Opportunity set:
work for employer, work on other projects, relax, etc.
Resource constraints:
time, money, knowledge, etc.
Utility:
preferences for money, working conditions, leisure, etc.
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5. First: Agency Theory and Self-interested Behavior
Fundamental assumption of economics applied in agency theory:
Individuals act in their own self-interest to maximize utility.
Fundamental assumption of levers of control:
Human Motives:
Want to contribute
Generally choose to do right
Strive to Achieve
Like to Innovate
Want to do Competent Work
How do we reconcile these two?

6. Principal-Agent Model
Economic model of relationships in a firm
Principals are managers or firm owners
Agents are employees or independent contractors
Agents perform functions for principals
Numerous principal-agent relationships exist in firms
Agency costs
Reductions in firm value caused when agents pursue their own interests to the detriment of the principal (goals are incongruent)
A major use of internal accounting systems is to control agency costs
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7. Contract Issues to Consider
Agents cannot be compensated on effort (input) which is not observable by the principal.
Thus as indicated in the text, portfolio performance (output) can be selected as a performance measure.
However, since factors not under the control of the agent can influence this output performance measure, possibly negating the value of all his effort (input), the agent must be compensated for the higher risk inherent in an output measure contract.
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8. Agency Problems
Free-rider problem: Agents have incentives to shirk because their individual efforts are not directly observable. Solutions: Incentive contracts, monitoring, etc. Horizon problem: Agents expecting to leave firm in near future place less weight on long-term consequences. Employee theft: Employees take firm resources for unauthorized purposes. Solutions: Buy fidelity bond, monitoring, inventory control, etc. Empire-building: Managers seek to manage larger number of agents to increase their own job security or compensation. Solutions: Modify incentive contracts, benchmarking, etc.
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9. Agency Asymmetry Problems
Adverse selection: Prior to contracting, agents have better private information than principals.
Solutions: pre-contract investigation, post-contract penalties.
Moral hazard: After contracting, agents have an incentive to deviate because the principal cannot readily observe deviations (hidden action or hidden information).
Solutions: inspecting, monitoring.
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10. Decision Rights
Decision rights are restrictions on how economic assets of a firm can or cannot be used.
Management determines how decision rights are to be allocated among various agents within a firm.
Alternative styles of allocating decision rights:
Centralize (“micro-management”)
Decentralize (employee empowerment)
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11. Decision Rights
Decision rights are restrictions on how economic assets of a firm can or cannot be used.
Management determines how decision rights are to be allocated among various agents within a firm.
Alternative styles of allocating decision rights:
Centralize (“micro-management”)
Decentralize (employee empowerment)
Linking knowledge and decision rights is a key issue for organizational architecture.
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12. Sorry – a bit flippant…

13. Responsibility Centers
What is a responsibility center?
One example from your ad hoc group
One positive
One challenge

14. 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
Types of responsibility centers: cost, profit, investment.
See Table 5-1 in text.
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16. TODAY’S APPROACH
As we explore the types of responsibility centers, lets think in terms of –
What could go wrong with this approach?
What can we do to avoid that?

17. Cost Center - Design Knowledge: Decision rights:
Central manager knows optimal production quantity and budget
Cost center manager knows optimal mix of inputs
Decision rights:
Cost center manager chooses quantity and quality of inputs used in cost center (labor, material, supplies)
Measurement/Evaluation:
Minimize total cost for a fixed output
Maximize output for a fixed budget
What could go wrong?
How to avoid?

18. Cost Center - Problems
Minimizing average costs does not necessarily maximize profits. Production 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.
Examples?
Academic departments in university (online vs in-class)
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20. Profit Center - Design Knowledge: Decision rights:
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/evaluation:
Actual profits
Actual profits compared to budget
What could go wrong?
How to avoid?
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21. 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
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22. Why can’t you tell a kleptomaniac a joke
Why can’t you tell a kleptomaniac a joke? Because they always take things – literally.

23. Investment Centers Knowledge: Decision rights: Measurement:
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)
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24. 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.
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25. 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.
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26. Economic Value Added
EVA is the same as residual income with some adjustments to accounting the reported accounting numbers.
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.
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27. Economic Value Added What could go wrong? How to avoid?
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
What could go wrong?
How to avoid?
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28. Investment Center - Problems
Disputes over how to measure income and capital.
Difficult to compare investment centers of different sizes (for RI and EVA).
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.
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29. 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.)
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30. What Might Cause Overinvestment?
Discuss the implications of using ROI, RI, and/or EVA individually or in combinations as a way to preclude “overinvestment”.
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31. How Could You Deter Underinvestment if You are Limited to the Use of ROI?
Provide a solution which is
Practical – from a cost/effectiveness point of view, and
Effective – from a goal congruence point of view
Be specific!
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32. 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)
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33. 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
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34. 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
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35. 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.
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37. 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
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38. 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.
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