1. Chapter 5 – Responsibility Accounting and Transfer Pricing

2. 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

3. 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

4. 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.

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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.

16. 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

17. 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

18. 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

19. 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.”

20. 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

21. 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

22. 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.)

23. 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

24. 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.

25. 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.

26. 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

27. Figure 8-1

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

29. 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

30. 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

31. 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

32. Figure 8-2

33. 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

34. 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

35. 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.

36. 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

37. 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

38. Source: Horngren, Cost Accounting, 2009

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

40. 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.

41. 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

42. Problems/Cases P5-12 – University Lab Testing P5-17 – Stale-Mart
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