Chapter two

CHAPTER TWO

Responsibility accounting: Core concept, Techniques & Practices

2.1. Definition & Salient features:

Responsibility accounting is a system of collecting and presenting of accounting data that

segregates and identifies revenue and /or cost and the resultant profitability with the areas of

personal responsibility in order to evaluate the performance of persons to whom responsibility

has been assigned to carry out the corporate plans and objectives.

According to CIMA1, London “Responsibility accounting is a system of management Accounting

under which accountability is established according to the responsibility delegated to various

levels of management and management information and reporting system instituted to give

adequate feedback in terms of delegated responsibility. Under this system divisions or units of an

organisation under specified authority in a person are developed as responsibility centers and

evaluated individually for their performance. A good system of transfer pricing is essential to

establish at the performance and result of each responsibility center. Responsibility accounting is

thus used as control technique."

Eric. L. Kohler2 defines Responsibility accounting as “method of accounting in which costs are

identified with persons assigned to their control rather than with product or function."

According to Schaltke, R.W and Jonson H.G 3 “Responsibility accounting system is a system of

accounting in which costs and revenue are accumulated and reported to managers on the basis

of manager’s control over these costs and revenues. The managerial accounting system that ties

budgeting and performance reporting to a decentralized organization is called responsibility

accounting.” As observed by Landouceur A G 4 “Responsibility Accounting for most part is a

change in emphasis from conventional product accounting to the cost control aspects of

accounting and management control, wherein the statement flowing throughout the management

hierarchy on a vertical basis or throughout the various components of the organization emphasize

measurement of performance based on decision variable identified with the particular level of the

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segment. In this respect RA has provided a tool which did not exist on a systematized basis prior

to 1950.”

The definition as above gives a logical derivation of its features as under:

2 .1.1. Different from the product or functional accounting, it is a positional accounting

system fitted into an environment of the delegated responsibility in favour of individual

for execution of organisational plans and evaluation of actual performance for

determining whether actual operations have gone according to what .was planned. And

also, if the actual are in a deviating path, then the extent thereof, the causes for deviation

and the contemplated remedial measures to bring in the future actions more in line with

the plan. According to Horngren CT5 “The corner stone of management control system in

a decentralized structure is the concept of Responsibility Accounting ( RA). RA is a

system which recognizes various responsibility or decision centers within the organization

and traces costs, revenues and resources to individual managers who are primarily

responsible for making decision about them." The significance is that, the accounting

under this system is not directly related to product or function with a consequent

difference that in the concept of accounting of product or function, only a passive

cognizance in accounting term is taken for the person ill charge of that. The personal

responsibility remains outside the ambit of being measured in terms of accounting. This

gives rise to analysing the organisational structure in its aspects and extent of

centralisation and decentralisation. The individual responsibility can be measured only

when his authority to influence the cost and/ or revenue can be identified and assigned

to with reasonable clarity, in a centralised organisation as one extreme, the product or

function may have persons in charge with no reasonable decision making authority for

the operation of respective product or function. In this case, the scope of responsibility

accounting shall be too insignificant and the accounting will be more oriented towards

product / function rather than the individual. “One of the earliest writers to make a

systematic presentation of Responsibility Accounting was Riggings. His main task

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centered on developing an accounting system which aimed at controlling expenditure by

relating the latter to the individuals in organization who are responsible for their control.

Thus the system would result in the preparation of accounting statements for all level of

management so that the operating personnel could effectively use them as a tool for

controlling their operations. Higgin's postulation implied a sound budget system, realistic

standards and participation of responsible managers in goal setting as pre-requisites for

successful application of Responsibility Accounting”.4

•>»

2 .1 .2 . Focus on Controllable and Non-controllable cost differentiation: As may follow from

above, the responsibility accounting system is associated with delegated authority at the

discretion of the individual responsible for execution of a task. More the delegation, more

the controllable cost at the discretion of the individual and more the scope of accounting

the responsibility of the individuals. Authority is the power of autonomy and this can be

the guiding factor for determining the assignment of responsibility for each activity and for

each corresponding item of expenses, income, capital expenditure and assets

investment. In establishing the responsibility accounting system, the corporate may

decide on certain guidelines for assigning cost to individual for reporting. The American

Accounting Association7 has recommended the following:

a If the person has authority over both the acquisition and use of service, he should be

charged with the cost of such services. The cost of resources deployed by a

responsibility center head for his own operation is an example of such cost.

□ If the person significantly influences the cost through his own action, he may be charged

with such cost. Regional allocation for example may come under this category, where a

Business Area manager has reasonable influence to direct regional sales personnel to do

his job even though, they are not reporting to him. The additional cost so triggered by the

BA manager should be charged to him.

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 Chapter two

□ Even if the person cannot significantly influence the cost through his direct action, he may

be charged with those elements with which corporate management desires him to be

concerned so that he will help to influence those who are responsible.

2 .1 .3 . Control rather than m em accounting: Responsibility accounting is a concept that aims

at helping achieve a fit between planning & control system and managerial responsibility.

-Under the conventional system of cost accounting, overhead accumulated are allocated

amongst different cost centers defined for this purpose. A cost center as we know is.the

unit of an organisation in which the individual in charge administers his activities directly.

Obviously, this definition of cost center seems necessary from the point of view of the

cost control and to determine responsibility. But cost allocation at best is loaded with

assumption and in many cases highly arbitrary methods of apportionment are employed

in practice. Product is not an appropriate unit of cost control. Through this conventional

system of cost accounting an individual in charge of cost center is burdened with a large

number of overheads over which he may have little control. Hence, the system of

responsibility accounting is recommended whereby, the person controlling or initiating a

particular cost should be held responsible for it. It is therefore, very clear to note that the

very purpose of introducing this concept is to work as a management control tool for the

corporate office as well as for toe responsibility center head with a view to deciding about

his operation.

2 .1 .4 . Not an accounting by Itself: Responsibility accounting as a concept of cost control

uses various accounting and cost control techniques like budgeting, standard costing,

financial trend line analysis, operating leverage and pricing techniques with only

difference that it has a bias towards fixation of responsibility of individual as against a

product or function. It just makes use of different financial accounting and costing tools to

assess the performance of the person who can best influence the cost and revenue of a

business unit he is responsible for.

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2 .1 .5 . Pricing o f interdepartmental transactions: The value of services rendered by one

division / department to others need to be quantified for evaluating the value addition

done by one unit for other and for the organisation as a whole. Unless the inter-divisional

transactions are identified and quantified, the managerial output cannot be measured in

an objective way. Responsibility accounting system is also a tool for assessing individual

performance in certain predetermined financial and non-financial terms, which has given

rise to the need for identifying and quantifying the interdivisional transaction value.

,2.2. Nature of responsibility center

One of the principles of responsibility accounting is that the overall objectives of an organization

are divided and subdivided into the objectives of its constituent part. A responsibility center as

one of such constituent parts exists to accomplish one or more of such purposes and these

purposes are its objectives. The company as a whole has goals and the top management has

decided a set of strategies to accomplish these goals. The objectives of a responsibility center

are to help implement these strategies. Because, the organization is the sum of its responsibility

centers, if strategies are sound and if each responsibility center meets its objectives, the whole

organization should achieve its goals. A responsibility center uses resource-inputs, which are

physical quantities of material, hours of various types of labour, cost of using premises & facilities

and a variety of other services. These inputs under the business process get converted into

outputs that may be classified as goods, if they are tangible or services if they are intangible.

Every responsibility center has output, that is, it does something. In a production plant, the

outputs are Products and in a project execution function, the output is commissioning of Projects.

For many responsibility centers, especially staff units, output are difficult to measure,

nevertheless, they exist. Engineering department of many organizations for example provides

services to the various operating BUs, which may be valued at certain hourly rate as may be

agreed upon.

The products (i.e. goods and services) produced by a responsibility center may be finished either

to another responsibility center or to the final customer. In the first case, the products are inputs

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to the other responsibility centers and in the latter case they are output of the whole organization.

Revenues are the amounts earned from providing these outputs.

2.3 Relation between inputs and outputs

Management is responsible for obtaining the optimum relationship between inputs and outputs. In

some situations, the relationship is causal and direct. In a production department for example, the

inputs of raw material resources become a physical part of finished goods outputs. Control

focuses on producing the output at the time needed, in the desired quantities according to the

contract specification and quality standards and with minimum input.

In many situations, however, inputs are not directly related outputs. Advertising expenses are the

input that is expected to increase sales revenue, but revenue is affected by many factors other

than advertising. So the relationship between additional amount of advertising and resulting

revenue rarely is known. Marketing decision on amount to spend for advertising is based on

judgement. For research & development, the relationship between input and output is even more

ambiguous in the short run; the value of today’s R&D effort may not be known for several years

and the optimum amount that a given company should spend for R&D may be indeterminable.

Business input, output and the relation between them constitute the basis of parameters of

performance evaluation. Responsibility accounting system percolates down this mechanism of

performance evaluation at the ground level of an organization. This gives a clear idea of the

degree of efficiency and effectiveness in operation earned out at different levels of an

organization. In this context, apart from the power plant EPC contractors, reference can be taken

from Indian Railway. The committee appointed for studying existing accounting system has come

out with the following recommendation*

‘ The committee has accordingly come to the conclusion that the cost incurred on performing

various activities at each of the three level's - functional, divisional and zonal- should be

maintained in such way that they can be looked at as distinct and separate from each other. In

other words, cost data and records should be compiled / documented / reported separately at / by

each level in keeping with the principles of Responsibility Accounting. To elaborate, the level that

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incurs the cost should maintain records of cost incurred at that level and render prescribed report

to the next higher level, which in turn should maintain records of cost incurred at that level,

amalgamate its cost distinctly with the cost reported from the lower level before reporting to the

next higher level and so on. Only then, each level will not only be aware of cost-in all its

constituents-incurred by it report to the next higher level, in juxtaposition with its own historical or

standard cost (wherever it is made available), and can be held responsible for deviations and

variations and can by itself, or at the instance of the next higher level, identifies required control

measures."

2.4. Areas of operation for control

Depending upon the nature of activities as well as the organizational philosophy, the units of

operation can be classified as under:

Cost center: A cost center in the CIMA’s9 official terminology is defined as “a product, services,

functions or items of equipment of which cost may be attributed to cost unit." Cost center denotes

a location, function or items of equipment in respect of which cost may be ascertained and related

to cost units for the purpose of control. It is the smallest of organizational sub-unit for which

separate cost allocation is attempted. It may be a personal or impersonal cost center. Whether it

is personal or impersonal, cost center represente organizational span for which separate cost

determination is aimed at for deciding the needs of the management. Managers of functional

department s like production: personnel and marketing are treated as heads of the respective

cost center and made ,responsible for their cost. If the responsibility is measured in financial

terms, the performance statement should analyze the cost a) which are directly attributable /

controllable by the concerned cost center and b) which may not be the result of significance

influence by the cost center manager, but the management wants him to be concerned with such

cost.

Illustration: In order to control the execution of an on going power project, the EPC contractor

decided that the TG Island would be designated as cost center. The cost pertaining to this cost

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 Chapter two

center is originated and controlled by the following department / divisions of the organization. The

TG Island erection in charge was the cost center head.

A c tiv itie s R e s p o n s ib ility

1. Supply of turbine, generator and Head of Supply management group
ancillaries
2. Erection of TG Islands according to the Turbine erection in charge, who belongs to
design the erection department, which is a
business unit of the organization and is
responsible for the erection &
commissioning at a transfer price.
3. Commissioning of TG Islands Head of Engineering Department, a
separate BU
4. Overhead at project site The project site manager
5. Erection department’s overhead Head of erection department

The management wanted the TG Island in charge, to co-ordinate the supplies at site although it

was not directly his responsibility. He would also be loaded with a specified amount of the project

site overhead as well as that of the parent BU (i.e. erection unit). The cost center performance

report shall reflect the followings as the responsibility of the various group heads:

E vents A c c o u n ta b ility

1 Delay in supplies due to problem with Head of Supply management group

suppliers that resulted into additional cost to
make up the overrun
2 Delay in mounting the Turbine due to civil A co-ordination problem, hence the
front not being ready thus raising the go- TG Island in charge is accountable
down charges and other related expenses.
3 Increase in sub-contracting cost not as a An increase in controllable cost under
result of above the responsibility of the TG Island in
charge
4 Increase in allocated BU overhead as For the excess of allocated overhead,
compared with the budgeted estimate the head of erection group is
' accountable.

Building up and reporting of cost under this guideline will not only depict the total cost of the cost

center (TG Island in this case), and the variation from the budgeted ones but also the efficiency

level of the different individuals. It also does bring into limelight the areas that require attention to

take necessary corrective measures to initiate effectively the process of perfection. Since, the

responsibility of controlling the operational cost is pulled down to the much lower level of

organizational hierarchy, where the cost is really committed by the actions of the operational staff,

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 Chapter two

th e r e is e v e ry p o s s ib ility of p u ttin g th e e ffe c tiv e -m o s t endeavor to honor th e in d iv id u a l

c o m m itm e n t. C o s t c on tro l c a n b e v o lu n ta ry a n d re m a in s le s s lik e ly to s u ffe r th e h a lf-h e a rte d n e s s

c a u s e d b y im p o s itio n fro m th e to p le v e l. It a ls o instills a s e n s e o f c o s t a w a r e n e s s a n d fu lfillm e n t o f

in d iv id u a l re s p o n s ib ility .

R evenue c e n t e r : It e m a n a te s fro m th e a c t o f d iv is io n a lis a tio n o f e a rn in g . T h u s , a re v e n u e

c e n te r m a y b e d e fin e d a s a n o p e ra tio n a l re s p o n s ib ility th a t is d e v o te d to ra is in g r e v e n u e w ith no

d ire c t a c c o u n ta b ility fo r th e c o s t o f g o o d s o r s e rv ic e s s o ld b y th is o p e ra tio n . M a rk e tin g a n d s a le s

c e n te r c a n th e re fo re b e rig h tly c a te g o riz e d a s r e v e n u e c e n te rs w ith th e e x p e c ta tio n th a t th e

c o n c e rn e d m a n a g e r ’s e ffo rt w ill p ro p o rtio n a te ly in c re a s e o r d e c r e a s e th e re v e n u e .

T h e c o m m itte e e m p lo y e d b y th e In d ia n R a ilw a y fo r id e n tific a tio n o f c o s t / p ro fit c e n te rs a n d th e

re la te d fin a n c ia l is s u e s , h a v e in tro d u c e d a n d d e s c r ib e d th e c o n c e p t o f r e v e n u e c e n te r . A c c o rd in g

to th e c o m m itte e th e m a jo rity o f re s p o n s ib ility c e n te rs o f In d ia n R a ilw a y ( IR ) i.e . th e fu n c tio n a l

u n its o f a ll s e rv ic e d e p a rtm e n ts P e rfo rm s a c tiv itie s th a t e v e n tu a lly c o n trib u te to th e p ro d u c tio n o f

tra n s p o rt s e rv ic e s a n d r e la te d a c tiv itie s . F o r e x a m p le a p e r m a n e n t w a y in s p e c to r ( P W I ) o f th e

civil e n g in e e r in g d e p a r tm e n t is re s p o n s ib le fo r th e u p k e e p o f th e p e r m a n e n t w a y , s ig n a l in s p e c to r

o f th e S & T d e p a rtm e n t m a in ta in s th e s ig n a lin g e q u ip m e n t a n d s o o n . In th e a b s e n c e th e c o n c e p t

o f tra n s fe r p ric in g , th e s e rv ic e s p ro v id e d b y th e fu n c tio n a l u n its o f v a rio u s d e p a r tm e n t in c u rs o n ly

c o s t a n d n o re v e n u e o f th e ir o w n . H e n c e , th e y h a v e b e e n te r m e d a s c o s t c e n te rs . S im ila rly , th e

fu n c tio n a l u n its th a t a r e re s p o n s ib le fo r b o o k in g a n d h a n d lin g t h e tra ffic fo r c a rria g e s u c h a s

g o o d s s h e d s , p a s s e n g e r a n d p a rc e l b o o k in g o ffic e e tc . a r e th e u n its th a t a r e re s p o n s ib le fo r th e

b o o k in g all tra ffic a n d c o lle c tin g th e r e v e n u e . T h e c o s ts in c u rre d b y t h e s e u n its a r e fo r th o s e

fu n c tio n s a r e v e ry s m a ll a s c o m p a re d to th e r e v e n u e g e n e r a te d . In o th e r w o rd s , in th e c a s e o f

s u c h c e n te rs , r e v e n u e p re d o m in a te s c o s t. T h e r e v e n u e th u s g e n e r a te d a t th o s e fu n c tio n a l units

a d d s u p to th e to ta l r e v e n u e o f th e IR o r a t le a s t th e b u lk o f it. H e n c e , t h e y h a v e b e e n te rm e d a s

r e v e n u e c e n te rs . T h e p rin c ip a l a ctiv ity o f s u c h c e n te r is b o o k in g o f tra ffic . T h e in d iv id u al

o p e ra tio n a l a c tiv itie s s u c h a s b o o k in g o f g o o d s , p a s s e n g e rs a n d p a r c e ls m a y b e te rm e d a s s u b ­

a c tiv itie s o f th e c o n c e rn e d s ta tio n (th e m a in a c tiv ity c e n te r) fo r th e p u rp o s e o f e v a lu a tio n o f

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performance of those sub-activity centers. The revenue generated by each sub-activity center is

accounted for through various returns prepared by it, cumulating into the balance sheet of the

station.

P ro fit cen ter: A profit center may be construed as the smallest possible functional unit for which

both revenue and expenditure can be worked out in actual terms. This would enable

determination of accountability right from the grass root level, especially when the organization is

vast, multi-location and multi-product in nature. For a profit center organization to be established,

it is necessary to have units of an organization to which both revenue and cost can be separately

attributed. Managers of profit centers should be responsible both for the revenue as well as cost,

which implies that there should be sufficient decentralization of authority within the organization to

permit the profit center managers to make decisions about the selling prices and the output level

at those prices. A profit center performance report measured in absolute terms would show profit

as the bottom line. A profit center may have sub -profit centers within it. How a responsibility

center may take the form of Profit Center has been explained by Anthony Robert N 10 when he

says “A given responsibility center is a profit center only if the top management decides to

measure its output in monetary terms and believes it to be a good idea to do so. No accounting

principle requires that revenue be measured for individual responsibility centers within the

company. With some ingenuity, practically, any cost (or expenses) center could be turned into a

profit centers can be found. The question is whether there are sufficient positive benefits in doing

so.”

illustration: The erection and commissioning division of a power plant EPC contractor, which

has been defined as profit center may have under it, different on going project sites operating as

profit center by themselves. Although, in their cases the control over revenue by the respective

project site managers would be restricted only to the additional revenue that they can generate by

doing extra and out of the scope work. Whereas, the erection & commissioning operation as a

whole, which is the parent profit center, the sources of revenue by way of direct marketing and

inter divisional transfer order are both reasonably controllable by the said profit center head. The

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project performance can be measured by the project profitability, as a part of the erection &

commissioning profit center and the latter’s performance by profit earned by various projects

executed under different project -site mangers. The individual project manager gets the targeted

profitability in consultation with the parent profit center, which he can influence either by reducing

input cost or by raising additional revenue by way of proper claim management among others or

both. The parent profit center is responsible for maintaining the profitability target fixed by the

corporate management by allocating and employing resources to various functions like marketing

and project management within well defined control system. In profit center both input and output

are capable of measurement in financial terms and it provides more effective assessment of the

managerial performance since, both costs and revenue are measured in monetary terms.

The two major aspects of profit center accounting under responsibility center concept are transfer

pricing and non-controllable cost. Corporate and segmental allocations are the example of non-

controllable items arising out of the vertical relation between the profit centers and the controlling

bodies. This apart, there may be lateral movement of common cost allocation by other profit

centers along the same hierarchy. The budgeted level of such cost may be loaded to the

particular profit center as the receiver of services in exchange but of course not the variation

therefrom, which may be due to the efficiency level of other bodies, laterally or / and vertically.

Illustration: The profit target of a responsibility center X attached to a particular segment of a

firm was fixed at 30 MINR, which included expenses allocated by segment 3 MINR, corporate

charges 2 MINR and also I MINR as the share of location office. The annual account of X

showed a profit of 28 MINR after charging segment allocation of 5 MINR, corporate charges 2

MINR and location allocation 1.5 MINR. The increase in segment cost has neither been

influenced by, nor any additional services accruing to the profit center “X". The rise in location

allocation was on account of an increase in legal expenses relating to X and was incurred at the

behest of the manager of that profit center. The business performance in terms of profit is in fact

30 MINR and therefore, has not been in variation from the compliance level affixed to the

manager of ‘X’ as the responsibility center head. The additional charge of 0.5 MINR from location

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 Chapter two

has been duly accommodated by corresponding reduction in other expenses of the profit center

concerned.

In v e s tm e n t C e n te r: As noted by Manohar Bhatia," Another concept related to profit center

concept is the “Investment Center”. An investment center is a unit or division of the company,

which is responsible to the top a management for its profitability in relation to its investment base.

As in profit centers, revenue and expenses are measured but in addition the assets employed in

the division are also measured with a view to determining its investment base. Thus, an

investment center is an extension of profit center idea. Profit is measured in both, but only in

investment center is this profit related to the size of the investment involved." Thus, a factory or

an erection function as BUs, can be considered as investment center to measure the return on

investment. In fact, even Profit Centers, where there is no significant amount of tangible

investment, still can be measured in terms of Investment center because, all the BUs need some

value of investment as input resources and working capital requirement is one of them.

2.5. Profit center accounting under the concept of responsibility accounting

Profit center accounting in essence is the collecting, analyzing and presenting of data relating to

cost, revenue and profitability of an area of operation, which is so defined and designated by the

corporate strategy of an organization. The profit center accounting measures and reports the

performance of the concerned profit center as a whole without any primary attention towards the

people behind its management. One profit center can have more than one person to influence the

related objects of control and reporting; and as if in disregard of this the concept of profit center

accounting will focus on the abstract of the area of operation concerned. It is thus oriented to the

product or function. In a power plant business, the activities involving servicing of turbines and

other machines of various plants in the country and abroad may be a functional profit center,

whereas, the business of supplying turbine and other machines may be considered profit center

dealing in products.

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Responsibility center concept fixes its attention to the controlling body of a cost / profit /

investment center. It tends to identify and focus on the prime mover of an operation, preferably a

human element, which is supposed to exercise his control over the desired compliance level. In

action, it churns out the controllable part of the activities of such areas of operation, attaches

them to various persons concerned and holds them responsible for their part of compliance. The

difference between these two concepts may be summarized as under:

1. Profit center accounting is more of reporting than control; and control being the primary

objective of responsibility accounting.

2. Profit center accounting is aimed at describing a product’s or function's performance level,

whereas, the concept of responsibility center accounting goes in for describing the extent of

compliance ensured by the individual concerned.

3. Profit center accounting is more in the nature of historic than the relatively more futuristic

objectivity that governs the responsibility accounting system.

4. The identification, extraction, analyzing and deciding the individual accountability around

them is.the key feature of the responsibility accounting, which has no relevance to the profit

center accounting concept.

5. Profit center can be defined without reasonable degree of delegation. It is a function of

divisionalisation such that control may be retained at corporate level. The responsibility

accounting on the other hand, is a functional delegation of authority in favour of the person

whom the management would like to hold responsible.

6. In fact, profit center is the pre-requisite of implementing the responsibility center, which on the

other hand is valid for a profit center which is the offspring of both divisionalisation as

decentralisation of authority.

The following observation brings out the difference between the concept of responsibility center

and profit center in reporting the degree of management efficiency in a BU’s performance:

Products and plants are two profit centers of business area ‘x \ During the year 1999, it did a

business of total 217 MINR with 77 MINR and 240 MiNR for product and plant respectively at a

capacity level of 60 %. Total 36 number employees of this BA have been allocated to products

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a n d p la n ts a s 1 5 a n d 21 re s p e c tiv e ly . T h e B A o v e rh e a d s w e r e a llo c a te d to th e s a id p ro fit c e n te rs

o n t h e b a s is o f th e n u m b e r o f e m p lo y e e s . In a d d itio n to th is , th e B A is lo a d e d w ith s e g m e n ta l

a llo c a tio n b a s e d o n th e v o lu m e o f re v e n u e . T h e p ro fita b ility s ta te m e n t o f th e B A ‘x ’ h a s b e e n

fu rn is h e d a s u n d e r.

B u s i n e s s P e r f o r m a n c e K e v D a t a . B A ,x ’

P ro d u c t P la n t T o ta l

R evenue 77 140 217

M a te r ia l c o s t 61 114 175

C o n trib u tio n 16 26 42

A s % o f re ve n u e 21% 18% 19%

P e rs o n n e l cost 5 7 12

in d ire c t o v e r h e a d s 8 11' 19

A m o rtiz a tio n o f T e c h n ic a l k n o w h o w fe e s 3 3

In te r e s t & d e p re c ia tio n 1 2 3

S e g m e n t a llo c a tio n 1 2 3

T o ta l c o s t 79 136 215

In c o m e b e fo re T a x -2 4 2

T h is g iv e s a p ic tu re o f th e p ro fit c e n te r p e rfo rm a n c e u n d e r th e B A ‘x \ It s h o w s c le a rly , th a t

a lth o u g h th e B A h a s e a r n e d a p ro fit o f 2 M l N R , its p ro d u c t b u s in e s s is ru n n in g a t lo s s . T h e lo ss

h a s b e e n o ffs e t b y th e p la n t b u s in e s s o n th e o th e r h a n d . C o n tin u in g w ith th is re v e la tio n , th e profit

c e n te r a c c o u n tin g w o u ld g o fu rth e r to a n a ly z e th e a r e a s o f c o n c e rn s a s th e c a u s e o f th e lo s s . It

a n a ly s e s th e d e v ia tio n fro m b u d g e t fo r th e p ro d u c t b u s in e s s a n d m a d e th e fo llo w in g n o te s .

□ T h e a c tu a l c o n trib u tio n le v e l h a s b e e n 2 1 % a s a g a in s t th e b u d g e t e x p e c ta tio n o f 2 0 % .

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□ For the nature and volume of the product business carried out during 1999, there was a

budget allocation of 10 numbers of employees at a total cost of 3 MINR, which actually

turned to be15 numbers with a cost of 5 MINR as reported by the said Profit center.

□ Indirect Overheads based on the same number of employees was budgeted at 5 MINR

against at actual of 8 MINR.

□ Interest & Depreciation increased by 0.10 MINR over a budget of 1.10 MINR and

□ Segment allocation had been .80 MINR as against a budget of 1.30 MINR.

The difference in actual profit level attained vis-a-vis budget as the corporate expectation had

been reconciled as below:

Budgeted profit for product business 2.00 MINR

Increase in personnel cost -2.00 MINR

Increase in overhead -3.00 MINR

Increase in interest & Depreciation -0.10 MINR

Decrease in segment allocation 0.50 MINR

Decrease in material cost 0.60 MINR

Reported profitability -2.00 MINR

This is one of the best what profit center accounting can do i.e. identifying and allocations of

revenue and cost to different profit centers; analyzing and reconciling the deviations and

assigning reasons to that for remedial actions. It treats that profit center as an historical object of

the business house and does not focus on the element of controlling as the guiding force behind

the activities and this has become the entry point for the application of the concept of

responsibility accounting. In fact, it is a supplementary to the profit center accounting concept. It

can be noted below, in continuance of the derivatives given in the study, how the responsibility

center accounting concept provides the finishing touch thus spelling out the role of individual who

can be held responsible for the compliance level of the organization's plan as relating to a profit

center. It is thus a feature that is involved in describing a process— the management control

process, while the profit center accounting is inclined to give the final result of the performance of

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product / function as the control process aided by the responsibility accounting system. In the

light of this, the responsibility center accounting report will describe the performance of the profit

center as under.

Business Area performance Report Figures in MINR

R e s p o n s ib ility D is trib u tio n

Budget Actual Product M anager BA Head Segm ent C hief

Revenue 77.00 77.00

Material cost 61.60 61.00 0.60 (F)

Contribution 15.40 16.00

Amortization of TKH 3.00 3.00

Personnel cost 3.00 5.00 2 .0 0 (A )

Indirect overhead 5.00 8.00 3.00 (A)

Interest expenses 1.10 1.20 0.10 (A )

Segment charges 1.30 0.80 0 .5 0 (F )

Profit before Tax 2.00 -2.00 0.50 (F) 5.00 (A) 0.50 (F)

Conclusion: Although the product business has suffered loss, from operational point of view, it

has ended up with a bit of profit by the effort of the concerned Manager. There, has been

improvement in material utilization part, which was entirely on the responsibility of the Product

Manager, even though the gain therefrom had been partly offset by the sub-optimum utilization of

the assets allocated. The rise in interest cost reflects it. The major problem affecting this business

line being a non-controllable item for the product manager of the BA ‘x’ is under absorption

caused by the inadequate volume. As much as 5 MINR of unabsorbed cost had been loaded to

this line of business, on which the product manager had no control. The responsibility of raising

the volume of business was given on the BA manager. The interesting point to note is that

although these two different lines of businesses i.e. product and plant are treated as profit centers

for arriving at the profitability, the line managers did not have the responsibility to explore

business. Hence, their profitability targets could be triggered by only the possible cost reduction,

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which the product manager had reasonably carried out. The overall BA’s not so satisfactory

performance can be solely attributed to the BA Manager. In spite of the loss reported by the profit

center accounting the product-in- charge can surely not be held responsible.

2.6. Allocation for services

Corporate allocation: Every responsibility center has to share the part of corporate expenses

according to the corporate strategic resources consumed by the respective responsibility centers.

The share of corporate expenses is consisting of the services extended to the SBUs’ by way o f :

1. Corporate personnel services

2. Corporate finance & treasury function

3. Regional marketing services

4. Other corporate services like IT, secretarial and taxation matters.

in fact, corporate and segment allocations are the charges for common services rendered to the

SBUs. Since, a business area / unit cannot function without the overall corporate intervention, the

resulting expenses are to be recovered against the revenue earned by individual business unit.

In determining the BAs’ contribution to the organization the routine and specific value- of the

corporate and segment function needs to be accounted for. Depending upon the nature of

organization, a segment office may come in between the corporate and cluster of SBUs attached

to a particular segment. In that case the nature of segment allocation represents the following:

1. Segment personnel cost

2. Engineering expenses including design and drawing relating to one or more of the attached

SBUs.

3. Administrative and other expenses

Corporate and segment allocation becomes the uncontrollable part of the expenses on the part of '

a business area / ‘unit manager, and are taken care in Budgeting and reporting. The typical

responsibility accounting will report these allocations as under

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 Chapter tw o

RESPONSIBILITY DISTRIBUTION

P r o fit c e n te r B u s in e s s A re a Segm ent C o rp o ra te

R evenue
L e s s: O w n cost

P ro fit 1

L ess: B A a llo c a tio n

P ro fit 2

L ess: S e g m e n t a llo c a tio n

p ro fit 3

Less: C o r p o r a te a llo c a tio n

P r o je c t P ro fit
R e s p o n s ib ility L e v e l --------------------- ►

P rofit 1 re p r e s e n t s th e re s u lt o f th e g a m e p la n o f th e pro fit c e n te r h e a d , w h ic h is r e d u c e d b y th e

c o s t o f s e rv ic e s re n d e re d fro m th e le v e l o f th e B A m a n a g e m e n t, in c lu d in g th e c o s t o f u n d e r­

re c o v e ry , if a n y . T h e p ro fit 2 s o a rriv e d a t is s u b je c te d to th e s e g m e n t a llo c a tio n , w h ic h is m e a n t

fo r re c o v e rin g s e g m e n t c q s t. In th e s a m e w a y th e p ro d u c t’s / p ro je c t's p ro fita b ility is fin a lly

d e te rm in e d b y re d u c in g th e s h a re o f c o rp o ra te c o s t a ttrib u ta b le to th e s a id p ro fit c e n te r.

2 .7 . In te r fa c e a n d in te rd e p e n d e n c e a m o n g s t r e s p o n s ib ility c e n te rs :

R e s p o n s ib ility c e n te rs a r e h ig h ly s p e c ia liz e d in th e ir re s p e c tiv e fie ld a n d th e r e fo r in th e total

b u s in e s s p ro c e s s c a n n o t b e in d e p e n d e n t o f o n e a n o th e r. T h e s e q u e n c e o f th e w o rk flo w a n d th e

p o s itio n o f d iffe re n t S B U s in th a t flo w b rin g s a b o u t th e c o n fig u ra tio n o f th e s a id in te rd e p e n d e n c e .

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Illustration: There are five profit centers of business segment. One is responsible for the

marketing and project management of small sized (<50 MW) power plant and is named as CP,

there are two other SBUs namely, US and GP engaged in power projects of different size and

nature which are not relevant in this context. Second related one being the erection &

commissioning group (EC), which is common for all the power projects of different size & nature

executed by this segment. The third SBU concerned is manufacturing & supply management

(ES), which is responsible for the manufacturing and procurement of material for different power

projects. The SBU CP got an order form an industry house and as usually awarded the erection

& commissioning part to the SBU EC at an agreed price for an agreed scope. Now according to

the work schedule, this group can start work when civil fronts are ready, drawings are clear and

the materials reach the site. Supplying materials at site has been the responsibility of the supply

management group i.e. ES whereas making the civil front ready by a separate contractor has

been kept within the project management group (CP) itself. The interfaces of these three groups

are as under:

ES
v_________ /

Interfaces amongst SBUs in a common process flow

The erection function is dependent on PC for civil front, which is direct and vertical interface. On

the other hand, the dependence of EC on ES for material delivery at site is lateral and indirect.

Because, ES is not responsible to EC for on time delivery. These interfaces have the bearing on

the nature of re-defining controllable and non-controllable cost around a responsibility center in a

matching manner.

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Let us assume that, CP has booked the order at a price of 200 crones. It passed on the

engineering and supply part to ES at RS 150 Crones and erection & commissioning part to EC at

RS 20 crones. These prices are based on the offer submitted by the concerned SBUs. The

transfer prices of RS 150 crones and RS 20 crones contain a permitted 7,5% margin for the

SBUs. While executing the project following points were noted.

The SBU, Es could not from time to time stick to the delivery schedule at the project site. The idle

hour of the erection SBU (EC) on account of project staff & labour was computed at RS 40 lacs,

of which unit’s own overhead accounts for Rs.10 lacs. And after the material reached, in order to

reduce the time over run, crash programmes were taken up by employing further more number

of contract labour by overtime deployment. This resulted into extra cost of another RS. 40 lacs.

On the other hand due to delay in completion of civil fronts, there has been unplanned expense of

another RS. 25 lacs. The delay on the part of the supply management BU was partly because of

alteration in design & drawing specifications and has been quantified at Rs. 20 lacs. At the end of

the project ( duration of one year), the profitability of this project in the books of three different

SBUs looked as under.

Summarised Profit & Loss statemnet in crores

CP EC ES
Revenue ( Direct) 200
Revenue ( IDTO) 20 150
Purchases & subcontracting ( Direct) 8 17.5 144
Purchases & subcontracting ( IDTO) 170
Engineering & others 5
Overhead 15 2.5 5.5
Profit before Tax 2 0 0.5

The project shows dismal performance in the books of all the SBUs in varying degree. However,

it does not reflect the true performance by three different SBU management, because, the

influence of one SBU on other has not been reported. The profit & loss statement can be recast

as under according the responsibility accounting concept.

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SUMMARISED PROFIT & LOSS STATEMNT In crore

CP EC ES
Revenue 200.00 20.00 150.00
Controllable cost:
Purchase & subcontracting 178.45 16.55 144.60
Overhead & others 20.00 2.40 5.50
Total controllable cost 198.45 18.95 150.10
Controllable profit 1.55 1.05 -0.10

Uncontrollable cost
Subcontracting : Idle hour 0.55 0.20
: Overtime 0.40
Overhead : Idle hour 0.10
Total uncontrollable cost 0.00 1.05 0.20
Total cost 198.45 20.00 150.30
Profit of other SBUs 0.45 0.00 0.80
Total profit before Tax as per Profit & Loss a/c 2.00 0.00 0.50

The difference may be noted. The controllable profit is what really can be attributable to the

performance of individual SBU managers. The profit of other BUs appearing against the BUs as

above, represents the profit lost by the said other BUs. Out of 45 Lacs shown under CP, 25 lacs

belongs to the EC and similarly, the entire 80 lacs appearing under ES actually belongs to EC.

The effect does not get reported in the normal Profit &Loss account. The alternative solution to

this problem is claim management and claim accounting. The cost of extended duration for

example, can be presented before the SBU “CP” as claim by SBU “EC" and the same can be

accounted for in normal course. An example of claim proposal for extended duration is given

under: .■ -

Mr. X is site manager of a project of 24 months-scheduled duration. The project price is 200

MINR with a variable cost of 55 % of revenue and fixed cost of 24 M INR p.a. The project went on

smoothly till the 25 % of its actual work was over. Soon after, there occurred an inordinate delay

in material supply. The project work stopped for four months without much variation in the fixed

cost. Finally, the problem was over and stringent action plan was made to expedite the activities.

Overtime increased and so did the variable cost that rose to a level of 65% . Ultimately the project

was completed with two months’ delay. There is good case of lodging claim on the customer

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(internal or external) for the loss suffered by the extended duration of the project. The claim paper

would look like as under:

Project duration as per schedule : 24 Months

Actual duration : 26 Months

Fixed cost for extended duration : 4 MINR

Additional variable cost (150 MINR *10%) : 15 MINR

Total minimum claim : 19 MINR

On settlement of the claim, the amount would be offset against the additional cost in the books

and the corresponding increase in the profitability would be reported in normal course .

In the matter of such claim with the other SBUs, the major objection to this practice is the

uncalled for accounting exercise, out of which the company as a whole does not gain anything.

2.8. Decentralization and responsibility accounting

As Elwood & Miller11 have observed, “As with many concepts, decentralization has several

meanings. Activities, operations, physical facilities and management structures are often reflected

to as decentralized. The first three references pose few barriers to understanding. Since they

represent tangible things that are separated and often dispersed widely. Management structures

and or organizations however, do pose problems since an intangible— authority— is the frame of

reference.’ Therefore, responsibility can best be discharged when it goes with the corresponding

degree of authority. Reasonable decentralization in decision-making authority therefore happens

to be a pre-requisite for discharging and measuring one's responsibility in executing a task in an

effective way. To understand how decentralization affects the responsibility accounting system,

the two situations mentioned hereunder deserve consideration.

S itu a tio n 1: KPA Ltd. is engaged in power plant supply, commissioning and transmission

business. Its operation is controlled by the Managing Director (MD). It has three line functional

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units namely manufacturing, service and erection. Other functions like marketing, engineering,

supplies, HR and finance cater to the said operational groups. There are eight functional heads

all reporting to the MD. The HO is situated at Delhi and the manufacturing unit is at Mathura. The

marketing function procures business from the field of public utility and independent power

producers (IPP) both including gas and steam turbine for different use. The Finance & accounts

function headed by Director finance is responsible for corporate finance, project finance and

maintenance of complete accounting. Company’s total turnover in 1999 was 500 Crores including

all the businesses. All the operating departments’ cost like production, services and erection are

monitored by detailed budget & variance analysis both in financial and non-financial parameters.

The departments collect their operational data on their own which are presented upto the level of

trial balance. Assets and customers accounts are maintained at HO. Within erection department,

power projects worth more than Rs.100 lacs make their own Trial Balance, which is sent to HO

for analysis and consolidation. At the HO, all of the projects’ expenses -direct and indirect - are

collected and apportioned against each project to ascertain the project's profitability. In case of

manufacturing activities also, the expenses of all the other related functions are allocated at HO

level to find out the cost of individual product. The local finance & accounting Department at

Mathura and various project sites are to report direct to the central finance at HO with of course

remaining administratively responsible to the location head and individual project site manager.

Operational performance in terms of Budget and deviation analysis are periodically furnished to

the central finance as a part of report from the location finance and/or project site finance

department. Suppliers bill worth more than Rs 10,000/- is to be sent to HO for scrutiny and

approval. Similarly, all the POs more than Rs. 10,000 /- are to be vetted by HO. Assets worth Rs

10, 000 and more are to be procured from HO. Apart from these, product pricing, recruitment

and promotion are decided at HO. Costing is product and / or project oriented and monitored by

budget and variance analysis.

Situation 2 : The company acquired another organization in similar business. The new

management opted for large-scale decentralisation. It restructured the organization in terms of

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four strategic business units ( SBUs) namely, manufacturing, erection & commissioning, servicing

and transmission, headed by experts in the respective field of specialization. Every SBU got its

own marketing, operational and finance set up as well as individual sets of books of accounts.

Each SBU becomes the balance sheet point of activities. Every business area manager is given

responsibility equipped with matching power to attain their preset goals as means of achieving

the corporate objectives.

The ambit and application of responsibility accounting for these two different set up is distinct

enough. The first one is an orientation towards centralization, while the second one portrays an

environment of decentralisation. While in situation 2 the accounting function is placed under

respective functional heads, it is independent of their actions and decisions in the case of

situation 1. With the decentralisation, the accounting function too becomes decentralized with

each part attached to individual SBU. In this process of transition of significant part of decision­

making authority from corporate to operational level, two important consequences involving

finance & accounting functions take place. Firstly, each SBU manager gets the finance function

under his disposal and secondly, the accounts department of each SBU tends to lose its thread

link with the corporate finance— the skeleton remains of the erstwhile massive accounting

function under the direct supervision of the apex body of an organization. Since, the accounting

function is a process of procurement, disbursement and analyzing the various kinds of

organizational resources and since the SBU managers are given flexibility of taking prompt

decision; the accounting function as the custodian of organization's resource is quite

understandably placed at the reasonably sole discretion of the SBU Chiefs. Consequently, the

communication link of the operational accounting functionaries with the corporate accounts as a

result of this corporate philosophy tends to become insignificant enough. The performance of a

SBU as well as its Supremo both are measured in terms of certain predetermined sets of

parametric financial and non-financial terms.

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Effect of decentralization on responsibility accounting: certain major features

Features Decentralized Centralized Effect on Responsibility

unit unit accounting system

1 Identification of responsibility More Less Capturing and allocation of

in financial terms for financial data is possible and
individual responsibility is more objective in
centers as SBUs. decentralized unit.
2 Nature of responsibility center Profit center / Cost center Cost budget and variance
Investment analysis is relatively more in
center centralized unit , whereas,
cost and profit both can be
distinctively attributed to a
SBU in case of decentralized
organization.
3 Extent of non-controllable Less More Separate application of
cost attributable to a responsibility accounting
functional chief concept is required in
centralized set-up, whereas, it
trysts with the profit center
accounting in case of
absolute Decentralisation.
4 Nature of accounting set-up Own set-up Shared set­ Complete profit & Loss
up account and Balance sheet
can be drawn up in case of
own set-up, while in common
set-up, cost center wise direct
cost and apportioned cost are
only available.
5 Objectivity in performance More Less Profitability and ROI are more
measurement objective measures of
performance and can be
integrated to the corporate
philosophy than only cost
variance analysis.

2.8.1. Non-Controllable cost and decentralisation

Non-controllable cost in the context of the concept of responsibility Accounting denotes that part

of the cost as are influenced and allocated by any other position in the organizational hierarchy

either vertically or laterally and consequently remain out of the control of that particular

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responsibility center. For example, an assembly shop being a cost center, the apportioned cost of

the space used is non-controllable in the hands of the assembly shop supervisor. Similarly, the

variation from the budgeted amount of corporate charge is not at the control of a SBU chief. The

significance of the controllable cost is that, while analyzing the total cost variation, the

responsibility center head is held accountable only for the cost at his control, since his

responsibility was fixed for the variation in cost that can be influenced by him only. Non-

controllable items from the point of view of a responsibility center are segregated and left out for

the purpose of measuring the individual accountability. This brings about clarity in identifying and

evaluating the extent of discharging the executive responsibility at various points of organizational

activity centers as captured by different SBUs. Resultantly, more the existence of non-controllable

cost, less is the scope for one’s responsibility allocation and performance assessment. The

existence of non-controllable cost is the function o f :

1) Common operational cost at cost center and / or profit center level and

2) Corporate decision on the extent of decentralisation

Com m on operational cost: When two or more responsibility centers are catered to by common

operational resources on which none of them has control, the cost of such resources may be

considered non-controllable for them. For example, the maintenance department may control the

repair of factory lighting and the painting-shop manager may not have any control over them.

Similarly, a short term cost center as turbine erection & commissioning at a project site will have

the project establishment cost beyond the control of its manager, since the establishment

expenses are controlled by the project administration department. Common operational cost is

more frequent in small functional units of an establishment. While cost data are collected and

presented about the independent cost / profit center in disregard of their controllability, the

concept of responsibility accounting focuses on the controllable part thereof with a view to

measuring the accountability of the concerned responsibility center head. While the cost / profit

center concept is more inclined to the efficacy of the cost / profit center as a whole, the

responsibility accounting concept is aimed at giving a personal touch by highlighting the

contribution by a person in charge towards the efficacy of the cost / profit center. One main

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 Chapter two

reason for the emergence of common cost is the existence of cost / profit center within a parent

cost / profit center. The project site operation for example, of an organization may be a profit

center, within which various activities may be clustered into different strategic cost center / profit

centers. Common operational cost may therefore become non-controllable part for many of them.

Extent of decentralisation: One reason for the occurrence of common allocable cost is lower

volume of business. A cost center / profit center may not be completely segregated from their

common establishment bondage just because that may not be affordable. The decentralisation

has its own cost. Hence, the definition of the cost / profit center being the smallest possible

functional unit of an organization has a meaning of relativity in the sense that the word smallest is

a function of economic viability of decentralisation.

Illustration: Servicing may be a profit center of a power plant EPC g ia n t. It is a by business by

itself having its own marketing, operation and control set-up. The job of servicing includes that of

Turbine and Boiler of various sizes. Another organization having much bigger set-up operates

through different servicing units like that of Turbine and Boiler separately with separate

marketing and other functions altogether. In both the cases Turbine and Boiler servicing are two

separate profit centers, yet in case of the former they have common cost for allocation while the

commonality in this matter will be minimal in the latter organization. The definition of the smallest

functional unit is different in these two organizations due to variations in the degree of

decentralisation.

The very existence of the non-controllable cost speaks for centralized control over a function or

sub-function. The act of delegation of authority is guided by the corporate philosophy and need.

The corporate may decide that marketing function for all the categories of business like utility, IPP

and industrial Turbine will be centrally handled and all the different business units will be loaded

with the specific share of the marketing cost. In this case all the concerned SBUs have to bear

the share of the centralized marketing cost, which may not be controllable by the SBUs. On the

other hand marketing function of industrial turbine may be delegated to the concerned SBU and

made free from the corresponding charges of corporate marketing fees. Decentralisation has

therefore the effect of reducing the degree of this non-controllable element.

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In the extreme possibility, there can be no non-controllable cost other than the bare minimum

corporate charges. In that case, the profit center accounting and responsibility accounting

converge. The extent of non-controllable expenses reaches the minimal point.

2.9. Significance of dissecting the uncontrollable cost allocated to a

responsibility center: Attaching the various allocated costs to respective level of

responsibility tends to project the different hierarchy of a business organization in their right level

of managerial competence. It neutralizes the effect of the uncontrollable allocated cost with

remote relation to a responsibility center. Since the allocations are generally fixed in nature

(because, the allocated expenses are basically sunk and committed at various level), the effect of

say for example, under / over recovery due to the market forces may come in way to adjudge the

viability of a business unit in the long run. Let us consider an example. A business area has made

a budget of 500 MINR of revenue with an overhead of 40 MINR, thus giving an 8% overhead

recovery rate. However, since the BA’s revenue ultimately came to be 200 M INR with the same

amount of overhead, all the Profit center of that BA were charged @ 20%and accordingly the

profitability of each profit center got reduced to that extent. The cost sheet of a profit center was

as under:

Profit Center xx of BA YY

Revenue 50 MINR
Own cost 45 MINR
Profit before BA cost 5 MINR

BA allocation 10 MINR
Profit (-) 5 MINR

The profit center xx, which is a project order, was found to be at loss by 5 MINR. The loss

consists of a BA allocation of 20 % of xx’s revenue. This 20% once again consists of under

absorption charges, as the budgeted overhead recovery rate is 8% only. The balance 12% of

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 Chapter two

revenue i.e. 6 M INR becomes an additional charge to the project's profitability. If the allocation

represents the value of services received by a profit / cost center, this 6 MINR has in fact nothing

to do with such services. Excluding this, the project has actually earned a pre-tax profit of I MINR,

which should surely go to the credit of the project manager. It is important to note that while

pricing a project / product adequate consideration to this factor is essential to remain competitive

in the market. The responsibility accounting can highlight this factor. Since, in the matter of

executive performance measurement, while the traditional costing attribute cost to a function or a

cost object, the concept of responsibility accounting confines the cost and revenue to be defined

in terms of a person / position. Hence, the additional 6 MINR has to go to hold the concerned

level of management of the organization, responsible for analyzing and deciding necessary

strategy; which in the given case would be an increase in the business volume or reduction in

various establishment cost or both. The focus therefore, seems to be more objective.

2.10. Transfer Pricing

t

Business activities consisting of those right from 'get work’ to 'execute work' are the part of entire

business process undertaken towards accomplishment of the corporate mission. The

responsibility center concept positions the distinguished and related group of activities along the

process flow such that one is dependent on others. As a result the process output of a BA / BU

becomes process input of other/s or the final product to the end users. The process value chain

thus flows through the small unfts of Business, which are specialized in adding value to the

business process in progress. Let us consider a Business Unit GT having the mission of

execution of Gas Turbine projects across the country. It has expertise in marketing, engineering

and procurement, which are the different functional wings of this business unit. However, project

execution, servicing and operation & maintenance (O&M) are the specialization of other BUs. The

driving input to the organization for these projects are work orders with specification while the

final output is handing over with closing of all open points. With these two extreme points come

the activities stratified into different BUs according to the corporate philosophy.

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 Chapter two

T h u s , th e B U ( G T ) a w a r d s th e e re c tio n & c o m m is s io n in g a c tiv itie s to th e B U ( P E ) , w h ic h is

re s p o n s ib le fo r th e c o m m is s io n in g o f th e p ro je c ts s u c c e s s fu lly a c c o rd in g to th e c o n d itio n a n d

stipulation a s m a y b e a g r e e d u p o n . S im ila rly , th e B U ( G T ) m a y o ffe r th e s e rv ic in g c o n tra c t to th e

B U (P S ) till w a r r a n ty p e rio d a n d O & M re s p o n s ib ility to B U ( O M ) fo r a p e rio d a s s tip u la te d in th e

c o n t a c t w ith th e u ltim a te c u s to m e rs . T h is illu s tra te s a s h o w tra n s fe r o f s e rv ic e s a r is e to c o m p le te

a p ro c e s s . T h e B U th a t tra n s fe r th e s e rv ic e is k n o w n a s in d e p e n d e n t u n it v is -a -v is th e B U s th a t

o ffer s e rv ic e s a n d k n o w n a s d e p e n d e n t unit.

Methods of Transfer Pricing

T h e p ra c tic e g e n e r a lly fo llo w e d is 1 ) T a r g e t c o s t a n d 2 ) m a r k e t p ric e . T a r g e t c o s t a llo w s th e

d e p e n d e n t u n its to e v a lu a te th e s c o p e o f s e rv ic e s / s u p p lie s in m o n e ta ry te rm a d d in g th e re o n a

s p e cified ra te o f m a rg in a c c o rd in g to th e c o rp o ra te p o licy. T h e p ric e s o a rriv e d a t o n b e in g a g r e e d

upon by b o th th e u n its b e c o m e s th e r e p re s e n ta tiv e v a lu e o f s e rv ic e s /s u p p lie s u n d e rta k e n b y th e

d e p e n d e n t units.

T h e c o m p u ta tio n o f T r a n s fe r p ric e o n ta rg e t c o s t b a s is p o s s e s s e s o n e d is tin c t a d v a n ta g e . It m a y

b e c o n s id e re d a s r e p re s e n ta tiv e c o s t o f th e d e p e n d e n t B U b e c a u s e , th e B U c o n c e rn e d is a llo w e d

to ta k e c o g n iz a n c e o f all th e a s p e c ts o f o p e ra tio n a l a n d o th e r c o s t o f th e d e p e n d e n t B U . T h e le v e l

o f c a p a c ity u tiliza tio n a n d th e o p e ra tio n a l e ffic ie n c y a re ta k e n in to c o n s id e ra tio n s o th a t m a y h e lp

ove ra ll c o s t re d u c tio n p o s s ib le . H o w e v e r , in th e s a m e b re a th , p o ss ib ility o f g o in g o th e r w a y ro u n d

a n d th e re b y , in fla tin g th e c o s t b y full c o s t m o d e l th a t m a y c o n ta in a la rg e c h u n k o f u n a b s o rb e d

cost w h e re u n d e r c a p a c ity u tiliza tio n h a p p e n s to b e a fe a tu re . A ls o , ta rg e t c o s t te n d s to p a s s o n

th e o p e ra tio n a l in e ffic ie n c y to th e a w a rd in g unit a n d th e re is n o a p p a r e n t c h e c k o f re d u c in g

e le m e n ts o f o p e ra tio n a l in e ffic a c y .

T h e ta rg e t c o s t p ric in g m a y b e c o m p u te d o n th e b a s is a ) a c tu a l c o s t o f p ro d u c tio n o n full c o s t

m o d el b ) s ta n d a rd c o s t o r c ) m a rg in a l c o s t. O n full c o s t m o d e l, th e c o s t re p re s e n ts d ire c t c o s t

b a s e d on th e s c o p e o f w o rk a n d in d ire c t o v e rh e a d a llo c a te d a c c o rd in g to e x is tin g n o rm s ,

s ta n d a rd c o s t m a y c o v e r th e e n tire p ro d u c t / s u p p lie s o n u n it b a s is o r a p a rt o f th a t lik e a llo c a tio n

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of processing cost. Marginal costing takes into account the incremental cost in executing the

scope of work.

Cost base price however, tends to create a monopolistic result with a rising price level. This,

especially where there are number of units to offer their prices to constitute the final price for the

customer, there is every possibility of ultimate price being higher than the market rate and

consequently the order from the final customer comes into severe threat.

Following illustrations may be considered:

Full cost model using standard costing

A factory of a power plant supplies & erection organization has received an order for engineering,

procuring and commissioning of power plant. This is to be handled by one BU of that organization

delegate for this job according to the work distribution. It awarded the manufacturing of condenser

worth Rs 800 lacs in favor of another BU of the same organization that has the manufacturing set

up as well as the required expertise. The price was fixed on the basis of the following cost sheet.

Items of cost Amount Basis of costing

In lacs

Imported materials 127.60 Actual based on Estimated BOM

Boughtouts 110.20 Actual based on Estimated BOM

Manufacturing overhead 16.60 Standard rate of Rs 400 for 4150 Hrs.

Administrative overhead ( factory) 19.20 Standard absorption @ 6% of Sales price

Financial Charges @ 3% 9.60 Standard absorption @ 3% of Sales price

Corporate allocation @ 4% 12.80 Corporate instruction

IDTO Margin @ 7.5% 24.00 Corporate instruction

Total Price 320.00

The cost as above has been computed on the basis of actual cost as well as standard cost of

different cost groups. Imported material and bought outs have been priced on the basis of

engineering estimate of Bill of Material (BOM). Manufacturing overhead consisting of assembly,

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fa b ric a tio n , q u a lity c o m p lia n c e e tc a n d in c lu d e d th e re o n th e c o s t o f la b o u r, p o w e r a n d utilities

h a v e b e e n re c o v e r e d a t th e ra te o f R S 4 0 0 / p .h ., w h ic h is a n o u tp u t o f s ta n d a rd c o s tin g . S im ila rly ,

A d m . o v e r h e a d , fin a n c ia l c h a r g e s a n d c o rp o ra te a llo c a tio n h a v e b e e n re c o v e r e d a t a s ta n d a rd

ra te in a g iv e n c o s t s tru c tu re a n d le v e l o f c a p a c ity u tiliza tio n .

Pricing based on exclusively standard costing formula

P ricing fo r d e p u ta tio n o f te c h n ic a l p e rs o n a t s ite is a n e x a m p le w h ic h is b a s e d o n s ta n d a rd c o s t

s a y R S 5 0 0 0 / p e r d a y p e r p e rs o n fo r a s s is tin g c o m m is s io n in g o f a p o w e r p la n t. S im ila rly , e re c tio n

p ric e is a ls o a s c e rta in e d o n th e b a s is o f to n n a g e . T h u s , e re c tio n o f b o ile r o f a p a rtic u la r

s p e c ific a tio n m a y b e p ric e d a t R s 1 0 , 0 0 0 / p e r to n th a t in c lu d e s a ll th e c o s t in g re d ie n ts .

Marginal costing & discriminatory pricing

O n e im p o rta n t fe a tu r e o f in te r d iv is io n a l, p ric in g is th a t th e r e m a y b e a lr e a d y a p ric e g iv e n b y th e

in d e p e n d e n t d iv is io n s u c h th a t fa lls s h o rt o f th e p ric e c o m p u te d b y th e c o n c e rn e d d e p e n d e n t unit

on th e b a s is o f fu ll c o s t m o d e l. T h e c o n c e p t o f m a rg in a l c o s tin g c a n w e ll c o m e to b rid g e th e

d iffe re n c e s u c h th a t b o th th e p a rtie s re m a in b e n e fite d . In fa c t th e in d e p e n d e n t d e p a r tm e n t m a y

h a v e c o n s tra in t in g o in g b e y o n d a p ric e le v e l a n d th e d e p e n d e n t u n it m a y fin d it d iffic u lt to o ffe r its

e x p e rtis e s e rv ic e s / s u p p lie s a t th a t p ric e . In this s itu a tio n , th e o r d e r m a y b e g iv e n to a th ird p a rty

if fitte d in to t h e p ric e ra n g e a n d th is o f c o u rs e is n o t in th e o v e ra ll in te re s t o f th e o rg a n iz a tio n a s a

w h o le . T h e c o m p u ta tio n o f p ric e o n t h e b a s is o f m a rg in a l c o s tin g in t h e g iv e n c irc u m s ta n c e m a y

s h o w th a t th e c o n tra c t c a n b e e x e c u te d a t a p ric e lo w e r th a n th e fu ll c o s t a n d c a rry in g o u t th e jo b

a t th e g iv e n p ric e is m o re b e n e fic ia l to lo s in g th e jo b . T h e fo llo w in g c o n d itio n s a r e to b e n o te d :

a. T h e d e p e n d e n t u n it is w o rk in g b e lo w c a p a c ity le v e l a n d th e re c o v e ry o f fix e d c o s t is a n

im p o rta n t is s u e .

b. T h e d e p e n d e n t u n it h a s a lr e a d y r e a c h e d th e b r e a k -e v e n le v e l a n d th u s fix e d c o s t fo r th e y e a r

is a lr e a d y re c o v e re d . T h e jo b c o n c e rn e d w ill b e c o m p le te d w ith in th e re s t o f th e y e a r le ft o u t.

Illustration: A b u s in e s s u n it o f a n o rg a n iz a tio n is e n g a g e d in re n d e rin g s e rv ic e s to v a rio u s p o w e r

p la n t e q u ip m e n t F o r q u o tin g o n e s u c h o rd e r, th e c o s t o f th e jo b a n d th e c o n s e q u e n t p ric e b y

a d d in g a m a r k u p o f 1 0 % w a s c o m p u te d a s u n d er:

S e rv ic e s p e r s o n n e l @ R s 4 0 0 0 p e r d a y , 1 0 d a y s 4 0 0 ,0 0 0

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S ta y & tr a v e l e x p e n s e s @ R s 4 0 0 p e r d a y , 1 0 d a y s 4 0 ,0 0 0

Payment to sub-contractors 600,000

O v e rh e a d s @ 1 0 % 1 0 4 ,0 0 0

F in a n c ia l c h a rg e s 3 1 ,2 0 0

C o n tin g e n c y @ 1 % 1 0 ,4 0 0

T o ta l c o s t 1 2 7 9 ,2 0 0

M a rk u p @ 1 0 % 1 2 7 ,9 2 0

P ric e q u o te d 1 4 0 7 ,1 2 0

It is w o rth m e n tio n in g th a t, th e b u s in e s s is to u s e re s o u rc e s lik e s e rv ic e p e r s o n n e l, o v e rh e a d s

a n d fin a n c ia l c h a rg e s a n d c o n tin g e n c ie s o n th e c o s t o f s e rv ic e p e rs o n n e l fro m o u t o f its o w n a n d

e x is tin g p o o l a n d th e e x p e n s e s a r e s u n k a n d c o m m itte d in n a tu re . T h e jo b is e x p e c te d to b e

c o m p le te w ith in a m o n th a n d th e re is n o p ro b le m w ith a v a ila b ility o f s e rv ic e p e r s o n n e l a n d o th e r

fa c ilitie s . T h e m a rk e t is h ig h ly c o m p e titiv e a n d th e p ric e to p la y a m a jo r ro le to g e t th e jo b . B a s e d

o n th e m a r k e t tre n d , th e in d e p e n d e n t B U o ffe re d a tra n s fe r p ric e o f 1 2 L a c s o n ly . O th e r w is e , this

w o rk c a n b e a w a r d e d to a third p a rty . T h e m a rg in a l co s tin g p rin c ip le c a n b e u s e d b y re c a s tin g th e

c o s t s h e e t a s u n d e r w h e r e th e in c re m e n ta l c a s h flo w h a s b e e n c o n s id e re d .

S u b c o n tra c to r c o s t 6 0 0 ,0 0 0

S ta y & tra v e l 4 0 ,0 0 0

V a ria b le o v e r h e a d 1 4 7 ,2 0 0

M a rk u p 1 2 7 ,9 2 0

T o ta l 9 1 5 ,1 2 0

T h e b u s in e s s c o u ld re c o v e r th e jo b c o s t a n d p a rt o f its fix e d o v e r h e a d e v e n if it w o u ld e x e c u te

th e w o rk a t a p ric e o f R s 9 1 5 , 1 2 0 / . T h e o rg a n iz a tio n w ill in fa c t lo s e in a b s o lu te te rm if th e B U

s tic ks to its full c o s t a n d a llo w th e o rd e r to s lip in fa v o r o f a third p a rty .

Market Price

U n d e r th is m e th o d , re fe re n c e is m a d e to th e p re v a ilin g m a rk e t p ric e fo r a s c o p e o f s e rv ic e s /

s u p p lie s . T h is g iv e s a to u c h o f c o m p e titiv e b id d in g in th e p ro c e s s o f p ric in g . T h e d e p e n d e n t u n it’s

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degree of competence vis-&-vis the market condition gets exposed when pricing under this

method. This gives a thrust on improving the competency level unlike the cost based pricing

where cost of operational & managerial incompetence is passed on to the awarding unit and

finally to the end user. The major problems with the market price method are as under:

a. The price of exact scope o work is not always available in the market.

b. The market may be monopolistic and the price is therefore at the higher side, making it

incomparable.

c. The market price takes into consideration selling & market development cost like

advertisement etc. that may irrelevant for internal pricing. This distinction is necessary to be

quantified.

d. The market price lose its relevance when the organization is market leader or monopolistic.

e. The margin embedded in the market price may be different from that fixed up by the

corporate policy in the matter of internal pricing. The price variation because of this is difficult

to assess.

f. The market price of different activities is interdependent of various other factors. Thus, for •

instance erection price may be different if the manufacturer of major equipment is different.

Problems of Transfer Pricing:

Transfer pricing in essence is a notional amount of charges to compensate the services received

/ rendered from / to a Division of the same organization. The following problems in the transfer

price mechanism is perceptible:

Obligation to load other units: Within an organization, one unit may be used as compulsory

lead center for supplying other units. This restricts the later to have their own choice and

preference as to deciding their customers / supplies. This may also restrict their control over

pricing. However, many organizations have made it a policy that one unit is not expected to

accept price from other unless it is mutually decided. This point has been examined and

explained by Ray H Garrison as follow “A question often arises as to how much autonomy

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should be granted to division in setting their own transfer prices and in making decisions

concerning whether to sell internally or to sell outside. Should the divisional heads have complete

authority to make these decisions or should top corporate management step in if it appears that a

decision is about to be made that would result in sub-optimization. For example, if idle capacity

exists in the selling divisions and the divisional managers are unable to agree on a transfer price,

should top corporate management step in and force settlement of the dispute?

Effort should always be made, of course to bring disputing managers together. But the almost

unanimous among top corporate executives is that divisional heads should not be forced in to an

agreement over a transfer price. That is, if a particular divisional head flatly refuses to change his

or her position in a dispute, then this decision should be represented even if it results in sub-

optimization. This is simply the price that is paid for the concept of divisional autonomy”

This again is fraught with a possibility of internal bickering as to the price. As observed by

Subhash Sharma14, “There may be disagreement between divisions on transfer prices. Such

disagreements are resolved by referring the decision to headquarters and seeking its arbitration.

If there are too many disagreements, it may indicate that the company needs to rethink the profit

center concept. However, such factors do not suggest that divisionalisation should not be done

and performance evaluation of the division should not be followed. The question to be answered

is, should the focus on performance evaluation be on profit or cost? “

Shifting o f Profit / Loss: In case Pricing is done by one unit on marginal costing basis with a

view to utilize the unabsorbed capacity, the price so paid by the buying unit is likely to generate

additional profit, which does not have any attributability to the performance of the said BU. For

example, in other way, an erection division of an organization, catering to the need for others

Units is not allowed to go to external market for Business. The Inter Divisional Prices from other

divisions are computed at a level that may be lower than the market price. The additional profit

earned by the other BUs is in fact nothing to do with their individual performance.

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Unsuitable In case of Interdependence am ongst BUs: ‘ In case the division is exclusively

selling to other divisions and the option to sell to an outside customers does not exist, the

divisional manager’s principal responsibilities will be for control of costs, control of quality and

production schedules. The divisional manager has hardly any marketing responsibility and

therefore his revenue is determined by the marketing decision of the buying division. Since, the

volume of sales and hence pricing decisions are not within the control of the selling division, the

profits of the selling division are not a true indicator of managerial performance. Thus, the failure

of the buying division to market the products of the selling division will be reflected in the poor

profit performance of the selling division. In such circumstance, holding the manager of the selling

division responsible for a poor profit picture will be unfair.

If an organization is not interested in determining the profit performance of divisions, there would

be no need to bother about the transfer price. The transfer price is fundamentally an attempt to

simulate the externa) market condition within the organization. The concern for profit performance

is important because managers get better motivated if their divisions are regarded as profit

centers. The lower the idea of profit center is pushed, the higher is the achievement of the ideal of

d ec e n tra liza tio n ,In fact too much interdependence amongst BUs comes in the way of the utility

of Transfer Price. As pointed out by Noert PA “ th a t' indeed, if profit of one division depends on

the performance of another division ...decentralization then does not result in a better means of

controlling managerial performance. Neither will the second purpose of decentralization, viz. to

improve motivation, be realized for the same reason. Divisional performance should then be

measured on a cost performance basis".

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References:

1. CIMA, London, Terminologies

2. Eric. L Kohler: Management Accounting
3. Schaltke R W and Johnson H G : Management Accounting

4. Landouceur A G : Tailoring sophisticated accounting to small firms, financial executives,

November 1966 p50-54
5. Homgren C T : Cost Accounting— A Managerial emphasisl 973, p 158
6. Higgins John A: Responsibility Accounting, Topics in Managerial Accounting p257-270
7. American Accounting Association: Bulletin
8. Recommendation of Committee formed by Indian Railway on responsibility Accounting
9. C IM A , London
10. Anthony Robert N and James S Reece: Management Accounting- Text & Cases, 1975 p676
11. Manohar Bhatia: Profit center, Practice and perspective, p4
12. Elwwod & Miller: Responsibility Accounting and Performance evaluation
13. Ray H Garrison: Management Accounting— Concept for planning, Control and decision
making
14. Subhas Sharma: Management control system, Text & cases, p 100
15. Subhas Sharma: Management controls system, Text & cases, p 97
16. Noert P A: Measuring performance in a decentralized firm with inter related divisions, Profit
center Vs Cost Center. The Engineering Economist, Volume 18, No 2 winter, p99

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