ACT2121: Introductory

Management Accounting

LECTURE 19 RESPONSIBILITY ACCOUNTING

Instructor: Rui Shen

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Outline
• Decentralization in Organizations
• Responsibility Accounting
• Evaluating Investment Center Performance
❑ ROI v.s. Residual Income
• Transfer Pricing
• Service Department Charges

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Decentralization in Organizations: Benefits
Top management
Benefits of freed to concentrate
Decentralization on strategy.
Lower-level decisions
often based on
better information. Lower level managers
can respond quickly to
customers.
Lower-level managers
gain experience in
decision-making. Decision-making
authority leads to
job satisfaction.

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Decentralization in Organizations: Disadvantage
Lower-level managers
may make decisions
without seeing the
Lower-level manager’s
“big picture.”
objectives may not
be those of the Disadvantages of
organization. May be a lack of Decentralization
coordination among
autonomous
May be difficult to managers.
spread innovative ideas
in the organization.
Key Concepts
• Responsibility Accounting: managers are held responsible for and only for
those items that the manager can actually control to a significant extent.
• Responsibility Center: any part of an organization whose manager has control
over and is accountable for cost, profit, or investments.

Cost Center
Responsibility
Profit Center
Center
Investment
Center

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Cost Center
A segment whose manager has
control over costs but not over
revenues or investment funds.

Finance Legal HR Manufacturing

Department Department Department Facilities

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Profit Center
A segment whose manager
has control over both costs Revenues
and revenues but no control Sales
over investment funds. Interest
Other
Costs
Parks in Mfg. costs
Disneyland Costco Stores Commissions
series Salaries
Other

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Investment Center
A segment whose manager has
control over costs, revenues, and
investments in operating assets.

President
Directing Board CEO/COO
Vice President

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 Responsibility Centers Example
Investment
Superior Foods Corporation
Centers Corporate Headquarters
Profit President and CEO

Centers
Operations Finance Legal Personnel
Vice President Chief FInancial Officer General Counsel Vice President

Salty Snacks Beverages Confections

Product Manger Product Manager Product Manager
Cost Centers
Bottling Plant Warehouse Distribution
Manager Manager Manager

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Evaluating Investment Center Performance

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Return on Investment (ROI) Formula
Income before interest
and taxes (EBIT)

Net operating income

ROI =
Average operating assets

Cash, accounts receivable, inventory,

plant and equipment, and other
productive assets.

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Net Book Value versus Gross Cost
• Most companies use the net book value of depreciable assets to calculate
average operating assets.

Acquisition cost
Less: Accumulated depreciation
Net book value .

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Understanding ROI
• Decomposition of ROI:

Net Operating Income

ROI =
Average Operating Assets
NOI Sales
= ×
Profitability
Sales Avg OA Efficiency

= Margin × Turnover

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 Determinants of ROI
• Margin v.s Turnover may be decided by
business models.

Exxon Walmart Apple

Margin 19.40% 3.93% 24.15%
Turnover 1.08 4.01 14.47

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Increasing ROI: An Example
• Regal Company reports the following:
Average operating assets $ 200,000
Sales $ 500,000
Operating expenses $ 470,000
Net operating income $ 30,000

• What is Regal’s ROI?

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Increasing ROI: An Example
• What is Regal’s ROI?

Net operating income Sales

ROI = 
Sales Average operating assets

$30,000 $500,000
ROI = 
$500,000 $200,000

ROI = 6%  2.5 = 15%

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Investing in Operating Assets to Increase Sales –
An Example
• Assume that Regal’s manager invests in a $30,000 piece of equipment
that increases sales by $35,000 while increasing operating expenses by
$15,000.
• What is Regal’s ROI?
Average operating assets $230,000
Sales $535,000
Operating expenses $485,000
Net operating income $ 50,000

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Investing in Operating Assets to Increase Sales –
An Example
• What is Regal’s ROI?

Net operating income Sales

ROI = 
Sales Average operating assets

$50, 000 $535, 000

ROI = 
$535, 000 $230, 000 Margin Increases
from 6% to 9.35%;
ROI = 9.35%  2.33 = 21.8% Turnover decreases
from 2.5 to 2.33.

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Criticisms of ROI
• In the absence of the balanced scorecard, management may take sub-
optimal actions to increase ROI.
• Managers often inherit many committed costs over which they have no
control.
• Managers evaluated on ROI may reject profitable investment
opportunities.

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Residual Income – Another Measure of Performance
• Residual income is net operating income above some minimum return
on operating assets.

Residual Net  Average Minimum 

 
income = operating −  operating  required rate of 
 assets 
income  return 

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Residual Income – An Example
• The Retail Division of Zephyr, Inc. has average operating assets of
$100,000 and is required to earn a return of 20% on these assets. In the
current period, the division earns $30,000.
• What is the residual income?

Residual Net  Average Minimum 

 
income = operating −  operating  required rate of 
 assets 
income  return 

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Residual Income – An Example
• What is the residual income?

Operating assets $100,000

Required rate of return × 20%
Minimum required return $ 20,000

Actual income $ 30,000

Minimum required return (20,000)
Residual income $ 10,000

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Motivation for Residual Income
• Residual income encourages managers to make profitable investments that would be
rejected by managers using ROI.
• Example: Redmond Awnings has a net operating income of $60,000 and average operating
assets of $300,000. The required rate of return for the company is 15%. The firm considers
an investment of $100,000 that would generate additional net operating income of
$18,000 per year.
❑ Is the investment beneficial to the firm?
❑ Will the manager take it if she is evaluated by ROI or Residual Income?

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Example - ROI
• If ROI is used to evaluate managers:
❑ Original ROI:
ROI = NOI/Average operating assets
= $60,000/$300,000 = 20%
❑ New ROI:
ROI = NOI/Average operating assets
= ($60,000 + $18,000)/($300,000+ $100,000)
= 19.5% < 20%
❑ Investment will not be adopted.

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Example – Residual Income
• If residual income is used to evaluate managers, and the minimum required
rate of return is 15%:
❑ Original Residual Income:
Residual income = NOI – (Avg OA * Minimum Return%)
= $60,000 - $300,000 * 15% = $15,000
❑ New Residual Income:
Residual income = NOI – (Avg OA * Minimum Return%)
= ($60,000 + $18,000)- ($300,000+ $100,000) * 15%
= $18,000 > $15,000
❑ Investment will be adopted.

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Motivation for Residual Income
• Residual income encourages managers to make profitable investments that would
be rejected by managers using ROI.
• Remarks:
❑ For firms, any investments with returns above the required rate are beneficial.
❑ Investments with returns above the required rate always increase residual income.
❑ Only investments with returns above the current ROI can increase ROI.

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Transfer Pricing

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Overview of Transfer Pricing
• Divisions in a company often supply goods and services to other divisions within
the same company.
❑ e.g., inter-branch leasing of warehouses, inter-subsidiary transactions
• Such transfers do not affect the whole firm, but have big impacts on segment
performance evaluation.
❑ exception: tax concerns

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Overview of Transfer Pricing
A transfer price is the price
charged when one segment of a
company provides goods or
services to another segment of
the company.

The fundamental objective in setting

transfer prices is to motivate
managers to act in the best interests
of the overall company.

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Three Primary Approaches

There are three primary approaches

to setting transfer prices:
1. Negotiated transfer prices;
2. Transfers at the cost to the selling
division;
3. Transfers at market price.

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Negotiated Transfer Prices
• A negotiated transfer price results from discussions
between the selling and buying divisions.
• Advantages:
❑ Preserve the autonomy of the divisions, consistent with the spirit
of decentralization.
❑ The managers negotiating the transfer price are likely to have
much better information about the potential costs and benefits of
the transfer than others in the company.

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Example: Grocery Storehouse
West Coast Plantations and Grocery Mart (both companies
are owned by Grocery Storehouse).
West Coast Plantations:
Naval orange harvest capacity per month 10,000 crates
Variable cost per crate of naval oranges $10 per crate
Fixed costs per month $100,000
Selling price of navel oranges on the outside market $25 per crate
Grocery Mart:
Purchase price of current naval oranges $20 per crate
Monthly sales of naval oranges 1,000 crates

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Example: Grocery Storehouse
Let’s calculate the lowest and highest acceptable transfer
prices under three scenarios.
The selling division’s (West Coast Factory) lowest acceptable transfer
price is:
Variable cost Total contribution margin on lost sales
Transfer Price  +
per unit Number of units transferred

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Example: Grocery Storehouse
Let’s calculate the lowest and highest acceptable transfer
prices under three scenarios.
The buying division’s (Grocery Mart) highest acceptable transfer price is:

Transfer Price  Cost of buying from outside supplier

If no outside suppliers, the highest acceptable transfer price is:

Transfer Price  Profit to be earned per unit sold (not including the transfer price)

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Case 1: Sellers have Sufficient Capacity
• If West Coast Plantations has sufficient capacity (3,000 crates) to satisfy Grocery Mart’s
demands (1,000 crates), without sacrificing sales to other customers, then the lowest and
highest possible transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
$−
Transfer price  $10 + = $10
1, 000

Buying division’s highest possible transfer price:

Transfer price ≤ Cost of buying from outside supplier = $20
• Range of acceptable transfer prices is $10 − $20.

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Case 2: Sellers have No Idle Capacity
• If West Coast Plantations has no idle capacity (0 crates) and must sacrifice other customer
orders (1,000 crates) to meet Grocery Mart’s demands (1,000 crates) , then the lowest and
highest possible transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
($25 − $10) 1, 000
Transfer price  $10 + = $25
1, 000

Buying division’s highest possible transfer price:

Transfer price ≤ Cost of buying from outside supplier = $20
• No range of acceptable transfer prices.

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Case 3: Sellers have Some Idle Capacity
• If West Coast Plantations has some idle capacity (500 crates) and must sacrifice other
customer orders (500 crates) to meet Grocery Mart’s demands (1,000 crates) , then the
lowest and highest possible transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
($25 − $10)  500
Transfer price  $10 + = $17.50
1, 000

Buying division’s highest possible transfer price:

Transfer price ≤ Cost of buying from outside supplier = $20
• Range of acceptable transfer prices is $17.5 − $20.

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Evaluation of Negotiated Transfer Prices
If a transfer within a company would result in
higher overall profits for the company, there is
always a range of transfer prices.

If managers are pitted against each other rather than against

their past performance or reasonable benchmarks, a non-
cooperative atmosphere is almost guaranteed.

Given the disputes that often accompany the negotiation process, most
companies rely on some other means of setting transfer prices.

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Transfers at the Cost to the Selling Division
• Many companies set transfer prices at either the variable cost or full (absorption)
cost incurred by the selling division.
• Disadvantages:
❑ Using full cost as a transfer price can lead to suboptimization.
◦ Suppose full cost at full capacity is $15 (= $10 var + 500/100 fixed); outside purchase price is $12;
◦ For the buying division, is it better to buy internally or externally?
◦ For the whole firm, is it better to buy internally or externally?
❑ The selling division will never show a profit on any internal transfer.
❑ Cost-based transfer prices do not provide incentives to control costs.

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Transfers at Market Price
• A market price is often regarded as the best approach to the transfer pricing
problem.
• Remarks:
❑ A market price approach works best when the product or service is sold in its present form to
outside customers and the selling division has no idle capacity.
❑ A market price approach does not work well when the selling division has idle capacity.

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Service Department Charges

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Operating versus Service Departments

Operating Departments
• Carry out central purposes of organization.

Service Departments
• Do not directly engage in operating activities.

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Reasons for Charging Service Department Costs

To provide operating To encourage operating

departments with more departments to wisely use
complete cost data for service department
making decisions. resources.

To help measure the To create an incentive for

profitability of operating service departments to
departments. operate efficiently.

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Charging Costs by Behavior
• Variable and fixed service department costs should be charged to operating
departments separately.
❑ Variable service department costs should be charged according to cost drivers;

❑ Fixed service department costs should be charged based on predetermined lump-sum amounts
based on the consuming department’s peak-period or long-run average servicing needs.
• Remark:
❑ Budgeted rates should be used, instead of actual rates. Why?

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Sipco – An Example
• Sipco has a maintenance department and two operating departments: Cutting and Assembly.
Variable maintenance costs are budgeted at $0.60 per machine hour. Fixed maintenance costs are
budgeted at $200,000 per year.
• Allocate maintenance costs to the two operating departments.

Percent of
Peak-Period
Operating Capacity Hours
Departments Required Planned Hours Used
Cutting 60% 75,000 80,000
Assembly 40% 50,000 40,000
Total hours 100% 125,000 120,000

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Sipco – End of the Year
Cutting Assembly
Department Department
Variable cost allocation:
$0.60 × 80,000 hours $ 48,000
$0.60 × 40,000 hours $ 24,000
Fixed cost allocation:

. .

Total allocated cost . .

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 Sipco – End of the Year
Cutting Assembly
Department Department
Variable cost allocation:
$0.60 × 80,000 hours $ 48,000
$0.60 × 40,000 hours $ 24,000
Fixed cost allocation:
60% × $200,000: 60% × $200,000 120,000
Percent of peak-
period capacity 40% × $200,000 80,000
Total allocated cost $168,000 $104,000

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Problem in Allocating Fixed Costs
• Allocate fixed costs with an allocation base that fluctuates period to period.
❑ Fixed costs allocated to one department are heavily influenced by what happens in
other departments.
❑ e.g., Sales dollars as the allocation base to allocate $80,000 of service department costs

Departments
YEAR 1
New Used Parts Total
Sales by department $1,500,000 $900,000 $600,000 $3,000,000
Percentage of total
50% 30% 20% 100%
sales
Allocation of service
$40,000 $24,000 $16,000 $80,000
department costs

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Problem in Allocating Fixed Costs
• In year 2, sales of the new car department increases by $500,000. Allocation
changes.
Departments
YEAR 2
New Used Parts Total
Sales by department $2,000,000 $900,000 $600,000 $3,500,000
Percentage of total sales 57% 26% 17% 100%
Allocation of service
$45,714 $20,571 $13,715 $80,000
department costs

Unreasonable as now allocation is not reflecting consumption of service!

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