BULLET NOTES ON RESPONSIBILITY ACCOUNTING AND TRANSFER PRICING

The Concept of Responsibility Accounting

 Responsibility accounting involves accumulating and reporting costs (and revenues)
on the basis of the manager who has the authority to make the day-to-day decisions
about the items.
 Under responsibility accounting, a manager’s performance is evaluated on matters
directly under that manager’s control.
 Responsibility accounting can be used at every level of management in which the
following conditions exist:
 Costs and revenues can be directly associated with the specific level of management
responsibility.
 The costs and revenues can be controlled by employees at the level of responsibility
with which they are associated.
 Budget data can be developed for evaluating the manager’s effectiveness in
controlling the costs and revenues.
 The reporting of costs and revenues under responsibility accounting differs from
budgeting in two respects:
 A distinction is made between controllable and noncontrollable items.
 Performance reports either emphasize or include only items controllable by the
individual manager.
 A cost over which a manager has control is called a controllable cost. It follows that:
 All costs are controllable by top management because of the broad range of its
activity.
 Fewer costs are controllable as one moves down to each lower level of managerial
responsibility because of the manager’s decreasing authority.
 Noncontrollable costs are costs incurred indirectly and allocated to a responsibility
level.
 A responsibility reporting system involves the preparation of a report for each level of
responsibility in the company’s organization chart.
 Responsibility reports for cost centers compare actual controllable costs with
flexible budget data. The reports show only controllable costs and no distinction is
made between variable and fixed costs.

Decentralization:
 Decentralization refers to the separation or division of the organization into more
manageable units wherein each unit is managed by an individual who is given decision
authority and is held accountable for his or her decisions.
 Goal congruence occurs when units of organization have incentives to perform for a
common interest. The purpose of a responsibility system is to motivate management
performance that adheres to company overall objectives.
 Sub-Optimization occurs when one segment of a company takes action that is in its
own best interests but is detrimental to the firm as a whole.

Responsibility Centers
There are four basic types of responsibility centers: cost centers, profit centers, and
investment centers.
 A revenue center is responsible primarily for generating revenues.
 A cost center incurs costs (and expenses) but does not directly generate revenues.
 A profit center incurs costs (and expenses) and also generates revenues.

 An investment center incurs costs (and expenses) and generates revenues. In

addition, an investment center has control over decisions regarding the assets available
for use.
BULLET NOTES – RESPONSIBILITY ACCOUNTING & TRANSFER PRICING Compiled by Vhin

Responsibility Reports
 The evaluation of a manager’s performance for cost centers is based on his or her
ability to meet budgeted goals for controllable costs.
 To evaluate the performance of a profit center manager, upper management needs
detailed information about both controllable revenues and controllable costs. The
report is prepared using the cost-volume-profit income statement. In the report:
 Controllable fixed costs are deducted from contribution margin.
 The excess of contribution margin over controllable fixed costs is identified as
controllable margin.
 Noncontrollable fixed costs are not reported.

Measuring the Performance of Investment Centers

 Return on Investment (ROI) is the most common measure of performance for
investment centers.

ROI = Operating Income ÷ Average Operating Assets

Operating income refers to earnings before interest and taxes. Operating assets
includes all assets acquired to generate operating income.

ROI is patterned after the DuPont technique to compute Return on Assets:

Return on Assets = Return on Sales x Asset Turnover

Net Income ÷ Assets = (Net Income ÷ Sales) x (Sales ÷ Assets)

 Residual Income (RI) – is the difference between operating income and the minimum
peso return required on a company’s operating assets.

RI = Operating Income – (Minimum Rate of Return x Operating Assets)

 ECONOMIC VALUE ADDED (EVA) – more specific version of residual income that
measures the investment center’s real economic gains. It uses the weighted average cost
of capital (WACC) to compute the required income.

After-tax operating income (EBIC x [1 - Tax Rate] xx

Less: Desired Income
(After-tax WACC x [Total assets - Non-interest bearing Current liabilities] xx
Economic Value Added (EVA) xx

Principles of Performance Evaluation

 The human factor is critical in evaluating performance. Behavioral principles include:
o Managers of responsibility centers should have direct input into the process of
establishing budget goals of their area of responsibility.
o The evaluation of performance should be based entirely on matters that are
controllable by the manager being evaluated.
o Top management should support the evaluation process.
o The evaluation process must allow managers to respond to their evaluations.
o The evaluation should identify both good and poor performance.
 Performance evaluation under responsibility accounting should be based on certain
reporting principles. Performance reports should:
o Contain only data that are controllable by the manager of the responsibility
center.
o Provide accurate and reliable budget data to measure performance.
o Highlight significant differences between actual results and budget goals.
ο Be tailor-made for the intended evaluation.
ο Be prepared at reasonable intervals.
BULLET NOTES – RESPONSIBILITY ACCOUNTING & TRANSFER PRICING Compiled by Vhin

TRANSFER PRICING

Transfer Price is the monetary value, or the price charged by one segment of a firm for the
goods and services it supplies to another segment of the same firm.

Objectives of Transfer Pricing:

 To facilitate optimal decision-making.
 To provide a basis in measuring divisional performance.
 To motivate the different department heads in improving their performance and that of
their departments.

Basis of Transfer Price:

 Cost-Based Price
 Market-Based Price
 Negotiated Price
 Arbitrary Price

General Rules in Choosing a Transfer Price:

 The maximum price should be no greater than the lowest market price at which the
buying segment can acquire the goods or services externally.
 The minimum price should be no less than the sum of the selling segment’s
incremental costs associated with the goods or services plus the opportunity cost of
the facilities used.
 A good should be transferred internally whenever the minimum transfer price (set
by the selling division) is less than the maximum transfer price (set by the buying
division). By doing this, total profits of the firm are not decreased by an internal
transfer.

Maximum vs. Minimum Transfer Prices

 To minimize the effect of sub-optimization, a range for transfer price must be set based
on the following limits:
o Maximum transfer price: Cost of buying from outside suppliers
o Minimum transfer price: Variable cost per unit + Lost Contribution Margin per
unit on outside sales
o When a company segment is operating at full capacity, the lost CM per unit on
outside sales is the opportunity cost of transferring products to another
company segment.

Internal Sales
 The transfer of goods between divisions of the same company is called internal sales.
Divisions within vertically integrated companies normally sell goods to other company
divisions as well as to outside customers.
 The charge for labor time is expressed as a rate per labor hour which includes:
ο The direct labor cost of the employee (hourly rate or salary and fringe benefits).
ο Selling, administrative, and similar overhead costs.
ο An allowance for a desired profit or ROI per hour of employee time.
 The charge for materials typically includes a material loading charge which covers
the costs of purchasing, receiving, handling, and storing materials, plus any desired
profit margin on the materials themselves.
 The charges for any particular job are the sum of the:
o Labor charge
o Charge for materials
o Material loading charge

Cost-Based Transfer Prices

 One method of determining transfer prices is to base the transfer price on the costs
incurred by the division producing the goods.
 A cost-based transfer price may be based on full cost, variable cost, or some
modification including a markup.
 The cost-based approach often leads to poor performance evaluations and purchasing
decisions. Under this approach, divisions sometimes use improper transfer prices
which leads to a loss of profitability and unfair evaluations of division performance.
BULLET NOTES – RESPONSIBILITY ACCOUNTING & TRANSFER PRICING Compiled by Vhin

 The cost-based approach does not provide the selling division with proper incentive.
In addition, this approach does not reflect the selling division’s true profitability
and doesn’t even provide adequate incentive for the selling division to control costs since
the division’s costs are passed on to the buying division.

Absorption Cost Approach

 The absorption-cost approach uses total manufacturing cost as the cost base and
provides for selling/administrative costs plus the target ROI through the markup.
 The absorption-cost approach involves three steps:
ο Compute the unit manufacturing cost.
ο Compute the markup percentage (the percentage must cover both the desired
ROI and selling and administrative expenses).
ο Set the target selling price.
 The markup percentage is computed by dividing the sum of the desired ROI per unit
and selling and administrative expenses per unit by the manufacturing cost per unit.
 The target selling price is computed as:

Manufacturing cost per unit + (Markup percentage x Manufacturing cost per

unit).

 Most companies that use cost-plus pricing use either absorption cost or full cost as the
basis because:
ο Absorption cost information is most readily provided by a company’s cost
accounting system.
ο Basing the cost-plus formula on only variable costs could encourage managers to
set too low a price to boost sales.
ο Absorption cost or full-cost pricing provides the most defensible base for
justifying prices to managers, customers, and government.

Variable Cost Pricing

 Variable cost pricing uses all of the variable costs, including selling and
administrative costs, as the cost base and provides for fixed costs and target ROI
through the markup.
 Variable cost pricing is more useful for making short-run decisions because it
considers variable cost and fixed cost behavior patterns separately.
 Variable-cost pricing involves the following steps:
o Compute the unit variable cost.
o Compute the markup percentage.
o Set the target selling price.
 The markup percentage is computed by dividing the sum of the desired ROI per unit
and fixed costs per unit by the variable cost per unit.
 The target selling price is computed as:

Variable cost per unit + (Markup percentage x Variable cost per unit).

 The specific reasons for using Variable-cost pricing are:

o It is more consistent with cost-volume-profit analysis used to measure the
profit implications of changes in price and volume.
o This approach provides the type of data managers need for pricing special
orders.
o It avoids arbitrary allocation of common fixed costs to individual product
lines.

Market Based Transfer Prices

 The market-based transfer price is based on existing market prices of competing
goods. This system is often considered the best approach because it is objective and
generally provides the proper economic incentives.
 When the selling division has no excess capacity, it receives market price and the
purchasing division pays market price.
 If the selling division has excess capacity, the market based system can lead to actions
that are not in the best interest of the company.
BULLET NOTES – RESPONSIBILITY ACCOUNTING & TRANSFER PRICING Compiled by Vhin

 In many cases, there is not a well-defined market for the good being transferred. As
a result, a reasonable market value cannot be developed, and companies must resort to
a cost-based system.

Negotiated Transfer Prices

 Under negotiated transfer pricing, the selling division, establishes, a minimum
transfer price and the purchasing division establishes a maximum transfer price.
 Companies often do not use negotiated transfer pricing because:
ο Market price information is sometimes not easily obtainable.
ο A lack of trust between the two negotiating divisions may lead to a breakdown
in negotiations.
ο Negotiations often lead to different pricing strategies from division to division
which is sometimes costly to implement.