Responsibility Accounting and Transfer Pricing Chapter 22 Chapter 22: Responsibility Accounting and Transfer Pricing

Responsibility Centers Large complex businesses are divided into responsibility centers enabling managers to have a smaller effective span of control. Even the best managers can only do so much. It is necessary to divide large businesses into smaller departments so a manager’s span of control is not too large.

The Need for Information About Responsibility Center Performance The accounting system provides information about resources used and outputs achieved. This information is used to: Plan and allocate resources. Control operations. Evaluate the performance of center managers. All departments, whether production, sales, or service, use resources to achieve desired outcomes. If our accounting system is properly designed and implemented, we can evaluate performance, control operations, and take corrective action where needed. One of top management’s objectives for this type of system is to be able to allocate more resources to those departments who are performing at the highest level.

Cost Centers, Profit Centers, and Investments Centers A business section that has control over the incurrence of costs, but no control over revenues or investment funds. A cost center is a segment whose manager has control over costs but cannot control revenues or investment funds. Cost center managers are evaluated on the their ability to control costs.

Cost Centers, Profit Centers, and Investments Centers Revenues Sales Interest Other Costs Mfg. costs Commissions Salaries Profit Center A part of the business that has control over both costs and revenues, but no control over investment funds. Profit centers are evaluated on the basis of profits. Profit center managers must generate revenues and control costs to sustain profits.

Cost Centers, Profit Centers, and Investments Centers Investment Center A profit center where management also makes capital investment decisions. In an investment center, the manager controls costs, revenues, and investments in operational assets.

Cost Centers, Profit Centers, and Investments Centers Cost control Quantity and quality of services Profit Investment Return on assets (ROA) Residual income (RI) Evaluation Measures Profitability We evaluate cost centers based on cost control and quantity and quality of services. We evaluate profit centers based on the level of profitability. Finally, we evaluate investment centers by measuring return on assets and residual income.

Responsibility Accounting Systems Prepare budgets for each responsibility center. Measure performance of each responsibility center. Responsibility accounting systems include three key components. First, we prepare budgets for each responsibility center emphasizing items controllable by the responsibility center manager. Second, we measure performance on those controllable items. Third, we issue timely reports to responsibility center managers comparing actual performance with budgeted amounts. Prepare timely performance reports comparing actual amounts with budgeted amounts.

Responsibility Accounting Systems To be of maximum benefit, responsibility reports should . . . Be timely. Be issued regularly. Be understandable. Compare budgeted and actual amounts. Responsibility performance reports should be timely, issued on a regular schedule, and presented in a usable, easily understood format to be of maximum benefit to managers. Since performance is being evaluated and reported, the responsibility report should include comparisons of budgeted costs and actual costs.

Assigning Revenue and Costs to Responsibility Centers Two guidelines should be followed in allocating costs to the various parts of a business . . . According to cost behavior patterns: Fixed or variable. According to whether the costs are directly traceable to the centers involved. Tracing costs to responsibility systems can be more difficult. Direct costs can be readily traced to one responsibility center because they are incurred for the sole benefit of that one center. Indirect costs cannot be traced to one responsibility center because they are common to two or more centers. For example, if two departments are located in the same building, the cost of replacing the roof on the building benefits both departments. When we prepare responsibility reports, we should classify costs according to behavior and according to traceability. Let’s look at an example of profit center reporting where we have fixed and variable costs, and direct and indirect costs.

Contribution Margin Responsibility Reports After computing contribution margin, we subtract $90,000 of traceable fixed costs to get responsibility margin. This is a probably a new term for you. Responsibility margin is the amount that the Television division contributes to the overall company operations. A positive responsibility margin indicates that the Television division has covered all of its direct costs, both variable costs and traceable fixed costs, and has margin left to help cover common company costs. Responsibility margin is the Television Division’s contribution to overall operations.

Traceable Fixed Costs Traceable fixed costs would disappear over time if the center itself disappeared. No computer division means . . . No computer division manager. How do we know if a fixed cost is traceable or common? Traceable fixed costs can be avoided if a responsibility center is discontinued. For example, if Webber decides to outsource its information systems work to an outside vendor, it would no longer have an in-house computer division. Without a computer division, there would be no need for a computer division manager. The computer division manager’s salary is a traceable fixed cost.

Common Fixed Costs Common fixed costs arise because of overall operation of the company and are not due to the existence of a particular center. No computer division means . . . We still have a company president. Common fixed costs are incurred for the benefit of two or more responsibility centers. If one of these responsibility centers is discontinued, the common fixed costs would not be avoided. For example, if Webber decides to outsource its information systems work to an outside vendor, it will still have a company president. The company president’s salary is a common fixed cost.

Contribution Margin Responsibility Reports Here we see the responsibility reports for the Television Division and the Computer Division as parts of the overall company’s operating results. Note that the company’s common costs are deducted from the total responsibility margin. The common costs are incurred for the benefit of both divisions, but cannot be traced to either division. Common costs arise because of overall operating activities and are not due to the existence of a particular division.

Responsibility Margin Responsibility margin is the best gauge of the long-run profitability of a business center. Responsibility margin is the best measure of the long-run profitability of a profit center because it tells us how much the center is contributing to the company’s common costs and income. Profits Time

Transfer Prices The amount charged when one division sells goods or services to another division. A transfer price is the amount charged when one division of a company sells goods or services to another division of the same company. In the example on your screen, the battery manufacturing division of a company sells batteries to the auto assembly division of the same company. Batteries Battery Division Auto Division

Transfer Prices Many companies use the external market value of goods transferred as the transfer price. Although the individual profits of the two divisions are affected by transfer prices, the overall net income of the company is not affected. The transfer price that is a cost for the buying division is a revenue for selling division, so when we combine the statements of both divisions to get total income for the company, the amounts offset each other. When the selling division can also sell the goods in an external market, then there is objective evidence of the market price that others are willing to pay. Having this external market price, many companies use it for the transfer price of goods transferred internally from one division to another. Transfer prices have no direct effect upon the company’s overall net income.

Negotiated transfer price Transfer Prices When the external market value of goods transferred is unavailable . . . Negotiated transfer price Cost-plus transfer price When an external market price is not available, companies use negotiated transfer prices based on the selling division’s cost. Usually the negotiated transfer price is cost plus a markup to provide the selling division with a reasonable profit on the transferred goods. Transfer prices have no direct effect upon the company’s overall net income.

End of Chapter 22 End of Chapter 22.