responsibilty accouting and trsfer pricing

Editor's Notes

• #1: Chapter 22: Responsibility Accounting and Transfer Pricing
• #2: 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. 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. A responsibility accounting system uses the concept of controllable costs to evaluate a manager’s performance. Responsibility for controllable costs is clearly defined and performance is evaluated based on the ability to manage and control those costs. 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.
• #3: 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. Profit centers are evaluated on the basis of profits. Profit center managers must generate revenues and control costs to sustain profits. In an investment center, the manager controls costs, revenues, and investments in operational assets. 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.
• #4: A responsibility accounting system makes use of organization charts to determine lines of authority and levels of responsibility. The amount of detail in performance reports varies according to reporting level in an organization. In general, lower-level managers receive detailed reports, but the level of detail decreases at higher levels of management.
• #5: 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.
• #6: Tracing revenue to the appropriate responsibility center is not difficult. Because sales transaction are recorded, revenues are entered in the accounting system at the point of sale.
• #7: 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.
• #8: 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 NuTech decides to outsource some of its repair work to an outside vendor, it may no longer have an in-house repair department at the 42nd Street Store. Without a repair department, there may be no need for a repair department manager. The repair department manager’s salary is a traceable fixed cost to the 42nd Street Store.
• #9: 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 NuTech decides to outsource some of its repair work to an outside vendor, it will still have a company president. The company president’s salary is a common fixed cost.
• #10: 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.
• #11: Profit center managers should be evaluated on how well they manage controllable costs, and on the amount of responsibility margin they generate. A cost is controllable by a manager if the manager has the power to determine, or strongly influence, the amounts incurred. Not all departmental direct costs are controllable by the department manager. For example, the department manager’s salary is directly traceable to the department, but the department manager does not control the salary. The key issue is controllability.
• #12: We did not allocate the common fixed costs to responsibility centers in our examples. Allocating common costs will reduce the reported profitability of a responsibility center, but the common fixed costs are unrelated to the center’s operations. The key to responsibility reports is controllability. Since a responsibility center manager does not control common fixed costs, we should not allocate them in responsibility reports.
• #13: A transfer price is the amount charged when one division of a company sells goods or services to another division of the same company. 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. 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.
• #14: We have emphasized financial performance measures, but it would be shortsighted for a business to maximize one type of performance measure and exclude other, possibly equally important performance measures such as quality, customer relations, employee morale, capacity utilization. Businesses have the responsibility to serve several interested parties, including employees, owners, and customers. A balanced approach to serving all parties will lead to long-run success.
• #15: End of Chapter 22.