CHAPTER 20: RESPONSBILITY ACCOUNTING PRE- REQUISITES TO THE INITIATION AND

AND TRANSFER PRICING MAINTENANCE OF AN EFFECTIVE

RESPONSIBILITY ACCOUNTING SYSTEM
Decentralization, concept
1. A well-defined organization structure-
It is an organization in which decision-making is  Spheres of jurisdiction must clearly be
NOT confined to a few top executives but is establish and understood in the
spread out throughout the organization. ORGANIZATIONAL CHART
 SEGMENT REPORTING – Is of importance 2. Well defined and established standards
in organization that are decentralized. It of performance in revenues costs and
is where costs, revenues are assigned to investments
segments to enable management to see  Requires and INTEGRATED PLAN for the
where responsibility lies for control control of operations which would
purposes. provide for standards as well as the
necessary procedures to effectuate the
Responsibility Accounting, concept ( Activity plan.
planning or profitability planning) 3. A system of Accounting that identifies
revenue ,expenses and assets to specific
A system that recognizes various decision
units in the organization
centers throughout the organization and traces
4. A system that provides for the
costs ( revenues, assets, liabilities) by areas of
preparation of regular performance
responsibility
reports
 RESPONSIBILITY CENTER- a specific unit  System of preparing regular reports (
of an organization assigned to a showing actual vs planned + variances)
manager who is responsible and held that includes only those that are
accountable for its operation and controllable by the manager.
resources ( only for those are
controllable by him) RESPONSIBILITY CENTER AND THEIR
EVALUATION
Works on the premise that managers should be
held responsible for:
Essential :
a. Their performance  To determine the range
b. Activities of their subordinates of authority and
c. Activities within their responsibility influence of manager
centers over control of
d. Responsible for held deviations between revenues, costs and
actual and budgeted goals investment.
e. Items of revenues and costs that is
TYPES OF RESPONSIBILITY CENTERS:
controllable
A. Cost Center
OBJECTIVE: Through responsibility accounting,
B. Profit Center
managers will be compelled to set managerial
C. Investment Center
target and formulate strategies to attain the
D. Revenue Center
firms overall objectives. ( Control mechanism are
provided which will serve as basis for evaluation COST CENTER PROFIT CENTER
of actual results) Manager is Responsible for
responsible for generation of
ADVANTAGES OF RESPONSIBILITY ACCOUNTING: MINIMIZING COSTS REVENUE and
1. Facilitates delegation of decision making subject to output CONTROL COST
2. Helps promote management by constraint
objective. Responsible for
making of costs based
3. Aids in establishing standards of
on the expected level
performance
of operation
4. Permits the effective use of Evaluated through : Evalauted through:
management by exception ( reports from Income statement
concentrating on factors which are standard costs and using the
deviations from the plan) flexible budgets ( contribution
actual vs planned) approach
 INVESTMENT CENTER REVENUE CENTER Where: Operating Asset includes all assets held
Responsible for Responsible for for PRODUCTIVE USE and exclusive of those not
CONTROL OF selling budgeted considered as operating asset ( Land held for
REVENUES, COSTS & quantity of products future use, investment in another company etc)
INVESTMENT @ budgeted price
Uses: ( To evaluate) Uses: Variance in OTHER CRITERIA TO BE CONSIDERED OTHER
a. ROI sales price and sales THAN ROI
b. Residual mix to monitor
i. Growth in market share
Income operation
c. EVA ii. Increase in productivity
Responsible for iii. Product innovation
achieving budgeted iv. Peso profit
level of CM by v. Receivable and inventory turnover
controlling the vi. Ability to venture into new and
number of unit sold, profitable areas
sales mix and SP
Residual Income
Net operating income that an investment center
Investment Center, elaborated
is able to earn ABOVE some MINIMUM RETURN
Objectives: ON THE OPERATING ASSETS

a. Motivate manager to exert HIGH LEVEL Advantages:

of effort to achieve the goal of the firm
b. Provide the right INCENTIVE
managers to make decision in
congruence with goal of the firm
c. Determine fairly the rewards earned by
managers for their effort and skill
Return on Investmnet (ROI)
Improved by : Increasing sales, reducing
expenses or assets
a. Pursues the investment opportunity as
for
long as it exceeds the minimum rate of
return
b. Rate of return can be adjusted for
differences in risk and type of assets
c. It is possible to calculate different
investment charge for different type of
assets
Limitations:

Advantages: a. Not a percentage – not useful for units

of significantly different size
a. Easily understood
b. Not as intuitive as ROI
b. Comparable to interest rate of returns of
c. It may be difficult to obtain a minimum
alternative situations.
rate of return.
Limitations:

a. Tends to emphasize SHORT RUN Formula:

performance
Operating Income x
b. Investment opportunities with expected
Less; Minimum required rate of return (x)
return lower than ROI are usually Residual Income xxx
REJECTED ( even though it’s a higher
than the minimum rate of return) Economic Value Added (EVA)
c. ROI may not be fully controllable due to
COMMITED FIXED costs. A business income after taxes and after
d. Difficulty in DISTINGUISHING between deducting COST OF CAPITAL.
performance of the manager vs the  Cost of capital- usually
performance of the center itself. obtained by calculating
a weighted average of
the cost of the firm’s
Formula two sources of funds
(borrowing and selling
𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 stock)
𝑅𝑂𝐼 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠 EVA does not follow conventional, conservative
accounting policies and focuses on creating
Or value for shareholders by earning profit grater
𝑅𝑂𝐼 = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 𝑥 than the costs of capital.

𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛 𝑜𝑣𝑒𝑟 ( 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑎𝑙𝑒𝑠)

Revenue Center, elaborated  The INDIRECT effect is the
influencing of decision of the
Variances:
division manager.
1. SALES PRICE VARIANCE
Transfer Pricing is a TOOL to:

𝑆𝑃𝑉 = ( 𝐴𝑐𝑡𝑢𝑎𝑙 𝑆𝑃 i. Motivate division managers

ii. Establish and maintain control system
− 𝑀𝑎𝑠𝑡𝑒𝑟 𝐵𝑢𝑑𝑔𝑒𝑡 𝑆𝑃) for measuring internal performance
𝑋 𝐴𝑐𝑡𝑢𝑎𝑙 𝑢𝑛𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 iii. Create a transfer pricing policy – to
encourage managers to make an
2. SALES VOLUME VARIANCE economically optimal decision for the
company without reducing their
𝑆𝑉𝑉 authority and still pursue goal
= ( 𝐴𝑐𝑡𝑢𝑎𝑙 𝑢𝑛𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 congruence.
− 𝑀𝑎𝑠𝑡𝑒𝑟 𝑏𝑢𝑑𝑔𝑒𝑡 𝑢𝑛𝑖𝑡𝑠 𝑠𝑎𝑙𝑒𝑠)
ALTERNATIVE PRICING SCHEMES
𝐶𝑀
𝑋 𝑀𝑎𝑠𝑡𝑒𝑟 𝑏𝑢𝑑𝑔𝑒𝑡 𝐴𝑣𝑒 1. Minimum Transfer price
𝑢𝑛𝑖𝑡
2. Market based transfer price
3. SALES MIX VARIANCE 3. Cost based Transfer price
𝑆𝑀𝑉 1. Variable cost
𝐶𝑀 2. Full cost
= (𝐹𝑙𝑒𝑥𝑖𝑏𝑙𝑒 𝐵𝑢𝑑𝑔𝑒𝑡 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 3. Alternative cost
𝑢𝑛𝑖𝑡
𝐶𝑀 measure
− 𝑀𝑎𝑠𝑡𝑒𝑟 𝐵𝑢𝑑𝑔𝑒𝑡 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 ) 4. Negotiated Transfer
𝑢𝑛𝑖𝑡
Price
𝑥 𝐴𝑐𝑡𝑢𝑎𝑙 𝑈𝑛𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
MINIMUM TRANSFER PRICE

𝑇𝑃 = 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 ( 𝑉𝐶) +

Where:
𝐿𝐶𝑀 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑛 𝑂𝑢𝑡𝑠𝑖𝑑𝑒 𝑠𝑎𝑙𝑒𝑠
Master Budget Ave CM/unit
( 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 )
𝑀𝑎𝑠𝑡𝑒𝑟 𝐵𝑢𝑑𝑔𝑒𝑡 𝑇𝑜𝑡𝑎𝑙 𝐶𝑀
=
𝑀𝑎𝑠𝑡𝑒𝑟 𝑏𝑢𝑑𝑔𝑒𝑡 𝑢𝑛𝑖𝑡 𝑠𝑎𝑙𝑒𝑠
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑢𝑛𝑖𝑡𝑠 𝑥 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐶𝑚
The formula represents the LOWER LIMIT – it is
Master Budget Total CM = the least amount that the selling division must
𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝑈𝑛𝑖𝑡

receive in order to be “ as well of as if it is sold to

Flexible Budget Ave CM/unit
outside costumers”
𝐹𝑙𝑒𝑥𝑖𝑏𝑙𝑒 𝐵𝑢𝑑𝑔𝑒𝑡 𝑡𝑜𝑡𝑎𝑙 𝐶𝑀
=  Transfer price can be
𝐴𝑐𝑡𝑢𝑎𝑙 𝑈𝑛𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 more but cannot exceed
𝐴𝑐𝑡𝑢𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑥 𝐵𝑢𝑑𝑔𝑒𝑡𝑒𝑑 𝐶𝑚
Flexible Budget CM= the purchase price from
𝐴𝑐𝑡𝑢𝑎𝑙 𝑈𝑛𝑖𝑡𝑠 𝑈𝑛𝑖𝑡
outside supplier.

If selling division has:

TRANSFER PRICING:
a. Sufficient capacity to meet the demand
Issue: Placing of a fair value of exchange of
of another division
goods and services between segments within
 Does not have
the company ( Problem of Transfer pricing)
opportunity cost;
 Transfer Price - the price charge when HENCE, the acceptable
one segment of the company provides transfer price will be
goods or services to another segment of equal to Variable cost
the company. per unit.
 It will affect the sales of the  Note: From Buyer
selling division and cost of the perspective: the
buying division. BUT will no MAXIMUM transfer
have any DIRECT effect on the price is equivalent to
company’s profit. the price offered by
outside supplier.
MARKET BASED TRANSFER PRICE
Under this approach, the transfer price is the
price @ which goods are sold on the open
market.
 Designed for situation in which there is
an outside market for the transferred
product/ service.
 Suitable method when there is no IDLE
capacity
 The real cost of the transfer is
the opportunity cost of the
lost revenue on the outside
sale ( the production cost
them are exactly the same, so
no lost would incur)
 Considered as the best transfer price
because it makes profit base
performance evaluation feasible at
many levels of organization.
Guidelines:
a. The buying division must purchase
internaly so long as the selling division
meets all outside price and wants to sell
internally.
b. Selling division must be free to reject
internal business
c. If selling division does not meet the
outside price then the buying division is
free to purchase outside
d. An independent and impartial body
must be established to settle
disagreement between transfer prices.
COST BASED TRANSFER PRICE
A. Variable Cost Transfer Price
The transfer price is based only on
variable or differential costs
Advantages:
1. It ensures in the short run, the
best use of total corporate
facilities because it focuses on
the CM and how it increases
short run profitability
Disadvantages:
1. If fixed costs are ignored, the
approach may be profitable in
the short run but not in the long
run.
2. Allows 1 segment manager to
make a profit @ the expense of
another segment because the
receiving segment receives all
the profit
3. This method could lead to
dysfunctional decisions
4. Transfer price based on
differential costs diminish the
autonomy in decision making of
the profit centers. ( Because it is
dependent on the demand of
the buying division)
B. Full Cost Transfer Price
It includes the ACTUAL manufacturing
costs ( variable and fixed) PLUS portions
of marketing and administrative costs.
a. It is easy and convenient to
apply
b. It leaves no intracompany
profits in inventory to eliminate
in preparing consolidated
statements
c. It allows simple and adequate
end product costing for profit
analysis by product lines
Limitations
a. It is not suitable for companies with
decentralized operations ( segments
become complacent when they know
that their cost are passed to the next
segment)
b. It does not create incentives for segment
managers to control or reduce costs
c. It departs from goal congruence
Standard Full Cost Historical Ave Costs
Eliminates the
negative effect of
fluctuations in
production efficiency
C. Alternative Cost Measures
i. Full absorption Cost- based
transfer price
 Used when there difficulty in
determining the opportunity
costs
 Advantages:
a. Cost are available in the
company’s record
b. Provide selling division with a
CM equal to the excess of full
absorption cost over variable
costs which give the selling
division an incentive to
transfer cost internally
c. Better measure of differential
cost of transferring internally
because other costs are
considered.
ii. Cost Plus Transfer
 Applies normal mark up to costs TRANSFER PRICE FOR SERVICE
as a substitute for market prices
Establish equitable transfer price to appraise the
when they are NOT AVAILABLE.
performance.

4. NEGOTIATED TRANSFER PRICE
This method permits managers to negotiate the
price for internally transferred goods or services
( usually use strategies similar to those with the
outside market)
 Negotiated price- an attempt to
stimulate arm’s length transaction
between supplying and buying segment.
Advantage:
a. Preserve the autonomy of the division
manager
Steps:
1. Identify the different departments
contributing to various expenses
2. Evaluate the corresponding skill and
experience of personnel involve in
delivering services.
3. Estimate the cost involved in providing
services
4. Adopt or apply any principles of any
transfer pricing method.
MULTINATIONAL TRANSFER PRICING
Objectives: Focus on Minimizing:

Limitations: 1. Taxes
2. Duties
a. Time consuming
3. Tariffs
b. Require frequent reexamination and
4. FOREX risk
revision of prices.
c. Eliminates objectivity necessary to Managers should be sensitive to geographic,
ensure maximization of companywide political and economic circumstances and set
profit. price in a way that it conforms with the law in
d. May distort segment FS and mislead top country they operate.
management.

DISTRESS PRICE:

Market price drops below their historical

average that are temporary.

Question of what price to use:

 The distress price

Note: In the short run
Manager may use the distress price as
long as it exceed the incremental cost of
supplying the product and STOP if not,
thus, the buying division should buy
outside.

 Long run average price- provides a

better measure of the long run viability
of the supplier division.

Note: if the price remains low in the long

run, then the company can use the
distress price.
 Normal market price

Note:

In the short run

Manager may use the distress price as long as it

exceed the incremental cost of supplying the
product and STOP if not, thus, the buying division
should buy outside.