Responsibility Accounting, Segment

Reporting, Performance Measures, and

Transfer Pricing
THE CONCEPT OF DECENTRALIZATION

Decentralization ref ers to the separation or division of the organization into more
manageable units wherein each unit is managed by individual who is given decision
authority and held accountable f or his decisions.
The primary distinction between centralized and decentralized organizations is in the
degree of f reedom of decision making by managers at many levels. In centralized
organization, decision making is consolidated so that activities throughout the
organization may be more ef fectively coordinated f rom the top. In decentralized
organization, decision making is at as low a level as possible. The premise is that the
local manager can make more inf ormed decisions than a manager f arther f rom the
decision.
Benefits of Decentralization
1. The organization is divided into units of manageable size.
2. Sound decisions are more likely to result because they are made at the level where
the decision maker is aware of the real problem as well as the relevant inf ormation
and other f actors related thereto.
3. Decisions can be made on a more timely-basis because the decision maker is
always at hand when a problem is encountered.
4. The managers’ active participation in decision making may boost their morale,
increase their level of job satisfaction, and enable them to be more motivated to
act in a manner most beneficial to the f irm.
5. The subunits serve as a training ground f or f uture leaders where the managers
develop their skills so they can be qualif ied f or promotion to higher levels of the
organization.
Cost of Decentralization
1. The negative effect of some decisions made in one subunit to the other subunits or
to the organization as a whole. Sometimes the benefits of a decision made by one
department are more than of fset by the cost brought by the same decision to the
other departments or to the whole company.
2. Increase in cost of gathering and reporting data as decentralization needs
elaborated reporting system.
3. Job duplication or overlapping f unctions
RESPONSIBILITY ACCOUNTING

Responsibility Accounting is a system of accounting wherein costs and revenues are

accumulated and reported by levels of responsibility or by responsibility centers within the
organization. A responsibility accounting system is designed primarily f or cost control
and performance evaluation.

Responsibility Centers
A decentralized organization is divided into responsibility centers 1 to f acilitate local
decision making. Responsibility Centers are clearly def ined parts or segment of an
organization that are accountable for specified function or set of activities. There are four
(4) types of responsibility centers are generally recognized.
1. A cost center, e.g., a maintenance department, is responsible f or costs or
expenses incurred in the segment only. Cost drivers are the relevant performance
measures. Service Centers exist primarily and sometimes solely to provide
specialized support to other organizational subunits. They are usually operated as
cost centers. Disadvantages of cost centers:
• The potential cost shif ting, f or example, replacement of variable costs for
which a manager is responsible with f ixed costs f or which (s)he is not.
• Long-term issues may be disregarded when the emphasis is on, for
example, annual cost amounts.
• Allocation of service department costs to cost centers.
2. A revenue center, e.g., a sales department, is responsible f or revenues only.
Revenue drivers are the relevant performance measures. They are f actors that
inf luence unit sales, such as changes in prices and products, customer service,
marketing efforts, and delivery terms.
3. A profit center, e.g., an appliance department in a retail store, is responsible for
both revenues and expenses.
4. An investment center, e.g., a branch of fice, is responsible f or revenues,
expenses, and invested capital. The advantage of an investment center is that it
permits an evaluation of perf ormance that can be compared with that of other
responsibility centers or other potential investments on a return on investment
basis, i.e., on the basis of the ef f ectiveness of asset usage.

Classification of Costs in Responsibility Accounting

Controllable Costs are costs which may be directly regulated at a given level of managerial
authority. A cost is controllable by a person if :
1. Has authority over both the acquisition and use of the services f or which the cost
is incurred;
2. Can signif icantly inf luence the amount or the incurrence of cost through his action;
3. Though cannot directly inf luence the incurrence of such cost, the management
wishes him to be concerned with the cost items involved so he can help to inf luence
those who are responsible.
Two important notes regarding controllability of costs must be emphasized at this point:
f irst, it ref ers to a specific responsibility center and second, it results f rom a
significant influence and not f rom a complete inf luence.

1
Also called Strategic Business Units (SBUs) or Accountability Centers
Controllable Costs and Direct Costs
Direct costs are costs that can be specifically identif ied to a certain responsibility center.
Controllable costs, theref ore, which must be directly charged to a specif ic business
segment, must be direct costs.
Indirect costs, on the other hand, are composed mostly of costs that are merely allocated
to the responsibility center under consideration. Indirect costs, therefore, are
noncontrollable by the manager of segment to which the cost is allocated.
Not all Direct Costs are Controllable. For instance, the salary of the manager of a
department is a direct cost to his department but def initely is not controllable by such
manager.
SEGMENT REPORTING

A segment is a product line, geographical area, or other meaningf ul subunit of the

organization. As the examples on the f ollowing page illustrate, contribution margin
reporting is extremely usef ul f or manager decision making. In determining whether to
drop a product or customer, the deciding f actor is whether the product or customer is
generating sufficient contribution margin to cover f ixed costs.
A. Product profitability analysis allows management to determine whether a product
is providing any coverage of f ixed costs.

Illustrative Example | At f irst glance, a dairy operation appears to be comfortably

prof itable.

Sales ₱ 540,000.0
Variable Costs 312,000
Contribution margin ₱ 228,000
Other traceable costs:
Marketing 116,000
R&D 18,000 134,000
Product line margin ₱ 94,000
Fixed costs 24,000
Operating Income ₱ 70,000

A product profitability analysis shows an entirely different picture. Two product lines are
losing money, and one is not even covering its own variable costs.
Cottage
Milk Cream Cheese Total
Sales ₱ 300,000 ₱ 60,000 ₱ 180,000 ₱ 540,000
Variable Costs 110,000 62,000 140,000 312,000
Contribution margin ₱ 190,000 ₱( 2,000) ₱ 40,000 ₱ 228,000
Other traceable costs:
Marketing 66,000.00 10,000.00 40,000.00 116,000.00
R&D 8,000.00 4,000.00 6,000.00 18,000.00
Product line margin ₱ 116,000 ₱( 16,000) ₱( 6,000) ₱ 94,000
Fixed costs 24,000
Operating Income ₱ 70,000

B. Area office profitability analysis performs the same f unction on the segment level.

Illustrative Example | A geographic profitability analysis f or a company that provides

research services allows management to see which branch offices are the most profitable.

Cartagena Riyadh Mumbai Osaka Total

Sales ₱ 1,200,000 ₱ 800,000 ₱ 2,000,000 ₱4,600,000 ₱ 8,600,000
Variable Costs of Sales 800,000 460,000 1,400,000 3,200,000 5,860,000
Other Variable Costs 256,000 176,000 320,000 544,000 1,296,000
Contribution margin ₱ 144,000 ₱ 164,000 ₱ 280,000 ₱ 856,000 ₱ 1,444,000
Traceable fixed costs 150,000 100,000 160,000 220,000 630,000
Area Office Margin ₱( 6,000) ₱ 64,000 ₱ 120,000 ₱ 636,000 ₱ 814,000
Nontraceable Fixed Costs 200,000
Operating Income ₱ 614,000
C. Customer profitability analysis enables management to make decisions about
whether to continue servicing a given customer.

Illustrative Example | At f irst, it might appear that the two unprof itable customers
should be dropped.
Gonzales Abdullah Patel Kawanishi Total
Sales ₱ 10,000 ₱ 40,000 ₱ 62,000 ₱ 22,000 ₱ 134,000
Cost of goods sold 7,200 26,000 41,000 18,100 92,300
Other relevant costs 1,000 2,200 4,400 4,100 11,700
Customer margin ₱ 1,800 ₱ 11,800 ₱ 16,600 ₱( 200) ₱ 30,000
Allocated fixed costs 2,000 6,000 8,800 4,000 20,800
Operating income ₱( 200) ₱ 5,800 ₱ 7,800 ₱( 4,200) ₱ 9,200

Dropping Kawanishi makes sense. However, Gonzales is contributing to the coverage of

f ixed costs, which would have to be shif ted to the other customers if Gonzales were
dropped.

Issues involved in determining product prof itability, business unit prof itability, and
customer profitability include.
1. Cost measurement involves calculating correct costs and not undercosting (i.e.,
product consumes a high amount of resources but is reported as having low cost
per unit) or overcosting (i.e., business unit consumes a low amount of resources
but is reported as having high costs).
2. Cost allocation is the assignment of costs to the appropriate product, business
unit, and customer. Incorrect costs assignment will lead to overcosting and
undercosting. Thus, providing erroneous f eedback on the prof itability of the
applicable product, business unit, and/or customer will lead management to base
decisions on inaccurate f inancial results.
3. Investment measurement involves calculating the cost to expand production,
develop new products, or enter new business markets through acquisition or
internal development. This process involves (a) identif ying investments, (b)
determining the resources required, and (c) projecting the expected amounts and
timing of returns. Hence, sound decisions regarding projected favorable returns on
investments (i.e., ranking the identif ied investments) are contingent on accurate
valuations of potential investment.
4. Other measures include but are not limited to (a) nonvalue-added costs and
inef f icient production activities, (b) selection and placement of value-added and
ef ficient production activities, (c) response to customer requirements, and (d) high-
quality products produced with less resources. Successful monitoring and
management of these processes are ways to improve profitability and/or identify
production activities, products, or customers requiring disposal.

Allocating Common Costs

Common costs are the costs of products, activities, facilities, services, or operations shared
by two or more cost objects. The dif ficulty with common costs is that they are indirect
costs whose allocation may be arbitrary.
A direct cause-and-effect relationship between a common cost and the actions of the cost
object to which it is allocated is desirable. Such a relationship promotes acceptance of the
allocation by managers who perceive the f airness of the procedure, but identif ication of
cause and ef fect may not be f easible.
An alternative allocation criterion is the benef it received. For example, advertising costs
that do not relate to particular products may increase sales of all products. Allocation
based on the increase in sales by organizational subunits is likely to be accepted as
equitable despite the absence of clear cause-and-effect relationships.
Allocating costs to f oster competition may also be appropriate. Care must be taken to
ensure this competition is healthy f or organizational dynamics.
Headquarters Costs. A persistent problem in large organizations is the treatment of the
costs of headquarters and other central support costs. Such costs are frequently allocated.
The allocation reminds managers that support costs exist and that the managers would
incur these costs if their operations were independent. The allocation also reminds
managers that profit center earnings must cover some amount of support costs.
Research has shown that central support costs are allocated to departments or divisions
f or the f ollowing reasons:
1. The allocation reminds managers that support costs exist and that the managers
would incur these costs if their operations were independent.
2. The allocation reminds managers that prof it center earnings must cover some
amount of support costs.
3. Departments or divisions should be motivated to use central support services
appropriately.
4. Managers who must bear the costs of central support services that they do not
control may be encouraged to exert pressure on those who do. Thus, they may be
able to restrain such costs indirectly. However, department or division managers
pressuring central managers is not a healthy organizational dynamic.

Effects of Arbitrary Allocations

1. Managers' morale may suffer when allocations depress operating results.
2. Dysf unctional conflict may arise among managers when costs controlled by one are
allocated to others.
3. Resentment may result if cost allocation is perceived to be arbitrary or unf air. For
example, an allocation on an ability-to-bear basis, such as operating income,
penalizes successful managers and rewards underachievers and may therefore
have a demotivating effect.

Allocation Alternatives
1. If allocation is based on actual sales or contribution margin, responsibility centers
that increase their sales (or contribution margin) will be charged with increased
overhead.
2. If central administrative or other fixed costs are not allocated, responsibility centers
might reach their revenue (or contribution margin) goals without covering all f ixed
costs (which is necessary to operate in the long run).
3. Allocation of overhead, however, is motivationally negative; central administrative
or other f ixed costs may appear noncontrollable and be unproductive.
4. A much-preferred alternative is to budget a certain amount of contribution margin
earned by each responsibility center to the central administration based on
negotiation. The intended result is f or each unit to see itself as contributing to the
success of the overall entity rather than carrying the weight (cost) of central
administration. Central administration can then make the decision whether to
expand, divest, or close responsibility centers
Calculating Common Cost Allocation
Two specif ic approaches to common cost allocation are in general use.
1. Under the stand-alone method, the common cost is allocated to each cost object
on a proportionate basis.
2. Under the incremental method, the cost objects are sorted in descending order
by total traceable cost, and the common cost is allocated up to the amount of each.

Illustrative Example | The proportionate costs of servicing three customers are

presented in the table below. The common cost of providing service to these customers is
₱8,000.

Cost of
Servicing %
Luciano ₱ 7,000 70%
Ratzinger 2,000 20%
Wojtyla 1,000 10%
Total ₱ 10,000 100%

Stand Alone Method

Total Cost to be Allocation Allocated
Allocated % Cost
Luciano ₱ 8,000 x 70% = ₱ 5,600
Ratzinger 8,000 x 20% = 1,600
Wojtyla 8,000 x 10% = 800
Total ₱ 8,000

Incremental Method
Allocated Remaining
Traceable Cost Cost Unallocated
To be allocated ₱ 8,000
Luciano ₱ 7,000 ₱ 7,000 1,000
Ratzinger 2,000 1,000 -
Wojtyla 1,000 - -
Total ₱ 10,000 ₱ 8,000

Allocating Service Department Costs

Reasons f or charging service department costs:
1. To encourage managers of operating departments to make wise use of services
provided by service departments.
2. To provide more complete cost data for making decisions in operating departments.
3. To help measure profitability in operating departments.
4. To put pressure on service departments to operate efficiently.
Charges should be based on budgeted, not actual, service department costs. Charging
based on actual costs would allow the service department to simply pass on any excess
costs and would implicitly make the operating departments responsible f or how well costs
are controlled in the service departments.
Fixed and variable service department costs should be charged separately. Charges for
variable service department costs should be based on whatever causes those costs.
Charges f or variable service department costs should be determined by multiplying the
budgeted rate by the actual level of activity in the using department. Fixed costs are
incurred to provide capacity. Therefore, f ixed costs should be charged to operating
departments in predetermined lump-sum amounts, in proportion to their demands for
capacity (the using department’s peak-period or long-run average needs).

Illustrative Example | White Company 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.
Data relating f or next year follow:

Percentage of
Peak Period Budgeted Actual
Requirements Hours Hours
Cutting Department........ 60% 75,000 80,000
Assembly Department..... 40% 50,000 40,000
Total .......................... 100% 125,000 120,000

Assume that actual Maintenance Department costs f or the year are: variable, ₱0.65 per
machine hour (₱78,000 total); f ixed, ₱210,000.
Maintenance Department Charges at the End of the Year
Cutting Assembly
Department Department
Variable cost charges:
₱0.60 per hour × 80,000 hours .......... ₱ 48,000
₱0.60 per hour × 40,000 hours .......... ₱ 24,000
Fixed cost charges:
₱200,000 × 60%............................ 120,000
₱200,000 × 40%............................ 80,000
Total cost charged............................. ₱168,000 ₱104,000

As shown below, some of the actual year-end costs are not charged to the operating
departments:

Variable Fixed
Actual costs incurred.............................. ₱78,000 ₱210,000
Costs charged above.............................. 72,000 200,000
Spending variance—not charged ............... ₱ 6,000 ₱ 10,000

The spending variance is the responsibility of the Maintenance Department and is not
charged to the operating departments.
PERFORMANCE MEASURES AND MANAGER MOTIVATION

Each responsibility center is structured such that a logical group of operations is under the
direction of a single manager. Measures are designed f or every responsibility center to
monitor performance.
Controllability. The perf ormance measures on which the manager’s incentive package
are based must be, as f ar as practicable, under the manager’s direct responsibility and
authority. “Controllable” f actors can be thought as those f actors that a manager can
inf luence in a given time period. Inevitably, some costs, especially common costs such
as the costs of central administrative functions, cannot be traced to particular activities or
responsibility centers.
Controllable cost is not synonymous with variable cost. Of ten this classif ication is
particular to the level of the organization. For instance, the f ixed cost of depreciation may
not be a controllable cost of the manager of a revenue center but is controllable by the
division vice president to which the manager reports.
Goal congruence. These perf ormance measures must be designed such that the
manager’s pursuit of them ties directly to accomplishment of the organization’s overall
goals. Sub-optimization results when segments of the organization pursue goals that are
in the segment’s own best interests rather than those of the organization as a whole.
Along with the responsibility, a manager must be granted sufficient authority to control
those f actors on which his or her incentive package is based.

PERFORMANCE MEASURES — COST, REVENUE, AND PROFIT

CENTERS (CONTRIBUTION MARGIN REPORTING)

Cost Centers and Revenue Centers

Since managers of cost and revenue centers can inf luence only one type of factor, variance
analysis is the most appropriate perf ormance measurement technique f or these
responsibility centers. To be effective, a performance measure should be based on a cause-
and-effect relationship between the outcome (effect) being measured and a driver (cause)
that is under the manager’s control. An appropriate performance measure f or a cost or
revenue center might not be even f inancial. Examples might include number of invoices
processed per hour or percentage of customer shipments correctly f illed.

Profit Centers
The Contribution Margin Approach to reporting (in contrast to the f inancial reporting
approach) is extremely usef ul in performance measurement f or prof it centers. The
contribution margin approach isolates the ef fects of variable and f ixed costs and thus
highlights the ef fects of a manager’s choices regarding improving the contribution margin.
In addition to contribution margin and operating income, this approach can also be used
to calculate multiple intermediate measures, as shown below:
 Contribution Margin Income Statement
Sales ₱ 150,000
Variable production costs ( 40,000)
Manufacturing contribution margin ₱ 110,000
Variable S&A expenses ( 20,000)
Contribution margin ₱ 90,000
Controllable fixed costs:
Fixed production costs 30,000
Fixed S&A expenses 25,000 ( 55,000)
Short-run performance margin ₱ 35,000
Traceable fixed costs:
Depreciation 10,000
Insurance 5,000 ( 15,000)
Segment margin ₱ 20,000
Allocated common costs ( 10,000)
Segment operating income ₱ 10,000

PERFORMANCE MEASURES —INVESTMENT CENTERS

Perf ormance measures f or investment center reveal how ef ficiently the manager is
deploying capital to produce income f or the organization. Thus, most perf ormance
measures relate the center’s resources (balance sheet) to its income (income statement).

Return on Investment (ROI) is one of the most widely used performance measures for
an investment center. These measures allow an investor to assess how ef fectively and
ef ficiently management is using assets to obtain a return.

Income of business unit

ROI =
Assets of business unit

Income means operating income unless otherwise noted. Operating income is known as
earnings before interest and taxes (EBIT).

Some ref erences use Average Operating Assets in the ROI Formula, instead of Total
Assets.
Net Operating Income
ROI =
Average Operating Assets

Or
Profit Margin Ratio x Asset
ROI =
Turnover Ratio

Where:

Profit Margin Ratio = Net Operating Income

Sales

Asset Turnover Ratio = Sales

Average Operating Assets
Illustrative Example | The ROI calculations f or the branch offices in previous example.

Cartagena Riyadh Mumbai Osaka

Income of business unit ₱( 6,000) ₱ 64,000 ₱ 120,000 ₱ 636,000
Total assets 121,000 825,000 1,015,000 9,900,000
Return on investment -5.0% 7.8% 11.8% 6.4%

Even though the managers of the Osaka branch generated by f ar the largest contribution,
they were not as efficient in the deployment of the resources at their disposal as were the
managers of the Riyadh or Mumbai branches. This example illustrates the principle that
the appraisal of individual perf ormance must consider more f actors than simple pesos.
Benef its with the application of ROI include, but are not limited to, the f ollowing:
1. Improve projects by analyzing data collected to determine how the projects
should change in order to achieve f avorable returns.
2. Secure funding through the use of positive ROI f orecasts.
3. Comparative analysis assists in making comparisons between dif ferent business
units in terms of profitability and asset utilization.
4. Discontinue ineffective products or operations by using ROI data to support
that the product or operation does not add value.
A limitation with the application of ROI is that an investment center with a high ROI may
not accept a profitable investment even though the investment’s return is higher than the
center’s target ROI.
Illustrative Example | An investment center has an 8% ROI, and its investors expect
2%. If the decision makers look only at current ROI, they will reject a project earning 6%,
even though that return exceeds the target.

Residual Income is a variation of ROI that measures performance in peso terms rather
than as a percentage return.
Income of business unit – (Assets of business unit x
Residual Income =
Required rate of return)

Income means operating income unless otherwise noted. Operating income is known as
earnings before interest and taxes (EBIT).

Residual income is a signif icant ref inement of the ROI concept because it f orces business
unit managers to consider the opportunity cost of capital. Opportunity cost represents
the return on the best alternative investment of similar risk that would have been
generated if management had invested.

ROI vs. Residual Income

Residual income is of ten considered preferable to ROI because it deals in absolute pesos
rather than percentages. A manager with a 10% ROI would be reluctant to invest in a
project with only an 8% return because his or her average overall return would decline.
This would be detrimental to the company as a whole if the cost of capital were only 5%.
However, under the residual income method, the manager would invest in any project with
a return greater than the cost of capital or the hurdle rate that (s)he has been assigned.
Thus, overall, the company would be better off even though the individual manager’s ROI
declined.

Illustrative Example | The residual income calculations f or the branch offices in previous
example.

Cartagena Riyadh
Income of business unit ₱( 6,000) ₱ 64,000
Total assets ₱ 121,000 ₱ 825,000
Times: Target rate of return 6% 6%
Opportunity cost of capital 7,260 49,500
Residual Income ₱( 13,260) ₱ 14,500

Mumbai Osaka
Income of business unit ₱ 120,000 ₱ 636,000
Total assets ₱ 1,015,000 ₱ 9,900,000
Times: Target rate of return 6% 6%
Opportunity cost of capital 60,900 594,000
Residual Income ₱ 59,100 ₱ 42,000

This calculation reveals that, by employing the most resources, the Osaka branch has by
f ar the highest threshold to clear f or profitability.

Additional Example — ROI | Regal Company reports the f ollowing data f or last year’s
operations:
Net operating income ................. ₱30,000
Sales...................................... ₱500,000
Average operating assets ............ ₱200,000

₱ 30,000 ₱ 500,000
ROI = x = 6% x 2.5 = 15%
₱ 500,000 ₱ 200,000

To increase ROI, at least one of the f ollowing must occur:

1. Increase sales
Assume that Regal Company is able to increase sales to ₱600,000 and net operating
income increases to ₱42,000. Also assume that operating assets are not affected.
₱ 42,000 ₱ 600,000
ROI = x = 7% x 3.0 = 21%
₱ 600,000 ₱ 200,000
(compared to 15% before)

2. Reduce expenses
Assume that Regal Company is able to reduce expenses by 10,000 per year, so
that net operating income increases f rom ₱30,000 to ₱40,000. Also assume that
sales and operating assets are not affected.
₱ 40,000 ₱ 500,000
ROI = x = 8% x 2.5 = 20%
₱ 500,000 ₱ 200,000
(compared to 15% before)
 3. Reduce operating assets
Assume that Regal Company is able to reduce its average operating assets from
₱200,000 to ₱125,000. Also assume that sales and net operating income are not
af fected.
₱ 30,000 ₱ 500,000
ROI = x = 6% x 4.0 = 24%
₱ 500,000 ₱ 125,000
(compared to 15% before)

Additional Example — ROI | Marsh Company has two divisions, A and B. Each division
is required to earn a minimum return of 12% on its investment in operating assets.

Division A Division B
Average operating assets (given) ....................... ₱1,000,000 ₱3,000,000

Net operating income (given) ............................ ₱ 200,000 ₱ 450,000

Minimum required return:
12% × average operating assets ..................... 120,000 360,000
Residual income............................................. ₱ 80,000 ₱ 90,000

Marsh Company’s Division A has an opportunity to make an investment of ₱250,000 that

would generate a return of 16% on invested assets (i.e., ₱40,000 per year). This
investment would be in the best interests of the company because the rate of return of
16% exceeds the minimum required rate of return. However, this investment would reduce
the division’s ROI:

New
Present Project Overall
Average operating assets (a)............ ₱1,000,000 ₱250,000 ₱1,250,000
Net operating income (b)................. ₱200,000 ₱40,000 ₱240,000
ROI (b) ÷ (a) .............................. 20.0% 16.0% 19.2%

On the other hand, this investment would increase the division’s residual income:

Average operating assets (a)............ ₱1,000,000 ₱250,000 ₱1,250,000

Net operating income (b)................. ₱ 200,000 ₱ 40,000 ₱ 240,000

Minimum required return:
12% × (a) ............................... 120,000 30,000 150,000
Residual income ............................ ₱ 80,000 ₱ 10,000 ₱ 90,000

Comparability Issues with Investment Center Performance Measures

Alternative income measurements include income of business unit, income of business
unit adjusted f or price level changes, cash f low, and earnings before interest and taxes
(EBIT).

Invested capital may be def ined in various ways, f or example, as

1. Total assets available
2. Total assets employed, which excludes assets that are idle, such as vacant land
 3. Working capital plus other assets, which excludes current liabilities (i.e., capital
provided by short-term creditors). This investment base assumes that the manager
controls short-term credit.
Dif f erent attributes of f inancial inf ormation will also af fect the elements of the investment
base.
1. Historical cost
2. Replacement cost
3. Market value
4. Present value
The comparability of perf ormance measures may be af f ected by dif f erences in the
accounting policies used by dif f erent business units. For example, policies regarding
depreciation, decisions to capitalize or expense, inventory f low assumptions, and revenue
recognition can lead to comparability issues f or performance measures. These dif ferences
may be heightened f or the business units of a multinational enterprise.
Issues other than accounting policy may also af fect comparability.
1. Dif f erences in the tax systems in the jurisdictions where business units operate
2. The presence of items that are of an unusual nature and/or occur inf requently
3. Allocation of common costs
4. The varying availability of resources
Perf ormance evaluation in multinational companies is impacted by the f ollowing:
1. Expropriation is a f oreign government’s seizure (nationalization) of the assets of
a business f or a public purpose and f or just compensation.
2. Repatriation is conversion of funds held in a f oreign country into another currency
and remittance of these f unds to another nation. A f irm of ten must obtain
permission f rom the currency exchange authorities to repatriate earnings and
investments. Regulations in many nations encourage a reinvestment of earnings in
the country.
3. Tariffs are taxes imposed on imported goods. Tariffs can discourage consumption
of f oreign goods, raise revenue, or both.
4. Import quotas set limits on the quantity of dif f erent products that can be
imported.
5. Inflation risk is the risk that purchasing power of the currency will decline.
6. Exchange rate risk is the risk of loss because of f luctuation in the relative value
of a f oreign currency in which the investment is payable.
7. Political risk is the probability of loss f rom actions of governments, such as
changes in tax laws or environmental regulations or expropriation of assets.

Revenue and Expense Recognition Principles

A company’s revenue and expense recognition policies may af fect the measurement of
income and thus reduce comparability among business units. For example, a company
that uses last-in, f irst-out (LIFO) f or inventory valuation will of ten show lower inventories
and higher costs than a company that uses the f irst-in, first out (FIFO) methodology. As a
result, the company could appear to have a lower rate of return than if it had used the
FIFO method. Other ratios would also be impacted, such as inventory turnover and asset
turnover.
Thus, when comparing companies or units on the basis of either ROI or residual income,
the analyst must be sure that both companies or units are using the same accounting
policies in the determination of income.
The sharing of assets by subunits within an organization may also af f ect measures of
return. For instance, assets normally appear on the books of only one division, even though
another division might have access to those assets. Therefore, the division that shares its
assets with another division may find that it has a lower rate of return than the division
that has access to the use of the assets.
Similarly, a company or division that uses straight-line depreciation on its plant assets will
have lower expenses in the early years of an asset's lif e than if an accelerated method
were being used. Thus, the straight-line division would appear to be more profitable than
the division using the accelerated method. Of course, the accelerated method may be
pref erred by top management because it results in a tax savings, but the implication of
the ROI measure might be that the straight-line division is more profitable.
International operations may not always be comparable to domestic divisions, since the
complication of changes in f oreign-currency exchange rates might make income
comparisons difficult. Also, transfer pricing is complicated in the international arena, since
dif f erences in tax rates between countries may have a role in the selection of the transfer
prices selected. For example, a company will set a transf er price at a level that will limit
the prof its in high-tax countries and shift that profit to the low-tax country. Similarly, high
prof its in a f oreign country might not always be transferable to the home country; thus,
to say that the f oreign subsidiary is more profitable is meaningless if that profit cannot be
enjoyed by the parent company.

Economic Profit, EVA, and MVA

Economic prof it and economic value-added measures stress the importance of making
investments only when the return exceeds cost and, in the process, value to the
stockholder is maximized. Economic profit is accounting profit minus the cost of capital.
EVA is a variation of economic profit. Economic Value Added (EVA) is net operating profit
(income) af ter taxes (NOPAT) minus the af ter-tax weighted-average cost of capital
(WACC) multiplied by total assets (TA) minus current liabilities (CL) (net assets).

EVA = Net operating profit after taxes (NOPAT) – [(TA – CL) × WACC]

Market value added is the dif ference between the market value of a company (both equity
and debt) and the capital that lenders and shareholders have entrusted to it over the years
in the f orm of loans, retained earnings and paid-in capital. Market value added is a
measure of the dif ference between “cash in” (what investors have contributed) and “cash
out” (what they could get by selling at today’s prices).

MVA = Market Value Equity (shares outstanding x market price) – Equity

Supplied by Shareholders

OTHER PERFORMANCE MEASURES

The Balanced Scorecard consists of an integrated set of perf ormance measures—

f inancial and non-financial—that are derived from the company’s strategy and that support
the company’s strategy throughout the organization. Importantly, the measures included
in a company’s balanced scorecard are unique to its specific strategy.
The balanced scorecard enables top management to translate its strategy into f our groups
of perf ormance measures – financial, customer, internal business process, and
learning and growth − that employees can understand and inf luence.
1. Financial Perspective. This perspective f ocuses on return on investment and
other supporting f inancial performance measures. Example performance measures
include prof itability, return on invested capital, and revenue growth.
2. Customer perspective. This perspective focuses on performance in areas that are
most critical to the customer. Example performance measures include customer
satisf action and customer retention.
3. Internal business processes perspective. This perspective f ocuses on
operating ef fectively and efficiently and includes perf ormance measures on cost,
quality and time f or processes that are critical to the customers. It f ocuses on
business processes, which are the structured activities of an organization that
produce a product or service. Example performance measures include number of
def ects and cycle time.
4. Learning and growth perspective. This perspective f ocuses on perf ormance
measures relating to employees, infrastructure, teaming and capabilities necessary
f or the internal processes to achieve customer and f inancial objectives. Example
perf ormance measures include employee satisf action, hours of training per
employee, and inf ormation technology expenditures per employee.

The premise of these f our groups of measures is that learning is necessary to improve
internal business processes, which in turn improves the level of customer satisf action,
which in turn improves f inancial results.

The balance scorecard relies on non-financial measures in addition to f inancial measures

f or two reasons:

1. Financial measures are lag indicators that summarize the results of past actions.
Non-f inancial measures are leading indicators of f uture f inancial performance.
2. Top managers are ordinarily responsible f or f inancial performance measures – not
lower level managers. Non-financial measures are more likely to be understood and
controlled by lower level managers.

While the entire organization has an overall balanced scorecard, each responsible
individual should have his or her own personal scorecard as well. A personal scorecard
should contain measures that can be inf luenced by the individual being evaluated and that
support the measures in the overall balanced scorecard.
A balanced scorecard, whether f or an individual or the company as a whole, should have
measures that are linked together on a cause-and-effect basis. In essence, the balanced
scorecard lays out a theory of how a company can take concrete actions to attain desired
outcomes. If the theory proves f alse or the company alters its strategy, the measures
within the scorecard are subject to change.
Incentive compensation for employees probably should be linked to balanced
scorecard performance measures. However, this should only be done af ter the
organization has been successfully managed with the scorecard f or some time – perhaps
a year or more. Managers must be conf ident that the measures are reliable, not easily
manipulated, and understandable by those being evaluated with them.
Some Important Measures of Internal Business Process Performance

Delivery cycle time is the elapsed time f rom when a customer order is received to when
the completed order is shipped.
Throughput (manufacturing cycle) time is the amount of time required to turn raw
materials into completed products. This includes process time, inspection time, move time,
and queue time. Process time is the only value-added activity of the f our mentioned.
Manufacturing cycle efficiency (MCE) is computed by dividing value-added time by
throughput time. An MCE less than 1.0 indicates that non-value-added time is present in
the production process.

Value-added time Process time

MCE = =
Throughput time Throughput time

An MCE of 0.4 indicates that 60% (1.0 – 0.4 = 0.6) of the total production time consists
of queuing, inspection, and move time, and theref ore only 40% of the total time is
productive. Reducing the non-value-added activities of queuing, inspection, and moving
will lead to improvement in MCE.

Cycle Time and Velocity

Cycle Time is the time required to produce a unit of output.

Cycle Time = Time ÷ Units Produced

Velocity is the number of units of output that can be produced in a given period of time.
Velocity = Units Produced ÷ Time

Productivity is the relationship between outputs and inputs

Productivity = Output ÷ Input

Partial Productivity is the ratio of output to the quantity of a single f actor of

production. Example: output per direct material.
Total Productivity (or Total Factor Productivity) is the ratio of output to the cost of
all relevant inputs used.
TRANSFER PRICING

Transfer prices are the amounts charged by one segment of an organization for goods and
services it provides to another segment of the same organization. The principal challenge
is determining a price that motivates both the selling and the buying manager to pursue
organizational goal congruence.
In a decentralized system, each responsibility center theoretically may be completely
separate. Thus, Division A should charge the same price to Division B as would be charged
to an outside buyer. The reason f or decentralization is to motivate managers, and the best
interests of Division A may not be served by giving a special discount to Division B if the
goods can be sold at the regular price to outside buyers. However, having A sell at a
special price to B may be to the company's advantage.

Transfer Pricing Schemes

Four basic methods of transfer price setting are in common use: variable cost, full cost,
market price, and negotiated price.
1. Variable Cost. By allowing the buyer to purchase at the selling division's variable
cost, unused production capacity will be utilized (this method should only be used
when the selling division has excess capacity).
However, there is no incentive f or the selling division, since it will be producing the
products at a loss (even though the company as a whole will benef it f rom the
arrangement). In practice, companies who wish to f ollow this philosophy actually
adopt a negotiation policy wherein the transfer price will be something greater than
variable costs but less than f ull costs. At least the seller would have a positive
contribution margin if the price is set slightly above variable costs.
The advantage of using variable costs is that the buyer is motivated to solve the
company's excess capacity problem, even though that excess capacity is not in the
buyer's division.

2. Full (Absorption) Cost. Full (absorption) cost includes materials, labor, and full
allocation of manufacturing overhead. The use of full (absorption) cost ensures that
the selling division will not incur a loss and provides more incentive to the buying
division to buy internally than does use of market price. However, there is no
motivation f or the seller to control production costs since all costs can be passed
along to the buying division.

3. Market Price. A market price is the best transfer price to use in many situations.
For example, if the selling division is operating at f ull capacity and can sell all of its
output at the market price, then there is no justif ication to use a lower price as the
transf er price f or intracompany transfers.
Alternatively, if the selling division is not producing at f ull capacity, the use of
market prices f or internal transfers is not justif ied. A lower price might be more
motivational to either the buyer or the seller.

4. Negotiation. A negotiated price may result when organizational subunits are free
to determine the prices at which they buy and sell internally. Hence, a transfer
price may simply ref lect the best bargain that the parties can strike between
themselves. The transfer price need not be based directly on particular market or
cost inf ormation. A negotiated price may be especially appropriate when market
prices are subject to rapid f luctuation.

The lowest acceptable price f rom the viewpoint of the selling division:

Transfer ≥ Variable Total Contribution Margin Lost Sales

+
Price Cost Number of Units Transferred

The highest acceptable price f rom the viewpoint of the buying division when the
unit can be purchased f rom an outside supplier:

Transfer ≤ Cost of Buying f rom Outside Supplier

Price

Illustrative Example | The Battery Division of Barker Company makes a standard

12-volt battery.

Production capacity (number of batteries)..... 300,000

Selling price per battery to outsiders ........... ₱40
Variable costs per battery ......................... ₱18
Fixed costs per battery (based on capacity)... ₱7

Barker Company has a Vehicle Division that could use this battery in its f orklift
trucks. The Vehicle Division would like to buy 50,000 batteries per year. It is
presently buying these batteries f rom an outside supplier f or ₱39 per battery.

Battery
Division Selling price: $40 Outside
Market
for
Transfer Price: ? Vehicle
Batteries

Purchase price: $39

Vehicle
Division

Forklift
Trucks

Situation 1. Suppose the Battery Division is operating at capacity. What is the

lowest acceptable transfer price f rom the viewpoint of the selling division?

Transfer Variable Total Contribution Margin Lost Sales

≥ +
Price Cost Number of Units Transferred
Transfer (₱40-₱18) x 50,000
≥ ₱ 18 +
Price 50,000

Transfer ≥ ₱18 + (₱40-₱18) = ₱40

Price
But the buying division will not pay more than ₱39, the cost f rom buying the
batteries f rom the outside. So, the two managers will not be able to agree to a
transf er price and no transf er will voluntarily take place.

Transfer ≤ Cost of Buying f rom Outside Supplier = ₱39

Price

From the standpoint of the entire company, no transfer should take place because
the company gives up ₱40 in revenues, but saves only ₱39 in costs.

Situation 2. Assume again that the Battery Division is operating at capacity, but
suppose that the division can avoid ₱4 in variable costs, such as selling
commissions, on transf ers within the company. What is the lowest acceptable
transf er price f rom the viewpoint of the selling division?

Transfer (₱40-₱18) x 50,000

≥ (₱18-₱4) +
Price 50,000

≥ ₱14 + (₱40-₱18) = ₱36

Once again, the buying division will not pay more than ₱39, the cost from buying
the batteries f rom the outside. In this case an agreement is possible. Any transfer
price within the range ₱36 ≤ Transfer price ≤ ₱39 will increase the profits of both
of the divisions. From the standpoint of the entire company, this transf er should
take place because the cost of the transfer is ₱36 and the company saves ₱39, for
a net gain of ₱3.
Situation 3. Ref er to the original data. Assume that the Battery Division has
enough idle capacity to supply the Vehicle Division’s needs without diverting
batteries f rom the outside market, but there is no savings in variable costs on the
transf er inside the company. What is the lowest acceptable transfer price from the
viewpoint of the selling division? In this case there are no lost sales.

Transfer ₱0
≥ ₱ 18 +
Price 50,000
≥ ₱ 18

Once again, the buying division will not pay more than ₱39, the cost of buying the
batteries f rom the outside. And again, in this case an agreement is possible. Any
transf er price within the range ₱18 ≤ Transfer price ≤ ₱39 will increase the profits
of both of the divisions. From the standpoint of the entire company, this transfer
should take place because the cost of the transfer is ₱18 and the company saves
₱39, f or a net gain of ₱21.

Situation 4. The Vehicle Division wants the Battery Division to supply it with
20,000 special heavy-duty batteries. The variable cost for each heavy-duty battery
would be ₱27. The Battery Division has no idle capacity. Heavy-duty batteries
require more processing time than regular batteries; they would displace 22,000
regular batteries f rom the production line. What is the lowest acceptable transfer
price f rom the viewpoint of the selling division?
 Transfer (₱40-₱18) x 22,000
≥ ₱27 +
Price 20,000
≥ ₱27 + ₱24.20 = ₱51.20

In this case, the opportunity cost of producing one of the special batteries is ₱24.20,
the average amount of lost contribution margin.

Choice of Transfer Pricing Policy

The choice of a transfer pricing policy (which type of transf er price to use) is normally
decided by top management at the corporate level. The decision typically includes
consideration of multiple f actors.
1. Goal congruence factors. The transfer price should promote the goals of the
company as a whole.
2. Segmental performance factors. The segment making the transfer should be
allowed to recover its incremental cost plus its opportunity cost of the transfer. The
opportunity cost is the benef it f orgone by not selling to an outsider. For this
purpose, the transfer should be at market price. The selling manager should not
lose income by selling within the company.
Properly allocating revenues and expenses through appropriate transfer pricing also
f acilitates evaluation of the performance of the various segments.
3. Negotiation factors. If the purchasing segment could purchase the product or
service outside the company, it should be permitted to negotiate the transfer price.
The purchasing manager should not have to incur greater costs by purchasing
within the company.
4. Capacity factors. If Division A has excess capacity, it should be used for producing
products f or Division B. If Division A is operating at f ull capacity and selling its
products at the f ull market price, profitable work should not be abandoned to
produce f or Division B.
5. Cost structure factors. If Division A has excess capacity and an opportunity arises
to sell to Division B at a price in excess of the variable cost, the work should be
perf ormed f or Division B because a contribution to cover the f ixed costs will result.
6. Tax factors. A wide range of tax issues on the interstate and international levels
may arise, e.g., income taxes, sales taxes, value-added taxes, inventory and
payroll taxes, and other governmental charges.
In the international context, exchange rate f luctuations, threats of expropriation,
and limits on transfers of profits outside the host country are additional concerns.
Thus, because the best transfer price may be a low one because of the existence
of tarif fs or a high one because of the existence of f oreign exchange controls, the
ef fect may be to skew the performance statistics of management.
The high transf er price may result in f oreign management appearing to show a
lower return on investment than domestic management, but the ratio dif ferences
may be negated by the f act that a dif f erent transfer pricing f ormula is used.

Illustrative Example | Division A produces a small part at a cost of ₱6 per unit. The
regular selling price is ₱10 per unit. If Division B can use the part in its production, the
cost to the company (as a whole) will be ₱6. Division B has another supplier who will sell
the item to B at ₱9.50 per part. Division B wants to buy the ₱9.50 part from the outside
supplier instead of the₱10 part f rom Division A, but making the part f or ₱6 is in the
company's best interest. What amount should Division A charge Division B?
The answer is complicated by many factors. For example, if Division A has excess capacity,
B should be charged a lower price. If it is operating at f ull capacity, B should be charged
₱10.
Also consider what portion of Division A's costs is f ixed. For example, if a competitor
of fered to sell the part to B at ₱5 each, can Division A advantageously sell to B at a price
lower than ₱5? If Division A's ₱6 total cost is composed of ₱4 of variable costs and ₱2 of
f ixed costs, it is benef icial f or all concerned f or A to sell to B at a price less than ₱5. Even
at a price of ₱4.01, the parts would be providing a contribution margin to cover some of
A's f ixed costs.

Dual Pricing
Under dual pricing, the selling and buying units record the transfer at dif ferent prices. For
example, the seller could record the transfer to another segment as a sale at the usual
market price that would be paid by an outsider. The buyer, however, would record a
purchase at the variable cost of production. Each segment's reported perf ormance is
improved by the use of a dual-pricing scheme. The f irm as a whole would benefit because
variable costs would be used f or decision-making purposes. In a sense, variable costs
would be the relevant price f or decision-making purposes, but the regular market price
would be used f or evaluation of production divisions.
However, under a dual-pricing system, the prof it f or the company will be less than the
sum of the prof its of the individual segments. In ef f ect, the seller is given a corporate
subsidy. The dual-pricing system is rarely used because the incentive to control costs is
reduced. The seller is assured of a high price, and the buyer is assured of an artif icially
low price. Thus, neither manager must exert much effort to show a prof it on segmental
perf ormance reports. Also, an elimination entry must be recorded at the end of the period
to reconcile the f act that sales were recorded at an amount dif f erent f rom the
corresponding purchases.
Illustrative Example | Division 1, which produces a product at a cost of ₱10 per unit
may be allowed to sell to Division 2 at a transfer price of ₱15. Division 2, on the other
hand, may be allowed to record the purchase of the goods from Division 1 at a transfer
price (or purchase cost) of ₱10. If Division 2 incurs ₱4 to process each unit received from
Division 1 and sells it at ₱18, the result will be as f ollows

DIVISION 1 DIVISION 2
Sales to Division 2 ₱ 15 Sales ₱ 18
Cost 10 Costs:
Profit ₱ 5 From Div. 1 ₱ 10
Processing Cost 4 14
Profit ₱ 4

In this case, both divisions will be happy because each one satisfies its needs — selling at
a prof it and buying at a low purchase price.