Chapter Five

Responsibility Accounting and Transfer

Pricing

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Outline of Chapter 5
Responsibility Accounting and
Transfer Pricing

 Responsibility Accounting
 Transfer Pricing

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 Responsibility Accounting
Characteristics of responsibility centers are:
 Knowledge of the centers’ managers is difficult to acquire,
maintain, or analyze at higher levels
 Decision rights are specified for each center
 Performance measurement is obtained from internal
accounting system
(Recall organizational architecture concepts in Chapter 4.)

Types of responsibility centers: cost, profit, investment.

See Table 5-1.

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 Cost Center - Design
Knowledge:
 Central manager knows optimal production quantity and budget
 Cost center manager knows how to optimally mix inputs

Decision rights:
 Cost center manager chooses quantity and quality of inputs used in
cost center (labor, material, supplies)

Measurement:
 Minimize total cost for a fixed output
 Maximize output for a fixed budget

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 Cost Center - Problems
 Minimizing average costs does not
necessarily maximize profits. Cost centers
have an incentive to produce more units to
spread fixed costs over a large number of
units.

 Quality of products produced by cost center

must be monitored.

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 Profit Center - Design
Knowledge:
 Profit center managers’ knowledge of product mix, demand, and
pricing is difficult to transfer to central management

Decision rights:
 Can chose input mix, product mix, and selling prices
 Given fixed capital budget

Measurement:
 Actual profits
 Actual profits compared to budget

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 Profit Center - Problems
 Setting appropriate transfer prices on goods
and services transferred within the firm

 How to allocate corporate overhead costs to

responsibility centers

 Profit centers that focus only on their own

profits often ignore how their actions affect
other responsibility centers
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 Investment Centers
Knowledge:
 Investment center manager has knowledge of investment
opportunities and operating decisions

Decision rights:
 Ratify and monitor decisions of cost and profit centers
 Decide amount of capital invested or disposed

Measurement:
 Return on Investment (ROI)
 Residual Income (RI)
 Economic Value Added (EVA)

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 Return on Investment
Return on Investment (ROI) =
Accounting net income for an investment center
 Total assets invested in that investment center

DuPont formula separates ROI into two components:

ROI = Sales turnover  Return on sales
ROI = (Sales  Total Investment)  (Net Income  Sales)

ROI increases with smaller investments and larger profit margins.

Focusing on ROI can cause underinvestment.

See Self Study Problem 1, part a.

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 Residual Income
Residual income (RI) =
Accounting net income of investment center
 (Required rate of return  Capital invested in that center)

 RI is determined with financial accounting measurements

of net income and capital
 Each investment center could be assigned a different
required rate of return depending on its risk
 RI can be increased by increasing income or decreasing
investment

See Self Study Problem 1, part b.

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 Economic Value Added
EVA is a refinement of residual income that uses economic measures of
income and capital rather than financial accounting measures.

Economic value added (EVA) =

Adjusted accounting net income of investment center
 (Weighted average cost of capital  Capital invested in that center)

Examples of EVA adjustments to accounting:

 Research and development (R&D) is amortized over 5 years for EVA,
but expensed immediately for financial accounting.
 Unamortized R&D is included in capital for EVA, but treated is
treated as an expired cost (zero value) for financial accounting.

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 Economic Value Added
 EVA can be increased by three basic methods:
 Increase the efficiency of existing operations, and thus
the spread between the investment return and the
firm’s weighted average cost of capital
 Increase the amount of capital invested in projects
with positive spreads between investment return and
the firm’s weighted average cost of capital
 Withdraw capital from operations where the
investment return is less than the firm’s weighted
average cost of capital

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 Investment Center - Problems
 Disputes over how to measure income and capital.

 Difficult to compare investment centers of

different sizes.

 Firm’s central management must monitor product

quality and market niches of investment centers to
reduce possibility for self-interested investment
center to damage firm’s reputation.

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 Controllability Principle
Controllability Principle:
 Hold center managers responsible for only those costs
and decisions for which they have authority

Drawbacks of controllability principle:

 If managers suffer no consequences from events
outside their direct control, they have no incentive to
take actions that can affect the consequences of
uncontrollable events (such as storms, corporate
income taxes, etc.)

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What Might Cause Overinvestment?

 Discuss the implications of using ROI, RI,

and/or EVA individually or in combinations
as a way to preclude “overinvestment”.

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 How Could You Deter Underinvestment if
You are Limited to the Use of ROI?

 Provide a solution which is

 Practical – from a cost/effectiveness point of
view, and
 Effective – from a goal congruence point of
view
 Be specific!

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 Transfer Pricing - Defined
Transfer Price defined:
the internal price (or cost allocation) charged by one segment of a
firm for a product or service supplied to another segment of the
same firm

Examples of transfer prices:

 Internal charge paid by final assembly division for components
produced by other divisions
 Service fees to operating departments for telecommunications,
maintenance, and services by support services departments
 Cost allocations for central administrative services (general
overhead allocation)

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 Transfer Pricing and Firm Value
Transfer prices have multiple effects on firm value:

Performance measurement:
 Reallocate total company profits among business segments
 Influence decision making by purchasing, production, marketing,
and investment managers

Rewards and punishments:

 Compensation for divisional managers

Partitioning decision rights:

 Disputes over determining transfer prices

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 Ideal Transfer Pricing
Ideal transfer price would be
 Opportunity cost, or the value forgone by not
using the transferred product in its next best
alternative use
 Opportunity cost is the greater of variable
production cost or revenue available if the
product is sold outside of the firm

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 Transfer Pricing Methods
 External market price
 If external markets are comparable
 Variable cost of production
 Exclude fixed costs which are unavoidable
 Full-cost of production
 Average fixed and variable cost
 Negotiated prices
 Depends on bargaining power of divisions

See Self-Study Problem 2.

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 Transfer Pricing Implementation
 Disputes over transfer pricing occur frequently because transfer
prices influence performance evaluation of managers

 Internal accounting data are often used to set transfer prices,

even when external market prices are available

 Classifying costs as fixed or variable can influence transfer

prices determined by internal accounting data

 To reduce transfer pricing disputes, firms may reorganize by

combining interdependent segments or spinning off some
segments as separate firms

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 Transfer Pricing for
International Taxation
When products or services of a multinational firm are transferred between
segments located in countries with different tax rates, the firm attempts to
set a transfer price that minimizes total income tax liability.

Segment in higher tax country:

Reduce taxable income in that country by charging high prices on imports
and low prices on exports.

Segment in lower tax country:

Increase taxable income in that country by charging low prices on imports
and high prices on exports.

Government tax regulators try to reduce transfer pricing manipulation.

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