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Chapter Five: Responsibility Accounting and Transfer Pricing
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
5-2
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.)
5-3
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
5-4
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.
5-5
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
5-6
Profit Center - Problems
Setting appropriate transfer prices on goods
and services transferred within the firm
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)
5-8
Return on Investment
Return on Investment (ROI) =
Accounting net income for an investment center
Total assets invested in that investment center
5-9
Residual Income
Residual income (RI) =
Accounting net income of investment center
(Required rate of return Capital invested in that center)
5-10
Economic Value Added
EVA is a refinement of residual income that uses economic measures of
income and capital rather than financial accounting measures.
5-11
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
5-12
Investment Center - Problems
Disputes over how to measure income and capital.
5-13
Controllability Principle
Controllability Principle:
Hold center managers responsible for only those costs
and decisions for which they have authority
5-14
What Might Cause Overinvestment?
5-15
How Could You Deter Underinvestment if
You are Limited to the Use of ROI?
5-16
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
5-17
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
5-18
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
5-19
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
5-20
Transfer Pricing Implementation
Disputes over transfer pricing occur frequently because transfer
prices influence performance evaluation of managers
5-21
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.
5-22