Responsibility Transfer Price

Chapter 13:
Responsibility Accounting, Support

Department Cost Allocations, and
Transfer Pricing
Cost Accounting Principles, 9e
Raiborn ● Kinney
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accessible website, in whole or in part.
Learning Objectives
 Which factors determine whether a firm should be
decentralized or centralized?
 How are decentralization and responsibility accounting
related?
 What are the four primary types of responsibility centers, and
what distinguishes them from each other?
 How are revenue variances computed?
 Why and how are support department costs allocated to
operating departments?
 What types of transfer prices are used in organizations, and
why are such prices used?
 What difficulties can be encountered by multinational
companies using transfer prices?
Organizational Structure
 Centralization
Decentralization
 Top management delegates
makes all major
authority,
decisions and
retains full authority
responsibility, and decision-making
and responsibility
rights
for the
to
organization’s
subunit managers
activities
Decentralization Continuum (slide 1 of 2)
Factor Centralized Decentralized
Age of firm Young Mature
Size of firm Small Large
Stage of product
development Stable Growth
Growth rate Slow Rapid
Impact on profits
of incorrect decisions High Low
Management’s
confidence in
subordinates Low High
Degree of control Tight Moderate/loose
Decentralization Continuum (slide 2 of 2)
Factor Centralized Decentralized
Geographic
diversity Local Widespread
Cost of communications Low High
Ability to resolve
conflicts Easy Difficult
Level of employee
motivation Low Moderate to high
Level of organizational
flexibility Low High
Response time to
changes Slow Rapid
Advantages and Disadvantages of
Decentralization
 Advantages  Disadvantages
 Lack of goal congruence
 Personnel
 Train and screen aspiring  Suboptimization
managers  Pursuing the subunit
 Develop leadership manager’s goals instead of
qualities, problem-solving the company’s goals
abilities, and decision-  Requires more effective
making skills communication skills
 Compare managers’ results  Managers must relinquish
 Increase job satisfaction control
and job enrichment  Expensive
 Effective means of  Train managers in decision-
achieving organizational making skills
goals  Absorb cost of poor decisions
 Reduces decision-making  Requires a sophisticated
time planning and reporting system
 Allows management by
exception
Responsibility Accounting
Managers delegate decision-making authority
but retain responsibility for outcomes.
 Reporting system
 Provides information about subunits
 Allows management to measure subunit performance
 Consistent with
 Standard costing
 Activity-based costing
 Monetary and nonmonetary
 Adjusted for the planning, controlling, and decision-
making needs of each unit manager
 Separates costs as controllable or noncontrollable
by the unit manager
Responsibility Report
DEPARTMENT MANAGER
Budgeted Actual
Costs Costs Variance
Itemized Costs
Controllable
Noncontrollable
Nonmonetary items
Nonmonetary Measures
 Reductionmeasures
Capacity of non-value-added time
 Target ROIsuggestions received/implemented
Employee
 Desired/actual
Unplanned production
market share
interruptions
 Throughput
Schedule changes
 Defects
Engineering changes
 Backorders
Safety violations
 Complaints
Absenteeism
 On-time delivery
 Manufacturing cycle efficiency
Control Process Steps
 Prepare a plan using budgets and standards and
use it to communicate output expectations and
delegate authority
 Use responsibility accounting system gather, record,
and summarize data for each organizational unit
 Monitor the differences between planned and actual
data at scheduled intervals
 Exert influence in response to significant differences
 Continue comparing data and responding and then
begin the process again
Responsibility Reporting
 Upward flow of information
 From operations to top management
 Unit level reports are detailed
 Upper-level reports are summarized
 Encourages management by exception
 Major deviations are highlighted
Responsibility Reporting System
Division data
are reported
to the CEO
To CEO
Department Division A Total
data are
Division B Total
reported to
Total for Company
the Division
Division A
Division B
Dept Q Totals
Dept X Totals
Dept R Totals
Dept Y Totals
Total for Division
Total for Division
Dept Q Costs Dept R Costs
Itemized Itemized
Total for Dept Total for Dept
Disadvantages of Responsibility
Accounting
 Disadvantages of responsibility accounting
include
 Important details may not be visible at upper
management levels
 Managers might “promote” their unit while
“blaming” their competitor units
 Could lead to lack of goal congruence
 Departmental interdependencies might not be
visible
Responsibility Centers
 Responsibility
accounting systems
identify, measure, and
report on activities in
responsibility centers
 Cost center
 Revenue center
 Profit center
 Investment center
Cost Centers
 Authority to incur costs
 Evaluated on how well costs are controlled
 Revenues
 Do not exist
 Example: equipment maintenance center

 Exist but are not under manager’s control
 Example: community libraries
 Exist but cannot be measured
 Example: R&D center
 Focus on variances outside acceptable range
Revenue Centers
 Responsible for generating revenue

 No control of selling price or costs
 Example: Individual sales departments in retail stores
 Revenue and Limited Cost Center
 Some involvement in planning and controlling
costs
Profit Centers
 Responsible for generating revenues—set
selling prices
 Responsible for controlling expenses —allowed
to purchase at most economical price
 Goal is to maximize the center’s profit
 Independent units
 Examples:
 Bank branches
 Educational divisions
 18-wheelers
 Evaluate on profit variance
Investment Centers
 Responsible for generating revenues and

planning and controlling expenses
 Responsible for plant assets
 Goal is maximize rate of return on assets
 Evaluate on rate of return on assets and
other performance measures
 Example: Divisions or subsidiaries
Responsibility Centers
 To control cost center performance,

management may:
 Assign costs incurred in cost centers to revenue-
producing areas through service department cost
allocation
 “Create” revenue through a system of internal
charges (charge-backs) for the center’s tangible
or intangible output used by other company units
Service Department Cost Allocation
 Service departments  Administrative

provide functional tasks departments provide
for other internal units management activities
 Purchasing for the organization
 Maintenance  Human resources
 Engineering  Accounting
 Security  Legal
 Warehousing  Insurance
Allocating Service Costs: Full Cost
Objective
 Reasons against:
for:
 Managers
Cost recovery
cannot control costs
 Awareness
Arbitrary costs
of support
not useful
costs
in decision making
 “Fair share”
Confuses costing
of costs
and pricing issues
 Regulations for some pricing instances
Allocating Service Costs: Motivation
for Managers Objective
for:
 Distorts profits
Awareness of support
with subjective
costs in allocations
production managers
 Relates unit’s
Managers cannot
profitcontrol
to totalcosts
company profits
 Reflects
Not material
usage
to profits
of services
 Encourages
Creates interdivisional
cost control ill will
 Encourages
Not cost beneficial
usage of certain services
Allocating Service Costs: Compare
Alternate Courses of Action Objective
for:
 Unnecessary
Relevant information
if costs helps
do notcompare
change among
alternatives
alternatives
 Provides allocations
Arbitrary best cost estimates
distort cash
when
flow
comparing
and profitsalternatives
for
alternatives
Allocation Bases for Service
Department Costs
 Rational and systematic base
 Benefit received by revenue-producing department
 Causal relationship
 Fairness or equity of the allocations
 Ability of revenue-producing department to bear the
allocated cost
 Methods
 Direct method
 Step method
 Benefits-provided ranking
 Algebraic method
 Simultaneous equations
Direct Method
Assigns costs straight to revenue-producing areas
Service Revenue
1 2 A B C
Step 1 $
Step 2 $
Does not recognize service provided
to other service departments
Service Method
Partially recognizes relationships
among service departments
Service Revenue
1 2 A B C
Step 1 $
Step 2 $
Does not recognize the two-way exchange of
services between service departments
Algebraic Method Provides the best
allocation
information
Service Revenue
1 2 A B C
At the $
same
time $
Recognizes all interrelationships among departments
Service Cost Allocation
 Allocated service department costs are

included in the overhead application rate for
the revenue-producing areas
 Service department costs are allocated to
products or jobs through normal overhead
assignment procedures
Transfer Pricing
 Internal charges for the  Advantages
exchange of goods or services  Encourage development
within the organization
of beneficial services
 Promote goal congruence
 Promote cost
 Ensure optimal resource
allocation consciousness of
 Promote operational efficiency services provided
 Promote making a
 Make performance evaluation
among segments more service department a
comparable profit center
 Transform a cost center into a
pseudo-profit center Transfer prices are for internal use
 Encourages managers to be only. They are eliminated on external
entrepreneurial financial reports.
Setting the Transfer Price
 Maximum—no higher than the lowest

market price
 Minimum—no less than the sum of
 Selling segment’s incremental costs plus
 The opportunity cost of the facilities used
 Ease of determining the transfer price

 Managers should understand how to
compute and evaluate the transfer price
Cost-Based Transfer Prices
 Definition of cost
 Variable cost vs. absorption cost
 Actual vs. standard
 Standard cost is superior to actual cost

 Actual costs vary according to season and
production volume
 Standard costs are stable measures of
production costs
 Variances are attributed to selling division
Market-Based Transfer Prices
 Objective, arm’s-length measure

 Potential problems when the market
determines the transfer price
 No exact counterpart in the external market
 Ignores internal cost savings
 Market price varies
 Current depressed price vs. long-run market price
 Different prices, discounts, and credit terms for
different buyers
Negotiated Transfer Prices
 Below market purchase price

 Above the incremental and opportunity costs
of the selling unit
 If negotiation fails
 Managers can purchase on the market
 Arbitration by top management
Dual Pricing
 Seller transfers at market or negotiated price

 Buyer records transfer at cost-based amount
 Eliminates need to divide profits artificially
 Provides relevant information for decision
making and performance evaluation
 Requires internal reconciliation
Advantages and Disadvantages of
Transfer Pricing Systems
 Advantages
Disadvantages
 May cause
Permit evaluation
disagreement
of segment
amongperformance
managers
 Allow costs
Adds for rational
and takes
acquisition
time of goods and services between
 corporate
May not workdivisions
for all departments

 Provide
May causeflexibility to respondortooverutilization
underutilization changes of services

 Encourage
May cause and reward goal
dysfunctional congruencebehavior
organizational
 Causes a need for year-end entries to eliminate transfer prices
Multinational Transfer Pricing
 Develop guidelines
Differences in that are followed on a consistent basis
  Tax
Set systems
transfer prices that reflect an arm’s-length transaction
 Customs duties
 Be prepared for transfer pricing audits
 Freight and insurance costs
 Consider Advance Pricing Agreements—binding contracts
 Import/export regulations
between a company and taxing authorities that set an
 Foreign-exchange controls
acceptable transfer pricing methodology
Transfer Pricing Audit
Multinational Transfer Pricing
Objectives
 Internal
External
 Fewer goal
Better taxescongruence
and tariffs
 Better performance
Fewer foreign exchange
evaluations
risks
 More motivated
Better competitive
managers
positions
 Better relations
cash management
with government
Questions
 What are some advantages and

disadvantages of decentralization?
 What are the four types of responsibility
centers?
 Why are transfer prices used?
Potential Ethical Issues
 Managers who make decisions to benefit
themselves but not always the firm
 Burying important details in responsibility reports
 Allocating costs using “ability-to-bear” criterion
 Shifting support department costs to inappropriate
departments
 Not allowing managers to buy or sell externally in a
transfer pricing situation
 Using transfer pricing to shift costs to low- or no-tax
locations

Responsibility Transfer Price

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Chapter 13:

Responsibility Accounting, Support

 Example: equipment maintenance center

 Responsible for generating revenue

 Responsible for generating revenues and

 To control cost center performance,

 Service departments  Administrative

Recognizes all interrelationships among departments

 Allocated service department costs are

 Maximum—no higher than the lowest

 The opportunity cost of the facilities used

 Ease of determining the transfer price

 Actual vs. standard

 Standard cost is superior to actual cost

 Objective, arm’s-length measure

 Below market purchase price

 Seller transfers at market or negotiated price

 What are some advantages and

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