Chapter 14

Responsibility Accounting and Transfer Pricing in Decentralized

Operations

1. When are decentralized operations appropriate?

2. How does responsibility accounting relate to

decentralization?

3. What are the differences among the four types of

responsibility centers?

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Learning Objectives

4. What is suboptimization and what are its

effects?

5. How and why are transfer prices for products

used in organizations?

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Continuing . . . Learning Objectives

6. What are the differences among the various

definitions of product cost?

7. How and why are transfer prices for services

used in organizations?

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Continuing . . . Learning Objectives

Centralization

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The majority of

authority is retained

by top management.

Decentralization

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Top management delegates

decision making to

subordinate

managers.

Completely Centralized

Completely Decentralized

Continuum of Authority in

Organizational Structure

Age of firm Young ----------> Mature

Size of firm Small ----------> Large

Stage of productdevelopment Stable ----------> Growth

Growth rateof firm Slow ---------> Rapid

Expected impact of incorrect decisionson profits High ---------> Low

Pure Pure Factor Centralization Decentralization

Continuum of Authority in

Organizational Structure

Top management’s confidence in subordinates Low ----------> High

Historical degree of control in firmTight ----------> Moderate

Use of technology Low ----------> High

Rate of change in the firm’s market Slow ----------> Rapid

Pure Pure Factor Centralization Decentralization

Advantages of Decentralization

• Helps top management recognize and develop managerial talent

• Allows managerial performance to be comparatively evaluated

• Often leads to greater job satisfaction

Continuing . . . Advantages of Decentralization

• Makes the accomplishment of organizational goals and objectives easier

– Reduction in decision-making time

– Minimization of difficulties resulting from attempts to communicate problems and instructions through an organizational chain of command

– Quicker perceptions of environmental changes

• Allows the use of management by exception

Disadvantages of Decentralization

• May result in a lack of goal congruence or suboptimization

• Requires more effective communication abilities

• May create personnel difficulties upon introduction

– Employees asked to do too much too soon

– Some managers have difficulty relinquishing control

Continuing . . .

Disadvantages of Decentralization

• Can be extremely expensive– Training lower-level managers

– Potential cost of poor decisions

– Duplication of activities

– Developing and operating sophisticated planning and reporting system

• Requires accepting inappropriate decisions as it is a training ground

Responsibility Accounting Systems

Responsibility accounting refers to an accounting system that provides information to top management about the performance of organizational subunits.

One purpose of a responsibility accounting system is to “secure control at the point where costs are incurred instead of assigning them all to products and processes remote from the point of incurrences.”

Control Procedures

Control procedures are implemented for the following three reasons:• Managers attempt to cause actual operating results to

conform to planned results (effectiveness)

• Managers attempt to cause, at a minimum, the standard output to be produced from the actual input costs incurred (efficiency)

• Managers need to ensure, to the extent possible, a reasonable utilization of plant and equipment

Responsibility Report

• Assists each successively higher level of management in evaluating performance of subordinate managers and their respective organizational units

• Contains monetary and nonmonetary information• Separates costs into those controlled by unit

managers and those not controlled by unit managers

Basic Steps in a Control Process

Compare

Monitor

Plan

Gather

actual

dataManagerial

influence

Manager’s Performance Report

Actual FlexibleResults Budget Variance

Direct Materials 163,400$ 166,400$ (3,000)$ Direct Labor 255,200 253,000 2,200Supplies 24,600 23,400 1,200Indirect Labor 59,600 58,600 1,000Power 50,200 52,200 (2,000)RepairsMaintenance 17,200 16,200 1,000Other 11,400 11,000 400 Total 581,600$ 580,800$ 800$

Production Vice-President’s

Performance Report

Actual FlexibleResults Budget Variance

Adminitrative Office-VP 243,000$ 240,000$ 3,000$ Inspect, Polish & Package 112,600 113,400 (800)Finishing 168,000 169,600 (1,600)Cutting & Assembly 581,600 580,800 800 Total 1,105,200$ 1,103,800$ 1,400$

President’s Performance Report

Actual FlexibleResults Budget Variance

Admin. Office-President 267,200$ 264,000$ 3,200$ Financial Vice-President 313,200 316,600 (3,400)Production Vice-President 1,105,200 1,103,800 1,400Sales Vice-President 368,800 366,000 2,800 Total 2,054,400$ 2,050,400$ 4,000$

Nonmonetary Information for

Responsibility Reports

• Departmental/divisional throughput• Number of defects (by product, product line,

supplier)• Number of orders backlogged (by date,

quantity, cost, and selling price)• Number of customer complaints (by type and

product); method of complaint resolution• Percentage of orders delivered on time

Nonmonetary Information for

Responsibility Reports

• Manufacturing (or service) cycle efficiency• Percentage of reduction of non-value-added

time from previous reporting period (broken down by idle time, storage time, quality control time)

• Number of employee suggestions considered significant and practical

• Number of employee suggestions implemented• Number of unplanned production interruptions

Nonmonetary Information for

Responsibility Reports

• Number of schedule changes• Number of engineering change orders;

percentage change from previous period• Number of safety violations; percentage change

from previous period• Number of days of employee absences;

percentage change from previous period

Responsibility Center

• Cost center

• Revenue center

• Profit center

• Investment center

Classification of center based on manager’s scope of authority and type of financial responsibility

Profit Center Master Budget

MasterBudget Actual Variance

Delivery revenues 180,000$ 186,000$ 6,000$ Variable costs 50,040 51,500 (1,460)Contribution margin 129,960$ 134,500$ 4,540$ FOH-controllable 38,400 38,000 400Segment margin 91,560$ 96,500$ 4,940$ FOH-common 27,000 29,250 (2,250)Profit center income 64,560$ 67,250$ 2,690$

Profit Center Master Budget

FlexibleBudget Actual Variance

Delivery revenues 186,000$ 186,000$ -$ Variable costs 51,708 51,500 208Contribution margin 134,292$ 134,500$ 208$ FOH-controllable 38,400 38,000 400Segment margin 95,892$ 96,500$ 608$ FOH-common 27,000 29,250 (2,250)Profit cent income 68,892$ 67,250$ (1,642)$

Critical Success Factors

Examples are:

• Quality

• Customer service

• Efficiency

• Cost control

• Responsiveness to change

Critical success factors are those items that are so important that, without them, the organization would cease to exist.

Suboptimization

• Top management must be aware that suboptimization can occur and develop ways to avoid it

• Primary way to limit suboptimization is by communicating corporate goals

Suboptimization exists when individual managers pursue goals and objectives that are in their own and/or their segments’ particular interests rather than in the company’s best interests.

Transfer Price

• General rules to set price for internal use:– The maximum price should be no greater than the lowest market

price at which the buying segment can acquire the goods or services externally.

– The minimum price should be no less than the sum of the selling segment’s incremental production costs plus the opportunity cost of the facilities used.

A transfer price is an internal charge established for the exchange of goods or services between organizational units of the same company.

Cost-Based Transfer Prices

• Absorption cost– Does not produce same amount of income that would be

generated if transferring division sold goods externally

From Exhibit 14-11:

DM + DL + VOH + FOH = $160 + $48 + $72 +$78 = $358

Continuing . . .

Cost-Based Transfer Prices

Variable cost – production or total?– May have motivation problem for selling department

From Exhibit 14-11:

Production: DM + DL + VOH = $160 + $48 + $72 = $280

Total: Variable Production Cost + Variable S & A =

$280 + $8 = $288

Cost-Based Transfer Prices

• Actual cost– Inefficiencies in production may not be corrected

• Standard cost– “Buyer” could pay more than actual cost for goods

Market-Based Transfer Prices

• Advantages– Both seller and buyer should accept

• Problems– Product may not be sold in open market

– Internal cost savings may exist

– External market may temporarily be high or low

– Determination of “right” market price may be difficult

Negotiated Transfer Prices

• Normally below external sales price• Above unit’s incremental costs, including

opportunity cost• Managers must have authority to go outside the

company if negotiations fail

Dual Pricing

• Different prices for seller and for buyer• Profit for seller and minimal cost to buyer• Managers to have most relevant information

for decision making and performance evaluation

Transfer Pricing

in Multinational Settings

• Extremely difficult to set– Tax systems

– Customs duties

– Freight and insurance costs

– Import/export regulations

– Foreign exchange controls

– Internal and external objectives of transfer differ

• May use different transfer prices for different countries; make certain of legality.