A PROJECT REPORT ON

Responsibility Accounting

SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR

MASTER OF MANAGEMENT STUDIES TO

UNIVERSITY OF MUMBAI

BYASHVANI RAVINDRA BHAGAT

ROLL NO. 032011-2013

UNDER THE GUIDANCE OF Dr. Kinnarry Thakkar

SMT. K. G. MITTAL INSTITUTE OF MANAGEMENTMAHALAXMI, MUMBAI – 400 034

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A PROJECT REPORT ON

TITLE OF THE PROJECT

SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR MASTER OF MANAGEMENT STUDIES

TOUNIVERSITY OF MUMBAI

BYFULL NAME OF THE STUDENT

ROLL NO. 2010-2012

UNDER THE GUIDANCE OF DR. / PROF.

SMT. K. G. MITTAL INSTITUTE OF MANAGEMENTMAHALAXMI, MUMBAI – 400 034

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DECLARATION

I hereby declare that this dissertation submitted in partial fulfillment of the requirement for the award of MASTER OF MANAGEMENT STUDIES (MMS) of the University of Mumbai is my original work and has not been submitted for award of any other degree or diploma fellowship or other similar title or prizes.

I further certify that I have no objection and grant the rights to SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT to publish any chapter or project if they deem fit in journals or magazines and newspaper etc. without my permission.

NAME: ASHVANI RAVINDRA BHAGAT

CLASS: MMS II SEM IV

BATCH: 2011-2013

ROLL NO.: 03

DATE: 17th MARCH , 2012

PLACE: MUMBAI

SIGNATURE(ASHVANI BHAGAT)

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PROJECT GUIDE CERTIFICATE FORM

I Mr. Ashvani Ravindra Bhagat, the undersigned Roll No. 03 studying in the Third Year of MMS is doing my project work under the guidance of Dr./ Prof. DEEPA CHAVAN wish to state that I have met my internal guide on the following dates mentioned below for Project Guidance:-

SR. NO. DATE SIGNATURE OF THE INTERNAL GUIDE

______________________ ______________________Signature of the Candidate Signature of Internal Guide

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Smt. K. G. Mittal Institute of Management, IT and ResearchMarwari Vidyalaya Sanchalit

(Approved By AICTE, New Delhi, Government of Maharashtra, DTE, Affiliated to University of Mumbai)

Certificate

This is to certify that the dissertation submitted in partial fulfillment of the requirement for the award of MMS of the University of Mumbai is a result of the bonafide work carried out by Mr. ASHVANI RAVINDRA BHAGAT under my supervision and guidance. No part of this report has been submitted for award o f any other degree, diploma fellowship or other similar titles or prizes. The work has also not been published in any scientific journals/ magazines.

DATE: 17th MARCH 2012 NAME: ASHVANI R. BHAGAT

PLACE: MUMBAI ROLL NO.: 03

------------------------------ ---------------------------Dr. Vidya Hattangadi Dr. /Prof (Project Guide) (Director)Smt. K. G. Mittal Institute Of Management

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ACKNOWLEDGEMENT

This project has been a great learning experience for me. I take this opportunity to

thank Dr. / Prof. DEEPA CHAVAN, my internal project guide whose valuable

guidance & suggestions made this project possible. I am extremely thankful to

him/her for his/her support. He/She has encouraged me and channelized my

enthusiasm effectively.

I express my heart-felt gratitude towards my parents, siblings and all those friends

who have willingly and with utmost commitment helped me during the course of

my project work.

I also express my profound gratitude to Dr. Vidya Hattangadi, Director of SMT.

K. G. MITTAL INSTITUTE OF MANAGEMENT for giving me the opportunity

to work on the project and broaden my knowledge and experience. My sincere

thanks to Prof. Deepa Chavan for her valuable guidance and advice in completing

this project.

I would like to thank all the professors and the staff of SMT. K. G. MITTAL

INSTITUTE OF MANAGEMENT especially the Library staff who were very

helpful in providing books and articles I needed for my project.

Last but not the least, I am thankful to all those who indirectly extended their co-

operation and invaluable support to me.

EXECUTIVE SUMMARY

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Responsibility Accounting are a set of practices that have become recognized as one of

the essential features of effective management in organizations of all sizes, in both the public and

the private sectors, throughout the world.

Management controls may be briefly defined as the organization, policies, and

procedures used to help ensure that government programmers achieve their intended results; that

the resources used to deliver these programmers are consistent with the stated aims and

objectives of the organizations concerned; that programmers are protected from waste, fraud and

mismanagement; and that reliable and timely information is obtained, maintained, reported, and

used for decision making.

Effective management controls are clearly essential to the success and well-being of

government organizations, both as a safeguard against waste, abuse, and fraud and as a means of

ensuring that the policies laid down by top management are properly implemented by the

organization. However, even the most carefully designed control systems have their limitations,

partly because, while they allow top managers to control the organization, they do not control the

top managers themselves. Continuing vigilance is required to ensure that the systems are not

undermined by instances of fraud or by failure to respond to changes in circumstances and

operating procedures

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Chapter No. 1

Introduction8

A responsibility centre is an organizational unit which is headed by a responsible person

namely a manager. He is responsible for the activities of the unit. An organization is composed

of a number of responsibility centre. These responsibility centre. These responsibility centres are

created based on the need of the organization. The responsibility centres from a hierarchy with

section, department, work shifts etc existing at the lowest level and department and a business

unit at a higher level. The costs assigned to the responsibility centre are intended to measure the

inputs that it consumer in a specified period of time. Management control on the behavior of

managers in responsibility centres.

The performance of responsibility centres is judged by the criteria of efficiency and

effectiveness. Revenue in the revenue centres are measured and controlled separately from

expenses centres. In discretionary expenses centres, budget describe the amounts that can be

spent but it is not possible to determine the optimum level of these expenses. Therefore,

Financial controls are not intended to measure its effectiveness. The principal types of

discretionary expense centres are Administrative and Support centres, Research and

Development centre and Marketing centres.

A responsibility centre can be defined as an organizational unit which is headed by a

responsible person namely a manager. He is responsibility for the activities of the unit.

Responsibility centre is responsible for performing certain function which is its output. A

company is a collection of responsibility centre, each of which is represented by a box on the

organization chart. These responsibility centres from a hierarchy. The responsibility centre at the

lower level are work shifts and small organizational units. Higher in the hierarchy are the

department or business unit. The entire Company is a responsibility centre from the point of view

of senior management and the board of directors.

These responsibility centre use resources or inputs while performing their functions. The

costs assigned to a responsibility centre are intended to measure the input that it ensures in a

specified period of the time such as a week or a month. Management control focuses on the

behavior of manager in responsibility centres. An organization is composed of a number of

responsibility centres. These centres are created by the management based on the needs of the

business organisations.

Responsibility centres constitute the structure of a control system. The assignment of the

responsibility to organizational subunits should reflect the organizational strategy. A

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responsibility centre is an organizational unit which is headed by a management and he is

responsible for its objectives. These are two types of responsible centre which are important i.e.

revenue centre and expense centre.

Objectives of Responsibility Accounting:

The objectives of responsibility accounting are the following:

a. Overall organizational goals are broken down into small goals, each of the small goals is

meant for better achievement of a responsibility center.

b. With the attached responsibility each responsibility center is tied up & there is adequate

authority so that responsibility can be discharged.

c. At the end of a period, evaluation is done of the performance of each responsibility center

& comparison of the performance is done with the predetermined targets.

d. Thorough study is made of the achievements which are above or below the targets &

remedial measures are adopted.

e. Assessment is made of the contribution made by each responsibility center &

examination is done of how far it’s possible for the contribution to fulfilling its share in

the ultimate organizational growth.

f. Emphasize is given on the control of cost through planning.

g. Use is made of the principle of ‘management by exception’ for the purpose of recording

only those data where the actual performance of responsibility center falls short of the set

target & where the variance is beyond the reasonable limit.

Nature of Responsibility centre:

Responsibility centres are created by conscious acts of management. It is a unit of an

organization. The aims of such units is to achieve certain objectives. The objectives are to

implement the strategy for accomplishing the goals of the organization centres. The entire

organization is responsible for achieving its objectives. A responsibility centre uses certain

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inputs and then generates the output. The input includes labor, material and others services. The

responsibility centres process these resources by using plant and machinery, furniture, vehicles

and working capital. The output is created out of these inputs. The output may be in the form of

intangible goods or tangible goods. The output generated from finance, logistics, insurance,

marketing are in the form of services. The output of the responsibility centre may be sold in the

market in exchange of money. It can be also be used by another responsibility centre of the

organization. The amount of money generated by a responsibility centre is called as 'Revenue'.

Pre-requisites of effective responsibility accounting:

         The pre-requisites of the effective responsibility accounting are the following:

a. Under the supervision of a manager should be each responsibility center & for the purpose of operating, it must be separable & identifiable.

b. The independent measurement of performance of each center must be capable of being done.

c. Each responsibility center should have clearly set targets.d. Each responsibility center’s budget should set targets which should be neither too high

nor too low i.e., the budget should be one which can be realised.e. The top management should fully support the system.f. All managers of responsibility centers should participate in the formulation of plans &

policies relating to responsibility centers for the purpose of providing motivation.g. For sincere performance of each responsibility center the organizational environments

must be conducive.

Advantages of Responsibility Accounting:

          For the purpose of exercising control, responsibility accounting is an important tool in the

hands of management. For the purpose of effecting efficient control on operations & achieving

the organizational goal, responsibility accounting system should be introduced by the

organizations which have large dimensions & complex & operations which are decentralized.

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         Since for the purpose of achieving the overall goal in a piecemeal way; to various

responsibility centers, overall responsibility & authority are decentralized, continuous

communication should be there between the overall responsibility center & various sub-

responsibility centers. Thus a communication system is automatically established by

responsibility accounting.

         The following advantages can be expected from responsibility accounting system:

a. Allocation is made of all the activities of the organization, all the items of income &

expenditure including capital expenditure to the well defined responsibility centers. Profit

of each responsibility center is also identified. It should be understood by the manager of

the centre what has to be performed by him with what resources & in what time period.

He gets the things done by making his own way without any interference. Thus much

importance is given to human resources.

b. The managers of responsibility centers worked independently which helps in achieving

the ultimate goal.

c. There is a relationship between efforts & achievement, thereby, loopholes, if any, in the

operations gets easily detected.

d. The overall goals of the organization & individual goals of responsibility centers are

communicated to all so that by keeping a view on that, guidance can be given the

managers in their respective centers to the operations.

e. Among the managers & their subordinates, cost-consciousness gets generated which

results in automatically reducing cost.

f. It becomes easy to detect the weak areas in the organization. So for the purpose making

the weak areas strong, corrective measures are taken.

g. By recording the negative variances between the actual performance & target,

introduction of management by exception can be done.

h. For the purpose of exercising best managerial control over the affairs of the organization

& achieving the desired goal, responsibility accounting system & budgetary control

system can work together.

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i. As realistic goals are fixed for a responsibility centre, its achievement by the employees

becomes easy. Their contribution can be assessed by themselves for the purpose of

achieving the goal of the organization as a whole. A sense of belonging to the

organization is created among the employees by the systematic responsibility accounting

as the reward of the employees for accomplishment is not unsatisfactory.

j. As managers of responsibility centers are allowed to sit with the top management for

exchanging of views & opinions, appropriate decision making is almost assumed.

         As against expected advantages there are also some apprehended disadvantages.

Disadvantages of Responsibility Accounting:

         The following are the apprehended disadvantages of responsibility accounting:

a. Solely upon the sincere efforts put in by the managers of the responsibility centers, the

success of the responsibility accounting depends. Whether the system will succeed or not

shall be decided by the personal factors of the managers.

b. The place of good management cannot be ever taken by the responsibility accounting

because the latter is only a tool in the hands of the former.

c. Although theoretically, the manager of each organization is given free hand, in actual

practice, neglect of employees’ reaction, interference etc. is often noticed. Thus, in the

way of proper discharging of responsibility, this stands.

d. In modern organizations, among the departments, inter-relations & inter-departments are

mostly observed. So it becomes almost impossible to demarcate responsibility centers by

clear-cut outlines.

e. Manager of the responsibility center prepares & communicates performance reports. The

desired result will not be achieved by the responsibility accounting system, if there is any

shortcoming in the report.

f. Remuneration, future prospects, rewards, good working condition, welfare work & many

others account for the individual interest of employees. Co-operation from the employees

may be required where there is a clash between individual interest & the organizational

interest.

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Chapter No. 2

Responsibility Centres

Responsibility Structure

The responsibility structure of an organization consists of responsibility centers and related

performance measurement systems. These responsibility

centers work towards the achievement of the organizational goals. This hierarchical placement of

the responsibility center helps the top management to ensure that decisions made in one part of

the organization are congruent with decisions made in other parts. The responsibility structure

includes an accounting system. A responsibility accounting system helps managers to record the

plans and performances of the center for which the manager is accountable. The measurement of

the performance of a responsibility center is done through cost, profit, revenue, investment and

quality goals set by the organization. There are three different methods of measuring the

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performance of a responsibility center. They are:

• The efficiency measure • The process measure • Effectiveness measure

The ‘efficiency measure’ measures performance in terms of inputs received over a specified

period of time for a given level of output. The process measure pertains to the production

process, and the ‘effectiveness’ measure gauges the output of the organization in terms of its

goals and objectives. The above mentioned methods of performance evaluation help in assessing

the progress of each subunit, and this is done with those variables for which the manager has

reasonable amount of control in mind.

Overall Effectiveness Measures: Return on Investment (ROI)

The most important objective of a firm is to achieve a good return on investment. The logic

behind the hierarchy of responsibility centers and the responsibility accounting system is to make

all the decentralized subunits of an organization responsible for various elements of ROI. The

performance of responsibility centers in an organization is based on cost, quality, revenue and

investment.

Donaldson Brown of General Motors divided ROI into a number of elements for easy

understanding. These elements are helpful in establishing performance measures for various

subunits of a division that are goal congruent and would have an influence over the performance

measures. ROI= Net profit/invested capital

ROI can be divided into two components- net profit, which is a percentage of the sales revenue,

and the turnover of investments in relation to the sales revenue.

Profit margin = net profit/sales revenue

Investment turnover = sales revenue/invested capital

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Types of Responsibility Centres

Revenue centers

Revenue centers are those organizational units in which outputs are measured in monetary terms.

These centers are marketing organizations and they are not directly responsible for profits.

Revenue centers are also called expense centers, as the revenue center managers are held

responsible for expenses incurred by the unit. The main objective of revenue centers is to

maximize revenues. For example, a marketing organization is a sales revenue center. Such a

center is devoted to increasing the revenue, and assumes no responsibility for production.

In this center, the manager is responsible for the level of revenue or outputs of a center,

measured in monetary terms, but is not responsible for the costs of the goods or services that the

center offers.

Expense centers

In expense centers, inputs or expenses are measured in monetary terms whereas the outputs are

not measured in monetary terms. There are two types of expense centers-engineered expense

centers and discretionary expense centers. There are two types of cost involved in engineered

expense centers and discretionary expense centers respectively-engineered costs and

discretionary costs. Engineered costs are costs that can be estimated to a reasonable extent by the

management. Examples are direct labor and direct material. Discretionary costs, on the other

hand, are costs that cannot be estimated by the management.

Engineered expense centers

In these centers, inputs or expenses are measured in monetary terms and outputs are measured in

physical terms. These centers are usually found in the manufacturing units that use a standard

cost system. There are certain responsibility centers within administrative and support

departments that actually are engineered expense centers. In these centers, the cost of the product

is determined by multiplying the output of each unit with its standard cost. Its efficiency is

measured by comparing the actual cost with the standard cost.

Discretionary expense centers

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In discretionary expense centers, the output cannot be measured in monetary terms.

Discretionary expense centers include administrative and support units like legal, accounting,

industrial and public relations units. Here, the efficiency is not the difference between

budgeted and actual expense, but the difference between the budgeted input and actual input. In

discretionary expense centers the management decides on certain policies that should govern the

company's operation. These relate to the amount of money that should be spent on R&D,

financial planning, public relations, etc. The decisions related to such activities depend on the

way a company operates.

Control characteristics for expense centers

The management control systems for expense centers are discussed, taking into consideration

factors like budget preparation, cost variability, financial control and measurement of

performance.

Budget preparation: The decisions regarding the budget of expenses for a discretionary expense

center is different from that for an engineered expense center. In engineered expense centers, the

costs are determined by the management, taking into view the operating budget required to

perform the task effectively in the future. However, in a discretionary expense center, the

principal task is to decide on the magnitude of the job that has to be performed. These tasks are

of two types-continuing and special. Continuing tasks take place year after year (like financial

statements) while special tasks are one-time tasks, for example, developing a profit budgeting

system for a newly acquired division.

Management by objectives is a useful technique in preparing budgets for a discretionary expense

center. Management by objectives is a technique where the objectives of performance are jointly

determined by subordinates and their superiors. The progress towards these objectives is

periodically reviewed and the rewards are allocated on the basis of performance. Another method

used to understand the appropriate level of spending in a discretionary expense center is

sensitivity analysis. According to this technique, the budget has a section which explains the

activities that can be undertaken if the budget is increased. Sensitivity analysis is mostly not

taken by companies as they think that it is important for a manager to prepare the possible budget

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for accomplishing activities that should be undertaken.

Cost variability: The costs, in a discretionary expense center, tend to vary from one year to

another according to the volume. However, these are not influenced by short-term fluctuations in

volume within a year. In engineered expense centers, costs vary with short-term fluctuations in

volumes. Financial control: The financial control in a discretionary expense center is different

from that in an engineered expense center. Here, the operating costs are minimized by setting a

standard for the costs and comparing the actual costs with this standard. In discretionary expense

centers, costs are controlled by determining the tasks that have to be undertaken and the amount

of effort that is required for each task. Financial control is, hence, determined at the planning

stage.

Measurement of performance: The financial performance report of a discretionary

expense center does not help in evaluating the efficiency of the manager, whereas in engineered

expense centers the financial report helps in evaluating the efficiency of the manager. If the two

centers are not properly distinguished, the management may consider the performance report of a

discretionary center as an indication of its efficiency.

Administrative and support centers

Administrative centers include the senior corporate management, the business unit management

and the managers responsible for their staff units. Support centers provide services to other

responsibility centers.

Problems related to control in administrative and support centers include difficulty in measuring

output, as they basically provide service and advice to the responsibility centers. Therefore, it

becomes difficult to set cost standards. Hence, their performance cannot be branded as efficient

or inefficient. Secondly there is lack of congruence between goals of staff units and

responsibility centers. The suggestions that staff departments may provide regarding the

development of systems, programs or functions may be too costly when one thinks of the

additional profits that these would generate. The severity of the problems is also related to the

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organizational level. At the operational level, the staff activity is controlled by the plant manager,

and at the business unit level, by the business unit manager. When compared to the plant level,

there is more discretion of tasks at the business unit level. Support centers charge a particular

price for the services they provide to other responsibility centers.

Budget preparation: The budget for a support center consists of expenses, and is prepared by

comparing with the current year’s actuals. This budget consists of the following components- the

basic costs of running a center (for which there is no need of management decisions), costs

incurred by the discretionary

activities of the center, and a section containing proposed increases in budget (other than those

related to inflation).

Research and development centers

Control problems in research and development: The problems in research and development are:

Difficulty in measuring quality: The inputs for an R&D activity can be measured whereas the

outputs are difficult to measure. For R&D activities, the time taken for a particular research

cannot be estimated as it may take months or sometimes years for a particular activity. Also the

output is difficult to measure because of its technical nature.

Lack of goal congruence: As in administrative centers, goal congruency is lacking in R&D

centers, too. Conflict may arise between the research manager and the business unit manager.

The research manager may want to build the best research and development center, no matter

what the expense be, while it may not be possible for the company to afford it. Also, the

researchers may not have sufficient knowledge about the business, in some cases. The research

and development costs cannot be controlled on a year-to-year basis because a research project

may take years to show results and the organization would have to bear the cost of the project for

that period of time, mainly the cost on labor.

Marketing centers

There are two types of marketing activities in every organization: order filling (logistics) and

order getting. Order getting is an actual marketing activity. Order filling activities include

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transferring goods from the company to the customer, and receiving the appropriate pay from the

customer. These are mostly engineered expense centers. Order getting activities include test

marketing, training sales force, advertising, sales promotion, etc. Though the output of a

marketing organization can be measured, it is difficult to evaluate the marketing effort, as the

marketing department has no control over economic conditions or competitors’ actions. These

actions may be different from what was expected when the sales budgets were established. In

such situations, it is difficult to achieve management control. Also, it becomes difficult to

measure the efficiency and effectiveness of these costs.

Profit centers

When financial performance of a responsibility center is measured in terms of the organization’s

profit, then it is called a profit center. In a profit center, performance is measured in terms of the

numerical difference between revenues (outputs) and expenditure (inputs). A profit center is

given the responsibility of earning profits. It is involved in the manufacture and sale of outputs,

and it measures how well the center is doing economically. The profit center also determines the

efficiency of the manager in charge of the center. A profit center helps in motivating managers to

perform well in areas they control and also encourages managers to take initiatives. The profit

center helps the organization to make the best use of specialized market knowledge of the

divisional managers, and entrusts the local managers the responsibility of tradeoffs.

Profit centers have been used as a major management control tool. The major advantages of

profit centers are:

• These help in increasing the speed of making operating decisions as they do not have to be

referred to corporate headquarters.

• As the decision-making authority lies with the managers they can make better decisions

related to the task they are performing, because they can understand the nature of the work

better.

• Since profit centers make their day-to-day decisions themselves headquarters can

concentrate on broader issues of the organization.

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• Managers are motivated to perform more effectively, as they are responsible for

increasing the profit of their unit.

• Managers use their imagination, take initiatives to perform more effectively, to increase

the profit of their unit.

However, there are certain difficulties associated with the creation of profit centers. The

management cannot have considerable control over the different profit centers when decisions

are centralized. The top management has to depend on management control reports which may

not be as effective as the personal knowledge of an operation. There may be no place for

competent general managers in a functional organization because of lack of opportunities for

them to develop creative management skills.

Organizational units compete with one another, and this may, sometimes, result in conflict

between different centers and reduction in cooperation between different units and sharing of

resources.

Types of profit centers

Functional units can be classified as different types of profit centers. A multibusiness company

can be divided into independent profit generating units such as marketing, finance,

manufacturing etc. The decisions regarding whether a particular functional unit can be a profit

center depends on the responsibility center manager's ability to influence, if not control, other

activities that affect the company's bottom line. The different types of profit centers are discussed

below:

Marketing: A marketing activity becomes a profit center if it is charged with the cost of the

products sold. A marketing activity can be given the responsibility of making profit when the

marketing manager has the authority to make principal cost/revenue trade off in terms of

marketing a product, spending on sales promotion, the appropriate time for this expenditure and

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on which media to spend.

Manufacturing: This is an expense center and the management of activities here is based on

performance against standard costs and overhead budgets. Problems in measurement may occur

because of inadequate quality control, shipping of inferior quality products, and so on, to obtain

standard cost credit. At times, there may arise the need to accommodate an order in-between

production schedules, and the manufacturing managers may be reluctant to interrupt these

schedules. In manufacturing units, when performance is measured against standards, there may

be no incentives for manufacturing products that are difficult to produce. These factors may

demotivate the managers, and eventually, they may not try to improve standards. Hence, while

measuring the performance of manufacturing activities against standard costs, it is important to

take into consideration quality control, production scheduling and the make or buy decisions.

Measuring profitability: Profitability measurements in a profit center can be of two types-

management performance and economic performance. Management performance focuses on

the manager’s performance while economic performance relates to how well a profit center is

performing as an economic entity. Management performance is a measure used for planning,

controlling and coordinating the day-to-day activities of the profit center. The performance

measures of profit centers can be different and hence, the necessary purpose for the information

should not be obtained from a single set of data. For example, the management performance

report can show excellent performance of a profit center manager. But the economic and

competitive forces for that particular report can show poor economic performance. As a result,

the center may run into losses and may even have to close shop.

Types of profitability measures:

The parameters that can be used for measuring the profitability of a profit center are

contribution margin, direct profit, controllable profit, income before taxes and net income.

Contribution margin: This performance measure is used on the premise that, since fixed expenses

are not controllable by the manager, the focus should rest on maximizing the difference between

revenues and variable expenses. The problems of using contribution margin is that since many of

the center’s expenses may vary according to the discretion of the profit center manager, focus on

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the contribution margin tends to direct the attention of the profit center manager away from the

goals of the center.

Direct profit: This measure helps in understanding the contribution of the profit center to the

general overhead profit of the corporation. It encompasses all the expenses directly incurred by

profit centers or related to profit centers, irrespective of whether the expenses are controllable by

the profit center manager. However, it does not include corporate expenses.

Controllable profit: The headquarters expenses in an organization can be divided into two

categories-controllable and uncontrollable. Controllable expenses include expenses that are

controlled by the business unit manager. The advantage of including such costs in the

measurement system is that the profit will be calculated after the deduction of expenses that can

be influenced by the profit center manager. Hence, these are controllable profits. As

uncontrollable headquarters expenses are taken into consideration while calculating controllable

profits, controllable profits cannot be compared directly with published data or with trade

association data, which report the profits of other companies in the industry.

Income before taxes: In this method, all corporate overhead profit is allocated to the profit

center. The amount of expense incurred by each profit center forms the basis of allocation of

profit. Such allotment has its own drawbacks. Firstly, the costs in departments like finance, and

HR are not controllable by the profit center and hence, profit centers should not be held

accountable for such costs. Also, it is difficult to quantify the amount that has been spent on

human resources in each profit center. However there are certain advantages in allocating costs.

Corporate service units often have a tendency to spend lavishly to make their units as excellent

as possible without paying due attention to the value they create for the company. Once such

costs are allocated to profit centers, the profit center managers will try to keep a check on the

expenditure. The performance of profit centers is easily comparable to that of competitors’

performance who pay for similar services.

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Since the profit center can earn profit only when it has recovered all its costs, including allocated

corporate overhead costs, the profit center manager will be motivated to make long-term

marketing decisions such as pricing, product mix, and so on, because the center will have to

recover its share of corporate overhead costs.

For profit centers to function with the allocated costs in mind, it is important that they are

allocated budgeted costs, and not actual costs. This ensures that the profit center managers will

perform without complaining about the arbitrariness of the allocated costs, since there would be

no variances in the allocated overheads in the performance reports.

Net income: The performance is measured by taking into consideration the net income after the

payment of taxes. The disadvantage of using this method is that many decisions that have an

impact on the income taxes are made at headquarters, and profit center managers should not be

judged by these decisions. If the income after tax payment is constant percentage of the income

before tax payment, then there would be no need to measure performance based on this method.

This method would be useful if profit centers influence decisions like installing credit policies or

disposing of equipment. This method is also useful to motivate the manager to minimize taxes in

case the taxable income differs from income, as measured by using generally accepted

accounting principles. The performance of profit centers can be measured by comparing actual

results with one or more of the measures discussed above with budgeted amounts. In addition,

data on competitors and industry provide a good crosscheck on the appropriateness of the

budget.

Investment centers

An investment center has control over sales revenues and operating costs, and the assets used to

generate profit. An investment unit manager must be in a position to influence the size of the

investment and profit variables. An investment center is a measure of economic performance,

and it analyzes all elements of profit and investment. The objective of this center is to maximize

profit, given the amount of investment required to generate the profit.

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Cost centers

The objective of cost center is to minimize the variance between standard costs and actual costs.

A cost center is a production or service function, activity or item of equipment the costs of which

may be attributed to cost units. Cost centers are basically related to costs, and not to the revenues

or assets and liabilities of the organization. A cost center is a separate organizational unit

for which separate cost allocation is done. A cost center forms the basis for building up cost

records for cost measurements, budgeting and control. From a functional point of view, a cost

center is a production cost center (where only production is undertaken like a assembly

department), a service cost center (offering service to production departments like personnel,

accounting etc.,) or an ancillary manufacturing center (producing packing materials).

Chapter No. 3

Segment Reporting and Profitability

Decentralization and segment reporting

A segment is a part or activity of an organization about which managers need to know

cost, revenue or income data. Examples of segments include divisions of a company

(responsibility centers), sales territories, projects, product families, individual stores, programs,

operational departments, individual customers, services categories and product lines.

Effective decentralization requires segment reporting, so the companywide income

statement, reports are needed for individual segments of the organizations. These segmented

25

income statements are useful in analyzing the profitability of segments and measuring the

performance of segment managers.

A different kind of income statement is required for evaluating the performance of a cost

center, a profit center or an investment center. This income statement should emphasize on the

segment rather than the performance of the company as a whole. A contribution margin or a

residual contribution margin, format income statement is used to evaluate the performance of

different types of segments.

In a contribution margin format income statement cost of the segment consists only of the

direct costs (variable and fixed costs). To prepare an income statement for a particular segment

variable costs are traced for the resources which use depends of the degree of the activity of the

segment and the fixed costs don´t depends of the degree of the activity, but are related with the

segment. This fixed cost are designated by traceable fixed and are assigned to the segments but

non-traceable or common fixed costs are not assigned to segments.

Segment Contribution Margin

The segment contribution margin is obtained by deducting the variable and the traceable

fixed costs from the segment revenues. It represents the margin that is available after a segment

has covered all of its own costs. The segment contribution margin can be the best gauge of the

long-run profitability of a segment, since it includes only those costs that are caused by the

segment. If a segment cannot cover is own costs, then that segment probably should not be

retained (unless it has an important side effects on other segments or is strategic relevant).

From a decision making point of view, the segment contribution margin is most useful in

major decisions that affect capacity such as dropping a segment, including decisions relating to

short-run changes in volume, such as pricing special orders that involve utilization of existing

26

capacity.

Example

As an example, a segmented report is shown, where the segments have been defined as

divisions. Report also has a column of total company performance for the period. We can see

that divisional segment margin is Rs60,000 for business product division and Rs40,000 for the

consumer product division. This report is very useful for company's divisional managers they

may want to know how much each of their divisions is contributing to the company's profit.

Segments defined as divisions (values in mRs):

Total

__Segments_____

_

Company Division A Division B

Revenues (ex: sales) 100,000 60,000 40,000

Variable expenses:

Cost of goods sold 36,000 24,000 12,000

Other variable expenses 10,000 6,000 4,000

Total variable expenses 46,000 30,000 16,000

Margin 54,000 30,000 24,000

Traceable fixed expenses 34,000 18,000 16,000

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Divisional Contribution margin 20,000 12,000 8,000

Common fixed expenses (not

traceable to the individual divisions)17,000

Net operating income 3,000

Traceable and Common Fixed Costs

One of the most puzzling aspects of segmented income statements is probably the

treatment of fixed costs. While preparing segmented income statements the fixed cost is divided

into two parts, one is traceable fixed cost and other is common fixed cost. Only traceable fixed

costs are assigned to the segment. If a cost is not traceable then it is not assigned to segments.

Following paragraphs define explain these two types of fixed costs.

Traceable fixed cost:

A traceable fixed cost is a fixed cost that is incurred because of the existence of a

segment. If the segment had never existed, the fixed cost would have not been incurred; and if

the segment were eliminated, the fixed cost would disappear.

Examples:

Examples of traceable fixed costs:

The salary of the Division A manager is a traceable fixed cost of the Division A. The

renting of the equipment to produce exclusively the “Product Line P”, is a traceable fixed cost of

the Product Line P.

The depreciation of a car for rent is a traceable fixed cost of the “renting business” in a rent a

car company.

Common fixed cost:

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A common fixed cost is a fixed cost that supports the operations of more than one

segment, but is not traceable in whole or in part to any one segment. Even if a segment were

entirely eliminated, there would be no change in true common fixed cost.

Examples:

Example of common fixed cost includes the following:

The salary of general manager who controls all the segments. The salary of CEO at

TELECOM is also an example of common fixed cost. No single segment can be regarded as the

sole reason of this cost.

The salary of receptionist at an office shared by a number of doctors is a common fixed cost

of the doctors. The cost is traceable to the office, but not to any one of the doctors individually.

Identifying traceable and common fixed costs is crucial in segment reporting, since the

traceable fixed costs are charged to the segments and common fixed costs are not charged to

segments. In actual situations, it is sometimes hard to determine whether a cost should be

classified as traceable or common. The general guideline is to treat as traceable costs only those

costs that would disappear over time if the segment itself disappeared.

Fixed cost that is traceable to one segment is, usually, a common cost for another

segment. For example, one Trading Company might want a segmented income statement that

shows the segment margin for each territory where is operating and for each client. The fixed

territory manager salary is a traceable fixed cost of one territory, but it is a common fixed cost of

the client segment of that territory. So, traceable and common cost is relative concepts.

Problems to Proper Cost Assignment in Segmented Reporting:

For segment reporting to accomplish its intended purposes, costs must be properly

assigned to segments. If the purpose is to determine the profits being generated by particular

segment or division, then all of the costs attributable to that division or segment--and only those

29

costs--should be assigned to it. Unfortunately, three practices greatly hinder proper cost

assignment:

Omission of costs:

The costs assigned to a segment should include all costs attributable to that segment from

the company's entire value chain. The value chain consists of major business functions that add

value to a company's products and services. All of these functions, from research and

development, through product design, manufacturing, marketing, distribution, and customer

service, are required to bring a product or service to the customer and generate revenues.

Inappropriate methods for allocating costs among segments:

Cost distortion, occurs when costs are improperly assigned among a company's segment.

Cross-subsidization can occur in two ways; first, when companies fail to trace costs directly to

segments in those situations where it is a feasible to do so; and second, when companies use

inappropriate bases to allocate costs.

Costs that can be traced directly to a specific segment of a company should not be

allocated to other segments. Rather, such costs should be charged directly to the responsible

segment. For example, the rent for a branch office should be charged directly against the branch

office rather than included in a companywide overhead pool and then spread throughout the

company.

Some companies allocate costs to segments using arbitrary bases such as sales value or cost of

goods sold. For example, under the sales value approach, costs are allocated to the various

segments according to the percentage of company sales generated by each segment. If a segment

generates 20% of total company sales, it would be allocated 20% of the company's overheads

expenses as its fair share. This same basic procedure is followed if cost of goods sold or some

other measure is used as the allocation base. For this approach to be valid, the allocation base

must actually drive the overhead cost. Or at least the allocation base should be highly correlated

30

with the cost driver of the overhead cost. For example, when sales value is used as the allocation

based for SG&A expense, it is implicitly assumed that overheads expenses change in proportion

to change in value sales. If that is not true, the allocated expenses to segments will be misleading.

Arbitrarily dividing common costs among segments

The third business practice that leads to distorted segment costs is the practice of

assigning no traceable costs to segments. For example, some companies allocate the costs of the

corporate headquarters building to products on segment reports. However, in a multiproduct

company, no single product is likely to be responsible for any significant amount of this cost.

Even if a product were eliminated entirely, there would usually be no significant effect on any of

the costs of the corporate headquarters building. There is no cause and effect relation between

the cost of the corporate headquarters building and the existence of any one product. As a

consequence, any allocation of the cost of the corporate headquarters building to the products

must be arbitrary.

Residual Income

Residual income is the net operating income that an investment center earns above the

minimum required return on its operating assets. Residual income is a consistent approach to

measuring an investment center's performance. Economic Value Added (EVA) is an adoption of

residual income that has recently been adopted by many companies. When residual income or

EVA is used to measure managerial performance, the objective is to maximize the total amount

of residual income or EVA.

Example

31

For the purpose of illustrating, consider the following data for an investment center of a

company.

Basic Data for Performance Evaluation

Average operating assets Rs 80,000

Net operating income Rs18,000

Minimum required rate of return15%

The company has long had a policy of evaluating investment center managers based on

ROI, but it is considering a switch to residual income. The following table shows how the

performance of the division would be evaluated under each of the two methods:

Alternative Performance

Measures

ROI Residual

Income

1. Average operating assets Rs 80,000 Rs 80,000

2. Net operating income Rs 18,000 Rs 18,000

ROI, (2) ÷ (1) 22,5%

Minimum required return (15% Rs 12,000

Rs80,000)

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Rs 6,000

Residual income

Comparison of return on investment (ROI) and residual income:

One of the primary reasons why controllers of companies would like to switch from ROI

to residual income has to do with how managers view new investment under the two

performance measurement schemes. The residual income approach encourages managers to

make investments that are profitable for the entire company but that would be rejected by

managers who are evaluated by ROI formula.

To illustrate consider the data mentioned above and further suppose that the manager of

the division is considering purchasing a machine. The machine would cost Rs 25,000 and is

expected to generate additional operating income of Rs 4,500 a year. From the stand point of the

company, this would be a good investment since it promises a rate of return of 18% [(Rs4,500 /

Rs25,000) ×100], which is in excess of the company's minimum required rate of return of 15%.

If the manager of the division is evaluated based on residual income, he would be in favor of the

investment in the machine as shown below.

Performance evaluated using residual income

Present New Project Overall

Average operating assets Rs 80,000 Rs 25,000 Rs 105,000

Net operating income Rs 18,000 Rs 4,500 Rs 22,500

Minimum required return Rs 12,000 Rs 3,750 Rs 15,750

Rs 6,000 Rs 750 Rs 6,750

Residual income

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Since the project would increase the residual income of the division, the manager would

want to invest in the new machine.

Now suppose that the manager of the division is evaluated based on the return on

investment (ROI) method. The effect of the machine on the division's ROI is computed as below:

Performance evaluated using residual income

Present New project Overall

Average operating assets (1) Rs 80,000 Rs 25,000 Rs105,000

Net operating income (2) Rs 18,000 Rs 4,500 Rs 22,500

ROI, (2) ÷ (1) 22,5% 18% 21,4%

The new project reduces the ROI from 22, 5% to 21,4%. This happens because the 18%

rate of return on the new machine, while above the company's15% minimum rate of return, is

below the division's present ROI of 22,5%. Therefore the new machine would drag the division's

ROI down even though it would be a good investment from the standpoint of the company as a

whole.

Basically, a manager who is evaluated based on ROI will reject any project whose rate of

return is below the division's current ROI even if the rate of return on the project is above the

minimum rate of return for the entire company. In contrast, any project whose rate of return is

above the minimum required rate of return of the company will result in an increase in residual

income. Since it is in the best interest of the company as a whole to accept any project whose rate

of return is above the minimum rate of return, managers who are evaluated on residual income

will tend to make better decisions concerning investment projects than manager who are

evaluated based on ROI. So, in financial point of view, residual income leads managers to take

decisions more aligned with overall company interest. Residual income is more convergent than

ROI.

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Chapter No. 4

ROLE IN PRACTICING A PERFORMINGMANAGEMENT

A responsibility centre corresponds to an inferior level of responsibility for the enterprise and, in

the same time, it is the base for calculating the performances of the one responsible with the

accomplishment of the undertaken tasks. From the economic viewpoint, the responsibility

centres can be classified into profit centres and costs centres. The profit centres can be

considered those divisions of an enterprise, which are realizing in fact the outlet, such as the

basis wards. The costs centres are those divisions of an enterprise, which are determining only

the expenses (costs). From budgeting the profit and cost centres, meaning the responsibility

35

centres, we can forecast the complete posts regarding the determination of the supplying prices.

The budget laying down methodology supposes the following steps: A. Elaborating the outlet

cost’s budget; B. Elaborating the general administrating expenses budget; C. Elaborating the

marketing expenses budget.

Enterprise’s goals achievement is materialized for each structural level, which imposes

the forecasts’ study on enterprise’s divisions, called responsibility centres.

The responsibility centre is regarded as “an interconnected elements ensemble, which is

forming an entirety, having a certain autonomy level in using and optimizing the resources

available”.

A responsibility centre corresponds to an inferior level of responsibility for the enterprise

and, in the same time, it is the base for calculating the performances of the one responsible with

the accomplishment of the undertaken tasks.

Usually, a responsibility centre can be assimilated to a managerial entity having precise

structural characteristics. It is defined as an ensemble in one physic person’s responsibility, as an

official service provided with self-means, which are allowing it to accomplish its attributions and

goals.

Considering that available grouping of the responsibility centres are not valid if the units

specific and their structure relieve a diversity of possibilities.

Some authors delimitate partial and global responsibility centres depending on the main

purchases. From the economic viewpoint, the responsibility centres can be classified into:

- Profit centres;

- Costs centres.

The profit centres can be considered those divisions of an enterprise, which are realizing

in fact the outlet, such as the basis wards. It is the strategic link where we can calculate the profit

as a difference between the revenues and expenses.

36

The costs centres are those divisions of an enterprise, which are determining only the

expenses (costs) - in this case we can control only the costs’ level. The responsibility centres

structure can be illustrated as it follows in the next diagram:

Figure no. 1. Responsibility centres structuring into profit and costs centres.

Regarding the costs calculation depending on costs’ centres, we have to specify that, the

structure is particular depending on the outlet’s specific and enterprise’s organizational

framework. The costs centres represent “the enterprise’s technique, productive, organizational

and managing frame’s divisions, depending on which is organized the planning and analytic

supervising of the outlet expenses”. The concrete result of the outlet process is individualized in

costs’ calculation, designated as “costs’ bearers, represented through products, works and

services obtained in the outlet process, which have generated the exploitation expenses for which

the cost is determined and the activity’s supervising is realized also”. The costs’ calculation

structure regards the costs’ centres (productive wards) in which the costs are allocated on

different bearers.

The costs bearer accomplishes the individual costs identifying function, as well as the

37

control function regarding the enterprise’s activity volume.

Excepting the costs and profit centres there are revenues centres, as divisions generating

revenues (for example, the sells department) or investment centres, which reflects the revenues

from the outlet selling, and as well, the investments done for the outlet finality.

The profit centres are the ones that generate revenues able to cover entirely the activity’s

expenses, and finally obtaining an over income, meaning a profit.

The cost centres have only maximum limits for the expenses that are ensuing from a

normal activity.

From budgeting the profit and cost centres, meaning the responsibility centres, we can

forecast the complete posts regarding the determination of the supplying prices. The budget

laying down methodology supposes the following steps:

A. Elaborating the outlet cost’s budget (ward cost), which includes

- Raw materials direct expenses’ budget;

- Salaries and accessories direct expenses budget;

- Outlet indirect expenses budget (outlet administrating expenses);

B. Elaborating the general administrating expenses budget

C. Elaborating the marketing expenses budget.

Synthetically the complete commercial cost’s budget can be presented as it follows:

38

Figure no. 2. Complete Commercial Cost’s Budget

A. The complete commercial cost’s budget can be determined by using the following

mathematical models:

1) BCCC = BOC + BGAE + BME

Where:

BCCC - Complete Commercial Cost’s Budget; BOC - Outlet Cost’s Budget;

BGAE - General Administrating Expenses’ Budget; BME - Marketing Expenses’ Budget.

Outlet Cost’s Budget (BOC) - it includes the direct outlet expenses’ budget and indirect outlet

expenses’ budget, and is calculated as it follows:

2) BOC = BDE + BOIE

Where:

39

BDE - Direct Expenses’ Budget; BOIE -Outlet Indirect Expenses’ Budget.

Direct Expenses’ Budget (BDE) includes the raw materials direct expenses’ budget and the direct

salaries expenses’ budget. So:

3) BDE = BRMDE + BSDE

Where:

BRMDE - Raw Material Direct Expenses’ Budget; BSDE - Salaries Direct Expenses’ Budget.

Raw Material Direct Expenses’ Budget (BRMDE) - is determined based upon the technological

consumption’s norms and the acquisition/outlet’s costs of the raw materials and direct materials.

4) BRMDE = Q * ? nci * ci

Where:

Q - Fabricated product quantity;

nci - Technological consumption norm for i material; ci - Acquisition/outlet cost for the i

material; n - Used materials’ number.

The budget’s measure determined before considers the finished good obtained quantity. For the

average (per unit) determination of the budget we report the obtained amount at the outlet’s

volume.

Salaries Direct Expenses’ Budget (BSDE) - it is established considering the time norms for

realizing the operations necessary for costs’ bearers outlet and the hourly tariffs corresponding to

each operation.

5) BSDE = Q * ?nti * ti

Where:

nti - time norm corresponding for the i operation; ti - hourly tariff for the i operation;

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n - The necessary number of operations for the product’s fabrication

Outlet Indirect Expenses’ Budget (BOIE) - is determined for each ward separately. It supposes the

added of the installations maintenance and functioning expenses with the general expenses of the

ward, as it follows:

6) BOIE = BMFE + BWGE

Where:

BMFE - Installations Maintenance and Functioning Expenses’ Budget; BWGE - Ward’s General

Expenses’ Budget.

At the enterprise’s level the total outlet indirect expenses’ budget is obtaining through the

addition of the outlet indirect budget with the outlet wards budgets. Mathematically:

7) BTOIE = BOIE1 + BOIE2 + … + BOIEn = ? BOIEi

Where:

BTOIE - Total Outlet Indirect Expenses’ Budget; BOIEi - Outlet Indirect Expenses’ Budget for the

i ward; n - The enterprise’s wards number.

If we consider the two elements of the outlet indirect expenses’ budget, then the formula above is

becoming:

8) BTOIE = ? BOIEi = ? (BMFEi + BWGEi)

Where:

BTOIEi - Installations Maintenance and Functioning Expenses’ Budget for the i ward; BWGEi -

Ward’s General Expenses Budget for the i ward.

Installations Maintenance and Functioning Expenses’ Budget (BMFEi) - includes: -

Technological installations and transportation means’ maintenance and functioning,

technique reviews and current reparations expenses for the ward;

41

- Expenses regarding the depreciation of the technologic installations and transportation means

of the ward;

- Expenses regarding the depreciation of the special destination installations and the inventory

objects of the ward;

- Expenses regarding the energy, fuel and other expenses with the materials used for

technological goals of the ward;

- Other expenses regarding the installations’ maintenance and functioning and the

transportation means of the ward.

Ward’s General Expenses Budget (BWGE) - includes two budgets: the general interest expenses’

budget of the ward and husbandry expenses’ budget.

The first one includes:

- Expenses regarding the salaries and the salaries’ accessories of the managing, technique,

economic and other specialty personnel;

- Expenses regarding the current reparations of the buildings and other means of general interest

of the ward, as well as the capital reparations of the buildings and ward’s fixed means;

- Expenses regarding the buildings and other ward’s fixed means’ depreciation; - Expenses

regarding labor protection inside the ward;

- Other general interest expenses of the ward. The second budget includes:

- Expenses regarding maintenance and cleaning of the husbandry buildings of the ward; -

Expenses regarding the energy for husbandry use;

42

- Expenses regarding water, sanitation and for the husbandry needs of the ward; - Expenses

regarding the office materials for the ward’s needs;

- Expenses regarding the magazines, books, publications and subscriptions for the ward’s needs

and the Post’s expenses;

- Other husbandry expenses of the ward.

B. General Administrating Expenses’ Budget (BGAE) includes the entirety of the general

interest expenses and the enterprise’s husbandry expenses.

1) BGAE = BEGIE + BEHE

Where:

BEGIE - Enterprise’s General Interest Expenses’ Budget; BEHE - Enterprise’s Husbandry

Expenses Budget.

the Enterprise’s General Interest Expenses’ Budget (BEGIE) - are included: - Expenses regarding

the salaries and salaries accessories of the managing, technique, economic, other specialty,

administrative, service and security personnel of the enterprise; - Expenses regarding the

buildings current reparations;

Expenses regarding the depreciation of the enterprise’s fixed means; - Expenses regarding the

researches, experiences, studies, investments and general interest innovations;

- Expenses regarding the general labor protection; - Expenses regarding enterprise’s interest

rates;

- Other enterprise’s expenses (personnel transportation’s cost, buildings’ taxes, insurance

policies).

The Enterprise’s Husbandry Expenses’ Budget (BEHE) includes: - Expenses regarding the

office’s materials;

43

Expenses regarding the acquisition of books, magazines and subscriptions; - Expenses

regarding the business travels, detaches or transfers in the country with or without trips abroad

for the company’s interest;

- Expenses regarding the energy consumption for husbandry goals; - Post’s expenses of the

enterprise;

- Expenses regarding the water, sanitation for management and husbandry purposes; - Others

expenses for enterprise’s husbandry.

Depending on the services number and complexity (finances, marketing, personnel)

offered by the management can be laid down two or more budgets. Regarding the small

companies it can be only one budget.

C. Marketing Expenses’ Budget (BME) includes the entirety of expenses generated by the

outlet selling process, such as:

- Expenses regarding the products’ transportation and manipulation, products that are delivered

to the internal customers;

- Internal transportation, manipulation, storage, reconditioning and clearance expenses of the

products delivered for export;

- Wrapper expenses for the delivered products; - Advertising expenses.

Chapter No. 5

Transfer Pricing

When an organization has a decentralized structure, it has several separate profit centers1.

Goods and services are transferred internally from one profit center to another, before the final

product/service is brought to the market. Companies find it useful to account for the value of

goods and services exchanged, even if the exchange is only internal and does not involve the

market at all. This helps the company to assess the contribution of each of the profit centers

44

separately. To help in such assessment, a mechanism called transfer pricing has been developed.

Transfer pricing helps to determine the value of goods and services transferred before calculating

the profits of the company. A transfer price is defined as “the price that is assumed to have been

charged by one part of a company for products and services it provides to another part of the

same company, in order to calculate each division's profit and loss separately.” In this chapter

we will discuss the objectives of transfer pricing, various methods of transfer pricing and ways of

administering these prices.

PRINCIPLE OF TRANSFER PRICING

The fundamental principle of transfer pricing is that the “transfer price should be similar to the

price that would be charged if the product were sold to outside customers or purchased from

outside vendors”.

Goal Congruence

While designing the mechanism for transfer pricing, the interests of profit centers should neither

supersede the interests of the overall organization, nor should there be a clash of interests

between the organization and its profit centers. In other words, there should be goal congruency

between profit centers and parent organization. Some of the prerequisites for achieving goal

congruency are:

Competent people

Good organizational atmosphere

Details of market prices

Freedom to source

Availability of information

Organizations need managers who can balance long-term and short-term goals. Managers are

often accused of sacrificing long-term gains for shortterm profits. This approach can prove

disastrous for the organization. Transfer pricing can be misused for manipulating profits, and this

gives a wrong picture of the position of the company. Hence, organizations should have

competent people skilled at negotiation and arbitration, who are capable of determining the

appropriate transfer prices. This makes goal congruency possible.

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Good atmosphere

In order to achieve goal congruency, managers of profit centers, especially the buying profit

centers, should ensure that the transfer prices charged by the selling profit centers are just. This

will create an atmosphere of trust between selling profit center and buying profit centers.

Details of market prices

When a product is transferred from one profit center to another, the normal market price for the

identical product can be taken as the basis for establishing the transfer price. The market price

should reflect the same conditions in terms of quantity, quality, time for delivery, etc. as

characterize the product to which the transfer price applies. The market price can be adjusted to

reflect savings due to lower expenses on advertising and marketing as the product is sold within

the company.

Freedom to source

Managers of selling profit centers should be given freedom to sell their goods in the external

market, while managers of buying profit centers should be allowed to buy their goods from the

external market. Thus the market becomes the main determinant of the transfer price.

Availability of information

Managers should be fully aware of market conditions and should have all the necessary

information available to them, before they take any decision. For example, managers should be

aware of the alternatives available and the relevant costs of and revenues derivable from each

alternative.

Scope for negotiation

There must be a mechanism for negotiating contracts, and managers who take transfer pricing

decisions should be trained in negotiation.

If all the above conditions are met, then companies can devise a mechanism for transfer pricing

based on the market price. But quite often these conditions are not fulfilled, and it becomes

difficult to achieve goal congruency. Some situations that are not favorable for achieving goal

congruency are:

46

• Limited markets

• Excess or shortage of capacity in the industry

Limited markets

Markets for buying and selling the goods of the profit centers may be either very small or

nonexistent. Some of the reasons for this are:

Firstly, the profit center may have spare internal capacity, but may not wish to make any external

sales. Secondly, if the company is the sole producer of a differentiated product then outside

capacity does not exist. Thirdly, a company that has invested heavily in facilities will not want to

source goods from outside unless the selling price in the market is as low as its own variable

cost.

Excess or shortage of industry capacity

There may be situation of excess capacity or shortage of capacity in the industry. The selling

profit center does not sell in the outside market when there is excess capacity in the industry. The

buying profit center may purchase from outside vendors even though there is capacity available

inside the company. Thus the company, as a whole, may not be optimizing its profits. In a

situation of insufficient capacity in the industry, the buying profit center may be unable to obtain

products it needs from the external market, whereas the selling profit center is able to make

profits by selling the product in the external market. This situation occurs when demand is high

and industry capacity is low. Here also, the company, as a whole, may not be able to optimize

profits.

Sourcing constraints

When there is an excess or shortage of industrial capacity, the sourcing decisions taken by the

company are vital. A company may allow its buying profit center to buy goods from outside, if

the profit center is getting a better deal in terms of quality, price and service. In the same way, a

selling profit center may be allowed to sell its products in the open market if it gets a better profit

by selling in the market. Whatever be the case, the management should not get bogged down by

pressures within the company and should try to take decisions that optimize the profit of the

47

company.

METHODS OF CALCULATING TRANSFER PRICE

Methods used for calculating the transfer price differ from company to company. Companies

should evaluate all the methods before adopting one that is most suitable for them. The following

criteria should be used to evaluate the methods for calculating transfer price.

Goal congruence: As already discussed, transfer prices should balance between goals of

enterprise as a whole and its profit centers. Rationality: Transfer prices should not interfere with

the process by which the buying center manager rationally strives to minimize costs and the

selling center manager rationally strives to maximize revenues.

Transfer Pricing

Autonomy: Each profit center manager should be free to satisfy his center’s needs either

internally or externally at the best possible price. Performance evaluation: Transfer pricing

should aid in objective evaluation of the activities of the profit center. It should be used as a tool

for making proper decisions. It should also aid in appraisal of managerial performance and of the

enterprise as a whole.

The three methods of calculating transfer price that are used commonly are:

• Market-based pricing method

• Cost-based pricing method

• Negotiated pricing method

Market-Based Pricing Method

Companies that use this method price the goods and services they transfer between their profit

48

centers at a price equal to that prevailing for those goods and services in the open market. This is

similar to ‘arm’s length’ pricing as intracompany transfers are priced the same as those for

external customers. Market-based pricing method has two main advantages for a company.

Firstly, business units can operate as independent profit centers with the managers of these units

being responsible for their own performance as well as that of the business unit. When managers

are made responsible for performance of the business unit, it increases their motivation and it

also becomes easier for the headquarters to assess the actual operating performance of its

business units. Secondly, tax and customs authorities favor the market price method because it is

more transparent and they can crosscheck the price details provided by the company by

comparing them with market prices on that date. In practice, however, the use of a market price

as a benchmark is difficult because often there is no competitive market which can provide a

comparable price. For some types of complex capital equipment, an external market may not

exist at all. In some cases, prices may be distorted by monopoly elements. Moreover, a definitive

market price may be difficult to determine because of variance in prices from one market to

another due to changes in exchange rates, transportation costs, local taxes and tariffs etc. In

addition, a company may set its selling price depending on the supply and demand conditions

prevalent in a specific market. In sum, these factors mean that a unique market price for

companies to follow does not always exist.

Cost-Based Pricing Method

The cost-based pricing method calculates transfer price on the basis of the cost of a good or

service. The cost of a good or service is available in the cost accounting records of the company.

This method is generally accepted by the tax and customs authorities since it provides some

indication that the transfer price approximates the real cost of item. Cost-based approaches are,

however, not as transparent as they may appear. A company can easily manipulate its cost

accounts to alter the magnitude of the transfer price. Companies that adopt the cost-based

transfer pricing method have to choose between alternative approaches, which are listed below:

• Actual costs approach

• Standard costs approach

• Variable costs approach

• Marginal costs approach

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Apart from this, companies also have to decide on the treatment of fixed costs, and research and

development costs. These issues can prove problematic for the company that adopts a cost-based

transfer pricing method. Cost-based methods usually create difficulties for the selling profit

center, as their incentive to be cost-effective may fall, if they know that they can recover

increased costs simply by raising the transfer price. Without an incentive to produce efficiently,

the transfer price may erode the competitiveness of the final product in the market place.

Negotiated Pricing Method

In this approach, buying and selling business units freely negotiate a mutually acceptable

transfer price. Since each unit is responsible for its own performance, this will encourage

cost minimization and encourage the parties to seek a transfer price which yields them an

appropriate profit return. However the tax authorities have their reservations about this method

because companies that use this method have greater scope of manipulating transfer prices, to

minimize their tax liability.

Chapter No.6

RESEARCH METHODOLOGY

Research is a systematic method of finding solutions to problems. It is essentially an

investigation, a recording and an analysis of evidence for the purpose of gaining knowledge.

According to Clifford woody, “research comprises of defining and redefining problem,

formulating hypothesis or suggested solutions, collecting, organizing and evaluating data,

50

reaching conclusions, testing conclusions to determine whether they fit the formulated

hypothesis”

Sampling Design.

A sample design is a finite plan for obtaining a sample from a given population. Simple random

sampling is used for this study.

Universe.

The universe chooses for the research study is the employees of Lubrizol India Pvt Ltd.

Sample Size.

Number of the sampling units selected from the population is called the size of the sample.

Sample of 50 respondents were obtained from the population.

Sampling Procedure.

The procedure adopted in the present study is probability sampling, which is also known as

chance sampling. Under this sampling design, every item of the frame has an equal chance of

inclusion in the sample.

Nature of Research.

Descriptive research, also known as statistical research, describes data and characteristics about

the population or phenomenon being studied. Descriptive research answers the questions who,

what, where, when and how.

Although the data description is factual, accurate and systematic, the research cannot describe

what caused a situation. Thus, descriptive research cannot be used to create a causal relationship,

where one variable affects another. In other words, descriptive research can be said to have a low

requirement for internal validity.

Questionnaire.

A well defined questionnaire that is used effectively can gather information on both overall

performance of the test system as well as information on specific components of the system. A

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defeated questionnaire was carefully prepared and specially numbered. The questions were

arranged in proper order, in accordance with the relevance.

Sample

A finite subset of population, selected from it with the objective of investigating its properties

called a sample. A sample is a representative part of the population. A sample of 50 respondents

in total has been randomly selected. The response to various elements under each questions were

totaled for the purpose of various statistical testing.

Presentation of Data.

The data are presented through tables

Research Hypothesis

Based on the theoretical frame and the previous studies, the following hypotheses were formed:

HO1: the Lubrizol India Pvt. Ltd. do not divide the organizational structure into centers of

responsibility.

52

HO2: the Lubrizol India Pvt. Ltd. do not authorize the managers of responsibility centers with

clear powers.

HO3: the costs and the revenues are not distributed to the centers of responsibility according to

each center’s capability and powers in the Lubrizol India Pvt. Ltd.

HO4: the Lubrizol India Pvt. Ltd. do not link previously the estimated budgets with the centers

of responsibility.

HO5: the estimated budgets are not used for control and performance evaluation in the Lubrizol

India Pvt. Ltd.

Research

For achieving the objectives of the study, the descriptive analytical method was used. In

addition, the suitable statistical procedures, MS Excel were used for testing the hypotheses and

for presenting and analysis of the data.

Methods for Collecting Data

The researcher depended on two kinds of data during collecting it

Secondary data: the related studies of auditing about the subject of the study were reviewed from

different references, magazines, studies, periodicals, etc. for developing the theoretical

background of the study.

Primary data: the researcher made a comprehensive field survey for the population of the study

by using a questionnaire to collect data and test the hypotheses of the study. The questionnaire

consisted of two parts. The first part aimed at collecting general data to identify the

characteristics of the sample of the study. The second part aimed at getting data related to study

hypotheses.

The population and the sample of study

53

The population of the study is represented by all the Lubrizol India Pvt. Ltd. of the sample was

represented by a random sample consists of 50 assistants of the general managers. 55

questionnaires were distributed but 50 were retrieved with a percent 91%.

Table (1) The description of the sample

Scientific qualification N Portion

Diploma 3 6%

Bachelor 35 70%

Master 10 20%

Doctorate 2 4%

Age

Less than 25 years 7 14%

25-34 8 16%

35-44 26 52%

More than 45 years 9 18%

Practical experience

Less than 5 3 6%

5-9 years 9 18%

10-14 years 28 56%

More than 15 10 20%

Job title

Assistant of general manager 2 4%

Head of department 8 16%

Branch’s manager 18 36%

Head section 15 30%

Employee 7 14%

Statistical analysis of data

The following statically methods were used to analyze data and test the hypothesis according to

SPSS:

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1- Testing the reliability of the tool of the study: It was used to measure the internal reliability of

the questionnaire’s items and the internal consistency among the responses of the respondents

which was 72% and this value is acceptable as it is higher than 60% so the results could be

generalized.

2- Normality Distribution Test: It was used to test the normality of the distribution of data.

And the results showed that the data was distributed normally. It is illustrated from the table that

the significance level 5% for all the hypotheses of the study which was bigger than the level of

significance Z, was distributed normally.

Normality Distribution Test

               

Hypothesis 1st 2nd 3rd 4th 5th 6th 7th

  0.737 1.176 0.855 1.079 0.945 0.835 0.829

3- Testing the hypothesis

One Sample T-Test at the level of significance 5% was used to test the hypotheses of the 

study, and according to the rule of the acceptance of the hypotheses if the calculated T was less 

than the tabulated one. The descriptive analysis, which includes frequencies means and the 

standard deviations of accepting or rejecting the hypothesis, was used. 

The first hypothesis: The Lubrizol India Pvt. Ltd. do not divided the organizational

structure to centers of responsibility. This hypothesis was tested through the first seven

items of the questionnaire, and the results were as follows:

Results of testing the first hypothesis

           

T calculated T tabulated Sig Result of null Mean Std

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hypothesis

11.95 1.96 0 Rejection 3.76 0.451

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and

accepting the alternative one and the mean of the hypothesis is more than 3 which means it is

acceptable. So the Lubrizol India Pvt. Ltd. divide the organizational structure to centers of

responsibility. And table shows the mean and the standard deviation of the items of the first

hypothesis

The items of the first hypothesis

N Item Mean Std

1 There is an organizational structure divided

into administrative units according the

nature of the activity.

3.96 1.02

2 There is clarity in dividing the work in the

administrative units.

4.02 0.84

3 There is a clear description to the centers of

responsibility.

4.28 0.755

4 There is a coordination and clarity in the

relation between the centers of

responsibility

4.2 0.67

5 There is a specialized manager for each

center of responsibility.

3.88 0.98

6 Every center of responsibility has one type

of activity

2.44 0.97

7 The operations inside the center of

responsibility are characterized by

homogeneity

3.7 1.05

The second hypothesis: The Lubrizol India Pvt. Ltd. do not authorize the managers

56

of responsibility centers with clear powers. And this hypothesis was tested through the

items (8 - 13) of the questionnaire. And the results were as follows:

Results of testing the second hypothesis

           

T

calculate

d

T

tabulated

Sig T Result of

null

hypothesis

Mean Std

12.085 1.96 0 Rejection 3.97 0.57

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis

and accepting the alternative one and the mean of the hypothesis is more than 3 which means it is

acceptable according Lickert scale. So the Lubrizol India Pvt. Ltd. authorized the managers of

responsibility centers with clear powers. The table showed the mean and standard deviation of

the items of the second hypothesis:

The items of the second hypothesis

N Item Mean Std

8 The manager is told his duties in the center of

responsibility

3.86 0.92

9 The manager of the center is granted

appropriate authorities to do his work.

3.92 0.98

10 There is a description and identification of the

responsibilities and the authorities of every

job

3.94 0.99

11 The employees of the center of responsibility

have the needed expertise to do their work in

the center

4 0.92

12 The manager of the center is given enough 4.02 0.74

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time to do their work.

13 The employees’ accountability suits their

responsibilities.

4.08 0.96

The third hypothesis : The costs and the revenues are not distributed to the centers of

responsibility according to each center’s capability and powers in the Lubrizol India Pvt.

Ltd. This hypothesis through the items (14 - 18) of the questionnaire, and the results were

as follows:

Results of the third hypothesis

           

T

calculated

T tabulated Sig T Result of null

hypothesis

Mean Std

11.9 1.96 0 Rejection 3.92 0.54

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and

accepting the alternative one and the mean of the hypothesis is more than 3 which means it is

acceptable according Lickert scale. So there is a distribution of the costs and the revenues to the

centers of responsibility according to each center and its powers in the Lubrizol India Pvt. Ltd.

Table showed the mean and the standard deviation of the items of the third hypothesis

  The items of third hypothesis    

N Item Mea

n

Std

14 All the revenues regarding the center of responsibility are identified and

recorded.

3.68 0.97

15 All the costs regarding the center of responsibility are identified and

recorded.

4.04 1.009

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16 There is clarity in the system of comparing the revenues with the costs of the

center of responsibility

3.8 1.1

17 There is a clear policy regarding the indirect costs’ distribution to the

centers of responsibility

4.1 0.88

18 There is a clear and identified system of the costs distribution and the

revenues.

3.9 0.839

The fourth hypothesis : The Lubrizol India Pvt. Ltd. do not link previously the

estimated budgets with the centers of responsibility. This hypothesis was tested through

the items ( 19-23) of the questionnaire and the results were as follows:

Results of the fourth hypothesis

           

T calculated T tabulated Sig T Result of null

hypothesis

Mean Std

6.805 1.96 0 Rejection 3.37 0.39

As the calculated T is bigger than tabulated T this means rejecting the null hypothesis and

accepting the alternative one and the mean of the hypothesis is more than 3 which means it is

acceptable according Lickert scale which means that the Lubrizol India Pvt. Ltd. link the

estimated budgets with each of the center of responsibility previously. Table 10 showed the

mean and the standard deviation of the items of the 4th hypothesis

The items of the fourth hypothesis

       

N Item Mean Std

19 A clear and a realistic objective is identified

for every center of responsibility in the

organization complies with the performance

3.8 0.92

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standards.

20 Necessary adjustments on the estimated

budgets of the centers are carried out

wherever there is the need

3.62 0.87

21 The estimated budgets are prepared

regarding every center separately.

3.48 1.03

22 The organization trains the employees of the

centers and encourage them to achieve

these centers’ objectives

3.65 0.92

23 All the employees of the center participate in

preparing the center’s budget according to

their job

2.42 1.21

The fifth hypothesis : The estimated budgets are not used for control and

performance evaluation in the Lubrizol India Pvt. Ltd. This hypothesis was tested

through items ( 24-28) of the questionnaire and the results were as follows:

Results of testing the fifth hypothesis

           

T calculated T tabulated Sig T Result of null

hypothesis

Mean Std

11.243 1.96 0 Rejection 3.79 0.49

As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis

and accepting the alternative one and the mean of the hypothesis is more than 3 which means it is

acceptable according Lickert scale. So the estimated budgets are used for control and evaluating

the performance in the Lubrizol India Pvt. Ltd. And table 12 showed the mean and standard

deviation of the items of the 5th hypothesis.

N Item Mean Std

60

       

24 Comparing the employees Actual

performance with the planned one in every

center facilitates the communication

between the administrative levels.

3.72 0.99

25 Comparing the employees Actual

performance with the planned one in every

center helps in evaluating the employees’

performance

3.64 0.66

26 Comparing the employees Actual

performance with the planned one in every

center provides appropriate information in

the proper time.

3.9 0.9

27 Comparing the actual performance of the

employees supports the policies of control.

3.88 0.91

28 Comparing the employees Actual

performance with the planned one in every

center aims to

3.84 0.97

Chapter No. 7

Findings

The Lubrizol India Pvt. Ltd. are committed to the application of the elements of the

responsibility accounting regarding the division of the organizational structure into

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centers of responsibilities in terms of a clear existence of centers of responsibility in the

organization.

There is a coordination and clarity between the centers of responsibility in the

organization, clarity in dividing the work between the administrative units in the

organizations, division of the organizational structure in the organization into

administrative units according to the nature of the activity and there is a specialized

manager to every center of responsibility in the organization, and the operations inside

the center are homogeneous while the sample’s attitudes were negative towards having

one type of activity in every center of responsibility.

The Lubrizol India Pvt. Ltd. committed to the application of the responsibility accounting

features regarding delegation of clear authority for the managers of the centers of

responsibility which are represented by the employees’ accounting in the responsibility

centers that suit their responsibilities, granting the manager of responsibility center the

sufficient time to achieve his missions and the employees have the expertise of their

work. And the manager of the center is shown his responsibilities and granted the proper

authorities to do his work. There is also a description and identification to the

responsibilities and authorities of every job in the organization.

The Lubrizol India Pvt. Ltd. commit to the application of features responsibility

accounting regarding the distribution of the revenues and the costs to the centers of

responsibility according the capability of every center and its authorities which are

represented by having clear policy in the organization concerning distributing the indirect

costs to the centers of responsibility and determining and recording all the center’s costs.

there is also an identified and clear system for the distribution of costs and revenues in

the organization and clarity in the system of comparing the revenues and the costs of the

centers of responsibility in the organization and identifying all the revenues regarding the

center of the responsibility.

The Lubrizol India Pvt. Ltd. commit to the application of the responsibility accounting

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concerning linking previously the estimated budgets with every center of responsibility

which is represented through identifying clear and realistic objective for every center that

complies with the standards of performance, and the organizations commit to train the

employees of these centers and encourage them to achieve these centers’ objectives, to

carry out all the necessary adjustments of the estimated budgets of these centers

whenever there is a need. But these organizations do not commit to involve all the

centers’ employees in preparing the budgets according to every one’s work.

Chapter No. 8

Recommendations

It is necessary for the banks to have the employees in the centers of responsibility

involved in setting the objectives and preparing the estimated budgets of their centers

according to every one’s specialization and capability and this is a motive to the

employees to work harder which affects positively the banks’ performance.

63

To is necessary to have a coordination between the Central Bank and the administrations

of the banks to develop a guide recommended for application in the Jordanian banks that

includes objectives and advantages in using responsibility accounting to enhance

applying this method in the banks.

It is necessary for the professional organizations as the association of the banks to

encourage the banks to use the other modern administrative accounting methods in its

business as the application of Activity Based Costing system (ABC) and the balanced

Scored card (BSC) because of the importance of the role that these methods may play in

the operations of planning, control and performance evaluation which will improve the

revenues through achieving the best investment of the resources.

It is necessary for the banks to adopt systems of incentives that correlated with efficiency

and the good performance of the employees and achieved him satisfaction and self-

comfort.

It is necessary for the Jordanian banks to revise regularly the system of dividing the

organizational structure into centers of responsibility to verify the appropriateness of the

centers’ objectives with the general objectives of their banks.

It is necessary for the Jordanian banks to activate the principle of reflexive feedback to

investigate the employees’ opinions in different administrative levels according their

evaluation of the system of the responsibility accounting and to listen to their

suggestions.

Chapter No. 9

Conclusion

Assigning the right kind of autonomy and responsibility to employees will result in creative

ideas. But a manager should be able to strike the right balance between autonomy and control.

To understand autonomy, it is important to identify the variables that influence autonomy. They

can be grouped under three heads: Management style and process, responsibility structure and

64

reward systems. Management style, policies and procedures, diversification and business

strategy fall in the first group. Reward systems are designed on the basis of the manager's

ability to manage costs and investments. Responsibility structure consists of responsibility

centers and related performance measurement systems. Responsibility structure establishes

the physical, human and financial resources that are entrusted to the profit center manager.

The availability of resources influences the decision-making authority of the

responsibility center managers. Responsibility centers can be classified into revenue centers,

expense centers, profit centers, investment centers and cost centers. Revenue center are mainly

responsible for raising the revenue, and assume no responsibility for profits. In expense centers,

inputs are measured in monetary terms, whereas outputs cannot be easily quantified. There

are two types of expense centers: Engineered expense centers and discretionary expense

centers. In profit centers, financial performance is measured in terms of the numerical difference

between revenues and expenditures. An investment center is a measure of economic performance

and it analyzes all elements of profit and investments. Cost centers are supposed to minimize the

variance between standard costs and actual costs. When divisional autonomy is provided to

centers, it becomes important to measure the performance of decentralized operations. Factors

ROI, are important for measuring performance. Managing inter-profit center relations is a major

task in an organization. It is necessary to integrate the activities of the different responsibility

centers so that they work towards the accomplishment of the goals of the organization.

Bibliography

Books

C.R.Kothari,”Research Methodology, Methods & Techniques”, 2nd edition,

2004, New Age International Publication.

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Hehner, Barbara, ed. The Spirit of Canada. Toronto: Malcolm Lester Books,

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Puzo, Mario. The Family: A Novel. Completed by Carol Gino. New York:

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The Hindu Business Line Sunday,18 December 2005 – Maruti Insurnace

ramps up sales

Deccan Herald, Online edition of Sunday, 20 March 2007 – Maruti Suzuki’s

First driving school in Bangalore

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IBM. Advertisement. 23 Mar. 2003

http://www.bharatiyahockey.org/2000Olympics/ ibm.htm

http://www.hul.co.in

http://en.wikipedia.org/wiki/pureit

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