Performance Evaluation

ANGELES UNIVERSITY FOUNDATION
Masters in Business Administration
MANAGERIAL ACCOUNTING
RESPON SIBILITY ACCOUNTING

Prepared and Reported by: Mar k Jan Vincent D. Enriquez
Reinalyn Castro
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RESPONSIBILITY ACCOUNTING MANAGERIAL ACCOUNTING Jan Vincent D. Enriquez & Reinalyn Castro By: Mark
DEFINITION RESPONSIBILITY ACCOUNTING Responsibility accounting involves the creation of responsibility centres. A responsibility centre may be defined as an organization unit for whose performance a manager is held accountable. Responsibility accounting enables accountability for financial results and outcomes to be allocated to individuals throughout the organization. The objective is to measure the result of each responsibility center. It involves accumulating costs and revenues for each responsibility centre so that deviation from performance target (typically the budget) can be attributed to the individual who is accountable for the responsibility centre. An example to explain Responsibility Accounting An integrated textile unit showed a net profit after tax of Rs.272 million. Its ROI (Return on Investment), was 17.5% which is much above the supposed cost of capital of 12.5%. The company was operating three divisions: (i) Spinning Unit, (ii) Weaving Unit and (iii) a Finishing Unit. As of now, it is not apparent who earned what. So managers of the three departments would be asking for bonuses or rewards. Now suppose, the company asks its accountants to prepare Division-wise P&L account and present the same to the management for performance appraisal of the three managers.
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Only the manager, Spinning Division, deserves the bonus. Manager Weaving has just broken even by earning profit equal to cost of capital. Manager Finishing was really a drag on the companys resources and its losses were only hidden in consolidated statements because of substantial contribution made by Spinning Unit. However, this is over-simplified example but it brings glaring facts to the notice of the management and other users of the accounts.
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MANAGERIAL PERFORMANCE AND ECONOMIC PERFORMANCE All businesses operate in a complex environment. The traditional approach of centralized control is not possible. There is a shift towards decentralization. At the same time, the management wants to retain some sort of control over activities of its managers.
When authority is decentralized and passed on to managers, there is congruence. This means that the management will constantly review activities of individual divisions to insure that none of them is working objectives of the company. Such a behavior is called dysfunctional and company.
a problem of goalall operations and against the overall is damaging to the
While evaluating, performance of an individual manager, two factors have to be considered:

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Should the managers job be separated and a manager is rewarded or penalized only for those activities over which the manager has control. Should the managers decision be seen in a wider prospective and final judgment be given only after reviewing full impact of such decisions.
It is obvious that a manager's decisions should be evaluated after seeing their impact on the bottom line i.e. profitablity of the comany. But such policy would not be motivational for the individual manager and the good results may be nullified by the factors not under the control of the particular manager. Hence, the company follows first appraoch i.e. managerial performance. Controllability Concept An underlying concept of responsibility accounting is referred to as controllability. Conceptually, a manager should only be held responsible for those aspects of performance that he or she can control. In my view, this concept is rarely, if ever, applied successfully in practice because of the system variation present in all systems. Attempts to apply the controllability concept produce responsibility reports where each layer of management is held responsible for all subordinate management layers as illustrated below.
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Responsibility accounting has been an accepted part of traditional accounting control systems for many years because it provides an organization with a number of advantages. Perhaps the most compelling argument for the responsibility accounting approach is that it provides a way to manage an organization that would otherwise be unmanageable. In addition, assigning responsibility to lower level managers allows higher level managers to pursue other activities such as long term planning and policy making. It also provides a way to motivate lower level managers and workers. Managers and workers in an individualistic system tend to be motivated by measurements that emphasize their individual performances. However, this emphasis on the performance of individuals and individual segments creates what some critics refer to as the "stovepipe organization." Others have used the term "functional silos" to describe the same idea. Information flows vertically, rather than horizontally. Individuals in the various segments
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and functional areas are separated and tend to ignore the interdependencies within the organization. Segment managers and individual workers within segments tend to compete to
optimize their own performance measurements rather than working together to optimize the performance of the system.
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RESPONSIBILITY CENTRES The main focus of responsibility accounting lies on the responsibility centres. A responsibility centre is a sub unit of an organization under the control of a manager who is held responsible for the activities of that centre. The responsibility centres are classified as follows: 1) Cost Centres When the manager is held accountable only for costs incurred in a responsibility centre, it is called a cost centre. It is the inputs and not outputs that are measured in terms of money. In a cost centre records only costs incurred by the centre/unit/division, but the revenues earned (output) are excluded form its purview. It means that a cost centre is a segment whose financial performance is measured in terms of cost without taking into consideration its attainments in terms of output. The costs are the planning and control data in cost canters. The performance of the managers is evaluated by comparing the costs incurred with the budgeted costs. The management focuses on the cost variances for ensuring proper control. A cost centre does not serve the purpose of measuring the performance of the responsibility centre, since it ignores the output (revenues) measured in terms of money. For example, common feature of production department is that there are usually multiple product units. There must be some common basis to aggregate the dissimilar products to arrive at the overall output of the responsibility centre. If this is not done, the efficiency and effectiveness of the responsibility centre cannot be measure.
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2) Profit Centres When the manager is held responsible for both Costs (inputs) and Revenues (output) it is called a profit centre. In a profit centre, both inputs and outputs are measured in terms of money. The difference between revenues and costs represents profit. The term revenue is used in a different sense altogether. According to generally accepted principles of accounting, revenues are recognized only when sales are made to external customers. For evaluating the
performance of a profit centre, the revenue represents a monetary measure of output arising from a profit centre during a given period, irrespective of whether the revenue is realized or not. The relevant profit to facilitate the evaluation of performance of a profit centre is the pretax profit. The profit of all the departments so calculated will not necessarily be equivalent to the profit of the entire organization. The variance will arise because costs which are not attributable to any single department are excluded from the computation of the departments profits and the same are adjusted while determining the profits of the whole organization. Profit provides more effective appraisal of the managers performance. The manager of the profit centre is highly motivated in his decision-making relating to inputs and outputs so that profits can be maximized. The profit centre approach cannot be uniformly applied to all responsibility centres. The following are the criteria to be considered for making a responsibility centre into a profit centre. A profit centre must maintain additional record keeping to measure inputs and outputs in monetary terms. When a responsibility centre renders only services to other departments, e.g., internal audit, it cannot be made a profit centre. A profit centre will gain more meaning and significance only when the divisional managers of responsibility centres have empowered adequately in their decision making relating to quality and quantity of outputs and also their relation to costs. If the output of a division is fairly homogeneous (e.g., cement), a profit centre will not prove to be more beneficial than a cost centre. Due to intense competition prevailing
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among different profit centres, there will be continuous friction among the centres arresting the growth and expansion of the whole organization. A profit centre will generate too much of interest in the short-run profit to the detriment of long-term results. 3) Investment Centres When the manager is held responsible for costs and revenues as well as for the investment in assets, it is called an Investment Centre. In an investment centre, the performance is measured not by profits alone, but is related to investments effected. The manager of an investment centre is always interested to earn a satisfactory return. The return on investment is usually

referred to as ROI, serves as a criterion for the performance evaluation of the manager of an investment centre. Investment centres may be considered as separate entities where the manager are entrusted with the overall responsibility of inputs, outputs and investment.
TRANSFER PRICING When profit centres are to be used, transfer prices become necessary in order to determine the separate performances of both the buying profit centres. Generally, the measurement of profit in a profit centre is further complicated by the problem of transfer prices. The transfer price represents the value of goods/services furnished by a profit centre to other responsibility centres within an organization. When internal exchanges of goods and services take place among the different divisions of an organization, they have to be expressed in monetary terms which are otherwise called the transfer price. Thus, transfer pricing is the process of determining the price at which goods are transferred from one profit centre to another profit
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centre within the same company. If transfer prices are set too high, the selling centre will be favored whereas if set too low the buying centre exercise which does not effect the overall profitability of the firm. However, in certain circumstances, transfer pricing may have an indirect effect on overall company profitability by influencing the decisions made at divisional level. The fixation of appropriate transfer price is another problem faced by the profit centres. The transfer price forms revenue for the selling division and an element of cost of the buying division. Since the transfer price has a bearing on the revenues, costs and profits or responsibility canters, the need for determination of transfer prices becomes all the more important. But the transfer price determination involveschoosing one among the various alternatives available for the purpose.

These are three objectives that should be considered for setting-out a transfer price. (a) Autonomy of the Division. The prices should seek to maintain the maximum divisional autonomy so that the benefits, of decentralization (motivation, better decision making, initiative etc.) are maintained. The profits of one division should not be dependent on the actions of other divisions,
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(b) Goal congruence: The prices should be set so that the divisional managements desire to maximize divisional earrings is consistent with the objectives of the company as a whole. The transfer prices should not encourage suboptimal decision-making.
(c) Performance appraisal: The prices should enable reliable assessments to be made of divisional performance.
There are two board approaches to the determination of the transfer price and they are: (1) cost-based and (2) market based. Based on the broad classification, there are five different types of transfer prices they are (1) cost (2) cost plus a normal mark-up; (3) incremental cost; (4) market price and (5) negotiated price..

Transfer Pricing Methods

(i)
Market based transfer pricing: Where a market exists outside the firm for the intermediate product and where the market is competitive (i.e., the firm is a price taker)
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then the use of market price as the transfer price between divisions will generally lead to optimal decision-making.
(ii)
Cost based pricing: Cost based transfer pricing systems are commonly used because the conditions for setting ideal market prices frequently do not exist; for example, there may be no intermediate market which does exist may be imperfect. Providing that the required information is available, a rule which would lead to optimal decision for the firm as a whole would be to transfer at marginal cost up to the point of transfer, plus any opportunity cost to the firm as whole. The two main cost derived methods are those based on full cost and variable cost.
(iii)
Full cost transfer pricing: this method, and the variant which is full costs plus a profit mark-up, has the disadvantage that suboptimal decision-making may occur particularly when there is idle capacity within the firm. The full cost (or cost plus) is likely to be treated by the buying division as an input variable cost so that external selling price decisions, may not be set at levels which are optimal as far as the firm as a whole is concerned.
(iv)
Variable cost transfer pricing: Under this system transfers would be made at the variable costs up to the point of transfer. Assuming that the variable cost is a good approximation of economic marginal cost then this system would enable decisions to be made which would be in the interests of the firm as a whole. However, variable cost based prices will result in a loss for the setting division so performance appraisal becomes meaningless and motivation will be reduced.

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(v)
Negotiated transfer pricing: Transfer prices could be set by negotiation between the buying and selling divisions. This would be appropriate if it could be assumed that such negotiations would result in decisions which were in the interests of the firm as a whole and which were acceptable to the parties concerned.
Relevant points (1) Transfer pricing is the pricing of internal transfers between profit centres. (2) Ideally the transfer prices should, promote goal congruence, enable effective performance appraisal and maintain divisional autonomy. (3) Economy theory suggests that the optimum transfer price would be the marginal cost equal for buying divisions marginal revenue product. Transfer prices should always be base on the marginal costs of the supplying division plus the opportunity costs to the organization as a whole. (4) Because of information deficiencies, transfers pricing in practice does not always follow theoretical guidelines. Typically prices are market based, cost based or negotiated. (5) Where an appropriate market price exists then this is an ideal transfer price. However, there may be no market for the intermediate product, the market may be imperfect, or the price considered unrepresentative. (6) Where cost based systems are used then it is preferable to use standard costs to avoid transferring inefficiencies. (7) Full cost transfer pricing for full cost plus a mark up) suffers from a number of limitations,; it may cause suboptimal decision-making, the price is only valid at one output level, it makes genuine performance appraisal difficult.

RESPONSIBILITY ACCOUNTING
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MANAGERIAL ACCOUNTING Jan Vincent D. Enriquez & Reinalyn Castro
By: Mark
(8) Providing that variable cost equates with economic marginal cost then transfers at variable cost will avoid gross sub optimality but performance appraisal becomes meaningless.
(9) Negotiated transfer prices will only be appropriate if there is equal bargaining power and if negotiations are not protracted.
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Bibliography
http://www.basiccollegeaccounting.com/what-is-responsibility-accounting/ http://www.accountancy.com.pk/articles_students.asp?id=55 http://www.accountingweb.co.uk/cgi http://www.bin/item.cgi?id=23118&d=789&h=788&f=785 http://www.atkinson.yorku.ca/~garys/abky17/tsld003.htm http://www.pondiuni.org/DDE/ManagementAccounting.pdf
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Performance Evaluation

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ANGELES UNIVERSITY FOUNDATION

Masters in Business Administration

RESPON SIBILITY ACCOUNTING

ANGELES UNIVERSITY FOUNDATION

ANGELES UNIVERSITY FOUNDATION

a problem of goalall operations and against the overall is damaging to the

While evaluating, performance of an individual manager, two factors have to be considered:

ANGELES UNIVERSITY FOUNDATION

ANGELES UNIVERSITY FOUNDATION 5|Page

Masters in Business Administration

ANGELES UNIVERSITY FOUNDATION

ANGELES UNIVERSITY FOUNDATION

ANGELES UNIVERSITY FOUNDATION

ANGELES UNIVERSITY FOUNDATION

Transfer Pricing Methods

ANGELES UNIVERSITY FOUNDATION

ANGELES UNIVERSITY FOUNDATION

MANAGERIAL ACCOUNTING Jan Vincent D. Enriquez & Reinalyn Castro

ANGELES UNIVERSITY FOUNDATION

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