Responsibility Accounting

By Sudha Agarwal
Chartered Accountant

Contents

Introduction to Responsibility Accounting Advantages and Disadvantages of Responsibility Accounting Types of Responsibility Centres Transfer Pricing Transfer Pricing methods

Introduction

Responsibility Accounting is a method for dividing the organisation structure into various responsibility centres to measure the performance of each of the responsibility centres It is a device to measure divisional performance It focuses on what and not how well the performance is

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.

Advantages and Disadvantages of Responsibility Accounting

1. 2. 3. 4.

5. 1. 2.

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4. 5.

ADVANTAGES Helps manage a large and diversified organization Motivate Manager to optimize their performance Provide manager freedom to make local decisions Top management get more time for policy making and strategic planning Supports management and individual specialisation based on comparative Advantages DISADVANTAGES May create conflicts between various divisions Undue competition may become dysfunctional Narrows down vision as overall company prospective are not considered by individual managers. May prove costly due to duplication Problem in coordination across divisions

Types of Responsibility Center

Cost Center - that incurs costs but does not directly generate revenues Profit Center - that incurs costs but also generates revenue Investment Center - that incurs costs, generates revenues, and has control over the investment funds available for use

Responsibility Centre and their Evaluation

RESPONSIBILITY CENTRES

EVALUATION METHODS

Revenue Centre

Cost Centre

Profit Centre
Investment Centre

Sale Price Variance Sale Quantity Variance Sale Mix Variance Raw Material Variances: Labor Variances Overhead Variances Gross Profit Contribution Margin ROI Residual Income Economic Value Added

Types of Responsibility Center

Cost Center financial performance is measured in terms of cost. The analysis is restricted to use of resources in the division, what has been achieved as a consequence is not considered Cost center evaluation techniques include variance analysis and job and process costing Profit Center - financial performance is measured on the basis of profit. The traditional income statement can be modified to include categories :- (i) Controllable contribution margin (ii) Segment contribution margin (iii) Segment profit contribution (iv) segment net income It is used (i) for evaluation and ranking of profit centers (ii) As a basis for decisions to modify operations of profit centers Investment Center is an extension of the profit center. The measure of performance is based on the relationship between the segment profit contribution and segment assets. There are 2 ways to relate both (i) Segment ROI (SROI) (ii) Segment residual income

Types of Responsibility Center

(1) SROI = segment profit contribution (SPC)/(Segment resources/assets (SR/SA)) There are 2 variations to SROI, SROI = SPC before interest/Segment total assets SROI (net) = SPC after interest/Segment net assets SROI can also be viewed as the product of 2 components, segment profit margin and segment assets turnover ie SROI = SPC/segment sales revenue * segment sales revenue/Segment assets (2) SRI = SPC-(SROI * SR), where SRI = segment residual income, SPC = segment profit contribution, SROI = desired segment ROI, SR = segment resources

Transfer Pricing

A Transfer Price is that notional value at which goods and services are transferred between divisions in a decentralized organization. Transfer prices are normally set for intermediate products, which are goods, and services that are supplied by the selling division to the buying division. A question arises as to how the transfer of goods and services between divisions should be priced. The following factors should be taken into consideration before fixing the transfer prices :Transfer price should help in the accurate measurement of divisional performance. It should motivate the divisional managers to maximize the profitability of their divisions. Autonomy and authority of a division should be ensured. Transfer Price should allow Goal Congruence which means that the objectives of divisional managers match with those of the organization.

Transfer Pricing Methods Cost Based

1.

Cost Based Pricing: - In these methods, cost is the base and the following methods fall under this category. Actual Cost of Production: - This is in fact the simplest method of fixation of transfer price. In this method, the actual cost of production is taken as transfer price for inter divisional transfers. The actual cost of production may consist of only variable costs or total costs including fixed cost. Full Cost Plus: - In this method, the total cost of sales plus some percentage of profit is charged by the transferring division to the transferee division. The percentage of profit may be on the capital employed or on the cost of sales. The benefit of this method is that the profit measurement becomes possible. Standard Cost: - Standard cost is predetermined cost based on technical analysis for material, labor and overhead. Under this method, transfer price is fixed based on standard cost. The transferring unit absorbs the variance, i.e. difference between standard cost and actual cost. This method is quite simple for operation once the standards are set. However it becomes essential to revise the standards at regular intervals, otherwise the standard cost may become outdated. Marginal Cost Pricing: - Under this method, only the marginal cost is charged as transfer prices. The logic used in this method is that fixed costs are in any case unavoidable and hence should not be charged to the buying division. Therefore only marginal cost should be taken as transfer price.

Transfer Pricing Methods Market Based

2.

Market Based Pricing: Under this method, the transfer price will be determined according to the market price prevailing in the market. The forces of demand and supply will determine the market price in the long run and profit generated will be a very good parameter for measuring efficiency. The logic used in this method is that if the buying division would have purchased the goods/services from the open market, they would have paid the market price and hence the same price should be paid to the selling division. One of the variation of this method is that from the market price, selling and distribution overheads should be deducted and price thus arrived should be charged as transfer price. The reason behind this is that no selling efforts are required to sell the goods/services to the buying division and therefore these costs should not be charged to the buying division. Market price based transfer price has the following advantages :Actual costs are fluctuating and hence difficult to ascertain. On the other hand market prices can be easily ascertained. Profits resulting from market price based transfer prices are good parameters for performance evaluation of selling and buying divisions.

Transfer Pricing Methods Market Based

However, the market price based transfer pricing has the following limitations :There may be resistance from the buying division. They may question buying from the selling division if in anyway they have to pay the market price? Like cost based prices, market prices may also be fluctuating and hence there may be difficulties in fixation of these prices. Market price is a rather vague term as such prices may be ex-factory price, wholesale price, retail price etc. Market prices may not be available for intermediate products, as these products may not have any market. This method may be difficult to operate if the intermediate product is for captive consumption. Market price may change frequently. Market prices may not be ascertained easily.

Transfer Pricing Methods Negotiated

3.

Negotiated Pricing: In the above two methods, transfer prices are fixed on the basis of either the cost price or market price. However the transfer prices may be fixed on the basis of Negotiated Prices that are fixed through negotiations between the selling and the buying division. Sometimes it may happen that the concerned product may be available in the market at a cheaper price than charged by the selling division. In this situation the buying division may be tempted to purchase the product from outside sellers rather than the selling division. Alternatively the selling division may notice that in the outside market, the product is sold at a higher price but the buying division is not ready to pay the market price. Here, the selling division may be reluctant to sell the product to the buying division at a price, which is less than the market price. In all these conflicts, the overall profitability of the firm may be affected adversely. Therefore it becomes beneficial for both the divisions to negotiate the prices and arrive at a price, which is mutually beneficial to both the divisions. Such prices are called as Negotiated Prices. In order to make these prices effective care should be taken that both, the buyers and sellers should have access to the available data including about the alternatives available if any. Similarly buyers and sellers should be free to deal outside the company, but care should be taken that the overall interest of the organization is not jeopardized. The main limitation of this method is that lot of time is spent by both the negotiating parties in fixation of the negotiated prices. Negotiating skills are required for the managers for arriving at a mutually acceptable price, otherwise there is a possibility of conflicts between the divisions.

Transfer Pricing Methods Opportunity Cost

4.

Opportunity Cost Pricing: - This pricing recognizes the minimum price that the selling division is ready to accept and the maximum price that the buying division is ready to pay. The final transfer price may be based on these minimum expectations of both the divisions. The most ideal situation will be when the minimum price expected by the selling division is less than the maximum price accepted by the buying division. However in practice, it may happen very rarely and there is possibility of conflicts over the opportunity cost.

Transfer Pricing Models

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Models based on Economic theory a series of marginal revenue, marginal cost and demand curves for transfer of an intermediate product from one business to another is developed These curves are used to establish transfer prices, under various economic assumptions that would maximise the total profit of he 2 business units It is based on assumption that it is possible to estimate the demand curve for the intermediate product, the assumed condition remains stable and there are no alternative uses for facilities used to make the intermediate product Models based on Linear Programming It is based on opportunity cost approach Also incorporates capacity constraints The model calculates a company wide production pattern and using this pattern, it calculates a set of values that impute the profit contributions of each of the scarce resources. These are called shawdow prices and if variable cost of the intermediate product is added to the shawdow prices, a set of transfer prices results that motivate business units to produce according to the optimum production pattern for the entire company It is based on assumption that demand curve is known, it is static, cost function is linear and alternative uses of production facilities and their profitability can be estimated in advance

Transfer Pricing Models

3.

Models based on Shapley value Method of dividing the profits of a coalition (combination) of companies or individuals among its members in proportion to the contribution each of them made. Computation is lengthy unless there are few products involved in the transfer.

Problem 1 & Solution

Problem 2

Solution to Problem 2

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