2016-17 Term 1

ACCT112 Management
Accounting
Week 11/12
Responsibility
Accounting
Balanced Scorecard
Transfer Pricing
2016-17-T1-Aug to Dec 2016

Seminar Outline
Understand the importance of responsibility
accounting for performance evaluation
Understand the use of ROI, Residual Income
and Economic Value Added as performance
measures and their limitations
Construct and use a Balanced Scorecard to
measure performance
Understand the methods to determine transfer
price

2016-17-T1-Aug to Dec 2016

Centralisation vs Decentralisation

How to manage a LARGE company with

different products, markets, locations,
constraints, etc.
How much decision-making to delegate?
How to motivate all sub-units to work
towards a common goal?

2016-17-T1-Aug to Dec 2016

Decentralised Organisation
HQ

Division

Division

Dept

Dept

Dept

Dept

How to link managers decision-making

authority with accountability for the outcomes
those decisions?
of
Responsibility
accounting: Hold a manager
of a subunit responsible for those items and
only those items that the manager can
control
a significant extent
actually
Each subunit
is atoresponsibility
centre
2016-17-T1-Aug to Dec 2016

Types of Responsibility Centers

Responsibility
Subunit
Center
Cost
centers: managers are e.g. accounting
accountable for costs.
dept, HR dept,
Managers are expected to
general admin
minimise costs while
dept, machining
providing the level of
work centre of
products and services
production dept
Revenue
demandedcenters:
by other parts of
e.g. sales dept
the organisation.
managers
are accountable
revenues
for
Profit
centers: managers
e.g. retail
has control over both costs
branch
Investment
and revenues.
centers:
e.g. division
managers are accountable
for profits and invested
capital used by the subunit
2016-17-T1-Aug to Dec 2016
to generate its profit.

Illustration of Responsibility
Presiden Accounting
Investment
t

Consulti
ng
Division

Sales
Dept

Design
Work
Centre

Comput
er
Division
China
Singapo
Plant
re Plant

Purchasin
g Dept
Assembly
Work
Centre

Productio
n Dept
Packagin
g Work
Centre

2016-17-T1-Aug to Dec 2016

Centre
Investment
Centre
Profit Centre
Revenue
Centre
Cost Centre

Cost Centre
6

Performance Reports
Budge
t

Actual

Varian
ce

Company
Computer Div
Consulting Div
Total Profit

$M
$N
$P

$...
$...
$...

$...
$...
$...

Computer Div
Singapore Plant
China Plant
Total Profit

$J
$K
$M

$...
$...
$...

$...
$...
$...

Singapore
Plant
Sales Revenue
Production Costs
Other Costs
Total Profit

$G
$F
$H
$J

$...
$...
$...
$...

$...
$...
$...
$...

Production
Dept
Design costs
Assembly costs
Packaging costs
Total Costs

$C
$D
$E
$F

$...
$...
$...
$...

$...
$...
$...
$...

Design Work

Responsibility Accounting:
Behavioural Impacts
(1) Do we blame the manager for all
unfavourable
Is production variances?
manager always responsible for all
cost variances?
E.g.
DM Qty Var = (AQ of DM TSQ of
DM) x SP
If unfav DM qty variance is due to poor quality
DM bought by the Purchasing Mgr, how can RA
help?

2016-17-T1-Aug to Dec 2016

Responsibility Accounting:
Behavioural
Impacts
(2) Does manager
really have
full revenue or
cost controllability?
E.g. 1: If sales drop, does it mean that the sales
manager is at fault?
Sales
Less COGS:
DM
DL
etc

Actual
Budget
$500,000 $600,000
$120,000 $200,000

2016-17-T1-Aug to Dec 2016

Responsibility Accounting:
Behavioural
Impacts
E.g. 2: Fair to
hold the Computer
Div manager
responsible for $3,000 loss?
Computer Consulting Compa
Division
Division
ny
$500,00
$300,000
$200,000
0

Sales
Less
Variable COGS/cost
of services sold
120,000
60,000
Variable S&A
30,000
20,000
Total variable
expenses
150,000
80,000
Contribution margin 150,000
120,000
Allocated fixed
expenses
153,000
102,000
Net operating
2016-17-T1-Aug to Dec 2016
income
-$3,000
$18,000

180,000
50,000
230,000
270,000
255,000
$15,000 10

Responsibility Accounting:
Behavioural
Impacts
(3) How can
desired behaviour
be motivated?
E.g. There is a rush order that will incur OT
Company
costs
Company
Yes, only if
s interests
incremental
revenue >
incremental costs
Sales Manager Production Mgr
Managers (Revenue
(Cost Centre):
interests Centre):
No, OT will increase
Yes, to earn
costs and blow
more revenue
budget
Using responsibility accounting, the cost of the
rush order is assigned to the Sales Manager. Now,
will his decision be the same as the companys?
2016-17-T1-Aug to Dec 2016

11

Investment Centre (Division)

Performance
Measures
Investment
centres use Operating
assets to earn
Operating Income

use
maximi
effectively
se
Return on Investment (ROI) =
Operating Income before interest and tax
or EBIT
Average
Operating Assets
Residual Income (RI)
=
Operating Income before interest and tax - (Min.
required rate of returna x Average Operating
Note a = cost of capital
Assets)
Economic Value Added (EVA) =
Operating Incomeb - (Min. req rate of return x
Economic Capital Investedb)
Note b =
adjusted

2016-17-T1-Aug to Dec 2016

12

Divisional Performance Measures:

Example
Revenue
Expenses
Operating Income
(EBIT)
Interest expense
Income before tax
Tax at 30%
Net Income

Div A
Div B
Company
$1,200,000 $1,850,000 $3,050,000
1,000,000 1,500,000 2,500,000
$200,000

$350,000

$550,000
120,000
430,000
129,000
$301,000

Current assets
$400,000 $500,000 $900,000
Long-term assets
600,000 1,500,000 2,100,000
Total assets
$1,000,000 $2,000,000 $3,000,000
Current liabilities
$50,000 $150,000 $200,000
Long-term debt
1,300,000
Companys
required rate of 1,500,000
Shareholders'
equity
return
= 2016-17-T1-Aug
12% to Dec 2016
Total liabilities
+ SH
Equity
$3,000,000 13

Divisional Performance Measures:

Example
Compan
Div A
ROI
$200K
[Operating Income/Total
$1,000K
Assets]
= 20%
RI
$200K [Operating Income
(12%*
(12% x Total Assets]
$1,000K)
=
Another view of
$80,000
ROI:
Operating
ROI
x
Sale
Income
=
s
=
x
Margin

Div B
$350K
$2,000K
= 17.5%
$350K(12%*
$2,000K)
=$110,0
00
Sale
s
Total
Assets
Turnover

y
$550
$3,000
= 18.3%
$550K (12% *
$3,000K)
=
$190,00
0

ROI (Div A) = ($200K/$1,200K) x ($1,200K/

$1,000K)
2016-17-T1-Aug to Dec 2016
= 16.7% x 1.2 = 20%

14

Some Dysfunctional Behaviour using

ROI
E.g. Div A could increase operating
income by $70,000 if it invests in a
machine
that
costs $500,000.
ROI for the
machine
= $70,000/$500,000
= 14%

Higher
than companys
required
of
From
companys
perspective
rate
Invest
return 12%
Div A
Current ROI = $200,000/$1m = 20%
ROI after investing in machine
= ($200,000+$70,000)/($1m+$0.5m)
= 18%
If you are the manager of Div A, would you
invest in the machine?
2016-17-T1-Aug to Dec 2016

15

Some Dysfunctional Behaviour using

The example illustrates
ROI the problem if a
divisions ROI is higher than the
companys Costs of Capital, the division
will tend to reject projects lower than
their current ROI even though it earns
more than Costs of Capital.
In such situations, Residual Income
method will better sync divisions
performance with the companys:
Current RI = $200,000 (12% x $1m) =
$80,000
New RI = $270,000 (12% x $1.5m) =
$90,000
2016-17-T1-Aug to Dec 2016

16

RI vs ROI as Performance Measure

ROI (new) = Weighted Average of (Current ROI and
Project ROI)
Project will be rejected by Division even though
its ROI > companys cost of capital if Project
ROI < Div Current ROI
RI (new) = Current RI + Project RI
When Project RI > 0, RI (new) > Current RI i.e.
Accept Project
Project RI > 0 when project is profitable i.e.
Projects ROI > companys cost of capital
Thus RI is a more desirable performance
measure as it encourages managers to
accept profitable projects reject nonprofitable ones.
2016-17-T1-Aug to Dec 2016

17

RI vs ROI as Performance Measure

BUT is RI the perfect measure of performance?
E.g. Does it mean Div B has performed better
than Div A because RI of Div B is higher than Div
A?
Div A
Div B
Company
Operating
Income
$200,000 $350,000 $550,000
Total assets
ROI
RI

$1,000,000 $2,000,000 $3,000,000

20%
$80,000

18%

18%

$110,000 $190,000

Neither ROI nor RI provides a perfect measure of

performance.

2016-17-T1-Aug to Dec 2016

18

Economic Value Added (EVA): a

variation of RI

RI = Operating Income before interest and tax (Cost of Capital x Average Operating Assets)
EVA = Operating incomea - (Cost of Capital x
Economic Capital Investedb)
Adjustments to Operating income a
E.g. Capitalising R&D; capitalizing business
development expenses

Adjustments to Operating assets b

E.g. Price level adjustments to reflect current year
currency values; use gross book values to reflect
The main reason for adjustments is to
assets actual economic value
motivate divisional managers to make
decisions that will benefit the company in the
2016-17-T1-Aug to Dec 2016
19
long term.

Issues with ROI, RI, EVA

Relating to
How will managers
Income
behave to improve
Timing
Income?
Income is usually
measured for a financial
year
Investment projects are long-term with
lower returns in early years ad higher
returns in later years
Short term actions to increase ROI vs long Accrual
term interest
of company
Accounting
income
Cash flows
Large income does not mean large cash
flows
Internal
transfers
Divisional income is dependent on transfer
price
Div A sells to Div B. Div A reports a
higher income
than Div B. Does it mean 20
2016-17-T1-Aug to Dec 2016

Issues with ROI, RI, EVA

Relating to
Assets
Matching
Performance should be measured for a
period of time
Operating assets are computed as at a
point of time
Gross
Use or
NBV
average?
NBV is determined by depreciation
methods, which are arbitrary
NBV favours Divisions that have old assets
Cost or Market
During inflation, historical cost asset values
do not reflect cost of replacing assets.
2016-17-T1-Aug to Dec 2016

21

Non-Accounting Measures
Share price performance?
Align managers interests to those of
shareholders
Managers have full control over share prices?
Business units (e.g. work centres, depts) are
Portfolio approach view investment centre as
not listed
collection
of investments and evaluate its longterm performance
Evaluate profit for a time period instead of a
single yearmeasures e.g. delivery times;
Non-financial
Post audit of investment decisions
inventory levels?

Focus on drivers of profit

Recognise time lags between non-financial
and financial performance
Balanced scorecard
2016-17-T1-Aug to Dec 2016

22

The Balanced Scorecard

A balanced scorecard consists of an
integrated set of performance measures
Performance measures influence behavior
E.g. Performanc
Behaviour
e measures
(a) Sales
?
targets
?
(b) Cost target per unit
produced
?
(c) No. of calls handled in 1
hour
Thus, set performance measures must be
derived from the companys objectives and
strategy
E.g. if the company aims to create value by
giving excellent customer service, would (c)
2016-17-T1-Aug to Dec 2016
achieve this objective?

23

BSC Measures are interlinked

Measures are linked together on a cause-and-effect
basis. If we improve this performance measure, then
this other performance measure should also improve.
Financial
Perspective

Customer
Perspective

Vision &
Strategy

Learning &
Growth

Internal
Processes

2016-17-T1-Aug to Dec 2016

24

Has
Indicat
company
ors
objective
been met

Laggin
g

Leading
Indicators

Can predict if
company objective
will be met

Using Performance Measures to execute

Strategy e.g. SIA
Strategy:
Success through excellent
customerand
service
Competent
motivated
employees
Effective & Efficient internal
processes & operations
Customer satisfaction
Higher Revenue & Lower Costs
-> PROFITABILITY = Success?
2016-17-T1-Aug to Dec 2016

25

Measures are derived from Strategy

Performance Measures
must be quantifiable &
unambiguous
Financial
$ profit; % growth in profit;
growth in share price

Customer
% growth in market share
No. of repeat customers
Internal Business
Processes
No.
of accidents
No. of new routes
Time taken to process
booking
Learning and Growth
No. of pilot training hours
% of automated processes

What are our

financial goals?
Vision
How well are we in winning
and
and retaining customers? Strate
gy
What internal business processes are
critical to providing
value to customers?
Do we have the
capability to
carry out the key
processes?

2016-17-T1-Aug to Dec 2016

26

E.g. Jaguars Strategy is to attract customers

by offering wide variety of options and fast
turnaround time
+
Profit

Financial

+
+
Contribution per car
Number of cars sold +

Customer
Number of customer
complaints

Internal
Business
Processes
Learning
and Growth

Number of
+
options available

Time to
install option

No. of skilled
employees
2016-17-T1-Aug to Dec 2016

+
27

Horngren E13-3 Balanced Scorecard

Illustrated

2016-17-T1-Aug to Dec 2016

28

Transfer Pricing
Transfer price: Price charged when one segment
of a company provides goods or services to
another segment of the same company.
Company
Z
Division Sell @ Division
X
Y
part $TP
(Selling)

(Buying)

Does TP matter to Div X? Div Y? Company Z

as
a whole?
Common
approaches to set transfer prices:

Market based
Cost based
Negotiated
Top management decide
2016-17-T1-Aug to Dec 2016

29

Example
Company Z has 2 divisions: Div X and Div Y.
Div X produces a part that it can sell to external
customers or internally to Div Y.
The cost of producing the part by Div X is $6.
Div Y produces a finished product that uses the
part.
Div Y can buy the part from external suppliers or
internally from Div X.
The cost of producing the finished product
excluding the cost of the part = $10.
Div Y sells the finished product at $30.

2016-17-T1-Aug to Dec 2016

30

Market-based TP: Selling Div has NO Excess

Capacity
The Whole Company (Z)
Sell
Unit cost=
Unit cost excl part =
finished Outside
$6
$10
@ $30
product
Division X
Division Y
TP =$?

(Selling)
(Buying)
Customer
Q
Market price of
@
Outside the part
$15
Outside

Customer
Supplier
P

Div X has no excess

capacity sell to
either Customer P or
Div Y but not to both

Div Y can buy from

either Div X or Outside
Supplier

Div Y will buy from

Div X will sell to Div
Div X only if TP
Y only if TP $15
$15
Thus, for internal transfer
to take
place, TP = $15, the market price of
2016-17-T1-Aug to Dec 2016
the part

31

Market-based TP: Pitfall (1)

If Div X has excess capacity i.e. it can sell to both
Customer P and Div Y; and if the market price of
the part is too high, using market-based TP may
not benefit the company as a whole.

The Whole Company (Z)

Sell
Unit cost=
Unit cost excl part =
finished Outside
$6
$10
@ $30
product
Division X
Division Y
TP = $?

(Selling)
(Buying)
Customer
Q
Market price of the @
Outside part
$25
Outside

Customer
Supplier
P

If Div X insists on TP = $25, Div Y will not make and sell

the finished product as total cost ($10 + $25) > selling
price
What $30.
is the loss to the company as a whole?
2016-17-T1-Aug to Dec 2016

32

Market-based TP: Pitfall (1)

The Whole Company (Z)
Sell
Unit cost=
Unit cost excl part =
finished Outside
$6
$10
@ $30
product
Division X
Division Y
TP = $?

(Selling)
(Buying)
Customer
Q
Market price of the @
Outside part
$25
Outside

Customer
Supplier
P

For the company as a whole,

The cost of producing the finished product = $6 + $10 =
$16
There is no opportunity cost (no lost sale of the part to
Outside Customer P) as Div X has excess capacity
Revenue from sale of finished product to Outside
Customer Q = $30
Company loses $14 if
Profit from sale of finished product = $30 - $16 = $14

there is no internal
2016-17-T1-Aug to Dec 2016
transfer

33

Market-based TP: Pitfall (2)

What if the market price of the part is
too low?
The Whole Company (Z)
Sell
Unit cost=
Unit cost excl part =
finished Outside
$6
$10
@ $30
product
Division X
Division Y
TP = $?

(Selling)
(Buying)
Customer
Q
Market price of the@ $4
Outside part
Outside

Customer
Supplier
P

Cheaper to buy from Outside Supplier than to

produce
internally
Close
down
Div
X?
2016-17-T1-Aug to Dec 2016

34

Cost-based TP: Variable or Full Cost?

The Whole Company (Z)
Sell
Unit var cost=
Unit cost excl part = finished Outside
$3
@ $30
product
$10

Unit fixed
Division X
Division Y
TP = $?
Customer
cost=$3
(Selling)
(Buying)
Q
Sell @ $4
Outside
part

Supplier

If use Full cost,

Div X will sell to Div Y
at $6
Will Div Y buy from Div X
at
No,$6?
Div Y will buy from Outside Supplier at
$4
2016-17-T1-Aug to Dec 2016

35

Cost-based TP: Variable or Full Cost?

The Whole Company (Z)
Sell
Unit var cost=
Unit cost excl part = finished Outside
$3
@ $30
product
$10

Unit fixed
Division X
Division Y
TP = $?
Customer
cost=$3
(Selling)
(Buying)
Q
Sell @ $4
Outside
part

Supplier

If Div X has excess capacity,

what is the impact of Div Ys
decision on the company as a
Incremental
cost to produce part = $3 (unit
whole?
var cost)
Cost
if buy from Outside
supplier
= $4
Company
is worse off
by $1
2016-17-T1-Aug to Dec 2016

36

Other TP Methods
Negotiated e.g. when no external market
exists for the transferred product
Negotiation skills vs best interests of
company
Top Management decide e.g. for tax
advantage
Division X in
Division Y in
Country A
Country B

Tax Rate = 15%

Tax Rate = 35%

Top Mgmt will want TP to be as ________ as

possible

Tax authorities are not stupid

Arms length transaction value = price if
good or service were sold to an independent
party
Top mgmt interference = Centralisation?
2016-17-T1-Aug to Dec 2016
37
Defeats purpose
of decentralisation

Some Qn that you can answer now

Why do need performance measures?
What are the considerations when you design
performance measures?
How do you motivate your managers to do
what is best for the company as a whole?

2016-17-T1-Aug to Dec 2016

38