Responsibility Accounting and Transfer Pricing

RESPONSIBILITY ACCOUNTING AND TRANSFER PRICING

Responsibility Accounting – an accounting information system and a managerial control device that involves:

Identifying responsibility centers with their corresponding objectives
Developing measures of achievement of such objectives
Preparing and analyzing reports of such measures by the responsibility centers

Responsibility centers – A subunit of an organization whose manager has authority over, and is responsible and accountable for a specific or defined group of activities

Cost center – manager has control over the incurrence of cost and not revenues and investments.
Revenue center – manager has control over revenues.
Profit center – manager has control over both costs and revenues.
Investment center – manager has control over revenues, costs and investments in assets such as receivables, inventory and property plant and equipment.

Organizational Structures

Centralized – top management makes most decisions and controls most activities of the segments
Decentralized – employee empowerment  top management grants subordinate managers a significant degree of autonomy and independence in operating and making decisions relating to their sphere of responsibility. (Responsibility accounting works best in this structure.)

Performance Evaluation

Contribution Margin for each responsibility center
Segment Margin = Contribution Margin less direct or traceable fixed cost
Operating Income for each responsibility center = Segment margin less allocated common cost
Return on Investment = Operating income divided by Investment
Residual Income = Excess of income earned by an investment center over the desired income.

-Desired income = investment x cost of capital

-Minimum required return to sufficiently pay cost of using funds.

Transfer Price – amount charged by one segment or center of an organization for goods transferred and/or services provided to another segment or center of the same organization.

Factors considered in selecting a transfer pricing policy:

Goal Congruence – a transfer price should permit a segment to operate as an independent entity and achieve its goals while functioning in the best interest of the organization as a whole.
Ex. Between two profit centers, the selling segment should not incur a loss
Segment Performance – the selling segment should not lose income by selling within the company
Negotiation – the buying segment should not incur greater costs by buying within the company. If the product or service could be purchased outside the company, the buying segment should be allowed to negotiate the transfer price.
Capacity
If the selling segment has excess capacity, it can be used to produce goods for transfer within the company.
No opportunity cost
If there is no excess capacity, the selling segment should not incur a loss by selling to another segment within the same organization.
Opportunity cost is profit foregone in selling outside (to regular buyers)
Cost structure – costs to be considered in a transfer price should be broken down into variable and fixed, so that it would be easier to identify what are the relevant costs.
Determine what costs are relevant or what are sunk

Types of Transfer Prices:

Market price
Goods and services are measured at the prevailing market price.
Cost plus markup
Goods and services are measured by Full cost + markup
Incremental cost plus opportunity cost to the seller
Consider opportunity cost only if operation is at maximum capacity
Incremental cost is VC
The opportunity cost is usually the contribution margin to be lost from outside customers if the goods are transferred to the buying segment within the organization.
Opportunity cost will arise if the selling segment has insufficient capacity.
Negotiated transfer price (applicable when prices are fluctuating rapidly)
Consider the range
Minimum price (seller’s pt. of view) – incremental cost plus opportunity cost (if any)
Maximum price (buyer’s pt of view) – prevailing market price

Exercises

The following information pertains to the product produced by the clothing division of Kalbo Corporation:

Per unit

Selling Price P 150

Manufacturing costs:

Prime cost 75

Variable manufacturing overhead 15

Direct Fixed manufacturing overhead (Total of P80,000) 8

Selling costs:

Variable 18

Direct Fixed (Total is P60,000) 6

During the current period, the division produced 10,000 units and sold 90% of this production. There were no beginning and ending work-in process inventories and there was no beginning finished goods inventory during the period. Variable manufacturing costs vary with production while variable selling costs vary with sales in units. Central administration cost is allocated to the different divisions of the company as a proportion of division sales to the total company sales. Total company sales amounted to P13.5 million while total company central administration cost amounted to P1.5 million.

Required: Prepare an income statement using the contribution margin format to show the performance of the clothing division of Kalbo Corporation. In the income statement show the following: contribution margin, segment margin and operating income. Compute the operating profit margin of the division. For the manager to receive an incentive, the operating profit margin should at least be 8%. Based on the performance of the current period, will the division manager receive an incentive?

The Kyusi Division of Pinas Company is treated as an investment center for performance measurement purposes. Selected financial information for such division for last year is given below:

Net SalesP 200,000

Cost of Goods Sold 176,250

General and admin cost 3,750

Average working capital 31,250

Average plant and equipment 68,750

Weighted average cost of capital 15%

What was Kyusi’s return on investment last year?
What was Kyusi’s residual income last year?

Villar is the manager of C-5 Products Division of Hirap Corporation. As a manager of this investment center, Villar’s performance is measured using the residual income. For the coming year, Villar wants to achieve a residual income target of P100,000 using a weighted average cost of capital of 20%. Other forecasted figures for the coming year are as follows:

Working CapitalP 90,000

Plant and Equipment 860,000

Cost and Expenses1,210,000

How much should revenues be next year to achieve the residual income target?

Megatronics Corporation, a massive retailer of electronic products, is organized in four separate divisions. The four divisional managers are evaluated at year-end, and bonuses are awarded based on return on investment. Last year, the company as a whole produced a 13% return on its investment.

During the past week, management of the company’s Western Division was approached about the possibility of buying a competitor that had decided to redirect its retail activities. The data that follow relate to recent performance of the Western Division and the competitor:

Western Division / Competitor
Sales / P 4,200,000 / P 2,600,000
Variable Costs / 70% of sales / 65% of sales
Fixed Costs / 1,075,000 / 835,000
Invested Capital / 925,000 / 312,500

Management has determined that in order to upgrade the competitor to Megatronics’ standards, and additional P187,500 of invested capital would be needed.

Required: Answer the following questions based on the information provided:

Compute the current return on investment of the Western Division and the division’s return on investment if the competitor is acquired.
What is the likely reaction of the divisional manager toward the acquisition? Why?
What is the likely reaction of the Megatronics’ top management toward the acquisition? Why?
Would the division be better off if it did not upgrade the competitor to the company’s standards? Show computations to support your answer.
Assume that Megatronics uses residual income to evaluate performance and desires a 12% minimum required rate of return on invested capital. Compute the current residual income of the division and the residual income of the division if the competitor is acquired. Will divisional management be likely to change its attitude toward the acquisition? Why?

Cabinet Inc. has two divisions: the Handles Division, which manufactures cabinet handles, and the Assembly Division, which assembles various parts to produce cabinets, the main product of Cabinet Inc.

The Handles Division currently has excess capacity of 1,500 units. It produces handles at variable cost of P70 per handle. Total fixed manufacturing cost incurred in production is P150,000. The handles can be sold in the outside market for P100 per handle. The Assembly Division requires 1,400 handles for the cabinets that it produces. It can buy such handles from an outside supplier at P90 per handle or it can just buy them from the Handles Division.

What is the natural bargaining range for the two divisions regarding the transfer price of handles?
Refer to the original data. Also assume that the Handles Division is operating at full capacity instead of having excess capacity. What is the minimum price that Handles Division would quote Assembly Division? Would there be a negotiation for transfer?

a / Handles -Seller / Assembly - Buyer
no opportunity cost
Transfer Price Range / 70 / 90
minimum price of one unit / 70 / X
maximum price of one unit / X / 90
b
no excess capacity
incremental cost / 70
opportunity cost / 42000 / total CM / selling price / 100
1400 / no of units / VC / 70
30 / CM / 30
minimum price / 100 / no of units / 1400
Total CM lost / 42000
mamimum price / 90
no sale

Gripo Inc. has several divisions operating as decentralized profit centers. Gripo’s Faucet Division produces showerhead sets using subcomponents produced by two of Gripo’s other divisions. The Flexi Hose Division manufactures a flexible hose, one type that is made for the Faucet Division. This hose can also be sold to the outside market. The market price (if sold to outside market), as well as the cost per unit of the flexible hose, are as follows:

Market Price:P 125

Cost per unit: Materials 25

Labor 47

Variable Overhead 20

Fixed Overhead 8

Assuming that Flexi Hose has excess capacity, what would be the transfer price if the managers of the 2 divisions want a price that will divide the resulting profit/savings equally between the two divisions?

let x be transfer price
let y be profit from selling division/savings from buying division
selling
Incremental cost / 92 / x - 92 = y
equal to VC
buying
maximum price / 125 / 125 - x = y
x = / 108.5

- END -

Budgeting

Financial performance for the coming acc period

What is Budgeted revenues / income

What is budgeted expenses

Financial position for the coming acc period

When to recognize:

Assets
Liabilities
Equity

Identify potential bottlenecks in operations

Ex. If there is insufficient cash, should borrow money, therefore interest

Compare actual results with budgets

Then identify the variances

Cash budget

Beginning cash balance

Total cash inflow

Total cash disbursements

Total Manuf Cost

Cost of goods manuf & cost of goods sold

Problem 1

Diamond inc.

a / Jan / Feb / March
AR (start) / 33,000.00
Jan Sales / 270,000.00 / 157,500.00
Feb sales / 324,000.00 / 189,000.00
March sales / 333,000.00
Proceeds from disposal of eq / 15,000.00
Total collections / 303,000.00 / 481,500.00 / 537,000.00
b / Jan / Feb / March
AP (start) / 66,000.00
Jan Purch / 189,000.00 / 81,000.00
Feb Purchases / 210,000.00 / 90,000.00
March Purchases / 294,000.00
Cash op cost / 93,000.00 / 72,000.00 / 135,000.00
Total payments / 348,000.00 / 363,000.00 / 519,000.00