Chapter 13: Responsibility Acctg., Support Dept. Cost Allocations & Transfer Pricingim 1

Chapter 13: Responsibility Acctg., Support Dept. Cost Allocations & Transfer PricingIM 1

Learning Objectives

After reading and studying Chapter 13, you should be able to answer the following questions:

Which factors determine whether a firm should be decentralized or centralized?
How are decentralization and responsibility accounting related?
What are the four primary types of responsibility centers, and what distinguishes them from each other?
How are revenue variances computed?
Why and how are support department costs allocated to operating departments?
What types of transfer prices are used in organizations, and why are such prices used?
What difficulties can be encountered by multinational companies using transfer prices?

Terminology

Administrative Department:an organizational unit that performs management activities that benefit the entire organization and include top management personnel, legal, payroll, insurance, and organization headquarters

Advance pricing agreement: a binding contract between the IRS and a company that provides details of how a transfer price is to be set and establishes that no adjustments or penalties will be made if the agreed-upon methodology is used

Algebraic method:a method of allocating support department costs that considers all interrelationships of the departments and reflects these relationships in simultaneous equations

Benefits-provided ranking:a listing of support departments in an order that begins with the one providing the most service to all other corporate areas and ends with the support department providing the least service to all other support areas

Centralization:term used to describe an organization’s approach to decision making in which top management retains the major portion of decision-making authority

Cost center: a responsibility center in which the manager has the authority only to incur costs and is specifically evaluated on the basis of how well costs are controlled

Decentralization:is a transfer of authority, responsibility, and decision-making rights from the top to the bottom of the organization structure

Direct method: a process of support department cost allocation that assigns support department costs only to operating areas

Dual pricing arrangement: a transfer pricing system that allows the selling division to record the transfer of goods or services at a market or negotiated market price and the buying division to record the transfer at a cost-based amount

Goal congruence: a situation that exists when the personal and organizational goals of decision makers throughout the firm are consistent and mutually supportive

Investment center: an organizational unit in which the manager is responsible for managing revenues and current expenses and has the authority to acquire, use, and dispose of plant assets in a manner that seeks to earn the highest feasible rate of return on the center’s asset base

Negotiated transfer price: an intracompany charge for goods or services that has been set through a process of bargaining between the selling and purchasing unit managers

Profit center: a responsibility center in which the manager is responsible for generating revenues and managing expenses related to current activity

Pseudo-profit center:unit created when one responsibility center uses a transfer price to artificially “sell” goods or services to another responsibility center thus creating artificial revenues and profits

Responsibility accounting system: a system that facilitates decentralization by providing information about the performance, efficiency, and effectiveness of organizational subunits and their managers

Responsibility center: a cost object under the control of a manager such as a division, department, or geographical region

Responsibility report: report that assist each successively higher level of management in evaluating the performances of its subordinate managers and their respective organizational units

Revenue center: an organizational unit for which a manager is accountable only for the generation of revenues and has no control over setting selling prices or budgeting costs

Sales price variance (SPV): the variance calculated by multiplying the actual number of units sold by the difference between actual and budgeted sales prices; indicates the portion of the total revenue variance that is related to a change in selling price

Sales volume variance (SVV): the variance calculated by multiplying the budgeted sales price by the difference between the actual and budgeted sales volumes; indicates the portion of the total revenue variance that is related to a change in sales volume

Service department: an organizational unit (e.g., maintenance department) that provides one or more specific functional tasks for other internal units

Shared service: support function for various organizational units from a central location also referred to as a "back office" function. Typical functions include accounting/cash management, HR, IT, legal, etc.

Step method: a process of support department cost allocation that allows a partial recognition of the effects of interactions among support departments

Suboptimization: a situation in which individual managers pursue goals and objectives that are in their own and/or their segments’ particular interests rather than in the company’s best interests

Support departments:service departments that provide one or more specific functional tasks for other internal units and administrative departments that perform management activities that benefit the entire organization

Transfer price:an internal price established for the exchange of goods or services between organizational units of the same company

Lecture Outline

LO.1: Which factors determine whether a firm should be decentralized or centralized?

Introduction
One of the most common progressions made by high-growth companies is from highly centralized organizational structures to highly decentralized structures.
This chapter describes the accounting methodsthat are appropriate in decentralized organizations: responsibility accounting, support department cost allocations, and transfer pricing.
Decentralization
The degree of centralization can be viewed as a continuum.
Centralization exists when a single individual (normally the company owner or president) performs all decision making and retains full authority and responsibility for that organization’s activities.
Decentralization exists when authority, responsibility, and decision-making rights are transferred from the top to the bottom of the organizational structure.
Text Exhibit 13.1 (p. 503) summarizes the advantages and disadvantages of decentralization.
Either extreme of the centralization-decentralization continuum represents an undesirable arrangement.
In a totally centralized company, a single individual may not have the expertise or sufficient and timely information to make effective decisions in all functional areas.
In a totally decentralized organization, subunits may act in ways that are not consistent with the goals of the total organization.
Most businesses tend to structure themselves according to the pure centralization versus pure decentralization factors listed in text Exhibit 13.2 (p. 504).
The combination of managers’ personal characteristics, the nature of decisions required for organizational growth, and the nature of organizational activities help a company find the appropriate degree of decentralization.
Decentralization does not necessarily mean that a unit manager has the authority to make all of the decisions concerning a unit, as top management selectively determines the types of authority to delegate and the types to withhold from lower-level managers.
Many functions remain centralized even in a decentralized environment. These support functions are often referred to as a shared service and include functions such as accounting/cash management, HR, IT, legal, and procurement.
The need to address environmental issues has presented new challenges when deciding to centralize or decentralize function addressing these environmental issues. Text Exhibit 13.3 (p. 505) outlines considerations for both decentralizing and centralizing the responsibility and decision making for environmental issues.

LO.2: How are decentralization and responsibility accounting related?

Responsibility Accounting Systems
A responsibility accounting system facilitates decentralization by providing information about the performance, efficiency, and effectiveness of organizational subunits and their managers and is the key management control tool in a decentralized organization.
Responsibility reports are reports that assist each successively higher level of management in evaluating the performances of its subordinate managers and their respective organizational units.
Text Exhibit 13.4 (p. 506) provides examples of information that can be shown in responsibility reports.
A manager’s responsibility report should reflect his or her degree of influence and should include only the revenues and/or costs under that manager’s control.
Some unit costs are not entirely controlled by the unit manager, causing the responsibility report to take one of two forms: a single report showing all costs incurred in the unit, separately classified as either controllable or noncontrollable, or separate reports, one for the organizational unit and one for the unit manager.
A responsibility accounting system helps organizational unit managers conduct the following basic control functions:
prepare a plan (for example, using budgets and standards) and use it to communicate output expectations and delegate authority;
gather actual data classified in accordance with the activities and categories specified in the plan;
monitor the differences between planned and actual data at scheduled intervals;
exert managerial influence in response to significant differences; and
continue comparing data and responding and at the appropriate time begin the process again.
Responsibility reports reflect the upward flow of information from operational units to company top management and illustrate the broadening scope of responsibility.
Managers receive detailed information on the performance of their immediate areas of control and summary information on all organizational units for which they are responsible.
Reports at the lowest level of units are highly detailed, whereas more general information is reported to the top of the organization.
Text Exhibit 13.5 (p. 507)presents a responsibility report that illustrates this pyramiding of information.
Variances are itemized in performance reports at the lower levels so that the appropriate manager can take corrective action related to significant variances.
Under the management by exception principle, major deviations from expectations are highlighted to assist upper-level managers in determining whether they need to become involved in their subordinates’ operations.
The process of responsibility accounting creates some issues for management.
The idea of rolling up information to each successively higher level allows potentially important details to be buried.
Assuming different units within the responsibility accounting system are competing with each other for resources, managers could try to promote their own agendas, thus leading to a lack of goal congruence between or among organizational units.
Goal congruence exists when the personal and organizational goals of decision makers throughout the firm are consistent and mutually supportive.
Additionally, by partitioning each responsibility unit as a separate part of the report, interdependencies among units might be obscured.
Responsibility accounting’s focus is on the manager who has control over a particular cost object.
In a decentralized company, the cost object is an organizational unit or responsibility center.
A responsibility center is a cost object (e.g., a division, department, or geographical region) under the control of a manager.

LO.3: What are the four primary types of responsibility centers, and what distinguishes them from each other?

Types of responsibility centers
Responsibility accounting systems identify, measure, and report on the performance of responsibility centers and their managers.
Responsibility centers are generally classified according to their manager’s scope of authority and type of financial responsibility: costs, revenues, profits, and/or asset base.
The four primary types of responsibility centers are illustrated in textExhibit 13.6 (p. 508).
Cost Center
Acost center is a responsibility center in which the manager has the authority only to incur costs and is specifically evaluated on the basis of how well costs are controlled.
Cost centers commonly include service and administrative departments.
In the traditional manufacturing environment, the production department is the largest cost center.
Cost center managers often concentrate only on the unfavorable standard cost variances and ignore the efficient performance indicated by favorable variances.
If the management by exception principle is applied properly, top management should investigate ALL variances (favorable and unfavorable) that fall outside the range of acceptable deviations.
In some instances, a cost center can generate revenue, but the revenues are either not under the manager’s control (e.g., tax dollars provided to a community library by the local taxing authority) or are not effectively measurable (e.g., research and development center).
Such revenues should not be included in the manager’s responsibility accounting report.

LO.4: How are revenue variances computed?

Revenue Center
Arevenue center is an organizational unit for which a manager is accountable only for the generation of revenues and has no control over setting selling prices or budgeting costs.
Actual performance in revenue centers (as well as in any other area that has control over revenue) should be compared against budgeted performance to determine variances from expectations.
Budgeted and actual revenues may differ either because of volume of units sold or price of units sold.
The sales price variance is calculated by multiplying the actual number of units sold by the difference between actual and budgeted sales prices. This variance indicates the portion of the total revenue variance that is related to a change in selling price.
The sales volume variance is calculated by multiplying the budgeted sales price by the difference between the actual and budgeted sales volumes.
The model for computing revenue variances is as follows:

ASP x ASV BSP x ASV BSP x BSV

Sales Price Variance Sales Volume Variance

Total Revenue Variance

whereASP = actual sales price; ASV = actual sales volume

BSP = budgeted sales price; BSV = budgeted sales volume

In most instances, pure revenue centers do not exist because managers are also responsible for managing some costs in their centers. Thus, a more appropriate term for this organizational unit is a revenue and limitedcost center.

Profit Center
A profit center is a responsibility center in which the manager is responsible for generating revenues and managing expenses related to current activity.
The major goal of a profit center manager is to maximize the center’s net income.
Profit centers should be independent organizational units whose managers:
have the ability to obtain resources at the most economical prices;
sell products at prices that will maximize revenue; and
have a goal of maximizing the center’s profit.
Investment Center
An investment center is an organizational unit in which the manager is responsible for managing revenues and current expenses and also has the authority to acquire, use, and dispose of plant assets in a manner to earn the highest feasible rate of return on the center’s asset base.
Many investment centers are independent free-standing divisions or corporate subsidiaries.
Suboptimization is a situation in which individual managers pursue goals and objectives that are in their own and/or their segments’ particular interests rather than in the company’s best interests.
A unique challenge for the design of responsibility centers arises from the instance in which one center supplies its outputs largely to other internal centers.
Top management must make judgments about the nature and extent of the costs and revenues to include in such responsibility centers.
Frequently, rather than attempting to make performance assessments about cost centers, management assigns the costs incurred in cost centers to operating areas through a process of support department cost allocation.
Alternatively, management can attempt to “create” revenues for the cost center by using an internal transfer pricing system to assign a price to the center’s tangible or intangible output that is used by other company units.

LO.5: Why and how are support department costs allocated to operating departments?

Support Department Cost Allocation
General
Organizations incur two types of overhead costs: those directly related to the operating (or primary revenue-generating) activities and those indirectly related to operating activities.
As the number of product lines or service types increases, so does the need for additional indirectly-related activities. An organization’s support departments include both service and administrative departments.
A service department is an organizational unit (such as central purchasing, maintenance, engineering, security, or warehousing) that provides one or more specific functional tasks for other internal units.
An administrative department is an organizational unit that performs management activities that benefit the entire organization and include top management personnel, legal, payroll, insurance, and organization headquarters.
All support department costs must be covered in the long run by sales of products and services.
Support department costs must therefore be allocated to production departments to meet the objectives of full cost computation, managerial motivation, and managerial decision making.
See text Exhibit 13.7 (p. 511) for the reasons for and against allocating support department costs.
Allocation Bases
Four criteria must be considered in determining a rational and systematic allocation base:
measure the benefits the operating department receives from the support department;
capture the causal relationship existing between factors in the operating department and costs incurred in the support department;
reflect the fairness or equity of the allocations between operating departments; and
measure the ability of operating departments to bear the allocated costs.
Text Exhibit 13.8 (p. 512) providesalternative bases for assigning various types of support department costs.
Methods of Allocating Support Department Costs
The idea underlying support department cost allocations is that the responsibility centers that benefit from the services provided by support units should bear the costs of such support units.
Three basic methods are used to allocate the pooled support department costs to the operating departments:
The direct method assigns support department costs only to operating areas;
This is the simplest method but may result in distorted cost allocations if there is significant exchange of services among support departments as well as operating departments.
The step method allows a partial recognition of the effects of interactions among support departments in assigning costs; and
A benefits-providedranking is a listing of support departments in an order that begins with the one providing the most service to all other support areas and ends with the support department providing the least service to all other support areas. The two most common approaches used to implement the ranking are the dollar volume of services and the percentage of total assistance to other support areas.
The algebraic (or reciprocal) method considers all departmental interrelationshipsand reflects these relationships in simultaneous equations.
The algebraic method is the most complex method but it is also the most theoretically correct and, if relationships are properly formulated, provides the most accurate and reliable allocations.
Support Department Cost Allocation Illustration
The text uses an example company, Athens Supplements Co. (ASC) to illustrate the three methods of allocating budgeted support department costs.
Budgeted costs of each support department are first allocated to each operating division using one of the three methods of support area cost allocation and are then added to the budgeted overhead costs of those divisions to determine an appropriate divisional overhead application rate.
Text Exhibit 13.9 (p. 513) provides an abbreviated budget of the direct and indirect costs for each support department and operating division of ASC.
Text Exhibit 13.10 (p. 514) presents the bases selected for allocating ASC’s support department costs. These bases are proxies for the quantity of services consumed by each service area and operating division.
Direct Method Allocation
The direct methodassigns support department costs only to operating areas.
Text Exhibit 13.11 (p. 514)illustrates the direct method of allocating support department costs to operating areas at ASC.
Text Exhibit 13.12 (p. 515)presents the company’s total budget pre-tax profits by operating area if support department costs are allocated using the direct method.
Step Method Allocation
The step methodassigns support department costs to operating departments as well as to certain other support departments.
The benefits-provided ranking was provided in text Exhibit 13.10.
Text Exhibit 13.13 (p. 516) illustrates the step method of allocating support department costs to operating areas at ASC.
Note that under the step method allocation process, a support department is “eliminated” once its costs have been assigned.
The step method is a hybrid between the direct and algebraic methods in that while it does recognize relationships among support departments, it does so only partially.
Algebraic Method of Allocation
The algebraic methodconsiders all interrelationships of the departments and reflects these relationships in simultaneous equations.
Text Exhibit 13.14 (p. 517) presents theallocation proportional relationships for ASC’s support departments.
The simultaneous equations are developed in the text narrative and text Exhibit 13.15 (p. 518) presents the resulting allocations.
The algebraic method can be solved manually if the company has only a few departmental interrelationships. However, a computer is needed if numerous variables are present.
Determining Overhead Application Rates
Regardless of the method used to allocate support department costs, the final step is to determine the overhead application rates for the operating areas.
After support department costs have been assigned to production, they are included as part of production overhead and allocated to products or jobs through normal overhead assignment procedures.
As shown in text Exhibit 13.16 (p. 518), the total allocated overhead costs of ASC’s two operating areas will be divided by an appropriate overhead allocation base to assign both manufacturing and non-manufacturingoverhead to products.
In conclusion, allocating support department costs to operating divisions makes managers more aware of, and responsible for, controlling support service usage.
However, if such allocations are made, evaluation of the operating manager’s performance should exclude these allocations. While operating managers can control their usage of support services, they cannot control the actual incurrence of support department costs.
An alternative to using cost allocation to assign support costs to operating units is to use a transfer pricing system.

LO.6: What types of transfer prices are used in organizations, and why are such prices used?