session 3 and 4_responsibility accounting_transfer pricing

7/31/2019 Session 3 and 4_Responsibility Accounting_Transfer Pricing

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Responsibility Accounting

By Sudha Agarwal

Chartered Accountant


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Contents

Introduction to Responsibility Accounting Advantages and Disadvantages of Responsibility

Accounting

Types of Responsibility Centres

Transfer Pricing Transfer Pricing methods


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Introduction

Responsibility Accounting is a method for dividingthe 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


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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.


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Advantages and Disadvantages of Responsibility Accounting

ADVANTAGES

1. Helps manage a large and diversified organization

2. Motivate Manager to optimize their performance

3. Provide manager freedom to make local decisions

4. Top management get more time for policy making and strategic

planning5. Supports management and individual specialisation based on

comparative Advantages

DISADVANTAGES

1. May create conflicts between various divisions

2. Undue competition may become dysfunctional

3. Narrows down vision as overall company prospective are not

considered by individual managers.

4. May prove costly due to duplication

5. Problem in coordination across divisions


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Responsibility Centre and their Evaluation

RESPONSIBILITY CENTRES EVALUATION METHODS Revenue Centre Sale Price Variance

Sale Quantity Variance

Sale Mix Variance

Cost Centre Raw Material Variances: Labor Variances

Overhead Variances

Profit Centre Gross Profit

Contribution Margin

Investment Centre ROI

Residual IncomeEconomic Value Added


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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 hasbeen achieved as a consequence is not considered

Cost center evaluation techniques include variance analysis and joband 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) Segmentcontribution margin (iii) Segment profit contribution (iv) segment netincome

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 thesegment profit contribution and segment assets. There are 2 ways torelate both (i) Segment ROI (SROI) (ii) Segment residual income


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Types of Responsibility Center

(1) SROI = segment profit contribution (SPC)/(Segmentresources/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


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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 thebuying division.

A question arises as to how the transfer of goods and servicesbetween divisions should be priced.

The following factors should be taken into consideration before fixingthe transfer prices :-

Transfer price should help in the accurate measurement of divisionalperformance.

It should motivate the divisional managers to maximize the profitabilityof 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 theorganization.


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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 ofprofit 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.


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Transfer Pricing Methods Market Based

2. Market Based Pricing: -

Under this method, the transfer price will be determined according to themarket price prevailing in the market.

The forces of demand and supply will determine the market price in the longrun and profit generated will be a very good parameter for measuringefficiency.

The logic used in this method is that if the buying division would havepurchased the goods/services from the open market, they would have paidthe market price and hence the same price should be paid to the sellingdivision.

One of the variation of this method is that from the market price, selling anddistribution overheads should be deducted and price thus arrived should becharged as transfer price. The reason behind this is that no selling effortsare required to sell the goods/services to the buying division and thereforethese 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 goodparameters for performance evaluation of selling and buying divisions.


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Transfer Pricing Methods Market Based

However, the market price based transfer pricing hasthe following limitations :-

There may be resistance from the buying division. Theymay question buying from the selling division if in anywaythey have to pay the market price?

Like cost based prices, market prices may also befluctuating and hence there may be difficulties in fixationof these prices.

Market price is a rather vague term as such prices maybe ex-factory price, wholesale price, retail price etc.

Market prices may not be available for intermediateproducts, as these products may not have any market.

This method may be difficult to operate if theintermediate product is for captive consumption.

Market price may change frequently.

Market prices may not be ascertained easily.


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Transfer Pricing Methods Negotiated

3. Negotiated Pricing: -

In the above two methods, transfer prices are fixed on the basis of either the costprice or market price.

However the transfer prices may be fixed on the basis of Negotiated Prices that arefixed through negotiations between the selling and the buying division.

Sometimes it may happen that the concerned product may be available in the marketat a cheaper price than charged by the selling division. In this situation the buyingdivision may be tempted to purchase the product from outside sellers rather than theselling 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 themarket price. Here, the selling division may be reluctant to sell the product to thebuying 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 andarrive 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 theavailable data including about the alternatives available if any.

Similarly buyers and sellers should be free to deal outside the company, but careshould 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 negotiatingparties in fixation of the negotiated prices.

Negotiating skills are required for the managers for arriving at a mutually acceptableprice, otherwise there is a possibility of conflicts between the divisions.


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Transfer Pricing Methods Opportunity Cost

4. Opportunity Cost Pricing: -This pricing recognizes theminimum 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.


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Transfer Pricing Models

1. Models based on Economic theory

a series of marginal revenue, marginal cost and demand curves for transferof an intermediate product from one business to another is developed

These curves are used to establish transfer prices, under various economicassumptions that would maximise the total profit of he 2 business units

It is based on assumption that it is possible to estimate the demand curvefor the intermediate product, the assumed condition remains stable andthere are no alternative uses for facilities used to make the intermediate

product2. 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 thispattern, 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 thatmotivate business units to produce according to the optimum productionpattern for the entire company

It is based on assumption that demand curve is known, it is static, costfunction is linear and alternative uses of production facilities and their

profitability can be estimated in advance


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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.


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Problem 1 & Solution


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Problem 2


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Solution to Problem 2


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Thank You

session 3 and 4_responsibility accounting_transfer pricing

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