11. Responsibility accounting

Question 1

Responsibility Centers

Answer 1

• The primary distinction between centralized and decentralized organizations is in the degree of freedom of decision making by managers at any level
• Centralized organizations are more effectively coordinated from the top. Decentralized organizations makes decision making at a low level possible
• A successful responsibility accounting system is dependent upon proper delegation of authorities
• The basic purpose of responsibility accounting system is motivation
• A decentralized organization is divided into responsibility centers also called strategic business units to facilitate local decision making.
• Types of Responsibility centers
  1) Cost Center
  2) Revenue Center
  3) Profit Center
  4) Investment Center
• Cost center includes maintenance department, production department. A disadvantage is a potential cost shifting i;e replacement of variable cost for which manager is responsible to fixed cost. An advantage that long term issues may be DISREGARDED such as annual cost amount
• Service center are cost centers such as finance, IT, HR
• Revenue center are sales department, car service department. Departmental budget contains ONLY revenue i;e store manager is responsible for revenue only
• Profit center are appliance department, car sale department which are responsible for both cost and revenue
• Investment centers like branch office responsible for cost, revenue and invested capital. An advantage is that it permits an evaluation of performance that can be compared with other responsibility centers or other potential investments on a ROI basis i;e on the basis of the effectiveness of asset usage. It is considered as INDEPENDENT business
• Performance measures are designed for every responsibility center to monitor performance
• Not ALL factors are controllable by someone. Controllable costs is NOT a synonymous with variable cost for instance fixed cost of depreciation is controllable by the division vice president to which that manager report.
• Goal congruence ensures that performance measured must be designed so that a manager ties them directly to accomplish organizational goals
• Sub optimization results when segments pursue goals that are in the segment OWN best interest
• Along with RESPONSIBILITY a manager must be granted AUTHORITY to control factors on which his incentive package is based
• FOH SHOULDN’T be included in INTERNAL reports on a responsibility accounting centers as it CAN’T be controlled by a manager of responsibility center

Question 2

Performance Measures (Cost, Revenue and Profit Centers)

Answer 2

• Cost Center is the BEST option to evaluate performance because not all centers have profit. Cost and revenue centers are often controlled by comparing actual with budget variance system (variance analysis).
• A performance measure should be based on cause and effect relationship between the outcome (effect) being measured and driver (cause) that is under manager control - Financial and non financial measures are acceptable
• Profit center managers are MOST likely able to control and evaluate performance using contribution margin approach
• Profit center performance measurement techniques:
  1) Comparison between CY and PY income
  2) Compare with other profit center
  3) Contribution margin
• Profitability accounting is the accounting of profit center
• A segment is a Product line, Geographical area and Customer - it is under profit centers
• Product profitability analysis allows management to determine whether a product is providing any coverage of fixed costs
• Issues involved in determining product profitability, business area profitability and customer profitability:
  1) Cost measurement involves calculating correct costs and not undercosting or overcosting
  2) Cost Allocation is he assignment of costs to appropriate product, area and customer
  3) Investment measures involves calculating the cost to expand production, develop new products or enter new business
  4) Other measures involves non financial measures

Question 3

Performance Measures (Investment center)

Answer 3

• Performance measures reveals how efficiently the managers is deploying capital to produce income - allow an investor to assess how effectively and efficiently management is using assets to obtain a return
• ROI is a percentage that increases when revenue increase and cost decrease.
• Under ROI it is difficult to compare divisions that vary in AGE because older assets will be removed (depreciated)
• A firm earning a profit can increase its return on investment by increasing sales revenues and operating expenses by the same percentage.
• Under ROI best comparison is when when long term assets are evaluated using CURRENT VALUE
• High inflation rate would result in a higher ROI. Divisions in areas of high inflation when valuing assets at net book value will result in the highest ROI since the ROI is calculated using local currency. The local currency will depreciate due to the inflation, which in turn inflates the ROI. High inflation would result in higher ROI.
• Each division in the firm should have an ROI based on the strategic goals of the firm
• Benefits of ROI:
  1) Improve projects
  2) Secure funding
  3) Comparative analysis
  4) Discountinue ineffective product or operations
• A limitation of ROI is that ROI of NEW investment must be HIGHER than CURRENT ROI
• Residual Income is the excess of ROI over a firm cost of capital or over targeted amount.
• Residual income is a significant refinement of the ROI concept because it forces business unit managers to consider OPPORTUNITY COST OF CAPITAL
• Goal congruence is more likely to be promoted using residual income
• Residual income is more likely to promote goal congruence in a low-profit location versus return on investment.
• When comparing the residual income of several investment centers, the validity of comparisons may be destroyed by features of each investment
• Under residual income a project will have increased income if it’s ROI is higher than the firm cost of capital
• Best benefit of residual income is allowing manager to maximize an absolute amount and invest as long as the required return is earned
• Under residual income Invested capital consists of:
  1) Total assets available
  2) Total assets employed, which excludes idle assets such as land held for a new plant
  3) Working capital plus other assets
• The comparability of performance measures may be AFFECTED by ACCOUNTING POLICIES used such as policies regarding depreciation, decision to capitalize or expense, inventory flow
• Issues other than accounting policies that might affect comparability:
  1) Difference in tax systems
  2) The presence of items that are unusual or infrequent
  3) Allocation of common costs
  4) The varying availability of resources
• Performance evaluation in multinational is impacted by:
  1) Expropriation is a foreign government seizure of the assets of a business
  2) Repatriation is conversion of funds held in a foreign country into another currency
  3) Tariffs are taxed imposed on imported goods
  4) Import quotas set limits on the quantity of different products that can be imported
  5) Inflation risk is that risk that purchasing power of the currency will decline
  6) Exchange rate risk is the risk of loss because fluctuation in the relative value of foreign currency
  7) Political risk is the probability of loss from actions of government
• Any measures involving the firm stock is inappropriate for measuring segment performance, stock prices reflects company performance as a whole.

Question 4

Comparing ROI to Residual Income

Answer 4

• Residual income considered preferable from ROI because it deals in absolute dollars rather than percentage
• Under residual income rate of return should be HIGHER than cost of capital
• Under ROI the new investment should have higher ROI than the current
• When comparing companies or units of the basis of either ROI or residual income, the analyst must be sure that both companies or units are using the same accounting policies in the determination of income
• The division that shares its assets with another division may find that it has lower rate of return than the division that has access to use the resources
• International operations may not always be comparable to domestic divisions since the complication of changes in foreign currency exchange rates might make income comparison difficult
• ROI and residual income calculations generally require the use of unpublished financial information. INTERNAL USE

Question 5

Allocating Common Costs

Answer 5

• Are costs of products, activities, facilities, services or operations shared by 2 or more cost objects
• Common costs consist primary of INDIRECT COSTS
• Best way of allocating common costs is cause and effect, the second alternative is benefits received
• Allocation based on increase in sales by organizational subunits is likely to be ACCEPTABLE as equitable DESPITE the absence of clear cause and effect relationships
• Allocation of common costs is allocated based on following reasons:
  1) BEST reason for allocation to remind managers that support service exists and the managers would incur these costs if their operations were independent
  2) Allocation reminds managers that profit center earning must cover come of support costs
  3) Departments or divisions should be motivated to use central support service
  4) Division managers will be encouraged to control their department costs as they CAN’T control support services cost - Department manager pressuring central managers is NOT a healthy organization dynamic
• Arbitrary allocation DOESN’T likely give accurate costs - also called dysfunctional motivation due to a allocating costs based on ability to bear basis
• Allocation alternatives:
  1) Allocation based on actual sales or contribution margin - will have negative impact
  2) If central administrative or other fixed costs are not allocated, responsibility center might reach their revenue without covering all fixed costs
  3) Allocation of OH is motivationally negative
  4) A MUCH preferred alternative is based on NEGOTIATION

Question 6

Transfer Pricing

Answer 6

• Transfer prices are the amount charged by one segment for goods or service to another segment within same organization
• The principle challenge is determining a price that motivates both selling and buying manager to pursue GOAL CONGRUENCE
• Used for Profit and Investment centers
• Transfer price used based on actual consts can lead to suboptimal decisions for the company as a whole. Setting the transfer price based on actual costs rather than standard costs would give the selling division little incentive to control costs
• Transfer pricing schemes:
  1) Variable cost (Manufacturing costs) used with EXCESS CAPACITY
  2) Full absorption cost (VC + FC) used if the firm has NO EXCESS CAPACITY
  3) Market Price is the BEST and OPTIMAL used with FULL CAPACITY
  4) Negotiated price may reflect BEST BARGAIN and would achieve Goal Congruence
• Under Variable cost the is NO incentive for the selling division since they will be producing at loss even though the company as a whole will benefit from the arrangement
• Companies who wish to follow this philosophy actually adopt a negotiation price wherein transfer price will be something GREATER than VC but LESS than Full cost. At least the seller would have a positive contribution margin. An advantage of using VC is that buyer is motivated to SOLVE excess capacity problem even though the excess capacity is not in the buyers division
• Under VC if the seller have excess capacity he should LOWER transfer price to outside prices
• Full absorption costing ensures that the selling division will NOT incur a LOSS and provides more incentive to the buying division to buy internally rather than does use of market price. There is NO motivation for seller to control production costs since ALL costs can be passed to the buyer
• Advantage of using cost based transfer price is that it is EASY to implement
• Under Market price if the selling division is NOT producing at FULL capacity, the use of market price for internal transfers is NOT justified. A lower price might be more motivational for the buyer and the seller. The price would be LOWER than market price but HIGHER than full cost.
• The existence of Market Price enhances long term competitiveness of the firm because internal suppliers will tend to be more efficient
• A profit center is affected by market price
• Negotiation price may results when organizational subunits are free to determine the prices at which they buy and sell internally. The transfer price need NOT be based on market or cost transfer information
• Negotiated price may be specially appropriate when market prices are subject to rapid fluctuation
• The choice of a transfer pricing policy is normally decided by TOP management
• The segment making the transfer should be allowed to recover its incremental costs PLUS opportunity cost. For this purpose transfer price should be market price
• Transfer price for multinational firm DOESN’T allow firms to correctly price products in each country in which it operates
• Multinational may reduce their profit by increasing the prices of goods transferred into divisions in these countries if influenced by restrictions that some countries place on the repatriation of profit to the parent
• Under Dual pricing the selling and buying units record transfer at different prices. It is rarely used because the incentive to control cost is REDUCED
• Advantage of dual pricing arrangement is that it promotes goal congruence between supply and buyer subunits.

Question 7

Rules for Calculation

Answer 7

• Segment Margin = Contribution margin - Fixed costs (Executive salaries SHOULDN’T be included because they are fixed costs)
• Segment economic performance = Net sales - ALL costs EXCEPT fixed manufacturing costs
• ROI = Income of business / Asset of business
  Income is operating income unless otherwise stated

Asset of Business = Working Capital + PPE

• Residual Income = Income of business - (Asset of business * required rate of return)
  Required rate of return also called imputed interest rate
• Target profit = Opportunity cost of capital + Residual income
• Two basis of allocating service department:
  1) Variable cost = budget rate * standard hours allowed
  2) Fixed cost = budget rate * capacity available
• Two approaches to calculate common costs: P.11
  1) Stand alone method - Proportionate basis (percentage) the common costs are allocated by weighting the cost of each user as a separate entity
  2) Incremental method - total traceable cost
• Variable cost Plus = VC + additional markup (but less than market price)