Hilton 1e ch 12

© 2010 McGraw-Hill Ryerson Ltd.© 2010 McGraw-Hill Ryerson Ltd. 11

Chapter 12Chapter 12

Responsibility Responsibility Accounting,Accounting,Investment Investment Centres, and Centres, and TransferTransferPricingPricing


Learning ObjectivesLearning Objectives

1.1. Explain Explain the role of responsibility accounting the role of responsibility accounting

in fostering goal congruence.in fostering goal congruence.

2.2. Define and give an exampleDefine and give an example of a cost centre, of a cost centre,

a revenue centre, a profit centre, and an a revenue centre, a profit centre, and an

investment centre.investment centre.

3.3. PreparePrepare a performance report and a performance report and explainexplain

the relationships between the performance the relationships between the performance

reports for various responsibility centres.reports for various responsibility centres.


Learning Objectives (con’d)Learning Objectives (con’d)

4.4. UseUse a cost allocation base to allocate costs. a cost allocation base to allocate costs.

5.5. PreparePrepare a segmented income statement. a segmented income statement.

6.6. ComputeCompute an investment centre's return on an investment centre's return on

investment (ROI), residual income (RI), investment (ROI), residual income (RI),

and economic value added (EVA).and economic value added (EVA).

7. 7. ExplainExplain how a manager can improve ROI. how a manager can improve ROI.


Learning Objectives (con’d)Learning Objectives (con’d)

8. 8. DescribeDescribe some advantages and disadvantages some advantages and disadvantages of both ROI and residual income as divisional of both ROI and residual income as divisional performance measures.performance measures.9. 9. Explain Explain how to measure a division's income how to measure a division's income and invested capital.and invested capital.10. 10. UseUse the general economic rule to set an the general economic rule to set an optimal transfer price.optimal transfer price.11. 11. ExplainExplain how to base a transfer price on market how to base a transfer price on market prices, costs, or negotiations.prices, costs, or negotiations.


Learning Objective 1Learning Objective 1Responsibility AccountingResponsibility Accounting

Responsibility accountingResponsibility accounting is used to is used to measure the performance of people and measure the performance of people and departments to foster goal congruence.departments to foster goal congruence.

Responsibility accountingResponsibility accounting is used to is used to measure the performance of people and measure the performance of people and departments to foster goal congruence.departments to foster goal congruence.


Learning Objective 2Learning Objective 2Responsibility CentresResponsibility Centres

A subunit in an organization A subunit in an organization whose manager is held whose manager is held

accountable for specified accountable for specified financial results.financial results.

A subunit in an organization A subunit in an organization whose manager is held whose manager is held

accountable for specified accountable for specified financial results.financial results.


Responsibility Centres (con’d)Responsibility Centres (con’d)

Cost CentreCost Centre Segment has Segment has

control over control over the incurrence the incurrence

of costs.of costs.

Cost CentreCost Centre Segment has Segment has

control over control over the incurrence the incurrence

of costs.of costs.

The Paint DepartmentThe Paint Departmentin an automobile plant.in an automobile plant.

Revenue Centre

Segmentis responsible

for the revenue of a unit.

Revenue Centre

Segmentis responsible

for the revenue of a unit.

The ReservationsThe ReservationsDepartment of an airline.Department of an airline.

LO-2


Responsibility Centres (con’d)Responsibility Centres (con’d)

Profit CentreProfit Centre Segment has Segment has

control over control over bothboth costs and costs and

revenues.revenues.

Profit CentreProfit Centre Segment has Segment has

control over control over bothboth costs and costs and

revenues.revenues.

Company-owned Company-owned restaurant in a fast-food restaurant in a fast-food

chain.chain.

Investment Centre

Segment has control over profits and

invested capital.

Investment Centre

Segment has control over profits and

invested capital.

A division of aA division of alarge corporation.large corporation.

LO-2


Learning Objective 3Learning Objective 3Performance ReportsPerformance Reports

Show the budgeted and actual amounts, and the variances

between these amounts, of key financial results appropriate for the type of responsibility centre.

Show the budgeted and actual amounts, and the variances

between these amounts, of key financial results appropriate for the type of responsibility centre.


Performance Reports (con’d)Performance Reports (con’d)February Year to Date February Year to Date February Year to Date

Company . . . . . . . . . . . . . . . . . . . . . . $30,660 $64,567 $30,716 $64,570 $56 F $ 3 FMaui Division . . . . . . . . . . . . . . . . . . $18,400 $38,620 $18,470 $38,630 $70 F $10 FOahu Division . . . . . . . . . . . . . . . . . . 12,260 25,947 12,246 25,940 14 U 7 UTotal profit . . . . . . . . . . . . . . . . . . . . $30,660 $64,567 $30,716 $64,570 $56 F $ 3 FOahu DivisionWaimea Beach Resort . . . . . . . . . . . $6,050 $12,700 $6,060 $12,740 $10 F $40 FDiamond Head Lodge. . . . . . . . . . . 2,100 4,500 2,050 4,430 50 U 70 UWaikiki Sands Hotel . . . . . . . . . . . . . 4,110 8,747 4,136 8,770 26 F 23 FTotal profit . . . . . . . . . . . . . . . . . . . . $12,260 $25,947 $12,246 $25,940 $14 U $ 7 UWaikiki Sands HotelGrounds and Maintenance . . . . . . . . ($45) ($90) ($44) ($90) $ 1 F —Housekeeping and Custodial . . . . . . (40) (90) (41) (90) 1 U —Recreational Services . . . . . . . . . . . . 40 85 41 88 1 F $ 3 F Hospitality . . . . . . . . . . . . . . . . . . . . 2,800 6,000 2,840 6,030 40 F 30 F Food and Beverage . . . . . . . . . . . . . 1,355 2,842 1,340 2,832 15 F 10 U Total profit . . . . . . . . . . . . . . . . . . . . $4,110 $8,747 $4,136 $8,770 $26 F $23 F Food and Beverage DepartmentBanquets and Catering . . . . . . . . . . . $600 $1,260 $605 $1,265 $ 5 F $ 5 F Restaurants . . . . . . . . . . . . . . . . . . . 1,785 3,750 1,760 3,740 25 U 10 U Kitchen. . . . . . . . . . . . . . . . . . . . . . . (1,030) (2,168) (1,025) (2,173) 5 F 5 U Total profit . . . . . . . . . . . . . . . . . . . . $1,355 $2,842 $1,340 $2,832 $15 U $10 U KitchenKitchen staff wages . . . . . . . . . . . . . ($80) ($168) ($78) ($169) $ 2 F $ 1 U Food . . . . . . . . . . . . . . . . . . . . . . . . (675) (1,420) (678) (1,421) 3 U 1 U Paper products. . . . . . . . . . . . . . . . . (120) (250) (115) (248) 5 F 2 F Variable overhead. . . . . . . . . . . . . . . (70) (150) (71) (154) 1 U 4 U Fixed overhead. . . . . . . . . . . . . . . . . (85) (180) (83) (181) 2 F 1 U Total expense . . . . . . . . . . . . . . . . . . ($1,030) ($2,168) ($1,025) ($2,173) $ 5 F $ 5 U

*Numbers w ithout parentheses denote profit; numbers w ith parentheses denote ex penses; numbers in thousands.

†F denotes fav orable v ariance; U denotes unfav orable v ariance.

Flexible Budget* Actual Results* Variance†

LO-3


Performance Reports Performance Reports (con’d)(con’d)

The report is based on the The report is based on the organizational hierarchy, with less organizational hierarchy, with less detail shown for higher levels of the detail shown for higher levels of the organization. organization.

LO-3


Learning Objective 4Learning Objective 4Cost AllocationCost Allocation

The process of assigning the costs in the cost pool to the cost objects is called cost allocation or cost distribution.


Cost Allocation Bases (con’d)Cost Allocation Bases (con’d)

An allocation base is a measure of

activity, physical characteristic, or

economic characteristic that is associated with the

responsibility centres, which are the cost objects in

the allocation process.

LO-4


Activity-Based Responsibility Activity-Based Responsibility AccountingAccounting

Traditional responsibility-accounting systems tend to focus on the financial performance measures of cost, revenue, and profit for subunits of the organization.

Activity-based costing systems associate costs with the activities that drive those costs. In activity-

based responsibility accounting attention is directed not only to costs incurred but also to the

activity creating the cost.

Activity-based costing systems associate costs with the activities that drive those costs. In activity-

based responsibility accounting attention is directed not only to costs incurred but also to the

activity creating the cost.LO-4


Learning Objective 5Learning Objective 5Segmented ReportingSegmented Reporting

Segmented reporting refers to the preparation of accounting reports by

segment and for the organization as a whole.

A segment is any part or activity of an organization about which a

manager seeks cost, revenue, or profit data.


Segmented Reporting (con’d)Segmented Reporting (con’d)

DivisionsDivisions•

Units•

Aloha Hotels and Resorts

Aloha Hotels and Resorts

Oahu DivisionOahu DivisionMaui DivisionMaui Division

Waikiki Sands Hotel

Waikiki Sands Hotel

Diamond Head Lodge

Diamond Head Lodge

Waimea Beach Resort

Waimea Beach Resort

LO-5


Segmented Reporting (con’d)Segmented Reporting (con’d)

LO-5


Key Features of Segmented Key Features of Segmented ReportingReporting

Contribution format.Controllable versus uncontrollable expenses.Segmented income statement.

Contribution format.Controllable versus uncontrollable expenses.Segmented income statement.

LO-5


Learning Objective 6Learning Objective 6Measuring PerformanceMeasuring Performancein Investment Centresin Investment Centres

Investment Centre Investment Centre managers make managers make decisions that decisions that

affect both profit affect both profit and invested and invested

capital.capital.Corporate HeadquartersCorporate Headquarters

InvestmentCentre

Evaluation

Return on investment, residual income, or

economic value added


Return on Investment (ROI)Return on Investment (ROI)

ROI = Income

Invested Capital

ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

SalesMargin

SalesMargin

CapitalTurnover

CapitalTurnover

LO-6


Residual IncomeResidual Income

Investment centre profit– Investment charge = Residual income

Investment capital× Imputed interest rate= Investment charge

Investment centre’sminimum required

rate of returnLO-6


Economic Value AddedEconomic Value AddedEconomic value added tells us how much

shareholder wealth is being created.

LO-6


Economic Value Added (con’d)Economic Value Added (con’d)

Investment centre’s after-tax operating income– Investment charge = Economic Value Added

Weightedaverage

cost of capital

Investmentcentre’s

total assets

Investmentcentre’s

current liabilities–( )

After-taxcost ofdebt

Marketvalue

of debt

Cost ofequity capital

Marketvalue

of equity( () )

Marketvalue

of debt

Marketvalue

of equity

LO-6


Learning Objective 7Learning Objective 7Improving R0IImproving R0I

Three ways to improve ROIThree ways to improve ROI

IncreaseIncrease SalesSales Prices Prices

DecreaseDecrease ExpensesExpenses

LowerLower InvestedInvested Capital Capital


Learning Objective 8Learning Objective 8ROI Advantages and ROI Advantages and

DisadvantagesDisadvantages ROI measures return in a percentage ROI measures return in a percentage

form rather than in absolute dollars, form rather than in absolute dollars, which is helpful when comparing which is helpful when comparing segments of different sizes.segments of different sizes.

A drawback to using ROI is the A drawback to using ROI is the potential of decreased goal potential of decreased goal congruence. congruence.


RI Advantages and RI Advantages and DisadvantagesDisadvantages

As long as the residual income of a project is As long as the residual income of a project is a positive amount, the project is deemed a positive amount, the project is deemed attractive because it increases a manager's attractive because it increases a manager's income pool. Thus, any project that returns income pool. Thus, any project that returns more than the corporate goal will be more than the corporate goal will be accepted in accordance with top accepted in accordance with top management's desire. management's desire.

Since residual income is expressed in Since residual income is expressed in absolute dollar terms, an analyst forfeits the absolute dollar terms, an analyst forfeits the ability to compare firms/divisions of differing ability to compare firms/divisions of differing sizes on a common basis.sizes on a common basis.

LO-8


In SummaryIn Summary

Both ROI and residual income are Both ROI and residual income are useful, but both tools have useful, but both tools have drawbacks. Therefore, companies drawbacks. Therefore, companies will use a combination of ROI and will use a combination of ROI and residual income (as well as other residual income (as well as other measures) to evaluate performance.measures) to evaluate performance.

LO-8


Learning Objective 9Learning Objective 9Issues: Measuring Investment Issues: Measuring Investment

CapitalCapital

Three issues must be considered before Three issues must be considered before

we can properly measure the investment we can properly measure the investment

capital:capital:

First, what assets should be included?First, what assets should be included?

1.1. Total assets.Total assets.

2.2. Total productive assets.Total productive assets.

3.3. Total assets less current liabilities.Total assets less current liabilities.

4.4. Only the assets controllable by the manager Only the assets controllable by the manager being evaluated.being evaluated.


Measuring Investment Capital Measuring Investment Capital (con’d)(con’d)

The Second IssueThe Second Issue

1.1. Should we measure the investment at Should we measure the investment at the beginning or end-of-period amount, the beginning or end-of-period amount, or should we use an average of or should we use an average of beginning and end-of- period amounts?beginning and end-of- period amounts?

2.2. Should the assets be shown at Should the assets be shown at historical or current cost?historical or current cost?

LO-9


Measuring Investment Capital Measuring Investment Capital (con’d)(con’d)

The Third IssueThe Third Issue

Should net book value or gross value of long-lived Should net book value or gross value of long-lived assets be used to value them?assets be used to value them?

Issues to consider in this decision include:Issues to consider in this decision include:1. The use of net book value produces valuations that are 1. The use of net book value produces valuations that are consistentconsistent

with those shown on the balance sheet.with those shown on the balance sheet.2. The methods to compute depreciation could be criticized as 2. The methods to compute depreciation could be criticized as beingbeing

arbitrary.arbitrary.3. The use of declining net book values could result in misleading 3. The use of declining net book values could result in misleading

increases in ROI, residual income, and EVA over time. increases in ROI, residual income, and EVA over time.

LO-9


Measuring InvestmentMeasuring InvestmentCentre IncomeCentre Income

Division managers should be Division managers should be evaluated on profit margin they evaluated on profit margin they control.control. Exclude these costs:Exclude these costs:

Costs traceable to the division but not Costs traceable to the division but not controlled by the division manager.controlled by the division manager.

Common costs incurred elsewhere and Common costs incurred elsewhere and allocated to the division.allocated to the division.

The key issue is controllability.

LO-9


The transfer price affects the profit measure for The transfer price affects the profit measure for both the selling division and the buying division.both the selling division and the buying division.

A higher transferprice for batteries

means . . .

greaterprofits for the

battery division.

Auto DivisionBattery Division

Learning Objective 10Learning Objective 10Transfer PricingTransfer Pricing

lower profitsfor theauto

division.


Goal CongruenceGoal Congruence

The ideal transfer price allowseach division manager to make

decisions that maximize thecompany’s profit, while

attempting to maximize his/herown division’s profit.

The ideal transfer price allowseach division manager to make

decisions that maximize thecompany’s profit, while

attempting to maximize his/herown division’s profit.

LO-10


General-Transfer-Pricing RuleGeneral-Transfer-Pricing Rule

Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity cost

per unit to theorganizationbecause ofthe transfer

= +

LO-10


The Battery Division makes a standard 12-volt The Battery Division makes a standard 12-volt battery.battery.

Production capacityProduction capacity 300,000 units300,000 units

Selling price per batterySelling price per battery $40 (to outsiders)$40 (to outsiders)

Variable costs per batteryVariable costs per battery $18$18

Fixed costs per batteryFixed costs per battery $7 (at 300,000 units)$7 (at 300,000 units) The Battery division is currently selling The Battery division is currently selling

300,000 batteries to outsiders at $40. The 300,000 batteries to outsiders at $40. The Auto Division can use 100,000 of these Auto Division can use 100,000 of these batteries in its X-7 model. batteries in its X-7 model.

Scenario I: No Excess CapacityScenario I: No Excess Capacity

What is the appropriate transfer price?LO-10


Transferprice



Opportunity costper unit to theorganizationbecause ofthe transfer

= +

Transferprice = $18 variable

cost per battery +$22 Contribution

lost if outsidesales given up

Transferprice = $40 per battery

Scenario I: No Excess Capacity Scenario I: No Excess Capacity (con’d)(con’d)

LO-10



$40transfer

price

Auto division canpurchase 100,000batteries from anoutside supplier

for less than $40.

Auto division canpurchase 100,000batteries from anoutside supplier

for more than $40.

Transferwill notoccur.

Transferwill

occur.

LO-10


General Rule:General Rule:

When the selling division is When the selling division is operating at capacity, the operating at capacity, the transfer price should betransfer price should be set at the market price. set at the market price.


LO-10


The Battery Division makes a standard 12-volt The Battery Division makes a standard 12-volt battery.battery.

Production capacityProduction capacity 300,000 units300,000 units

Selling price per batterySelling price per battery $40 (to outsiders)$40 (to outsiders)

Variable costs per batteryVariable costs per battery $18$18

Fixed costs per batteryFixed costs per battery $7 (at 300,000 units)$7 (at 300,000 units) The Battery division is currently selling 150,000 The Battery division is currently selling 150,000

batteries to outsiders at $40. The Auto Division can batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. It use 100,000 of these batteries in its X-7 model. It can purchase them for $38 from an outside supplier. can purchase them for $38 from an outside supplier.

Scenario II: Excess CapacityScenario II: Excess Capacity

What is the appropriate transfer price?LO-10


Transferprice



Opportunity costper unit to theorganizationbecause ofthe transfer

= +

Transferprice = $18 variable

cost per battery +

Transferprice = $18 per battery


$0

LO-10


General Rule:General Rule:

When the selling division is When the selling division is operating below capacity, operating below capacity,

the minimum transfer price the minimum transfer price is the variable cost per unit.is the variable cost per unit.

So, the transfer price will be no lowerthan $18, and no higher than $39.


LO-10



Transferwill

occur.

$18transfer

price

$39transfer

price



LO-10


Learning Objective 11Learning Objective 11Setting Transfer PricesSetting Transfer Prices

The value placed on transfer goods The value placed on transfer goods is used to make it possible to is used to make it possible to

transfer goods between divisions transfer goods between divisions while allowing them to while allowing them to retain their retain their

autonomyautonomy..


Goal CongruenceGoal Congruence

Conflicts may arise between the Conflicts may arise between the company’s interests and an individual company’s interests and an individual

manager’s interests when transfer-price-manager’s interests when transfer-price-based performance measures are used.based performance measures are used.

LO-11


Conflicts may be resolved by . . .Conflicts may be resolved by . . .

1.1. Direct intervention by top management.Direct intervention by top management.

2.2. Centrally established transfer price Centrally established transfer price

policies.policies.

3.3. Negotiated transfer prices. Negotiated transfer prices.

Setting Transfer PricesSetting Transfer Prices

LO-11


Top management may become Top management may become swamped with pricing disputes swamped with pricing disputes

causing division managers to lose causing division managers to lose autonomy.autonomy.

I just won’t

pay $65 for

that part!

You really don’t have any

choice!

Setting Transfer Prices (con’d)Setting Transfer Prices (con’d)

Now, here is what the twoof you are going to do.

LO-11


As a general rule, a market-based transfer As a general rule, a market-based transfer pricing policy contains the following pricing policy contains the following

guidelines . . .guidelines . . .

1.1. The transfer price is usually set at aThe transfer price is usually set at a discount from the cost to acquire the discount from the cost to acquire the itemitem on the open market. on the open market.

2.2. The selling division may elect to transfer The selling division may elect to transfer oror to continue to sell to the outside. to continue to sell to the outside.

As a general rule, a market-based transfer As a general rule, a market-based transfer pricing policy contains the following pricing policy contains the following

guidelines . . .guidelines . . .

1.1. The transfer price is usually set at aThe transfer price is usually set at a discount from the cost to acquire the discount from the cost to acquire the itemitem on the open market. on the open market.

2.2. The selling division may elect to transfer The selling division may elect to transfer oror to continue to sell to the outside. to continue to sell to the outside.

Market-Based Transfer Market-Based Transfer PricesPrices

LO-11


Negotiated Transfer PriceNegotiated Transfer Price

A system where transfer prices are A system where transfer prices are arrived at through negotiation arrived at through negotiation

between managers of buying and between managers of buying and selling divisions.selling divisions.

A system where transfer prices are A system where transfer prices are arrived at through negotiation arrived at through negotiation

between managers of buying and between managers of buying and selling divisions.selling divisions.

Much managementtime is used in the

negotiation process.

Much managementtime is used in the

negotiation process.Negotiated price may notbe in the best interest of

overall company operations.

Negotiated price may notbe in the best interest of

overall company operations. LO-11


Cost-Based Transfer PricesCost-Based Transfer Prices

Some companies use the following Some companies use the following measures of cost to establish measures of cost to establish

transfer prices . . .transfer prices . . . Variable costVariable cost Full absorption costFull absorption cost

Beware of treating unit fixed costs as Beware of treating unit fixed costs as variable. variable.

LO-11


Undermining Divisional Undermining Divisional AutonomyAutonomy

Transfer prices are used in a Transfer prices are used in a decentralized environment where decentralized environment where managers have authority to make managers have authority to make decisions and control operations. When decisions and control operations. When disputes arise, top management should disputes arise, top management should step aside and let the division step aside and let the division managers resolve the issues, as such managers resolve the issues, as such intervention undermines divisional intervention undermines divisional autonomy.autonomy.

LO-11


An International PerspectiveAn International Perspective

Since tax rates and import duties are Since tax rates and import duties are different in different countries, companies different in different countries, companies have incentives to set transfer prices that have incentives to set transfer prices that will:will:

1.1. Increase revenues in low-tax countries.Increase revenues in low-tax countries.

2.2. Increase costs in high-tax countries.Increase costs in high-tax countries.

3.3. Reduce cost of goods transferred to high-Reduce cost of goods transferred to high- import-duty countries. import-duty countries.

LO-11

Hilton 1e ch 12

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