Lesson 4.2 to 4.

3: Responsibility Accounting - Control mechanism will be provided which will serve as the
basis for evaluating the actual results or performance.
Decentralized Organization
Advantages of Responsibility Accounting
- It is one in which decision-making is not confined to few top
executives but rather is spread out throughout the 1. It facilitates delegation or decision-making.
organization, with managers at various levels making key 2. It helps the management promote the concept of
operating decisions relating to their sphere of responsibility. management by objectives wherein the management agree
- Managers have found that segment reporting is of greatest on a common set of goals and their performance evaluated
value in organizations that are decentralized. on the basis of the attainment of goals.
- In segment reporting, costs and revenues are assigned to 3. It aids in establishing standards of performance which are
segments to enable management to see where used in evaluating the efficiency and effectiveness of the
responsibility lies for control purposes and to measure the different units in the organization.
performance of segment managers. 4. It permits effective use of management by exception which
provides that manager will maximize efficiency by
Basic Concepts concentrating on those operational factors which are
- In a well-managed organization, responsibilities for specific deviations from plans.
functions among its employees are clearly defined. Prerequisites of Effective Responsibility Accounting System
- A responsibility center is a specific unit of an organization
assigned to a manager who is held accountable for its 1. A well-defined organization structure.
operations and resources. 2. Well-defined and established standards of performance in
- Each manager’s performance is judged by how well he/she revenues, costs and other investments.
managers those items under his/her control. 3. A system of accounting that identifies any revenues,
expenses and assets to specific units in the organization.
RESPONSIBILITY ACCOUNTING 4. A system that provides for the preparation of regular
performance reports.
- It is a system that recognizes various decision centers
throughout an organization and traces costs by areas of Responsibility Centers and their Evaluation
responsibility.
- This system is also known as accounting and profitability  It is to determine the range of authority and influence of
accounting. manager to have control over revenues, costs and
- It operates on the premise that managers should be held investments.
responsible for their performance, the activities of their  A responsibility centers is a unit within the organization
subordinates and all activities within their responsibility which has control over costs, revenues and/or investments.
center.  Types of responsibility centers include cost centers, profits
centers and investment centers.
Objectives of Responsibility Accounting

- Through responsibility accounting, managers will be

compelled to set managerial targets and formulate
strategies to attain the firm’s overall objectives.
COST CENTER exceed the expected contribution to indirect costs or
common costs of the company.
- This is a unit within the organization wherein the manager is
responsible for minimizing costs subject to some output INVESTMENT CENTER
constraints.
- This is a unit or segment within the organization where the
- It has no control over generating revenue or the use of
manager is responsible for the control of revenues, costs
investment funds.
and investments made in that center.
- The manager is responsible for making projection or cost
- Examples include corporate headquarters or division of a
budget in his unit base on the expected level of operation
large decentralized organization such as (1) Magnolia
for the period.
Products Division of San Miguel Corporation; (2)
- When approved by the higher authorities (BOD), the
Pharmaceutical Division of Novartis (Phils.) Inc.; (3)
budgets will serve as the basis of transactions or activities
Subsidiary companies
for the ensuing period.
- Performance of a cost center is evaluated by using the Objectives of Investment Center
performance reports or variance analysis reports based on
standard cost or flexible budget.  Motivate managers to exert a high level of effort to achieve
- The performance report will show the comparison between the goals of the firm
the actual cost and the budgeted cost incurred.  Provide the right incentive for managers to make decisions
that are consistent with the goals of top management
- The difference between the two costs if any, if significant
 Determine fairly the rewards earned by the managers for
will be analyzed.
their effort and skill
- Responsibility for the incurrence will be pinpointed and the
manager concerned will be required to explain or justify the Return on Investment
variance.
- The efficiency of the manager of the cost center to control  Net Operating Income – is generally used because it is
the cost in his unit will be evaluated. consistent with the base to which it is applied, that is
operating assets.
PROFIT CENTER  Operating assets – include cash, accounts receivable,
inventory, PPE, etc. held for productive use in the
- This is a unit or segment within the organization where in
organization. Examples of assets not to be included are land
the manager is responsible for the generation of revenues
held for future use, as investment in another company or a
and control of cost incurred in the center.
factory building rented to someone else.
- The manager of the profit center will likewise be responsible
for preparing the budget in his unit. Advantage of ROI
- Performance of a profit center is measured by preparing the
 It is easily understood and has gained wide usage.
income statements using the contribution approach,
 It is comparable to interest rates of returns of alternative
presenting both the actual results and budgeted figures. The
investments.
statement will show the comparative revenue, direct costs
and the profit center’s contribution to indirect costs.
- The operating performance of the profit center is generally
considered satisfactory if it is able to generate or even Limitations of ROI
  Although ROI is widely used in evaluating performance, this  Since residual income is not a percentage, it suffers the
method is subject to some criticisms. One of these is that same problem of profit centers in that it is not useful for
ROI tends to emphasize short-run performance rather than composing units of significantly different sizes.
long-run profitability.  It forms larger unit that would be expected to have larger
 Managers may be motivated to reject profitable investment residual income, even with relatively poor performance.
opportunities if the expected rate of return is lower than the  It is not as intuitive as ROI.
current ROI.  It may be difficult to obtain minimum rate of return.
 ROI may not be fully controllable by the division manager
due to the presence of committed costs.
 It results to disincentive for high ROI units to invest in Lesson 4.4: Transfer Pricing
projects with ROI greater than the minimum rate of return
but less than unit’s current ROI. Rationale
 It is therefore advisable to use multiple criteria in evaluating
- A problem common to most companies operating with
performance rather than relying on ROI as a sole measure.
decentralized segments is that of placing a fair value of
 Other criteria include: growth in market share, increase in
exchange of goods and services between segments within
productivity, product innovation, peso profit, receivable and
the company - the problem of Transfer Pricing.
inventory turnover and ability to venture into new and
profitable areas. What is Transfer Price?

Residual Income - A transfer price is the price charged when one segment of
a company provides goods or services to another segment
- It is the net operating income that an investment center is
of the company.
able to earn above some minimum return on the operating
 When the bakery of division of Rustan’s Inc. transfer
assets.
bread to the Supermarket Division, transfer price must
- Generally, the larger the residual income figure, the better is
be agreed upon.
the performance rating received by the division’s manager.
 Most companies in the oil industry such as shell have
Advantages of Residual Income petroleum refining and retail sales divisions.
 The petroleum refining division processes crude oil into
 A unit pursues an investment opportunity costs as long as gasoline, kerosene, lubricants, and other end products.
the return from the investment exceeds the minimum rate The retail sales division takes gasoline and other
of return set by the firm products from the refining division and sells them
 The firm can adjust the required rates of return for through the company’s chain of service stations.
differences in risk and types of assets  Each product has a price for transfers within the
 It is possible to calculate different investment charge for company. Suppose the transfer price for gasoline is
different types of assets P46.16 a gallon. Then the refining division gets credit for
P46.16 a gallon of revenue on its segment report and the
retailing division must deduct P46.16 a gallon as an
expense on its segment report.
 Clearly, the refining division would like the transfer price
Limitations of Residual Income
to be as high as possible, whereas the retailing division
 would like the transfer price to be as low as possible. Cost-Based Transfer Price (Variable cost)
However, the transaction has no direct effect on the
entire company’s reported profit. It is like taking money - Under this approach, the transfer price is based only on
out of one pocket and putting it into the other. variable or differential costs. Variable costs approximate
differential costs in many situations. But when fixed costs
- Transfer price is the value assigned to goods and services
increase because of a transfer of goods between segments,
transferred between segment within the company.
they are differential costs and therefore should be included
 The transfer price of interdivisional sales will affect the
in the transfer price cost.
selling divisions’ sales and the buying divisions' costs but
will not have any direct effect on the company's profit. Cost-Based Transfer Price (Full cost)
However, the transfer price policy of the company can
have an indirect effect on the company profit by - Full cost includes actual manufacturing costs (variable and
influencing decisions of the division manager. fixed) plus portions of marketing and administrative costs.
Many companies use full cost because of the following
The Need for Transfer Price reasons:
 Transfer pricing becomes complex because of the need to 1. It is easy and convenient to apply
evaluate an organization's segments. 2. It leaves no intracompany profits in inventory to
 Transfer prices have a direct bearing on segment margin. eliminate when preparing consolidated statement
Corporate managers should set transfer pricing policies 3. It allows simple and adequate end-product costing for
ensuring that divisions do not purchase outside when profit analysis by product lines
internal facilities with high fixed cost can provide the - This approach however is not suitable for companies with
product. Allowing these facilities to be idle is detrimental to decentralized structures that measure profitability of
the overall company. autonomous units. Segments tend to become complacent
and less concerned about controlling costs when they know
Market-Based Transfer Price their costs are merely passed along to the next segment.
- Also, full-cost method departs from goal- congruence.
- Under this approach, the transfer price is the price at which
the goods are sold on the open market. Negotiated Transfer Price
- If the selling division has no idle capacity, the market price
in the outside market is the perfect choice for the transfer  Under this system, managers are permitted to negotiate the
price. The reason for this is that if the selling division can price for internally transferred goods and services.
sell a transferred item on the outside market instead, then  A negotiated price is an attempt to simulate an arm's-
the real cost of the transfer as far as the company is length transaction between supplying and buying segment.
concerned is the opportunity cost of the lost revenue on the  The major advantage of negotiated transfer prices is that
outside sale. they preserve the autonomy of the division manager.
However, negotiation may be very time-consuming and
- Whether the item is transferred internally or sold on the
require frequent re-examination and revision of prices.
outside market, the production costs are exactly the same. If
the market price is used as the transfer price, the selling
division will not lose anything by making the transfer, and
the buying division manager will get the correct signal about
how much it really costs the company for the transfer to
take place.