FAR EASTERN UNIVERSITY

Institute of Accounts, Business and Finance

ACT1123 - Strategic Cost Management
Responsibility Accounting and Transfer Pricing

Introduction

Based on the previous lessons we already learned that management functions are forecasting,
planning, controlling and performance evaluation. Management achieve those functions in many
ways, depending on the form of organization or management style the firm chose to implement. The
two general forms of organization or management style the firm chose to implement.

There are two general forms of management, they are called centralized and decentralized.

Centralized

- is a form of organization's management style where the firm requires the top
management to make most decisions, and controls most activities of the organization. The
president of the company or the owner performs all the decision making and maintains full
authoriy and responsibility for such organization or firm.

Decentralized
- is a form of organization's management style where the firm is divided into smaller units.
These units are called by various names, such as divisions, segments, business units, center
or department. Each unit has designed responsible officer who does most of the decision
making for each division.

The focus in these topic is the management accounting for decentralized form of management.

Advantages of Decentralized form of Management

1.) Training - Allowing managers some authority in decision making provides managerial training for
future higher-level manager.

2.) Enhanced Specialization - Managers of the organization's sub-units must consider specialization.
Through training they develop specialized skill that enable them to manage their units the most
effective way.

3.) Motivation - Managers with some decision making authority usally exhibit greater motivation than
those who merely execute the decision.
4.) Defined Span of Control - Responsible officers are given specified span of control which then can be
more focused and thus avoiding conflict between managers.

5.) Greater focused on strategic planning - Delegating to lower level managers provides time relief to
upper-level managers, enabling them to devote more time to more strategic planning.

6.) Faster- decision making - Delegating decision-making to the lowest level possible enables an
organization to give a timely response to opportunities as they rise.

Responsibility Accounting
- is an accounting system that will make a decentralized form of organization operate
effectively. It provides information to top management about the performance of the units
and sub-units.

Responsibility Reports
-are reports that assist each successively higher level of management in evaluating
performances of its subordinate managers and their respective organizational units and
subunits.

Responsibility Center
- is a unit within the organization, which has control over costs, revenues or investment
funds. The types of responsibility centers and the appropriate performance evaluation
methods are:

1.) Cost Center

- a cost center is a responsibility center in which the manager has the authority to incur
costs and it specifically evaluated on the basis of how well costs are controlled and utilized.
The manager is reponsible for minimizing costs under the cost center.

Performance of a cost center is evaluated through variance analysis reports based on

standard costs and flexible budgets.

2.) Profit/ Revenue Center

- a profit center or revenue center is an organizational unit for which a manager is

accountable only for the generation of revenues and has no control on budgeting costs. A
profit center is responsible for the generation of revenue based on the current production.

Performance of a profit/revenue center is measured by using the contribution margin

approach.
3.) Investment Center
- An investment center is an organizational unit in which the manager is responsible for
generating revenues, planning and controlling expenses, and has the authority to acquire,
utilize and dispose of assets in a manner that would seek to earn the highest feasible rate
of return return on the center's investment cost.

Performance evaluation for an investment center normally includes computation of

payback period, net investment, return on investment (ROI) etc.

TRANSFER PRICING

Introduction

In many organizations, one sub-unit manufactures a product that is then transferred to another
sub-unit or provides a service to another segment in the same organization. These price at which
products or services are transferred between two sub-units in an organization is called transfer price.
This is called "transfer pricing". Transfer prices guide managers to make the best possible decision as
to whether they should buy or sell products and services inside or outside the total organization.

Since transfer price affect both of the profit of both the buying and selling division, the transfer price
affects the performance evaluation of these responsibility centers.

Transfer Pricing
- the amount charged when one division sells goods or services to another division is called
the transfer price.

Objectives of Transfer Pricing

- Management's objective in setting a transfer price is to encourage goal congruence.

Goal congruence
- is a situation in which people in multiple levels of an organization share the same goal.

The transfer price should be the price that maximize the profit of the Company as a whole.
General Rule on Transfer Pricing

Maximum Transfer Price Selling price from the Supplier

(POV of buying division) /Market Price

Excess Capacity Variable Cost less any avoidable VC

Minimum Transfer
Price
(POV of the selling division) Without excess Variable Cost + Forgone CM-
capacity avoidable VC
/selling price of the selling division

Note: Variable cost is also called incremental cost if there is an excess capacity.
Variable cost plus forgone CM is also called incremental cost if there is an excess
capacity.
TRANSFER PRICING EXCERCISES

THEORIES

1.) A transfer price is:

a.) an accounting device to turn profit center into investment center

b.) the price charged by one segment of the Company for goods or services provided to another
segment
c.) only useful in a segment that deals with outsiders as well as with other segments of the same
company.
d.) the amount charged by cost center for a service performed for a profit center.

2.) Tranfer prices

a.) reduce employee turnover

b.) are necessary for investment centers
c.) should encourage the kinds of behavior that upper-level management wants
d.) are not used for departments with high amount of fixed costs.

3.) The criteria used for evaluating performance

a.) should be designed to help achieve goal congruence

b.) can only be used only with profit centers and investment centers
c.) should be used to compare past performances with current performance
d.) motivate people to work in the company's best interests.

4.) With autonomous divisions managers, the price of goods transferred between the divisions needs
to be approved by:

a.) corporate management

b.) both divisions manager
c.) both divisions manager and corporate management
d.) corporate management and the manager of the buying division.

5.) the minimum transfer price is determined by

a.) incremental costs in the selling division

b.) the lowest outside price for the good
c.) the extent of idle capacity in the buying division
d.) negotiations between the buying and the selling division
PROBLEMS

Problem 1

ABC Corporation produces various products used in the construction industry. Division A produces
100,000 copper fittings each month. Relevant information for the last month are as follows:

Total sales (all external) P250,000

Expenses (all on a per unit basis)
Variable manufacturing 0.5
Fixed manufacturing 0.25
Variable selling 0.3
Fixed selling 0.4
Variable G&A 0.15
Fixed G&A 0.5
Total sales (all external) P2.1

Top-level managers are trying to determine how a transfer price can be set on a transfer of 10,000
units of the copper fittings from Division A to Division B:

1.) A transfer price based on variable cost will be set at how much per unit?

a.) P0.50 c.) P0.95

b.) P0.80 d.) P0.75

2.) A transfer price based on full production cost would be set at?

a.) P0.75 c.) P1.45

b.) P2.10 d.) P1.60

3.) If division A sells 100,000 fittings per month to outside customers, the per unit transfers price is
not likely to be below:

a.) P0.75 c.) P2.10

b.) P1.60 d.) P2.50
Problem 2

Division A of DEF Company makes a part that can either be sold outside to customers or transferred
internally to Division B for further processing. Annual data relating to this part are as follows:

Annual Production Capacity 80,000 units

Selling price of the item to outside suppliers P35
Variable cost per unit 23
Fixed cost per unit 5

Division B of DEF Company requires 15,000 units per year and is currently paying an outside supplier
for P33 per unit. Cosider each question below independently.

1.) If outside customers demand only 50,000 units per year, what is the lowest acceptable transfer
price from the view point of the Division A?

a.) P35 c.) P28

b.) P33 d.) P23

2.) If outside customers demand 80,000 units, what is the lowest acceptable transfer price from the
viewpoint of the selling division.

a.) P35 c.) P28

b.) P33 d.) P23

3.) If outside customers demand 80,000 units and if by selling to division B, Division A can avoid P4 per
unit in variable selling expense, what is the lowest acceptable transfer price from the viewpoint of the
selling division.

a.) P35 c.) P31

b.) P21 d.) P33

4.) If outside customers demand 70,000 units, what is the lowest acceptable transfer price from the
viewpoint of the selling division for each of the 15,000 units needed by Division B

a.) P33 c.) P28

b.) P27 d.) P29