Module - Background
TRANSFER PRICING AND RESPONSIBILITY CENTERS
Modular Learning Objectives
Keep the following objectives in mind as you work through the material in this module:
· Define the role of responsibility accounting.
· Differentiate between controllable and uncontrollable costs.
· Analyze structure of a decentralized organization.
· Define profit centers, cost centers, and investment centers.
· Compute transfer prices.
· Identify three main transfer pricing approaches.
Required Reading
This module covers the role of responsibility accounting and responsibility centers. Explore these topics further while keeping the above six objectives in mind. Click on the three arrows to explore each topic in more detail:
The term responsibility accounting refers to an accounting system that collects, summarizes, and reports accounting data relating to the responsibilities of individual managers. A responsibility accounting system provides information to evaluate each manager on the revenue and expense items over which that manager has primary control (authority to influence).
A responsibility accounting report contains those items controllable by the responsible manager. When both controllable and uncontrollable items are included in the report, accountants should clearly separate the categories. The identification of controllable items is a fundamental task in responsibility accounting and reporting.
To implement responsibility accounting in a company, the business entity must be organized so that responsibility is assignable to individual managers. The various company managers and their lines of authority (and the resulting levels of responsibility) should be fully defined. Not all managers have equal authority and responsibility. The degree of a manager’s authority varies from company to company.
The controllability criterion is crucial to the content of performance reports for each manager. For example, at the department supervisor level, perhaps only direct materials and direct labor cost control are appropriate for measuring performance. A plant manager, however, has the authority to make decisions regarding many other costs not controllable at the supervisory level, such as the salaries of department supervisors. These other costs would be included in the performance evaluation of the store manager, not the supervisor.
Watch this short video to further explain the concept of responsibility accounting. https://www.youtube.com/watch?time_continue=1&v=EsS0socI3I4
Decentralization is the dispersion of decision-making authority among individuals at lower levels of the organization. In other words, the extent of decentralization refers to the degree of control that segment managers have over the revenues, expenses, and assets of their segments. When a segment manager has control over these elements, the investment center concept can be applied to the segment. Thus, the more decentralized the decision-making is in an organization the more appli ...
Module - BackgroundTRANSFER PRICING AND RESPONSIBILITY CENTERS
1. Module - Background
TRANSFER PRICING AND RESPONSIBILITY CENTERS
Modular Learning Objectives
Keep the following objectives in mind as you work through the
material in this module:
· Define the role of responsibility accounting.
· Differentiate between controllable and uncontrollable costs.
· Analyze structure of a decentralized organization.
· Define profit centers, cost centers, and investment centers.
· Compute transfer prices.
· Identify three main transfer pricing approaches.
Required Reading
This module covers the role of responsibility accounting and
responsibility centers. Explore these topics further while
keeping the above six objectives in mind. Click on the three
arrows to explore each topic in more detail:
The term responsibility accounting refers to an accounting
system that collects, summarizes, and reports accounting data
relating to the responsibilities of individual managers. A
responsibility accounting system provides information to
evaluate each manager on the revenue and expense items over
which that manager has primary control (authority to influence).
A responsibility accounting report contains those items
controllable by the responsible manager. When both
controllable and uncontrollable items are included in the report,
accountants should clearly separate the categories. The
identification of controllable items is a fundamental task in
responsibility accounting and reporting.
To implement responsibility accounting in a company, the
business entity must be organized so that responsibility is
assignable to individual managers. The various company
managers and their lines of authority (and the resulting levels of
responsibility) should be fully defined. Not all managers have
2. equal authority and responsibility. The degree of a manager’s
authority varies from company to company.
The controllability criterion is crucial to the content of
performance reports for each manager. For example, at the
department supervisor level, perhaps only direct materials and
direct labor cost control are appropriate for measuring
performance. A plant manager, however, has the authority to
make decisions regarding many other costs not controllable at
the supervisory level, such as the salaries of department
supervisors. These other costs would be included in the
performance evaluation of the store manager, not the
supervisor.
Watch this short video to further explain the concept of
responsibility accounting.
https://www.youtube.com/watch?time_continue=1&v=EsS0socI
3I4
Decentralization is the dispersion of decision-making authority
among individuals at lower levels of the organization. In other
words, the extent of decentralization refers to the degree of
control that segment managers have over the revenues,
expenses, and assets of their segments. When a segment
manager has control over these elements, the investment center
concept can be applied to the segment. Thus, the more
decentralized the decision-making is in an organization the
more applicable is the investment center concept to the
segments of the company. The more centralized the decision
making is, the more likely responsibility centers are to be
established as expense centers.
Some advantages of decentralized decision making are:
· Managing segments trains managers for high-level positions in
the company. The added authority and responsibility also
represent job enlargement and often increase job satisfaction
and motivation.
· Top management can be more removed from day-to-day
decision-making at lower levels of the company and can manage
by exception. When top management is not involved with
3. routine problem solving, it can devote more time to long-range
planning and to the company’s most significant problem areas.
· Decisions can be made at the point where problems arise. It is
often difficult for top managers to make appropriate decisions
on a timely basis when they are not intimately involved with the
problem they are trying to solve.
· Since decentralization permits the use of the investment center
concept, performance evaluation criteria such as ROI and
residual income (to be explained later) can be used.
There are three main types of responsibility centers—cost
centers, profit centers, and investment centers. The fourth type,
the revenue center will not be discussed here. In designing a
responsibility accounting system, management must examine
the characteristics of each segment and the extent of the
responsible manager’s authority. Care must be taken to ensure
that the basis for evaluating the performance of a cost center,
profit center, or investment center matches the characteristics of
the segment and the authority of the segment’s manager. The
following sections discuss the characteristics of each of these
centers and the appropriate bases for evaluating the
performance of each type.
https://www.youtube.com/watch?v=N84VVslVctU
A cost center is a responsibility center incurring only expense
items and producing no direct revenue from the sale of goods or
services. Examples of expense centers are service centers (e.g.
the maintenance department or accounting department) or
intermediate production facilities that produce parts for
assembly into a finished product. Managers of expense centers
are held responsible only for specified expense items.
The appropriate goal of an expense center is the long-run
minimization of expenses. Short-run minimization of expenses
may not be appropriate. For example, a production supervisor
could eliminate maintenance costs for a short time, but in the
4. long run, total costs might be higher due to more frequent
machine breakdowns.
A profit center is a responsibility center having both revenues
and expenses. Because segmental earnings equal segmental
revenues minus related expenses, the manager must be able to
control both of these categories. The manager must have the
authority to control selling price, sales volume, and all reported
expense items. To properly evaluate performance, the manager
must have authority over all of these measured items.
Controllable profits of a segment result from deducting the
expenses under a manager’s control from revenues under that
manager’s control.
Closely related to the profit center concept is an investment
center. An investment center is a responsibility center having
revenues, expenses, and an appropriate investment base. When a
firm evaluates an investment center, it looks at the rate of return
it can earn on its investment base.
Typical investment centers are large, autonomous segments of
large companies. The centers are often separated from one
another by location, types of products, functions, and/or
necessary management skills. Segments such as these often
seem to be separate companies to an outside observer. But the
investment center concept can be applied even in relatively
small companies in which the segment managers have control
over the revenues, expenses, and assets of their segments.
Let us start with a brief video about transfer pricing.
https://www.youtube.com/watch?v=_Qwz_cMAnvg
Profit centers and investment centers inside companies often
exchange products with each other. The Pontiac, Buick, and
other divisions of General Motors buy and sell automobile parts
from each other, for example. No market exchange takes place,
so the company sets transfer prices that represent revenue to the
selling division and costs to the buying division.
A transfer price is an artificial price used when goods or
5. services are transferred from one segment to another segment
within the same company. Accountants record the transfer price
as a revenue of the producing segment and as a cost, or expense,
of the receiving segment. Usually no cash actually changes
hands between the segments. Instead, the transfer price is an
internal accounting transaction.
Segments are generally evaluated based on some measure of
profitability. The transfer price is important because it affects
the profitability of the buying and selling segments. The higher
the transfer price, the better for the seller. The lower the
transfer price, the better for the buyer.
Ideally, a transfer price provides incentives for segment
managers to make decisions not only in their best interests but
also in the interests of the entire company. For example, if the
selling segment can sell everything it produces for USD 100 per
unit, the buying segment should pay the market price of USD
100 per unit. A seller with excess capacity, however, should be
willing to transfer a product to the buying segment for any price
at or above the differential cost of producing and transferring
the product to the buying segment (typically all variable costs).
In practice, companies mostly base transfer prices on (1) the
market price of the product, (2) the cost of the product, or (3)
some amount negotiated by the buying and selling segment
managers.
Check Your Understanding
Check your understanding to make sure that you have a good
grasp of the background material. If you are not comfortable
with the concepts, review some of the material again or go to
the optional resource for more examples.
Final Thoughts
A responsibility center is a part or subunit of a company for
which a manager has authority and responsibility. The
company's detailed organization chart is a logical source for
determining responsibility centers. The most common
6. responsibility centers are the departments within a company.
When the manager of a responsibility center can control only
costs, the responsibility center is referred to as a cost center. If
a manager can control both costs and revenues, the
responsibility center is known as a profit center. If a manager
has authority and responsibility for costs, revenues, and
investments the responsibility center is referred to as an
investment center.
The existence of responsibility centers necessitates the setting
of an internal price for the transfer of parts, goods, and services
among units and responsibility centers. Transfer prices are
contentious because management intervenes by creating policies
which have an effect on the income of a responsibility center or
unit.
Transfers among international jurisdictions involve additional
considerations. Not only accounting rules, but income taxation
and duties affect pricing strategies. Most countries have
regulations to help prevent the use of this pricing method as a
means of evading taxes or similar unethical and illegal
activities.
Reading
For further detail refer to Dr. Walther’s accounting text and
videos.
Walther, L. (2017). Chapter 23: Reporting to Support
Managerial Decisions.
http://www.principlesofaccounting.com/chapter-23/
Module 3 – Case Assignment Question
TRANSFER PRICING AND RESPONSIBILITY CENTERS
Assignment Overview
Coffee Maker's Incorporated (CMI)
Three divisions of a CMI are involved in a dispute. Division A
purchases Part 101 and Division B purchases Part 201 from a
7. third division, C. Both divisions need the parts for products that
they assemble. The intercompany transactions have remained
constant for several years.
Recently, outside suppliers have lowered their prices, but
Division C refuses to do so. In addition, all division managers
are feeling the pressure to increase profit. Managers of
divisions A and B would like the flexibility to purchase the
parts they need from external parties at a lower cost and
increase profitability.
The current pattern is that
· Division A purchases 2,700 units of product part 101 from
Division C (the supplying division) and another 1,300 units
from an external supplier.
· Division B purchases 1,100 units of Part 201 from Division C
and another 700 units from an external supplier.
· Note that both divisions A and B purchase the needed supplies
from both the internal source and an external source at the same
time.
The managers for divisions A and B are preparing a new
proposal for consideration.
· Division C will continue to produce Parts 101 and 201. All of
its production will be sold to Divisions A and B. No other
customers are likely to be found for these products in the short
term, given that supply is greater than demand in the market.
· Division A will buy 2,000 units of Part 101 from Division C at
the existing transfer price; and
· 2,000 units from an external supplier at the market price of
$900 per unit.
· Division B will buy 900 units of Part 201 from Division C at
the existing transfer price; and
· 900 units from an external supplier at $1,800 per unit.
Division C Data Based on the Current Agreement
Part
101
201
Annual volume (units)
8. 2,700
1,100
Transfer price/unit
$1,000
$2,000
Variable expenses/unit
$700
$1,200
The fixed overhead for Division C is $1,200,000.
Case Assignment
Required:
Computations (use Excel)
· Set up a table similar the one below to compute the difference
between the current situation and the proposal for Divisions A
and B.
Division A
Current Situation
Proposal
No. of Units
Purchase Price
Total Purchases
No. of Units
Purchase Price
Total Purchases
Internal purchases
2,700
$
2,000
$
10. current agreement and the proposed agreement.
· Is the revised agreement a good idea? Support your answer
with computations.
Memo (use Word)
Write a 4- or 5-paragraph memo to the division manager
explaining the analysis performed. Start with an introduction
and end with a recommendation. Each of the four or five
paragraphs should have a heading.
Short Essay (use Word)
Start with an introduction and end with a summary or
conclusion. Use headings.
Evaluate and discuss the implications of the following transfer
pricing policies:
· Transfer price = cost plus a mark-up for the selling division
· Transfer price = fair market value
· Transfer price = price negotiated by the managers
Why is transfer pricing such a significant issue both from a
financial and managerial perspective?
Assignment Expectations
Each submission should include two files: (1) An Excel file and
(2) a Word document. The Word document shows the memo
first and short essay last. Assume a knowledgeable business
audience and use required format and length. Individuals in
business are busy and want information presented in an
organized and concise manner.
Double space
APA Format
Reference credible sources only
The following resources are notacceptable for this course, keep
in mind, there are many others:
· Wikipedia.com
· Ehow.com
· About.com
· Smallbusiness.chron.com
· Diffen.com
· Yourbusiness.azcentral.com
11. · Investopedia.com
· Boundless.com and Lumen
· Course hero
· Chegg
Top of Form
Rubric Name: Case Grading Rubric for Quantitative Business
Courses -Timeliness v1
Criteria
Level 4 - Excellent
Level 3 - Proficient
Level 2 - Developing
Level 1 - Emerging
Assignment-Driven Criteria
19 points
Demonstrates mastery covering all key elements of the
assignment in a substantive way.
18 points
Demonstrates considerable proficiency covering all key
elements of the assignment.
17 points
Demonstrates partial proficiency covering all key elements of
the assignment.
16 points
Demonstrates limited or poor proficiency covering all key
12. elements of the assignment.
Presentation, Computation, and Relevance of Quantitative
Information
10 points
Demonstrates mastery in presenting quantitative information in
a format appropriate for the discipline. Supporting computations
are relevant and accurate.
9 points
Demonstrates considerable proficiency in presenting
quantitative information in a format appropriate for the
discipline. Supporting computations are mostly relevant and
accurate.
8 points
Demonstrate partial proficiency in presenting quantitative
information in a format appropriate for the discipline.
Supporting computations are not necessarily relevant and
somewhat misleading.
7 points
Demonstrates limited or poor proficiency in presenting
quantitative information in a format appropriate for the
discipline. Supporting computations are not relevant,
misleading or absent.
Critical Thinking
10 points
Analyzes quantitative and qualitative information as the basis
for deep and thoughtful discussion, drawing insightful, carefully
qualified conclusions from this work.
9 points
Analyzes quantitative and qualitative information as the basis
for competent and thoughtful discussion, drawing reasonable
13. and appropriately qualified conclusions from this work.
8 points
Analyzes quantitative and qualitative information as the basis
for workmanlike (without inspiration or nuance, ordinary)
discussion, drawing plausible conclusions from this work.
7 points
Analyzes quantitative and qualitative information as the basis
for tentative or limited discussion; and is hesitant or uncertain
about drawing conclusions from this work.
Business Writing
6 points
Demonstrates mastery and proficiency in written communication
to an appropriately specialized audience.
5 points
Demonstrates considerable proficiency in written
communication to an appropriately specialized audience.
4 points
Demonstrate partial proficiency in written communication to an
appropriately specialized audience.
3 points
Demonstrates limited or poor proficiency in written
communication to an appropriately specialized audience.
Timeliness
5 points
Assignment submitted on time or collaborated with professor
for an approved extension on due date.
3 points
Assignment submitted 1-2 days after module due date.
14. 2 points
Assignment submitted 3-4 days after module due date.
0 points
Assignment submitted 5 or more days after module due date.
Overall Score
Level 4
45 or more
Level 3
40 or more
Level 2
35 or more
Level 1
0 or more
Bottom of Form
Close
Module Overview
Transfer Pricing Policies
The fundamental objective in setting transfer prices is to
motivate managers to act in the best interests of the
organization, and not just their division. A good transfer price
is one that encourages division managers to do whatever is in
the best interest of the entire organization.
There are three primary approaches to setting transfer prices,
namely (1) negotiated transfer prices, (2) transfers at market
price transfers, and (3) transfers at cost (or cost plus set profit)
to the selling division.
15. The objectives of domestic transfer pricing include:
· Creating greater divisional autonomy.
· Providing greater motivation for managers.
· Enabling better performance evaluation.
· Establishing better goal congruence.
The objectives of international transfer pricing include:
· Lowering taxes, duties, and tariffs.
· Lowering foreign exchange risks.
· Improving competitive position.
· Improving relations with foreign governments