CHAPTER 1 RESPONSIBILITY ACCOUNTING AND PERFORMANCE MEASURES

Management functions are forecasting, planning, controlling, and performance evaluation. Management achieves those
functions in many ways, depending on the form of organization or management style the firm chose to implement.

Two general forms of management:

1. Centralization firm requires the top management to make most decisions. The president of the company or the
owner performs all decision making.
2. Decentralization firm is divided into smaller units. These units are called by various names, such as divisions,
segments, business units, center, and departments.

Most organizations chose a decentralized form of organization as this is found to be more effective in bigger
organizations especially in multinational companies.

Sometimes, subunits act in ways that are not consistent with the goals of the total organization; thus control
mechanisms must be provided. These measures could be achieved through responsibility accounting.

Advantages of Decentralization:

Training
Enhanced specialization
Motivated Managers
Defined Span of Control
Greater Focused on Strategic Planning
Faster decision-making

Concerns of Decentralization:

Need for competent people

Need for establishing the most suited measurement system
Inherent sub-optimization issues on segments manager

Responsibility accounting system will make a decentralized form of organization operate effectively. It provides
information to top management about the performace of the units and subunits.

Responsibility reports reports that assist each succesively higher level of management in evaluating the performances
of its subordinate managers and their respective organizational units and subunits

Basic Concepts of Responsibility Accounting:

Recognizes various decision centers

Also known as activity accounting or profitability accounting
No universal definitions, but does link authority and control
Financial reporting by segment/divisions/work centers

Objective of Responsibility Accounting:

Goal congruence
Helps the organization to reap the benefits of decentralization, while minimizing costs

Advantages of Responsibility Accounting:

 Delegation of decision making
Management-by-Objective
Establishing standards of performance
Effective use of management by exception

Prerequisites to the Initiation and Maintenance of an Effective Responsibility Accounting System:

A well-defined organization structure

Well-defined and established standards of performance in revenues, costs and investments
An accounting system
A system that provides for the preparation of regular performance reports (feedback)

Responsibility Centers and Evaluation Methods (Performance Reports):

Responsibility center unit within the organization, which has control over costs, revenues and or investment funds

1. Cost center
Incur costs
How well costs are controlled and utilized
Evaluated through variance analysis (comparison between budget and actual) reports based on
standard costs and flexible budgets
Measures the performance of the responsible officer:
Controllable costs may be influenced by unit managers in a given time period
Uncontrollable costs assigned only to the responsibility center by upper management,
not under the control of the responsible officer
Measures the performance of the responsibility center:
Direct costs could be both variable and fixed costs. Exist by the existence of the center.
Also called avoidable costs.
Indirect costs allocated only to the center as its share in the total costs incurred by the
entire organization. Also called unavoidable costs.
2. Revenue center
Generation of revenues
3. Profit center
Generating revenues, planning and controlling expenses
Most of the time profit center exists rather than purely revenue center
Maximize the segment net income
Measured by using the contribution margin approach

Sales Pxxx
Less: Variable Manufacturing Cost (xxx)
Manufacturing Contribution Margin Pxxx
Less: Variable Non-Manufacturing Cost (xxx)
Contribution Margin Pxxx
Less: Controllable Fixed Cost (manager has the authority) (xxx)
Controllable Margin/Shortrun Performance Margin (evaluating person) Pxxx
 Less: Non-Controllable Direct Fixed Cost (xxx)
Segment Margin (evaluating margin) Pxxx
Less: Allocated Common Costs (xxx)
Operating Income Pxxx

Budgeted revenues and costs will be done using flexible budget (recomputed budgeted costs
based on actual activity results)
These would determine the amount contributed by the segment to recover costs incurred by the
higher segment (indirect costs).
Positive direct contribution margin performing favorably, its revenue could recover all
its direct costs and contributes profit to the entire organization
Negative direct contribution margin revenue is not enough to recover its own direct
costs, and contributes loss to the organization, such segment should be eliminated to
minimize loss for the entire organization
4. Investment center
Generating revenues, planning and controlling expenses, and acquire, utilize, and dispose of assets in a
manner that would seek to earn the highest feasible rate of return on the centers investment cost
Independent/autonomous divisions
Separate economic entities that exist for the same basic organization goals
Measured through the measures used for profit and cost centers. However, additional measures are
used to determine the profitability, these are Return on Investment (ROI) and Residual Income (RI)
Return on Investment (ROI) most common investment center performance measure
Segment Net Income
ROI=
Invested Capital

or (DuPont Model)

Segment Net Income Sales Revenue

ROI =
Sales Revenue Invested Capital

ROI=Profit Margin Asset Turnover

Net income
Profit margin=
Sales

Sales
Asset turnover=
Asset

Segment net income usually called Controllable Segment Net Income here assumes
that such net income has been derived by deducting the investment centers revenues
and its direct costs
If the investment center has been charged by allocated costs from entire organization,
allocated costs must not be considered
Residual Income (RI) allows an organization to use different rates of interest for various
organizational assets. Its main advantage is it overcomes some limitations of ROI
(suboptimization).

Actual Segment Net Income P xxx

Less: Imputed investment centers income:
Invested capital (initial or average) P xxx
Multipled by imputed interest rate x% xxx
Residual Income P xxx
 Neither ROI nor RI provides a perfect measure of investment center performance. ROI can undermine goal
congruence. RI distorts comparisons between investment centers of different sizes.

CHAPTER 2 TRANSFER PRICING

Transfer price amount charged when one division sells good or services to another division

Minimum TP (Sellers POV)

At full capacity, to external: Minimum TP = VC + OC
At excess capacity: Minimum TP = VC + 0
Maximum TP (Buyers POV)
Purchase price from external supplier
Lower than outside

High transfer price would result in a high profit of the selling division and low profit for the buying division and vice versa.

Objectives of Transfer Pricing:

Encourage goal congruence among the division managers involved in the transfer
Make performance evaluation among segments more comparable
Transform a cost center into a profit center

General rule formula:

Transfer price = Additional Outlay Cost incurred because goods are transferred + Opportunity Cost to the
organization because of the transfer

Where: Outlay cost = incurred by the division that produces the goods/services to be transferred; includes
direct variable costs and any other outlay costs
Opportunity cost = benefit foregone as a result of taking a particular action, such as, the contribution
margin lost by the selling division from outside market

Other Related Issues on Transfer Pricing:

Dysfunctional behavior any action taken in conflict with organizational goals

Basing transfer prices on full cost entails a serious risk of causing dysfunctional decision-making behavior. Full-
cost based transfer prices lead the buying division to view costs that are fixed for the company as a whole but as
variable costs to the buying division.
Transfer prices should not be based on full cost. The risk is too great that the cost behavior in the producing
division will be obscured. This can also result in poor decisions in the buying division.

Some Important Issues and Terminologies:

 Transferring goods between divisions located in countries with different tax rates.
o Companies must pay income tax in the country where income is generated in order to maximize income
and minimize income tax.
o Many companies prefer to report more income in countries with low tax rates, and less income in
countries with high tax rates.
o Accomplished by adjusting transfer prices
Used only for internal reporting purposes in a company that has independent segments, units or divisions.
Appropriate transfer price should be one that ensures optimal resource allocation and promotes operating
efficiency.
Maximum price should not be greater than the lowest market price at which the buying subunit or segment
can acquire the goods/services from the outside or external market.
Minimum price should not be less than the sum of the selling unit or segments incremental costs associated
with the goods/services plus the opportunity costs of the facilities.
General methods for determining transfer prices:
o Cost-based transfer price
equal to the total unit cost calculated using the absorption costing, variable costing, or modified
variable/absorption costing method
With mark-up/without mark-up
Standard (mostly use)/actual (reduces accountability on cost control of selling unit)
o Market-based transfer price
Most objective measure of value
Simulates the selling price that would exist if the segments or subunits were independent
companies
Mirrorring what is happening outside
Not easily available
o Negotiated transfer price
Intracompany charge
Has been set through a process of negotiation between the selling and purchasing subunit or
segments managers
Encourages decentralization
o Arbitrary transfer price
Top management assigns the transfer price
Benefit of whole company
No use of decentralization
o Dual transfer price
Different recorded amounts of 2 units
Normally not acceptable
Final determination of transfer pricing system should reflect the circumstances of the organizational units and
corporate goals.
Transfer prices must not be set and used permanently. This should be frequently revised.
Carefully set transfer price will provide the following advantages:
o Appropriate basis for calculation and evaluation of segment performance
o Rational acquisition/use of goods and services between corporate divisions
o Flexibility to respond to changes in demand or market conditions
o Means of motivation to encourage and reward goal congruence by managers in decentralized operations

Goal congruence personal goals of the decision maker, goals of the decision makers unit and goals of the broader
organization are mutually supportive and consistent

Sub-optimization individual managers pursue goals and objectives that are in their own and or their segments
particular interests rather than in the companys best interests
 CHAPTER 3 PRICING DECISIONS

Major factors affecting pricing decisions:

Customer Demand
Market
Utmost importance
Product design issues and pricing considerations
Identifying customer demand is critically important and on a continuous process
Could be done through market research, customer surveys and test-marketing programs, as well as some
feedback from sales people
Competitors Actions
Watchful eye on the firms competitors actions
Carefully defining its product as well as thoroughly knowing the companys type of market
Market players
Market benefits

Market Forces
Law of supply and demand
cartel
Government Regulations
Deregulation on some industries, which were previously under the price control law, is implemented
such as the fuel industry
Management is prevented to change their prices without prior approval of the government

RA 10667 Philippine Competition Act

Prohibits price collussion between competitors

1. Price fixing monopoly pricing
2. Bid rigging
3. Output limitations
4. Market sharing
5. Predatory pricing
6. Discriminatory behavior customer favoritism
7. Exclusivity arrangements
Costs
Varies widely
In a manufacturing firm, absorption cost pricing is used

List of Products and their Normal Price Setting Bases:

Market driven prices

Consumer products
Service activities
New products
Cost driven prices
Industrial and durable goods
Capital intensive industries

Environmental considerations affecting prices:

Legal area

Certain laws
Prohibit companies from discriminating among their customers in setting prices, collusion in price setting (cartel),
where the major firms all agree to set their prices at high levels

Political considerations

Reaping unfairly large profits

Political pressures on legislators to tax those profits differently

Image-related issues

Public image
A firm with a reputation for very high quality products may set the price of a new product high to be consistent
with its image

Normal Pricing Computations and their Normal Formula:

Selling Price = Cost + Mark-up

Where: Cost = could be based on:

Total full cost (manufacturing and operating costs)
Total manufacturing costs only/absorption cost approach
Total variable manufacturing costs only
Total variable costs/contribution approach (manufacturing and selling & administrative
expenses)
Any other cost incurred by the firm used
Mark-up = certain percent of the base used
Most common basis used in determining mark-up percentage is the desired rate of
return

Desired ROI+ Costsnot included costbase
Markup = base / unit
Annual Volume x

Target profit = Average investment x Desired ROI rate

Some Important issues and Terminologies:

To compute a target cost, the company determines its target selling price. Difference between the target price
and desired profit is the target cost of the product.

Cost-plus pricing establishing a cost base and adding to this cost base a markup to determine a target selling price.

Target selling price = Cost + (Markup % x Cost)

Compute the selling price for services using cost of time and cost of materials and to determine the cost of
services provided

Time and material pricing two pricing rates are set, one for labor used on a job and another for the material
 Labor rate
Direct labor time
Other employee costs
Material charge
Costs of direct parts and materials used
Material loading charge for related overhead costs