Notes: UNIT - 4

UNIT - 4

Objective:
To enable the students to understand the role of responsibility accounting and transfer pricing in the growth of modern organisations.

UNIT OVERVIEW

Topics covered: Responsibility Accounting: Concept and various approached to Responsibility Accounting: Concept of Investment Center, Cost Center, Profit Center, Responsibility Center and its managerial implications, Transfer Pricing –Multinational Transfer Pricing, Market Based Transfer Pricing, Cost-Based Transfer Pricing, Cost of Quality and Time.






Responsibility Accounting

Responsibility Accounting collects and reports planned and actual accounting information about the inputs and outputs of the responsibility centers.

Main Features:
1. Input and Output Analysis.
2. Planned and Actual performance evaluation.
3. Creation of responsibility centres to measure the performance.

Objectives:
1. Determination of contribution of a division.
2. Evaluation of quality of performance.
3. Motivation consistent with organisational goals.

Types of Responsibility Centres:
1. Cost Center
2. Profit Center
3. Investment Center

Cost Centers

Decision rights:
1. Labor
2. Supplies
3. Materials


Performance measures:
1. Minimize total cost for a selected level of output.
2. Maximize total output for a given budget.

Problems:
1. Quality for Quantity Tradeoff Average cost crates incentive to overproduce



Profit Centers

Decision Rights;
1. Input Mix (same as Cost Centers)
2. Product Mix
3. Selling Price

Performance Measurements:
1. Accounting profits compared to budgets or some expectations.

Problems:
1. Interdependencies of profit centers
2. Transfer Pricing
3. Cost allocation.

Investment Centers

Decision Rights:
1. Input Mix
2. Product Mix
3. Selling Prices
4. Capital Investment
Performance measures:
1. Net Income
2. Return on Investment
3. Residual Income

TRANSFER PRICING

The determination of an exchange price when different business units within a firm exchange products or services.

Objectives of Transfer Pricing:

ΠTo motivate managers.
 To provide an incentive for managers to make decisions consistent with the firm’s goals.
Ž To provide a basis for fairly rewarding the managers.

Transfer-Pricing Methods:

•Variable cost – sets the transfer price equal to the variable cost of the selling unit.
•Full cost – sets the transfer price as the variable cost plus allocated fixed cost for the selling unit.
•Market price – Set the transfer price as the current price for the selling unit’s product in the market.
•Negotiated price – involves a negotiation process and sometimes arbitration between units to determine the transfer price.


Variable cost Method:

Advantage: Causes buyer to act as desired, to buy inside.
Limitation: Unfair to seller if seller is profit or investment SBU.

Full Cost Method

Advantage:
> Easy to implement
> Intuitive and easily understood.
> Preferred by tax authorities over variable cost.
Limitation:
> Irrelevance of fixed cost in decision making; fixed costs should be ignored in the buyer’s choice of whether to buy inside or outside the firm.
> If used, should be standard rather than actual cost.

Market Price Method
Advantage:
Helps to preserve unit autonomy.
Provide for the selling unit to be competitive with outside suppliers.
Has arm’s-length standard desired by taxing authorities.
Limitation:
Often intermediate products have no market price.
Should be adjusted for cost savings such as reduced selling costs, no commissions, etc.

Negotiated Price Method


Advantage: May be most practical approach when there is significant conflict.
Limitation:
Need negotiation rule and/or arbitrations procedure, and this may reduce autonomy.
Potential tax problems; may not be considered arm’s length.


Choosing the Right Transfer Price

If there is no outside supply-

ΠDecision to Transfer: Buy inside.
 Transfer Price: Cost or negotiated price.


Choosing the Right Transfer Price

If there is an outside supply-
And if the seller’s variable cost is grater than outside price?

ΠDecision to Transfer: Buy outside (i.e. no transfer)
 Transfer Price: No transfer price.



Choosing the Right Transfer Price

If there is an outside supply-
And if the seller’s variable cost is less than outside price? And seller has excess capacity?

ΠDecision to Transfer: Buy inside.
 Transfer Price: Low – variable cost. High – market price.

Choosing the Right Transfer Price

If there is an outside supply . . .
And if the seller’s variable cost is less than outside price? And seller has no excess capacity?
If contribution from outside purchase is grater than the contribution from inside purchase-

ΠDecision to Transfer: Buy outside.
 Transfer Price: No transfer price.


v In other words, we compare the savings from a transfer purchase (market price – internal variable costs) to the opportunity cost of the external sales (contribution margin of our sales) that we would have to give up in order to transfer.
v When the opportunity cost exceeds the savings, purchase from outside supplier.


Choosing the Right Transfer Price

If there is an outside supply-
And if the seller’s variable costs is less than outside price? And seller does not have excess capacity?
And If contribution from outside purchase is less than the contribution from inside purchase.

ΠDecision to Transfer: Buy inside.
 Transfer Price: Market price.

v Again, we compare the savings from a transfer purchase (market price – internal variable costs) to the opportunity cost of the external sales (contribution margin of our sales) that we would have to give up in order to transfer.

v But if the savings is greater than the opportunity cost, we should effect the transfer, at the market price (so transferor is not penalized) General Guideline.


COST OF QUALITY
What is it?
The price of nonconformance (Philip Crosby) or the cost of poor quality (Joseph Juran), the term 'Cost of Quality', refers to the costs associated with providing poor quality product or service.
Why is it important?
Quality processes cannot be justified simply because "everyone else is doing them" - but return on quality (ROQ) has dramatic impacts as companies mature. Research shows that the costs of poor quality can range from 15%-40% of business costs (e.g., rework, returns or complaints, reduced service levels, lost revenue). Most businesses do not know what their quality costs are because they do not keep reliable statistics. Finding and correcting mistakes consumes an inordinately large portion resource. Typically, the cost to eliminate a failure in the customer phase is five times greater than it is at the development or manufacturing phase. Effective quality management decreases production costs because the sooner an error is found and corrected, the less costly it will be. When to use it?
Cost of quality comprises of four parts:
External Failure Cost
cost associated with defects found after the customer receives the product or service. ex: processing customer complaints, customer returns, warranty claims, product recalls.

Internal Failure Cost
Cost associated with defects found before the customer receives the product or service ex: scrap, rework, re-inspection, re-testing, material review, material downgrades.
Inspection (appraisal) Cost
Cost incurred to determine the degree of conformance to quality requirements (measuring, evaluating or auditing) ex: inspection, testing, process or service audits, calibration of measuring and test equipment.
Prevention Cost
Cost incurred to prevent (keep failure and appraisal cost to a minimum) poor quality ex: new product review, quality planning, supplier surveys, process reviews, quality improvement teams, education and training.
How to use it?
1. Gather some basic information about the number of failures in the system,
2. Apply some basic assumptions to that data in order to quantify the data,
3. Chart the data based on the four elements listed above and study it,
4. Allocate resources to combat the weak-spots,
5. Do this study on a regular basis and evaluate your performance



COST OF TIME


REFERENCE:
v www.thequalityportal.com
v www.indiainfoline.com
v www.npd-solutions.com
v www.google.com
v www.altavista.com