10-1

Responsibility Accounting System

CHAPTER 11

Managerial Accounting
17th edition

10-2

Decentralization in Organizations:
Benefits
◦ Top management freed to concentrate on overall strategy.

◦ Lower-level decisions often based on better operational

decisions.

◦ Lower level managers can respond quickly to customers.

◦ Lower-level managers gain experience in decision-

making.

◦ Increases motivation resulting in increased job satisfaction

and retention.

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10-3

Decentralization in Organizations:
Disadvantages
◦ Lower-level managers may make decisions without seeing
the “big picture.”

◦ May be a lack of coordination among autonomous

managers.

◦ Lower-level managers’ objectives may not be those of the

organization.

◦ May be difficult to spread innovative ideas in the

organization.

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10-4

Responsibility Accounting
Responsibility accounting systems link lower-level
managers’ decision-making authority with
accountability for the outcomes of those decisions.

The term responsibility center is used for any part of

an organization whose manager has control over,
and is accountable for cost, profit, or investments.

Responsibility centers:
◦ Cost centers
◦ Profit centers
◦ Investment centers

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4
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10-5

Cost Center
A segment
whose manager has control over costs
but not over revenue or investment funds

 Service departments such as accounting, general

administration, legal, and personnel are usually
classified as cost centers, as are manufacturing
facilities.
 Standard cost variances and flexible budget
variances, such as those discussed in earlier
chapters, are often used to evaluate cost center
performance.

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10-6

Profit Center
A segment whose manager has
control over BOTH costs and revenues,
but no control over investment funds

 Revenues:  Costs:
◦ Sales ◦ Manufacturing costs
◦ Interest ◦ Commissions
◦ Other ◦ Salaries
◦ Other

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6
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10-7

Investment Center
A segment whose manager has
control over costs, revenues, and investments
in operating assets

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10-8

Learning Objective 1

Compute return on
investment (ROI) and
show how changes in
sales, expenses, and
assets affect ROI.

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8
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10-9

Return on Investment (ROI) Formula

Net operating income
ROI =
Average operating assets

Net operating income is the income before

interest and taxes (EBIT).
Average operating assets is the cash, accounts
receivable, inventory, plant and equipment, and
other productive assets.

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10-10

Net Book Value versus Gross Cost

Most companies use the net book value of

depreciable assets to calculate average operating
assets.

Acquisition cost
Less: Accumulated depreciation
Net book value

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10
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10-11

Understanding ROI
Du Pont pioneered the use of ROI and recognized
the importance of looking at the components of ROI

Net operating income

ROI =
Improved by increasing sales or
reducing operating expenses
Average operating assets
Net operating income
Excessive funds tied up in Margin =
operating assets depress Sales
turnover and lower ROI
Sales
Turnover =
Average operating assets

ROI = Margin × Turnover

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11

10-12

Increasing ROI: An Example

Regal Company reports the following:
Net operating income $ 30,000
Average operating assets 200,000
Sales 500,000
Operating expenses 470,000

What is Regal Company’s ROI?

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12
10-7

10-13

Increasing ROI: An Example –

Solution

ROI = Margin  Turnover

Net operating income Sales
ROI = ×
Sales Average operating assets

$30,000 $500,000
ROI = ×
$500,000 $200,000
ROI = 6%  2.5 = 15%

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13

10-14

Investing in Operating Assets to

Increase Sales: An Example
Suppose that Regal’s manager invests in a $30,000
piece of equipment that increases sales by $35,000,
while increasing operating expenses by $15,000.
Regal Company reports the following:

Net operating income $ 50,000

Average operating assets 230,000
Sales 535,000
Operating expenses 485,000

Let’s calculate the new ROI!

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14
10-8

10-15

Investing in Operating Assets to

Increase Sales: An Example – Solution

ROI = Margin  Turnover

Net operating income Sales
ROI = ×
Sales Average operating assets
$50,000 $535,000
ROI = ×
$535,000 $230,000
ROI = 9.35%  2.33 = 21.8%

ROI increased from 15% to 21.8%.

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15

10-16

Criticisms of ROI
In the absence of the balanced scorecard,
management may not know
how to increase ROI.
Managers often inherit many committed costs
over which they have no control.
Managers evaluated on ROI may reject
profitable investment opportunities.

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16
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10-17

Learning Objective 2

Compute residual income and

understand its strengths and
weaknesses.

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17

10-18

Residual Income – Another Measure

of Performance

Residual income is the net operating income

that an investment center earns above the
minimum required return on its assets

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10-19

Calculating Residual Income

Residual income =
Net operating income − (Average operating
assets × Minimum required rate of return)

This computation differs from ROI.

ROI measures net operating income earned relative
to the investment in average operating assets.
Residual income measures net operating income
earned less the minimum required return on average
operating assets.

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19

10-20

Residual Income – An Example

The Retail Division of Zephyr, Inc. has average
operating assets of $100,000 and is required to earn
a return of 20% on these assets.
In the current period, the division earns $30,000.
Let’s calculate residual income!

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10-21

Residual Income – An Example: Solution

Operating assets $100,000

Required rate of return × 20%
Minimum required return $ 20,000

Actual income $ 30,000

Minimum required return (20,000)
Residual income $ 10,000

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21

10-22

Motivation and Residual Income

Residual income encourages

managers to make profitable investments
that would be rejected by
managers using ROI

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10-12

10-23

Concept Check 1
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000.
The required rate of return for the company is
15%. What is the division’s ROI?
A. 25%
B. 5%
C. 15%
D. 20%

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23

10-24

Concept Check 2
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000. If
the manager of the division is evaluated
based on ROI, will she want to make an
investment of $100,000 that would generate
additional net operating income of $18,000
per year?
A. Yes
B. No

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24
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10-25

Concept Check 3
The company’s required rate of return is 15%.
Would the company want the manager of the
Redmond Awnings division to make an
investment of $100,000 that would generate
additional net operating income of $18,000 per
year?
A. Yes
B. No

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25

10-26

Concept Check 4
Redmond Awnings, a division of Wrap-up
Corp., has a net operating income of $60,000
and average operating assets of $300,000.
The required rate of return for the company is
15%. What is the division’s residual income?
A. $240,000
B. $45,000
C. $15,000
D. $51,000

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26
10-14

10-27

Concept Check 5
If the manager of the Redmond Awnings
division is evaluated based on residual
income, will she want to make an investment
of $100,000 that would generate additional net
operating income of $18,000 per year?
A. Yes
B. No

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27

10-28

Divisional Comparisons and Residual

Income

The residual income approach has one

major disadvantage: It cannot be used to
compare the performance of divisions of
different sizes.

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10-15

10-29

Zephyr, Inc. – Part 1

Recall the following information for the Retail
and Wholesale Divisions of Zephyr, Inc.:
Retail Wholesale

Operating assets $100,000 $1,000,000

Required rate of return × 20% 20%

Minimum required return $ 20,000 $ 200,000

Retail Wholesale

Actual income $30,000 $220,000

Minimum required return (20,000) (200,000)

Residual income $10,000 $ 20,000

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10-30

Zephyr, Inc. – Part 2

The residual income numbers suggest that the

Wholesale Division outperformed the Retail Division
because its residual income is $10,000 higher.
However, the Retail Division earned an ROI of 30%
compared to an ROI of 22% for the Wholesale
Division.
The Wholesale Division’s residual income is larger
than the Retail Division simply because it is a
bigger division.

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10-16

10-31

Learning Objective 3

Compute transfer price and

encourage corporate goal
congruence

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31

10-32

Transfer price

A TRANSFER PRICE is the price at which goods

and services are transferred from one department
to another.

Transfer pricing is used when divisions of an organisation

need to charge other divisions of the same organisation for
goods and services they provide to them.

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32
10-17

10-33

Transfer price

EXTERNAL
DIVISION A DIVISION B
CUSTOMER

 If Division A is a profit centre and it needs a ‘revenue’ from a

TP.
 Division B realise that Division A does not make the goods for
free, Division B needs a ‘cost’ from a TP.
 The TP is therefore a signalling mechanism, hopefully to
encourage divisional managers to act in a way to maximise
shareholder wealth (goal congruence).

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33

10-34

Benefits of transfer pricing

 Encourage goal congruence

 Discourage dysfunctional decision making

 Allow reasonable measure of managerial performance

 Support divisional autonomy

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10-35

General rules
Transfer prices should fall between:

The minimum price (Floor price): The sum of the

supplying division’s marginal cost and opportunity cost of
the item transferred.

The maximum price (Ceilling price): The lowest market

price at which the receiving division could purchase the
goods or services externally less any internal cost savings
in packaging and delivery.

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35

10-36

Example of general rules

Division X produces product L at a marginal cost per unit of
£100. If a unit is transferred internally to division Y £25 is
forgone on an external sale. The item can be purchased
externally for £150.

Calculate the minimum and maximum transfer price.

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10-37

Answer
 The minimum price: division X will not agree to a
transfer price of less than £125 = (100 + 25)

 The maximum price: division Y will not agree to a

transfer price in excess of £150.

The difference between the minimum and

maximum (£25) represents the savings from
producing internally as opposed to buying
externally.

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37

10-38

Opportunity cost
The opportunity cost included in determining the
lower limit will be one of the following:
1. The maximum contribution forgone by the supplying
division in transferring internally rather than selling
goods externally
2. The contribution forgone by not using the same facilities
in the producing division for their next best alternative
use.

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10-39

Opportunity cost
3. Standard variable cost of production if there is no
external market and no alternative use
4. If there is an external market for the item being
transferred and no alternative more profitable use for the
facilities in that division, transfer price = market price

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39

10-40

The transfer price at full and spare

capacity

Strike Co focused exclusively on making soles for work

boots and football boots which it sold to boot manufacturers.
Last year the company expanded into making football
boots. The company is now set up at two divisions; Boot
and Sole.

The Boot division purchases its soles from outside

suppliers.

Management have decided that Boot should by some soles

from its own Sole division.

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40
10-21

Boot Sole
division division
£ £
Selling price of boot 100 Selling price of 28
sole

CONTRIBUTION
MARGINS
Variable cost of boot 45 Variable cost 21
excluding sole per sole
Cost of sole 25
purchased from
outside supplier
Contribution per unit 30 Contribution per 7
unit

 Suggest a fair transfer price if Sole sells 10,000

soles to Boot.
 The answer depends on whether the Sole
division has spare capacity.

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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

41

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No spare capacity

If the Sole division has no

spare capacity it must
charge Boot a price that will
cover its variable costs plus £21 + £7 = £28
the lost contribution from
not selling to the external
market.

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10-43

Spare capacity

The maximum is
Assume the Sole
£25 because Boot
division has The minimum
can buy from
available capacity transfer price is £21
external suppliers
of 10,000 units
at this price.

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43

10-44

Transfer pricing method

Practical
method

Cost-
Market Two Dual
plus
Price part TP Pricing
Price

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10-45

Market price basis

If an external market price exists for transferred goods,
profit centre managers will be aware of the price they could
obtain or would have to pay for goods on the external
market.
They will compare market price with transfer price.

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Market price basis

A B Total
£ £ £
External sales 8,000 24,000 32,000

Costs of production 12,000 10,000 22,000

Company profit 10,000

A company has two profit centres, A and B. A sells half its output
on the open market and transfers the other half to B

What are the consequences of setting a transfer price at market

value?

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10-47

Market price basis

A B Total
£ £ £ £ £
Market sales 8,000 24,000 32,000
Transfer sales 8,000
16,000 24,000
Transfer costs 8,000
Own costs 12,000 10,000 22,000
12,000 18,000
Profit 4,000 6,000 10,000

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10-48

Market price basis

If the transfer price is at market price, A would be happy to
sell the output to B for £8,000 which is what A would get by
selling it externally instead of transferring it.

The transfer sales of A cancel with the transfer cost of B so

overall profit is unaffected but spread between A and B.

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10-49

Market price basis

A division earns the same profit on transfers

CONSEQUENCES
as on external sales.

B division must pay a commercial price for

goods.

Both divisions have their profit measured in

a fair way.

A division will be indifferent about selling

externally or transferring to B division.

B division can ask for as many units as it

wants from A division.

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The merits of market value BASIS

 Divisional autonomy

 Corporate profit maximisation

 Divisional performance measurement

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10-51

Disadvantages of market value BASIS

It may act as a
The market price
disincentive to use
may be temporary
up spare capacity

Many products do There might be an

not have a market imperfect external
price market

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10-52

Cost based approaches

Problems arise with the use of cost based transfer
prices because one party or the other is liable to
perceive them as unfair.

Cost based approaches to transfer pricing are often

used because;

1. There is no external market for the product being

transferred

2. The external market is imperfect

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10-53

Transfer prices based on full cost

The full cost which includes an apportion of fixed

overheads incurred by the supplying division is
charged to the receiving division

The division supplying the product makes NO PROFIT

so it is not motivated to supply internally

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53

10-54

Transfer price at variable cost

THE SUPPLYING DIVISION DOES NOT

COVER ITS FIXED COSTS

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54
10-28

10-55

Transfer price by negotiation

Establish the output and sales quantities that will optimise
the profits of the company or group as a whole. The range
within which transfer prices should fall
SUPPLY DIVISION
Min TP = Unit incremental cost + Opportunity cost per unit

BUYING DIVISION
Max TP = External purchase price – saving cost

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Transfer price and cost identification

A predetermined standard cost should

be used to prevent divisional profit
being distorted. The Transfer price
should be based on total cost to
ensure overheads are recovered by
the supplying division.

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10-57

Transfer price and cost identification

 However, the supplying divisions fixed costs will
then be perceived as variable by the receiving
division.
 The supplying division may also ‘over recover’ its
fixed costs. This may lead the recovering division to
outsource purchases when this is sub-optimal for
the overall business.

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Two-part transfer price

As the name suggests, the transfer is accounted for in two
parts:

Part 1 = standard variable cost

Part 2 = periodic fixed charge

This ensures the recovering division is aware of the cost

behaviour patterns of the supplying division.

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10-59

Dual pricing transfer price

Each division records the TP at a different amount
to encourage optimal decision making.
 Supplying division – records revenue at market price or
full cost-plus price.

 Receiving division – records purchases at the supplying

divisions standard variable cost only.

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Transfer price and cost identification

The dual pricing method and Two part pricing method

can be effective in avoiding sub-optimal decisions
but it can be administratively cumbersome

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10-61

CONCEPT CHECK 6A
Basic situation
MCa = £30 MCb = £55 Sale Price = £120
Div A Div B sell outside
◦ Div A makes goods at a marginal cost/unit (MCa) of £30
◦ Div B takes A’s product and turns it into a finished good incurring its
own cost of £55 (MCb).
(a) Does the company make a positive contribution?
(b) What is the minimum TP that A will accept?
(c) What is the maximum TP that B will pay?
(d) What is an acceptable range of TPs?

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CONCEPT CHECK 6B

A can sell to external market

Sale Price
MCa = £30 MCb = £55
= £120
Div A Div B
(outside)
(£3) costs
Sales price = £45
(outside)
A wants to maximise its own profits. It can sell externally and/or
internally.
(a) What is the net sales price/unit A gets selling externally?
(b) What is the max TP B will pay?
(c) What is the lowest TP A will accept if A is at full capacity?
(d) What is the lowest TP A willaccept if A has spare capacity?

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10-63

CONCEPT CHECK 6C

A can sell to external market

Sale Price
MCa = £30 MCb = £55
= £120
Div A Div B
(outside)
(£3) costs
Sales price = £45 External supplier
(outside) purchase price = £39

What should each division do to maximise company profitability

(a) If A is at full capacity, what is the situation?
(b) If A has spare capacity, what is the situation?

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CONCEPT CHECK 6D

A can sell to external market

Sale Price
MCa = £30 MCb = £55
= £120
Div A Div B
(outside)
(£3) costs
Sales price = £45 External supplier
(outside) purchase price = £26

What should each division do to maximise company profitability

(a) If A is at full capacity, what is the situation?
(b) If A has spare capacity, what is the situation?

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10-65

CONCEPT CHECK 6E

C and V are two divisions of a company. Division C makes a product,

Mad. Unit production cost and the market price are as follows:
Labour £26
Materials £14
Absorbed fixed cost £8
Total Absorption Cost £48
Prevailing market price £64
Mad is sold outside the company to an external market and also
internally to Division V. Division C incurs an £8 variable selling cost if it
sells Mad outside. Total demand for Mad is sufficient for Division C to
manufacture to capacity.
What is the minimum transferprice the company will set?

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End of Chapter 11

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66