Session 10

Responsibility Accounting
And Transfer Pricing

- CA Gayatri Galvankar
 Introduction
• Responsibility Accounting and Responsibility Centre
• Investment Centre
• Profit Centre
• Revenue centre
• Cost Centre
• Focus on ROI
• ROI
• Residual Value
• Economic Value added
• Factors affecting Responsibility Center’s performance
• Transfer Pricing
• Methods of transfer pricing
 Responsibility Accounting
WHAT?
• Tool that assists managers to identify costs, revenue sand profits
of a product or process so as to arrive at appropriate decisions
and strategies.
• Also provides information about costing components and their
controllability mechanism so as to manage responsibility centre
more effectively and efficiently.
• It helps the management to control costs more systematically
through budgeting and budgetary process
 Responsibility Centre
WHAT?
• A unit or division in a firm that is managed and headed by a
manager who is directly responsible for achieving its goals and
objectives
• Generally a sub set of a business.
• Fixes responsibility and goals to the heads of the centers.

HOW?
• The center disseminates available information and data about
their performance to the concerned responsibility managers. Eg:
Target vs Actuals
• Managers can use the required information in the interest of the
center.
• The information is also used as a tool for motivating,
incentivizing and controlling the actions of each centre’s
manager.
 Responsibility Centre
Classification:

1. Revenue Centre –Centres assigned the task of managing

revenue.

2. Investment Centre –It is responsible for costs, revenue and

investments

3. Profit Centre –Profit centre focuses on targeted profits of the

firm

4. Expenditure / Cost Centre –The responsibility of Cost Centre is

to keep vigil on incurrence of certain costs.

Different Responsibility centers function independently but in close

coordination with each other. They perform different types of
responsibilities, have different focus; but their goals are common.
 Responsibility Centre
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 Revenue Centre
Revenue centers are the centers that are assigned the task of
managing and controlling Revenue or Sales.
They are also involved in controlling other units such as costs,
investment or profit.

Examples
Regional sales office of a national or MNC
A restaurant in a large chain of restaurants or
A book store in a general department store.
 Profit Centre
• Responsibility center where the team division and its head are
responsible to control both the revenues and the costs of the
products or services-
• Also responsible to meet pre-determined goals.
• A profit center is also an independent business.
• The only difference is that investment activities of the centre are
monitored and controlled by the top management. The
responsibility center manager has no role in investment
decisions.

Example: In a firm, the manager of one store in a chain of stores has

the responsibility for pricing, product selection, purchasing and
promotion, but he does not decide the level of investment in the
store. This particular store is responsible only to meet the goals to
be evaluated as fixed for the profit center.
 Profit Centre
WHY?
• Motivation: To perform to their best capacity in areas under their
control.
• Encourages Initiative: Managers are encouraged to take
initiatives and innovations for bringing more efficiency in the
functioning of the center.
• Market Data: Helps the firm to make optimum use of specialized
market knowledge of the divisional heads.
• Strategizing and Decision Making: Manager can take decisions
and make strategies based on their own experiences and
expertise and in the overall interest of the centre.
• Performance evaluation: In the profit earning, targets and
achievements, contribution margin, direct earnings by the
division, income before taxes and net income, etc., play important
role, and all these components are evaluated while measuring the
performance of the profit centre.
 Investment Centre
• It is a firm, basically responsible for controlling sales revenue
and operating costs and other assets that generates profit for the
business.
• Investment center manager has to acquire professional
competencies to appropriately assess and manage the size of the
investment and other profit variables.
• This center, significantly contributes to financial efficiency and
economic performance of the firm.
• The prime responsibility of this center is to make an analysis of
various risk factors and take suitable investment decisions to
augment the return on investments and thereby contribute to
the growth of profit.
• The ultimate goal of this center is to maximize profit, given the
overall amount of investment required to generate the profit.
 Investment Centre
• The very objective of a firm is to achieve pre-determined returns
on investments (ROI).
• While allocating resources, the top management often views
these resources as investment and expects appropriate returns
on it.
• In practice, all the performance measurement systems and
financial performance evaluation systems in a firm are designed
and developed following certain fundamental principles, focusing
ROI.
• Therefore, individual responsibility centers should contribute to
ROI as per the expectations of top management
• However, the extent of contribution of each center depends on
allocation of resources to individual center and nature of
responsibility
 Cost Centre
• Established to control and optimize the cost of operations in an
organization.
• The prime responsibility of a cost centre is to control costs.
• The cost centre is not responsible for controlling the revenues,
profit or investment activities of an organization.
Eg : Firms where services are processed such as a cleaning plant
in a dry cleaning business, front desk operations in a hotel etc.

A cost centre’s performance should not be measured only by its

ability to control and reduce costs, but factors such as Quality,
Response time, ability to meet production schedules, employee
motivation, employee safety and respect for the organization’s
ethical and environmental commitments should also be considered.
Features of Responsibility Centres
 Set-up of Responsibility Centre
• The set up and structure of responsibility centre is an important
parameter to ensure smooth functioning and effective discharge of
responsibilities assigned to different centres.
• This will also help the management in measuring the
performance of responsibility centres.
• These responsibility centres work toward the achievement of the
organizational goals.
• Therefore, an appropriate set up of responsibility centres helps
the top management ensure that strategies and decisions taken
across the centres are standard.
• An important element of responsibility structure is accounting
system, which has to be self-sufficient to provide the required
information.
• An efficient and effective responsibility accounting system proves
to be a useful tool for responsibility center heads, so as to record
the plans, performances and improve their efficiency in
responsibility areas that have been assigned to them.
 Set-up of Responsibility Centre
• Evaluation of performance of a responsibility center is taken up
by analyzing its performance profit, revenue, investment and
quality goals set by the top management
• The performance evaluation methods of responsibility centers can
be categorized in the following three categories:
1. Parameters that measure efficiency of a responsibility centre.
2. Process as an evaluation criterion.
3. Parameters to measure the effectiveness of the responsibility
centres.
• The responsibility of a responsibility centre can be measured in
terms of achievement of pre-determined goals and objectives.
• If the goals are achieved as per the expectations as budgeted, a
center is treated as effective
 Focus on Returns
Key Concepts:
• Return on Investment
• Residual Income
• Economic Value Added (EVA)
 Return on Investment
• Most commonly used parameter to calculate Returns
• The 2 major components to calculate this are:
• Total investments made by the firm
• Expected income

• ROI is calculated as the ratio of investment center income to

invested capital as follows:

• ROI of a firm can also be expressed as a simple function of its

margin and turnover.
Sales Margin Capital Turnover

Margin Turnover
 Residual Income
• Residual Income is directly related to the investment to find out
the minimum rate of return.
• It is Net Operating income the Investment center could earn
above imputed interest charges on Capital investment
• This is calculated in quantitative terms
• The imputed interest can be calculated as minimum rate of return

Residual Income = Investment Center profit – (Investment center

invested Capital* imputed interest rate)
 Residual Income

ROI is same for all at 25%, however RI is different.

ROI calculates Return as a percentage on Investment whereas

Residual Income calculates Income after considering minimum
return on Investment
 Economic Value Added
EVA or Economic Profit is based on Residual Income Technique.

Rationale:
Real Value is created when additional returns are generated for the
shareholders over and above the minimum required rate of return.

Represents After Tax Operating Profits minus Annual Cost of

Capital of the investment center.

EVA = After tax operating profit

Less:
(Total Assets – Total Liabilities )* Weighted average cost of
capital
 Factors affecting Performance
1. Coordination: will lead to better performance in terms of goal
achievements by individual responsibility collectively.
2. Integration: of various activities among the responsibility centers
will encourage managers to perform collectively.
3. Performance Evaluation: The monitoring and control systems
have to be perfect to evaluate the performance of the individual
responsibility centers, to assess their performance and
accordingly guide them to take suitable strategies for better
performance.
4. MIS: A well-organized Management Information System (MIS)
to collect and analyze all the related information data on both
financial and non-financial parameters.
5. Financial Evaluation mechanism: Unbiased and standardized
evaluation mechanisms on various components, such as sales,
inventories, production levels, fund flow, cashflow, profit
margins, return on investments, etc., need to be built.
 Factors affecting Performance
6. Control systems: There should be proper controlling system
designed for individual responsibility centers such as marketing,
finance, administration, etc.
7. Value Analysis: primarily focusing on systematic analysis and
evaluation of various activities.
8. Transfer Pricing mechanism: There has to be proper transfer
price mechanism for transferring business transactions among
the divisions. This should be encouraged while keeping in view
the interests of both the divisions, that is, transferor and
transferee divisions.
 Transfer Pricing
WHAT?
Price at which transfers are made.

WHY?
• In practical business scenario, it happens that product of one
division is used as supportive raw material by another unit
within the same organization.
• Here the price has to be determined as the division supplying the
product needs to be compensated for its costs and also the profit
margin and division buying the product should be charged as the
cost of the product.
• The interest of both the product should be kept in view. This is
known as Transfer Pricing or Internal Price or Charge Back Price.
 Objectives of Transfer Pricing
• It provides equal opportunity for arriving cost and revenue of a
product to transferor and transferee divisions. It motivates both
the division managers.
• It provides useful information for evaluating the managerial and
economic performance of the divisions.
• Since transfer pricing is done at corporate level, it is a notional
amount that is considered.
• The profit moves internally between the divisions
• The divisions supplying the product are dually compensated

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 Methods
1. Market based transfer pricing:
Price charged is the price as prevailing in the market for similar
product / service.
2. Market price and Price difference in intermediate market:
Pricing in any range between variable cost and market price if
the division is not operating on full capacity.
3. Modified Market Price:
Price to be set at a market price giving allowances for marketing
efforts and transportation cost.
The principle is that there is no publicity cost and transportation
costs involved in the internal transfers.
Modified market price = Market price – Estimated Selling cost.
Essence is that the benefits on account of reduced selling cost
should be passed on to the transferee division
 Methods
4. Cost- based transfer pricing:
Selling division supplies the goods to the buying division at cost
price foregoing the profit.
Different types of costs considered:
a) Variable Costs: Only Variable cost is recovered, no recovery
towards fixed cost or profits.
b) Absorption Costs: Total Cost is recovered (fixed and variable)
c) Standard Cost: The assumption under this approach is that
increased cost more than standard cost occurs on account of
inefficiencies in the production process. The transferee
division should not be burdened with the cost of inefficiency.
It may also happen vice versa where the actual cost may be
lower than the standard cost but benefits of efficiency are
not passed on to the buying division.
Incentives for operating efficiently are enjoyed by the selling
unit.
 Methods
d) Cost plus: Additional cost added to arrive at Standard
Transfer Price. Generally addition is at a percentage.
Acts as an incentive to selling department.
e) Negotiated Transfer Price: Bargaining between the
departments to arrive at a mutual transfer price.
Both the division heads have open discussion on the price to
be fixed keeping in view the market price, savings in terms of
selling cost and transport cost, capacity utilization and other
considerations and thus arrive at a mutual transfer price.
Both the divisions are also free to deal in open market.
The effects of this approach are that it may lead to certain
conflicts between divisions. The division head who has better
negotiation skills may get better advantage.
Example
Example
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Examples