MAS-08 (Responsibility Accounting & Transfer Pricing) PDF

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY CPA Review Batch 43  May 2022 CPA Licensure Examination  Week No. 8 MANAGEMENT ADVISORY SERVICES C. LEE  E. ARAÑAS  K. MANUELnullMAS-08: RESPONSIBILITY ACCOUNTING & TRANSFER PRICINGRESPONSIBILITY ACCOUNTING  RESPONSIBILITY ACCOUNTING is a performance ...

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ReSA - THE REVIEW SCHOOL OF ACCOUNTANCY CPA Review Batch 43  May 2022 CPA Licensure Examination  Week No. 8

MANAGEMENT ADVISORY SERVICES

C. LEE  E. ARAÑAS  K. MANUEL

MAS-08: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING RESPONSIBILITY ACCOUNTING  RESPONSIBILITY ACCOUNTING is a performance measurement tool where managers are held responsible for their performance, actions of subordinates and all activities within their area of authority and control.  Responsibility accounting is consistent with MANAGEMENT BY OBJECTIVES (MBO) -- the management process in which managers and subordinates agree on goals as well as the methods to achieve them and subordinates are subsequently evaluated with reference to the agreed plan.  Responsibility accounting system functions best under a decentralized form of organization as DECENTRALIZATION allows the separation of an entity into manageable units wherein each unit is managed by an individual who is given decision authority and is held accountable for his/her decisions.  Decentralized organizations must avoid SUB-OPTIMIZATION, which happens when managers decide in favor of their own unit even at the expense of the entire organization as a whole.  Most decentralized organizations are divided into responsibility centers (also called STRATEGIC BUS INESS UNITs) to facilitate improved decision making through the use of more information at the local level.  A RESPONSIBILITY CENTER is a component of an entity (e.g., product line, department, and division) whose manager has authority over, and is responsible and accountable for, a particular set of activities.  The four common types of responsibility centers are: A) COST CENTER – managers are responsible mainly for the costs incurred by the unit B) REVENUE CENTER – managers are responsible mainly for the revenues generated by the unit C) PROFIT CENTER – managers are responsible for both revenues and costs of the unit D) INVESTMENT CENTER - managers are responsible for revenues, costs and investment of capital.  The PERFORMANCE REPORT, which is often considered as the end-product of the responsibility accounting, shows and compares actual results with the intended (budgets or standards) results of a responsibility center, thereby highlighting material deviations that need corrective actions. The contents would normally depend on type of responsibility center presenting the performance report: RESPONSIBILITY CENTER Cost Center Revenue Center

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KEY PERFORMANCE MEASURES Variance Analysis: Actual Costs vs. Budgeted/Standard Costs Variance Analysis: Actual Sales vs. Budgeted/Target Sales Variance Analysis: Actual Profit vs. Budgeted/Target Profit Profit Center Segmented Income Statement Variance analysis: Actual Profit vs. Budgeted/Target Profit Segmented Income Statement Investment Center ROI, Residual Income, EVA The SEGMENTED INCOME STATEMENT is a detailed version of the contribution format of income statement. This income statement presentation highlights controllability of costs by behavioral classification. In addition to the usual variable costs and fixed costs, a more detailed classification of costs may be made: ✓ Direct costs are separable costs that are attributable or traceable to

Sales Less: VARIABLE Manufacturing Costs Manufacturing Contribution Margin Less: VARIABLE Non-Manufacturing Costs Contribution Margin Less: Controllable Direct FIXED Costs Controllable or Performance Margin Less: Non-Controllable Direct FIXED Costs Segment Margin Less: Allocated Common Costs Profit

the segment or business unit.

✓ CONTROLLABILITY is based on degree of influence a manager can exercise over an amount with reference to assigned responsibilities.

✓ Most controllable costs are discretionary costs by nature. ✓ Non-controllable costs are either committed costs or costs that are controllable by others or by a higher authority.

✓ CONTROLLABLE or PERFORMANCE MARGIN is usually used to evaluate the performance of the manager.

✓ SEGMENT MARGIN is usually used to evaluate the performance of the segment or business unit (e.g., continue vs. shutdown).

✓ Common costs allocated to a segment are usually not controllable by the manager of the same segment.

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RETURN ON INVESTMENT (ROI):

ROI Operating Income Operating Assets ✓ ✓ ✓

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=

=

Margin

x

Turnover

Operating Income Sales

x

Sales Operating Assets

✓ ROI broken down into margin and turnover is based on the Du Pont Technique. ✓ ROI is also known as return on assets. ✓ MARGIN - net profit margin, return on sales. ✓ TURNOVER - assets turnover, investment turnover, capital turnover.

‘Operating income’ for most investment centers is based on earnings before interests & taxes (EBIT). ‘Operating assets’ are preferably based on the average balance for the reporting period and composed of productive assets used to earn the operating income (i.e., idle assets are excluded). The term ‘invested capital’ is sometimes used as the denominator for the ROI formula. While the term means operating assets for most investment centers, invested capital may also mean total assets, owners’ equity or total assets less current liabilities, depending on the situation and application.

RESIDUAL INCOME (RI):

RI = Operating Income – Required Income where: Required Income = Operating Assets x Minimum ROI

✓ ✓

✓ Minimum ROI is also known as desired rate of return, business quota or minimum required rate of return.

The ‘Minimum ROI’ under RI is usually based on the imputed interest rate, which is imposed and set by a higher authority like a head office (for branches) or a holding company (for subsidiaries).

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY

MAS-08

Week 8: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING 

ECONOMIC-VALUE ADDED (EVA):

EVA = Operating Income after Tax – Required Income where: Required Income = (Total Assets – Current Liabilities) x WACC

✓ WACC is also called hurdle rate, cutoff rate, target rate, standard rate or minimum acceptable rate of return.

EVA is a specific form of RI that measures a segment’s economic profit based on residual wealth after accounting for the costs of capital; EVA is often used for incentive compensation & investor relations. ✓ Unlike RI, EVA uses the Weighted Average Costs of Capital (WACC) as the minimum required rate of return to determine the amount of required income. ✓ WACC is computed based on the long-term sources of financing -- debt and equity -- hence, the computation: (total assets – current liabilities) being equal to (long-term liabilities and equity). [WACC shall be exhaustively discussed in MAS-14 (Capital Structure & Costs of Capital) during Week 15] ✓ Under EVA, ‘operating income after tax’ is based on the formula: EBIT (100% - tax rate) ROI vs. RI: ➢ Under ROI method, division managers tend to accept only the investments whose returns exceed the division’s ROI; under RI method, division managers would accept an investment as long as it earns an amount in excess of the minimum required return. ➢ RI has the advantage of having a better measure of performance than ROI because it encourages investment in projects that would otherwise be rejected under ROI. ➢ A major disadvantage of RI is that it cannot be used to compare divisions of different sizes or asset base -- RI tends to favor larger divisions because of larger peso amount involved. ➢ Consider the following relationship between ROI vs. RI and their corresponding implications: ROI = Minimum ROI Residual Income = 0 (nil) Indifference point ROI > Minimum ROI Residual Income > 0 (positive) Performance is generally satisfactory ROI < Minimum ROI Residual Income < 0 (negative) Performance is generally unsatisfactory ✓

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TRANSFER PRICING  When one division of a manufacturing company supplies components or materials to another division, the price charged by the selling (producing) division to the buying division is known as the TRANSFER PRICE.  Transfer prices are usually determined by one of the following methods: A) MARKET price – regarded as the best transfer price that maximizes the over-all company profit, provided that: (1) a competitive market price exists, and (2) divisions are independent of each other. B) COST-BASED price – easy to understand and convenient to use but inefficiencies of the selling division may be passed on to the buying division – selling division will have little incentive to control costs. Costbased price can be based on selling division’s variable cost, full (absorption) cost or cost-plus. C) NEGOTIATED price – widely used when market prices are subject to rapid fluctuation or when there is no intermediate market price that exists. In negotiating a transfer price, the usual range shall be based on the following: ➢ Maximum price (buying division): market price ➢ Minimum price (selling division): outlay cost + opportunity cost D) ARBITRARY price – normally imposed by the corporate headquarters to promote over-all company goals with neither the selling division nor the buying division having a control over the price.  When managers of both selling and buying divisions act in their own individual interests, the entire organization may suffer from SUB-OPTIMIZATION. Management hence establishes the methodology for setting transfer prices in such a way to promote GOAL CONGRUENCE, which occurs when division managers make decisions that are consistent with the goals and objectives of the organization as a whole.  Aside from goal congruence, other important factors considered in setting the transfer price include cost structure, capacity constraints, segmental performance, negotiation flexibility and tax implications.  The following transfer pricing rule helps to ensure goal congruence among divisions and managers: Transfer price per unit = outlay cost per unit + opportunity cost per unit OUTLAY COST includes selling division’s variable production costs (e.g., materials, labor and variable overhead) plus any additional costs incurred (e.g., storage, transportation, administrative). ➢ OPPORTUNITY COST refers to the margin or profit sacrificed by transferring units internally rather than selling them to external customers. Depending on sales demand and production capacity of the selling division, there may or may not be an opportunity cost associated with the internal transfer: ✓ Selling division is operating at capacity (FULL Capacity):  Opportunity cost = contribution margin (given up for sacrificing external sales) ✓ Selling division is operating at less than full capacity (EXCESS/IDLE Capacity):  Opportunity cost = zero (nothing to sacrifice when there is no need to give up external sales) ➢ When selling division is operating at capacity, market price is the ‘theoretically correct’ transfer price. ➢ When selling division has an excess capacity, transfer price must be based on the variable costs incurred to produce each unit. In practice, this price usually serves as the MININUM (floor) or lower threshold in a transfer price negotiation or as the basis for cost-based pricing. DUAL PRICING is an attempt to eliminate the internal conflicts associated with transfer prices by giving both the buying and selling divisions the price that works best for them: ➢ Selling division: uses market price as its transfer-out price to prevent decrease in divisional income ➢ Buying division: uses variable cost as its transfer-in price to minimize divisional costs and avoid ‘profit sharing’ with selling division by agreeing to a transfer price above cost. Dual pricing is rarely used nowadays because of the little incentive to control costs -- neither manager from both buying divisions (assured of a low price) and selling divisions (assured of high price) must exert much effort to show a profit on segmental performance reports. ➢

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY Week 8: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING EXERCISES: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING

1. Responsibility Centers Indicate how each of the business situations below is most likely to be organized: cost center (CC), revenue center (RC), profit center (PC), or investment center (IC) A. The assembly department of Toyota Motors Corporation. B. The Ayala Mall car park ticket outlets. C. The Magnolia product division of San Miguel Corporation. D. The accounting department of SM Malls. E. The Project 8 branch of Starbucks Coffee. F. The College of Accountancy of the España University. G. The parts department of Suzuki Motors Corporation. H. The convenience store (Mini-Stop) that is owned by a chain organization; the head office supplies all the goods to be sold and determines the selling prices. 2. Controllable vs. Non-Controllable Costs, Direct vs. Indirect Costs The supervisor of the PAINTING DEPARTMENT of Honda Cars is in-charge of (1) purchasing supplies, (2) authorizing repairs, and (3) hiring labor for the department. Various costs are given: 1 2 3 A) Sales, salaries and commission A P 60,000 × B) Salary, supervisor of Painting department B 50,000 × C) Factory heat and light C 40,000 × D) General office salaries D 30,000 × E) Depreciation, factory E 20,000 × ✓ F) Supplies, Painting department F 10,000 ✓ G) Repairs and maintenance, Painting department G 20,000 H) Factory insurance H 30,000 × ✓ I) Labor costs, Painting department I 40,000 J) Salary of factory supervisor J 50,000 × TOTAL COSTS REQUIRED: Determine the following: 1. Total costs controllable by the supervisor of the Painting department. 2. Total costs directly identified with the Painting department. 3. Total costs allocated to the factory departments. 4. On the basis of the answers above, which is a FALSE statement? a. All controllable costs by the supervisor are direct costs of the Painting department. b. All direct costs of the Painting department are controllable costs by its supervisor. c. Painting department costs not controllable by its supervisor may be controlled by others. d. Common costs allocated to the Painting department are not controllable by its supervisor. 3. Segmented Income Statement Mr. Rastaman, the QC branch manager of ABZ Company, recently reported annual sales of P 1,000,000 and presented the following cost information: Variable manufacturing costs 440,000 Allocated corporate overhead costs 170,000 Variable selling & administrative expenses 220,000 Controllable fixed costs traceable to QC branch 140,000 Uncontrollable fixed costs traceable to QC branch 230,000 REQUIRED: 1. Determine the following: A) Manufacturing contribution margin B) Controllable or performance margin C) Segment margin 2. Identify the appropriate margin that shall be used to evaluate the performance of: A) Manager (Mr. Rastaman) B) Business unit (QC Branch of ABZ Corp) 4. Return on Investment, Residual Income & ROI Pricing For each of the following independent cases, the minimum desired Division Lugaw Division LBM Sales P 400,000 P 700,000 Operating Income P 42,000 (1) _____ Operating Assets (2) _____ (5) _____ Margin 15% (6) _____ Turnover (3) _____ (7) _____ (8) _____ Return on Investments 30% (4) _____ Residual Income P 22,000

Return on Investment (RoI) is 20%. Division Lugaw  Unit selling price: P 20  Total fixed costs: P 100,000 Division LBM  Unit selling price: P 700  Total fixed costs: P 258,000

REQUIRED: 1. Compute for each division’s missing items (1) to (8). 2. How many more units shall be sold by Lugaw to achieve a 40% ROI? 3. How much increase in selling price will allow LBM to reach 50% ROI from its current unit sales?

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MAS-08

ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY Week 8: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING 5. Economic Value Added (EVA) Fink Company presents the following year-end data: Current assets Non-current assets Current liabilities Non-current liabilities (10% interest rate) Stockholders’ equity

Book Value P 800,000 3,200,000 400,000 1,000,000 2,600,000

Fair Value

P 1,000,000 3,000,000

Additional data:  Income before interests and taxes: P 800,000.  Income tax rate: 20%.  Cost of equity capital: 12%. REQUIRED: 1. Weighted Average Costs of Capital (WACC) 2. Economic Value-Added (EVA) 6. Transfer Price Computation Pakyaw Company is operating with two divisions. Division S is producing a product line that is required as a component part of the product being manufactured by Division B. For Division S, the costs of producing the component part per unit are: Direct materials P 10 Direct labor P8 Variable factory overhead P5 Fixed factory overhead P2 The product of Division S is being sold in a highly competitive market for P 30 per unit. Division B is currently buying 80% of the production output of Division S at a negotiated price of P 28 per unit. It is expected that 25,000 units of product will be produced by Division S. With emphasis on divisional welfare rather than the company’s welfare, a new transfer price must be developed. It is suggested that a 40% mark-up on cost will be added when transferring the product from Division S to Division B. The unit selling price of the product of Division B is P 45 while the additional unit processing cost is P 8. REQUIRED: Determine Division B’s gross profit per unit under each of the following independent assumptions: A) Transfer price is full-cost based. B) Transfer price is cost-based plus mark-up. C) Transfer price is based on a negotiated price. D) Transfer price is market-based. 7. Transfer Pricing Domagisko Company’s Division ‘S’ (selling division) produces a small tool used by other companies as a key part in their products. Cost and sales data related to the small tool are given below: Selling price per unit P Variable costs per unit P Fixed costs per unit* P * based on capacity of 40,000 tools

50 30 12 per year.

The company’s Division ‘B’ (buying division) is introducing a new product that will use the same tool such as the one produced by Division S. An outside supplier has quoted the Division B a price of P 48 per tool. Division B would like to purchase the tools from Division S, only if an acceptable transfer price can be worked out. REQUIRED: Consider the following independent cases: 1. Division S has ample idle capacity to handle all the Division B’s needs: A) What is the minimum transfer price for Division S? B) What is the maximum transfer price for Division B? 2. Division S is presently selling all the tools it can produce to outside customers: A) What is the minimum transfer price? B) Shall the Division B purchase the tools from Division or from the outside supplier? Why? 3. Division S is presently selling 36,000 tools per year to outside customers while Division B requires 10,000 tools per year: A) What is the minimum transfer price for Division S? B) Shall the company make-and-transfer 10,000 tools or buy the tools from the outside supplier? Why?

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ReSA – THE REVIEW SCHOOL OF ACCOUNTANCY

MAS-08

Week 8: RESPONSIBILITY ACCOUNTING & TRANSFER PRICING

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WRAP-UP EXERCISES (MULTIPLE-CHOICE) Which sequence reflects increasing level of responsibility? a. Cost center, profit center, investment center b. Cost center, investment center, profit center c. Profit center, cost center, investment center d. Investment center, cost ...