Week 8 - Lesson 7 Responsibility Accounting, Segment Evaluation and Transfer Pricing PDF

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Managerial Accounting Responsibility Accounting, Segment Evaluation and Transfer Pricing 1Course ModuleModule 007 : Responsibility Accounting,Segment Evaluation and Transfer PricingCourse Learning Outcomes: At the end of this module, the student will be able to: Understand the importance of organiza...

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Managerial Accounting Responsibility Accounting, Segment Evaluation and Transfer Pricing

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Module 007: Responsibility Accounting, Segment Evaluation and Transfer Pricing Course Learning Outcomes: At the end of this module, the student will be able to: 1. Understand the importance of organizational structure to managerial reporting. 2. Differentiate centralization from decentralization and empowerment. 3. Distinguish authority, responsibility and accountability. 4. Identify the different types of responsibility centers. 5. Explain the concept of controllability in relation to responsibility accounting. 6. Apply various measurements in evaluating segment performance. 7. Prepare a segment performance report. 8. Explain the importance of transfer pricing to segment reporting. 9. Identify the various transfer prices and explain their importance to segment evaluation.

Centralization, Decentralization and Empowerment Decisions forge an organization. Making decisions could either be centralized or decentralized. Centralized organization exists when decision rests only to the top management. When the authority to make decisions is delegated to responsible officers in different organizational levels, there is a decentralized organization. Either model, centralization or decentralization, could fashion great results. However, managers have realized that by doing things along with others, they can produce outstanding results and more wealth. When they trust others and delegate authority, decisions are faster, actions are quicker and services become more satisfying to customers. These organizational attributes are needed to stay abreast and relevant in a competitive market. This premise strengthens the practice of decentralization. New organizations are bolder in their approach of trusting men up to the level of the production supervisor and his teammates in the quality circle. The power to make decisions may also be delegated up to the organization’s grassroots to the level of ordinary workers. This is called empowerment. This powerful model in managing organizational men is not covered in our discussions. Authority, Responsibility and Accountability As authority is shared, responsibility must be performed in line with the principle of accountability. Authority is the power to give orders, to give command, to give instructions, Course Module

or to make decisions. Responsibility is the duty to do or not to do an activity, to perform and produce results. Accountability is the answerability on the consequences of what has been done or not done. Authority and responsibility must go together. One should not be present without the other. Authority without responsibility is absolute power and absolute power corrupts absolutely. Responsibility without authority is blind obedience, a plain servitude. Using equation, we could express that: Authority = Responsibility The manner authority is exercised and the effects of the acts performed to fulfill a responsibility should be evaluated. This is the moving concept of accountability. Without it, there would be no logical value of assessing how things are done and what have been done. Without accountability, there would be no compelling reasons to evaluate performance fairly and objectively. In an expanded equation, we could say: Authority = Responsibility = Accountability

Responsibility Centers In a decentralized organizational structure, divisions, departments, segments, or units are considered responsibility centers. Each center is managed by a responsible officer. A responsibility center could be an investment center, profit center, revenue center or cost center. An investment center manager decides on which strategic business opportunity should the company take. A profit center manager controls the occurrence or nonoccurrence of both revenues and costs. A revenue center manager controls the generation of revenue. A cost center manager has a control or influence over the incurrence of costs. Controllability and Responsibility Centers The span of authority given to a manager defines what he controls over with. Controllability refers to the power of manager to decide or influence the incurrence or non-incurrence of an item. This concept of controllability is extremely important in measuring a manager’s performance. With the principle of decentralization is the truism that a manager should be evaluated only on matters that he has control over. Each responsibility center manager has his own breadth and depth of authority. The authority given should commensurate with the responsibility given to him. Consequently, he is accountable to his actions or inaction! This model stresses the need for performance evaluation. Performance Evaluation A manager’s performance should be evaluated in line with the established objectives of his center. Different responsibility center managers should be evaluated differently in as much as their authority, responsibility and accountability vary from each other. Performance evaluation (i.e., performance measurement, feedback) is a matter of control. It could be done before, during or after a process. Performance is assessed based on reports submitted to and gathered by the manager. Therefore, an effective, reliable, timely, verifiable and relevant reporting system must be in place. Responsibility accounting reports may either be information reports or performance reports.

Managerial Accounting Responsibility Accounting, Segment Evaluation and Transfer Pricing

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Reports submitted by a responsibility manager should segregate the controllable from the non-controllable items. Managers’ performance should be measured for items they have control over. The techniques used in measuring managers’ performance are presented below. Responsibility Center Manager Cost center manager Revenue center manager Profit center manager Investment center manager

Evaluation Techniques Cost variance analysis Revenue variance analysis Segment margin analysis Return on investment (ROI) Residual income model Economic value added (EVA), etc.

Cost Center Manager’s Performance A cost center manager has control or influence over the incurrence or non-incurrence of costs. His report should separate the controllable from the non-controllable costs and should highlight the variances between the actual and budgeted costs. Variances are identified as either favorable (F) or unfavorable (U). Unfavorable variances indicate excessive costs and should be avoided. Favorable variances mean savings, however, should also be investigated. Revenue Center Manager’s Performance A revenue center manager has control or influence in generating revenue but not costs. His performance should be focused on getting the variances between actual revenue and budgeted revenue. When the actual revenue is greater than budgeted revenue, there is a favorable variance, and vice-versa. A favorable variance should be encouraged and be given a commensurate reward while an unfavorable variance should be avoided. Responsibility centers that are responsible in developing and maintain sources of supply such as sources of materials and labor may be classified as revenue centers. Profit Center Manager’s Performance A profit center manager has control over revenues and costs. His managerial performance is evaluated based on controllable margin while the center’s performance is evaluated based on segment (or direct) margin. Once more, the controllable margin and segment margin computations are presented below: Contribution margin Less: Controllable direct fixed costs and expenses Controllable margin Less: Non-controllable direct fixed costs and expenses Segment margin Course Module

Px x x x Px

Deduct the allocated (or indirect or unavoidable) fixed costs and expenses from the segment margin, you get the operating profit. The difference between controllable margin and segment margin is fixed cost and expenses controllable not by the concerned manager but by others. The actual controllable margin and segment margin should be compared with the budgeted amounts to get the variances and evaluate performances. Illustration: Segment Performance JKL Corporation has been experiencing negative operating results in the last 6 quarters. Its most recent income statement is as follows: Sales Less: Variable costs Contribution margin Less: Fixed costs Net loss

P6,300,000 3,474,000 2,826,000 2,906,000 P (80,000)

The company operates three product lines which has the following related data: Sales Controllable direct fixed costs Allocated fixed costs Non-controllable direct fixed costs Variable cost ratio

Product A P1,200,000

Product B P2,100,000

Product C P3,000,000

Total P6,300,000

220,000 102,000

880,000 102,000

800,000 102,000

1900,000 306,000

220,000 56%

100,000 42%

800,000 64%

1,120,000

Required: Computed the segment margin for each of the product lines and the total for the corporation. Evaluate the data. Solutions/Discussions: 

The segment margins of the three product lines are determined as follows: Sales Less: Variable costs Contribution margin Less: Controllable direct fixed costs Controllable margin Less: Non-controllable direct fixed costs Segment margin Less: Allocated fixed costs Profit (loss)

Product A P1,200,000 672,000 528,000

Product B P2,100,000 882,000 1,218,000

Product C Total P3,000,000 P6,300,000 1,920,000 3,474,000 1,080,000 2,826,000

220,000 308,000

880,000 338,000

800,000 280,000

1,900,000 926,000

220,000 88,000

100,000 238,000

800,000 (520,000)

1,120,000 (194,000)

102,000 P(14,000)

102,000 P136,000

102,000 P(622,000)

306,000 P(500,000)

Managerial Accounting Responsibility Accounting, Segment Evaluation and Transfer Pricing





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Product line B registers the best performance in terms of peso amount amounting to a segment margin of P238,000 and margin return on sales of 11% (i.e., P238,000/P2,100,000). Product line C produces a negative segment margin of P520,000. This product line does not contribute to the overall profitability of the company but rather reduces the overall amount of the company’s profit by the amount of its negative segment margin. Product line C, based on the computations above, should be disposed. In terms of individual segment manager’s performance, the manager of product line B still registers the best performance posting a controllable margin of 16% (i.e., P338,000/P2,100,000) compared to that of product line C’s manager of 9% (i.e., P280,000/P3,000,000) and that of product line A’s manager of 3% (i.e., P308,000/P1,200,000).

Investment Center Manager’s Performance The investment center manager has authority to decide over which investment opportunity should be considered. As such, their performance is evaluated based on the results of decisions on investments. The cost-benefit criterion plays a vital role in the investment selection decision process. The benefit refers to the returns derived from investments while the cost revers to the amount used in undertaking the opportunity. There are several models in evaluating investment center performance. Some of these are the return on equity, return on investment (DuPont Model), residual income, economic value added, equity spread, total shareholders return, and the market value added. We will take up only three – the ROI (return on investment) model, the residual income model, and the economic value added (EVA). The Return on Investment (ROI) The ROI is sometimes referred to as return on assets (ROA) or accounting rate of return (ARR). It is computed as follows: ROI = Segment Profit / Segment Investment ROI is a measure of benefit over cost analysis. Benefit is represented by the net income while the cost is the amount of investment. The higher the ROI, the better it will be for the business. The issue, therefore, is how to increase ROI. Quantitatively speaking, ROI is increased by increasing net income and reducing investment. Increase in ROI = Increase in profit / Decrease in Investment

The DuPont Model E.I. du Pont de Nemours and Company, commonly referred to as DuPont, an American chemical company that was founded in July 1802 and is the world’s third largest chemical company based on market capitalization, evaluates the performance of its numerous business investments using an extended ROI model as follows: Course Module

ROI = Profit / Net Sales x Net Sales /Investment ROI = Return on Sales x Assets Turnover This model encourages investment center managers to take investments only those which are of relevance to their operations. This will result to efficiency in allocating investment funds. Only those investments of which the investment center manager has control and use in operations shall be included in the ROI determination. Illustration: Return on Investment JKL Corporation’s balance sheet indicates that the company has an investment of P5,000,000 in operating assets. During 2018, JKL earned P1,100,000 of net income on P11,000,000 of sales. Required: 1. 2. 3. 4.

Compute JKL’s margin for 2018. Compute JKL’s turnover for 2018. Compute JKL’s return on investment for 2018. Recompute JKL’s ROI under each of the following independent assumptions: a. Sales increase from P5 million to P6 million and income increases from P1,100,000 to P1,300,000. b. Sales remain constant, costs and expenses decrease, and income increases by P400,000. c. The amount of investment is decreased by P400,000 without affecting net income.

Solutions/Discussions: 1. Margin on sales or return on sales is computed as follows: Return on sales = Profit/Net sales = P1,100,000/P11,000,000 = 10% 2. The turnover referred to here is the assets is the assets turnover and is determined as follows: Assets turnover = Net sales/Assets = P11 million/P5 million = 2.2 3. ROI = Return on sales x Assets turnover = 10% x 2.2 = 22% Or, ROI may be computed directly as: ROI = Profit/Average assets used = P1,100,000/P5,000,000 = 22% 4. a. ROI = P1,300,000/P6,000,000 = 21.67% b. ROI = (P1,100,000 + P400,000)/P5,000,000 = 30% c. ROI = P1,100,000/P4,600,000 = 23.91% The ROI and Its Limitations The use of ROI has several limitations. Significant differences in the amount of investment from one project to another and the differences in the life of the asset used in investment opportunities may render the use of ROI difficult to apply. To highlight these limitations, consider the following: Return on investment Amount of investment

Company A 20% P1 billion

Company B 40% P1 million

Managerial Accounting Responsibility Accounting, Segment Evaluation and Transfer Pricing

Life of assets in years

15 years

7

2 years

Using the ROI model, Company B is better BUT… The size matters… Using the ROI company B manager with 40% ROI, would be better off than that of company A manager with 20% ROI. However, considering the amount of investment supervised by each manager respectively, we could easily say managing a million worth of business (e.g., Company B) is a lot much easier than managing a billion of resources (e.g., Company A). The asset life also matters… Also, considering the life span of the assets used, company B’s performance in an utter dismay because only 80% of the investment would be recovered in 2 years, which is the life of the investment, given a 40% ROI per annum. This performance falls short of recovering the entire amount of investment over its operational life. Whereas company A has a total return of 300% (e.g., 20% x 15 years) which means investment in company A is recoverable three times and is better than the 80%recovery rate of company B. The special assignment matters… ROI model may not also be the most suitable method in evaluating the performance of an excellent manager who is assigned to make a turnaround performance, say to deliver a profitable performance of a previously unprofitable operations.

The Residual Income Model The limitations encountered in applying the ROI is improved by the residual income model that uses amount as a basis of evaluating the acceptance of a prospective investment or in evaluating the performance of an investment project. The residual income is computed as follows: Segment Income Less: Minimum income (Investment x Implied interest rate) Residual income

P x x Px

The segment income is income expressed before tax. Segment income also refers to earnings before interest and tax (e.g., EBIT) or is called now as profit before income tax (PBIT). Minimum income is sometimes labeled as imputed income, implied income, implicit income or desired income. The investment base used in computing the minimum income is to the amount agreed upon by the corporate headquarter and the investment center manager. The imputed interest rate is to be determined by the corporate headquarter management. Normally, the imputed interest rate is based on the prevailing market rate from which the business generates profit without accepting a high business risk. The imputed rate is ordinarily the pre-tax cost of capital, and in principle, should reflect the degree of risk of the reporting responsibility center. If the residual income is positive, the performance is above Course Module

standard and is, therefore, favorable. Residual income is considered superior than the ROI because it considers two levels of assessments, the compliance to minimum return and the size of the excess return over the designated minimum return. Illustration: Residual Income JKL Corporation gathered the following data relative to Northern Division’s performance: Net Sales Costs and expenses Average operating assets Desired minimum (or imputed) rate of return established by management Average industry rate of return Income tax rate

P12,000,000 11,000,000 5,000,000 15% 28% 40%

Compute the Northern Division’s residual income. Solutions/Discussions: Segment profit (P12 million – P11 million) Less: Minimum income (P5 million x 15%) Residual income 



P1,000,000 750,000 P 250,000

The average industry rate of return may be considered in setting the minimum desired rate of return but is not considered in determining the residual income. The desired minimum income is normally expressed in amount before tax, hence, it is compared with operating income. Since the residual income of a division is positive, the division has met the expectations or standards set by top management in terms of profitability and is therefore considered acceptable.

Economic Value Added The economic value added (EVA) is a more specific after-tax version of residual income. It represents the business unit’s true economic profit because a change in the cost of equity capital is implicit in the cost of capital. The cost of equity is an opportunity cost, that is, the return that could have been obtained with the best alternative investment having similar risk. The EVA is computed as follows: Operating profit after tax (PBIT x after-tax rate) Less: Minimum income (Investment x weighted average cost of capital) Economic value added

P x x Px

The operating profit after tax (OPAT) is computed by multiplying the profit before interest and tax (PBIT) by the after-tax rate. The weighted average cost of capital is computed after tax. EVA measures the marginal benefit obtained by using resources in relation to the business of increasing shareholders’ value. Some adjustments in PBIT are needed such as research and development costs which are capitalized and amortized over 5 years. The true

Managerial Accounting Responsibility Accounting, Segment Evaluation and Transfer Pricing

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