CHAPTER SIX

RESPONSIBILITY ACCOUNTING AND TRANSFER

PRICING IN DECENTRALIZED ORGANIZATIONS

SINTAYEHU T.
 LEARNING OBJECTIVES

After Accomplishing this Chapter, you will able to knows;

1. Explain the organizational characteristics used to determine if a

firm should be centralized or decentralized.

2. Clarify the relationship between responsibility accounting and

decentralization Contrast the four types of responsibility centers.

3. Explain why and how service department costs are allocated to

revenue-producing departments
 LEARNING OBJECTIVES

4. Explain why transfer prices are used and describe the types of
transfer prices

5. Explain the difficulties that multinational companies may

encounter when using transfer prices
 Decentralization

 The degree of centralization can be viewed as a continuum.

 It reflects a chain of command, authority and responsibility
relationships, and decision-making capabilities.
 In a completely centralized firm, a single individual (usually the
company owner or president) performs all major decision making
and retains full authority and responsibility for that organization’s
activities.
 Decentralization

 Decentralized organization would have virtually no central authority, and

each subunit would act as a totally independent entity.
 Either extreme of the centralization–decentralization continuum represents
a clearly undesirable arrangement.
 Totally centralized company, the single individual may have neither the
expertise nor sufficient and timely information to make effective decisions
in all areas.
 Totally decentralized firm, subunits may act in ways that are inconsistent
with the organization’s goals.
 Decentralization Continuum

Factor Centraliz Decentraliz

ed ed
Age of firm Young Mature
Size of firm Small Large
Stage of product development Stable Growth
Growth Rate Low Rapid
Impact on profits of incorrect High Low
decisions
Management’s confidence in Low High
subordinates
Degree of Control Tight Moderate/
Loose
 Decentralization Continuum

Factor Centraliz Decentralize

ed d
Geographic diversity Local Widespread
Cost of communications Low High
Ability to resolve Easy Difficult
conflicts
Level of employee Low Moderate to
motivation High
Level of organizational Low High
flexibility
Response time to Slow Rapid
changes
 Advantages of Decentralization

 Personnel
 Train and screen aspiring managers
 Develop leadership qualities, problem-solving abilities, and decision-
making skills
 Compare managers’ results
 Increase job satisfaction and job enrichment
 Effective means of achieving organizational goals
 Reduces decision-making time
 Allows management by exception
 Disadvantages of Decentralization

 Lack of goal congruence

 Suboptimization
 Pursuing the subunit manager’s goals instead of the company’s goals
 Requires more effective communication skills
 Managers must relinquish control
 Expensive
 Train managers in decision-making skills
 Absorb cost of poor decisions
 Requires a sophisticated planning and reporting system
 Responsibility Reports

 Monetary and non-monetary

 Adjusted for the planning, controlling, and decision-making needs
of each unit manager
 Separates costs as controllable or noncontrollable by the unit
manager
 Non-monetary Measures

 Capacity measures  Reduction of non-value-added

 Target ROI time
 Desired/actual market  Employee suggestions
share received/implemented
 Throughput  Unplanned production
 Defects interruptions
 Backorders  Schedule changes
 Complaints  Engineering changes
 On-time delivery  Safety violations
 Manufacturing cycle  Absenteeism
efficiency
 Control Process Steps

Compare Plan
Gather
actual
Managerial
data
influence
Compare
 Responsibility Reports

Upward flow of information

- from operations to top management

Unit level reports are detailed
Upper-level reports are summarized
Encourages management by exception

– Major deviations are highlighted

 Responsibility Reports

Disadvantages of responsibility accounting include

 Important details may not be visible at upper management levels
 Managers might “promote” their unit while “blaming” their
competitor units
 Departmental interdependencies might not be visible
 Responsibility Center

Responsibility accounting systems identify, measure, and report on

activities in responsibility centers
 Cost center
 Revenue center
 Profit center
 Investment center
 Service Cost Allocation Methods

• Direct method
• Step method
– Benefits-provided ranking
• Algebraic method
– Simultaneous equations
 Service Cost Allocation Methods

 Allocated service department costs are included in the overhead

application rate for the revenue-producing areas

 Service department costs are allocated to products or jobs through

normal overhead assignment procedures

 Transfer Pricing

Internal charges for the exchange of goods or services within the

organization
 Promote goal congruence
 Make performance evaluation among segments more comparable
 Transform a cost center into a pseudo- profit center
 For internal use only
– Eliminated on external financial reports
 Encourages managers to be entrepreneurial
 Transfer Pricing System

 May cause disagreement among managers

 Add costs and take time
 May not work for all departments
 May cause dysfunctional behavior
 May cause underutilization or overutilization of services
 Complicate tax planning for multinationals
 Multinational Transfer Pricing

Internal Objectives External Objectives

 Better goal congruence  Less taxes and tariffs
 Better performance  Less foreign exchange risks
evaluations  Better competitive positions
 More motivated managers  Better relations with
 Better cash management government
 Multinational Transfer Pricing

 Develop guidelines that are followed on a consistent basis

 Set transfer prices that reflect an arm’s-length transaction
 Be prepared for transfer pricing audits
 Consider Advance Pricing Agreements –binding contracts
between a company and taxing authorities that set an
acceptable transfer pricing methodology
 Questions

1. What are some advantages and disadvantages of

decentralization?
2. What are the four types of responsibility centers?
3. Why are transfer prices used?
 Responsibility Accounting
 Responsibility accounting tries to figure out the causal relationship
between managers‘ actions and the achievement of organization‘s
objectives as clearly as possible
 isolating other influences
 accounting for known outside effects
 considerable noise in the measures will remain
 Responsibility center (Definition)
 any part, segment, or subunit of a business that needs
control.
 Types of Responsibility Centers
 Cost Center
 Profit Center
 Controllability
Definition
 property of a performance measure such as
 costs
 revenues
 department profit
 return on investment;
A performance measure is controllable to the degree the responsible
manager can exert influence on it.
 Controllability is less relevant a property for responsibility accounting than is
informativeness on the actions of the manager
 any (costlessly available) performance measure that is informative on the
manager‘s action should enter his or her performance evaluation
 e.g. benchmarking information