PAMANTASAN NG LUNGSOD NG VALENZUELA

STRATEGIC BUSINESS ANALYSIS

LECTURE: RESPONSIBILITY ACCOUNTING
SEGMENT EVALUATION
TRANSFER PRICING

RESPONSIBILITY ACCOUNTING – a system of accounting wherein costs and revenues are accumulated and
reported by levels of responsibility or by responsibility centers within the organization.

Responsibility center (also called accountability center)

- A clearly identified part or segment of an organization that is accountable for a specified function or set of
activities.
- Any part of the organization that a particular manager is responsible for

TYPES OF RESPONSIBILITY CENTERS:

a. Cost Center (or expense center) – a segment of an organization in which managers are held responsible for the
costs or expenses incurred in the segment.
b. Revenue Center – where management is responsible primarily for revenues.
c. Profit Center – a segment of the organization in which the manager is held responsible for both revenues and
costs.
d. Investment Center – a segment of the organization where the manager controls revenues, costs and
investments. The center’s performance is measured in terms of the use of the assets as well as the revenues
earned and the costs incurred.

CLASSIFICATION OF COSTS IN RESPONSIBILITY ACCOUNTING

a. By responsibility center
b. By cost type, as to controllability
c. By specific cost items or cost elements within each classification in (1) and (2).

RESPONSIBILITY vs. ACCOUNTABILITY

Responsibility has two facets, (1) the obligation to secure results, and (2) the obligation to report back the results
achieved to higher authority.

Accountability denotes the obligation to report results achieved to higher authority.

THE CONCEPT OF DECENTRALIZATION

Decentralization refers to the separation or division of the organization into more manageable units wherein each
unit is managed by an individual who is given decision authority and held accountable for his decisions.

 Goal congruence – all members of an organization have incentives to perform for a common interest.
 Sub-optimization – occurs when one segment of a company takes action that is in its own best interests, but
is detrimental to the firm as a whole.

BENEFITS OF DECENTRALIZATION
1. Better access to local information
2. Cognitive limitations
3. More timely response
4. Focusing of central management
5. Training and evaluation
6. Motivation
7. Enhanced competition

COSTS OF DECENTRALIZATION
1. Some decisions made in one sub-unit may bring about negative effect to the other sub-units or the organization
as a whole.
2. Decentralization necessitates a more elaborate reporting system hence, the costs of gathering and reporting data
increase.
3. Job duplication or overlapping of functions is usually encountered in a decentralized set-up.

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MEASURING THE PERFORMANCE OF INVESTMENT CENTERS
Performance measures for investments usually attempt to assess how well managers are utilizing invested assets of the
division to produce profits by relating operating profits to assets.

Return on Investment (ROI) is the most common measure of performance for investment centers.
ROI can be defined as follows:
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐼 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠

Operating income refers to earnings before interest and taxes. Operating assets include all assets acquired to generate
operating income, including cash, receivables, inventories, land, buildings and equipment.

The ROI formula can also be broken down into the product of margin and turnover. Margin is the ratio of operating
income to sales. Turnover is defined as sales divided by average operating assets.

𝑅𝑂𝐼 = 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

or
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠
𝑅𝑂𝐼 = ×
𝑆𝑎𝑙𝑒𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠

Three advantages of using ROI to evaluate the performance of investment centers:

1. It encourages managers to pay careful attention to the relationships among sales, expenses and investment, as
should be the case for a manager of an investment center.
2. It encourages cost efficiency.
3. It discourages excessive investment in operating assets.

Two disadvantages of using ROI are:

1. It discourages managers from investing in projects that would decrease the divisional ROI but would increase
the profitability of the company as a whole. (Generally, projects with an ROI less than a division’s current ROI
would be rejected.)
2. It can encourage myopic behavior, in that managers may focus on the short run at the expense of the long-run.

Residual Income (RI) – the difference between operating income and the minimum peso return required on a
company’s operating assets. The equation for RI can be expressed as follows:

𝑅𝐼 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 − (𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 × 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡𝑠)

Economic Value Added (EVA) – a more specific version of residual income. It represents the segment’s true
economic profit because it measures the benefits obtained by using resources in a particular way.

After-tax operating income [EBIT x (1 – Tax Rate)] xx

Less: Desired income
[After-tax WACC x (Total Assets – Non-interest bearing current liabilities] xx
Economic Value Added (EVA) xx

PROBLEM 1: Best Workplace (BW), a division of Modular Office Corporation, buys and installs modular office
components. For the most recent year, the division had the following performance targets:
Asset turnover 2.5
Profit margin 6.0 %
Target rate of return on investments for RI 13.0 %
Cost of capital 10.0 %
Income tax rate 40.0 %

Actual information concerning the company’s performance for last year follows:
Total assets at beginning of year P 3,600,000
Total assets at end of year 5,300,000
Total invested capital (annual average) 8,000,000

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 Sales 9,000,000
Variable operating costs 3,650,000
Direct fixed costs 4,770,000
Allocated fixed costs 675,000

Required:
a. For BW, compute the segment margin and the average assets for the year.
b. Based on segment margin and average assets, compute the profit margin, asset turnover and ROI.
c. Evaluate the ROI performance of BW.
d. Using your answers from part b, compute the residual income of BW.

PROBLEM 2: The Sporty Company produces a wide variety of sports equipment. Its newest division, Golf Pro,
manufactures and sells a single product, AccuClub, a golf club that uses global positioning satellite technology to
improve the accuracy of golfer’s shots. The demand for AccuClub is relatively intensive to price changes. The
following data are available for Golf Pro, which is an investment center for Sporty:
Total annual fixed costs P 30,000,000
Variable cost per AccuClub P 500
Number of AccuClub sold each year 150,000 units
Average operating assets invested in the division. P 48,000,000

Required:
1. Compute Golf Pro’s ROI if the selling price of AccuClub is P720 per club.
2. If management requires ROI of at least 25% from the division, what is the minimum selling price that the Golf Pro
Division should charge per AccuClub?
3. Assume Sporty judges the performance of its investment centers on basis of RI rather than ROI. What is the
minimum selling price that Golf Pro should charge per AccuClub if the company’s required rate of return is 20%?

PROBLEM 3: Adan Inc. reported these data at year-end:

Pre-tax operating income P 5,000,000
Current assets 8,000,000
Long-term assets 22,000,000
Current liabilities 3,000,000
Long-term liabilities 5,000,000
Weighted average cost of capital 10 %
Income tax rate 30 %

Required: Calculate the Economic Value Added EVA).

TRANSFER PRICING – the monetary value or the price charged by one segment of a firm for the goods and services
it supplies to another segment of the same firm.

Objectives of Transfer Pricing

1. To facilitate optimal decision-making.
2. To provide a basis in measuring divisional performance.
3. To motivate the different department heads in improving their performance and that of their departments.

Approaches for Determining Transfer Price:

1. Negotiated transfer price
2. Cost-based transfer price
3. Market-based transfer price
General rules in Choosing a Transfer Price:
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  The maximum price should be no greater than the lowest market price at which the buying segment can
acquire the goods or services externally.
 The minimum price should be no less than the selling segment’s incremental costs associated with the
goods or services plus the opportunity cost of the facilities used.
 A good should be transferred internally whenever the minimum transfer price (set by the selling division)
is less than the maximum transfer price (set by the buying division). By using this rule, total profits of the
firm are not decreased by an internal transfer.

PROBLEM 1: Electric Division of Engineered Products Co. has developed a wind generator that requires a special
“S” ball bearing. The Ball Bearing Division of Engineered Products Co has the capability to produce such a ball
bearing.

Unfortunately, the Ball Bearing Division is operating at capacity and will need to reduce production of another existing
product, “T” bearing, by 1,000 units per month to provide the 600 “S” bearings needed each month by the Electric
Division. The “T“ bearing currently sells for P50 per unit. Variable costs incurred to produce the “T” bearing are P30
per unit; variable costs to produce the new “S” bearing would be P60 per unit.

Electric Division has found an external supplier that would furnish the needed “S” bearings at P100 per unit. Assume
that both Electric Division and Ball Bearing Division are independent, autonomous investment centers.

Required:
1. What is the maximum price per unit that Electric Division would be willing to pay the Ball Bearing Division for
the “S” bearing?
2. What is the minimum price that Ball Bearing Division would consider to produce the “S” bearing?
3. How would your answer to question “b” be different if Ball Bearing did not need to forfeit any of its existing sales
to produce the “S” bearing?

PROBLEM 2: GreenThumb, Inc., is a nursery products firm. It has three divisions that grow and sell plants: the
Western Division, the Southern Division and the Central Division.

Recently, the Southern Division of GreenThumb acquired a plastics factory that manufactures green plastics pots.
These pots can be sold both externally and internally. Company policy permits each manager to decide whether to buy
or sell internally. Each divisional manager is evaluated on the basis of return on investment and EVA.

The Western Division had bought its plastic pots in lots of 100 from a variety of vendors. The average price paid was
P75 pre box of 100 pots. However, the acquisition made Nay Sy, manager of Western Division, wonder whether a
more favorable price could be arranged. She decided to approach Flint, manager of Southern Division, to see if he
wanted to offer a better price for an internal transfer. She suggested a transfer of 3,500 boxes at P70 per box.

Flint gathered the following information regarding the cost of a box of 100 pots:
Direct materials , P 35; Direct labor, P8; Variable overhead, P10; Fixed overhead*, P10; Selling price, P75
Production capacity, 20,000boxes
*Fixed overhead is based on P200,000/20,000boxes.

Required:
1. Suppose that the plastics factory is producing at capacity and can sell all that it produces to outside customers. How
should Flint respond to Nay’s request for a lower transfer price?
2. Now assume that the plastics factory is currently selling 16,000 boxes. What are the minimum and maximum
transfer prices? Should Flint consider the transfer at P70 per box?
3. Suppose that GreenWorld’s policy is that all transfer prices be set at full cost plus 20%. Would the transfer take
place? Why or why not?

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