1. Responsibility
Accounting and
Transfer Pricing

2. RESPONSIBILITY CENTERS
Characteristics of responsibility centers are:
 Decision rights are specified for each center.
 Performance measurement is measured by an
internal accounting information system.
Types of responsibility centers:
cost, profit, investment.

3. COST CENTERS
Types of Knowledge:
 Central management knows the desired production
quantity.
 Cost center manager knows how to mix inputs.
Decision rights:
 The cost center manager can choose the quantity and
quality of inputs (labor, material, supplies).
Measurement:
 Minimize total cost.
 Maximize output.

4. COST CENTERS
 Minimizing average cost does not maximize
profits.
 Cost centers have an incentive to produce
more units to spread fixed costs over a large
number of units.
 Quality of products must be monitored.

5. PROFIT CENTERS
Types of Knowledge:
 Profit center managers know their market including
correct product mix, demand and pricing.
Decision rights:
 Profit center managers can chose input mix, product
mix, and selling prices.
 Fixed capital budget.
Measurement:
 Profits.
 Profits compared to budget.

6. CHALLENGES WITH PROFIT CENTERS
 Setting transfer prices between centers.
 Allocating corporate overhead costs to
centers.
 Profit centers that focus only on profits often
ignore how their actions affect other
responsibility centers.

7. INVESTMENT CENTERS
Types of Knowledge:
 Investment center managers have knowledge of
investment opportunities and operating decisions.
Decision rights:
 Approve decisions of subsidiary cost and profit centers .
 Decide on amount of capital to be invested.
Measurement Methods:
 Return on Investment (ROI)
 Residual Income (RI)
 Economic Value Added (EVA)

8. INVESTMENT CENTER MEASURES
Return on Investment (ROI) =
Accounting net income Total assets invested
DuPont formula separates ROI into two components:
ROI= Sales turnover  Return on sales
ROI= (Sales  Total Investment)  (Net Income 
Sales)
Focusing on ROI can cause underinvestment.

9. INVESTMENT CENTER MEASURES
Residual income (RI) =
Net income  (Required rate of return  Capital
invested)
 RI is determined by accounting measurements of
net income and capital.
 Each investment center can be assigned a different
rate of return depending on its risk.
 RI can be increased by increasing income or
decreasing investment.

10. INVESTMENT CENTER MEASURES
Economic value added (EVA) =
Adjusted net income (Weighted average cost of
capital  Capital invested)
Examples of EVA adjustments to net income:
 Research and development (R&D) is amortized over
5 years for EVA, but expensed immediately for
financial accounting.
 Unamortized R&D is included in capital for EVA, but
treated is treated as an expired cost (zero value)
for financial accounting.

11. EVA
 EVA can be increased in three ways:
◦ Increase the efficiency of existing operations.
◦ Increase the amount of capital invested when
the return is greater than the weighted average
cost of capital.
◦ Withdraw capital from operations when the
investment return is less than the firm’s
weighted average cost of capital.

12. CHALLENGES WITH INVESTMENT CENTER
MEASURES
 Disputes over how to measure income and
capital.
 Difficult to compare investment centers of
different sizes.
 Central management must monitor product
quality and market strategies of investment
centers to reduce possibility of damage to
firm’s reputation.

13. MEASUREMENT ISSUES
Controllability Principle:
 Hold center managers responsible for only
those costs and decisions for which they can
control.
Drawbacks of controllability principle:
 If managers suffer no consequences from
events outside their direct control, they have
no incentive to take actions to mitigate the
consequences of uncontrollable events (such as
storms, corporate income taxes, etc.)

14. TRANSFER PRICING
Transfer Price defined:
The internal price charged by one segment of a
firm for a product or service supplied to another
segment of the same firm.
Examples of transfer prices:
 Prices paid by a final assembly division for
components produced by other divisions.
 Service fees to operating departments for
telecommunications, maintenance, and services by
support services departments.
 Cost allocations for central administrative services.

15. Transfer prices have multiple effects:
Performance measurement:
 Transfer prices reallocate company profits among
business segments.
 Influence decision making by division managers.
Incentives:
 Compensation of divisional managers.
Partitioning decision rights:
 Disputes over determining transfer prices.

16. DIFFERENT CONCEPTS OF TRANSFER PRICE
 External market price
◦ If external markets are comparable
 Variable cost of production
◦ Exclude fixed costs which are unavoidable
 Full-cost of production
◦ Average fixed and variable cost
 Negotiated prices
◦ Depends on bargaining power of divisions

17. CHALLENGES OF TRANSFER PRICING
 Disputes over transfer pricing occur because transfer
prices influence performance evaluations of managers.
 Internal accounting data are often used to set transfer
prices, even when external market prices are available.
 Classifying costs as fixed or variable can influence
transfer prices determined by internal accounting data.
 To reduce transfer pricing disputes, firms may combine
interdependent segments or spin off some segments as
separate firms.

18. When products or services of a multinational firm are
transferred between segments located in countries
with different tax rates, the firm attempts to set a
transfer price that minimizes total income tax
liability.
Segment in higher tax country:
Reduce taxable income in that country by charging
high prices on imports and low prices on exports.
Segment in lower tax country:
Increase taxable income in that country by
charging low prices on imports and high prices on
exports.