Design and use of cost systems, responsibility accounting and transfer pricing

18 important questions on Design and use of cost systems, responsibility accounting and transfer pricing

Cost center - knowledge


- Central manager knows optimal production quantity and budget
- Cost center manager knows how to optimally mix inputs

Cost center - decision rights

Cost center manager chooses quantity and quality of inputs used in cost center (labor, material, supplies)

Cost center - measurement


- Minimize total cost for a fixed output
- Maximize output for a fixed budget
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Cost center - problems


- Minimizing average costs does not necessariliy maximize profits. Cost centers have an incentive to product more units to spreak fixed costs over a large number of units.

- Quality of products produced by costs center must be monitored.

Profit Center - knowledge

Profit center managers' knowledge of product mix, demand, and pricing is difficult to transfer to central management.

Profit Center - decision rights


- Can chose input mix, product mix and selling prices
- Given fixed capital budget

Profit Center - measurement


- Actual profits
- Actual profits compared to budget

Profit Center - problems


- Setting appropriate transfer prices on goods and services transferred within the firm
- How to allocate corporate overhead costs to responsibility centers
- Profit centers that focus onlu on their own profits often ignore how their actions affect other responsibility centers.

Investment center - knowledge

Investment center manager has knowledge of investment opportunities and operating decisions.

Investment center - decision rights


- Ratify and monitor decisions of cost and profit centers
- Decide amount of capital invested or disposed

Drawbacks of controllability principle

If managers suffer no consequences from events outside their direct control, they have no incentive to take actions that can affect the consequences of uncontrollable events (such as storms, corporate income taxes, etc)

What are multiple effects on firm value from transfer pricing?


- Performance measurement: reallocate total company profits among business segments and influence decision making by purchasing, production, marketing and investment managers.
- Rewards and punishments: compensation for divisional managers
- Partitioning decision rights: disputes over determining TP

What would be ideal TP?

Opportunity costs, or the value forgone by not using the transferred product in its next best alternative use. The opportunity cost is the greater of variable production cost or revenue available if the product is sold outside of the firm.

Cost-based transfer pricing


- Standard cost (engineered)
- Profit mark-up
- Danger: double marginalization

Upstream fixed costs & profits


- Agreement among BU's
- Two-step pricing: variable cost unit basis + fixed costs and profits lump sum

Incentive Effects: Discourage Cooperation

Evaluating performance evaluation on individual's variances. This emphasizes individual instead of team efforts en creates a reluctance to help others look good. A solution is to base the reward system on both individual and departmental (team) variances. However, to much weight on teamwork can lead to shirking (free-rider problem)

Incentive effects: mutual monitoring

Method where managers or employees at the same level monitor each other's performance

Incentive effects: satisficing


Satisficing behavior: managers have incentives to achieve standard but go no further.


However, the firm value would increase if managers attempted 1) continuous improvement beyond standard and 2) innovate to meet competitive threats.

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