MODULE 4

Management Advisory Services 2

SESSION TOPIC 4 : Responsibility Accounting and Transfer Pricing

LEARNING OUTCOMES:
The following specific learning objectives are expected to be realized at the end of the session:
1. Introduce concepts and techniques for performance measurement.
2. Discuss and give appreciation to responsibility accounting and transfer pricing.

KEY POINTS

Responsibility Accounting Responsibility Center Transfer Pricing

CORE CONTENT
Introduction:
This module covers the discussion of
a. Responsibility Accounting;
b. Transfer Pricing.

IN-TEXT ACTIVITY
What is Responsibility Accounting?
Responsibility accounting is a system that involves identifying responsibility centers and their objectives, developing
performance measurement schemes, and preparing and analyzing performance reports of the responsibility centers.
Responsibility accounting involves gathering and reporting revenues and costs by areas of responsibility.

Advantages of Responsibility Accounting

1. Responsibility accounting delegates decision making. Line managers, department heads, and supervisors are
entrusted with operational decisions. The top management (executives) could then focus on strategic or long-term
organizational objectives.
2. It provides a guide to the evaluation of performance. It helps to establish standards which are used for comparison with
actual results.
3. It promotes management by objectives and management by exception.

Management by Objectives and Management by Exception

Management by objectives is an approach in which a manager agrees on a set of goals or objectives (hence the term
management by objective). The performance of the manager and his or her subordinates are evaluated based on
achievement of these goals.

Management by exception is another managerial approach in which management gives attention to matters that
materially deviate from established standards. For example: when a department has very high costs compared to what
was budgeted, the management will focus on finding out the reason behind it and fixing the concern perhaps by cutting
costs, process re-engineering, establishing new standards, etc.

Requisites of Effective Responsibility Accounting

For effective implementation of responsibility accounting, the following must be met.
1. A well-defined organizational structure. Authority and responsibility must be clearly established and understood by all
levels of management.
2. Performance evaluation measures and standards must be clearly established.
3. Only items that are under the influence of the manager of the responsibility center are included in performance
evaluation reports. The manager should not be evaluated based on matters that are out of his or her control.

Responsibility Centers
A responsibility center can be classified according to control over costs, revenues, and investments.

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1. Cost center - A sub-unit of the organization that has control over cost only. It has no control over revenues and
investments. Examples include: production department, maintenance department, accounting department, legal
department, etc. Cost centers are evaluated using variance analysis of costs.

2. Revenue center - has control over revenue generation, but has no control over costs and investment, e.g. the sales
and marketing department. Revenue centers are evaluated using variance analysis of revenues.

3. Profit center - has control over both revenues and costs. Examples include branches operating in different geographic
locations. The performance of profit centers are evaluated by measuring segment income (based on controllable
revenues and costs).

4. Investment center - A sub-unit that has control over revenues, costs, and investments (assets such as receivables,
inventory, fixed assets, etc.). Since investment centers are given authority to decide over its investments, it operates like a
separate entity. Examples include corporate headquarters and subsidiaries. Investment centers are evaluated using
different profitability measures such as return on investment, residual income, economic value-added, and others.

What Is Transfer Pricing?

Transfer pricing is an accounting practice that represents the price that one division in a company charges another
division for goods and services provided. Transfer pricing allows for the establishment of prices for the goods and services
exchanged between a subsidiary, an affiliate, or commonly controlled companies that are part of the same larger
enterprise. Transfer pricing can lead to tax savings for corporations, though tax authorities may contest their claims.

How Transfer Pricing Works?

Transfer pricing is an accounting and taxation practice that allows for pricing transactions internally within businesses and
between subsidiaries that operate under common control or ownership. The transfer pricing practice extends to cross-
border transactions as well as domestic ones.

A transfer price is used to determine the cost to charge another division, subsidiary, or holding company for services
rendered. Typically, transfer prices are priced based on the going market price for that good or service. Transfer pricing
can also be applied to intellectual property such as research, patents, and royalties.

Multinational companies (MNC) are legally allowed to use the transfer pricing method for allocating earnings among their
various subsidiary and affiliate companies that are part of the parent organization. However, companies at times can also
use (or misuse) this practice by altering their taxable income, thus reducing their overall taxes. The transfer pricing
mechanism is a way that companies can shift tax liabilities to low-cost tax jurisdictions.

Transfer Pricing and Taxes

To better understand how transfer pricing impacts a company's tax bill, let's consider the following scenario. Let's say that
an automobile manufacturer has two divisions: Division A, which manufacturers software while Division B manufactures
cars.

Division A sells the software to other carmakers as well as its parent company. Division B pays Division A for the software
typically at the prevailing market price that Division A charges other carmakers.

Let's say that Division A decides to charge a lower price to Division B instead of using the market price. As a result,
Division A's sales or revenues are lower because of the lower pricing. On the other hand, Division B's costs of goods sold
(COGS) are lower, increasing the division's profits. In short Division A's revenues are lower by the same amount as
Division B's cost savings—so there's no financial impact on the overall corporation.

However, let's say that Division A is in a higher tax country than Division B. The overall company can save on taxes by
making Division A less profitable and Division B more profitable. By making Division A charge lower prices and pass those
savings onto Division B, boosting its profits through a lower COGS, Division B will be taxed at a lower rate. In other words,
Division A's decision not to charge market pricing to Division B allows the overall company to evade taxes.

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In short, by charging above or below the market price, companies can use transfer pricing to transfer profits and costs to
other divisions internally to reduce their tax burden. Tax authorities have strict rules regarding transfer pricing to attempt to
prevent companies from using it to avoid taxes.

Transfer Price and Managerial Accounting

In managerial accounting, the transfer price represents the price at which one subsidiary, or upstream division, of a
company, sells goods and services to another subsidiary, or downstream division. Goods and services can include labor,
components, parts used in production, and general consulting services.

Transfer prices affect three managerial accounting areas.

 First, transfer prices determine costs and revenues among transacting divisions, affecting the performance of each
division.
 Second, transfer prices affect division managers' incentives to sell goods either internally or externally. If the transfer
price is too low, the upstream division may refuse to sell its goods to the downstream division, potentially impairing
the company's profit-maximizing goal.
 Finally, transfer prices are especially important when products are sold across international borders. The transfer
prices affect the company's tax liabilities if different jurisdictions have different tax rates.

Determining a Transfer Price

Transfer prices can be determined under the market-based, cost-based, or negotiated method. Under the market-based
method, the transfer price is based on the observable market price for similar goods and services.

Under the cost-based method, the transfer price is determined based on the production cost plus a markup if the
upstream division wishes to earn a profit on internal sales.

Finally, upstream and downstream divisions' managers can negotiate a transfer price that is mutually beneficial for each
division.

Impact of a Transfer Price

Transfer prices determine the transacting division's costs and revenues. If the transfer price is too low, the upstream
division earns a smaller profit, while the downstream division receives goods or services at a lower cost.

This affects the performance evaluation of the upstream and downstream divisions in opposite ways. For this reason,
many upstream divisions price their goods and services as if they were selling them to an external customer at a market
price.

If the upstream division manager has a choice of selling goods and services to outside customers and the transfer price is
lower than the market price, the upstream division may refuse to fulfill internal orders and deal exclusively with outside
parties.

Even though this can bring extra profit, this may harm the overall organization's profit-maximizing objective in the long
term. Similarly, a high transfer price may provide the downstream division with the incentive to deal exclusively with
external suppliers, and the downstream division may suffer from unused capacity.

Transfer Prices and Tax Liabilities

Transfer prices play a large role in determining the overall organization's tax liabilities. If the downstream division is
located in a jurisdiction with a higher tax rate compared to the upstream division, there is an incentive for the overall
organization to make the transfer price as high as possible. This results in a lower overall tax bill for the entire
organization.

However, there is a limit to what extent multinational organizations can overprice their goods and services for internal
sales purposes. A host of complicated tax laws in different countries limit the ability to manipulate transfer prices.

The Bottom Line

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The transfer price impacts the performance of both subsidiaries that transact with one another. A price that is too low
disincentivizes an upstream division from selling to a downstream division as it results in lower revenues. A price that is
too high disincentives the downstream division from buying from the upstream division, as costs are too high.

Arriving at a fair transfer price is not only beneficial to both subsidiaries but allows a company to reach profit maximization,
as well as allowing a company to possibly take advantage of favorable tax setups.

SESSION SUMMARY
 Responsibility accounting involves the separate reporting of revenues and expenses for each responsibility center in
a business. Doing so improves the management of operations. For example, the cost of rent can be assigned to the
person who negotiates and signs the lease, while the cost of an employee’s salary is the responsibility of that
person’s direct manager. This concept also applies to the cost of products, for each component part has a standard
cost (as listed in the item master and bill of materials), which it is the responsibility of the purchasing manager to
obtain at the correct price. Similarly, scrap costs incurred at a machine are the responsibility of the shift manager.
 Transfer pricing is an accounting practice that represents the price that one division in a company charges another
division for goods or services provided.
 A transfer price is based on market prices in charging another division, subsidiary, or holding company for services
rendered.
 However, companies have used inter-company transfer pricing to reduce the tax burden of the parent company.
 Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging a lower price
(increasing profits) for divisions in low-tax countries.
 The transfer price is the price that goods and services are sold by one subsidiary in a company to another subsidiary
in a company.
 The goods and services that subsidiaries sell to one another can include labor, manufacturing parts, and other
supplies.
 Transfer prices impact three managerial accounting areas: division performance, managerial incentives, and taxes.
 Transfer prices can be determined under the market-based, cost-based, or negotiated method.
 Depending on the tax jurisdictions of both subsidiaries, transfer pricing can improve a company's overall tax burden.
 The transfer price affects the performance of both subsidiaries in opposite ways.

SELF-ASSESSMENT
Assignment : Computation on responsibility accounting and transfer pricing
Quiz : Problem on responsibility accounting and transfer pricing

REFERENCES
Refer to the references listed in the syllabus of the subject.

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