Chapter 10 : Responsible Accounting

Responsibility Accounting

1. Chapter 10 Responsibility Accounting

2. TABLE OF CONTENTS Summary Understand the meaning and essential and features of responsibility accounting. Steps involved in responsibility accounting. Responsibility centres -cost ,profit and investment centres . Transfer prices. Advantages of responsibility accounting

3. SUMMARY

4. SUMMARY Responsibility accounting is a system of dividing an organization into similar units, each of which is to be assigned particular responsibilities. These units may be in the form of divisions, segments, departments, branches, product lines and so on. Each department is comprised of individuals who are responsible for particular tasks or managerial functions. The managers of various departments should ensure that the people in their department are doing well to achieve the goal. Responsibility accounting refers to the various concepts and tools used by managerial accountants to measure the performance of people and departments in order to ensure that the achievement of the goals set by the top management. Responsibility accounting, therefore, represents a method of measuring the performances of various divisions of an organization. The test to identify the division is that the operating performance is separately identifiable and measurable in some way that is of practical significance to the management. Responsibility accounting collects and reports planned and actual accounting information about the inputs and outputs of responsibility centers.

5. SUMMARY A responsibility center is a part or subunit of a company for which a manager has authority and responsibility. The company's detailed organization chart is a logical source for determining responsibility centers. The most common responsibility centers are the departments within a company. When the manager of a responsibility center can control only costs, the responsibility center is referred to as a cost center. If a manager can control both costs and revenues, the responsibility center is known as a profit center. If a manager has authority and responsibility for costs, revenues, and investments the responsibility center is referred to as an investment center.

6. SUMMARY Steps in Responsibility Accounting: To make responsibility accounting effective and efficient, the following steps are suggested: ( i ) Targets are set and should be communicated to each manager Or executive. (ii) A continuous appraisal of actual performance is to be made and actual results are to be conveyed to each manager of concerned responsibility centre . (iii) The variances are to be reported to the higher management together with the names of managers of responsibility centres . (iv) The corrective measures are to be suggested or taken and communicated to the concerned manager of each responsibility centre .

7. SUMMARY Transfer pricing is the method used to sell a product from one subsidiary to another within a company. It impacts the purchasing behavior of the subsidiaries, and may have income tax implications for the company as a whole. Here are the key issues: Revenue basis . The manager of a subsidiary treats it in the same manner that he would the price of a product sold outside of the company. It forms part of the revenue of his subsidiary, and is therefore crucial to the financial performance on which he is judged. Preferred customers . If the manager of a subsidiary is given the choice of selling either to a downstream subsidiary or to outside customers, then an excessively low transfer price will lead the manager to sell exclusively to outside customers, and to refuse orders originating from the downstream subsidiary. Preferred suppliers . If the manager of a downstream subsidiary is given the choice of buying either from an upstream subsidiary or an outside supplier, then an excessively high transfer price will cause the manager to buy exclusively from outside suppliers. As a result, the upstream subsidiary may have too much unused capacity, and will have to cut back on its expenses in order to remain profitable.

8. SUMMARY 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.

9. Understand the meaning and essential and features of responsibility accounting Section 1

10. MEANING AND DEFINITION OF REPONSIBILITY ACCOUNTING Responsibility accounting is a system of accounting that recognizes various responsibility centres throughout the organization and actions of each of these centres by assigning particular revenues and costs to the one having the pertinent responsibility. It is also called profitability accounting and activity accounting. Charles, T.Horngreen Responsibility accounting is that type of management accounting that collects and reports both planned actual accounting information in terms of responsibility centres .” Anthony and Reece

11. FEATURES OF RESPONSIBILITY ACCOUNTING 1 . INPUTS AND OUTPUTS OR COST AND REVENUE : The implementation and maintenance of responsibility accounting system is based upon information relating to inputs and outputs. Inputs expressed In the monetary term are known as cost and output expressed in monetary terms are called revenue. 2 . PLANNED AND ACTUAL INFORMATION OR USAGE OF BUDGETING : Effective responsibility accounting requires both planned and actual financial information . It is not only the historical cost and revenue data but also the planned future data which is essential for the implementation of responsibility accounting system . It is through budget that responsibility for implementing the plans is communicated to each level of management.

12. FEATURES OF RESPONSIBILITY ACCOUNTING 3. IDENTIFICATION OF RESPONSIBILITY CENTRES : For effective control ,a large firm isusually ,divided into meaningful segments ,departments or divisions of organization are called responsibility centres . Responsibility centres are usually classified under three categories : 1)cost centres ; 2)profit centres ; 3)investment centres 4. RELATIONSHIP BETWEEN ORGANISATION STRUCTURE AND RESPONSIBILITY ACCOUNTING SYSTEM : A sound organization structure with clear cut lines of authority –responsibility relationship is a prerequisite for establishing a successful responsibility accounting system. Further ,responsibility accounting system must be so designed as to suit the organisation structure of the organisation .

13. FEATURES OF RESPONSIBILITY ACCOUNTING 5. ASSIGNING COST TO INDIVIDUALS AND LIMITING THEIR EFFORTS TO CONTROLABLE COSTS : Only those costs and revenues over which an individual has a definite control can be assigned to him for evaluating his performance .Responsibility accounting has an appeal because it distinguishes between controllable and uncontrollable cost CONTROLABLE COST : are those costs which can be controlled or influenced by a specified person or a level of management of an undertaking. UNCONTROLABLE COST : are those which cannot be so controlled or influenced by the action of specified individual or undertaking.

14. FEATURES OF RESPONSIBILITY ACCOUNTING 6. TRANSFER PRICING POLICY : In large scale enterprises having decentralized divisions ,there is a common practice of transferring of goods and services from one segment of the organization to another .in such situation ,there is a need to determine the price at which the transfer should take place so that cost and revenues could be properly assigned .The significance of the transfer price can well be judged from the fact that for transferring division it will be a source of revenue , whereas for the division to which transfer is made it will be an element of cost .

15. FEATURES OF RESPONSIBILITY ACCOUNTING 7. PERFORMANCE REPORTING :As responsibility account is a control device .A control system to be effective should be such that plans must be reported at the earliest so as to take corrective action for the future. The deviations can be known only when performance is reported . Thus ,responsibility accounting system is focused on performance reports also known as ‘responsibility reports’ ,prepared for each responsibility unit.

16. FEATURES OF RESPONSIBILITY ACCOUNTING 8. PARTICIPATIVE MANAGEMENT : The function of responsibility accounting system becomes more effective if participative or democratic style of management is followed, wherein ,the plans are laid or budgets/standards are fixed according to the mutual consent and the decisions reached after consulting the subordinates. It provides motivation to the workers by ensuring their participation and self imposed goals.

17. FEATURES OF RESPONSIBILITY ACCOUNTING 9. MANAGEMENT BY EXCEPTION : An effective responsibility accounting system must provide for management be exception, i.e., it should focus attention of the management on significant deviations and not burden them with all kinds of routine matters condensed reports requiring their attention must be sent to them particularly at higher levels of management.

18. FEATURES OF RESPONSIBILITY ACCOUNTING 10. HUMAN ASPECT OF RESPONSIBILITY ACCOUNTING : The aim of responsibility accounting is not to place blame. Instead it is to evaluate the performance and provide feed back so that future operations can be improved . Goals and objectives are achieved through people and hence responsibility accounting system should motivate people

19. Steps involved in responsibility accounting. Section 2

20. STEPS INVOLVED IN RESPONSIBILITY ACCOUNTING 1. The organisation is divided into various responsibility centres each responsibility centre is put under the charge of responsibility manager. The manger are responsible for the performance of their department. 2. The targets of each responsibility centre are set in . the targets or goals are set in consultation with the manager of the responsibility centre so that he may be able to give full information about his department. The goal of the responsibility centres are properly communicated to them

21. STEPS INVOLVED IN RESPONSIBILITY ACCOUNTING 3. The actual performance of each responsibility centre is recorded and communicated to the executives concerned and the actual performance is compared with goals set and it helps in assessing the work of these centres . 4. If the actual performance of a department is less than the standard set , then the variances are conveyed to the top management . The names of those persons who were responsible for that performance are also conveyed so that responsibility may be fixed.

22. STEPS INVOLVED IN RESPONSIBILITY ACCOUNTING 5. Timely action is taken to take necessary corrective measures so that the work does not suffer in future. The directions of the top level management are communicated to the concerned responsibility centre so that corrective measure are initiated at the earliest .

23. Responsibility centres -cost ,profit and investment centres . Section 3

24. TYPES OF RESPONSIBILITY CENTRES Responsibility Centre Cost/expense centre Profit centre Investment centre

25. TYPES OF RESPONSIBILITY CENTRES 1. Cost or Expense Centre : Cost centres are segments in which managers are responsible only for the cost incurred but have no revenue responsibilities. The performance of a cost centre is measured in terms of quantity of inputs used in producing a given level of output. A comparison between the actual input used and predetermined budgeted inputs is made to determine the variances which represent the efficiency of the cost centre . Cost centres can be further classified on the basis of (a)Types of cost (b)Functions performed

26. COST/EXPENSE CENTRE (classification on basis of type of cost) Cost/expense centre (classification on basis of type of cost) Engineered expense centres Discretionary expense centre

27. COST/EXPENSE CENTRE (classification by functional basis)

28. ENGINEERED AND DISCRETIONARY EXPENSE CENTRE

29. TYPES OF RESPONSIBILITY CENTRES 2. Profit centre : Responsibility centres may have both inputs and outputs. The inputs are taken as cost and outputs are revenues. The difference between the revenue and cost gives the profit. When a responsibility centre gets revenue from output, it will be called a profit centre .When the output is meant for outsiders ,then the revenue will be measured from the price charged from customers and if the output is meant for other responsibility centre ,then the management takes a decision whether to treat it as profit centre or not.

30. TYPES OF RESPONSIBILITY CENTRES 2. Profit centre : Establishment of profit centre may be suitable if the following conditions are satisfied: There exist a decentralized form of organization. The divisional manager has access to all relevant information needed for decision making. The divisional manager is sufficiently independent. Internal transfer of output from one division/ centre to another division are not significant. A definite measure of performance is available.

31. ADVANTAGES OF PROFIT CENTRE Establishment of profit centre offers the following advantages It encourages initiative as a manager of profit centre is subject to a lesser degree of control of the top management. It may improve the quality of decisions. It quickens the decision making process as these need not be referred to top management. It saves time of the top management. It enhances profit consciousness in the entire organization. It promotes competition amongst managers of various profit centres and improves their performance. It helps in training divisional managers for top management responsibilities.

32. DISADVANTAGES OF PROFIT CENTRE Loss of top management control over different divisions. Faulty decision at divisional level Conflict among individual interests of divisions and the organization as a whole. Too much emphasis on short term profitability Increased cost due to multiple requirement of facilities and personnel at each profit centre . Transfer pricing problems amongst profit centres

33. TYPES OF RESPONSIBILITY CENTRES 3. Investment centre : “An investment centre is an entity segment in which a manager can control not only revenue and cost but also investment ”.The manager is made responsible for properly utilizing the assets used in his centre and earn fair return on the amount employed in assets in his centre . The performance of an investment centre can be measured by relating profit to the investment base. The two commonly used methods are as follows: Return On Investment/Capital Employed Economic Value Added/Residual Income Approach

34. RETURN ON INVESTMENT/CAPITAL EMPLOYED It establishes the relationship between profits and capital employed. The term capital employed refers to the total investment made in the investment centre /business . RETURN ON CAPITAL EMPLOYED= NET PROFIT(BEFORE TAX)/CAPITAL EMPLOYED X100 OR ROI= NET PROFIT/SALES x SALES/CAPITAL EMPLOYED x 100 OR ROI= NET PROFIT RATIO x CAPITAL TURNOVER RATIO (Where , Net Profit = Total Assets – Current Liabilities)

35. ECONOMIC VALUE ADDED/RESIDUAL INCOME APPROACH Economic value added is a measure of performance evaluation the was originally employed by Stern Stewart and Co . It is a popular method used to measure the surplus value created by an investment or portfolio of investments . It is considered to be a better measure of divisional performance as compared to return on investment or assets. EVA= NET OPERATING PROFIT AFTER TAX – COST OF X CAPITALCAPITAL INVESTED OR EVA = CAPITAL EMPLOYED (Return on investment- cost of capital) According to this approach an investment can be accepted if surplus(EVA) is positive . It is only the positive EVA that will add value and enhance the wealth oF shareholders. EXAMPLE: Suppose an investment generates net operating profit after tax of $20 millions and cost of financing investment is $16 millions. The value added by the investment shall be $4 millions and hence it should be accepted.

36. Transfer prices Section 4

37. TRANSFER PRICES A Transfer price is a price used to measure the price of goods or services furnished by a profit centre to other responsibility centres within a company”. It is necessary for managerial evaluation within the company through profit centres in the cases where various profit centres exchange goods and services, Hence it is required to determine the monetary values , called transfer prices at which the transfer should take place so that cost and revenue could be properly assigned.

38. METHODS USED FOR DETERMINING THE TRANSFER PRICES 1. COST PRICE : Under this method goods and services are transferred from one segment of the company to another on the basis of unit cost of production of transferring division . Cost can be taken to be either the actual cost of production or the standard cost of production. Advantage : It is very simple and convenient. Disadvantage : Profit of the transferring centre shall be underestimated and that of the centre to which it is transferred is over estimated.

39. METHODS USED FOR DETERMINING THE TRANSFER PRICES 2. COST PLUS A NORMAL MARK-UP : To overcome the shortcomings of the first method ,companies add to the cost a margin of profit to determine the transfer price. So the transferring department charges the actual unit cost of production plus a mark up for profit. Advantage : It is very simple and convenient Disadvantage :Inefficiencies of one department is transferred to another department.

40. METHODS USED FOR DETERMINING THE TRANSFER PRICES 3. INCREMENTAL COST : Incremental cost can be computed in two ways depending upon the circumstances. In case entire production is transferred to another division within the same company, the incremental cost will be the total of variable cost of transferring centre plus any fixed costs which are directly attributable to that centre /division. The incremental cost so calculated suffers from the same defects as that of cost price method. The second approach may be used when goods and services are sold to outside customers as well as transferred within the same company. In such a case, incremental cost may be taken as the opportunity cost in the form of loss of revenue which the transferring division would have charged from the outside customers. The second approach is similar to the market price basis and is more useful for profit- centre analysis.

41. METHODS USED FOR DETERMINING THE TRANSFER PRICES 4. SHARED PROFIT RELATIVE TO THE COST . According to this method no price is charged for the intra company transfers. Rather out of the total sales revenue of the company the aggregate cost of various divisions is deducted to find out the profit for the company as a whole; and then the profit is shared by the various profit centres relative to the cost basis of each centre . Thus, in this method profit is shared according to the cost of each division. Disadvantage :inefficiencies are not evaluated, and hence, it is not an appropriate methodfor profit centre analysis                   Share of profit of a particular centre = Profit of the company cost of a centre     Total cost X 100                      

42. METHODS USED FOR DETERMINING THE TRANSFER PRICES 5.MARKET PRICE : In this method , the prices charged for intra-company transfers are determined on the basis of market price and not on the cost basis. There are three ways of computing the market price . Firstly , the prevailing market price , after making adjustment for discounts and other selling costs , may be taken as transfer price if there is an active market for goods and services transferred between division of the same company. The main advantage of this method is that it protects the profitability

43. METHODS USED FOR DETERMINING THE TRANSFER PRICES 6. STANDARED PRICE : Transferred prices can also be fixed on predetermined standard price basis. The standard price may be determined on the basis of cost of production and the prevailing market conditions. Thus, division working at less than the desired efficiency will show lesser profits as compared to the efficient divisions. However, difficulties may arise infixing the standard price agreeable to the different divisions.

44. METHODS USED FOR DETERMINING THE TRANSFER PRICES 7. NEGOTIATED PRICE : The intra-company transfer price can also be determined on the basis of negotiations between the buying and the transferring division. The price arrived at after negotiations will be mutually agreed price. Such a pricing method will be advantageous to both the divisions as well as the company as a whole. However, this method could be used only when both the buying as well as transferring divisions have alternative choices available with them.

45. METHODS USED FOR DETERMINING THE TRANSFER PRICES 8. DUAL OR TWO-WAY PRICE : According to this method, the transferring division is allowed to give credit at one price, whereas, the buying division is charged at a different price. It enables better evaluation of profit centres and avoids conflict among them on account of transfer prices. However, the total profits of the various segments would differ from the actual profit of the company as a whole. But, it poses no problems for the company as transfer prices are meant for internal purposes of performance evaluation only.

46. SELECTION OF TRANSFER PRICING METHOD The study of the various transfer pricing methods reveals that there is no particular method which could be termed as the best method for all situations. The selection of a particular method will depend upon the particular circumstances which may differ from case to case . However, the following general criteria should be kept in mind while determining the transfer price

47. SELECTION OF TRANSFER PRICING METHOD the transfer price should be objectively determinable ; the transfer price should compensate the transferring division and charge the buying division commensurate with the value of the goods/services exchanged; it should contribute to congruence between the goals of the divisions and the goals of the organization; it should provide for profit centre evaluation ; and it should maximize the efforts towards achievement of organizational goals.

48. Advantages of responsibility accounting Section 5

49. ADVANTAGES OF RESPONSIBILITY ACCOUNTING 1. Assigning of Responsibility : Each and every individual in the organization is assigned some responsibility and they are accountable for there work. Everybody knows what is expected of him. The responsibility can easily be identified as satisfactory and unsatisfactory performances of various persons are known. Nobody can shift responsibility to anybody else if something goes wrong. So, under this system responsibility is assigned individually.

50. ADVANTAGES OF RESPONSIBILITY ACCOUNTING 2. Improves Performance : The assigning of tasks to specific persons acts as a motivational factor too. The persons in charge for different activities know that their performance will be reported to the top management. They will try to improve their performance. On the other hand, it acts as a deterrent for low performance also because persons know that they are accountable for their work and they will have to explain for their low performance.

51. ADVANTAGES OF RESPONSIBILITY ACCOUNTING 3. Helpful in Cost Planning ; Under the system of responsibility accounting , full information is collected about costs and revenues. This data is helpful in planning of future costs and revenues, fixing of standards and preparing of budgets.

52. ADVANTAGES OF RESPONSIBILITY ACCOUNTING 4. Delegation and Control: This system enables management to delegate authority while retaining overall control. The authority is delegated according to the requirements of the task assigned. On the other hand, responsibility of various persons is fixed which is helpful in controlling their work. The control remains with top management because performance of every cost centre is regularly reported to it. So management is able to delegate authority and at the same time to retain control.

53. ADVANTAGES OF RESPONSIBILITY ACCOUNTING 5. Helpful in Decision-Making : Responsibility accounting is not only a control device but also helpful in decision-making. The information collected under this system is helpful to management in planning its future actions. The past performance of various cost centres also helps in fixing their future targets. So this system enables management to take important decisions.