Management Accounting
Quiz 07
1. Discuss “Responsibility Centers”.
a) Expense Center
- It is also known as a cost center. A cost or expense center is a
segment and division of an organization in which the managers are
held responsible for the cost incurred in that segment. They may not
be responsible for revenue. The expense center managers have
control over some or all of the costs in their segment of business but
not over revenues. In a manufacturing organization, the production
and service departments are classified as expense centers. In a
marketing department, a sales region or a single sales representative
may be taken as an expense center. The expense center managers
are responsible for the costs that are controllable by them and their
subordinates. There are two general types of expense centers l)
Engineered expense centers and 2) Discretionary expense centers
correspond to two types of costs. Engineered costs are those
elements of costs that can be predicted with a fair degree of accuracy
e.g. cost of raw material, direct labor, water, electricity, etc.
Discretionary costs (also called managed costs) are costs for which
output can't be measured in monetary terms, e.g. administrative and
support units like the accounts department, legal department, public
relations department, research, and development department, most of
the marketing activities, etc.
b) Revenues Center
- Revenue center is a segment of the organization which is primarily
responsible for generating sales revenue. The revenue center
manager has control over the expenses of the marketing department
but he has no control over cost or the investment in assets. The
performance of revenue center managers is evaluated by comparing
actual revenues with the budgeted revenue and actual marketing
expenses with budgeted marketing expenses.
c) Profit Center
- Profit Centre is a segment of business often called a division that is
responsible both for revenue and expenses. In a non-profit
organization, the revenue center may be used instead of the profit
center, as profit is not the primary objective of such an organization.
The main purpose of a profit center is to earn the targeted profit. In
fact, the profit center managers are more concerned with finding ways
to increase the center’s revenue by increasing production or
improving distribution methods. The performance of the profit center
is evaluated in terms of whether the center has achieved its budgeted
or target profit or not.
d) Investment Center
- An investment center is responsible for the profits and investment. If a
manager controls investment, that area of responsibility can be called
an investment center. He is responsible for the returns on the
investment. He is required to control the amounts invested is the
center’s assets. The manager of the investment center has more
authority and responsibility than the manager of either the cost center
or profit center.
2. Discuss transfer pricing and relate it with income taxation.
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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 subsidiaries,
affiliates, 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.
Transfer prices directly affect the allocation of groupwide taxable
income across national tax jurisdictions. Hence, a company’s transferpricing policies can directly affect its after-tax income to the extent
that tax rates differ across national jurisdictions.
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 manufactures
software, and Division B, which 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 on
to 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.
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.
3. Discuss transfer pricing and relate it to cost-cutting.
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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 reflective of 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 corporations (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 helps in reducing the duty costs by shipping goods
into high-tariff countries at minimal transfer prices so that the duty
base associated with these transactions is low. Companies even
lower their expenditure on interrelated transactions by avoiding tariffs
on goods and services exchanged internationally.
For example, consider ABC Co., a U.S.-based pen company
manufacturing pens at a cost of 10 cents each in the U.S. ABC Co.’s
subsidiary in Canada, XYZ Co., sells the pens to Canadian customers
at $1 per pen and spends 10 cents per pen on marketing and
distribution. The group’s total profit amounts to 80 cents per pen.
Now, ABC Co. will charge a transfer price of between 20 cents and 80
cents per pen to its subsidiary. In the absence of transfer price
regulations, ABC Co. will identify where tax rates are lowest and seek
to put more profit in that country. Thus, if U.S. tax rates are higher
than Canadian tax rates, the company is likely to assign the lowest
possible transfer price to the sale of pens to XYZ Co.
Companies use transfer pricing to reduce the overall tax burden of the
parent company and 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.