Management Accounting Concepts & Techniques for Performance Measurement
Jazz
RESPONSIBILITY ACCOUNTING & TRANSFER PRICING
DECENTRALIZATION AND PERFORMANCE MEASURES
RESPONSIBILITY ACCOUNTING- a system of accounting that is implemented to an organization so
that performance, in terms of costs and/or revenues, are recorded and reported by levels of
responsibility within an organization.
RESPONSIBILITY ACCOUNTING
Cost Center
Revenue Center
Profit Center
Controllable
Non-controllable
Controllable
Non-controllable
Controllable
Non-Controllable
Investment Center
Controllable
Non-controllable
“ROI”
PERFORMANCE
REPORT
Direct Labor
Maintenance Expense
Supplies Expense
(among others)
……………………
……………………
……………………
……………………
“EVA”
“Residual Income”
STEPS IN IMPLEMENTING RESPONSIBILITY ACCOUNTING
1) Responsibility accounting requires that costs and/or revenues be classified according to
responsibility centers.
RESPONSIBILITY CENTER-is a segment of organization that is engaged in the performance of
a single function or a group of closely related functions. This segment is usually governed by
a manager, who is accountable and responsible for the activities of the segment. Also
called accountability center.
TYPES OF RESPONSIBILITY CENTERS:
a. COST CENTER-managers are held responsible for the costs incurred by the segment.
b. REVENUE CENTER-managers are held primarily for revenues of the segment
c. PROFIT CENTER-managers are held responsible for both revenues and costs of the
segment
d. INVESTMENT CENTER-managers are held responsible for revenues, costs, and
investments. The central performance is measured in terms of the use of the assets as
well as revenues earned and the costs incurred. The following may be used as basis
of evaluating performance:
 Return on investment (ROI) = operating Income/Operating Assets
= Margin x Turnover
Where: margin = operating Income/Sales
Turnover = Sales/Operating Assets
ROI computation is based on the DuPont formula:
Return on Assets = Assets Turnover x Return on Sales
 RESIDUAL INCOME – REQUIRED INCOME
Where: Required Income = Operating Assets x Minimum ROI
Economic value-added (EVA)-more specific version of residual income that measures the
investment center’s real economic gains. It uses the weighted-average cost of capital
(WACC) to compute the required income.
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Management Accounting Concepts & Techniques for Performance Measurement
Jazz
EVA = Operating Income after Tax – required Income
Where: required Income = (Total Assets – Current Liabilities) x WACC
STEPS IN IMPLEMENTING RESPONSIBILITY ACCOUNTING (CONTINUED)
2) Within each responsibility center, costs should be classified either controllable or noncontrollable.
Generally, all costs are controllable. The key difference lies in the level of management
who can control the costs:
 CONTROLLABLE COSTS are those items that may be directly regulated at lower levels
of management.
 NON-CONTROLLABLE COSTS are costs that cannot be regulated at a particular
management level other than the top level.
Costs may also be classified into DIRECT (attributable to a particular segment) or INDIRECT
(Common to a number of segments), the latter being subject to arbitrary allocation.
3) Within the controllable classification, costs shall be further classified according to the
nature of expense.
4) A performance report us furnished by each center and reported to the appropriate
level of management.
The PERFORMANCE REPORT is the end product of responsibility accounting process. It is a
report that shows and compares actual results with the intended (budgets or standards)
results of a responsibility center, thereby highlighting deviations that need corrective
actions.
The ‘contribution’ format to computing results of operations (income) is emphasized in
responsibility accounting. This income statement presentation highlights controllability of
costs by behavioural classification. In addition to the usual variable costs and fixed costs, a
more detailed classification of costs may be made. Consider the following illustrative
example:
Sales
Variable manufacturing costs
Manufacturing contribution margin
Variable selling and administrative costs
Contribution margin
Controllable fixed costs:
Manufacturing
Selling and administrative
Short-run performance margin
Non-controllable fixed costs:
Depreciation
Rent and leases, insurance
Segment margin
Allocated common costs
Income
P500,000
(150,000)
P350,000
(50,000)
P300,000
P 100, 000
75, 000
P 40, 000
10, 000
(175, 000)
P 125, 000
(50, 000)
75, 000
(30, 000)
P 45, 000
TRANSFER PRICING
TRANSFER PRICE = the amount charged by one segment of a firm for products or services that
are supplied to another segment of the same firm. It is also known as intersegment price.
PRIMARY OBJECTIVE
To evaluate performance by virtually transforming cost centers into profit centers so that
performance of the manager mainly cost centers can be measured reliably in terms of
both revenues and expenses.
SECONDARY OBJECTIVE
To save on costs involved in producing or buying a product by in-sourcing rather than
outsourcing.
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Management Accounting Concepts & Techniques for Performance Measurement
Jazz
Cost Center
virtually
transforms
into
Cost Center
Profit Center
BASIS OF TRANSFER PRICE
 COST-BASED TRANSFER PRICE
o Variable cost
o Full cost
o
o



Full absorption cost
Cost-plus
MARKET-BASED TRANSFER PRICE
o Market price
o Modified market
( variable and fixed manufacturing and nonManufacturing costs)
(variable and fixed manufacturing costs)
(variable costs /full costs /full absorption costs
plus mark-up)
(regular selling price)
(selling price adjusted for any allowance for d
discounts, etc.)
NEGOTIATED PRICE
ARBITRARY PRICE
MAXIMUM vs. MINIMUM TRANSFER PRICES
For transfer pricing not to defeat its purpose, organization normally sets a limitation as to the
transfer price being charged by one segment to the other segments. To minimize the effects of
sub-optimization, a range for transfer price must be set based on the following limits:
 UPPER LIMIT
MAXIMUM TRANSFER PRICE = COST OF BUYING FROM OUTSIDE SUPPLIERS**
 LOWER LIMIT
MINIMUM TRANSFER PRICE = VARIABLE COST PER UNIT + LOST CM PER UNIT on outside
sales
**Strictly the higher amount of:
1. Cost of buying from outside suppliers, OR
2. Selling price to outside customers.
When a company segment is operating at full capacity, the lost CM per unit on outside sales is
the opportunity cost of transferring products to another company segment, instead of selling
products to outside customers.
DUAL PRICING CONCEPT
The ‘selling’ center could transfer to another segment at the usual market price that would
be paid by an outsider. The ‘buying’ center, however, would record a purchase at the
variable cost of production. This practice is now rarely applied because neither manager
from both the buying and selling center must exert much effort to show a profit on a
segmental performance reports.
TRANSFER PRICING DECISION CONSIDERATIONS

GOAL CONGRUENCE FACTORS
Will the transfer price promote the goals of company as a whole?

SEGMENTAL PERFORMANCE FACTORS
Will the transfer price promote the interest of the segment under the manager’s
responsibility?
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Management Accounting Concepts & Techniques for Performance Measurement
Jazz

CAPACITY FACTORS
Does the seller have excess capacity to accommodate further inter-segment transfer?

COST STRUCTURE FACTORS
What portions of production costs are variable or fixed, direct or indirect?
DECENTRALIZATION
DECENTRALIZATION-refers to the separation or division of the organization into more
manageable units wherein each unit is managed by an individual who is given decision
authority and is held accountable for his or her decisions.
DECENTRALIZATION-RELATED CONCEPTS
GOAL CONGRUENCE=all units of organization have incentives to perform for a common
interest. The purpose of a responsibility system is to motivate management performance
that adheres to company overall objectives.
SUB-OPTIMIZATION= this happens when one segment of a company takes action that is in its
own best interests but is detrimental to the firm as a whole.
NOTE: Aside from its control function, responsibility accounting is designed to achieve goal
congruence and discourage sub-optimization within an organization.
ORGANIZATIONAL CHART=a chart that shows the responsibility relationship among
managers in an organization. It sets forth each principal management position and helps
define authority, responsibility, and accountability. A well-designed organizational chart
helps a decentralized organization in carrying out duties with clear lines of responsibilities
delegated to each of the segment of an organization.
BENEFITS OF DECENTRALIZATION:
1. Better access to local information
2. Cognitive limitations
3. More timely response
4. Focusing of central management
5. Training and evaluation
6. Motivation
7. Enhanced competition
COSTS OF DECENTRALIZATION
1. Some decisions made in one sub-unit may bring about negative effect to the other subunits or the organization as a whole.
2. Decentralization necessitates a more elaborate reporting system hence, the costs of
gathering and reporting of data increase.
3. Job duplication or overlapping of functions is usually encountered in a decentralized set-up.
THE BALANCED SCORECARD: STRATEGIC-BASED CONTROL
The Balanced Scorecard is a strategic management system that defines a strategic-based
responsibility accounting system.
A strategy is defined as choosing the market and customer segments the business unit intends to
serve, identifying the critical internal and business processes that the unit must excel at to deliver
the value propositions to customers in the targeted market segments, and selecting the
individual and organizational capabilities required for the internal, customer, and financial
objectives.
The Balance Scorecard translates an organization’s mission and strategy into operational
objectives and performance measures for four different perspectives: the financial perspective,
the customer perspective, the internal business process perspective, and the learning and
growth (infrastructure) perspective.
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Management Accounting Concepts & Techniques for Performance Measurement
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Common Characteristics of Balanced Scorecards
1. It should be possible, by examining a company’s balanced scorecard, to infer its strategy
and the assumptions underlying that strategy.
2. The balanced scorecard should emphasize continuous improvement rather than just
meeting present standards or targets.
3. Some of the performance measures on the balanced scorecard should be non-financial.
4. The scorecards for individuals should contain only those performance measures they can
actually influence.
5. The ultimate objectives of the organization are usually financial, but better financial results
cannot be attained without improving customer’s perceptions of the company’s
products and services. In order to improve customer’s perceptions of products and
services, it is usually necessary to improve internal business processes so that the products
and services are actually better. And in order to improve the business processes, it is
necessary that employees learn.
The balanced scorecard as a motivation and feedback mechanism. The performance measures
on the balanced scorecard provide motivation and feedback for improving.
The Financial Perspective
The financial perspective establishes the long and short term financial performance
objectives. The financial perspective is concerned with the global financial consequences of the
other three perspectives. Thus, the objectives and measures of the other perspectives must be
linked to the financial objectives. The financial perspective has three strategic themes: revenue
growth, cost reduction, and asset utilization.
The Customer Perspective
The customer perspective is the source of the revenue component for the financial
objectives. The perspective defines and selects the customer and market segments in which the
company chooses to compete.
The Process Perspective
To provide the framework needed for this perspective, a process value chain is defined. The
process value chain is made up of three processes: the innovation process, the operations
process, and the post sales process.
Cycle time is the time required to produce one unit of product.
Velocity is the number of units that can be produced in a given period of time
The Learning and Growth Perspective
The learning and growth perspective is the source of the capabilities that enable the
accomplishment of the other three perspectives’ objectives.
INTERNAL BUSINESS PROCESS PERFORMANCE MEASURES
a.
Delivery Cycle Time. This is the total elapsed time between when an order is placed by a
customer and when it is shipped to the customer. Part of this time is wait time that occurs
before the order is placed into production.
b.
Throughput (Manufacturing Cycle) Time. This is the total elapsed time between when an
order is initiated into production and when it is shipped to the customer. It consists of process
time, inspection time, move time, and queue time. The only element that adds value is
processing time. Inspection time, move time, queue time, and their associated activities do
not add value and should be minimized.
c.
Manufacturing Cycle Efficiency (MCE). MCE is the ratio of value-added time (process time)
to total throughput time. It represents the percentage of time an order is in production in
which useful work is being done. The rest of the time represents non-value-added time
(inspection time, move time and queue time).
MCE =
Processing time_______________
Processing time + move time + inspection time + wait time
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Management Accounting Concepts & Techniques for Performance Measurement
Jazz
QUALITY COST MEASUREMENT:
Quality-linked activities are those activities performed because poor quality may or does exist.
Costs of quality are costs that exist because poor quality may or does exist.
Control Activities are performed by an organization to prevent or detect poor quality. Control
costs are the costs of performing control activities. There are two broad categories of control
costs: prevention costs and appraisal costs. Prevention costs are incurred to prevent poor quality
in the products or services being produced. Appraisal costs are incurred to determine whether
products and services are conforming to their requirements or customer needs.
Failure activities are performed by an organization or its customers in response to poor quality.
Failure costs are the costs incurred by an organization because failure activities are performed.
There are two broad categories of failure costs: Internal and external failure costs. Internal failure
costs are incurred because products and services do not conform to specifications or customer
needs and the nonconformance is detected prior to being delivered to outside parties. External
failure costs are incurred because products or services fail to conform to requirements or satisfy
customer needs and the nonconformance is detected after being delivered to outside parties.
Exercises:
1. Given the following information for the Jazz Division:
Asset base
Sales Revenues
Expenses
P500,000
P725,000
P662,500
Required:
A.
What are the margin, turnover, and ROI for Reardon Division?
B.
Reardon has an option to make an additional investment that would add
P100,000 to the asset base. It would generate an additional P50,000 in sales
revenue and no additional expenses. What would be the effect on margin,
turnover and ROI?
C.
Another option (independent of alternative B) for Reardon is to run an
advertising campaign that would require additional advertising expenses of
P37,500, but the best estimate is the campaign would generate an additional
P75,000 of revenue. What would be the effect on margin, turnover and ROI?
2. Jazz Manufacturing earned operating income last year as shown in the following income
statement:
Sales
Cost of goods sold
Gross margin
Selling and administrative
expense
Operating income
P620,000
P316,000
P304,000
P219,000
P85,000
Less: Income taxes (at 40%)
P34,000
Net income
P51,000
At the beginning of the year, the value of operating assets was P263,000. At the end of the year,
the value of operating assets was P336,000. Monfett Manufacturing requires a minimum rate of
return of 15%. Total capital employed equal P350,000 and actual cost of capital is 6%.
A. Average operating assets
B. Margin
C. Turnover
D. Return on investment
E. Residual Income
F. EVA
(Carry computations out to two decimal places.)
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Management Accounting Concepts & Techniques for Performance Measurement
Jazz
3.
Pretty Lady is an upscale boutique that operates various stores throughout Florida. The
company, which has three divisions (Miami, Naples, and Tampa), reported the following
information for the year just ended (in thousands):
Sales revenue
Divisional contribution margin
Profit margin controllable by division
manager
Divisional profit margin
Miami
P9,000
6,400
1,500
Naples
P6,000
4,400
1,900
Tampa
P5,000
3,500
1,000
1,000
700
200
Pretty Lady also reported P600 of common fixed expenses that top management wants
to allocate to the divisions on the basis of sales revenue. As the company's chief
executive office notes, "Each division helped to incur a portion of these costs and, as a
result, should absorb its fair share." The firm has adopted various responsibility accounting
procedures to evaluate division personnel.
Required:
A. Compute the company's total sales revenue.
B. Calculate the amount of variable operating expense incurred by the Naples Division.
C. Calculate the fixed costs controllable by Miami's management.
D. Calculate the fixed costs traceable to the Tampa Division but controllable by others.
E. Pretty Lady desires to promote a division manager to the corporate office to oversee
selected operations. In determining which individual to promote, should Pretty Lady's
top management focus on the profit margin controllable by the division manager or
the overall divisional profit margin? Briefly explain.
F. If the company follows the desires of top management, how much of the common
fixed expenses would be allocated to the Tampa Division?
G. Do cost allocations such as those in part "F" typically appear on a segmented income
statement?
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