COST MANAGEMENT BASICS
COST ACCOUNTING
1
Agenda
•
•
•
•
•
•
Accounting Overview
Financial Accounting
Budgetary Accounting
Management Accounting
Output Costs
Transfer Pricing
2
Accounting Overview
3
Definition of Accounting
“is the production of financial records about an
organization. Accountancy generally produces
financial statements that show in money terms the
economic resources under the control of
management; selecting information that is relevant
and representing it faithfully. The principles of
accountancy are applied to accounting, bookkeeping,
and auditing.”
Source Wikipedia
4
Accounting Domains
Financial Accounting – focuses on reporting to external
users (e.g. investors, creditors, and governmental agencies) to
communicate a financial position
Budgetary Accounting - the process of implementing a
budget and the consumption of the budget utilizing special
subset of accounts. An additional accounting requirement for
State or Federal Government funded entities
Cost Accounting – records, measures, analyzes and
reports financial and non-financial information to managers to
aide in making decisions to meet objectives. Commonly
referred to as managerial accounting
5
Financial Accounting
• Concerned with preparation of financial statements for
external users (e.g. investors, creditors, and governmental
agencies) to communicate a financial position
• Primary users are external looking to judge the health of the
entity and for comparison with other entities
• Not intended for day-to-day running of the
company/organization since historical in nature (monthly,
quarterly, annual reports)
• Govern by local and international accounting standards; e.g.
Financial Accounting Standards Board (FASB)
• Follows Generally Accepted Accounting Principles (GAAP)
• Certification/Professionals are CPAs
• Has limited influence on employee behavior outside of
employee stock holding
6
Budgetary Accounting
• Concerned with preparation of budgetary statements for
external users (e.g. governmental agencies) to communicate
a budget position
• Primary users are external looking to judge the compliance of
a government entity to funded Budgets
• Not intended for day-to-day running of the
company/organization since historical in nature (monthly,
quarterly, annual reports)
• Govern by oversight entities; e.g. Government Accounting
Standards Board (GASB),
• Typically follows Generally Accepted Accounting Principles
(GAAP) with some differences
• Certification/Professionals are CGFMs
• Has limited influence on employee behavior (influences when
to consume budget)
7
Cost/Managerial Accounting
• Concerned with preparation of statements for internal users
(e.g. Product Line or Customer Managers) to communicate a
Profit/Loss position
• Primary users are internal management looking to benchmark
the management of inputs with corresponding outputs
• Intended for day-to-day running of the company/organization
since predictive in nature (daily, monthly, quarterly, annual,
forecasts, simulations)
• Not governed to a specific rule or formatting; focus is
information to make appropriate decisions
• Typically follows Generally Accepted Accounting Principles
(GAAP) with some differences
• Certification/Professionals are any focusing on
efficiency/effectiveness or performance improvements (e.g.
CMAs, Internal Auditors, PMPs)
• Designed to influence employee behavior (change process to
decrease costs, spend $ to increase market-share, etc.)
8
Summary of Accounting Domains
Financial
Accounting
Budgetary
Accounting
Managerial
Accounting
Purpose
Communicate financial
position to outsiders
Communicate Budget
position to outsiders
Decision making
Primary
Users
External users
External users
Internal managers
Regulating
Bodies
SEC, IRS, FASB, IASB
OMB, GASB, GAO
IMA/IFAC
Focus/
Emphasis
Past-oriented
Past-oriented
Future-oriented
Rules
GAAP compliant;
CPA audited
Modified GAAP
Do not have to follow
GAAP; cost vs. benefit
Time Span
Historical monthly,
quarterly reports
Historical monthly,
quarterly reports
Ultra current to very long
time horizons
Behavioral
Impacts
Indirect effects on
employee behavior
Indirect effects on
employee behavior
Designed to influence
employee behavior
4
Financial Accounting
10
Accounting Methods
• Cash Basis: Record when Pay
Plan
Order
Receive
Pay
• Accrual Basis: Record when receive the Benefit
Plan
Order
Receive
Pay
11
The Accrual Basis of Accounting
• Focuses on exchange of Economic Resources
• Records Revenues in the period in which they
are EARNED
– Providing a service
– Selling a product
Plan
Take
Orders
Complete
Service or
Ship
Product
Collect
Cash
Revenue & Non-Cash Asset
12
Revenue Comparison
• Cash Basis:
Plan
Take
Orders
Complete
Service or
Ship
Product
Collect
Cash
Complete
Service or
Ship
Product
Collect
Cash
• Accrual Basis:
Plan
Take
Orders
Revenue & Non-Cash Asset
13
The Accrual Basis of Accounting
• “Matches” Revenues with Expenses
• It takes money to make money
• Records Expenses in period INCURRED
• Resources Consumed
Plan
Order
Receive
Pay
Asset & Liability  Remove Liability 
Expense
14
What is the Accounting Cycle?
The Accounting Cycle is the
systematic process by which
accounting information is
recorded, compiled, and
reported to users.
15
The Financial Accounting Cycle
Record
Post-Closing Transactions
Post to
Trial Balance
Ledger
Close
Accounts
Prepare
Statements
Adjusted
Trial Balance
Prepare
Trial
Balance
Adjust
Accounts
16
The Journal
• Accounting events are recorded in the JOURNAL
– The Journal is a chronological record of all
transactions
• Each transaction requires a journal entry
• Each journal entry consists of at least one Debit and
one Credit: “Double Entry” Accounting
• Debit amounts must equal Credit amounts
• Debit: an entry on the left-hand side of the account
• Credit: an entry on the right-hand side of the account
17
Debits and Credits
• Debits and credits are neutral
– Debit ≠ decrease
– Credit ≠ increase
– It depends on the type of account
• Some accounts types record increases with a
debit, some record increases with a credit
• The side of the account which records an
increase is the account’s NORMAL BALANCE
18
Anatomy of a Journal Entry
Explanation of
Transaction
Amount Debited
& Credited
19
2 Basic Types of Adjustments
• Prepayments: Cash is paid before the resource
is consumed
– When cash is paid in advance, an asset is created
– At the end of the period, some of the asset may have
been consumed  expense
Pay
Consume
Record Asset  Reduce Asset, Record Expense
20
2 Basic Types of Adjustments
• Accruals: Resources have been consumed but
no cash has been paid
– Results in a liability
Consume
Pay
Expense & Liability  Remove Liability
21
Equipment and Depreciation
• Depreciation is the accounting process of
assigning a portion of equipment’s cost to the
periods in which it is used
• A portion of the benefit of owning the equipment
has been received in the current period 
expense
• The future benefit is reduced
• There is Financial depreciation which tends to
be straight-line (Tank life is expected to be 10
years) and Cost Depreciation which tends to be
usage-based (Tank life is 100000 kilometers)
22
Budgetary Accounting
23
Budgetary Accounting
• Provides a control mechanism to prevent
overspending funds
• Does proper budgetary accounting prevent
deficits? Why or why not?
• It DOES prevent overspending
• It does NOT prevent revenue shortfalls
• It does NOT prevent over-appropriating by the
legislative body
24
Current Army Focus
• Focused on the “Budget” domain
• The “Budget” domain consists of creation of the budget
requests/submissions, determination of the year of
execution budget (e.g. availability control and informal
budgets), actual execution, and reporting of the status of
execution against the budget (e.g. the PPB&E process)
• Primary focus of budget execution is the Obligation
(consumption of the budget)
• Budget Accounting focuses on 4 series accounts –
status of Budget and consumption
• Budget Management focuses on the status of available
funds, which includes both current and prior years funds
25
Budget Terms
• Budget = What Can Be Spent
• Commitment = a thought to procure a product/service
• Obligation = a promise to procure a product/ service
(e.g. to spend)
• Budget  Obligations
• Budget – Obligations = Availability (e.g. what is left to
spend)
• Expenditure is the receipt of the product/service
which was obligated (e.g. what was spent)
• Expenditures or collection of expenses/expenditures
determines Costs
• Disbursement is the outlay of cash
26
Budgetary Comparison
• Cash Basis:
Plan
Order
Receive
Pay
Receive
Pay
• Accrual Basis:
Plan
Order
• Budgetary Basis:
Commitment  Obligation
Plan
Order
 Expenditure  Disbursement
Receive
Pay
27
The Budgetary Accounting Cycle
Obtain Budget
Close Budget Revenue
Distribute
Year
to
Allotment
Manage
Availability
Commit
Funds
Disburse
Cash
Expense
Funds
Obligate
Funds
28
The Budgetary Accounts
• Exist solely for the purpose of recording and
tracking the budget
– Budget = a legally binding spending plan
• Account Titles:
–
–
–
–
Estimated Revenue = Expected Income
Appropriations = Authorized Spending
Budgetary Fund Balance = Planned Change
Unreserved Fund Balance = Savings
29
Procurement Process
Commitment
Obligation
Expenditure
Liability
Payment
30
Budgeting Participation
Encourage top-down
flow of information
and plans
Budgets
attempt to
Encourage bottomup flow of
information
31
Budget - Color of Money
Appropriations
Program Elements
OMA
$
IMCOM
$BOS
$SRM
$
AFH
$
Fund Centers
Jackson
$ GFEBS
Benning
Knox
RDT&E
Elements
Of Resources
Supplies
Training
Travel
Equipment
Labor
Etc.
32
Cost Vs.Budget
Knowing your obligations is not the same as knowing your costs!
Obligations
Costs
A legally binding commitment by the federal government that will result
in outlays, immediately or in the future. Budgetary resources must be
available before obligations can be incurred legally.
The price or cash value of resources used (expenditures) to produce a
program, project or activity. All relevant costs may not appear in the
organization’s budget.
Costs
Obligations
Cost will contain expenses
from different years, source
of funds, organizations, etc.
33
Budget vs Cost Domains
Budget Formulation
Budget Execution
Cost Management
Budget
–President’s financial plan
and the priorities for the
Federal Government
Budget Authority
–Authority to incur
obligations
Cost
–Valuation of resources
used to produce outputs,
basis for decision making
Focus
–requirements
Focus
–availability, obligations
Focus
–full costs, Plan vs. Actual
Key Data Elements
–appropriation, FTE
Key Data Elements
–appropriations, EOR’s,
PE, MDEP, projects,
BLIN, etc.
Questions
–What do I need?
–What will I ask for?
Questions
–What funding did I get?
–What obligations were
executed?
Key Data Elements
–operational entity (e.g.
cost centers), services,
rates, products, projects,
etc.
Questions
–What was expensed?
–What did I get for it?
–How well was it used?
34
Managerial Accounting
35
Three Common Features of
Cost Accounting
1. Calculates the cost of products, services, and
other cost objects
2. Tracks information for planning & control, and
performance evaluation
3. Analyzes relevant information for decision
making
36
An Easy Definition of Cost
…. “a cost is the value of money that has been used up to
produce something”
# Clean Dishes
37
Basic Cost Terms
• Cost: a sacrifice of resources
• Cost Object: any item or activity for which a separate
measurement of cost is desired – cost objects are the
“something” in a statement
• Cost Driver: any factor whose change ‘causes’ a
change in the total cost of a related cost object – cost
drivers can be factors other than volume
38
The Many Types of ‘Cost’
•
•
•
•
•
•
•
•
•
•
Direct Cost: a cost such as labor, material/supplies that can be
directly traced to producing a specific output of organization,
product, or service
Indirect Cost: a cost that cannot be directly traced to a specific
organization, product or service output
Funded Cost: the value of goods or services received because of
an obligation of funds (obligation authority), by an organization
performing the work
Unfunded Cost: a cost that is financed by another organization’s
or activity’s appropriations
Variable Cost: a cost that changes with change in the output
Fixed Cost: a cost that remains the same regardless of the
change in output
Recurring Cost: a cost that is incurred repeatedly for each
organization and/or product and service produced
Non-recurring Cost: a cost that is unusual and unlikely to occur
again
Avoidable Cost: a cost incurred on an object that will no longer
be incurred due to a decision to change the output
Unavoidable Cost: a cost incurred on an object that will be
incurred regardless of the decision to change
•
•
Common understanding
of different types of
costs is necessary for
informed decision
making
Each decision should
be focused on ONLY
relevant cost that
impact the decision
39
Some Characteristics of Costs
Costs may be:
• Direct or indirect
• Recurring or nonrecurring
• Burdened or unburdened
• Variable or fixed
40
Direct vs. Indirect
Direct Cost
• Can be easily and conveniently traced to a specific cost
element/objective
– Example: The cost of ammunition fired in a training event at the firing
range
Indirect Cost
• Cannot be easily and conveniently traced to a specific cost
element/objective
– Example: Installation support to the firing range (utilities, upkeep, etc)
41
Recurring vs. Non-recurring
Recurring Cost
•
Cost that is incurred regularly in producing a product or providing a service
– Examples: Civilian and military personnel who conduct the activity,
recurring sustainment of facilities, supplies, personnel training, utilities,
equipment maintenance, janitorial service, office supplies
Non-Recurring Cost
• Cost that only occur once or infrequently.
– Examples: Major items of equipment, major and minor construction, onetime training in new procedures, activities conducted in direct support of
individual process improvement efforts
42
Burdened vs. Unburdened
Unburdened Cost
•
Cost of a product/service that does not consider other related costs necessary
to provide that product/service.
– Examples: Direct compensation, cost of a gallon of fuel in a theater of
operations, etc.
Burdened Cost
•
Cost of a product/service plus an apportioned cost of other related costs
necessary to provide that product/service.
– Examples: Salary plus the cost of benefits (health, retirement, etc.),
facilities support cost allocated to an activity or personnel
– There are degrees of burden in a CBA. For example:
• Direct compensation for military and civilian personnel is always
burdened with the cost of personnel benefits
• Facilities support cost is allocated to a COA only if it can
demonstrated that the COA causes the cost to be incurred
43
Variable vs. Fixed
Variable Cost
• A cost that varies based on the level of activity or output. This can be either a linear
relationship or a step function.
– Examples: Fuel cost for vehicles varies in a linear fashion relative to the number of
miles driven. The number of instructors needed to teach a class can vary in a step
function based on the number of students (e.g., 1 instructor for 25 students, 2
instructors for 26-50 students, etc).
Fixed Cost
• A cost that does not vary based on the level of activity or output.
– Example: At an Army installation, the cost associated with the commander and
his/her immediate staff is unlikely to vary as the installation population or other
variables change.
Fuel Cost as a
Function of Miles
Traveled
100
80
60
40
20
0
Instructors as a
Function of Class Size
5
4
3
2
1
Cost of Cmd Gp ($K)
as a Function of
Installation
Population
1000
900
800
700
600
500
400
300
200
100
0
0
100
200
300
Variable
400
Note: Most
5 10 15 20 25 30 35 40 45 50
costs are semiSemi-Variable
variable
Fixed Cost
44
Sunk Costs
Costs that have already been incurred and
cannot be changed no matter what action is
taken in the future are called Sunk Costs
Example: Paul is assembling his new home theatre system.
He has spend 5 hours thus far and estimates he will complete
the assembly in 2 more hours. Joan informs him he is doing
it the hard way and describes a simpler approach which will
take one hour to undo his work and re-assemble the system
completely
45
Opportunity Costs
• The size of a foregone opportunity of using
a resource is the Opportunity Cost
Example
• The opportunity cost of accepting a job is
forgoing the opportunity to do something
else with our time
• If our best alternative to working is playing
golf the opportunity cost of working is the
forgone opportunity of playing golf
46
Marginal Costs
• Marginal Costs are the costs to produce
one more additional unit of output
• Marginal costs are highest at very low
output rates and at output rates near
capacity
• The slope of the ‘Total Cost Curve’ at any
given level of production is the marginal
cost for one more unit
47
Marginal Costs
Total cost
C
Cost
High marginal costs
A
B
Lowest marginal costs
High marginal costs
Output
48
Average Costs
Average Cost is calculated by
dividing the total cost by the total
units produced
Average Cost is very high at low
levels of output
49
Cost Behavior
• Variable costs: changes in total in proportion to
changes in the related level of activity or volume
– Variable costs are constant on a per-unit basis
– If a product takes 5 pounds of materials each, it stays the same per unit
regardless of number of units produced
• Fixed costs: remain unchanged in total regardless of
changes in the related level of activity or volume
– Fixed costs change inversely with the level of production
– As more units are produced, the same fixed cost is spread over more units,
reducing the cost per unit
• Costs are fixed or variable only with respect to a specific
activity or a given time period
50
Cost Behavior Summarized
Total Dollars
Dollars
Cost per
Total
Per Unit
Unit
Change
in
Change
in proportion
Unchanged in
with outputwith
proportion
Variable Costs More output = More relation to output
Variable Costs
output
cost
More output = More cost
Fixed Costs
Fixed Costs
Change inversely
Change
inversely
Unchanged in
with output
with
output
relation
to output
Unchanged
in
More
output
More
output
= lower=cost
relation to output lower cost per
perunit
unit
51
Cost in More Detail
Resources
Resources
Consumed
“Cost” is a monetary measure of the sacrifice associated
with:
• expending resource functionality to achieve a specific objective, or
• utilizing resource output required to achieve a specific objective, or
• the provision of resource functionality or resource output while not
using it
52
Resources/Inputs
Cost = Converting and
Measurement of Work
Cost Center
Organization - Labor, Materials, Supplies
Asset / Equipment
Outputs
Project / Program
Plant, Property & Equipment
Building Project, Weapon System
Internal Order
Services, Events (SSP, Course)
WBS / Work Order
Job (Set of Tasks) – Maint & Repair
53
Problems in Identifying and
Measuring Costs
How do I measure the
cost of poor quality?
What is the cost of a
dissatisfied customer?
What is the cost of
requiring employees
to work overtime?
What is the cost of
using raw materials in
inventory?
Planning
Decisions
How do I measure the
cost of setting my
price too high?
What is the cost of
postponing this year’s
training program?
What is the cost
of using current
facilities?
54
Costing Philosophies
55
Costing Philosophies
When determining how to develop the cost model
to be utilized to generate the Cost Accounting data
there are multiple Costing Philosophies to be
considered:
• Standard Costing
• Traditional Costing
• Activity-based Costing
• Grenzplankostenrechnung (GPK)
• Resource Consumption Accounting (RCA)
56
Standard Costing
• Traces direct costs to output by multiplying the
standard prices or rate by the standard
quantities of inputs allowed for actual outputs
produced
• Allocates overhead costs on the basis of the
standard overhead-cost rates time the standard
quantities of the allocation bases allowed for the
actual outputs produced
• Replaced by Traditional Costing once actual
data collection was automated
57
Activities Based Costing
• “ABC as an approach to the costing and monitoring of
activities which involves tracing resource consumption and
costing final outputs. Resources are assigned to activities,
and activities to cost objects based on consumption
estimates. The latter utilize cost drivers to attach activity
costs to outputs1”
• ABC seeks to improve the tracing of indirect costs to
products/customer by recognizing the different levels of
activities that lead to indirect product/customer costs
• ABC is useful to provide visibility into support activities
required to address complexities in products or customers
• Typically Full-absorption (all costs associated to the product)
which caused inappropriate product/customer decisions
1
Source Wikipedia
58
Cost Allocation & Assignments
59
Accounting for Overhead
• Actual costs will almost never equal
budgeted/planned costs
• Accordingly, an imbalance situation exists
between the two overhead accounts
– If Overhead Control > Overhead Allocated, this is
called Under-allocated Overhead
– If Overhead Control < Overhead Allocated, this is
called Over-allocated Overhead
60
Accounting for Overhead
• This difference will be eliminated in the end-ofperiod adjusting entry process, using one of
three possible methods
• The choice of method should be based on such
issues as materiality, consistency and industry
practice
61
Cost Allocation
• Assigning indirect costs to cost objects
• These costs are not traced
• Indirect costs often comprise a large percentage
of Total Overall Costs
62
Purposes of Cost Allocation
63
Criteria for Cost-Allocation
Decisions
• Cause and Effect: variables are identified that
cause resources to be consumed
– Most credible to operating managers
– Integral part of ABC
• Benefits Received: the beneficiaries of the
outputs of the cost object are charged with costs
in proportion to the benefits received
64
Criteria for Cost-Allocation
Decisions
• Fairness (Equity): the basis for establishing a
price satisfactory to the government and its
suppliers
– Cost allocation here is viewed as a “reasonable” or “fair”
means of establishing selling price
• Ability to Bear: costs are allocated in proportion
to the cost object’s ability to bear them
– Generally, larger or more profitable objects receive
proportionally more of the allocated costs
65
Cost Allocation Illustrated
66
GFEBS Manual Cost Allocation
67
Allocating Costs of a Supporting
Department to Operating Departments
• Supporting (Service) Department: provides
the services that assist other internal
departments in the company
• Operating (Production) Department: directly
adds value to a product or service
68
Methods to Allocate
Support Department Costs
• Single-rate method: allocates costs in each
cost pool (service department) to cost objects
(production departments) using the same rate
per unit of a single allocation base
– No distinction is made between fixed and variable
costs in this method
69
Methods to Allocate
Support Department Costs
• Dual-Rate method: segregates costs within
each cost pool into two segments: a variablecost pool and a fixed-cost pool
• Each pool uses a different cost-allocation base
70
Allocation Method Tradeoffs
• Single-Rate method is simple to implement, but
treats fixed costs in a manner similar to variable
costs
• Dual-Rate method treats fixed and variable costs
more realistically, but is more complex to implement
71
Allocation Bases
•
Under either method, allocation of support costs
can be based on one of the three following
scenarios:
1. Budgeted overhead rate and budgeted hours
2. Budgeted overhead rate and actual hours
3. Actual overhead rate and actual hours
•
Choosing between actual and budgeted rates:
budgeted is known at the beginning of the
period, while actual will not be known with
certainty until the end of the period
72
Allocating Common Costs
• Common Cost: the cost of operating a facility,
activity, or cost object that is shared by two or
more users at a lower cost than the individual
cost of the activity to each user
73
Title IX
•
Unequal aggregate expenditures for members of each sex or unequal expenditures
for male and female teams if a recipient operates or sponsors separate teams will
not constitute noncompliance with this section, but the Assistant Secretary [of
Education for Civil Rights] may consider the failure to provide necessary funds for
teams for one sex in assessing equality of opportunity for members of each sex.
3 Prong Test:
• Providing athletic participation opportunities that are substantially proportionate to
the student enrollment. This prong of the test is satisfied when participation
opportunities for men and women are "substantially proportionate" to their
respective undergraduate enrollment.
• Demonstrating a continual expansion of athletic opportunities for the
underrepresented sex. This prong of the test is satisfied when an institution has a
history and continuing practice of program expansion that is responsive to the
developing interests and abilities of the underrepresented sex (typically female).
• Accommodating the interest and ability of underrepresented sex. This prong of the
test is satisfied when an institution is meeting the interests and abilities of its female
students even where there are disproportionately fewer females than males
participating in sports.
74
Output Costs
75
Capture Output Costs
Overview
• In addition to capturing cost, non-financial
quantity information is necessary to support Cost
Management
• Non-financial quantity information can be:
– Quantitative, e.g. # of helpdesk tickets, # students
– Qualitative, e.g. average # days to close helpdesk
ticket, % Completion Rate
76
Capture Output Costs
Decisions
• Does the output quantity support the cost by
BCT/ARFORGEN? HQ Need? or Field product/services?
– (e.g. ammo used for training, # soldiers)
• Is the output quantity currently used by
scheduling/operational managers on a timely basis?
• Can an output change the behavior of an
organization/individual to be more efficient and effective
(e.g. # cancelled course registrations in ATAARS)
• Are output quantities used for justifications and/or
requests for funding?
• If it supports cost management – efficiently & effectively then it is considered
77
Capturing Output Costs
Analysis
• Understanding the dollar amount of unit provided, based
on number delivered Cost/Per
• Understanding the relationship between Resource
Capacity to Output generation (e.g. 3 Hrs: 1 Output)
100%
80%
Capacity
60%
40%
Actual Output
20%
0%
Month 1
Month 2
Month 3
Month 4
Month 5 Month N
78
Capturing Output Costs
Analysis
• Visibility across the Army as to what tasks should costs
Number of Tickets
– Supports comparative
analysis between sites,
tasks, types of work, and
groups of resources to
identify best practice vs.
inefficiencies
– Allows for realization of
trade-offs between delivery
and resource consumption
Cost of Closing Tickets
79
Capture Output Costs
Analysis
2ABM0065: AMMO SUPPLY
2ABM0014: LEGAL (ILO)
Name
Cost
Element Amount
Amount Quantity
Quantity
Name Cost
Element
Ammo
Perm
9400.AMMO $5,000
6100.11B1
10hrs
EA
100
AMMO
FIRED
10
rounds
at $50
WARS
Training Event (UIC)
Name
Cost Element
Ammo
9400.AMMO
Amount
Quantity
$500
10 EA
Qty is
valuated
with rate
AMOUNT AND QUANTITY ARE
THE OUTPUTS OF THIS
PROCESS
80
Agency Problems
81
Various Types of Agency
Problems
• Moral Hazard
– Tendency to take risks because the costs that could incur will not
be felt by the party taking the risk. In other words, a tendency to
be more willing to take a risk, knowing that the potential costs or
burdens of taking such risk will be borne, in whole or in part, by
others.
• Free rider
– Benefiting from resources, goods, or services without paying for
the cost of the benefit.
• Adverse Selection
– The buyer of a good (or the seller) attracts potential sellers (or
borrowers) that offer low quality goods (have a high probability of
default). The quality of the goods is not readily observable.
Output Manipulation
• Managers may seek to manipulate income by
producing too many units
• Production beyond demand will increase the
amount of inventory on hand
• This will result in more fixed costs being
capitalized as inventory
• This will leave a smaller amount of fixed costs to
be expensed during the period
• Profit increases, and potentially so does a
manger’s bonus
83
Countermeasures for Output
Manipulation
• Careful budgeting and inventory planning
• Incorporate an internal carrying charge for
inventory
• Change (lengthen) the period used to evaluate
performance
• Include non-financial as well as financial
variables in the measures to evaluate
performance
84
Transfer Pricing
85
Transfer Pricing
• The amount charged when one division sells
goods or services to another division
• The transfer price affects the profit measure
for the selling division and the buying
division
86
The External and Internal
Transfer
of
Products
External
Supplier
Raw Materials
Division A
Intermediate
Product
Division B
Finished Product
External
Customer
87
Reasons for Transfer
Pricing
1. Control (incentives and performance
measures)
2. Decentralized planning decisions
3. International/tax reasons
88
Summary of Transfer Pricing
Methods
Method
Advantages
Disadvantages
Market-Based
•Approximates opportunity cost if competitive
market exists
•Excludes effects of internal transaction costs on
transfer price
•May not have external market for intermediate
goods
•Excludes effects of internal transaction costs of
transfer price
Variable Cost
•Approximates opportunity cost if fixed costs are
sunk
•Does not allow selling division to recover fixed
costs
•Provides incentive for selling division to convert
fixed costs to variable costs
Full Cost
•Reduces disputes as the figure is objective
•Simple to compute as it parallels accounting
system figures
•Approximates opportunity cost if division is
operating at capacity
•Overstates opportunity cost if excess capacity
exists
Negotiated
•Maintains managerial autonomy
•Preserves upper-management time
•Is time consuming and relies on negotiation
skills of divisional managers
•May not be the optimal transfer price for the firm
as a whole
•Can lead to conflicts between responsibility
centers
89
Control Issues
Transfer prices can be used as inputs to the
performance measurement system
Transfer pricing assigns costs to managers
who are responsible for the costs
90
Transfer Pricing
The ‘Parts’ division manufactures parts that it sells to
the ‘Assembly’ division
The cost to the ‘Parts’ division is £10 per unit.
The ‘Assembly division’ assembles the part at a cost of £4 per unit and
sells the product to another organization for £23 per unit.
What is the profit per unit if the transfer price is £12 each
What is the profit per unit if the transfer price is £10 each
Parts Division
£
Assembly Division
£
Revenue per unit
10
Revenue per unit
Parts cost per unit
10
Profit per unit
0
Parts Division
£
Assembly Division
£
23
Revenue per unit
12
Revenue per unit
23
Parts cost per unit
10
Parts cost per unit
10
Parts cost per unit
12
Assembly costs
4
Profit per unit
2
Assembly costs
4
Profit per unit
7
Profit per unit
9
91
Transfer Pricing for Decentralized
Planning Purposes
• Some divisions are required to buy internally
produced items
• The internal producer may not have an
incentive to keep costs down
• When managers have the choice to buy
“outside,” the internal producer must stay
competitive on both quality and cost
92
Transfer Prices for Decentralized
Planning Decisions
Circumstance
Transfer Price
Market price exists
Market price
No market price exists; supplying division has no
alternative use of capacity
Variable cost
No market price exists; supplying division has
alternative use of capacity
Full Cost*
*The full cost is intended to be a rough approximation of the forgone opportunity of using
the facilities of the supplying division to do something else
93
Choosing Transfer Prices
A transfer price that maximizes firm value (a
planning issue) may not maximize a manager’s
performance measure (a control issue)
Negotiated transfer prices are more effective when
there is an external market alternative
94
Globalization and Transfer
Pricing
Tax Minimization: if a multi-national transfers
products between two countries with different tax
rates the company will try to set a transfer price to
minimize its total tax liability in the two countries
Political Considerations can affect the transferpricing decision, if there is a risk of
expropriation of assets the company may use
high transfer prices to reduce the apparent
profitability of their foreign subsidiaries
95
Conclusion
96