Responsibility Accounting and Divisional Performance Measurement - 2 | Commerce & Accountancy Optional Notes for UPSC PDF Download

Essentials of Success of Responsibility Accounting

Responsibility accounting, on its own, does not yield benefits; its success depends on specific conditions and factors.
These conditions are outlined below:

• Support of All Levels of Management through "Participative Budgeting": The foundation of responsibility accounting lies in budgeted performance. Managers are more likely to be responsive to a budget they have actively contributed to through a participative budgeting process. When the responsibility center's budget is a result of negotiation between its manager and immediate supervisor, the manager is more motivated to achieve it. This active involvement in goal-setting enhances motivation and acceptance of resulting performance measures.
• Individual Manager's Responsibility: The system is built on the responsibility of individual managers who incur costs. Each manager should be held accountable for their expenditures.
• Separation of Costs into Controllable and Non-controllable Categories: The system necessitates the categorization of costs into controllable and non-controllable groups to facilitate effective control and evaluation.
• Restructuring the Organization Along Decision-Making Lines of Authority: The organization needs to be structured in alignment with decision-making lines of authority to ensure that responsibility centers are appropriately defined.
• Organization Plan Establishing Objectives and Goals: A well-defined organization plan that establishes clear objectives and goals is essential for the effective implementation of responsibility accounting.
• Delegation of Authority and Responsibility: Authority and responsibility for cost incurrence should be delegated through a system of policies and procedures.
• Motivation through Standards and Incentives: Individual motivation is enhanced by developing performance standards and offering incentives tied to achieving those standards.
• Timely Reporting and Analysis: Regular and timely reporting, coupled with analysis of differences between goals and actual performance, is crucial. A system of records and reports facilitates this process.
• Appraisal or Internal Auditing System: An appraisal or internal auditing system is needed to ensure that unfavorable variances are clearly identified. Follow-up and corrective action should be applied accordingly.
• In responsibility accounting, revenues and expenses are accumulated and reported by levels of responsibility to compare actual costs with budgeted performance data by the responsible manager. The ultimate goal is to satisfy the "data requirements for responsive control."

Segment Performance

• A segment or division within an organization can take the form of either a profit center, responsible for both revenues and operating costs, or an investment center, which also holds responsibility for assets in addition to revenues and operating costs.
• As an organization expands, the necessity to create divisions or segments arises to effectively control the operations of different units. This process requires accounting information that not only reveals the objectives and performances of individual divisions but also assesses whether each division is contributing to the overall interests of the organization. This section illustrates how segment data should be presented to enable meaningful decisions regarding segment performance.
• Managers of each segment have the autonomy to make decisions concerning the performance of their respective centers. Typically, a manager's performance is evaluated by comparing incurred costs with budgeted costs. Therefore, it is crucial to allocate appropriate costs to the relevant segments. When allocating costs, it's important to exclude costs related to general administration or the head office from being charged to any specific segment. This is because these costs remain constant regardless of the sales volume of each department and should not unfairly impact the evaluation of individual segment performance. By accurately allocating costs and presenting segment data in a meaningful manner, organizations can make informed decisions about the effectiveness and contributions of each division to the overall success of the organization.

Measuring Segment Performance

• The primary purpose of responsibility accounting is to evaluate the individual performance of segments within an organization. Managers of different cost centers within the organization are tasked with the responsibility of generating acceptable profits, typically measured through segment margin or the rate of return on sales for profit centers. Segment margin signifies the income earned by a specific segment.
• For the manager of an investment center, the responsibility extends to earning a specific rate of return on the segment's investment in assets. Various criteria can be employed to measure divisional performance, including profit on turnover, sales per employee, and sales growth.
• Two of the most widely used and popular criteria for evaluating divisional performance are:
  1. Return on Investment (ROI) 
  2. Residual Income (RI)

Return on Investment

Divisional operating profit is generally, used as a common measure of performance. But divisional profit by itself does not provide a basis for measuring a divisions performance in generating a return on the funds invested in the division. For example, Division A and Division B had an operating profit of Rs.1,00,000 and Rs.80,000 respectively does not necessarily mean that Division A was more successful than Division B. The difference in profit levels may be due to the difference in the size of the divisions. Therefore, a suitable measure may be used to scale the profit for the amount of capital invested in the division. One common method is Return on Investment (ROI) which will be calculated as follows :

If the investment in the Division A and Division B, in the above example was Rs. 10,00,000 and Rs.5,00,000 respectively,

If investment in respective divisions is considered, Division B is more profitable than division A.
The ROI of partial segment must be high enough to provide adequate rate of return for the firm as a whole. It is always better to require a segment to earn a higher minimum rate of return on their investment. To improve this rate of return, a segment can increase its return on sales, increase its investment turnover or do both. The other way of increasing ROI is to reduce expanses and investment. If a segment reduces its investment without reducing sales, its ROI will increase. The ROI for the firm as a whole must not fail to meet the goals of top management. Though ROI is used widely to measure the segment performance, it has many limitations. One of the most limitations is that it can motivate managers to act contrary to the aims of goal congruence. If managers are encouraged to have a high ROI, they may turn down investment opportunities that are above the minimum acceptable rate, but below the current ROI of the divisional performance. For example, where a division earns a profit

Suppose there is an opportunity to make an additional investment of Rs. 2,00,000 which would earn a profit of Rs. 40,000 per annum.  The ROI for additional investment is Assume that the company requires a minimum requires a minimum return of 15 per cent on its investment, the additional investment clearly qualifies, but it would reduce the investment centre ROI from 25% to 23.3% 

Consequently the manager of the division might decide not to make such an investment because the comparison of old and new returns would imply that performance had worsened. The centres manager might hesitate to make such investment, even though the investment would have positive benefit for the company as a whole.  To over come this drawback, Residual Income Method is used to evaluate the acceptability of a project proposal.

Residual Income

Residual income is the profit that remains after subtracting the cost of capital on investment, representing the excess of net earnings over the cost of capital. Any income exceeding the cost of capital contributes to the firm's overall profit. The cost of capital applied to each division is typically the same rate that applies to the entire organization. The higher the income earned beyond the cost of capital, the more favorable the financial position of the firm.
The formula for calculating Residual Income (RI) is as follows:
RI = Profit − (Capital Charge × Investment Centre Asset)
Here, capital represents the minimum acceptable rate of return on investment. This approach is employed as an alternative to or in conjunction with Return on Investment (ROI) for evaluating managerial performance. It serves to motivate managers to align their actions with the goals of the organization. The firm's objective is to maximize income above the cost of capital. When divisional managers are evaluated solely based on ROI, there is no guarantee that they will strive to maximize Residual Income. By encouraging managers to maximize Residual Income, they are inclined to accept all projects exceeding the minimum acceptable rate of return. This recognition of the limitations of ROI is why many managers consider Residual Income as a valuable metric, especially when ROI is impacted by new investments.

Transfer Pricing

• Large businesses often adopt a divisional organizational structure for effective management control. When divisions within a business supply their finished output to another division, the concept of transfer pricing comes into play. Transfer pricing refers to the price at which the supplying division sells its output to the user division. This price serves as revenue for the selling division and a cost for the buying division. It is important to note that this is an internal transfer and not an external sale. Transfer prices are established at the time of the transfer rather than waiting until the manufacturing process is completed and the goods are sold to an external party.
• The determination of appropriate transfer pricing poses a challenge, as it can significantly impact the performance evaluation of divisions. Questions arise about what the transfer price should be. Should it equal the manufacturing cost of the selling division or the amount at which the selling division could sell its output externally? Alternatively, should the transfer price be a negotiated amount between the selling division's manufacturing cost and the external market price? The selection of a transfer price depends on factors such as the nature of the product, product type, and the organization's policies.
• In this context, the transferring division aims to secure the highest possible price, while the receiving division seeks the lowest possible price. It is crucial to consider goal congruence when setting the transfer price. This ensures that the actions of one division do not adversely affect the overall performance of the entire group. Achieving alignment with organizational goals is a key consideration in determining transfer pricing to foster cooperation and overall success.

Methods of Transfer Pricing

Various methods exist for pricing the output of one division to another, and the choice of an appropriate transfer price significantly impacts decision-making, product costing, and the performance evaluation of different divisions within an organization.
These transfer pricing methods can generally be categorized into two broad groups: (1) Market Price Based and (2) Cost-based. Within each category, several alternative methods are employed:

Market Price Based Methods

• Market Price: This approach involves using an available market price or the price of a comparable product in the market. Both the selling and buying divisions can engage in transactions at this market price, and managers from both divisions are indifferent to trading internally or externally. This method is effective when there is a competitive external market for the transferred product, providing an opportunity cost for divisions considering internal purchases.
• Adjusted Market Price: Derived from the market price, this method involves adjustments to account for costs such as sales commissions and bad debts that should not be incurred within the divisions.
• Negotiated Price: This method comes into play when divisional managers have a basis for negotiation. The negotiated price can be based on various factors such as the contribution margin on the transferred product or the total cost proposed by the transferor or transferee. Negotiation occurs between these figures, and sometimes the negotiated price is based on manufacturing cost plus an additional percentage to approximate the market price.

Regardless of the basis chosen, the company must avoid arbitrary pricing between divisions to ensure fairness. Negotiated prices should not unfairly favor one division over another. While top-level management may impose negotiated prices at times, it is essential to maintain the autonomy of divisional managers and prevent distortion of the financial performance of any division.

Cost Price Based Methods

When external markets are nonexistent or information about external market prices is not readily available, companies may opt for cost-based transfer pricing methods. These methods include:

• Absorption Cost: Absorption or full cost is determined by considering the total cost incurred in manufacturing a product. When cost alone is used for transfer pricing, the selling division cannot realize any profit on the transferred goods. A disadvantage of this method is that any excess cost due to inefficiency may be passed on to other divisions.
• Cost Plus Profit Margin: Under absorption costing, where cost alone is used for transfer pricing, the selling division cannot make a profit on the transferred goods, which can be a disincentive. To address this, some companies set transfer prices based on cost plus a profit margin. This includes the cost of the item plus a markup or other profit allowance, allowing the selling division to obtain a profit contribution on the transferred units. However, this method shares the drawback of absorption costing, as inefficiencies may also affect other divisions.
• Marginal Cost: This method considers all costs that change in response to a change in the level of activity for transfer pricing. However, it may fail to motivate divisional managers as it does not contribute towards fixed overheads and profit.
• Standard Cost: Instead of using actual costs, standard costs are often employed for transfer pricing in cost-based systems to promote responsibility in the selling division and isolate variances within divisions. Using standard costs reduces the risk to the buyer, as they avoid being charged with the seller's cost overruns.
• Opportunity Cost: Opportunity cost represents the foregone opportunity by choosing one course of action over another. If goods are transferred internally, the organization might lose a contribution to profit that could have been obtained from an external sale. This approach is used to establish a range of transfer prices in imperfect market situations.

In situations where the selling division has sufficient sales in the intermediate market and would have to forgo those sales to transfer internally, the transfer price is equal to the differential cost to the selling division plus the implicit opportunity cost to the company if goods are transferred internally.
Differential costs are those that change based on alternative courses of action. The transfer is encouraged as long as the transfer price is greater than the opportunity cost of the selling division and less than the opportunity cost of the buying division. A transfer is in the company's best interest if the opportunity cost for the selling division is lower than the opportunity cost for the buying division.
Regardless of the method adopted, transfer prices play a crucial role in measuring divisional performance. The chosen method should not only be fair to each division but also align with the overall best interests of the company. The use of inappropriate transfer prices may lead to conflicts among different divisions and hinder the enterprise's ultimate objectives.