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Chapter 11

Chapter 11 part II BU247.docx

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BU247 Chapter 11 – Financial Control Week 12 Evaluating Responsibility Centres Using the Controllability Principle to Evaluate Responsibility Centres -The controllability principle states that the manager of a responsibility centre should be assigned responsibly only for the revenues, costs, or investments responsibility centre personnel control -Revenues, costs, and investments that people outside the responsibility centre control should be excluded from the assessment of the centre’s performance -A significant problem in applying the controllability principle is that in most organizations many revenues and costs are jointly earned or incurred -The activities that create the final product in this company are sequential and highly interdependent -Processing should be evaluated as a cost centre -The choice of the performance measure should influence decision-making behaviour Using Segment Margin Reports -The profit measure is so comprehensive and pervasive that organizations prefer to treat many of their organization units as profit centres -The segment margin report divides the organization into responsibility centres -One column is devoted to ach profit centre -Organizations use different approaches to evaluate whether the segment margin numbers are good or bad: 1. Past performance – Is performance this period reasonable, given past experience? 2. Comparable organizations – How does performance compare with similar organizations? -Segment margin statements should be interpreted carefully because they reflect many assumptions that disguise underlying issues -The segment margin report contains arbitrary numbers because they rely on subjective revenue and cost allocation assumptions over which there can be legitimate disagreement – these arbitrary numbers are called soft numbers -The revenue figures reflect important assumptions and allocations that sometimes can be misleading -Organizations need to design and present responsibility centre income statements so that they isolate the discretionary components included in the calculation of each centre’s reported income -Conventional segment margin statements cannot capture the interactive effects of such actions -Responsibility centre income statements have to be interpreted with considerable caution and healthy skepticism Transfer Pricing -Transfer pricing is the set of rules an organization uses to allocate jointly earned revenue among responsibility centres -Transfer pricing rules can be arbitrary when a high degree of interaction exists among the individual responsibility centres BU247 Chapter 11 – Financial Control Week 12 Approaches to Transfer Pricing -The relevance and purpose of transfer prices depend on whether the transfer price has the intended effect on organization decision makers -The goal of using transfer prices is always to motivate the decision maker to act in the organization’s best interests Market-Based Transfer Prices -The most appropriate basis for pricing the transferred good or service between responsibility centres -The market price provides an independent valuation of the transferred product or service and how much each profit centre has contributed to the total profit earned by the organization on the transaction Cost-Based Transfer Prices -When the transferred good or service does not have a well-defined market price, one alternative to consider is a transfer price based on cost -Some common transfer prices are variable cost, variable cost plus some percent markup on variable cost, full cost, and full cost plus some percent markup on full cost -Leads organization members to choose a lower-than-optimal level of transactions, causing an economic loss to the overall organization -Do not promote the goal of having the transfer pricing mechanism support the calculation of unit incomes -Provide no incentive to the supplying division to control costs, since the supplier can always recover its costs -Assumes the organization can compute a product’s cost in a reasonably accurate way -Does not provide the proper economic guidance when operations are capacity constrained -The dual rate approach is where the receiving division is charged only for the total variable costs to the point of transfer of producing the unit supplied and the supplying division is credited with the net realizable value of the unit supplied -Another cost-based approach charges the buying division with the target variable cost in addition to an assignment of the supplying division’s committed costs
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