4.

Financial Result Controls

 Three core elements of financial results controls:

– Financial responsibility centers (Chapter 7)

» The apportioning of accountability for financial results within
the organization.

– Formal management processes (planning & budgeting, Chapter

8)
» To define performance expectations and standards for
evaluating performance.

– Motivational contracts (Chapter 9)

» To define the links between results and various organizational
incentives.
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 Responsibility centers
 Responsibility center
» Organization unit headed by a manager with
responsibility for a particular set of inputs
and/or outputs.
 Financial responsibility center
» Responsibility center in which the manager's
responsibilities are defined at least partially
in financial terms.

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 Revenue centers
 Managers of revenue centers are held accountable for generating
revenues (a financial measure of outputs).
» e.g., Sales departments in commercial organizations;
» e.g., Fundraising managers in not-for-profit organizations.

 No formal attempt is made to relate inputs (measured as

expenses) to outputs.
» However, most revenue center managers are also held accountable for some
expenses (e.g. salespeople's salaries and commissions);
» But, still they are not profit centers because:
 These costs are only a tiny fraction of the revenues generated;
 Revenue centers are not charged for the costs of the goods they sell.

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 Expense centers
 Managers of expense (cost) centers are held accountable
for expenses (financial measure of the inputs consumed by
the responsibility center).
» Standard cost centers or engineered expense
centers
 Inputs can be measured in monetary terms;
 Outputs can be measured in physical terms; and,
 Causal relationship between inputs and outputs.
– e.g., manufacturing departments, warehousing.

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Expense centers (continued)
» Managed cost centers or discretionary
expense centers
 Outputs produced are difficult to measure; and,
 Relationship between inputs-outputs is not well known.
– e.g., R&D, Training expenditures, Marketing activities.

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 Control in expense centers
 Engineered expense centers
» Standard cost vs. actual cost
 i.e., the cost of inputs that should have been consumed in
producing the output vs. the cost that was actually incurred.

» Additional controls
 Volume produced; quality; training.

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 Control in expense centers
(continued)
 Discretionary expense centers
» Ensuring that managers adhere to the budgeted level of
expenditures while successfully accomplishing the tasks
of their center.
» Subjective, non-financial controls
 e.g., quality of service as perceived/evaluated by users.

» Personnel controls

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 Profit centers
 Managers of profit centers are held accountable for
generating profits (a financial measure of the
difference between revenues and costs).
 As a measure of performance, profit is
» Comprehensive
 i.e., it incorporates many aspects of performance;
» Unobtrusive
 i.e., the profit center manager makes the revenue/cost tradeoffs.

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 Measuring “profit”
Gross Incomplete Before-tax Complete
Margin Profit Profit Profit
Center Center Center Center

Revenue    
Cost of goods sold    
Gross margin    
Advertising and promotion   
Research and development  
Profit before tax  
Income tax 
Profit after tax 

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 Investment centers
 Managers of investment centers are held
accountable for the accounting returns
(profits) on the investment made
to generate those returns.
» Objective = return on investment (ROI);
» Absolute differences in profits are not meaningful
if business units use different amounts of
resources.

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 BU A BU B
Profit $ 1,000,000 $5,000,000
Investment 10,000,000 100,000,000
ROI 10% 5%

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Investment centers (continued)
 In fact, managers have two performance
objectives:
» Generate maximum profits from the resources at
their disposal;
» Invest in additional resources only when such an
investment will produce an adequate return.

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 Organization structure
President
(IC)
Administrative
and Financial
Vice Presidents
Group Group (DCC)
Vice President Vice President
(IC) (IC)

SBU Manager SBU Manager SBU Manager SBU Manager

(PC) (PC) (PC) (PC)
... ... Divisional Staff Functions (DCC)
... ... ... ...
Procurement Manufacturing Sales
(ECC) (ECC) (RC)

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 Transfer Pricing
Decentralization: to empower employees
Advantages of decentralization
–Better and quicker response to local needs
–Increase motivation
–Foster development and training
–Top management: focus on strategic issues

*Horngren et al., 2019, Cost Accounting: A Managerial Emphasis, 8 th

Canadian Edition,
Chapter 21, pages 859-892.
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 Disadvantages of decentralization
– Goal incongruence
– Duplication of activities
– Decrease loyalty toward organization
– Increase cost of gathering information
 Autonomy: BUs function as separate entity
– How to account for internal transfer of products

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 Outsider Outsider
BU A BU B BU N

Goals Goals Goals

Input—Process--Output Input—Process--Output Input—Process--Output

P/L Statements P/L Statements P/L Statements

-Revenues -Revenues -Revenues
-Expenses -Expenses -Expenses
-Net Income -Net Income -Net Income

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 Definition-Transfer Pricing
 The price at which products or services are
transferred between profit centers within the
same corporation.
– It affects the revenues of the producing profit
center (PC), the costs of the buying PC, and hence,
the profits of both entities.

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 Purposes
– Provide proper economic signals so that PC
managers make good economic decisions from a
corporate standpoint;
– Provide information for evaluating PC
performance;
– Purposely move profits between company
entities/locations.
» e.g., for tax purposes, or in joint-ventures.

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 Market-based transfer prices
 Where a (perfectly competitive) external market
exists.
 Managers of both the selling and buying PC will
make decisions that are optimal from a corporate
perspective, and reports of their performances will
provide good information for evaluation purposes.

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 Market-based transfer prices
 Actual price charged to external customers, listed
price of a similar product, or the price a competitor
is offering (bid price). Deviations can be allowed
that reflect differences between internal and
external sales:
» Savings in marketing, selling, and collecting costs;
» Differences in quality standards, special features, or
special services provided.

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•Market-based price: selling and buying divisions should be
free to sell/buy products in the most advantageous market.
•Factors to be considered when using market-based transfer
prices:
a. existence of internal capacity: highly integrated industry
b. sole producer of a differentiated product

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 Full-cost transfer prices
 Popular in practice
 Relatively easy to implement
» Firms have cost systems in place to calculate the
full cost of production;
» But, full costs rarely reflect actual, current costs of
producing the products because of financial
accounting conventions
(e.g. depreciation) and arbitrary overhead cost
allocations.

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 Full-cost transfer prices
 There is no incentive for the selling PC to
transfer internally since there is no profit
margin.
 The profit of the selling PC is understated.

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 Full-cost and mark-up
 It allows the selling PC to earn a profit on
internally transferred products/services.

 Crude approximation of the market price in cases

where no competitive external market price
exists.
– Such transfer prices, however, are not responsive
to market conditions.
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 Negotiated transfer prices
 Transfer prices are negotiated between the
selling and buying PC managers themselves.
» Both PC managers should have some bargaining
power
(i.e. some possibilities to sell or source outside).

» The outcome is often not economically optimal, but

rather depends on the negotiating skills of the
managers involved.

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 Negotiated transfer prices
 It is costly (management time), accentuates
conflicts between PC managers, and often
requires corporate management
intervention.

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 Guidelines to determine the negotiated transfer pricing
•Minimum TP= VC + Loss of CM on outside sale
•Optimum TP= Min TP </= Opt TP </= Mkt Price
(Buying Division)
•Example:

Company A has two division: Pulp and Paper. The

Pulp division has the following data:
Capacity 300,000 tons
Selling price per ton to outside customers $400
Variable cost per ton $180
Fixed cost per ton (based
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fourth lecture capacity) $70 27
The Paper division can use the Pulp as raw materials for its
paper products. The paper division is now buying 100,000
tons of pulp per year from an outside suppliers at $390 per ton.
Should the Pulp division sell to the Paper division and
what is the optimal TP?
1. The Pulp division is operating at capacity
2. The Pulp division is operating at capacity and can
avoid $40 in VC
3. Current operating level of the Pulp division is
150,000 tons and the pulp division can avoid $40 in VC

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 Full Capacity: 300,000 ton

Pulp $400/ton Outside Customers

Transfer?
$390/ton
Paper Outside Suppliers

Currently buy 100,000 ton

from outside suppliers

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1. Pulp division is at full capacity:
Minimum TP: $ 180 + $220 = $ 400/ton
Market price of buying division (Paper division) = $390/ton
No internal transfer

2. Pulp division is at full capacity. It can save $40 variable cost per ton.
Minimum TP : $140 + $220 = $360
Range of TP: $360 ≤ TP ≤ $390
Transfer internally with TP between $360 and $390

3. Pulp division is at 150,000 capacity. It can save $40 variable cost per
ton.
Minimum TP: $140 + 0 = $140
Range of TP: $140 ≤ TP ≤ $390
Transfer internally with TP between $140 and $390

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•Factors to be considered when using cost-based transfer
prices
•Upstream fixed costs and profit: the profit centers that
finally sells to the outside customers may not be aware of
the amount of upstream fixed costs and profit included in
its internal purchase price (or might be reluctant to reduce
its own profit) to optimize company profit.

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Example:
1.Current condition: Selling division has the following information regarding product
A: Variable cost: $200/unit; Fixed cost: $50/unit; Total $100,000; Selling price to
outside customers: $300/unit. Sales volume: 800 units
BEP (in unit): Total FC/CM per unit: 100,000/100= 1,000 units
Revenue: 800 X $300 = $240,000
Variable costs 800 X $200 (160,000)
Fixed costs: (100,000)
Profit (loss) = $ 20,000 (loss)

2.Special order: 800 units @ $240

Revenue: 800 X $300 = $240,000
800 X $240 192,000
Variable costs 1,600 X $200 (320,000)
Fixed costs: (100,000)
Profit (loss) = $ 12,000 (profit)

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 Sales Revenue

TC
Sales
Revenue/
Costs VC

BEP

FC

800 1,000
Sales Volume

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 Sales Revenue
Sales Revenue
with Special Order

TC
Sales
Revenue/ New
Costs BEP VC

BEP

FC

800 1,000 1,600

Sales Volume

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3 Methods to mitigate the problem of upstream fixed costs
and profit :
1. Two-step pricing: First, charge each product to the
buying units based on its standard variable cost.
Second, charge the buying units with periodic fixed
cost on a lump-sum basis.

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•Example:
•Selling division has the following information
regarding product A: Standard variable cost: $200;
Fixed cost: $50/unit. Total fixed cost $5,000; Selling
price to outside customers: $300.
•If transferred to buying division, product A needs to be
process further and needs: Variable cost: $100; Fixed
costs: $60; Selling price to outside customers: $500

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 Selling Division Buying Division
Two-Step Pricing  
Variable cost:
Account Receivable $200 WIP Inventory $200
Sales Revenue $200 Account Payable $200
COGS $200  
Inventory $200  
Fixed cost:  
Account Receivable $50 WIP inventory $50
Sales Revenue $50 Account Payable $50
COGS $50  
Inventory $50  
  Buying division’s own cost:
  WIP inventory (VC) $100
  WIP inventory (FC) 60
  Materials/Labor/FOH $160
   
  Sell to outside customers:
  Account receivable $500
  Sales Revenue $ 500
  COGS $410
  Inventory $410
   

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2. Profit sharing:
•The product is transferred to the buying unit at
standard variable cost
•Afterthe product is sold to outside customers, the
business units share the contribution margin earned,
which is the selling price minus the variable
manufacturing, selling, and administrative expenses.

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 Selling Division Buying Division
Profit Sharing  
Variable cost:
Account Receivable $200 WIP Inventory $200
Sales Revenue $200 Account Payable $200
COGS $200  
Inventory $200  
Fixed cost:  
Account Receivable $50 WIP inventory $50
Sales Revenue $50 Account Payable $50
COGS $50  
Inventory $50  
  Buying division’s own cost:
  WIP inventory (VC) $100
  WIP inventory (FC) 60
  Materials/Labor/FOH $160
   
  Sell to outside customers:
  Account receivable $500
  Sales Revenue $ 500
  COGS $410
  Inventory $410
  Contribution Margin: Selling Price - VC
  =$500-300
  =$200
  Share contribution based on VC:
200/300*200 = 133.33 100/300*200=66.67
Account receivable $133.33 Income summary $133.33
Income summary $133.33 Bus 424 fourth lecture presentation
Account payable $133.33 39
3. Two sets of prices (dual pricing): the selling unit’s
revenue is credited at the outside sales price, and the
buying unit is charged at the standard variable costs (or
total cost). The difference is charged to a headquarters
account and eliminated when the business unit
statements are consolidated.

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 Selling Division Buying Division
Two Sets of Pricing (Dual Pricing)  
Account Receivable $200 WIP Inventory $200
Head Quarter (corporate) 100 Account Payable $200
Sales revenue $300

Fixed cost:  
Account Receivable $50 WIP inventory $50
Sales Revenue $50 Account Payable $50
 

COGS $250

Inventory $250  
   
  Buying division’s own cost:
  WIP inventory (VC) $100
  WIP inventory (FC) 60
To close the headquarter account (consolidation): Materials/Labor/FOH $160
Income summary $100  
Head quarter $100 Sell to outside customers:
  Account receivable $500
  Sales Revenue $ 500
  COGS $410
  Inventory $410

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