Tells u About Management Control System

1. A PROJECT REPORT ON
Responsibility Accounting
SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS
FOR
MASTER OF MANAGEMENT STUDIES
TO
UNIVERSITY OF MUMBAI
BY
ASHVANI RAVINDRA BHAGAT
ROLL NO. 03
2011-2013
UNDER THE GUIDANCE OF
Dr. Kinnarry Thakkar
SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT
MAHALAXMI, MUMBAI – 400 034
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2. A PROJECT REPORT ON
TITLE OF THE PROJECT
SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS
FOR MASTER OF MANAGEMENT STUDIES
TO
UNIVERSITY OF MUMBAI
BY
FULL NAME OF THE STUDENT
ROLL NO.
2010-2012
UNDER THE GUIDANCE OF DR. / PROF.
SMT. K. G. MITTAL INSTITUTE OF MANAGEMENT
MAHALAXMI, MUMBAI – 400 034
2

3. DECLARATION
I hereby declare that this dissertation submitted in partial fulfillment of the
requirement for the award of MASTER OF MANAGEMENT STUDIES
(MMS) of the University of Mumbai is my original work and has not been
submitted for award of any other degree or diploma fellowship or other similar
title or prizes.
I further certify that I have no objection and grant the rights to SMT. K. G.
MITTAL INSTITUTE OF MANAGEMENT to publish any chapter or project if
they deem fit in journals or magazines and newspaper etc. without my permission.
NAME: ASHVANI RAVINDRA BHAGAT
CLASS: MMS II SEM IV
BATCH: 2011-2013
ROLL NO.: 03
DATE: 17th MARCH , 2012
PLACE: MUMBAI
SIGNATURE
(ASHVANI BHAGAT)
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4. PROJECT GUIDE CERTIFICATE FORM
I Mr. Ashvani Ravindra Bhagat, the undersigned Roll No. 03 studying in the Third
Year of MMS is doing my project work under the guidance of Dr./ Prof. DEEPA
CHAVAN wish to state that I have met my internal guide on the following dates
mentioned below for Project Guidance:-
SR. NO. DATE SIGNATURE OF
THE INTERNAL
GUIDE
______________________ ______________________
Signature of the Candidate Signature of Internal Guide
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5. Smt. K. G. Mittal Institute of Management, IT and Research
Marwari Vidyalaya Sanchalit
(Approved By AICTE, New Delhi, Government of Maharashtra, DTE,
Affiliated to University of Mumbai)
CERTIfICATE
This is to certify that the dissertation submitted in partial fulfillment of the
requirement for the award of MMS of the University of Mumbai is a result of the
bonafide work carried out by Mr. ASHVANI RAVINDRA BHAGAT under my
supervision and guidance. No part of this report has been submitted for award o f
any other degree, diploma fellowship or other similar titles or prizes. The work
has also not been published in any scientific journals/ magazines.
DATE: 17th MARCH 2012 NAME: ASHVANI R. BHAGAT
PLACE: MUMBAI ROLL NO.: 03
------------------------------ ---------------------------
Dr. Vidya Hattangadi Dr. /Prof (Project Guide)
(Director)
Smt. K. G. Mittal Institute Of Management
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6. ACKNOWLEDGEMENT
This project has been a great learning experience for me. I take this opportunity to
thank Dr. / Prof. DEEPA CHAVAN, my internal project guide whose valuable
guidance & suggestions made this project possible. I am extremely thankful to
him/her for his/her support. He/She has encouraged me and channelized my
enthusiasm effectively.
I express my heart-felt gratitude towards my parents, siblings and all those friends
who have willingly and with utmost commitment helped me during the course of
my project work.
I also express my profound gratitude to Dr. Vidya Hattangadi, Director of SMT.
K. G. MITTAL INSTITUTE OF MANAGEMENT for giving me the opportunity
to work on the project and broaden my knowledge and experience. My sincere
thanks to Prof. Deepa Chavan for her valuable guidance and advice in
completing this project.
I would like to thank all the professors and the staff of SMT. K. G. MITTAL
INSTITUTE OF MANAGEMENT especially the Library staff who were very
helpful in providing books and articles I needed for my project.
Last but not the least, I am thankful to all those who indirectly extended their co-
operation and invaluable support to me.
EXECUTIVE SUMMARY
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7. Responsibility Accounting are a set of practices that have become recognized as one of
the essential features of effective management in organizations of all sizes, in both the public
and the private sectors, throughout the world.
Management controls may be briefly defined as the organization, policies, and
procedures used to help ensure that government programmers achieve their intended results;
that the resources used to deliver these programmers are consistent with the stated aims and
objectives of the organizations concerned; that programmers are protected from waste, fraud and
mismanagement; and that reliable and timely information is obtained, maintained, reported, and
used for decision making.
Effective management controls are clearly essential to the success and well-being of
government organizations, both as a safeguard against waste, abuse, and fraud and as a means of
ensuring that the policies laid down by top management are properly implemented by the
organization. However, even the most carefully designed control systems have their limitations,
partly because, while they allow top managers to control the organization, they do not control
the top managers themselves. Continuing vigilance is required to ensure that the systems are
not undermined by instances of fraud or by failure to respond to changes in circumstances and
operating procedures
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8. Chapter No. 1
8

9. Introduction
A responsibility centre is an organizational unit which is headed by a responsible person
namely a manager. He is responsible for the activities of the unit. An organization is composed
of a number of responsibility centre. These responsibility centre. These responsibility centres are
created based on the need of the organization. The responsibility centres from a hierarchy with
section, department, work shifts etc existing at the lowest level and department and a business
unit at a higher level. The costs assigned to the responsibility centre are intended to measure the
inputs that it consumer in a specified period of time. Management control on the behavior of
managers in responsibility centres.
The performance of responsibility centres is judged by the criteria of efficiency and
effectiveness. Revenue in the revenue centres are measured and controlled separately from
expenses centres. In discretionary expenses centres, budget describe the amounts that can be
spent but it is not possible to determine the optimum level of these expenses. Therefore,
Financial controls are not intended to measure its effectiveness. The principal types of
discretionary expense centres are Administrative and Support centres, Research and
Development centre and Marketing centres.
A responsibility centre can be defined as an organizational unit which is headed by a
responsible person namely a manager. He is responsibility for the activities of the unit.
Responsibility centre is responsible for performing certain function which is its output. A
company is a collection of responsibility centre, each of which is represented by a box on the
organization chart. These responsibility centres from a hierarchy. The responsibility centre at the
lower level are work shifts and small organizational units. Higher in the hierarchy are the
department or business unit. The entire Company is a responsibility centre from the point of
view of senior management and the board of directors.
These responsibility centre use resources or inputs while performing their functions. The
costs assigned to a responsibility centre are intended to measure the input that it ensures in a
specified period of the time such as a week or a month. Management control focuses on the
behavior of manager in responsibility centres. An organization is composed of a number of
responsibility centres. These centres are created by the management based on the needs of the
business organisations.
9

10. Responsibility centres constitute the structure of a control system. The assignment of the
responsibility to organizational subunits should reflect the organizational strategy. A
responsibility centre is an organizational unit which is headed by a management and he is
responsible for its objectives. These are two types of responsible centre which are important i.e.
revenue centre and expense centre.
Objectives of Responsibility Accounting:
The objectives of responsibility accounting are the following:
a. Overall organizational goals are broken down into small goals, each of the small goals is
meant for better achievement of a responsibility center.
b. With the attached responsibility each responsibility center is tied up & there is adequate
authority so that responsibility can be discharged.
c. At the end of a period, evaluation is done of the performance of each responsibility
center & comparison of the performance is done with the predetermined targets.
d. Thorough study is made of the achievements which are above or below the targets &
remedial measures are adopted.
e. Assessment is made of the contribution made by each responsibility center &
examination is done of how far it’s possible for the contribution to fulfilling its share in
the ultimate organizational growth.
f. Emphasize is given on the control of cost through planning.
g. Use is made of the principle of ‘management by exception’ for the purpose of recording
only those data where the actual performance of responsibility center falls short of the
set target & where the variance is beyond the reasonable limit.
Nature of Responsibility centre:
Responsibility centres are created by conscious acts of management. It is a unit of an
organization. The aims of such units is to achieve certain objectives. The objectives are to
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11. implement the strategy for accomplishing the goals of the organization centres. The entire
organization is responsible for achieving its objectives. A responsibility centre uses certain
inputs and then generates the output. The input includes labor, material and others services. The
responsibility centres process these resources by using plant and machinery, furniture, vehicles
and working capital. The output is created out of these inputs. The output may be in the form of
intangible goods or tangible goods. The output generated from finance, logistics, insurance,
marketing are in the form of services. The output of the responsibility centre may be sold in the
market in exchange of money. It can be also be used by another responsibility centre of the
organization. The amount of money generated by a responsibility centre is called as 'Revenue'.
Pre-requisites of effective responsibility accounting:
The pre-requisites of the effective responsibility accounting are the following:
a. Under the supervision of a manager should be each responsibility center & for the
purpose of operating, it must be separable & identifiable.
b. The independent measurement of performance of each center must be capable of being
done.
c. Each responsibility center should have clearly set targets.
d. Each responsibility center’s budget should set targets which should be neither too high
nor too low i.e., the budget should be one which can be realised.
e. The top management should fully support the system.
f. All managers of responsibility centers should participate in the formulation of plans &
policies relating to responsibility centers for the purpose of providing motivation.
g. For sincere performance of each responsibility center the organizational environments
must be conducive.
Advantages of Responsibility Accounting:
For the purpose of exercising control, responsibility accounting is an important tool in the
hands of management. For the purpose of effecting efficient control on operations & achieving
the organizational goal, responsibility accounting system should be introduced by the
organizations which have large dimensions & complex & operations which are decentralized.
11

12. Since for the purpose of achieving the overall goal in a piecemeal way; to various
responsibility centers, overall responsibility & authority are decentralized, continuous
communication should be there between the overall responsibility center & various sub-
responsibility centers. Thus a communication system is automatically established by
responsibility accounting.
The following advantages can be expected from responsibility accounting system:
a. Allocation is made of all the activities of the organization, all the items of income &
expenditure including capital expenditure to the well defined responsibility centers.
Profit of each responsibility center is also identified. It should be understood by the
manager of the centre what has to be performed by him with what resources & in what
time period. He gets the things done by making his own way without any interference.
Thus much importance is given to human resources.
b. The managers of responsibility centers worked independently which helps in achieving
the ultimate goal.
c. There is a relationship between efforts & achievement, thereby, loopholes, if any, in the
operations gets easily detected.
d. The overall goals of the organization & individual goals of responsibility centers are
communicated to all so that by keeping a view on that, guidance can be given the
managers in their respective centers to the operations.
e. Among the managers & their subordinates, cost-consciousness gets generated which
results in automatically reducing cost.
f. It becomes easy to detect the weak areas in the organization. So for the purpose making
the weak areas strong, corrective measures are taken.
g. By recording the negative variances between the actual performance & target,
introduction of management by exception can be done.
h. For the purpose of exercising best managerial control over the affairs of the organization
& achieving the desired goal, responsibility accounting system & budgetary control
system can work together.
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13. i. As realistic goals are fixed for a responsibility centre, its achievement by the employees
becomes easy. Their contribution can be assessed by themselves for the purpose of
achieving the goal of the organization as a whole. A sense of belonging to the
organization is created among the employees by the systematic responsibility accounting
as the reward of the employees for accomplishment is not unsatisfactory.
j. As managers of responsibility centers are allowed to sit with the top management for
exchanging of views & opinions, appropriate decision making is almost assumed.
As against expected advantages there are also some apprehended disadvantages.
Disadvantages of Responsibility Accounting:
The following are the apprehended disadvantages of responsibility accounting:
a. Solely upon the sincere efforts put in by the managers of the responsibility centers, the
success of the responsibility accounting depends. Whether the system will succeed or not
shall be decided by the personal factors of the managers.
b. The place of good management cannot be ever taken by the responsibility accounting
because the latter is only a tool in the hands of the former.
c. Although theoretically, the manager of each organization is given free hand, in actual
practice, neglect of employees’ reaction, interference etc. is often noticed. Thus, in the
way of proper discharging of responsibility, this stands.
d. In modern organizations, among the departments, inter-relations & inter-departments are
mostly observed. So it becomes almost impossible to demarcate responsibility centers by
clear-cut outlines.
e. Manager of the responsibility center prepares & communicates performance reports. The
desired result will not be achieved by the responsibility accounting system, if there is
any shortcoming in the report.
f. Remuneration, future prospects, rewards, good working condition, welfare work & many
others account for the individual interest of employees. Co-operation from the
employees may be required where there is a clash between individual interest & the
organizational interest.
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14. Chapter No. 2
Responsibility Centres
Responsibility Structure
The responsibility structure of an organization consists of responsibility centers and related
performance measurement systems. These responsibility
centers work towards the achievement of the organizational goals. This hierarchical placement
of the responsibility center helps the top management to ensure that decisions made in one part
of the organization are congruent with decisions made in other parts. The responsibility
structure includes an accounting system. A responsibility accounting system helps managers to
record the plans and performances of the center for which the manager is accountable. The
measurement of the performance of a responsibility center is done through cost, profit, revenue,
investment and quality goals set by the organization. There are three different methods of
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15. measuring the performance of a responsibility center. They are:
• The efficiency measure • The process measure • Effectiveness measure
The ‘efficiency measure’ measures performance in terms of inputs received over a specified
period of time for a given level of output. The process measure pertains to the production
process, and the ‘effectiveness’ measure gauges the output of the organization in terms of its
goals and objectives. The above mentioned methods of performance evaluation help in
assessing the progress of each subunit, and this is done with those variables for which the
manager has reasonable amount of control in mind.
Overall Effectiveness Measures: Return on Investment (ROI)
The most important objective of a firm is to achieve a good return on investment. The logic
behind the hierarchy of responsibility centers and the responsibility accounting system is to
make all the decentralized subunits of an organization responsible for various elements of ROI.
The performance of responsibility centers in an organization is based on cost, quality, revenue
and investment.
Donaldson Brown of General Motors divided ROI into a number of elements for easy
understanding. These elements are helpful in establishing performance measures for various
subunits of a division that are goal congruent and would have an influence over the performance
measures. ROI= Net profit/invested capital
ROI can be divided into two components- net profit, which is a percentage of the sales revenue,
and the turnover of investments in relation to the sales revenue.
Profit margin = net profit/sales revenue
Investment turnover = sales revenue/invested capital
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16. Types of Responsibility Centres
Revenue centers
Revenue centers are those organizational units in which outputs are measured in monetary
terms. These centers are marketing organizations and they are not directly responsible for
profits. Revenue centers are also called expense centers, as the revenue center managers are held
responsible for expenses incurred by the unit. The main objective of revenue centers is to
maximize revenues. For example, a marketing organization is a sales revenue center. Such a
center is devoted to increasing the revenue, and assumes no responsibility for production.
In this center, the manager is responsible for the level of revenue or outputs of a center,
measured in monetary terms, but is not responsible for the costs of the goods or services that the
center offers.
Expense centers
In expense centers, inputs or expenses are measured in monetary terms whereas the outputs are
not measured in monetary terms. There are two types of expense centers-engineered expense
centers and discretionary expense centers. There are two types of cost involved in engineered
expense centers and discretionary expense centers respectively-engineered costs and
discretionary costs. Engineered costs are costs that can be estimated to a reasonable extent by
the management. Examples are direct labor and direct material. Discretionary costs, on the other
hand, are costs that cannot be estimated by the management.
Engineered expense centers
In these centers, inputs or expenses are measured in monetary terms and outputs are measured in
physical terms. These centers are usually found in the manufacturing units that use a standard
cost system. There are certain responsibility centers within administrative and support
departments that actually are engineered expense centers. In these centers, the cost of the
product is determined by multiplying the output of each unit with its standard cost. Its efficiency
is measured by comparing the actual cost with the standard cost.
Discretionary expense centers
16

17. In discretionary expense centers, the output cannot be measured in monetary terms.
Discretionary expense centers include administrative and support units like legal, accounting,
industrial and public relations units. Here, the efficiency is not the difference between
budgeted and actual expense, but the difference between the budgeted input and actual input. In
discretionary expense centers the management decides on certain policies that should govern the
company's operation. These relate to the amount of money that should be spent on R&D,
financial planning, public relations, etc. The decisions related to such activities depend on the
way a company operates.
Control characteristics for expense centers
The management control systems for expense centers are discussed, taking into consideration
factors like budget preparation, cost variability, financial control and measurement of
performance.
Budget preparation: The decisions regarding the budget of expenses for a discretionary
expense center is different from that for an engineered expense center. In engineered expense
centers, the costs are determined by the management, taking into view the operating budget
required to perform the task effectively in the future. However, in a discretionary expense
center, the principal task is to decide on the magnitude of the job that has to be performed.
These tasks are of two types-continuing and special. Continuing tasks take place year after year
(like financial statements) while special tasks are one-time tasks, for example, developing a
profit budgeting system for a newly acquired division.
Management by objectives is a useful technique in preparing budgets for a discretionary
expense center. Management by objectives is a technique where the objectives of performance
are jointly determined by subordinates and their superiors. The progress towards these
objectives is periodically reviewed and the rewards are allocated on the basis of performance.
Another method used to understand the appropriate level of spending in a discretionary expense
center is sensitivity analysis. According to this technique, the budget has a section which
explains the activities that can be undertaken if the budget is increased. Sensitivity analysis is
mostly not taken by companies as they think that it is important for a manager to prepare the
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18. possible budget for accomplishing activities that should be undertaken.
Cost variability: The costs, in a discretionary expense center, tend to vary from one year to
another according to the volume. However, these are not influenced by short-term fluctuations
in volume within a year. In engineered expense centers, costs vary with short-term fluctuations
in volumes. Financial control: The financial control in a discretionary expense center is different
from that in an engineered expense center. Here, the operating costs are minimized by setting a
standard for the costs and comparing the actual costs with this standard. In discretionary
expense centers, costs are controlled by determining the tasks that have to be undertaken and the
amount of effort that is required for each task. Financial control is, hence, determined at the
planning stage.
Measurement of performance: The financial performance report of a discretionary
expense center does not help in evaluating the efficiency of the manager, whereas in engineered
expense centers the financial report helps in evaluating the efficiency of the manager. If the two
centers are not properly distinguished, the management may consider the performance report of
a discretionary center as an indication of its efficiency.
Administrative and support centers
Administrative centers include the senior corporate management, the business unit management
and the managers responsible for their staff units. Support centers provide services to other
responsibility centers.
Problems related to control in administrative and support centers include difficulty in measuring
output, as they basically provide service and advice to the responsibility centers. Therefore, it
becomes difficult to set cost standards. Hence, their performance cannot be branded as efficient
or inefficient. Secondly there is lack of congruence between goals of staff units and
responsibility centers. The suggestions that staff departments may provide regarding the
development of systems, programs or functions may be too costly when one thinks of the
additional profits that these would generate. The severity of the problems is also related to the
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19. organizational level. At the operational level, the staff activity is controlled by the plant
manager, and at the business unit level, by the business unit manager. When compared to the
plant level, there is more discretion of tasks at the business unit level. Support centers charge a
particular price for the services they provide to other responsibility centers.
Budget preparation: The budget for a support center consists of expenses, and is prepared by
comparing with the current year’s actuals. This budget consists of the following components-
the basic costs of running a center (for which there is no need of management decisions), costs
incurred by the discretionary
activities of the center, and a section containing proposed increases in budget (other than those
related to inflation).
Research and development centers
Control problems in research and development: The problems in research and development are:
Difficulty in measuring quality: The inputs for an R&D activity can be measured whereas the
outputs are difficult to measure. For R&D activities, the time taken for a particular research
cannot be estimated as it may take months or sometimes years for a particular activity. Also the
output is difficult to measure because of its technical nature.
Lack of goal congruence: As in administrative centers, goal congruency is lacking in R&D
centers, too. Conflict may arise between the research manager and the business unit manager.
The research manager may want to build the best research and development center, no matter
what the expense be, while it may not be possible for the company to afford it. Also, the
researchers may not have sufficient knowledge about the business, in some cases. The research
and development costs cannot be controlled on a year-to-year basis because a research project
may take years to show results and the organization would have to bear the cost of the project
for that period of time, mainly the cost on labor.
Marketing centers
There are two types of marketing activities in every organization: order filling (logistics) and
order getting. Order getting is an actual marketing activity. Order filling activities include
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20. transferring goods from the company to the customer, and receiving the appropriate pay from
the customer. These are mostly engineered expense centers. Order getting activities include test
marketing, training sales force, advertising, sales promotion, etc. Though the output of a
marketing organization can be measured, it is difficult to evaluate the marketing effort, as the
marketing department has no control over economic conditions or competitors’ actions. These
actions may be different from what was expected when the sales budgets were established. In
such situations, it is difficult to achieve management control. Also, it becomes difficult to
measure the efficiency and effectiveness of these costs.
Profit centers
When financial performance of a responsibility center is measured in terms of the organization’s
profit, then it is called a profit center. In a profit center, performance is measured in terms of the
numerical difference between revenues (outputs) and expenditure (inputs). A profit center is
given the responsibility of earning profits. It is involved in the manufacture and sale of outputs,
and it measures how well the center is doing economically. The profit center also determines the
efficiency of the manager in charge of the center. A profit center helps in motivating managers
to perform well in areas they control and also encourages managers to take initiatives. The profit
center helps the organization to make the best use of specialized market knowledge of the
divisional managers, and entrusts the local managers the responsibility of tradeoffs.
Profit centers have been used as a major management control tool. The major advantages of
profit centers are:
• These help in increasing the speed of making operating decisions as they do not have to be
referred to corporate headquarters.
• As the decision-making authority lies with the managers they can make better decisions
related to the task they are performing, because they can understand the nature of the work
better.
• Since profit centers make their day-to-day decisions themselves headquarters can
concentrate on broader issues of the organization.
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21. • Managers are motivated to perform more effectively, as they are responsible for
increasing the profit of their unit.
• Managers use their imagination, take initiatives to perform more effectively, to increase
the profit of their unit.
However, there are certain difficulties associated with the creation of profit centers. The
management cannot have considerable control over the different profit centers when decisions
are centralized. The top management has to depend on management control reports which may
not be as effective as the personal knowledge of an operation. There may be no place for
competent general managers in a functional organization because of lack of opportunities for
them to develop creative management skills.
Organizational units compete with one another, and this may, sometimes, result in conflict
between different centers and reduction in cooperation between different units and sharing of
resources.
Types of profit centers
Functional units can be classified as different types of profit centers. A multibusiness company
can be divided into independent profit generating units such as marketing, finance,
manufacturing etc. The decisions regarding whether a particular functional unit can be a profit
center depends on the responsibility center manager's ability to influence, if not control, other
activities that affect the company's bottom line. The different types of profit centers are
discussed below:
Marketing: A marketing activity becomes a profit center if it is charged with the cost of the
products sold. A marketing activity can be given the responsibility of making profit when the
marketing manager has the authority to make principal cost/revenue trade off in terms of
marketing a product, spending on sales promotion, the appropriate time for this expenditure and
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22. on which media to spend.
Manufacturing: This is an expense center and the management of activities here is based on
performance against standard costs and overhead budgets. Problems in measurement may occur
because of inadequate quality control, shipping of inferior quality products, and so on, to obtain
standard cost credit. At times, there may arise the need to accommodate an order in-between
production schedules, and the manufacturing managers may be reluctant to interrupt these
schedules. In manufacturing units, when performance is measured against standards, there may
be no incentives for manufacturing products that are difficult to produce. These factors may
demotivate the managers, and eventually, they may not try to improve standards. Hence, while
measuring the performance of manufacturing activities against standard costs, it is important to
take into consideration quality control, production scheduling and the make or buy decisions.
Measuring profitability: Profitability measurements in a profit center can be of two types-
management performance and economic performance. Management performance focuses on
the manager’s performance while economic performance relates to how well a profit center is
performing as an economic entity. Management performance is a measure used for planning,
controlling and coordinating the day-to-day activities of the profit center. The performance
measures of profit centers can be different and hence, the necessary purpose for the information
should not be obtained from a single set of data. For example, the management performance
report can show excellent performance of a profit center manager. But the economic and
competitive forces for that particular report can show poor economic performance. As a result,
the center may run into losses and may even have to close shop.
Types of profitability measures:
The parameters that can be used for measuring the profitability of a profit center are
contribution margin, direct profit, controllable profit, income before taxes and net income.
Contribution margin: This performance measure is used on the premise that, since fixed
expenses are not controllable by the manager, the focus should rest on maximizing the
difference between revenues and variable expenses. The problems of using contribution margin
is that since many of the center’s expenses may vary according to the discretion of the profit
22

23. center manager, focus on the contribution margin tends to direct the attention of the profit center
manager away from the goals of the center.
Direct profit: This measure helps in understanding the contribution of the profit center to the
general overhead profit of the corporation. It encompasses all the expenses directly incurred by
profit centers or related to profit centers, irrespective of whether the expenses are controllable
by the profit center manager. However, it does not include corporate expenses.
Controllable profit: The headquarters expenses in an organization can be divided into two
categories-controllable and uncontrollable. Controllable expenses include expenses that are
controlled by the business unit manager. The advantage of including such costs in the
measurement system is that the profit will be calculated after the deduction of expenses that can
be influenced by the profit center manager. Hence, these are controllable profits. As
uncontrollable headquarters expenses are taken into consideration while calculating
controllable profits, controllable profits cannot be compared directly with published data or
with trade association data, which report the profits of other companies in the industry.
Income before taxes: In this method, all corporate overhead profit is allocated to the profit
center. The amount of expense incurred by each profit center forms the basis of allocation of
profit. Such allotment has its own drawbacks. Firstly, the costs in departments like finance, and
HR are not controllable by the profit center and hence, profit centers should not be held
accountable for such costs. Also, it is difficult to quantify the amount that has been spent on
human resources in each profit center. However there are certain advantages in allocating costs.
Corporate service units often have a tendency to spend lavishly to make their units as excellent
as possible without paying due attention to the value they create for the company. Once such
costs are allocated to profit centers, the profit center managers will try to keep a check on the
expenditure. The performance of profit centers is easily comparable to that of competitors’
performance who pay for similar services.
23

24. Since the profit center can earn profit only when it has recovered all its costs, including
allocated corporate overhead costs, the profit center manager will be motivated to make long-
term marketing decisions such as pricing, product mix, and so on, because the center will have
to recover its share of corporate overhead costs.
For profit centers to function with the allocated costs in mind, it is important that they are
allocated budgeted costs, and not actual costs. This ensures that the profit center managers will
perform without complaining about the arbitrariness of the allocated costs, since there would be
no variances in the allocated overheads in the performance reports.
Net income: The performance is measured by taking into consideration the net income after the
payment of taxes. The disadvantage of using this method is that many decisions that have an
impact on the income taxes are made at headquarters, and profit center managers should not be
judged by these decisions. If the income after tax payment is constant percentage of the income
before tax payment, then there would be no need to measure performance based on this method.
This method would be useful if profit centers influence decisions like installing credit policies
or disposing of equipment. This method is also useful to motivate the manager to minimize
taxes in case the taxable income differs from income, as measured by using generally accepted
accounting principles. The performance of profit centers can be measured by comparing actual
results with one or more of the measures discussed above with budgeted amounts. In addition,
data on competitors and industry provide a good crosscheck on the appropriateness of the
budget.
Investment centers
An investment center has control over sales revenues and operating costs, and the assets used to
generate profit. An investment unit manager must be in a position to influence the size of the
investment and profit variables. An investment center is a measure of economic performance,
and it analyzes all elements of profit and investment. The objective of this center is to maximize
profit, given the amount of investment required to generate the profit.
24

25. Cost centers
The objective of cost center is to minimize the variance between standard costs and actual costs.
A cost center is a production or service function, activity or item of equipment the costs of
which may be attributed to cost units. Cost centers are basically related to costs, and not to the
revenues or assets and liabilities of the organization. A cost center is a separate
organizational unit for which separate cost allocation is done. A cost center forms the basis for
building up cost records for cost measurements, budgeting and control. From a functional point
of view, a cost center is a production cost center (where only production is undertaken like a
assembly department), a service cost center (offering service to production departments like
personnel, accounting etc.,) or an ancillary manufacturing center (producing packing materials).
Chapter No. 3
Segment Reporting and Profitability
Decentralization and segment reporting
A segment is a part or activity of an organization about which managers need to know
cost, revenue or income data. Examples of segments include divisions of a company
(responsibility centers), sales territories, projects, product families, individual stores, programs,
operational departments, individual customers, services categories and product lines.
Effective decentralization requires segment reporting, so the companywide income
statement, reports are needed for individual segments of the organizations. These segmented
25

26. income statements are useful in analyzing the profitability of segments and measuring the
performance of segment managers.
A different kind of income statement is required for evaluating the performance of a cost
center, a profit center or an investment center. This income statement should emphasize on the
segment rather than the performance of the company as a whole. A contribution margin or a
residual contribution margin, format income statement is used to evaluate the performance of
different types of segments.
In a contribution margin format income statement cost of the segment consists only of
the direct costs (variable and fixed costs). To prepare an income statement for a particular
segment variable costs are traced for the resources which use depends of the degree of the
activity of the segment and the fixed costs don´t depends of the degree of the activity, but are
related with the segment. This fixed cost are designated by traceable fixed and are assigned to
the segments but non-traceable or common fixed costs are not assigned to segments.
Segment Contribution Margin
The segment contribution margin is obtained by deducting the variable and the traceable
fixed costs from the segment revenues. It represents the margin that is available after a segment
has covered all of its own costs. The segment contribution margin can be the best gauge of the
long-run profitability of a segment, since it includes only those costs that are caused by the
segment. If a segment cannot cover is own costs, then that segment probably should not be
retained (unless it has an important side effects on other segments or is strategic relevant).
From a decision making point of view, the segment contribution margin is most useful in
major decisions that affect capacity such as dropping a segment, including decisions relating to
short-run changes in volume, such as pricing special orders that involve utilization of existing
26

27. capacity.
Example
As an example, a segmented report is shown, where the segments have been defined as
divisions. Report also has a column of total company performance for the period. We can see
that divisional segment margin is Rs60,000 for business product division and Rs40,000 for the
consumer product division. This report is very useful for company's divisional managers they
may want to know how much each of their divisions is contributing to the company's profit.
Segments defined as divisions (values in mRs):
Total
__Segments_____
_
Company Division A Division B
Revenues (ex: sales) 100,000 60,000 40,000
Variable expenses:
Cost of goods sold 36,000 24,000 12,000
Other variable expenses 10,000 6,000 4,000
Total variable expenses 46,000 30,000 16,000
Margin 54,000 30,000 24,000
Traceable fixed expenses 34,000 18,000 16,000
Divisional Contribution margin 20,000 12,000 8,000
Common fixed expenses (not
traceable to the individual divisions)17,000
Net operating income 3,000
27

28. Traceable and Common Fixed Costs
One of the most puzzling aspects of segmented income statements is probably the
treatment of fixed costs. While preparing segmented income statements the fixed cost is divided
into two parts, one is traceable fixed cost and other is common fixed cost. Only traceable fixed
costs are assigned to the segment. If a cost is not traceable then it is not assigned to segments.
Following paragraphs define explain these two types of fixed costs.
Traceable fixed cost:
A traceable fixed cost is a fixed cost that is incurred because of the existence of a
segment. If the segment had never existed, the fixed cost would have not been incurred; and if
the segment were eliminated, the fixed cost would disappear.
Examples:
Examples of traceable fixed costs:
 The salary of the Division A manager is a traceable fixed cost of the Division A.  The
renting of the equipment to produce exclusively the “Product Line P”, is a traceable fixed cost
of the Product Line P.
 The depreciation of a car for rent is a traceable fixed cost of the “renting business” in a rent a
car company.
Common fixed cost:
A common fixed cost is a fixed cost that supports the operations of more than one
segment, but is not traceable in whole or in part to any one segment. Even if a segment were
entirely eliminated, there would be no change in true common fixed cost.
Examples:
28

29. Example of common fixed cost includes the following:
 The salary of general manager who controls all the segments. The salary of CEO at
TELECOM is also an example of common fixed cost. No single segment can be regarded as the
sole reason of this cost.
 The salary of receptionist at an office shared by a number of doctors is a common fixed cost
of the doctors. The cost is traceable to the office, but not to any one of the doctors individually.
Identifying traceable and common fixed costs is crucial in segment reporting, since the
traceable fixed costs are charged to the segments and common fixed costs are not charged to
segments. In actual situations, it is sometimes hard to determine whether a cost should be
classified as traceable or common. The general guideline is to treat as traceable costs only those
costs that would disappear over time if the segment itself disappeared.
Fixed cost that is traceable to one segment is, usually, a common cost for another
segment. For example, one Trading Company might want a segmented income statement that
shows the segment margin for each territory where is operating and for each client. The fixed
territory manager salary is a traceable fixed cost of one territory, but it is a common fixed cost
of the client segment of that territory. So, traceable and common cost is relative concepts.
Problems to Proper Cost Assignment in Segmented Reporting:
For segment reporting to accomplish its intended purposes, costs must be properly
assigned to segments. If the purpose is to determine the profits being generated by particular
segment or division, then all of the costs attributable to that division or segment--and only those
costs--should be assigned to it. Unfortunately, three practices greatly hinder proper cost
assignment:
Omission of costs:
29

30. The costs assigned to a segment should include all costs attributable to that segment
from the company's entire value chain. The value chain consists of major business functions that
add value to a company's products and services. All of these functions, from research and
development, through product design, manufacturing, marketing, distribution, and customer
service, are required to bring a product or service to the customer and generate revenues.
Inappropriate methods for allocating costs among segments:
Cost distortion, occurs when costs are improperly assigned among a company's segment.
Cross-subsidization can occur in two ways; first, when companies fail to trace costs directly to
segments in those situations where it is a feasible to do so; and second, when companies use
inappropriate bases to allocate costs.
Costs that can be traced directly to a specific segment of a company should not be
allocated to other segments. Rather, such costs should be charged directly to the responsible
segment. For example, the rent for a branch office should be charged directly against the branch
office rather than included in a companywide overhead pool and then spread throughout the
company.
Some companies allocate costs to segments using arbitrary bases such as sales value or cost of
goods sold. For example, under the sales value approach, costs are allocated to the various
segments according to the percentage of company sales generated by each segment. If a segment
generates 20% of total company sales, it would be allocated 20% of the company's overheads
expenses as its fair share. This same basic procedure is followed if cost of goods sold or some
other measure is used as the allocation base. For this approach to be valid, the allocation base
must actually drive the overhead cost. Or at least the allocation base should be highly correlated
with the cost driver of the overhead cost. For example, when sales value is used as the allocation
based for SG&A expense, it is implicitly assumed that overheads expenses change in proportion
to change in value sales. If that is not true, the allocated expenses to segments will be
misleading.
30

31. Arbitrarily dividing common costs among segments
The third business practice that leads to distorted segment costs is the practice of
assigning no traceable costs to segments. For example, some companies allocate the costs of the
corporate headquarters building to products on segment reports. However, in a multiproduct
company, no single product is likely to be responsible for any significant amount of this cost.
Even if a product were eliminated entirely, there would usually be no significant effect on any
of the costs of the corporate headquarters building. There is no cause and effect relation between
the cost of the corporate headquarters building and the existence of any one product. As a
consequence, any allocation of the cost of the corporate headquarters building to the products
must be arbitrary.
Residual Income
Residual income is the net operating income that an investment center earns above the
minimum required return on its operating assets. Residual income is a consistent approach to
measuring an investment center's performance. Economic Value Added (EVA) is an adoption of
residual income that has recently been adopted by many companies. When residual income or
EVA is used to measure managerial performance, the objective is to maximize the total amount
of residual income or EVA.
Example
For the purpose of illustrating, consider the following data for an investment center of a
company.
Basic Data for Performance Evaluation
31

32. Average operating assets Rs 80,000
Net operating income Rs18,000
Minimum required rate of return15%
The company has long had a policy of evaluating investment center managers based on
ROI, but it is considering a switch to residual income. The following table shows how the
performance of the division would be evaluated under each of the two methods:
Alternative Performance
Measures
ROI Residual
Income
1. Average operating assets Rs 80,000 Rs 80,000
2. Net operating income Rs 18,000 Rs 18,000
ROI, (2) ÷ (1) 22,5%
Minimum required return (15% Rs 12,000
Rs80,000)
Rs 6,000
Residual income
Comparison of return on investment (ROI) and residual income:
One of the primary reasons why controllers of companies would like to switch from ROI
to residual income has to do with how managers view new investment under the two
32

33. performance measurement schemes. The residual income approach encourages managers to
make investments that are profitable for the entire company but that would be rejected by
managers who are evaluated by ROI formula.
To illustrate consider the data mentioned above and further suppose that the manager of
the division is considering purchasing a machine. The machine would cost Rs 25,000 and is
expected to generate additional operating income of Rs 4,500 a year. From the stand point of the
company, this would be a good investment since it promises a rate of return of 18% [(Rs4,500 /
Rs25,000) ×100], which is in excess of the company's minimum required rate of return of 15%.
If the manager of the division is evaluated based on residual income, he would be in favor of the
investment in the machine as shown below.
Performance evaluated using residual income
Present New Project Overall
Average operating assets Rs 80,000 Rs 25,000 Rs 105,000
Net operating income Rs 18,000 Rs 4,500 Rs 22,500
Minimum required return Rs 12,000 Rs 3,750 Rs 15,750
Rs 6,000 Rs 750 Rs 6,750
Residual income
Since the project would increase the residual income of the division, the manager would
want to invest in the new machine.
Now suppose that the manager of the division is evaluated based on the return on
investment (ROI) method. The effect of the machine on the division's ROI is computed as
below:
Performance evaluated using residual income
Present New project Overall
33

34. Average operating assets (1) Rs 80,000 Rs 25,000 Rs105,000
Net operating income (2) Rs 18,000 Rs 4,500 Rs 22,500
ROI, (2) ÷ (1) 22,5% 18% 21,4%
The new project reduces the ROI from 22, 5% to 21,4%. This happens because the 18%
rate of return on the new machine, while above the company's15% minimum rate of return, is
below the division's present ROI of 22,5%. Therefore the new machine would drag the
division's ROI down even though it would be a good investment from the standpoint of the
company as a whole.
Basically, a manager who is evaluated based on ROI will reject any project whose rate
of return is below the division's current ROI even if the rate of return on the project is above the
minimum rate of return for the entire company. In contrast, any project whose rate of return is
above the minimum required rate of return of the company will result in an increase in residual
income. Since it is in the best interest of the company as a whole to accept any project whose
rate of return is above the minimum rate of return, managers who are evaluated on residual
income will tend to make better decisions concerning investment projects than manager who are
evaluated based on ROI. So, in financial point of view, residual income leads managers to take
decisions more aligned with overall company interest. Residual income is more convergent than
ROI.
34

35. Chapter No. 4
ROLE IN PRACTICING A PERFORMING
MANAGEMENT
A responsibility centre corresponds to an inferior level of responsibility for the enterprise and, in
the same time, it is the base for calculating the performances of the one responsible with the
accomplishment of the undertaken tasks. From the economic viewpoint, the responsibility
centres can be classified into profit centres and costs centres. The profit centres can be
considered those divisions of an enterprise, which are realizing in fact the outlet, such as the
basis wards. The costs centres are those divisions of an enterprise, which are determining only
the expenses (costs). From budgeting the profit and cost centres, meaning the responsibility
centres, we can forecast the complete posts regarding the determination of the supplying prices.
The budget laying down methodology supposes the following steps: A. Elaborating the outlet
cost’s budget; B. Elaborating the general administrating expenses budget; C. Elaborating the
marketing expenses budget.
Enterprise’s goals achievement is materialized for each structural level, which imposes
the forecasts’ study on enterprise’s divisions, called responsibility centres.
The responsibility centre is regarded as “an interconnected elements ensemble, which is
forming an entirety, having a certain autonomy level in using and optimizing the resources
available”.
35

36. A responsibility centre corresponds to an inferior level of responsibility for the
enterprise and, in the same time, it is the base for calculating the performances of the one
responsible with the accomplishment of the undertaken tasks.
Usually, a responsibility centre can be assimilated to a managerial entity having precise
structural characteristics. It is defined as an ensemble in one physic person’s responsibility, as
an official service provided with self-means, which are allowing it to accomplish its attributions
and goals.
Considering that available grouping of the responsibility centres are not valid if the units
specific and their structure relieve a diversity of possibilities.
Some authors delimitate partial and global responsibility centres depending on the main
purchases. From the economic viewpoint, the responsibility centres can be classified into:
- Profit centres;
- Costs centres.
The profit centres can be considered those divisions of an enterprise, which are realizing
in fact the outlet, such as the basis wards. It is the strategic link where we can calculate the
profit as a difference between the revenues and expenses.
The costs centres are those divisions of an enterprise, which are determining only the
expenses (costs) - in this case we can control only the costs’ level. The responsibility centres
structure can be illustrated as it follows in the next diagram:
36

37. Figure no. 1. Responsibility centres structuring into profit and costs centres.
Regarding the costs calculation depending on costs’ centres, we have to specify that, the
structure is particular depending on the outlet’s specific and enterprise’s organizational
framework. The costs centres represent “the enterprise’s technique, productive, organizational
and managing frame’s divisions, depending on which is organized the planning and analytic
supervising of the outlet expenses”. The concrete result of the outlet process is individualized in
costs’ calculation, designated as “costs’ bearers, represented through products, works and
services obtained in the outlet process, which have generated the exploitation expenses for
which the cost is determined and the activity’s supervising is realized also”. The costs’
calculation structure regards the costs’ centres (productive wards) in which the costs are
allocated on different bearers.
The costs bearer accomplishes the individual costs identifying function, as well as the
control function regarding the enterprise’s activity volume.
Excepting the costs and profit centres there are revenues centres, as divisions generating
37

38. revenues (for example, the sells department) or investment centres, which reflects the revenues
from the outlet selling, and as well, the investments done for the outlet finality.
The profit centres are the ones that generate revenues able to cover entirely the activity’s
expenses, and finally obtaining an over income, meaning a profit.
The cost centres have only maximum limits for the expenses that are ensuing from a
normal activity.
From budgeting the profit and cost centres, meaning the responsibility centres, we can
forecast the complete posts regarding the determination of the supplying prices. The budget
laying down methodology supposes the following steps:
A. Elaborating the outlet cost’s budget (ward cost), which includes
- Raw materials direct expenses’ budget;
- Salaries and accessories direct expenses budget;
- Outlet indirect expenses budget (outlet administrating expenses);
B. Elaborating the general administrating expenses budget
C. Elaborating the marketing expenses budget.
Synthetically the complete commercial cost’s budget can be presented as it follows:
38

39. Figure no. 2. Complete Commercial Cost’s Budget
A. The complete commercial cost’s budget can be determined by using the following
mathematical models:
1) BCCC = BOC + BGAE + BME
Where:
BCCC - Complete Commercial Cost’s Budget; BOC - Outlet Cost’s Budget;
BGAE - General Administrating Expenses’ Budget; BME - Marketing Expenses’ Budget.
Outlet Cost’s Budget (BOC) - it includes the direct outlet expenses’ budget and indirect outlet
expenses’ budget, and is calculated as it follows:
2) BOC = BDE + BOIE
Where:
39

40. BDE - Direct Expenses’ Budget; BOIE -Outlet Indirect Expenses’ Budget.
Direct Expenses’ Budget (BDE) includes the raw materials direct expenses’ budget and the direct
salaries expenses’ budget. So:
3) BDE = BRMDE + BSDE
Where:
BRMDE - Raw Material Direct Expenses’ Budget; BSDE - Salaries Direct Expenses’ Budget.
Raw Material Direct Expenses’ Budget (BRMDE) - is determined based upon the technological
consumption’s norms and the acquisition/outlet’s costs of the raw materials and direct materials.
4) BRMDE = Q * ? nci * ci
Where:
Q - Fabricated product quantity;
nci - Technological consumption norm for i material; ci - Acquisition/outlet cost for the i
material; n - Used materials’ number.
The budget’s measure determined before considers the finished good obtained quantity. For the
average (per unit) determination of the budget we report the obtained amount at the outlet’s
volume.
Salaries Direct Expenses’ Budget (BSDE) - it is established considering the time norms for
realizing the operations necessary for costs’ bearers outlet and the hourly tariffs corresponding
to each operation.
5) BSDE = Q * ?nti *
ti
Where:
nti - time norm corresponding for the i operation; ti - hourly tariff for the i operation;
40

41. n - The necessary number of operations for the product’s fabrication
Outlet Indirect Expenses’ Budget (BOIE) - is determined for each ward separately. It supposes
the added of the installations maintenance and functioning expenses with the general expenses
of the ward, as it follows:
6) BOIE = BMFE + BWGE
Where:
BMFE - Installations Maintenance and Functioning Expenses’ Budget; B WGE - Ward’s General
Expenses’ Budget.
At the enterprise’s level the total outlet indirect expenses’ budget is obtaining through the
addition of the outlet indirect budget with the outlet wards budgets. Mathematically:
7) BTOIE = BOIE1 + BOIE2 + … + BOIEn = ? BOIEi
Where:
BTOIE - Total Outlet Indirect Expenses’ Budget; BOIEi - Outlet Indirect Expenses’ Budget for the
i ward; n - The enterprise’s wards number.
If we consider the two elements of the outlet indirect expenses’ budget, then the formula above
is becoming:
8) BTOIE = ? BOIEi = ? (BMFEi +
BWGEi)
Where:
BTOIEi - Installations Maintenance and Functioning Expenses’ Budget for the i ward; B WGEi -
Ward’s General Expenses Budget for the i ward.
Installations Maintenance and Functioning Expenses’ Budget (BMFEi) - includes: -
Technological installations and transportation means’ maintenance and functioning,
technique reviews and current reparations expenses for the ward;
41

42. - Expenses regarding the depreciation of the technologic installations and transportation means
of the ward;
- Expenses regarding the depreciation of the special destination installations and the inventory
objects of the ward;
- Expenses regarding the energy, fuel and other expenses with the materials used for
technological goals of the ward;
- Other expenses regarding the installations’ maintenance and functioning and the
transportation means of the ward.
Ward’s General Expenses Budget (BWGE) - includes two budgets: the general interest expenses’
budget of the ward and husbandry expenses’ budget.
The first one includes:
- Expenses regarding the salaries and the salaries’ accessories of the managing, technique,
economic and other specialty personnel;
- Expenses regarding the current reparations of the buildings and other means of general
interest of the ward, as well as the capital reparations of the buildings and ward’s fixed means;
- Expenses regarding the buildings and other ward’s fixed means’ depreciation; - Expenses
regarding labor protection inside the ward;
- Other general interest expenses of the ward. The second budget includes:
- Expenses regarding maintenance and cleaning of the husbandry buildings of the ward; -
Expenses regarding the energy for husbandry use;
42

43. - Expenses regarding water, sanitation and for the husbandry needs of the ward; - Expenses
regarding the office materials for the ward’s needs;
- Expenses regarding the magazines, books, publications and subscriptions for the ward’s needs
and the Post’s expenses;
- Other husbandry expenses of the ward.
B. General Administrating Expenses’ Budget (B GAE) includes the entirety of the general
interest expenses and the enterprise’s husbandry expenses.
1) BGAE = BEGIE + BEHE
Where:
BEGIE - Enterprise’s General Interest Expenses’ Budget; BEHE - Enterprise’s Husbandry
Expenses Budget.
the Enterprise’s General Interest Expenses’ Budget (B EGIE) - are included: - Expenses
regarding the salaries and salaries accessories of the managing, technique, economic, other
specialty, administrative, service and security personnel of the enterprise; - Expenses regarding
the buildings current reparations;
Expenses regarding the depreciation of the enterprise’s fixed means; - Expenses regarding the
researches, experiences, studies, investments and general interest innovations;
- Expenses regarding the general labor protection; - Expenses regarding enterprise’s interest
rates;
- Other enterprise’s expenses (personnel transportation’s cost, buildings’ taxes, insurance
policies).
The Enterprise’s Husbandry Expenses’ Budget (BEHE) includes: - Expenses regarding the
office’s materials;
43

44. Expenses regarding the acquisition of books, magazines and subscriptions; - Expenses
regarding the business travels, detaches or transfers in the country with or without trips abroad
for the company’s interest;
- Expenses regarding the energy consumption for husbandry goals; - Post’s expenses of the
enterprise;
- Expenses regarding the water, sanitation for management and husbandry purposes; - Others
expenses for enterprise’s husbandry.
Depending on the services number and complexity (finances, marketing, personnel)
offered by the management can be laid down two or more budgets. Regarding the small
companies it can be only one budget.
C. Marketing Expenses’ Budget (BME) includes the entirety of expenses generated by the
outlet selling process, such as:
- Expenses regarding the products’ transportation and manipulation, products that are delivered
to the internal customers;
- Internal transportation, manipulation, storage, reconditioning and clearance expenses of the
products delivered for export;
- Wrapper expenses for the delivered products; - Advertising expenses.
Chapter No. 5
Transfer Pricing
When an organization has a decentralized structure, it has several separate profit
centers1. Goods and services are transferred internally from one profit center to another, before
the final product/service is brought to the market. Companies find it useful to account for the
value of goods and services exchanged, even if the exchange is only internal and does not
involve the market at all. This helps the company to assess the contribution of each of the profit
44

45. centers separately. To help in such assessment, a mechanism called transfer pricing has been
developed. Transfer pricing helps to determine the value of goods and services transferred
before calculating the profits of the company. A transfer price is defined as “the price that is
assumed to have been charged by one part of a company for products and services it provides to
another part of the same company, in order to calculate each division's profit and loss
separately.” In this chapter we will discuss the objectives of transfer pricing, various methods
of transfer pricing and ways of administering these prices.
PRINCIPLE OF TRANSFER PRICING
The fundamental principle of transfer pricing is that the “transfer price should be similar to the
price that would be charged if the product were sold to outside customers or purchased from
outside vendors”.
Goal Congruence
While designing the mechanism for transfer pricing, the interests of profit centers should neither
supersede the interests of the overall organization, nor should there be a clash of interests
between the organization and its profit centers. In other words, there should be goal congruency
between profit centers and parent organization. Some of the prerequisites for achieving goal
congruency are:
• Competent people
• Good organizational atmosphere
• Details of market prices
• Freedom to source
• Availability of information
Organizations need managers who can balance long-term and short-term goals. Managers are
often accused of sacrificing long-term gains for shortterm profits. This approach can prove
disastrous for the organization. Transfer pricing can be misused for manipulating profits, and
this gives a wrong picture of the position of the company. Hence, organizations should have
competent people skilled at negotiation and arbitration, who are capable of determining the
appropriate transfer prices. This makes goal congruency possible.
45

46. Good atmosphere
In order to achieve goal congruency, managers of profit centers, especially the buying profit
centers, should ensure that the transfer prices charged by the selling profit centers are just. This
will create an atmosphere of trust between selling profit center and buying profit centers.
Details of market prices
When a product is transferred from one profit center to another, the normal market price for the
identical product can be taken as the basis for establishing the transfer price. The market price
should reflect the same conditions in terms of quantity, quality, time for delivery, etc. as
characterize the product to which the transfer price applies. The market price can be adjusted to
reflect savings due to lower expenses on advertising and marketing as the product is sold within
the company.
Freedom to source
Managers of selling profit centers should be given freedom to sell their goods in the external
market, while managers of buying profit centers should be allowed to buy their goods from the
external market. Thus the market becomes the main determinant of the transfer price.
Availability of information
Managers should be fully aware of market conditions and should have all the necessary
information available to them, before they take any decision. For example, managers should be
aware of the alternatives available and the relevant costs of and revenues derivable from each
alternative.
Scope for negotiation
There must be a mechanism for negotiating contracts, and managers who take transfer pricing
decisions should be trained in negotiation.
If all the above conditions are met, then companies can devise a mechanism for transfer pricing
based on the market price. But quite often these conditions are not fulfilled, and it becomes
difficult to achieve goal congruency. Some situations that are not favorable for achieving goal
46

47. congruency are:
• Limited markets
• Excess or shortage of capacity in the industry
Limited markets
Markets for buying and selling the goods of the profit centers may be either very small or
nonexistent. Some of the reasons for this are:
Firstly, the profit center may have spare internal capacity, but may not wish to make any
external sales. Secondly, if the company is the sole producer of a differentiated product then
outside capacity does not exist. Thirdly, a company that has invested heavily in facilities will
not want to source goods from outside unless the selling price in the market is as low as its own
variable cost.
Excess or shortage of industry capacity
There may be situation of excess capacity or shortage of capacity in the industry. The selling
profit center does not sell in the outside market when there is excess capacity in the industry.
The buying profit center may purchase from outside vendors even though there is capacity
available inside the company. Thus the company, as a whole, may not be optimizing its profits.
In a situation of insufficient capacity in the industry, the buying profit center may be unable to
obtain products it needs from the external market, whereas the selling profit center is able to
make profits by selling the product in the external market. This situation occurs when demand is
high and industry capacity is low. Here also, the company, as a whole, may not be able to
optimize profits.
Sourcing constraints
When there is an excess or shortage of industrial capacity, the sourcing decisions taken by the
company are vital. A company may allow its buying profit center to buy goods from outside, if
the profit center is getting a better deal in terms of quality, price and service. In the same way, a
selling profit center may be allowed to sell its products in the open market if it gets a better
profit by selling in the market. Whatever be the case, the management should not get bogged
47

48. down by pressures within the company and should try to take decisions that optimize the profit
of the company.
METHODS OF CALCULATING TRANSFER PRICE
Methods used for calculating the transfer price differ from company to company. Companies
should evaluate all the methods before adopting one that is most suitable for them. The
following criteria should be used to evaluate the methods for calculating transfer price.
Goal congruence: As already discussed, transfer prices should balance between goals of
enterprise as a whole and its profit centers. Rationality: Transfer prices should not interfere with
the process by which the buying center manager rationally strives to minimize costs and the
selling center manager rationally strives to maximize revenues.
Transfer Pricing
Autonomy: Each profit center manager should be free to satisfy his center’s needs either
internally or externally at the best possible price. Performance evaluation: Transfer pricing
should aid in objective evaluation of the activities of the profit center. It should be used as a tool
for making proper decisions. It should also aid in appraisal of managerial performance and of
the enterprise as a whole.
The three methods of calculating transfer price that are used commonly are:
• Market-based pricing method
• Cost-based pricing method
• Negotiated pricing method
Market-Based Pricing Method
48

49. Companies that use this method price the goods and services they transfer between their profit
centers at a price equal to that prevailing for those goods and services in the open market. This
is similar to ‘arm’s length’ pricing as intracompany transfers are priced the same as those for
external customers. Market-based pricing method has two main advantages for a company.
Firstly, business units can operate as independent profit centers with the managers of these units
being responsible for their own performance as well as that of the business unit. When managers
are made responsible for performance of the business unit, it increases their motivation and it
also becomes easier for the headquarters to assess the actual operating performance of its
business units. Secondly, tax and customs authorities favor the market price method because it
is more transparent and they can crosscheck the price details provided by the company by
comparing them with market prices on that date. In practice, however, the use of a market price
as a benchmark is difficult because often there is no competitive market which can provide a
comparable price. For some types of complex capital equipment, an external market may not
exist at all. In some cases, prices may be distorted by monopoly elements. Moreover, a
definitive market price may be difficult to determine because of variance in prices from one
market to another due to changes in exchange rates, transportation costs, local taxes and tariffs
etc. In addition, a company may set its selling price depending on the supply and demand
conditions prevalent in a specific market. In sum, these factors mean that a unique market price
for companies to follow does not always exist.
Cost-Based Pricing Method
The cost-based pricing method calculates transfer price on the basis of the cost of a good or
service. The cost of a good or service is available in the cost accounting records of the company.
This method is generally accepted by the tax and customs authorities since it provides some
indication that the transfer price approximates the real cost of item. Cost-based approaches are,
however, not as transparent as they may appear. A company can easily manipulate its cost
accounts to alter the magnitude of the transfer price. Companies that adopt the cost-based
transfer pricing method have to choose between alternative approaches, which are listed below:
• Actual costs approach
• Standard costs approach
• Variable costs approach
49

50. • Marginal costs approach
Apart from this, companies also have to decide on the treatment of fixed costs, and research and
development costs. These issues can prove problematic for the company that adopts a cost-based
transfer pricing method. Cost-based methods usually create difficulties for the selling profit
center, as their incentive to be cost-effective may fall, if they know that they can recover
increased costs simply by raising the transfer price. Without an incentive to produce efficiently,
the transfer price may erode the competitiveness of the final product in the market place.
Negotiated Pricing Method
In this approach, buying and selling business units freely negotiate a mutually acceptable
transfer price. Since each unit is responsible for its own performance, this will encourage
cost minimization and encourage the parties to seek a transfer price which yields them an
appropriate profit return. However the tax authorities have their reservations about this method
because companies that use this method have greater scope of manipulating transfer prices, to
minimize their tax liability.
Chapter No.6
RESEARCH METHODOLOGY
Research is a systematic method of finding solutions to problems. It is essentially an
investigation, a recording and an analysis of evidence for the purpose of gaining knowledge.
According to Clifford woody, “research comprises of defining and redefining problem,
50

51. formulating hypothesis or suggested solutions, collecting, organizing and evaluating data,
reaching conclusions, testing conclusions to determine whether they fit the formulated
hypothesis”
Sampling Design.
A sample design is a finite plan for obtaining a sample from a given population. Simple random
sampling is used for this study.
Universe.
The universe chooses for the research study is the employees of Lubrizol India Pvt Ltd.
Sample Size.
Number of the sampling units selected from the population is called the size of the sample.
Sample of 50 respondents were obtained from the population.
Sampling Procedure.
The procedure adopted in the present study is probability sampling, which is also known as
chance sampling. Under this sampling design, every item of the frame has an equal chance of
inclusion in the sample.
Nature of Research.
Descriptive research, also known as statistical research, describes data and characteristics about
the population or phenomenon being studied. Descriptive research answers the questions who,
what, where, when and how.
Although the data description is factual, accurate and systematic, the research cannot describe
what caused a situation. Thus, descriptive research cannot be used to create a causal
relationship, where one variable affects another. In other words, descriptive research can be said
to have a low requirement for internal validity.
Questionnaire.
51

52. A well defined questionnaire that is used effectively can gather information on both overall
performance of the test system as well as information on specific components of the system. A
defeated questionnaire was carefully prepared and specially numbered. The questions were
arranged in proper order, in accordance with the relevance.
Sample
A finite subset of population, selected from it with the objective of investigating its properties
called a sample. A sample is a representative part of the population. A sample of 50 respondents
in total has been randomly selected. The response to various elements under each questions
were totaled for the purpose of various statistical testing.
Presentation of Data.
The data are presented through tables
Research Hypothesis
Based on the theoretical frame and the previous studies, the following hypotheses were formed:
HO1: the Lubrizol India Pvt. Ltd. do not divide the organizational structure into centers of
52

53. responsibility.
HO2: the Lubrizol India Pvt. Ltd. do not authorize the managers of responsibility centers with
clear powers.
HO3: the costs and the revenues are not distributed to the centers of responsibility according to
each center’s capability and powers in the Lubrizol India Pvt. Ltd.
HO4: the Lubrizol India Pvt. Ltd. do not link previously the estimated budgets with the centers
of responsibility.
HO5: the estimated budgets are not used for control and performance evaluation in the Lubrizol
India Pvt. Ltd.
Research
For achieving the objectives of the study, the descriptive analytical method was used. In
addition, the suitable statistical procedures, MS Excel were used for testing the hypotheses and
for presenting and analysis of the data.
Methods for Collecting Data
The researcher depended on two kinds of data during collecting it
Secondary data: the related studies of auditing about the subject of the study were reviewed
from different references, magazines, studies, periodicals, etc. for developing the theoretical
background of the study.
Primary data: the researcher made a comprehensive field survey for the population of the study
by using a questionnaire to collect data and test the hypotheses of the study. The questionnaire
consisted of two parts. The first part aimed at collecting general data to identify the
characteristics of the sample of the study. The second part aimed at getting data related to study
53

54. hypotheses.
The population and the sample of study
The population of the study is represented by all the Lubrizol India Pvt. Ltd. of the sample was
represented by a random sample consists of 50 assistants of the general managers. 55
questionnaires were distributed but 50 were retrieved with a percent 91%.
Table (1) The description of the sample
Scientific qualification N Portion
Diploma 3 6%
Bachelor 35 70%
Master 10 20%
Doctorate 2 4%
Age
Less than 25 years 7 14%
25-34 8 16%
35-44 26 52%
More than 45 years 9 18%
Practical experience
Less than 5 3 6%
5-9 years 9 18%
10-14 years 28 56%
More than 15 10 20%
Job title
Assistant of general manager 2 4%
Head of department 8 16%
Branch’s manager 18 36%
Head section 15 30%
Employee 7 14%
Statistical analysis of data
The following statically methods were used to analyze data and test the hypothesis according to
SPSS:
1- Testing the reliability of the tool of the study: It was used to measure the internal reliability of
the questionnaire’s items and the internal consistency among the responses of the respondents
54

55. which was 72% and this value is acceptable as it is higher than 60% so the results could be
generalized.
2- Normality Distribution Test: It was used to test the normality of the distribution of data. And
the results showed that the data was distributed normally. It is illustrated from the table that the
significance level 5% for all the hypotheses of the study which was bigger than the level of
significance Z, was distributed normally.
Normality Distribution Test
Hypothesis 1st 2nd 3rd 4th 5th 6th 7th
0.737 1.176 0.855 1.079 0.945 0.835 0.829
3- Testing the hypothesis
One Sample T-Test at the level of significance 5% was used to test the hypotheses of
the study, and according to the rule of the acceptance of the hypotheses if the calculated T
was less than the tabulated one. The descriptive analysis, which includes frequencies means
and the standard deviations of accepting or rejecting the hypothesis, was used.
• The first hypothesis: The Lubrizol India Pvt. Ltd. do not divided the organizational
structure to centers of responsibility. This hypothesis was tested through the first seven
items of the questionnaire, and the results were as follows:
Results of testing the first hypothesis
T calculated T tabulated Sig Result of null Mean Std
hypothesis
11.95 1.96 0 Rejection 3.76 0.451
As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and
accepting the alternative one and the mean of the hypothesis is more than 3 which means it is
55

56. acceptable. So the Lubrizol India Pvt. Ltd. divide the organizational structure to centers of
responsibility. And table shows the mean and the standard deviation of the items of the first
hypothesis
The items of the first hypothesis
N Item Mean Std
1 There is an organizational structure divided 3.96 1.02
into administrative units according the
nature of the activity.
2 There is clarity in dividing the work in the 4.02 0.84
administrative units.
3 There is a clear description to the centers of 4.28 0.755
responsibility.
4 There is a coordination and clarity in the 4.2 0.67
relation between the centers of
responsibility
5 There is a specialized manager for each 3.88 0.98
center of responsibility.
6 Every center of responsibility has one type 2.44 0.97
of activity
7 The operations inside the center of 3.7 1.05
responsibility are characterized by
homogeneity
• The second hypothesis: The Lubrizol India Pvt. Ltd. do not authorize the managers of
responsibility centers with clear powers. And this hypothesis was tested through the
items (8 - 13) of the questionnaire. And the results were as follows:
Results of testing the second hypothesis
T calculated T tabulated Sig T Result of null Mean Std
hypothesis
12.085 1.96 0 Rejection 3.97 0.57
56

57. As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis
and accepting the alternative one and the mean of the hypothesis is more than 3 which means it
is acceptable according Lickert scale. So the Lubrizol India Pvt. Ltd. authorized the managers of
responsibility centers with clear powers. The table showed the mean and standard deviation of
the items of the second hypothesis:
The items of the second hypothesis
N Item Mean Std
8 The manager is told his duties in the center of 3.86 0.92
responsibility
9 The manager of the center is granted 3.92 0.98
appropriate authorities to do his work.
10 There is a description and identification of the 3.94 0.99
responsibilities and the authorities of every
job
11 The employees of the center of responsibility 4 0.92
have the needed expertise to do their work in
the center
12 The manager of the center is given enough 4.02 0.74
time to do their work.
13 The employees’ accountability suits their 4.08 0.96
responsibilities.
• The third hypothesis: The costs and the revenues are not distributed to the centers of
responsibility according to each center’s capability and powers in the Lubrizol India Pvt.
Ltd. This hypothesis through the items (14 - 18) of the questionnaire, and the results
were as follows:
Results of the third hypothesis
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58. T T tabulated Sig T Result of null Mean Std
calculated hypothesis
11.9 1.96 0 Rejection 3.92 0.54
As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis and
accepting the alternative one and the mean of the hypothesis is more than 3 which means it is
acceptable according Lickert scale. So there is a distribution of the costs and the revenues to the
centers of responsibility according to each center and its powers in the Lubrizol India Pvt. Ltd.
Table showed the mean and the standard deviation of the items of the third hypothesis
The items of third hypothesis
N Item Mean Std
14 All the revenues regarding the center of responsibility are identified and 3.68 0.97
recorded.
15 All the costs regarding the center of responsibility are identified and 4.04 1.009
recorded.
16 There is clarity in the system of comparing the revenues with the costs of the 3.8 1.1
center of responsibility
17 There is a clear policy regarding the indirect costs’ distribution to the 4.1 0.88
centers of responsibility
18 There is a clear and identified system of the costs distribution and the 3.9 0.839
revenues.
• The fourth hypothesis: The Lubrizol India Pvt. Ltd. do not link previously the estimated
budgets with the centers of responsibility. This hypothesis was tested through the items (
19-23) of the questionnaire and the results were as follows:
Results of the fourth hypothesis
T calculated T tabulated Sig T Result of null Mean Std
hypothesis
58

59. 6.805 1.96 0 Rejection 3.37 0.39
As the calculated T is bigger than tabulated T this means rejecting the null hypothesis and
accepting the alternative one and the mean of the hypothesis is more than 3 which means it is
acceptable according Lickert scale which means that the Lubrizol India Pvt. Ltd. link the
estimated budgets with each of the center of responsibility previously. Table 10 showed the
mean and the standard deviation of the items of the 4th hypothesis
The items of the fourth hypothesis
N Item Mean Std
19 A clear and a realistic objective is identified 3.8 0.92
for every center of responsibility in the
organization complies with the performance
standards.
20 Necessary adjustments on the estimated 3.62 0.87
budgets of the centers are carried out
wherever there is the need
21 The estimated budgets are prepared 3.48 1.03
regarding every center separately.
22 The organization trains the employees of the 3.65 0.92
centers and encourage them to achieve
these centers’ objectives
23 All the employees of the center participate in 2.42 1.21
preparing the center’s budget according to
their job
• The fifth hypothesis: The estimated budgets are not used for control and performance
evaluation in the Lubrizol India Pvt. Ltd. This hypothesis was tested through items ( 24-
28) of the questionnaire and the results were as follows:
Results of testing the fifth hypothesis
59

60. T calculated T tabulated Sig T Result of null Mean Std
hypothesis
11.243 1.96 0 Rejection 3.79 0.49
As the calculated T is bigger than tabulated T, this means rejecting the null hypothesis
and accepting the alternative one and the mean of the hypothesis is more than 3 which means it
is acceptable according Lickert scale. So the estimated budgets are used for control and
evaluating the performance in the Lubrizol India Pvt. Ltd. And table 12 showed the mean and
standard deviation of the items of the 5th hypothesis.
N Item Mean Std
24 Comparing the employees Actual 3.72 0.99
performance with the planned one in every
center facilitates the communication
between the administrative levels.
25 Comparing the employees Actual 3.64 0.66
performance with the planned one in every
center helps in evaluating the employees’
performance
26 Comparing the employees Actual 3.9 0.9
performance with the planned one in every
center provides appropriate information in
the proper time.
27 Comparing the actual performance of the 3.88 0.91
employees supports the policies of control.
28 Comparing the employees Actual 3.84 0.97
performance with the planned one in every
center aims to
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61. Chapter No. 7
Findings
• The Lubrizol India Pvt. Ltd. are committed to the application of the elements of the
responsibility accounting regarding the division of the organizational structure into
centers of responsibilities in terms of a clear existence of centers of responsibility in the
organization.
• There is a coordination and clarity between the centers of responsibility in the
organization, clarity in dividing the work between the administrative units in the
organizations, division of the organizational structure in the organization into
administrative units according to the nature of the activity and there is a specialized
manager to every center of responsibility in the organization, and the operations inside
the center are homogeneous while the sample’s attitudes were negative towards having
one type of activity in every center of responsibility.
• The Lubrizol India Pvt. Ltd. committed to the application of the responsibility
accounting features regarding delegation of clear authority for the managers of the
centers of responsibility which are represented by the employees’ accounting in the
responsibility centers that suit their responsibilities, granting the manager of
responsibility center the sufficient time to achieve his missions and the employees have
the expertise of their work. And the manager of the center is shown his responsibilities
and granted the proper authorities to do his work. There is also a description and
identification to the responsibilities and authorities of every job in the organization.
• The Lubrizol India Pvt. Ltd. commit to the application of features responsibility
accounting regarding the distribution of the revenues and the costs to the centers of
61