Cost accounting - PowerPoint Presentation

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Cost accounting

COST MANAGEMENT BASICS

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Agenda

Accounting Overview

Financial Accounting

Budgetary Accounting

Management AccountingOutput CostsTransfer Pricing

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Accounting Overview

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“is the production of financial records about an organization. Accountancy generally produces financial statements that show in money terms the economic resources under the control of management; selecting information that is relevant and representing it faithfully. The principles of accountancy are applied to accounting, bookkeeping, and auditing.

”

Source Wikipedia

Definition of Accounting

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Accounting Domains

Financial Accounting

–

focuses on reporting to external users (e.g. investors, creditors, and governmental agencies) to communicate a financial position

Budgetary Accounting - the process of implementing a budget and the consumption of the budget utilizing special subset of accounts. An additional accounting requirement for State or Federal Government funded entitiesCost Accounting – records, measures, analyzes and reports financial and non-financial information to managers to aide in making decisions to meet objectives. Commonly referred to as managerial accounting

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Financial Accounting

Concerned with preparation of financial statements for external users (e.g. investors, creditors, and governmental agencies) to communicate a financial position

Primary users are external looking to judge the health of the entity and for comparison with other entities

Not intended for day-to-day running of the company/organization since historical in nature (monthly, quarterly, annual reports)

Govern by local and international accounting standards; e.g. Financial Accounting Standards Board (FASB)Follows Generally Accepted Accounting Principles (GAAP)Certification/Professionals are CPAsHas limited influence on employee behavior outside of employee stock holding

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Budgetary Accounting

7

Concerned with preparation of budgetary statements for external users (e.g. governmental agencies) to communicate a budget position

Primary users are external looking to judge the compliance of a government entity to funded Budgets

Not intended for day-to-day running of the company/organization since historical in nature (monthly, quarterly, annual reports)

Govern by oversight entities; e.g. Government Accounting Standards Board (GASB),

Typically follows Generally Accepted Accounting Principles (GAAP) with some differences

Certification/Professionals are CGFMs

Has limited influence on employee behavior (influences when to consume budget)Slide8

Cost/Managerial Accounting

8

Concerned with preparation of statements for internal users (e.g. Product Line or Customer Managers) to communicate a Profit/Loss position

Primary users are internal management looking to benchmark the management of inputs with corresponding outputs

Intended for day-to-day running of the company/organization since predictive in nature (daily, monthly, quarterly, annual, forecasts, simulations)

Not governed to a specific rule or formatting; focus is information to make appropriate decisions

Typically follows Generally Accepted Accounting Principles (GAAP) with some differences

Certification/Professionals are any focusing on efficiency/effectiveness or performance improvements (e.g. CMAs, Internal Auditors, PMPs)

Designed to influence employee behavior (change process to decrease costs, spend $ to increase market-share, etc.)Slide9

Summary of Accounting Domains

Financial Accounting

Budgetary Accounting

Managerial Accounting

Purpose

Communicate financial position to outsiders

Communicate Budget position to outsiders

Decision making

Primary Users

External users

External users

Internal managers

Regulating Bodies

SEC, IRS, FASB, IASB

OMB, GASB, GAO

IMA/IFAC

Focus/ Emphasis

Past-oriented

Past-oriented

Future-oriented

Rules

GAAP compliant;

CPA audited

Modified GAAP

Do not have to follow GAAP; cost vs. benefit

Time Span

Historical monthly, quarterly reports

Historical monthly, quarterly reports

Ultra current to very long

time horizons

Behavioral Impacts

Indirect effects on employee behaviorIndirect effects on employee behaviorDesigned to influence employee behavior

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Financial Accounting

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Accounting Methods

Cash Basis: Record when Pay

Accrual Basis: Record when receive the Benefit

Plan

Order

Receive

Pay

Plan

Order

Receive

Pay

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The Accrual Basis of Accounting

Focuses on exchange of Economic

R

esources

Records Revenues in the period in which they are EARNEDProviding a serviceSelling a productPlan

Take

Orders

Complete Service or Ship Product

Collect

Cash

Revenue & Non-Cash Asset

12Slide13

Revenue Comparison

Cash Basis:

Accrual Basis:

Plan

Take

Orders

Complete Service or Ship Product

Collect

Cash

Plan

Take

Orders

Complete Service or Ship Product

Collect

Cash

Revenue & Non-Cash Asset

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The Accrual Basis of Accounting

“Matches” Revenues with Expenses

It takes money to make money

Records Expenses in period INCURRED

Resources ConsumedPlan

Order

Receive

Pay

Asset & Liability



Remove Liability



Expense

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What is the Accounting Cycle?

The Accounting Cycle is the systematic process by which accounting information is recorded, compiled, and reported to users.

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The

Financial Accounting Cycle

Record Transactions

Post to Ledger

Prepare Trial Balance

Adjust Accounts

Adjusted

Trial Balance

Prepare

Statements

Close Accounts

Post-Closing Trial Balance

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The Journal

Accounting

events

are

recorded in the JOURNALThe Journal is a chronological record of all transactionsEach transaction requires a journal entryEach journal entry consists of at least one Debit and one Credit: “Double Entry” Accounting

Debit amounts

must

equal Credit amounts

Debit

: an entry on the left-hand side of the account

Credit

: an entry on the right-hand side of the

account

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Debits and Credits

Debits and credits are

neutral

Debit ≠ decrease

Credit ≠ increaseIt depends on the type of accountSome accounts types record increases with a debit, some record increases with a credit The side of the account which records an increase is the account’s NORMAL BALANCE

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Anatomy of a Journal Entry

19

Amount Debited &

Credited

Explanation of TransactionSlide20

2 Basic Types of

Adjustments

Prepayments

:

Cash is paid before the resource is consumedWhen cash is paid in advance, an asset is createdAt the end of the period, some of the asset may have been consumed  expenseConsume

Pay

Record Asset

 Reduce Asset, Record Expense

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2 Basic Types of

Adjustments

Accruals

:

Resources have been consumed but no cash has been paidResults in a liabilityConsume

Pay

Expense & Liability

 Remove Liability

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Equipment and Depreciation

Depreciation is the accounting process of assigning a portion of equipment’s cost to the periods in which it is used

A portion of the benefit of owning the equipment has been received in the current period

 expense

The future benefit is reducedThere is Financial depreciation which tends to be straight-line (Tank life is expected to be 10 years) and Cost Depreciation which tends to be usage-based (Tank life is 100000 kilometers)22Slide23

Budgetary Accounting

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Budgetary Accounting

Provides a

control

mechanism to prevent overspending funds

Does proper budgetary accounting prevent deficits? Why or why not?It DOES prevent overspendingIt does NOT prevent revenue shortfallsIt does NOT prevent over-appropriating by the legislative body

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Current Army Focus

Focused on the “Budget” domain

The “Budget” domain consists of creation of the budget requests/submissions, determination of the year of execution budget (e.g. availability control and informal budgets), actual execution, and reporting of the status of execution against the budget (e.g. the PPB&E process)

Primary focus of budget execution is the Obligation (consumption of the budget)

Budget Accounting focuses on 4 series accounts – status of Budget and consumptionBudget Management focuses on the status of available funds, which includes both current and prior years funds

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Budget Terms

Budget

= What Can Be Spent

Commitment

= a thought to procure a product/serviceObligation = a promise to procure a product/ service (e.g. to spend)Budget  ObligationsBudget – Obligations = Availability (e.g. what is left to spend)

Expenditure

is the receipt of the product/service which was obligated (e.g. what was spent)

Expenditures or collection of expenses/expenditures determines

Costs

Disbursement

is the outlay of cash

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Budgetary Comparison

Cash Basis:

Accrual Basis:

Budgetary Basis:

Plan

Order

Receive

Pay

Plan

Order

Receive

Pay

Commitment



Obligation



Expenditure



Disbursement

Plan

Order

Receive

Pay

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The

Budgetary Accounting Cycle

Obtain Budget Revenue

Distribute to Allotment

Commit

Funds

Obligate Funds

Expense

Funds

Disburse Cash

Manage Availability

Close Budget Year

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The Budgetary Accounts

Exist solely for the purpose of recording and tracking the budget

Budget = a legally binding spending plan

Account Titles:

Estimated Revenue = Expected IncomeAppropriations = Authorized SpendingBudgetary Fund Balance = Planned ChangeUnreserved Fund Balance = Savings

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Procurement Process

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Budgeting

Participation

Encourage bottom-up flow of information

Encourage top-down flow of information and plans

Budgets

attempt to

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IMCOM

Jackson

Benning

Knox

Budget - Color of Money

$

$

BOS

$

$

Appropriations

Program Elements

Fund Centers

Elements

Of Resources

Supplies

Training

Travel

Equipment

Labor

Etc.

OMA

AFH

SRM

$

GFEBS

$

RDT&E

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Cost

Vs.Budget

Knowing your

obligations

is not the same as knowing your costs!

Obligations

A legally binding commitment by the federal government that will result in outlays, immediately or in the future. Budgetary resources must be available before obligations can be incurred legally.

The price or cash value of resources used (expenditures) to produce a program, project or activity. All relevant costs may not appear in the organization’s budget.

Costs

Costs

Obligations

Cost



Obligation

Full cost can exceed individual business unit budget allocations

Cost will contain expenses from different years, source of funds, organizations, etc.

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Budget Formulation

Budget Execution

Cost Management

Budget

President’s financial plan and the priorities for the Federal Government

Cost

Valuation of resources used to produce outputs, basis for decision making

Budget Authority

Authority to incur obligations

Focus

requirements

Key Data Elements

appropriation, FTE

Focus

availability, obligations

Key Data Elements

appropriations, EOR’s, PE, MDEP, projects, BLIN, etc.

Key Data Elements

operational entity (e.g. cost centers), services, rates, products, projects, etc.

Focus

full costs, Plan

vs. Actual

Questions

What do I need?

What will I ask for?

Questions

What funding did I

get?

What obligations were executed?

Questions

What was expensed?

What did I get for it?How well was it used?Budget vs Cost Domains34Slide35

Managerial

Accounting

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Three Common Features of

Cost Accounting

Calculates

the cost of products, services, and other cost objects

Tracks information for planning & control, and performance evaluationAnalyzes relevant information for decision making

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An Easy Definition of Cost

…. “a

cost

is the value of money that has been used up to produce something”

# Clean Dishes

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Basic Cost Terms

Cost: a sacrifice of resources

Cost Object:

any item or activity for which a separate measurement of cost is desired – cost objects are the “something” in a statement

Cost Driver: any factor whose change ‘causes’ a change in the total cost of a related cost object – cost drivers can be factors other than volume38Slide39

The Many Types of ‘Cost’

Direct Cost:

a cost such as labor, material/supplies that can be directly traced to producing a specific output of organization, product, or service

Indirect Cost

: a cost that cannot be directly traced to a specific organization, product or service outputFunded Cost: the value of goods or services received because of an obligation of funds (obligation authority), by an organization performing the workUnfunded Cost: a cost that is financed by another organization’s or activity’s appropriationsVariable Cost: a cost that changes with change in the outputFixed Cost: a cost that remains the same regardless of the change in outputRecurring Cost: a cost that is incurred repeatedly for each organization and/or product and service producedNon-recurring Cost: a cost that is unusual and unlikely to occur againAvoidable Cost: a cost incurred on an object that will no longer be incurred due to a decision to change the outputUnavoidable Cost: a cost incurred on an object that will be incurred regardless of the decision to change

Common understanding of different types of costs is necessary for informed decision making

Each decision should be focused on ONLY relevant cost that impact the decision

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Costs may be:

Direct or indirectRecurring or nonrecurringBurdened or unburdened

Variable or fixed

Some Characteristics of Costs

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Direct Cost

Can be easily and conveniently traced to a specific cost element/objective

Example:

The cost of ammunition fired in a training event at the firing range

Indirect CostCannot be easily and conveniently traced to a specific cost element/objectiveExample: Installation support to the firing range (utilities, upkeep, etc)Direct vs. Indirect

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Recurring vs. Non-recurring

Recurring Cost

Cost that is incurred regularly in producing a product or providing a service

Examples:

Civilian and military personnel who conduct the activity, recurring sustainment of facilities, supplies, personnel training, utilities, equipment maintenance, janitorial service, office suppliesNon-Recurring CostCost that only occur once or infrequently.Examples: Major items of equipment, major and minor construction, one-time training in new procedures, activities conducted in direct support of individual process improvement efforts

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Burdened vs. Unburdened

Unburdened Cost

Cost of a product/service that does not consider other related costs necessary to provide that product/service.

Examples:

Direct compensation, cost of a gallon of fuel in a theater of operations, etc.Burdened CostCost of a product/service plus an apportioned cost of other related costs necessary to provide that product/service.Examples: Salary plus the cost of benefits (health, retirement, etc.), facilities support cost allocated to an activity or personnelThere are degrees of burden in a CBA. For example:Direct compensation for military and civilian personnel is always burdened with the cost of personnel benefits

Facilities support cost is allocated to a COA only if it can demonstrated that the COA causes the cost to be incurred

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Variable vs. Fixed

Variable Cost

A cost that varies based on the level of activity or output. This can be either a linear relationship or a step function.

Examples:

Fuel cost for vehicles varies in a linear fashion relative to the number of miles driven. The number of instructors needed to teach a class can vary in a step function based on the number of students (e.g., 1 instructor for 25 students, 2 instructors for 26-50 students, etc).Fixed CostA cost that does not vary based on the level of activity or output.Example: At an Army installation, the cost associated with the commander and his/her immediate staff is unlikely to vary as the installation population or other variables change.

Variable

Semi-Variable

Fixed Cost

Note: Most costs are semi-variable

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Example

: Paul

is

assembling his new home theatre system. He has spend 5 hours thus far and estimates he will complete the assembly in 2 more hours. Joan informs him he is doing it the hard way and describes a simpler approach which will take one hour to undo his work and re-assemble the system completely

Sunk CostsCosts that have already been incurred and cannot be changed no matter what action is taken in the future are called Sunk Costs

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Opportunity Costs

The size of a foregone opportunity of using a resource is the

Opportunity Cost

Example

The opportunity cost of accepting a job is forgoing the opportunity to do something else with our time If our best alternative to working is playing golf the opportunity cost of working is the forgone opportunity of playing golf

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Marginal Costs

Marginal Costs

are the costs to produce one more additional unit of output

Marginal costs are highest at very low output rates and at output rates near capacity

The slope of the ‘Total Cost Curve’ at any given level of production is the marginal cost for one more unit

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Marginal Costs

Output

Cost

Total cost

High marginal costs

A

C

High marginal costs

B

Lowest marginal costs

48Slide49

Average Costs

Average Cost is very high at low levels of output

Average Cost

is calculated by dividing the total cost by the total units produced

49Slide50

Cost Behavior

Variable costs:

changes in total in proportion to changes in the related level of activity or volume

Variable

costs are constant on a per-unit basisIf a product takes 5 pounds of materials each, it stays the same per unit regardless of number of units producedFixed costs: remain unchanged in total regardless of changes in the related level of activity or volumeFixed costs change inversely with the level of production As more units are produced, the same fixed cost is spread over more units, reducing the cost per unit

Costs are fixed or variable only with respect to a specific activity or a given time period

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Cost Behavior Summarized

Total Dollars

Cost per Unit

Variable Costs

Change in proportion with output

More output = More cost

Fixed Costs

Unchanged in relation to output

Change inversely with output

More output = lower cost

per unit

Total Dollars

Cost Per Unit

Variable Costs

Change in proportion with output

More output = More cost

Unchanged in relation to output

Fixed Costs

Unchanged in relation to output

Change inversely with output

More output = lower

cost per

unit

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Cost in More Detail

“Cost”

is a monetary measure of the sacrifice associated with:

expending

resource functionality

to achieve a specific

objective

, or

utilizing

resource output

required to achieve a specific objective, or

the provision of resource functionality or resource output while not using it

Resources

Resources

Consumed

52Slide53

Cost = Converting and Measurement of Work

Cost Center

Asset / Equipment

Project / Program

Internal Order

WBS / Work Order

Organization - Labor, Materials, Supplies

Resources/Inputs

Outputs

Plant, Property & Equipment

Building Project, Weapon System

Services, Events (SSP, Course)

Job (Set of Tasks) – Maint & Repair

53Slide54

Problems in Identifying and Measuring Costs

Planning Decisions

What is the cost of a dissatisfied customer?

How do I measure the cost of setting my price too high?

How do I measure the cost of poor quality?

What is the cost of postponing this year’s training program?

What is the cost of using current facilities?

What is the cost of requiring employees to work overtime?

What is the cost of using raw materials in inventory?

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Costing Philosophies

55Slide56

Costing Philosophies

When determining how to develop the cost model to be utilized to generate the Cost Accounting data there are multiple Costing Philosophies to be considered:

Standard Costing

Traditional Costing

Activity-based Costing

Grenzplankostenrechnung

(GPK)

Resource Consumption Accounting (RCA)

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Standard Costing

Traces direct costs to output by multiplying the standard prices or rate by the

standard quantities

of inputs

allowed

for actual outputs produced

Allocates overhead costs on the basis of the standard overhead-cost rates time the

standard quantities

of the allocation bases

allowed

for the actual outputs produced

Replaced by Traditional Costing once actual data collection was automated

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Activities Based Costing

“ABC as an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs

1

”

ABC seeks to improve the tracing of indirect costs to products/customer by recognizing the different levels of activities that lead to indirect product/customer costs

ABC is useful to provide visibility into support activities required to address complexities in products or customers

Typically Full-absorption (all costs associated to the product) which caused inappropriate product/customer decisions

58

1

Source WikipediaSlide59

Cost Allocation & Assignments

59Slide60

Accounting for Overhead

Actual costs will almost never equal budgeted/planned costs

Accordingly, an imbalance situation exists between the two overhead accounts

If Overhead Control > Overhead Allocated, this is called

Under-allocated OverheadIf Overhead Control < Overhead Allocated, this is called Over-allocated Overhead

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Accounting for Overhead

This difference will be eliminated in the end-of-period adjusting entry process, using one of three possible methods

The choice of method should be based on such issues as materiality, consistency and industry practice

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Cost Allocation

Assigning indirect costs to cost objects

These costs are not traced

Indirect costs often comprise a large percentage of Total Overall Costs

62Slide63

Purposes of Cost Allocation

63Slide64

Criteria for Cost-Allocation Decisions

Cause and Effect:

variables are identified that cause resources to be consumed

Most credible to operating managers

Integral part of ABCBenefits Received: the beneficiaries of the outputs of the cost object are charged with costs in proportion to the benefits received64Slide65

Criteria for Cost-Allocation Decisions

Fairness (Equity):

the basis for establishing a price satisfactory to the government and its suppliers

Cost allocation here is viewed as a “reasonable” or “fair” means of establishing selling price

Ability to Bear: costs are allocated in proportion to the cost object’s ability to bear themGenerally, larger or more profitable objects receive proportionally more of the allocated costs65Slide66

Cost Allocation Illustrated

66Slide67

GFEBS Manual Cost Allocation

67Slide68

Allocating Costs of a Supporting

Department to Operating Departments

Supporting (Service) Department:

provides the services that assist other internal departments in the company

Operating (Production) Department: directly adds value to a product or service68Slide69

Methods to Allocate

Support Department Costs

Single-rate method:

allocates costs in each cost pool (service department) to cost objects (production departments) using the same rate per unit of a single allocation base

No distinction is made between fixed and variable costs in this method 69Slide70

Methods to Allocate

Support Department Costs

Dual-Rate method:

segregates costs within each cost pool into two segments: a

variable-cost pool and a fixed-cost poolEach pool uses a different cost-allocation base70Slide71

Allocation Method Tradeoffs

Single-Rate method is simple to implement, but treats fixed costs in a manner similar to variable costs

Dual-Rate method treats fixed and variable costs more realistically, but is more complex to implement

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Allocation Bases

Under either method, allocation of support costs can be based on one of the three following scenarios:

Budgeted overhead rate and budgeted hours

Budgeted overhead rate and actual hours

Actual overhead rate and actual hoursChoosing between actual and budgeted rates: budgeted is known at the beginning of the period, while actual will not be known with certainty until the end of the period

72Slide73

Allocating Common Costs

Common Cost:

the cost of operating a facility, activity, or cost object that is

shared

by two or more users at a lower cost than the individual cost of the activity to each user73Slide74

Title IX

Unequal aggregate expenditures for members of each sex or unequal expenditures for male and female teams if a recipient operates or sponsors separate teams will not constitute noncompliance with this section, but the Assistant Secretary [of Education for Civil Rights] may consider the failure to provide necessary funds for teams for one sex in assessing equality of opportunity for members of each sex.

3 Prong Test:

Providing athletic participation opportunities that are substantially proportionate to the student enrollment. This prong of the test is satisfied when participation opportunities for men and women are "substantially proportionate" to their respective undergraduate enrollment.

Demonstrating a continual expansion of athletic opportunities for the underrepresented sex. This prong of the test is satisfied when an institution has a history and continuing practice of program expansion that is responsive to the developing interests and abilities of the underrepresented sex (typically female). Accommodating the interest and ability of underrepresented sex. This prong of the test is satisfied when an institution is meeting the interests and abilities of its female students even where there are disproportionately fewer females than males participating in sports.

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Output Costs

75Slide76

Capture Output Costs

Overview

In addition to capturing cost, non-financial quantity information is necessary to support Cost Management

Non-financial quantity information can be:

Quantitative, e.g. # of helpdesk tickets, # studentsQualitative, e.g. average # days to close helpdesk ticket, % Completion Rate

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Capture Output Costs

Decisions

Does the output quantity support the cost by BCT/ARFORGEN? HQ Need? or Field product/services?

(e.g. ammo used for training, # soldiers)

Is the output quantity currently used by scheduling/operational managers on a timely basis?Can an output change the behavior of an organization/individual to be more efficient and effective (e.g. # cancelled course registrations in ATAARS)Are output quantities used for justifications and/or requests for funding?If it supports cost management – efficiently & effectively - then it is considered

77Slide78

Capturing Output Costs

Analysis

Understanding the dollar amount of unit provided, based on number delivered Cost/Per

Understanding the relationship between Resource Capacity to Output generation (e.g. 3 Hrs: 1 Output)

0%

20%

40%

60%

80%

100%

Month 1

Month 2

Month 3

Month 4

Month 5

Month N

Capacity

Actual Output

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Capturing Output Costs

Analysis

Cost of Closing Tickets

Number of Tickets

Visibility across

the Army as to what tasks should costs

Supports

comparative

a

nalysis

between sites, tasks, types of work,

and

groups

of resources to identify best practice

vs.

inefficiencies

Allows for realization of trade-offs between delivery and resource consumption

79Slide80

2ABM0014: LEGAL (ILO)

Name

Cost Element

Amount

Quantity

Perm

6100.11B1

$5,000

100 hrs

Capture Output Costs Analysis

Training Event (UIC)

10

rounds

at $50

Qty is valuated

with rate

2ABM0065: AMMO SUPPLY

Name

Cost Element

Amount

Quantity

Ammo

9400.AMMO

10 EA

Name

Cost Element

Amount

Quantity

Ammo

9400.AMMO

$500

10 EAAMMO FIRED

WARS

AMOUNT AND QUANTITY ARE THE OUTPUTS OF THIS PROCESS

80Slide81

Agency Problems

81Slide82

Various Types of Agency Problems

Moral Hazard

Tendency

to take risks because the costs that could incur will not be felt by the party taking the risk. In other words,

a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.Free riderBenefiting from resources, goods, or services without paying for the cost of the benefit.Adverse SelectionThe buyer of a good (or the seller) attracts potential sellers (or borrowers) that offer low quality goods (have a high probability of default). The quality of the goods is not readily observable.Slide83

Output Manipulation

Managers may seek to manipulate income by producing too many units

Production beyond demand will increase the amount of inventory on hand

This will result in more fixed costs being capitalized as inventory

This will leave a smaller amount of fixed costs to be expensed during the periodProfit increases, and potentially so does a manger’s bonus

83Slide84

Countermeasures

for Output Manipulation

Careful budgeting and inventory planning

Incorporate an internal carrying charge for inventory

Change (lengthen) the period used to evaluate performanceInclude non-financial as well as financial variables in the measures to evaluate performance

84Slide85

Transfer Pricing

85Slide86

Transfer Pricing

The amount charged when one division sells goods or services to another division

The transfer price affects the profit measure for the selling division and the buying division

86Slide87

The External and Internal Transfer of Products

External

Supplier

Division A

Division B

External

Customer

Intermediate

Product

Finished Product

Raw Materials

87Slide88

Reasons for Transfer Pricing

Control (incentives and performance measures)

Decentralized planning decisions

International/tax reasons

88Slide89

Summary of Transfer Pricing Methods

Method

Advantages

Disadvantages

Market-Based

Approximates opportunity cost if competitive market exists

Excludes effects of internal transaction costs on transfer price

May not have external market for intermediate goods

Excludes effects of internal transaction costs of transfer price

Variable Cost

Approximates opportunity cost if fixed costs are sunk

Does not allow selling division to recover fixed costs

Provides incentive for selling division to convert fixed costs to variable costs

Full Cost

Reduces disputes as the figure is objective

Simple to compute as it parallels accounting system figures

Approximates opportunity cost if division is operating at capacity

Overstates opportunity cost if excess capacity exists

Negotiated

Maintains managerial autonomy

Preserves upper-management time

Is time consuming and relies on negotiation skills of divisional managers

May not be the optimal transfer price for the firm as a whole

Can lead to conflicts between responsibility centers

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Control Issues

Transfer prices can be used as inputs to the performance measurement system

Transfer pricing assigns costs to managers who are responsible for the costs

90Slide91

Transfer

Pricing

Parts Division

£

Assembly Division

£

Revenue per unit

12

Revenue per unit

23

Parts cost per unit

10

Parts cost per unit

12

Profit per unit

2

Assembly costs

4

Profit per unit

7

The

‘Parts’

division manufactures parts that it sells to the

‘Assembly’

division

The cost to the

‘Parts’

division is £10 per unit.

The ‘Assembly division’

assembles the part at a cost of £4 per unit and sells the product to another organization for £23 per unit.

What is the profit per unit if the transfer price is £12 eachWhat is the profit per unit if the transfer price is £10 eachParts Division£Assembly Division£Revenue per unit10Revenue per unit23

Parts cost per unit

10

Parts cost per unit

10

Profit per unit

0

Assembly costs

4

Profit per unit

9

91Slide92

Transfer Pricing for Decentralized Planning Purposes

Some divisions are required to buy internally produced items

The internal producer may not have an incentive to keep costs down

When managers have the

choice to buy “outside,” the internal producer must stay competitive on both quality and cost

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Transfer Prices for Decentralized Planning Decisions

Circumstance

Transfer Price

Market price exists

Market price

No market price exists; supplying division has no alternative use of capacity

Variable cost

No market price exists; supplying division has alternative use of capacity

Full Cost*

*The full cost is intended to be a rough approximation of the forgone opportunity of using the facilities of the supplying division to do something else

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Choosing Transfer Prices

A transfer price that maximizes firm value (a planning issue) may not maximize a manager’s performance measure (a control issue)

Negotiated transfer prices are more effective when there is an external market alternative

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Globalization and Transfer Pricing

Tax

Minimization:

if

a multi-national transfers products between two countries with different tax rates the company will try to set a transfer price to minimize its total tax liability in the two countriesPolitical Considerations can affect the transfer-pricing decision, if there is a risk of expropriation of assets the company may use high transfer prices to reduce the apparent profitability of their foreign subsidiaries

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Conclusion

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