Responsibility accounting & responsibility centers

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 Budgeting and Responsibility
Accounting
• Responsibility center—a part, segment, or subunit of an
organization whose manager is accountable for a
specified set of activities.
• Responsibility accounting—a system that measures the
plans, budgets, actions, and actual results of each
responsibility center.
• Generally, we consider 4 levels of responsibility center.

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 Types of Responsibility Centers
1. Cost—accountable for costs only
2. Revenue—accountable for revenues only
3. Profit—accountable for revenues and costs
4. Investment—accountable for investments, revenues,
and costs

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 Budgets and Feedback
• Budgets offer feedback in the form of variances: actual
results deviate from budgeted targets.
• Variances provide managers with:
– Early warning of problems
– A basis for performance evaluation
– A basis for strategy evaluation

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 Responsibility & Controllability
• Controllability is the degree of influence that a manager has over costs,
revenues, or related items for which he or she is being held responsible.
• Responsibility accounting helps managers to first focus on whom they should ask
to obtain information and not on whom they should blame.
• Responsibility accounting focuses on gaining information and knowledge, not
only on control.
• The fundamental purpose of responsibility accounting is to enable future
improvement.

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Transfer Pricing

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 Transfer Pricing
Explain the basic issues associated with transfer pricing.

• Transfer price:
The value assigned to the goods or services sold or rented
(transferred) from one unit of an organization to another.

• Treatment is the same as a sale to an outside customer.

– Revenue to the selling unit
– Cost to the buying unit

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15 - 7
• Setting transfer prices is a difficult process because the price affects
center’s profitability.
– A high transfer price results in high profit for the selling center
and low profit for the buying center
– A low transfer price results in low profit for the selling center and
high profit for the buying center

• The price must be set to establish incentives for decentralized center

managers to make decisions that support the overall goals of the
organization.

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• Intermediate Product – the product or service transferred between
subunits of an organization

• Transfer pricing is one of the most strategic activities in strategic

business unit management.
• It affects materials and parts sourcing decision, tax planning and
potentially, the marketing of the final and intermediate products.

• Eg. A car manufacturer has a separate division that

manufacturers engines. The transfer price is the price the
engine division charges when it transfer engines to the car
assembly division.

Importance
• Transfer of products and services between business units is most common in firms with a
high degree of vertical integration.
• Vertically integrated firm engage in a number of different value-creating activities in the
value chain. 9
• A computer manufacturer must determine transfer prices if it manufacturers the chips,
Objective….
• To provide an appropriate incentive for managers to make
decisions consistent with the firm’s goals.
• To provide a basis for fairly rewarding manager.
• To minimize taxes locally and internationally.

By setting a high transfer price for goods shipped to a relatively high taxed country, a firm
can reduce its firm level tax liability. This would increase cost and reduce the income of
the purchasing unit in the high tax country, thereby minimize taxes there and higher
profits shown by the selling unit would be taxed at lower rates in the seller’s home
country

• To develop strategic partnership.

A high transfer price may induce internal unit to purchase from external suppliers. The external
suppliers might get assistance from the firm in its effort to supply quality materials to the firm. As
a result, newer or weaker unit becomes more healthy.

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 1. Sell
Cost
Cost 5000
5000

2. Buy
Country A –TaxRate 25%
Country B –TaxRate 0%

3. Sell
Cost
Cost 5000
5000

4. Buy
Country C –TaxRate 10% Country D –TaxRate 50%

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International Objective

• Tax issues
• Minimizing custom charges,
• Minimizing currency restriction and
• Minimizing risk of expropriation by foreign
government.
Expropriation occurs, when a government takes ownership and control
of assets a foreign investor has invested in the country.

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Custom Charges
• If custom charges are significant on the parts and components imported,
relatively low transfer price on these imports would be beneficial to reduce
the custom charges.

Currency Restriction
• Repatriations of profits to the parent firm are restricted in some countries.
One way to deal in such circumstances, is to set the transfer price in such
a way that the profits become low and repatriations are easy.

Expropriation
• When risk of expropriation exists, transfer price may be used as a devise to
remove funds from the foreign country as quickly as possible.

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 Three Transfer Pricing Methods
• Market-based Transfer Prices

• Cost-based Transfer Prices

• Negotiated Transfer Prices

General Transfer-Pricing Rule

Additional outlay cost per Opportunity cost per unit
Transfer Price = unit incurred because + to the organization
goods are transferred because of the transfer

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 Market-Based Transfer Prices
• Top management chooses to use the price of similar
product or service that is publicly available. Sources of
prices include trade associations, competitors, etc.
• Lead to optimal decision-making when three
conditions are satisfied:
The market for the intermediate product is perfectly
competitive
Interdependencies of subunits are minimal
There are no additional costs or benefits to the
company as a whole from buying or selling in the
external market instead of transacting internally 17
 Market-Based Transfer Prices
• A perfectly competitive market exists when there is a
homogeneous product with buying prices equal to
selling prices and no individual buyer or seller can
affect those prices by their own actions

• Allows a firm to achieve goal congruence, motivating

management effort, subunit performance evaluations,
and subunit autonomy

• Perhaps should not be used if the market is currently in

a state of “distress pricing”
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 Therefore, External Market Price
– Use if the selling unit has no excess capacity and perfect competition exists.
– Here, the general transfer rule and the external market price are equal
– The long-run average external market price should be used, because
distressed market prices can severely affect transfer pricing profitability.

• Transfer price is the current price of the selling

unit’s product in the market. It satisfies
criterion both for management and for tax
purposes.
• The disadvantage is that the market price for
intermediate products, may not always be
available.

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 Negotiated Transfer Price
– It is common for managers to negotiate transfer prices from the
external market price.
– This can split the cost savings between both units, but can lead to
divisiveness and competition between investment centers.

• Occasionally, subunits of a firm are free to negotiate the

transfer price between themselves and then to decide whether
to buy and sell internally or deal with external parties

• May or may not bear any resemblance to cost or market data

• Often used when market prices are volatile

• Represent the outcome of a bargaining process between the

selling and buying subunits
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Negotiated Price Method

• Therefore, involves negotiation, arbitration

between units to determine transfer price.
• It is a better method to avoid conflict and to
agree on an acceptable price.
• The disadvantage of this method is that it may
reduce the desired autonomy of the units.

• Firms commonly use two or more methods,

called dual pricing. When numerous conflicts
exist between two units.
• standard full cost might be used as the buyer’s
transfer price, while the seller might use market
price

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 Cost-Based Transfer Prices
• Top management chooses a transfer price based on the costs of
producing the intermediate product. Examples include:
Variable Production Costs
Variable and Fixed Production Costs
Full Costs (including life-cycle costs)
One of the above, plus some markup
• Useful when market prices are unavailable, inappropriate, or too
costly to obtain
• Prorating the difference between the maximum and minimum cost-
based transfer prices
• Dual-Pricing – using two separate transfer-pricing methods to price
each transfer from one subunit to another. Example: selling division
receives full cost pricing, and the buying division pays market pricing 22
 Variable Cost
– The biggest drawback with using variable cost is that when excess capacity
exists, the selling unit can’t show contribution margin on the transferred goods.
• This method sets the transfer price equal to the selling unit’s variable cost
and used when objective is to satisfy the internal demand for the goods.
The relatively low price encourages buying internally.
• This method is not suitable when selling unit is a profit unit.

 Full Cost
– The biggest drawback affects the buying unit’s view of costs as fixed for the
company as a whole
– This method sets the transfer price equal to variable costs plus
selling units allocated fixed cost. The advantage is that the price is
well understood and information is readily available in accounting
records.
• Disadvantage is that the price includes fixed costs, which are some
time erroneous, because of improper uses of allocation bases.

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Comparison of Transfer-Pricing Methods

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Right Transfer Price
• Three key factors are to be considered for
decision on right transfer price:
• Existence of outside supplier
• Sellers variable cost less than market price
• Selling unit operating at full capacity.

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Existence of outside supplier
• If no outside supplier --- the best transfer price is on cost or
negotiated price.
• If there is an outside supplier, market price should be considered in
relation to seller’s variable cost

Seller’s variable cost less than market price

• If variable cost is more than market price , the buyer should buy
outside.
• If variable cost is less than the market price, the transfer price
should be the market price.

Selling unit operating at Full Capacity

• If internal buyer does not cause any disruption of sales opportunities
outside, the transfer price should be between variable cost and
market price.
• If internal buyer affects the sales opportunities, the transfer price
should be the market price.

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 1.Divisional Profits: Transfer pricing affects the profits of
individual divisions (Las Vegas and Reno) because it
determines how revenue and costs are allocated between
them.

2.Overall Company Profit: The total profit of Nevada Inc.

remains unaffected because the internal transfer pricing
does not change the company's external revenue or total
costs.

Correct Answer:

•Las Vegas Profit: Affected

•Reno Profit: Affected
•Nevada Profit: Not affected

This matches Choice B. Transfer pricing influences

divisional profits but does not impact the overall company
profit since inter-divisional transfers cancel out at the
company level.
B 27
1.New York Profit: A higher transfer price increases
New York's revenue, thus increasing its profit.

2.Arizona Profit: A higher transfer price increases costs

for Arizona, decreasing its profit.

3.Thurmond Profit (Overall Company): Since the

transaction is internal, the overall company profit is not
affected, as the transfer price impacts only the
allocation of profit between divisions, not the company's
total profit.

Correct Answer:
•New York Profit: Increase
•Arizona Profit: Decrease
•Thurmond Profit: No Effect
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This matches Choice B.
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Why choice C in previous slide?
ADK GPT answer

Step 1: Understanding the Importance of Income Taxes

• Situation 1 (Both Divisions in India):
• Indian income tax laws are not typically a major consideration because the
transfer pricing happens between divisions within the same country. Tax
implications are less relevant as both divisions are subject to the same tax
laws and rates.
• Situation 2 (Cross-Border Transaction):
• Since Division A is in India and Division B is in Bangladesh, Indian income
tax laws become critical for determining the transfer price. Cross-border
transactions require compliance with transfer pricing regulations under
Indian tax law to prevent profit shifting and ensure tax compliance in both
countries. 37
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• Addl ..not for exams

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Transfer Pricing
Regulations

47
 Impact of TP
S-I S-2 S-3 S-4 S-5
C Transfers to X 200 280 300 400 500
Cost to C 100 100 100 100 100
SP of X 300 300 300 300 300
Tax Rate for C 20%
Tax Rate for X 60%

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 S-1 S-2 S-3
C X Total C X Total C X Total
SP 200 300 500 280 300 580 300 300 600
Cost 100 200 300 100 280 380 100 300 400
PBT 100 100 200 180 20 200 200 0 200
Tax 20 60 80 36 12 48 40 0 40
PAT 80 40 120 144 8 152 160 0 160

S-4 S-5
C X Total C X Total
SP 400 300 700 500 300 800
Cost 100 400 500 100 500 600
PBT 300 -100 200 400 -200 200
Tax 60 60 80 80
PAT 240 240 320 320

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 Transactions

Internal External
(W ithin the country) (outside the country)

Inter Company Intra Company Inter Comapny Intra Company

Revenue Profit Control System Non-Related: Rela ted Control Systems

Capital Gain cost centres Profit/Dividend/Royalty Profit/Dividend/Royalty Forex Fluctuations
Royalty revenue centres Forex Fluctuations Transfer Pricing Accounting
profit/Investment centre Accounting Forex/Accounting Transfer Pricing

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 Transfer Price: What and Why?
• TP means the value or price at which transactions take place
amongst related parties.
• TP are the prices at which an enterprise transfers physical goods and
intangible property and provides services to associated enterprises
• TP gain significance because these can be used by the controlling
party to their advantage to minimise tax incidence.

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 Transfer Price: What and Why?
• Approximately 60% of the total transactions across the
world are between related parties.
• If the transactions are across different tax jurisdictions,
where tax rates are different, shifting is beneficial.

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 Factors Affecting Transfer Pricing
• Internal factors: Performance Measurement and Evaluation
• External Factors:
– Accounting Standard
– Income Tax
– Custom Duty
– Currency Fluctuations
– Risk of Expropriation

53
 Transfer Price Regulations
International
India
• OECD
The Finance
formulated
Act 2001
“Guidelines
introduced
on transfer
the detailed
pricing”.
TPR w.e.f.
They serve
1 st April
as
generally accepted practices by the tax authorities
2001
• The Income Tax Act
• AS-18
• Other Relevant Acts

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 Accounting Standard 18
Requires disclosure of ‘any elements of the related party
transactions necessary for an understanding of the financial
statements’.

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 Related Parties
• Control by ownership
– 50% of the voting right
• Control over composition of board of directors
– Power to appoint or remove the directors
• Control of substantial interest
– 20% or more interest in the voting power

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 AS-18 and Transactions
• Purchase and sale of goods;
• Rendering or receiving services;
• Agency arrangements;
• Leasing arrangements;
• Transfer of research and development;
• Licence aggrements;
• Finance
• Guarantees and collaterals;
• Management contracts.

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 Income Tax Act and TP
• Finance Act 2001 substituted the old section
of 92 of the ITA by sections 92, 92A to
92 F.
• These sections are the backbone of Indian
TPR.
• These sections define the meaning of
related parties, international transactions,
pricing methodologies etc.

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 TPR: Some Important Concepts
• Income/Expenses/Cost arising from an international
transaction shall be computed having regard to arm’s
length price (ALP).
• ALP provisions can be applied if it leads to decrease
in taxable income or increase in losses.

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 Associate Enterprise: 92A
• Direct Control/Control through intermediary
• Holding 26% of voting power
• Advance of not less than 51% of the total assets of borrowing
company.
• Guarantees not less than 10% on behalf of borrower
• Appointment of more than 50% of the BoD
• Dependence for 90% or more of the total raw material or other
consumables

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 International Transactions: 92B
• Transaction between two or more AE of which either both
or anyone is a non-resident.
• Transactions:
– Purchase/Sale/Lease
– Provision of service
– Lending or borrowing

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 Arm’s Length Price
• Price which two independent firms would agree on.
• Price which is generally charged in a transaction between
persons other than associated enterprises.

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 Arm’s Length Price: 92C
• Comparable uncontrolled price method
• Resale price method
• Cost plus method
• Profit split method

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 Comparable uncontrolled price method
• CUP method compares the price transferred in a controlled
transaction to the price charged in a comparable uncontrolled
transaction.
• CUP method is the most direct and reliable way to apply the
arm’s length principle.

64
• A UK manufacturing company, Blast, manufactures the Rapid Dry Xtreme – a
high-power, professional-standard chemical solution that is up to five times more
effective in certain condition than other solutions on the market.
• There is only one other UK manufacturer that produces a solution with similar
performance to the Rapid Dry Xtreme – manufacturing company Chem Tech
Solutions, with its Supersonic XL chemical solution.
• Both Blast and Chem Tech Solutions operate in a similar way when it comes to
manufacturing, pricing and selling their products, with both companies selling via
associated and third-party distributors.
• Blast receives an order for one shipment of Rapid Dry Xtreme from its
distribution company, All Things Chemical, which is an associated enterprise of
Blast.

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• In order for Blast to apply an accurate transfer price for the transaction, it needs
to first choose a transfer pricing method.
• As Chem Tech Solutions, its competitor, has a similar product and operates in a
similar way, it will potentially be possible to access reliable data for comparable
uncontrolled transactions, so Blast opts for the CUP method.
• While other methods may also work, the OECD recommends the CUP method
above all others if you have access to data on comparable uncontrolled
transactions.
• When it comes to finding the price of a comparable transaction using the CUP
method, Blast has two options:
1) it can refer to the price at which it sells the Rapid Dry Xtreme product to
unrelated third-party distributors (known as an ‘internal comparable’);
2) or it can refer to the price at which a competitor sells the Supersonic XL product
to unrelated third-party distributors (so the price at which the product is sold
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between two unrelated parties, known as an ‘external comparable’).
• Both options are acceptable under the CUP method, although it is preferable to use internal
comparables as these generally provide substantial evidence that your pricing is at arm’s
length.
• In addition, both products are branded products, and although they may have similar
properties, they may target different markets and price points, and thus may be not comparable
• If Blast’s pricing for the sale of a Rapid Dry Xtreme to its associated enterprise distributor, All
Things Chemical, is the same as the pricing seen in the comparable uncontrolled transaction,
then Blast’s pricing can be said to be at arm’s length.
• If the two prices are different, then the commercial and financial relations between Blast and
All Things Chemical may be not at arm’s length, and transfer pricing adjustments may be
required.
• If the two prices are different, Blast will need to substitute the controlled price with the
uncontrolled price (as in, base the analysis on the price given in the comparable uncontrolled
transaction), so that it can see what the commercial and financial relations between itself and
All Things Chemical need to look like to achieve arm’s length.

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 Resale price method
• The resale price method begins with the price at which a
product is resold to an independent enterprise (IE)by an
associate enterprise.
– X sold to AE at Rs. 1000 (profit: 300)
– AE sold to an IE at Rs. 2000
• (profit of Rs. 500 for relevant IE)
– Arms length price = 2000 - 500 = 1500

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 Profit Split Method
• PSM is used when transactions are inter-related and is not
possible to evaluate separately.
• PSM first identifies the profit to be split for the AE. The
profit so determined is split between the AE on the basis of
the functions performed/assets/CE

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 Cost Plus Method
• In CP method, first the cost incurred is determined. An
appropriate cost plus mark-up is then added to the cost to
arrive at an appropriate profit. The resultant figure is the
arm’s length price.

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 Some Transactions subject to ALP
• Purchase at little or no • Exchanging property
cost. • Selling of real estate at
• Payment for services a price different from
never rendered. MP
• Sales below MP/ • Use of trade names or
Purchase above MP patents at exorbitant
• Interest free rates even after their
borrowings expiry.

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