Describe Problem Faced By Organisations Using Multiple Financial Responsibility Center

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Lecture Three (week 4)
Financial Responsibility
Centers
Financial Control Module 26164
Dr. Amal Ahmad Khair

2014/15

The aim of this lecture is to ensure that you are able to:
 Describe the advantages of financial results control systems
 Discuss the types of financial responsibility centres (i.e. investment, profit, revenue, or cost) and its choices
 Describe problem faced by organisations using multiple financial responsibility centres; i.e. transfer pricing problem

Hull University Business School 2

Chapter 7:
Financial Responsibility Centers

Financial results controls

Responsibility centers

1.
2.
3.
4.

Revenue
Expense
Profit
Investment

Revenue centers

Expense centers

Control in expense centers

Profit centers

Profit centers (cont..)

Measuring “profit”

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

Gross
Margin
Center

Incomplete
Profit
Center

Before-tax
Profit
Center

Complete
Profit
Center


























Investment centers

Organization structure
President
(IC)

Group
Vice President
(IC)

SBU Manager
(PC)

...

... ... ...

Administrative and Financial
Vice Presidents

Group
Vice President
(IC)

SBU Manager
(PC)

...

...
Procurement
(ECC)

SBU Manager
(PC)

(DCC)

SBU Manager
(PC)

Divisional Staff Functions (DCC)

Manufacturing
(ECC)

Sales
(RC)

Transfer pricing

Definition

Transfer pricing alternatives

1. Market-based price
2. Marginal cost
3. Full costs
4. Full cost plus a mark up
5. Negotiated price

1Market-based transfer prices
• Where a (perfectly competitive) external market exists.
• Managers of both the selling and buying PC will make decisions that are optimal from a corporate perspective, and reports of their performances will provide good information for evaluation purposes.
• Actual price charged to external customers, listed price of a similar product, or the price a competitor is offering
(bid price). Deviations can be allowed that reflect differences between internal and external sales:
• Savings in marketing, selling, and collecting costs;
• Differences in quality standards, special features, or special services provided.

2 Marginal cost transfer prices
• It excludes upstream fixed costs and profits, and hence, the marginal costs remain visible for the
PC that finally sells to outside customers.
• It provides poor information for evaluation purposes • The selling PC incurs a loss;
• The profits of the buying PC are overstated.

• Rarely used in practice
• Variation: Marginal cost and lump-sum fee
• The marginal cost of the transfer remains visible;
• The selling PC can recover its fixed cost and a profit margin through the lump-sum fee;
• Problem: estimation of capacity to reserve for internal sales.

3

Full-cost transfer prices

• Popular in practice
• Relatively easy to implement
• Firms have cost systems in place to calculate the full cost of production;
• But, full costs rarely reflect actual, current costs of producing the products because of financial
accounting
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