Transfer Price

Responsibility centers and transfer pricing

Chapter 7 of

Managerial Accounting

Responsibility centers

• All organizations are divided into units, each is granted decision rights and then evaluated based on performance objectives • For example: the firm can be organized into marketing, manufacturing and distribution departments • These units are called responsibility centers

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• Depending on the decision rights, we can distinguish between: cost centers, profit centers and investment center

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Cost Center

Decision rights:

• Cost center manager chooses quantity and quality of inputs used in cost center (labor, material, supplies)

Measurement:

• Minimize total cost for a fixed output • Maximize output for a fixed budget

Example:

• Manufacturing department of certain parts of a product • Food service in a hospital (maximize the number of meals)

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Cost Center - Problems

• Minimizing average costs does not necessarily maximize profits. Cost centers have an incentive to produce more units to spread fixed costs over a large number of units.

• Quality of products produced by cost center must be monitored.

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Profit Center

Decision rights:

• Can chose input mix, product mix, and selling prices • Given fixed capital budget

Measurement:

• Actual profits • Actual profits compared to budget

Example:

• Buick and Chevrolet are two profit centers within General Motors

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Profit Center - Problems

• Setting appropriate transfer prices on goods and services transferred within the firm • How to allocate corporate overhead costs to responsibility centers • Profit centers that focus only on their own profits often ignore how their actions affect other responsibility centers

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Investment Centers

Decision rights: Measurement:

• Same decision rights as cost and profit centers • Decide amount of capital invested or disposed • Net income • Return on Investment (ROI)

Example:

• A firm producing electronics has a “consumer electronics” department ,...