Responsibility Accounting for the CPA BAR Exam
Complete guide to responsibility accounting for the CPA BAR section. Covers cost centers, profit centers, investment centers, transfer pricing, and controllability principles.
What Is Responsibility Accounting?
Responsibility accounting is a system that measures the performance of each organizational unit based on the revenues and costs that the unit's manager can control. The fundamental principle is that managers should be held accountable only for the items they can influence. This system assigns revenues and costs to the individuals who have the authority to make decisions affecting those items.
Responsibility accounting requires clearly defined organizational authority, the ability to trace revenues and costs to the responsible manager, the establishment of budgets or standards for each responsibility center, and a reporting system that highlights deviations from planned performance.
Types of Responsibility Centers
Cost Centers
A cost center is a unit whose manager is responsible for controlling costs but does not control revenue or investment decisions. Examples include production departments, maintenance departments, and human resources. Performance is evaluated by comparing actual costs to budgeted or standard costs, with emphasis on favorable and unfavorable variances.
Cost center managers are evaluated on efficiency (output relative to input) and effectiveness (whether the department meets its objectives). Key metrics include cost variances, unit costs, and measures of output quality and timeliness.
Revenue Centers
A revenue center is a unit whose manager is responsible for generating revenue but does not control production costs or capital investment. The sales department is a typical revenue center. Performance is measured by comparing actual revenues to budgeted revenues, considering both sales volume and selling prices.
Profit Centers
A profit center is a unit whose manager controls both revenues and costs. The manager makes decisions about pricing, product mix, and cost management. Performance is measured using metrics such as contribution margin, controllable margin, and segment profit. Division managers in decentralized organizations are often treated as profit center managers.
Investment Centers
An investment center is a unit whose manager controls revenues, costs, and the level of capital investment. This is the broadest level of responsibility. Performance is measured using return on investment (ROI), residual income, and economic value added (EVA). Corporate divisions in large, diversified companies are typically investment centers.
The Controllability Principle
The controllability principle states that managers should be evaluated only on items they can control. A production manager should not be penalized for increases in the cost of raw materials caused by market forces beyond the manager's control. Similarly, a division manager should not be held responsible for allocated corporate overhead that is determined at the corporate level.
In practice, strict application of the controllability principle can be difficult. Many costs are jointly influenced by multiple managers or by external factors. The solution is to distinguish between controllable and uncontrollable costs in performance reports and to focus evaluation on controllable items while providing information about uncontrollable costs for context.
Transfer Pricing
When divisions of the same company trade goods or services with each other, a transfer price must be established. The transfer price affects the reported profit of both the selling and buying divisions and therefore affects the performance evaluation of both division managers.
Transfer Pricing Methods
Market-based transfer prices use the external market price for the product or service. This is generally considered the best method when a competitive external market exists because it reflects the opportunity cost of the internal transfer. Cost-based transfer prices use the selling division's cost (variable cost, full cost, or cost plus markup) as the transfer price. Negotiated transfer prices are determined through negotiation between the two division managers, typically falling between the market price and the variable cost.
The General Transfer Pricing Rule
The minimum transfer price that should be acceptable to the selling division is: Variable Cost per Unit + Opportunity Cost per Unit. The opportunity cost equals the contribution margin per unit forgone by selling internally rather than externally. If the selling division has excess capacity, the opportunity cost is zero, and the minimum transfer price equals variable cost. If the selling division is operating at full capacity, the opportunity cost equals the lost contribution margin from external sales.
Segment Reporting and Common Costs
Responsibility accounting reports should separate direct (traceable) costs from indirect (common) costs. Common costs are shared by multiple segments and cannot be directly traced to any single segment. Allocating common costs to segments can distort segment performance and lead to poor decisions. Best practice is to report segment margin (revenue minus direct costs) without allocating common costs, providing a clearer picture of each segment's contribution to the organization.
Exam Preparation Tips
- Know the four types of responsibility centers and the appropriate performance measures for each.
- Understand the controllability principle and how it applies to performance evaluation.
- Be able to calculate the minimum and maximum transfer prices using the general transfer pricing rule.
- Know the advantages and disadvantages of market-based, cost-based, and negotiated transfer prices.
- Recognize the importance of separating traceable costs from common costs in segment reporting.
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