Transfer pricing is a value attached to the output of a department to measure the value of the trade with other departments within the organization. Transfer prices will not affect the organization’s profit results. This contributes directly to the process of departmental performance measurement and indirectly to the measurement of a product performance (Finkler, Ward, & Baker, 2007).
If Western Hospital purchases from an outside laboratory the Academic Hospital division will stop, and the combined profit will increase from $4,500 to $39,000. Methods of Allocation Allocation of cost is a term used where the cost of an item is charged to a specific cost center without the need for any estimation procedure. For example, the salary of a sales manager will be allocated to the selling overhead cost center. The methods include direct method, elimination, method, and repeated distribution method. 1. Direct method – a cost is allocated to the concerned cost center directly.
The approach may be implemented using two methods. a. The repeated distribution method taking into account the reciprocal nature of the service costs. b. An algebraic approach is used as an alternative to the repeated distribution method. This method requires that the reciprocal nature of the service costs is expressed in a set of simultaneous equations that are solved using matrix algebra. 2. Elimination method – the cost of each service cost centers are re-apportioned in turn. The costs of the first service center will be reapportioned to all user centers including other service centers.
The first service center however, is eliminated for furher reapportionment. The cost of the second service center, including any costs already reapportioned from the first service center, is then reapportioned to all user centers other than the first service center. The process is continued until all service centers are eliminated. 3. Repeated distribution method – this method differs from the elimination method because it continues to reapportion to a share of a service cost center to other service centers instead of eliminating a center once the costs have been reapportioned in the first instance.
The cycle is repeated until the numbers become so small that no further reapportionments are required. Determination of Cost Centers Cost center is a production service location activity on an item whose cost may be attributed to the cost unit. Therefore, any unit of the organization to which cost can be attributed. Performance measurement in cost center can be accomplished through variance analysis or through efficiency measures such as an output-input ratio.
The two hospitals were different with distinct specialties. The was the base of determining cost center as Academic Hospital specialized in maternity services, and Western Hospital specialized in internal laboratory and each hospital could incur costs on their own and still generate revenue. Fixed and Variable Costing Differences The two major drawbacks to the full cost approach concern is the inability to motivate the supplying division’s manager to improve performance and the danger of making incorrect decisions.
Because all costs are past on irrespective of the economy or efficiency in the supply division there remains little incentive for the managers of supply divisions to cut costs or to operate more efficiently. Once the costs are passed on, fixed costs of the supplying divisions are interpreted as variable costs of the receiving division and therefore possible for divisions to make short-term decisions that are suboptimal for the organization. Variable cost-based systems overcome the decision-making problem of a full cost system and consequently transfers among departments are made at variable costs.
Standard variable costs will overcome the problem of passing on inefficiencies and diseconomies from division to division.
References Finkler, S. , & Ward, D. (2006). Accounting Fundamentals for Health Care Management. Sudbury, MA: Jones and Bartlett. Finkler, S. , Ward, D. , & Baker, J. (2007). Essentials of Cost Accounting for Health Care Organizations (3rd ed. ). Sudbury, MA: Jones and Bartlett. . doi: Retrieved from University of Phoenix (2010). Week five overview. Retrieved December 7, 2010, from University of Phoenix , Week Five, rEsource. ACC561- Accounting in Healthcare Course Web site.