Chapter 12 Financial performance measures and transfer pricing.

Chapter 12

Financial performance measures and transfer

pricing

Decentralisation

When managers in divisions and departments are given levels of decision-making authority

A high level of goal congruence needed to encourage effectiveness

Goal congruence can be promoted through responsibility accounting systems

Benefits of decentralisation

Better local information for decisionsManagerial training for future higher-level

managersMotivation and job satisfactionCorporate level managers have more time

for strategic decisionsQuicker reaction to opportunities and

problems

Costs of decentralisation

Managers in decentralised organisations may focus narrowly on their own subunit’s performance, rather than the organisation’s overall goals

Managers of a subunit may ignore the consequences of their actions on other subunits

Some tasks or services are duplicated

Obtaining goal congruence: a behavioural challenge

Difficult to achieve managers unaware of the effects of their

decisions on others managers more concerned with their own

achievements than of the overall organisation’s achievements

How to achieve carefully designed performance measures and

reward systems to provide the right incentives

Responsibility centres

A subunit in an organisation whose manager is held responsible for the subunit's activities

Emerge as organisations become to large to be centrally controlled

Based on geographic location, specific markets or other bases

Types of responsibility centres

Cost centre - responsibility for costs incurred

Revenue centre - responsibility for revenue generated

Profit centre - responsibility for profitInvestment centre - responsibility for profit,

and invested capital used to generate profit

Financial performance reports

Show the key financial results appropriate for the type of responsibility centre the variance between budgeted and actual

results

Segmented profit and loss statements show the profits for the major responsibility

centres, and for the entire organisation

Performance of subunits versus subunit managers

Economic performance of subunits the revenues and costs attributable to that

subunit

Manager’s performance the revenues and costs which the manager can

control or significantly influence

Distinction important to prevent penalising good managers who manage poor subunits

Cost allocations in performance reports

Some costs are allocated on a causal basis a responsibility centre causes the organisation

to incur a cost

Common costs result from activities that are incurred for the

benefits of more than one responsibility centre not clearly attributable to activities of subunits arbitrary allocation basis used

Financial measures in investment centres: return on investment (ROI)Used to measure the performance of an

investment centre

ROIofit

Invested

ofit margi

xSales reve

Pr

Pr

capital

n x Asset turnover

= Profit

sales revenue

nue

invested capital

Advantages of ROI

Encourages managers to focus on both the profits and the assets required to generate those profits

Discourages excessive investment in assetsCan be used to evaluate the relative

performance of investment centres

Limitations of ROI

Encourages managers to focus on short-term financial performance, at the expense of long-term viability and competitiveness

Encourages managers to defer asset replacement

Discourages managers from investing in some projects which are acceptable from the organisation’s point of view

Minimising the behavioural problems of ROI

Use ROI as one of a series of performance measures that focus on both short-term and long-term performance

Consider alternative ways of measuring invested capital to minimise dysfunctional decisions

Use alternative financial measures, such as residual income

Residual income

Residual income profit - (invested capital x imputed interest rate)

Imputed interest charge - based on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capital

Advantages of residual income

Promotes goal congruenceTakes account of the organisation’s

required rate of return in measuring performance

Encourages investment in projects which yield a positive residual income

Limitations of residual income

Cannot be used to assess relative performance of different-sized businesses

Formula is biased, in favour of larger businesses

Can encourage short-term orientation/focus

Measuring invested capital

Total assets - investment centre manager is responsible for decisions about all assets

Total productive assets - investment centre managers retains non-productive assets

Total assets less current liabilities - investment centre responsible for decisions about assets + manages short-term liabilities

Choose average or end-of-year balances

Asset management: original cost, net book value or market value?Advantages of net book value

consistency with balance sheet prepared for external reporting purposes

consistent with the definition of profit

advantages of gross book value depreciation is arbitrary and should not be allowed

to affect calculations depreciating non-current assets may provide a

disincentive to invest in new equipment

Measuring profit

Profit margin controllable by investment centre manager suitable when the focus is performance of the

manager

profit margin attributable to investment centre to calculate the investment centre ROI

Transfer pricing

Internal selling price used when goods or services are transferred between profit centres within a divisionalised organisation

Transfer prices are sales revenue of the supplying unit and costs of the buying unit

Who determines transfer prices?

Autonomy for prices may lie with the managers of profit centres and investment centres

Direct intervention may come from corporate management either by setting the price developing policies to guide transfer pricing

practices

General transfer pricing rule

Minimum transfer price = additional outlay costs per unit incurred by the supplying business + opportunity cost per unit to the supplying business

No excess capacity vs excess capacity

Goal congruence and transfer pricing

General transfer pricing rule will always promote goal-congruent decision making

Difficulties with implementing the general rule the external market may not be perfectly

competitive uniqueness of the transferred goods or service

Transfers based on the external market price

The price that can be obtained in the external market consistent with responsibility accounting

concepts and decentralisation philosophies encourages business unit managers to focus on

business unit profitability results in a reasonable calculation of profit

contributions

Transfers base on market price

No excess capacity general transfer pricing rule, price = external

market price

Excess capacity (or the external market is imperfectly competitive) general transfer pricing rule price will differ

from the external market price can result in suboptimal decisions from a

company perspective

Negotiated transfer prices

Managers of businesses negotiate prices based on external market prices no external market exists - cost recovery may

be the basis for negotiating prices

Can cause divisiveness and competitiveness between participating managers

May lead to evaluating business unit managers on negotiating skills

Cost-based transfer prices

Cost-based prices intermediate products - no external market external market price exists, but supplying unit

has excess capacity

Variable cost plus mark-up, or absorption cost?

Standard or actual costs?

Transfer pricing methods used in practice

Taxation regimes can influence transfer pricing practices where companies transfer goods between countries with

different taxation rates it is prudent to maximise any tax advantages available

Transfer pricing is used in service industries where services are transferred between business units

Exhibit 12.1