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 decisions
Managerial training for future higher-level
managers
Motivation and job satisfaction
Corporate level managers have more time
for strategic decisions
Quicker 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 profit
Investment 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
Pr ofit
ROI
Invested capital
Pr ofit margin x Asset turnover
Profit Sales revenue
= x
sales revenue 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 assets
Can 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 congruence
Takes 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
