Chapter 12 Financial performance measures and transfer pricing.
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Transcript of 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