12 Divisional performance measurement and transfer pricing

Question 1

What is a cost centre?

Answer 1

Division incurs costs but has no revenue stream

Question 2

What is a profit centre?

Answer 2

Division has both costs and revenues - manager does not have the authority to alter the level of investment

Question 3

What is an investment centre?

Answer 3

Division has both costs and revenue - Manager does have the authority to invest in new assets or dispose of existing ones

Question 4

What is the formula for Return on investment?

Answer 4

ROI = Controllable profit / capital employed x 100

Question 5

What is capital employed?

Answer 5

Capital employed is total assets less current liabilities or total equity plus long term debt

Question 6

What are some advantages of ROI as a performance measure? (3)

Answer 6

• Widely used and accepted since it is in line with ROCE
• As a relative measure to enable comparisons to be made
• Can be broken down into secondary ratios

Question 7

What are some disadvantages of ROI as a performance measure? (4)

Answer 7

• May lead to dysfunctional decision making
• ROI increases with age which may leave managers to hold on to inefficient machines
• May encourage manipulation
• Different accounting policies may confuse comparisons

Question 8

What is the residual income formula?

Answer 8

Controllable profit –Notional interest on capital

Question 9

How is notional interest on capital calculated?

Answer 9

The capital employed in the division multiplied by a notional cost of capital or interest rate.

Question 10

What are advantages of RI as a performance measure (3)?

Answer 10

• Encourages investment centres to make new investments
• Making a specific charge for interest helps to make managers aware of the cost of assets under their control
• Risk can be incorporated by the choice of interest rate used

Question 11

What are disadvantages of RI as a performance measure (3)?

Answer 11

• It does not facilitate comparisons between divisions

- Based on accounting measures of profit and capital employed which may be subject to manipulation

Question 12

What are some other ways of comparing divisional performance?

Answer 12

Variance analysis
Ratio analysis
Other management ratios
Other information

Question 13

What is transfer pricing?

Answer 13

A transfer price is the price at which goods or services are transferred from one division to another within the same organisation

Question 14

What are the 4 objectives for a transfer pricing system?

Answer 14

Goal congruence
Performance measurement
Autonomy
Recording the movement of goods and services

Question 15

What is meant by goal congruence in a transfer pricing system?

Answer 15

The decisions made by each profit centre manager should be consistent with the objectives of the organisation as a whole

Question 16

What is meant by performance measurement in a transfer pricing system?

Answer 16

The buying and selling divisions will be treated as profit centres. The transfer price should allow the performance of each division to be assessed fairly. Divisional managers will be demotivated if this is not achieved.

Question 17

What is meant by autonomy in a transfer pricing system?

Answer 17

The system used to set transfer prices should seek to maintain the autonomy of profit centre managers. If autonomy is maintained, managers tend to be more highly motivated but suboptimal decisions may be made.

Question 18

What is meant by recording the movement of goods and services in a transfer pricing system?

Answer 18

Is simply to assist in recording the movement of goods and services.

Question 19

What is the market based approach of transfer pricing?

Answer 19

If an external market exists for the transferred goods then the transfer price could be set at the external market price

Question 20

What are advantages of using a market based method for transfer pricing? (2)

Answer 20

• The transfer price should be deemed to be fair by the managers of the buying and selling divisions.
• The company’s performance will not be impacted negatively by the transfer price

Question 21

What are the disadvantages of using a market based method for transfer pricing? (3)

Answer 21

• May not be an external market price
• External market price may not be stable
• Savings may be made from transferring the goods internally

Question 22

What is a cost based approach for transfer pricing?

Answer 22

The transferring division would supply the goods at cost plus a % profit