C. Managing and controlling the performance of organisational units Flashcards
what does decentralisation seek to overcome?
aka divisionalisation
the problem of managing a large organisation by creating a structure based on several autonomous decision-making units
what are the objectives of decentralisation?
ensure goal congruence
increase motivation of management
reduce head office bureaucracy
provide better training for junior and middle management
what is the major disadvantage of dividionalisation?
dysfunctional decision making i.e in their own best interest
can be overcome with a suitable system of performance evaluation or responsibility centres
what is responsibility accounting?
a specific manager takes responsibility for a particular aspect of the budget. the are then accountable for actual performance in their area of responsibility
what is a responsibility centre?
the area of operations for which a manager is responsible
-usually a hierarchy of responsibility centres
what is a cost centre?
production or service location, function, activity or item of equipment for which costs are accumulated
- could be large or small
goal: minimise costs
what is a revenue centre?
responsibility centre that is devoted to raising revenue (or generating sales) without any link to the associated costs
might be encountered in the NFP sector or in marketing/sales operation of an org
goal:generate revenues
what is a profit centre?
if manager is responsible for the revenue as well as costs as they are held accountable for the profitability of the operations she is accountable for
- could be several cost centres
goal: maximise profit
what is an investment centre?
if a manager is responsible for the investment decisions i.e return on investments as well as the profitability of the devisions
- could be several profit centres
goal: maximise rate of return on assets
what are the consequences of structuring the departments as profit centres?
- improved DECISION MAKING due to local knowledge
- departmental managers will become more MOTIVATED and AUTONOMOUS
- senior management will find the new structure more TIME-CONSUMING to handle
- possible LOSS OF CONTROL from senior management
- dysfunctional decision making
- DUPLICATION of functions and costs
what is a controllable cost?
one which can be influenced by its budget holder
-variable and directly attributable fixed costs i.e can be avoided in shutdown decision s they are fully allocated to a cost centre
what is the difference between a committed fixed cost and discretionary fixed cost?
committed: can’t be changed in short term
discretionary: can be cut down
what is a manager responsible for if the principle of controllability is applied?
a manager should be made responsible and accountable only for the costs and revenues that he or she is in a position to control
why are some variable costs unable to be influences by managers in the short term?
direct labour is not entirely controllable for salaried jobs in the short term
what are the advantages to controllability in responsibility accounting?
- profit centre managers are made aware of the SIGNIFICANCE of other overhead costs
- profit centre managers are made aware that they need to earn a SUFFICIENT PROFIT to cover a fair share of other overhead costs
what are the disadvantages of controllability in responsibility accounting?
- profit centre managers are made accountable for a share of other overhead costs, but they can do nothing to CONTROL them
- the APPORTIONMENT of other overhead costs between profit centres, like overhead apportionment generally, is usually a matter of judgement, lacking any economic or commercial justification
what are some profitability KPIs?
ROCE = profit margin x asset turnover
what are the equations for the profitability KPIs?
ROCE= PBIT/ capital employed
profit margin = PBIT / turnover
asset turnover = turnover / capital employed
capital employed = equity + LT finance
what are the 2 liquidity ratios?
current ratio = CA/CL
acid test or quick ratio: CA-inv/ CL
what does ROCE show?
operating profit generated from capital employed i.e asset base
why is a higher ROCE desirable?
more value for money for shareholders
-can be understood between by calculating profit margin and asset turnover
what does the operating profit margin show?
how well indirect costs of business are being managed
- compare to gross profit margin, if in line then profit is issue
- either prices too low or costs too high
what does the asset turnover show?
how efficiently management have utilised assets to generate revenue
what are liquid assets?
- cash
- short-term investments that can be readily sold if the need arises
- liquidity is improved by unused bank borrowing facilities
what are the key liquidity metrics?
current ratio = CA/CL
quick ratio (acid test) = (CA-inv)/CL
what does a low liquidity ratio indicate?
poor liquidity and a risk of cash flow difficulties
- compare to industry standard
- compare to previous years
- quick ratio <1
- current ratio <2
what are the issues of a high liquidity ratio?
excessive liquidity, capital tied up
what are the typical measures used to assess a cost centre’s performance?
- total cost and cost per unit
- cost variances
- non-financial performance indicators (NFPIs) related to quality, productivity & efficiency
what are the typical measures used to assess a revenue centre’s performance?
total revenue and revenue per unit
revenue (sales) variances
what are the typical measures used to assess a profit centre’s performance?
same measures as cost & revenue centre and:
- total sales and market share
- profit
- sales variances
- working capital ratios (depending on the dividion concerned)
- NFPIs e.g productivity, customer satisfication
what are the typical measures used to assess investment centre’s performance?
same as previous centres PLUS:
- ROI
- RI
what is ROI?
used to appraise the investment decisions of an individual department
-ROCE is whole org
what is controllable profit and capital employed in the ROI or ROCE equations?
profit after depreciation but before tax
capital employed = net assets - CL or total equity - LT debt
-use net assets if capital employed is not given
what could non-current assets be valued at?
cost, net replacement cost or net book value (NBV)
what are the advantages of the ROI as a performance measure?
- WIDELY used and accepted as in line with ROCE
- RELATIVE measure, ROI allows comparisons between divisions and companies
- can be BROKEN DOWN into secondary ratios for more detailed analysis i.e profit margin and asset turnover
what are the disadvantages of the ROI as a performance measure?
- may lead to DYSFUNCTIONAL DECISION MAKING e.g too ROI focused
- ROI increases with AGE of the asset if NBV USED, thus incentivising managers an incentive to hang on to possible inefficient, obsolescent machines
- may encourage the manipulation of profit and capital employed figures to improve results e.g in order to obtain a bonus payment
- different accounting policies can confuse comparisons e.g depreciation policy
what is RI? (residual income)
profit (controllable profit, at a divisional level) less an imputed interest charge for invested capital
controllable profit - notional interest on capital
what is the imputed interest charge?
same as the notional interest on capital
the capital employed in the division multiplied by a notional cost of capital or interest rate
what are the advantages of RI compared to ROI?
- RI resolves DYSFUNCTIONAL aspect of ROI measure
- RI reduces ROCE ‘s problem of rejecting projects with a ROCE in excess of the company’s target, but lower than the division’s current ROCE
- the cost of financing a division is brought home to divisional managers
what are the disadvantages of RI compared to ROI?
- RI does not facilitate comparisons between divisions
- RI does not relate the size of a division’s profit to the assets employed in order to obtain that profit
- RI can also mislead, as it increases over time
what are some other methods that can be used to compare divisional performance other than ROI and RI?
- variance analysis:must make sure to identify controllable variances
- ratio analysis
- other management ratios:sales per employee etc
- other information:staff turnover etc
issues in comparing divisional performance?
- divisions may operate in different environments
- transfer pricing policy may distort divisional performance
- divisions may have assets of different ages distorting ROI
- difficulty in comparing divisions with different accounting policies e.g depreciation
- evaluating performance on the basis of a few indicators may lead to manipulation of data
what is the economic value added? (EVA)
measure of performance similar to residual income, except the profit figure used is the ECONOMIC profit and the capital employed figure used is the ECONOMIC capital employed
what is NOPAT?
net operating profit after tax
what are the advantages of EVA?
- PERFORMANCE MEASURE that attempts to put a figure to the increase (or decrease) that should have arisen during a period from the operations of a company or individual divisions within a company
- like accounting return and residual income, it can be measured for each financial reporting period
- it is based on economic profit and economic values of assets, not accounting profits and asset values
what is the underlying principle of EVA?
- company objective is to max shareholder wealth
- value of org depends on extent to which shareholders expect future economic profits to exceed the cost of the capital invested
- share price therefore depends on expectations of EVA
- current performance (EVA) is reflected in the current share price, so in order to increase the share price a company must achieve a sustained increase in EVA
what are the issues in measuring EVA?
accurately establishing the economic profit in a period and economic value of accounting profits
- acc profits are based on accruals concept of accounting, whereas NOPAT for EVA is based on cash flow profits. adjustments have to be made to convert from an accruals basis to a cash flow basis
- depreciation of NCAs is a charge in calculating EVA as well as accounting profit. Economic depreciation is the fall in the economic value of an asset during the period
- an adjustment might be necessary for intangible NCA such as goodwill
- need to adjust for provision for doubtful debts
- spending on dev costs should not be charged in full against profit in the year the expenditure occurs, should be capitalised as it has added to the economic value of capital employed
- all leases should be capitalised
where can EVA be used?
- set targets for performance for investment centres (divisions) and company as whole
- measure actual performance
- plan and make decisions on the basis of how the decision will affect EVA
how can EVA be used for control purposes?
encourage managers to:
- identify highest EVA products
- identify high EVA customers and prioritise them
- eliminate non EVA activities
- identify capital that is not providing sufficient return to cover cost of capital
what is report visualisation?
process of presenting report formats that represent data and information in a pictorial or graphical format
-helps recipient to understand the significance of the content more easily than if presented in a traditional report format
what are the 5 principles for effective report visualisation?
DATA: ensure it is optimised for report visualisation
VISUALISATION TOOL: use relevant tool
LAYOUT:appropriate layout chosen
READER: the reader experience must be optimised, engaging with the report user is key
DELIVERY CHANNEL:visualisation to the appropriate delivery channel must be optimised
DVDLR
when i comes to reporting for each type of responsibility centre, what two key areas are fundamental to quality reporting?
- Data and master data that are subject to robust control which ensures reporting INTEGRITY
- Standards in reporting that drive commonality across the whole organisation and aid assimilation to the consumer. e.g. if ‘red’ is CONSISTENTLY used to display variances
what areas need to be considered to ensure data is optimised for report visualisation?
- where is the data source
- can the data be refreshed in time to make the report relevant?
- can we drill down the data further?
what is the principle factor in choosing the relevant visualisation tool?
what the user for the report feels comfortable with
what are some common guiding principles for choosing the relevant visualisation tool?
variance analysis=waterfall charts/bridges as it easy to spot significant variances
overview of business= dashboards providing relevant summary7 drill down
trend analysis or time-based results = line charts
different areas/regions = mapping charts
comparing data built up from component parts:side by side pie charts
what factors should be considered when choosing an appropriate report layount?
- layout:simple and clean
- digital delivery:shouldn’t require scrolling
- positioning:left to right or top to bottom, key message positioned optimally
- colours:attract to important info, green good & red bad (conditional formatting)
- scaling: appropriate to data
what factors need to be considered to ensure the reader experience is optimised?
paper: size, weight of pack and consider dividers
digitally: personalised, intuitive, interactive, customised
what is author once/run everywhere?
the functionality that automatically renders the report and layout based on the delivery device
what is a fixed budget?
produced for a single level of production
- remain the same regardless of amount produced
- used for planning, not control
what is a flexible budget?
adjusted for different levels of volume
-useful for control as it can be flexed and compared against actual
what is a flexed budget?
a flexible budget calculated at the actual level of production
-used fo control
what is the difference between the original standard and revised standard?
planning variance
- uncontrollable so managers not accountable
- standard is set during budget so unexpected variances may occur
what is the difference between the revised standard and the actual budget?
operational variance
-controllable costs so accountable
what is the traditional variance?
compares original standard to actual
what are the shortcomings of financial indicators?
- only tell what has happened over a LIMITED period in the immediate past
- they give no indication of what is going to happen in the FUTURE
- they are vulnerable to MANIPULATIOn and to the choice of accounting policy e.g. depreciation and inventory valuation
- they do not relate to the strategic management of the business and may induce ‘SHORT-TERMISM’ at the expense of motivation, quality and efficiency
what are NFPIs?
non-financial performance indicators (NFPIs)
measure of performance based on non -financial information that may originate in, and be used by, operating departments to monitor and control their activities without any accounting input
what should NFPIs measure?
a business’ key success factors
what are some possible NFPIs?
competitiveness activity level productivity quality of service customer satisfaction quality of staff experience innovation
what is the NFPI COMPETITIVENESS and what are some possible measures? How are they gathered?
how to achieve equal or better profitability than competitors
can use regular market surveys drawing on both internal and external sources of information
- sales growth by product or service
- size of customer base
- market share by product, service or customer group
what is the NFPI ACTIVITY LEVEL and what are some possible measures? How are they gathered?
mainly drawn from internal sources with checks to ensure accuracy
- number of units sold
- labour and machine hours worked
- number of passengers carried
- number of overdue debts collected
what is the NFPI PRODUCTIVITY and what are some possible measures? How are they gathered?
mostly internal sources
- manufacturing cost per unit produced
- capacity utilisation of facilities and labour fore
- average number of units produced per day or per man-day
- average setting up time for new production run
what is the NFPI QUALITY OF SERVICE and what are some possible measures? How are they gathered?
mostly internal sources but can be reinforced by periodic customer surveys
- no/ units rejected in manufacturing
- no/ units failing in service
- no/ visits by representatives to customer premises
- no/ new accounts gained or lost
- no/ repeat customer orders received
what is the NFPI CUSTOMER SATISFACTION and what are some possible measures? How are they gathered?
info mainly from customer surveys, some internal sources could be used. Should ensure sufficient sample size and representation
- avg time taken to respond to customer enquiry or order
- expressed customer satisfaction with sales staff
- expressed customer satisfaction with technical representatives
- no/ customer complaints received
what is the NFPI QUALITY OF STAFF EXPERIENCE and what are some possible measures? How are they gathered?
some info from internal sources but much would be from colleges and external trainers. Exit interviews and confidential staff opinion surveys could also be used
- absence per week
- staff turnover
- no/ new qualifications by staff
- no/ new skills certified
- expressed job satisfaction
- qualification levels of newly recruited staff
what is the NFPI INNOVATION and what are some possible measures? How are they gathered?
- no/ new products or services brought to market
- proportion of sales relating to new products
- technical lead relative to competitors
- lead time to bring new products to market
what are the 2 main problems in assessing performance of NFP organisations?
- problem of identifying and measuring objectives
- problem of identifying and measuring outputs
what are the 3 Es of the Value For Money approach?
economy
efficiency
effectiveness
what is the economy measure of VFM?
money spent v inputs purchased
what is the efficiency measure of VFM?
inputs purchased vs outputs purchased
what is the effectiveness measure of VFM?
outputs produced vs objectives achieved
what is benchmarking?
the establishment, through data gathering that permit relative levels of performance to be identified
-identify ideal way of achieving high competitive standards
what are the 4 main categories of bencmarking?
functional
internal
competitive
strategic
FICS
what is the Balanced Scorecard?
incorporates non-financial measures of the drivers of future performance as well as financial measures of past performance
what are the 4 areas of vision and strategy in the Balanced Scorecard?
financial perspective:appearance to shareholders?
customer perspective:how should we appear to customers?
internal business process perspective:what business processes must we excel at?
learning and growth perspective:how will we sustain ability to change and improve?
FLIC
how a re budgetary control and responsibility accounting linked?
- make sure someone is accountable for each area
- reflect in organisation chart
- each centre has its own budget
why is it important to distinguish between controllable and uncontrollable costs?
- incorrect allocation could demotivate and demoralise managers and their subordinates
- common reason for adverse variances
what are the benefits of planning and operational variances?
- in volatile and changing environments, standard costing and variance analysis are more useful using this approach
- operational variances provide up to date information about current levels of efficiency
- operational variances are likely to make the standard costing system more acceptable and to have a positive effect on motivation
- emphasises the importance of the planning function in the preparation of standards and helps to identify planning deficiencies
problems of planning and operational variances?
- there is an element of subjectivity in determining the ex-post standards as to what is ‘realistic’
- there is a large amount of labour time involved in continually establishing up to date standards and calculating additional variances
- there is a great temptations to put as much as possible of the total variances down to outside, uncontrollable factors e.g. planning variances
- there can then be a conflict between operating and planning staff, each laying the blame at each other’s door
why use NFPIs?
give more timely indication of levels of performance achieved compared to financial measures (forward looking)
less susceptible to deception and manipulation
what is the objective of NFP organisations?
provide the best possible service within a limited resource budget
what are the issues with output measurements of NFPs?
- not monetary and sometimes non-quantifiable
- open to debate and judgement
- not driven by desire to maximise profits
what are the reasons for benchmarking?
- to receive an alarm call about the need for change
- learning from others in order to improve performance
- gaining a competitive edge (in private sector)
- improving services (in public sector)
what is internal benchmarking?
compare units to best division
-popular within UK government
what is competitive benchmarking?
compare to more successful competitor
- have to use external info
- could dismantle product (reverse engineer)
what is functional benchmarking?
compare to similar function in other organisation
-e.g. buying function in restaurant vs supermarket
what is strategic benchmarking?
companies in same industry might agree to join a collaborative benchmarking process, managed by an independent third party such as a trade organisation
- each org submits performance to the scheme organiser
- organiser calculated average performance figures from data
- participant is given industry average data against which they compare
what is customer benchmarking?
compare corporate performance with the performance expected by customers
do all companies use 4 perspectives in a Balanced Scorecard?
- very rare any use less than 4
- sometimes environmental perspective is added
what are some possible measures for the financial perspective?
SURVIVAL: cash flow, gearing
SUCCESS: sales growth, operating income
PROSPERITY: increase in market share and ROI
what are some possible measures for the customer perspective?
- customer profitability
- customer retention
- customer satisfaction
- customer acquisition
- market share
- % of sales from new products
- % of on-time deliveries
- preferred supplier status
- lead time from receipt of order to delivery
- no/ customer complaints
what are some possible measures for internal business process perspective?
- % of sales from new products
- % of sales from proprietary products
- new product introduction vs competitors also new product intro vs plan
- manufacturing process capabilities
- time to develop next generation of products
- cycle time
- unit cost
- efficiency
what are some possible measures for the learning and growth perspective?
- employee satisfaction
- employee retention
- employee productivity
- time to market
- % of products giving 80% of sales
how does the head office apply control to profit and investment centres?
through performance management as they are held accountable for their returns
what are the purposes of decentralisation?
- give autonomy to local centre managers in decision-making
- motivate centre managers to improve performance: with profit centres and investment centres, this includes motivating them to increase profitability
- through performance enhancement at a profit centre level, to achieve better results for the organisation as a whole
what are the behavioural consequences of performance management?
- can create tension between local centre level and head office management
- managers might take decisions that improve returns but damage org interests
- might cause head office to alter decisions or make new decision thereby taking away local autonomy
what is transfer pricing?
what inter-divisional transfers are priced at
- transfer treated as an internal sale and internal purchase
- sales income of one division is offset by the purchase cost of the other division
- affects divisional profits but no net effect on overall profit
why is the transfer price significant?
- determines how the total profit is shared between the two divisions
- in some circumstances, it could affect decisions by the divisional managers about whether they are willing to sell to or buy from the other division
why must both divisions benefit from the transaction if interdivisional sales take place?
- a selling division will not agree to sell items to another division unless it is profitable for the selling division to do so
- similarly, a buying division will not wish to purchase items from another division unless it is profitable for the division
how are transfer prices established and agreed?
- could be set locally or centrally
- could be imposed by head office
- alternatively, they could be decided by commercial negotiation between the profit centre managers
- if decentralisation is to allow the power of decision making to profit centre managers, they should have the authority to agree transfer prices by discussion or negotiation between themselves
what broad company policy should be applied to the ‘selling division’ in transfer pricing?
given the choice between making a sale to an external customer or supplying goods or services to another division within the group, preference should be to sell INTERNALLY
what broad company policy should be applied to the ‘buying division’ in transfer pricing?
given the choice between purchasing from an external customer or purchasing from another division within the group, preference should be to sell INTERNALLY
when can a division buy/sell to an external customer?
if it has a good commercial reason e.g. offering higher price or lower price for purchase
what are the objectives of transfer pricing?
goal congruence
performance measurement
maintaining divisional autonomy
minimising the global tax liability
recording the movements of goods and services
fair allocation of profits between divisions
how does transfer pricing system exhibit goal congruence?
the task of the transfer pricing policy in particular is to ensure that what is good for an individual division is good for the company as a whole
how is performance measurement and objective of the transfer pricing system?
the transfer pricing system should result in a report divisional profits that is a reasonable measure of the managerial performance
how does a transfer pricing system maintain divisional autonomy?
divisionalisation allows managers to exercise greater autonomy, there is little point in granting additional autonomy and then imposing transfer prices that will affect the probability of the division
how does the transfer pricing system minimise global tax liability?
for multinational companies, can and do use transfer pricing policies to move profits around the world and thereby minimise their global tax liabilties
why is it important that there i s a fair allocation of profits between division in the transfer pricing system?
most of the advantages claimed for divisionalisation are behavioural, it is essential that managers perceive the allocation of corporate profit as being fair if the motivational benefits are to be retained
what are the 3 bases for setting a transfer price?
- market -based prices
- cost-based prices
- negotiated prices
what is an intermediate market?
external market for the goods/services of the selling division
-basis for market based transfer price
what is a market-based transfer price?
price for the item in the external market or at a discount to the external market price, to allow for a share of the savings in selling costs that the selling division enjoys by transferring internally rather than selling externally
what is a cost-based transfer price?
- the marginal cost to the selling division of making the product or providing the service
- the selling division’s marginal cost plus a mark-up for profit
- the full cost to the selling division of making the product
- the selling division’s full cost plus a mark-up for profit
why is it more suitable for transfer price to be based on budgeted cost over actual?
- standard costs are known in advance, can invoice immediately
- actual costs are not known until after the end of the accounting period, thereby delaying price transfers and issuing invoices
- if transfers are at standard, the selling division’s manage could be motivated to improve profits by actually keeping costs below standard or budgeted amount
what are the different market conditions of the intermediate market?
- perfect
- imperfect
- non-existent
how does a perfect intermediate market affect suppliers?
all suppliers are able to sell at market price, no restrictions to sales demand and no individual dominated market supply
how does a perfect intermediate market affect sellers?
- sell all output on the external market at the market price
- provided that it can sell at a price above MC, the only limitation on profitability from external sales is the output capacity of the division
what does an imperfect intermediate market mean for selling divisions?
unable to sell at market price due to a dominant influence in the market
must sell larger volumes of output in the intermediate market, the division is therefore required to reduce the sales price
why does the imperfect intermediate market result in an issue in identifying a suitable transfer price?
may be possible to establish for the intermediate market a ‘demand curve’, showing volumes of sales demand at different prices
in a perfect market, what is the marginal revenue?
the market price of an item as all output can be sold at that price
in an imperfect market, what is marginal revenue?
marginal revenue is always lower than market price
how do we arrive at the MR equation from the demand curve?
demand curve P=a+bQ
total revenue = P x Q
substitute TR into demand curve to get (a+bQ) x Q = aQ + bQ^2
differentiate to get marginal revenue (MR) = a + 2bQ
in an imperfect market, where are profits maximised?
MR=MC
how does cost differ in economics and accounting?
in economics: cost includes and element of normal profit
in accounting: marginal cost does not include a profit element
what is the general rule for decision making in transfer pricing?
all goods and services should be transferred at opportunity cost
what are the 3 possible situations for transfer pricing?
- a situation where there is a COMPETITIVE MARKET for an intermediate product
- a situation where the selling division has SELLING CAPACITY
- a situation where there are PRODUCTION CONSTRAINTS, and the selling division has NO SURPLUS CAPACITY
in a competitive market/perfect market, how is the optimum TP calculated?
optimum TP= market price + any small adjustments
how is transfer pricing calculated in a perfect intermediate market with no variable selling costs?
TP = MP
how is transfer pricing calculated in a perfect intermediate market with variable selling costs?
will cost selling division more to sell externally and buying more to purchase externally
-cheaper and more profitable to transfer internally
minimum TP = market price = external selling price - external variable selling cost
max TP = external SP
what is the optimum TP if the selling division has surplus capacity?
- limit to amount it can sell externally
- has spare capacity so 0 opp cost
optimum TP = marginal cost
what are 3 possible solutions to the problem in transferring at marginal cost, which is unlikely to be fair to the supplying division?
2 part tariff
cost-plus pricing
dual pricing
what is a 2 part tariff?
the transfer price is marginal cost, but in addition a fixed sum is paid per annum or per period to the supplying division to go at least part of the way towards covering fixed costs and possibly even to generate a profit
what are the disadvantages of a 2-part tariff?
- it may not provide motivation to the selling division manager
- the measurement of the performance of the selling division may not be fair
- the negotiation process may be time consuming and a fair profit may have to be imposed by head office
how is cost-plus pricing a solution to transfer pricing at marginal cost?
TP is the MC or full cost plus a markup.
using standard costs should be fair and up-to-date. if transfers are made at actual costs instead of standard costs, there is no incentive for the suppliers to control costs, as they can all be passed on the the buying division
how does dual pricing help when transferring at marginal cost to a buying division?
dual pricing is where one transfer price is recorded by the supplying division and a different transfer price is recorded by the buying division
an adjustment account in the HQ books holds the differences between the divisions
what is the shadow price?
opportunity cost of the lost contribution from the other product or it is the extra contribution tat would be earned if more of the scarce resource were available
what is the optimum Tp for production constraints and the division has no surplus capacity?
optimum TP= MC + shadow price
what is the problem with transferring at MC?
unlikely to be fair to the supplying division
is the min and max when the selling division has surplus capacity?
minimum price selling division willing to accept
maximum price buying division will pay, lower of:
-external selling price
-net marginal revenue = selling price - MC of buyer’s final product
what is the min and max transfer price negotiated between when the selling division does not have surplus capacity?
min price selling division will accept= MC + shadow price
max price buying division will pay, which is lower of:
-external selling price
-net marginal revenue=selling price - MC of buyer’s final product
what are the behavioural considerations of transfer pricing?
- demotivation is actual cost used
- deters competition
how do transfer prices tend to vary over the product life cycle?
intro: cost plus fixed fee or cost plus a profit share
growth: price related to closest substitute
maturity: price based on identical products
- identical products only show up in maturity stag, no basis for comparison before
why does actual cost pricing not motivate supplying division?
they can pass on cost inefficiencies, if they stick to budget they must keep costs under control
how can transfer pricing be used to deter competitors/
cant compete with the low profits the vertically integrated company is taking and they may not be able to achieve a satisfactory return if they are only operating in a limited area of the value chain
what is international transfer pricing?
transfers within an international group will often be cross-border, between divisions in different countries
how could a multinational company use transfer pricing to reduce total tax liability?
- reduce the profitability of its subsidiaries in high-tax countries
- increase the profitability of its subsidiaries in low-tax countries
what is transfer pricing’s effect on international pre tax and post tax profit?
total pre-tax:same
total post tax:redistributed between subsidiaries
if more pre-tax profit is earned in low-tax countries and less in high-tax, total tax bill reduced
why is there a temptation to set up marketing subsidiaries in countries with low corporation tax rates?
transfer products at a relatively low transfer price
-when sold to final customer, a low rate of tax will be paid on the difference between the two prices
what are double taxation agreements?
mean that companies pay tax on specific transactions in one country only
however is the tax authorities spot unrealistic transfer prices to minimise tax, company will pay tax in both countries i.e double tax
why were the OECD guidelines produced?
with the aim of standardising national approaches to transfer pricing as part of the OECD’s charter to encourage the freedom of world trade
what is an arm’s length transaction?
price that would have been arrived at by 2 unrelated companies acting independently
what might a country with the status of a ‘tax haven’ offer?
- low rate of tax on profits
- low withholding tax on dividends paid to foreign holding companies
- tax treaties with other countries
- no exchange controls
- a stable economy
- good communications with the rest of the world
- well-developed legal framework, within which company rights are protected
how can firms use transfer pricing to manage cash flows?
- multinational companies might sell goods or services to a subsidiary in the country concerned from other division in other countries, and charge very high transfer prices as a means of getting cash out of the country
- govt might place legal restrictions on dividend payments from foreign parent companies
- not possible to do when country’s tax laws require that transfer prices should be set on an arm’s length basis
what are the implications for an international group of currency risk in transfer prices?
- with interdivisional trading between subsidiaries in different currency zones, one sub or other will be exposed to a risk of losses from adverse movements in the exchange rate
- when one subsidiary makes a loss on an adverse exchange rate movement, the other will make a profit
- the company as a whole should manage its exposures to currency risks. This might be the the responsibility of either the profit centre managers or a treasury department
- when it is fairly certain which way an exchange rate might move in the future, a multinational company might be tempted to set transfer prices in a currency such that any currency losses arise in the subsidiary in the high-tax country, and currency profits arise in the country with the lower tax rate
