Chapter 12 - Divisional Performance Measurement And Transfer Pricing

Question 0

Return on Investment (ROI)

Answer 0

ROI = Controllable profit/ Capital employed x 100

Capital employed = Total assets less current liabilities or total equity plus long term debt. (Use net assets if capital employed not given).

Question 1

Divisional performance management

Answer 1

1. Cost centre
   Incurs costs but has no revenue stream e.g. The IT support department of an organisation.

Measure used to assess performance:-
Total cost and cost per unit.
Cost variances.
NFPIs related to quality, productivity & efficiency.

2. Profit centre
   Division has both costs and revenue.
   Manager does not have the authority to alter the level of investment in the division.

Measures used to assess performance:
All of the above plus
Total sales and market share
Profit
Sales variances
Working capital ratios
NFPIs

3. Investment centre
   Division has both cost and revenue.
   Manager does have the authority to invest in new assets or dispose of existing ones.

Measures used to assess performance:
ROI
RI

Question 2

Advantages/ disadvantages of ROI

Answer 2

Advantages:

1. Widely used and accepted since it is line with ROCE.
2. Enables comparisons to be made with divisions or companies of different sizes.
3. Can be broken down into secondary ratios for more detailed analysis i.e. Profit margin and asset turnover.

Disadvantages:

1. May lead to dysfunctional decision making.
2. ROI increases with the age of the asset if NBVs are used so managers possibly could hang on to inefficient machines.
3. Encourage manipulation of profit and capital employed figures to improve results.
4. Different accounting policies can confuse comparisons.

Question 3

Residual income (RI)

Answer 3

RI = Controllable profit - Notional Interest on capital.

Notional interest on capital = Capital employed in the division multiplied by a notional cost or interest rate.

Question 4

Transfer pricing and objectives.

Answer 4

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

Goal congruence:
The transfer price should assist in maximising overall company profits.

Performance measurement:
The buying and selling is treated as profit centres.

Autonomy:
The system used should maintain the autonomy of profit centre managers.

Recording the movement of goods and services.

Question 5

Setting the transfer price: Market based approach

Answer 5

Advantages:

1. The transfer price deemed fair by the managers of the buying and selling divisions. The selling division will receive the same amount for any internal or external sales. The buying division will pay the same for goods if they buy them internally or externally.
2. The company’s performance will not be impacted negatively by the transfer price.

Disadvantages:-

1. May not be an external market price.
2. The external market price may not be stable.
3. Savings may be made from transferring the goods internally.

Question 6

Setting the transfer price - Cost based approach

Answer 6

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

A standard cost should be used:
Full cost
Marginal cost
Opportunity cost