Chapter 14 - Divisional performance measurement and transfer pricing

Question 1

What is the formula for Return on Investment (ROI)

Answer 1

ROI = (Controllable profit/Capital employed) × 100

Question 2

When is controllable profit taken?

Answer 2

After depreciation but before tax.

Question 3

What is capital employed?

Answer 3

Total assets - Current liabilities

or

Total equity + Long term debt`

Question 4

What are the advantages of ROI

Answer 4

• Widely accepted
• Can be used to compare with similar sized companies
• It can be broken down into secondary ratios (Profit margin/ asset turnover)

Question 5

What are the disadvantages of ROI?

Answer 5

• Dysfunctional decision making trying to maintain really high ROI.
• ROI increases with age (Encourages holding on of old assets)
• Encourages manipulation of figures to improve results
• Different accounting policies can confuse comparisons. (E.g depn)

Question 6

What is the formula for Residual income? (RI)

Answer 6

RI = Controllable profit – Notional interest on capital

Question 7

How do you calculate the notional interest on capital?

Answer 7

capital employed x notional cost of capital

capital employed x interest rate

Question 8

What are the advantages of Residual income? (RI)

Answer 8

• Helps prevent the dysfunctional behavior of ROI
• Makes managers more aware of costs of assets
• Can change interest to suit risk

Question 9

What are the disadvantages of Residual income? (RI)

Answer 9

• Cannot compare between divisions as it is based on size of divisions
• Based on measures which can be manipulated for higher bonus.

Question 10

What is the transfer price?

Answer 10

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

Question 11

What are the objectives of transfer pricing?

Answer 11

Goal congruence - Maximise organisation profits
Performance measurement - Each division assessed fairly
Autonomy
Recording the movement of goods and services

Question 12

What are the two main methods of setting a transfer price?

Answer 12

• Market based approach

- Cost based approach

Question 13

What is the market based approach of transfer pricing?

Answer 13

Set the transfer price at the external market price.

Question 14

What are the advantages of the Market based approach?

Answer 14

• Should be deemed fair by managers

- This will not negatively impact the company performance.

Question 15

What are the disadvantages of the Market based approach?

Answer 15

• There may not be an external market price
• The price may not be suitable e.g discounts offered
• Savings may be made from internal transfers (may need adjusted market price)

Question 16

What is the cost based approach of transfer pricing?

Answer 16

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

Question 17

Why should a standard cost be used rather than an actual cost?

Answer 17

• Actual costs do not encourage selling to divisions to control costs
• With standard costs the buying division will know the cost in advance.

Question 18

What are the three standard costs?

Answer 18

• Full cost
• Marginal (variable) cost
• Opportunity cost.