Chapter 9 - Divisional performance appraisal and transfer pricing Flashcards
Describe the problem with divisional structures below.
Co-ordination
Difficult to co-ordinate all the functions to achieve overall goal.
Describe the problem with divisional structures below.
Goal congruence
There is a potential loss of control as managers will be motivated to improve their division potentially at the expense of the larger organisation
Describe the problem with divisional structures below.
Controllability
Divisional managers should only be held accountable for the factors that they can control. Its difficult to determine what is controllable.
Describe the problem with divisional structures below.
Inter-dependence of divisions
Performance of one division may depend on another making it difficult to measure performance levels.
Describe the problem with divisional structures below.
Head office costs
Whether or how the head office costs should be reapportioned.
Describe the problem with divisional structures below.
Transfer prices
How these prices should be set as they move profit from one division to another.
Describe a cost centre
Incurs costs but has no revenue stream.
Describe a Profit centre
- Division has both costs and revenue.
- Manager does not have the authority to make investment decisions.
Describe an investment centre
- Division has both costs and revenue.
- Manager does have the authority to invest in new assets or dispose of existing ones.
What are some performance measures we can use for cost centres?
- costs, e.g. cost ratios and variances
- relevant non-financial measures, for example based on productivity or efficiency
What are some performance measures we can use for profit centres?
- costs, revenues and profit, e.g. profitability ratios and cost/sales variances
- relevant non-financial measures, for example based on customer satisfaction
What are some performance measures we can use for investment centres?
- return on investment (ROI)
- residual income (RI)
- economic value added (EVA)
What does ROI show?
The operating profit that is generated for every $1 of assets employed.
What is the formula for ROI?
Operating profit ÷ Capital employed x 100
What profit and capital employed figures should be used in ROI?
The controllable ones
What are three advantages of ROI?
- Widely accepted
- Enables comparison with companies of different sizes
- Can be broken down into secondary ratios for more detailed analysis
What are five disadvantages of ROI?
- Dysfunctional decision making
- Increases with age of asset (NBV)
- Not aligned to maximising shareholder wealth
- Differences between divisions make comparison less meaningful
- Encourages manipulation of profit
What can be done to address the behaviour of holding onto assets to increase ROI?
Use RI
How do you calculate RI?
Operating profit
Less: Imputed interest (Capital employed x cost of capital)
What are four advantages of RI?
- Reduces problems of ROI
- Interpreting results is easy
- Cost is clearer to divisional managers
- Cost of capital can be adjusted
What are four disadvantages of RI?
- Decision may not always be in best interest of company
- Comparison not easy
- Decision on cost of capital
- Manipulation of profit
What does economic value add represent?
The economic value generated by the company for its shareholders
What is the calculation for EVA
Net operating profit after tax (NOPAT)
Less:
Adjusted value of capital employed at beginning of the year × WACC
EVA
Where do you start for the NOPAT calc?
Controllable operating profit
What do you add for the NOPAT calculation?
- Accounting depreciation
- Increase in provisions
- Non-cash expenses
- Advertising, R&D and employee training costs
What do you deduct for the NOPAT calculation?
- Economic depreciation
- Decrease in provisions
- Ammortisation of Advertising, R&D and employee training
- Tax paid plus tax relief on interest
What are six advantages of EVA?
- Aims to maximise shareholder wealth
- Avoid accounting policy distortion
- No appeal to hold onto old assets
- Cost of financing is made clear to managers
- Can capitalise long term investments redcuing short-terminism
- Easy to intrepret results
What do you deduct for the NOPAT calculation?
- Economic depreciation
- Decrease in provisions
- Amortisation of Advertising, R&D and employee training
- Tax paid plus tax relief on interest
