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Finance > Transfer Pricing And Performance Management > Flashcards

Transfer Pricing And Performance Management Flashcards

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1
Q

What is the key issue of transfer pricing?

A

Goal congruence

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2
Q

Organizations segment their operations in order to gain effective control. List the types of segments within a organization.

A
  1. cost centre
  2. Revenue centre
  3. Profit centre
  4. Investment centre
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3
Q

What is performance evaluation?

A

Subjective process of judging the quality of performance performed by managers.

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4
Q

What is a revenue centre?

A

It specializes in the sale and delivery of products or services.

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5
Q

How is a revenue centre evaluated?

A

It is evaluated on the basis of revenue generated

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6
Q

What is a cost centre?

A

It produces a product or service. The manager is responsible for costs.

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7
Q

How is a cost centre evaluated?

A

On the basis of the cost and the long term measures

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8
Q

What is an investment centre and how is it evaluated?

A

It produces, sell and invest in current and long term assets. They are held responsible for maintaining an adequate ROI. Long term performance is very important in evaluating an investment centre.

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9
Q

What is divisionalisation?

A

Dividing the organization into different divisions across various product lines. Each division would function independently as a profit or an investment centre under the control of a divisional manager.

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10
Q

What are some issues surrounding transfer pricing?

A
  1. The transfer price is a source of income for the transferring division. The higher the price the higher the profit generated by that division
  2. The transfer price is a cost for the receiving division. They will strive towards the minimization of costs therefore the lower the price paid the higher the profit
  3. The transfer price that is set must be consistent with the company’s objective of profit maximization
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11
Q

What will complicate the transfer pricing decision?

A
  1. The existence of capacity constraint on the transferring division
  2. The ability to acquire the product transferred on the open market
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12
Q

What is a transfer price?

A

A range of prices that ensures that company wide contribution is maximized (best interest of the company as a whole)

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13
Q

What are the three objectives of transfer pricing system?

A
  1. The price set must encourage goal congruence
  2. The transfer pricing system must facilitate measurement of performance
  3. The division should function autonomously
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14
Q

What is the fundamental of transfer pricing?

A

In setting transfer pricing, on,y variable costs are fixed and the transfer price set will not have an impact on the amount of fixed costs incurred. Therefore transfer price computations are based in contribution.

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15
Q

What is the minimum transfer price?

A

Price that is acceptable to the transferring division, and out of a range of acceptable prices, it is the one that would be the best for the company

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16
Q

What is the formula for minimum transfer price?

A

Minimum transfer price = variable costs -internal savings + opportunity costs

17
Q

If there is no market in which the transferring department can sell its product, such a division will function as a cost centre, what would be the acceptable transfer price?

A

The acceptable price will be the variable costs

18
Q

What is the principle for minimum price for a cost centre with no intermediates market or capacity constraint?

A

When the transferring division is a cost centre, the minimum acceptable price for the transferring division will be calculated as the variable cost per unit.

19
Q

However, if an intermediate market exist in which the product being transferred can be sold, and there are not capacity constraints, what would be the minimum acceptable price?

A

The minimum acceptable acceptable price would be at least coverage of the variable cost of making the product.

20
Q

The variable cost of a product transferred internally may be lower than the cost of making a product to be sold externally, why?

A

As a result of savings in packaging and selling cost

21
Q

When there is a capacity constraint, what would be minimum acceptable price?

A

Whenever there are production constraints, the transfer price is set as follow:
Variable costs per unit + loss contribution expressed into unit transferred

22
Q

What are some factors that could affect the maximum transfer price?

A
  1. The receiving division’s contribution per unit before acquiring the transferred
  2. Whether or not the required input can be acquired from the open market. The maximum acceptable price could be limited by the market price.
23
Q

What is the basic principle for maximum transfer price?

A
  1. The division manager of the receiving division will be satisfied with the price quoted by another division as long as he is not generating a lower contribution than before
  2. The maximum acceptable transfer price is calculated as the indifference point between the position before and after selling the final product
  3. Whenever the buying division can acquire the same input externally for less, the maximum price calculated per the indifference formula must be limited to the market price of the input
  4. The maximum transfer price is calculated as the indifference point between the first and second best alternatives
24
Q

What would be the contribution generated before?

A
  1. If the division sells another product on the market, then it will be the contribution generated from the sale of that product on the market
  2. If the division is new, then any product that it chooses to manufacture should at least yield a contribution. But the maximum point will be where the division adds no value to the company. I.e. generates zero contribution. Fixed costs will have to be covered too.
25
Q

How do you calculate the indifference point for maximum transfer price?

A

Indifference point = contribution before + additional contribution = contribution before.
Therefore where additional contribution = 0

26
Q

If the receiving division can obtain the required input externally at a cheaper price, what would be the maximum price?

A

The price to acquire externally would be the maximum acceptable price for the receiving division.

27
Q

What is the final transfer price set?

A

It must lie between the range of transfer prices established as minimum and maximum. This will take place through negotiation between the transferring and receiving divisions.

28
Q

How will the apportionment of total profit be done between the transferring and receiving division?

A
  1. Allocated on the basis of gross profit margin
  2. Allocated on the basis of value added by each division towards the final product
  3. Allocated on any other basis
29
Q

What are the advantages of ROI as basis of performance evaluation?

A
  1. Comparability
  2. Easy to calculate due to the availability of information
  3. Simple to understand
  4. Indicates relationship between income and size of investment
  5. Indicates effectiveness of asset management
30
Q

What are the disadvantages of using ROI as a performance measure?

A
  1. A reduce in investment base could cause ROI to increase
  2. Investment bases could differ in different department or different companies
  3. Suboptimal decision, management could be encouraged by ROI not to accept investments which will cause their ROI to decrease while this return could contribute to an increase in the return of the company as a whole.
  4. Short term is emphasized
  5. ROI encourages an increased percentage rather than return in absolute term
31
Q

What is the advantage of using residual income as basis of performance measure?

A
  1. Suboptimal decision are discouraged, it encourages management to make investment decision which will yield a return which is higher than cost of capital
  2. The contribution of the department to the group’s marginal income is measured
  3. Comparability through various required rates of return
32
Q

What are the disadvantages of using residual income as a basis if performance measure?

A
  1. Size of investment is not related to size of income
  2. Rate of return is arbitrary, information not directly available from accounting system
  3. Residual income is not easily understandable to management as the ROI
  4. The short term is emphasized
33
Q

What are some advantages of divisionalisation?

A
  1. Quality of decisions
  2. Speed of decisions
  3. Top management can devote their time to strategic planning
  4. A divisionalised structure serves as a good training ground for prospective mangers
  5. Motivation and efficiency
  6. Freedom to mangers
34
Q

What are some disadvantages of divisionalisation?

A
  1. Inter-divisional competition and rivalry could be to the detriment of the company as a whole
  2. Costs of activities that are common to all divisions may be duplicated such as finance and procurement
  3. Top management loses some control by delegating decision making to lower levels.
35
Q

How do you calculate controllable contribution?

A 
Total sales revenue
Less: variable costs
= variable contribution margin
Less: controllable fixed costs
= controllable contribution
36
Q

What is controllable contribution?

A

Most appropriate measure of a divisional manager’s performance, it measures the ability of managers to use the resources under their control effectively.

37
Q

How do you evaluate a divisional economic performance?

A 
Total sales revenue
Less: variable costs
= variable contribution margin
Less: controllable fixed costs
= controllable contribution
Less: non-controllable fixed costs
= divisional contribution
Less: allocated corporate expenses
= divisional profit before tax
38
Q

How do you calculate the residual income for evaluating the performance of divisional managers?

A

Residual income = controllable contribution - cost of capital charged on investment controlled by the divisional manager

39
Q

How do you calculate the residual income for evaluating the economic performance of the division?

A

Residual income = divisional contribution - cost of capital charged on the total investment in assets employed by the division

Finance (12 decks)

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