Chapter 12

1. Chapter 12 Financial performance measures and transfer pricing

2. Decentralisation • When managers in divisions and departments are given levels of decision-making authority • A high level of goal congruence needed to encourage effectiveness • Goal congruence can be promoted through responsibility accounting systems

3. Benefits of decentralisation • Better local information for decisions • Managerial training for future higher-level managers • Motivation and job satisfaction • Corporate level managers have more time for strategic decisions • Quicker reaction to opportunities and problems

4. Costs of decentralisation • Managers in decentralised organisations may focus narrowly on their own subunit’s performance, rather than the organisation’s overall goals • Managers of a subunit may ignore the consequences of their actions on other subunits • Some tasks or services are duplicated

5. Obtaining goal congruence: a behavioural challenge • Difficult to achieve • managers unaware of the effects of their decisions on others • managers more concerned with their own achievements than of the overall organisation’s achievements • How to achieve • carefully designed performance measures and reward systems to provide the right incentives

6. Responsibility centres • A subunit in an organisation whose manager is held responsible for the subunit's activities • Emerge as organisations become to large to be centrally controlled • Based on geographic location, specific markets or other bases

7. Types of responsibility centres • Cost centre - responsibility for costs incurred • Revenue centre - responsibility for revenue generated • Profit centre - responsibility for profit • Investment centre - responsibility for profit, and invested capital used to generate profit

8. Financial performance reports • Show the key financial results appropriate for the type of responsibility centre • the variance between budgeted and actual results • Segmented profit and loss statements • show the profits for the major responsibility centres, and for the entire organisation

9. Performance of subunits versus subunit managers • Economic performance of subunits • the revenues and costs attributable to that subunit • Manager’s performance • the revenues and costs which the manager can control or significantly influence • Distinction important to prevent penalising good managers who manage poor subunits

10. Cost allocations in performance reports • Some costs are allocated on a causal basis • a responsibility centre causes the organisation to incur a cost • Common costs • result from activities that are incurred for the benefits of more than one responsibility centre • not clearly attributable to activities of subunits • arbitrary allocation basis used

11. Financial measures in investment centres: return on investment (ROI) • Used to measure the performance of an investment centre

12. Advantages of ROI • Encourages managers to focus on both the profits and the assets required to generate those profits • Discourages excessive investment in assets • Can be used to evaluate the relative performance of investment centres

13. Limitations of ROI • Encourages managers to focus on short-term financial performance, at the expense of long-term viability and competitiveness • Encourages managers to defer asset replacement • Discourages managers from investing in some projects which are acceptable from the organisation’s point of view

14. Minimising the behavioural problems of ROI • Use ROI as one of a series of performance measures that focus on both short-term and long-term performance • Consider alternative ways of measuring invested capital to minimise dysfunctional decisions • Use alternative financial measures, such as residual income

15. Residual income • Residual income • profit - (invested capital x imputed interest rate) • Imputed interest charge - based on the required rate of return that the firm expects of its investments, which is based on the organisation’s cost of capital

16. Advantages of residual income • Promotes goal congruence • Takes account of the organisation’s required rate of return in measuring performance • Encourages investment in projects which yield a positive residual income

17. Limitations of residual income • Cannot be used to assess relative performance of different-sized businesses • Formula is biased, in favour of larger businesses • Can encourage short-term orientation/focus

18. Measuring invested capital • Total assets - investment centre manager is responsible for decisions about all assets • Total productive assets - investment centre managers retains non-productive assets • Total assets less current liabilities - investment centre responsible for decisions about assets + manages short-term liabilities • Choose average or end-of-year balances

19. Asset management: original cost, net book value or market value? • Advantages of net book value • consistency with balance sheet prepared for external reporting purposes • consistent with the definition of profit • advantages of gross book value • depreciation is arbitrary and should not be allowed to affect calculations • depreciating non-current assets may provide a disincentive to invest in new equipment

20. Measuring profit • Profit margin controllable by investment centre manager • suitable when the focus is performance of the manager • profit margin attributable to investment centre • to calculate the investment centre ROI

21. Transfer pricing • Internal selling price used when goods or services are transferred between profit centres within a divisionalised organisation • Transfer prices are sales revenue of the supplying unit and costs of the buying unit

22. Who determines transfer prices? • Autonomy for prices may lie with the managers of profit centres and investment centres • Direct intervention may come from corporate management either by • setting the price • developing policies to guide transfer pricing practices

23. General transfer pricing rule • Minimum transfer price = additional outlay costs per unit incurred by the supplying business + opportunity cost per unit to the supplying business • No excess capacity vs excess capacity

24. Goal congruence and transfer pricing • General transfer pricing rule will always promote goal-congruent decision making • Difficulties with implementing the general rule • the external market may not be perfectly competitive • uniqueness of the transferred goods or service

25. Transfers based on the external market price • The price that can be obtained in the external market • consistent with responsibility accounting concepts and decentralisation philosophies • encourages business unit managers to focus on business unit profitability • results in a reasonable calculation of profit contributions

26. Transfers base on market price • No excess capacity • general transfer pricing rule, price = external market price • Excess capacity (or the external market is imperfectly competitive) • general transfer pricing rule price will differ from the external market price • can result in suboptimal decisions from a company perspective

27. Negotiated transfer prices • Managers of businesses negotiate prices • based on external market prices • no external market exists - cost recovery may be the basis for negotiating prices • Can cause divisiveness and competitiveness between participating managers • May lead to evaluating business unit managers on negotiating skills

28. Cost-based transfer prices • Cost-based prices • intermediate products - no external market • external market price exists, but supplying unit has excess capacity • Variable cost plus mark-up, or absorption cost? • Standard or actual costs?

29. Transfer pricing methods used in practice • Taxation regimes can influence transfer pricing practices where • companies transfer goods between countries with different taxation rates • it is prudent to maximise any tax advantages available • Transfer pricing is used in service industries where services are transferred between business units

30. Exhibit 12.1