Chapter 12 Financial performance measures and transfer pricing

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

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

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

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

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

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

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

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

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

Financial measures in investment centres: return on investment (ROI)  Used to measure the performance of an investment centre ROI  Pr ofit Invested capital  Pr ofit margi n x Asset turnover Profit = sales revenue Sales reve nue x invested capital

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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?

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

Exhibit 12.1