Chapter 12: Divisional performance measurement and transfer pricing

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the meaning of, and calculate from supplied data, return on investment (ROI) in the context of divisional performance appraisal
• discuss the shortcomings and benefits of using ROI for divisional performance appraisal
• explain the meaning of, and calculate from supplied data, residual income (RI) in the context of divisional performance appraisal
• discuss the shortcomings and benefits of using RI for divisional performance appraisal
• compare divisional performance using supplied data and recognise the problems that can arise from the comparison
• explain, using simple numerical examples, the basis for setting a transfer price using variable cost
• explain, using simple numerical examples, the basis for setting a transfer price using full cost
• explain, using simple numerical examples, how transfer prices can distort the performance assessment of divisions and decisions made, including dysfunctional decision making
• explain, using simple numerical examples, the principles behind allowing for intermediate markets.

1 Divisional performance measurement

Important point: For each of these care must be taken toassess managers on controllable factors only. So for example, themanager of a cost centre should only be assessed on controllable costs.

Return on investment (ROI)

This is a similar measure to ROCE but is used to appraise the investment decisions of an individual department.

• Controllable profit is usually taken after depreciation but before tax. However, in the exam you may not be given this profit figure and so you should use the profit figure that is closest to this. Assume the profit is controllable, unless told otherwise.
• Capital employed is total assets less long term liabilities or total equity plus long term debt. Use net assets if capital employed is not given in the question.
• Non-current assets might be valued at cost, net replacement cost or net book value (NBV). The value of assets employed could be either an average value for the period as a whole or a value as at the end of the period. An average value for the period is preferable. However, in the exam you should use whatever figure is given to you.

Test your understanding 1 - ROI calculation

An investment centre has reported a profit of $28,000. It has the following assets and liabilities:

Required:

Calculate the ROI for the division. State any additional information that would be useful when calculating the ROI.

Additional example on ROI

Division A of Babbage Group had investments at the year end of $56million. These include the cost of a new equipment item costing $3million that was acquired two weeks before the end of the year. Thisequipment was paid for by the central treasury department of Babbage,and is recorded in the accounts as an inter-company loan.

The profit of division A for the year was $7 million before deducting head office recharges of $800,000.

Required:

What is the most appropriate measure of ROI for Division A for the year?

Solution

Since the new equipment was bought just two weeks before the yearend, the most appropriate figure for capital employed is $53 million,not $56 million.

The figure for profit should be the controllable profit of $7 million.

ROI = $7 million/$53 million = 13.2%

Evaluation of ROI as a performance measure

ROI is a popular measure for divisional performance but has someserious failings which must be considered when interpreting results.

Advantages

• It is widely used and accepted since it is line with ROCE which is frequently used to assess overall business performance.
• As a relative measure it enables comparisons to be made with divisions or companies of different sizes.
• It can be broken down into secondary ratios for more detailed analysis, i.e. profit margin and asset turnover.

Disadvantages

• It may lead to dysfunctional decision making, e.g. a division with a current ROI of 30% would not wish to accept a project offering a ROI of 25%, as this would dilute its current figure. However, the 25% ROI may meet or exceed the company's target.
• ROI increases with the age of the asset if NBVs are used, thus giving managers an incentive to hang on to possibly inefficient, obsolescent machines.
• It may encourage the manipulation of profit and capital employed figures to improve results, e.g. in order to obtain a bonus payment.
• Different accounting policies can confuse comparisons (e.g. depreciation policy).

Test your understanding 2 - Disadvantages of ROI

Nielsen Ltd has two divisions with the following information:

Division A has been offered a project costing $100,000 and givingannual returns of $20,000. Division B has been offered a project costing$100,000 and giving annual returns of $12,000. The company's cost ofcapital is 15%. Divisional performance is judged on ROI and theROI-related bonus is sufficiently high to influence the managers'behaviour.

Required:

(a) What decisions will be made bymanagement if they act in the best interests of their division (and inthe best interests of their bonus)?

(b) What should the managers do if they act in the best interests of the company as a whole?

Residual income (RI)

RI = Controllable profit – Notional interest on capital

• Controllable profit is calculated in the same way as for ROI.
• Notional interest on capital = the capital employed in the division multiplied by a notional cost of capital or interest rate.
  • Capital employed is calculated in the same way as for ROI.
  • The selected cost of capital could be the company's average cost of funds (cost of capital). However, other interest rates might be selected, such as the current cost of borrowing, or a target ROI. (You should use whatever rate is given in the exam).

Test your understanding 3 - RI calculation

An investment centre has net assets of $800,000, and made profitsbefore interest and tax of $160,000. The notional cost of capital is12%.

Required:

Calculate and comment on the RI for the period.

Evaluation of RI as a performance measure

Compared to using ROI as a measure of performance, RI has several advantages and disadvantages:

Advantages

• It encourages investment centre managers to make new investments if they add to RI. A new investment might add to RI but reduce ROI. In such a situation, measuring performance by RI would not result in dysfunctional behaviour, i.e. the best decision will be made for the business as a whole.
• Making a specific charge for interest helps to make investment centre managers more aware of the cost of the assets under their control.

Disadvantages

• It does not facilitate comparisons between divisions since the RI is driven by the size of divisions and of their investments.
• It is based on accounting measures of profit and capital employed which may be subject to manipulation, e.g. in order to obtain a bonus payment.

Test your understanding 4 - ROI vs RI

An investment centre has net assets of $800,000, and made profitsbefore interest of $160,000. The notional cost of capital is 12%. Thisis the company's target return.

An opportunity has arisen to invest in a new project costing$100,000. The project would have a four-year life, and would makeprofits of $15,000 each year.

Required:

(a) What would be the ROI with andwithout the investment? (Base your calculations on opening book values).Would the investment centre manager wish to undertake the investment ifperformance is judged on ROI?

(b) What would be the average annual RIwith and without the investment? (Base your calculations on opening bookvalues).Would the investment centre manager wish to undertake theinvestment if performance is judged on RI?

Additional example on ROI and RI

Two divisions of a company are considering new investments.

Company’s required ROI = 18%

Required:

Assess the projects using both ROI and RI.

Solution

Consider divisional performance:

Without project

Based on ROI, Division X will reject its project as it dilutes itsexisting ROI of 25%. This is the wrong decision from the companyperspective as the project ROI of 20% beats the company hurdle of 18%.

Likewise Division Y will accept its project, which should be rejected as it fails to hit the company target.

In each case there is a conflict between the company and divisional viewpoints.

RI does not have this problem as we simply add the project RI to the divisional figures.

Comparing divisional performance

Divisional performance can be compared in many ways. ROI and RI are common methods but other methods could be used.

• Variance analysis – is a standard means of monitoring and controlling performance. Care must be taken in identifying the controllability of, and responsibility for, each variance.
• Ratio analysis – there are several profitability and liquidity measures that can be applied to divisional performance reports.
• Other management ratios – this could include measures such as sales per employee or square foot as well as industry specific ratios such as transport costs per mile, brewing costs per barrel, overheads per chargeable hour.
• Other information – such as staff turnover, market share, new customers gained, innovative products or services developed.

Test your understanding 5

Comment on the problems that may be involved in comparing divisional performance.

2 Transfer pricing

Introduction

A transfer price is the price at which goods or services aretransferred from one division to another within the same organisation.

Objectives of a transfer pricing system

• Goal congruence

The decisions made by each profit centre manager should beconsistent with the objectives of the organisation as a whole, i.e. thetransfer price should assist in maximising overall company profits. Acommon feature of exam questions is that a transfer price is set thatresults in sub-optimal behaviour.

• Performance measurement

The buying and selling divisions will be treated as profit centres.The transfer price should allow the performance of each division to beassessed fairly. Divisional managers will be demotivated if this is notachieved.

• Autonomy

The system used to set transfer prices should seek to maintain theautonomy of profit centre managers. If autonomy is maintained, managerstend to be more highly motivated but sub-optimal decisions may be made.

• Recording the movement of goods and services.

In practice, an extremely important function of the transferpricing system is simply to assist in recording the movement of goodsand services.

Setting the transfer price

There are two main methods available:

Method 1: Market based approach

If an external market exists for the transferred goods then the transfer price could be set at the external market price.

Advantages of this method:

• The transfer price should be deemed to be fair by the managers of the buying and selling divisions. The selling division will receive the same amount for any internal or external sales. The buying division will pay the same for goods if they buy them internally or externally.
• The company's performance will not be impacted negatively by the transfer price because the transfer price is the same as the external market price.

Disadvantages of this method:

• There may not be an external market price.
• The external market price may not be stable. For example, discounts may be offered to certain customers or for bulk orders.
• Savings may be made from transferring the goods internally. For example, delivery costs will be saved. These savings should ideally be deducted from the external market price before a transfer price is set.

Method 2: Cost based approach

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

A standard cost should be used rather than the actual cost since:

• Actual costs do not encourage the selling division to control costs.
• If a standard cost is used, the buying division will know the cost in advance and can therefore put plans in place.

There are a number of different standard costs that could be used:

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

Each of these will be reviewed.

Test your understanding 6 - Full cost and marginal cost

A company has two profit centres, Centre A and Centre B. Centre Asupplies Centre B with a part-finished product. Centre B completes theproduction and sells the finished units in the market at $35 per unit.There is no external market for Centre A's part-finished product.

Budgeted data for the year:

Required:

Calculated the budgeted annual profit for each division and for thecompany as a whole of the transfer price for the components supplied bydivision A to division B is:

(a) Full cost plus 10%

(b) Marginal cost plus 10%

(c) Evaluate both transfer prices fromthe perspective of each individual division and from the perspective ofthe company as a whole.

Test your understanding 7 - Opportunity cost approach

A company operates two divisions, Able and Baker. Able manufacturestwo products, X and Y. Product X is sold to external customers for $42per unit. The only outlet for product Y is Baker.

Baker supplies an external market and can obtain its semi-finishedsupplies (product Y) from either Able or an external source. Bakercurrently has the opportunity to purchase product Y from an externalsupplier for $38 per unit. The capacity of division Able is measured inunits of output, irrespective of whether product X, Y or a combinationof both are being manufactured.

The associated product costs are as follows:

Required:

Using the above information, advise on the determination of anappropriate transfer price for the sale of product Y from division Ableto division Baker under the following conditions:

(i)when division Able has spare capacity and limited external demand for product X

(ii) when division Able is operating at full capacity with unsatisfied external demand for product X.

Additional example on transfer pricing

Archer Group has two divisions, Division X and Division Y. DivisionX manufactures a component X8 which is transferred to Division Y.Division Y uses component X8 to make a finished product Y14, which itsells for $20. There is no external market for component X8.

Costs are as follows:

• Excluding the cost of transferred units of X8.

The budgeted output and sales for Product Y14 is 20,000 units. Oneunit of component X8 goes into the manufacture of one unit of Y14.

The profit of the company as a whole will be maximised if DivisionsX and Y produce up to their capacity, or to the maximum volume of salesdemand. For each extra unit sold, the marginal revenue is $20 and themarginal cost is $8 ($5 + $3); therefore the additional contribution is$12 for each extra unit of Y14 made and sold.

Since there is no external market for component X8, the transferprice will be cost-based. ‘Cost' might be marginal cost or full cost.The transfer price might also include a mark-up on cost to allow aprofit to Division X.

The maximum transfer price that the buying division will pay

Division Y has a marginal cost of $3 per unit, and earns revenue of$20 for each unit sold. In theory, Division Y should therefore beprepared to pay up to $17 ($20 — $3) for each unit of X8.

It could be argued, however, that Division Y would not want to sellProduct Y14 at all if it made a loss. Division Y might therefore wantto cover its fixed costs as well as its variable costs. Fixed costs inDivision Y, given a budget of 20,000 units, are $4 per unit. The totalcost in Division Y is $7 ($3 + $4). On this basis, the maximum transferprice that Division Y should be willing to pay is $13 ($20 — $7).

Transfer price = marginal cost

The short-term opportunity cost to Division X of transferring units of X8 to Division Y is the marginal cost of production, $5.

At a transfer price of $5, Division X would be expected to sell asmany units of X8 to Division Y as Division Y would like to buy.

However, although marginal cost represents the opportunity cost toDivision X of transferring units of X8, it is not an ideal transferprice.

• At a transfer price of $5, Division X would make $0 contribution from each unit transferred. The Division would therefore make a loss of $40,000 (its fixed costs).
• This transfer price would not motivate the manager of Division X to maximise output.
• It is unlikely that the manager of Division X would be prepared to negotiate this price with Division Y, and a decision to set the transfer price at $5 would probably have to be made by head office.
• If Division X is set up as a profit centre, a transfer price at marginal cost would not provide a fair way of measuring and assessing the division's performance.

Transfer price = marginal cost plus

If the transfer price is set at marginal cost plus a mark-up forcontribution, the manager of Division X would be motivated to maximiseoutput, because this would maximise contribution and profit (or minimisethe loss).

As indicated earlier, Division Y would want to buy as much aspossible from Division X provided that the transfer price is no higherthan $17, or possibly $13.

If a transfer price is set at marginal cost plus a mark-up forcontribution, the ‘ideal' range of prices lies anywhere between $5 and$17. The size of the mark-up would be a matter for negotiation.Presumably, the transfer price that is eventually agreed would beeither:

• imposed by head office, or
• agreed by negotiation between the divisional managers, with the more powerful or skilful negotiator getting the better deal on the price.

Additional requirement:

Discuss the implications of setting the transfer cost at full cost plus.

Solution

There is an argument that the opportunity cost of transfer, in the absence of an intermediate market, is full cost.

This assumes that, if the selling division decided against makingany transfers at all, it would save all costs, both marginal and fixedcosts, by shutting down.

In the above example, the full cost for Division X of making component X8 is $7 ($5 variable plus $2 fixed).

At this price, Division X would want to sell as many units aspossible to Division Y, and Division Y would buy as many units as itcould, subject to the limit on capacity or sales demand.

However, although full cost represents the long-term opportunitycost to Division X of transferring units of X8, it is not an idealtransfer price.

• At a transfer price of $7, Division X would make $0 profit from each unit transferred. If output and sales are less than the budget of 20,000, Division X would make a loss due to the under-absorbed fixed overhead. If output and sales are more than the budget of 20,000, Division X would make a profit due to the over-absorbed fixed overhead. The only ways in which Division X could make a profit are therefore:
  • to hope that sales demand exceeds the budgeted volume, and/or
  • reduce its variable costs and fixed cost expenditures.
• It is unlikely that the manager of Division X would be prepared to negotiate this price with Division Y, and a decision to set the transfer price at $7 would probably have to be made by head office.
• If Division X is set up as a profit centre, a transfer price at full cost would not provide a fair way of measuring and assessing the division's performance.

Test your understanding 8 - Additional example

Manuco company has been offered supplies of special ingredient Z ata transfer price of $15 per kg by Helpco company, which is part of thesame group of companies. Helpco processes and sells special ingredient Zto customers external to the group at $15 per kg. Helpco bases itstransfer price on full cost plus 25% profit mark-up. The full cost hasbeen estimated as 75% variable and 25% fixed. Internal transfers toManuco would enable $1.50 per kg of variable packing cost to be avoided.

Required:

Discuss the transfer prices at which Helpco should offer totransfer special ingredient Z to Manuco in order that group profitmaximising decisions are taken in each of the following situations:

(i)Helpco has an external market for all its production of special ingredient Z at a selling price of $15 per kg.

(ii) Helpco has production capacity for9,000kg of special ingredient Z. An external market is available for6,000 kgs of material Z.

(iii)Helpco has production capacity for3,000 kg of special material Z. An alternative use for some of its spareproduction capacity exists. This alternative use is equivalent to2,000kg of special ingredient Z and would earn a contribution of $6,000.There is no external demand.

3 Chapter summary

Test your understanding answers

Test your understanding 1 - ROI calculation

• ROI might be measured as: $28,000/$142,000 = 19.7%.
• However, suppose that the centre manager has no responsibility for debt collection. In this situation, it could be argued that the centre manager is not responsible for trade receivables, and the centre's CE should be $112,000. If this assumption is used, ROI would be $28,000/$112,000 = 25.0%. 

Test your understanding 2 - Disadvantages of ROI

(a)

The manager of Division A will not want to accept the project asit lowers her ROI from 30% to 27.5%. The manager of Division B will likethe new project as it will increase their ROI from 10% to 11%. Althoughthe 11% is bad, it is better than before.

(b) Looking at the whole situation fromthe group point of view, we are in the ridiculous position that thegroup has been offered two projects, both costing $100,000. One projectgives a profit of $20,000 and the other $12,000. Left to their owndevices then the managers would end up accepting the project giving only$12,000. This is because ROI is a defective decision-making method anddoes not guarantee that the correct decision will be made.

Test your understanding 3 - RI calculation

If performance is measured by RI, the RI for the period is:

(Note: Capital employed is not available in this question and therefore net assets should be used as a substitute value).

Investment centre managers who make investment decisions on thebasis of short-term performance will want to undertake any investmentsthat add to RI, i.e. if the RI is positive.

Test your understanding 4 - ROI vs RI

(a) ROI

ROI would be lower; therefore the centre manager will not want tomake the investment. since his performance will be judged as havingdeteriorated. However, this results in dysfunctional behaviour since thecompany's target is only 12%.

(b)RI

The investment centre manager will want to undertake the investmentbecause it will increase RI. This is the correct decision for thecompany since RI increases by $3,000 as a result of the investment.

Test your understanding 5

Problems may include:

• Divisions may operate in different environments. A division earning a ROI of 10% when the industry average is 7% may be considered to be performing better than a division earning a ROI of 12% when the industry average is 15%.
• The transfer pricing policy may distort divisional performance.
• Divisions may have assets of different ages. A division earning a high ROI may do so because assets are old and fully depreciated. This may give a poor indication of future potential performance.
• There may be difficulties comparing divisions with different accounting policies (e.g. depreciation).
• Evaluating performance on the basis of a few indicators may lead to manipulation of data. A wider range of indicators may be preferable which include non-financial measures. It may be difficult to find non-financial indicators which can easily be compared if divisions operate in different environments.

Test your understanding 6 - Full cost and marginal cost

(a)

(b)

Working 1

Working 2

(c)

• Division A would prefer the transfer price to be set at full cost plus 10%. This would give them a budgeted profit of $16,000, compared to a loss of $50,000 when the marginal cost transfer price is used.
• Division B would prefer the transfer price to be set at variable cost + 10%. This gives them a profit of $160,000 compared with a profit of $94,000 if the full cost transfer price is used.
• There is a natural conflict between the divisions and the transfer price would have to be negotiated to ensure that each division views it as being fair.
• The company as a whole will be indifferent to the transfer price. There is no external market for Division A's goods and the profit will be $110,000 regardless of the transfer price set.

Test your understanding 7 - Opportunity cost approach

(i)The transfer price should be setbetween $35 and $38. Able has spare capacity, therefore the marginalcosts to the group of Able making a unit is $35. If the price is setabove $38, Baker will be encouraged to buy outside the group, decreasinggroup profit by $3 per unit.

(ii) If Able supplies Baker with a unitof Y, it will cost $35 and they (both Able and the group) will lose $10contribution from X ($42 sales – $32 variable cost). So long as thebought-in external price of Y to Baker is less than $45, Baker shouldbuy from that external source. The transfer price should therefore beset at $45.

Test your understanding 8 - Additional example

(i)Since Helpco has an external market,which is the opportunity foregone, the relevant transfer price would bethe external selling price of $15 per kg. This will be adjusted to allowfor the $1.50 per kg avoided on internal transfers due to packing costsnot required.

The transfer price offered by Helpco should be $15 — $1.50 = $13.50 per kg.

(ii) In this situation Helpco has noalternative opportunity for 3,000kg of its special ingredient Z. Itshould, therefore, offer to transfer this quantity at marginal cost.This is variable cost less packing costs avoided = $9 (W1) — $1.50 =$7.50 per kg.

Working 1: Total cost = $15 × 80% = $12, Variable cost = $12 × 75% = $9.)

If Manuco require more than 3,000 kgs the transfer price shouldbe set at the adjusted selling price of $13.50 per kg as in (i) above.

(iii)Helpco Ltd has an alternative usefor some of its production capacity, which will yield a contributionequivalent to $3 per kg of special ingredient Z ($6,000/2,000kg). Thebalance of its square capacity (1,000kg) has no opportunity cost andshould still be offered at marginal cost.

Helpco should offer to transfer:

2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50per kg (= MC).

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