1. Financial performance measures and transfer pricing
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