Chapter 14: Divisional performance measurement and transfer pricing Flashcards
What is a cost centre division and measures used to assess performance?
Description:
incurs costs but has no revenue stream e.g IT support department
Measures:
Total cost and cost per unit
Cost variances
NFPIs related to quality, productivity & efficiency
What is a revenue centre division and measures used to assess performance?
description:
Only responsible for generation of revenue
Measures:
total revenue and revenue per unit
revenue (sales) variances
What is a profit centre division and measures used to assess performance?
description:
Has costs and revenues
Manager doesn’t have the authority to alter the level of investment in the division
Measurement:
total cost & cost per unit/ cost variances/ NFPIS related to quality, productivity & efficiency
total rev & rev per unit/ rev (sales) variances)
total sales & market share
profit
sales variances
working capital ratios
NFPIs
What is a Investment centre division and measures used to assess performance?
description:
costs and revenue
manager doesn’t have authority to invest in new assets or dispose of existing ones
Measures:
total cost & cost per unit/ cost variances/ NFPIS related to quality, productivity & efficiency
total rev & rev per unit/ rev (sales) variances)
total sales & market share
profit
sales variances
working capital ratios
NFPIs
ROI
Residual Income (RI)
used to assess the investment decisions by managers
What is the return on investment (ROI)
appraise investment decisions of individuals departments
(controllable profit/ capital employed)*100
Controllable expenses= after depreciation before tax (use profit figure closest to this)
Capital employed = total assets- current liabilities or total equity + LT debt . use net assets if capital employed isn’t given in the question
Non-current assets- valued at cost, net replacement cost or carrying value. value of assets employed could be either an average value for the period as a whole or end. average value for period is preferable
What are the advantages of ROI
1) widely used & accepted - in line with ROCE which is frequently used
2) relative measure enables comparisons to be made with divisions/ companies of different sizes
3) broken down into secondary ratios for more detailed analysis i.e profit margin and asset turnover
What are the disadvantages of ROI
1) Can lead to dysfunctional decision making e.g the % may not be what they’re looking for but the actual amount could meet company target
2) ROI increases with age of asset if carrying values are used- give managers an incentive to hand onto inefficient machines
3) fraudulent manipulation of profit & capital employed figures to improve results e.g meet bonus target
4) Different accounting policies can confuse comparisons (e.g depreciation policy)
What is residual income?
Controllable profit- notional interest on capital
notional interest on capital = capital employed in the division* notional cost of capital or IR
selected cost of capital could be the company’s average cost of funds (cost of capital) or other IR e.g current cost of borrowing or target ROI
Advantages of ROI
1) encourages investment centre managers to make new investments if they add to RI- could reduce ROI but measuring in RI wouldn’t result in dysfunctional behaviour - best decision made for the business as a whole
2) a specific charge for interest makes the investment centre managers more aware of the cost of assets under their control
3) risk incorporated by the choice of IR used
Disadvantages of RI
1) can’t compare divisions as RI is driven by size of divisions and their investments
2) Based on accounting measures of profit & capital employed which could be subject to fraudulent manipulation
Comparing divisional performance methods
RI and ROI
Variance analysis - monitor and control performance. care taken to identify the controllability and responsibility of each variance
Ratio Analysis- profitability and liquidity measures that can be applied to reports
Other management ratios - sales per employee, transport cost per mile, brewing cost per barrel, OH per chargeable hour
Other info - staff turnover, market share, new customers gained, innovative products
What is a transfer price
price where goods/ services are transferred from one division to another within the same organisation
Objectives of the transfer pricing system
1) goal congruence- decisions in profit centres in line with whole company. In exam normally a transfer price set at sub-optimal behaviour which can result in reduced profits as transfer price is set too high
2) Performance measurement- buying and selling divisions treated as profit centres. TP should allow the performance of each division to be assessed fairly. Div managers demotivated if not achieved
3) Autonomy- need to remain in tact so managers are more motivated but sub-optimal decisions can be made e.g decide to buy/sell externally when internal transfer benefits the company more
4) recording movement of goods and services
P&L including transfer prices
Revenue X X
Internal Y
Costs
Internal VC (Y)
External VC (X) (X)
External FC (X) (X)
Profit
Setting the transfer price: market based approach
If an external market exists the price could be set for that market
Advantages:
TP deemed fair by managers of buying and selling division. Selling & buying division receives same amount for internal or external sales.
company performance not negatively impact by TP because they’re the same
Disadvantages:
may not be an external market
external market price may not be stable e.g discounts offered to certain customers/ bulk buy
savings can be made from transferring goods internally e.g delivery costs saved. savings should be deducted from external market price before TP is set to give an adjusted market price
