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Contents
External Considerations and Behavioural Aspects................................................................. 3
EXTERNAL CONSIDERATIONS: ............................................................................................ 3
BEHAVIOURAL ASPECTS:..................................................................................................... 4
Building Block Model .............................................................................................................. 5
Divisional Performance Measures ......................................................................................... 7
KEY MEASURES AND CHARACTERISTICS: ............................................................................ 7
RETURN ON INVESTMENT (ROI): ........................................................................................ 7
RESIDUAL INCOME (RI): ...................................................................................................... 8
DIFFERENCES BETWEEN ROI AND RI: ................................................................................. 8
Transfer pricing ...................................................................................................................... 9
DEFINITION: ........................................................................................................................ 9
OBJECTIVES OF TRANSFER PRICING: .................................................................................. 9
VARIABLE COST OR FULL COST? ....................................................................................... 11
STANDARD OR ACTUAL COST? ......................................................................................... 12
NON-FINANCIAL CONSIDERATIONS:................................................................................. 12
Divisional Performance Measures ....................................................................................... 13
KEY MEASURES AND CHARACTERISTICS: .......................................................................... 13
RETURN ON INVESTMENT (ROI): ...................................................................................... 13
RESIDUAL INCOME (RI): .................................................................................................... 14
DIFFERENCES BETWEEN ROI AND RI: ............................................................................... 14
Transfer pricing .................................................................................................................... 15
DEFINITION: ...................................................................................................................... 15
OBJECTIVES OF TRANSFER PRICING: ................................................................................ 15
VARIABLE COST OR FULL COST? ....................................................................................... 17
STANDARD OR ACTUAL COST? ......................................................................................... 18
1
NON-FINANCIAL CONSIDERATIONS:................................................................................. 18
PM – Revision ....................................................................................................................... 19
MCQ trial - Divisional Performance Assessment .............................................................. 19
2
External Considerations and Behavioural Aspects
EXTERNAL CONSIDERATIONS:
Performance management needs to allow for external considerations. This will include:
Employees;
Shareholders;
Banks;
a) Internal. This category will include anybody internal to the business (e.g., employees
and management). They will be interested in the organisation’s continued growth
and profitability. In addition, they will have personal interests such as salary,
bonuses, or promotion aspects;
c) External. They are not directly connected to the business in any way but do have a
legitimate interest (e.g., government, local authorities, professional bodies, pressure
groups). External stakeholders, in particular, induce both social and ethical
obligations.
3
2) Market conditions. There are various aspects here that could be considered:
Inflation;
BEHAVIOURAL ASPECTS:
Many organisations adopt some form of reward scheme that is linked to performance
measurement. However, there are certain problems that can arise with such schemes
depending on how the scheme has been devised and how the manager is being measured:
Managers can make decisions in their own best interest which are contrary to the
longer term success of the business;
Long-term measures may not motivate people as the reward is too distant in the future.
Certain managers may not even consider that they will still be employed by the
organisation at that point in the future;
Too much effort can be focused only on certain areas of work, the ones that are being
measured.
4
Building Block Model
Fitzgerald and Moon devised the building block model in an attempt to overcome some of
the problems associated with performance measurement in the service area. The model
suggests that a performance management system can be analysed into three building
blocks:
Dimensions of performance
Financial performance
Results Competitiveness
Service quality
Determinants Flexibility
Resource utilisation
Innovation
Standards Rewards
Ownership Clarity
Realistic Achievement
Equitable Responsibility
1) The Dimensions of performance are the aspects of the business that are to be
measured. There are six key aspects to performance measurement:
Financial performance. This will incorporate all the usual financial performance
indicators, such as profit growth, and gross and net profit margins;
Competitiveness. This will typically include measures, such as growth in sales or the
success rate of converting an enquiry into a sale;
Service quality. This would include the number of complaints or customer satisfaction
scores;
Resource utilisation. This would include measures around capacity utilisation and
efficiency measures;
5
Innovation. Typical measures here would be the number of new services offered over a
given time period.
2) The Standards block concerns setting the standards of performance. However, this
cannot be done until the dimensions of performance have been selected and agreed
upon. Fitzgerald and Moon identified three aspects to setting the standards of
performance:
Ownership. Iindividuals need to feel that they own the standards and targets for
which they will be made responsible;
Realistic. This means that the standards need to realistic and achievable;
Equitable. This means that the standards and targets should be fair and
equitable for all concerned.
3) The Rewards building block refers to the structure of the rewards system and details
how individuals will be rewarded for successful achievement of the performance
targets. Fitzgerald and Moon identified three aspects for the rewards system:
Clarity. The system of both setting the targets and reward system should be clear
and transparent;
6
Divisional Performance Measures
KEY MEASURES AND CHARACTERISTICS:
There are two key measures which are used to assess the performance of a company
division:
The following characteristics are desirable when looking to successfully appraise a division’s
performance:
1) Goal Congruence. Divisional managers should make decisions that are in the best
interests of the division and the company (or group) as a whole;
2) Autonomy. The divisional manager should be able to act and make decisions
independently of the company head office;
Note: A conflict between goal congruence and autonomy can often arise if managers are
allowed too much autonomy and they may make decisions that are not in the best interests
of the company as a whole. However if autonomy is withdrawn, this can make it difficult to
accurately assess performance.
Net profit
Return on investment (ROI) =
Investment cost
Note: Using ROI will encourage divisional managers to make decisions that are in their best
interests but not necessarily the best interests of the company as a whole, which is referred
to as dysfunctional behaviour or non-goal congruent behaviour.
7
RESIDUAL INCOME (RI):
Note: If the residual income is positive, the investment is acceptable to the division.
RI ROI
- Could be viewed as the superior - Can result in dysfunctional behaviour
method of investment meaning company profits are
appraisal as goal congruence should be not maximised thus hampering fair
achieved; evaluation of division’s performance;
- It is expressed as an absolute measure - It is a relative measure expressed as a
which makes it percentage, which facilitates
more difficult to compare divisional inter-divisional comparisons and makes it
performance; easier to understand;
- Estimation of a cost of capital is - No cost of capital estimation is
required for the RI calculation. required when calculating ROI.
How buoyant is the market for each division’s goods and services?
8
Transfer pricing
DEFINITION:
The transfer price is the price at which an internal sale occurs. In other words, if one division
of a group sells to another division of the same group the transfer price is the price they set
for this sale.
Financial accountants may at first view appear to be supremely indifferent to what this
number is. After all, the revenue in one division equals the costs in the other division, and
the two simply cancel out on consolidation for financial reporting purposes.
There are four main objectives that should be considered with a transfer price:
1) Goal congruence - the decisions that divisional managers make as a result of the
transfer price set should be consistent with group objectives.
4) Tax - to a limited degree, tax implications should be considered with transfer pricing
that involves divisions located in different countries. It’s worth pointing out however
that tax legislation is tightening up in this area and opportunities for tax planning are
reducing globally.
Note: These four objectives can be remembered with the word GAPTax.
9
Example:
Suppose we have two divisions: A and B. Division A manufactures a component which can
be sold to the outside world for $10. Division B also uses this component in their own
production process. In Division B’s local market they can acquire a similar component that is
perfectly adequate for $9.
$ per unit A B
Total cost 7 14
Suppose initially division A has some spare capacity in its factory. This is important as it
means transferring internally to division B won’t cause division A to have to give up some
external sales of the component. In these circumstances, firstly let’s consider what is best
for the group as a whole.
Should the group produce this component and transfer it internally, or should the group buy
it in from the outside at a cost of $9?
The cost of making extra components for internal transfer is only $5, compared to the
external price of $9. In these circumstances, it's best for the group if the internal transfer
occurs.
Secondly, let’s consider what transfer price will cause this to happen. Division A will be
happy so long as they receive more than $5 per component. This is the variable cost of
manufacture. Note the fixed cost is irrelevant as by definition it will not vary with output.
The buying division, division B, will be happy provided it pays less than $9. This is the price it
pays for buying the component in from the outside world.
So, a transfer price in the range $5-$9 would appear to encourage goal congruent
behaviour, say $7 (half way between the two). At $7, the seller will want to sell, the buyer
will want to buy, and this is best for the group as a whole.
10
Let’s now consider how this decision might change if division A is operating at full capacity.
The significance of this is that division A will have to sacrifice some external sales to be able
to make internal transfers. Let’s first consider what is best for the group:
The cost of an internal transfer would be the variable cost of manufacture of $5 per
component plus the lost contribution from the external sale they had to give up, being $10
revenue less $5 variable cost which equals $5, so a total cost to the group is $10 per
component internally transferred.
This is more than the $9 it costs to buy the component in from the outside. In these
circumstances, it is better for division A to make all the components it can and sell into the
outside world, and for division B to buy all their components locally.
There is, therefore, no optimal transfer price as the transfer should not occur. In fact, any
number you care to pick will mean either the seller doesn’t want to sell or buyer doesn't
want to buy. The seller will only be happy if they receive more than $10 to compensate
them for the costs incurred in the internal transfer, and the buyer will only accept the
internal transfer if it costs less than the nine dollars it costs them to buy it in from the
outside. There is no price that is simultaneously more than $10 and less than $9. This
reflects the point that there is no optional transfer price in this case, as the transfer should
not happen.
If the intermediate market is perfect (in other words, there is infinite capacity and only one
market price), then the only logical place for the transfer price to be is at that market price.
If the universal market price for a component was $10, there is no reason why the seller
should accept any less than $10 and no reason why the buyer should pay any more than
$10. This approach to transfer pricing is known as market-based, or opportunity-cost based
transfer pricing.
Lots of businesses use a cost plus approach, i.e. they base their transfer price on accounting
style cost plus a markup. Firstly, let’s consider whether the cost figure should be variable
cost or full cost.
Full cost plus a markup might be very expensive for the buying division, and they may
choose to purchase from the outside. This may not be in the best interests of the group as a
whole because the fixed costs element of manufacture would happen anyway and therefore
the true cost of manufacture may well better be expressed by excluding fixed cost.
11
An alternative might be to use variable cost plus a markup. However, care will need to be
taken to make sure that the selling division is making a sufficient return to encourage the
internal transfer if that is indeed optimal for the group.
Secondly, let’s consider whether the cost base should be actual cost or standard cost when
setting transfer prices. In general, standard cost should be used.
If we were to use the actual cost of the selling division, this will discourage cost control in
the selling division because they know they can recover their costs through transfer
price.This encourages inefficiency.
Using standard cost should overcome this because if the selling division overruns on cost,
the excess cost stays in the selling division if the only revenue they get is based on the
standard.
It’s worth noting that sometimes an internal transfer is actually less expensive than an
external sale. There can be some genuine cost savings such as distribution, packaging,
ordering costs. It is only fair that the savings should be shared between the buyer and the
seller through the transfer price that is chosen.
NON-FINANCIAL CONSIDERATIONS:
Finally, there are some non-financial considerations to bear in mind with transfer pricing.
For example, although it might be cheaper to purchase from the outside than to transfer
internally, a company may still want to ensure the internal transfer happens. For example, a
prestigious car brand would not want cheap bought-in components from another
manufacturer when they have superior quality components within their own brand
manufactured internally. It may protect the brand overall if components are made
internally, and this may need to be enforced centrally.
12
Divisional Performance Measures
KEY MEASURES AND CHARACTERISTICS:
There are two key measures which are used to assess the performance of a company
division:
The following characteristics are desirable when looking to successfully appraise a division’s
performance:
4) Goal Congruence. Divisional managers should make decisions that are in the best
interests of the division and the company (or group) as a whole;
5) Autonomy. The divisional manager should be able to act and make decisions
independently of the company head office;
Note: A conflict between goal congruence and autonomy can often arise if managers are
allowed too much autonomy and they may make decisions that are not in the best interests
of the company as a whole. However if autonomy is withdrawn, this can make it difficult to
accurately assess performance.
Net profit
Return on investment (ROI) =
Investment cost
Note: Using ROI will encourage divisional managers to make decisions that are in their best
interests but not necessarily the best interests of the company as a whole, which is referred
to as dysfunctional behaviour or non-goal congruent behaviour.
13
RESIDUAL INCOME (RI):
Note: If the residual income is positive, the investment is acceptable to the division.
RI ROI
- Can result in dysfunctional behaviour
- Could be viewed as the superior
meaning company profits are not maximised thus
method of investment appraisal as
hampering fair evaluation of division’s
goal congruence should be achieved;
performance;
- It is expressed as an absolute
- It is a relative measure expressed as a
measure which makes it more
percentage, which facilitates inter-divisional
difficult to compare divisional
comparisons and makes it easier to understand;
performance;
- Estimation of a cost of capital is - No cost of capital estimation is required
required for the RI calculation. when calculating ROI.
Other factors to be considered when evaluating or comparing divisional performance:
How buoyant is the market for each division’s goods and services?
14
Transfer pricing
DEFINITION:
The transfer price is the price at which an internal sale occurs. In other words, if one division
of a group sells to another division of the same group the transfer price is the price they set
for this sale.
Financial accountants may at first view appear to be supremely indifferent to what this
number is. After all, the revenue in one division equals the costs in the other division, and
the two simply cancel out on consolidation for financial reporting purposes.
There are four main objectives that should be considered with a transfer price:
1) Goal congruence - the decisions that divisional managers make as a result of the
transfer price set should be consistent with group objectives.
4) Tax - to a limited degree, tax implications should be considered with transfer pricing
that involves divisions located in different countries. It’s worth pointing out however
that tax legislation is tightening up in this area and opportunities for tax planning are
reducing globally.
Note: These four objectives can be remembered with the word GAPTax.
15
Example:
Suppose we have two divisions: A and B. Division A manufactures a component which can
be sold to the outside world for $10. Division B also uses this component in their own
production process. In Division B’s local market they can acquire a similar component that is
perfectly adequate for $9.
$ per unit A B
Total cost 7 14
Suppose initially division A has some spare capacity in its factory. This is important as it
means transferring internally to division B won’t cause division A to have to give up some
external sales of the component. In these circumstances, firstly let’s consider what is best
for the group as a whole.
Should the group produce this component and transfer it internally, or should the group buy
it in from the outside at a cost of $9?
The cost of making extra components for internal transfer is only $5, compared to the
external price of $9. In these circumstances, it's best for the group if the internal transfer
occurs.
Secondly, let’s consider what transfer price will cause this to happen. Division A will be
happy so long as they receive more than $5 per component. This is the variable cost of
manufacture. Note the fixed cost is irrelevant as by definition it will not vary with output.
The buying division, division B, will be happy provided it pays less than $9. This is the price it
pays for buying the component in from the outside world.
So, a transfer price in the range $5-$9 would appear to encourage goal congruent
behaviour, say $7 (half way between the two). At $7, the seller will want to sell, the buyer
will want to buy, and this is best for the group as a whole.
16
Let’s now consider how this decision might change if division A is operating at full capacity.
The significance of this is that division A will have to sacrifice some external sales to be able
to make internal transfers. Let’s first consider what is best for the group:
The cost of an internal transfer would be the variable cost of manufacture of $5 per
component plus the lost contribution from the external sale they had to give up, being $10
revenue less $5 variable cost which equals $5, so a total cost to the group is $10 per
component internally transferred.
This is more than the $9 it costs to buy the component in from the outside. In these
circumstances, it is better for division A to make all the components it can and sell into the
outside world, and for division B to buy all their components locally.
There is, therefore, no optimal transfer price as the transfer should not occur. In fact, any
number you care to pick will mean either the seller doesn’t want to sell or buyer doesn't
want to buy. The seller will only be happy if they receive more than $10 to compensate
them for the costs incurred in the internal transfer, and the buyer will only accept the
internal transfer if it costs less than the nine dollars it costs them to buy it in from the
outside. There is no price that is simultaneously more than $10 and less than $9. This
reflects the point that there is no optional transfer price in this case, as the transfer should
not happen.
If the intermediate market is perfect (in other words, there is infinite capacity and only one
market price), then the only logical place for the transfer price to be is at that market price.
If the universal market price for a component was $10, there is no reason why the seller
should accept any less than $10 and no reason why the buyer should pay any more than
$10. This approach to transfer pricing is known as market-based, or opportunity-cost based
transfer pricing.
Lots of businesses use a cost plus approach, i.e. they base their transfer price on accounting
style cost plus a markup. Firstly, let’s consider whether the cost figure should be variable
cost or full cost.
Full cost plus a markup might be very expensive for the buying division, and they may
choose to purchase from the outside. This may not be in the best interests of the group as a
whole because the fixed costs element of manufacture would happen anyway and therefore
the true cost of manufacture may well better be expressed by excluding fixed cost.
An alternative might be to use variable cost plus a markup. However, care will need to be
taken to make sure that the selling division is making a sufficient return to encourage the
internal transfer if that is indeed optimal for the group.
17
STANDARD OR ACTUAL COST?
Secondly, let’s consider whether the cost base should be actual cost or standard cost when
setting transfer prices. In general, standard cost should be used.
If we were to use the actual cost of the selling division, this will discourage cost control in
the selling division because they know they can recover their costs through transfer
price.This encourages inefficiency.
Using standard cost should overcome this because if the selling division overruns on cost,
the excess cost stays in the selling division if the only revenue they get is based on the
standard.
It’s worth noting that sometimes an internal transfer is actually less expensive than an
external sale. There can be some genuine cost savings such as distribution, packaging,
ordering costs. It is only fair that the savings should be shared between the buyer and the
seller through the transfer price that is chosen.
NON-FINANCIAL CONSIDERATIONS:
Finally, there are some non-financial considerations to bear in mind with transfer pricing.
For example, although it might be cheaper to purchase from the outside than to transfer
internally, a company may still want to ensure the internal transfer happens. For example, a
prestigious car brand would not want cheap bought-in components from another
manufacturer when they have superior quality components within their own brand
manufactured internally. It may protect the brand overall if components are made
internally, and this may need to be enforced centrally.
18
PM – Revision
MCQ trial - Divisional Performance Assessment
QUESTION
Question 1
Fleet Co has two divisions, Cars and Vans. Each division is currently considering the following
separate projects:
If residual income is used as the basis for the investment decision, which Division(s) would
choose to invest in the project?
Answer:
1B
19
Question 2
Fleet Co has two divisions, Cars and Vans. Each division is currently considering the following
separate projects:
If return on investment (average investment) is used as the basis for the investment decision,
which Division(s) would choose to invest in the project?
Answer:
2A
Cars Division: Operating Profit = $105m x 35% = $36.75m. Annual depreciation = ($300m-
$200m)/10 = $10m, so average annual accounting profit = $36.75m - $10m = $26.75m
Return on investment - $26.75m / $250m = 10.7%. This is MORE than the current return in the
division of 10% so is acceptable.
Vans Division: Operating Profit = $68m x 40% = $27.2m. Annual depreciation = ($200m-$50m)/9
= $16.67m, so average annual accounting profit = $27.2m - $16.67m = $10.53m
Return on investment - $10.53m / $125m = 8.4% This is LESS than the current return in the
division of 10% so is unacceptable.
20
Question 3
A Statement 1 only
B Statement 2 only
Statement 1: False. It is true that residual income eliminates SOME dysfunctional decision
making. For example a project may be rejected when its return on investment is above the
group average if it is below the current DIVISIONAL return. However, some dysfunctional
decision making may still remain even when using residual income. For example, residual
income will discourage investment in research and development if short term residual income
targets are set, as research and development involves increases cost(and so reducing profit
and/or increasing the capital charge) in the short term. The decision to withhold investment
may not maximise shareholder wealth.
Statement 2: False. Residual income also encourages the overuse of assets, as assets that are
written down to zero in the accounts incur no capital charge.
21