ACCA F5: Chapter 13 - Divisional performance measurement and transfer pricing

1.

1 Divisional performance measurement

1 Divisional performance measurement

What are the three types of division?

Cost centre, Profit centre, Investment centre.

1 Divisional performance measurement

1 Divisional performance measurement

2.

What is a cost centre? What are the typical measures used to assess performance?

Division incurs costs but has no revenue stream, e.g. the IT support department of an organisation - Total cost and cost per unit - Cost variances. - NFPIs related to quality, productivity & efficiency
1 Divisional performance measurement

1 Divisional performance measurement

3.

What is a profit centre? What are the typical measures used to assess performance?

- Total cost and cost per unit - Cost variances - NFPIs related to quality, productivity & efficiency - Total sales and market share - Profit - Sales variances - Working capital ratios (depending on the division concerned). - NFPIs e.g. related to productivity, quality and customer satisfaction
1 Divisional performance measurement

1 Divisional performance measurement

What is an investment centre?

Division has both costs and revenue. Manager does have the authority to invest in new assets or dispose of existing ones - Total cost and cost per unit - Cost variances - NFPIs related to quality, productivity & efficiency - Total sales and market share

4.

What are the typical measures used to assess performance?

- Profit - Sales variances - Working capital ratios (depending on the division concerned). - NFPIs e.g. related to productivity, quality and customer satisfaction - ROI - RI
1 Divisional performance measurement

1 Divisional performance measurement

5.

1) What is ROI (Return on investment)? 2) What is controllable profit? 3) What is capital employed?

1) This is a similar measure to ROCE but is used to appraise the investment decisions of an individual department. ROI = (Controllable profit / capital employed) * 100 2) 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 3) 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

1 Divisional performance measurement

- It is widely used and accepted since it is line with ROCE which is frequently used to assess overall

6.

1 Divisional performance measurement

What are the advantages of ROI?

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.
1 Divisional performance measurement

7.

1 Divisional performance measurement

What are the disadvantages of ROI?

- 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).
1 Divisional performance measurement

1) RI = Controllable profit Notional interest on capital 2) 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 3) Notional interest on capital =

1 Divisional performance measurement

8.

1) What is risidual income? 2) What is controllable profit? 3) What is notional interest on capital?

the capital employed in the division multiplied by a notional cost of capital or interest rate. - 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 - The selected cost of capital could be the companys 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).

1 Divisional performance measurement

9.

1 Divisional performance measurement

Advantages of RI as a performance measure?

- 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.
1 Divisional performance measurement

1 Divisional performance measurement

10.

Disadvantages of RI as a performance measure?

- 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.
1 Divisional performance measurement

1 Divisional performance measurement

11.

What other ways can divisonal performance be measured?

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.
1 Divisional performance measurement

1 Divisional performance measurement

12.

Problems with comparing divisional performance

- 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 nonfinancial measures. It may be difficult to find non-financial indicators which can easily be compared if divisions operate in different environments
2 Transfer pricing 2 Transfer pricing

13.

What is a transfer price?

A transfer price is the price at which goods or services are transferred from one division to another within the same organisation.
2 Transfer pricing

2 Transfer pricing

14.

What are the objectives of a transfer pricing system?

- Goal congruence: The decisions made by each profit centre manager should be consistent with the objectives of the organisation as a whole, i.e. the transfer price should assist in maximising overall company profits. A common feature of exam questions is that a transfer price is set that results 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 be assessed fairly. Divisional managers will be demotivated if this is not achieved. - Autonomy: The system used to set transfer prices should seek to maintain the autonomy of profit centre managers. If autonomy is maintained, managers tend 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 transfer pricing system is simply to assist in recording the movement of goods and services.

2 Transfer pricing

2 Transfer pricing

15.

What are the two main methods for setting a transfer price?

Market based approach and the cost based approach.

2 Transfer pricing

16.

2 Transfer pricing

What is the market based approach?

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

2 Transfer pricing

2 Transfer pricing

17. What are the advantages of the market based

approach?

- 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.
2 Transfer pricing

- There may not be an external market price -The external market price may not be stable. For example, discounts may be offered to

2 Transfer pricing

18.

What are the disadvantages of the market based approach?

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.
2 Transfer pricing

2 Transfer pricing

19.

What is the cost based approach? What type of cost should be used and why? What different type of standard cost can be used?

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 and If a standard cost is used, the buying division will know the cost in advance and can therefore put plans in place. Full, marginal and opportunity.