Divisionalisation is the situation where managers of business areas are given a degree of autonomy to make decision such as set selling prices, choose suppliers and so on without referring to senior management. Therefore, divisional structure leads to decentralisation. But because of this, problems occur when measuring divisional performance. Responsibility accounting is the term used to describe decentralisation of authority and each divisional management performance is measured according to their responsibility. Normally divisional performance is measured by return on investment (ROI) or residual income (RI), these will be discussed in this article and in addition transfer pricing.
Part 1 Transfer pricing
Idea of transfer pricing
Transfer price is the price that one division set for goods or services and sell (transferred) to another division, for another division transfer price will then be their cost. The idea is the sale of one division is the purchase of another division. Transfer pricing will therefore occur when divisions are having transaction with each other. Also note that for the buying division, the transfer price is the variable cost to them.
There are problems with transfer pricing such as:
1. Maintaining the right level of divisional autonomy – decisions taken by a divisional manager might be of his own interests but against the interests of another divisions and organisation as a whole.
2. Ensuring divisional performance measurement is fair – the transfer price set by selling division could largely improve its profit but only little profit is earned by the buying division. It is not fair to compare the profits of these two divisions.
3. Ensuring corporate profits maximisation – It is often that the divisional manager considers the profitability of its own division rather than corporate profit maximisation. Goal congruence is not easy to achieve.
Setting transfer price
In exam, you are normally told to calculate transfer price according to the pricing policy of the selling division. The basis of setting transfer price includes using variable cost, full cost, cost plus and market value. Selling division will normally sell a part-finished goods and buying division buys it, manufactures it and sells it to the market.
Transfer price at variable cost plus
Example: Division A sells its output to division B using the pricing policy of variable cost plus of 50%. Information about costs and revenues for A and B are as follow:
$ per unit $ per unit
Direct material 2
Direct labour 3
Variable overhead 5
Fixed overhead 3
Sales to market 20
Solution: With this example, you can understand the big picture, we assume that A sells finished goods to B.
Variable cost (2 + 3 + 5) 10
Mark-up 50% 5
Transfer price 15
Transfer cost (15)
Sales to market 20
Profit 2 (15 – 10 – 3) 5
In this case, both divisions are able to make a profit per unit of sales, the transfer price is acceptable. As you can see, division A cannot accept a transfer price of less than $13 ($15 - $2) and division B cannot accept a transfer price of more than $20 ($15 + $5) so that they do not make a loss. The range of acceptable transfer price is therefore $13 ≤ x ≤ $20.
The problem of transfer price at variable cost is that selling price may not cover its fixed cost, therefore the mark-up percentage needs to be high enough.
Transfer price at full cost plus
The mark-up percentage needs to be lower than using variable cost plus so that the buying division will accept the transfer price.
Example: Division A sells its output to division B using the pricing policy of full cost plus 20%. Information about costs and revenues for A and B are as follow:
$ per unit $ per unit
Total cost 15 2
Sales to market 20
Purchase of part-finished goods externally 16
Solution: Again I will state the range of transfer price, you don’t need to state it unless required by the examiner.
Full/total cost (2 + 3 + 5 + 5) 15 (2)
Mark-up 20% 3
Transfer price 18
Transfer cost (18)
Sales to market 20
Profit 3 (18 – 15) 0
Using full cost plus of 20%, B makes no profit, however B has the option to buy part-finished goods from external supplier with only $16 per unit, with this B can get a profit of $2 ($20 - $16 - $2). However if B buys from external supplier, A cannot earn the profit of $3 per unit. The range of transfer price should take into account the price by external supplier. A cannot accept the transfer price which is below its costs, ie. $15 and A might not accept the transfer price which is higher than price by external supplier, ie. $16. Range of transfer price will be $15 ≤ x ≤ $16.
Transfer price at market value
If external market price exists, divisional managers would compare market price with the transfer price.
Example: A company has two profit centres, A and B. A sells half of its output on the open market and transfers the other half to B. Costs and external revenues are as follows.
External sales 8000 24000
Costs of production 12000 10000
Market sales 8000 24000
Transfer sales 8000
Transfer costs (8000)
Own costs (12000) (10000)
Profit 4000 6000
Using the transfer price at market value, both A and B are able to make profits. The transfer price will seem to be fair for A and B, A is selling the part-finished goods using the price it sold to the market and B is buying with the price that can earn profit. A market-based transfer price seems to be the ideal transfer price.
However, market price may only be a temporary price as it can change depending on the economic conditions.
Transfer price at variable cost and total cost
If the selling division sells the part-finished goods to buying division at its variable cost, it will make a loss because it did not cover the fixed cost, however sometime this will largely increase the profit of the organisation as a whole. If the selling division manager acts in self-interest only, he will not sell at variable cost.
If the transfer price is based on total cost, the selling division does not make any profit and again the self-interest manager will not sell at this price to the buying division even if this can increase the overall profitability of the organisation. If the divisional manager’s performance is measured only by profitability, the performance measurement will be distorted.
Sensible/economic transfer price rule
There are general rules to determine what transfer price to be set.
If there is no market price or the market price cannot be compared due to imperfect market, then:
1. Minimum transfer price (fixed by selling division) ≥ variable cost of selling division.
2. Maximum transfer price (fixed by buying division) ≤ net marginal revenue or contribution of buying division.
Therefore, variable cost of selling division ≤ transfer price ≤ contribution of buying division.
If there is market price exists in a perfect market, the transfer price must be as good as the outside selling price so that the buying division will choose to transfer-in (buy from selling division). In this case, the economic transfer price rule will be:
1. Minimum transfer price ≥ variable cost of selling division + any lost contribution of not selling outside (opportunity cost).
2. Maximum transfer price ≤ the lower of contribution of buying division and external purchase price.
Therefore, (variable cost of selling division + opportunity cost) ≤ transfer price ≤ lower of contribution of buying division and external purchase price.
Example: Immediate product/part-finished goods can be bought and sold in the market at $60. The following information is available:
Transfer-in price 50
Variable cost 18 10
Fixed cost 12 10
Divisional profit mark-up 20 20
Transfer price/final sale price 50 90
Solution: In this case, division B would rather buy from division A ($50 beats $60), but division A would sell as much as possible outside at $60 in preference to transferring to Division B at $50. If A has limited capacity, it might sell all of its output to the market and this is not good to the organisation as a whole as B will have to buy outside for $60 (variable cost for the group) which A only incur variable cost of $18 (ie. group's variable cost will become $60 instead of $18). Therefore, we must encourage A to supply to B and we can do this by setting a transfer price that is high enough to compensate for the lost contribution that A could have made by selling outside.
Minimum transfer price = $18 + $42 (loss contribution of not selling outside = $60 - $18) = $60.
This is the theory behind minimum transfer price when there is market price.
Example: Using the above example, let say the immediate product/part-finished goods can be bought and sold in the market at $40.
Solution: Division A would rather transfer to division B, because receiving $50 is better than receiving $40. B would rather buy in at the cheaper $40, but that would be bad for the organisation as a whole because there is now a variable cost to the group of $40 instead of only $18 (A’s variable cost). Therefore, the transfer price should compete with external price and must not be higher than that. The transfer price should also be lower than the contribution that B will get, ie. $80 ($90 - $10) so that B can avoid negative contribution.
Maximum transfer price = $40 (lower of net marginal revenue and market price).
This is the theory behind maximum transfer price when there is market price.
Effects of different transfer prices
1. Performance measurement – normally the performance of the divisions is measured using ROI or RI. Transfer price can have a significant effect on the ROI or RI as both are profitability measures. If the selling division sells at a self-interested transfer price, its profitability can increase at the expense of buying division which made the comparison of both divisions’ performance unfair.
2. Decision making – if the transfer price is too high, the buying division might not want to buy from the selling division. Buying division might decide to abandon the product line or buy-in cheaper immediate products from outside.
3. Motivation – if a transfer price was such that one division found it impossible to make a profit, then the employees in that division would probably be demotivated. In contrast, the other division would make profits easily and it would not be motivated to work more efficiently.
4. Investment appraisal – cash inflows arising from an investment will be affected by transfer price, so capital investment decisions can depend on the transfer price.
Conclusion of transfer pricing for F5
The calculation of transfer price is easy, usually told by examiner what basis to use. However you have to understand that different basis used will have different problems. The logic is important for you to answer any type of question. Economic transfer pricing rule may not be important for F5 but it can help you to understand the bigger picture and important for P5. In conclusion, transfer prices are very important because they will affect performance measurement, motivation and decision making.
Part 2 Return on investment and residual income
Return on investment (ROI)
ROI = profit before interest and tax (PBIT)/capital employed x 100%. It is similar to the calculation of ROCE but ROCE is normally used to measure the performance of the organisation as a whole while ROI is used to measure investment centre’s performance and investment appraisal. ROI shows how much profit has been made with the capital invested and it is a relative measure, ie. in percentage. Remember that capital employed is normally the net assets (capital + reserves + non-current liabilities or total assets – current liabilities) of the company.
Advantages of ROI
1. It is a relative measure and so it facilitates comparison of performance between the divisions.
2. Easy to understand as the amount is in percentage.
3. Information needed to calculate ROI is readily available in income statement and statement of financial position.
Disadvantages of ROI
1. ROI will increase as assets get older (accumulated depreciation reduces the value of non-current assets and therefore the capital employed). This can encourage managers to retain outdated plant and machinery. Therefore, the improving of performance over time is giving a false view.
2. Sometime it is not fair to compare performance of divisions using ROI because of different depreciation method used.
3. The disposal of non-current assets can increase the ROI as well but it may affect the efficiency of the business.
4. Can cause short-termism as managers might attempt to increase the ROI at the expense of long-term performance.
Residual income (RI)
RI = operating profit before tax – imputed interest charged on capital employed. Imputed interest rate is normally the cost of capital of the division and therefore RI = operating profit before tax – cost of capital x capital employed. It is an absolute measure, ie. in $. If the company if generating profits higher than that required by the interest charge, RI will be positive, if lower then RI will be negative.
Advantages of RI
1. It makes divisional managers aware of the cost of financing their divisions.
2. It is an absolute measure of performance, positive figure means good.
3. All divisions will be motivated to take projects which have a higher return than the company’s cost of capital.
4. In the long run it supports the net present value approach to investment appraisal (present value of a project’s RI equals net present value of that project).
Disadvantages of RI
1. Residual income gives the symptoms not the causes of problems. If residual income falls the figures give little clue as to why.
2. Problems exist in comparing the performance of different sized divisions (large divisions will earn larger residual incomes simply due to their size). This is because RI is an absolute measure.
3. RI when applied on a short term basis is a short term measure of performance and may lead to short-termism.
4. Require an estimate of the cost of capital which can be difficult to calculate.
5. Some managers may be unfamiliar with RI.
Comparison of divisional performance
It can be difficult to compare the divisional performance. This is firstly because the size of the divisions can be different, the use of RI will not be appropriate. Secondly, the inventory valuation and depreciation method can be different, this will cause differences in capital employed. Thirdly, the issue of transfer pricing can affect the ROI and RI, if the transfer price is set unfairly, the result will not be fair. Fourthly, one division may be operating in a country with an advantage of lower fixed cost such as rental, the comparison of performance with this division would be unfair.
Therefore, the comparison of divisional performance is not easy in practice due to many factors, top management may instead set a target for each division and to avoid short-termism, the target could be for example achieving ROI of 20% and lower than 5 customer complaints.
In conclusion, there are many problems in divisional performance measurement. Always be aware of the problems of using ROI and RI to measure the performance and be prepared to suggest non-financial performance indicators (NFPIs). There should be no difficulty in this topic if you have clearly understood transfer pricing, ROI and RI.
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