D5- Divisional Performance and Transfer Pricing

D5: Performance Measurement and Control | Divisional Performance and Transfer Pricing (ACCA F5)

Divisional Performance and Transfer Pricing explains the basis for setting a transfer price; explains how transfer prices can distort performance assessments; explains Return on Investment (ROI) and Residual Income (RI); and explains how to compare divisional performance.

Divisional Performance and Transfer Pricing

Note: Transfer pricing is  when you charge other departments/ divisions in the organisation for the goods and services that you provide them. There are two main approaches to setting transfer prices – market based approach and cost based approach.

a) Explain and illustrate the basis for setting a transfer price using variable cost, full cost and the principles behind allowing for intermediate markets

With a full cost-based approach to transfer pricing (cost plus transfer pricing), the receiving division is charged the full cost incurred by the supplying division plus a fixed percentage.

With a variable cost-based approach to transfer pricing, the receiving decision is charged the variable cost or marginal cost incurred by the supplying division.

b) Explain how transfer prices can distort the performance assessment of divisions and decisions made.

The transfer price should be one that both divisions are comfortable with because the level of the transfer price can affect profitability and performance. If the transfer price is too high, the profits of one division will increase while the other will decrease. Unrealistic transfer prices can also result in misleading profits which have affect motivation levels.

c) Explain the meaning of, and calculate, Return on Investment (ROI) and Residual Income (RI), and discuss their shortcomings.

Return on investment and residual income are used to measure divisional performance.

Return on investment is a key performance measure that “shows how much profit has been made in relation to the amount of capital invested.”

Formula: Return on Investment = (Profit ÷ Capital Employed) x 100%

 Note: The profit figure used to calculate the ROI, should be the profit before any interest is charged .

Shortcomings of ROI include:

  • Can have “behavioural implications and lead to dysfunctional decision making”
  • Focuses on short-run performance instead of life-long performance
  • If calculated by dividing profits by net assets, it is difficult to compare the performance of the investment centres
  • If calculated used gross book values, the age factor is ignored and the old and new assets are not distinguished

Residual income is the “measure of the centre’s profits after the notional or imputed interest cost is deducted.

Shortcomings of RI include:

  • Does not allow for comparisons between investment centres
  • Does not “relate the size of a centre’s income to the size of the investment”

d) Compare divisional performance and recognize the problems of doing so.

Some of the problems with comparing divisional performance are:

  • Divisions might have different goals
  • Managers may be motivated to improve the performance of their division and not the organization as a whole
  • Head office costs might be apportioned differently
  • Divisions might have differently aged assets which could affect performance and accounting

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