Module 14 – Accounting for Divisions
14.2 Why Divisionalize?
 A company usually grows either organically (by itself) or through acquisitions
 With both, there is the managerial problem of control
 Operations sometimes must be separated from other parts of the company and given
their own management team – this is called divisionalization
14.2.1 Advantages for Divisions
 Specialization – e.g. sales teams know their local market
 Size – too large = unwieldy
 Motivation – if decisions are made too far away from the employees
 Sharper decisions – otherwise slow to react to local competitors
 Career mobility
14.3.1 Disadvantages
 Lack of control
 Cost – each division will need its own support services
 Internal rivalries
14.3 Types of Divisions:
1. Cost centers – divisions which are responsible only for cost, not revenues e.g. a
department in a university
2. Revenue centers – e.g. seat reservation dept of an airline
3. Profit Centers – costs and revenues are matched and bottom line profit is the
measure of success
4. Investment centers – where a divisions’ net assets are taken into account as well as
its profit performance. One division may have less profits than another but a better
return on investment
14.4 Defining Profits and Investment
 One of the aims of divisional accounting is to allow the performance of its
management to be measured, so only the revenues, costs and net assets under its
control should be included
Division XYZ: Profit and Loss Account
Sales
Cost of Sales
Materials
Labor
Production Overheads
Machinery Depreciation
Gross Profit
Other Controllable costs
Rent and Rates
Sales and Marketing
R&D
HQ services: personnel
Controllable profit
Non Controllable Costs
Head Office Sales and Marketing
Centralized R&D
Depreciation on Computers
Lease of corporate aircraft
Net Profit


9000
2000
1500
500
500
1000
355
700
200
495
300
100
100
4500
4500
2255
2245
995
1250
Division XYZ feels ownership of the $2245 profit rather than the $1250
In the case of net assets, if they are situated physically in the division then the division
can be expected to control them unless
- certain productive or research capacity may be made of them by another
division
- Divisions may be required to keep surplus assets for future use by other parts
of the company
14.5 Asset Base Valuation
 Before assessing the performance of a division, we first must decide how to value the
assets of that division – by the net book value or by some other method agreed
between head office and the division
14.5.1 Net Book Value
 Net book value is the difference between an assets original purchase price and
accumulated depreciation
 Net book value should fall year by year, so producing a rising return on investment
Example
A division reports annual controllable profits of $10M. Its fixed asset base of $100M
remains the same in physical composition but is depreciated by 20% annually straight
line.
Year One
Year 2
Year 3
Divisional Profit
Net book value of fixed assets
ROI
$10M
$100M
10%
$10M
$80M
12.5%
$10M
$60M
16.67%

Because of this increasing ROI, managers may not want to replace aging assets even
though its in the long term interest of the division and the company to do so
 Usually net book value is not the only asset, the previous years profits would be
ploughed back into assets, both fixed and current
14.5.2 Current Replacement Cost
 Here the current value as opposed to the depreciated historic cost is used for
performance measurement
 The subjectivity involved in determining the replacement cost as well as the time it
takes to find that cost means that most companies use net book value
14.6 Residual Income: An Alternative to ROI
 In an attempt to overcome the problem with ROI outlined above, companies may use
residual income (RI) measures
 With RI, each division is charged interest on its invested capital, the interest being at
the company’s cost of capital
 Management’s goal should be to accept investment proposals that exceed the
imputed interest rate
 RI is measured in $, ROI is %
Example
A company charges each of its three divisions 12% for use of corporate resources for
investment purposes.
Division 1
Division 2
Division 3
Controllable Profit
$100M
$240M
$95M
Investment in Net assets $350M
$850M
$300M
Performance Measures
ROI
28.57%
28.23%
31.66%
RI
Controllable Profit $100M
$240M
$95M
12% Interest on
net assets $42M
$102M
$36M
RI
$58M
$138M
$59

Division 3 has best ROI, but Division 2 is performing the best with the imputed 12%
interest charge
 RI encourages investment that ROI would have discouraged:
Example
Lets say Division 3 has an opportunity to increase its profit by $15M for an investment of
$50M i.e. an ROI of 15/50 x 100 = 30%. This is attractive to corporate management
because it compares favorably to the cost of capital of 12%. But the mangers of the
division would resist this as it would result in a drop in their divisional ROI:
Before investment: 95/300 = 31.6%
After investment: $95M + $15M
$300M + $50M
= 31.4%
A Small drop in % , but maybe enough for division 3 to pass on the opportunity
If they use RI, the decision would be different:
RI before investment = $95M – (12% of $300M) = $95M - $36M = $59M
RI after investment = ($95M + $15M) – (12% of $350M) = $68M
Two problems with RI:
 The imputed charge for capital has to be determined
 Valuation of an asset base is a significant factor
14.7 The imputed rate of interest does matter
 Low interest rates favor divisions which have a high investment in net assets
 Higher rates favor divisions which have a smaller investment in net assets
 This is an example of gearing
14.7.1 DIY Case Study
31st March 1997
Net Assets
Controllable Profit
ROI before
Chip
192
48
25%
PC
270
90
33.3%
Printer
168
50.4
30%
Drive
120
15.6
13%
Chip
252
60
23.8%
3
PC
225
81
36%
1
Printer
216
56.4
26.1%
2
Drive
168
22.32
13.28%
4
After investment
Net Assets
Controllable Profit
ROI After
Ranking
Compare the ROIs on these investments / dis-investments to the corporate interest rate
of 13%:
Chip
PC
Printer
Drive
Investment
60
(45)
48
48
Associated Profit 12
(9)
6
6.72
ROI
20%
(20%)
12.5%
14%
Corporate Interest 13%
13%
13%
13%
Difference
Ranking
+7%
1
Compare the RI’s
Chip
Investment 60
Profit
12
13% of Inv. 7.8
RI
$4.2M
Ranking
1
-33%
4
PC
(45)
(9)
(5.85)
-$3.15M
4
-.5%
3
Printer
48
6
6.24
-.$24M
3
+1%
2
Drive
48
6.72
6.24
$0.48M
2
So from the corporate point of view, the Chip and Drive divisions have a positive effect
on the company’s finances, whereas PC and Printer don’t.
Requirement 2
From the RI figures above we would choose the Chip and Drive investment proposals
Requirement 3
Question is asking the RI for PC division to be 0.
0 = $9M - (13% of X)
0.13X = $9M
X = $69.23M
Requirement 4
After investment
Net Assets
Controllable Profit
13% Interest
RI
Chip
252
60
32.76
27.24
PC
225
81
29.25
51.75
Printer
216
56.4
28.08
28.32
Drive
168
22.32
21.84
0.48
14.8 A Cautionary Note about Performance Measures
 ROI/RI comparisons between divisions does not take into account the management
talent of each division
14.9 Transfer Pricing
 How do establish a price when one division is trading with another?
14.10 Criteria for establishing a Transfer Price
 Since divisional managers are autonomous, they should be free to set their own
prices and be free to source a product externally

However, a situation where two divisions buy/sell product externally rather than
internally may be good for both divisions, but bad for the company
Example:
Division A makes and sells a product to external customers for $10 each. Division B
has a need for this product but can get it for $8 externally – so it does.
But Division A’s selling price comprises of $5 cost and $5 profit, so the company is
losing $3 per product that B buys externally.

Two prices are possible for transferring goods and services between divisions –
market prices and cost based prices
14.10.1 Market Prices
 This is the best method because it can objectively tested by both divisions involved
 In the above example the fair market price is $8
14.10.2 Cost Based Prices
 Where market price is not readily determinable, cost based price may be used
 There are a couple of different costs that can be used:
Full costs
 Here the selling division would calculate its transfer price based on the variable plus a
proportion of fixed costs, using the normal absorption formula of the division
 Because the selling division’s cost control may be slack, it may be necessary to allow
the buying division to audit the cost structure before agreeing to the deal
 The buying price becomes the variable cost of the buying division, to which it would
add its own costs
Example:
Division A’s (the seller) cost structure
Variable Cost
Fixed Cost
Full Cost
Profit
Selling Price
3
2
5
5
10
Division B’s (buyer) cost structure assuming that full cost is used
Variable Cost
Division A’s component
Material and Labor
Fixed Costs
Selling price

5
10
5
20
Division B may be able to drop its price to the company variable cost of $13 (A’s
variable cost + B’s material and labor)
Variable Costs
 From a company’s point of view, using variable costs alone for the transfer price may
seem to solve the problems above
 But A may feel hard done by as it makes nothing from the deal
Negotiated Costs
 The two divisions come to some arrange which takes into account the costs of both
14.11 The International Dimension
 Transfer pricing can be used to ensure that most of the profit is made by a division
which is in a low tax country, the overall tax bill of the company is reduced
 Select a low transfer price for the division in a high tax country => lower earnings =>
lower taxes
 And vice versa
 Tax authorities usually require proof of transfer pricing to put a stop to such artificial
tax avoidance schemes
 The above scheme could also be used to repatriate profits
14.11.11 DIY case study
Look at the profit generated by both divisions:
Freezer
Sales price
22500
Costs
13500
Profit
9000
Box
33750
30,375 (13500+16875)
3,375
The Freezer company should not be forced to sell to the Box division as the Freezer
company can make a much larger contribution to the company’s profits.
Since the Freezer division is able to get $22,500 for its product, it seem that the market
price is a fair one.
2. If the freezer division cannot sell all its products to the external market, than the
transfer price of $22,500 becomes invalid. The full cost of $13,500 seems fair, as the
freezer dept breaks even on the surplus and the Box division is able to make $3375
profit on each of the 300 containers it sells.
3.
Sales price
Costs
Profit
Freezer
16875
13500
3375
Box
33750
33,750 (16875+16875)
0
It seems unfair to the Box company that it makes nothing while the Freezer company
continues to make a profit. A negotiated transfer price seems the best thing for the
company, a transfer price between 13500 and 16875 would give both divisions a profit.
Review Questions
1. FALSE
2. d
3. c
4. b
5. FALSE
6. d
7. Controllable costs = Cost of Sales + Sales & Marketing + R&D = 5.5 + 0.5 + 0.6 =
6.6 = b
8. 10 – 6.6 = 3.4 =d
9. a
10. a
11. b
12. a+ d
13. ROI for French = 130/600 = 21.6% = d
14. ROI for Italian = 85/220 = 38.7% = d
15. RI for the Irish = 120 – (15% of 360) = $66M=a
16. RI for French = 130 – (15% of 600) = $40M = a
17. ROI before investment = 120/360 = 33.3%
An investment of $5M yielding 35% ROI means is yields a profit of $1.75M
ROI After Investment = (120+1.75)/(360+5) = 33.356%
Accept, since divisional ROI is lower than project ROI = c
18. RI for French is $40M. Profit from this project is 14% of $40M = $5.6M
RI after investment = ($130M+$5.6M) – 15% of (600+40) = 135.6 – 96 = 39.6
Reject, since divisional RI would be reduced = c
19. FALSE – gearing at work
20. ROI = 50/140 = 35.7% = c
21. b
22. RI = $50,000 – (25% of 140,00)= $15,000 = a
23. c
24. FALSE
25. d
26. c
27. TRUE
28. d
29. Electronics Division:
Sale Price $90
Variable Costs $35 per turntable
Fixed Cost $25
Profit
$30
Assembly Division
Sale price
$140
Variable
From ED
$90 (market price)
From AD
$25
Fixed Costs $10 $125
Profit
$15
Ans: c (Market Price)
30. d - $115 would mean AD had no contribution to fixed costs
31. d
32. d – this would cover variable costs
33. c
Case Study 14.1
1. Investment = $300,000, profit = $90,000 => ROI = 30%
Medical
Before ROI = 30.83%
Defence:
Before ROI = 38.75&
Scientific
Before = 11.8%
Only scientific should consider
2.
Medical RI = 90,000 – 16% of 300K = $42,000
Defence = 30K
Scientific = 54K
Still choose scientific as they have most to gain
3. DD buys component @ $2250
MD produces it for $2552
DD needs to get it at or below $2250 – this means variable cost only from MD i.e.
$2120.