Chapter 12
Financial performance
measures and transfer
pricing
Decentralisation
§ When managers in divisions and
departments are given levels of decisionmaking authority
§ A high level of goal congruence needed to
encourage effectiveness
§ Goal congruence can be promoted through
responsibility accounting systems
Benefits of decentralisation
§ Better local information for decisions
§ Managerial training for future higher-level
managers
§ Motivation and job satisfaction
§ Corporate level managers have more time
for strategic decisions
§ Quicker reaction to opportunities and
problems
Costs of decentralisation
§ Managers in decentralised organisations
may focus narrowly on their own subunit’s
performance, rather than the organisation’s
overall goals
§ Managers of a subunit may ignore the
consequences of their actions on other
subunits
§ Some tasks or services are duplicated
Obtaining goal congruence: a
behavioural challenge
§ Difficult to achieve
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managers unaware of the effects of their
decisions on others
managers more concerned with their own
achievements than of the overall organisation’s
achievements
§ How to achieve
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carefully designed performance measures and
reward systems to provide the right incentives
Responsibility centres
§ A subunit in an organisation whose manager
is held responsible for the subunit's
activities
§ Emerge as organisations become to large to
be centrally controlled
§ Based on geographic location, specific
markets or other bases
Types of responsibility centres
§ Cost centre - responsibility for costs
incurred
§ Revenue centre - responsibility for revenue
generated
§ Profit centre - responsibility for profit
§ Investment centre - responsibility for profit,
and invested capital used to generate profit
Financial performance reports
§ Show the key financial results appropriate
for the type of responsibility centre
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the variance between budgeted and actual
results
§ Segmented profit and loss statements
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show the profits for the major responsibility
centres, and for the entire organisation
Performance of subunits versus
subunit managers
§ Economic performance of subunits
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the revenues and costs attributable to that
subunit
§ Manager’s performance
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the revenues and costs which the manager can
control or significantly influence
§ Distinction important to prevent penalising
good managers who manage poor subunits
Cost allocations in performance
reports
§ Some costs are allocated on a causal basis
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a responsibility centre causes the organisation
to incur a cost
§ Common costs
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result from activities that are incurred for the
benefits of more than one responsibility centre
not clearly attributable to activities of subunits
arbitrary allocation basis used
Financial measures in investment
centres: return on investment (ROI)
§ Used to measure the performance of an
investment centre
ROI 
Pr ofit
Invested capital
 Pr ofit margin x Asset turnover
=
Profit
Sales revenue
x
sales revenue invested capital
Advantages of ROI
§ Encourages managers to focus on both the
profits and the assets required to generate
those profits
§ Discourages excessive investment in assets
§ Can be used to evaluate the relative
performance of investment centres
Limitations of ROI
§ Encourages managers to focus on shortterm financial performance, at the expense
of long-term viability and competitiveness
§ Encourages managers to defer asset
replacement
§ Discourages managers from investing in
some projects which are acceptable from
the organisation’s point of view
Minimising the behavioural
problems of ROI
§ Use ROI as one of a series of performance
measures that focus on both short-term and
long-term performance
§ Consider alternative ways of measuring
invested capital to minimise dysfunctional
decisions
§ Use alternative financial measures, such as
residual income
Residual income
§ Residual income
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profit - (invested capital x imputed interest rate)
§ Imputed interest charge - based on the
required rate of return that the firm expects
of its investments, which is based on the
organisation’s cost of capital
Advantages of residual income
§ Promotes goal congruence
§ Takes account of the organisation’s required
rate of return in measuring performance
§ Encourages investment in projects which
yield a positive residual income
Limitations of residual income
§ Cannot be used to assess relative
performance of different-sized businesses
§ Formula is biased, in favour of larger
businesses
§ Can encourage short-term orientation/focus
Measuring invested capital
§ Total assets - investment centre manager is
responsible for decisions about all assets
§ Total productive assets - investment centre
managers retains non-productive assets
§ Total assets less current liabilities investment centre responsible for decisions
about assets + manages short-term liabilities
§ Choose average or end-of-year balances
Asset management: original cost,
net book value or market value?
§ Advantages of net book value
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consistency with balance sheet prepared for
external reporting purposes
consistent with the definition of profit
§ advantages of gross book value
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depreciation is arbitrary and should not be
allowed to affect calculations
depreciating non-current assets may provide a
disincentive to invest in new equipment
Measuring profit
§ Profit margin controllable by investment
centre manager
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suitable when the focus is performance of the
manager
§ profit margin attributable to investment
centre
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to calculate the investment centre ROI
Transfer pricing
§ Internal selling price used when goods or
services are transferred between profit
centres within a divisionalised organisation
§ Transfer prices are sales revenue of the
supplying unit and costs of the buying unit
Who determines transfer prices?
§ Autonomy for prices may lie with the
managers of profit centres and investment
centres
§ Direct intervention may come from
corporate management either by
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setting the price
developing policies to guide transfer pricing
practices
General transfer pricing rule
§ Minimum transfer price = additional outlay
costs per unit incurred by the supplying
business + opportunity cost per unit to the
supplying business
§ No excess capacity vs excess capacity
Goal congruence and transfer
pricing
§ General transfer pricing rule will always
promote goal-congruent decision making
§ Difficulties with implementing the general
rule
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the external market may not be perfectly
competitive
uniqueness of the transferred goods or service
Transfers based on the external
market price
§ The price that can be obtained in the
external market
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consistent with responsibility accounting
concepts and decentralisation philosophies
encourages business unit managers to focus on
business unit profitability
results in a reasonable calculation of profit
contributions
Transfers base on market price
§ No excess capacity
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general transfer pricing rule, price = external
market price
§ Excess capacity (or the external market is
imperfectly competitive)
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general transfer pricing rule price will differ
from the external market price
can result in suboptimal decisions from a
company perspective
Negotiated transfer prices
§ Managers of businesses negotiate prices
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based on external market prices
no external market exists - cost recovery may
be the basis for negotiating prices
§ Can cause divisiveness and competitiveness
between participating managers
§ May lead to evaluating business unit
managers on negotiating skills
Cost-based transfer prices
§ Cost-based prices
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intermediate products - no external market
external market price exists, but supplying unit
has excess capacity
§ Variable cost plus mark-up, or absorption
cost?
§ Standard or actual costs?
Transfer pricing methods used in
practice
§ Taxation regimes can influence transfer pricing
practices where
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companies transfer goods between countries with
different taxation rates
it is prudent to maximise any tax advantages available
§ Transfer pricing is used in service industries
where services are transferred between business
units
Exhibit 12.1