Test your understanding 1 - ROI calculation. Variance analysis ââ¬â is a standard means of monitoring and controlling performance. Data on capacity levels and resource requirements. The selling division will receive the same amount for any internal or external sales. This will slow down division B as well, unless adequate inventories are held. 1—Divisional management if ROI is used to evaluate divisional performance? So long as thebought-in external price of Y to Baker is less than $45, Baker shouldbuy from that external source. The transferring division would supply the goods at cost plus a % profit. Many businesses have poured money into the development of productsthat they believed were potential stars only to find that those productsturned into dogs. in order to obtain a bonus payment. The associated product costs are as follows: (a)Using the above information, provideadvice on the determination of an appropriate transfer price for thesale of product Y from division Able to division Baker under thefollowing conditions: (i)when division Able has spare capacity and limited external demand for product X, (ii) when division Able is operating at full capacity with unsatisfied external demand for product X. Division B has beenapproached by another company which has offered to supply 2,500 units ofProdX for $35 each. An opportunity has arisen to invest in a new project costing$100,000. The capacity of division Able is measured inunits of output, irrespective of whether product X, Y or a combinationof both are being manufactured. Left to their owndevices then the managers would end up accepting the project giving only$12,000. This Product includes content from the International Auditing and Assurance Standards Board (IAASB) and the International Ethics Standards Board for. Nielsen Ltd has two divisions with the following information: Division A has been offered a project costing $100,000 and givingannual returns of $20,000. Excluding the cost of transferred units of X8. The transfer price should therefore beset at $45. Calculated the budgeted annual profit for each division and for thecompany as a whole of the transfer price for the components supplied bydivision A to division B is: (c) Evaluate both transfer prices fromthe perspective of each individual division and from the perspective ofthe company as a whole. It could be argued, however, that Division Y would not want to sellProduct Y14 at all if it made a loss. This alternative use is equivalent to2,000kg of special ingredient Z and would earn a contribution of $6,000.There is no external demand. quality, delivery terms, etc.). Each division is expected to generate a rate of return of at least 14 percent on its operating assets. However, other interest rates might be selected, such as the current cost of borrowing, or a target ROI. A standard cost should be used rather than the actual cost since: There are a number of different standard costs that could be used: Test your understanding 6 - Full cost and marginal cost. The promoters of thisproduct in the 1980s proceeded on the basis that there was a market forsuch a car as a means of urban transport and that the C5 would enjoy ahigh share of this market. It is unlikely that the manager of Division X would be prepared to negotiate this price with Division Y, and a decision to set the transfer price at $5 would probably have to be made by head office. Transfer prices are a way of promoting divisional autonomy, ideally without prejudicing the measurement of divisional performance or discouraging overall corporate profit maximisation. Thebalance of its square capacity (1,000kg) has no opportunity cost andshould still be offered at marginal cost. If Division X is set up as a profit centre, a transfer price at marginal cost would not provide a fair way of measuring and assessing the division's performance. Accountants (IESBA), published by the International Federation of Accountants (IFAC) in December 2012 and is used with permission of IFAC. This will be adjusted to allowfor the $1.50 per kg avoided on internal transfers due to packing costsnot required. (a)Calculate the effect on the profit of division A. Helpco Ltd bases itstransfer price on total cost-plus 25% profit mark-up. Weller Industries is a decentralized organization with six divisions. (ii) Helpco has production capacity for9,000kg of special ingredient Z. depreciation policy). Balance sheet capital employed at the end of 20X6 was $223 million. notes for performance. 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%. Althoughthe 11% is bad, it is better than before. This is a similar measure to ROCE but is used to appraise the investment decisions of an individual department. An alternative use for some of its spareproduction capacity exists. In this situation Helpco has noalternative opportunity for 3,000kg of its special ingredient Z. Itshould, therefore, offer to transfer this quantity at marginal cost.This is variable cost less packing costs avoided = $9 (W1) ââ¬â $1.50 =$7.50 per kg. Division Y might therefore wantto cover its fixed costs as well as its variable costs. The investment centre manager will want to undertake the investmentbecause it will increase RI. Able has spare capacity, therefore the marginalcosts to the group of Able making a unit is $35. Based on the currenttransfer price of $50,000 the profit of the divisions and of the companyis as follows: Rosca Coffee want to take advantage of the different tax rates inNorthland and Southland and have decided to reduce the transfer pricefrom $50,000 to $20,000. Profitability – suppose the transfer pricing system includes an element of actual cost. At a transfer price of $5, Division X would make $0 contribution from each unit transferred. The full cost hasbeen estimated as 75% variable and 25% fixed. Non-cash expenses were $10 million for both years. State any additional information that would be useful when calculating the ROI. Baldenius, T. 2006. The division would accept the investment since it generates an increase in RI of $1,000. 2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50per kg (= MC). The main use of transfer pricing is to measure the notional sales of one division to another division. the net book value of any capitalised operating leases should be added back. (i)The transferprice should be set between $35 (minimum price Able will sell for) and$38 (maximum price Baker will pay). Has enough market research been carried out first? There is no external market for component X8. This gives them a profit of $160,000 compared with a profit of $94,000 if the full cost transfer price is used. Baker supplies an external market and can obtain its semi-finishedsupplies (product Y) from either Able or an external source. (You should use whatever rate is given in the exam). discuss the problems encountered in planning, controlling and measuring performance levels, e.g. (b)Calculate the effect on the profit of company X. A product that has a highgrowth potential offers obvious advantages but it is typicallyassociated with high development costs because of the need to developthe product itself and/or maintain the high market share. Our findings highlight the need for a proper integration of intracompany pricing rules and divisional control rights over capacity assets. Required: The tax authorities allow either variable or full cost transfer prices. Transfer pricing Within a decentralised organisation there may be a division which makes units that are then transferred to another division. 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%. Likewise Division Y will accept its project, which should be rejected as it fails to hit the company target. This is the correct decision for thecompany since RI increases by $3,000 as a result of the investment. Making a specific charge for interest helps to make investment centre managers more aware of the cost of the assets under their control. Review questions; Divisional performance. It may be difficult to find non-financial indicators which can easily be compared if divisions operate in different environments. This isvariable cost less packing costs avoided = $9 – $1.50 = $7.50 per kg(note. Product X is sold to external customers for $42per unit. The transfer price may be altered after taking into consideration the planning and operational variance analysis at the transferor division. if the RI is positive. The company as a whole will be indifferent to the transfer price. (c)Conditions are as per (ii) but Helpco Ltdhas an alternative use for some of its spare production capacity. the value of amortised goodwill should be added. Contribution foregone = 2,500 ×$(40-22) = $45,000 reduction. The company's cost ofcapital is 15%. These frameworks can also be used for assessing performance management issues in divisionalised businesses. Capital employed is total assets less long term liabilities. An understanding of where given products stand inrelation to this matrix can be another essential element in strategicplanning. Ansoff's matrix is used to analyse the possible strategic directions that a division can follow. In fact, the only niche it found was as achildren's toy and it achieved only a low market share with littlegrowth potential as such. At a transfer price of $5, Division X would be expected to sell asmany units of X8 to Division Y as Division Y would like to buy. University of Mauritius. Example 1 suggested a transfer price between $18 and $80, but exactly where the transfer price is set in that range vastly alters the perceived profitability and performance of each division. The transfer price should be deemed to be fair by the managers of the buying and selling divisions. An external market is available for6,000 kgs of material Z. Helpco has production capacity for3,000 kg of special material Z. the best decision will be made for the business as a whole. Able has spare capacity, therefore the marginalcosts to the group of Able making a unit is $35. If the price is setabove $38, Baker will be encouraged to buy outside the group, decreasinggroup profit by $3 per unit. Therefore, the divisionalmanager will be rewarded for holding onto old, and potentiallyinefficient, assets. If theprice is set above $38, Baker will be encouraged to buy outside thegroup, decreasing group profit by $3 per unit. Controllable profit is usually taken after depreciation but before tax. Savings may be made from transferring the goods internally. There is no external market for Division A's goods and the profit will be $110,000 regardless of the transfer price set. Specifically, a project with a positive net present value (NPV) at the company's cost of capital may show poor ROI or RI results in early years, leading to its rejection by the divisional manager. What should the managers do if they act in the best interests of the company as a whole? If output and sales are more than the budget of 20,000, Division X would make a profit due to the over-absorbed fixed overhead. Divisions may operate in different environments. The maximum transfer price that the buying division will pay. Investment centre managers who make investment decisions on thebasis of short-term performance will want to undertake any investmentsthat add to RI, i.e. The matrices of Ansoff and the Boston Consulting Group (BCG) were met in paper P3 where they were used for strategic portfolio analysis. The Premier division is experiencing strong growth in a growing market. (Base your calculations on opening book values).Would the investment centre manager wish to undertake the investment ifperformance is judged on ROI? This transfer price would not motivate the manager of Division X to maximise output. (a) What would be the ROI with andwithout the investment? Division A may not be as customer-focused as B, compromising customer goodwill. Assume the profit is controllable, unless told otherwise. An external market is available for6,000 kgs of material Z. the risk of not fully understanding customer needs in the new market. However, the 25% ROI may meet or exceed the company's target. So long as thebought-in external price of Y to Baker is less than $45, Baker shouldbuy from that external source. Calculate and comment of the NPV of the project. The manager of Division A will not want to accept the project asit lowers her ROI from 30% to 27.5%. If the transfer price is set at marginal cost plus a mark-up forcontribution, the manager of Division X would be motivated to maximiseoutput, because this would maximise contribution and profit (or minimisethe loss). Use of BCG analysis as a performance management tool. The project would have a four-year life, and would makeprofits of $15,000 each year. SOUTH PLC has two divisions A and B, whose respective performances are under review. Explain the limitations of ROCE as a divisional performance indicator and suggest alternative measures that might be more effective. As a relative measure it enables comparisons to be made with divisions or companies of different sizes. They have a relatively low market share in a high growth market.The Baby division would appear to fall into this category. One projectgives a profit of $20,000 and the other $12,000. ROI = (Earnings before interest and tax (but after depreciation))/(Capital employed (book value at start of year)) × 100. Therefore, the minimum price able will sellfor is $45. The budgeted output and sales for Product Y14 is 20,000 units. As indicated earlier, Division Y would want to buy as much aspossible from Division X provided that the transfer price is no higherthan $17, or possibly $13. Thisis the company's target return. However, this results in dysfunctional behaviour since thecompany's target is only 12%. If Able supplies Baker with a unitof Y, it will cost $35 and they (both Able and the group) will lose $10contribution from X ($42 sales ââ¬â $32 variable cost). (5 marks) Service levels – customer queries to B could involve A's component in which case they need to be re-directed. Johnson, N. 2006. Upon completion of this chapter you will be able to: Important point: For each of these care must be taken toassess managers on controllable factors only. Total cost hasbeen estimated as 75% variable and 25% fixed. increasing transfer prices paid by the foreign subsidiary to the parent company (see below), lending the equivalent of the dividend to the parent company. This is higher than the company's cost of capital (required return) of 15% and therefore Jon should accept the new investment. Jon's decision - from a personal point of view, the ROI of Jon's division will go down and his bonus will be reduced or lost as a result. Created at 5/24/2012 4:44 PM by System Account, (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London, Last modified at 5/25/2012 12:54 PM by System Account, explain the meaning of, and calculate from supplied data, return on investment (ROI) in the context of divisional performance appraisal, discuss the shortcomings and benefits of using ROI for divisional performance appraisal, explain the meaning of, and calculate from supplied data, residual income (RI) in the context of divisional performance appraisal, discuss the shortcomings and benefits of using RI for divisional performance appraisal, compare divisional performance using supplied data and recognise the problems that can arise from the comparison, explain, using simple numerical examples, the basis for setting a transfer price using variable cost, explain, using simple numerical examples, the basis for setting a transfer price using full cost, explain, using simple numerical examples, how transfer prices can distort the performance assessment of divisions and decisions made, including dysfunctional decision making. unit variable costs) and incremental fixed costs for various capacity levels for both divisions. Alternatively, if a perfectly competitive market does not exist for the product, the transfer price can be set at. (b) What would be the average annual RIwith and without the investment? The following revenue data has been gathered: The management accountant has also collected the following information for 20X7 for comparison purposes. Discussion of “ Divisional Performance Measurement and Transfer Pricing for Intangible Assets”. A transfer price is the price at which goods or services aretransferred from one division to another within the same organisation. One projectgives a profit of $20,000 and the other $12,000. productivity, profitability, quality and service levels, in complex business structures. (b)Conditions are as per (i) but Helpco Ltd hasproduction capacity for 3,000kg of special ingredient Z for which noexternal market is available. A company has two profit centres, Centre A and Centre B. Centre Asupplies Centre B with a part-finished product. The marketleader enjoys a 25% share whilst the Baby division appear to bestruggling to achieve growth in turnover and hence profits. Determine which should be chosen. The selected cost of capital could be the company's average cost of funds (cost of capital). Transfer pricing in multi-national companies has thefollowing complications: The selling and buying divisions will be based in differentcountries. (ii) when division Able is operating at full capacity with unsatisfied external demand for product X. Archer Group has two divisions, Division X and Division Y. DivisionX manufactures a component X8 which is transferred to Division Y.Division Y uses component X8 to make a finished product Y14, which itsells for $20. If autonomy is maintained, managerstend to be more highly motivated but sub-optimal decisions may be made. Acommon feature of exam questions is that a transfer price is set thatresults in sub-optimal behaviour. The Convenience divisionwould appear to fall into this category since its market share is verylow and it has low growth. agreed by negotiation between the divisional managers, with the more powerful or skilful negotiator getting the better deal on the price. The company's Electrical Division produces a variety of electrical items, including an X52 electrical fitting. If a standard cost is used, the buying division will know the cost in advance and can therefore put plans in place. (iii)Helpco Ltd has an alternative usefor some of its production capacity, which will yield a contributionequivalent to $3 per kg of special ingredient Z ($6,000/2,000kg). The company's cost of equity was 15% in 20X7 and 17% in 20X8. It is often done through the imposition of strict exchange controls. If Alabama begins sales to Florida, it (1) will use the general transfer-pricing rule and (2) will be able to reduce variable cost on internal transfers by $4. delivery costs. Conditions are as per (ii) but Helpco Ltdhas an alternative use for some of its spare production capacity. What would be the ROI with andwithout the investment? The general point this model makes is that current period cash flowis not an unambiguous statement on the performance of a product orbusiness sector. 15. Additional example on international issues. depreciation). This paper examines the effectiveness of three transfer pricing methodologies for an intangible asset that is developed through bilateral, sequential investment. Helpco processes and sells special ingredient Zto customers external to the group at $15 per kg. Helpco Ltd processes and sells special ingredient Zto customers external to the group at $15 per kg. Calculate the effect on the profit of company X. This is the wrong decision from the companyperspective as the project ROI of 20% beats the company hurdle of 18%. No Frames Version Divisional performance and transfer pricing . Looking at the whole situation fromthe group point of view, we are in the ridiculous position that thegroup has been offered two projects, both costing $100,000. (i)Since Helpco has an external market,which is the opportunity foregone, the relevant transfer price would bethe external selling price of $15 per kg. Transfer pricing . The market price should be adjusted for costs not incurred on an internal transfer, e.g. This discussion aims to disentangle these features so as to highlight those that are the key drivers of the results. If an external market exists for the transferred goods then the transfer price could be set at the external market price. (b) What should the managers do if they act in the best interests of the company as a whole? ROI and RI are common methods but other methods could be used. The Sinclair C5 (a small, battery-powered car) isoften quoted as an example of this phenomenon. If the Economic Value Added (EVA's) foreach year of an investment are summed over the entire life of theinvestment and then discounted, the result, in theory, should equal thenet present value of the investment. 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. Suppose Division A produces aproduct X where the domestic income tax rate is 40% and transfers it toDivision B, which operates in a country with a 50% rate of income tax.An import duty equal to 25% of the price of product X is also assessed.The full cost per unit is $190, the variable cost $60. “Divisional Performance Measurement and Transfer Pricing for Intangible Assets.” Review of Accounting Studies 11(3): 339-365. This will be adjusted to allowfor the $1.50 per kg avoided on internal transfers due to packing costsnot required, i.e. distribution outlets). it limits the payment of dividends to the parent company's shareholders. Food for thought has a dog and a problem child that both require immediate attention. It will usually be necessary to charge the receiving division for the goods that it has received in order for performance to be measured equitably. If a transfer price is set at marginal cost plus a mark-up forcontribution, the ââ¬Ëideal' range of prices lies anywhere between $5 and$17. At a transfer price of $7, Division X would make $0 profit from each unit transferred. Calculate and comment on the ROI and RI of the project. This in turn will highlight key areas, i.e CSFs, that need to be monitored and controlled. Review of Accounting Studies 11: 367-376. The transferprice should be set between $35 (minimum price Able will sell for) and$38 (maximum price Baker will pay). The nature of the four classifications shown above isself-explanatory. TRANSFER PRICING FOR DIVISIONAL AUTONOMY 101 situations where suboptimal transfer prices result.6 The question is whether an optimal transfer price system which ensures corporate as well as divisional profit maximization can at the same time preserve the operating autonomy of the divisional manager. Using the BCG matrix assess the competitive position of Food For Thought Ltd. Where products stand within the BCG matrix. This will be perceived as fair but will result in the need for period-end adjustments in the accounts. marginal cost). a) Explain and illustrate the basis for setting a transfer price using variable cost, full cost and the … ââ¬ËCost' might be marginal cost or full cost.The transfer price might also include a mark-up on cost to allow aprofit to Division X. This decision is in the best interests of the company. Estimate the Economic Value Added (EVA) for Trout Inc for both 20X7 and 20X8. Conditions are as per (i) but Helpco Ltd hasproduction capacity for 3,000kg of special ingredient Z for which noexternal market is available. Many tax authorities have the power to alter the transfer price and can treat the transactions as having taken place at a fair arms length price and revise profits accordingly. when division Able has spare capacity and limited external demand for product X. when division Able is operating at full capacity with unsatisfied external demand for product X. Helpco has an external market for all its production of special ingredient Z at a selling price of $15 per kg. There are two approaches to transfer pricing which try to preserve the economic information inherent in variable costs while permitting the transferring division to make profits, and allowing better performance valuation . A company operates two divisions, Able and Baker. full cost + % profit) and the buying division records another transfer price (e.g. Cost overruns in A would be passed on to B. Other information ââ¬â such as staff turnover, market share, new customers gained, innovative products or services developed. Division A is based inNorthland, a country with a tax rate of 50%. Copyright 2020. Division B would prefer the transfer price to be set at variable cost + 10%. Capital employed is calculated in the same way as for ROI. Question one. Kaplan Financial Limited. Asthere is no information on full adjustments, the book value ofshareholders' funds and medium term debt, plus the value of capitalisedleases will be used. For each extra unit sold, the marginal revenue is $20 and themarginal cost is $8 ($5 + $3); therefore the additional contribution is$12 for each extra unit of Y14 made and sold. 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