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Chapter learning objectives Upon completion of this chapter you will be able to:
1 Divisional performance measurement Important point: For each of these care must be taken toassess managers on controllable factors only. So for example, themanager of a cost centre should only be assessed on controllable costs. Return on investment (ROI) This is a similar measure to ROCE but is used to appraise the investment decisions of an individual department.
An investment centre has reported a profit of $28,000. It has the following assets and liabilities: Required: Calculate the ROI for the division. State any additional information that would be useful when calculating the ROI. Additional example on ROIDivision A of Babbage Group had investments at the year end of $56million. These include the cost of a new equipment item costing $3million that was acquired two weeks before the end of the year. Thisequipment was paid for by the central treasury department of Babbage,and is recorded in the accounts as an inter-company loan. The profit of division A for the year was $7 million before deducting head office recharges of $800,000. Required: What is the most appropriate measure of ROI for Division A for the year? Solution Since the new equipment was bought just two weeks before the yearend, the most appropriate figure for capital employed is $53 million,not $56 million. The figure for profit should be the controllable profit of $7 million. ROI = $7 million/$53 million = 13.2% Evaluation of ROI as a performance measure ROI is a popular measure for divisional performance but has someserious failings which must be considered when interpreting results. Advantages
Disadvantages
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. Division B has been offered a project costing$100,000 and giving annual returns of $12,000. The company's cost ofcapital is 15%. Divisional performance is judged on ROI and theROI-related bonus is sufficiently high to influence the managers'behaviour. Required: (a) What decisions will be made bymanagement if they act in the best interests of their division (and inthe best interests of their bonus)? (b) What should the managers do if they act in the best interests of the company as a whole? Residual income (RI) RI = Controllable profit – Notional interest on capital
An investment centre has net assets of $800,000, and made profitsbefore interest and tax of $160,000. The notional cost of capital is12%. Required: Calculate and comment on the RI for the period. Evaluation of RI as a performance measure Compared to using ROI as a measure of performance, RI has several advantages and disadvantages: Advantages
Disadvantages
An investment centre has net assets of $800,000, and made profitsbefore interest of $160,000. The notional cost of capital is 12%. Thisis the company's target return. An opportunity has arisen to invest in a new project costing$100,000. The project would have a four-year life, and would makeprofits of $15,000 each year. Required: (a) What would be the ROI with andwithout the investment? (Base your calculations on opening book values).Would the investment centre manager wish to undertake the investment ifperformance is judged on ROI? (b) What would be the average annual RIwith and without the investment? (Base your calculations on opening bookvalues).Would the investment centre manager wish to undertake theinvestment if performance is judged on RI? Additional example on ROI and RITwo divisions of a company are considering new investments. Company’s required ROI = 18% Required: Assess the projects using both ROI and RI. Solution Consider divisional performance: Without project Based on ROI, Division X will reject its project as it dilutes itsexisting ROI of 25%. This is the wrong decision from the companyperspective as the project ROI of 20% beats the company hurdle of 18%. Likewise Division Y will accept its project, which should be rejected as it fails to hit the company target. In each case there is a conflict between the company and divisional viewpoints. RI does not have this problem as we simply add the project RI to the divisional figures. Comparing divisional performance Divisional performance can be compared in many ways. ROI and RI are common methods but other methods could be used.
Comment on the problems that may be involved in comparing divisional performance. 2 Transfer pricing Introduction A transfer price is the price at which goods or services aretransferred from one division to another within the same organisation.Objectives of a transfer pricing system
The decisions made by each profit centre manager should beconsistent with the objectives of the organisation as a whole, i.e. thetransfer price should assist in maximising overall company profits. Acommon feature of exam questions is that a transfer price is set thatresults in sub-optimal behaviour.
The buying and selling divisions will be treated as profit centres.The transfer price should allow the performance of each division to beassessed fairly. Divisional managers will be demotivated if this is notachieved.
The system used to set transfer prices should seek to maintain theautonomy of profit centre managers. If autonomy is maintained, managerstend to be more highly motivated but sub-optimal decisions may be made.
In practice, an extremely important function of the transferpricing system is simply to assist in recording the movement of goodsand services. Setting the transfer price There are two main methods available: Method 1: Market based approach If an external market exists for the transferred goods then the transfer price could be set at the external market price. Advantages of this method:
Disadvantages of this method:
Method 2: Cost based approach The transferring division would supply the goods at cost plus a % profit. A standard cost should be used rather than the actual cost since:
There are a number of different standard costs that could be used:
Each of these will be reviewed. Test your understanding 6 - Full cost and marginal costA company has two profit centres, Centre A and Centre B. Centre Asupplies Centre B with a part-finished product. Centre B completes theproduction and sells the finished units in the market at $35 per unit.There is no external market for Centre A's part-finished product. Budgeted data for the year: Required: 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: (a) Full cost plus 10% (b) Marginal cost plus 10% (c) Evaluate both transfer prices fromthe perspective of each individual division and from the perspective ofthe company as a whole. Test your understanding 7 - Opportunity cost approachA company operates two divisions, Able and Baker. Able manufacturestwo products, X and Y. Product X is sold to external customers for $42per unit. The only outlet for product Y is Baker. Baker supplies an external market and can obtain its semi-finishedsupplies (product Y) from either Able or an external source. Bakercurrently has the opportunity to purchase product Y from an externalsupplier for $38 per unit. The capacity of division Able is measured inunits of output, irrespective of whether product X, Y or a combinationof both are being manufactured. The associated product costs are as follows: Required: Using the above information, advise on the determination of anappropriate transfer price for the sale of product Y from division Ableto division Baker under the following 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. Additional example on transfer pricingArcher 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. There is no external market for component X8. Costs are as follows:
The budgeted output and sales for Product Y14 is 20,000 units. Oneunit of component X8 goes into the manufacture of one unit of Y14. The profit of the company as a whole will be maximised if DivisionsX and Y produce up to their capacity, or to the maximum volume of salesdemand. 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. Since there is no external market for component X8, the transferprice will be cost-based. ‘Cost' might be marginal cost or full cost.The transfer price might also include a mark-up on cost to allow aprofit to Division X. The maximum transfer price that the buying division will pay Division Y has a marginal cost of $3 per unit, and earns revenue of$20 for each unit sold. In theory, Division Y should therefore beprepared to pay up to $17 ($20 — $3) for each unit of X8. It could be argued, however, that Division Y would not want to sellProduct Y14 at all if it made a loss. Division Y might therefore wantto cover its fixed costs as well as its variable costs. Fixed costs inDivision Y, given a budget of 20,000 units, are $4 per unit. The totalcost in Division Y is $7 ($3 + $4). On this basis, the maximum transferprice that Division Y should be willing to pay is $13 ($20 — $7). Transfer price = marginal cost The short-term opportunity cost to Division X of transferring units of X8 to Division Y is the marginal cost of production, $5. 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. However, although marginal cost represents the opportunity cost toDivision X of transferring units of X8, it is not an ideal transferprice.
Transfer price = marginal cost plus 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). 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. If a transfer price is set at marginal cost plus a mark-up forcontribution, the ‘ideal' range of prices lies anywhere between $5 and$17. The size of the mark-up would be a matter for negotiation.Presumably, the transfer price that is eventually agreed would beeither:
Additional requirement: Discuss the implications of setting the transfer cost at full cost plus. Solution There is an argument that the opportunity cost of transfer, in the absence of an intermediate market, is full cost. This assumes that, if the selling division decided against makingany transfers at all, it would save all costs, both marginal and fixedcosts, by shutting down. In the above example, the full cost for Division X of making component X8 is $7 ($5 variable plus $2 fixed). At this price, Division X would want to sell as many units aspossible to Division Y, and Division Y would buy as many units as itcould, subject to the limit on capacity or sales demand. However, although full cost represents the long-term opportunitycost to Division X of transferring units of X8, it is not an idealtransfer price.
Manuco company has been offered supplies of special ingredient Z ata transfer price of $15 per kg by Helpco company, which is part of thesame group of companies. Helpco processes and sells special ingredient Zto customers external to the group at $15 per kg. Helpco bases itstransfer price on full cost plus 25% profit mark-up. The full cost hasbeen estimated as 75% variable and 25% fixed. Internal transfers toManuco would enable $1.50 per kg of variable packing cost to be avoided. Required: Discuss the transfer prices at which Helpco should offer totransfer special ingredient Z to Manuco in order that group profitmaximising decisions are taken in each of the following situations: (i)Helpco has an external market for all its production of special ingredient Z at a selling price of $15 per kg. (ii) Helpco has production capacity for9,000kg of special ingredient Z. An external market is available for6,000 kgs of material Z. (iii)Helpco has production capacity for3,000 kg of special material Z. An alternative use for some of its spareproduction capacity exists. This alternative use is equivalent to2,000kg of special ingredient Z and would earn a contribution of $6,000.There is no external demand. 3 Chapter summary Test your understanding answers Test your understanding 1 - ROI calculation
(a) The manager of Division A will not want to accept the project asit lowers her ROI from 30% to 27.5%. The manager of Division B will likethe new project as it will increase their ROI from 10% to 11%. Althoughthe 11% is bad, it is better than before. (b) 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. One projectgives a profit of $20,000 and the other $12,000. Left to their owndevices then the managers would end up accepting the project giving only$12,000. This is because ROI is a defective decision-making method anddoes not guarantee that the correct decision will be made. Test your understanding 3 - RI calculationIf performance is measured by RI, the RI for the period is: (Note: Capital employed is not available in this question and therefore net assets should be used as a substitute value). Investment centre managers who make investment decisions on thebasis of short-term performance will want to undertake any investmentsthat add to RI, i.e. if the RI is positive. Test your understanding 4 - ROI vs RI(a) ROI ROI would be lower; therefore the centre manager will not want tomake the investment. since his performance will be judged as havingdeteriorated. However, this results in dysfunctional behaviour since thecompany's target is only 12%. (b)RI The investment centre manager will want to undertake the investmentbecause it will increase RI. This is the correct decision for thecompany since RI increases by $3,000 as a result of the investment. Test your understanding 5Problems may include:
(a) (b) Working 1 Working 2 (c)
(i)The transfer price should be setbetween $35 and $38. 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. (ii) 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 – $32 variable cost). So long as thebought-in external price of Y to Baker is less than $45, Baker shouldbuy from that external source. The transfer price should therefore beset at $45. Test your understanding 8 - Additional example(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. This will be adjusted to allowfor the $1.50 per kg avoided on internal transfers due to packing costsnot required. The transfer price offered by Helpco should be $15 — $1.50 = $13.50 per kg. (ii) 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) — $1.50 =$7.50 per kg. Working 1: Total cost = $15 × 80% = $12, Variable cost = $12 × 75% = $9.) If Manuco require more than 3,000 kgs the transfer price shouldbe set at the adjusted selling price of $13.50 per kg as in (i) above. (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). Thebalance of its square capacity (1,000kg) has no opportunity cost andshould still be offered at marginal cost. Helpco should offer to transfer: 2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50per kg (= MC).
Which of the following is common component between the calculation of residual income and calculation of economic value added?Return on invested capital (ROIC) is a common method that also uses a residual income approach.
Which of the following formulas best describes the return on investment calculation?The most common is net income divided by the total cost of the investment, or ROI = Net income / Cost of investment x 100.
Which of the following formulas calculates the return on investment ROI )?Return on Investment (ROI) A calculation of the monetary value of an investment versus its cost. The ROI formula is: (profit minus cost) / cost.
What is the formula to calculate economic value added?The formula for calculating EVA is: EVA = NOPAT - (Invested Capital * WACC) Where: NOPAT = Net operating profit after taxes. Invested capital = Debt + capital leases + shareholders' equity.
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