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KNGX NOTES
ACCT2522

7. TRANSFER PRICING
7.1 PERFORMANCE MEASUREMENT SYSTEMS

PURPOSE OF PERFORMANCE MEASUREMENT

Performance measures can be used within a planning and control system:

- Performance measures can be used to communicate the strategy and plans for the business and align
employees’ goals with those of the organisation  Goal Congruence
- Managers use performance measures to track their own performance against targets and taking
corrective actions if necessary
- Used by senior managers to evaluate subordinates’ performance and as the basis for rewards
- Used by senior managers to guide them in developing future strategies and operations by providing
information on the outcomes of past decisions and indicating the capability of the firm in the future

CHARACTERISTICS OF EFFECTIVE PERFORMANCE MEASUREMENT SYSTEMS

A performance measurement system is a set of processes that includes the collection, analysis and reporting
of actual performance, usually compared to some target.

An effective performance measurement system may have the following characteristics:

- Link to strategy and the goals of the organization: to help promote goal congruence and may
encourage employees to focus their efforts in the right direction
- Recognise controllability: when employees are responsible for achieving certain performance
measures, these measures should relate to the activities and processes that are under their control
- Embrace participation and empowerment: to encourage managers and employees to accept
performance measures as fair, it is important that they are involved in the formulation and operation
of the measures
- Be simple: measures should be understandable and easy to communicate to employees
- Emphasise the positive: to motivate improvements, performance measures should be expressed in
positive rather than negative terms
- Be timely: performance measures should be reported as close as possible to the period to which they
relate
- Include benchmarking: to lift performance to meet the demands of the customer and competition
- Include only a few performance measures: too many performance measures can confuse and
obscure real performance
- Link to rewards: many companies believe that performance measures are motivational if they are
linked to incentives

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ACCT2522

7.2 DECENTRALISATION & RESPONSIBILITY ACCOUTNING

Decentralisation: (i) structuring of the organisation into units and (ii) assigning particular operations and
decision-making responsibilities to each unit

MANAGING A DECNTRALISED ORGANISATION

When decision making is delegated, it is important that the goals of managers in the various departments are
aligned with the goals of the organization:

- Goal Congruence: is the alignment of the goals of managers with the goals of the organization
- One way in which an organization can help promote goal congruence is through the operation of
responsibility accounting system
- Responsibility Accounting System: a system in which managers are held responsible for the activities
and performance in their area of the business (responsibility centre)
o Involves assignment of responsibility, performance measurement, and performance
evaluation and rewards
o Managers should only be responsible for what they can control

Other Issues that need to be considered:

- Empowerment of managers
- Need for coordination and communication between various units

BENEFITS VS. COSTS

Benefits Costs


- Better local information lead to more

- Goal incongruence leads to suboptimal
effective management
decisions
- Quicker response to opportunities and
o E.g., competition between sub-
problems
units ‘rival units’
- Provides managerial training
- May lead to greater motivation and job - Duplication of tasks and actions

satisfaction - Increase cost of communication and
- Allows corporate managers to focus on coordination
strategic issues

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ACCT2522

7.3 RESPONSIBILITY CENTRES

Responsibility Centre: a unit in an organisation where the manager is held accountable for activities and
performance

Four types:

1. Cost centre: a unit in which the manager is held accountable for costs incurred in that unit
2. Revenue centre: a unit in which the manager is held accountable for revenue generated by that unit
3. Profit centre: a unit in which the manager is accountable for the profit of that unit
4. Investment centre: a unit in which the manager is accountable for profit generated and invested
capital used to generate profit in that unit

Examples Financial Responsibility Financial Performance

Measures
Investment Centre Subsidiary Profit and invested Return on investment
companies/divisions capital (assets) used to (i.e. profit invested
generate profit in that capital)
centre
Profit Centre Subsidiary Profit – all revenues and Some measure of profit
companies/divisions, costs – of that centre
production plants
Revenue Centre Sales departments Revenues of that Revenues
department
Cost Centre Administrative Costs of running the Costs, detailed cost
departments, department or area variance
production teams,
production
departments,
production lines, process
lines

Note: in practice profit centres and investment centres are used interchangeably and are sometimes referred
to as strategic business units

Shared Business Unit (SBU): a profit centre or investment centre that has its own clearly defined strategies
and markets and is regarded as its own ‘independent business’

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ACCT2522

7.4 MORE COMPLEX STRUCTURES

SHARED SERVICE UNITS

Shared Services Unit: concentration of some support services that are typically spread across a
decentralised organisation into a separate unit to service multiple internal customers

- Usually a ‘profit centre’ rather than a ‘cost centre’ (negative connotation of cost centres)
- Shares certain aspects of centralised services
- Aim is to reduce cost and to improve the quality of services delivered

Shared Service Units Centralised Service Units

 The focus is on the needs of internal  Head office concerns dominate
customers, such as business units and divisions  Services tend to be standardised, regardless of
 The type of services are negotiated and the needs of the business units being serviced
defined, based on customer needs
 The location is chosen to best serve internal  Usually located at corporate headquarters
customers
 The unit has full responsibility for both the cost  Support service managers have little
and the quality of services delivered accountability for quality and customer
 Usually structured as a profit centre, but often satisfaction
only required to achieve break-even  Structures as a cost centre, reporting to head
office managers
 Performance is assessed against service level  Performance is judged against budget and
agreements (SLAs), which outline the type of corporate objectives
service to be provided to internal customers,
the standard of the service in terms of specific
performance measures and targets (including
response times, quality, deadlines and prices)

Mainbenefits of Shared Services Units:

- Cost management: economies of scale and reduction of duplicate services

- Enhance quality: through specialisation
- Customisation: focus on internal customer needs

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TEAM-BASED STRUCUTRES

Firms now adopt a flat organisational structure that involve fewer levels of management which result in the
formation of self-managed work teams.

Trade-offs in the implementation of self-managed work teams

The benefits The costs/risks

 Improved response time to customer  Increased cost of employee selection and training
delivery needs  Increased labour costs as team members’ salaries
 Improved response time to recovery increase
from equipment breakdown  Disruption to operations in the transition from
 Improved job satisfaction and feelings departments to teams
of self-worth for team members  Supervisors and middle managers have difficulty
 Enhanced enthusiasm for customer adjusting when their jobs change from direction to
interactions among team members facilitation
 Increased opportunities for team  Resource commitments are made by team members with
members to improve the quality of less appreciation for the long-term impact of their
operations directly decisions
 Improved customer service  Resistance to change from employees who are asked to
 Increased goal congruence among form teas ad take on the added responsibilities
team members  Increased stress among team members from the
additional responsibility

7.5 TRANSFER PRICING SYSTEMS

Transfer Pricing: the internal selling price used when goods and services are transferred between profit
centres and investment centres in a centralised organisation

- Buying (selling) unit records a cost (revenue)

Advantages of using transfer price:

- Allows accurate performance evaluation of certain responsibility centres

- Preserves and encourages autonomy within business units
- Promotes goal-congruence behaviour (if the right transfer price is set)

Who has the authority to set transfer prices?

- Managers of profit centres and investment centres (but to different degrees)

- Top management:
o Direct intervention which is inconsistent with the philosophy of decentralisation
o Setting a general policy for transfer pricing

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ACCT2522

DETERMINING TRANSFER PRICING

Methods

1. Market-Based Prices
2. Cost-Plus Price
3. Negotiated Transfer Price

1. MARKET-BASED PRICES

Setting transfer prices at market price usually results in decisions that are consistent with responsibility
accounting and decentralisation philosophies, however do not always encourage goal-congruent behaviour.

Considerations:

- Does an external market exist?

- Is there reliable information on market price?
- Are there any SGA (Selling, General, Administrative) expenses relating to external sales?
o Can use ABC to help!

2. COST-PLUS PRICE (NO EXTERNAL MARKET)

Look at cost to produce a unit plus a mark-up.

- Costs:
o Standard cost (predetermined or budgeted costs) should be used over actual cost
This gives the supplying unit incentive to
o Variable cost vs absorption cost
o Activity based cost

- Plus:
o Mark-up to cover remaining costs
o Cost of capital and profit

Used when:

- There is no external market

- If there is excess capacity (as no opportunity cost will be incurred by seeling at cost)

3. NEGOTIATED TRANSFER PRICE

Issues associated with negotiations between divisional mangers:

- Potential conflict of interests

- Do managers have the required negotiating skills?
- But reflects autonomy

Market price may form the starting point, and cost may be the lower boundary

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ACCT2522

- Whether or not the supplying division has excess capacity can influence the appropriate level of
transfer price

GENERAL TRANSFER PRICING RULE

Transfer Variable Cost and Additional Outlay Opportunity Cost Per Unit to the
= +
Price Costs Per Unit Incurred Supplying Division

- Provides guidance on the appropriate transfer price

- Represents a minimum transfer price
- May guide divisional manager to make goal-congruent decisions

TRANSFER PRICING: DIFFERENT SCENARIOS

- With External Market and:

o Sc1: Excess Capacity Rule = VC; TP < MP
o Sc2: No Excess Capacity Rule = MP; TP ≈ MP
o Sc3: Limited capacity Rule = (VC, MP); TP: includes OC
in the supplying division
- No External Market and:
o Sc4: Excess Capacity Rule = VC; TP = VC + %
o Sc5: No excess capacity Rule = VC + OC; TP includes OC
in the supplying division

ADDITIONAL

OTHER USES OF TRANSFER PRICING

Reducing Tax in MNCs: Transfer pricing allows the shifting of profits between countries due to different tax
rates and tax regulations:

By Service firms and not-for-profit firms when services are transferred between business units