Management Advisory Service

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Arth Vince Malaca

MANAGEMENTADVISORY

SERVICEPre-Finals


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MANAGEMENT ADVISORY SERVICE

Table of Contents

Pricing Policies and Prota!ilit" Anal"sis######################################################$

%# Factors In&'encing the Price o( a Prod'ct###########################################)*# Mar+ets################################################################################################,

# Price and De.and Relationshi/###########################################################,

$# Price Elasticit" o( De.and###################################################################0

1# Prot Ma2i.i3ation############################################################################%4

)# Pricing Strategies##############################################################################%

,# Prota!ilit" Anal"sis##########################################################################%0

Di5isional Per(or.ance Meas'res##############################################################*1

%# O!6ecti5es#########################################################################################*1

*# Centrali3ation and Decentrali3ation##################################################*)

# Conce/ts o( Res/onsi!ilit" Centres###################################################*,

$# Financial Per(or.ance Meas'res o( In5est.ent Centre#####################*,

1# Trans(er Pricing##################################################################################$

Trans(er Pricing Methods############################################################################$*

%# The Need (or Trans(er Pricing############################################################$$

*# Trans(er Pricing Methods###################################################################$1

Di5isional Per(or.ance Meas'res##############################################################11

%# O!6ecti5es#########################################################################################11

*# Centrali3ation and Decentrali3ation##################################################1)

# Conce/ts o( Res/onsi!ilit" Centres###################################################1,

$# Financial Per(or.ance Meas'res o( In5est.ent Centre#####################10

1# Trans(er Pricing##################################################################################)$

Seg.ent Per(or.ance Meas're.ents#######################################################,

%# Allocation o( Costs and Seg.ent Re/ort###########################################,$

*# General As/ects in Per(or.ance Meas're.ents###############################,1

Cha/ter %% Strategic Manage.ent Acco'nting and Processes##################,7

%# 8hat is Strateg"9##############################################################################04

*# :e5els o( Strateg"#############################################################################0%

E2a./le % ; :e5els o( strateg"##################################################################0%

# Mission< Goals and O!6ecti5es###########################################################0%

$# Cor/orate A//raisal= En5iron.ental Anal"sis###################################0*

1# Cor/orate A//raisal= Position A'dit###################################################0,

)# Other Strategic Cost Manage.ent Techni>'es#################################71

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)#* Total ?'alit" Manage.ent @T?M###################################################71

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Pricing Policies and Profitability Analysis

LEARNING OBJECTIVES

1. Explain the factors that influence the price of a product.2. Establish the price/demand relationship of a product.3. Establish the optimum price/output level when considering profit maximization and

maximization of revenue.4. Calculate prices using full cost and marginal cost as the pricing base.. !iscuss the advantages and disadvantages of these pricing bases.". !iscuss the pricing polic# in the context of price s$imming% penetration pricing%

complementar# product pricing and price discrimination.&. 'ppreciate the importance of profitabilit# anal#sis in decision ma$ing.

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* r i c i n g

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$ i m m i n g

* r i c i n g

, a r $ e t

* e n e t r a t i o n

* r i c i n g

C o m p l e m e n t a r #

* r o d u c t

* r i c i n g

* r i c e

! i s c r i m i n a t i o n

, a r $ e t b a s e d

* r i c i n g

+ a r g e t

* r i c i n g

E t h i c a l

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* r i c i n g t r a t e g i e s

# * r o d u c t

# C u s t o m e r s

* r o f i t a b i l i t #' n a l # s i s

* r i c i n g

a n d

* r o f i t a b i l i t #

' n a l # s i s

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1. (actors )nfluencing the *rice of a *roduct

!ec ""#

1.1 everal factors underlie all pricing decisions and effective decisions will be based on a

careful consideration of the following.

Infl$ence E%&lanation'E%a(&le

*rice sensitivit# ensitivit# to price levels will var# amongst purchasers. +hosethat can pass on the cost of purchases will be the least sensitiveand will therefore respond more to other elements of perceivedvalue. (or example% a business traveller will be moreconcerned about the level of service in loo$ing for an hotelthan price% provided that it fits the corporate budget. )ncontrast% a famil# on holida# are li$el# to be ver# pricesensitive when choosing an overnight sta#.

*rice perception *rice perception is the wa# customers react to prices. (orexample% customers ma# react to a price increase b# bu#ingmore. +his could be because the# expect further priceincreases to follow the# are stoc$ing up0.

5ualit# +his is an aspect of price perception. )n the absence of other information% customers tend to 6udge 7ualit# b# price. +hus a

price rise ma# indicate improvements in 7ualit#% a pricereduction ma# signal reduced 7ualit#.

)ntermediaries )f an organisation distributes products or services to the mar$etthrough independent intermediaries% such intermediaries are

li$el# to deal with a range of suppliers and their aims concerntheir own profits rather than those of suppliers.

Competitors )n some industries such as petrol retailing0 pricing moves inunison8 in others% price changes b# one supplier ma# initiate a

price war. Competition is discussed in more detail below.

uppliers )f an organisations suppliers notice a price rise for theorganisations products% the# ma# see$ a rise in the price fortheir supplies to the organisation.

)nflation )n periods of inflation the organisation ma# need to changeprices to reflect increases in the prices of supplies% labour% rentand so on.

9ewness :hen a new product is introduced for the first time there areno existing reference points such as customer or competitor

behaviour8 pricing decisions are most difficult to ma$e in suchcircumstances. )t ma# be possible to see$ alternative reference

points% such as the price in another mar$et where the newproduct has alread# been launched% or the price set b# acompetitor.

)ncomes )f incomes are rising% price ma# be a less important mar$etingvariable than product 7ualit# and convenience of accessdistribution0. :hen income levels are falling and/orunemplo#ment levels rising% price will be more important.

*roduct range *roducts are often interrelated% being complements to each

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other or substitutes for one another. +he management of thepricing function is li$el# to focus on the profit from the wholerange rather than the profit on each single product. (orexample% a ver# low price is charged for a loss leader to ma$econsumers bu# additional products in the range which carr#higher profit margins eg selling razors at ver# low priceswhilst selling the blades for them at a higher profit margin0.

*roduct life c#cle !uring the life of an individual product% several stages areapparent; introduction% growth% maturit# and decline. +heduration of each stage of the life c#cle varies according to thet#pe of product% but the concept is nevertheless important aseach stage is li$el# to influence the firmou $now from #our personal experience as a consumer that the theor# of demand isessentiall# true% the higher the price of a good% the less will be demanded.

3.2 )f #ou thin$ about how #ou decide which goods to bu#% #ou will realize that there areman# factors entering into the decision.

Infl$ence E%&lanation'E%a(&le

*rice +his is probabl# the most significant factor. (or each of the goods%the higher the price% the less li$el# people are to bu# it.

)ncome )n general% the more people earn% the more the# will bu#. +hedemand for most goods increases as income rises% and these goodsare $nown as nor(al goods.

+his does not appl# to inferior goods% such as low 7ualit# foodstuffs.+hese are cheap goods which people might bu# when on a low

income% but as their incomes rises% the# switch to more attractive

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alternatives.

*rice of substitutegoods

+wo or more goods are defined as substitutes if the# areinterchangeable in giving consumers utilit#. (or example% Co$e and*epsi are substitutes% a rise in t*e &rice of Co+e ,ill ca$se a rise inde(and for t*e Pe&si% and vice versa.

*rice ofcomplementar#

Complements are goods which must be used together. (or example% acompact disc pla#er is no good without compact discs. )f the &rice ofa co(&le(ent rises% then de(and for anot*er co(&le(entarygood ,ill fall.

+aste +aste is influenced b# man# different things. 'dvertising ma# ma$esomething popular or unpopular.

,ar$et size +he size of total demand de&ends on t*e n$(ber of &eo&lewho areaware of the good


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)gnoring the minus sign% price elasticit# is 1.12

+he demand for this good% at a price of @1.2A per unit% would be referred to as elasticbecause the price elasticit# of demand is greater than 1.

4.2 pecial values of price elasticit#

4.2.1 +here two special values of price elasticit# of demand.a0 Perfectly inelastic *E! A0. +here is no change in 7uantit# demanded%

regardless of the change in price. +he demand curve is a vertical straight line.

b0 *erfectl# elastic *E! F0. Consumers will want to bu# an infinite amount%but onl# up to a particular price level. 'n# price increase above this will reducedemand to zero. +he demand curve is a horizontal straight line.

4.3 *E! and revenue

4.3.1 PE! and re.en$e

a0 :hen demand is elastic% total re.en$e rises as &rice falls and .ice .ersa.+his is because the 7uantit# demanded in ver# responsive to price changes.

b0 :hen demand is inelastic% total re.en$e falls as &rice fallsbecause a fall inprice causes a less than proportionate rise in 7uantit# demanded.

4.3.2 )t would be .ery $sef$l to a &rod$cer to +no, ,*et*er *e is at an elastic or

inelastic part of his demand curve. +his will enable him to predict the effect onrevenue of raising or lowering his price.



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. *rofit ,aximization

.1 Profit (a%i(i/ation

Profits are (a%i(i/ed using marginalist theor# when (arginal cost )C# 0(arginal re.en$e )R#. +he optimal selling price can be determined usinge7uations. +he optimum selling price can also be determined using tabulation.

.2 )n economics% profit maximisation is the process b# which a firm determines the priceand output level that returns the greatest profit. +here are two common approaches tothis problem.a0 +he Total re.en$e TR# 1 Total cost TC#method is based on the fact that

profit e7uals revenue minus cost.b0 +he )arginal re.en$e )R# 1 )arginal cost )C# method is based on the

fact that total profit in a perfect mar$et reaches its maximum point wheremarginal revenue e7uals marginal cost.

.3 (rom the graph above it is evident that the difference between total costs and totalrevenue is greatest at point 5. +his is the profit maximising output 7uantit#.

.4 E%a(&le 2

' has used mar$et research to determine that if a price of @2A is charged forproduct G% demand will be 12%AAA units. )t has also been established that demand will

rise or fall b# units for ever# @1 fall/rise in the selling price. +he marginal cost ofproduct G is @BA.

Re3$ired-

)f marginal revenue ,-0 a = 2b5 when the selling price *0 a = b5% calculatethe profitmaximising selling price for product G.

Sol$tion-

b change in price / change in 7uantit# @1 / A.2

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a @2A H 12%AAA A.2 @2%"A

,- 2%"A = 2 A.205 2%"A = A.45

*rofit are maximized when ,- ,C% i.e.

BA 2%"A = A.455 "%42

9ow% substitute the values into the demand curve e7uation to find the profitmaximising selling price

* a = b5

* 2%"A = A.2 "%42 @1%3"

. +he o&ti($( selling &ricecan also be determined using tabulation. +o determine theprofitmaximising selling price;

a0 :or$ out the de(and c$r.eand hence the &rice and t*e total re.en$e* 50 at various levels of demand.

b0 Calculate total costand hence (arginal costat each level of demand.c0 (inall# calc$late &rofitat each level of demand% thereb# determining the price

and level of demand at which profits are maximized.

4$estion "

'n organisation operates in a mar$et where there is imperfect competition% so that to sellmore units of output% it must reduce the sales price of all the units it sells. +he following datais available for prices and costs.

+otal outputInits

ales price per unit '-0@

'verage cost of output 'C0@ per unit

A

1 A4 &2A

2 4&1 4A2

3 43D 2BB

4 4A& 231 3&& 2A1

" 34" 1BD

& 31& 1B2

B 2BB 1BA

D 2D 1B"

1A 232 1DB

+he total cost of zero output is @"AA.

Re3$ired-

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Complete the table below to determine the output level and price at which the organisationwould maximise its profits% assuming that fractions of units cannot be made.

Inits *rice +otal

revenue

,argina

lrevenue

+otal

cost

,argina

l cost

*rofit

@ @ @ @ @ @

A

1

2

3

4

"

&

B

D

1A

". *ricing trategies

".1 Costplus pricing!ec 567 J$n "57 !ec "57 !ec ""7 J$n "27 !ec "8#

".1.1 Cost9&l$s &ricing

(ull costplus pricing is a method of determining the sales price b# calculating thefull cost of the product and adding a percentage mar$up for profit.

".1.2 In &ractice cost is one of t*e (ost i(&ortant infl$ences on &rice . ,an# firms baseprice on simple costplus rules costs are estimated and then a profit margin is added inorder to set the price0.

".1.3 +he full cost ma# be a full# absorbed production cost onl#% or it ma# include someabsorbed administration% selling and distribution overhead.

".1.4 ' business might have an idea of the percentage profit margin it would li$e to earn%

and so might decide on an average profit mar$up as a general guideline for pricingdecisions.

".1. Ad.antagesof full costplus pricinga0 )t is a 3$ic+7 si(&le and c*ea&method of pricing which can be delegated to

6unior managers.b0 ince the size of the profit margin can be varied% a decision based on a price in

excess of full cost should ensure that a compan# wor$ing at normal capacit#will co.er all of its fi%ed costs and (a+e a &rofit.

".1." !isadvantages of full costplus pricinga0 )t fails to recognise t*at since de(and (ay be deter(ining &rice % there will

be a profitmaximising combination of price and demand.b0 +here ma# be a need to ad:$st &rices to (ar+et and de(and conditions.

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c0 B$dgeted o$t&$t .ol$(eneeds to be established. Jutput volume is a $e#factor in the overhead absorption rate.

d0 ' s$itable basis for o.er*ead absor&tion ($st be selected% especiall# wherea business produces more than one product.

".1.& E%a(&le ;

' compan# budgets to ma$e 2A%AAA units which have a variable cost of production of@4 per unit. (ixed production costs are @"A%AAA per annum. )f the selling price is to

be 4A? higher than full cost% what is the selling price of the product using the fullcostplus method

Sol$tion-

(ull cost per unit variable cost H fixed costKariable cost @4 per unit

(ixed cost @"A%AAA/2A%AAA @3 per unit(ull cost per unit @4 H @3 @&elling price using full costplus pricing method @& 14A? @D.BA

".2 ,arginal costplus pricing

".2.1 )arginal cost9&l$s &ricing

,arginal costplus pricing/mar$up pricing involves adding a profit margin to themarginal cost of production/sales.

".2.2 :hereas a full costplus approach to pricing draws attention to net profit and the netprofit margin% a variable costplus approach to pricing dra,s attention to gross &rofitand t*e gross &rofit (argin7 or contrib$tion.

".2.3 E%a(&le 8

' product has the following costs.

@

!irect materials

!irect labour 3

Kariable overheads &

(ixed overheads are @1A%AAA per month. udgeted sales per month are 4AA units toallow the product to brea$even.

Re3$ired-

!etermine the profit margin which needs to be added to marginal cost to allow theproduct to brea$ even.

Sol$tion-

rea$even point is when total contribution e7uals fixed costs.

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't brea$even point% @1A%AAA 4AA price = @10@2 price = @1*rice @4A*rofit margin 4A = 10/1 1AA? 1""."&?

".2.4 Ad.antagesof marginal costplus pricinga0 )t is a si(&le and easymethod to use.b0 +he mar$up percentage can be varied% and so mar$up pricing can be ad6usted

to reflect demand conditions.c0 )t draws management attention to contribution% and the effects of higher or

lower sales volumes on profit. (or example% if a product costs @1A per unit anda mar$up of 1A? @10 is added to reach a price of @2 per unit%management should be clearl# aware that ever# additional @1 of sales revenuewould add "A cents to contribution and profit @1 L @2 @A."A0.

".2. !isad.antagesof marginal costplus pricinga0 'lthough the size of the mar$up can be varied in accordance with demand

conditions% it does not ens$re that s$fficient attention is &aid to de(andconditions% co(&etitors< &rices and &rofit (a%i(isation.

b0 )t ignores fi%ed o.er*eadsin the pricing decision% but the sales price must besufficientl# high to ensure that a profit is made after covering fixed costs.

".3 ,ar$et s$imming pricing

".3.1 )ar+et s+i((ing &ricing

*rice s$imming involves c*arging *ig* &rices ,*en a &rod$ct is first la$nc*edinorder to (a%i(i/e s*ort9ter( &rofitability. )nitiall# there is heav# spending onadvertising and sales promotion to obtain sales. 's the product moves into the laterstages of its life c#cle growth% maturit# and decline0 &rogressi.ely lo,er &rices arec*arged. +he profitable cream is thus s$immed off in stages until sales can onl# besustained at lower prices.

".3.2 +he aim of mar$et s$imming is to gain high unit profits earl# in the products life.Migh unit prices ma$e it more li$el# that competitors will enter the mar$et than iflower prices were to be charged.

".3.3 uch a polic# ma# be a&&ro&riatein the cases below.a0 +he product is ne, and different% so that customers are prepared to pa# high

prices so as to be one up on other people who do not own it.b0 +he strength of de(andand the sensitivit# of demand to price are $n+no,n.

)t is better from the point of view of mar$eting to start b# charging high pricesand then reduce them if the demand for the product turns out to be price elasticthan to start b# charging low prices and then attempt to raise them substantiall#if demand appears to be insensitive to higher prices.

c0 Migh prices in the earl# stages of a products life might generate *ig* initialcas* flo,s. ' firm with li7uidit# problems ma# prefer mar$ets$imming for

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this reason.d0 +he firm can identif# different (ar+et seg(ents for the product% each

prepared to pa# progressivel# lower prices. )t ma# therefore be possible tocontinue to sell at higher prices to some mar$et segments when lower pricesare charged in others.

e0 *roducts ma# have a s*ort life cycle% and so need to recover their developmentcosts and ma$e a profit relativel# 7uic$l#.

".3.4 *roducts to which the polic# has been applied include mobile phone% computers% videorecorders% etc.

".4 ,ar$et penetration pricing

".4.1 )ar+et &enetration &ricing

*enetration pricing is a polic# of lo, &riceswhen a product is first la$nc*ed in

order to obtain s$fficient &enetration into t*e (ar+et.

".4.2 ' penetration polic# ma# be a&&ro&riatein the cases below.a0 +he firm wishes to disco$rage ne, entrantsinto the mar$et.b0 +he firm wishes to s*orten t*e initial &eriodof the products life c#cle in

order to enter the growth and maturit# stages as 7uic$l# as possible.c0 +here are significant econo(ies of scale to be ac*ie.edfrom a high volume

of output.d0 !emand is *ig*ly elasticand so would respond well to low prices.

". Complementar# product pricing

"..1 Co(&le(entary &rod$ct &ricing

a0 Complementar# products are goods that tend to be bought and used together.b0 Complementar# products are sold separatel# but are connected and dependant

on each other for sales% for example% an electric toothbrush and replacement

toothbrush heads. +he electric toothbrush ma# be priced competitivel# toattract demand but the replacement heads can be relativel# expensive.

"..2 ' loss leaderis when a compan# sets a .ery lo, &rice for one &rod$ctintending to(a+e cons$(ers b$y ot*er &rod$ctsin the range which carr# higher profit margins.'nother example is selling razors at ver# low prices whilst selling the blades for themat a higher profit margin. *eople will bu# man# of the high profit items but onl# oneof the low profit items = #et the# are loc$ed in to the former b# the latter. +his canalso be described as ca&ti.e &rod$ct &ricing=

"." *rice discrimination



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".".1 Price discri(ination

+he use of price discrimination means that the sa(e &rod$ct can be sold atdifferent &rices to different c$sto(ers. +his can be ver# difficult to implement in

practice because it relies for success upon the continued existence of certain mar$et

conditions.

".".2 +here are a number of bases on which such discriminating prices can be set.a0 By (ar+et seg(ent. ' crosschannel ferr# compan# would mar$et its services

at different prices in England and (rance% for example. ervices such ascinemas and hairdressers are often available at lower prices to old age

pensioners and/or 6uveniles.b0 By &rod$ct .ersion. ,an# car models have add on extras which enable one

brand to appeal to a wider crosssection of customers. +he final price need notreflect the cost price of the add on extras directl#; usuall# the top of the range

model would carr# a price much in excess of the cost of provision of theextras% as a prestige appeal.

c0 By &lace. +heatre seats are usuall# sold according to their location so thatpatrons pa# different prices for the same performance according to the seatt#pe the# occup#.

d0 By ti(e. +his is perhaps the most popular t#pe of price discrimination. Jffpea$ travel bargains% hotel prices and telephone charges are all attempts toincrease sales revenue b# covering variable but not necessaril# average cost of

provision. -ailwa# companies are successful price discriminators% chargingmore to rush hour rail commuters whose demand is inelastic at certain times ofthe da#.

".& ,ar$etbased pricingJ$n "27 !ec "8#

".&.1 )ar+et9based &ricing

*rices are determined in an attempt to capture mar$et share.

".B +arget pricing!ec "57 J$n "2#

".B.1 Target &ricing

+arget pricing is the price at which a seller &ro:ects t*at a b$yer ,ill b$y a&rod$ct. +arget costing determines the cost of a product or service according to thetarget price that a customer is willing to pa# and it is an estimated longrun cost.

".D Ethical pricing!ec 56#

".D.1 Et*ical &ricing

ometimes pricing polic# should be based on certain et*ical &rinci&les. usinesswithout ethics is a sin. :hile setting the prices% some moral standards are to be

followed. +he pricing polic# has to secure reasonable amount of profits to a firm to

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preserve the interests of the communit# and promote its welfare.

&. *rofitabilit# 'nal#sis

&.1 )ntroduction

&.1.1 )n running a business% management has to $now the profitabilit# of their products%customers and other business segments as the# want to $now what segment the#should focus on. +o achieve such purpose% the# should be able to distinguish betweenabsolute profitabilit# and relative profitabilit#.

&.1.2 'bsolute profitabilit# is measured b# the segment


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? of revenue0 "."&?0 4?0 ?0'dministration? of revenue0

%AAA3.33?0

"%AAA2.4?0

11%AAA2.&?0

Oabour? of revenue0

3%AAA2?0

3%AAA1.2?0

"%AAA1.?0

Jthers? of revenue0

2%AAA1.33?0

3%AAA1.2?0

%AAA1.2?0

Total fi%ed costs 2A%AAA13.3?0

22%AAAB.B?0

42%AAA1A.?0

O&erating &rofit 67555 "27>55 257>55

Jperating surplus ?0 "? &3? &A.1?*rofit contribution ?0 34.D? ".1? 1AA?

:hen management considers the resource allocation and strateg# formulation% it candetermine whether the compan# should put more emphasis on a particular product or

whether the# would allocate the costs differentl# to get a better margin for theproduct group.

&.3 Customer profitabilit# anal#sis C*'0

&.3.1 C*' is ver# important to decision ma$ing of management% as best customers impliescustomers who contributes the highest sales. +hus% we need to understand what

products and services customers bu# and the associated product and services costswhen designing business strategies.

&.3.2 E%a(&le

' simple C*' can be conducted as follow;C$sto(er A C$sto(er B Total

? ? ?

Sales 1A%AAA3&.?0

2A%AAA"2.?0

4AA%AAA1AA?0

Cost of sales

Jngoing service N support 1&%AAA 2%AA 42%AAJther direct customer costs 1%AAA 2A%AAA 3%AAA+otal cost of sales 11%BAA

&B.&?02A4%AAB1.B?0

322%AABA."?0

Jther costsCustomer ac7uisition 1A%AAA 1A%AAA 2A%AAACustomer mar$eting %AAA "%AAA 11%AAACustomer termination %AAA "%AAA 11%AAA

Total ot*er c$sto(er costs 257555 227555 827555

Profit by c$sto(er gro$&s 67555

;8=6#

"27>55

>="#

257>55

"55#



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E%a(ination Style 4$estions

4$estion 2 1 )arginal cost &l$s &ricing and s&ecial order

MP)''+ *E )) ,anagement 'ccounting !ecember 2AA3 5"0

4$estion ; 1 Cost &l$s &ricing7 target &ricing and balanced scorecard



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MP)''+ *E )) ,anagement 'ccounting and (inance !ecember 2A1A 5"0

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4$estion 8 1 C$sto(er &rofitability analysis

RE4DIRE!-

a0 !etermine the profitabilit# of each customer t#pe using the traditional approach ofassigning customerrelated activit# costs in proportion to the sales revenue earned b#each customer t#pe. !iscuss the problems of this measure of customer profitabilit#.

mar$s0b0 # using the activit# rates to assign customerrelated activit# costs to each customer

t#pe% recalculate the profitabilit# of each customer categor#. !iscuss how #ou% as amanager% would use this information. 11 mar$s0

c0 !escribe briefl# the nature of valueadded and nonvalueadded activities and give anexample of each t#pe of activit#. 4 mar$s0

+otal 2A mar$s0MP)''+ *E )) ,anagement 'ccounting !ecember 2AA& 530

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!i.isional Perfor(ance )eas$res

1. Jb6ectives

1.1 Inderstand the concepts of responsibilities centres in an organization.1.2 'dvantages and disadvantages of decentralization in a sizable organization.1.3 Explain how to evaluate the performance of the various responsibilities centres.1.4 Inderstand the use of return on investment -J)0% residual income -)0 and economic

value added EK'0.1. Inderstand how transfer pricing methods affect the performance of independent units.1." Explain the different transfer pricing methods.

1.& !etermine the optimal transfer price between the selling division and bu#ing division.

' d v a n t a g e s

a n d

! i s a d v a n t a g e s

C e n t r a l i z a t i o n

a n d

! e c e n t r a l i z a t i o n

1 . C o s t c e n t r e

2 . - e v e n u e c e n t r e

3 . * r o f i t c e n t r e

4 . ) n v e s t m e n t c e n t r e

- e s p o n s i b i l i t #

C e n t r e s

' d v a n t a g e s

a n d


1 . - J )

2 . - )

3 . E K '

( i n a n c i a l

* e r f o r m a n c e

, e a s u r e s

1 . , a r $ e t b a s e d

2 . C o s t b a s e d

a . ( u l l c o s t N

b . K a r i a b l e c o s t

3 . 9 e g o t i a t e d

* r i c i n g

4 . ! u a l r a t e

* r i c i n g

+ r a n s f e r

* r i c i n g

, e t h o d s

! i v i s i o n a l


, e a s u r e s

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2. Centralization and !ecentralization

2.1 !efinitionsa0 Centrali/ed organi/ation is an organization in which to& (anage(ent

(a+es (ost decisions and control most activities from the centralhead7uarters.

b0 !ecentrali/ationis defined as delegating a$t*ority to (a+e decisions.

)n general% a divisional structure will lead to decentralization of the decisionma$ing process and divisional managers ma# have the freedo(to set selling

prices% choose suppliers% ma$e product mix and output decisions and so on.

2.2 Ad.antages of decentrali/ation

a0 Si/e= the process of decentralization brea+san organization up into (ore(anageable $nits% this enables decision9(a+ing to proceed 3$ic+ly andeffecti.elyand% in theor#% a closer controlto be maintained on the da# to da#running of a business


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3. Concepts of -esponsibilit# Centres

3.1 9owada#s% most sizable organizations are decentralizing as their operations are gettingmore complex while the# have operations globall#. Geographical and complicatedoperations ma$e management more difficult to control and thus managers of businessunits are responsible for a range of decisions considered b# the head office.

3.2 !efinitions

a0 Cost centre = a production or service location% function% activit# or iteme7uipment whose costs ma# be attributed to cost units% e.g. pac$agingdepartment% administration department% etc.

b0 Re.en$e centre = is a centre devoted to raising re.en$e with no

responsibilit# for production% e.g. sales and mar$eting departments.c0 Profit centre= is a part of business acco$ntable for costs and re.en$e. )t

also calls a business centre% business unit or strategic business unit. *rofitcentre operating revenue is mainl# from sales to external sales and internaltransfer to other divisions% e.g. wholesale division and the retail division.

d0 In.est(ent centre is the responsibilit# center within an organization thathas control o.er re.en$e7 cost7 and in.est(ent f$nds% e.g. subsidiar#.

3.3 +he following table shows the principal performance measures for each centre;

Ty&es ofres&onsibility

)anager *as control o.er Princi&al &erfor(ance(eas$res

Cost centre Controllable costs Kariance anal#sisEfficienc# measures

-evenue centre -evenues onl# -evenues

*rofit centre Controllable costsales prices including transfer price0

*rofit

)nvestment centre Controllable costsales prices including transfer price0Jutput volumes)nvestment

-eturn on investment-esidual incomeJther financial ratios

4. (inancial *erformance ,easures of )nvestment Centre

A# Ret$rn on in.est(ent ROI#

4.1 ROI

ROIshows how much profit has been made in relation to the amount of capitalinvested and is calculated as profit/capital emplo#ed0 x 1AA?.

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4.2 E%a(&le "

uppose that a compan# has two investment centres ' and % which show results forthe #ear as follows.

'

@ @*rofit "A%AAA 3A%AAA

Capital emplo#ed 4AA%AAA 12A%AAA

-J) 1? 2?

)nvestment centre ' has made double the profits of investment centre % and in termsof profits alone has therefore been more successful. Mowever% has achieved its

profits with a much lower capital investment% and so has earned a much higher -J).+his suggests that has been a more successful investment than '.

4.3 +here is no generall# agreed method of calculating -J) and it can lead tod#sfunctional decision ma$ing when used as a guide to investment decisions. )tfocuses attention on shortrun performance whereas investment decisions should beevaluated over their full life.

a0 *rofit after depreciation as a ? of net assets emplo#ed

4.4 +his is probabl# the most common method% but it does present a problem. )f aninvestment centre maintains the same annual profit% and $eeps the same assets withouta polic# of regular replacement of noncurrent assets% its -J) will increase #ear b##ear as the assets get older. +his can gi.e a false i(&ression of i(&ro.ing

&erfor(ance o.er ti(e.

4. E%a(&le 2

(or example% the results of investment centre Q% with a polic# of straightlinedepreciation of assets over a #ear period% might be as follows.

>ear 1 >ear 2 >ear 3

*rofit before depreciation 4%AAA 4%AAA 4%AAA

!epreciation 1%AAA0 1%AAA0 1%AAA0

9et profit 3%AAA 3%AAA 3%AAA

9K = E7uipment %AAA 4%AAA 3%AAA

-J) "A? &? 1AA?

+his table of figures is intended to show that an investment centre can i(&ro.e itsROI#ear b# #ear% simpl# by allo,ing its non9c$rrent assets to de&reciate% andthere could be a disincenti.eto investment centre managers to rein.est in ne, orre&lace(ent assets% because the centres -J) would probabl# fall.

4." E%a(&le ;

' further disadvantage of measuring -J) as profit divided b# net assets is that% for

similar reasons% it is not eas# to compare fairl# the performance of investment



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centres.

(or example% suppose that we have two investment centres.

@ @ @ @:or$ing capital 2A%AAA 2A%AAA

9oncurrent assets at cost 23A%AAA 23A%AAA'ccumulated depreciation 1&A%AAA 1A%AAA

9K "A%AAA 22A%AAA

Capital emplo#ed BA%AAA 24A%AAA

*rofit 24%AAA 24%AAA-J) 3A? 1A?

)nvestment centres * and 5 have the same amount of wor$ing capital% the same valueof noncurrent assets at cost% and the same profit. ut *s noncurrent assets have

been depreciated b# a much bigger amount presumabl# *s noncurrent assets aremuch older than 5s0 and so *s -J) is three times the size of 5s -J). +heconclusion might therefore be that * has performed much better than 5. +hiscomparison% however% would not be fair% because the difference in performancemight be entirel# attributable to the age of their noncurrent assets.

4.& +hearg$(ents for $sing net boo+ .al$esfor calculating -J)a0 )t is the nor(ally acce&ted method of calculating -J).b0 Jrganisations are contin$ally b$ying ne, non9c$rrent assets to re&laceold

ones that wear out% and so on the whole% the total net boo+ .al$eof all noncurrent assets together will re(ain fairly constantassuming nil inflation andnil growth0.

b0 *rofit after depreciation as a ? of gross assets emplo#ed

4.B )nstead of measuring -J) as return on net assets% we could measure it as return ongross assets i.e. before depreciation. +his would re(o.e t*e &roble( of ROIincreasing o.er ti(e as non9c$rrent assets get older.

4.D E%a(&le 8

)f a compan# ac7uired a noncurrent asset costing @4A%AAA% which it intends todepreciate b# @1A%AAA pa for 4 #ears% and if the asset earns a profit of @B%AAA pa afterdepreciation% -J) might be calculated on net boo$ values or gross values% as follows.

>ear *rofit 9Kmid#ear

value0

-J) basedon 9K

Grossvalue

-J) basedon gross

value@ @ @

1 B%AAA 3%AAA 22.D? 4A%AAA 2A?2 B%AAA 2%AAA 32.A? 4A%AAA 2A?3 B%AAA 1%AAA 3.3? 4A%AAA 2A?

4 B%AAA %AAA 1"A.A? 4A%AAA 2A?

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+he -J) based on net boo$ value shows an increasing trend over time% simpl#because the assets value is falling as it is depreciated. +he -J) based on gross boo$value suggests that the asset has performed consistentl# in each of the four #ears%which is probabl# a more valid conclusion.

4.1A Ad.antages of ROI

a0 's a relati.e (eas$re% it enables co(&arisonsto be made with divisions orcompanies of different si/e.

b0 )t is used externall# and is ,ell $nderstood by $sersof accounts.c0 -J) forces (anagers to (a+e good $se of e%isting ca&ital reso$rcesand

focuses attention on them% particularl# when funds for further investment arelimited.

4.11 !isad.antages of ROI

a0 !isincenti.e to in.est= +he most conventional depreciation methods willresult in -J) improving with the age of an asset% this might encouragedivisions hanging on to old assets and again deter them from investing in newones.

b0 S$b:ect to (ani&$lation= +he calculation of -eturn on )nvestment can beeasily (odified based on the anal#sis ob6ective. )t depends on what weinclude in revenues and costs.

c0 Lac+ of goal congr$ence= for example% it is possible that divisional -J) canbe increased b# actions that will ma$e the compan# as a whole worse off andconversel#% actions that decrease the divisional -J) ma# ma$e the compan#

as a whole better off.d0 Not s$itable for in.est(ent decisions= it might be affected b# the effect

the# would have on the division 1 Lac+ of goal congr$ence

!ivision Q !ivision >

)nvestment pro6ect available @1A million @1A millionControllable contribution @2 million @1.3 million-eturn on the proposed pro6ect 2A? 13?

-J) of divisions at present 2? D?

)t is assumed that neither pro6ect will result in an# changes in noncontrollable costsand that the overall cost of capital for the compan# is 1?. +he manager of divisionQ would be reluctant to invest the additional @1A million because the pro6ect would wish to invest the @1A million because the return on the proposed

pro6ect of 13? is in excess of the present return of D?. Conse7uentl#% the managersof both divisions would ma$e decisions that would not be in the best interests of thecompan#.

B# Resid$al Inco(e RI#

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4.13 RI

RI is a (eas$re of t*e centres &rofits after ded$cting a notional or i(&$ted

interest cost or cost of ca&ital c*arge=

a0 +he centre


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4.1& EVA

EK' is an alternati.e absol$te &erfor(ance (eas$re. )t is similar to -) and iscalculated as follows;

EK' net operating profit after tax 9J*'+0 less capital chargeCapital charge :'CC x net assets

4.1B Economic value added EK'R0 is a registered trade mar$ owned b# tern tewart NCo. )t is a specific t#pe of residual income -)0. Mowever% there are differences asfollows;a0 +he profit figures are calculated differentl#. EK' is based on an econo(ic

&rofitwhich is derived b# (a+ing a series of ad:$st(ents to t*e acco$nting&rofit.

b0 +he notional capital charges use different bases for net assets. +he

re&lace(ent cost of net assets is $s$ally $sedin the calculation of EK'.4.1D +here are also differences in the wa# that 9J*'+ is calculated compared with the

profit figure that is used for -)% as follows;a0 Costs which would normall# be treated as expenses% but which are considered

within an EK' calculation as in.est(ents b$ilding for t*e f$t$re% are addedbac$ to 9J*'+ to derive a figure for economic profit. T*ese costs areincl$ded instead as assets in the figure for net assets emplo#ed% ie asinvestments for the future. Costs treated in this wa# include items such asgood,ill7 researc* and de.elo&(ent e%&endit$re and ad.ertising costs.

b0 'd6ustments are sometimes made to the depreciation charge% whereb#accounting depreciation is added bac$ to the profit figures% and econo(ic

de&reciationis subtracted instead to arrive at 9J*'+. Economic depreciationis a c*arge for t*e fall in asset .al$e d$e to ,ear and tear or obsolescence.

c0 'n# lease c*arges are e%cl$ded fro( NOPAT and added in as a &art ofca&ital e(&loyed.

4.2A 'nother point to note about the calculation of 9J*'+% which is the same as thecalculation of the profit figure for -)% is that interest is e%cl$ded fro( NOPATbeca$se interest costs are ta+en into acco$nt in t*e ca&ital c*arge.

4.21 E%a(&le F 1 EVA calc$lation

'n investment centre has reported operating profits of @21 million. +his was aftercharging @4 million for the development and launch costs of a new product that isexpected to generate profits for four #ears. +axation is paid at the rate of 2 per centof the operating profit.

+he compan# has a ris$ ad6usted weighted average cost of capital of 12 per cent perannum and is pa#ing interest at D per cent per annum on a substantial long term loan.

+he investment centres noncurrent asset value is @A million and the net currentassets have a value of @22 million. +he replacement cost of the noncurrent assets isestimated to be @"4 million.

Re3$ired-Calculate the investment centres EK' for the period.



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Sol$tion-

Calc$lation of NOPAT @mJperating profit 21'dd bac$ development costs 4Oess; one #ear


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negated b# the ad6ustments made to it in the EK' model.c0 N$(ber of ad:$st(ents needed to (eas$re EVA. ,a$ing the necessar#

ad6ustments can be problematic as sometimes a large n$(ber ofad:$st(entsare re7uired.

d0 Co(&arison of li+e ,it* li+e. )nvestment centres% which are larger in size%ma# have larger EK' figures for this reason. Allo,ance for relati.e si/emust be made when comparing the relative performance of investmentcentres.

. +ransfer *ricing

.1 +ransfer pricing is used when di.isions of an organisation need to c*arge ot*erdi.isions of t*e sa(e organisation for goods and ser.icesthe# provide to them. (orexample% subsidiar# ' might ma$e a component that is used as part of a product made

b# subsidiar# of the same compan#% but that can also be sold to the external mar$et%including ma$ers of rival products to subsidiar# s product. +here will therefore betwo sources of revenue for '.a0 External sales revenue from sales made to other organisations.b0 )nternal sales revenue from sales made to other responsibilit# centres within

the same organisation% valued at the transfer price.

.2 Transfer &ricing

+ransfer prices are a wa# of &ro(oting di.isional a$tono(y% ideall# withoutpre6udicing the (eas$re(ent of di.isional &erfor(ance or discouraging overallcorporate profit maximisation.

Transfer &rices should be set at a level which ens$res t*at &rofits for theorganisation as a whole are (a%i(ised.

.3 Criteria of a good transfer &ricing &olicy

+here are four specific criteria that a good transfer pricing polic# should have;a0 *rovide motivation for divisional managersb0 ,aintain divisional autonom# and independence

c0 'llow divisional performance to be assessed ob6ectivel#d0 Ensure the divisional managers ma$e decisions that are in the best interests of

the divisions and also of the compan# as a whole i.e. goal congruence% whichis most important among all0.

.4 General r$les

+he li(itswithin which transfer prices should fall are as follows.a0 +he (ini($(. +he sum of the suppl#ing division


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sa.ings in &ac+aging and deli.ery.

. +he minimum results from the fact that the suppl#ing division will not agree totransfer if the transfer price is less than the marginal cost H opportunit# cost of the

item transferred because if it were the division would incur a loss0.." +he maximum results from the fact that the receiving division will bu# the item at the

cheapest price possible.

.& E%a(&le

!ivision Q produces product O at a marginal cost per unit of @1AA. )f a unit istransferred internall# to division >% @2 contribution is foregone on an external sales.+he item can be purchased externall# for @1A.

+he minimum. !ivision Q will not agree to a transfer price of less than @1AA H

20 @12 per unit. +he maximum. !ivision > will not agree to a transfer price in excess of @1A.

+he difference between the two results @20 represents the savings from producinginternall# as opposed to bu#ing externall#.

.B +ransfer *ricing ,ethods

A# )ar+et9based a&&roac*

.B.1 )f an e%ternal (ar+et &rice e%istsfor transferred goods% profit centre managers willbe aware of the price the# could obtain or the price the# would have to pa# for theirgoods on the external mar$et% and the# would inevitabl# compare this price with thetransfer price.

.B.2 'dvantages;a0 !i.isional a$tono(y = )n a decentralised compan#% divisional managers

should have the autonom# to ma$e output% selling and bu#ing decisions whichappear to be in the best interests of the divisions performance. )f ever#division optimises its performance% the compan# as a whole must inevitabl#achieve optimal results.0

b0 Cor&orate &rofit (a%i(i/ation= )n most cases where the transfer price is at

mar$et price% internal transfers should be expected% because the b$yingdi.ision is li+ely to benefit fro( a better 3$ality of ser.ice7 greater

fle%ibility7 and de&endability of s$&&ly. Bot* di.isions ma# benefit fro(c*ea&er costs of ad(inistration7 selling and trans&ort. ' mar$et price as thetransfer price would therefore result in decisions which would be in the bestinterests of the compan# or group as a whole.

.B.3 !isadvantages;a0 +he (ar+et &rice (ay be a te(&orary one% induced b# adverse economic

conditions% or dumping% or the mar$et price might depend on the volume of

output supplied to the external mar$et b# the profit centre.b0 ' transfer price at mar$et value might% under some circumstances% act as a

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disincenti.e to $se $& any s&are ca&acity in t*e di.isions . ' price based onincremental cost% in contrast% might provide an incentive to use up the spareresources in order to provide a marginal contribution to profit.

c0 ,an# products do not *a.e an e3$i.alent (ar+et &rice so that the price of asimilar% but not identical% product might have to be chosen. )n suchcircumstances% the option to sell or bu# on the open mar$et does not reall#exist.

d0 +here might be an i(&erfect e%ternal (ar+etfor the transferred item% so thatif the transferring division tried to sell more externall#% it would have to reduceits selling price.

B# Cost9based a&&roac*

.B.4 Costbased approaches to transfer pricing are often used in practice% because inpractice the following conditions are common.

a0 +here is no e%ternal (ar+etfor the product that is being transferred.b0 'lternativel#% although there is an external mar$et it is an i(&erfect onebecause the mar$et price is affected b# such factors as the amount that thecompan# setting the transfer price supplies to it% or because there is onl# alimited external demand.

.B. !isadvantages;a0 )t can lead to bad decisions% for example% the# don


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)n some cases transfer prices are negotiated bet,een t*e (anagersof the suppl#ingand receiving divisions. )nformation about the mar$et prices and marginal or fullcosts often provide an input into these negotiations.

.B.D 'dvantages;a0 Encourage the management of the selling division to be (ore conscio$s of

cost control.b0 enefit the bu#ing division b# purchasing the product at a lo,er cost t*an

t*at of its co(&etitors.c0 *rovide the basis for a (ore realistic (eas$re of di.isional &erfor(ance

controllable b# the divisional mangers through negotiations..B.1A !isadvantages;

a0 +he agreed transfer price can depend on the negotiating s$ills and bargainingpower of the managers involved% the final outcome ma# not be close to being

o&ti(al.b0 +he# can lead to conflict between divisions and the resolution of suchconflicts ma# re7uire top management to mediate.

c0 +he# are ti(e9cons$(ing for the managers involved% particularl# where alarge number of transactions involved.

!# !$al9rate transfer &ricing

.B.11

!$al9rate transfer &ricing

)t uses t,o se&arate transfer &ricesfor suppl#ing division and receiving division.(or example% the suppl#ing division ma# receive the full cost plus a mar$up oneach transaction and the receiving division ma# be charged at the marginal cost ofthe transfers.


4$estion " 1 ROI and ot*er (eas$re(ents

*ace Compan# *C0 runs a large number of wholesale stores and is increasing the number ofthese stores all the time. )t measures the performance of each store on the basis of a target

return on investment -J)0 of 1?. tore managers get a bonus of 1A? of their salar# if theirstore 255 255F 255

ales @AAA0 2AA 2AA 1BA 1&AGross profit @AAA0 BA &A "3 1

9et profit @AAA0 13 14 1A B

9et assets at start of #ear @AAA0 1AA BA "A 4A



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+he mar$et in which *C operates has been growing steadil#. +#picall#% *C


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should be ta$en into consideration% offering to reduce the mar$up on costs to 1A? in thiscase. +he retail stores are unhapp# with the current pricing polic# arguing that it results in

prices that are often higher than comparable products available on the mar$et.

9ail has provided the following information to enable a price comparison to be made of thetwo possible pricing policies for one of its products.

Garden s*ears

teel; the shears have AT4$g of high 7ualit# steel in the final product. +he manufacturingprocess loses ? of all steel put in. teel costs @4%AAA per tonne 1 tonne 1%AAA$g0.

Jther materials; Jther materials are bought in and have a list price of @3 per $g althoughMammer secures a 1A? volume discount on all purchases. +he shears re7uire AT1$g of thesematerials.

+he labour time to produce shears is AT2 hours per unit and labour costs @1A per hour.

Kariable overheads are absorbed at the rate of 1A? of labour rates and fixed overheads areBA? of the variable overheads.

!eliver# is made b# an outsourced distributor that charges 9ail @ATA per garden shear fordeliver#.

Re3$ired-

a0 Calculate the price that 9ail would charge for the garden shears under the existingpolic# of variable cost plus 3A?. " mar$s0

b0 Calculate the increase or decrease in price if the pricing polic# switched to total costplus 1A?. 4 mar$s0

c0 !iscuss whether or not including fixed costs in a transfer price is a sensible polic#.4 mar$s0

d0 !iscuss whether the retail stores should be allowed to bu# in from outside suppliers ifthe prices are cheaper than those charged b# 9ail. " mar$s0

2A mar$s0'CC' ( *erformance ,anagement Uune 2A1A 540

4$estion ; 1 ROI and RIrace Co is split into two divisions% ' and % each with their own cost and revenue streams.Each of the divisions is managed b# a divisional manager who has the power to ma$e allinvestment decisions within the division. +he cost of capital for both divisions is 12?.Mistoricall#% investment decisions have been made b# calculating the return on investment-J)0 of an# opportunities and at present% the return on investment of each division is 1"?.

' new manager who has recentl# been appointed in division ' has argued that using residualincome -)0 to ma$e investment decisions would result in Sbetter goal congruence< throughoutthe compan#.

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Each division is currentl# considering the following separate investments;

*ro6ect for !ivision ' *ro6ect for !ivision Capital re7uired for investment @B2.B million @4A." millionales generated b# investment @44." million @21.B million

9et profit margin 2B? 33?

+he compan# is see$ing to maximise shareholder wealth.

Re3$ired-

Calculate both the return on investment and residual income of the new investment for each ofthe twodivisions. Comment on these results% ta$ing into consideration the manager


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Trans(erPricing

Methods

Need (or

Trans(er/ricing

Methods

Mar+et-!ased

Cost-!ased

F'll-cost

Varia!le cost

Negotiated/ricing

D'al-rate/ricing




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1. +he 9eed for +ransfer *ricing

1.1 +ransfer pricing is used when di.isions of an organisation need to c*arge ot*er

di.isions of t*e sa(e organisation for goods and ser.icesthe# provide to them. (orexample% subsidiar# ' might ma$e a component that is used as part of a product made

b# subsidiar# of the same compan#% but that can also be sold to the external mar$et%including ma$ers of rival products to subsidiar# s product. +here will therefore betwo sources of revenue for '.a0 External sales revenue from sales made to other organisations.b0 )nternal sales revenue from sales made to other responsibilit# centres within


1.2 Transfer &ricing



1.3 Criteria of a good transfer &ricing &olicy

+here are four specific criteria that a good transfer pricing polic# should have;

a0 *rovide motivation for divisional managersb0 ,aintain divisional autonom# and independencec0 'llow divisional performance to be assessed ob6ectivel#d0 Ensure the divisional managers ma$e decisions that are in the best interests of


1.4 General r$les !ec 56#



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1.& E%a(&le "


+he minimum. !ivision Q will not agree to a transfer price of less than @1AA H

20 @12 per unit. +he maximum. !ivision > will not agree to a transfer price in excess of @1A.


2. +ransfer *ricing ,ethods

2.1 ,ar$etbased approachJ$n "5#

2.1.1 )f an e%ternal (ar+et &rice e%istsfor transferred goods% profit centre managers willbe aware of the price the# could obtain or the price the# would have to pa# for theirgoods on the external mar$et% and the# would inevitabl# compare this price with thetransfer price.

2.1.2 Ad.antages-a0 !i.isional a$tono(y = )n a decentralised compan#% divisional managers


b0 Cor&orate &rofit (a%i(i/ation= )n most cases where the transfer price is atmar$et price% internal transfers should be expected% because the b$yingdi.ision is li+ely to benefit fro( a better 3$ality of ser.ice7 greater


2.1.3 !isad.antages-

a0 +he (ar+et &rice (ay be a te(&orary one% induced b# adverse economicconditions% or dumping% or the mar$et price might depend on the volume ofoutput supplied to the external mar$et b# the profit centre.

b0 ' transfer price at mar$et value might% under some circumstances% act as adisincenti.e to $se $& any s&are ca&acity in t*e di.isions . ' price based onincremental cost% in contrast% might provide an incentive to use up the spareresources in order to provide a marginal contribution to profit.


d0 +here might be an i(&erfect e%ternal (ar+etfor the transferred item% so thatif the transferring division tried to sell more externall#% it would have to reduce

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its selling price.

2.2 Costbased approach

2.2.1 Costbased approaches to transfer pricing are often used in practice% because inpractice the following conditions are common.a0 +here is no e%ternal (ar+etfor the product that is being transferred.b0 'lternativel#% although there is an external mar$et it is an i(&erfect one

because the mar$et price is affected b# such factors as the amount that thecompan# setting the transfer price supplies to it% or because there is onl# alimited external demand.

2.2.2 !isad.antages-a0 )t can lead to bad decisions% for example% the# don


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controllable b# the divisional mangers through negotiations.2.3.3 !isad.antages-

a0 +he agreed transfer price can depend on the negotiating s$ills and bargainingpower of the managers involved% the final outcome ma# not be close to beingo&ti(al.

b0 +he# can lead to conflict between divisions and the resolution of suchconflicts ma# re7uire top management to mediate.


2.4 !ualrate transfer pricing

2.4.1 !$al9rate transfer &ricing

)t uses t,o se&arate transfer &ricesfor suppl#ing division and receiving division.(or example% the suppl#ing division ma# receive the full cost plus a mar$up on eachtransaction and the receiving division ma# be charged at the marginal cost of thetransfers.


4$estion " 1 !eter(ination of t*e range of transfer &rice and disad.antages of cost9

based and (ar+et9based transfer &ricing (et*ods

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MP)''+ *E *aper )) ,anagement 'ccounting Uune 2AA 540

4$estion 2



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MP)''+ *E *aper )) ,anagement 'ccounting !ecember 2AA" 510

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4$estion ;

MP)''+ *E *aper )) ,anagement 'ccounting Uune 2AAB 540



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4$estion 8

MP)''+ *E *aper )) ,anagement 'ccounting !ecember 2AA2 540

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4$estion >

MP)''+ *E *aper )) ,anagement 'ccounting Uune 2AA3 510

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!i.isional Perfor(ance )eas$res

1. Jb6ectives

1.1 Inderstand the concepts of responsibilities centres in an organization.1.2 'dvantages and disadvantages of decentralization in a sizable organization.1.3 Explain how to evaluate the performance of the various responsibilities centres.1.4 Inderstand the use of return on investment -J)0% residual income -)0 and economic

value added EK'0.1. Inderstand how transfer pricing methods affect the performance of independent units.1." Explain the different transfer pricing methods.

1.& !etermine the optimal transfer price between the selling division and bu#ing division.

' d v a n t a g e s

a n d


C e n t r a l i z a t i o n

a n d

! e c e n t r a l i z a t i o n

1 . C o s t c e n t r e

2 . - e v e n u e c e n t r e

3 . * r o f i t c e n t r e

4 . ) n v e s t m e n t c e n t r e

- e s p o n s i b i l i t #

C e n t r e s

' d v a n t a g e s

a n d


1 . - J )

2 . - )

3 . E K '

( i n a n c i a l


, e a s u r e s

1 . , a r $ e t b a s e d

2 . C o s t b a s e d

a . ( u l l c o s t N

b . K a r i a b l e c o s t

3 . 9 e g o t i a t e d

* r i c i n g

4 . ! u a l r a t e

* r i c i n g

+ r a n s f e r

* r i c i n g

, e t h o d s

! i v i s i o n a l


, e a s u r e s



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2. Centralization and !ecentralization

2.1 !efinitionsa0 Centrali/ed organi/ation is an organization in which to& (anage(ent

(a+es (ost decisions and control most activities from the centralhead7uarters.

b0 !ecentrali/ationis defined as delegating a$t*ority to (a+e decisions.

)n general% a divisional structure will lead to decentralization of the decisionma$ing process and divisional managers ma# have the freedo(to set selling

prices% choose suppliers% ma$e product mix and output decisions and so on.

2.2 Ad.antages of decentrali/ation

a0 Si/e= the process of decentralization brea+san organization up into (ore(anageable $nits% this enables decision9(a+ing to proceed 3$ic+ly andeffecti.elyand% in theor#% a closer controlto be maintained on the da# to da#running of a business


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3. Concepts of -esponsibilit# Centres

3.1 9owada#s% most sizable organizations are decentralizing as their operations are gettingmore complex while the# have operations globall#. Geographical and complicatedoperations ma$e management more difficult to control and thus managers of businessunits are responsible for a range of decisions considered b# the head office.

3.2 !efinitions

a0 Cost centre = a production or service location% function% activit# or iteme7uipment whose costs ma# be attributed to cost units% e.g. pac$agingdepartment% administration department% etc.

b0 Re.en$e centre = is a centre devoted to raising re.en$e with no

responsibilit# for production% e.g. sales and mar$eting departments.c0 Profit centre= is a part of business acco$ntable for costs and re.en$e. )t

also calls a business centre% business unit or strategic business unit. *rofitcentre operating revenue is mainl# from sales to external sales and internaltransfer to other divisions% e.g. wholesale division and the retail division.

d0 In.est(ent centre is the responsibilit# center within an organization thathas control o.er re.en$e7 cost7 and in.est(ent f$nds% e.g. subsidiar#.

3.3 +he following table shows the principal performance measures for each centre;

Ty&es ofres&onsibility

)anager *as control o.er Princi&al &erfor(ance(eas$res

Cost centre Controllable costs Kariance anal#sisEfficienc# measures

-evenue centre -evenues onl# -evenues

*rofit centre Controllable costsales prices including transfer price0

*rofit

)nvestment centre Controllable costsales prices including transfer price0Jutput volumes)nvestment

-eturn on investment-esidual incomeJther financial ratios

4. (inancial *erformance ,easures of )nvestment Centre

A# Ret$rn on in.est(ent ROI#

4.1 ROI

ROIshows how much profit has been made in relation to the amount of capitalinvested and is calculated as profit/capital emplo#ed0 x 1AA?.



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4.2 E%a(&le "

uppose that a compan# has two investment centres ' and % which show results forthe #ear as follows.

'

@ @*rofit "A%AAA 3A%AAA

Capital emplo#ed 4AA%AAA 12A%AAA

-J) 1? 2?

)nvestment centre ' has made double the profits of investment centre % and in termsof profits alone has therefore been more successful. Mowever% has achieved its

profits with a much lower capital investment% and so has earned a much higher -J).+his suggests that has been a more successful investment than '.

4.3 +here is no generall# agreed method of calculating -J) and it can lead to

d#sfunctional decision ma$ing when used as a guide to investment decisions. )tfocuses attention on shortrun performance whereas investment decisions should beevaluated over their full life.

a0 *rofit after depreciation as a ? of net assets emplo#ed

4.4 +his is probabl# the most common method% but it does present a problem. )f aninvestment centre maintains the same annual profit% and $eeps the same assets withouta polic# of regular replacement of noncurrent assets% its -J) will increase #ear b##ear as the assets get older. +his can gi.e a false i(&ression of i(&ro.ing&erfor(ance o.er ti(e.

4. E%a(&le 2

(or example% the results of investment centre Q% with a polic# of straightlinedepreciation of assets over a #ear period% might be as follows.

>ear 1 >ear 2 >ear 3

*rofit before depreciation 4%AAA 4%AAA 4%AAA

!epreciation 1%AAA0 1%AAA0 1%AAA0

9et profit 3%AAA 3%AAA 3%AAA

9K = E7uipment %AAA 4%AAA 3%AAA-J) "A? &? 1AA?

+his table of figures is intended to show that an investment centre can i(&ro.e itsROI#ear b# #ear% simpl# by allo,ing its non9c$rrent assets to de&reciate% andthere could be a disincenti.eto investment centre managers to rein.est in ne, orre&lace(ent assets% because the centres -J) would probabl# fall.

4." E%a(&le ;

' further disadvantage of measuring -J) as profit divided b# net assets is that% forsimilar reasons% it is not eas# to compare fairl# the performance of investment

centres.

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(or example% suppose that we have two investment centres.

@ @ @ @:or$ing capital 2A%AAA 2A%AAA

9oncurrent assets at cost 23A%AAA 23A%AAA'ccumulated depreciation 1&A%AAA 1A%AAA

9K "A%AAA 22A%AAA

Capital emplo#ed BA%AAA 24A%AAA

*rofit 24%AAA 24%AAA-J) 3A? 1A?

)nvestment centres * and 5 have the same amount of wor$ing capital% the same value

of noncurrent assets at cost% and the same profit. ut *s noncurrent assets havebeen depreciated b# a much bigger amount presumabl# *s noncurrent assets aremuch older than 5s0 and so *s -J) is three times the size of 5s -J). +heconclusion might therefore be that * has performed much better than 5. +hiscomparison% however% would not be fair% because the difference in performancemight be entirel# attributable to the age of their noncurrent assets.

4.& +hearg$(ents for $sing net boo+ .al$esfor calculating -J)a0 )t is the nor(ally acce&ted method of calculating -J).b0 Jrganisations are contin$ally b$ying ne, non9c$rrent assets to re&laceold

ones that wear out% and so on the whole% the total net boo+ .al$eof all non

current assets together will re(ain fairly constantassuming nil inflation andnil growth0.

b0 *rofit after depreciation as a ? of gross assets emplo#ed

4.B )nstead of measuring -J) as return on net assets% we could measure it as return ongross assets i.e. before depreciation. +his would re(o.e t*e &roble( of ROIincreasing o.er ti(e as non9c$rrent assets get older

4.D E%a(&le 8

)f a compan# ac7uired a noncurrent asset costing @4A%AAA% which it intends todepreciate b# @1A%AAA pa for 4 #ears% and if the asset earns a profit of @B%AAA pa afterdepreciation% -J) might be calculated on net boo$ values or gross values% as follows.

>ear *rofit 9Kmid#ear

value0

-J) basedon 9K

Grossvalue

-J) basedon gross

value@ @ @

1 B%AAA 3%AAA 22.D? 4A%AAA 2A?2 B%AAA 2%AAA 32.A? 4A%AAA 2A?3 B%AAA 1%AAA 3.3? 4A%AAA 2A?4 B%AAA %AAA 1"A.A? 4A%AAA 2A?

+he -J) based on net boo$ value shows an increasing trend over time% simpl#

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because the assets value is falling as it is depreciated. +he -J) based on gross boo$value suggests that the asset has performed consistentl# in each of the four #ears%which is probabl# a more valid conclusion.

4.1A Ad.antages of ROI

a0 's a relati.e (eas$re% it enables co(&arisonsto be made with divisions orcompanies of different si/e.

b0 )t is used externall# and is ,ell $nderstood by $sersof accounts.c0 -J) forces (anagers to (a+e good $se of e%isting ca&ital reso$rcesand

focuses attention on them% particularl# when funds for further investment arelimited.

4.11 !isad.antages of ROI

a0 !isincenti.e to in.est= +he most conventional depreciation methods willresult in -J) improving with the age of an asset% this might encouragedivisions hanging on to old assets and again deter them from investing in newones.

b0 S$b:ect to (ani&$lation= +he calculation of -eturn on )nvestment can beeasily (odified based on the anal#sis ob6ective. )t depends on what weinclude in revenues and costs.

c0 Lac+ of goal congr$ence= for example% it is possible that divisional -J) canbe increased b# actions that will ma$e the compan# as a whole worse off andconversel#% actions that decrease the divisional -J) ma# ma$e the compan#as a whole better off.

d0 Not s$itable for in.est(ent decisions= it might be affected b# the effectthe# would have on the division 1 Lac+ of goal congr$ence

!ivision Q !ivision >

)nvestment pro6ect available @1A million @1A millionControllable contribution @2 million @1.3 million-eturn on the proposed pro6ect 2A? 13?-J) of divisions at present 2? D?

)t is assumed that neither pro6ect will result in an# changes in noncontrollable costsand that the overall cost of capital for the compan# is 1?. +he manager of divisionQ would be reluctant to invest the additional @1A million because the pro6ect would wish to invest the @1A million because the return on the proposed

pro6ect of 13? is in excess of the present return of D?. Conse7uentl#% the managersof both divisions would ma$e decisions that would not be in the best interests of thecompan#.

B# Resid$al Inco(e RI#



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4.13 RI

RI is a (eas$re of t*e centres &rofits after ded$cting a notional or i(&$ted

interest cost or cost of ca&ital c*arge=

a0 +he centre


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EK' is an alternati.e absol$te &erfor(ance (eas$re. )t is similar to -) and iscalculated as follows;

EK' net operating profit after tax 9J*'+0 less capital charge

Capital charge :'CC x net assets

4.1B Economic value added EK'R0 is a registered trade mar$ owned b# tern tewart NCo. )t is a specific t#pe of residual income -)0. Mowever% there are differences asfollows;a0 +he profit figures are calculated differentl#. EK' is based on an econo(ic

&rofitwhich is derived b# (a+ing a series of ad:$st(ents to t*e acco$nting&rofit.

b0 +he notional capital charges use different bases for net assets. +here&lace(ent cost of net assets is $s$ally $sedin the calculation of EK'.

4.1D +here are also differences in the wa# that 9J*'+ is calculated compared with theprofit figure that is used for -)% as follows;a0 Costs which would normall# be treated as expenses% but which are considered

within an EK' calculation as in.est(ents b$ilding for t*e f$t$re% are addedbac$ to 9J*'+ to derive a figure for economic profit. T*ese costs areincl$ded instead as assets in the figure for net assets emplo#ed% ie asinvestments for the future. Costs treated in this wa# include items such asgood,ill7 researc* and de.elo&(ent e%&endit$re and ad.ertising costs.

b0 'd6ustments are sometimes made to the depreciation charge% whereb#accounting depreciation is added bac$ to the profit figures% and econo(icde&reciationis subtracted instead to arrive at 9J*'+. Economic depreciation

is a c*arge for t*e fall in asset .al$e d$e to ,ear and tear or obsolescence.c0 'n# lease c*arges are e%cl$ded fro( NOPAT and added in as a &art of

ca&ital e(&loyed.4.2A 'nother point to note about the calculation of 9J*'+% which is the same as the

calculation of the profit figure for -)% is that interest is e%cl$ded fro( NOPATbeca$se interest costs are ta+en into acco$nt in t*e ca&ital c*arge.

4.21 E%a(&le F 1 EVA calc$lation

'n investment centre has reported operating profits of @21 million. +his was aftercharging @4 million for the development and launch costs of a new product that is

expected to generate profits for four #ears. +axation is paid at the rate of 2 per centof the operating profit.

+he compan# has a ris$ ad6usted weighted average cost of capital of 12 per cent perannum and is pa#ing interest at D per cent per annum on a substantial long term loan.

+he investment centres noncurrent asset value is @A million and the net currentassets have a value of @22 million. +he replacement cost of the noncurrent assets isestimated to be @"4 million.

-e7uired;Calculate the investment centres EK' for the period.



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olution;Calculation of 9J*'+ @mJperating profit 21'dd bac$ development costs 4Oess; one #ear


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accounting policies on the starting profit figure ma# not be completel#negated b# the ad6ustments made to it in the EK' model.

c0 N$(ber of ad:$st(ents needed to (eas$re EVA. ,a$ing the necessar#ad6ustments can be problematic as sometimes a large n$(ber of

ad:$st(entsare re7uired.d0 Co(&arison of li+e ,it* li+e. )nvestment centres% which are larger in size%

ma# have larger EK' figures for this reason. Allo,ance for relati.e si/emust be made when comparing the relative performance of investmentcentres.

. +ransfer *ricing

.1 +ransfer pricing is used when di.isions of an organisation need to c*arge ot*erdi.isions of t*e sa(e organisation for goods and ser.icesthe# provide to them. (or

example% subsidiar# ' might ma$e a component that is used as part of a product madeb# subsidiar# of the same compan#% but that can also be sold to the external mar$et%including ma$ers of rival products to subsidiar# s product. +here will therefore betwo sources of revenue for '.a0 External sales revenue from sales made to other organisations.b0 )nternal sales revenue from sales made to other responsibilit# centres within


.2 Transfer &ricing



.3 Criteria of a good transfer &ricing &olicy

+here are four specific criteria that a good transfer pricing polic# should have;a0 *rovide motivation for divisional managers

b0 ,aintain divisional autonom# and independencec0 'llow divisional performance to be assessed ob6ectivel#d0 Ensure the divisional managers ma$e decisions that are in the best interests of


.4 General r$les



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could &$rc*ase the goods or services e%ternally% less an# internal costsa.ings in &ac+aging and deli.ery.

. +he minimum results from the fact that the suppl#ing division will not agree to

transfer if the transfer price is less than the marginal cost H opportunit# cost of theitem transferred because if it were the division would incur a loss0.

." +he maximum results from the fact that the receiving division will bu# the item at thecheapest price possible.

.& E%a(&le


+he minimum. !ivision Q will not agree to a transfer price of less than @1AA H20 @12 per unit. +he maximum. !ivision > will not agree to a transfer price in excess of @1A.


>= Transfer Pricing )et*ods

A# )ar+et9based a&&roac*

.B.1 )f an e%ternal (ar+et &rice e%istsfor transferred goods% profit centre managers willbe aware of the price the# could obtain or the price the# would have to pa# for theirgoods on the external mar$et% and the# would inevitabl# compare this price with thetransfer price.

.B.2 'dvantages;a0 !i.isional a$tono(y = )n a decentralised compan#% divisional managers


b0 Cor&orate &rofit (a%i(i/ation= )n most cases where the transfer price is atmar$et price% internal transfers should be expected% because the b$yingdi.ision is li+ely to benefit fro( a better 3$ality of ser.ice7 greater


.B.3 !isadvantages;a0 +he (ar+et &rice (ay be a te(&orary one% induced b# adverse economic

conditions% or dumping% or the mar$et price might depend on the volume of

output supplied to the external mar$et b# the profit centre.b0 ' transfer price at mar$et value might% under some circumstances% act as a



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disincenti.e to $se $& any s&are ca&acity in t*e di.isions . ' price based onincremental cost% in contrast% might provide an incentive to use up the spareresources in order to provide a marginal contribution to profit.


d0 +here might be an i(&erfect e%ternal (ar+etfor the transferred item% so thatif the transferring division tried to sell more externall#% it would have to reduceits selling price.

B# Cost9based a&&roac*

.B.4 Costbased approaches to transfer pricing are often used in practice% because inpractice the following conditions are common.

a0 +here is no e%ternal (ar+etfor the product that is being transferred.b0 'lternativel#% although there is an external mar$et it is an i(&erfect onebecause the mar$et price is affected b# such factors as the amount that thecompan# setting the transfer price supplies to it% or because there is onl# alimited external demand.

.B. !isadvantages;a0 )t can lead to bad decisions% for example% the# don


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)n some cases transfer prices are negotiated bet,een t*e (anagersof the suppl#ingand receiving divisions. )nformation about the mar$et prices and marginal or fullcosts often provide an input into these negotiations.

.B.D 'dvantages;a0 Encourage the management of the selling division to be (ore conscio$s of

cost control.b0 enefit the bu#ing division b# purchasing the product at a lo,er cost t*an


controllable b# the divisional mangers through negotiations..B.1A !isadvantages;

a0 +he agreed transfer price can depend on the negotiating s$ills and bargainingpower of the managers involved% the final outcome ma# not be close to being

o&ti(al.b0 +he# can lead to conflict between divisions and the resolution of suchconflicts ma# re7uire top management to mediate.


!# !$al9rate transfer &ricing

.B.11

!$al9rate transfer &ricing

)t uses t,o se&arate transfer &ricesfor suppl#ing division and receiving division.(or example% the suppl#ing division ma# receive the full cost plus a mar$up oneach transaction and the receiving division ma# be charged at the marginal cost ofthe transfers.

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