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Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 1
Performance
Indicators and
Measures for
Organisational Units
Part A
Suggested References
When you are studying this topic we suggest the following references.
Primary Reference
Garrison, R.H. Noreen, E., and Brewer P. C., Managerial Accounting (2006), 11th edition,
Chapters 10 and 12.
Supplementary References
Anthony, R.N. and Govindarajan, V., Management Control Systems, 12th edition, Chapters 6, 7
& 10.
Atkinson, A.A., Kaplan, R.S., Matsumura, E.M. and Young, S.M., Management Accounting, 5th
edition, Chapter 10.
Chan, Agnes; Cheung, Patrick; and Kwong, Patrick. “Taxing inter-company transactions” A Plus
(HKICPA), January 2010.
Feinschreiber, R. (Ed.), Transfer Pricing Handbook, 3rd edition.
Horngren, C.T., Datar, S.M., Foster, G., Ittner, C. and Rajan, M. Cost Accounting – A Managerial
Emphasis, 13th edition (2008), Chapters 7, 8, 22 and 23.
Kaplan, R.S. and Atkinson, A.A., Advanced Management Accounting, 3rd edition, Chapters 7 & 9.
Tang, R., Transfer Pricing Systems Management: Practical Issues and Cases, (IMA, 2001).
Bibliographic Journal References
Abdel-khalik, A.R. and Lusk, E. “Transfer pricing – A Synthesis” The Accounting Review, January
1974.
Hirshleifer, J. “On the Economics of Transfer pricing”, Journal of Business, July 1956.
Levey, M. “Transfer Pricing – What Next?”, International Financial Law Review”, June 2001.
Pass, C. “Transfer Pricing in Multinational Companies” Management Accounting, Sept. 1994.
Tang, R. “Transfer Pricing in the 1990s”, Management Accounting, February 1992.Tseng, Steven.
“Transfer Pricing in China”, A Plus, October 2006.
Section
8
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 2
Part B
Topic Learning Outcomes
On completion of this module, you should be able to:
i) Design appropriate performance measurement systems for different levels within the organisation, including cost centres, profit centres and investment centres.
ii) Identify and explain the respective advantages and limitations of common financial performance measures, such as residual income (RI), return on investment (ROI) and also non-financial measures.
iii) Apply the different transfer pricing methods.
Performance indicators and measures for organisational units:
• Nature of organisational units
• Performance measures – design and types
• Transfer pricing
• Budget analysis
iv) Analyse budgets prepared for:
1 cost centres,
2 investment centres and
3 profit centres, and make appropriate recommendations.
You may choose to complete this topic in a step-by-step way or skip ahead, depending on your
knowledge and assessment of your own competency in relation to the above Learning Outcomes.
Part C
Contents of this Section
8.1 Introduction ........................................................................................................................2 8.2 Nature of organisational units ............................................................................................3 8.3 Performance measures – design and types ......................................................................7 8.4 Transfer pricing ................................................................................................................13 8.5 Budget analysis................................................................................................................22
8.1 Introduction
Performance measures are a key component of a management control system. Financial
performance measures provide quantitative targets and enable both the organisation and its
managers to evaluate achievement relative to a budget. They also enable comparisons between
parts of the company. To the extent that these performance measures are regarded as being
representative of the performance of the individual manager, they will contribute to overall control
of the organisation. They will encourage individual managers to align their behaviour with the
aims of the organisation. This is called goal congruence because the goals of the individual and
the organisation are aligned or congruent.
8.1.1 Organisational Levels
Performance measures are used at different levels within the organisation. For example, they
may be related to corporate, strategic business units, responsibility centres, and individual
manager levels.
With any type of performance measure, it is necessary to determine which type of user the
measure is for. Are we preparing a performance measure for top management, divisional
management or supervisors in charge of small work teams? Are we preparing it for external
users such as shareholders or lenders? It is important to determine this at the outset, because
the measures differ for different types of users.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 3
8.1.2 Types of Performance Measure
There are also different types of performance measures, which vary across organisational levels.
In this regard, distinctions can be made between:
• financial and non-financial measures; and
• controllable and non-controllable variables.
By controllable we mean the ability of an individual or organisational unit to influence the value of
a variable. For example, evaluating a shoe store based on total shoe sales profit is not basing
the evaluation on controllable factors if the shoe prices are set by head office. Giving the shoe
store the power to set its prices means it exercises more control over its profit and the
performance measures are fairer and more accurate.
8.1.3 Structure of this Section
In this section we consider performance measurement for business units within any organisation.
In “8.2 Nature of organisations units” (page 3), we consider the different types of organisational
unit, in particular profit-seeking entities.
In “8.3 Performance measures - design and types” (page 7), we consider the performance
measures appropriate to the circumstances in each type of organisational unit, and when to
apply them.
In “8.4 Transfer pricing” (page 13), we cover the different methods of transfer pricing and
consider their respective strengths and weaknesses (application of those methods can have
serious pricing and behavioural consequences).
In “8.5 Budget analysis” (page 22), we consider variance calculation and how to analyse
variances. We also consider using budgets as performance evaluation tools for organisational
units.
8.2 Nature of Organisational Units
8.2.1 Types of Organisation
The structure of an organisation evolves as its goals, technology and employees change. Ideally,
it should be one that most effectively utilises the organization’s resources. As an organisation
grows, its structure normally progresses from highly centralised to highly decentralised. The
degree of centralisation is the extent to which authority, responsibility and decision making
capability is retained by or released from top management and delegated to lower levels of
management. In a centralised organisation, top management makes most decisions and
controls most activities from the organization’s central headquarters. In a decentralised
organisation, top management grants subordinate managers a degree of autonomy and
independence in making decisions for their organisational units.
8.2.2 Why Have Business Units?
Today many organizations are decentralising because their operations are becoming more
complex and they are establishing operations overseas. Complexity and geography make
operations more difficult to control. The solution is to decentralise and make managers of
business units responsible for a range of decisions previously considered by the head office.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 4
8.2.3 Types of Decentralised Structures
Anthony and Govindarajan identify three types of organizations:
• functional
• business unit or divisionalised
• matrix.
i) Functional
Business units are segregated by such functions as research and development,
sales and marketing, finance and administration, and production. With the
exception of sales and marketing, these business units usually operate as cost
centres, as outlined in 8.2.6.
ii) Divisional
Business units are segregated by geographic region. Usually they operate as
either investment or profit centres, as outlined in 8.2.8 and 8.2.9.
iii) Matrix
In a matrix organisational structure, business units have dual responsibilities.
The manager of a particular function, such as a marketing manager, may be
jointly responsible for various projects along with (say) a production manager.
The Continuum Concept:
The continuum concept illustrates the centralised versus decentralised structure because there
are many degrees of centralisation/ decentralisation.
Divisionalised Organisational Structure as a Continuum
Centralised Decentralised
I---------------------------------------------------------------------------------I
A fully centralised organisation would be one where ALL decisions, even the most trivial, are
made by top management, and no decisions are made at lower levels in the organisation.
Conversely, a fully decentralised organisation would be one in which NO decisions are made by
top management, and all decisions, even the most important strategic ones, are made at lower
levels in the firm.
Clearly neither of those extremes is found in practice. However, some firms tend to be towards
the centralised end of the continuum, some towards the decentralised end, and some towards
the middle.
In latter years more decentralised structures have become popular, but even in companies that
are highly decentralised, top management assumes responsibility for strategic planning and
management and for personnel decisions in respect of senior staff.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 5
8.2.4 Advantages of Decentralisation
• Creates greater responsiveness to local needs because the management team
is “at the coal face”.
For example, a fast food chain with a head office in Canada sets up operations
in Hong Kong. Management decisions continue to be made from the Canadian
head office. A strategic goal of the fast food chain is to standardise products.
Senior managers are puzzled as to why the MMQ chicken pieces with potatoes
pack does not sell nearly as well in Hong Kong as it does in Canada, North
America and Europe. They decide to decentralise the Hong Kong operation so
that regional management has responsibility for product and pricing decisions.
This results in significant increases in sales because regional management
changes the pack to “MMQ chicken pieces with rice”.
• Leads to gains from faster decision making. Decentralisation speeds decision
making, creating a competitive advantage over centralised organisations.
• Motivation and job satisfaction may be improved because divisional managers feel
that they are running their own business.
• Improves training by delegating more responsibility to divisional managers.
• Removes some operational control responsibility from top management, which
can concentrate on strategic issues.
After organizations make the decision to decentralise, they need some way of
controlling and measuring the performance of the divisions. The issues to
consider when designing these measures are discussed when we look at
transfer pricing.
8.2.5 Disadvantages of Decentralisation
• Behaviour may not be congruent with the strategic goals of the organisation (this
is also called dysfunctional decision making). In the fast food chain case sales
increase but the strategic goal of standardised products is not met.
Management may feel that it is more important to increase sales than to adhere
rigidly to organisational policy.
• Can result in competition among divisions. Some competition is healthy, but too
much may be destructive.
• Often, decentralised units duplicate functions (e.g. marketing, accounting and
payroll) and this can lead to increased costs for the organisation.
• Top management loses some control.
8.2.6 Cost Centre
A cost centre is any department, division or unit of an organisation in which the manager is
accountable for costs only. Examples include personnel, research and development and
production departments. Cost centre managers are responsible for total costs allocated to their
departments. For personnel departments, this is likely to include wages and training for
personnel staff, legal advice, contract preparation, external counselling for employees and so on.
8.2.7 Revenue Centre
A revenue centre is any department, division or unit at an organisation where the manager is
accountable for revenue only. Sales and marketing departments are often treated as revenue
centres, and their managers are evaluated by their ability to generate sales revenue.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 6
8.2.8 Profit Centre
A profit centre is any department, division or unit of an organisation where the manager is
accountable for revenues and costs. Profit centre managers are responsible for the profit of their
divisions.
Profit centre operating revenues can be from two sources:
• sales to external parties (external sales); or
• sales to other divisions (internal transfers).
We will discuss internal transfers in the transfer pricing section.
8.2.9 Investment Centre
An investment centre is any department, division or unit of an organisation in which the manager
is accountable for revenues, costs and the investment in the unit. Investment centre managers
are responsible for earning an adequate return on the capital employed in their investment
centres.
Example 1: Organisational Units
Responsibility for Costs
Responsibility for Revenues?
Responsibility for Investment Funds?
Cost centre Yes No No
Revenue centre No Yes No
Profit centre Yes Yes No
Investment centre Yes Yes Yes
Required
What are the main types of performance measures you would expect for each of these types?
Suggested Solution
Example 1: Organisational Units
Main types of performance measures
Cost centre Variance analysis (on costs)
Revenue centre Variance analysis (on revenues)
Profit centre Variance analysis (on revenues and costs)
Investment centre Residual income, ROI, other ratios
8.2.10 How Do We Know When to Decentralise?
The following questions help us decide whether to decentralise and, if we do, what sort of centre
we should set up. Of the division in question we should ask:
• Can we measure the output?
• Can we observe the output quality?
• Do the proposed divisional managers have the required expertise? For example, can
the Divisional Manager choose between competing capital projects? Can he/she identify
the capital equipment and other resources required? Does he/she know how to identify
the potential investment opportunities?
• Does the proposed manager know how to determine the optimal product mix?
• Does the proposed manager know how to set prices, etc?
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 7
8.3 Performance Measures – Design and Types
In this section we consider the design of performance measurement systems and the main types
of performance measures.
Performance measurement design is too broad an area to cover comprehensively in this section,
so we will deal with the basics and try to provide a general understanding. Similarly, there are
many types of performance measures and it is not possible to list them all. Instead, we will
discuss the types that are most applicable to organisational units. Section 9 will cover
performance measures for the whole organisation.
8.3.1 Design of Performance Measures
There are different aspects of organisational performance and the identification of key
performance indicators (KPIs) recognises that some are more important than others. A set of
key performance indicators represents the areas of organisational performance that
management considers as critical for the current and future success of the business.
There is no standard set of indicators appropriate for use in every organisation. There are
general guidelines, however, to assist management in developing key performance indicators.
Commentators suggested that indicators should be:
• aligned to the organization’s strategic goals/mission;
• measurable;
• controllable;
• relevant; and
• few in number.
The following practical process may be followed when determining indicators.
1. Determine Corporate Goals
These should have a clear link to:
• implementation of corporate strategy; and
• shareholders’ needs.
2. Identify Critical Success Factors (CSFs)
CSFs are key actions that must be performed to yield the highest probability of success, i.e. the
key results that determine success or failure. These directly impact upon the achievement of
strategies and goals.
3. Decide on Output Measures
Output performance measures must be determined by balancing the quality, time, and costliness
of the measures. These may be financial or non-financial.
4. Identify Key Activities
The organisation must analyse and determine the steps critical to the product, process, service
or practice. This may be achieved by asking operating managers what they really look at when
making decisions.
5. Decide Process Measures
Process measures are developed for key activities and feedback on these measures is obtained
from the operating managers.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 8
6. Implementation
At the implementation phase, a vital step is determining the reporting format for the measure.
This includes deciding the report’s format, accessibility, frequency and distribution.
7. Review
The process is ongoing and corrections are made to the measures as needed.
Note: To be an effective tool in the organisation’s overall control and performance evaluation
system, indicators must be well understood and accepted by both management and
employees. Failure to achieve this will likely result in dysfunctional behaviour by
participants.
8. Motivational and Behavioural Factors
Over the last four decades, accounting researchers have systematically examined the
behavioural effects of budgetary control systems. Much of this research has focused on the role
of supervisory style as it relates to the use of budget data for performance evaluation. Typically,
these studies have examined the effect of using budgetary control systems on a number of
dependent variables, including job related tension, interpersonal relations, motivation and
aspiration, dysfunctional behaviour, and performance.
Early studies indicated that managers were responding dysfunctionally to the way supervisors
used budgetary information to evaluate performance. The objective in designing a performance
evaluation system is to encourage behaviour congruent with the organisation’s objectives and
goals, but this will only occur if the organisation’s and the employee’s goals are aligned.
Inappropriate use of accounting information to evaluate performance may encourage
dysfunctional behaviour and harm the organisation because the employee’s goals (with their
attendant self-interested behaviour) are not congruent with those of the organisation. As a rule
of thumb, managers should participate in setting budget targets by which they will be evaluated
and should not be held accountable for performance indicators over which they have no control.
8.3.2 Types of Performance Measures
a) Cost Centres
A cost centre’s output must be measurable and the quality of its output observable. Consider the
following case.
A repair department in a large motor vehicle dealership operates as a cost centre. The
Manager’s evaluation is based on performance against the estimated standard cost of pre-
specified types of repairs. The Manager meets budget because he uses the cheapest parts and
cheapest labour, as a result of which repairs do not last very long. He does not see this as a
problem, because the repairs usually last at least to the end of the warranty period. However,
customer dissatisfaction by word-of-mouth is slowly decreasing the goodwill of the dealership.
Sales have begun to fall and the business is losing market share.
The problem here is that quality is not considered to be a critical success factor of the cost centre.
The situation could be resolved by also measuring the number of customer complaints or the
number of returned repaired vehicles as a proportion of total vehicles repaired.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 9
b) Profit and Investment Centres
Profitability measures return on investment (ROI) or return on assets (ROA):
The following tree diagram (“Du Pont Formula” Chart) illustrates the ROI/ROA calculation. Its
inherent strength is that it includes both of the main reports for an organisation: resource use
(Profit and Loss Account) and resource level (Balance Sheet).
“Du Pont Formula” Chart
The assumption is that sub-unit managers evaluated by ROI will be motivated to invest in new
projects only if the new project increases overall sub-unit ROI. This assumption is applicable both
to long term projects and short term projects.
The Du Pont1 formula chart highlights that the ROI comprises two main parts:
• The operating profit relationship with sales (profit margin)
• How assets were used in generating sales (asset turnover)
The Du Pont analysis is useful because it shows that a change in ROI can be attributed to one or
both of these parts. The profit margin shows how much profit is made (on average) for each
dollar of sales. The asset turnover shows how many dollars of sales each dollar of assets
generates.
However there are some accounting issues to be addressed in measuring ROI. The two major
components of ROI are profit (the numerator) and investment (the denominator).
1 It is called “Du Pont” because the technique was developed in the early 20th Century by the Du Pont organisation to
measure and analyse its own performance.
Profit/investment
(ROI or ROA)
Profit/sales(profit margin)
Sales/total investment(asset turnover)
Non-currentassets
Operatingexpenses
Currentassets
Further sub-analyses:
• Administration costs/sales
• Production costs/sales etc.
Further sub-analyses
• Debtors turnover
• Stock turnover etc.
+Sales
-
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 10
Issues in Measuring Profit
• The measure of profit could be net profit after interest and taxes; operating profit before
extraordinary items, but after interest and taxes; or operating profit before interest, taxes
and extraordinary items. The latter measure is often used since it excludes such non-
operating items as interest and extraordinary items. It also abstracts away from tax
management, which usually is not the province of sub-unit managers.
• Many of the problems which attend the measurement of profit for external reporting
purposes also impact profit measures for sub-units within the firm, e.g. depreciation
methods, inventory methods, variable vs. absorption costing, etc.
• Some costs which are common to more than one sub-unit may defy unequivocal
allocation among the sub-units.
• Only in the unlikely event that a manager has full control over all variables impacting a
sub-unit’s profit, will that profit be a true measure of the manager’s performance.
• The price placed on transfers of goods or services traded among sub-units will have a
direct impact on the profit of both parties to the trade. This is such an important issue
that it will be dealt with as a separate topic in this section of the CLP.
Issues in Measuring Investment
• We have to decide what constitutes the investment base. At least three options are
available: total assets, total assets minus total liabilities, and fixed assets plus working
capital. Some pundits argue for total assets on the grounds that ROI should measure the
use that a sub-unit has made of the assets with which it has been entrusted, regardless
of how those assets have been financed. Others opt for total assets minus total liabilities,
the “equity” that the company has invested in the sub-unit. A popular option is fixed
assets plus working capital, the argument being that this encourages sub-unit managers
to use effectively fixed assets and working capital.
• Valuation of fixed assets is an important issue. Should they be valued at net book value
(a common but flawed treatment), gross historical cost (i.e. before depreciation), or at
current replacement cost (the theoretically preferred but little used option).
• Among the other issues to be addressed are: the treatment of shared or corporate
assets; the treatment of leased assets; the impact of differing depreciation methods; and
whether beginning of year, end of year, or average assets balance should be used.
Consistency Is Important
No matter how many of these issues are resolved, it is important that they be applied consistently
from one accounting period to the next. This will ensure that results of sub-unit operations are
comparable and can be useful for managerial performance evaluation.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 11
Example 2: Performance Measures
Division P is an investment centre with total assets of HK$12,000,000 and net profit of
HK$3,000,000.
Required
i) Will the Manager of Division P undertake a project that would earn net profit of
HK$800,000 and cost HK$4,000,000, if that Manager’s performance is based on ROI?
ii) Discuss the ramifications of the Manager’s decision on the whole company. Assume the
results for the other two divisions are:
Q R
Profit 2,000 3,000
Total assets 10,000 20,000
ROI 20% 15%
Suggested Solution
Example 2: Performance Measures
i) Before and after tables give an indication of whether the Manager should invest.
Without Investment
With Investment
Investment Only
HK$ HK$ HK$
Profit 3,000,000 3,800,000 800,000
Total assets 12,000,000 16,000,000 4,000,000
ROI 25.00% 23.75% 20.00%
Because ROI drops from 25% to 23.75%, the Manager decides not to invest. This highlights a
potentially serious behavioural problem with ROI as a performance measure and as a measure
for evaluating capital projects in a decentralised organisational structure. In other words, this is
an example of myopic behaviour.
ii) The organisation as a whole may have been better off by investing in the project.
Consider the following table.
Division Q
HK$000
Division R
HK$000
Division P
Without Investment
HK$000
Division P
With Investment
HK$000
Company Without
Investment HK$000
Company With
Investment HK$000
Profit 2,000 3,000 3,000 3,800 8,000 8,800
Total assets 10,000 20,000 12,000 16,000 42,000 46,000
ROI 20.00% 15.00% 25.00% 23.75% 19.05% 19.13%
On a company-wide analysis, the project should have been undertaken because the company
ROI would have increased from 19.05% to 19.13%. The solution is to use discounted cash flow
techniques (NPV etc.) when evaluating capital projects. However this alone may not solve the
behavioural problems with capital investment decisions. For example, if the Q Divisional
Manager knew the project had a positive NPV, he still may not have allowed the proposal to be
put forward on the basis that his ROI would decrease.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 12
Residual Income (RI)
Residual income is often advocated instead of ROI because of the behavioural problems of ROI.
RI is, however, subject to the same profit and investment measurement issues as ROI. We
calculate RI as follows:
Net profit – [capital charge × total assets]
The type of capital charge used varies. Firms can use:
• the firm’s WACC;
• the average ROI over a period; or
• the current borrowing rate for the firm.
If managers are evaluated on RI, the behavioural problems are mitigated - i.e. goal incongruent
situations are less likely. Providing a project earns more than the amount of the capital charge,
the project goes ahead. For example, if the current period average ROI is used as the capital
charge for the above company, division P would accept the project because the RI is:
HK$800,000 – 0.1905 × HK$4,000,000
= HK$800,000 – HK$762,000
= +HK$38,000
The project would be accepted because the RI focuses on absolute magnitude and not on a ratio
number like ROI. Any positive RI should be accepted. Consider the following example.
Division X has an annual net profit of HK$200 million, total assets of HK$1 billion (HK$1,000
million) and a weighted average cost of capital of 15%. The RI for Division X is HK$50 million,
thus the Division has added HK$50 million to the company over the year.
The objective with RI is to maximise its value. However, RI is a short-term measure (like ROI)
that encourages actions beneficial in the short term and costly in the long term. Assume, for
example, that the repair and maintenance division mentioned in 8.3.2 is now part of a car
dealership, which is itself an investment centre. There are four other dealerships that form part
of one organisation and each dealership operates as an investment centre. If the dealership is
evaluated on RI (or ROI), it can increase these numbers by the same cost cutting techniques
used by the Manager and there is no incentive to maintain quality. Reducing costs increases RI
(and ROI) but the long-term effects can be severe.
Our calculation of RI is similar to Economic Value Added (EVA®). However there are differences
between RI and EVA®, including the fact that EVA® uses capital (net assets) and RI uses total
assets. It should be noted that the calculations for RI (and EVA®) differ among authors. For
example, the Stern Stewart Corporation, which registered the name “EVA”, uses net operating
profit after tax. Others have calculated RI using net assets rather than total assets, making RI
similar to of EVA®. What is important is to be consistent, regardless of how the number is
calculated.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 13
8.4 Transfer Pricing
8.4.1 Definition
A transfer price is “the price charged for transfer of goods or services between divisions of an
organisation”. Transfer prices are an essential feature of decentralised organisations where
there are movements of products or services between profit and investment centres. The
transfer price is reported either as revenue of the supplier division or a cost of the receiver division,
or both. It should be noted that transfer pricing does not only apply to manufactured goods. As
stated in the definition, it can also apply to services. A research and development department that
assists in improving methods of manufacture and a repair and service department of a motor vehicle
sales dealership, are two examples.
8.4.2 Objectives of Transfer Prices
Transfer prices should:
• provide financial data that allows fair measures of performance;
• promote goal congruence; and
• maintain decentralised managers’ autonomy.
Except for very specific situations, all three of these desirable properties of a transfer pricing
system are rarely achieved. The types of decisions based on transfer prices are related to output,
evaluation and allocation:
• Output - How much do we produce? How many units should we sell internally and how
many externally? How many units should we buy internally and how many externally?
• Evaluation - How well is the Division doing and how well is the Manager performing?
Should the organisation expand, contract or change its product line?
• Allocation - How much capital should the organisation allocate to this Division?
We have been concentrating on the performance measurement aspect of transfer prices.
However, we need to consider other elements, in particular output because it is closely related to
goal congruence. Transfer pricing is not easily resolved, usually involving a balancing act
between various internal and external forces. However, the problems that arise are not the direct
result of transfer pricing, but of the decision to decentralise the organisation into profit and
investment centres. The following questions best summarise the transfer pricing issues facing
decentralised firms.
• Does transfer pricing fairly measure the performance of the Divisional Manager?
• Does transfer pricing maintain the Division's autonomy?
• Does transfer pricing lead to divisional decisions that satisfy the requirement of global
profit maximisation (a goal congruence issue)?
These questions will be considered as we examine each transfer pricing method.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 14
8.4.3 Problems of Transfer Pricing
When organisations view their internal activities as part of a continuous chain, where value is
created at one link and then passed on to the next, there is often an attempt to define each link
as an independent strategic business unit (SBU). Once defined, each internal SBU could be
structured so that its output, which becomes the input of the next unit upstream, is transferred at
a price that includes an internal profit. The profit may be a small percentage structured to be a
minor buffer against potential cost fluctuations, or it could be carefully calculated to equate the
transfer price with that charged by an external provider.
The incorporation of profits into transfer prices may make the final price charged to the external
consumer higher than that of competitors and create pressures on the marketing and sales
functions. In extreme cases it may even result in the loss of sales and ultimately market share.
A further problem that may arise is when underlying cost calculations are not based on sound
methods or the costs are inflated through inefficiencies. This results in the transfer price being
inflated, with resulting distortions all the way up the chain. These distortions may then have an
impact on market share through loss of sales arising out of non-competitive pricing.
Distortions can also result in the under-pricing of products, through transfer prices that have been
understated both through cost distortions and incorrect perceptions of the competitive pricing
structures at each level in the chain.
A decentralised organisation has to decide which transfer pricing method will account for the
inter-divisional transfers of products/services and satisfy the three behavioural requirements
mentioned in 8.4.2 above. The organisation faces a dilemma:
The problem with a transfer pricing system is that individual divisions must be allowed to
pursue divisional goals that are coincident with the global organisational goals. However,
this "goal coincidence" may be difficult to operationalise. For example, it was agreed by
executives participating in a study conducted by the Industrial Conference Board that, in the
absence of conflict, corporate interests must take precedence over divisional interest even
though their personal incomes depend upon divisional performance."
(Abdel-khalik and Lusk, 1974, p.9).
This thirty-year-old quote is still relevant today. Transfer pricing is a balancing act between the
main methods and hybrids of those main methods. Methods best for one firm will be no good for
others.
8.4.4 Main Methods of Transfer Pricing
Organizations choose from four basic approaches to transfer pricing:
• market based;
• cost-based;
• negotiated; and
• mathematical.
Transfer price can also be administered or set by an organization’s head office using any one of
the above methods or a different method.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 15
a) Market Based
This is the price at which the product or service could be purchased by the receiving department
in the external market place. As a general rule, market price is the best possible transfer price
because it cannot be abused as easily as the other approaches. Both departments can make
rational decisions as if they are trading in the market place autonomously. Performance
measurement is not clouded by internal issues. However, the conditions under which this
transfer price is relevant are rare. For example, it is rare that a liquid market exists for the partly
completed product.
Most management accounting commentators agree that market price is the best possible
transfer price. Kaplan and Atkinson state: "If a highly competitive market for the intermediate
product exists, then the market price (less certain adjustments) is recommended as the correct
transfer price" (Kaplan and Atkinson, p.454). The "certain adjustments" to which Kaplan and
Atkinson are referring, are discounts on the transfer price to allow for savings on selling
expenses, delivery costs, and warranty terms when transferring internally. This discount will
encourage internal transfers and the organisation as a whole will optimise its returns.
Market based transfer prices have the following advantages:
• Internal policy decisions don't significantly affect the evaluation of the division and
management.
• Divisions can make independent decisions. Optimal decisions in the best interest of the
firm are most likely to be made without significant central office intervention.
• Closure of the production division will not affect the selling division’s profit.
As stated above, the conditions for market based transfer prices are rarely found in practice.
With market based transfer prices, we assume a perfect market for the intermediate good, the
conditions for which are:
• no restrictions on the mix of internal versus external sales (both divisions are free to deal
both internally and externally at any volume they desire);
• no restrictions on total volume produced or sold;
• no effect on the market price by level of divisional trading; and
• no taxes, transportation or transaction costs.
Given the above conditions, all three desirable properties (mentioned previously) will be met.
Unfortunately, these conditions are difficult to satisfy as many factors can violate the perfect
market assumption. For example, excess or shortage of capacity for the intermediate good may
exist in the market. In this situation, the selling division may be selling externally, while the
buying division is unable to obtain all its requirements externally. The result may be that total
company profits are not maximised, because the buying division’s output is being restricted. If
the central management decides to instruct one division to deal with the other, divisional
autonomy is compromised. They must decide whether the benefits of striving for optimisation of
company-wide profits outweigh the negative effects of not maintaining divisional independence.
Market based transfer prices have the following disadvantages:
• The external market may be imperfect. The quoted market price may not hold for
different volume levels of the product if the price is very elastic.
• Even in a perfect market, the price may be influenced by unusual or one-off factors such
as changing economic conditions or legislation influencing demand levels for short
periods.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 16
• In buying divisions with excess spare capacity, a market price based transfer price might
act as a disincentive to the buying division because of the cost. The result may be that
excess productive capacity is not used. However, a transfer price based on variable
costs may induce the buying division to use the excess capacity and buy the
intermediate product at that price. Company-wide profits may increase as a result.
Market prices do provide the ideal transfer price, but only under almost perfect circumstances
which are rarely found in practice.
b) Cost Based
There are a number of different cost-based methods:
• variable cost - marginal
- plus a mark-up;
• full cost - normal
- plus a mark-up.
i) Variable Cost
When the external market is not competitive, Hirshleifer (1956) suggests that the marginal cost of
production to the producing division is the optimal transfer price to use. He advocates setting
transfer prices along the manufacturing department’s marginal cost curve at the output level that
maximises global profits. The following limiting assumptions are made in the analysis:
• only two divisions;
• only one product;
• technological independence (i.e. operating costs of either division are independent of
one another);
• variable costs are readily determinable; and
• management in each division is autonomous.
His reasoning is based on classical economic theory, where the variable cost should be the
additional cost of producing one extra unit of output, at the "globally optimal output" level.
Because the theory is based on economic and not accounting variable costs, the system would
be difficult to implement. For example, economic variable cost is the additional cost of producing
another unit, where the cost includes returns on capital and all factors of production (fixed asset
investment, etc). Accounting variable costs are the variable costs incurred when one extra unit is
produced. Accounting costs do not include investment in capital, for example. Therefore,
accounting systems would need to be modified to provide the information necessary to
implement Hirshleifer's variable cost method.
Even more compelling reasons for rejecting Variable Cost as a viable practical method are that
neither the performance evaluation nor the autonomy criteria are met. That is, if the selling
division transfers at variable cost, losses will be suffered on the internal business and this will
impact unfavourably on the sub-unit’s profit performance.
Also, it would appear that the only way that a sub-unit manager would use such a method would
be if compelled to by top management. Autonomy would therefore be compromised. Surveys of
company transfer pricing policies such as those reported by Tang (1992 and 2001) suggest that
the variable cost method is little used in practice.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 17
ii) Full Cost
Despite this method being widely used in practice, the full cost method can lead to sub-optimal
decision making because application of one pricing rule can result in overpricing in the external
market. Full cost may also provide departments with the incentive to accumulate costs.
Consider the following case:
PENS organisation has three divisions, A, B, and C, each of which operates as a profit centre.
Head office has adopted a full cost policy where the transfer price is set at full cost plus 10%.
Monthly head office expenses are HK$12,000 and are allocated to the divisions equally. What
happens to this HK$12,000 as it moves between divisions? When Division A transfers its
intermediate product to Division B it will take the HK$4,000, add 10% to it and transfer HK$4,400
(along with the other relevant costs) to Division B. Division B adds the HK$4,400 to its own
allocated HK$4,000 and adds 10% (10% of HK$8,400 = HK$840), and transfers HK$9,240 to
Division C. Division C adds the HK$9,240 to its own allocated HK$4,000 and adds 10% (10% of
HK$13,240 = HK$1,324) to arrive at a final external selling price of HK$14,564. The result is that
head office costs have been compounded at a rate of 21.4%. Management at PENS is puzzled
as to why, despite its best efforts at cost reduction, competitors continually under-price the PENS
organisation. It is not hard to see why!
A "full cost plus" transfer pricing system has the following limitations:
a) the allocation of fixed costs is arbitrary;
b) pricing at full-cost-plus implies a willingness to incorporate inefficiencies that may be
passed on to the consumer. This may negate the operational controls used to evaluate
divisional performance; and
c) the search for improved productivity and technology in the manufacturing division may
be discouraged.
The PENS example illustrated limitation b). The following example illustrates limitation c):
Assume an organisation has a two division, full-cost-plus transfer pricing situation with
the following details:
Mark-up = 10%
Full cost to manufacturing division (Division 1) = HK$100
Selling price of selling division (Division 2) = HK$200
Quantity sold/transferred (units) = 1,000
Total selling costs of Division 2 = HK$50
The transfer price is therefore HK$110
[(TP = [1 + 10%] × HK$100)]
The profit of Division 2 is HK$40,000
[(HK$200 - HK$50 - HK$110) × 1,000]
The profit of Division 1 is HK$10,000
[(HK$110 - HK$100) × 1,000]
Total company profit is HK$50,000
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 18
If Division 1 discovered a breakthrough in the manufacturing process, which reduced its cost of manufacturing by half, other things being equal the new transfer price would be HK$55. [(TP = [1
+ 10%] ×HK$50)]
In this situation the profit of Division 2 is HK$95,000
[(HK$200 - HK$50 - HK$55) × 1,000]
The profit of Division 1 is HK$5,000
[(HK$55 - HK$50) × 1,000]
Total company profit is HK$100,000
The total company profit has increased by HK$50,000.
All the benefit of HK$50,000 has been passed onto the selling division, and the manufacturing division’s profit has been halved. Why? Because the percentage mark-up for division one is “fixed” at 10%. Division 2, therefore, gets all the benefit of Division 1’s cost-reduction improvements. Division 2’s mark-up is not fixed because it charges what the market can bear. It is likely that this will result in adverse motivational affects on division one. In addition to loss of autonomy due to the central office imposed pricing method (evaluation of Division 1 by examining profit alone) is not a true reflection of that division’s achievements. An alternative may be to share the additional profit or change the mark-up percentage. However, this may be difficult in an organisation where the mark-up is centrally determined. Globally optimal decisions will not be made under a full cost system when one pricing rule is universally adopted, as the above example illustrates.
However, surveys of practice (e.g. Tang 1992 and 2001) suggest that full cost based methods are widely used in practice. It appears that companies base their price on standard full cost, so that any cost over-runs become the responsibility of the selling sub-unit. In addition the amount of the profit mark-up is negotiated by the two units, or at least is mediated by corporate head office. This make the “standard full cost plus profit” method, a viable practical basis for setting transfer prices.
(iii) Negotiated Transfer Prices
Negotiated transfer prices are best used when a small, less than perfect external market exists for the intermediate product. Ideally, the negotiation process will decide on such minor adjustments to price as reduced freight, marketing and credit costs on internal sales. A second important factor is the sharing of all information between divisions. This “should enable the negotiated price to be close to the opportunity cost of one or preferably both divisions” (Kaplan and Atkinson, p.461). A third factor is that each divisional manager has the right to accept or reject the offer.
The most common criticism of negotiated transfer prices is that they will reflect the negotiating skills of management. The undesirable effect of this factor will vary indirectly with the existence of any external market. Therefore, negotiating skills will be most influential when:
• divisions attempt to create an internal market for the good, thereby simulating an external market; or
• the selling division is producing custom-made products.
Negotiation of transfer prices satisfies the requirement for autonomy and will have positive behavioural consequences. An important factor in business is settlement of conflicts by negotiation. Installing a negotiated transfer pricing system may aid company-wide morale, not just divisional morale. Despite the positive autonomy advantages, performance may be significantly influenced by personalities and negotiating ability. Consequently, evaluation will be clouded. In addition, company-wide optimal decision making is questionable without central office intervention.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 19
(iv) Mathematical Approaches
The appeal of mathematical programming approaches over other methods is that no simplifying
assumptions need to be made. Hirshleifer's method mentioned above assumes that only one
product is produced and transferred, and there are only two divisions. Therefore, mathematical
techniques are better suited to multi-division and/or multi-product situations than, for example,
the marginal cost method. In addition, mathematical techniques become more appropriate when
there is little or no external market for the intermediate good. All mathematical techniques
recommend a transfer price set at the opportunity cost of the good to be transferred. The models
measure the opportunity cost by calculating the shadow prices in a linear programming algorithm.
There is very little evidence of this method being used in practice.
(v) Economist’s Approach to Transfer Pricing
Following from the classical economic theory first discussed in a transfer pricing context by
Hirshleifer (1956) some economists have revisited the transfer pricing problem. They have
pointed out that the transfer price should reflect the real (“opportunity”) cost of transferring the
goods or services from one unit to another.
This would be represented by the outlay cost to the point of transfer plus the opportunity cost for
the firm as a whole. In an accounting sense the outlay cost would be approximated by the
variable cost in the selling sub-unit. If the selling unit is operating at full capacity, the opportunity
cost for the firm would be represented by the contribution margin foregone on sales to outside
customers. Consider the following example:
• Variable cost in selling sub-unit $ 7
• Selling price in intermediate market $10
• Classical economic price $7 + ($10 – $7) = $10 (This is the market price!)
However, if the selling sub-unit is not operating at full capacity, the opportunity cost for the firm
as a whole is likely to present practical measurement problems. This issue is explored in Practice
Question 1 at the conclusion of this section.
(vi) International Transfer Pricing
The rise of multinational organisations has generated a different range of issues and
perspectives on transfer pricing. The international transfer price is the price that an organisation
uses to transfer products or services between a business unit in one country and that in another
country. Given the international perspective of Hong Kong, this is an important issue.
There are two major points to note in relation to international transfer pricing. First, these
transfers are not at arm’s length. Second, in the absence of tax and tariff considerations,
international transfer pricing raises the same issues that we have discussed so far.
The presence of different tax and tariff rates in different countries introduces another layer of
complexity into transfer pricing. Consider a company that manufactures products in Hong Kong
that has a marginal tax rate of 16%, and sells those products in New Zealand, which has a
marginal tax rate of 33%. Obviously this firm would like to locate most of its profits in Hong Kong,
where the tax rate is the lowest. Therefore it will want to use the highest possible transfer price
for the transaction.
For many firms, such tax considerations as these outweigh the other considerations in setting a
transfer price, but may have dysfunctional behavioural effects. For example, the manager of the
New Zealand sub-unit would be earning little or no profit and this may impact unfavourably on
that person’s behaviour. Nevertheless the company may decide that this is the price that must be
paid for minimising the firm’s global taxes.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 20
Many tax authorities around the world are aware of this potential behaviour and have taken steps
to monitor and police it. The most important document relating to international transfer pricing is
the 1995 Organisation for Economic Co-operation and Development (OECD) guidelines
statement. In essence these guidelines suggest that, whenever possible, the transfer price
should reflect underlying economic circumstances. For a recent article on transfer pricing and tax
issues in Hong Kong see: Chan, Agnes; Cheung, Patrick; and Kwong, Patrick. “Taxing inter-
company transactions” A Plus (HKICPA), January 2010.
What transfer pricing practices are used around the world? Horngren et al (2006) report on page
774 a set of comparative statistics indicating how predominantly particular transfer pricing
methods are used in different countries. These statistics are summarised in the tables on the
next page:
Domestic Transfer Pricing Methods
Methods USA AUST CAN JAP INDIA UK NZ
Market-based 26% 13% 34% 34% 47% 26% 18%
Cost-based
Variable costs 3% - 6% 2% 6% 10% 10%
Full costs 49% - 37% 44% 47% 38% 61%
Other 1% - 3% - - 1% -
Total cost-based 53% 65% 46% 46% 53% 49% 71%
Negotiated 17% 11% 18% 19% - 24% 11%
Other 4% 11% 2% 1% - 1% -
Total 100% 100% 100% 100% 100% 100% 100%
International Transfer Pricing Methods
Methods USA AUST CAN JAP INDIA UK NZ
Market-based 35% - 37% 37% - 31% -
Cost-based
Variable costs 0% - 5% 3% - 5% -
Full costs 42% - 26% 38% - 28% -
Other 1% - 2% - - 5% -
Total cost-based 43% - 33% 41% - 38% -
Negotiated 14% - 26% 22% - 20% -
Other 8% - 4% - - 11% -
Total 100% - 100% 100% - 100% -
In the absence of perfect competition for the intermediate good, adoption of any transfer pricing
method in a decentralised profit centre organisation, will have some adverse effects. There is no
correct method to be universally applied. Instead, the method adopted should reflect the
organisation's structure and the external market for the transferred product. Furthermore, no one
method (apart from market prices in limited circumstances), can satisfy the three desired
behavioural consequences of decentralisation mentioned above.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 21
Example of International Transfer Pricing
Hong Kong Global Limited (HKGL) is a Hong Kong company with a manufacturing plant in
Thailand, and the company has been granted a 10 year tax break by the Government of Thailand.
Relevant details regarding the company are as follows (HK Dollars):
Unit manufacturing cost of product in Thailand $80
Unit freight cost to ship to Hong Kong $20
Selling price of product in Hong Kong $300
Taxes in Thailand 0%
Income taxes in Hong Kong 16%
Tariff in Hong Kong 0%
Annual production and sales 100,000 units
Consider the effect on overall after-tax company profit of two possible transfer pricing schemes:
1) Cost of production and freight ($100)
2) Cost of production and freight plus 100% ($200)
1) Cost Based Transfer Price ($100)
Thailand Hong Kong
Per Unit 100,000 Units Per Unit 100,000 Units
Selling Price $100 $10,000,000 $300 $30,000,000
Cost (or Transfer Price) ($100) ($10,000,000) ($100) ($10,000,000)
Profit Before Tax $0 $0 $200 $20,000,000
Income Taxes (HK 16%) $0 $0 ($32) ($3,200,000)
Profit After Tax $0 $0 $168 $16,800,000
2) Cost Plus 100% Transfer Price ($200)
Thailand Hong Kong
Per Unit 100,000 Units Per Unit 100,000 Units
Selling Price $200 $20,000,000 $300 $30,000,000
Cost (or Transfer Price) ($100) ($10,000,000) ($200) ($20,000,000)
Profit Before Tax $100 $10,000,000 $100 $10,000,000
Income Taxes (HK 16%) $0 $0 ($16) ($1,600,000)
Profit After Tax $100 $10,000,000 $84 $8,400,000
Summary: Cost Cost Plus 100%
Corporate Taxes $3,200,000 $1,600,000
Corporate Profit After Taxes $16,800,000 $18,400,000
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 22
Income Tax Regulations
This is a very simplistic example, but shows that there are obvious ways to minimize corporate
global taxes in the absence of Income Tax Regulation forbidding such arrangements.
In the U.S.A., the Internal Revenue Service has promulgated Section 482 which has voluminous
and detailed provisions to address such practices as those suggested in this example.
Hong Kong’s tax authorities, the Inland Revenue Department, have traditionally not focused on
transfer pricing issues because of Hong Kong’s relatively low tax rate. Thus, foreign investors
tend to channel profits into Hong Kong rather than out of Hong Kong, and the transfer pricing
regulation as stated in the Hong Kong Inland Revenue Ordinance is very brief. As revenue
competition from other low-tax or no-tax jurisdictions has become more intensive, the Inland
Revenue Department (IRD) is increasing its scrutiny on the transfer pricing issue.
(vii) Transfer Pricing in China
China’s tax authorities recently strengthened transfer pricing enforcement efforts and issued
guidance to taxpayers on a number of fronts. The impetus, in part, has been the belief that transfer
pricing has been used improperly – especially by some foreign investment firms – to shift profits out
of China and avoid tax liabilities.
As a result, the tax authorities are scrutinising taxpayers’ transfer pricing practices closely and
proposing much larger adjustments. These adjustments often result in an additional tax liability, a
shortening of the remaining life of tax holidays and, in some cases, even more serious
consequences.
China entered the transfer pricing arena at a relatively late stage, but the State Administration of
Taxation (SAT) appears to be eager to learn from and adopt leading transfer pricing practices from
around the world. For more information on this topic see Tseng, Steven, “Transfer Pricing in China”,
A Plus, October 2006.
8.5 Budget Analysis
8.5.1 Introduction
In Section 7 we considered how to prepare the general types of budget for an organisation. This
activity is part of planning. The next phase in understanding how our prior expectations have
turned out is to analyse performance against budget. This is sometimes called variance analysis.
In this section we reconsider the various types of budgets mentioned in Section 7. We consider
both manufacturing and non-manufacturing organisations.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 23
Comparisons of actual performance with the budget reveal any differences or variances that
have occurred during the period. The size and direction of a variance indicates the extent to
which operations are under control as defined by the alignment of performance with standards.
An assumption made here is that uncontrollable conditions have not changed (e.g. there has not
been an unexpected economic downturn). If we have zero or immaterial variances for our sales
budget in this scenario the sales have done exceptionally well. Conversely, if there is a sudden
increase in demand for our product type, then an actual equals standard report means we have
done badly. As a good general guide, variances should be investigated when actuals are
materially different from standards. Unfavourable variances occur when actual costs exceed
standard costs.
8.5.2 Budget Variances
You will recall that in Section 7 we discussed the formulation and analysis of the master budget
and the flexible budget. There follows below some budgetary data for SSS Limited, a
manufacturer of boxes. These data show for quarter one, the master budget at 100% activity
level, the flexible budget at 90% activity level, and cost variances relating to the flexible budget.
Activity Level Master Budget 100% Flexible Budget 90% Variances
Units HK$ Units HK$
Sales 13,950 279,000 12,555 251,100
Less: Variable costs:
Direct materials- A 62,775 56,498 6,278 (F)
Direct Materials- B 24,413 21,971 2,441 (F)
Direct Labour 59,288 53,359 5,929 (F)
Overheads 55,800 50,220 5,580 (F)
CONTRIBUTION 76,725 69,053 7,673 (U)
Less: Fixed costs
-Overheads 50,000 50,000
OPERATING PROFIT 26,725 19,053 7,673 (U)
Let us assume the following to be the actual results for the quarter one:
Sales (units) 12,555
HK$
Sales price (per unit) 19.00
Material cost – A (per unit) 0.5Kg X HK$ 8.00 per Kg 4.00
Material cost – B (per unit) 0.5Kg X HK$ 4.00 per Kg 2.00
Labour – 24minutes per unit X HK$10.00 per hour 4.00
Variable cost –(per unit) HK$ 11.25 per direct labour hour 4.50
Fixed overhead 40,000
The Standard figures assumed in the budget were:
Materials HK$
- Product A 1Kg @ HK$ 4.50 per Kg 4.50
- Product B 0.5Kg @ HK$ 3.50 per Kg 1.75
Labour 30 minutes per unit @ HK$ 8.50 per hour 4.25
Variable Overhead HK$ 8.00 per direct labour hour 4.00
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 24
We can now analyse the performance of SSS Limited for quarter one:
Actual
HK$
Production
Variances
HK$
Sales Price
Variances
HK$
Flexible
Budget
HK$
Volume
Variance
HK$
Master
Budget
HK$
Sales 238,545 12,555 (U) 251,100 27,900(U) 279,000
Less:
Dir Mat- A 50,220 6,278 (F) 56,498 6,278 (F) 62,775
Dir Mat- B 25,110 3,139 (U) 21,971 2,441 (F) 24,413
Dir. Lab 50,220 3,139 (F) 53,359 5,929 (F) 59,288
Var O/H 56,498 6,278 (U) 50,220 5,580 (F) 55,800
Cont.
Margin
56,497
12,555 (U)
69,052
7,673 (U)
76,725
Fixed O/H 40,000 10,000 (F) 50,000 50,000
Profit 16,497 10,000 (F) 12,555 (U) 19,052 7,673 (U) 26,725
SSS Limited performed worse than planned mainly because of the lower sales volume (1,395
boxes). This contributed to a lower actual profit than budgeted by HK$ 27,900 (1395 x $20). A
lower selling price per unit of HK$ 1.00 had an adverse effect of HK$ 12,555 on actual profit for
the quarter. The direct material variances for products A and B could be due to price difference
between budget and actual, or differences in the proportion of the product used to make a box of
washing powder. Further analysis of these variances can identify the specific cause of the
variance.
The following summary table is useful for further analysing the variance components.
Actual input
x
Actual price
Actual input
x
Standard price
Standard input for actual output
x
Standard price
Direct material
Price variance Efficiency (Usage) variance
Direct labour
Price (Rater) variance Efficiency variance
Variable overhead
Spending variance Efficiency variance
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 25
It is possible to analyse the individual production variances using this tree approach. Further
information for the first quarter for SPB Limited is as follows:
Analysis
Actual price (HK$) X actual
qty of input for actual
output
Price / Rate / Spending Variances
Standard price (HK$) X
actual qty allowed for
actual output
Efficiency / Usage
variances
Flexible budget
Standard price (HK$) X standard
qty for actual output
Direct Materials:
A $8 x.5x12,555
= $50,220
$21,971(U) $4.50 x 0.5 x 12,555
= $ 28,249
$28, 249 (F) $4.50 x 1 x 12,555
= $ 56,498
B $4 x.5x12,555
= $25,110
$ 3,139(U) $3.50 x 0.5 x 12,555
= $ 21,971
0 $3.50 x 0.5 x 12,555
= $ 21,971
Direct Labour 24m/60m x 12,555 x 10
=$50,220
$ 7,533(U) 24m/60m x 12,555 x 8.5
=$42,687
$10,672 (F) 30m/60m x 12,555 x 8.5
=$53,359
Variable Overhead
$11.25 x 12,555 x 24m/60m
= $56,498
$16,322(U) $8.00 x 12,555 x 24m/60m
= $40,176
$10,044 (F) 30m/60m x 12,555 x 8.0
=$50,220
Totals $ 182,048 $ 48,965(U) $ 133,083 $ 48,965 (F) $ 182,048
Product A’s price increase was anticipated in the master budget but it was significantly
underestimated. The price per kilogram of HK$8.00 is significantly higher than the master
budget unit price of HK$4.50. Before corrective action can be taken, the specific cause or
causes should be found. The price rise could be due to controllable or uncontrollable factors and
efforts should be made to address the causes.
When there is more than one input into the production process we can break down the efficiency
variance into a mix and a yield variance. The materials mix variance arises from mixing the
inputs in a ratio that is different to the ratio in the budget. The materials yield variance arises
when the output differs from that output that we would expect based on the quantity of inputs
(materials) used. The calculation of the materials mix and yield variances for SSS Limited is
described below.
SSS Limited's budget for 1 kg of washing power was to use 1 kg of product A and 0.5 kg of
product B at costs of HK$4.50 per kg and HK$3.50 per kg respectively. Therefore, 1.5 kg of
material input was expected to be used to product 1 kg of washing powder.
During the quarter, 6,278 kg of A and 6,278kg of B were used to produce 12,555kg of washing
powder (12,555 boxes). SSS limited has done well because instead of using 18,833kg to make
12,555 (as per the budget), it used only 12,555 kg to make 12,555 kg. If SSS limited had
actually used the budgeted mix of A and B to make 12,555 kg of output, it would have used
12,555 kg of A and 6,278 kg of B. If the actual amount of inputs used (12,555 kg), had been
used in the budgeted mix of A and of B then the following amounts of A and of B would have
been used:
1 / 1.5 x 12,555 = 8,370 kg
0.5 / 1.5 x 12,555 = 4,185 kg
Total 12,555 kg
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 26
We can show the materials mix and yield variances as follows:
Input Standard
Quantity
at std
mix
(1)
Actual
quantity
at std
mix
(2)
Actual
quantity
(3)
Material mix variance
Standard cost ×××× [(3) -
(2)]
Material yield variance
Standard cost ×××× [(2) - (1)]
A 12,555 8,370 6,278 2,092 × 4.50 = 9,414 F 4,185 × 4.50 = 18,833 F
B 6,278 4,185 6,278 2,093 × 3.50 = 7,326 U 2,093 × 3.50 = 7,326 F
18,833 12,555 12,555 2,088 F 26,159 F
The favourable mix variance of HK$2,088 shows us that the firm has benefited from the mix of
using more of the lower cost product (B) relative to the higher cost product (A). The favourable
yield variance of HK$26,159 shows us that the firm used significantly fewer quantities of inputs to
produce the quantity of output. The firm used 6,278kg less to produce the 12,555 kg of powder.
This is a very large difference and could indicate that the standards need to be revised. Further
investigation would be required. For example, it is possible that the higher priced materials
produced a favourable yield. Notice that the mix variance of HK$2,088 F plus the yield variance
of HK$26,159 F totals to the efficiency variance of HK$28,247 F.
(Note: differences in the above computation are due to rounding up of figures)
8.5.3 Investigation of Variances
Variance analysis has three phases:
• calculation;
• identification (of the variances significant to the organisation); and
• investigation (of significant variances).
Management does not investigate every variance, but only those regarded as significant, both
favourable and unfavourable. This is called “the exception principle” or “management by
exception”.
Allocating responsibility for every variance ensures that someone within the organisation will be
concerned with controlling that aspect of operations. This is fundamental to the concept of
control within the organisation. The variances typically reported by management and their
common causes are indicated in the following:
Variance Common causes
Materials Price Insufficient time spent on evaluation of suppliers;
Negligence in taking advantage of discounts; and
Changes in material quality and specifications.
Usage Changes in the quality of material;
Degree of labour and machine supervision;
Level of operator efficiency;
Non-standard production scheduling;
Technological changes;
Theft, obsolescence or deterioration; and
Changes in materials mix.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 27
Variance Common causes
Labour Rate Overtime payments;
Changes in class of labour used; and
Productivity bonuses;
Efficiency Inferior (superior) material quality;
Insufficient training;
Lack of supervision;
Changes in working methods;
Changes in general working conditions;
Machine efficiencies or inefficiencies;
The learning effect; and
Idle time.
Variable Rate / Price Incorrect split of overheads into fixed/variable
Overheads Over / under spending on variable overhead items
Change in nature of overheads.
Efficiency Since variable overheads are often assumed to be driven by labour efficiency (or lack of it), the common causes ascribed to labour variance are also likely to apply to variable overhead variances.
Fixed Price Over / under spending on fixed overhead items
Overheads Volume Machine breakdowns;
Material shortages;
Strikes (if staff are paid while on strike); and
Lack of demand (or increased demand) for production.
Several variances have inter-relationships. Some examples are:
• A food manufacturer seeking lowest cost farm produce may end up with high wastage
due to a certain percentage of the fruit and vegetables purchased being of a grade not fit
for use. In this case, the potential favourable material price variance may lead to an
unfavourable material usage variance and an unfavourable labour efficiency variance if
higher inspection rates are needed to detect the bad produce.
• A furniture manufacturer using higher skilled labour that costs more may have a
favourable labour efficiency variance and a favourable materials efficiency variance due
to the skills of the labour force producing more and causing less material wastage. The
company may however have an unfavourable labour price variance if it is forced to pay
above budgeted rates to secure the right calibre staff.
8.5.4 Analysis of Sales Budget Variances
You will recall that the sales budget is a formal statement to the Chief Manager in an
organisation about both quantity and price of sales revenue for the budget period. How can we
analyse differences from planned? The most common technique is to prepare a variance report
highlighting the dollar value difference.
Following is the most basic level analysis for the men’s bathers product line at AAA swimwear:
Sales Variance Report – Men’s Bathers Month ended 31 July 2009
Total Sales
Actual Budget Variance favourable/(unfavourable)
HK$35,000 HK$50,000 (HK$15,000)
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 28
What could be the explanation(s) for such a variance? Prima facie, this variance indicates poor
performance, but we must investigate the reasons because this basic analysis alone is not much
use. Possible explanations include:
a) Deductions from Sales
Deductions from sales could explain low unit prices and would be due to such factors as returns
and allowances (these would also affect quantity sold), discounts (these would only affect sales
price) and price adjustments (these would affect only price).
b) Cancellations of Orders
Cancellations could indicate that the customer has changed his or her mind, or they could
indicate poor customer relations and loss of sales to a competitor. This sort of information is
obtained by analysing total orders received. A performance measure like total sales divided by
total orders could highlight unfavourable trends, but an unfilled order may be due to production
rather than sales (if production can’t deliver, the customer may cancel the order).
Finding the reason(s) for variances is the way to understand and solve problems but this often
involves a much deeper analysis than just the basic variance calculation above. Take the
following example.
AAA Swimwear has three sales people. Total sales for May were under budgeted by HK$15,000.
You provided the above report to the General Manager who comes into your office one hour later
to say that the report is useless to him. He wants to know how much was sold, where it was sold,
who sold it and why there is a difference from budget. You do some analysis and present him
with the following reports and analysis:
Sales Variance Report – Men’s Bathers
Month ended 31 July 2009
Sales by area/store
Total sales
Store Actual Budget Variance
favourable/(unfavourable)
HK$ HK$ HK$
ABC 0 5,000 (5,000)
DEF 0 10,000 (10,000)
HIJ 8,500 10,000 (1,500)
LMN 7,500 5,000 2,500
OPQ 4,000 8,000 (4,000)
RST 2,000 2,000 0
Other 13,000 10,000 3,000
Total 35,000 50,000 (15,000)
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 29
Sales variance report – Men’s Bathers
Month ended 31 July 2009
Sales by sales person
Total sales
Sales person Actual Budget Variance
favourable/(unfavourable)
HK$ HK$ HK$
F. Po 2,000 10,000 (8,000)
F. Wang 12,000 20,000 (8,000)
A. Ong 21,000 20,000 1,000
Total 35,000 50,000 (15,000)
After speaking to the sales people you discover the following:
• F. Po did not know that the colour range for the bathers had expanded and had been
marketing them to department stores in the colours suggested at the first planning
meeting in January. He went on leave and when he returned in late April, began
marketing in earnest. He only discovered his error in mid May. In the meantime, the
department stores had chosen a competitor’s product.
• F. Wang, who has been selling to ABD and to DEF stores for many years, mixed up the
orders. When the respective orders arrived at each of the stores the receiving personnel
contacted each other and discussed the matter. After consultation with their respective
superiors, they decided to cancel their orders and go to a competitor, not because the
orders were mixed up but because they were put off by the way F. Wang handled the
mix up. First he tried to cover up his mistake by offering them a discount on another line
of clothing. Then he refused to arrange transportation for the stock to the correct store
because he did not want the additional expenses to be reported.
c) Uncontrollable Variances
In calculating some variances there is often a large, uncontrollable element, so caution should be
exercised when basing performance measurement on the figures. Also the performance measure
needs to be considered in light of the organisation’s strategic plan. Is the measure good news or
bad news in respect of the strategic plan? Consider the following case about direct materials.
On behalf of a production supervisor, your Assistant Accountant prepares a direct materials price
variance report for the first quarter of a new financial year. She states that the performance is
good news for the Supervisor and his department, because the variance is favourable. You say
the news is not good, because the Supervisor’s purchasing decision was based on price alone,
in spite of the fact that the organisation’s strategic plan has been amended to stress product
quality and customer satisfaction. You know that the supplier from whom the Supervisor
purchased the direct materials has a history of such problems as defective raw materials and low
quality product.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 30
Part D
Practice Question 1 [25 Marks]
Max’s Menswear (MM) operates a chain of men’s fashion shops in Hong Kong. The clothing
range consists of middle-of-the-road fashion items, and the design work is carried out in Hong
Kong at MM’s headquarters.
MM has recently established a sewing division in Vietnam to undertake the production of the
clothing, which is to be shipped to Hong Kong in bulk, where it is packaged attractively and
delivered to each retail outlet. Not only will this enable access to low cost labour in Vietnam, but
also MM will have the advantage of zero income tax in a Vietnam “special development zone”.
This tax advantage will be for 5 years.
The company wishes to establish a transfer pricing policy which, while being legal, will minimise
their overall taxation exposure. As a basis for analysing this issue Andrew Kwok, MM’s CFO, has
prepared some preliminary figures relating to a representative product – casual jerseys. These
data are based on an initial production run of 5,000 jerseys:
Vietnamese Sewing Division
Variable costs: 117,000 Dong per jersey Fixed costs: 24,750 Dong per jersey Market price: 258,750 Dong per jersey MM Hong Kong Variable costs: HK$ 22.00 per jersey Fixed costs: HK$ 10.00 per jersey Market price: HK$320.00 per jersey
The current exchange rate is: 1 HK$ = 2,250 Vietnamese Dong. Assume a 16% Hong Kong tax
rate.
You are a recently qualified accountant working in MM’s head office in Hong Kong. Andrew Kwok
has approached you to prepare some preliminary responses to the following issues:
1. Calculate in Hong Kong dollars, the transfer price for transfers of the jerseys from the
Vietnamese Sewing Division under two scenarios; full cost + 200% mark up, and market
price.
2. Calculate in Hong Kong dollars the annual pre-tax operating income for each division
and for the company as a whole, under each of the following scenarios:
a. Transfer price = full cost + 200% mark up, in the Vietnamese Sewing Division
b. Transfer price = market price in the Vietnamese Sewing Division.
3. Calculate in Hong Kong dollars the annual after-tax operating income for each division
and for the company as a whole, under each of the following scenarios:
a. Transfer price = full cost + 200% mark up, in the Vietnamese Sewing Division.
b. Transfer price = market price in the Vietnamese Sewing Division.
4. Which method will maximise company-wide after-tax operating income?
5. Comment on the impact the choice of transfer pricing method will have on the evaluation
of the performance of each division and its manager.
Required
Prepare a report to Andrew Kwok, addressing the five issues above.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 31
Suggested Solution
Practice Question 1 [25 Marks]
Timing (minutes) Part (1) 6 mins
(2) 10 mins
(3) 10 mins
(4) 7 mins
(5) 7 mins
Total time spent on question 40 mins
This is a two-country two-division transfer-pricing problem with two alternative transfer-pricing
methods.
Summary data in Hong Kong dollars are:
Vietnamese Sewing Division
Variable costs: 117,000 Dong ÷ 2,250 = HK$ 52.00 per jersey
Fixed costs: 24,750 Dong ÷ 2,250 = HK$ 11.00 per jersey
Market price: 258,750 Dong ÷ 2,250 = HK$ 115.00 per jersey
Hong Kong Clothing Division
Variable costs = $22.00 per jersey
Fixed costs = $10.00 per jersey
Market price = $320.00 per jersey
1. The transfer prices are:
a. Full costs + 200%
Vietnam Division to Hong Kong
= ($52 + $11) + [200% x ($52 + $11)] = $189 per jersey
b. Market price
Vietnam Division to Hong Kong
= $115 per jersey
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 32
2. Pre-tax operating income (in Hong Kong dollars)
200% Full Cost Market Price
Vietnam Division
Division revenues (5,000 x $189, $115) $945,000 $575,000
Division variable costs (5,000 x $52) 260,000 260,000
Division fixed costs (5,000 x $11) 55,000 55,000
Division total costs 315,000 315,000
Division operating income $630,000 $260,000
MM Hong Kong
Hong Kong revenues (5,000 x $320) $1,600,000 $1,600,000
Hong Kong transferred-in costs (5,000 x $189, $115) 945,000 575,000
Hong Kong variable costs (5,000 x $22) 110,000 110,000
Hong Kong fixed costs (5,000 x $10) 50,000 50,000
Hong Kong total costs 1,105,000 735,000
Hong Kong operating income $495,000 $865,000
Operating Income for MM Company $1,125,000 $1,125,000
3. After-tax operating income (in Hong Kong Dollars)
Note: this calculation is based upon a Hong Kong tax rate of 16%.
200% Full Cost Market Price
Vietnam Division
Division operating income $630,000 $260,000
Division tax at 0% 0 0
Division after-tax operating income $630,000 $260,000
MM Hong Kong
Hong Kong operating income $495,000 $865,000
Hong Kong tax at 16% 79,200 138,400
Hong Kong after-tax operating income $415,800 $726,600
MM Company After-tax Operating Income $1,045,800 $986,600
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 33
4. Which method maximises company-wide after-tax operating income?
Clearly, the 200% x Full Cost transfer price will maximise overall company after-tax operating
income. This is because it leaves more of the corporate pre-tax profits in the country which has
the zero income tax rate. If the mark up on full cost is more than 200%, the after-tax effect will be
more marked.
Among the issues to be addressed before such a strategy is followed, is in compliance with Hong
Kong regulations with respect to international transfer pricing. Since the cost plus 200%
calculation results in a price which is greater than the apparent market price, this could be a
sensitive issue.
5. Performance evaluation in the divisions.
When international transfer prices are set in such a way as to maximise the company-wide after-
tax operating income, care must be taken in evaluating the performance of participating divisions
and their management.
In the case above, if a cost plus 200% transfer price is used, more of the profits reside in the
Vietnamese Division than in the Hong Kong. This issue will be particularly relevant if the
managers of the units within the company are paid bonuses on the basis of divisional profits.
Clearly the Hong Kong manager would not be pleased with the cost plus 200% price, as that has
the effect of lowering the Hong Kong division’s profit, and hence the manager’s bonus.
If transfer prices are imposed on operating divisions by top management, other ways must be
found to evaluate the performance of the units and their management.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 34
Practice Question 2 [20 Marks]
The following accounting reports have been provided for Golden Travel Limited. The company
provides reservations software to the travel industry, and also operates a number of travel
agencies. The chief financial officer wants the performance of the company to be evaluated.
Golden Travel Limited
Summary Income Statements
Year end
31/12/2008
Year end
31/12/2009
$000 $000
Revenue
Air Services (International) 36,800 36,665
Leisure 19,865 18,995
Domestic 5,900 3,345
62,565 59,005
Expenses
Employee costs 32,745 29,525
Other costs 20,010 16,955
52,755 46,480
EBITDA 9,810 12,525
Depreciation 1,770 1,445
EBITA 8,040 11,080
Amortisation 725 700
EBIT 7,315 10,380
Interest Expense 550 600
Profit Before Income Tax 6,765 9,780
Income Tax Expense (17.5%) 1,183 1,711
Net Profit After Tax 5,582 8,069
Golden Travel Limited
Summary Balance Sheets
31/12/2008
31/12/2009
$000 $000
Current assets 14,300 18,100
Non-current assets 28,700 31,800
Total assets 43,000 49,900
Current liabilities 10,000 10,900
Non-current liabilities 6,000 8,500
Shareholders' equity 27,000 30,500
Total liabilities and shareholders' equity 43,000 49,900
Other information: Required rate of return: 10%
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 35
Required
a) Calculate the following measures of performance for 2008 and 2009:
(i) Return on investment (ROI);
(ii) Residual income (RI);
(iii) Return on equity (ROE); and
(iv) Return on sales (ROS).
b) Evaluate the usefulness of each of the above measures of performance for Golden Travel.
c) What are some other measures of performance that could be employed?
Suggested Solution
Practice Question 2 [20 Marks]
a) Calculations
For the following calculations, net profit after tax is used as the profit measure and total
assets as the asset measure. Candidates may choose other measures of profit and
investment as detailed in section 8.3.2.
2008 2009
(i) Return on investment (ROI) 13.0% 16.2%
(ii) Residual income (RI) $1,282,000 $3,079,000
(iii) Return on equity (ROE) 20.7% 26.5%
(iv) Return on sales (ROS) 8.9% 13.7%
b) Usefulness of each measure for Golden Travel:
(i) Return on investment (ROI)
• this measure has increased from 2008 to 2009 and both ROI percentages
are well above the desired return of 10%
• the results for these two years need to be considered in relation to
previous years (e.g. 5 years of data) in order to evaluate whether this
increase is part of a trend
• measures that include investment/assets are not always appropriate for
service organisations such as Golden Travel, as these organisations
typically have high employee costs and lower operating assets than, for
example, a manufacturer; because of the small size of investment (the
denominator of this ratio), small changes in the asset base can have a big
effect on ROI.
• large investments in one year (which would result in a much lower ROI)
may lead to prosperity in future years – therefore trends should be tracked
over several years.
Timing (minutes) Part (a) 8 mins
(b) 12 mins
(c) 10 mins
Total time spent on question 30 mins
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 36
(ii) Residual income (RI)
• both the RI figures are positive which is good, indicating that the return
from investment in the assets of the business exceed returns from
investing elsewhere
• however, the problems with small investment detailed under ROI also
apply to RI
(iii) Return on equity (ROE)
• these returns are higher than the required rate of return and increasing,
which is good (see comments about trends and alternative investment
under ROI and RI)
• the problems with small investments also apply to equity (as the company
has “low capital requirements”, and any small changes in equity have a big
effect on ROE)
(iv) Return on sales (ROS)
• ROS is increasing; again, you would want to examine the trend over
several years
• ROS is considered to be a more relevant measure of profitability in service
organisations because of the problem of smaller asset bases.
(v) Comments on financial/profitability measures
Overall, profitability measures alone do not necessarily reflect the long term
viability of the firm. Measures need to be developed that consider:
• the long run performance of the firm
• characteristics of service organisations
• the particular industry in which the firm is operating
• the economic, legal, cultural and political systems of countries in which the
firm is operating.
Focus solely on financial measures can lead to myopic behaviour. The inclusion
of non-financial measures can help mitigate this problem.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 37
c) What are some other measures of performance that could be employed?
Many measures may be suggested and be relevant; candidates should support their
suggestions with reference to service organisations and the particular sector of Golden
Travel, i.e. travel and tourism.
Some possible measures:
• size (in terms of both revenue and number of employees; also revenue per
employee)
• market share
• growth over time (e.g. sales growth relative to year of founding of the company)
• operating cash flow (should be positive at all times; analyse trends over time)
• customer measures, such as customer satisfaction, loyalty, retention, efficiency
and quality of service provision (because in a service organisation like Golden
Travel customers usually “experience service performance and quality at the
time of delivery”2 of the service)
• adaptability (e.g. number of successful new services/products introduced)
• performance in comparison with major competitors
• employee satisfaction (as pleasant, loyal and dedicated employees are crucial to
the success of a service organisation)
• responsiveness to changes in the market, the political situation, etc.
2 Haber, S. and Reichel, A. (2005) Identifying performance measures of small ventures – the case of the tourism
industry. Journal of Small Business Management, 43(3), 257-286.
Hong Kong Institute of CPAs
Financial Management Module (printed May 2010) 8 - 38
Part E
How do I know I have succeeded in this topic?
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Design appropriate performance measurement systems for different levels within the organisation, including cost centres, profit centres and investment centres.
Identify and explain the respective advantages and limitations of common financial performance measures, such as residual income (RI), return on investment (ROI) and also non-financial measures.
Apply the different transfer pricing methods.
Analyse budgets prepared for:
1. Cost centres,
2. Investment centres and
3. Profit centres and make appropriate recommendations.