Flashcards in Chapter 14 - Divisional performance measurement and transfer pricing Deck (18)
What is the formula for Return on Investment (ROI)
ROI = (Controllable profit/Capital employed) × 100
When is controllable profit taken?
After depreciation but before tax.
What is capital employed?
Total assets - Current liabilities
Total equity + Long term debt`
What are the advantages of ROI
-Can be used to compare with similar sized companies
-It can be broken down into secondary ratios (Profit margin/ asset turnover)
What are the disadvantages of ROI?
-Dysfunctional decision making trying to maintain really high ROI.
-ROI increases with age (Encourages holding on of old assets)
-Encourages manipulation of figures to improve results
-Different accounting policies can confuse comparisons. (E.g depn)
What is the formula for Residual income? (RI)
RI = Controllable profit – Notional interest on capital
How do you calculate the notional interest on capital?
capital employed x notional cost of capital
capital employed x interest rate
What are the advantages of Residual income? (RI)
-Helps prevent the dysfunctional behavior of ROI
-Makes managers more aware of costs of assets
-Can change interest to suit risk
What are the disadvantages of Residual income? (RI)
-Cannot compare between divisions as it is based on size of divisions
-Based on measures which can be manipulated for higher bonus.
What is the transfer price?
The price at which goods or services are transferred from one division to another within the same organisation.
What are the objectives of transfer pricing?
Goal congruence - Maximise organisation profits
Performance measurement - Each division assessed fairly
Recording the movement of goods and services
What are the two main methods of setting a transfer price?
-Market based approach
-Cost based approach
What is the market based approach of transfer pricing?
Set the transfer price at the external market price.
What are the advantages of the Market based approach?
-Should be deemed fair by managers
-This will not negatively impact the company performance.
What are the disadvantages of the Market based approach?
-There may not be an external market price
-The price may not be suitable e.g discounts offered
-Savings may be made from internal transfers (may need adjusted market price)
What is the cost based approach of transfer pricing?
The transferring division would supply the goods at cost plus a % profit.
Why should a standard cost be used rather than an actual cost?
-Actual costs do not encourage selling to divisions to control costs
-With standard costs the buying division will know the cost in advance.