Performance Section Indicators and Measures for 8 ... · Indicators and Measures for ... Anthony,...

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



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.



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.



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.



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.



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?



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.



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.



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

-



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.



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.



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.



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.



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.



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.



• 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.



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]


[(HK$110 - HK$100) × 1,000]

Total company profit is HK$50,000



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]


[(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.



(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.



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.



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



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.



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



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



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



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.



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)



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)



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.



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.



Suggested Solution


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



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



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.




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%



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


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



(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.



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.



Part E

How do I know I have succeeded in this topic?

Can I:

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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.

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