Divisional Performance Management

Divisionalisation
A divisionalized company is one whose organization and operations are segmented into semi- autonomous units each with
a large degree of responsibility for decision making within its respective unit. Divisionalisation has occurred in existing
single companies and also as a consequence of merger activity. Typically mergers result in a large, diversified group
consisting of a number of operating divisions, with various degrees of autonomy answerable to the holding company or to
the main Board of Directors.
Centralisation
This is where the top management of an organization makes all the decisions without delegating to subordinate managers.
It is the tendency to resist delegation of decision making in an organization usually by holding it at the top of the
organization’s structure. It is simply the opposite of decentralization.
Decentralisation
As an organization grows in size and complexity top management find themselves unable to make all decisions. In such
circumstances authority for certain types of decision making is delegated to subordinate managers and thus some decision
making moves away from the centre and decentralization takes place.
The amount of decentralization can vary widely. In theory, total decentralization could occur whereby a division operated
completely autonomously with authority to make all types of decisions and would thus in effect be a separate entity. Of
course, such a situation is unlikely to be encountered and whilst the amount of delegated authority varies considerably,
certain types of decisions invariably seem to be retained by central management. Typically these include: major
investment decisions, Senior staff appointments and salaries, an d pricing decisions although in certain types of industries,
for example, retailing and jobbing engineering, pricing may be considered an operational responsibility. If central
management delegated these and other such decisions it would lack strategic control of the enterprise.
Benefits of Decentralisation
a) It improve strategic decision making
b) It increases flexibility and reduces communication problem
c) It increase motivation of divisional managers
d) It may eliminate uneconomic activities
Costs Attributable to Decentralisation
a) Risk of non-optimal decisions being taken
b) High cost of control arising from increase in information or data costs through duplication of services
c) Problem of interdependence
d) Other problems associated with the treatment of transfer prices, motivation and assessment of divisional managerial
performance.
Advantages of Divisionalisation
a) It can improve the decision making process both from the point of view of the quality of the decision and the speed
with which the decision is taken.
b) The authority to act to improve performance should act as a motivator to divisional managers. provided that a suitable
reward structure exists management will want to achieve a good returns for their division.
c) Divisional organization frees top management from detailed involvement in day-to-day operations and allows them to
devote more time to strategic planning.
d) Divisions provide valuable training grounds for future members of top management by giving them experiences of
managerial skills in a less complex environment than that faced by top management.
e) In a large business organization, the central head office will not have the management resources or skills to direct
operation closely enough itself or some authority must be delegated to local operational managers.
Problems of Divisionalisation
a) Sub-Optimality: Divisional general managers will not necessarily pursue the best interests of the organization as a
whole. They may not make the same decision that top management would have made. This is an opposite of goal
congruency
b) Increased Costs: Activities which are common to divisions can be more effectively centralized to save costs through
economies of scale e.g. Costs of running purchasing departments and billing, bulk purchasing savings. Duplication of
activities is required to effect a divisionalised structure, along with the cost of running a head office activity.

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c) Loss of Control: A further argument against the use of divisions is that top management, by delegating decision
making to divisional managers, lose control since there are not aware of what is going on in the organization as a
whole.
Objectives of performance Evaluation
a) Promote goal congruence: The performance appraisal system and criteria employed should help local management
to direct operations and to make decisions in ways that fulfill overall company objectives. Ideally the goals of local
managements should coincide with overall company goals.
b) Provide relevant and regular feedback to central management: Central management needs regular feedback of
appropriate information in order to judge the capability of local management and also to assess the economic worth of
the division as an operating unit. These two aspects may be related but involved distinctively different considerations
and information requirements.
c) Encourage initiative and motivation: The performance appraisal system should not be narrowly conceived or so
rigidly applied that it stifles initiative. For example, if local management see an opportunity which would increase
overall company profits but which would reduce the profits of their own division, then the system should be flexible
enough for this to take place without local management feeling that they will be penalized. Local management must
be encouraged to feel that, within the prescribed limits, they have genuine autonomy.
d) Encourage long run views rather than short-term expedients: The long term success of the organization is the
primary objective and the performance appraisal systems and measures should encourage decision making which
contributes to this objective.
Responsibility Accounting
Responsibility accounting is defined as a system of accounting that segregates revenue and costs into areas of personal
responsibility in order to measure the performance attained by persons to whom authority has been assigned. It is the term
used to describe a system of decentralized authority with performance of the decentralized units measured in terms of
accounting results. There are three types of responsibility accounting unit or responsibility centre. CIMA defines a
responsibility centre as “A department or organizational function whose performance is the direct responsibility of a
specific manager. The three responsibility centres are: cost cenre, Profit centre and investment centre.
 Cost Centre
This is a department or section or function over which a designated individual has responsibility for expenditure.
According to CIMA, a cost centre is defined as “a location, function, department or section, in respect of which costs
may be ascertained and related to cost units for control purpose only.
For a cost centre to be adopted, it has to possess the following characteristics:
a) It must be relatively easy to establish
b) It should be for the basis for building up cost records for measurement, budgeting and control.
c) Managers of functional departments might be treated as cost centres and made responsible for their costs.
 Profit centre
This is a unit of an organization often called a division which is responsible for expenditures/costs, revenues and
profits. In other words it is a unit to which both revenue and costs are assigned, such that the profitability of the sub-
unit can be measured. The following conditions must exist before the adoption of a profit centre:
a) There must be units of the organization to which both revenues and costs can be separately attributed.
b) The revenue might come from external sources through sales of goods or services or from internal work done for
other profit centres for which transfer price can be charged.
c) There should be sufficient decentralization of authority within the company to permit profit centre managers to
make decisions about selling prices (including transfer prices) and output levels at those prices.
 Investment Centre
This is a unit of an organization where a divisional manager is allowed to exercise some discretion about the amount
of investment undertaken by the division. In assessing the result of the investment centre, the profit earned must be
related to the amount of capital employed (ROCE) otherwise referred to as return on investment.
The following conditions must exist before a centre is adopted as an investment centre:
a) All the conditions listed under profit centre.
b) The centre must make use of assets which can be separately attributed to it.
c) The centre must make use of assets which the centre manager has control over in terms of new investment
decisions, asset replacement decisions.

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Characteristics of Cost, profit and Investment Centres
a) Cost centre manager has control over costs (only controllable costs)
b) Profit centre manager has control over costs, sales price (including transfer prices) and output volumes.
c) Investment centre manager in addition to the characteristics of the profit centre has control over investment in fixed
and current assets.
Measures of Divisional Performance
a) Absolute profit
b) Residual income
c) Returns on capital employed
 Absolute profit
This is sometimes known as divisional, traceable, or direct profit. It is the profit that arises from divisional operations
which can be calculated without arbitrarily apportioned central costs. It is equivalent to controllable profit less
depreciation on divisional assets and other non-controllable divisional overheads. The divisional profit might then be
compared with the budgeted profit. It follows that a number of costs which are identifiable with the division are not
controllable by the division. The advantage of this method is that, it derives the needed profit figure from the normal
accounting profit. The following are the disadvantages.
a) Difficulty in comparing divisions of unequal sizes; and
b) Difficulty in determining controllable overhead costs.
 Residual Income (RI)
This is sales revenue less controllable divisional costs and interest imputed on the divisional investment. Divisional
residual income is divisional profit less an imputed interest charge on the net costs employed by the divisions. The
word imputed in the definition means that the charge is made irrespective of whether the company as a whole has
actually incurred an interest cost in the ordinary sense of cash disbursement.
Residual income = Net profit - Imputed cost
Imputed cost= Cost of capital X Capital employed.
 Return on capital employed (ROCE)
This is otherwise referred to as return on Investment (ROI). It measures the overall profitability by relating net income
to the level of investment. ROCE can be defined using the following formula:
ROCE = Net Income X 100
Investment
The advantages and weaknesses of RI compared with ROI
The advantages of using RI
(a) Residual income will increase when investments earning above the cost of capital are undertaken and investments
earning below the cost of capital are eliminated.
(b) Residual income is more flexible since a different cost of capital can be applied to investments with different risk
characteristics.
The weakness of RI is that it does not facilitate comparisons between investment centres nor does it relate the size of a
centre's income to the size of the investment.
RI versus ROI: marginally profitable investments
Residual income will increase if a new investment is undertaken which earns a profit in excess of the imputed interest
charge on the value of the asset acquired. Residual income will go up even if the investment only just exceeds the imputed
interest charge, and this means that 'marginally profitable' investments are likely to be undertaken by the investment
centre manager.
In contrast, when a manager is judged by ROI, a marginally profitable investment would be less likely to be undertaken
because it would reduce the average ROI earned by the centre as a whole.
Example
Suppose that Department H has the following profit, assets employed and an imputed interest charge of 12% on operating
assets.
N N
Operating profit 30,000
Operating assets 100,000
Imputed interest (12%) 12,000
Return on investment 30%

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Residual income 18,000
Suppose now that an additional investment of N10,000 is proposed, which will increase operating income in Department
H by N1,400. The effect of the investment would be:
N N
Total operating income 31,400
Total operating assets 110,000
Imputed interest (12%) 13,200
Return on investment 28.5%
Residual income 18,200
If the Department H manager is made responsible for the department's performance, he would resist the new investment if
he were to be judged on ROI, but would welcome the investment if he were judged according to RI, since there would be
a marginal increase of N200 in residual income from the investment, but a fall of 1.5% in ROI.
The marginal investment offers a return of 14% (N1,400 on an investment of N10,000) which is above the 'cut-off rate' of
12%. Since the original return on investment was 30%, the marginal investment will reduce the overall divisional
performance. Indeed, any marginal investment offering an accounting rate of return of less than 30% in the year would
reduce the overall performance.
Transfer pricing Decisions
Transfer pricing is the process of determining the price at which goods are transferred from one profit centre to another
within the same company. Transfer pricing becomes necessary in order to determine the separate performances of both the
buying and selling profit centres. If transfer prices are set too high, the selling centre will be favoured whereas if set too
low, the buying centre will receive an unwarranted proportion of the profits.
In general terms, transfer pricing is purely an internal, bookkeeping exercise which does not affect the overall profitability
of the firm. However, in certain circumstances, transfer pricing may have an indirect effect on overall company
profitability by influencing the decisions made at divisional level. For example, based on a proposed transfer price, a
divisional manager may decide to purchase an item externally rather than accept the internal transfer even though such a
decision may reduce overall company profitability.
Objectives which transfer prices should meet
The following are the objectives of transfer pricing:
a. Goal congruence: The prices should be set so that the divisional management’s desire to maximize divisional
earnings is consistent with the objectives of the company as a whole. The transfer prices should not encourage sub-
optimal decision making.
b. Performance appraisal/Evaluation: The prices should enable reliable assessments to be made of divisional
performance. The prices form part of information which should:
 Guide decision making
 Appraise managerial performance
 Evaluate the contribution made by the division to overall company profits
 Assess the worth of the division as an economic unit.
c. Divisional autonomy: The prices should seek to maintain the maximum ddivisional autonomy so that the benefits of
decentralization (motivation, better decision making, initiative etc) are maintained. The profit of one division should
not be dependent on the actions of other divisions.
Transfer Pricing Methods
a. Cost-based transfer pricing
b. Market –based transfer pricing
c. Negotiated transfer Pricing
d. Arbitrary transfer pricing
Cost-based transfer pricing
Under this method the selling division sells to the buying division at the cost of production incurred by the selling
division. The following are the various types of cost-based transfer pricing:
a. Full cost transfer pricing: Here the selling division sells to thee buying division at full cost i.e fixed cost + variable
cost or full cost plus a profit markup.
b. Marginal cost transfer pricing: Using this system, transfers would be made at the (standard) marginal/variable cost
up to the point of transfer.

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c. Standard cost transfer pricing: This approach will be adopted under a situation where the selling division is unable
to establish the actual cost of production.
Advantages
1. It is very useful in decision making analysis especially with the use of marginal cost approach
2. It allows effective cost information system to be maintained by an organization
3. The approach is not prone to market fluctuation
4. Cost based transfer pricing will motivate the buyer
5. It eliminates the complexities associated with stock valuation especially the need to eliminate the unrealized profit on
stock.
Disadvantages
1. Divisional managers are not allowed to use their own initiative in pricing decisions.
2. The approach may encourage sub-optimality among the divisional managers.
3. The approach will negate the concept of divisional autonomy.
4. The approach cannot be used to evaluate to evaluate divisional performances especially those identified as a profit or
an investment centre.
Market -based transfer pricing
Under this approach, the relevant transfer price to charge between the selling and buying divisional managers will
represent the prevailing market price as at the date of the transaction. This implies that both the selling and buying
divisional managers are expected to operate at arm’s length.
Advantages
1. Market based will enhance performance evaluation
2. It allows divisional initiatives in pricing decision
3. The approach will also guarantee divisional autonomy
4. It can be used to maximize organizational profit
5. The method is expected to motivate both the buyer and the seller.
Disadvantages
1. It is prone to market fluctuation
2. It is possible for the market based transfer price to encourage unhealthy rivalry among divisional managers.
3. It will complicate the process of stock valuation as a result of the need to eliminate the unrealized profit on stock.
4. It is not consistent with the historical accounting system.
Negotiated transfer pricing
Under this method, the selling and the buying division agree in advance to use a mutually acceptable transfer price.
Advantages
1. The approach will encourage friendship among divisional managers
2. Divisional managers are allowed to use their initiative in pricing decisions
3. The method is not prone to market fluctuation
4. It guarantees divisional autonomy.
Disadvantages
1. A lot of managerial time is being wasted through bargaining
2. The corporate interest may be subordinated to individual divisional interest
3. A negotiated price may be influenced by the negotiating ability, personality and fluency of the managers involved.
Arbitrary transfer pricing
Under this method the transfer price is determined centrally based on what top management conceived to be most
beneficial to the company as a whole. Individual divisional managers may have some say but no control over the price set.
Advantages
1. The time spent in negotiating is saved.
2. Uniformity and stability tend to prevail.
3. It will guarantee the concept of goal congruency
4. The approach is considered ideal for planning purpose because it is specific in nature.

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Disadvantages
1. The autonomy granted the divisional manger is eroded
2. The divisional managers are prevented from using their initiative in pricing.
Question 1
Abdul Ltd has four divisions operating in Ibadan, Sokoto, Calabar and Maiduguri. The following data are in respect of
them:
Ibadan Sokoto Calabar Maiduguri
N N N N
Total asset 12m 10m 14m 18m
Total Sales 20m 30m 36m 28m
Total Cost 18m 27m 33.6m 26m
Cost of capital (%) 14 18 16 10
Required:
i. Calculate the annual returns on investment
ii. Calculate the residual income
Question 2
A.B.C Division of X.Y.Z manufacturing Nigeria P.L.C is a mono-product division which sells externally and can also
transfer to other divisions within the organizations. A.B.C division has been set a performance target of a budget residual
income of N300,000 for the coming financial year.
Additional information of ABC division:
a. Maximum production/sales capacity: 120,000 units
b. Sales of external customers: 80,000 units @ N20 each
c. Variable cost per unit N14
d. Fixed cost directly attributable to the division N60,000.
e. Capital employed N1,600,000 with a cost of capital of 15%.
The I.J.k division of X.Y.Z manufacturing Nig Plc has asked A.B.C division to quote a transfer price for N40,000 units.
Required
Calculate the transfer price per unit which A.B.C division should quote to IJK division in order that its residual income
target will be achieved.
Question 3
ASAD Limited has created a new division with four investment opportunities. The firm‟s cost of capital is 20%. The
following additional information is available:
Opportunity Income Investment
N N
A 131,000 750,000
B 162,000 600,000
C 151,000 500,000
D 148,000 700,000
Required:
a. Calculate the Return On Investment for each project. (6 Marks)
b. Assume you are the Division Manager and you are being evaluated based on Return On Investment (ROI), select the
investment opportunities you would accept where the projects are mutually exclusive. Calculate the associated ROI
for the division. (2 Marks)
c. If, on the other hand, you were evaluated on Residual Income (RI) basis, identify the investments you would accept.
Calculate the Residual Income for the division?
d. Assume you are the Chairman of ASAD Limited, identify which project you would want the division to accept. State
the performance measure you would use to encourage this action.
Question 4
Dictum company Limited is a large integrated conglomerate with shipping, metals and mining operations throughout the
country. The General Manager of the shipping division has been directed by the Board to submit his proposed capital
budget for 2013 for inclusion in the company wide budget. The Divisional Manager is considering the following projects,
all of which require an outlay of capital and have equal risk.
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 Project Investment required Return
N’000 N’000
1 24,000 5,520
2 9,600 3,072
3 7,000 980
4 4,800 864
5 3,200 640
6 1,400 392
The divisional Manager must decide which of the projects to accept. The company has a cost of capital of 15%. An
amount of N60 million is available to the division for investment purposes.
Required:
Compute the total investment, total return on capital invested and residual income on each of the following assumptions,
indicating the preferred project:
a. The company has a rule that all projects promising at least 20% or more should be accepted.
b. The divisional manager is evaluated on his ability to maximize his return on capital invested.
c. The divisional manager is expected to maximize residual income as computed by using the 15% cost of capital.
Question 5
The Mofe Pass company Ltd is a multi-divisional company and its managers have been delegated full profit responsibility
and complete autonomy to accept or reject transfer from other divisions. Division A produces a sub-assembly with a ready
competitive market. This sub-assembly is currently used by division B. Division A charges market price per unit. Variable
costs are N520 and N600 for division A and B respectively. The manager of division B feels that division A should
transfer the sub-assembly at a lower price than the market price because at this price, division B is unable to make profit.
Division B sells the final product at N1,200 while division A sells the sub-assembly in the market at N700.
Required:
a. Compute Division B’s Contribution margin if transfers are made at the market prices and also the total contribution to
profit for the company.
b. Assume division A can sell in the open market only 500 units at N700 per units of 1,000 units that it can produce
every month and that a 20% reduction in price is necessary to sell at full capacity. Should transfers be made?. If so,
how many units should it transfer and at what price?. Submit a schedule showing comparisons of contribution margin
under four different alternatives to support your answer.
Question 6
Bart technical company Ltd is into assembly of calculators. Its battery division which is situated at Ameokohia Omesu
manufactures highly durable batteries that it sells primarily to the assembly division for inclusion with that division’s
main product- Heinz calculators.
In 2004, half of the batteries were sold to outside customers at a price of N20 each. The remaining batteries were
transferred to the assembly division. Cost data for 2005 for the batteries division are as follows:
Production 120,000 units
Variable manufacturing costs N1,200,000
Fixed Overhead N600,000
Selling expenses (All variable) N300,000
Administration Expenses (all fixed) N200,000
Required
a. What would be the transfer price for the batteries if the company uses:
i. Market price approach
ii. Variable cost approach
iii. Negotiated transfer price approach that will yield a markup of 20% on its production
b. Prepare a schedule of contribution for the battery division based on the three methods mentioned above
Question 7
Captain company Nig Ltd has two divisions A and B for one of the company’s products. Division A produces a major
sub-assembly and division B incorporates this sub assembly into a final product. There is a market for both sub-assembly

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and the final product and the divisions have been delegated profit responsibility. Transfer price for the sub-assembly has
been set at long-run average market. The following data are available to each division.

N
Estimate selling price for final product 300
Long-run average selling price for intermediate product 200
Outlay cost for completion in division B 150
Outlay cost in division A 120
The manager of division B has made the following calculation:
N N
Selling price- final product 300
Transfer- in cost 200
Outlay cost for completion 150 350
Loss in product (50)
Required
a. i. Should transfer be made to division B if there is no excess capacity in division A
ii What happens to the profit of the organization if there is transfer.
b. Assume that division A’s maximum capacity for the product is 1,000 units per month, sales to the immediate market
are presently 800 units. Should 200 units be transferred to division B. if so, at what relevant transfer price.
c. Suppose division A quoted a transfer price of N150. What would be the contribution to the firm as a whole if transfer
were made. As a manager of B, would you be inclined to buy at N150 (assume 1,000 unit capacity for division A, 800
units market demand and 200 units transfer to division B).
Question 8
a) List four criteria for efficient and effective transfer pricing in a divisionalised structure.
b) Vee-vee imagination has two divisions; Fabrics and clothing. The fabrics division has enough market even at full
capacity of 500,000 metres of fabrics. The clothing division requires 5 metres for each pair of Buba and sokoto.
The fabrics division has the following selling price and cost data:
N
Market price per metre 100
Variable cost per metre (80)
20
Fixed manufacturing cost is N8 million
Each pair of Buba and sokoto of clothing division sells for N1,000 and other variable costs; processing n430 and
selling 10% of sales. Capital investment by the head office in fabrics division amounted to N10 million.
You are required to:
1. Advice the management whether to buy from Fabrics Division, if transfer price is based on full cost basis
2. Advice whether the company as a whole would benefit if clothing division manager decides to buy from fabrics
division at full cost basis.