Chapter 12

Financial performance reports

and transfer pricing

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 Outline
• Performance management systems

• Structuring for control

• Complex structures

• Financial performance reporting

• Transfer pricing

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 Purpose of performance
management
• Communicates business strategy and
plans
• Management performance tracked
against targets
• Used to evaluate and reward
subordinates’ performance
• Guides future development of business
strategies and operations

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 Characteristics of effective
performance measurement
systems
• Links to organisational strategies and goals
• Recognises controllability
• Embraces participation and empowerment
• Simple measures

(cont.)
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 Characteristics of effective
performance measurement
systems (cont.)
• Emphasises the positives

• Reported in a timely manner

• Includes benchmarking

• Limited performance measures

• Linked to rewards

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 Structuring for control:
Decentralisation
• Decentralisation
– Each unit assigned particular operational and
decision-making responsibilities
• Goal congruence
– Alignment with organisational and
management goals
• Responsibility accounting
– Assigning responsibility to managers
(cont.)

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 Structuring for control:
Decentralisation (cont.)
• Benefits of decentralisation for managers
– More accurate and complete local
information about markets and operations
– Training for future higher-level managers
– Greater motivation and job satisfaction
– More time for strategic issues
– Delegation allows quicker responses to
opportunities and problems as they arise
(cont.)
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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-7
 Structuring for control:
Decentralisation (cont.)
• Costs of decentralisation
– Narrow focus on own unit’s goals
– Unnecessary duplication
• Goal congruence: a behavioural
challenge
– May be difficult to achieve in a decentralised
organisation
– Performance measures and reward systems
may provide direction and incentives
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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-8
 Responsibility centres
• A responsibility centre is a unit in an
organisation where the manager is held
accountable for the unit’s activities and
performance
– Investment centre
– Profit centre
– Cost centre
– Revenue centre
(cont.)
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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-9
 Responsibility centres (cont.)

(cont.)
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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-10
 Responsibility centres (cont.)
• Terminology used in practice
– Cost centre is commonly used
– Revenue centre seldom used
– Profit centre may refer to both profit centres
and investment centres
– Strategic business unit (SBU) often used to
refer to investment centres and occasionally to
profit centres which have their own distinct
markets and strategies

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 More complex structures
• Shared services
– The concentration of support services formed
into a separate unit to service multiple internal
customers
– May focus on non-strategic areas
– Capture the best aspects of centralised and
decentralised structures
– Business units may choose to use a shared
service unit or an outside provider
(cont.)

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-12
 Shared services versus
centralised services

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More complex structures (cont.)
• Team-based structures
– Move towards flatter structures
– Self-managed work teams
– Team responsibilities in the production area
– Manage some processes more effectively
– Promotion of employee satisfaction,
improved customer satisfaction and
productivity
– Teams are often set up as cost centres (cont.)
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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-14
More complex structures (cont.)

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 Financial performance reports
• Shows key financial results appropriate for
the types of responsibility centre
• Segmented profit statements
• A contribution margin format may be used
to provide more useful information
• Performance of units and unit managers
may differ
• Cost allocation in performance reports
(cont.)

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-16
 Financial performance reports
(cont.)
• A hierarchy of financial performance
reports may be prepared reflecting the
organisational structure
• Budgets and variance data may be
included in performance reports
• Allocated costs should be included in
performance reports when relevant
• Real time reporting

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-17
 Transfer pricing
• The internal selling price used when
goods and services are transferred
between profit centres and investment
centres in a decentralised organisation
• Allows the selling unit to earn profit to
reflect their effort in producing the
product
• The transfer price system

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-18
Who sets the transfer prices?
– Managers of profit centres and investment
centres may have considerable autonomy
– Direct intervention by corporate (head office)
managers to dictate specific transfer prices
may be inconsistent with the philosophy of
decentralisation
– Corporate management may develop
general policies to govern transfer pricing
practices

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-19
 Transfer pricing methods
• Market-based prices
• Negotiated prices
• Cost-plus prices

(cont.)
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Transfer pricing methods (cont.)
• Market-based prices
– Need competitive external markets
• Negotiated prices
– Market price may form the starting point
– Cost may be the lower boundary
• Spare capacity

(cont.)

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Transfer pricing methods (cont.)
• Cost-plus prices
– No external market price
– Intermediate products
– Standard variable cost plus mark-up
– Standard absorption cost
– Standard costs should always be used in
favour of actual costs

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 Transfer pricing
• General transfer pricing rule
– Provides guidance on the appropriate
transfer price
– Represents a minimum transfer price
– May guide unit managers to make
goal-congruent decisions

Additionaloutlay costs per unit opportunitycost per unit

Transferprice  
incurredby supplying unit to the supplying unit

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 Transfer pricing under
different scenarios
• An external market and spare capacity in
the supplying unit
– Where there is spare capacity the transfer of
product gives the supplying unit additional
profits that it would not otherwise have
– The two units may negotiate a transfer price
less than the market price to provide an
incentive for the buying unit to purchase from
the supplying unit
(cont.)
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Transfer pricing under different
scenarios (cont.)
• An external market and no spare capacity
in the supplying unit
– When there is no spare capacity the
supplying unit will need to take account of the
opportunity cost of lost profits
• External market and limited capacity in the
supplying unit
– Where capacity is limited an opportunity cost
needs to be accounted for
(cont.)
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 Transfer pricing under
different scenarios (cont.)
• No external market and spare capacity in
the supplying unit
– There is no opportunity cost associated with
the transfer so the transfer price may be
based on cost-plus
• No external market and no spare
capacity in the supplying unit
– The transfer price will need to account for
opportunity cost on lost sales
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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-26
Using the general rule for each
transfer pricing scenario

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 Transfer pricing: the influence
of income taxation
• Effectively ‘transfer profits’ between
business units in different countries
• International transfer prices may be
influenced by the different taxation rates
and different regulations
• International tax considerations
• Service firms and not-for-profit
organisations
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 Transfer pricing and service
level agreements
• A service level agreement (SLA) is a
contract between two units within an
organisation which
– establishes the nature of the service
– outlines the responsibilities of each party
– outlines terms of supply
– determines the transfer price of the service

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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-29
 Summary
• Purposes and characteristics of
performance measurement
• Structuring for control: Decentralisation
coupled with responsibility accounting
• More complex structures
• Financial performance report
• Performance of units versus the
performance of unit managers
(cont.)
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Langfield-Smith, Thorne, Smith, Hilton Management Accounting, 7e 12-30
 Summary (cont.)
• Transfer pricing is used in decentralised
organisations
• Transfer prices may be based on market
prices, costs or may be negotiated
• In a decentralised organisation
management may set broad policies to
govern practices
• General transfer pricing rule

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