Divisionalisation SMR PDF

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Divisionalisation & Transfer Pricing Decentalisation Most businesses operate in a complex environment and some form of decentralisation is needed in all but the smallest of organisations. Decentralization is the freedom of managers at lower levels of the organization to make decisions. Decentralization can take many forms, from separate companies who form part of a conglomerate (B&Q and Screwfix are part of the Kingfisher group) to departments within a much smaller organisation (the A&E department at a hospital). Organisations decentralize for many reasons but as you expect there is a trade-off between the costs & benefits. The table below which lists the advantages & disadvantages of adopting a decentralised structure: Advantage of Decentralization Provides incentives to department managers and individuals to optimize their individual performances. Local managers understand the business better & they should therefore make better & quicker decisions Provides top management with more time to make policy decisions and engage in strategic planning. Helps develop junior managers Motivates local employees as they feel they can make a difference Easier to spin off/divest operations

Dis-advantage of Decentralization It can cause competition between segments and individuals rather than cooperation and teamwork. Prevents goal congruence. Decisions are based on self interest rather than the best interest of the system. Local managers may not understand the wider strategic issues Results in the duplication of activities (it costs more) Decrease in loyalty towards the total organisation

Large organisations can adopt either a functional/centralized structure

Responsibility accounting Responsibility accounting is an underlying concept of accounting performance measurement systems. The basic idea is that large diversified organizations are difficult, if not impossible to manage as a single segment, thus they must be decentralized or separated into manageable parts”

Organisations decentralise by creating responsibility centres. Drury (2005) defines a responsibility centre as “a unit of a firm where an individual manager is held responsible for the unit’s performance”. There are four main types; 

Revenue centre – where a manager is responsible for revenues only (normally sales team)

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Cost centre - manager is accountable for costs only

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Standard cost centre, clear link between inputs and outputs, control through comparing standard costs with actual costs and resulting variance analysis

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Discretionary cost centre, no direct link between inputs and outputs, control exercised through reviewing actual expenditure to budgeted expenditure per expense category and reviewing achievement of tasks.

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Profit centre - manager is accountable for revenues and costs

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Investment centre - manager is accountable for investments, revenues and costs

But be careful of what you wish for – People respond to incentives: 

If you measure & reward maximising revenue it’s simple, you get market share & you should get higher profits but what are the unintended consequences?

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If you measure & reward minimizing cost it’s simple, you should get lower costs & thus more profit, but what are the unintended consequences?

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If you measure & reward maximizing returns on investment you should increase shareholder returns, but what are the unintended consequences?

The controllability principle When using responsibility accounting, controllability principle is important. As Drury notes “Responsibility accounting is based on the application of the controllability principle which means that it is appropriate to charge to an area of responsibility only those costs that are significantly influenced by the manager of that responsibility centre. The controllability principle can be implemented by either eliminating the uncontrollable items from the areas for which the managers are held accountable or calculating their effects so that the reports distinguish between controllable and uncontrollable items”. In short the controllability principle means don’t judge managers on things they can’t control.

Is responsibility accounting fit for purpose There is a very strong argument which suggests that divisionalisation and therefore responsibility accounting is no longer fit for purpose. Hierarchical organisational structures are great for exercising control over large groups of employees and eking out cost reductions, but they tend to create silos where departments compete with each other & have little connection to the final customer. However the modern organisation is very different, it needs to be flexible, agile & totally customer focused. You are more likely to work in value streams, on project teams or in a matrix organisation.

Transfer pricing “The price at which goods or services are transferred between different units of the same company. If those units are located within different countries, the term “international transfer pricing” is used. The extent to which the transfer price covers costs and contributes to (internal) profits is a matter of policy. A transfer price may, for example, be based upon marginal cost, full cost, market price or negotiation. Where the transferred products crosses national boundaries, the transfer prices used may have to be agreed with the governments of the countries concerned” “Transfer prices can have a profound effect on group performance because they not only affect divisional performance but also motivation and decision making” CIMA Official Terminology Transfer Pricing, what goes wrong?

Transfer pricing provides excellent examples of the coexistence of alternative legitimate views, and illustrates how the use of inappropriate figures can create misconceptions and can lead to wrong decisions” Source: ACCA Technical 10/09

A transfer pricing system We are now going to look at how organisations calculate these transfer prices……. Setting Transfer Prices - As we know large organisations often divisionalise, this creates an agent/principle relationship between the head office & the divisional managers. As you have seen throughout your studies, this agent principal relationship can cause problems, these problems include the issues created by the of setting a price for divisions who buy/sell goods or services to/from each other. The managers of divisions are normally rewarded on their performance and therefore either wish to obtain the highest prices (the supplier) or the lowest price (the customer). There are a number of ways to solve this problem but the overriding logic is to put the managers in the same risk and reward situation as the owners, if we can do that we are more likely to maximise shareholder value. Objectives of a transfer pricing system are to: 

Ensure goal congruence – The decisions made by managers should seek to ensure that corporate profits are maximized

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Motivate managers – the pricing system should encourage managers to act as principals (this means they should be able to make a profit & retain autonomy)

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Measure performance fairly - much of the logic behind divsionalisation is behavioral, therefore managers should perceive that divisional performance is measured fairly

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Minimize the global tax liability –Important if a company operates under more than one tax regime (Not the concern of this unit)

The general rule There are a number of ways to set a transfer price but a good general rule for setting transfer prices is that all goods & services should transferred at opportunity cost (what an organisation is giving up to supply or acquire the goods). This means that... 1. Where there is a perfectly competitive market for an intermediate product - The market price is used as the transfer price. A perfect market means that there is only one price in the market, there are no buying or selling costs and the market is able to absorb the entire output of the primary division and meet all of the requirements of the secondary division. The market price should be adjusted for costs not incurred on the transfer and the product should the same as that offered by the market (quality, delivery times, warranties etc)

2. Where there is surplus capacity - The transfer price should at least recover the marginal cost of the supplying division, but must be less than the marginal revenue of the buying division. (we can give a profit to the supplying division to motivate them) 3. Where there are production constraints - The transfer price is the opportunity cost of the lost contribution from the other product or it is the extra contribution that would be earned if more of the scarce resource were available. The maximum price is the must be less than the marginal revenue of the buying division. (we can give a profit to the supplying division to motivate them) Notes: Re point 1 - Organisations can make a sub-optimal decision and transfer below the market rate if the receiving division is strategically important Reference points 2 & 3 - Where cost is used to calculate transfer prices, organisations should use standard cost so the variance is reported & dealt with at source The diagram below summarises the rules for setting a transfer price...

Student activity

Group PLC has two subsidiaries Division 1 and Division 2. Division 2 produce a product which requires one Widget. Widgets are manufactured and supplied by Division 1. The two divisions are now trying to negotiate a suitable transfer price for the coming financial year. The following transfer prices have been suggested: 1. The general manager of Division 1 would like to charge the full cost plus enough profit to meet the required return on sales. To calculate the full cost per unit he would like to use the actual results for 2015 (see the table below). 2. Division 2 would like to be charged the standard variable cost of production. Widget Performance Report – Year Ending Dec 2015 Units Sales Revenue Variable Costs Production Overhead Allocation Profit Notes:

Budget 36,000 £936,000 £549,000 £271,000 £116,000

Actual 36,490 £948,740 £585,664 £274,430 £88,646

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Management bonuses are based on the achievement of a return on sales of 15%

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Division 1 are currently working to capacity

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Division 2 expect to order 36,200 Widgets in the coming financial year

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Division 1’s management believe that if they stopped manufacturing the Widget they could earn £180,000 per annum of contribution by supplying another product to an external customer.

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Group Plc insist that production fixed costs should be allocated on a percentage of total sales revenue basis.

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Division 2 sell the product the Widget goes into for £60 and incur a further £33 of cost in the process.

Required 1. Calculate the two suggested transfer prices and fully evaluate each price from the divisional managers and Group Plc’s perspective 2. Suggest and justify a suitable transfer price

Solutions: (there is a video after the calcs)

Part a) Calculate the two suggested transfer prices and fully evaluate each price from the divisional managers and Group Plc’s perspective Price 1 - Full cost plus required rate of return Calculation of transfer price = £23.57/ 0.85 = £27.73 Div 1 would be motivated as they would be able to make the required profit to obtain their bonus The use of actual cost rather than std cost doesn't not encourage Div 1 to look for cost /process improvements Div 2 would make a loss of £0.73 (£27- £27.73) per unit This would demotivate managers as they would not be able to meet their bonus target (thus bad for goal congruence) Price 2 standard variable cost Calculation of transfer price £15.25 Div 1 would lose $4.97 per unit in opportunity cost (£180,000/36200) & would production would decrease their chance to make the bonus The use of standard cost would encourage Div 1 to be more efficient Div 2 would make (£60 - £33 - 15.25) 11.75 per unit Div 2 would be on track to meet the bonus target £11.75/£60 = 19.6% Part b) Min Price = standard marginal cost + opportunity cost = £15.25 + £4.97 = £20.22 Max Price = Marginal revenue = £60 - £33 = £27 Transfer pricing summary: Transfer pricing often confuses students but generally speaking there are only 3 types of transfer pricing question 1. Calculate a suggested transfer pricing 2. Evaluate a transfer pricing (numerically and using the checklist) 3. Suggest & justify a transfer price (using our rules & our checklist)...