Introductory Management

Accounting
Lecture 13&14

Performance Measurement and Management

ChunLei Yang
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 Lecture Plan

1 Accounting for divisions 2 Transfer Pricing Issues

1.1 1.2 2.1 2.2

Decentralisation & The importance and General approaches to

Divisional Performance
Divisional Structure difficulties of transfer transfer pricing
Measures: ROI, RI and pricing
EVA
 Lecture 13
Performance Measurement and Management-1

Accounting for divisions

ChunLei Yang 3
Setting the
scene..
Business information

• Established in 1870 by Rockfeller & partners in

Ohio
• Now headquartered in Irving, Texas
• One of the world’s largest and most profitable oil
and gas companies
• Annual turnover approx. $280billion
• Vertically integrated: upstream-downstream-
chemicals

• Global operations: organized functionally into a

number of global operating divisions
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Setting the
scene..

ExxonMobil: worldwide operations

How do very large companies manage and co-ordinate business

activities across different geographical locations and product lines?

5
Setting the
scene..
Decentralisation and
multidivisional structure

Division A Division B
…

o Profitability as the key performance indicator

o Internal transfer of goods

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Real World Perspectives

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 Decentralisation: a balancing act

Advantages:
Disadvantages:
1) Top management freed from
1) Loss of bigger picture
everyday problems to focus on
2) Lack of coordination
strategic issues
3) Conflict of interest and agendas.
2) lower-level management gains
4) Communication
experience
3) Motivation
4) Better information
5) Evaluation of performance

How do you(the senior management) keep the ‘right’ balance? 8

 The Tension

Preserving divisional autonomy whilst

ensuring firm-wide optimisation.

Objective, accounting-based performance measurement

system

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 Real World Perspectives

Business turnaround at Ford Motor Corporation

• Ford founded • Fresh challenge from

Japan

1903 1940s 1980s

• Business turnaround by
Thornton’s whiz kids
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 Measures of divisional performance

Financial
Responsibili
ty centers

Cost Profit Investmen

centers centers t centers

Various cost Various profit ROI or RI/EVA

measures measures

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 Divisional Profit Measures
£

Sales 150,000
-Variable cost 110,000

Profit measure (1) Contribution margin 40,000

- Controllable fixed costs 5,000

Profit measure (2) Controllable profit 35,000

-non-controllable fixed costs 10,000

Profit measure (3) Divisional profit before HO allocation 25,000

-allocated HO costs 5,000

Profit measure (4) Divisional pre-tax profits 20,000

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 Return on Investment
ROI =Net profit/ Investment in net assets

or, = (Sales/Investment in net assets )×(Net profit/Sales)

=Asset Turnover × Profit Margin

ROI

Profit Assets
margin Turnover

Investment
Net Profit Sales Sales
in net assets

Operating Current Fixed

Sales
expenses assets assets

Selling Admin. Plant+

Cost of Cash+ stock+
expense expense equipment+
sales debtors
s s others

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 Real World Perspectives:
ExxonMobil—Defining ROCE
“Return on average capital employed is a performance measure ratio. From the
perspective of the business segments, ROCE is annual business segment earnings
divided by average business segment capital employed (average of beginning and
end of year amounts). These segment earnings include ExxonMobil’s share of
segment earnings of equity companies, consistent with our definition of capital
employed and exclude the cost of financing.”

“The corporation’s total ROCE is net income attributable to ExxonMobil

excluding the after-tax cost of financing, divided by total corporate average capital
employed. The corporation has consistently applied its ROCE definition for many
years and views it as the best measure of historical capital productivity in our
capital intensive, long term industry, both to evaluate management’s performance
and to demonstrate to shareholders that capital has been used wisely over the long
term. Additional measures, which are more cash flow based, are used to make
investment decisions.”

(Annual report 2019)

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 Real World Perspectives:
ExxonMobil—Defining Capital Employed

“Capital employed is a measure of net investment. When viewed from the

perspective of how the capital is used by the businesses, it includes
ExxonMobil’s net share of property, plant and equipment and other assets less
liabilities, excluding both short-term and long-term debt.”

“When viewed from the perspective of the sources of capital employed in

total for the Corporation, it includes ExxonMobil’s share of total debt and
equity. Both of these views include ExxonMobil’s share of amounts
applicable to equity companies, which the Corporation believes should be
included to provide a more comprehensive measure of capital employed.”

(Annual report 2019)

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 ROI-Evaluation

Advantages Potential problems

• The calculation of operating profit in

• Relative measure taking account each division—the determination of
of profit as well as all assets divisional revenue and expenses
invested in the firm/division
• The determination of the asset base:
• Compatible with conventional gross or net? Current or historical?
financial reports
• Transfer pricing problem
• Enables comparison between
firms/divisions. • Dysfunctional behaviour:
e.g.,
Existing ROI of division A : 20%
Expected return of the new project: 15%
Cost of capital of the company: 12%
Manager of division A: invest
or not?

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 Residual Income (RI)
Residual Income
= Controllable operating income-cost of capital*
*minimum desired rate of return × investment in the division
£

Controllable profit 300,000

Interest charge (12%*£2,000,000) 240,000
Residual Income 60,000

EVA (Economic Value Added)

= conventional divisional profit + accounting adjustments-cost of
capital charge on divisional assets.

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 ROI vs. RI

Use stockholder-relevant bench-marks

to set financial performance targets for
internal divisions.

BUT, sometimes evaluations are complicated by

internal transactions. 

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 Lecture 14

Performance Measurement and Management-2

Transfer Pricing problems

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 Topic Outline

1. General principles for pricing internally

transferred goods
2. Different approaches to transfer pricing

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 Transfer pricing: the context
• Decentralised company
• Profitability as the key performance indicator
• Internal transfer of goods
• The prices at which goods or services are sold on internal markets between
strategic business units or divisions of the same firm.

HQs

A B ……
P
?
“The most troublesome management control issue in our company.”
Manager, Weyerhaeuser
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 The significance of transfer pricing

Tax planning: Worldwide Divisional performance 

taxation, tariffs, import motivation
duties Decisions that increase the divisional
performance should also increase the
Chase was the oil companies’ preferred bank, performance of the whole company
and it had asked Hudson to study the petroleum
industry’s impact on the U.S. balance of
payments to provide ammunition that would
help the oil companies claim they were “good Managerial decisions at the
for America” and help them lobby for special divisional/strategic level:
-Buy/sell inside or outside the company?
government perks. One of his tasks on this
-How well are the divisions performing?
project was to find out where the oil companies
made their profits. At the producing end? At the
refineries? In the gas stations? David
Rockefeller, Chase’s president, arranged for Divisional autonomy
Hudson to meet Jack Bennett, Treasurer of Intervene or not?
Standard Oil of New Jersey, now part of the
ExxonMobil empire. Bennett gave him his
answer. “The profits are made right here in my
office,” the oilman said. “Wherever I decide.”

--from Treasure Islands, by Nicholas Shaxson 22

What is a good transfer price?
• Maximises the economic benefit of the company as a whole
• Facilitates localised decision making
• Appeals to divisional managers –they should be happy with
the prices
• Tax saving
• Others (ethical, organisational…) factors

The key point …

Transfer prices should motivate managers of individual divisions to act
in the best interests of the firm as a whole

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 Meeting the Challenge

Company goal
Divisional congruence
autonomy

Economic based transfer pricing:

.
Transfer price = opportunity cost

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 Three transfer pricing systems
1. Market-based transfer prices
– Applicable when an external competitive market exists
– Listed price of an identical or similar product on external
markets (possibly less a discount to reflect lower
transaction costs through internal transfer)
But,
– External market prices will often not exist for the
proprietary products that are transferred between divisions
(e.g., Toyota R in the case of Toyota)
– May not always be appropriate for the business as a whole
(spare capacity)
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 Three transfer pricing systems
2. Cost-based prices
– Variable-cost based transfer prices
– Full-cost based transfer prices

But,
– Slack
– May lead to wrong decisions
– Negotiation, power play and interpersonal skills…

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 Three transfer pricing systems

3. Negotiated prices
– More practical, widely used
But,
– Artificial
– Suffer all the disadvantages of cost-based
prices

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Question : Intermediate product A
Cost/
Metre
Variable cost
£2
Fixed cost
£5
Total costs
£7
Market price
1. £10
Suppose you are the senior manager:
Should thecapacity
Current internal transfer take unit
at selling place?
50%
Internal Offer from buying unit 5
A. Yes
B. No.

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Question : Intermediate product A
Cost/
Metre
Variable cost
£2
Fixed cost
£5
Total costs
£7
Market
2. Supposeprice
you are the head of the selling
£10
unit. Should you accept or decline the offer at
Current capacity at selling unit
£5?
50%
Internal Offer from buying unit 5
A. Yes
B. No.

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Question : Intermediate product A
Cost/
Metre
Variable cost
£2
Fixed cost
£5
Total costs
£7
Market price
3. What
£10 is the range of sensible
transfer
Currentprices?
capacity at selling unit
50%
A. 2-7
Internal Offer from buying unit 5
B. 7-10
C. 2-10
D. 5-7
(Variable costs, market prices)
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Question : Intermediate product A
Cost/
Metre
Variable cost
£2
Fixed cost
£5
Total costs
£7
Market
4. price
What is the range of sensible transfer
£10
prices if the selling unit is running at full
Current
capacity capacity
instead of half?at selling unit
50%
Internal Offer A. 7 from
plus buying unit 5
B. 7-10
C. 2-10
D. 10 minus
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 How does accounting contribute to
corporate profit planning and control?

Responsibility Standard Variance

Budgeting PMM
Accounting Costing Analysis

Accounting for profit planning and control: key points

Design an accounting-based management control system appropriate for the circumstances
Intelligent use of management control information
– Controllability
– Setting expectations
– Carefully manage performance targets—avoid the mistakes made by WorldCom,
Enron and, of course, the banks.

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 Study checklist
 Understand the trade-off of centralisation vs. de-centralisation
 Understand the principles of transfer pricing and apply them to set
transfer prices
 Understand the strength and limitations of accounting in managing
corporate performance
 Relevant reading: Atrill and McLaney, Chapter 10; “An empirical
Study of the Role of Accounting Data in Performance Evaluation”
(Hopwood, 1972)
 Prepare for the revision lecture:
– Consider how the module has expanded your understandings of
accounting
– Describe, in your own words, what management accounting is and what
its roles are in an organisation.
– Read through last year’s exam paper, find out what it looks like
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