Performance Measurement and Divisional Transfer Pricing
Domain focus
Performance measurement evaluates responsibility centres; transfer pricing sets internal prices between divisions. The exam tests ROI, residual income, EVA, balanced scorecard logic and transfer pricing methods.
Core rules
- ROI = divisional profit / divisional investment. It encourages efficiency but can cause underinvestment because a project may lower divisional ROI even when it earns above the cost of capital.
- Residual income = profit - (investment × imputed interest rate). It accepts projects earning above the charge but is an absolute amount, so size matters.
- Transfer price minimum for the selling division = variable cost + opportunity cost of lost external sales. With spare capacity, opportunity cost is zero, so variable cost is the floor.
- Market-based, cost-plus and negotiated transfer prices affect goal congruence and divisional profit.
Worked example
Division profit is ₹2,00,000; investment is ₹10,00,000; cost of capital is 15%. Current ROI = 20%. A new project needs ₹2,00,000 investment and earns ₹36,000, an 18% return. New ROI = (2,00,000 + 36,000) / (10,00,000 + 2,00,000) = 19.67%, so a manager judged on ROI rejects it. Residual income = 36,000 - (2,00,000 × 15%) = 36,000 - 30,000 = ₹6,000 positive; the project is good for the company. This illustrates the ROI underinvestment problem.
Traps
Comparing ROI across divisions of different sizes without context; using profit before the imputed charge in RI; setting transfer price at full cost when spare capacity exists; ignoring opportunity cost; rewarding divisional profit without considering invested capital.