Management controls and strategic

performance Measurement; STRATEGIC

INVESMENT UNITS AND TRANSFER
PERFORMANC
E EVALUATION
is the process by which managers at all levels gain information about
the performance of tasks within the firm and judge that performance
against: preestablished criteria set out in budgets, plans, and goals

Performance is evaluated at many different levels in the firm:

Top Management Mid-management Operating level of individual

production and sales employment
2
Management
control
refers to the evaluation by upper-level managers of the
performance of mid-level manager.

Operational
control
means the evaluation of operating level employees by
mid-level managers

3
Objectives of
management
control
1. Motivate managers to exert a high level of effort to
achieve goals set by top management.
2. Provide the right incentive for managers to make
decisions consistent with the goals set by top
management.
3. Determine fairly the rewards earned by managers for
their effort and skill and the effectiveness of their
decision making.
STRATEGIC INVESTMENT
UNIT (siu)
also known as Responsibility Center is a specific unit of an
organization assigned to a manager who is held accountable for
its operations and resources.

Each manager is held responsible for deviations between

budgeted goals and actual results. This concept is known as the
performance evaluation
and control.

5
 DECENTRALIZATION
Strategic AND SEGMENT
Performance REPORTING
Measurements A decentralized organization is one which decision making is not
confined to a few top executives but rather is spread throughout the
also knows as Responsibility Accounting is a system
organization, with managers at various levels making key operating
used by top management to evaluate SIU managers.
decisions relating to their sphere of responsibility.

In segment reporting, cost and revenues are assigned to segments to

enable management to see where responsibility lies for control
purposes and to measure the performance of segment managers.

6
Benefits and Limitations of
Decentralization
Benefits Drawbacks
 Use local knowledge  Can hinder coordination among SIUs
 Allows timely and effective response to  Can cause potential conflict among SIUs
customers
 Train Managers
 Motivates Managers
 Offers objective method of performance
evaluation

7
Prerequisites to the Initiation and
Maintenance of an Effective
Strategic Performance
Measurement or Responsibility
Accounting
1. A well-defined organization structure.
2. Well-defined and established standards of performance in
revenues, costs, and investments.
3. A system of accounting that identifies any revenues, expenses,
and assets to specific units in the organization.
4. A system that provides for the preparation of regular
performance reports.
Strategic Business Units (SBU) and
their Evaluation
is a unit within the organization which has control over costs,
revenues, profits, and/or investment funds.

The type of SBUs are:

Cost Profit Investment Revenue

9
10
COST SBU
 COST SBU
The manager is responsible for minimizing costs subject to some
output constraints. A distinguishing feature of a cost SBU is that it has
no control over generating revenue or the use of investment funds.

Examples:

maintenance dept. of a library section of a accounting department of a

manufacturing company school trading concern
12
 MANAGER,
COST SBU
responsible for making the projection or
budget of costs in his unit based on the
expected level of operation for the period.

When approved by the higher authorities (board of

directors), the budgets will serve as the basis for the
transactions or activities for the ensuing period.

Performance of a cost SBU is evaluated using the performance

reports or variance analysis reports based on standard costs and
flexible budget. The performance or responsibility cost report will
show the comparison between the two costs.

13
Responsibility cost
PRO-FORMA RESPONSIBILITY
COST REPORT
Costs Actual Budget Variance Remarks
Unfavorable
(Favorable)
Direct costs
Controllable
---- Pxx Pxx Pxx
---- xx xx xx
Total Pxx Pxx Pxx
Noncontrollable
---- Pxx Pxx Pxx
---- xx xx xx
Total Pxx Pxx Pxx
Indirect costs Xx Xx Xx
Total costs Pxx Pxx Pxx
 ILLUSTRATIVE   Budget Actual

PROBLEM Direct materials

Direct labor
P210,000
136,000
P208,600
137,800
     
The department supervisors at Meredith, Inc. are
Department costs:    
authorized to purchase the direct and indirect materials
Supervision 21,000 21,000
needed in production, hire, and assign the production Indirect materials 14,200 14,700
workers, and incur various overhead costs for their Repairs and maintenance 2,100 2,200
department. The equipment used in the department is Equipment operating cost 3,400 3,300
acquired at a higher management level, but supervisors Depreciation, equipment 4,000 4,000
are responsible for proper care and maintenance. The      
salaries of the supervisors are shown under the cost of Allocated plant costs:    
supervision. Superintendence 19,500 21,000
Heat, light and power 3,700 3,900
During the year, Department 7 manufactured 40,000 Taxes and insurance 5,400 6,100
units as budgeted. Budgeted and actual costs for Other plant occupancy cost 5,000 6,700
Department 7 are given  Depreciation, plant 7,000 7,000
  P431,300 P436.300
 REQUIREME
NTS

1 2 3

Compute the budgeted Prepare a responsibility Does it appear that the

unit cost of the product cost report. Show cost supervisor was
and the actual unit cost. variations from the budget responsible for a large
part of the variation
between budgeted and
actual costs?

17
SOLUTIONS
PROFIT SBU
 PROFIT SBU
The manager is responsible for the generation of revenues and
control of costs incurred in that SBU.

Examples:

loans and discounts ladies wear section college department of a

department of a of a department university
commercial bank store 22
 MANAGER,
PROFIT SBU
responsible for preparing the budget in his unit
and the approved projections will provide the
guidelines and authority for him to enter into
transaction for the budget period.

Performance of a profit SBU is measured by

preparing the income statements using the
contribution approach, presenting both the actual
results and budgeted figures.

23
Illustrative Problem 14-2

24
Solution:

Conclusion:

Product 3 contributes P17,500 to the recovery of the indirect expenses.

Therefore, in the absence of any other better alternative, it should be
dropped.

25
INVESTMENT SBU
This is a unit or segment within the organization where the manager
is responsible for the control of revenues, costs and investments made
in that SBU. Examples include corporate headquarters or division of a
large, decentralized organization such as :

1. Magnolia Products Division of San Miguel Corporation

2. Pharmaceutical Division of Novartis

3. Subsidiary companies

26
The objectives of an investment
SBU or business unit are:

A. Motivate managers to exert a high level of effort to achieve the goals

of the firm.

B. Provide the right incentive for managers to make decisions that are
consistent with the goals of top management.

C. Determine fairly the rewards earned by the managers for their effort
and skill.
Advantage of ROI

1. It is easily understood and has gained wide usage.

2. It is comparable to interest rates of returns of alternative

investments.

28
Net Operating Income is generally used because it is consistent with
the base to which is applied, that is, operating assets.

Operating assets include cash, accounts receivable, inventory, plant

and equipment, and all other assets held for productive use in the
organization. Examples of assets that generally would not be included
in the operating assets category are land held future use, as
investment in another company or a factory building rented to
someone else.

29
Limitations of ROI.
1. Although ROI is widely used in evaluating performance, this method is subject to some criticisms. One of
these criticisms is that ROI tends to emphasize short-run performance rather than long-run profitability.
Managers may be motivated to reject profitable investment opportunities if the expected rate of return is
lower than the current ROI. ROI may not be fully controllable by the division manager due to the presence
of committed costs. Hence, the ROI makes it difficult to distinguish between the performance of the division
manager and the performance of the division as an investment SBU.

2. It results in a disincentive for high ROI units to invest in projects with ROI greater than the minimum rate
of return but less than unit’s current ROI.

30
It is therefore advisable to use multiple criteria in evaluating performance
rather than relying on ROI as a sole measure. These other criteria include:

1. Growth In market share

2. Increase in productivity
3. Product innovation
4. Peso profit
5. Receivable and inventory turnover
6. Ability to venture into new and profitable areas

In investment SBU’s, ROI can be improved by either increasing sales, by

reducing expenses or by reducing assets.

31
Residual Income
Another approach to measuring performance in an investment SBU is
a concept known as Residual Income.

Residual Income is the net operating income that an investment SBU

can earn above some minimum return on the operating assets. The
larger the residual income figure, the better is the performance rating
received by the division’s manager.

32
Advantages of
Residual Income
1. A unit pursues an investment opportunity costs as long as the
return form the investment exceeds the minimum rate of return set
by the firm.

2. The firm can adjust the required rates of return for differences in
risk and types of assets.

3. It is possible to calculate a different investment charge for

different types of assets.

33
 Limitations of Residual Income
1. Since residual income is not a 2. It is not as intuitive as ROI.
percentage, it suffers the same
problem of profit SBUs in that is
not useful for composing units of 3. It may be difficult to obtain a
significantly different sizes. minimum rate of return.

34
 Economic Value
Added
Economic value added (EVA) is a business unit’s income after taxes and after
deducting the cost of capital.

To effectively motivate investment SBU managers and to properly measure

their performance.

The cost of capital is usually obtained by calculating a weighted average of the

cost of the firm’s two sources of funds – borrowing and selling stock.

35
EVA users do not follow conventional, conservative
accounting policies.

The main advantage of using EVA is that it focuses

manager’s attention of creating value for shareholders by
earning profit greater than firm cost of capital.

36
Illustrative Problem:
Case 1. MNO, division of Aeon Manufacturing has assets of
₱450,000.00 and an operating income of ₱110,000.00
a. What is the division’s ROI?
b. If the minimum rate of return is 12%, what is the division’s
residual income?

Solution:
 a. ROI = b. Operating income ₱110,000

= Less: Minimum required return

= 24.44% (12% x ₱450,000) 54,000

Residual Income ₱56,000 37

Case 2. Consider the following:
(000’s omitted)
Division A Division B
Operating assets ₱5,000 ₱12,500
Operating income ₱1,000 ₱2,250
ROI 20% 18%
 
1. Which is the more successful division in terms of ROI?

2. Using 16% as the minimum required rate of return, compute the residual
income for each divisions. Which division is more successful under this rate?

38
Solution:

1. Based on the information given, the more successful division

in terms of ROI is division A because it has a higher ROI.

2. Division A Division B
Operating assets ₱1,000 ₱2,250
Less: Minimum required return:
Division A (0.16 x₱P5,000) 800
Division B (0.16 x ₱12,500) 2,000

Residual income ₱200 ₱250

Division B is more successful in terms of residual income.

39
Case 3. The following data are given for the Blade division for 19A:

Return on investment (ROI) 25%

Sales ₱1,2000,000

Margin 10%

Minimum required rate of return 18%

a. Compute the division’s operating assets.

b. Compute the division’s residual income (RI).

40
 Solution:

a. ROI =

25% =

Operating assets = ₱480,000

b. Operating income ₱120,000

Less: Minimum required return

(18% x ₱480,000) 86,400

Residual income ₱33,600

41
Activity
42
Multiple Choice:
1. Strategic Investment Unit (SIU) is also known as:
a. Responsibility Accounting
b. Responsibility Center
b. Responsibility Method
 
2. The following are benefits of Decentralization except:
c. Train Managers
d. Motivates Managers
e. Use local knowledge
d. Allows timely and effective response to managers
 

43
3. The ______ is responsible for the generation of revenues and control of
cost incurred in profit SBU.
a. Shareholder
b. Stakeholder
c. Employee
d. Manager
 
4. It is measured by preparing the income statements using the
contribution approach, presenting both the actual results and budgeted
figures.
d. Performance of a Cost SBU
b. Performance of a Profit SBU
e. Performance of an Investment SBU
f. Performance of a Revenue SBU

44
5. The ____________ is usually obtained by
calculating a weighted average of the cost of the
firm’s two sources of funds – borrowing and selling
stock.
a. Economic Value Added
b. Return on Investment
c. Cost of Capital
c. Residual Income

45
Case 1. During the year, FTW division manufactured 30,000 units
as budgeted. Budgeted and actual costs for FTW division are given
below:

  Budget Actual
Direct materials P120,000 P110,800
Direct labor 125,000 126,800
     
Department costs:    
Supervision 21,000 21,000
Indirect materials 14,200 14,700
Repairs and maintenance 2,100 2,200
Equipment operating cost 3,400 3,300
Depreciation, equipment 4,000 4,000
     
Allocated plant costs:    
Superintendence 19,500 21,000
Heat, light and power 3,700 3,900
Taxes and insurance 5,400 6,100
Other plant occupancy cost 5,000 6,700
Depreciation, plant 7,000 7,000
  P330,300 P327,500

46
  Requirements:
a. Compute the budgeted unit cost of the product.
b. Compute the actual unit cost.

SOLUTION:

Budgeted Actual

a. 330,300 / 30,000 b. 327,500 / 30,000

= 11.01 = 10.92

47
Case 2. The following data are given for the FTW division for 4A:

Return on investment (ROI)15%

Sales ₱900,000

Margin 5%

Minimum required rate of return 12%

a. Compute the division’s operating assets.

b. Compute the division’s residual income (RI).

48
 Solution:

a. ROI =

15% =

Operating assets = ₱300,000

b. Operating income ₱45,000

Less: Minimum required return

(12% x ₱300,000) 36,000

Residual income ₱9,000

49
Thank you!
50
REVENUE SBU
 Revenue
sbu
is a unit or segment within an organization where the manager is
responsible for selling budgeted quantities of various products or
services at budgeted price.

Examples:

A sales representative selling A sales manager distributing Manager of the toys department
bread to supermarkets. automobile to dealers in in a local department store
specific geographic areas.
Revenue
sbu

Managers of revenue SBUs use variance in sales price

and sales mix to monitor or control their operations.
They are responsible for achieving budgeted levels of
contribution margin by controlling the number of units
sold, product mix, and selling prices
 Three types of
variances

Sales Price (Actual Sales Price – Master Budget Sales Price ) x Actual Unit
Variance Sales

Sales Volume Variance (Actual Unit Sales – Master Budget Unit Sales ) x Master Budget Average Contribution Margin Per Unit*

Master Budget Average = Master Budget Total Contribution Margin

Contribution Margin Per Unit
Master Budget Sales
 Three types of
variances

Sales Mix Variance Flexible Budget Average - Master Budget Average x Actual Unit Sales
Contribution Per Unit** Contribution Margin Per Unit

Flexible Budget Total Contribution Margin

**Flexible Budget Average =
Contribution Margin Per Unit Actual Unit Sales
Illustrative
problem:
Karen’s Company’s actual and budgeted sales and expense data for April are as follows:

REQUIRE
D:
Determine the following variances and
indicate whether they are favorable or
unfavorable
1. Sales Price Variance
2. Sales Volume Variance
3. Sales Mix Variance
solution:
1. Sales Price
Variance:
Product Zim = (P12.50 – P13) x 4,800 units Product Zoom = (P10 – P10) x 5,300 units
= P2,400 unfavorable = P0
 

Total Sales Price Variance:

Zim P2,400
unfavorable
Zoom P0
P2,400 unfavorable
 solution:
2. Sales Volume Variance:

= (10,100 units – 10,000 units) x P5.25 per unit*

= P525 favorable

Master budget average (5,000 x P6) + (5,000 x P4.50)

=
contribution margin per unit 10,000 units

= P5.25
 solution:
3. Sales Mix Variance:

= (P5.21287** - P5.25) x 10,100 units

= P5375 favorable

Flexible budget average (4,800 x P6) + (5,300 x P4.50)

=
contribution margin per unit 10,100 units

= P5.21287
Transfer
price
Is the value assigned to goods and services transferred
between segments within the company.

Example:
Bakery Division of Rustan’s Inc. transfers bread to the
Supermarket Division, some transfer price must be agreed upon
 Alternative
Transfer Pricing
Alternative Transfer
Pricing Schemes
In practice, four general approaches are used on setting transfer
prices.

Minimum Transfer Price

1

Market-based Transfer Price

2
Variable Cost

Cost-based Transfer Price Full-cost

3
Alternative Cost Measures
Negotiated Transfer Price
4
 Minimum
Transfer Price
A general rule for making transfers to maximize a company’s
profits in either perfect or imperfect market uses the formula:

generally the
Lost
variable costs
Differential Opportunity contribution
costs per unit costs per unit margin per unit
on outside sales

Transfer Price

represents the lower limit

Minimum
Transfer Price
⊹ The transfer price can be more than the amount shown by
the formula but for an internal transfer to take place, the
transfer price should not exceed the purchase price
from the outside supplier.

⊹ If the sales division has sufficient idle capacity to meet the

demand of another division, the lowest acceptable transfer price
will be equal to the differential or variable costs per unit.
⊹ From the perspective of a buying division, the maximum
acceptable transfer price is equivalent to the price offered by the
outside supplier.
Market-Based
Transfer Price
⊹ Under this approach the transfer price is the price at
which the goods are sold on the open market.
⊹ The market price approach is designed for situations in
which there is an outside market for the transferred
product or service.
⊹ If the selling division has no idle capacity, the market
price in the outside market is the perfect choice for the
transfer price.
Market-Based
Transfer Price
⊹ If the market price is used as the transfer price, the
selling division manager will not lose anything by
making the transfer, and the buying division manager
will get the correct signal about how much it really costs
the company for the transfer to take place.
Market-Based
Transfer Price
⊹ This is considered the best transfer price
because it dovetails well with the profit SIU
concept and makes profit-based performance
evaluations feasible at many levels of the
organization. By using market prices to control
transfer, all divisions or segments can show
profits for their efforts – not just the final
division in the chain of transfers.
Market-Based
Transfer Price
This market price approach is particularly useful in highly
decentralized organizations. Generally, this policy should contain the
following guidelines:

1. The buying division must purchase internally so long as the

selling division meets all bona fide outside prices and wants
to sell internally.
2. The selling division must be free to reject internal business if
it prefers to sell outside.
3. If the selling division does not meet all bona fide outside
prices, then the buying division is free to purchase outside.
4. As independent and impartial body must be established to
settle disagreements between divisions over transfer prices.
Cost-Based Transfer Price
1 Variable Cost

2 Full-cost

3 Alternative Cost Measures

Cost-Based Transfer Price
1 Variable Cost

Transfer price is based only on variable or differential costs. But

when fixed costs increase because of a transfer of goods between
segments, they are differential costs and therefore should be
included in the transfer price cost.
The advantage of using this basis is that it ensures in the short-
run the best use of total corporate facilities because it focuses
attention on the contribution margin a transfer generates and on
how it increases short-run profitability.
Cost-Based Transfer Price
Disadvantages of Variable Costs

(1) A company must cover all costs before earning a profit.

If fixed costs are ignored, a variable cost transfer price
may be profitable in the short run, but not in the long run.

(2) It allows one segment manager to make a profit at the

expense of another segment manager because the
receiving segment receives all the profit.
Cost-Based Transfer Price
Disadvantages of Variable Costs

(3) The use of this method could lead to dysfunctional

decisions if a segment must forgo outside sales to make
products for other internal segments.
(4) Transfer prices based on differential costs diminish the
autonomy in decision-making of the profit SIUs.
Cost-Based Transfer Price
2 Full-cost

Full cost includes actual manufacturing costs (variable and fixed)

plus portions of marketing and administrative costs. Many
companies use full cost because of the following reasons:
(1) It is easy and convenient to apply.
(2) It leaves no intracompany profits in inventory to eliminate
when preparing consolidated statement.
(3) It allows simple and adequate end-product costing for profit
analysis by product lines.
Cost-Based Transfer Price
2 Full-cost

This approach, however, is not suitable for companies with

decentralized structures that measure the profitability of
autonomous units.

Another criticism of full cost is that it does not create incentives

for segment managers to control or reduce costs. It likewise does
not provide management with a divisional profit figure for the
selling division.
Cost-Based Transfer Price
2 Full-cost

The full-cost method departs from goal-congruence. The use of

full-cost transfer price can lead to decisions that are not goal
congruent when the supplying division is not operating at
capacity.

For instance, a division may want to purchase outside the

company as an apparent savings. However, a reduction of the full-
cost transfer price to the outside market purchase price would
recover all variable costs and a portion of fixed costs.
Cost-Based Transfer Price
2 Full-cost

To avoid such suboptimization, top management must order the

lowering of transfer prices or require internal purchasing.
These solutions will both dilute the authority of individual
divisions.
Cost-Based Transfer Price
Standard full cost may also be used instead of the
historical average cost because it eliminates the
negative effect of fluctuations in production
efficiency in one division on the reported income of
another division. Division managers can determine
in advance what price they will receive or what price
they will pay for transferred goods.
 Alternative Cost Measures
a.) Full Absorption Cost-based Transfer Price

- Many manufacturing firms use full-absorption costs basis because of the

difficulty in determining the opportunity costs to the company of making
internal transfer.

Some advantages of this approach are:

1. Costs are available in the company’s records.

2. They provide the selling division with a contribution equal to the excess of
full-absorption costs over variable costs, which gives the selling division an
incentive to transfer internally.

78
3. This may be a better measure of the differential costs of transferring internally that the variable
costs because other costs such as unknown engineering and design cost are included.

b.) Cost-Plus Transfer

- Some companies use cost-plus transfer pricing based on either variable costs or full absorption
cost. These methods generally apply a normal markup to costs as a substitute for market prices
when intermediate market prices are not available.

79
Negotiated Transfer Price
- A negotiated price is an attempt to simulate an arm’s-length transaction between supplying and buying
segment.

- If companies give segment managers autonomous authority to buy and sell as they think necessary and if
they bargain in good faith, the result of this bargaining is the equivalent of a market price.

- The major advantage of negotiated transfer prices is that they preserve the autonomy of the division
manager.

- Furthermore, negotiated prices eliminates the objectivity necessary to ensure maximization of

companywide profits.
80
Distress Prices
- When supply outstrips demand, market prices may drop well below their
historical average. If the drop in prices is expected to be temporary, these low
market prices are sometimes called “distress prices”.

- Some companies use the distress prices themselves, but others use long-term
run average prices, or “normal” market prices.

81
- In the short-run, the manager of the selling division should meet the distress price as long as it exceeds
the incremental costs of supplying the product or service. If not, the selling division should stop selling
the product or service to the buying division, which should buy the product or services from an outside
supplier.

- In the long-run, market price is used, forcing the manager to buy internally at a price above the current
market price will hurt the buying division’s short-run performance and understate its probability.

82
Transfer Price for Services
- The department performing the services to a second department generates
revenues from such activity. The same transfer is the second department’s
purchase of services.

The following steps may be followed in setting transfer price for services:

1. Identify the different departments contributing various services.

2. Evaluate the corresponding skill and experience of personnel involved in delivering

services.

83
 3. Estimate the cost involved in providing the service. Factors such as time requirements,
qualifications, and cost of the facilities needed to provide the service should be considered.

4. Adopt one or any the principles applied to the transfer of products discussed in this chapter.

Multinational Transfer Pricing

- Transfer pricing is used worldwide to control the flow of goods and services between segments
of organizations.

84
- The objectives of international transfer pricing focus on minimizing taxes, duties, and tariffs, foreign
exchange risks along with enhancing a company’s competitive position and improving its relation with foreign
government.

- Corporations may change a transfer price that will reduce its total tax bill or that will strengthen a foreign
subsidiary.

- Sometimes import duties offset income tax effects. Usually import duties are based on the price paid for an
item, whether bought form an outside company or transferred to another division. Therefore, low transfer
prices will be used to lessen the import duties.

85
Illustrative Problem
14-7

86
S
O
L
U
T
I
O
N
87
88
89
Illustrative
Problem 14-8

90
Various members of the management have proposed the following
transfer process.

1. Differential Costs – P250

2. Full Cost – P295

3. Market Price – P315 (350 – 15 discount)

4. Full Cost plus markup - P350

5. Prime Cost – P215

6. Negotiated Price – P290

91
Illustrative problem 14-9

92
93
Solution:

94
95
96
Thank you! 97