Professional Documents
Culture Documents
Mahmood Reza
FRSA, MCMI, ATT, FCCA, DMS, PGCE, BSc (Hons)
www.proactiveresolutions.com
SYLLABUS SECTION B
• Pricing 22
• Stakeholder analysis 24
SYLLABUS SECTION C
• Responsibility Accounting Systems 25
SYLLABUS SECTION D
• Mission and Vision 27
• Aims and Objectives 27
• Rewards and Values 27
• The Strategic Triangle 28
• Divisionalisation and transfer pricing 28
• Activity two: transfer pricing 32
• Porter: industry analysis - the five forces 32
• Boston Box or the BCG Matrix 35
SYLLABUS SECTION E
• Performance management & evaluation 41
• Establishing a performance management system 41
• Criteria for designing performance indicators 42
• Types of performance measures 43
• Performance Pyramid, Lynch and Cross (1991) 43
• Balanced scorecard 45
• Table of potential scorecard measures 48
SYLLABUS SECTION F
• Target costing 49
• Performance prism 50
• Total Quality Management (TQM) 50
ACCA ARTICLES 52
The notes are provided to supplement existing texts and focus on areas that, in my
experience, students find more challenging. Any feedback regarding the notes (positive
or negative) would be greatly welcomed.
I have adopted a sectional approach to the notes, i.e. notes are provided by syllabus
section, some sectional notes being greater than others.
ACCA P5, in common with the other option papers does not enjoy significantly high pass
rates. However, people do pass the exam; a structured and focused approach to
studying is highly recommended, as well reading around the subject.
ACCA Qualification
The current ACCA Qualification syllabus was first examined in December 2007; a review
of the pass rates for the option papers is shown below.
Paper Dec 07 Jun 08 Dec 08 Jun 09 Dec 2009
P4 31 36 36 30 41
P6 28 36 41 37 39
P7 33 33 39 37 39
The ACCA Professional syllabuses are being updated with effect from June 2011, these
notes are based on the existing syllabus and study guide for the December 2010 exam
diet.
The strategic planning process was examined in detail in the P3 paper. In P5 the focus
is more on the performance management aspects of strategic planning and the role of
strategic management accounting.
The examiner’s approach interview complements the approach article and is very useful
when tackling the paper for the first time, giving you a real insight into what the examiner
is looking for in terms of exam performance. It covers the main themes of the paper,
information on how the exam is structured, advice on exam technique, tips on how to
succeed and potential pitfalls to avoid.
The examiner’s analysis interview builds on the approach interview and looks at student
performance in the December 2007, June 2008 and December 2008 exam sessions,
highlighting where students are performing well, where students are performing less
well, and how they can improve their performance. The analysis interview is related to
the examiner’s reports, which are published after each exam session and are another
very useful resource.
Paper P5 has a strong relationship with Paper P3, Business Analysis, in the areas of
strategic planning and control and performance measurement.
Section A of the syllabus focuses on strategic planning and control. This involves a
detailed examination of the role that strategic management accounting should play in
today’s organisations. This section also requires students to appraise alternative
approaches to budgeting in order to facilitate better control of business organisations.
We live in an ever-changing business environment and Section A considers the effects
of both evolving business structures and information technology on modern
management accounting practices.
Section B of the syllabus considers the impact of world economic and market trends, as
well as the impact of national fiscal and monetary policy on the performance of business
organisations. This section also explores other environmental and ethical issues facing
business organisations.
Section D of the syllabus is focused on the need for strategic performance management
in both public and private sector organisations. This section considers strategic
performance issues in complex organisations as well as divisional performance and
transfer pricing issues. Consideration is also given to behavioural aspects of
performance management.
The superscript numbers at the end of each outcome in the Study Guide indicate the
level at which students should understand a particular subject or topic area. These levels
of understanding, known as cognitive levels, are important as they indicate the depth to
which each part of the syllabus may be examined.
It is probable that each Paper P5 exam will contain several questions at levels 2 and 3,
and the Study Guide reflects this emphasis. It is important to realise that if Study Guide
outcomes indicate that learning is required at levels 2 or 3 then it is probable that the
exam will test that area at that cognitive level. The marking scheme will reflect this fact,
and answers that do not demonstrate this higher cognitive ability will be marked
accordingly. If, therefore, a question asks a candidate to ‘assess’ or ‘evaluate’ an
argument or a statement, answers that merely ‘describe’ will not achieve a ‘pass’
standard.
The syllabus for Paper P5 aims to ensure that candidates can apply relevant knowledge
and skills, and exercise professional judgement in selecting and applying strategic
management accounting techniques in different business contexts. It also enables
students to make a significant contribution to the evaluation of the performance of an
organisation and its strategic development. Candidates should remember that Paper P5
is equivalent in standard to a Masters degree, and the emphasis is on higher-level skills.
Section B contains three optional questions worth 20 marks each; candidates are
required to answer two of these questions. At least one of the questions in Section B will
require an entirely discursive answer.
In viewing the paper as a whole, the balance between computational and discursive
questions will not vary significantly from diet to diet.
There will not always be a unique or ‘correct’ solution to many of the questions that
feature in Paper P5 exams. A range of solutions will be equally valid, provided they are
supported by appropriate evidence. It is therefore important that if assumptions are
made concerning a given scenario, these assumptions are clearly stated. Some
questions may require candidates to draw on their experience, and interpret a topic
within the context of an organisation with which they are familiar.
One of the features of the Professional level exam papers is the awarding of
‘professional marks’. These are marks allocated, not for the content of an answer, but for
the degree of professionalism with which certain parts of the answer are presented.
They will usually be awarded in Section A (the compulsory part of the exam paper) and
will total between four and six marks.
It may be, for example, that one requirement asks you to present your answer in the
form of, say, a letter, a presentation, a memo, a report, briefing notes or similar. Some
KEY AREAS
As indicated in the syllabus, the key or core areas are:
Using strategic planning and control models to plan and monitor organisational
performance
Assessing and identifying relevant macro-economic, fiscal, and market factors
and key external influences on organisational performance
Identifying and evaluating the design features of effective performance
management information and monitoring systems
Applying appropriate strategic performance measurement techniques in
evaluating and improving organisational performance
Advising clients and senior management on strategic business performance
evaluation, and on recognising vulnerability to corporate failure
Identifying and assessing the impact of current developments in management
accounting and performance management on measuring, evaluating, and
improving organisational performance.
CONCLUSION
In order to pass the Paper P5 exam, students should:
Clearly understand the objectives of the exam as explained in the Syllabus and
Study Guide
Ensure that preparation for a Paper P5 exam has been based on a programme
of study set for the required syllabus and exam structure
Use an ACCA-approved textbook for Paper P5. Not only are they written
especially for the syllabus, but they are also reviewed by the examiner, making
them invaluable in terms of coverage and insight into what is examinable
Practise computational, analytical, and discursive questions under exam
conditions in order to improve speed and presentation skills
Carefully study all articles that appear in student accountant (or elsewhere),
which are relevant to topics within the syllabus for Paper P5
Be able to clearly communicate understanding and application of knowledge in
the context of a Professional level exam.
EXAMINERS COMMENTS
This provides a useful insight into the general problems that students encounter and
extracts have been reproduced below.
Many candidates would clearly benefit from planning their answers to discursive parts of
questions. For example, In their answers to Question 5 a number of candidates
discussed the mission statement of CFD in part (a)(i) although this was in fact a
requirement of part (a)(ii).
It was noticeable that many candidates begin their answers to discursive parts of
questions by rewriting the requirement of the question and in doing so waste valuable
time.
Many candidates had clearly memorised solutions to past examination questions and
were determined to include them in their answers to questions on the examination
paper. Question 5 was the most common place for this to happen e.g. using a past
question on hotels as a template for dog kennels and suggesting surveying the dogs on
quality of meals and room cleanliness!
Sadly, many candidates did not answer all of the question subsections and in not doing
so imposed limitations on the marks available to them.
Candidates need to be aware whether they have the knowledge to answer discursive
questions. If they do not then it is essential that they realise that the quantity of work
produced is not a substitute for quality. This was particularly evident from candidates’
answers to Question 3.
Workings were generally shown but were at times difficult to follow. Many candidates
continue to display their answers poorly, with a lack of clear labelling to indicate which
questions are being attempted. Each question should be started on a new page and
candidates must give more thought to the layout and organisation of their answers. This
is especially the case given the potential to earn professional marks in this or any other
of the professional level examination papers.
Question 2(d) provided cases of this practice. The question clearly asked for
performance measures to assess the quality of service of a software provider, yet there
were answers such as ‘the quality of meals, waiting time at reception, staff uniforms and
cleanliness, as well as specific mention of hotels. This practice was also evident from
candidates’ answers to Question 4(b) with many different organisations mentioned and
only the minority of candidates actually referring to BAG.
Also evident was the inability of many candidates to interpret the numbers and ratios and
translate them into ‘good’ and ‘bad’, even things such as a ‘lost items percentage’ being
higher than the target was seen as constituting good performance simply because the
number was higher! This suggests that candidates are taking a rote-learning approach
which is inappropriate for this level of examination.
The consensus of opinion from the marking team was that the paper provided the
opportunity to obtain relatively high marks. However, the examination revealed a large
number of candidates who performed poorly. The overall results for this diet were not
pleasing.
Many candidates who clearly had knowledge of the areas of the syllabus which featured
within the examination questions were unable to achieve a pass at this diet as a
consequence of poor examination technique which frequently manifested itself via poor
presentation and/or time management or not observing the specific requirements of
each question.
It was pleasing to observe that the vast majority of candidates attempted all four
questions. However, there was some evidence of poor time management, particularly
affecting Question 1 which a significant number of candidates attempted as their final
question.
Johnson and Scholes’ 3stage model of strategic planning is a useful framework for
seeing the ‘bigger picture’ of performance management and strategic management
accounting issues.
The term ‘strategic management accounting’ refers to the full range of management
accounting practices used to provide a guide to the strategic direction of an organisation.
BENCHMARKING
Benchmarking is the practice of measuring an organisations products or services against
“best practice”; the primary objective is to improve processes or activities. Through
benchmarking, organisations learn about their own practices and procedures, and the
best practices of others. Benchmarking enables them to identify where they fall short of
current best practice and determine action programmes to help then match and surpass
it.
Benchmarking originated in the USA in the 1970s, pioneered by Rank Xerox and was
‘exported’ to Europe and the UK in the 1980s. A number of commercial, public sector
and not for profit organisations have successfully embraced the technique, and it is a
popular and effective management process.
Any activity that can be measured can also be benchmarked. However this is neither
feasible nor practical. The starting point for any benchmarking exercise is to determine
the key performance areas; those are the areas that are critical to the organisation,
operationally and strategically. They should focus on those areas that (a) tie up most of
the resources; (b) significantly improve the relationship with their client groups; (c)
impact on the viability of the organisation. For example a charitable organisation that
relies on grant aid as its main source of income might benchmark fund raising activities.
Once the key performance areas have been decided upon an organisation must then set
the key standards and variables to measure, these are commonly known as “key
performance indicators” (KPIs). Having defined the benchmarks the hunt is on for
information to establish the benchmark performance. There are four types of
benchmarking
Organisations then need to specify programmes and actions to close the gap. Having
measured one’s actual performance and compared it with some form of target,
benchmarking moves from simple measurement through to performance improvements.
Many organisations forget this stage and therefore miss the real benefit of
benchmarking. It is essential that programmes and actions are implemented and that
ongoing performance is monitored.
Successful and effective benchmarking requires commitment and support from the
board and senior management. Managers need to be as specific as possible when
identifying areas to benchmark. For example, a company that wishes to benchmark
customer service needs to decide what specific aspect of customer service needs to be
examined. Customer service encompasses a diverse range of activities, such as
dealing with enquiries, handling disappointed customers, issuing refunds and taking
payments. Each of these activities is different, each with its own thought processes,
techniques and controls.
Once the best practices have been identified, the benchmarking team collects the data,
analyses it, and then plots their performance against best practice to help identify
improvement opportunities.
Finally the team decides what is needed to adapt the best practices to suit their own
particular circumstances, this will a re-evaluation and re-design of existing procedures
and approaches. A cost-benefit exercise will usually be carried out and an
implementation timetable with priorities is established.
Risk consists of three elements, namely choice, likelihood and consequence. Some
choice is needed in the situation, if there is no choice, a manager does not have a risky
situation a rather a bounded one beyond the manager's control; Likelihood infers some
A number of techniques exist for decision making under uncertainty, the more popular
being contingency tables and its associated interpretation:
Contingency Table
This is used for decisions made under uncertainty; it identifies & records all payoffs
where action affects outcomes.
Maximin
This maximises the smallest pay-off, it is indicative of a pessimistic and Risk-averting
approach
Maximax
This has the highest maximum pay-off, it is indicative of an optimistic approach, albeit
with the risk of loss to low returns
Minimax regret
This minimises the maximum possible regret and limits the potential ‘opportunity’ loss.
Regret is seen as the pay-off lost v. not pursuing optimal action
ACTIVITY ONE
A retailer needs to decide how many kilos of fruit he needs to buy from the market and
has assessed the possible daily demand as 60, 100, 125 or 175 kg
He can buy quantities of 50, 100, 150 or 200 kg at a price of £4 per 10 kg. The selling
price is £1 per kg with any unsold apples being scrapped.
Required
BUDGETING
Budgets have multiple functions, namely
Planning
Management produce detailed plans for implementation
Coordination
Actions of different parts of organisation are brought together
Communication
Everyone is informed of the plans and policies; top management communicates
to lower level management
Motivation
This influences managerial behaviour, individuals motivated to perform in line
with objectives. This can encourage inefficiency and conflict between managers
Control
Assists managers in controlling activities with managements attention
concentrated on deviations from a pre-set plan
Performance Evaluation
Measuring success of achieving the budget, rewards like bonuses are given in
some companies and is meant to iinfluence human behaviour
Incremental budgeting
Indirect cost and support activities are prepared incrementally
Strategic Control
The setting of corporate strategy and long term objectives for the organisation.
Operational Control
Operational control is ensuring that specific tasks are carried out. This is primarily
concerned with the processing of inputs and raw materials to get outputs.
Management Control
Management control is the coordination of the day to day activities in an
organisation to ensure that inputs and raw materials are used efficiently and
effectively towards achieving long term goals. Management control, therefore,
links strategic control and operational control.
The systematic comparison of planned inputs to actual results made using the budget,
followed by corrective action where deviations from plan exist, is known as a ‘control
system’. The system providing the reports for this control system is known as
‘responsibility accounting’. This will be discussed in more detail later in the session.
Feedback control - occurs where actual outputs are monitored against desired
outputs and corrective action is taken where there is a variance between the two.
Feed-forward control – predictions are made about future outputs and
compared to desired outputs and action is taken where there is a difference
between the two.
So, with feed-forward controls any likely errors can be foreseen and actions taken to
avoid them, whereas, with feedback control actual errors against the plan are identified
and corrective actions taken to achieve the remainder of the plan.
In putting budgets together, and submitting them to the budget committee, they are
compared against the future expectations of the organisation as outlined in the long term
plan. If the budget falls short of these expectations then it may be adjusted and
alternatives considered. This process may continue until a budget is agreed that will
meet long term expectations.
During the budget period actual results are compared to the budget and any deviations
from budget identified. Corrective actions are then taken to ensure that future results are
in line with the budget.
BEYOND BUDGETING
Budgets have conflicting roles and a single budget system can’t serve several purposes
with planning and motivating roles potentially in conflict.
The traditional budgeting model has been criticised for its dysfunctional impact on
performance improvement, design and decision making. This was highlighted by Hope
and Fraser in their article "Beyond Budgeting" which won the prestigious IFAC award for
best management accounting article of 1998.
Managers' performance bonuses can be linked to KPIs both at corporate and business
unit level.
Customer Profitability
The needs of customers can vary radically. In their efforts to retain existing customers
and attract new ones, companies can be drawn into providing widely different levels of
service in respect of many different service elements such as frequency of delivery,
number of order lines, quantity per order line, customer location, discounts given,
salesmen's visits and special orders.
These have one thing in common, they all have associated costs. Conventional cost
accounting techniques rarely recognise them. As a result companies do not know the
true cost of trading with these customers, or even with customer groups. Certain
customers may attract so much cost that they provide no profit contribution at all. In
addition, companies may be unaware of the true value their customers place on the level
ABB
The idea behind activity based budgeting is to develop an activity model (or series of
linked cost centre activity models) of resource requirements. This model can then be
flexed to affect different volume assumptions which may need to be evaluated after the
first stage of the budgeting process (external assessment). It can also be used as a
basis for identifying and producing performance improvement. Once the final budget
model has been agreed, it then forms the basis for management control through
variance analysis with a more complete understanding of the impact of changing
volumes on activity resource requirements.
Activity based budgeting can take this a stage further by identifying and modelling a
cascade of activity level volume drivers. For example, in order to achieve a target sales
volume, an organisation needs to process so many orders which will result in so many
invoices with so many complaints and queries to handle before the transactions can be
completed. Each of these activity level volume drivers carries with it a unit cost that can
be used to calculate the total value of the resources required.
Understanding these cost linkages is vital to a good understanding of cost behaviour and
this is at the heart of activity based budgeting. However, this understanding is not fully
exploited unless management can use it to make changes in the way the organisation
ABM
The determination of the cost of a product or service is vital at the strategic planning
level, as it is at the operational level. For example, organisations may need to evaluate
the market profitability and should they remain in it?
However the customer will perceive things from his/her own perspective. Essentially this
will involve making decisions about the value of the service or product to them compared
to its cost. Using a customer perspective for managing the business implies that
management will have to concern itself with some or all of the following issues:
How does the customer perceive the quality of our product versus that of our
competitors?
How can we continuously improve?
Do the activities undertaken by the company produce the value that the customer
requires - activity analysis?
What are the costs of these activities and are they being carried out efficiently?
How well are the activities/processes being performed relative to competitors?
What are the important things that we should be controlling?
Because the basis of this concern rests on the activities carried out this is called activity
based management.
In order to determine the cost of each activity it is necessary to determine how time is
spent and how costs build up. For example the profitability of a customer will depend not
only on the price and costs of the products purchased, but also on such factors as the
number of orders placed in a year, the number of calls made on the technical service
department and so on. This means that costs will have to be traced to this customer
from all over the company, not just the plant. This is done through cost drivers.
Cost drivers are those elements that give rise to the need for an activity such as the
number of orders for a sales order department, number of complaints for the customer
service department and so on. While there may be many identifiable cost drivers
management will need to identify the minimum set that will allow the costs to be
calculated.
Cost drivers apply at different levels:
Unit level
Number of hours required to produce a product
Batch level
These are costs such as machine set-up or inspection, these occur once per
batch
Processor product level
These cover such items as engineering change orders which refer to a product or
process.
Organisation level
They are incurred for supporting the continuing level of operations i.e. building
depreciation, division managers’ salary.
A key element underlying the BPR philosophy is that one should look at an organisation
as a series of processes, as opposed to functional specialties such as production, and
marketing. The approach advocated by Davenport (1992) is to
1. Develop the business vision and process objectives
2. Identify the business processes to be redesigned
3. Understand and measure the existing processes
4. Identify IT levers
5. Design and build a prototype of the new process
6. Adapt, if appropriate an organisations organisational structure and governance
model
Substitutes
Suppliers
Customers
Your Social
Political Organisation Entrants
Stakeholders
Competitors
Competitive
Environment
Technological
Macro
Environment
A mere listing of PESTEL influences has little value, it is important to identify the key
opportunities and threats facing the company (a) at present, (b) in the future and how
these are, in effect drivers for change. A PESTEL analysis should also examine the
differential impact of these macro environmental influences by asking how they affect
different companies differently. Some form of impact analysis and scenario planning is
especially useful to explore different possible futures. This exercise allows “what if”
questions to be explored.
SWOT
This is a strategic planning tool which summarises the key issues from the business
environment and the strategic capability of an organisation most likely to impact on
strategy development. This can be used as a basis against which to generate strategic
options and assess future courses of action.
A SWOT analysis should help focus discussion on future choices and the extent to
which an organisation is capable of supporting these strategies. An effective SWOT
should be limited to four to five factors, focus on major and not marginal areas, be open
and honest and have a priority and emphasis.
COST STRATEGIES
Marginal-Cost
Unit Selling Price = Variable Cost + % contribution
Normally used for short-run tactical or scarce resource situations
A danger that low prices become norm
Full-Cost
Unit Selling Price = Total Cost / Budget Volume + % Profit
This ensures that profits are above break-even volumes
There is a risk of a spiral of declining demand
Minimum-Price
Unit Selling Price = Incremental (cash) Costs only
ECONOMIC APPROACH
This is considered a theoretical approach to pricing for products exhibiting elastic
demand, these being ones that are
Homogenous
Has no distinctive USPs (Unique Selling Proposition)
Product substitutes exist
That there is no perceived value in the product
A strong correlation between price and demand, i.e. a % increase in price causes
a corresponding % decrease in demand (and vice versa).
Profit Maximisation occurs where marginal revenue = marginal cost, this can be
determined by graphical interpretation, tabulation, or differential calculus
The calculus approach effectively involves solving the equation of a straight line, where
P is known as the dependent variable and Q is the independent variable.
P= a - bQ
P = Price; a = Constant (Intercept); b = Gradient; Q = Quantity
Marginal revenue is the increase in total revenue from the sale of one additional unit
Marginal cost is the increase in total cost when output is increased by one additional unit
Stages
1. Establish cost function
TC = FC + Q×VC
TC = Total cost; FC = Fixed cost; VC = Variable cost; Q= Demand
STAKEHOLDER ANALYSIS
Stakeholders are normally seen as individuals or groups that are affected by
organisations activities, these consisting of providers of finance, managers, employees,
competitors, government, clients and suppliers.
Low A B
Stakeholder power
High C D
A. Minimal effort; Low High
Probability of exercising
B. Keep informed;
power/level of interest
C. Keep satisfied;
D. Key players.
1. Cost Centre – managers are responsible and accountable for costs only
2. Revenue Centre – managers are responsible and accountable for revenue only
3. Profit Centre – managers are responsible and accountable for both revenues
and costs
4. Investment Centre – managers are responsible and accountable for revenue,
costs and capital investment decisions
2. If a manager can control the quantity of the service or goods but not the
price paid for that service or goods then only the variance in usage should
be attributed to that manager.
3. If a manager cannot control either the quantity or price paid for a service
or goods then both usage and expenditure are uncontrollable and should
not be attributed to the manager.
Arbitrary costs
However, if managers do not see these costs then they will not understand the
costs that are incurred to support their business areas. There is an argument,
therefore, that managers should be made aware of arbitrary costs. This would
prevent the abuse of services, such as IT support. It should also be borne in
mind that they may have some influence on the costs involved.
MISSION
A mission statement is a statement of the overriding direction and purpose of an
organisation. It is the foundation for any strategic plan and expresses its “reason for
being”. A mission statement is the foundation for the entire strategic planning process. It
sets the standard to which the organisation aspires, now and in the future, and forces
the Board members and staff to align themselves around a specific agenda.
VISION
A statement of what the organisation will be, or be perceived to be. It often includes
references to products and services, customers, markets, employees, new technology
and social responsibility.
The term vision statement is used by some organisations instead as mission statement,
vision and/or value statements may also be developed alongside the mission statement.
AIMS
These normally flow from the mission statement and are subsequently used to develop
suitable organisational objectives. Organisational and strategic aims represent the link
between mission and objectives and act as a statement of intention. They tend to be
positive in nature and unquantifiable, unlike objectives.
OBJECTIVES
Objectives are statements of specific outcomes that are to be achieved, from the
strategic to operational levels. Objectives are developed and extended from an
organisations mission statement and goals; they can be stated in financial and non-
financial terms. Conventional wisdom is that unless objectives are SMART (Specific
Measurable Attainable Relevant Time Bound) then they are not helpful, however, some
organisational objectives are important but difficult to quantify or convert into measurable
terms, such as to be the leader in ones field. Milestones and indicators of achievements
are essential to monitor progress of all objectives.
Rewards
What we can expect as a result of our efforts. Rewards can be either financial or non-
financial. In most instances a mix of both and non-financial rewards will be expected.
Values
Those things that we believe to be important, and if they were not met, or respected,
would cause us to be unhappy.
Vision
VALUES
Mission Rewards
DIVISIONALISATION
As a business expands it eventually reaches the stage where it becomes appropriate to
split it up into smaller, more manageable units – to decentralise. Reasons may include:
It may well be the case that some degree of decentralisation arises as a result of the
way in which a business expands. If the expansion is by take-over of companies that
then become subsidiaries within group, a decentralised structure automatically arises.
One condition for a successful decentralisation is that the various divisions should be
more or less interdependent of each other. However, in practice, this is unlikely to be
the case and a certain amount of inter-divisional trading will take place. A transfer
pricing policy is needed if goods and services are passed between divisions.
DIVISIONAL STRUCTURE
TRANSFER PRICING
Transfer pricing deals with the problem of pricing products or services sold (Transferred
within an organisation). Decisions over suitable transfer prices are needed if a firm has
split itself into autonomous units i.e. it has decentralised or is involved in setting prices
between connected companies in different countries.
The approaches to setting transfer prices are similar to those for external sales, there
are cost-based methods and market based methods. At first sight it would seem that
setting prices for internal transfers is less critical than for external sales; however it has
to be appreciated that the divisions into which a large group will split itself expect to act
as self-contained units. The decision over transfer pricing is even more critical since top
management is in a position to identify whether it is more economical for a product or
It might appear that the credit to the supplying division is merely offset by an equal debit
to the receiving division and that therefore, as far as the whole organisation is
concerned, it has a net zero effect. This is true in terms of the physical application of a
transfer pricing system once it has been decided upon and implemented. However,
there are important behavioural and organisational elements associated with transfer
pricing and the choice of which method to adopt. The transfer price does affect the profit
of each division separately and, therefore, can affect the level of motivation of each
divisional manager.
The rules for the operation of a transfer pricing policy are the same for any policy in a
decentralised organisation. A system should be reasonably easy to operate and
understand as well as being flexible in terms of a changing organisational structure. In
addition there are four specific criteria which a good transfer pricing policy should meet:
• It should provide motivation for divisional managers
• It should allow divisional autonomy and independence to be maintained
• It should allow divisional performance to be assessed objectively
• It should ensure that divisional managers make decisions that are in the best
interests of the divisions and also of the company as a whole.(goal congruence)
The difference between the upper and lower prices represents the corporate
profit/savings generated by producing the product or service internally. The chosen price
“divides” the profit between the two segments. For external reporting this is irrelevant
since the profit element will be eliminated when the financial statements are
consolidated. However this division of profits may be extremely important for internal
reporting since it affects the results of the responsibility reports and hence the success
or failure of the segment.
There are three main methods used to set the transfer price.
Market-Based Cost
Market pricing is believed to be an objective arm’s length method of arriving at a transfer
price. If a supplying segment is operating efficiently it should be able to make a profit at
this price. Similarly if the receiving segment is operating efficiently it should be able to
make a profit since it would have to purchase at this price if the item was not
manufactured internally.
However several problems may exist in practice. First market price may not be
appropriate because internal production should lead to savings in bad debt, delivery and
marketing expenses. The product or service may not be available on the open market. If
the market price is temporarily depressed or increased due to events beyond the control
of either segment which price should be taken, the normal or the temporary? Finally, in a
market, discounts on price are ordinarily given when volume orders are placed or long-
term contracts are signed. Finally the market price may not equal the LRMC and in this
case the company will fail to set it price/output decisions correctly, although this is less
true of commodity products.
Dual Pricing
To overcome these problems companies can adopt the practice of dual pricing. Here the
agreed transfer price is used only for the purposes of financial reporting of individual
segment results. For management evaluation purposes the variable or absorbed cost is
applied to the results of one or both segments. The difference between the “entity” and
management price is called the “mark-up”.
The mark-up is accounted for by assigning it to a different account that is used for
reconciliation purposes. That is to say the amount of mark-up in the buying segment’s
accounts must equal the amount of mark-up in the selling segment’s accounts. This
reconciliation is the same as is done for the purposes of consolidation of the accounts.
Using dual pricing allows a company to get the best of both worlds. The transfer price
can be set to meet the regulatory and corporate finance constraints while the price used
by local management can be based on a close approach to the economist’s long-run
marginal costs so allowing the company’s global operations to optimize their third-party
pricing and output decisions on a decentralized management basis.
Receive Inc. manufactures a branded product sold in containers at a price of $30 per
container; the following cost information has been obtained.
Its direct product costs per container are:
Raw materials from Receive Inc. at a transfer price of $14 per container.
Additional processing costs at of $5 per container.
Receives monthly fixed costs are $60,000, a market research study has indicated that
Receive Inc. could increase their market share by 75% in volume if it were to reduce its
price by 20%.
Provide Inc. produces a standard product which can be converted and used for a
number of final products. It sells one quarter of its output to Receive Inc. and the
remainder to customers outside the group.
The production capacity of Provide Inc. is 52,000 containers per month, but competition
is tough and it plans to sell no more than 36,000 containers per month for the year
ending 31st March. Its variable processing costs are $7 per container and its monthly
fixed costs are $80,000 per month.
The Happy Group’s transfer pricing policy is to use market prices, where known.
Required
a. Calculate the monthly profit position for each of Provide Inc. and Receive Inc. if
the sales Receive Inc. are
(i) At their present level, and
(ii) At the higher potential level indicated by the market research, subject to a
cut in price of 15%.
Competition in an industry continually works to drive down the rate of return towards the
competitive floor rate of return.
Competitve
Rivalry
Bargaining
Bargaining Power of
Power of Your Buyers
Suppliers Organisation (customers)
Threat of
Substitutes
Buyer Power
Buyer power is the ability of the buyer to determine the price at which they will buy
irrespective of the decisions of the firm.
A group of buyers is powerful if for example a buyer purchases large amounts
relative to the seller’s total sales.
If the product bought represents a significant portion of the buyers total
purchases the buyer will tend to shop around for lower prices.
If the products are standard and undifferentiated the buyer will have more power
over prices.
If the buyer has few switching costs it will not be locked into a particular seller.
If the buyer has low profitability it will have to press for low prices.
If the product is unimportant to the quality of the buyers products or services.
If the buyer can exercise significant power over which products its customers
purchase as in large retail stores.
Substitute Products
Firms in one industry are also competing with firms in another that produce substitute
products. Substitutes limit returns in an industry by setting a ceiling on the prices the
industry can charge. The more attractive the price-performance of alternatives the firmer
the lid is on industry pricing.
Supplier Power
Profitable suppliers can squeeze profitability out of an industry if that industry cannot
recoup the cost of higher priced supplies in prices of its own products. The conditions
making suppliers powerful are:
Rivalry
Rivalry takes the form of price competition, advertising battles, product introductions,
increased customer service, improvements to warranties and so on. Price competition
can leave the whole industry worse off while advertising battles may increase demand
and hence wealth of firms. Intense rivalry is the result of a number of factors:
Numerous or equally balanced competitors.
Slow industry growth
High fixed or storage costs. The significant cost here is fixed cost relative to
value-added.
Lack of differentiation or switching costs.
Capacity augmented in large increments
Diverse competitors
High strategic stakes
High barriers to exit. Exit barriers can be economic, strategic and emotional.
They consist of specialised assets, fixed costs of exit, strategic interrelationships,
identification with the business, loyalty to the workforce, fear for one’s own
career, government denial or discouragement of exit and so on.
Threats of Entry
New entrants to an industry bring new capacity, the need to gain market share and they
can bring substantial resources. The threat of entry depends on the strength of the
barriers to entry:
Economies of scale. If these are large then the new entrant has to come in on a
large scale. However these economies of scale must be real. If they are not, as
Xerox discovered when Japanese entrants started following the expiry of patents,
the new entrant may enter at a lower price than the incumbents are
manufacturing for. Scale economies can vary by function, such as selling, or by
operation. For example there are large economies of scale in manufacturing
television colour tubes but not in cabinet making or assembly.
Product differentiation leads to brand identities and customer loyalties.
Capital requirements
Switching costs.
Access to distribution channels which may be difficult if they are controlled by the
industry.
Cost disadvantages to the entrant, not brought about by scale, as a result of
proprietary technology, favourable access to materials, favourable locations,
experience curve effects
PRODUCT PORTFOLIOS
Because of the inevitability of the eventual decline of all products and services,
businesses seek to reduce their exposure to the risk of a product decline by maintaining
a portfolio of products.
A balanced portfolio will contain products at various stages of the product life cycle.
Conglomerates will seek to minimise the risks found in individual industries by holding
investments in a range of industries.
There are various tools and techniques for analysing a product or Business Unit
investment, portfolio. The most widely used of these is the Boston Consulting Group
Matrix, often referred to either as the Boston Box or the BCG Matrix. This framework
allows the product portfolio to be identified in terms of market share and market growth.
Products/ services are placed in the matrix and identified as question marks, stars, cash
cows and dogs.
BCG MATRIX
High
Stars Question
Marks
Market
Growth
Low
High Low
Market Share
(Relative to biggest competitor)
A market development strategy is one where the company seeks to increase its
profitability by selling its existing products to new customers (markets) it has never sold
in before. This is most successful when it is based on the most profitable existing
products. The strategic information required here is the direct profit contribution by unit
and an investment strategy based on incremental/opportunity costing based on future
outcomes.
The diversification strategy requires the company to sell new products to new
customers. Here the management accounting system must be able to clearly identify the
competitive advantage by which the company is going to create its super-profit. Sadly
the evidence is that this is not only the most risky strategy but also one which is
frequently fails.
PERFORMANCE MEASURES
RETURN ON INVESTMENT (ROI)
ROI is similar to the ROCE concept; it is the use and application of the measure that is
different to ROCE. ROI is more commonly applied at the project or SBU (Strategic
Business Unit) level.
RESIDUAL INCOME
This is expressed as an absolute figure, it is normnally calculated as
The interest charge is a notional charge based normally on a risk adjusted cost of capital
applied to the book value of the value of the investment at the start if each year.
Advantages
It makes divisional managers aware of the cost of financing their divisions.
It is an absolute measure of performance and not subject to the problems of
relative measures such as return on investment.
In the long run it supports the net present value approach to investment appraisal
(the present value of a project’s residual income equals net present value of that
project).
Disadvantages
In common with most other divisional performance measures, problems exist in
defining controllable and traceable income and investment.
Residual income gives the symptoms not the cause of problems. If residual
income falls the figures give little clue as to why.
Problems exist in comparing the performance of different sized divisions (large
divisions will earn larger residual incomes simply due to their size
Residual income when applied on a short term basis is a short term measure of
performance and may lead managers to overlook projects whose payoffs are
long term.
EVA is seen to the true economic profit made by an enterprise, the concept being that
true shareholder value is created when an organisation generates economic profits in
The financing costs represent the target WACC applied to the economic capital
If the present value of the outflows exceeds the present value of the inflows, that is the
project yields a negative net present value, then the investment as projected is earning
less than the discount rate and should be rejected.
The discount rate used represents the rate of return required to make the investment
worthwhile, hence the accept/reject approach adopted above where respective positive
and negative net present values are achieved.
Once calculated, the IRR for a project is compared with the target return required by the
organisation. If it is greater than or equal to the latter, the project is likely to be worth-
while. If it is less than the target return, the project should be rejected. Investments in
mutually exclusive projects are ranked according to the size of the IRR.
Intangibles are generally still not regarded as assets in traditional accounting systems,
unless they comply with formal accounting recognition rules.
1. The project will require an investment of $66 million, it will have no residual value
and depreciation is calculated on a straight line basis.
2. The project is expected to generate annual revenue flows of $80m in year 1,
$90m in year 2 and $100m in year 3.
Year 1 Year 2 Year 3
Sales volumes 1.8 million 2 million 2½ million
Unit selling price $60 $60 $60
3. Incremental costs $40million $45million $50million
4. The project is forecast to have a contribution to sales ratio of 60% throughout the
three year period.
5. Immediate investment in working capital will be as below; these amounts would
be recovered in full at the end of the three year period.
Inventory $5m
Receivables $5m
Payables $3m
b. Calculate the projects Net Present Value (NPV) and Internal Rate of Return
(IRR)
In attempting to establish a clear link between performance and strategy it is vital that
management ensures that the performance measures target areas within the business
where success is a critical factor. The criteria for selecting performance measures for the
scorecard are
The above can be seen as a cascading effect, i.e. CSFs determine KPIs, we then set a
target and then consider ways to achieve the target KPI; the KPIs are then calculated,
monitored and reported to the board and operational managers. If the target KPIs are
not being met then appropriate action can be taken.
Some sense of prioritisation has to occur otherwise we will merely end up calculating
and monitoring a list of KPIs that have no cohesive linkage and can cause us to lose
sight of our main strategic purpose. This methodology, if developed and implemented
effectively replaces the conventional budgetary reporting system where the focus is
more on cost control – important but not the sole determinant of achieving our ultimate
mission.
Written comment
Reproduced from Strategic Performance Management, B Marr, 2006
Input Measures
At the lowest end of the performance measurement spectrum is the tracking of program
inputs. Typical inputs include staff time and budgetary recourses.
Inputs are generally the simplest elements to measure, but provide limited information
for decision – making and analysis of actual results.
Output measures
Results generated from the use of program inputs are the domain of the output measure.
Theses metrics track the number of people served, services provided, or units produced
by a program or service. They may sometimes be referred to as activity measures.
Depending on the nature of the program or services, output measures may provide
information on whether desired results are being achieved.
Outcome measures
Outcomes track the benefit received by stakeholders as a result of the organisation’s
operations. Whereas inputs and outputs tend to focus internally on the program or
service itself, outcomes reflect the concerns of the participants (clients, customers, other
stakeholders). Outcome measures shift the focus from activities to results, from how a
program operates to the good it accomplishes. Outcome measures offer many
advantages:
In proposing the use of the performance pyramid Lynch and Cross suggest measuring
performance across nine dimensions. These are mapped onto the organisation - from
corporate vision to individual objectives.
At the bottom level of the pyramid is what Lynch and Cross refer to as 'measuring in the
trenches'. Here the objective is to enhance quality and delivery performance and reduce
cycle time and waste. At this level a number of non-financial indicators will be used in
order to measure the operations. The four levels of the pyramid are seen to fit into each
other in the achievement of objectives. For example, reductions in cycle time and/or
waste will increase productivity and hence profitability and cash flow
The strength of the performance pyramid model lies in the fact that it ties together the
hierarchical view of business performance measurement with the business process
review. It also makes explicit the difference between measures that are of interest to
external parties - such as customer satisfaction, quality and delivery - and measures that
are of interest within the business such as productivity, cycle time and waste.
Lynch and Cross concluded that it was essential that the performance measurement
systems adopted by an organisation should fulfil the following functions:
1. The measures chosen should link operations to strategic goals. It is vital that
departments are aware of the extent to which they are contributing - separately
and together - in achieving strategic aims.
2. The measures chosen must make use of both financial and non-financial
information in such a manner that is of value to departmental managers. In
addition, the availability of the correct information as and when required is
necessary to support decision-making at all levels within an organisation.
3. The real value of the system lies in its ability to focus all business activities on the
requirements of its customers.
These conclusions helped to shape the performance pyramid which can be regarded as
a modeling tool that assists in the design of new performance measurement systems, or
alternatively the re-engineering of such systems that are already in operation.
BALANCED SCORECARD
The Balanced Scorecard was developed by Kaplan and Norton as an attempt to counter
a rather narrow-minded approach to performance management that relied too heavily on
financial measures. The Balanced Scorecard approach relies on the organisation
defining key dimensions of performance for which discreet yet linked measures can be
reported. The following categories, or perspectives, are measured:
Customers
Internal Process
Learning and growth
Financial
A framework is developed within each of the four perspectives that helps describe the
key elements of strategy; the framework is made up of:
Objectives
Measures
Targets
Initiatives
Customer
Whom do we define as
our customer?
How do we create value
for our customer?
Employee Learning
& Growth
How do we enable
ourselves to grow &
change, meeting
ongoing demands?
Customer Perspective
Two key questions need to be asked here:
The measures that are used and designed in this perspective will help close the gap.
Employee skills, employee satisfaction, education training, internal rewards and
recognition are examples of such measures.
Financial Perspective
The measures in this perspective tell us whether our strategy execution and
implementation, detailed through measures in the other perspectives, leads to improved
bottom-line results. Typical examples include shareholder value increase, gearing.
Target costing will necessitate comparison of current estimated cost levels against the
target level. This must be achieved if the desired levels of profitability, and hence return
on investment, are to be achieved. Where a gap exists between the current estimated
cost levels and the target cost, it is essential that this gap is closed.
What What
Price Features
Set Profit
When designing the prism, the five facets referred to above prompt specific questions
(and answers), namely
Stakeholder satisfaction – Who are the key stakeholders, what do they want and
need?
Strategies – What strategies do we need to put in place to satisfy the wants and
needs of our key stakeholders?
Processes – What critical processes do we need to put in place to enable us to
execute our strategies?
Capabilities – What capabilities do we need to put in place to allow us to operate,
maintain and enhance our processes?
Stakeholder contribution – What contributions do we want and need from our
stakeholders if we are to maintain and develop these capabilities?
The basic principle of TQM is that costs of prevention (getting things right first time) are
less than the costs of correction. This is contrasted with the ‘traditional’ approach which
takes the view that that less than 100% quality is acceptable as the costs of reaching
100% outweigh the benefits.
Appraisal costs
Costs incurred to ensure that materials & products meet quality conformance standards.
They include the costs of inspecting purchased parts, work in process & finished goods,
quality audits & field tests.
Opportunity costs
Advocates of TQM argue that the impact of less than 100% quality in terms of lost
potential for future sales also has to be taken into account.
Contribution
Minimum 30 20 0 -20
Maximum 30 60 90 95
Maximin 30
Maximax 95
Minimax regret
Max regret 65 35 30 50
Minimax 30
Containers
c. Spare capacity of Provide Inc. (52,000 – 36,000) 16,000
Additional output of Provide Inc. 6,750
Per container
Provide Inc.: existing variable cost $7
Investment
Year 0 Year 1 Year 2 Year 3
$m $m $m $m
Net book value (NBV) 66.0 66.0 44.0 22.0
EBITDA: million
(Contribution less incremental costs) $24.8 $27.0 $40.0
Less: depreciation
Profit -$22.0 -$22.0 -$22.0
(NCF minus depreciation) -$4.2 $5.0 $25.0
4.9 -5.2