Cost Accounting: Performance Measures and Transfer Pricing

This document discusses the performance measures and transfer pricing in cost accounting. It covers topics such as return on investment, economic value added, residual income, minimum transfer price, maximum transfer price, and the role of activity-based costing in transfer pricing.

Running Head: COST ACCOUNTING 1
COST ACCOUNTING

COST ACCOUNTING 2
Table of Contents
Question 1........................................................................................................................................3
Return on Investment...................................................................................................................3
Best performer..............................................................................................................................3
Economic Value Added...............................................................................................................3
Comparison..................................................................................................................................4
Recommendations........................................................................................................................4
B) Residual Income.........................................................................................................................5
Question 2........................................................................................................................................6
Minimum transfer price...............................................................................................................6
Maximum transfer Price:.............................................................................................................6
Reasons why internal transfer should take place:........................................................................7
Effect of transfer pricing between geographically dispersed divisions:......................................8
Role of Activity based costing in transfer pricing:..........................................................................9
Question 3......................................................................................................................................10
Features of Performance related pay..........................................................................................10
Appropriateness of the three measures......................................................................................10
Changes that need in the system or any other schemes.............................................................11
References......................................................................................................................................12

COST ACCOUNTING 3
Question 1
A)
Return on Investment
South Island
division
North Island
division
Fishing Fleet
division
Operating profit before
tax 5,400 1,200 900
Total assets 52,500 6,000 25,200
Current liabilities 12,000 3,000 2,400
Invested Assets 40,500 3,000 22,800
ROI 9.60% 28.80% 2.84%
Best performer
In terms of the percentage the division which has performed better is the North Island
Division where the rate of the return on investment is 28.80% followed by the South Island
Division at 9.60%. The major aspect that needs to be taken into consideration while when
interpreting the performance on the basis of the divisions are to take the operating profit after tax
in use and the to make use the net of the total assets and the current liabilities as the investing
assets for the purpose of calculation of ROI (Jakub, Viera & Eva, 2015).

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Economic Value Added
The computation for the economic value added for each division has been shown below
in the table.
Economic Value Added
South Island
division
North Island
division
Fishing Fleet
division
Capital Invested in the
beginning 40,500 3,000 22,800
WACC 8% 8% 8%
Finance Charge 3240 240 1824
NOPAT 3,888 864 648
Finance charge 3240 240 1824
Economic Value Added 648 624 -1,176
Comparison
According to the ROI the financial performance of North Island Division as the highest
ROI was recorded in this division however when the performance is compared on the basis of the
economic value addition the South Island division is performing better at $648. In both the cases
the one thing that needs to be observed is that Fishing Fleet division is not performing up to the
mark in both the cases. Also it was suggested that the return on investment shall be up to 10%of
profit and therefore it becomes crucial for the two islands that is the South Island division and
the fishing fleet division (Harvard Business Review, 2018).
Recommendations
From the above analysis it can be concluded that the North Island division is the key
driver and the rest of the two divisions needs the super attention. Further in order to get stabilize

COST ACCOUNTING 5
the management of the Ace Company shall focus on reducing the current liabilities and the costs
that have been deducted to arrive on operating profit. Further the expenses shall be bifurcated
into the overhead and the production expense as this will help the management to understand
which area needs more focus and how this will help in determining the potential investment of
the funds in the most appropriate areas (Chiwamit, Modell & Scapens, 2017).
B) Residual Income
Residual income is the other method for measuring the performance of investment
centers as and also helps in measuring the division of the shareholder and the addition the
residual income adds to it. It is considered as the alternative income to mitigate those problems
that arise when the ROI is calculated. It also assists the management in making the profitable
investments as these investments are being rejected by the managers who utilize the ROI as it
focuses on accelerating the corporate shareholder value. Nearly every major decentralized
company in United States makes use of the return on investment methodology for measuring the
performance of division. The two major limitations with the ROI are bifurcated into two
techniques namely the technical and implementation (Masters, Anwar, Collins, Cookson &
Capewell, 2017).
The first category s where there are events that cause the incongruities between the
divisional objectives and the company goals which ultimately results in the demotivation on the
part of the management and eventually these managers take the uneconomic actions. The second
category is involved with the implementation which is the result of the inability, under many
circumstances, to evaluate the accurate profit performance of the division managers. The residual
income takes care of both the scenarios and relates to the better management of profitability.

COST ACCOUNTING 6
This method encourages the managers to perform in a better way by making the optimum
utilization of the assets to earn the regular profit. This method also takes care about the
congruency of each division. Henceforth it can be concluded that the residual income eliminates
the limitations possessed by the method of the return on investment to a linear extent.

COST ACCOUNTING 7
Question 2
Transfer Pricing
Minimum transfer price
Calculation of minimum transfer depends upon the capacity utilization of The Transferee
division. The capacity utilization plays a vital role in determining the transfer price to be charged
on each product transferred. In case of under-utilization and over-utilization of the capacity, the
minimum transfer price would be equal to the total variable cost and if the Division is operating
at full capacity and the whole production has demand in open market then the transfer price
would be equal to total variable cost and opportunity cost due to diverting external sales to the
division (Klassen, Lisowsky & Mescall, 2017).
In given case, the transferee division has under-utilized its capacity and it has spare
capacity, so, in this case the transfer price would be equal to the variable cost. The calculation of
minimum transfer price is given below:

COST ACCOUNTING 8
Maximum transfer Price:
The maximum transfer price for the computer division would be the price at which they
used to purchase from external market because the purchasing division would not going to accept
any transfer price beyond the external price of such product. If they accept any price beyond the
price at which they purchase from external market would adversely affect the price of that
division. So, the maximum transfer price would be equal to the price at which they acquire such
goods from external market i.e. $ 21.50 per motherboard. Accepting the maximum transfer equal
to the market price will not divert the inherent profit to the outsider, it will remain within the
organization as a whole. Thus, the maximum transfer price should be $ 21.50 because the
product required for computer division is easily available in open market at $ 21.50 (Cristea &
Nguyen, 2016).
Reasons why internal transfer should take place:
The following are the reasons for placing transfer of goods internally besides purchasing
it from external market.
 Dilution of Portion of profit from external party to transferee division: currently the
transferee division has an ideal capacity of 150000 units of motherboard, which can be
utilized for transfer to the computer division. Suppose the Computer division has a
demand of 150,000 of Motherboards which is equal to the ideal capacity of Motherboard
division and the cost structures for computer division for external sales are Direct labor
cost is equal to $ 2.5/unit, Variable overhead cost is $ 3.00/unit and unavoidable fixed
overhead is $ 700,000 . So, the profitability and cost structure of the both division and
company has explained below (Bouwens & Steens, 2016).

COST ACCOUNTING 9
It can be observed from the above calculation that internal transfer has resulted into full capacity
utilization with significant reduction in the unavoidable fixed costs resulting into profit for the
company as a whole.
Effect of transfer pricing between geographically dispersed divisions:
Transfer price between two geographically dispersed divisions are mainly affected by the
following factors:
i. International taxation covering transfer pricing would affect the predetermined
transfer price to show the arm’s length pricing status in it.
ii. Trade as well as political relations between both the countries.

COST ACCOUNTING 10
iii. Extra costs such as custom duty, freight and other costs associated with the
transfer.
There are mainly three types of transfer pricing explained below:
a. Cost based transfer price: In this full cost based transfer pricing is used to compensate
transferee division the full production they have incurred for production of such product.
This will compensate the whole product cost of the transferee and mostly accepted by the
both divisions. The upper management generally prefer this method as this method
removes the question of ambiguity between both divisions.
b. Market based pricing: This method is quite useful when there is a ready market
available for the products of transferee divisions and it has no room for ideal capacity.
So, the management policy in this would be to recover the opportunity cost that has been
forgone due to internal transfer (Klassen, Lisowsky & Mescall, 2017).
c. Negotiated transfer pricing: In this, the management used to negotiate the most
acceptable transfer price between both to remove the question of ambiguity between both
divisions. The transfer price is decided after considering the arguments of the
management of the both divisions and the decision has to be in the favor of company as
whole.
Role of Activity based costing in transfer pricing:
Activity based costing uses cost driver as to allocate costs. It is the most scientific way of
cost allocation. The use of ABC in transfer pricing entails more detailed and scientific way of
cost allocation barring the manager of transferee division to overstate the profit from the division

COST ACCOUNTING 11
as this system will allocate the cost based on the cost drivers, which is more related to the
product. The ABC costing will not give any insight about the cost structure of the transferor
division because the whole cost has been allocated to the product is not in traditional way of cost
distribution. ABC costing also clears the points of confusion that may arise between both the
divisions as the method and procedure for allocating cost is purely based on the cost drivers,
which reflects the cost actually incurred for the product (Bouwens & Steens, 2016).
Question 3
Features of Performance related pay
Though the performance related pay has been adopted in different parts of the word and
by both the private and the public sector organizations however the evidence of its successful
implementation remains contested. Inn case of Elite systems Limited this concept has been
introduced where the major feature is the satisfaction of the employee in terms of the team work.
This system is also inculcating the habit of the team work and unity. This concept is introduced
to get an insight of the performance of each team and how well they are in coordination with
each other. As the incentives of the one team are dependent on the working style of the other
team therefore the team coordination is on the top. Further the performance related pay system
also helps in rewarding the best performer which ultimately is a positive initiative in accelerating
the retention policy. This concept can create a health environment for the development of the
organization but also the sense of competition will enhance the productivity of the individual
(Bellé, 2015).

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Appropriateness of the three measures
The three performance measures are appropriate for the assessment of the performance of
the employee if the criteria is set in such a manner that it does not fall in the category of the
biasness. The employee shall be recognized on different parameters each month as practically it
is impossible to set ten criteria’s to measure the performances. Henceforth, the management must
make sure that each month the parameters are set all together in a different manner so that every
employee gets the chance of being recognized or being awarded (Koskinen Sandberg, 2017).
Changes that need in the system or any other schemes
For the purpose of improving the system there are several strategies which the
organization must follow to avoid any loopholes in the organization. Currently the appraisal
process must be reviewed on the regular basis and on the other hand the managers shall be
trained and made competent enough to fight for the process. The pay review budget shall also be
designed into perform at the high level and to kill any kind of the differences at any kind of the
employment level. The engagement process of the employees is mandatory for the system to
prevail in the market. Employee engagement will help in creating the coordination between the
teams so that they can communicate the needs in a better manner and work to serve each other.
This way the clashes between the teams regarding skimping on material, distribution of the
faulty product to the process get eliminated and eventually the system hails in the organization.
Apart from this scheme the other incentive schemes are bonus, employee stock option plan
(Derks, Bakker, Peters & van Wingerden, 2016).

COST ACCOUNTING 13
References
Bellé, N. (2015). Performance‐related pay and the crowding out of motivation in the public
sector: A randomized field experiment. Public Administration Review, 75(2), 230-241.
Bouwens, J., & Steens, B. (2016). Full-cost transfer pricing and cost management. Journal of
Management Accounting Research, 28(3), 63-81.
Chiwamit, P., Modell, S., & Scapens, R. W. (2017). Regulation and adaptation of management
accounting innovations: The case of economic value added in Thai state-owned
enterprises. Management Accounting Research, 37, 30-48.
Cristea, A. D., & Nguyen, D. X. (2016). Transfer pricing by multinational firms: New evidence
from foreign firm ownerships. American Economic Journal: Economic Policy, 8(3), 170-202.
Derks, D., Bakker, A. B., Peters, P., & van Wingerden, P. (2016). Work-related smartphone use,
work–family conflict and family role performance: The role of segmentation
preference. Human Relations, 69(5), 1045-1068.
Harvard Business Review, (2018). The Case Against ROI Control. Retrieved from
https://hbr.org/1969/05/the-case-against-roi-control
Jakub, S., Viera, B., & Eva, K. (2015). Economic Value Added as a measurement tool of
financial performance. Procedia Economics and Finance, 26, 484-489.
Klassen, K. J., Lisowsky, P., & Mescall, D. (2017). Transfer pricing: Strategies, practices, and
tax minimization. Contemporary Accounting Research, 34(1), 455-493.

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Koskinen Sandberg, P. (2017). Intertwining gender inequalities and gender‐neutral legitimacy in
job evaluation and performance‐related pay. Gender, Work & Organization, 24(2), 156-170.
Masters, R., Anwar, E., Collins, B., Cookson, R., & Capewell, S. (2017). Return on investment
of public health interventions: a systematic review. J Epidemiol Community Health, 71(8),
827-834.