Financial Accounting:

Measuring Corporate Performance

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 Measuring Corporate Performance
1.Introduction
2.Context
3.Overview
4. Importance of ratios
5. Main ratios (profitability, efficiency, liquidity, gearing, CF & Investment)
6. Worked examples (traditional measurement)
7. Ratios and issue of overtrading
8. Use of ratio in predicting financial distress & limitation
9. Alternative theoretical perspectives on financial statement (social & environmental
reporting & intellectual capital), issue of creative accounting in financial reporting
10.Performance evaluation of business unit
10.1 Decentralised organisation & divisional performance measurement
10.2 Return on investment & residual income
10.3 Controllability & Transfer pricing
11 Latest trend in PMSs ;Balance scorecard, EVA, MVA, VBM, PP, ABC, ABM,Six Sigma :
Profiting from it. 2
 Introduction
 What is relevant about the size of firms asset base?
 The entity made a $1m profit-is this good or bad?
 Cash flow from operation is $600,000- is this
adequate?
 Overheads can kill !
 Can we manage earning ?, issue related to earning
quality ? Warren Buffet (CEOs have come to the view
that it’s okay to manipulate earnings to satisfy what
they believe are Wall Street’s desires, indeed, many of
them think this kind of manipulation is not only okay
but actually their duty…
 Do we need Harry Porter around ???
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 Introduction
• Financial analysis –assessment of entity’s past, present and
anticipated future performance and financial position
• Analysis of past data-make predictions about the future of the
entity.
• Interpretation of financial statement occurs when users evaluate
financial information to make judgements (investors/lenders).
• The danger ? Fail to interpret FA(business entity) on a wider
context.
* Main aspects (The traditional Tool of measurement)
i, Profitability
ii, Efficiency
iii, Liquidity
iv, Gearing
v, Cash flow
vi, Investment 4
 Context

Transaction occurs

Recorded in books by
double entry

Preparation of accounts

Interpretation of
accounts 5
Overview I

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 Overview II

1. Profitability
1. Return on capital employed
2. Gross profit ratio
3. Net profit ratio
2. Efficiency
1. Debtors collection period
2. Creditors payment period
3. Stock turnover ratio
4. Asset turnover ratio
3. Liquidity
1. Current ratio
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2. Quick ratio
 Overview III

4. Gearing
1. Gearing ratio

5. Cash Flow
1. Cash flow ratio (Operating Cash flow/Liabilities)

6. Investment
1. Dividend yield
2. Dividend cover
3. Earnings per share
4. Price/earnings ratio
5. Interest cover

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 Importance of Ratios

 Quick and easy snapshot

 Comparisons (horizontal & vertical)
 Uncover the underlying management’s philosophies

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Closer Look at Main Ratios II
John Enterprise

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Closer Look at Main Ratios I
John Enterprise

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 Closer Look at Main Ratios III
* Calculations based on John Enterprise, in £ms
1. Profitability Ratios
a, Return on Capital Employed
* measures effective use of capital

Net Profit before tax and loan interest = 60 = 17.9%

Capital+Reserve+LT loans 335
b, Gross Profit Ratio
* measures direct return on sales
Gross profit = 100 = 50%
Sales 200
c, Net Profit Ratio
* measures bottom line return
Net profit after taxation = 35 = 17.5%
sales 200 12
 Closer Look at Main Ratios IV

2. Efficiency Ratios

1. Average Settlement period for debtors

* Measures how long it takes customers to pay

Debtors = 40 X 365 days = 73 days

Credit sales 200

2. Average Settlement period for creditors

* measures how long it takes to pay suppliers

Creditors = 50 = 183 days

Credit purchases 100/365

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 Closer Look at Main Ratios V

3. Stock Turnover
* measures how quickly stock moves through business

Cost of sales = 100 = 1.66 times

Average stock 60

Stock holding period = Stock/COGS x 365 days

= 60/100 X 365
= 219 days
4. Asset Turnover Ratio (Net Asset Turnover)
* compares sales to total assets employed
Sales = 200 = 0.51 times
Total assets 395

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 Closer Look at Main Ratios VI

3. Liquidity Ratios
1. Current Ratio (Working capital)
* measures short-term liquidity

Current assets = 120 = 2

Current liabilities 60

2. Quick Ratio (acid test)

* measures extreme short-term liquidity
Current assets - stock = 120-60 = 1
Current liabilities 60

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 Closer Look at Main Ratios VII

4. Gearing
* Measures relationship between long-term borrowings and total capital.

Long-term borrowings(Liabilities) = 120 = 36%

Capital Employed 335

Long-term borrowings: preference share capital and debentures.

Capital Employed: share capital, long term borrowings and reserves.
5. Cash Flow

*
measures cash flow
A company with cash inflows £430,000 and outflows £410,000.

Total cash inflows = 430 = 1.05

Total cash outflows 410 16
 Closer Look at Main Ratios VIII
6. Investment Ratios (Shareholder return)
1. Dividend yield
* Dividend related to market price
Dividend per ordinary share = (£10 m/£150m) x100 = 10%
Market value per share £0.67p

2. Dividend Cover
* How many times profit covers dividends?
Profit after tax and preference dividends = 30 = 3 times
Ordinary dividends 10

3. Earnings per Share (EPS)

• Earnings generated by the company during a period & available to shareholders based on
the number of shares in issue
Profit after tax and preference dividends = 30 = 20p
Number of ordinary shares in issue 150
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 Closer Look at Main Ratios IX

4. Price Earnings Ratio

* Relates the market value of a share to the earnings per share
Market value per share = 67 = 3.35 times
Earnings per share 20

5. Interest Cover ratio

* Measures the amount of profit available to cover the interest payable (security for lenders)
Profit before tax and loan interest = 50 + 10 = 6 times
Loan interest payable 10

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 Worked Example I
Illustrative Example on Interpretation of
Accounts

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 Worked Example II
Illustrative Example on Interpretation of Accounts

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 Worked Example III

1. Vertical and Horizontal Analysis

2. Vertical analysis involves setting key figures in accounts to 100%

e.g., taxation in 20X1 is RM26 of sales RM350 is 7%.

* Horizontal analysis involves comparing across years

e.g., sales in 20X2, 29% up on 20X1 = (450-350)/350 x100%.

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 Worked Example IV

20X1 20X2
1. Return on Capital Employed
130 +8 = 18.4% 195 +10 = 24.7%
750 (911+750)  2

2. Gross Profit Ratio

215 = 61.4% 300 = 66.7%
350 450

3. Net Profit Ratio

104 = 29.7% 156 = 34.7%
350 450
4. Debtors Collection Period
(Debtor/sales) 80 x 365 = 83,42days 38 x 365 = 30.82 days
350 450
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 Worked Example V

20X1 20X2

5. Creditors Collection Period

80 = 216 days (80 + 60)  2= 170
days
135 365 150 365

6. Stock Turnover Ratio

135 = 5.4 times 150 = 4.5
times
25 (25+42) 2

7. Asset Turnover Ratio

350 = 0.42 times 450 = 0.5
times
(50+600+180) (300+1211+290)  2 23
 Worked Example VI

20X1 20X2
8. Current Ratio
180 = 2.2 110 = 1.8
80 60

9. Quick Ratio
180 - 25 = 1.9 110 -42 = 1.1
80 60

10. Gearing Ratio

230 = 30.7% 250 = 27.4%
750 911

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 Worked Example VII

11. Cash Flow

* First, draw up cash flow statement and take cash inflows and
outflows (summarised below)
Inflows Outflows
£000 £000
Net cash inflow from operating activities 210
Returns on investments and servicing
of finance 10
Taxation 39
Capital expenditure and financial investment 211
Equity dividends 15
Financing 20 _____
230 275

Cash inflows = 230 = 0.84

Cash outflows 275

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 Worked Example VIII

20x1 20x2
12. Dividend Yield 6÷300 = 2% 12÷300 = 2.7%
100 150

13. Dividend Cover 101 = 16.8 times 153 = 12.7 times

6 12

14. Earnings per Share 101 = 33.7p 153 = 51p

300 300

15. Price/Earnings Ratio 100 = 3.0 150 = 2.9

33.7 51

16. Interest Cover 130+8 = 17.2 times 195+10 = 20.5 times

8 10

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 What to note when interpreting firm’s
financial performance based on ratios
 Profitability
 Satisfactory biz performance requires an adequate return on shareholders’
funds (ROI) & ROCE. But improvement in ROI & ROCE may either be
because profits have increased and / or because the capital used to generate
those profits has altered. (or by increasing profit and reducing costs-
economies of scale or maintain profits while reducing assets and repaying
debts.
 Operating profitability as a proportion of sales (PBIT or EBIT) where
profitability growing at a faster rate than sales growth(due to a higher gross
margin (lower expenses).
 Note. Sales growth may result in a higher profit but not necessarily in a
higher rate of profit as a % of sales.
 Improvement in the rate of gross profit may due to a higher selling prices,
lower cogs, changes in the mix of product sold or different mkt segments that
give differential profitability

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 Liquidity
 A biz that has an acid test of less than 100% may experience
difficulty in paying its debts as they fall due but company with
too high a WC ratio may not be utilizing its assets effectively.
[Collier, 2003]
 Improvements in the WC and acid test ratios are the result of
changing the balance between CA and CL.
 In WC, money changes form between AR, Stock, bank and AP.
Therefore, borrowing over the long term in order to fund CA
will improve this ratio, profit & CF.
 On the other hand, using liquid funds to repay LT loans or
incurring losses will reduce the WC used to repay AP.

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 Gearing
 This ratio reflect s the balance between LT debt and
shareholders’ equity. It changes if ; more shares are
issued, raising new borrowing, repayment of debt.
 The higher the debt, the gearing ratio will also
increase, then the higher the risk of repaying debt and
interest. If interest cover ratio low, pressure to produce
more profit is necessary to fund interest charges.

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 Activity/efficiency ratio
 This ratio may improve either because of sales
increase or the total assets used reduce.
 Effective management of stock, AR, FA, & AP
is important.

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 Shareholder return
 Directors decide how much dividend to pay out and
normally the decision is based on the proportion of
profit they want to distribute and the capital needed to
be retained in the biz to fund growth.
 How much dividend the company should give/pay out?
 This is important question bcos the cost of retaining fewer
profits and then having to borrow additional funds to support
growth strategies.
 The number of share issues also affect this ratio
 Companies have little influence over their share price

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 Financial Ratios and the problem of overtrading
 Overtrading (activity that cannot be supported by the amount of finance that has been
committed). When this happen ;
 Current ratio is normally low
 Average stock turnover period is normally lower than expected.
Stock level is normally low because of the problem of financing
the stock.
 Average settlement period for debtors is normally lower than
expected because a business is suffering from liquidity problems
hence chasing debtors more vigorously so as to improve cash
flows.
 The average settlement period for creditors may be higher than
normally expected. Biz tries to delay payments because of
liquidity problems.

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 Use ratios in predicting financial distress
 Beaver (1966), Financial ratios as predictors of failure by comparing the
mean ratios of 70 businesses that failed over a ten-year period with a sample of 79
businesses that did not failed over this period. He found that certain mean ratios
exhibited a marked difference between the failed and non failed business for up to 5
years prior to failures.
 Zmijewski(1983), Predicting Corporate bankruptcy using a sample of 72 failed and
3,573 non failed businesses over a six year period and found that failed businesses
were characterised by; lower rate of return, higher levels of gearing, lower levels of
coverage for their fixed interest payments and more variable returns on shares.
 Zmijewski did not find that liquidity ratios particularly useful in identifying financial
distress.
 Both approaches are referred to as Univariate analysis (looking at one ratio at a
time)
 Multiple Discriminate Analysis (MDA)- using a statistical technique
to draw a boundary between those businesses that fail and those
businesses that do not.
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 Scatter diagram

C Ratio
……… Non failed Co.
xxxx x x ………
.. . X
xx xxxxx …
xx x xxx
Failed Co.
ROCE

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 The Z Score model-Altman (1968)
 Z=1.2a+1.4b+3.3c+0.6d+1.0e
 Where ;
a= working capital/Total assets
b=Accumulated retained profits/Total Assets
c= Profit before interest and taxation/Total Assets
d=Market value of ordinary and preference
shares/Total Liabilities at book value
e=Sales/Total assets

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 Interpretation of Z score
 Z score of < than 1.81 failed
 The lower the score the greater the probability
of failure
 Z score greater than 2.99 did not fail
 Z score between 1.81 and 2.99 occupied a zone
of ignorance and were difficult to classify
 Overall, the model was able to classify 95% of
the business correctly

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 Limitation of ratios
 Quality of financial statements. FS contains numerous
estimates.
 Alternative Accounting Methods- applying different accounting
policies such as depreciation methods, stock valuation methods,
writing off intangible assets)
 Cost. FS are based on cost and not adjusted for price level
changes
 Application of creative accounting, why creative accounting ?
 A typical data fiscal year end data may not be typical of the
financial condition during the year. Certain account balances
may not representative of the account balance during the year
 Diversification of firms- difficulty in making comparison

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 Incorporating Social & Environmental
elements in Financial Statement
 The concern with stakeholders rather than
shareholders began in the 1970s.
 Accounting academics began to question profit as
the sole measure of business performance and
suggested a wider social responsibility for
business.
 Concept of corporate social accounting and
socially responsible accounting attempt to
highlight the impact of organisation on society
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 Jones (1995) argues that
 Business organisations were insufficiently aware of the
social consequences of their activities.
 Demand by govt, pressure groups and institutional
investors for ethical investments- acctg has a role in
demonstrating how well organisations have fulfilled
their social contract (an implied contract between an
organisation and society).

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Little support for broader social accounting,
why ?
 Agents and principal relationship
 Social reporting could be seen as undermining the
power of shareholders & the foundation of the
capitalist economic systems
 Technical difficulties associated with the reporting
 Business leaders argue that Govt had the responsibility
to determine what was reported (MASB)/FASB !!!

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 Intellectual Capital ??
 “The hidden dynamic factors that underlie the visible
company”. Edvinsson & Malone(1997)
 “formalised, captured and leveraged knowledge”.
Stewart (1997)
 Traditional financial statement erode the value of IC as
a tool that support meaningful decision-making
(Guthrie, 2001).
 3 dimensions of IC ; Human (knowledge & skill),
Organisational (Internal structures, systems and
procedures) & Customer (loyalty, brand, image etc)
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Creating accounting & ethic in financial
reporting
 “Accounting choices are moral choices” Francis
 Why managers practice creating accounting ?
 Income smoothing / presenting performance in a better light
 To bring profits closer to forecasts
 Changing accounting policies to distract attention from poor
performance or maintaining or boosting share prices [Gowthorpe
and Blake, 1998]
 How creative accounting is done ? Practicing accruals, stock
valuation, creating or reducing provisions, capitalising or
expensing costs (Griffiths, 1996)
 Can we achieve genuine economic growth ?, what can we
do to prevent wide practices of CA in Malaysia ?

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 Key questions
 How do you measure your organisation performance all
these years ?
 Do you assess your organisation performance based on ?
– Financial ratios
– Economic conditions
– Change in the industry (regulation, technology)
– Competitive advantage (marketing, operations, distribution etc)
held by the business
– Social (values, attitudes,trends)
– Tools ?? (BS, EVA, MVA, VBM, ABC, ABM, PP, 6 Sigma)
– What tools can be used to capture & reflect the overall
functions/activities of an organisation ???
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 Latest trends in corporate performance measurement
 Performance measurement systems have gone through
various stages of evolution.
 Gates & Kulik, 1999 found that 1/3 of companies had
changed their performance measurement systems during
the previous three years. Why ?
 1980s, focus of PMS was too historical-measure the
wrong things. Theory of Organisational Structure by
Alfred D Chandler
 1990s, companies experienced difficulties in
implementing the systems (what to measure, how to
access data, whether to align rewards and so on?) 44
 Why companies need to change their PMS ?
 Decrease in profitability
 Change in strategy
 Enhance shareholder value
 Redesign of business processes
 New technology
 New competition
 Attract/retain people
(Maisal, 2001) AICPA

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 What are the latest PM philosophies-CIMA
 37 companies were investigated in UK.
 Traditionally managed, those subscribing to
VBM and those with explicit stakeholder
management approach.
 Result- no single approach shows any
superiority in terms of optimising performance
therefore, no company practised pure
performance measurement philosophy but takes
whatever approach it perceived to be beneficial

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 Factors required for a successful PMS
 It must be integrated with the overall strategy of the
business
 There must be a system of feedback and review
 The PMS must be comprehensive (traditional
accounting based measures are backward looking),
accounting measures take no account of the intangible
value drivers which can contribute significantly to the
company’s market value (knowledge intensive
companies)
 Controlling the bottom line-pushes many managers
into making short term decisions in order to boost their
earning streams (creative acctg prevails)
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Why companies still continue to employ the traditional accounting
measures ?
 The techniques were considered to be perfectly
adequate to meet the needs of the business
 The measures used were appropriate for their
major stakeholders
 The culture of the organisation itself is not
conducive to the introduction of new measures
and there is a lack of support for the adoption of
new techniques even after some consideration

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 Cont’d : required factors

 The system must be owned and supported

throughout the organisation
 Measures need to be fair and achievable
 The system needs to be simple, clear and
understandable

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 Common issues raised with PMS
 Key drivers of success are not easily measured
(innovation or flexibility) –intellectual capital report is
not easy (Skandia).
 Behavior is not in line with strategic objectives
 The system conflicts with the culture of the
organisation. Eg the advocates of a VBM approach
maintain that the shift to VBM will only work if the
culture is conducive to decentralised decision making
(Bannister, & Jesuthasan, 1973) [Cultural resistance]
 The development process is too time consuming or
difficult

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 Value-based Management (VBM)
 VBM is a return to economic values in assessing the
performance of the firm and places the concerns of
shareholders above others.
 Organisations’ strategy should be tested whether or not
it adds value for its s/holders
 Why s/holders values ?- key objective of many firms
where it is achieved when the ROCE in the business is
greater than the Cost of obtaining the funds.

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 Economics Value Added Vs MVA
 EVA is trying to measure the Economic Profit of the
firm [the difference between a company’s post tax operating
profit and the COC invested in the business]
 H/w, Stern Steward argue that MVA is advantageous because it
considers MV in terms of returns achieved from the investment
rather than simply investing as much capital as possible.
 Although Ehrbar, 1998 claims that EVA is a measure of those
true profit is bold considering (the process of risk adjustment by
calculating the firm’s WACC) but this approach is heavily
criticised. Why ? The risk adjusted rate method relies on an
accurate assessment of the riskiness of a project. How accurate
is your assessment ???

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 ABC & AB Management (ABM)
 ABC & ABM had led to radical changes in cost mgt
systems
 ABC focuses on the activities and processes within an
organisation and is based on principal that by
controlling the activities that consume resources, costs
can be controlled at source.
 Than ABM makes use of this information through
value analysis and performance measures which
support strategic and operational decision making.
 ABM can provide the data needs to plan and direct
improvement activities and eliminate waste
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 Balance Scorecard
: Prof Robert Kaplan & David Norton
 A tool to articulate, execute and monitor strategy using
a mix of financial and non financial measures
 It is designed to translate vision and strategy into
objectives and measures across four balanced
perspectives (Financial, Customers, Internal processes
& learning & growth)
 Cause & effect relationships between critical variables
and gives a framework for ensuring that strategy is
translated into a coherent set of performance measures

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ILLUSTRATIONS

Sample application of
Balance Scorecard
Developed by
Barnes & Noble And
Tribune

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 Other perspectives
 Johnston & Fitzgerald (2000) argued that the
BS and other performance measurement
frameworks have led to the use of more
measures over which managers may have little
or no influence.
 Nevertheless, BS can act as both a control
system and a management tool (for monitoring
performance as well as for strategic planning).
 It has been widely accepted by many large
corporations

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 Six sigma
 Pioneered by Motorola, GE, Citigroup and Honda.
 Is a measure of std deviation that how tightly clustered
observations are around a mean.
 A management tool designed to cut waste and make
better,cheaper or faster products and services. It is
aimed at improving quality by removing defects.
 Sigma Model (Define goals, Measure the system,
Analyse the system, Improve the system & Control the
new system - DMAIC)

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 The Performance Prism by
Cranfield University
 Where organisations need to consider the requirements of all
stakeholders in the development of a performance measurement
framework. 5 linked facets of the PP
 Stakeholder satisfaction –who are they and what do they want and
need?
 Strategies-what strategies do we have to put in place to satisfy the
wants and needs?
 Processes-what critical processes do we need to operate and
enhance these processes?
 Capabilities-what capabilities do we need to operate and enhance
these processes?
 Stakeholder contribution-what contributions do we require from our
stakeholders if we are to maintain and develop these capabilities?

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 Performance Evaluation of Business Units
The decentralised organisation and divisional
performance measurement
**********************************
 Business is organised in a centralised or decentralised manner
(due to capital expansions)
 Decentralization implies the devolution of authority to make
decisions. Divisionalization adds decentralisation the concept of
delegated profit responsibility (Solomon, 1965)
 Divisionalisation makes it easier for a company to diversify while
retaining overall strategic direction and control. Indeed
performance improvement can be enhanced by assessing
individual responsibility for divisional performance (where it is
normally linked to bonuses, profit sharing, share options etc)
 Shareholder value is the overall criterion for overall business
success and divisional performance is the criterion for divisional
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success.
Business should be assessed at its divisional level
by looking at the drivers of financial results

 Solomon (1965) suggested 3 reasons for

financial reporting at a divisional levels;
 To guide divisional managers in making decisions
 To guide top management in making decisions
 To enable top management to appraise the
performance of divisional management

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 Divisionalised Business Units may be;

 Cost centre-managers are responsible for controlling

costs within budget limits
 Profit centre-managers are responsible for sales
performance, achieve gross margin and controlling
expenses (operating within budget)
 Investment centre-managers have profit responsibility
and at the same time can influence the amount of
investment made by the centre.
 Is profit a good measure ????

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 Return on investment (ROI)
 A rate of return achieved on the capital employed
(DuPont Powder Company)
 Managerial and divisional success is judged according
to the Rate of Return (ROR) on the investment
 Issue- whether a high ROR on small capital investment
is better or worse than a lower ROR on a larger capital
????
Div A Div B
Capital invested 1 million 2 million
Operating profit 200k 300k
ROI 20% 15%

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 Residual Income
 RI is the profit remaining after deducting the notional
COC from the investment in the division. RI was
developed by GE.
 COC – the rate that must be earned in order to satisfy
the firm’s investor for a given level of risk
Div A Div B
Capital 1 million 2 million
Profit 200k 300k
Less : COC @17.5% 175K 350K
Residual Income 25k (50k)
Which division eroded shareholder value ??

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 In order for the above to happen, Solomon
argued that, managers should have the power to
influence the amount of capital investment and
cost charged to their responsibility centres

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 How much controllability do you have ?
“Individual should be held accountable only for results they
can control” Merchant (1987)
 Managers should realised that one of the
limitations of operating profit as a measure of
divisional performance is the inclusion of costs
over which the divisional managers has no control.
 Issue on corporate cost be allocated to divisions.
What happen when a division’s profit is not
sufficient to cover the HQ overheads ??
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 Solomon argued that “ corporate expenses are independent of
divisional activity and allocating corporate costs is irrelevant
because a positive contribution by divisions will cover at least one
of those costs.
Sales/revenues xxxx
Less: Variable COGS (xxx)
Other variable expenses (xxx)
Contribution margin xxxx
Less : Controllable divisional overheads (xxx)
Controllable profit xxxx
Less : Non controllable overheads (xxx)
Operating profit xxxx

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 Managers & Issues related to Transfer
Pricing
 Transfer pricing is a term used to describe all aspects of
intercompany pricing arrangements between related
business entities, and commonly applies to intercompany
transfers of tangible (goods) and intangible (services).
 Intercompany transactions across borders are growing
rapidly and are becoming much more complex. Global
integration and new business practices challenge
multinational corporations to find innovative transfer
pricing solutions.
 However, stricter penalties, new documentation
requirements, increased information exchange, improved
training and specialisation are some of the tools used by
tax authorities in this global "revenue race."
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 TP is a pricing decision that concerned with the price
at which goods or services are sold between
business units in the same company.
 What price to charge for in-company transactions?
- Affects the profitability of each business unit
a. Based on the market price to external customers (including
a normal profit margin)
b. Based on the market price to external customers but
including a lower profit margin
c. Based on the total cost of producing the goods or services,
(fixed and variable costs) but excluding any profit margin
d. Based on the marginal cost (incremental cost) of producing
one extra unit of output (goods or services), ie. including
only variable costs, with or without a profit margin
e. A negotiated price
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 Other issues in transfer pricing
 What will be the motivational effect on managers of
both the buying and selling business units ?
 Who may prefer to buy and sell on the open market?
 TP is normally done to ensure that reported profits are
earned in countries where lower corporation tax is
payable to maximise the after tax earnings of the
multinational corporation. OR
 Company that having high reported profit will be
charged for certain products/services in order to
reduce the profit !!!

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 Effects of TP within the
Decentralised Business Unit
 TP that are suitable for evaluating divisional
performance may lead to divisions acting contrary
to the corporate interest (say, profit maximisation)
(Solomon, 1965)
 See illustration
 From the illustration;
– When Division A increases its production volume, profit
also increase steadily and therefore, their goal is to
increase production but not for Division B, (when
purchases of product increased, company’s profit is
eroded) therefore, the best is to keep the production
level at 10,000 units.For a whole company perspective,
production volume should be maintained at 12, 000
units to maximise profit at $112,000 70
 Continued
 But neither division will be satisfied with this result as
both will see it as disadvantaging them in terms of
divisional profits against which Divisional Managers are
evaluated.
 In summary, followings are the common approaches to
TP;
– Market price (this decision is compatible with corporate profit
maximisation)
– Marginal Cost (Incremental Cost)- Less motivation to produce
if they just cover their incremental cost
– Full cost (cover F & V costs)-less motivation to produce
– Cost plus-top mgt needs to decide (how much margin?)
– Negotiated price-the most practical ways (taking divisional
profit, managers motivation, profit/cost sharing approaches)
71
 CONCLUSION

 Ratio analysis is a good way to overview an

organisation’s activities
 Profitability, efficiency, liquidity, gearing, cash flow
and investment ratios are still important
 Need consistent and comparable calculation,
Against ?
 Financial ratios can be supplemented with other
performance measurement systems
 Value and adopt only suitable PMS for your
business
 Decide a suitable transfer pricing approach that
benefits the company as a whole. 72
Assignment & case study

Assignment & case study

Refer to handout

73