ACCT5996 Chap.6 Performance, Transfer Pricing and Incentives
Performance, Transfer Pricing and Incentives
Decentralisation gives lower-level managers decision authority and therefore creates a need for responsibility accounting.
This chapter matches cost, revenue, profit and investment measures to authority, compares ROI with residual income, finds goal-congruent transfer-price ranges under spare and full capacity, and evaluates how individual, profit-sharing, gainsharing and team incentives shape behaviour.
The common thread is goal congruence.
Measures and internal prices should guide a manager toward actions that improve total organisational value while preserving fair accountability for controllable drivers. Capacity determines opportunity cost in transfer decisions; the required return separates value-creating projects from percentage protection; and reward design changes effort, cooperation, risk taking and time horizon.
The chapter therefore combines calculations with an explicit behaviour test: identify how someone could improve the reported metric while harming customers, processes, people or the wider company.
What this chapter covers
- 01
Cost, revenue, profit and investment centres
- 02
Centralisation and decentralisation
- 03
Market, negotiated and cost-based transfer prices
- 04
Variable cost and opportunity cost
- 05
Return on investment and its drivers
- 06
Residual income and project acceptance
- 07
Intrinsic motivation, expectancy and reward design
Worked example · free
Find a transfer range under limited spare capacity
- +1Spare capacity is 40,000 minus 32,000, giving 8,000 units.
- +1For spare-capacity units, opportunity cost is zero and minimum transfer price is $54.
- +1The buyer's maximum is the $84 external price, so the first 8,000 units have a $54 to $84 range.
- +1Beyond spare capacity, forgone contribution is $90 minus $54, or $36, making the minimum $90.
- +1Transfer 8,000 internally and buy 2,000 outside because $84 is below the $90 full-capacity minimum.
Key terms
- Responsibility centre
- A subunit whose manager is accountable for specified financial results.
- Decentralisation
- The delegation of decision authority to managers closer to operations.
- Transfer price
- The internal charge for goods or services moved between responsibility centres.
- Opportunity cost
- The contribution or benefit forgone by choosing one use of capacity over another.
- Return on investment
- Operating income expressed relative to invested capital.
- Residual income
- Operating income remaining after a required return charge on invested capital.
Performance, Transfer Pricing and Incentives FAQ
Why can decentralisation improve decisions?
Managers close to operations can respond quickly and use local knowledge. The design still needs coordination because one division can improve its reported result while reducing total company value.
When is market price a useful transfer price?
It is persuasive when a competitive external market exists and divisions can trade externally. Capacity, avoided selling costs, service conditions and quality differences may still require careful adjustment.
Why can ROI reject a good project?
A manager may reject a project whose return is below the division's current ROI even when it exceeds the company requirement. Residual income can reduce that conflict.
How does expectancy affect incentives?
People must believe effort can improve performance, performance will produce the promised outcome, and the outcome is attractive. Weakness in any link reduces sustained motivation.
What is the risk of team bonuses?
They can strengthen cooperation but weaken the link between individual effort and reward, creating free-riding or fairness concerns unless team design and peer accountability are credible.
Why does capacity change the transfer-price minimum?
With spare capacity, an internal unit does not displace an external contribution, so the seller's relevant minimum is normally the additional outlay cost. At full capacity, the unit uses capacity that could earn contribution elsewhere, so that forgone amount becomes opportunity cost. Analyse requested units in blocks when only part of the order fits within spare capacity.
How should performance measures be balanced?
Pair lagging financial outcomes with leading drivers of customer value, process reliability and capability, and match each measure to the manager's authority. Define calculations and data ownership before attaching rewards. Then test for gaming, short-termism and cross-division effects. A balanced set is useful when its measures explain one another, not when it merely contains many unrelated indicators.
Exam move
For responsibility questions, list the manager's decision rights before selecting a measure. For transfer pricing, calculate variable outlay cost and opportunity cost separately, then compare the seller's minimum with the buyer's outside option. For investment decisions, compute both project ROI and residual income.
Finish incentive answers by predicting the behaviour the measure invites and adding a safeguard against goal conflict. Draw capacity as separate blocks so the opportunity cost can change within one order. Reconcile the divisions' effects to total company contribution before discussing a negotiated price.
For incentives, map expectancy, instrumentality and valence independently, then test whether the reward timing, controllability and team boundary support the intended behaviour.
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