PERFORMANCE EVALUATION OF BUSINESS UNITS 201
Table 13.4 RI on additional investment
AB
Additional investment £1 million £1 millionAdditional contribution £200,000 £130,000
Less cost of capital @ 15% £150,000 £150,000Residual income £50,000 −£20,000A further problem associated with measuring divisional performance is that of
transfer pricing, which was introduced in Chapter 8.
Transfer pricing........................................
When decentralized business units conduct business with each other, an important
question is what price to charge for in-company transactions, as this affects the
profitability of each business unit. However, transfer prices that are suitable for
evaluating divisional performance may lead to divisions acting contrary to the
corporate interest (Solomons, 1965).
For example, consider a company with two divisions. Division A can produce
10,000 units for a total cost of £100,000, but additional production costs are £5 per
unit. Division A sells its output to Division B at £13 per unit in order to show a
satisfactory profit. Division B carries out further processing on the product. It can
convert 10,000 units for a total cost of £300,000, but additional production costs
are £15 per unit. The prices B can charge to customers will depend on the quantity
it wants to sell. Market estimates of selling prices at different volumes (net of
variable selling costs) are:
Volume Price
10,000 units £50 per unit
12,000 units £46 per unit
15,000 units £39 per unitThe financial results for each division at each level of activity are shown in
Table 13.5. Division A sees an increase in profit as volume increases and will
want to increase production volume to 15,000 units. However, Division B sees a
steady erosion of divisional profitability as volume increases and will seek to keep
production limited to 10,000 units, at which point its maximum profit is £70,000.
The company’s overall profitability increases between 10,000 and 12,000 units,
but then falls when volume increases to 15,000 units. From a whole-company
perspective, therefore, volume should be maintained at 12,000 units to maximize
profits at £112,000. However, neither division will be satisfied with this result,