Introduction to Management accounting
Allocation of scarce resources is a fundamental economic problem faced by everybody. Every company, government and society faces this problem. Management accounting is the principle source of information for decisions which are concerned with the allocation of resources within a company. Management accounting is a critical field that supports business performance. It is the information that managers use for decision making (Albelda, 2011). The information provided by management accounting helps managers to control activities within the firm. It helps them to decide as to what products are to be sold, where to be sold and how to source those products. In other words, it helps an organization decide which managers should be entrusted with the company’s resources.
A form of management accounting emphasizes on information that is related to factors which are external to the firm. This form of management accounting is known as strategic management accounting (Inman, 2010). Strategic management accounting also lays emphasis on non-financial information and internally generated information.
This project critically evaluates the use of Return on Investment and Economic Value Added as performance measures in an organization. Also, the ways by which these measures encourage the managers to be short-term in their focus and decision making are evaluated. Keeping in view the use of transfer pricing by many organizations for transferring products between different divisions of the same organization, this project also discusses in detail the advantages and disadvantages of some methods of transfer pricing. These methods are Market based transfer prices, Full cost transfer prices, Cost-plus a mark-up transfer prices and negotiated transfer prices.
Critically Evaluate The Following Statement
Management accounting is the process that aids in measuring and reporting information about economic activity in an organization. This information is used by managers in planning, performance evaluation and operational control. Managerial functions require information for better planning and control (Abdelazim, 2005). Management assignment help for this reason is very important for effective and successful management at all levels.
In context of management accounting, the metric used to measure the performance of departments in relative terms is the Return on Investment. The department’s return on their average operating assets is identified by this. With this, the earning power of assets is measured (Cadez and Guilding, 2012). This is the ratio of the net income to the average capital employed in a company or a project. A company’s management monitors its performance and makes decisions, by using financial and other data which is provided through management accounting. The net operating income as a percentage of average operating assets that a business generates in a certain period is measured by the return on investment (Hopper, 2011). Hence ROI tells a business how well it is using its resources to generate operating profit.
With the business environment becoming increasingly competitive, the managers developed consistent business strategies, tools and models which provide useful information to support strategic decision making, planning and control. Strategic management accounting is a form of management accounting which places emphasis on information related to the factors external to a firm as well as non-financial information and internally generated information (Inman, 2010).
Both Return On Investment (ROI) And Economic Value Added (EVA)
Return on Investment is a measure of divisional performance. It facilitates comparison of performance between divisions. This is because it is a relative measure. It is also easy to understand as the amount is in percentage (Cinquini and Tenucci, 2010). Hence can be interpreted, analyzed and used in decision making by managers. The income statement and statement of financial position make information easily available which is required to calculate return on investment. Return on Investment helps measure the performance of application of money. With the help of ROI a business can measure the link between the profits and the investment that is required to generate those profits.
The management frequently uses Return on Investment to measure performance against internal goals, competitors or a specific industry. ROI also assists managers in determining the allocation of future resources based on the profitability of previous investment (Jarvenpaa, 2009). It also helps the management to view the effects of investment expenses on return. The management is also able to see the past revenues with the help of Return on Investment. Hence ROI proves to be a good method for measurement and comparison of earning power of investments. As a simple and versatile measurement, return on investment helps to decide where the capital funds should be allocated. This makes it a very useful management decision making tool.
But, managers are encouraged to retain outdated plant and machinery because of ROI. This is because Return on Investment increases as assets get older. The value of non-current assets and therefore the value of capital employed are reduced by accumulated depreciation. In other words, it gives a false view of improving of business performance over time (Smith, 2008). Also, as different methods of depreciation are used, comparison of performance of divisions using return on investment does not prove to be fair always. Return on Investment increases due to the disposal of non-current assets. But as a result of this the efficiency of business may be affected.
Return on Investment is a short term measure. This is because, managers are encouraged to increase return on investment at the expense of long-term performance. Hence it is responsible for causing short-termism in managers (Vaivio, 2008). Return on Investment also results in sub-optimal behavior. The decisions made by the divisional managers with the use of ROI may not be in the interest of the company as a whole. These decisions may be self-interested. Also there may be a conflict in the return on Investment and net present value. It may lead to a situation where a project may show high ROI but negative net present value. Hence it may be taken care that a project with positive net present value should be chosen irrespective of the ROI (Gediehn, 2010).
In the past decade, new mechanisms for measuring value have been created owing to the firms focusing more on value creation. One of these mechanisms is Economic Value Added. This helps measuring the surplus value created by a firm in its existing environment (Zawawi and Hoque, 2010). The firms determine their value creation by it. Being a tool for investment decision, economic value added is a value based financial performance measure which reflects the absolute amount of shareholder value created. Excess return made on an investment when multiplied with the capital invested in that investment give the economic value added.
Being regarded as a simple measure, EVA provides a real picture of shareholder wealth creation. An economic value added system helps managers to make better investment decisions (Heidmann, 2008). It also helps them in identifying opportunities for improvement. With the help of economic value added system, the managers are able to consider both long-term and short-term benefits of the company. Managers get encouraged to create shareholder’s value because of EVA. It forms the basis of management compensation. EVA is also a reliable indicator as far as the future value growth of a company is concerned (Hoque, 2006).
Economic value added helps in converting a company’s strategy into objectives tangible for all employees. It proves to be a useful tool for allocating the scare resources of a company. With the implementation of EVA concept, the managers are able to make better decisions by having a deeper knowledge about capital and capital cost. Economic value added has become a preferred measure of the performance of a company (Sharma, 2013). It also helps in determining how logistics benefit a company. EVA gathers all the positive and negative points of the business decisions. This in turn helps managers to make intelligent choices.
EVA proves to be inadequate in assessing a company’s progress. (Dayal, 2013). EVA alone is an inappropriate measure of financial performance in certain industries. Also, economic value added is distorted by inflation. Hence its use to estimate actual profitability is not possible during inflationary times.
EVA increases the shortsightedness of managers. It encourages them to focus on present. This is because if the earnings are high today, the manager will be awarded today (Adler, 2013). As such, the future losses will not be able to harm the manager. This is because either the manager will have been promoted by then or will have left the company. Thus by using the concept of economic value added, a manager will have an incentive to run a division with more regard for short-term value (Ward, 2012).
The short term nature o Return on Investment and Economic Value added as performance measures could be overcome by integrating each of them with other business performance measures. Economic value added when used appropriately and calculated with adjustments would be a good measure for almost all companies to implement. Integration of EVA with Activity Based Costing helps remove some of the limitations of economic value added.
The Advantages And Disadvantages Of The Four Methods Of Transfer Pricing
- Market based transfer prices
- Full cost transfer prices
- Cost-plus a mark-up transfer prices
- Negotiated transfer pricing
A large number of multinational enterprises have emerged owing to rapid advances in technology, transportation and communication. These multinational enterprises have the ability to place their enterprises and activities anywhere in the world. A significant volume of global trade which occurs within a MNE group consists of international transfers of goods and services, capital and intangibles. Such transfers are called intra-group transactions (Ansari, Bell and Klammer, 2004). The structure of such transactions is governed not only by the market forces but also by the forces which are driven by the common interests of the entities of the group. Hence establishment of right price becomes essential for intra-group, cross-border transfer of goods, intangibles and services. This right price is called transfer price (Kumar, 2009).
Transfer pricing refers to the setting of right prices at which the transactions that involve the transfer of goods or services between associated enterprises of a MNE group occur. These transactions are also referred to as controlled transactions (Hopper, 2011). The degree of comparability between the controlled and uncontrolled transactions determines the reliability of various pricing methods.
Market based transfer prices
Market price is used by the firms as an upper bound for the transfer price when the outside market is well-defined, competitive and stable. In this method the transfer prices are based on market prices.
Transferring products or services at market prices leads to optimal decisions. This happens when the market for intermediate product is perfectly competitive; there are minimal interdependencies in the subunits and there are no additional costs or benefits to the company as a whole from buying and selling in the external market instead of transacting internally (Cadez and Guilding, 2012).
Market based transfer prices promote goal congruence. In perfectly competitive markets, there is no unused capacity. This enables the managers to buy and sell a much of the product or service at market price as they want.
Using the market price as the transfer price helps motivate the division managers. As a result, the managers are able to transact internally (Gediehn, 2010). It also enables them to take exactly the same actions that they would take if they were transacting in the external market.
As a result of product differentiation, there may be no comparable product or a single market price. Also the market price may vary. This can happen because of over-supply or under supply, product dumping by foreign competitors, or promotions.
Adopting market based transfer pricing method may lead selling division to ignore negotiation attempts from buying division and sell directly to outside customers. This may result in an internal shortage of materials (Abdelazim, 2005). It may also lead to a situation where even though the selling division makes profit, the overall profits of the company may fall.
Full cost transfer prices
The clarity and convenience of this method of transfer pricing makes it a popular method. The price determined by this method is viewed as a satisfactory approximation of outside market prices.
This method recognizes the significance of fixed cost in production. When production remains constant but sales fluctuate, absorption costing will show less fluctuation in net profit (Cadez and Guilding, 2012).
This method is of great help when the market prices are unavailable, inappropriate or too costly to obtain.
Full cost transfer pricing can lead to suboptimal decisions for the company as a whole. Conflict may arise between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy. For example, products and services are bought outside the company when is beneficial for the whole to source them internally (Heidmann, 2008). Use of full cost based transfer pricing method may lead to such situations. In this situation, the fixed cost of supplying division may appear to be the variable cost of the buying division.
Another disadvantage of this method is that if the full cost based transfer price uses actual costs rather than the standard costs, there may not be adequate incentives with the supplying division to control costs.
Cost-plus mark-up transfer prices
Cost plus method is used to analyze transfer pricing issues that involve tangible property or services. This method finds its application in manufacturing or assembling activities and relatively simple service providers (Dowling, 2011). The arm’s length nature of an inter-company charge is evaluated by this method by reference to the gross profit mark-up on the costs incurred by suppliers of services for the services provided. In a controlled transaction that involves tangible property, the cost plus method of transfer pricing compares the gross profit mark-up earned by the concerned company for providing the service to the gross profit markups earned by comparable companies.
The first advantage of cost-plus method of transfer pricing is that it is based on internal costs, the information on which is usually readily available to the multinational enterprise.
For most businesses, cost plus method is advantageous because it is simple to understand. The implementation of this method through most accounting systems is easy. Once the plus has been determined, it becomes easy to raise invoices and make payments (Sisaye and Birnberg, 2010). This method eliminates the need for complex spreadsheets to determine profit allocations or margins, which is required by some other methods.
This method is implemented because of the ease of implementing a cost plus policy on management accounting systems. These systems are set to capture standard costs and overhead.
The simplicity of implementation of this method makes it one of the most often inappropriately applied methods. For example, even when the manufacturer may be the owner and developer of valuable intangibles, cost plus method may be used by tax payers for pricing the sale of goods by the manufacturer to a related party. This can result in the distributor taking the residual profit or loss (Zawawi and Hoque, 2010). In this situation, the distributor in transfer pricing terms becomes the simpler and less risk bearing party.
Negotiated transfer price
This is the most common hybrid method. In this method, the rules for determining transfer prices are not specified by the firm. Here, the divisional managers are encouraged to negotiate a transfer price which is mutually agreeable (Ansari, Bell and Klammer, 2004). Negotiated transfer pricing is combined with free sourcing. These prices are used as a training ground for managers. In this approach, the top management does not split the eventual profits across the transacting divisions. The bargaining process between the buying and the selling sub units, results in the determination of transfer price (Hoque, 2006).
A negotiated transfer price helps in preserving the divisional autonomy. It also provides better information about costs and benefits.
Another advantage of this method is that it motivates each division manager to make efforts towards increasing the operating income of the division. It also gives managers the freedom to make decisions and act in the way which they consider as the best way to manage the company (Hopper, 2011). It trains the managers and teaches them how to negotiate. It also helps the top management in identifying the most skilled negotiators.
Negotiated transfer prices can sometimes lead to conflicts between managers. It leads to disputes among the negotiators on what the transfer prices should be. This happens when management compensation is based on profitability of the divisions. Hence, here the senior management has to step in or have an arbitration hearing to hear both sides (Smith, 2008).
This method is time consuming as the bargaining process consumes time. Bargaining and negotiations take time and may need repeated review with the change in conditions. Also, the bargaining power affects the transfer price and hence the performance evaluation of business managers (Kumar, 2009).
This method also has the risk of disharmony with opportunity costs.
Management accounting is a profession that provides expertise in financial reporting and control and assists management in the formulation and implementation of the strategy of an organization. For having strategic value, management accounting must help in the accomplishment of strategic objectives of quality, cost and time (Heidmann, 2008). Hence management accounting should provide information that takes a long term view of organizational strategies and actions. Organizations prefer to use Return on Investment and Economic value added as performance measures. But, the organizations must employ measures to overcome the limitations of these measures. This can be done by integrating them with other performance measures.
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- Heidmann, M., 2008. The Role of Management Accounting Systems in Strategic Sensemaking. Springer.
- Hoque, Z., 2006. Strategic Management Accounting: Concepts, Processes and Issues. 2nd ed. Pearson Education Australia.