## Learning Outcomes

After reading this article, you will be able to explain how divisionalisation, transfer pricing, and performance contracts interact in business performance measurement. You will understand key transfer pricing mechanisms, how they impact divisional and company-wide decision making, and how to appraise managerial performance with goal congruence in mind. You will be able to identify dysfunctional behaviours and recommend contract features that align divisional incentives with overall organisational aims.

## ACCA Performance Management (PM) Syllabus

For ACCA Performance Management (PM), you are required to understand the evaluation of divisional performance and the role of transfer pricing and contracts. Focus your revision on the following areas:

- The purpose and implications of decentralisation and divisionalisation
- The objectives and methods of transfer pricing, including variable cost, full cost, and market-based approaches
- How transfer prices influence divisional performance measurement and behaviours
- Calculation and interpretation of Return on Investment (ROI) and Residual Income (RI) for investment centres
- The importance of goal congruence and the risks of dysfunction
- Features and limitations of performance contracts used to incentivise divisional management

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What is goal congruence and why is it critical in divisionalised organisations?
2. Which two main methods can be used to set a transfer price between divisions?
3. If a division operates at full capacity with external demand, what is the minimum transfer price it should accept for internal transfers?
4. Briefly explain how a performance contract can help align the behaviour of a divisional manager with company objectives.

## Introduction

Modern organisations often divide their operations into self-contained units called divisions, each with its own responsibility for costs and revenues. Measuring divisional performance and setting appropriate transfer prices for goods or services moved between divisions are central to both overall profitability and the motivation of managers. Effective systems and contracts should create goal congruence—ensuring managers act in the best interests of the organisation as a whole, not simply for their own divisions.

> **Key Term: goal congruence**
> When the objectives of individual managers or divisions are aligned with the overall aims of the organisation.

### DIVISIONALISATION AND PERFORMANCE MEASUREMENT

In a divisional structure, each division functions as a mini-business responsible for a specific area or product line. Divisions may be assessed as:

- **Cost centres:** Focused on minimising costs
- **Revenue centres:** Responsible for maximising revenue
- **Profit centres:** Accountable for both costs and revenues
- **Investment centres:** Accountable for profit and for the assets employed

Performance of profit and investment centres is typically measured using profit, Return on Investment (ROI), and Residual Income (RI). These measures are critical for investment centres, where managers also control capital expenditure.

> **Key Term: transfer price**
> The notional price at which goods or services are transferred between divisions of the same organisation.
> **Key Term: performance contract**
> A formal agreement that specifies employees’ targets, rewards, and responsibilities, used to incentivise managers toward desired outcomes.

### THE IMPORTANCE OF GOAL CONGRUENCE

Goal congruence means that decisions by divisional managers support the profitability or value of the whole company, not just their own results. The risk in decentralised structures is that performance metrics (such as divisional profit or ROI) can encourage actions that improve reported performance for one division but harm the company as a whole. This is called dysfunctional behaviour.

> **Key Term: dysfunctional behaviour**
> Actions by managers that improve divisional results but reduce total organisational profit or value.

### Why is goal congruence at risk?

- Managers may be rewarded for short-term divisional performance, not company-wide results
- Transfer prices set incorrectly can distort true costs and revenues
- Different divisions may have conflicting objectives or different information

### TRANSFER PRICING: OBJECTIVES AND PRACTICAL METHODS

Transfer prices serve multiple functions:

![Transfer pricing methods classified into market-based, cost-based, and negotiated prices, with cost-based pricing split into variable cost, full cost, and cost-plus margin.](https://static.pastpaperhero.com/images/acca-pm-divisional-performance-and-transfer-pricing-goal-congruence-and-performance-contracts_00.png)

_Transfer price approaches are grouped as market-based, cost-based, or negotiated, with cost-based methods comprising variable cost, full cost, and cost-plus margin._

- Motivate managers to increase profit and efficiency
- Enable fair performance assessment of buying and selling divisions
- Provide autonomy to managers
- Record internal transactions for accounting purposes

To achieve these, transfer prices must balance competing interests and be consistent with external market realities when relevant.

### Common transfer pricing methods

1. Market-based transfer price
   Used when there is an active external market for the intermediate product.
   - Optimal when selling and buying divisions can trade externally; creates incentives for goal congruent decisions.

2. Cost-based transfer price
   When no external market exists, prices may be set at
   - Variable (marginal) cost
   - Full (absorption) cost
   - Cost plus a profit margin

   - Variable cost plus opportunity cost ensures selling division is not worse off from internal transfers.

### Worked Example 1.1

A company has two divisions: Alpha manufactures a part for \$20 per unit in variable costs and sells it externally for \$40. Beta, another division, wants to buy this part for internal use. Alpha is currently selling all it makes externally.

What is the minimum transfer price Alpha should accept for internal sales to Beta?

> **Answer:**
> Since Alpha is at full external capacity, selling internally would mean giving up a \$20 contribution per unit (\$40 market price – \$20 variable cost). The minimum acceptable transfer price is:
> Variable cost + opportunity cost = \$20 + \$20 = \$40 per unit.

### Worked Example 1.2

Suppose Alpha has spare capacity; it can sell externally for \$40 but currently only sells 60% of capacity. Beta requests internal transfers for the remaining capacity.

> **Answer:**
> Now, Alpha does NOT give up external sales when transferring internally. The opportunity cost is zero. Minimum transfer price is variable cost only: \$20 per unit.
>
> **Exam Warning:**
> Always check if the selling division is operating at full capacity. If there is spare capacity, the opportunity cost included in the transfer price is zero.

### TRANSFER PRICING AND PERFORMANCE ASSESSMENT

How transfer prices affect divisional performance:

- **High transfer prices:** Benefit selling division’s profit; harm buying division; may discourage internal trade even when optimal for the company.
- **Low transfer prices:** Benefit buying division; may leave selling division unable to cover its costs; demotivates managers.
- **Misaligned prices:** Result in suboptimal decisions, such as divisions buying externally when internal transfer is cheaper for the company.

> **Key Term: Return on Investment (ROI)**
> Operating profit divided by capital employed, used to assess the performance of investment centres.
> **Key Term: Residual Income (RI)**
> Operating profit minus a notional charge for the cost of capital employed, measuring additional profit over a minimum required return.

### Worked Example 1.3

A company’s investment centre earns an operating profit of \$100,000 on assets of \$500,000. The required cost of capital is 12%. A new project is available, requiring an investment of \$100,000 and offering \$15,000 per year profit.

Calculate the effect on ROI if the division accepts, and say if the manager will accept based solely on ROI.

> **Answer:**
> Without project: ROI = \$100,000 / \$500,000 = 20%
> With project: ROI = (\$100,000 + \$15,000) / (\$500,000 + \$100,000) ≈ 19.2%
> The ROI falls. If managers are rewarded on ROI, they may reject the project even though it earns more than the company’s required return (12%). This behaviour is dysfunctional and not goal congruent.

### PERFORMANCE CONTRACTS AND INCENTIVE SYSTEMS

Companies use performance contracts to link divisional targets to rewards. Good contracts:

- Specify measurable, controllable targets (e.g., profit, ROI, RI)
- Exclude items outside the manager’s control
- Use both financial and non-financial (NFPI) measures, such as quality, customer satisfaction, and innovation
- Encourage actions that raise company profit, not just divisional profit

### Common contract problems

- Basing bonuses only on divisional profit may encourage managers to turn down good group projects
- Setting inflexible targets can demotivate due to uncontrollable events
- Focusing only on financial targets can neglect customer, quality, and learning goals

> **Revision Tip:**
> Contracts should be reviewed regularly to ensure divisional managers are not penalised or rewarded for factors they cannot influence.

## Summary

Divisional performance measurement and transfer pricing are interconnected, especially when results influence manager rewards. Transfer prices should motivate goal congruent behaviours, while performance contracts must use metrics that drive both divisional and company success. Poorly designed systems risk dysfunctional behaviour, such as managers rejecting profitable projects or creating internal conflict.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Explain the purpose and pitfalls of divisional performance measurement
- Define transfer price and state its role in divisional autonomy and performance assessment
- Distinguish between market-based and cost-based transfer pricing, including calculation of minimum transfer price using opportunity cost
- Understand how transfer pricing can cause dysfunctional behaviour or goal congruence
- Define ROI and RI and explain their use in divisional performance measurement
- Discuss the role of performance contracts and incentives in aligning managerial actions with organisational objectives

## Key Terms and Concepts

- goal congruence
- transfer price
- performance contract
- dysfunctional behaviour
- Return on Investment (ROI)
- Residual Income (RI)


Divisional performance and transfer pricing - Goal congruence and performance contracts