## **Learning Outcomes**

After reading this article, you will be able to explain and evaluate the principles of divisional performance measurement using ROI and residual income, apply and justify methods of transfer pricing including opportunity cost, and assess performance in not-for-profit and public sector organisations using the value for money '3Es'—economy, efficiency, and effectiveness. You will also be able to identify and resolve exam pitfalls relating to sub-optimal performance measures for both profit-oriented and public sector entities.

## **ACCA Performance Management (PM) Syllabus**

For ACCA Performance Management (PM), you are required to understand how divisional performance is measured, how transfer prices can affect both performance assessment and divisional decision making, and how performance in not-for-profit and public sector organisations is evaluated. In your revision, focus on:

- Explain and illustrate the basis for setting a transfer price, including variable cost, full cost and opportunity cost, and the effect of intermediate markets.
- Evaluate how transfer prices impact divisional performance measurement and group profit maximisation.
- Calculate and interpret Return on Investment (ROI) and Residual Income (RI) for divisions; discuss their strengths and shortcomings.
- Comment on the problems of inter-divisional comparison and dysfunctional behaviour.
- Analyse and comment on performance measurement in not-for-profit organisations and public sector entities, including the role of non-financial objectives.
- Explain and apply the Value for Money (VFM) framework using the 3Es: economy, efficiency, and effectiveness.

## **Test Your Knowledge**

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

1. A division earns \$50,000 profit on net assets of \$400,000. If a new project is expected to earn 11% on investment, and the company’s required rate is 10%, should the manager accept it under ROI and RI performance measurement? Explain.
2. If Division X can sell components externally for \$25 or transfer internally to Division Y (variable cost \$15), what is the minimum transfer price X should accept if it is at full capacity?
3. An education charity sets targets of keeping admin costs below 8% of donations and providing at least 75% of requested care days. Which 3E (economy, efficiency, or effectiveness) does each target most closely relate to?
4. True or false? A transfer price based on marginal cost always encourages optimal divisional decisions and fair divisional performance measurement.

## **Introduction**

Performance in divisionalised organisations and public sector bodies requires careful measurement. For profit-seeking businesses, common approaches include Return on Investment (ROI) and Residual Income (RI), while transfer pricing both incentivises divisional managers and affects group profit. In not-for-profit and public sector contexts, direct profit-based measures are often unhelpful, so value for money is appraised using the '3Es'—economy, efficiency, and effectiveness—which focus on delivering objectives in the most resource-effective way.

> **Key Term: divisional performance measurement**
> Methods used to assess how well individual business units (divisions) are performing, balancing profit generation, asset use, and controllability.
>
> **Key Term: transfer price**
> The price at which goods or services are transferred between divisions of the same organisation.
>
> **Key Term: Value for Money (VFM) and 3Es**
> Value for Money means delivering objectives at the lowest whole-life cost consistent with required quality. The 3Es are:
>
> - **Economy**: Obtaining inputs at minimum cost for a given quality.
> - **Efficiency**: Maximising output from given inputs.
> - **Effectiveness**: Achieving organisational objectives through output delivered.

## **Divisional Performance Measurement: ROI and Residual Income**

**Return on Investment (ROI)** and **Residual Income (RI)** are key financial measures for assessing the performance of investment centres. ROI expresses controllable profit as a percentage of capital employed, enabling comparisons between different divisions (or with targets). RI deducts a notional interest charge from divisional profit, encouraging managers to accept any investment that beats the cost of capital, improving goal congruence.

> **Key Term: Return on Investment (ROI)**
> A ratio measuring division profit before interest and tax compared to division capital employed; usually expressed as a percentage.
>
> **Key Term: Residual Income (RI)**
> The profit earned by a division after subtracting a notional charge for capital tied up; measures absolute value added.

### **Worked Example 1.1**

A division reports profit of \$40,000 and capital employed of \$320,000. The company cost of capital is 12%. A project costing \$50,000 would bring in extra profit of \$5,500. What are the effects on ROI and RI if the division accepts the project?

> **Answer:**
>
> - ROI before project = \$40,000 / \$320,000 = 12.5%
> - ROI after project = (\$40,000 + \$5,500) / (\$320,000 + \$50,000) = \$45,500 / \$370,000 = 12.3%
> - RI before project = \$40,000 - (12% × \$320,000) = \$1,600
> - RI after project = \$45,500 - (12% × \$370,000) = \$1,100
>   The project delivers positive RI (it earns more than the cost of capital) but reduces ROI, so if the manager is judged on ROI, they may reject it—this is dysfunctional behaviour.

### **Exam Warning (ROI and RI)**

If a division is evaluated only on ROI, managers may reject projects with ROI above the group’s hurdle rate if accepting them would reduce their division’s average ROI. Always check for this incentive misalignment in exam scenarios.

### **Revision Tip (ROI and RI)**

RI usually avoids dysfunctional behaviour, but does not allow easy performance comparison between divisions of different sizes—use with care when comparing.

## **Transfer Pricing Principles and Practice**

Transfer prices affect both divisional motivation and group profit. A transfer price set too high or low can encourage managers to buy externally or refuse to transfer products internally, even when that is detrimental to group profitability. The aim is to set a price which encourages decisions in the interests of the group ("goal congruence"), preserves divisional autonomy, and allows for fair performance appraisal.

> **Key Term: opportunity cost (in transfer pricing)**
> The benefit forgone by transferring internally instead of pursuing the next best external alternative—often lost contribution on external sales.

Transfer prices can be set based on:

- **Market price**: if an efficient external market exists.
- **Variable (marginal) cost**: if the supplying division has spare capacity/no external sales are lost.
- **Full cost or cost-plus**: includes fixed costs and a mark-up.
- **Opportunity cost**: variable cost + any lost contribution on external sales.

### **Worked Example 1.2**

Division A sells a component externally for \$25, variable cost \$15. It can also supply Division B, which otherwise buys externally at \$25. Division A has full capacity and will lose an external sale for every unit transferred internally. What is the minimum transfer price A should accept?

> **Answer:**
>
> - Lost external sale: lost contribution = \$25 – \$15 = \$10 per unit.
> - Minimum transfer price = variable cost + lost contribution = \$15 + \$10 = \$25.
>   If transfer price is less than \$25, Division A is worse off; if it is set above \$25, Division B is better off buying externally, so \$25 sets the correct group-optimal price.

### **Exam Warning (Transfer Pricing)**

Never set a transfer price below supplying division’s opportunity cost when it is at full capacity—otherwise, group profit suffers and managers are demotivated.

### **Revision Tip (Transfer Pricing)**

If the supplying division has spare capacity (not at full capacity, and no external sales sacrificed), opportunity cost is zero. In this case, transfer price can be variable cost.

## **Challenges in Performance Measurement: Not-for-Profit and the 3Es**

In not-for-profit (NFP) organisations and the public sector, objectives are often non-financial and difficult to quantify. Standard profit-based measures are meaningless or may incentivise the wrong behaviours. Performance is usually judged by how well resources are used to achieve objectives—value for money (VFM), assessed using the **3Es: economy, efficiency, and effectiveness**.

### Economy

Are inputs (resources, staff, materials) obtained at minimum cost for the required quality?

### Efficiency

How well do resources translate to outputs? Are we getting the most output from available inputs?

### Effectiveness

Are objectives being achieved? Are we delivering the desired outcomes for beneficiaries or the public?

### **Worked Example 1.3**

A local authority operates a social care scheme with three objectives: (1) Keep admin costs under 8% of donations, (2) provide at least 80% of requested care days, (3) limit staff costs to market rates. In July, admin costs were 9%, 82% of requested care days were delivered, staff costs matched the market rate. Which 3Es do these results relate to, and how should performance be interpreted?

> **Answer:**
>
> - Admin costs under 8% = economy (input control).
> - Care days delivered = effectiveness (outcomes achieved).
> - Staff costs at market rate = economy (minimising input cost).
>   Performance is mixed: effectiveness is met, but economy is not fully achieved in admin costs, pointing to potential savings.

## **Summary**

In divisionalised businesses, ROI and RI are used to compare performance. ROI is straightforward but can drive dysfunctional behaviour—RI is less likely to do so. Transfer pricing, if set incorrectly, can also distort performance and demotivate. For public and not-for-profit sectors, non-financial objectives dominate, requiring different approaches, with the 3Es framework focusing on VFM through economy, efficiency, and effectiveness.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- The calculation and interpretation of ROI and RI as divisional performance measures, with their benefits and limitations
- How different transfer pricing methods (market, variable cost, full cost, opportunity cost) affect performance management and decision making
- The importance of setting transfer prices to encourage goal congruence and fair appraisals
- Understanding why profit measures are unsuitable for public sector/NFP and how the '3Es' framework is applied
- Distinguishing between economy, efficiency, and effectiveness in value for money evaluation

## **Key Terms and Concepts**

- divisional performance measurement
- transfer price
- Value for Money (VFM) and 3Es
- Return on Investment (ROI)
- Residual Income (RI)
- opportunity cost (in transfer pricing)


Divisional performance and transfer pricing - Not-for-profit and public sector performance (3Es)