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Performance measurement and controlSyllabus EROIResidual IncomeTransfer Pricing

ACCA · Question 31 · Performance measurement and control

Section C

QuantumGrid operates in the renewable energy sector and has two investment centers: SolarGen (which generates solar power) and GridDistribute (which manages the power grid and sells to consumers).

Part A (10 marks)
SolarGen currently generates a Return on Investment (ROI) of 14%. The division's total capital employed is $50 million. QuantumGrid's weighted average cost of capital (WACC) is 10%.
SolarGen's manager is considering a new solar farm project requiring an investment of $10 million. The project is expected to generate an annual controllable profit of $1.2 million.

Evaluate the new project using both ROI and Residual Income (RI). Discuss the behavioral implications of using ROI versus RI for evaluating the SolarGen manager's performance in this specific scenario.

Part B (10 marks)
SolarGen transfers electricity to GridDistribute. Currently, SolarGen has no spare capacity and can sell all the electricity it generates to the external national grid at a market price of $80 per MWh. The variable cost of generation is $30 per MWh.
GridDistribute currently buys electricity from the external market at $80 per MWh but is demanding that SolarGen transfer electricity internally at full cost ($50 per MWh) to improve GridDistribute's profitability.

Advise the board of QuantumGrid on the appropriate transfer pricing policy. Calculate the minimum and maximum transfer prices, and discuss the impact on divisional autonomy and goal congruence if the board forces SolarGen to transfer at $50 per MWh.

How to approach this question

For Part A, calculate the current metrics, the project metrics, and the combined metrics. Compare the outcomes and explain the concept of goal congruence. For Part B, apply the general rule for transfer pricing (Min TP = MC + Opportunity Cost). Discuss the qualitative aspects of autonomy and motivation.

Full Answer

This question tests the core concepts of divisional performance measurement and transfer pricing. ROI often leads to underinvestment because managers reject projects that yield less than their current average, even if the return exceeds the cost of capital. RI solves this by measuring absolute wealth creation. In transfer pricing, when a supplying division is at full capacity, the opportunity cost of internal transfers is the lost contribution from external sales. Forcing a transfer below market price in this scenario destroys autonomy and demotivates the supplying division.

Common mistakes

Part A: Failing to calculate the *new combined* ROI to prove why the manager rejects it. Part B: Stating the minimum transfer price is the variable cost ($30), forgetting to add the opportunity cost of lost external sales.
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