Strategic Management Accounting - Term Paper Example

?Strategic Management Accounting Table of Contents Introduction 3 Part A 4 Part B 6 Market based transfer pricing 6 2. Full cost transfer pricing 8 3. Cost plus a mark-up transfer prices 9 4. Negotiated transfer prices 10 Conclusion 11 Reference List 13 Introduction Financial management and strategic management have a lot of difference in the way the two are applied (Bajaj, 2001). For example, the financial management is mainly used for core financial purposes like maintain the books of accounts and maintain the financial soundness of the company. Financial management is mainly used for evaluating the profitability, liquidity, stability, efficiency and investment analysis of the company. It does not really help the managers to assess what is best for the company (Bonaccorsi and Daraio, 2009). For example, the financial management of the company is able to indicate if it is appropriate to take more debt by considering the present liquid status of the company. The decision may not have any link with the short term or long term strategic objective of the company. Thus, financial management is not able to see beyond the limitations of the financial data. Strategic management on the other hand is equipped to see beyond and the cover the limitations of the basic financial management. The conclusion derived from the basic financial management techniques can be further modified if the same decision is taken in the light of the strategic objectives of the company. For example, the financial management indicates that the recourse to further debt financing is going to increase the debt burden f the company (Chrol, 2011). If the company considers going for a strategic alliance with another company then the financial condition of the company can improve. The revenue generation capacity will improve from the synergy gained from such strategic alliance. Strategic financial management considers these kinds of variables and factors to obtain the most optimal decision. Thus, though normal financial management analysis may conclude that the company should not use debt for financing the capital needs, though strategic management may recommend the use debt financing. The research paper discusses some of the uses of strategic management accounting like use of Return on Investment (ROI) and Economic Value Added (EVA), for long term decision purposes and different types of transfer pricing techniques. Part A Critical evaluation of the statement “Both Return on Investment (ROI) and Economic Value Added (EVA), when used as performance measures in an organisation, encourage managers to be short-term in their focus and decision making” The managers have a tendency of using both ROI and EVA for performance evaluation for short term purposes. Although when it comes to using the two techniques for long term decision purposes the managers face difficulties in doing the same. The two types of techniques are different from each other in various respects and thus both of them need to be discussed separately to indicate the way they can be used for long term decision purposes. ROI is actually a combination of two different accounting heads, one is the asset turnover and the other one is the return on sales (Clark and Mathur, 2011). Return on the sales is indicative of the fact of (that) how efficient are managers in generating revenue for every dollar and the ability of the managers to control the expenses and the increase in revenue generating capacity. While asset turnover indicates the ability of the company to generate profit for every dollar invested. In between the two accounting heads asset turnover and return on sales, the focus will be on asset turnover. If the managers are able to modify the asset turnover value then ROI can be used for long term decision purposes. In order to control the asset turnover value the managers need to re-evaluate the policies regarding the capitalization and depreciation. Both aspects like investments and income are affected by the choice of the asset life and the type of depreciation method applied. This in turn will affect the ROI since it depends upon both investment and income. ROI increases and decreases with the decrease and increase in the rate of depreciation. Most of the time the managers give more importance to increase the sales value. Although the increase and decrease in the sales value does not lead to any change in the ROI. Adjustment in the policy of depreciation leads to less depreciation charging and at same time it also leads to more savings and thus increases in the amount of profit (Das, Quelch and Swartz, 2000). It is seen that managers usually decrease the asset life time from their usual value in order to enjoy greater amounts of tax benefits. This in turn has a negative effect on the ROI. Another important part is the capitalization policy. The capitalization policy indicates what kind of accounting heads can be considered as assets and what as expenses. If the managers are able to increase the asset base of the company through the use of pre paid expenses then the ROI can be improved. Pre-paid expenses are considered as assets and not as expenses. Through the increase in the long term prepaid expenses, the ROI can be used for taking long term decisions. The means of using EVA for long term decision purposes lies in specific adjustments in capital and operating income left after deducting taxes. Average capital invested and operating income left after tax is used for calculation of EVFA (Flint, Woodruff and Gardial, 2002). A tax as well as depreciation constitutes two important parts of the operating income. The managers can use EVA for long term decision taking purposes if instead of increasing the rate of depreciation, the same is decreased and deferred over a number of years. Decrease in the rate of depreciation leads to increase in the operating income. Apart from the way the depreciation is charged and carried out throughout the years, the tax paid constitutes an important part of the operating income. The payment of cash taxes can be used as prepayment expenses to increase the amount of asset. Since prepaid expenses are capitalised as assets instead of being treated as an expense. Early clearance of the cash taxes will help to increase the amount of operating income. The adjustments in the tax paid and adjustment in the depreciation rate is not enough to bring in the required changes in EVA, which will help the managers use it for long term decision purposes (Garrick, 2011). Thus, it is equally important to consider adjustment to the capitals. The adjustment to the capitals constitutes some of the most important techniques to control EVA for long term decision taking purposes. The objective is to make the adjustments in the capital in such a way that long term assets are incorporated as much as possible (Ger, 2000). One of the most efficient ways to increase the effect of the long term assets is to increase the amount of reserves especially for bad debts. Apart from these, the expense incurred in research and development and LIFO can also be increased and this will be treated as prepaid expenses. This will help to increase the asset base of the company (Gina, 2013). Thus, the discussion helps to realize that the depreciation policy and asset capitalization policy helps to make the necessary adjustments in the ROI and EVA and this in turn will also help to use the two techniques for long term decision purposes. Part B 1. Market based transfer pricing Advantages The price for product and the transfer price of the product are kept equal in amount in those markets which are competitive in nature. Unless other types of transfer prices, market based transfer pricing does not involve the time consuming and tedious negotiation and renegotiation process. The base price and the market price can be kept equal to each other as because of the reason that the companies does not possess any kind of idle capacity or extra capacity. The subunits can continue their autonomy if they resort to market based transfer pricing (Graham and Campbell, 2012). Apart from being able to hold on to the autonomy, market based transfer pricing also helps the suppliers to be more competitive with the suppliers and specially with those suppliers who are operating from outside the purview of the company. Market based transfer pricing also helps the companies to enjoy a greater degree of relaxation in tax obligations (Lev and Thiagarajan, 2013). The international authorities of taxation have preference for certain specific standards, one of them is the arms length standard. This kind of standard is in fact used in market based transfer pricings. This kind of transfer pricing can be interpreted and understood easily (Lipe, 2013). Market based transfer pricing makes the job of performance evaluation a lot easier since it reduced the bottlenecks in the evaluation process. Disadvantages This kind of transfer pricing can be applied only if it is a competitive market and other tan the main units specially the subunits, none of them are left with any kind of scope for production of synergies. If the market prices are not known then this kind of market pricing technique becomes problematic in nature. Negotiation has the ability to generate benefits through discussion, and bargaining and cooperation for both the parties involved. This kind of transfer pricing techniques does not involve any kind of negotiation thus generation of benefit gets ruled out. The inter-mediate products cannot be priced unlike the final products (Miller, 2004). The calculations can be tedious since frequent adjustments need to be made to factor in the different types of cost saving factors like reduced savings cost and no commission. Market based transfer pricing techniques does not help in developing long term goals. As already stated the market prices are applicable only if perfect market conditions exists, although most of the time the market does not behave in a less than perfect way (Miller, 2007). In other words the market condition does not remain to be in perfect condition most of the time. 2. Full cost transfer pricing Advantages Most of the time the market conditions are less than imperfect and as a result these kind of transfer pricings are applicable. The mother company or the main company has the supreme authority to govern the way the sub units can fix the transfer prices. Thus, the sub units are always under the authority of the main units or the mother units. These kinds of transfer pricing techniques help to fix the prices in such a way that all kinds of costs are considered under this method. This kind of transfer pricing techniques uses huge amount of financial data, which is readily available (Ou, 2012). Thus, the computation of the full cost transfer pricing becomes easier in nature. Unlike other kinds of transfer pricing tactics, full cost transfer pricing can be easily understood. Apart from that it helps to take a broad range of decisions for both long term as well as short term purposes. Moreover, this kind of transfer pricing is also favoured more by the tax authorities and thus is used more for the purpose of comprehensive tax calculation purposes. Disadvantages If the price of full cost remains to be more than the price of the transfer price then the performance of the sub units cannot be evaluated effectively. Since the natures of the results are arbitrary and not definite in nature so the performance of the sub units cannot be evaluated effectively (Lev and Thiagarajan, 2013). The sub units autonomy are lost if this kind of transfer pricing techniques are applied. Fixed costs are not considered by this kind of transfer pricing technique and this is one of the main disadvantages (Porter, 2007). The fixed costs are not taken into considerations on those occasions, mainly if the purchase decision is made by an external buyer. There is constant need to use the standard costs in place of the actual cost and this needs requires constant recalibration, which is tedious as well as time consuming. This kind of transfer pricing technique does not classify between the variable cost and the fixed cost and as a result this kind of transfer pricing techniques leads to dysfunctional behaviour. Full cost transfer pricing does not help in controlling the expenditures since this kind of transfer pricing helps to pass the ineffectiveness as well as the inefficiencies (Bajaj, 2001). As the department of purchase consider all the costs to be variable in nature so this at times lead to dysfunctional decisions. 3. Cost plus a mark-up transfer prices Advantages Cost plus mark up transfer prices can only be applied if there happens to be presence of excess capacity or unused capacity. There is another name to this technique of transfer pricing and it is called variable cost transfer pricing. As this kind of transfer pricing does not consider any kind of profit generated, so the unit which is acting as the buyer is in more advantageous position in comparison to the unit acting as the seller (Bonaccorsi and Daraio, 2009). There is another advantage to this kind of transfer pricing technique, which is achieving both long term as well as short term goals. The management is relieved from the constant need to keep a vigil on the cost if the budget cost is used as the base for creating this kind of transfer price (Ou, 2012). Disadvantages This kind of transfer price seriously undermines the importance of fixed cost. Those fixed costs which the company cannot avoid at all are not included in this kind of transfer pricing technique. During operations the company sometimes incurs different types of fixed costs. If these kinds of unavoidable fixed cost are not considered then it leads to incomplete decisions on the part of the management for achieving the long term goals. For example, the buyer who pays the price of transfer does not factor in the effect of unavoidable fixed costs (Das, Quelch and Swartz, 2000). Thus, the seller can realize only the variable cost and some part of the fixed cost and not the whole fixed cost. This kind of transfer pricing creates a distortion between the fixed costs and the variable costs. The management has less power on the control of the costs if the prices are fixed on the basis of the actual cost instead of the standard costs. 4. Negotiated transfer prices Advantages The managers of the regional offices are at the helm of the negotiation process and deals. Unlike other types of transfer pricing techniques, negotiated transfer prices are governed by the law of supply and demand. Since this kind of transfer pricing technique does not involve any kind of bureaucratic formalities like completing the legal formalities, so it does not involve much time to reach a stage of conclusion through subsequent discussions and process of negotiation (Flint, Woodruff and Gardial, 2002). This kind of transfer pricing techniques has some sort of advantages over the normal process of negotiation since most of the transfer pricing techniques are based on perfect market conditions although most of the time the market is less than perfect. So this kind of transfer pricing technique is best suited for those markets, which are imperfect in nature. As both external and internal costs are different so the markets which are imperfect in nature are characterised by different selling costs (Gina, 2013). If the planned price of the market or the prevailing price are below the transfer prices then the difference in the transfer prices occur. At time when the transfer prices becomes more than the market price or the prevailing price, it is said to be have reached an optimal condition. Disadvantages The process of negotiation is able to generate the benefit only if the managers who are entrusted with finalising the negotiation process share a healthy relationship with each other. This is because of the reason that this particular process of negotiation is informal in nature and thus informal relations matter more than formal relations. Another important disadvantage of this process of transfer pricing technique is that the managers of the sub units need to be more conversant with the process of the negotiation (Lipe, 2013). In other words the managers need to be skilled negotiators or else the negotiation process falls through. In case the managers do not have the required experience and skills then the managers need to be trained. Thus, this may lead to extra cost in the process of training and retraining. Sometimes it happens that the managers may not be able to reach to a conclusion because the market may be imperfect in nature and thus the intermediate products may not seem to posses any bargaining price in the market (Miller, 2007). The process of arbitration and negotiation may undermine the autonomy of the sub units. Conclusion Strategic management equips the managers to tackle the limitations of the normal financial management. Some of the topic discussed here like the use of the EVA and ROI for long term purposes and different types of transfer pricing techniques indicate that the managers will be able to use strategic effectively only of they have the required knowledge. ROI can be used for long term decision purposes if the net income and return on sales is increased. Since this will help to increase the income generated. The discussion also pointed out that increase of the asset base helps to increase the asset turnover. The increase in the asset turnover in turn helps to increase the ROI. Similarly the adjustment in the depreciation policy and in capitalization policy helps in EVA. The discussion on different types of transfer pricing indicates that the various ways the managers can use the pricing techniques depend upon three important factors, which are autonomy of the subunits, conditions of the market and the negotiation skills of the management. Among these three different types of variables, the most important of all the variables is the market condition. The condition of the market has a direct effect on the choice of the transfer pricing. Reference List Bajaj, C., 2001. Foreign Collaborations: An innovative option. IIMB Management Review, 6(3), pp.142-145. Bonaccorsi, A. and Daraio, C., 2009. Age effects in scientific productivity — the case of the Italian national research council (cnr). Scientometrics, 5(8), pp. 49–90. Chrol, R. S., 2011. 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