Difficulty: Intermediate | Prerequisites: Basic understanding of income statements, fixed vs variable costs, contribution margin, and the idea that divisions within a firm can trade with each other.
These topics deal with how firms evaluate performance and set internal prices. The balanced scorecard provides a framework for measuring performance across financial and non-financial dimensions. The choice between centralisation and decentralisation determines who makes decisions and who is held accountable. Absorption vs variable costing affects reported profit depending on whether production exceeds sales. Transfer pricing governs how divisions within the same firm price goods they sell to each other, with implications for divisional autonomy and overall firm profitability.
The balanced scorecard measures performance across four perspectives (financial, customer, internal process, learning and growth). Financial measures are lagging indicators; non-financial measures are leading ones. When production exceeds sales, absorption costing reports higher profit than variable costing because fixed overhead is deferred in inventory. The minimum transfer price equals the variable cost of the transferred product plus the opportunity cost of lost contribution from displaced external sales.
Balanced scorecard (BSC)
A performance measurement framework that supplements traditional financial measures with metrics across four perspectives: financial, customer, internal business process, and learning and growth.
Think of it as a dashboard that tracks not just the money but the drivers behind the money.
Financial perspective
Measures such as revenue growth, return on investment, and economic value added. These are lagging indicators: they reflect past decisions.
Customer perspective
Measures such as customer satisfaction, retention, and market share. These reflect how well the firm is serving its customers.
Internal business process perspective
Measures such as defect rates, cycle time, and on-time delivery. These track the efficiency and quality of the firm's operations.
Learning and growth perspective
Measures of employees' skills, capabilities, information system quality, and organisational alignment. This is the foundation that enables the other three perspectives.
In simple terms, this perspective asks: can the firm's people and systems keep improving?
Leading indicator
A metric that predicts future performance. Non-financial measures (customer satisfaction, employee training hours) are typically leading indicators.
Lagging indicator
A metric that reflects past performance. Financial measures (profit, ROI) are typically lagging indicators: they arrive too late to prevent problems.
Centralisation
The concentration of decision-making authority at the highest levels of the organisation.
Decentralisation
The delegation of decision-making authority to lower levels of the organisation.
Absorption costing (full costing)
A costing method that includes all manufacturing costs (both variable and fixed) in the cost of a product. Fixed manufacturing overhead is "absorbed" into inventory and expensed only when units are sold.
Variable costing (direct costing / marginal costing)
A costing method that includes only variable manufacturing costs in the cost of a product. All fixed manufacturing overhead is expensed in the period it is incurred, regardless of how many units are sold.
Transfer price
The price one division of a firm charges another division for goods or services. It affects divisional profit but not the firm's overall profit (because the revenue of one division is the cost of the other).
Minimum transfer price
The lowest price the selling division can accept without reducing its own profit. It equals the variable cost of the transferred product plus the opportunity cost per unit of the capacity used.
In simple terms: what it costs to make the item, plus what the selling division gives up by not using that capacity for something else.
Opportunity cost (in transfer pricing)
The contribution margin lost on external sales that the selling division must forgo to supply the buying division. If there is excess capacity, the opportunity cost is zero.
The BSC translates strategy into measurable objectives across four linked perspectives:
Financial: Revenue, profit, ROI. Tells shareholders whether value was created. Lagging.
Customer: Satisfaction, retention, acquisition, market share. Tells whether the firm is meeting customer needs. Mix of leading and lagging.
Internal business process: Cycle time, defect rates, on-time delivery, innovation pipeline. Tells whether operations are efficient. Leading.
Learning and growth: Employee skills and capabilities, information systems, organisational culture. Tells whether the firm can sustain improvement. Leading.
The perspectives form a causal chain: learning and growth drives process improvement, which drives customer satisfaction, which drives financial results.
Employees' skills and capabilities sit in the learning and growth perspective. This is a common exam question.
Financial performance measures are often lagging indicators that arrive too late to prevent problems. By the time profit declines, the root cause (poor quality, lost customers, underinvestment in training) has already done its damage. Non-financial measures, by contrast, are leading indicators: a drop in customer satisfaction today predicts a revenue decline next quarter.
Centralisation concentrates decision-making authority at the top of the organisation. Decentralisation pushes it down. Most large firms operate somewhere in between, decentralising operational decisions while centralising strategic ones.
The key difference: fixed manufacturing overhead.
Under absorption costing, fixed manufacturing overhead is included in product cost and sits in inventory until units are sold.
Under variable costing, all fixed manufacturing overhead is expensed in the period incurred.
When production exceeds sales (inventory is building), absorption costing reports higher profit than variable costing, because some of the period's fixed overhead is deferred in ending inventory rather than hitting the income statement.
When production equals sales, both methods report the same profit.
When production is less than sales (inventory is drawn down), absorption costing reports lower profit than variable costing.
Exam scenario (Redplum Computers): Zero beginning inventory, production exceeds sales. Under absorption costing, part of fixed manufacturing overhead is inventoried in finished goods. Under variable costing, all fixed manufacturing overhead is expensed. Therefore, profit is higher under absorption costing.
The minimum transfer price formula:
Minimum transfer price = Variable cost of transferred product + Opportunity cost per unit
The opportunity cost depends on whether the selling division has excess capacity.
Worked example (Division A screens):
Capacity: 20,000 screens per year
Standard screen: sells externally at $210, variable cost $90, contribution margin $120
Custom screen for Division B: variable cost $105, same capacity consumption
Division B wants 5,000 custom screens
Scenario A: Division A makes 12,000 standard screens (8,000 units of excess capacity)
Excess capacity of 8,000 is more than the 5,000 custom screens needed. No external sales need to be sacrificed. Opportunity cost = $0.
Minimum transfer price = $105 + $0 = $105 per custom screen
Scenario B: Division A makes 20,000 standard screens (at full capacity)
Division A must give up 5,000 standard screens to make 5,000 custom screens. Each standard screen contributes $120. Opportunity cost = $120 per unit.
Minimum transfer price = $105 + $120 = $225 per custom screen
Scenario C: Division A makes 16,000 standard screens (4,000 units of excess capacity, all-or-nothing order)
Division A has capacity for 4,000 of the 5,000 custom screens. The remaining 1,000 require sacrificing 1,000 standard screens.
Lost contribution = 1,000 x $120 = $120,000. Spread across all 5,000 custom screens: $120,000 / 5,000 = $24 per unit.
Minimum transfer price = $105 + $24 = $129 per custom screen
The logic in Scenario C is important: the opportunity cost is spread across all transferred units, not just the ones that displaced external sales. Division B's all-or-nothing requirement means the 5,000 units must be priced as a package.
Minimum transfer price:
Minimum TP = Variable cost of transferred product + Opportunity cost per unit
Opportunity cost per unit (partial capacity constraint):
Opportunity cost per unit = (Units displaced x Contribution margin per displaced unit) / Total units transferred
Absorption costing product cost:
Product cost = Direct materials + Direct labour + Variable manufacturing overhead + Allocated fixed manufacturing overhead
Variable costing product cost:
Product cost = Direct materials + Direct labour + Variable manufacturing overhead
(Fixed manufacturing overhead is a period cost, not a product cost.)
The balanced scorecard is used at firms like Hilton Hotels, which tracks customer satisfaction scores alongside revenue per available room. A hotel that cuts housekeeping staff might boost short-term profit (the financial measure) while damaging satisfaction scores (the customer measure), which predicts future revenue loss.
Transfer pricing is a major issue for multinational corporations. While the exam focuses on the economic logic (variable cost + opportunity cost), in practice, transfer prices also have tax implications: firms may set prices to shift profit to low-tax jurisdictions, which tax authorities scrutinise.
Students often think absorption costing always reports higher profit. It reports higher profit only when production exceeds sales (inventory is building). When sales exceed production, variable costing reports higher profit.
A common transfer pricing error is using the full cost (including allocated fixed overhead) as the minimum transfer price. The minimum is based on variable cost plus opportunity cost, not full cost.
Students sometimes forget that opportunity cost is zero when there is excess capacity. If the selling division can fill the internal order without giving up any external sales, the minimum transfer price is simply the variable cost.
The balanced scorecard's four perspectives are frequently confused. The most common mix-up: placing employee skills under "internal business process" instead of "learning and growth."
⚠️ The transfer pricing problem with three scenarios (excess capacity, full capacity, partial capacity with all-or-nothing) is a high-point question. Practise all three.
⚠️ Know which BSC perspective each type of measure belongs to. Employee skills = learning and growth. Defect rates = internal process. Market share = customer. ROI = financial.
⚠️ Financial measures = lagging, non-financial = leading. This distinction is tested directly.
⚠️ Absorption vs variable costing: the exam tests the direction of the profit difference given a production-vs-sales scenario. If production > sales, absorption profit > variable profit.
⚠️ Centralisation vs decentralisation is a definition question. Centralisation = decision authority at the top.
True or False: Employee training hours belong in the internal business process perspective of the BSC. (False. They belong in the learning and growth perspective.)
Fill in the blank: Financial measures are ________ indicators. (Lagging)
True or False: When production equals sales, absorption and variable costing report the same profit. (True.)
Fill in the blank: Minimum transfer price = Variable cost + ________. (Opportunity cost per unit)
True or False: If the selling division has excess capacity, the opportunity cost in the transfer pricing formula is zero. (True.)
Q: Division X makes a component at a variable cost of $30. It sells externally for $50. Division Y wants 2,000 units. Division X has capacity for 10,000 units and currently sells 9,000 externally. What is the minimum transfer price?
A: Division X needs to displace 1,000 external units (9,000 + 2,000 = 11,000 exceeds 10,000 capacity by 1,000). Contribution margin on each displaced unit = $50 - $30 = $20. Total lost contribution = 1,000 x $20 = $20,000. Opportunity cost per transferred unit = $20,000 / 2,000 = $10. Minimum TP = $30 + $10 = $40.
Q: A firm produces 10,000 units and sells 8,000. Beginning finished goods inventory is zero. Fixed manufacturing overhead is $200,000. Under absorption costing, how much fixed overhead is in ending inventory?
A: Ending inventory = 10,000 - 8,000 = 2,000 units. Fixed overhead per unit = $200,000 / 10,000 = $20. Fixed overhead in ending inventory = 2,000 x $20 = $40,000. This $40,000 is deferred under absorption costing but would be fully expensed under variable costing, explaining the profit difference.
Q: Which BSC perspective includes measures of defect rates and cycle time?
A: Internal business process perspective.
Q: A firm with zero beginning inventory produces 5,000 units and sells 4,000. Will absorption costing profit be higher, lower, or equal to variable costing profit?
A: Higher. Production exceeds sales, so some fixed overhead is deferred in ending inventory under absorption costing.
Q: What is the difference between centralisation and decentralisation?
A: Centralisation concentrates decision-making authority at the top of the organisation. Decentralisation delegates it to lower levels.
The balanced scorecard connects to variance analysis through the financial perspective: budget variances are one of the financial metrics a BSC might track. The non-financial perspectives provide context for why those variances occurred.
Transfer pricing connects to ABC and cost allocation. If a division uses a traditional cost system that distorts product costs, the transfer price based on those costs will also be distorted. An ABC-informed cost gives a better foundation for setting transfer prices.
Absorption vs variable costing connects to budgeting: a manager evaluated on absorption costing profit has an incentive to overproduce (building inventory defers fixed costs), which is a dysfunctional behaviour that budgetary controls should catch.
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