AAT L4 Transfer Pricing and Divisional Performance 1 — Questions and Answers
Question 1: Division A has operating profit of £150,000 and net assets of £600,000. What is Division A's Return on Investment (ROI)?
- 4%
- 25% (Correct answer)
- 40%
- 15%
Correct answer: 25%
ROI = Operating Profit ÷ Capital Employed = £150,000 ÷ £600,000 = 25%.
Question 2: What is the MINIMUM transfer price a selling division should accept when operating at full capacity?
- Variable cost only
- Variable cost plus contribution foregone on lost external sales (Correct answer)
- Full cost plus a profit margin
- Market price minus selling costs saved
Correct answer: Variable cost plus contribution foregone on lost external sales
At full capacity there is an opportunity cost; the minimum transfer price must cover variable cost plus the contribution foregone from displaced external sales.
Question 3: Residual Income (RI) is calculated as:
- Operating profit minus imputed interest on capital employed (Correct answer)
- Operating profit divided by capital employed
- Net profit after tax divided by equity
- Operating profit plus depreciation
Correct answer: Operating profit minus imputed interest on capital employed
RI = Operating Profit − (Cost of Capital × Capital Employed), deducting a capital charge to reflect the cost of funding.
Question 4: A company has a cost of capital of 12%. Division B has capital employed of £500,000 and operating profit of £80,000. What is Division B's Residual Income?
- £20,000 (Correct answer)
- £60,000
- -£20,000
- £140,000
Correct answer: £20,000
Imputed interest = 12% × £500,000 = £60,000; RI = £80,000 − £60,000 = £20,000.
Question 5: Which of the following is an advantage of using Return on Investment (ROI) as a divisional performance measure?
- It avoids dysfunctional decision-making by managers
- It is widely understood and can be compared across divisions of different sizes (Correct answer)
- It always leads to goal congruence with company objectives
- It eliminates the impact of different depreciation policies
Correct answer: It is widely understood and can be compared across divisions of different sizes
ROI is expressed as a percentage, making it straightforward to compare performance across divisions of different absolute sizes.
Question 6: Division X can sell its product externally for £50 per unit. Variable costs are £30 per unit. Division X has spare capacity. What is the minimum transfer price it should charge Division Y?
- £30 (Correct answer)
- £40
- £50
- £20
Correct answer: £30
With spare capacity there is no opportunity cost, so the minimum transfer price equals variable cost only — £30 per unit.
Question 7: Which statement best describes goal congruence in the context of transfer pricing?
- Market price transfer pricing always leads to goal congruence
- A transfer price should motivate divisional managers to make decisions that maximise overall company profit (Correct answer)
- Cost-based transfer prices always achieve goal congruence
- Negotiated transfer prices never achieve goal congruence
Correct answer: A transfer price should motivate divisional managers to make decisions that maximise overall company profit
Goal congruence means divisional managers' individual decisions align with the company's overall objectives, which a well-designed transfer price should encourage.
AAT L4 Transfer Pricing and Divisional Performance 1
Division A has operating profit of £150,000 and net assets of £600,000.
What is Division A's Return on Investment (ROI)?