Academic journal article Journal of Performance Management

Using Fund Transfer Pricing for Comparing Financial Performance among Business Units

Academic journal article Journal of Performance Management

Using Fund Transfer Pricing for Comparing Financial Performance among Business Units

Article excerpt

Introduction

Many organizations become decentralized in order to improve performance of business units. Decentralization is expected to improve business units' performance as it improves the speed of decision making and reduce the burden of centralised bureaucracy (Langfield-Smith et al, 2008). But once organizations become decentralized, there is the problem of how comparing financial performance among business units. Using financial measures to compare performance among business units may prove to be a problem for the organization. Profit may not be a reliable option for comparing financial performance among business units because business units may be exchanging services among them, and not necessarily such services are registered as income or expenses in the organization's accounts. Therefore, the objective of this paper is to provide an insight of how management can deal with the problem of comparing financial performance among business units.

In order to compare financial performance among business units considering an exchange of services among such business units a simplified version of the problem is provided in this paper. Thus this paper provides an analysis using profit centres in a financial institution, more specifically a bank with only two branches. The analysis could be simplified through a financial relation where one branch lends money to another in a bank with only two branches for profit centres. Thus one branch may seem profitable due to interest income from lending money to clients, whilst actually it is being funded by the other branch.

Decentralized profit centres may present some difficulties, such as loss of control by top management due to the decentralization of decisions, possible competition among business units that previously cooperated with each other, and additional costs due to duplication of tasks (Langfield-Smith et al, 2008). Furthermore, performance evaluation of business units using financial measures such as profit can lead to biased results. For Kimball (1997) banks need to implement fund transfer pricing systems as banks' business units generate disproportionate amounts of both assets and liabilities. For instance, some branches tend to have more deposits whilst other branches tend to provide more loans, thus some are net fund generators whilst others are net fund users.

Fund transfer price can be understood as a mechanism for distributing revenue between profit centres. The fund transfer price is not primarily an accounting instrument, but an instrument of action that motivates branch managers to make decisions aligned with the organization's strategy. Fund transfer pricing can contribute to a better financial performance evaluation of these business units. But the main issue is how to determine the transfer price among business units.

This study aims to demonstrate by a simplified analysis how fund transfer pricing can be used to measure financial performance taking into account the flow of resources in a bank with only two branches. The present study was developed in three sections. The first section provides information regarding fund transfer pricing and its characteristics. This is followed by a section with an analysis demonstrating how fund transfer pricing can assist top management to evaluate financial performance in a financial institutions with only two business units. Finally, the third section has the concluding remarks about the benefits and limitations of the use of fund transfer pricing.

Fund transfer pricing

The term transfer price can be conceptualized as a price charged for a product or service transferred between profit centres in a decentralized organization (Langfield-Smith et al, 2008). For instance, transfer pricing can be used as a mechanism of distribution of income from the sales of a product among centres responsible for product development, production and marketing. According to Payant (2000) funds transfer pricing is an internal measurement tool to demonstrate the financial impact of destination and source of funds. …

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