INTERNAL PERFORMANCE MEASUREMENT AND TRANSFER

PRICING

EMBA PresentationNovember 15,2012

Internal Performance Measurement Responsibility Centers Residual Income Return on Investment EVA

Responsibility Centers

Cost center Profit center Investment center

Schematic

CostCenter

CostCenter

CostCenter

CostCenter

ProfitCenter

ProfitCenter

InvestmentCenter

Summary of Performance Centers

Type of Center Decision RightsPerformance

Measures

Cost Input Mix Cost controls

Profit Product Mix, Selling Prices, Input Mix

Actual Profits, Budget Comparisons

Investment Input Mix, Product Mix, Selling Prices, Capital Invested

ROI, Residual Income, EVA

Schematic of the ROI Method

Sales

TotalInvestment

Earnings

Sales

SalesTurnover

ROI

Return onSales

Divided by

Divided by

Multiplied by

ROI Example

Sales $9,000,000Net Operating Income $ 720,000Total Investment $4,000,000

Sales Turnover $9,000,000 $4,000,000 = 2.25Return on Sales $720,000 $9,000,000 = 8%ROI 2.25 x .08 = 18%

Criticisms of ROI

Managers may make decisions that increase the ROI in the short run

Managers often inherit costs over which they have no control

Managers may reject investment opportunities that are good for the organization, but negatively impact the segment

Residual Income

Focuses on the residual return after deducting the minimum return required by top management

Residual Income = NOI – Average OperatingAssets

XMinimumRequiredRate of Return

Example of Residual IncomeGlobal Equities Corporation

Analyis of ROI and Residual Income Europa

Division

American

Division

Sales 3,000,000$ 9,000,000$ Net Operating Income 210,000$ 720,000$ Average Operating Assets 1,000,000$ 4,000,000$

Return on Investment (ROI) 21% 18%

Residual Income Approach:

Assume Global Expects a 15% return on net operating assets

Return on Average Operating Assets at 15% 150,000$ 600,000$

Net Operating Income 210,000$ 720,000$

Residual Income 60,000$ 120,000$

Greatest deficiency is that the method does not take into consideration size of the segment

Criticisms of Residual Income

Absolute number that ignores investment center size

Does not measure risk factors

Opportunity cost of capital is different between investment centers

Calculation of EVA

Adjusted Weighted Cost of Capital EVA = Accounting – X Earnings Total Capital

Calculation of EVA Earnings

• Earnings per GAAP• Less cost of capital used by the center• Plus R & D expenses deducted• Add amortization of R & D• Equals EVA Earnings

Capital Formula for EVA

Total Capital Invested Plus Capitalized R & D Costs

Example Using EVA

Operating Income plus R & D Expenses $900,000Less Amortization of R & D Expenses 100,000Adjusted Earning for EVA $800,000

Invested Capital $4,000,000Plus Capitalized R & D 1,000,000EVA Capital $5,000,000

EVA Rate 16%

Controllability Principle

Westinghouse Nuclear Case

Transfer Pricing Topics

What is transfer pricing? Terms Delco example Transfer pricing methods Car dealership example Summary of transfer pricing

methods International and tax ramifications

A transfer price is the price one sub-unit charges another for a product or service supplied to it

Terms

Full cost – includes both fixed and variable components

Variable cost – includes only the costs directly related to producing the product

Idle capacity – plant capacity available for additional manufacturing without incurring more fixed costs

Substitute products – competitive products are available in the open market a lower price

Congruence Problems

Management expects sub-units to act in a manner that maximizes firm-wide profits

Management desires that product family members be used throughout the firm

Unit managers operate in a manner that optimizes the profitability of their unit which is often reflected in their incentives

Delco Example

Delco

ManufacturesBatteries After Market

$40

Chevrolet

? Outside market $40Full cost $30Variable cost $20

Delco has excess capacity

Transfer Pricing Methods

Market based Cost based Negotiated Dual

Market Prices Lead to Optimal Decisions

When: The market for the intermediate

product is perfectly competitive Interdependence of subunits is

minimal No additional costs in buying or

selling in the external market compared to the internal

Cost Based Transfer Prices

Full cost – price includes both the fixed and variable component If excess capacity is used, there should be no

additional fixed costs Fixed costs may be allocated between external

and internal sales Full costing may be more appropriate where a

firm uses ABC costing

Variable cost – includes only the incremental cost

Negotiated Prices

Mutual agreement between sub-units May have no relationship to cost or

market prices May be affected by a unit’s ability to

negotiate

Dual Pricing

In this case, the selling division and the buying division do not pay or receive the same amount

Seller gets full cost and buyer pays market

Difference rolls to a corporate account May cause divisional tax calculation

problems Selling unit has no incentive to control

costs

Car Dealer Example

Departments: New Vehicles, Used Vehicles, Service, Body Shop, and Parts Department

New Used Body Service

Retail

Service labor rate $40 $40

$65

Body shop labor rate $40 $40 $40

$65

Parts mark-up 15% 15% 15% 15%

30%

Summary of Methods

Domestic Multinational

Market based 26% 35%

Cost based: Variable 3% 0% Full cost 49% 42% Other 1% 1% Total 53% 43%

Negotiated 17% 14%

Other 4% 8%

TOTAL 100% 100%

International and Tax Ramifications

Large firms are global in nature

Firms sell products between international subsidiaries or joint ventures

Tax rates vary between countries

International firms will transfer price to minimize total taxes paid

Taxes Paid on Box of Contact Lenses in The Netherlands

TransferPrice at

80 Euros

Transfer Price at

110 Euros

Taxes Paid in Netherlands:

Revenue (Transfer Price) € 80 €110

Variable Cost (50) (50)

Taxable Income € 30 € 60

Tax Rate 30% 30%

Dutch Taxes € 9 € 18

Taxes Paid in Australia

Transfer Price at

80 Euros

TransferPrice at

110 Euros

Taxes Paid in Australia:

Revenue (Australian Dollars) A$ 85 A$ 85

Transfer Price in Euros:

80 x .70A$

(56) -

110 x .70 - A$

(77)

Taxable Income A$ 29 A$ 8

Tax Rate 40% 40%

Australian TaxesA$

11.6 A$

3.20

Converted to Euros at .70 Rate€

16.57 € 4.57

Comparison of Results

TransferPrice at

80 Euros

Transfer Price at

110 Euros

Dutch Taxes € 9.00 €

18.00

Australian Taxes 16.57 4.57

Total €

25.57 €

22.57

Eastman Kodak Case

Copyright, Frank Ilett, 2012