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Investment Centersand Transfer Pricing

12Supplementary Supplementary SlidesSlidesChapter Twelve Chapter Twelve

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S upervisor S upervisor

M iddleM anagem ent

S upervisor S upervisor

M iddleM anagem ent

T opM anagem ent

Decision Makingis pushed down.

Delegation of Decision Making(Decentralization)

Decentralization often occurs as organizations continue to grow.

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Decentralization

AdvantagesAllows organization

to respond morequickly to events.

Frees top managementfrom day-to-day

operating activities.

Uses specializedknowledge and

skills of managers.

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Decentralization

ChallengeGoal Congruence:

Organization’s subunit managers make decisions that achieve

top-management goals.

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Measuring Performancein Investment Centers

Investment Center Investment Center managers make managers make decisions that decisions that

affect both profit affect both profit and invested and invested

capital.capital.Corporate HeadquartersCorporate Headquarters

InvestmentCenter

Evaluation

Return on investment, residual income, or

economic value added

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Return on Investment (ROI)

ROI = Income

Invested Capital

ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

SalesMargin

SalesMargin

CapitalTurnover

CapitalTurnover

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Holly Company reports the following:

Income $ 30,000

Sales Revenue $ 500,000

Invested Capital $ 200,000

Let’s calculate ROI.Let’s calculate ROI.

Return on Investment (ROI)

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ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

Return on Investment (ROI)

ROI = $30,000

$500,000×

$500,000$200,000

ROI = 6% × 2.5 = 15%

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Improving R0I

Three ways to improve ROI

IncreaseIncrease SalesSales Prices Prices

DecreaseDecrease ExpensesExpenses

LowerLower InvestedInvested Capital Capital

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Holly’s manager was able to increase Holly’s manager was able to increase sales revenue to $600,000 which sales revenue to $600,000 which increased income to $42,000.increased income to $42,000.

There was no change in invested capital.There was no change in invested capital.

Let’s calculate the new ROI.Let’s calculate the new ROI.

Improving R0I

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ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

Return on Investment (ROI)

ROI = $42,000

$600,000×

$600,000$200,000

ROI = 7% × 3.0 = 21%

Holly increased ROI from 15% to 21%.

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ROI - A Major Drawback As division manager at Winston, Inc., your As division manager at Winston, Inc., your

compensation package includes a salary plus bonus compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, based on your division’s ROI -- the higher your ROI, the bigger your bonus.the bigger your bonus.

The company requires an ROI of 15% on all new The company requires an ROI of 15% on all new investments -- your division has been producing an investments -- your division has been producing an ROI of 30%.ROI of 30%.

You have an opportunity to invest in a new project that You have an opportunity to invest in a new project that will produce an ROI of 25%.will produce an ROI of 25%.

As division manager would you As division manager would you invest in this project?invest in this project?

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As division manager,I wouldn’t invest in

that project becauseit would lower my pay!

ROI - A Major DrawbackGee . . .

I thought we weresupposed to do what

was best for the company!

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Residual Income

Investment center profit– Investment charge = Residual income

Investment capital× Imputed interest rate= Investment charge

Investment center’sminimum required

rate of return

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Residual Income

Flower Co. has an opportunity to invest Flower Co. has an opportunity to invest $100,000 in a project that will return $25,000.$100,000 in a project that will return $25,000.

Flower Co. has a 20 percent required rate of Flower Co. has a 20 percent required rate of return and a 30 percent ROI on existing return and a 30 percent ROI on existing business. business.

Let’s calculate residual income.Let’s calculate residual income.

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Residual Income

Investment center profit = $25,000– Investment charge = 20,000= Residual income = $ 5,000

Investment capital = $100,000× Imputed interest rate = 20% = Investment charge = $ 20,000

Investment center’sminimum required

rate of return

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Residual Income

As a manager at Flower As a manager at Flower Co., would you invest Co., would you invest the $100,000 if you the $100,000 if you were evaluated using were evaluated using residual income?residual income?

Would your decision be Would your decision be different if you were different if you were evaluated using ROI? evaluated using ROI?

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Residual Income

Residual income encourages managers to Residual income encourages managers to make profitable investments that wouldmake profitable investments that would

be rejected by managers using ROI.be rejected by managers using ROI.

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Economic Value Added

Economic value added tells us how much shareholder wealth is being created.

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Economic Value Added Investment center’s after-tax operating income– Investment charge = Economic Value Added

Weightedaverage

cost of capital

Investmentcenter’s

total assets

Investmentcenter’s

current liabilities–( )

After-taxcost ofdebt

Marketvalue

of debt

Cost ofequity capital

Marketvalue

of equity( () )

Marketvalue

of debt

Marketvalue

of equity

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Economic Value Added

The Atlantic Division of Suncoast Food Centers reportedthe following results for the most recent period:

Atlantic's pretax income 6,750,000$ Atlantic's total assets 45,000,000 Atlantic's current liabilities 600,000 Market value of Suncoast's debt 40,000,000 Market value of Suncoast's equity 60,000,000 Interest rate on Suncoast's debt 9%Cost of Suncoast's equity capital 12%Tax rate 30%

Compute Atlantic Division’s economic value added.

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Economic Value Added

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

$40,000,000 + $60,000,000= 0.0972

First, let’s compute theweighted-average cost of capital

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Economic Value Added

$4,725,000 After-tax operating income– 4,315,680= $ 409,320 Economic value added

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

$40,000,000 + $60,000,000

($45,000,000 – $600,000) × 0.0972 = $4,315,680

= 0.0972

$6,750,000 × (1 – 30%)

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Measuring Investment Capital

Three issues must be considered before we can properly measure the investment capital..

What assets should be included?What assets should be included? Total assets.Total assets. Total productive assets.Total productive assets. Total assets less current liabilities.Total assets less current liabilities. Only the assets controllable by the manager being Only the assets controllable by the manager being

evaluated.evaluated.

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Measuring Investment Capital

Three issues must be considered before we can properly measure the investment capital.

Should we measure the investment at the Should we measure the investment at the beginning or end-of-period amount, or should beginning or end-of-period amount, or should we use an average of beginning and end-of- we use an average of beginning and end-of- period amounts? period amounts?

Should the assets be shown at historical or Should the assets be shown at historical or current cost? current cost?

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Gross or Net Book Value

GrizzlyCo is considering an investment that is projected to GrizzlyCo is considering an investment that is projected to produce operating profits of $25,000 before depreciation for produce operating profits of $25,000 before depreciation for the next three years.the next three years.

At the beginning of the first year GrizzlyCo will invest At the beginning of the first year GrizzlyCo will invest $100,000 in an asset that has a ten-year life and no salvage $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used.value. Straight-line depreciation is used.

GrizzlyCo calculates ROI based on end-of-year asset values.GrizzlyCo calculates ROI based on end-of-year asset values.

Let’s calculate ROI using both the Let’s calculate ROI using both the gross and net book values gross and net book values..

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Gross or Net Book Value

Year

Profits before

Depreciation Depreciation

Expense Operating

Profits

Gross Book Value

Net Book Value

1 25,000$ 10,000$ 15,000$ 100,000$ 90,000$ 2 25,000 10,000 15,000 100,000 80,000 3 25,000 10,000 15,000 100,000 70,000

($100,000 – $0) ÷ 10 = $10,000 per year

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Gross or Net Book Value

Year

Profits before

Depreciation Depreciation

Expense Operating

Profits

Gross Book Value

Net Book Value

1 25,000$ 10,000$ 15,000$ 100,000$ 90,000$ 2 25,000 10,000 15,000 100,000 80,000 3 25,000 10,000 15,000 100,000 70,000

$100,000 – $10,000 = $90,000 net book value

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Year

Net Operating

Profits Net Book

Value ROI

Gross Book Value ROI

1 15,000$ 90,000$ 16.67% 100,000$ 15.00%2 15,000 80,000 18.75% 100,000 15.00%3 15,000 70,000 21.43% 100,000 15.00%

Gross or Net Book Value

$15,000 ÷ $100,000 = 15%

$15,000 ÷ $90,000 = 16.67%

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The ROI increases each year usingnet book value even though no operating changes take place.

Gross or Net Book Value

Year

Net Operating

Profits Net Book

Value ROI

Gross Book Value ROI

1 15,000$ 90,000$ 16.67% 100,000$ 15.00%2 15,000 80,000 18.75% 100,000 15.00%3 15,000 70,000 21.43% 100,000 15.00%

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Since older assets, with lower net bookvalues, result in higher ROI, managers arediscouraged from investing in new assets.

Gross or Net Book Value

Year

Net Operating

Profits Net Book

Value ROI

Gross Book Value ROI

1 15,000$ 90,000$ 16.67% 100,000$ 15.00%2 15,000 80,000 18.75% 100,000 15.00%3 15,000 70,000 21.43% 100,000 15.00%

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Measuring InvestmentCenter Income

Division managers should be evaluated on Division managers should be evaluated on profit margin they control.profit margin they control. Exclude these costs:Exclude these costs:

Costs traceable to the division but not Costs traceable to the division but not controlled by the division manager.controlled by the division manager.

Common costs incurred elsewhere and Common costs incurred elsewhere and allocated to the division.allocated to the division.

The key issue is controllability.

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Inflation: Historical Cost versusCurrent-Value Accounting

Use of current-value accounting impacts Use of current-value accounting impacts the amount of:the amount of: Invested capital.Invested capital. Income.Income.

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Other Issues in Segment Performance Evaluation

Short-run performance measures versus Short-run performance measures versus long-run performance measures.long-run performance measures.

Importance of nonfinancial information.Importance of nonfinancial information. Market position.Market position. Product leadership.Product leadership. Productivity.Productivity. Employee attitudes.Employee attitudes.

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Measuring Performance in Nonprofit Organizations

Since income is not the primary measure of performance in

nonprofit organizations, performance measures other thanROI and residual income are used.

Since income is not the primary measure of performance in

nonprofit organizations, performance measures other thanROI and residual income are used.

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Transfer Pricing

Let’s change topics!

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Transfer Pricing

The amount charged when one division sells The amount charged when one division sells goods or services to another divisiongoods or services to another division

Battery Division Auto Division

Batteries

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The transfer price affects the profit measure for The transfer price affects the profit measure for both the selling division and the buying division.both the selling division and the buying division.

A higher transferprice for batteries

means . . .

greaterprofits for the

battery division.

Auto DivisionBattery Division

Transfer Pricing

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lower profitsfor the

auto division.

The transfer price affects the profit measure for The transfer price affects the profit measure for both the selling division and the buying division.both the selling division and the buying division.

Auto DivisionBattery Division

Transfer Pricing

A higher transferprice for batteries

means . . .

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Goal Congruence

The ideal transfer price allowseach division manager to make

decisions that maximize thecompany’s profit, while

attempting to maximize his/herown division’s profit.

The ideal transfer price allowseach division manager to make

decisions that maximize thecompany’s profit, while

attempting to maximize his/herown division’s profit.

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General-Transfer-Pricing Rule

Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity costper unit to theorganizationbecause ofthe transfer

= +

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The Battery Division makes a standard 12-volt battery.The Battery Division makes a standard 12-volt battery.

Production capacityProduction capacity 300,000 units300,000 units

Selling price per batterySelling price per battery $40 (to outsiders)$40 (to outsiders)

Variable costs per batteryVariable costs per battery $18$18

Fixed costs per batteryFixed costs per battery $7 (at 300,000 units)$7 (at 300,000 units) The Battery division is currently selling 300,000 The Battery division is currently selling 300,000

batteries to outsiders at $40. The Auto Division can batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. use 100,000 of these batteries in its X-7 model.

Scenario I: No Excess Capacity

What is the appropriate transfer price?

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Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity costper unit to theorganizationbecause ofthe transfer

= +

Transferprice = $18 variable

cost per battery +$22 Contribution

lost if outsidesales given up

Transferprice = $40 per battery

Scenario I: No Excess Capacity

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Scenario I: No Excess Capacity

$40transfer

price

Auto division canpurchase 100,000batteries from anoutside supplier

for less than $40.

Auto division canpurchase 100,000batteries from anoutside supplier

for more than $40.

Transferwill notoccur.

Transferwill

occur.

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General Rule

When the selling division is When the selling division is operating at capacity, the transfer operating at capacity, the transfer

price should beprice should be set at the market price. set at the market price.

Scenario I: No Excess Capacity

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The Battery Division makes a standard 12-volt battery.The Battery Division makes a standard 12-volt battery.

Production capacityProduction capacity 300,000 units300,000 units

Selling price per batterySelling price per battery $40 (to outsiders)$40 (to outsiders)

Variable costs per batteryVariable costs per battery $18$18

Fixed costs per batteryFixed costs per battery $7 (at 300,000 units)$7 (at 300,000 units) The Battery division is currently selling 150,000 The Battery division is currently selling 150,000

batteries to outsiders at $40. The Auto Division can batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. It can use 100,000 of these batteries in its X-7 model. It can purchase them for $38 from an outside supplier. purchase them for $38 from an outside supplier.

Scenario II: Excess Capacity

What is the appropriate transfer price?

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Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity costper unit to theorganizationbecause ofthe transfer

= +

Transferprice = $18 variable

cost per battery +

Transferprice = $18 per battery

Scenario II: Excess Capacity

$0

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General Rule

When the selling division is operating When the selling division is operating below capacity, the minimum below capacity, the minimum

transfer price is the variable cost transfer price is the variable cost per unit.per unit.

So, the transfer price will be no lowerthan $18, and no higher than $38.

Scenario II: Excess Capacity

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Scenario II: Excess Capacity

Transferwill

occur.

$18transfer

price

$38transfer

price

Transferwill notoccur.

Transferwill notoccur.

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Setting Transfer Prices

The value placed on transfer goods is used The value placed on transfer goods is used to make it possible to transfer goods to make it possible to transfer goods

between divisions while allowing them to between divisions while allowing them to retain their autonomyretain their autonomy..

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Goal Congruence

Conflicts may arise between the company’s Conflicts may arise between the company’s interests and an individual manager’s interests and an individual manager’s interests when transfer-price-based interests when transfer-price-based performance measures are used.performance measures are used.

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Conflicts may be resolved by . . .may be resolved by . . .

Direct intervention by top management.Direct intervention by top management. Centrally established transfer price policies.Centrally established transfer price policies. Negotiated transfer prices.Negotiated transfer prices.

Setting Transfer Prices

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Top management may become swamped Top management may become swamped with pricing disputes causing division with pricing disputes causing division

managers to lose autonomy.managers to lose autonomy.

I just won’tpay $65 forthat part!

You really don’t have any

choice!

Setting Transfer Prices

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Now, here is what the twoof you are going to do.

Top management may become swamped Top management may become swamped with pricing disputes causing division with pricing disputes causing division

managers to lose autonomy.managers to lose autonomy.

Setting Transfer Prices

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As a general rule, a market price-based transfer pricing policy contains the following

guidelines . . .

The transfer price is usually set at a discount from the cost to acquire the item on the open market.

The selling division may elect to transfer or to continue to sell to the outside.

As a general rule, a market price-based transfer pricing policy contains the following

guidelines . . .

The transfer price is usually set at a discount from the cost to acquire the item on the open market.

The selling division may elect to transfer or to continue to sell to the outside.

Centrally EstablishedTransfer Prices

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As a general rule, a market price-based transfer pricing policy contains the following

guidelines . . .

The transfer price is usually set at a discount from the cost to acquire the item on the open market.

The selling division may elect to transfer or to continue to sell to the outside.

As a general rule, a market price-based transfer pricing policy contains the following

guidelines . . .

The transfer price is usually set at a discount from the cost to acquire the item on the open market.

The selling division may elect to transfer or to continue to sell to the outside.

Centrally EstablishedTransfer Prices

The discount dependson cost savings from

selling internally.Cost savings mayinclude items like

transportation.

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Negotiating the Transfer Price

A system where transfer prices are arrived at through negotiation between managers

of buying and selling divisions.

A system where transfer prices are arrived at through negotiation between managers

of buying and selling divisions.

Much managementtime is used in the

negotiation process.

Much managementtime is used in the

negotiation process. Negotiated price may notbe in the best interest of

overall company operations.

Negotiated price may notbe in the best interest of

overall company operations.

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Imperfect Markets

Transfer pricing can be quite complex Transfer pricing can be quite complex when selling and buying divisions cannot when selling and buying divisions cannot

sell and buy all they want in perfectly sell and buy all they want in perfectly competitive markets.competitive markets.

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Cost-Based Transfer Prices

Some companies use the following Some companies use the following measures of cost to establish transfer measures of cost to establish transfer

prices . . .prices . . . Variable costVariable cost Full absorption costFull absorption cost

Beware of treating unit fixed costs as Beware of treating unit fixed costs as variable. variable.

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An International Perspective

Since tax rates and import duties are different in different countries, companies have incentives to set transfer prices that will:

Increase revenues in low-tax countries.Increase revenues in low-tax countries.

Increase costs in high-tax countries.Increase costs in high-tax countries.

Reduce cost of goods transferred to high-Reduce cost of goods transferred to high- import-duty countries. import-duty countries.

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Behavioral Issues:Risk Aversion and Incentives

The design of a managerial performanceevaluation system using financial performance

measures involves a trade-off between:

Incentives for the manager to act inthe organization’s

interests.

Risks imposed on themanager because

financial performance measures are onlypartially controlledby the manager.

And

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Goal Congruence andInternal Control Systems

A well-designed internal control system includes a set of procedures to prevent these major lapses in responsible behavior: Fraud. Corruption. Financial Misrepresentation. Unauthorized Action.

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Let’s transfer some of yourLet’s transfer some of yourcapital to me so that my ratecapital to me so that my rate

of return will be higher!of return will be higher!