Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Investment Centers

and Transfer Pricing

Investment Centers

and Transfer Pricing

Chapter 13

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

1

Learning Objective

1

S u p erv iso r S u p erv iso r

M id d leM a na ge m e nt

S u p erv iso r S u p erv iso r

M id d leM a na ge m e nt

T opM a na ge m e nt

Decision Makingis pushed down.

Delegation of Decision MakingDelegation of Decision Making(Decentralization)(Decentralization)

Decentralization often occurs as organizations continue to grow.

13-3

13-4

DecentralizationDecentralization

AdvantagesAllows organization

to respond morequickly to events.

Frees top managementfrom day-to-day

operating activities.

Uses specializedknowledge and

skills of managers.

13-5

DecentralizationDecentralization

ChallengeGoal Congruence:

Managers of the subunits make decisions that achieve

top-management goals.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

2

Learning Objective

2

13-7

Measuring PerformanceMeasuring Performancein Investment Centersin 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

13-8

Return on Return on InvestmentInvestment (ROI) (ROI)

ROI = Income

Invested Capital

ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

SalesMargin

SalesMargin

CapitalTurnover

CapitalTurnover

13-9

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 Return on InvestmentInvestment (ROI) (ROI)

13-10

ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

Return on Return on InvestmentInvestment (ROI) (ROI)

ROI = $30,000

$500,000×

$500,000$200,000

ROI = 6% × 2.5 = 15%

13-11

Economic Value AddedEconomic Value Added

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

13-12

Economic Value AddedEconomic 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

13-13

Economic Value AddedEconomic 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.

13-14

Economic Value AddedEconomic 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

13-15

Economic Value AddedEconomic 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%)

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

3

Learning Objective

3

13-17

Improving R0IImproving R0I

Three ways to improve ROI

IncreaseIncrease SalesSales Prices Prices

DecreaseDecrease ExpensesExpenses

LowerLower InvestedInvested Capital Capital

13-18

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

• There was no change in invested capital.

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

Improving R0IImproving R0I

13-19

ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

Return on Return on InvestmentInvestment (ROI) (ROI)

ROI = $42,000

$600,000×

$600,000$200,000

ROI = 7% × 3.0 = 21%

Holly increased ROI from 15% to 21%.

13-20

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

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

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

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

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

13-21

Residual IncomeResidual Income

Investment center profit– Investment charge = Residual income

Investment capital× Imputed interest rate= Investment charge

Investment center’sminimum required

rate of return

13-22

Residual IncomeResidual Income

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

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

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

13-23

Residual IncomeResidual 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

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

4

Learning Objective

4

13-25

Residual IncomeResidual Income

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

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

13-26

Residual IncomeResidual 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.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

5

Learning Objective

5

13-28

Issues: Measuring Investment Issues: Measuring Investment CapitalCapital

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

capital: What assets should be included?

1. Total assets.

2. Total productive assets.

3. Total assets less current liabilities.

4. Only the assets controllable by the manager being evaluated.

13-29

Measuring Investment CapitalMeasuring Investment Capital

The Second Issue

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

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

13-30

Gross or Net Book ValueGross or Net Book Value• GrizzlyCo is considering an investment that is

projected to produce operating profits of $25,000 before depreciation for the next three years.

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

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

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

13-31

Gross or Net Book ValueGross 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

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

13-32

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 ValueGross or Net Book Value

$15,000 ÷ $100,000 = 15%

$15,000 ÷ $90,000 = 16.67%

Since older assets, with lower net bookvalues, result in higher ROI, managers are

discouraged from investing in new assets.

13-33

Measuring InvestmentMeasuring InvestmentCenter IncomeCenter Income

Division managers should be evaluated on profit margin they control.– 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.

13-34

Inflation: Historical Cost versusInflation: Historical Cost versusCurrent-Value AccountingCurrent-Value Accounting

Use of current-value accounting impacts the amount of:

1. Invested capital.

2. Income.

13-35

Other Issues in Segment Other Issues in Segment Performance EvaluationPerformance Evaluation

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

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

13-36

Measuring Performance in Measuring Performance in Nonprofit OrganizationsNonprofit 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.

13-37

Transfer PricingTransfer Pricing

Let’s change topics!

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

6

Learning Objective

6

13-39

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

A higher transferprice for batteries

means . . .

greaterprofits for the

battery division.

Auto DivisionBattery Division

Transfer PricingTransfer Pricing

lower profitsfor the

auto division.

13-40

Goal CongruenceGoal 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.

13-41

General-Transfer-Pricing RuleGeneral-Transfer-Pricing Rule

Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity costper unit to theorganizationbecause ofthe transfer

= +

13-42

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

Production capacity 300,000 units

Selling price per battery $40 (to outsiders)

Variable costs per battery $18

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

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

Scenario I: No Excess CapacityScenario I: No Excess Capacity

What is the appropriate transfer price?

13-43

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 CapacityScenario I: No Excess Capacity

13-44

Scenario I: No Excess CapacityScenario 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.

13-45

General Rule

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

be set at the market price.

Scenario I: No Excess CapacityScenario I: No Excess Capacity

13-46

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

Production capacity 300,000 units

Selling price per battery $40 (to outsiders)

Variable costs per battery $18

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

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

Scenario II: Excess CapacityScenario II: Excess Capacity

What is the appropriate transfer price?

13-47

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 CapacityScenario II: Excess Capacity

$0

13-48

General Rule

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

variable cost per unit.

So, the transfer price will be no lowerthan $18, and no higher than $39.

Scenario II: Excess CapacityScenario II: Excess Capacity

13-49

Scenario II: Excess CapacityScenario II: Excess Capacity

Transferwill

occur.

$18transfer

price

$39transfer

price

Transferwill notoccur.

Transferwill notoccur.

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

7

Learning Objective

7

13-51

Setting Transfer PricesSetting Transfer Prices

The value placed on transfer goods is used to make it possible to transfer goods between divisions while allowing them to

retain their autonomy.

13-52

Goal CongruenceGoal Congruence

Conflicts may arise between the company’s interests and an individual manager’s interests

when transfer-price-based performance measures are used.

13-53

Conflicts may be resolved by . . .

1. Direct intervention by top management.

2. Centrally established transfer price policies.

3. Negotiated transfer prices.

Setting Transfer PricesSetting Transfer Prices

13-54

Top management may become swamped with pricing disputes causing division

managers to lose autonomy.

I just won’t

pay $65 for

that part!

You really don’t have any

choice!

Setting Transfer PricesSetting Transfer Prices

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

13-55

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

following guidelines . . .

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

2. 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 . . .

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

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

Centrally EstablishedCentrally EstablishedTransfer PricesTransfer Prices

13-56

Negotiating the Transfer PriceNegotiating 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.

13-57

Cost-Based Transfer PricesCost-Based Transfer Prices

Some companies use the following measures of cost to establish transfer

prices . . .– Variable cost– Full absorption cost

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

13-58

An International PerspectiveAn International Perspective

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

1. Increase revenues in low-tax countries.

2. Increase costs in high-tax countries.

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

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Learning Objective

8

Learning Objective

8

13-60

Behavioral Issues:Behavioral Issues:Risk Aversion and IncentivesRisk 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

13-61

Goal Congruence andGoal Congruence andInternal Control SystemsInternal 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.

13-62

End of Chapter 13End of Chapter 13

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!