Investment Centers and Transfer Pricing CHAPTER 13 Copyright © 2015 McGraw-Hill Education. All...

Investment Centers and Transfer Pricing

CHAPTER 13

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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 Making(Decentralization)

Decentralization often occurs as organizations continue to grow.

13-2

DecentralizationDecentralization

AdvantagesAllows organization

to respond morequickly to events.

Frees top managementfrom day-to-day

operating activities.

Uses specializedknowledge and

skills of managers.

13-3

DecentralizationDecentralization

ChallengeGoal Congruence:

Managers of the subunits make decisions that achieve

top-management goals.

13-4

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

13-5

Return on Investment (ROI)Return on Investment (ROI)

ROI = IncomeInvested Capital

ROI = Income

Sales Revenue×

Sales RevenueInvested Capital

SalesMargin

SalesMargin

CapitalTurnover

CapitalTurnover

13-6


Holly Company reports the following:

Income $ 30,000Sales Revenue $ 500,000Invested Capital $ 200,000

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

13-7

ROI = Income

Sales Revenue×



ROI = $30,000

$500,000×

$500,000$200,000

ROI = 6% × 2.5 = 15%

13-8

Economic Value AddedEconomic Value Added

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

13-9

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

Weighted-average

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

13-10

Improving R0IImproving R0I

Three ways to improve ROI

IncreaseIncreaseSalesSalesPricesPrices

DecreaseDecrease ExpensesExpenses

LowerLower InvestedInvested Capital Capital

13-11

Improving R0IImproving R0I

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.

13-12

ROI = Income

Sales Revenue×



ROI = $42,000

$600,000×

$600,000$200,000

ROI = 7% × 3.0 = 21%

Holly increased ROI from 15% to 21%.

13-13

ROI - A Major DrawbackROI - A Major DrawbackAs 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?

13-14

Residual IncomeResidual Income Investment center profit– Investment charge = Residual income

Investment capital× Imputed interest rate= Investment charge

Investment center’sminimum required

rate of return13-15

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.

13-16

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 return13-17

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?

13-18

Residual IncomeResidual IncomeResidual 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.

13-19

Issues: Measuring Investment Issues: Measuring Investment CapitalCapital

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

capital:

1. What assets should be included? a. Total assets b. Total productive assets. c. Total assets less current liabilities. d. Only the assets controllable by the

manager being evaluated.

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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.

13-21

Measuring Performance in Nonprofit Measuring Performance in Nonprofit OrganizationsOrganizations

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.

13-22

Transfer PricingTransfer Pricing

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 Divisionlower profits

for theauto division.

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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.

13-24

General-Transfer-Pricing RuleGeneral-Transfer-Pricing Rule

Transferprice

Additional outlaycost per unit

incurred becausegoods aretransferred

Opportunity costper unit to theorganizationbecause ofthe transfer

= +

13-25

Scenario I: No Excess CapacityScenario I: No Excess CapacityThe Battery Division makes a standard 12-volt

battery.Production capacity 300,000 unitsSelling price per battery $40 (to outsiders)Variable costs per battery $18Fixed 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.

What is the appropriate transfer price?13-26

Transferprice




= +

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

13-27


$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.

13-28


General Rule

When the selling division is operating at capacity, the transfer price should be set at the market price.

13-29

Scenario II: Excess CapacityScenario II: Excess CapacityThe Battery Division makes a standard 12-volt

battery.Production capacity 300,000 unitsSelling price per battery $40 (to outsiders)Variable costs per battery $18Fixed 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.

What is the appropriate transfer price?13-30

Transferprice




= +

Transferprice = $18 variable

cost per battery +

Transferprice = $18 per battery

Scenario II: Excess CapacityScenario II: Excess Capacity

$0

13-31


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.

13-32


Transferwill

occur.

$18transfer

price

$39transfer

price



13-33

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.

13-34

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.

13-35

Setting Transfer PricesSetting Transfer PricesConflicts may be resolved by . . .

1. Direct intervention by top management.2. Centrally established transfer price

policies.3. Negotiated transfer prices.

13-36

Setting Transfer PricesSetting Transfer PricesTop 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!Now, here is what the two

of you are going to do.

13-37

Centrally EstablishedCentrally EstablishedTransfer PricesTransfer Prices

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.

13-38

Negotiating the Transfer PriceNegotiating the Transfer PriceA 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. 13-39

Cost-Based Transfer PricesCost-Based Transfer Prices

Some companies use the following measures of cost to establish

transfer prices . . .Variable 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 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.

13-41

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!

13-42

Investment Centers and Transfer Pricing CHAPTER 13 Copyright © 2015 McGraw-Hill Education. All...

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Transcript of Investment Centers and Transfer Pricing CHAPTER 13 Copyright © 2015 McGraw-Hill Education. All...