W. BentzEMBA 8021 Agenda Today Consider measures of profitability in terms of purpose, strengths and...

W. Bentz EMBA 802 1

Agenda TodayAgenda Today

• Consider measures of profitability in terms of purpose, strengths and weaknesses

• Introduce some reporting issues from chapter 12 as time permits

• Outline basic transfer pricing issues as time permits

W. Bentz EMBA 802 2

The Organization as a System of Interrelated Elements

W. Bentz EMBA 802 3

Economic PerformanceEconomic Performance

• In recorded history to date, the most limited resource has been capital.– Developing companies need capital

(unless they can sell the .com connection!)

– Undercapitalization is the leading cause of failure among small businesses.

– Developing countries are severely limited by a lack of capital.

W. Bentz EMBA 802 4

Economic PerformanceEconomic Performance

– Japan’s progress in the economic development race can be attributed to the financing of industry by patient banks and very high savings rates across the entire population. Excessive emphasis on growth and leverage have caused significant problems in recent history, but the emergence of Japan as an economic power is impressive nevertheless. The wealth of nations is a big deal.

W. Bentz EMBA 802 5

Dimensions of Economic Perf.Dimensions of Economic Perf.

• Purchasing power return per dollar invested (i.e., return from the most scarce resource)

• Risk of expected returns on investment (business risk and financial risk)

• Timing of the expected returns (time value of money and opportunity to recycle the purchasing power)

W. Bentz EMBA 802 6

The Performance IssueThe Performance Issue

• Guide, encourage and reward executive performance to achieve economic results that are accepted by current and prospective owners.– Strategic alignment– Shareholder value– Prudent risks– Avoid pitfalls of sunk costs, status-quo,

risk-avoidance, etc.

W. Bentz EMBA 802 7

Has the problem changed?Has the problem changed?

• Yes, the pace of innovation and change has increased with all the associated risks.

• Yes, global markets greatly increase the risks to local companies and to companies that once operated as local monopolies.

W. Bentz EMBA 802 8

Has the problem changed?Has the problem changed?• Yes, deregulation in telecommunications,

transportation, electricity generation, natural gas, interest rates, and other areas increases competition and risk. The next battleground will be financial services.

• Yes, governments are less concerned about monopolistic practices and abuses. Therefore, the rate of consolidation has accelerated almost across the board.

W. Bentz EMBA 802 9

The ObjectiveThe Objective

• Increased shareholder value– Actions– Plans– Communication

• Greater strategic focus

• Attention to job by executives

W. Bentz EMBA 802 10

Key ConceptsKey Concepts

• Cost of capital is the cash flow required to compensate investors for the riskiness of the business given the amount of capital invested.– Measuring the minimum required is not

so clear in the case of equity.– Investors appear to buy growth,

especially steady growth, even in the absence of current cash flow.

– Buybacks, dividends, splits, are relevant


Creating Shareholder ValueCreating Shareholder Value

• The EVA theory is that the firm creates shareholder value by investing in projects that earn more than the cost of capital, thus creating a “surplus.” This is consistent with the notion of investing in projects with a positive net present value, even if the firm continues to invest until the marginal return on investment equals the cost of capital.


Market Value AddedMarket Value Added

• Market value added is the difference between what investors have invested in a firm, and the market value (stocks, bonds, options, etc.) of that firm. This is the cumulative amount investors have contributed to the firm directly, not what they happened to have paid for their own stocks and bonds. It is a entity measure of performance.


MVA & CapitalMVA & Capital

• MVA = [market value of equity + market value of preferred shares + market value of debt] - total invested capital

• Assets = Liabilities + Owners’ Equity

• Assets = Liabilities + [Invested capital + Retained earnings (earned capital)]


Stern & Stewart’s EVAStern & Stewart’s EVA®®

• To get invested capital, S&S– allude to some 164 equity “adjustments”– address 20-25 in some detail– use around 5 adjustments in actual

practice



• More defensible ones include– R&D (add back and amortize)– LIFO (add reserve amount = FIFO -

LIFO)– Deferred taxes (add back amount)– Goodwill (add back cumulative

amortization)



• For their measure of return, S&S refer to NOPAT, net operating profit after tax

• We would call this “income from operations (adjusted) after tax”, but IFOAT is not as marketable.



• To their credit, S&S now recognize the impact of the above adjustments on “capital” as having a corresponding impact on NOPAT



• Start with income from operations

+ current R&D expense

- amortization of cumulative R&D

+ increase (decrease) in LIFO reserve

+ increase (decrease) in deferred taxes


• The good news--most positive actions should lead to an improvement in EVA, just as they would result in an increase in residual income.– Increase throughput and the utilization of

assets.– Disposal of excess assets– Find and implement projects earning at

least the cost of capital– Focus on more profitable products



• The not-so-good news--most positive actions that lead to the improvement of EVA also lead to the improvement in residual income.

• The incremental value of EVA does not appear to justify the hype and cost

• Many of the adjustments considered by S&S end up being more arbitrary than current financial reporting standards.


Investment CentersInvestment Centers

• See profit centers

• Probable additional controllable factors

–Investment in current operating assets

–Investment in plant & equipment


Investment CentersInvestment Centers

• Challenges–Allocation of common assets

• Cash

• Receivables

• Warehouse space

• Transportation resources

–Valuation of investment• Inflation and currency effects


Invest.Centers (Cont.)Invest.Centers (Cont.)

• Examples–Lazarus store in City Center

Mall

–Marysville Honda plant

–EDS processing centers


DivisionsDivisions

• Investment centers with broad responsibilities

• Not necessarily large entities when business units

• Associated with more decentralized control

• Financial controls dominate,

• Equivalent of large corporations


Transfer PricingTransfer Pricing

• A transfer price is the price at which a product or service is transferred from one entity to another entity within the same firm.

• Significant issue in international sales

• The pricing of transfers is necessary to simulate market forces on profit centers, investment centers and divisions.


Transfer Pricing f(decentralization)Transfer Pricing f(decentralization)

• Purposes– Decentralize managerial responsibilities to

local managers.– Provide managerial incentives to operating

executives– Distribute overall profitability among

contributing entities– Distribute overall profitability among taxing

entities– Isolate efficiency effects in the responsible

unit.

27 EMBA 802 W. Bentz

Linkage Example

Corporate

VPManufacturing

Plant Manager

DepartmentManager

ProcessDrivers

Return on Assets

Inventory days

Output/ equipment

$Output/square foot occupied

Manufacture cycle time

Finished goods inventory days

Days vendor lead time

Machine downtime

Percentage good output/total output

Number unplanned schedule changes

Defective subassembly

Parts availability Wait on QC

No manpower

Changeover times

Power failure

11-17 1996 Prentice Hall Business Publishing Management Accounting, 2nd ed., Atkinson, Banker, Kaplan, and Young


Transfer Pricing MethodsTransfer Pricing Methods

• Incremental cost (economic theory)

• Full cost (Where’s the profit?)

• Full cost plus a profit

• Negotiated price (Non-value)

• Administered price

• Market-based price


Transfer Price = Internal PriceTransfer Price = Internal Price

Primary or inter-mediate producer

Intermediate Producer or Distributor

External Customer

Transfer price

Final price

Corporate Entity


Note!!Note!!

• The selling division’s “price” is the buying division’s cost for divisional performance measurement purposes.

• Production mix and volume decisions are incremental analysis-type decisions in a multi-entity context.

W. BentzEMBA 8021 Agenda Today Consider measures of profitability in terms of purpose, strengths and...

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