5 Measuring Performance in Investment Centers Investment Center managers make decisions that affect both profit and invested capital.Corporate HeadquartersInvestmentCenter EvaluationReturn on investment,residual income, or economic value added
9 Three ways to improve ROI Improving R0IDecreaseExpensesIncreaseSales PricesLowerInvested CapitalThree ways to improve ROI
10 Improving R0I Let’s calculate the new ROI. 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.
11 Return on Investment (ROI) IncomeSales Revenue×Invested CapitalROI =$42,000$600,000×$200,000ROI = 7% × = 21%Holly increased ROI from 15% to 21%.
12 As division manager would you ROI - 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 youinvest in this project?
13 ROI - A Major Drawback Gee . . . I thought we were supposed to do what was best for thecompany!As division manager,I wouldn’t invest inthat project becauseit would lower my pay!
14 Investment center’s minimum required rate of return Residual IncomeInvestment center profit– Investment charge= Residual incomeInvestment capital× Imputed interest rate= Investment chargeInvestment center’s minimum required rate of return
15 Residual Income Let’s calculate residual 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.
16 Investment center’s minimum required rate of return Residual IncomeInvestment center profit = $25,000– Investment charge = 20,000= Residual income = $ 5,000Investment capital = $100,000× Imputed interest rate = 20%= Investment charge = $ 20,000Investment center’s minimum required rate of return
17 Residual IncomeAs 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?
18 Residual Income Residual income encourages managers to make profitable investments that wouldbe rejected by managers using ROI.
19 Economic Value AddedEconomic value added tells us how much shareholder wealth is being created.
20 ( ) ( ) Economic Value Added Investment center’s after-tax operating income– Investment charge= Economic Value AddedWeighted average cost of capitalInvestment center’stotal assetsInvestment center’s current liabilities–()After-tax cost of debtMarket value of debtCost of equity capitalMarket value of equity()
21 Economic Value AddedThe Atlantic Division of Suncoast Food Centers reported the following results for the most recent period:Compute Atlantic Division’s economic value added.
22 First, let’s compute the weighted-average cost of capital Economic Value AddedFirst, let’s compute the weighted-average cost of capital(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)$40,000, $60,000,000=
24 Measuring Investment Capital Three issues must be considered before we can properly measure the investment capital.What assets should be included?Total assets.Total productive assets.Total assets less current liabilities.Only the assets controllable by the manager being evaluated.
25 Measuring Investment Capital Three issues must be considered before we can properly measure the investment capital.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?Should the assets be shown at historical or current cost?
26 Let’s calculate ROI using both the gross and net book values. Gross or Net Book ValueGrizzlyCo 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.
27 Gross or Net Book Value($100,000 – $0) ÷ 10 = $10,000 per year
28 Gross or Net Book Value$100,000 – $10,000 = $90,000 net book value
29 Gross or Net Book Value $15,000 ÷ $90,000 = 16.67% $15,000 ÷ $90,000 = %$15,000 ÷ $100,000 = 15%
30 Gross or Net Book ValueThe ROI increases each year using net book value even though nooperating changes take place.
31 Gross or Net Book ValueSince older assets, with lower net book values, result in higher ROI, managers are discouraged from investing in new assets.
32 Measuring Investment Center Income Division managers should be evaluated on profit margin they control.Exclude these costs:Costs traceable to the division but not controlled by the division manager.Common costs incurred elsewhere and allocated to the division.The key issue is controllability.
33 Inflation: Historical Cost versus Current-Value Accounting Use of current-value accounting impacts the amount of:Invested capital.Income.
34 Other Issues in Segment Performance Evaluation Short-run performance measures versus long-run performance measures.Importance of nonfinancial information.Market position.Product leadership.Productivity.Employee attitudes.
35 Measuring Performance in Nonprofit Organizations Since income is not the primary measure of performance in nonprofit organizations, performance measures other than ROI and residual income are used.
37 Transfer PricingThe amount charged when one division sells goods or services to another divisionBatteriesBattery DivisionAuto Division
38 A higher transfer price for batteries means . . . Transfer PricingThe transfer price affects the profit measure for both the selling division and the buying division.A higher transfer price for batteries means . . .greaterprofits for thebattery division.Battery DivisionAuto Division5
39 A higher transfer price for batteries means . . . Transfer PricingThe transfer price affects the profit measure for both the selling division and the buying division.A higher transfer price for batteries means . . .lower profits for theauto division.Battery DivisionAuto Division6
40 Goal CongruenceThe ideal transfer price allows each division manager to make decisions that maximize the company’s profit, while attempting to maximize his/her own division’s profit.
41 General-Transfer-Pricing Rule Additional outlay cost per unit incurred because goods are transferredOpportunity cost per unit to theorganization because of the transferTransferprice=+
42 Scenario I: No Excess Capacity The 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, 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?9
43 Scenario I: No Excess Capacity Additional outlay cost per unit incurred because goods are transferredOpportunity cost per unit to theorganization because of the transferTransferprice=+$22 Contribution lost if outside sales given upTransferprice$18 variable cost per battery=+Transferprice=$40 per battery
44 Scenario I: No Excess Capacity Auto division can purchase 100,000 batteries from an outside supplier for less than $40.Auto division can purchase 100,000 batteries from an outside supplier for more than $40.Transfer will not occur.Transfer willoccur.$40 transfer price10
45 Scenario I: No Excess Capacity General Rule When the selling division is operating at capacity, the transfer price should be set at the market price.17
46 Scenario II: Excess Capacity The 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, 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?9
47 Scenario II: Excess Capacity Additional outlay cost per unit incurred because goods are transferredOpportunity cost per unit to theorganization because of the transferTransferprice=+Transferprice$18 variable cost per battery=+$0Transferprice=$18 per battery
48 Scenario II: Excess Capacity General RuleWhen 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 $38.14
49 Scenario II: Excess Capacity Transfer will notoccur.Transfer will occur.Transfer will notoccur.$18 transfer price$38 transfer price10
50 Setting 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.7
51 Goal CongruenceConflicts may arise between the company’s interests and an individual manager’s interests when transfer-price-based performance measures are used.25
52 Setting Transfer Prices Conflicts may be resolved by . . .Direct intervention by top management.Centrally established transfer price policies.Negotiated transfer prices.26
53 Setting Transfer Prices Top management may become swamped with pricing disputes causing division managers to lose autonomy.I just won’tpay $65 forthat part!You reallydon’t have anychoice!27
54 Setting Transfer Prices Top management may become swamped with pricing disputes causing division managers to lose autonomy.Now, here is what the twoof you are going to do.28
55 Centrally Established Transfer Prices 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.31
56 Centrally Established Transfer Prices 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.The discount dependson cost savings fromselling internally.Cost savings mayinclude items liketransportation.31
57 Negotiating the Transfer Price A system where transfer prices are arrived at through negotiation between managers of buying and selling divisions.Much management time is used in the negotiation process.Negotiated price may not be in the best interest of overall company operations.38
58 Imperfect MarketsTransfer pricing can be quite complex when selling and buying divisions cannot sell and buy all they want in perfectly competitive markets.29
59 Cost-Based Transfer Prices Some companies use the following measures of cost to establish transfer prices . . .Variable costFull absorption costBeware of treating unit fixed costs as variable.35
60 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 costs in high-tax countries.Reduce cost of goods transferred to high- import-duty countries.40
61 Behavioral Issues: Risk Aversion and Incentives The design of a managerial performance evaluation system using financial performance measures involves a trade-off between:Incentives for the manager to act in the organization’s interests.Risks imposed on the manager because financial performance measures are only partially controlled by the manager.And36
62 Goal Congruence and Internal 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.
63 End of Chapter 13Let’s transfer some of your capital to me so that my rate of return will be higher!