Copyright © 2008 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 © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 1

Decision Making is pushed down. Delegation of Decision Making (Decentralization) Decentralization often occurs as organizations continue to grow.

Decentralization Advantages Allows organization to respond more quickly to events. Frees top management from day-to-day operating activities. Uses specialized knowledge and skills of managers.

Decentralization Challenge Goal Congruence: Managers of the subunits make decisions that achieve top-management goals.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 2

Measuring Performance in Investment Centers Investment Center managers make decisions that affect both profit and invested capital. Investment Center managers make decisions that affect both profit and invested capital. Corporate Headquarters Investment Center Evaluation Return on investment, residual income, or economic value added

Return on Investment (ROI) ROI = Income Invested Capital ROI = Income Sales Revenue × Invested Capital Sales Margin Sales Margin Capital Turnover

Holly Company reports the following: Income $ 30,000 Sales Revenue$ 500,000 Invested Capital$ 200,000 Let’s calculate ROI. Return on Investment (ROI)

ROI = Income Sales Revenue × Invested Capital Return on Investment (ROI) ROI = $30,000 $500,000 × $200,000 ROI = 6% × 2.5 = 15%

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

Economic Value Added Investment center’s after-tax operating income – Investment charge = Economic Value Added Weighted average cost of capital  Investment center’s total assets Investment center’s current liabilities – () After-tax cost of debt Market value of debt Cost of equity capital Market value of equity  (() ) Market value of debt Market value of equity  

Economic Value Added The Atlantic Division of Suncoast Food Centers reported the following results for the most recent period: Compute Atlantic Division’s economic value added.

Economic Value Added (9% × (1 – 30%) × $40,000,000) + (12% × $60,000,000) $40,000,000 + $60,000,000 = First, let’s compute the weighted-average cost of capital

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) × = $4,315,680 = $6,750,000 × (1 – 30%)

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 3

Improving R0I Three ways to improve ROI Ê Increase Sales Prices Sales Prices Ë Decrease Expenses Expenses Ì Lower Invested Capital Invested Capital

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. Improving R0I

ROI = Income Sales Revenue × Invested Capital Return on Investment (ROI) ROI = $42,000 $600,000 × $200,000 ROI = 7% × 3.0 = 21% Holly increased ROI from 15% to 21%.

ROI - 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 invest in this project?

As division manager, I wouldn’t invest in that project because it would lower my pay! ROI - A Major Drawback Gee... I thought we were supposed to do what was best for the company!

Residual Income Investment center profit – Investment charge = Residual income Investment capital × Imputed interest rate = Investment charge Investment center’s minimum required rate of return

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.

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’s minimum required rate of return

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Residual 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?

Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 5

Issues: Measuring Investment Capital Three issues must be considered before we can properly measure the investment capital: Ê What assets should be included? –Total assets. –Total productive assets. –Total assets less current liabilities. –Only the assets controllable by the manager being evaluated.

Measuring Investment Capital The Second Issue Ë 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? Ì Should the assets be shown at historical or current cost?

Gross 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.

Gross or Net Book Value ($100,000 – $0) ÷ 10 = $10,000 per year

Gross or Net Book Value $100,000 – $10,000 = $90,000 net book value

Gross or Net Book Value $15,000 ÷ $100,000 = 15% $15,000 ÷ $90,000 = 16.67%

Since older assets, with lower net book values, result in higher ROI, managers are discouraged from investing in new assets. Gross or Net Book Value

Measuring Investment Center Income Division managers should be evaluated on profit margin they control. –Exclude these costs: l Costs traceable to the division but not controlled by the division manager. l Common costs incurred elsewhere and allocated to the division. The key issue is controllability.

Inflation: Historical Cost versus Current-Value Accounting Use of current-value accounting impacts the amount of: Ê Invested capital. Ë Income.

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.

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.

Transfer Pricing Let’s change topics!

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 6

Transfer Pricing The amount charged when one division sells goods or services to another division Battery DivisionAuto Division Batteries

The transfer price affects the profit measure for both the selling division and the buying division. A higher transfer price for batteries means... greater profits for the battery division. Auto DivisionBattery Division Transfer Pricing

lower profits for the auto division. The transfer price affects the profit measure for both the selling division and the buying division. Auto DivisionBattery Division Transfer Pricing A higher transfer price for batteries means...

Goal Congruence The 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.

General-Transfer-Pricing Rule Transfer price Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer = +

The Battery Division makes a standard 12-volt battery. Production capacity300,000 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 Capacity What is the appropriate transfer price?

Transfer price Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer = + Transfer price = $18 variable cost per battery + $22 Contribution lost if outside sales given up Transfer price = $40 per battery Scenario I: No Excess Capacity

$40 transfer price 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 will occur.

General Rule When the selling division is operating at capacity, the transfer price should be set at the market price. Scenario I: No Excess Capacity

The Battery Division makes a standard 12-volt battery. Production capacity300,000 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 Capacity What is the appropriate transfer price?

Transfer price Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer = + Transfer price = $18 variable cost per battery + Transfer price = $18 per battery Scenario II: Excess Capacity $0

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 lower than $18, and no higher than $39. Scenario II: Excess Capacity

Transfer will occur. $18 transfer price $39 transfer price Transfer will not occur. Transfer will not occur.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 7

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.

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

Conflicts may be resolved by... Ê Direct intervention by top management. Ë Centrally established transfer price policies. Ì Negotiated transfer prices. Setting Transfer Prices

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 Prices

Now, here is what the two of you are going to do. Top management may become swamped with pricing disputes causing division managers to lose autonomy. Setting Transfer Prices

As a general rule, a market price-based transfer pricing policy contains the following guidelines... Ê The transfer price is usually set at a discount from the cost to acquire the item on the open market. Ë 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... Ê The transfer price is usually set at a discount from the cost to acquire the item on the open market. Ë The selling division may elect to transfer or to continue to sell to the outside. Centrally Established Transfer Prices

As a general rule, a market price-based transfer pricing policy contains the following guidelines... Ê The transfer price is usually set at a discount from the cost to acquire the item on the open market. Ë 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... Ê The transfer price is usually set at a discount from the cost to acquire the item on the open market. Ë The selling division may elect to transfer or to continue to sell to the outside. Centrally Established Transfer Prices The discount depends on cost savings from selling internally. Cost savings may include items like transportation.

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.

Imperfect Markets Transfer pricing can be quite complex when selling and buying divisions cannot sell and buy all they want in perfectly competitive markets.

Cost-Based Transfer Prices Some companies use the following measures of cost to establish transfer prices... –Variable cost –Full absorption cost l Beware of treating unit fixed costs as variable.

An International Perspective Since tax rates and import duties are different in different countries, companies have incentives to set transfer prices that will: Ê Increase revenues in low-tax countries. Ë Increase costs in high-tax countries. Ì Reduce cost of goods transferred to high- import-duty countries.

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. And

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.

End of Chapter 13 Let’s transfer some of your capital to me so that my rate of return will be higher!