1. Investment Centers and Transfer Pricing
Chapter 13
Investment Centers
and Transfer Pricing
Chapter 13: Investment Centers and Transfer Pricing
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. Delegation of Decision Making (Decentralization)
Decision-Making is pushed down.
As organizations grow, decision-making must be pushed down to lower level managers.
Organizations often decentralize into subunits to take advantage of the specialized skills and talents of their sub-managers. (LO1)
Decentralization often occurs as organizations continue to grow.
13-2

3. Advantages Decentralization
Allows organization to respond more quickly to events.
Uses specialized knowledge and skills of managers.
Some of the advantages of pushing decision-making down to lower level managers are: it allows managers to respond more quickly to events, it uses the skills of those managers, and it frees upper management to focus on long-term planning and other strategic goals. (LO1)
Frees top management from day-to-day operating activities.
13-3

4. Challenge Decentralization Goal Congruence: Managers of the subunits
make decisions that achieve top-management goals.
The challenge, for a decentralized organization, is to induce managers to behave in a manner that achieves organizational goals, rather than focusing on the goals of the subunit. (LO1)
13-4

5. Return on Investment (ROI)
Income
Invested Capital
ROI =
Income
Sales Revenue ×
Invested Capital
Sales
Margin
Capital Turnover
Return on investment is calculated by simply dividing the investment center’s net income by the amount invested in the division.
The ROI figure can be broken into two insightful measurements, the center’s sales margin and the turnover ratio. (LO2)
13-5

6. Return on Investment (ROI)
Holly Company reports the following:
Income $ 30,000
Sales Revenue $ 500,000
Invested Capital $ 200,000
Here is an example of the return on investment calculation.
Holly Company had income of $30,000; Sales of $500,000; and the investment was $200,000. (LO2)
Let’s calculate ROI.
13-6

7. Return on Investment (ROI)
Income
Sales Revenue ×
Invested Capital
ROI =
$30,000
$500,000 ×
$200,000
The margin is calculated by taking Holly’s net income and dividing it by its sales.
The turnover is calculated by dividing sales by the amount the parent company has invested in Holly.
When we multiply the two, we get the ROI, or return on investment.
In this example, Holly had a margin of 6% and a turnover of 2.5.
The resulting ROI is 15%.
A margin of 6% means that Holly made 6 cents in net income for every dollar of sales revenue.
The turnover of 2.5 means that every dollar invested in Holly produced 2.5 times that, or, $2.50 worth of sales for each dollar invested.
When the margin is multiplied times the turnover, we get an ROI of 15%, which means that, each dollar invested in Holly produced 15 cents worth of net income. (LO2)
ROI = 6% × = 15%
13-7

8. Economic Value Added
Economic value added tells us how much shareholder wealth is being created.
Economic value added is another investment center performance measure. It measures how much shareholder wealth is being created. (LO2)
13-8

9. ( ) ( ) 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  ( ) 
To calculate the EVA measure, we take the operating income less the charge for the investment.
The charge for the investment is calculated by multiplying the net worth of the division, assets minus liabilities, times the weighted-average cost of capital.
The weighted-average cost of capital is calculated by taking the cost of debt times the value of the debt and adding it to the cost of equity times the market value of the equity.
This result is then divided by the market value of debt plus the market value of equity.
Study the formulas on the slide carefully. (LO2)
13-9

10. Three ways to improve ROI
Improving R0I
Decrease
Expenses
Increase
Sales Prices
Lower
Invested Capital
Several things that managers can do to improve their investment center’s ROI are; increase their sales price, decrease their center’s expenses, or decrease the amount invested in the subunit. (LO3)
Three ways to improve ROI
13-10

11. 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?
Would you, as the manager of Flower Co., accept the investment? (LO4)
13-11

12. Residual Income Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
Since the investment returns more than the cost of the investment, it is considered an acceptable investment, even if it does not meet the ROI that is currently being achieved. (LO4)
13-12

13. Gross or Net Book Value ($100,000 – $0) ÷ 10 = $10,000 per year
Depreciation on the asset is straight-line. Since there is no salvage value on the asset, depreciation is calculated by taking the cost and dividing it by the ten-year life.
Book value is calculated by subtracting the accumulated depreciation from the original, or historical cost of the asset. (LO5)
$100,000 – $10,000 = $90,000 net book value
13-13

14. Gross or Net Book Value $15,000 ÷ $90,000 = 16.67%
$15,000 ÷ $90,000 = %
Notice how the returns differ considerably when using different values for the asset.
When using original cost, the return differs only if the operating profit differs.
When using the book value of the asset in the computation, the return continues to increase over the life of the asset.
Older assets tend to bring increased ROI’s, which can discourage managers from investing in newer, modern assets. (LO5)
$15,000 ÷ $100,000 = 15%
Since older assets, with lower net book values, result in higher ROI, managers are discouraged from investing in new assets.
13-14

15. 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.
Performance of division managers should be measured only on the assets that they can control.
Division performance should not be measured using shared or allocated costs. (LO5)
The key issue is controllability.
13-15

16. A higher transfer price for batteries means . . .
Transfer Pricing
The transfer price affects the profit measure for both the selling division and the buying division.
A higher transfer price for batteries means . . .
Transfer pricing occurs when one division transfers its product or service to a second division.
Here the battery division transfers batteries to the auto division.
The transfer price affects the profit for both the selling and the buying divisions.
Higher prices on the transferring division results in higher profits for it.
The receiving division has lower profits due to the higher cost. (LO6)
Battery Division
greater
profits for the
battery division.
Auto Division
lower profits for the
auto division.
13-16 5

17. 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.
Management’s objective in setting a transfer price is to encourage goal congruence among the division managers involved in the transfer.
The ideal situation maximizes both the operating division and the parent company’s profit. (LO6)
13-17

18. General-Transfer-Pricing Rule
Additional outlay cost per unit incurred because goods are transferred
Opportunity cost per unit to the
organization because of the transfer
Transfer
price = +
The general transfer price rule transfers goods at the additional costs incurred plus the opportunity cost of the transfer. (LO6)
13-18

19. 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.
Upper management can set transfer pricing policies.
A market based transfer price policy is usually discounted from the actual cost to acquire the item on the open market.
Also, the selling division should retain the ability to sell outside the company.
The amount of the discount depends on costs that can be saved by buying internally.
For example, internal buyers would not need fancy packaging, instruction sheets, or incur usual transportation costs. (LO7)
13-19 31

20. 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.
Managers can negotiate their internal transfer price.
Sometimes the negotiating skills of one manager are better than another manager, negotiating takes time, and might not be in the best interests of the parent company.
Transfer pricing can be quite complex when selling and buying divisions cannot sell and buy all they want in perfectly competitive markets.
A problem with market based pricing is that sometimes the market is not perfect.
For example, Heavy Sports Utility Vehicles (SUV) are popular when gas prices are low, but when gas prices rise, SUV sales drop, thus lowering their prices. (LO7)
Negotiated price may not be in the best interest of overall company operations.
13-20 38

21. Cost-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 variable.
A cost-based transfer price might be the answer to an imperfect market.
Costs can range between the variable cost to a full absorption cost. (LO7)
13-21 35

22. 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.
The designer of a performance-evaluation system for responsibility-center managers must consider many factors.
Trade-offs often must be made between competing objectives.
The overall objective is to achieve goal congruence by providing incentives for managers to act in the best interests of the organization as a whole. (LO8)
And
13-22 36

23. 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.
Most business professionals have high ethical standards.
A well-designed internal control system is designed to help keep them that way by preventing major lapses in responsible behavior. (LO8)
13-23