1. Segment Reporting and Transfer Pricing
Module 23
Segment Reporting and Transfer Pricing

2. Segment Reports Segment Reports Follow the Organization Structure:
Cost Center – Ex.: Maintenance Department
Compare actual costs with the budget
Revenues—Ex.: Western Sales Territory
Compare actual sales with the budgeted sales
Profits—A Movie
Compare profits with the budgeted profits
Profits and Investment—Electronics, Inc. (Sub.)
Compare Ret. on Investment to required ROI

3. Terms for Costs of Segments
Variable costs
Ex: Materials usage
Direct fixed costs
FC directly traceable to segment: Segment manager
Allocated common costs
Indirect tracing of costs to a unit: share of a engineering cost by product lines on time
Unallocated common costs
Central costs of many segments: Home office should not be allocated, but some companies do…

4. Example
Profit Centers
North Territory
South Territory
Total
Sales
$16,000.
$18,000.
$34,000.
Less variable costs
(5,600)
(6,100)
(11,700)
Contribution margin
10,400.
11,900.
22,300.
Less direct fixed costs
(2,000)
(1,600)
(3,600)
Territory margin
8,400.
10,300.
18,700.
Less allocated segment costs
(1,200)
(1,400)
(2,600)
Territory income
$ 7,200.
$ 8,900.
16,100.
Less unallocated common costs
(1,500)
Net income
$14,600.
Segment margin is relevant for measuring the short-term effects of decisions to continue or discontinue a segment.
Segment income is relevant for measuring the long-term effects of decisions to continue or discontinue a segment.

5. Return on Investment (ROI)
A measure of the earnings per dollar of an investment
Assumes financing decisions are made at the corporate level
Investment center income
Investment center asset base
ROI =
Evaluated by comparing to previously identified performance criteria, such as
Overall company ROI
Budget ROI
Often rank ordered with awards of bonuses/raises to highest performers and bottom performers warned or dumped.

6. However…
High ROI divisions tend to only take on extremely high return projects resulting in slow growth.
Example:
West Texas Division has an ROI of 50% on an asset base of $20 million: Superstars—BIG Bonuses!
Now Project X12 has a promised return of 30% and requires an investment of $10 million.
If West Texas takes on the project then ROI decreases:
[50%*$20MM + 30%*$10MM]/[$20MM+$10MM)=
[$10,000,000 + $3,000,000]/$30,000,000 = 43.3%
Superstars would be less shiny!
Will West Texas Division take on this project? (Never…)
Also, West Texas would be better off to shrink any part of their organization that earns less than 50%!

7. Residual Income Residual Income is an alternative measure to ROI:
RI = Division Income – Min Rate of Return X Asset Base
West Texas:
Set required return to 15%.
Residual income before X12:
50%*$20MM – 15%*$10MM = $8,500,000
Residual income with X12:
$8,500,000 + [30%*$10 MM – 15%*$10MM]= $10,000,000
West Texas Division should expand as long as projects earn more than the required return.

8. Economic Value Added (EVA®)
Used to evaluate investment center performance
A variation of residual income
Significant differences from residual income
Weighted average cost of capital used instead of required rate of return
Net assets are used as the evaluation base
After-tax income is used as investment center income
Corrects for potential distortions in economic net income caused by GAAP
Total assets less current liabilities
An average of the after-tax cost of all long-term borrowing and the cost of equity financing

9. The West Texas Division added $4,500,000 in value to AST Distributors.
Economic Value Added
AST Distributors has an 10% cost of capital and a 40% income tax rate. Amounts for the West Texas Division for 2012 are:
Assets
$20,000,000
Division income
$ 10,000,000
Current liabilities
$ 5,000,000
EVA = Division income after tax - Cost of capital x (Assets – Current Liabilities]
= ($10,000,000×( ) – ×($20,000,000–$5,000,000) =
= $6,000,000 - $1,500,000 = $4,500,000
The West Texas Division added $4,500,000 in value to AST Distributors.

10. Balanced Scorecard In general: “We get what we measure”
With ROI, Residual Income, EVA we tend to get short-term behaviors!
Long-term performance requires customer relations, new products, well trained & loyal employees…
Balanced Scorecard: A comprehensive performance measurement system that includes financial measures and measures related to:
Customers
Internal processes
Innovation and learning

11. Examples of Key Indicators
Key financial indicators
Cost, Revenue, Profit, or Cash Flow
Return on investment (ROI), Residual Income,
or Economic Value Added
Key customer indicators
Average customers per hour
Number of customer complaints per period
Number of sales returns per period
Key operating indicators
On-time delivery
Quality of units produced
Employee turnover per period
Key growth and innovation indicators
New products introduced during period
Products discontinued during period
Number of sales promotions
Special offers, discounts, etc.

12. Transfer Pricing
The transfer price is an internal value assigned a product or service that one division provides to another.
Normally occurs between profit or investment centers
Higher transfer prices result in:
More profits to the selling divisions and less to the buying divisions
Lower volume and profit for company as a whole
Transfer prices may be based on market prices (where available) or costs, or they may be negotiated.

13. Market Price as the Transfer Price
Best method of setting transfer prices, if there is an existing market with established prices for internal products, BUT most often there is not an established market.
Preserves divisional autonomy and leads divisions to act in a manner that maximizes corporate profits
Assuming divisions are free to buy and sell outside the firm
Often specified as market price minus a discount when selling and administrative costs are lower on transfers.

14. Cost Plus Markup as Transfer Price
Allows supplying divisions to increase earnings
May result in some undesired behavior:
Passing along inefficiencies, no penalty for inefficiency
Stifle buyers’ demand and profits in low volume periods
Supplying divisions tend to have higher ROI than buying divisions…
Variations on “cost” and “markup”: variable only, standardized, total costs including administration, dual transfer price (e.g. VC and FC+MU%), opportunity costs, fixed fees versus % markup

15. Negotiated Price as the Transfer Price
Supplying and buying divisions agree on a price through negotiation
Use for relatively few transfers with similar powered negotiators
Divisions should be free to withdraw and go elsewhere