CHAPTER 11

INVESTMENT CENTER PERFORMANCE EVALUATION Questions, Exercises, Problems, and Cases: Answers and Solutions 11.1 11.2 See text or glossary at the end of the book. Transfer prices exist in centralized organizations to record the transfer of goods and services from one unit to another for the same reasons such organizations allocate costs (e.g., inventory valuation, cross department monitoring!. #arket based transfer pricing is considered optimal under many circumstances, because it preserves divisional autonomy, yet encourages division managers to make economically optimal decisions for the company, $hen divisions operate at capacity. The limitations of market based transfer prices exist $hen the market price does not reflect the opportunity cost of the goods and services, for example if idle capacity is present. &lso, temporary short run fluctuations in market prices could lead to suboptimal long run decisions. 'ut the key limitation is that market prices are often not readily available. The advantages of a centrally administered transfer price are that it promotes short run profits by ensuring proper action by divisional managers and allo$s division managers to maintain their autonomy. The disadvantages of such a transfer price are that top management $ill become too involved in pricing disputes, and that division managers $ill lose flexibility in their decision making. The company also loses the other advantages of decentralization. *ompanies often use prices other than market prices for interdivisional transfers because (1! market prices may not be available, (2! market prices can lead to suboptimal behavior $hen the supplier division has idle capacity, or ("! the company is not other$ise indifferent bet$een internal and external buying. The disadvantages of a negotiated transfer price system are that a great deal of management effort may be used on the negotiating process and that the negotiated price may be based more upon the manager,s ability to negotiate rather than other factors.

11."

11.%

11.(

11.)

11.+

11 1

Solutions

11.-

This occurs $hen the benefits of an action to one division are more than offset by harmful effects to another division. .or example, the sale of a critical component by one division to outside customers rather than to another division may be harmful to the company as a $hole if the second division cannot obtain the component from other sources. Transfer prices are necessary if the profit performances of individual divisions are to be evaluated as if the divisions $ere separate entities. 0ithout the use of transfer prices, units sold to outsiders $ould be reflected in the division,s revenues, but units sold to other divisions $ould not be reflected. Transfer prices establish a 1revenue2 value to be included in the evaluation of a division3s operations. They are also necessary for tax purposes in international business. The use of the term 5price5 suggests an exchange of cash or promise to pay cash. 6ivisions seldom actually exchange cash. The 7nternal 8evenue Service (78S! disputed the transfer price because it $as not ad9usted do$n in the face of decreasing demand for the product. This caused the :.S. subsidiary to report lo$er profits and hence pay less taxes than they $ould using the market price. .or this reason, the 78S $anted the transfer price lo$ered to $hat the 78S considered to be a market price. 7n setting transfer prices bet$een divisions in different countries, the affects on tax liabilities, royalties, other payments re;uired by differing la$s, and the ability to transfer profits out of a country should be considered. & cost based transfer pricing method $ould be necessary. 0e recommend using differential standard costs to the supplier plus supplier,s opportunity costs of the internal transfer, if any. 7f a dual transfer pricing system is used, the supplier could be given a mark up $ithout charging it to the buyer. The economic basis for transfer pricing systems is that as long as the transfer price is greater than the opportunity cost of the selling division and less than the opportunity cost of the buying division, a transfer $ill be encouraged. 7n evaluating the division manager, top management is concerned $ith those revenues and expenses over $hich the division manager has some reasonable degree of control. .actors that are noncontrollable may be deducted to compute 8<7 for this purpose. 7n evaluating the division, top management is concerned $ith the division,s contribution as an entity to the profits of the company. The salary of the division manager may not be deducted in evaluating the division but $ould be deducted in calculating the 8<7 used to evaluate the performance of the division manager.

11./

11.14 11.11

11.12

11.1"

11.1%

11.1(

Solutions

11 2

11.1)

This statement may be correct depending on ho$ 8<7 is calculated. 7f assets are stated at ac;uisition cost and depreciable assets are stated net of accumulated depreciation, then the statement is correct. The assets of divisions $ith ne$er assets $ill be stated at more recent higher costs, assuming inflation, and at a higher proportion of their ac;uisition costs. 0ith a larger denominator, the 8<7 of ne$ divisions $ill be lo$er than for older divisions, other things being the same. 8<7 measures scale the division accounting profit by the investment re;uired, $hich facilitates comparison bet$een divisions of various sizes. &lso, managers $ould have incentives to maximize accounting measures of profit $ithout regard to the investment re;uired. (:se of economic profits $ould not have this problem, of course.! 7f the return on a specific pro9ect is greater than the company,s cost of capital, but has an accounting 8<7 that is lo$er than the division,s 8<7, a division manager $ould have an incentive to avoid that pro9ect even though it meets the company,s cost of capital re;uirements. This is because it $ould lo$er the division3s 8<7, $hich is $eighted according to investment and return. 'y maximizing economic value added, managers $ill accept all pro9ects above the minimum acceptable rate of return. &ccording to the general rule $hen the selling division is belo$ capacity the transfer price should be set at the differential cost. The buying division $ill then choose the least costly alternative bet$een internal or external purchasing, $hich $ill also be the least costly for the company. Setting the transfer price higher can lead to the incorrect decisions for the company as a $hole.

11.1+

11.1-

11.1/ 11.24

11 "

Solutions

11.21

(Transfer pricing.! a. Market !ase" Trans$er Pri%e

Ne& 'ork *i+ision Ne& (erse) *i+ision

b. Ne#otiate" Trans$er Pri%e

Ne& 'ork *i+ision Ne& (erse) *i+ision

Sales............................ *osts of >oods Sold..... Selling and &dminis trative ?xpenses........ <perating @rofit............ Total *ompany.............

= )44,444a =1,(44,444 = %+4,444c =1,(44,444 (%%4,444! (-%4,444!b (%%4,444! (+14,444!d (124,444! (244,444! (124,444! (244,444! = %4,444 = %)4,444 = (/4,444! = (/4,444 =(44,444 =(44,444

a=)44,444 A =.%4 X 1,(44,444 gallons. b=-%4,444 A (=.%4 X 1,"44,444 gallons! B ="24,444. c=%+4,444 A (=.%4 X 244,444 gallons! B (=."4 X 1,"44,444 gallons!. d=+14,444 A (=."4 X 1,"44,444 gallons! B ="24,444. c. &lthough the company has the same total profit, the statement is incorrect if the type of transfer price used has an effect on the decisions of people in either division. .or example, the use of a cost based transfer price may provide no incentive for divisions to control costs because they $ill al$ays have zero net income. #anagers may choose not to sell to other divisions at a loss to their divisions, forcing the buying divisions to go outside the company.

Solutions

11 %

11.22

(8eturn on investment computations.! &ll amounts in thousands of dollars (444 omitted!. a. #iami 6ivisionC =(44D=%,444A 12.(EF Gansas *ity 6ivisionC =(44D=(,444A 14EF Seattle 6ivisionC b. =(44D=),444A -.""E.

&llocations of corporate expenses as follo$sC #iamiC =%(4 x %D1( A =124 Gansas *ityC =%(4 x (D1( A =1(4 SeattleC =%(4 x )D1( A =1-4 Ho$ subtract each of the above allocations from =(44 and divide by each division3s divisional investment. .or #iami, for exampleC #iamiC (=(44 =124!D=%,444 A /.(E Gansas *ityC +.4E SeattleC (.""E

c.

&llocations of corporate expenses as follo$sC #iamiC =%(4 x 2%D)4 A =1-4 Gansas *ityC =%(4 x 24D)4 A =1(4 SeattleC =%(4 x 1)D)4 A =124 Ho$ subtract each of the above allocations from =(44 and divide by each division3s divisional investment. .or #iami, for exampleC #iamiC (=(44 =1-4!D=%,444 A -.4E Gansas *ityC +.4E SeattleC ).""E

d.

&llocations of corporate expenses as follo$sC #iamiC =%(4 x 22.(D%( A =22( Gansas *ityC =%(4 x 12D%( A =124 SeattleC =%(4 x 14.(D%( A =14( Ho$ subtract each of the above allocations from =(44 and divide by each division3s divisional investment. .or #iami, for exampleC #iamiC (=(44 =22(!D=%,444 A ).--E Gansas *ityC +.)E SeattleC ).(-E

11 (

Solutions

11.2"

(8<7 computations $ith a capital charge.! a. ?astern 6ivisionC *entral 6ivisionC 0estern 6ivisionC b. ?astern 6ivisionC *entral 6ivisionC 2".""E 0estern 6ivisionC 12.22E c. =%44,444D=(,444,444 A -.4EF =",444,444D=/,444,444 A "".""EF =%,444,444D=1-,444,444 A 22.22E. =%44,444 .14 x =(,444,444D=(,444,444 A 2EC .14 x =/,444,444D=/,444,444 A .14 x =1-,444,444D=1-,444,444 A

=",444,444 =%,444,444

&s the above calculations demonstrate, the ranking of the divisions does not change. The 8<7 before deducting the use of capital charge is simply reduced by the 14 percent charge. 7t can be argued, therefore, that from the standpoint of top management, it does not matter $hich approach is follo$ed as long as it is used consistently. :se of the measure in @art a., ho$ever, may lead divisions to improper decisions. & division may be inclined to accept pro9ects $hich $ill increase its 8<7 even though the pro9ect $ill not return an amount to cover the charge for the use of capital. Therefore, it is preferable from the vie$point of the company as a $hole to allocate the investment funds to a division that can earn at least 14 percent.

11.2%
Solutions

(8<7 computations $ith replacement costs.!

11 )

a. b. c.

Toronto 6ivisionC =-44,444D=%,444,444A 24E @hoenix 6ivisionC =1,244,444D=+,(44,444 A 1)E Toronto 6ivisionC =-44,444D=),444,444 A 1".""E @hoenix 6ivisionC =1,244,444D=-,444,444 A 1(E &nalysts make t$o principal arguments for using ac;uisition cost in the denominator as in @art a. .irst, it is easily obtained from the firm,s records and does not re;uire estimates of current replacement costs. Second, it is consistent $ith the measurement of net income in the numerator (that is, depreciation expense is based on ac;uisition cost and unrealized holding gains are excluded!. There are also t$o principal arguments for using current replacement cost in the denominator as in @art b. .irst, it eliminates the effects of price changes and permits the division $hich uses the depreciable assets most efficiently to sho$ a better 8<7. Second, as discussed in the chapter, it may lead division managers to make better e;uipment replacement decisions. 7f ac;uisition cost is used as the valuation basis in calculating 8<7, divisions $ith older, more fully depreciated assets may be reluctant to replace them and thereby introduce higher, current amounts in the denominator. 7f current replacement cost is used in the denominator, the asset base $ill be the same regardless of $hether or not the assets are replaced. Thus, the replacement decision can be made properly (that is, based on net present value! independent of any effects on 8<7.

11.2(

(8<7 computations comparing net and gross book value.!

11 +

Solutions

a. :.S. 6ivisionC =",444,444D=24,444,444 A 1(E &ustralian 6ivisionC =%,444,444D=(4,444,444 A -E b. :.S. 6ivisionC =",444,444D=1(,444,444 A 24E &ustralian 6ivisionC =%,444,444D=1(,444,444 A 2).)+E c. There is no universal 5best5 response to this ;uestion. 7t can be argued that the 8<7 on assets net of accumulated depreciation (@art b.! is biased in favor of divisions $ith older depreciable assets. 'y calculating 8<7 based on gross assets, the bias caused by differences in the age of depreciable assets is removed. Io$ever, another bias is introduced if gross assets are used. The ac;uisition costs of the assets of &ustralian 6ivision are more out of date than those of :.S. 6ivision, $hich $ere ac;uired more recently. ?ach division might have assets of e;ual operating efficiency, but the amount at $hich they are stated in the denominator of 8<7 $ill be different. 6uring periods of inflation, use of 8<7 based on assets gross of accumulated depreciation also tends to be biased in favor of divisions $ith older depreciable assets.

Solutions

11 -

11.2)

(*omparing profit margin and 8<7 as performance measures.! The return on investment (8<7!, profit margin percentage, and asset turnover ratio of the three divisions are as follo$s. &ll amounts are in thousands of dollars (444 omitted!. Return on In+est-ent He$ <rleans 6istrictC =244D=2,444 =1,/44D=2,444 14E *hicago 6istrictC =-,(44D=),2(4 =(44D=),2(4 -E 6enver 6istrictC =1,444D=-,444 $10,000/$8,000 12.(E a. b. c. A A A A A , A Pro$it Mar#in Per%enta#e
X

Asset Turno+er Ratio X ./( X

=244D=1,/44 14.("E X

=(44D=-,(44 (.--E X 1.")

=1,444D=14,444 14E X 1.2(

:sing the profit margin percentage, the ranking of the districts is He$ <rleans, 6enver, and then *hicago. :sing 8<7, the ranking of districts is 6enver, He$ <rleans, and then *hicago. The 8<7 is a better measure of overall performance because it relates profits to the investment, or capital, re;uired to generate those profits. He$ <rleans had the largest profit margin percentage. Io$ever, it re;uired more capital to generate a dollar of sales than did 6enver. Thus, its overall profitability is less. Hote that *hicago had the largest asset turnover ratio. Io$ever, it generated the smallest amount of operating profit per dollar of sales, resulting in the lo$est 8<7 of the three districts.

11 /

Solutions

11.2+

(@rofit margin and investment turnover ratio computations.!

a. 8<7 A @rofit #argin @ercentage

A Jear + =1,244D=14,444 =24,444D=14,444 12E A

X &sset Turnover 8atio (&mounts in thousands of dollars 444 omitted.! X

A =1,244D=24,444 )E
X

2.4
X

Jear =1,144D=11,444 =24,444D=11,444 14E b. A

A =1,144D=24,444 (.(E
X

1.-2

The cost savings programs resulted in a reduction in expenses and a decrease in net income based on the same level of sales. Thus, the profit margin percentage decreased from ) percent to (.( percent. The cost savings programs resulted in an increase in investment, probably from larger amounts of inventory and fixed assets. Since sales remained the same, the asset turnover ratio decreased.

11.2-

(8<7 and ?K& computations.! &nnual 7ncome A =+4,444 a. ROI 'ear 1 2 " % ( In+est-ent !ase = 1)4,444 12-,444a /),444 )%,444 "2,444 /012333 9 !ase 2".-E 2/.+E "/.)E (/.%E 11-.-E A ="-,444 b. EVA ./012333 X 41 5 .1678 5 .4!ase 5 /37 X .:68 (= +,+44! "44 -,"44 1),"44 2%,"44

a'ase decreases by annual depreciation of ="2,444.

Solutions

11 14

11.2/

(Transfer pricing L*@& adaptedM.! 7t $ould cost the company =%(,444 if @re .ab purchased units from the outside supplier for =2"4 each. This =%(,444 is the difference bet$een the price paid for the units from an outside supplier (=2"4! and the differential cost of producing in the Iard$are 6ivision (=244! times the 1,(44 units in the order. The fixed costs are sunk and, therefore, do not enter into the decision. 'oth the company and Iard$are $ould be =%(,444 $orse off if @re .ab purchased from an outsider. @re .ab $ould not be affected $hether paying =2"4 per unit to hard$are or to an outsider. 7f management enforced the =2)4 transfer price and insisted that @re .ab purchase the units from Iard$are, then the overall company profits $ould not be affected by the transfer price increase. Io$ever, Iard$are $ould gain =%(,444 $hile @re .ab $ould lose =%(,444 compared to the current situation.

11."4

(Transfer pricing.! a. Au"itors 4!u)ers7 @ay =244 Consultants 4Sellers7 8eceive = 244 @ay +4 8eceive = 244 @ay +4 Total A%%ountin# Fir@ays = 4 @ays +4 @ays = +4 8eceives = 24 @ays +4 @ays = (4

'uy Services 7nternally

'uy Services ?xternally

@ay

=1-4

Ience, it is advantageous to buy consulting services externally. Hote that this result depends on $hether the consulting group operates at capacity. (See @art b.! b. Au"itors 4!u)ers7 @ay =244 Consultants 4Sellers7 8eceive =244 @ay +4 8eceive @ay 4 4 Total A%%ountin# Fir@ays = 4 @ays +4 @ays = +4 @ays @ays @ays =1-4 4 =1-4

'uy Services 7nternally

'uy Services ?xternally

@ay

=1-4

Ience, it is better to buy consulting services internally.

11 11

Solutions

11."1

( 8<7 and ?K& using the internet.! a. Students3 calculation of return on investment and residual income $ill depend on the company selected and the year $hen the internet search is conducted. Students $ill need to decide ho$ to determine the income and the invested assets to use in both calculations. The discussion in the text $ill serve as a guide in this regard. Some companies3 annual reports include a calculation and discussion of 8<7 in the 1management report and analysis2 section or the 1financial highlights2 section. Students3 calculation of 8<7 may differ from management3s due to differing assumptions about the determination of income and invested capital.

b.

11."2

('ella Kista 0ood$ork *ompanyF 8<7 and ?K& calculations.! a. Return on In+est-entC :.S. &sia ?urope b. 8<7 A =2(,(44D=1(4,444 A 1+E 8<7 A =2-,444D=12(,444 A 22.%E 8<7 A =2/,(44D=1+(,444 A 1)./E U.S. Het <perating 7ncome after Taxes (24E!.......................... *ost of *apital ?mployedC (=1(4,444 N =14,444! X 4.14. (=12(,444 N =(,444! X 4.14. . . (=1+(,444 N =1(,444! X 4.14. ?conomic Kalue &dded............. c. =24,%44 (1%,444! (12,444! = ),%44 =14,%44 (1),444! = +,)44 Asia =22,%44 Euro;e = 2",)44

E%ono-i% Value A""e"

The manager of the &sia 6ivision is doing the best 9ob based on 8<7 because it has the highest return. The &sia 6ivision manager is also doing best $ith ?K& of =14,%44. &lthough ?urope has the next highest ?K&, it is earned $ith substantially more assets (=1+(,444 versus =1(4,444! and more capital employed (=1)4,444 versus =1%4,444! than the :.S. *oupled $ith the fact that the :.S. has a slightly higher 8<7, the :.S. probably earns the overall second place as to divisional performance.

Solutions

11 12

11.""

(Geller *ompanyF transfer pricing.! a. 7ncremental *ash <utflo$ of the *omputers 6ivision (=2,444 X %44 :nits!........................................................ = -44,444 7ncremental *ash Savings of the Het$orks 6ivision (=1,%44 X %44 :nits!........................................................ (()4,444! Het 7ncremental *ash <utflo$............................................. = 2%4,444 The company $ill be $orse off by =2%4,444 if the *omputers 6ivision purchases the component externally. b. Het 7ncremental *ash <utflo$ from @art a.......................... 7ncremental *ash Savings of the Het$orks 6ivision............ (1(4,444! Het 7ncremental *ash <utflo$............................................. = 2%4,444 = /4,444

The company $ill be $orse off by =/4,444 if the *omputers 6ivision purchases the component externally. c. 7ncremental *ash <utflo$ of the *omputers 6ivision (=1,-44 X %44 :nits!........................................................ 7ncremental *ash Savings of the Het$orks 6ivisionC Kariable *osts (=1,%44 X %44!.......................................... (()4,444! <perating Savings........................................................... (1(4,444! Het 7ncremental *ash <utflo$............................................. = +24,444

= 14,444

The company $ill be $orse off by =14,444 if the *omputers 6ivision purchases the component externally. d. 'efore responding, the president should raise three ;uestions. .irst, $hich of the three conditions in @arts a. to c. is most likely to occurO The president should only consider interceding if the *omputers 6ivision,s action $ill be detrimental to the company. Second, $ill the conditions expected to occur be short lived or continually recurringO The president may permit the *omputers 6ivision to purchase the component externally if it is anticipated that the outside market price $ill soon increase to =2,244 or higher. 7n this $ay, divisional decision making autonomy is maintained. 7f the president intercedes, division managers may react negatively and harm the decentralized organization structure. The third, and perhaps most critical, ;uestion then is the effect of intercession on divisional performance.

11 1"

Solutions

11. "%. Transfer pricing, $ith taxes a. :se =+ million transfer price 8evenue Third party costs Transferred goods costs Taxable income Tax rate Tax liability Total tax liability b. :se =1% million transfer price 8evenue Third party costs Transferred goods costs Taxable income Tax rate Tax liability Total tax liability c. The optimal price for incentive purposes is =) million. :sing =) million as the transfer priceC 8evenue Third party costs Transferred goods costs Taxable income Tax rate Tax liability Total tax liability Asian =1%,444,44 4 ( ),444,444! PPPPPPPPP =-,444,444 x %4E = ",244,444 Euro;ean ="4,444,444 ( -,444,444! (1%,444,444! = -,444,444 x +4E =(,)44,444 Asian =+,444,444 (),444,444! PPPPPPPPP =1,444,444 x %4E =%44,444 Euro;ean ="4,444,444 ( -,444,444! ( +,444,444! =1(,444,444 x +4E =14,(44,444

=14,/44,444

=-,-44,444

Asian =),444,444 ( ),444,444! PPPPPPPPP 4 x %4E 4

Euro;ean ="4,444,444 ( -,444,444! (),444,444! = 1),444,444 x +4E =11,244,444

=11,244,444

Solutions

11 1%

11."(

('iases in 8<7 computations.! 1. Some of the standard cost variances may be noncontrollable by the divisional manager. .or example, if the company maintains a centralized purchasing department, the materials price variance $ill not be controllable by the division,s manager. & case can be made for only attributing variances sub9ect to some reasonable control by the manager in determining divisional net income. products to other divisions in the firm. 7f so, the ;uestion arises as to $hat transfer price is used. The manager is likely to feel the bonus plan is unreasonable if the division is forced to sell to the other divisions at a prescribed transfer price. 7n this case, perhaps the bonus should be based only on sales to external parties. ". T$o ;uestions can be raised regarding the allocation of central corporate expenses. .or purposes of calculating the manager,s bonus, it is ;uestionable $hether central corporate expenses should be allocated. The manager cannot control the amount of these expenses and may react negatively to having them affect the annual bonus. & second ;uestion regards the e;uity in using sales as the basis for the allocation. 7t is unlikely that the incurrence of central corporate expenses is related to sales, unless there is centralized advertising. 7n addition, there may be a tendency for divisions to re9ect certain opportunities to sell products in order to hold do$n sales and the amount of central corporate expenses allocated. .or example, a division may receive a special order at a price exceeding incremental divisional expenses. Io$ever, acceptance of the offer $ould mean a reduction in divisional net income after allocation of central corporate expenses. 7t is in the best interest of the company that such orders be accepted but the bonus arrangement may lead to re9ection of the order. Several ;uestions can be raised regarding the measurement of divisional investment. .irst, are both of the divisions involved in manufacturingO The Qight *hocolate 6ivision may purchase products for resale and therefore have relatively little investment in fixed assets $hile the 6ark *hocolate 6ivision may be a capital intensive manufacturing division. 7f so, the 8<7 measure $ill be biased in favor of the Qight *hocolate 6ivision. Second, assuming both divisions are involved in manufacturing, is one of the divisions ne$er $ith relatively high cost fixed assets and the other division relatively old $ith lo$er cost, more fully depreciated assetsO 7f so, the 8<7 measure $ill be biased in favor of the older division. To overcome these problems, fixed assets could be stated gross, rather than net, of

2. & ;uestion can be raised as to $hether either of these divisions sells

%.

11 1(

Solutions

accumulated depreciation or even stated at current replacement cost in ne$ condition. (. & ;uestion can be raised as to $hether the divisions, 8<7s are comparable as a base for determining bonuses. .or example, one division may be much more risky than the other. 7f so, a return of 1( percent in the Qight *hocolate 6ivision may be e;uivalent to the 14 percent return for the 6ark *hocolate 6ivision $hen risk is considered.

Solutions

11 1)

11.")

(7ssues in designing 8<7 measures.! The follo$ing factors should be consideredC 1. Should the 8<7 be calculated in terms of the 'razilian currency or the :.S. dollarO 6epending on the exchange rate used (for example, current rate, historical rate $hen assets $ere ac;uired!, the measure of 8<7 could be different. 7f 8<7 is to be calculated in dollars, $hich exchange rate (that is, the current rate or the historical rate! $ill be used for each financial statement itemO 0ill the measure of 5return5 in the numerator of 8<7 be the amount actually received by Safety &larm from its foreign division or $ill it be the amount earned by the foreign divisionO >iven the additional risk involved in investing in this foreign country, it may be desirable to base the performance measure on the amount actually received in cash. 6o the domestic divisions get charged for the use of capital in calculating their 8<7sO 7f not, the 8<7 of the foreign division $ill not be comparable. Io$ $ill 57nvestment5 in the denominator be measuredO <ne ;uestion concerns $hether the measure should be total assets or stockholders, e;uity. &n argument can be made for the latter since this represents Safety &larm3s investment in the division. &nother ;uestion concerns valuation. Should historical cost or current replacement cost be usedO >iven the rates of inflation in 'razil in recent years, a case can be made for using some type of current value. 0hat is the basis for the transfer price set for central engineering servicesO 6oes this represent a market price for the services in 'razilO 7f not, the foreign division should probably have the flexibility to purchase the services locally. 7s the 8<7 of the foreign divisions directly compared to those of the domestic divisions in evaluating performanceO 7f so, the 8<7s may not be comparable because of differences in risk.

2.

".

%.

(.

).

+.

11 1+

Solutions

11."+ (8<7 and residual income.! a. 8<7 before the proposed purchase of ShrimpC =-44,444D=%,444,444 A 24E 8<7 after the proposed purchase of ShrimpC =--4,444D=%,-44,444 A 1-.""E Hote that the 8<7 $ill be lo$er after the purchase of Shrimp. b. 8esidual income before proposed purchaseC =-44,444 N (14E x =%,444,444! A =%44,444 8esidual income after proposed purchaseF =--4,444 N (14E x =%,-44,444! A =%44,444 Hote that residual income $ill be unchanged after the purchase of Shrimp. c. d. 7f the 8<7 for a division decreases then the 8<7 for the company $ill also decrease, holding everything else constant. (2! and the manager might choose either ("! or (%!. :sing 8<7 to measure performance, the manager of Shellfish has incentives not to purchase Shrimp because that purchase $ill lo$er Shellfish3s 8<7. :sing residual income, the Shellfish manager $ould be indifferent about the purchase because the purchase $ould not affect Shellfish3s residual income. 7n our experience, managers are risk averse. The manager of Shellfish $ould not purchase Shrimp if risk averse because there is likely a (4E probability that the residual income $ill be negative instead of zero.

Solutions

11 1-

11."-. (8<7 and ?K&! The problem does not specify pre tax or after tax results. 0e generally accept either, but point out that many companies use the after tax result for sales margin and 8<7. ?K& routinely uses after tax amounts. 7n addressing re;uirement c, one should use after tax amounts for 8<7 to make the measures comparable to ?K&. a 6ivision & Sales margin A =)4,444(1 ."4!D=2"4,444 A 1-.2)E (or $60,000/$ !0,000 " 6.0#$ be%ore tax& 6ivision ' Sales margin A =/4,444(1 ."4!D=(24,444 A 12.12E (or $#0,000/$' 0,000 " ().!($ be%ore tax& 6ivision & 8<7 A =)4,444(1 ."4!D=1-4,444 A 2".""E (or $60,000/$(*0,000 " !!.!!$ be%ore tax& 6ivision ' 8<7 A =/4,444(1 ."4!D="-4,444 A 1).(-E (or $#0,000/$!*0,000 " !.6*$ be%ore tax& 6ivision & ?K& A =)4,444(1 ."4! .12(=1-4,444 =%4,444! A =%2,444 =1),-44 A =2(,244 6ivision ' ?K& A =/4,444(1 ."4! .12(="-4,444 A =)",444 ="/,)44 A =2",%44 =(4,444!

b. 6ivision & has the higher 8<7, implying that it uses its assets more efficiently. 6ivision & is also generating more economic profit than 6ivision ' even though it is smaller. 7f the 8<7 numbers are recomputed using ?K&3s measure of investment (assets N current liabilities! then the ne$ 8<7 numbers are the follo$ingC & =%2,444D=1%4,444 A "4EF ' =)",444D=""4,444 A 1/.4/E. 6ivision &3s 8<7 is greater than 6ivision '3s 8<7. 6ivision & $ins. c. 8<7C He$ 6ivision 8<7 using the same approach as in re;uirement a. 6ivision &, ne$ 8<7 A (=)4,444 B =14,444!(1 ."4!D(=1-4,444 B =)4,444! A 24.%2E. *ompare to 2".""E in re;uirement a. 6ivision &, ne$ ?K& A (=)4,444 B =14,444!(1 ."4! .12(=1-4,444 B =)4,444 =%4,444 =%,444! A =%/,444 =2",(24 A =2(,%-4. *ompare to =

11 1/

Solutions

2(,244 in re;uirement a.

8<7 $ould drop, $hile ?K& $ould increase a little. :sing the 8<7 performance measure creates a conflict for the manager. Taking the pro9ect $ould be good for company value because it has a positive H@K, but the manager $ould look $orse because divisional 8<7 $ould decrease.

Solutions

11 24

11."/

(8<7 and ?K&!

The problem does not specify pre tax or after tax results. 0e generally accept either, but point out that many companies use the after tax result for sales margin and 8<7. ?K& routinely uses after tax amounts. 7n addressing re;uirement c, one should use after tax amounts for 8<7 to make the measures comparable to ?K&. a 6ivision R Sales margin A =(4,444(1 .%4!D=244,444 A 1(E (or $'0,000/$ 00,000 " '$ be%ore tax& 6ivision S Sales margin A =/4,444(1 .%4!D=(44,444 A 14.4-E (or $#0,000/$'00,000 " (*.00$ be%ore tax& 6ivision R 8<7 A =(4,444(1 .%4!D=1-4,444 A 1).)+E (or $'0,000/$(*0,000 " ).)*$ be%ore tax& 6ivision S 8<7 A =/4,444(1 .%4!D=")4,444 A 1(E (or $#0,000/$!60,000 " '$ be%ore tax& 6ivision R ?K& A =(4,444(1 .%4! .12(=1-4,444 ="4,444! A ="4,444 =1-,444 A =12,444 6ivision S ?K& A =/4,444(1 .%4! .12(=")4,444 A =(%,444 ="+,244 A =1),-44 =(4,444!

b. 6ivision R has the higher 8<7, implying that it uses its assets more efficiently. Io$ever, 6ivision S is also generating more economic profit than 6ivision R because it is larger. 7f one could invest in only one or the other division, then the investor $ould choose 6ivision S because it generates more economic value than 6ivision R. c. 8<7C He$ 6ivision 8<7 using the same approach as in re;uirement a. 6ivision R, ne$ 8<7 A (=(4,444 B =14,444!(1 .%4!D(=1-4,444 B =)4,444! A 1(E. *ompare to 1).)+E in re;uirement a. 6ivision R, ne$ ?K& A (=(4,444 B =14,444!(1 .%4! .12(=1-4,444 B =)4,444 ="4,444 =%,444! A ="),444 =2%,+24 A =11,2-4. *ompare to =12,444 in

11 21

Solutions

re;uirement a.

8<7 $ould drop. ?K& $ould decrease very little. :sing the 8<7 performance measure creates a conflict for the manager. Taking the pro9ect $ould be good for company value because it has a positive H@K, but the manager $ould look $orse because divisional 8<7 $ould decrease. :sing ?K&, the division3s performance $ould look $orse, but not by as much.

Solutions

11 22

11.%4

(?valuating profit impact of alternative transfer price L*#& adaptedM.! (444 omitted in all calculations! a. (1! The bottle division profitsC 8evenue............. *ost.................... =14,444 +,244

@rofit................

= 2,-44

(2! The cologne division profitsC 8evenue............. *ost.................... @rofit.................. =)",/44 (-,%44 (=%-,%44 B =14,444! = (,(44

("! The corporation profitsC 8evenue............. *ost.................... b. (1! Jes. 'ottle 6ivisionC *ases........................................... 2,444 8evenue...................................... = %,444 *ost............................................. ",244 @rofit............................................ = -44 (2! Ho. *ologne 6ivisionC *ases........................................ 8evenue.................................... *osta......................................... @rofit......................................... ("! Jes. *orporationC *ases........................................ 8evenue.................................... *ostb......................................... @rofit......................................... 2,444 =2(,444 1/,)44 = (,%44 Volu-e %,444 =%(,)44 "+,)44 = -,444 ),444 =)",/44 ((,)44 = -,"44 2,444 =2(,444 24,%44 = %,)44 Volu-e %,444 =%(,)44 "/,%44 = ),244 ),444 =)",/44 (-,%44 = (,(44 Volu-e %,444 = +,444 (,244 = 1,-44 ),444 =14,444 +,244 = 2,-44 =)",/44 ((,)44 (=%-,%44 B =+,244! = -,"44

a(7n thousands! =24,%44 A =1),%44 *ologne 6ivision costs plus =%,444 paid to 'ottle 6ivisionF ="/,%44 A ="2,%44 B =+,444F

11 2"

Solutions

=(-,%44 A =%-,%44 B =14,444. b(7n thousands! =1/,)44 A =",244 cost to 'ottle 6ivision B =1),%44 cost to *ologne 6ivisionF etc. This apparent inconsistency, $here the 'ottle 6ivision and the *orporation are the most profitable at ),444,444 volume and the *ologne 6ivision is most profitable at %,444,444 volume, comes from the cost and revenues changing differently for the 'ottle 6ivision, *ologne 6ivision, and the total *orporation as volume changes. :sing market transfer prices, the divisions achieve maximum profit for themselves at different levels of sales based on the market price at the various levels relative to the division cost at these various levels. The corporation achieves maximum profit based on the selling price to outsiders relative to the total cost of making the product.

Solutions

11 2%

11.%1

(7mpact of division performance measures on management incentives.! Re<e%t A%%e;t Ne& Pro<e%t Ne& Pro<e%t *i+ision A 7ncome fromC ?xisting &ssets (.%4 X =)4,444!.............. =2%,444 =2%,444 He$ @ro9ect (."4 X ="4,444!................... /,444 (1! Het 7ncome................................................ =2%,444 ="",444 &ssets ?mployedC ?xisting &ssets................................... =)4,444 =)4,444 He$ @ro9ect,s &ssets.......................... "4,444 (2! Total &ssets............................................... =)4,444 =/4,444 8ate of 8eturn on 7nvestment (1!D(2!......... %4.4E ").+E Het 7ncome................................................ =2%,444 ="",444 Qess #inimum &cceptable 8eturn on 7nvested &ssets LA .24 X (2!M................. 12,444 1-,444 7ncome in ?xcess of *ompany #inimum. . . =12,444 =1(,444 *i+ision ! 7ncome fromC ?xisting &ssets (.2( X =)4,444!.............. He$ @ro9ect (."4 X ="4,444!................... (1! Het 7ncome................................................ &ssets ?mployedC ?xisting &ssets................................... He$ @ro9ect,s &ssets.......................... (2! Total &ssets............................................... 8ate of 8eturn on 7nvestment (1!D(2!......... Het 7ncome................................................ Qess #inimum &cceptable 8eturn on 7nvested &ssets LA .24 X (2!M................. 7ncome in ?xcess of *ompany #inimum. . .

=1(,444 =1(,444 =)4,444 =)4,444 2(.4E =1(,444 12,444 = ",444

=1(,444 /,444 =2%,444 =)4,444 "4,444 =/4,444 2).+E =2%,444 1-,444 = ),444

11 2(

Solutions

11.%1 continued. DiscussionC #anagement of 6ivision & is behaving rationally given the behavior of the home office staff. &s the calculations above sho$, the rate of return on investment in 6ivision & $ill decline if the ne$ pro9ect is accepted. (<f course, one does not need to do a calculation to sho$ that a ne$ pro9ect earning only "4 percent $ill reduce the rate of return on a division already earning %4 percent.! 7f management of 6ivision & believes that it is being evaluated on the rate of return on investment and on the changes in that rate, then management is correct to turn do$n a pro9ect that is better than the company average but $orse than its o$n. @rofessor 8obert S. Gaplan likes to point out that if one evaluates $ith a ratio, then the evaluatee can increase his or her score not only by increasing the numerator, but also by decreasing the denominator. 0e have to be concerned that people may be achieving a good score by keeping the denominator artificially small. <ur suggestion to the home office staff is that it evaluate division management $ith a criterion based on a measure of income in excess of the minimum acceptable return on investment. This calculation is also sho$n for both divisions for both the 5re9ect5 and 5accept5 alternatives. So long as a ne$ investment pro9ect returns a rate larger than the minimum acceptable rate, the income in excess of the company minimum $ill increase. ?valuation of management ought, in our opinion, to be based on this measure of excess income, rather than on an 8<7 calculation. 7f the home office staff $ill change its measurement criterion, then management of 6ivision & $ill find the ne$ pro9ect to be $orth an 1extra2 =",444 per year, as the management of 6ivision ' does.

Solutions

11 2)

11.%2

(6iversified ?lectronicsF capital investment analysis and decentralized performance measurementTa comprehensive case.! a. 8alph 'ro$ning,s ne$ product proposal $as re9ected because its 8<7 $as less than 1( percent after tax. @ro9ect 8<7 A A L=2"4,444 (1.4.%4!MD=1,444,444 A 1".-E. The decision $as not correct because it is inappropriate to use a short term measure like 8<7 to evaluate a long term decision, ignoring completely the pro9ect,s cash flo$s. &lso, a performance measure that is suitable for measuring past performance should not be used for an investment decision. (This is $hy accrual accounting might be appropriate for evaluating past performance $hile cash flo$s are used for decision making. 7f the company had used 6*. (6iscounted *ash .lo$s!, the results $ould have been as sho$n on the follo$ing page.

11 2+

Solutions

11.%2 a. continued.
Pro<e%t 'ear In+est-ent (1! Qand (2! @lant and ?;uipment ("! <perating *ash .lo$s (14E 7ncrease each year! (%! Tax on <perating *ash .lo$s at a %4E 8ate ((! 6epreciation Tax Shieldb ()! Tax on Qand Sale Het *ash .lo$ @K .actors (1(E! @K of *ash .lo$s Het @resent Kalue 3 = (244,444! (-44,444! =""4,444a =")",444 ="//,"44 (1"2,444! )%,444 (1%(,244! (1(/,+24! 142,%44 )4,-44 1 : 0 = 6 > ? 1 =%44,444

=%"/,2"4 (1+(,)/2! %),%44

=%-",1(" (1/",2)1! %),%44

=("1,%)(212,(-+!

=(-%,)1(

)%",4++

(2"",-%)! (2(+,2"1!

=(1,444,444! =2)2,444 1.444 .-)/(+

="24,244 ="44,"-4 .+()1% .)(+(2

="4/,/".(+1+( =1++,24+

=""),2/2 .%/+1=1)+,1/-

="1-,--1 .%"2"" =1"+,-)2

(-4,444!c ="(4,+)/ =+4(,-%) ."+(/% ."2)/4

=(1,444,444! =22+,-2+ = (12,"2(

=2%2,11) =1/+,(4)

=1"1,-)- =2"4,+%1

aHet cash operating flo$sC 8evenue.......................................... =+44,444 Kariable costs.................................. ("44,444! .ixed costs (excluding depreciation! = ""4,444 b6epreciation tax shieldC 'ear 1 2 " % ( !ase =-44,444 =-44,444 =-44,444 =-44,444 =-44,444

(+4,444!

ACRS *e;re%iation Rate X .24 X X ."2 X X .1/ X X .1%( X X .1%( X

Ta@ Rate .%4 .%4 .%4 .%4 .%4

A A A A A

Ta@ SAiel" = )%,444 =142,%44 = )4,-44 = %),%44 = %),%44

c=-4,444 A (=%44,444 N =244,444! X %4E.

Solutions

11 2-

11.%2 continued. b. 7t appears that 6iversified ?lectronics, management $anted the focus of division managers to be profitability on assets rather than profits. Ience, the choice of the investment center concept for performance evaluation. Therefore, 6iversified ?lectronics, choice of a measure like 8<7 makes sense since it is a measure of profitability of assets used. The possible benefits of this approach include reduction in cost of corporate administration, improvement in operational decision making, increased motivation at division level, and freeing corporate management up for more effective utilization. Io$ever, some unexpected 8<7 related pitfalls that 6iversified ?lectronics did not anticipate areC 1. 7t may be inappropriate to use one 8<7 performance standard for all divisions, considering differences in products, operations, risks, and differences in measurement because of asset age. These divisions cannot be compared $ith the same yardstick. 2. 6iversified ?lectronics values its investments using net book valueF hence, there may be a disincentive to make ne$ investments $hich could, in most cases, increase the investment base more than the net income, lo$ering 8<7. ". The inclusion of allocated corporate administrative expenses in the 8<7 figure means that divisions and division managers are held accountable for costs over $hich they have no control. Possible Mo"i$i%ation to tAe Present S)ste1. 0ithin a division there could be a corporate 8<7 for evaluating the division and another 8<7 for evaluating the manager. ?ach should only include items controllable by the division and manager, respectively. 2. There should be different 8<7s for different divisions, each reflecting the characteristics peculiar to that industry to $hich the division belongs. ". :se of gross book values andDor current values in the investment base $ould standardize performance measures. %. The residual income method may be used if managers have incentives to re9ect pro9ects having a return that is greater than the cost of capital but less than currently earned 8<7.

11 2/

Solutions

11.%2 continued. c. 0hen a performance evaluation measure like 8<7 is used by divisions at the same time as 6*. models for capital budgeting, managers often have conflicting incentives. #anagers $ill have incentives to re9ect positive H@K pro9ects if these pro9ects do not have a positive impact on 8<7 for several years. &lso, there $ill be a disincentive for them to invest in any positive H@K pro9ect that may lo$er division 8<7 by increasing the denominator by a relatively larger proportion than the numerator.

Solutions

11 "4

11.%"

(*ustom .reight Systems (&!F transfer pricing.! a. The Qogistics 6ivision should accept the bid from the .or$arders 6ivision. *ustom .reight Systems is =+2 better off if the Qogistics division uses the .or$arders division for this contract. O;tion IB Pur%Aase Internall) Air Car#o For&ar"ers Lo#isti%s *i+ision *i+ision *i+ision Sales........................................... Kariable *ostsC (=1(( X )4E!......................... (=1+( N =1((!........................ (from &ir *argo 6ivision!....... (from .or$arders 6ivision!.... <perating @rofitD(*ost!............... Total *ompany *ost...................

= 1(( /"

= 214 24 1(( = "( = (11"!

= )2

= 214 = (214!

O;tion IIB Pur%Aase E@ternall) 4Unite" S)ste-s7 Total *ompany *ost A =(1-(! b. 7f $e assume it is optimal for the transfer to be made internally, then the ;uestion arises as to the appropriate transfer price. The economic transfer pricing rule for making transfers to maximize a company3s profits is to transfer at the differential outlay cost to the selling division plus the opportunity cost to the company of making the internal transfers.
O;;ortunit) Cost o$ Trans$errin# Internall)

*i$$erential Outla) Cost

Trans$er Pri%e

7f the seller (the division supplying the goods or ser vices! has idle capacity......... 7f the seller has no idle capacity.................................

=1+( =1+(

B B

A A

=1+( =214

= "( (=214 sell ing price N =1+( variable cost!

11 "1

Solutions

11.%" continued. c. ?spinosa has many alternatives to intervention or to forcing the manager of the .or$arders division to lo$er his price belo$ =214. ?ach has advantages and disadvantages. U ?spinosa must trade off the benefits of intervention on this particular transaction against the impact of intervention on decentralization as a policy. Too much intervention by ?spinosa $ill eliminate the benefits of decentralization. Tell the Qogistics and .or$arders divisions that the transfer price $ill be bet$een differential cost of =11" ($hich is the sum of the &ir *argo variable cost of =/" and the added variable cost for .or$arders of =24! and the lo$est outside market price of =1-( and allo$ them to negotiate the profit. ?spinosa could reorganize the company combining the divisions into one operating company. Io$ever, *ustom .reight Systems $ould lose all of the benefits of decentralization. ?spinosa could simply do nothing and let the managers maintain their autonomy. This $ould not be in the best interests of *ustom .reight Systems. Io$ever, it might be better to sub optimize for this transaction and obtain more general benefits from decentralizing.

d.

The re$ard system at *ustom .reight Systems creates an environment that encourages managers to act in the best interests of their division rather than for the corporation. #anagers are re$arded on their return on assets and profits, $hich discourages discounting to other divisions of *ustom .reight Systems and ultimately costs the corporation more.

Solutions

11 "2

11.%%

(*ustom .reight Systems ('!F transfer pricing.! Similar to *ase &, the Qogistics 6ivision should accept the bid from the .or$arders 6ivision. Io$ever, if $e eliminate the .or$arders 6ivision from the bidding process, the bid from 0orld should be accepted. ?mphasize that even though 0orld3s bid is =14 per hundred higher than :nited3s, the overall cost to *ustom .reight Systems is lo$er because other divisions of *ustom .reight Systems are included in the bid. O;tion IB Pur%Aase Internall) Air Car#o For&ar"ers Lo#isti%s *i+ision *i+ision *i+ision Sales........................................... Kariable *ostsC (=1(( X )4E!......................... (=1+( N =1((!........................ (from &ir *argo 6ivision!....... (from .or$arders 6ivision!.... <perating @rofitD(*ost!............... Total *ompany *ost...................

= 1(( /"

= 214 24 1(( = "( = (11"!

= )2

= 214 = (214!

O;tion IIB Pur%Aase E@ternall) 4Unite" S)ste-s7 Total *ompany *ost A =(1-(! O;tion IIIB Pur%Aase E@ternall) 4Dorl" Ser+i%es7 Air Car#o For&ar"ers Lo#isti%s *i+ision *i+ision *i+ision Sales........................................... Kariable *ostsC <perating @rofitD(*ost!............... Total *ompany *ost...................

= 1(( /" = )2

= 4 = 4 =(1""!

4 = 1/( = (1/(!

11 ""

Solutions