Chapter 13

Investment Centers

and Transfer Pricing

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective 1: Explain the role of managerial accounting in achieving goal congruence

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Delegation of Decision Making (Decentralization)

Top Management
Decision Making is pushed down.

Middle Management

Middle Management

Supervisor

Supervisor

Supervisor

Supervisor

Decentralization often occurs as organizations continue to grow.

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Decentralization

Advantages
Allows organization to respond more quickly to events. Uses specialized knowledge and skills of managers.

Frees top management from day-to-day operating activities.

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Decentralization

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

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Learning Objective 2: Compute an investment center's return on investment (ROI), residual income (RI), and economic value added (EVA).
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Measuring Performance in Investment Centers

Investment Center managers make decisions that affect both profit and invested capital.
Investment Center Evaluation

Corporate Headquarters Return on investment, residual income, or economic value added

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Return on Investment (ROI)

Income ROI = Invested Capital
ROI =

Income Sales Revenue

Sales Margin

Sales Revenue Invested Capital

Capital Turnover
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Return on Investment (ROI)

Holly Company reports the following:
Income Sales Revenue Invested Capital $ 30,000 $ 500,000 $ 200,000

Lets calculate ROI.

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Return on Investment (ROI)

ROI = ROI = Income Sales Revenue Sales Revenue Invested Capital

$30,000 $500,000

$500,000 $200,000

ROI = 6% 2.5 = 15%

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Economic Value Added

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

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Economic Value Added

Investment centers after-tax operating income Investment charge = Economic Value Added

(
(

Investment centers total assets

Investment centers current liabilities

Weighted average cost of capital

After-tax Market cost of value debt of debt Market value of debt

) (

Cost of Market equity value capital of equity Market value of equity

)
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Improving R0I
Hollys manager was able to increase sales revenue to $600,000 which increased income to $42,000. There was no change in invested capital.

Lets calculate the new ROI.

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Return on Investment (ROI)

ROI = ROI = Income Sales Revenue Sales Revenue Invested Capital

$42,000 $600,000

$600,000 $200,000

ROI = 7% 3.0 = 21%

Holly increased ROI from 15% to 21%.
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ROI - A Major Drawback

As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your divisions 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?
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Residual Income
Investment center profit Investment charge = Residual income Investment capital Imputed interest rate = Investment charge

Investment centers minimum required rate of return

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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.

Lets calculate residual income.

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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 centers minimum required rate of return

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Learning Objective 4: Describe some advantages and disadvantages of both ROI and residual income as divisional performance measures.

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

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Learning Objective 5: Explain how to measure a division's income and invested capital.

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Issues: Measuring Investment Capital

Three issues must be considered before we can properly measure the investment capital:
What assets should be included?
1. 2. 3. 4. Total assets. Total productive assets. Total assets less current liabilities. Only the assets controllable by the manager being evaluated.
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Measuring Investment Capital

The Second Issue 1. 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? 2. Should the assets be shown at historical or current cost?
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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.

Lets calculate ROI using both the gross and net book values.
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Gross or Net Book Value

Year 1 2 3 Profits Gross before Depreciation Operating Book Depreciation Expense Profits Value $ 25,000 $ 10,000 $ 15,000 $ 100,000 25,000 10,000 15,000 100,000 25,000 10,000 15,000 100,000 Net Book Value $ 90,000 80,000 70,000

($100,000 $0) 10 = $10,000 per year $100,000 $10,000 = $90,000 net book value

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Gross or Net Book Value

Year 1 2 3 Net Gross Operating Net Book Book Profits Value ROI Value ROI $ 15,000 $ 90,000 16.67% $ 100,000 15.00% 15,000 80,000 18.75% 100,000 15.00% 15,000 70,000 21.43% 100,000 15.00%

$15,000 $90,000 = 16.67%

$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.

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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.

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Inflation: Historical Cost versus Current-Value Accounting

Use of current-value accounting impacts the amount of:
1. Invested capital. 2. Income.

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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.

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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.

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Transfer Pricing

Lets change topics!

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Learning Objective 6: Use the general economic rule to set an optimal transfer price.

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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 . . .

Battery Division

greater profits for the battery division.

lower profits for the auto division.

Auto Division
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Goal Congruence
The ideal transfer price allows each division manager to make decisions that maximize the companys profit, while attempting to maximize his/her own divisions profit.

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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

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Scenario I: No Excess Capacity

The Battery Division makes a standard 12-volt battery. Production capacity 300,000 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. What is the appropriate transfer price?
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Scenario I: No Excess Capacity

Transfer price

Additional outlay cost per unit incurred because goods are transferred $18 variable cost per battery $40 per battery

Opportunity cost per unit to the organization because of the transfer $22 Contribution lost if outside sales given up

Transfer price Transfer price

= =

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Scenario I: No Excess Capacity

Auto division can purchase 100,000 batteries from an outside supplier for less than $40. Transfer will not occur. Auto division can purchase 100,000 batteries from an outside supplier for more than $40. Transfer will occur.

$40 transfer price

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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.

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Scenario II: Excess Capacity

The Battery Division makes a standard 12-volt battery. Production capacity 300,000 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.
What is the appropriate transfer price?
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Scenario II: Excess Capacity

Transfer price

Additional outlay cost per unit incurred because goods are transferred $18 variable cost per battery $18 per battery

Opportunity cost per unit to the organization because of the transfer

Transfer price Transfer price

= =

$0

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Scenario II: Excess Capacity

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.
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Scenario II: Excess Capacity

Transfer will not occur. Transfer will occur. Transfer will not occur.

$18 transfer price

$39 transfer price

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Learning Objective 7: Explain how to base a transfer price on market prices, costs, or negotiations
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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.

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Goal Congruence
Conflicts may arise between the companys interests and an individual managers interests when transferprice-based performance measures are used.

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Setting Transfer Prices

Conflicts may be resolved by . . .
1. Direct intervention by top management. 2. Centrally established transfer price policies. 3. Negotiated transfer prices.

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Setting Transfer Prices

Top management may become swamped with pricing disputes causing division managers to lose autonomy.
You really dont have any choice!

Now, here is what the two of you are going to do.

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Centrally Established Transfer Prices

As a general rule, a market price-based transfer pricing policy contains the following guidelines . . .
1. The transfer price is usually set at a
discount from the cost to acquire the item on the open market. 2. The selling division may elect to transfer or to continue to sell to the outside.
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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.
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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.

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An International Perspective
Since tax rates and import duties are different in different countries, companies have incentives to set transfer prices that will:
1. Increase revenues in low-tax countries. 2. Increase costs in high-tax countries. 3. Reduce cost of goods transferred to highimport-duty countries.

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Learning Objective 8: Understand the behavioral issues of incentives, goal congruence, and internal controls.

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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 organizations interests. Risks imposed on the manager because financial performance measures are only partially controlled by the manager.
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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.

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

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Class work
Problem 9-45 (Budget problem) Problem 13-44 Problem 13-48 Problem 12-32 Problem 12-43 Problem 11-26 Problem 11-43 Date 06/01/2013

Home work
Problem 13-45 Problem 13-4 Due 13/01/2013 at 1.00 pm