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Chapter 13

Transfer Pricing
ROI, RI, EVA

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

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

Frees top management


from day-to-day
operating activities.
Measuring Performance
in Investment Centers
Investment Center
managers make
decisions that
affect both profit
and invested
capital. Corporate Headquarters

Investment Return on investment,


Center residual income, or
Evaluation economic value added
Return on Investment (ROI)

Income
ROI =
Invested Capital

Income Sales Revenue


ROI = ×
Sales Revenue Invested Capital

Sales Capital
Margin Turnover
Return on Investment (ROI)

Holly Company reports the following:

Income $ 30,000
Sales Revenue $ 500,000
Invested Capital $ 200,000

Let’s calculate ROI.


Return on Investment (ROI)

Income Sales Revenue


ROI = ×
Sales Revenue Invested Capital

$30,000 $500,000
ROI = ×
$500,000 $200,000

ROI = 6% × 2.5 = 15%


Improving R0I
 Decrease
Expenses
 Increase  Lower
Sales Invested
Prices Capital

Three ways to improve ROI


Improving R0I
• 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.


Return on Investment (ROI)

Income Sales Revenue


ROI = ×
Sales Revenue Invested Capital

$42,000 $600,000
ROI = ×
$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?
ROI - A Major Drawback
Gee . . . As division manager,
I thought we were I wouldn’t invest in
supposed to do what that project because
was best for the it would lower my pay!
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
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.
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

Investment Investment Weighted


( center’s
total assets
– center’s
current liabilities )  average
cost of capital

After-tax Market Cost of Market


( cost of  value
debt of debt ) (  equity  value
capital of equity )
Market Market
value  value
of debt of equity
Economic Value Added
The Atlantic Division of Suncoast Food Centers reported
the following results for the most recent period:

Atlantic's pretax income $ 6,750,000


Atlantic's total assets 45,000,000
Atlantic's current liabilities 600,000
Market value of Suncoast's debt 40,000,000
Market value of Suncoast's equity 60,000,000
Interest rate on Suncoast's debt 9%
Cost of Suncoast's equity capital 12%
Tax rate 30%

Compute Atlantic Division’s economic value added.


Economic Value Added

First, let’s compute the


weighted-average cost of capital

(9% × (1 – 30%) × $40,000,000) + (12% × $60,000,000)


= 0.0972
$40,000,000 + $60,000,000
Economic Value Added
$6,750,000 × (1 – 30%)

$4,725,000 After-tax operating income


– 4,315,680
= $ 409,320 Economic value added

($45,000,000 – $600,000) × 0.0972 = $4,315,680

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)


= 0.0972
$40,000,000 + $60,000,000
Issues: Measuring Investment Capital

Three issues must be considered before


we can properly measure the investment
capital:
 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

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

($100,000 – $0) ÷ 10 = $10,000 per year


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

$100,000 – $10,000 = $90,000 net book value


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

$15,000 ÷ $90,000 = 16.67%

$15,000 ÷ $100,000 = 15%


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

Since older assets, with lower net book


values, result in higher ROI, managers are
discouraged from investing in new assets.
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.


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