13 Chapter

Thirtee
n
Investment Centers
and Transfer Pricing

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning
Objective
1

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Delegation of Decision Making
(Decentralization)
Decision Making
is pushed down.
Top
M anagem ent

M id d le M id d le
M anagem ent M anagem ent

S u p e r v is o r S u p e r v is o r S u p e r v is o r S u p e r v is o r

Decentralization often occurs as organizations continue to grow.

1-3
 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.

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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

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

1-7
 Return on Investment (ROI)

Income
ROI =
Invested Capital

Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital

Sales
Sales Capital
Capital
Margin
Margin Turnover
Turnover

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 Return on Investment (ROI)

Holly Company reports the following:

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

Let’s calculate ROI.

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 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%

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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 center’s after-tax operating income
– Investment charge
= Economic Value Added

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

( ) ( )
After-tax Market Cost of Market
cost of  value  equity  value
debt of debt capital of equity
Market Market
value  value
of debt of equity
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 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.

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 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

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 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

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 Learning
Objective
3

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Improving R0I
 Decrease
Expenses
 Increase  Lower
Sales Invested
Prices Capital

Three ways to improve ROI

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 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.

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 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%.

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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 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?
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 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!

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 Residual Income
Investment center profit
– Investment charge
= Residual income

Investment capital
× Imputed interest rate
= Investment charge

Investment center’s
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.

Let’s 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 center’s
minimum required
rate of return
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 Learning
Objective
4

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

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

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 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?

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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.
Let’s calculate ROI using both the
gross and net book values.

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 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

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 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

1-33
 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%

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 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.

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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:
 Invested capital.
 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
Since income
income isis not
not the
the primary
primary
measure
measure ofof performance
performance in in
nonprofit
nonprofit organizations,
organizations,
performance
performance measures
measures other
other than
than
ROI
ROI and
and residual
residual income
income areare used.
used.

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 Transfer Pricing

Let’s change topics!

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 Learning
Objective
6

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

The amount charged when one division sells

goods or services to another division

Batteries

Battery Division Auto Division

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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 . . .

greater
Battery Division profits for the Auto Division
battery division.
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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 . . .

lower profits
Battery Division for the Auto Division
auto division.
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 Goal Congruence

The
The ideal
ideal transfer
transfer price
price allows
allows
each
each division
division manager
manager to to make
make
decisions
decisions that
that maximize
maximize thethe
company’s
company’s profit,
profit, while
while
attempting
attempting to to maximize
maximize his/her
his/her
own
own division’s
division’s profit.
profit.

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 General-Transfer-Pricing Rule

Additional outlay Opportunity cost

cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

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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
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

$22 Contribution
Transfer $18 variable
price = cost per battery + lost if outside
sales given up
Transfer
price = $40 per battery

1-48
Scenario I: No Excess Capacity

Auto division can Auto division can

purchase 100,000 purchase 100,000
batteries from an batteries from an
outside supplier outside supplier
for less than $40. for more than $40.

Transfer Transfer
will not $40 will
occur. transfer occur.
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
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

Transfer $18 variable

price = cost per battery + $0

Transfer
price = $18 per battery

1-52
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 Transfer Transfer

will not will will not
occur. occur. occur.

$18 $39
transfer transfer
price price

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 Learning
Objective
7

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 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 company’s
interests and an individual manager’s interests
when transfer-price-based performance
measures are used.

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 Setting Transfer Prices
Conflicts may be resolved by . . .

 Direct intervention by top management.

 Centrally established transfer price
policies.
 Negotiated transfer prices.

1-58
 Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.
I just won’t
You really pay $65 for
don’t have any that part!
choice!

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 Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.

Now, here is what the two

of you are going to do.

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 Centrally Established
Transfer Prices
As
As aa general
general rule,
rule, aa market
market price-based
price-based
transfer
transfer pricing
pricing policy
policy contains
contains thethe
following
following guidelines
guidelines .. .. ..
 The
 The transfer
transfer price
price isis usually
usually set
set at
at aa
discount
discount from
from the
the cost
cost toto acquire
acquire the the item
item
on
on the
the open
open market.
market.
 The
 The selling
selling division
division maymay elect
elect to
to transfer
transfer or
or
to
to continue
continue toto sell
sell to
to the
the outside.
outside.

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 Centrally Established
Transfer Prices
As aa general
AsThe general rule,
rule, a
a market
market price-based
price-based
discount depends on cost savings from
transfer
transfer pricing
pricing policy
selling internally. policy contains
contains
Cost savings may thethe
following
include guidelines
items like
following .. .. ..
transportation.
guidelines
 The
 The transfer
transfer price
price isis usually
usually set
set at
at aa
discount
discount from
from the
the cost
cost toto acquire
acquire the the item
item
on
on the
the open
open market.
market.
 The
 The selling
selling division
division maymay elect
elect to
to transfer
transfer or
or
to
to continue
continue toto sell
sell to
to the
the outside.
outside.

1-62
 Negotiating the Transfer Price
AA system
system where
where transfer
transfer prices
prices are
are arrived
arrived at
at
through
through negotiation
negotiation between
between managers
managers of of
buying
buying and
and selling
selling divisions.
divisions.

Much
Much management
management
time
time is
is used
used in
in the
the
negotiation
negotiation process.
process. Negotiated
Negotiated price
price may
may not
not
be
be in
in the
the best
best interest
interest of
of
overall
overall company
company operations.
operations.
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 Imperfect Markets

Transfer pricing can be quite complex

when selling and buying divisions
cannot sell and buy all they want in
perfectly competitive markets.

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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:
 Increase revenues in low-tax countries.
 Increase costs in high-tax countries.
 Reduce cost of goods transferred to high-
import-duty countries.

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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:
Risks imposed on the
Incentives for the manager because
manager to act in financial performance
the organization’s
And measures are only
interests. partially controlled
by the manager.

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 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
Let’s transfer some of your
capital to me so that my rate
of return will be higher!

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