Chapter 13

Investment Centers
and Transfer Pricing

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Delegation of Decision Making
(Decentralization)

Top Decision-Making
is pushed down.
M anagem ent

M i d d le M i d 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.

13-2
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.

13-3
Decentralization

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

13-4
Return on Investment (ROI)

ROI = Income
Invested Capital

Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital

Sales
Sales Capital
Capital
Margin
Margin Turnover
Turnover

13-5
Return on Investment (ROI)

Holly Company reports the following:

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

Let’s calculate ROI.

13-6
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%

13-7
Economic Value Added
Economic value added tells us how much
shareholder wealth is being created.

13-8
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
13-9
Improving R0I
Decrease
Expenses
Increase Lower
Sales Invested
Prices Capital

Three ways to improve ROI

13-10
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?

13-11
Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

13-12
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

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

13-13
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%

Since older assets, with lower net book

values, result in higher ROI, managers are
discouraged from investing in new assets.
13-14
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.

13-15
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

lower profits
Auto Division
profits for the
battery division. for the
auto division.
13-16
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.

13-17
 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

13-18
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 .. .. ..
1.
1. The
Thetransfer
transferprice
priceisisusually
usuallyset
setatataa
discount
discountfrom
fromthe
thecost
costto
toacquire
acquirethe
theitem
item
on
onthe
theopen
openmarket.
market.
2.2. The
Theselling
sellingdivision
divisionmay
mayelect
electto
totransfer
transferor
or
to
tocontinue
continuetotosell
sellto
tothe
theoutside.
outside.

13-19
Negotiating the Transfer Price
AAsystem
systemwhere
wheretransfer
transferprices
pricesare
arearrived
arrivedatatthrough
through
negotiation
negotiationbetween
betweenmanagers
managersof ofbuying
buyingand
andselling
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.
13-20
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.

13-21
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.
13-22
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.

13-23