Chapter 13

Investment Centers
and Transfer Pricing

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning
Objective
1

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Delegation of Decision Making
(Decentralization)
T op Decision Making
is pushed down.
M a na ge m e nt

M id d le M id d le
M a na ge m e nt M a na ge m e nt

S u p erv is or S u p erv is or S u p e rv is or S u p e rv is or

Decentralization often occurs as organizations continue to grow.

13-3
 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.

13-4
 Decentralization

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

13-5
 Learning
Objective
2

McGraw-Hill/Irwin Copyright © 2009 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

13-7
 Return on Investment (ROI)

Income
ROI =
Invested Capital

Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital

Sales Capital
Margin Turnover

13-8
 Return on Investment (ROI)

Holly Company reports the following:

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

Let’s calculate ROI.

13-9
 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.

13-11
 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
13-12
 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
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%

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

= 0.0972
$40,000,000 + $60,000,000

13-14
 Economic Value Added
Atlantic's pretax income $ 6,750,000
Atlantic's total assets 45,000,000
Atlantic's current liabilities 600,000

$6,750,000 × (1 – 30%) Market value of Suncoast's debt

Market value of Suncoast's equity
Interest rate on Suncoast's debt
40,000,000
60,000,000
9%
Cost of Suncoast's equity capital 12%
Tax rate 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

13-15
 Learning
Objective
3

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Improving R0I
 Decrease
Expenses
 Increase  Lower
Sales Invested
Prices Capital

Three ways to improve ROI

13-17
 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.

13-18
 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%.

13-19
 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?
13-20
 Residual Income
Investment center profit
– Investment charge
= Residual income

Investment capital
× Imputed interest rate
= Investment charge

Investment center’s
minimum required
rate of return
13-21
 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.

13-22
 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
13-23
 Learning
Objective
4

McGraw-Hill/Irwin Copyright © 2009 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?

13-25
 Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

13-26
 Learning
Objective
5

McGraw-Hill/Irwin Copyright © 2009 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?
1. Total assets.
2. Total productive assets.
3. Total assets less current liabilities.
4. Only the assets controllable by the manager
being evaluated.

13-28
 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?

13-29
 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.

13-30
 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

13-31
 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.
13-32
 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.

13-33
Inflation: Historical Cost versus
Current-Value Accounting
Use of current-value accounting impacts the
amount of:
1. Invested capital.
2. Income.

13-34
 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.

13-35
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.

13-36
 Transfer Pricing

Let’s change topics!

13-37
 Learning
Objective
6

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.
13-39
 Goal Congruence

The ideal transfer price allows

each division manager to make
decisions that maximize the
company’s profit, while
attempting to maximize his/her
own division’s profit.

13-40
 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

13-41
 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?

13-42
 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

13-43
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
13-44
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.

13-45
 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?

13-46
 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

13-47
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.
13-48
Scenario II: Excess Capacity

Transfer Transfer Transfer

will not will will not
occur. occur. occur.

$18 $39
transfer transfer
price price

13-49
 Learning
Objective
7

McGraw-Hill/Irwin Copyright © 2009 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.

13-51
 Goal Congruence
Conflicts may arise between the company’s
interests and an individual manager’s interests
when transfer-price-based performance
measures are used.

13-52
 Setting Transfer Prices
Conflicts may be resolved by . . .

1. Direct intervention by top management.

2. Centrally established transfer price
policies.
3. Negotiated transfer prices.

13-53
 Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.
You really
don’t have any Now, here is what the two
choice!
of you are going to do.
Ij
pa ust
y w
th $6 on
at 5 ’t
p a f or
rt !

13-54
 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.

13-55
 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.
13-56
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.

13-57
 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 high-
import-duty countries.

13-58
 Learning
Objective
8

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 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.

13-60
 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.

13-61
End of Chapter 13
Let’s transfer some of your
capital to me so that my rate
of return will be higher!

13-62