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13. Chapter Thirteen. Investment Centers and Transfer Pricing. Delegation of Decision Making (Decentralization). Decision Making is pushed down. Decentralization often occurs as organizations continue to grow. Decentralization. Advantages.

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investment centers and transfer pricing

13

ChapterThirteen

Investment Centers

and Transfer Pricing

delegation of decision making decentralization
Delegation of Decision Making(Decentralization)

Decision Makingis pushed down.

Decentralization often occurs as organizations continue to grow.

decentralization
Decentralization

Advantages

Allows organization to respond morequickly to events.

Uses specializedknowledge andskills of managers.

Frees top managementfrom day-to-dayoperating activities.

decentralization4
Decentralization

Challenge

Goal Congruence:Organization’s subunit managers

make decisions that achievetop-management goals.

measuring performance in investment centers

Return on investment,

residual income, oreconomic value added

Measuring Performancein Investment Centers

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

Corporate Headquarters

Investment

CenterEvaluation

return on investment roi

Income

Invested Capital

ROI =

Income

Sales Revenue

Sales Revenue

Invested Capital

ROI =

×

Sales

Margin

CapitalTurnover

Return on Investment (ROI)
return on investment roi7
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 roi8

Income

Sales Revenue

Sales Revenue

Invested Capital

ROI =

×

$30,000

$500,000

$500,000

$200,000

ROI =

×

Return on Investment (ROI)

ROI = 6% × 2.5 = 15%

improving r0i
Improving R0I
  • Decrease
  • Expenses

Three ways to improve ROI

  • Increase
  • Sales Prices
  • Lower
  • Invested Capital
improving r0i10
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 roi11

Income

Sales Revenue

Sales Revenue

Invested Capital

ROI =

×

$42,000

$600,000

$600,000

$200,000

ROI =

×

Return on Investment (ROI)

ROI = 7% × 3.0 = 21%

Holly increased ROI from 15% to 21%.

roi a major drawback
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 drawback13

Gee . . .

I thought we were

supposed to do what

was best for the

company!

ROI - A Major Drawback

As division manager,

I wouldn’t invest in

that project because

it would lower my pay!

residual income
Residual Income

Investment center profit

– Investment charge

= Residual income

Investment capital

×Imputed interest rate

= Investment charge

Investment center’sminimum requiredrate of return

residual income15
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 income16

Investment center profit = $25,000

– Investment charge = 20,000

= Residual income = $ 5,000

Residual Income

Investment capital = $100,000

×Imputed interest rate = 20%

= Investment charge = $ 20,000

Investment center’sminimum requiredrate of return

residual income17
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 income18
Residual Income

Residual income encourages managers to

make profitable investments that would

be rejected by managers using ROI.

economic value added
Economic Value Added

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

economic value added20

Weightedaveragecost of capital

(

)

Investmentcenter’s

total assets

Investmentcenter’scurrent liabilities

(

)

(

)

After-taxcost ofdebt

Marketvalueof debt

Cost ofequity capital

Marketvalueof equity

Marketvalueof debt

Marketvalueof equity

Economic Value Added

Investment center’s after-tax operating income

– Investment charge

= Economic Value Added

economic value added21
Economic Value Added

The Atlantic Division of Suncoast Food Centers reportedthe following results for the most recent period:

Compute Atlantic Division’s economic value added.

economic value added22

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

= 0.0972

$40,000,000 + $60,000,000

Economic Value Added

First, let’s compute theweighted-average cost of capital

economic value added23
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

measuring investment capital
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 capital25
Measuring Investment Capital

Three issues must be considered before we can properly measure the investment capital.

  • 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
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 value27
Gross or Net Book Value

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

gross or net book value28
Gross or Net Book Value

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

gross or net book value29
Gross or Net Book Value

$15,000 ÷ $90,000 = 16.67%

$15,000 ÷ $100,000 = 15%

gross or net book value30
Gross or Net Book Value

The ROI increases each year usingnet book value even though no

operating changes take place.

gross or net book value31
Gross or Net Book Value

Since older assets, with lower net bookvalues, result in higher ROI, managers arediscouraged from investing in new assets.

measuring investment center income

The key issue is controllability.

Measuring InvestmentCenter 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.
inflation historical cost versus current value accounting
Inflation: Historical Cost versusCurrent-Value Accounting

Use of current-value accounting impacts the amount of:

  • Invested capital.
  • Income.
other issues in segment performance evaluation
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
Measuring Performance in Nonprofit Organizations

Since income is not the primary measure of performance innonprofit organizations, performance measures other thanROI and residual income are used.

transfer pricing
Transfer Pricing

Let’s change topics!

transfer pricing37

Batteries

Transfer Pricing

The amount charged when one division sells goods or services to another division

Battery Division

Auto Division

transfer pricing38
Transfer Pricing

The transfer price affects the profit measure for both the selling division and the buying division.

A higher transferprice for batteriesmeans . . .

greater

profits for the

battery division.

Battery Division

Auto Division

transfer pricing39
Transfer Pricing

The transfer price affects the profit measure for both the selling division and the buying division.

A higher transferprice for batteriesmeans . . .

lower profitsfor the

auto division.

Battery Division

Auto Division

goal congruence
Goal Congruence

The ideal transfer price allowseach division manager to makedecisions that maximize thecompany’s profit, whileattempting to maximize his/herown division’s profit.

general transfer pricing rule
General-Transfer-Pricing Rule

Additional outlaycost per unitincurred becausegoods aretransferred

Opportunity costper unit to the

organizationbecause ofthe transfer

Transfer

price

+

=

scenario i no excess capacity
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?

scenario i no excess capacity43
Scenario I: No Excess Capacity

Additional outlaycost per unitincurred becausegoods aretransferred

Opportunity costper unit to the

organizationbecause ofthe transfer

Transfer

price

+

=

$22 Contributionlost if outsidesales given up

Transfer

price

$18 variable cost per battery

=

+

Transfer

price

=

$40 per battery

scenario i no excess capacity44
Scenario I: No Excess Capacity

Auto division canpurchase 100,000batteries from anoutside supplierfor less than $40.

Auto division canpurchase 100,000batteries from anoutside supplierfor more than $40.

Transferwill notoccur.

Transferwill

occur.

$40transferprice

scenario i no excess capacity45
Scenario I: No Excess Capacity

General RuleWhen the selling division is operating at capacity, the transfer price should be set at the market price.

scenario ii excess capacity
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?

scenario ii excess capacity47
Scenario II: Excess Capacity

Additional outlaycost per unitincurred becausegoods aretransferred

Opportunity costper unit to the

organizationbecause ofthe transfer

Transfer

price

+

=

Transfer

price

$18 variable cost per battery

=

+

$0

Transfer

price

=

$18 per battery

scenario ii excess capacity48
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 $38.

scenario ii excess capacity49
Scenario II: Excess Capacity

Transferwill not

occur.

Transferwilloccur.

Transferwill not

occur.

$18transferprice

$38transferprice

setting transfer prices
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.

goal congruence51
Goal Congruence

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

setting transfer prices52
Setting Transfer Prices

Conflicts may be resolved by . . .

  • Direct intervention by top management.
  • Centrally established transfer price policies.
  • Negotiated transfer prices.
setting transfer prices53
Setting Transfer Prices

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

I just won’t

pay $65 for

that part!

You really

don’t have any

choice!

setting transfer prices54
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.

centrally established transfer prices
Centrally EstablishedTransfer Prices

As a general rule, a market price-based transfer pricing policy contains the following guidelines . . .

  • The transfer price is usually set at adiscountfrom the cost to acquire the item on the open market.
  • The selling division may elect to transfer or to continue to sell to the outside.
centrally established transfer prices56
Centrally EstablishedTransfer Prices

As a general rule, a market price-based transfer pricing policy contains the following guidelines . . .

  • The transfer price is usually set at adiscountfrom the cost to acquire the item on the open market.
  • The selling division may elect to transfer or to continue to sell to the outside.

The discount depends

on cost savings from

selling internally.

Cost savings may

include items like

transportation.

negotiating the transfer price
Negotiating the Transfer Price

A system where transfer prices are arrived at through negotiation between managers of buying and selling divisions.

Much managementtime is used in thenegotiation process.

Negotiated price may notbe in the best interest ofoverall company operations.

imperfect markets
Imperfect Markets

Transfer pricing can be quite complex when selling and buying divisions cannot sell and buy all they want in perfectly competitive markets.

cost based transfer prices
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.
an international perspective
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.
behavioral issues risk aversion and incentives
Behavioral Issues:Risk Aversion and Incentives

The design of a managerial performanceevaluation system using financial performancemeasures involves a trade-off between:

Incentives for the manager to act inthe organization’sinterests.

Risks imposed on themanager becausefinancial performance measures are onlypartially controlledby the manager.

And

goal congruence and internal control systems
Goal Congruence andInternal 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.
end of chapter 13
End of Chapter 13

Let’s transfer some of yourcapital to me so that my rateof return will be higher!