Chapter 13

Investment Centers
and Transfer Pricing

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Delegation of Decision Making

(Decentralization)
Decision Making
is pushed down.

Decentralization often occurs as organizations continue to grow.

Decentralization

Advantages
Allows organization
to respond more
quickly to events.

Uses specialized
knowledge and
skills of managers.

Frees top management

from day-to-day
operating activities.

1-4

Decentralization

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

1-5

Learning
Objective
2

McGraw-Hill/Irwin

Copyright 2011 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.
Investment
Center
Evaluation

Corporate Headquarters
Return on investment,
residual income, or
economic value added
1-7

Return on Investment (ROI)

Income
ROI =
Invested Capital
ROI =

Income
Sales Revenue
Sales
Margin

Sales Revenue

Invested Capital
Capital
Turnover
1-8

Return on Investment (ROI)

Holly Company reports the following:
Income
Sales Revenue
Invested Capital

$ 30,000
$ 500,000
$ 200,000

Lets calculate ROI.

1-9

Return on Investment (ROI)

ROI =

Income
Sales Revenue

ROI =

$30,000
$500,000

Sales Revenue

Invested Capital

$500,000
$200,000

ROI = 6% 2.5 = 15%

1-10

Economic Value Added

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

1-11

Economic Value Added

Investment centers after-tax operating income
Investment charge
= Economic Value Added

(
(

Investment
centers
total assets

Investment
centers
current liabilities

After-tax
Market
cost of value
debt
of debt
Market
value
of debt

Weighted

average
cost of capital

Cost of
Market
equity value
capital
of equity
Market
value
of equity

) (

)
1-12

Economic Value Added

The Atlantic Division of Suncoast Food Centers reported
the following results for the most recent period:
Atlantic's pretax income
Atlantic's total assets
Atlantic's current liabilities
Market value of Suncoast's debt
Market value of Suncoast's equity
Interest rate on Suncoast's debt
Cost of Suncoast's equity capital
Tax rate

6,750,000
45,000,000
600,000
40,000,000
60,000,000
9%
12%
30%

Compute Atlantic Divisions economic value added.

1-13

Economic Value Added

First, lets 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
1-14

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
1-15

Learning
Objective
3

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Improving R0I
Decrease
Expenses
Increase
Sales
Prices

Lower
Invested
Capital

Three ways to improve ROI

1-17

Improving R0I
Hollys manager was able to increase sales
revenue to $600,000 which increased
income to $42,000.
There was no change in invested capital.

Lets calculate the new ROI.

1-18

Return on Investment (ROI)

ROI =

Income
Sales Revenue

ROI =

$42,000
$600,000

Sales Revenue

Invested Capital

$600,000
$200,000

ROI = 7% 3.0 = 21%

Holly increased ROI from 15% to 21%.
1-19

ROI - A Major Drawback

As division manager at Winston, Inc., your
compensation package includes a salary plus
bonus based on your divisions 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?
1-20

Residual Income
Investment center profit
Investment charge
= Residual income
Investment capital
Imputed interest rate
= Investment charge

Investment centers
minimum required
rate of return
1-21

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.

Lets calculate residual income.

1-22

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 centers
minimum required
rate of return
1-23

Learning
Objective
4

McGraw-Hill/Irwin

Copyright 2011 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?
1-25

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

1-26

Learning
Objective
5

McGraw-Hill/Irwin

Copyright 2011 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.
2.
3.
4.

Total assets.
Total productive assets.
Total assets less current liabilities.
Only the assets controllable by the manager
being evaluated.
1-28

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?
1-29

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.

Lets calculate ROI using both the

gross and net book values.
1-30

Gross or Net Book Value

Year
1
2
3

Profits
Gross
before
Depreciation Operating
Book
Depreciation
Expense
Profits
Value
$
25,000 $
10,000 $
15,000 $ 100,000
25,000
10,000
15,000
100,000
25,000
10,000
15,000
100,000

Net
Book
Value
$ 90,000
80,000
70,000

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

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

1-31

Gross or Net Book Value

Year
1
2
3

Net
Gross
Operating
Net Book
Book
Profits
Value
ROI
Value
ROI
$
15,000 $ 90,000 16.67% $ 100,000 15.00%
15,000
80,000 18.75% 100,000 15.00%
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.
1-32

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.

1-33

Inflation: Historical Cost versus

Current-Value Accounting
Use of current-value accounting impacts the
amount of:
1. Invested capital.
2. Income.

1-34

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.

1-35

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.

1-36

Transfer Pricing

Lets change topics!

1-37

Learning
Objective
6

McGraw-Hill/Irwin

Copyright 2011 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
profits for the
battery division.

lower profits
for the
auto division.

Auto Division
1-39

Goal Congruence
The ideal transfer price allows
each division manager to make
decisions that maximize the
companys profit, while
attempting to maximize his/her
own divisions profit.

1-40

General-Transfer-Pricing Rule

Transfer
price

Additional outlay
cost per unit
incurred because
goods are
transferred

Opportunity cost
per unit to the
organization
because of
the transfer

1-41

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?
1-42

Scenario I: No Excess Capacity

Transfer
price

Additional outlay
cost per unit
incurred because
goods are
transferred

Transfer
price

$18 variable
cost per battery

Transfer
price

$40 per battery

Opportunity cost
per unit to the
organization
because of
the transfer

$22 Contribution
lost if outside
sales given up

1-43

Scenario I: No Excess Capacity

Auto division can
purchase 100,000
batteries from an
outside supplier
for less than $40.

Auto division can

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

Transfer
will not
occur.

Transfer
will
occur.

$40
transfer
price

1-44

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.

1-45

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?
1-46

Scenario II: Excess Capacity

=

Additional outlay
cost per unit
incurred because
goods are
transferred

Transfer
price

$18 variable
cost per battery

Transfer
price

$18 per battery

Transfer
price

Opportunity cost
per unit to the
organization
because of
the transfer

$0

1-47

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.
1-48

Scenario II: Excess Capacity

Transfer
will not
occur.

Transfer
will
occur.

$18
transfer
price

Transfer
will not
occur.

$39
transfer
price

1-49

Learning
Objective
7

McGraw-Hill/Irwin

Copyright 2011 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.

1-51

Goal Congruence
Conflicts may arise between the
companys interests and an individual
managers interests when transferprice-based performance measures are
used.

1-52

Setting Transfer Prices

Conflicts may be resolved by . . .
1. Direct intervention by top management.
2. Centrally established transfer price
policies.
3. Negotiated transfer prices.

1-53

Setting Transfer Prices

Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.
You really
dont have any
choice!

Now, here is what the two

of you are going to do.

1-54

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.
1-55

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.
1-56

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.

1-57

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 highimport-duty countries.

1-58

Learning
Objective
8

McGraw-Hill/Irwin

Copyright 2011 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:
Incentives for the
manager to act in
the organizations
interests.

And

Risks imposed on the

manager because
financial performance
measures are only
partially controlled
by the manager.
1-60

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.

1-61

End of Chapter 13
Lets transfer some of your
capital to me so that my rate
of return will be higher!

1-62