Internal Performance Measurement and Transfer Pricing EMBA Presentation November 17, 2016 Internal Performance Measurement and Transfer Pricing

Internal Performance Measurement Responsibility Centers Residual Income Return on Investment EVA

Responsibility Centers Cost center Profit center Investment center

Schematic Investment Center Profit Center Profit Center Cost Center

Summary of Performance Centers Type of Center Decision Rights Performance Measures Cost Input Mix Cost controls Profit Product Mix, Selling Prices, Input Mix Actual Profits, Budget Comparisons Investment Input Mix, Product Mix, Selling Prices, Capital Invested ROI, Residual Income, EVA

Schematic of the ROI Method Sales Sales Turnover Divided by Total Investment ROI Multiplied by Earnings Return on Sales Divided by Sales

ROI Example Sales $9,000,000 Net Operating Income $ 720,000 Total Investment $4,000,000 Sales Turnover $9,000,000  $4,000,000 = 2.25 Return on Sales $720,000  $9,000,000 = 8% ROI 2.25 x .08 = 18%

Criticisms of ROI Managers may make decisions that increase the ROI in the short run Managers often inherit costs over which they have no control Managers may reject investment opportunities that are good for the organization, but negatively impact the segment

Residual Income Focuses on the residual return after deducting the minimum return required by top management Average Operating Assets Minimum Required Rate of Return Residual Income = NOI – X

Example of Residual Income

Criticisms of Residual Income Absolute number that ignores investment center size Does not measure risk factors Opportunity cost of capital is different between investment centers

Calculation of EVA Adjusted Weighted Cost of Capital EVA = Accounting – X Earnings Total Capital

Calculation of EVA Earnings Earnings per GAAP Less cost of capital used by the center Plus R & D expenses deducted Add amortization of R & D Equals EVA Earnings

Capital Formula for EVA Total Capital Invested Plus Capitalized R & D Costs

Example Using EVA Operating Income plus R & D Expenses $900,000 Less Amortization of R & D Expenses 100,000 Adjusted Earning for EVA $800,000 Invested Capital $4,000,000 Plus Capitalized R & D 1,000,000 EVA Capital $5,000,000 EVA Rate 16%

Controllability Principle

Westinghouse Nuclear Case

Transfer Pricing Topics What is transfer pricing? Terms Delco example Transfer pricing methods Car dealership example Summary of transfer pricing methods International and tax ramifications

A transfer price is the price one sub-unit charges another for a product or service supplied to it

Terms Full cost – includes both fixed and variable components Variable cost – includes only the costs directly related to producing the product Idle capacity – plant capacity available for additional manufacturing without incurring more fixed costs Substitute products – competitive products are available in the open market a lower price

Congruence Problems Management expects sub-units to act in a manner that maximizes firm-wide profits Management desires that product family members be used throughout the firm Unit managers operate in a manner that optimizes the profitability of their unit which is often reflected in their incentives

Delco Example Delco $40 Manufactures Batteries After Market ? Outside market $40 Full cost $30 Variable cost $20 Delco has excess capacity Chevrolet

Transfer Pricing Methods Market based Cost based Negotiated Dual

Market Prices Lead to Optimal Decisions When: The market for the intermediate product is perfectly competitive Interdependence of subunits is minimal No additional costs in buying or selling in the external market compared to the internal

Cost Based Transfer Prices Full cost – price includes both the fixed and variable component If excess capacity is used, there should be no additional fixed costs Fixed costs may be allocated between external and internal sales Full costing may be more appropriate where a firm uses ABC costing Variable cost – includes only the incremental cost

Negotiated Prices Mutual agreement between sub-units May have no relationship to cost or market prices May be affected by a unit’s ability to negotiate

Dual Pricing In this case, the selling division and the buying division do not pay or receive the same amount Seller gets full cost and buyer pays market Difference rolls to a corporate account May cause divisional tax calculation problems Selling unit has no incentive to control costs

Car Dealer Example Departments: New Vehicles, Used Vehicles, Service, Body Shop, and Parts Department New Used Body Service Retail Service labor rate $40 $40 $65 Body shop labor rate $40 $40 $40 $65 Parts mark-up 15% 15% 15% 15% 30%

Summary of Methods Domestic Multinational Market based 26% 35% Cost based: Variable 3% 0% Full cost 49% 42% Other 1% 1% Total 53% 43% Negotiated 17% 14% Other 4% 8% TOTAL 100% 100%

International and Tax Ramifications Large firms are global in nature Firms sell products between international subsidiaries or joint ventures Tax rates vary between countries International firms will transfer price to minimize total taxes paid

Eastman Kodak Case

Copyright, Frank Ilett, 2016