Performance Measurement and Transfer Pricing

Financial and Nonfinancial Performance Measures Some organizations present financial and nonfinancial performance measures for their subunits in a single report – the balanced scorecard. Most scorecards include: – profitability measures – customer-satisfaction measures – internal measures of efficiency, quality, and time – learning and growth (innovation) measures

Management Control Systems A management control system is a means of gathering and using information to coordinate the planning and control functions of the company. It guides the behavior of managers towards attaining the goals shown in the Balanced Scorecard.

Evaluating Management Control Systems Motivation Goal congruence Effort Lead to rewards Monetary Nonmonetary

Organization Structure Total centralization Total decentralization

Benefits of Decentralization Allows for greater responsiveness to local needs Leads to gains from quicker decision making Increases motivation of subunit managers Assists management development and learning Allows top management to focus on strategy

Costs of Decentralization Suboptimal decision making may occur Focuses the manager’s attention on the subunit rather than the organization as a whole Lack of coordination among autonomous managers Results in duplication of activities

Responsibility Centers Cost center Revenue center Profit center Investment center

Measuring Managers Performance Evaluation Tool Cost/Revenue Center Standard Cost/Flexible Budget Variances Profit Center Budgeted income statement Investment Center Return on investment, residual income and EVA

Accounting-Based Performance Measure Example Relax Inns owns three small hotels – one each in Bombay, Delhi, and Manali. At present, Relax Inns does not allocate the total long-term debt of the company to the three separate hotels.

Delhi Hotel Current assets 400,000 Long-term assets 600,000 Total assets 1,000,000 Current liabilities 150,000 Revenues 1,200,000 Variable costs 310,000 Fixed costs 650,000 Operating income 240,000

Relax Inns Balance Sheet Total current assets 1,350,000 Total long-term assets 6,150,000 Total assets 7,500,000 Total current liabilities 500,000 Long-term debt 4,800,000 Stockholders’ equity 2,200,000 Total liabilities and equity 7,500,000

Approaches to Measuring Performance Three approaches include a measure of investment: Return on investment (ROI) Residual income (RI) Economic value added (EVA®) A fourth approach, return on sales (ROS), does not measure investment.

Return on Investment Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment. Return on investment (ROI) = Income ÷ Investment

What is the return on investment for the Delhi Hotel? Denver Hotel: 240,000 Operating income ÷ 1,000,000 Total assets = 24%

Residual Income Residual income (RI) = Income – (Required rate of return × Investment) Assume that Relax Inns’ required rate of return is 12%. What is the residual income from the Delhi hotel?

Residual Income = 240,000 - (1,000,000 X 12%) Delhi Hotel: Residual Income = 240,000 - (1,000,000 X 12%) = 120,000

Economic Value Added Economic value added (EVA®) = After-tax operating income – [Weighted-average cost of capital × (Total assets – current liabilities)]

Economic Value Added Total assets minus current liabilities can also be computed as: Long-term assets + Current assets – Current liabilities, or… Long-term assets + Working capital

Economic Value Added Economic value added (EVA) substitutes the following specific numbers in the RI calculations: 1. Income equal to after-tax operating income 2. A required rate of return equal to the weighted-average cost of capital 3. Investment equal to total assets minus current liabilities

Economic Value Added Example Assume that Relax Inns has two sources of long-term funds: 1. Long-term debt with a market value and book value of 4,800,000 issued at an interest rate of 10% 2. Equity capital that also has a market value of 4,800,000 and a book value of 2,200,000 Tax rate is 30%.

Economic Value Added Example What is the after-tax cost of debt? 0.10 × (1 – Tax rate) = 0.07, or 7% Assume that Relax Inns’ cost of equity capital is 14%. What is the weighted-average cost of capital?

Economic Value Added Example WACC = [(7% × Market value of debt) + (14% × Market value of equity)] ÷ (Market value of debt + Market value of equity) WACC = [(0.07 × 4,800,000) + (0.14 × 4,800,000)] ÷ 9,600,000 WACC = 336,000 + 672,000 ÷ 9,600,000 WACC = 0.105, or 10.5%

Economic Value Added Example What is the after-tax operating income for the Denver Hotel? Denver Hotel: Operating income 240,000 × 0.7 = 168,000

Economic Value Added Example What is the investment? Delhi Hotel: Total assets 1,000,000 – Current liabilities 150,000 = 850,000

Economic Value Added Example What is the weighted-average cost of capital times the investment for Delhi? Delhi Hotel: 850,000 × 10.5% = 89,250

Economic Value Added Example What is the economic value added? Delhi Hotel: 168,000 – 89,250 = 78,750 The EVA® charges managers for the cost of their investments in long-term assets and working capital.

Return on Sales The income-to-revenues (sales) ratio, or return on sales (ROS) ratio, is a frequently used financial performance measure. What is the ROS for the Delhi hotel? Delhi Hotel: 240,000 ÷ 1,200,000 = 20%

Transfer Pricing The amount charged when one division sells goods or services to another division Batteries Battery Division Auto Division

Transfer-Pricing Methods Negotiated transfer prices Cost-based transfer prices Market-based transfer prices

Negotiated Transfer Prices A negotiated transfer price results from discussions between the selling and buying divisions. Upper limit is determined by the buying division. Lower limit is determined by the selling division. Range of Acceptable Transfer Prices A negotiated transfer price results from discussions between the selling and buying divisions.   Negotiated transfer prices have two advantages. First, they preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company. Second, the range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase. The lower limit is determined by the selling division. The upper limit is determined by the buying division.

Barker Company – An Example Assume the information as shown with respect to The Battery Division and Vehicle Division (both Division’s are owned by Barker Company). Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder).

Barker Company –Scenario 1 Suppose that the Battery Division is operating at capacity. What is the lowest acceptable transfer price from the viewpoint of the Battery Division? What is the highest acceptable transfer price from the viewpoint of the Vehicle Division? Will a transfer take place? The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as shown. The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as shown. If Pizza Maven had no outside supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses. Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

General Guideline for Determining a Minimum Transfer Price = Incremental costs per unit incurred up to the point of transfer + Opportunity costs per unit to the selling division

Barker Company – Scenario 1 As indicated, the Battery Division is operating at capacity. The Battery Division’s acceptable transfer price is calculated as: The Vehicle Division’s acceptable transfer price is calculated as: The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as shown. The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as shown. If Pizza Maven had no outside supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses. Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

Barker Company – Scenario 1 If Battery Division has no idle capacity (0 batteries) and must sacrifice other customer orders (50,000 batteries) to meet Vehicle Division’s demands (50,000 barrels), then the lowest and highest possible transfer prices are computed as follows: Selling division’s lowest possible transfer price: Part I If Imperial Beverages has no idle capacity and must sacrifice other customer orders (two thousand barrels) to meet the demands of Pizza Maven (two thousand barrels), then the lowest and highest possible transfer prices will be computed as shown. Part II The lowest acceptable transfer price, as determined by the seller, is twenty pounds. Part III The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, there is no range of acceptable transfer prices. This is a desirable outcome for Harris Louder because it would be illogical to give up sales of twenty pounds to save costs of eighteen pounds. Buying division’s highest possible transfer price: Therefore, there is no range of acceptable transfer prices.

Barker Company – Scenario 2 Refer to the original data. Assume that the Battery Division has enough idle capacity to supply the Vehicle Division’s needs without diverting batteries from the outside market. What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place? Part I If Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Maven’s demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown. Part II The lowest acceptable transfer price, as determined by the seller, is eight pounds. Part III The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

Barker Company – Scenario 3 Refer to the original data. Suppose the Battery Division is selling 275,000 batteries per month on the outside market. The Vehicle Division can put only one kind of batteries in its vehicles. It cannot buy 25,000 batteries from an outside supplier and 25,000 batteries from the Battery Division: it must buy all of its batteries from one source. The Battery Division must sacrifice some outside customer orders to meet the Vehicle Division’s demands. What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place? Is this transfer “goal-congruent” for the Company (Barker)? Part I If Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Maven’s demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown. Part II The lowest acceptable transfer price, as determined by the seller, is eight pounds. Part III The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

An Example Materials used by the Truck Division of Structure Motors are currently purchased from outside suppliers at a cost of $260 per unit. However, the same materials are available from the Component Division. The Component Division has unused capacity and can produce the materials needed by the Truck Division at a variable cost of $190 per unit. If a transfer price of $230 per unit is established and 40,000 units of material are transferred with no reduction in the Component Division’s current sales, how much would Structure Motors’ total income from operations increase? How much would the Truck Division’s income from operations increase? How much would the Component Division’s income from operations increase? Let’s change the transfer price to $250. Recalculate a, b and c above. What additional insights can we gain? Part I If Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Maven’s demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown. Part II The lowest acceptable transfer price, as determined by the seller, is eight pounds. Part III The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

Cost-Based Transfer Prices Some companies use the following measures of cost to establish transfer prices . . . Variable cost (₤18 for the Battery Division). The selling division will never show a profit on any internal transfer. Full absorption cost (₤25 for the Battery Division) Will the Battery Division transfer at Full Cost if it has no capacity? What happens if the Battery Division has capacity and the Auto Division can sell batteries at ₤23 in a foreign country? Mark-up (e.g. 120% of full cost, or ₤30 per battery). 35

Transfers at Market Price A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem. Note: 1. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. In the Battery Division example, the price would be set at ₤40. 2. A market price approach does not work well when the selling division has idle capacity. What happens if the Battery Division has excess capacity? Will it prefer to sell at a price below ₤40? A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.   It works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. With no idle capacity the real cost of the transfer from the company’s perspective is the opportunity cost of the lost revenue on the outside sale. It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole.

An International Perspective Since tax rates 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. 40