FINANCIAL PERFORMANCE MEASUREMENT AND TRANSFER PRICING Chapter 18 FINANCIAL PERFORMANCE MEASUREMENT AND TRANSFER PRICING  

Divisionalized financial performance measures Market versus accounting measures  Measuring performance in financial terms may be based on (financial) market measures or accounting measures. Their applicability has some limits and disadvantages. First, market measures are only available for listed companies.   Second, market measures may suffer from fluctuations largely beyond the control of managers. Third, market prices largely reflect investors’ expectations about future financial performance of the firms, rather than an evaluation of the actual (past) performance of the managers  Fourth, investors may not be fully informed of or correctly evaluate existing information  Finally, in large organizations the performance of most employees, when considered individually, is likely to have a negligible impact on the overall firm market value.

Divisionalized financial performance measures Accounting measures have been widely adopted alternatives to market measures. Accounting systems are usually pervasive in all types of organizations, although with varying degrees of sophistication  Accounting measures are also less subject to market fluctuations beyond managers’ control and less dependent on expectations and evaluations of market participants.   So, when compared with market measures, accounting measures capture more directly the consequences of past performance, both at higher and lower responsibility levels

Divisionalized financial performance measures Return on investment Return on investment (ROI) is widely used to measure the financial performance of divisions. In a generic formula, ROI divides divisional profit by the assets used by the division: ROI = Profit ÷ Investment ROI-type measures have numerous advantages that explain their widespread use. These measures combine revenues, costs and investments, thereby encouraging managers to simultaneously evaluate the interactions and trade-offs between these three major variables.

Divisionalized financial performance measures By expressing profit as a percentage of assets, rather than an absolute figure, ROI enables the profitability of divisions of different size to be compared. More generally, since ROI is a percentage, it is also often used to compare the financial performance of divisions in different industries, competitors and different types of investments. Finally, there is an important non-technical advantage which is very significant: ROI has been so widely used for so long, that most managers recognize it, are familiar with what it means and know how they can take decisions to improve it.  

Divisionalized financial performance measures But usage of ROI has its problems. Using ROI to evaluate managers and determine their bonuses may lead divisional managers to adopt decisions that improve the ROI of their division (and their bonuses) but make the company globally worse off, and vice versa.     The second problem is that ROI’s usage of accounting profit may promote myopic, short-term behaviour.

Divisionalized financial performance measures Residual income   Residual income (RI), unlike ROI, includes the cost of capital tied up in the division. Residual income subtracts from profit a cost of capital charge for the investment:   RI = Profit – (Required rate of return × Investment)   Return on investment may make capital seem almost free for divisions, promoting excessive investments (creating huge inventories ‘just in case’ or building excessively sophisticated offices are recurrent real-life examples). Residual income addresses this problem by giving a major emphasis to the cost of capital.  

Divisionalized financial performance measures Despite its advantages, RI has not been popular among companies, In addition, RI’s usage has two limitations First, RI is an absolute measure of performance and hence limited when comparing divisions of different size. There are two ways to mitigate this limitation: (1) calculate the additional measure of RI as a percentage of investment – this percentage is comparable across divisions; (2) calculate the percentage change in RI, from  year to year.

Divisionalized financial performance measures This second approach may allow comparisons across divisions, although it may stop being meaningful when RI is negative or is positive, but very small (with very small RI, percentage changes tend to be very large). The second limitation is that RI does not address the myopia problem of ROI: managers are still encouraged to cut discretionary expenses to improve short-term profit, potentially sacrificing long-term success.

Divisionalized financial performance measures Economic value added   Economic value added (EVA®) is a variation of RI, developed and registered as a trademark by Stern Stewart & Co. Economic value added has a strong presence within the academic and professional media, which announce its adoption by several major global firms.   We consider EVA as after-tax operating profit minus after-tax cost of capital employed, plus/minus accounting adjustments, that is:   EVA = After-tax operating profit - [after-tax WACC × (total assets - current liabilities)] ± accounting adjustments  

Divisionalized financial performance measures Major differences between EVA and RI concern EVA’s adoption of after-tax measures (regarding profit and the cost of capital charge) and numerous adjustments to accounting figures (of profit and assets) to convert them into economic profit and assets.

Divisionalized financial performance measures Advantages of EVA include those of RI (in particular, making capital cost very clear to divisional managers) and those from approaching an economic perspective of the company. The accounting adjustments may reduce the managerial myopia risk of ROI and RI. Expenses in intangible items important for long-term success no longer hit the performance measure under EVA. So, managers are less likely to cut them than when accounting profit is used in indicators as ROI and RI. Limitations of EVA: First, it shares the RI characteristic of being an absolute value (rather than a percentage), so it is not suitable to compare divisions of different size. Second, EVA’s accounting adjustments cannot totally create an economic measure reflecting estimates of future cash flows, since EVA is still grounded on accounting information primarily reflecting past events. Economic value added does not totally eliminate the myopia bias.  

Divisionalized financial performance measures Recent studies have produced mixed results about EVA’s superiority to other financial measures, including traditional accounting measures, to explain companies’ market performance. Kumar and Sharma (2011) reviewed such mixed results and provided further results against EVA® adequacy. Some of these studies have led to developments of the original EVA measure. For example, Warr (2005) found that EVA, as a nominal measure, is distorted by inflation even in low-inflation periods; so, they proposed real EVA, adjusting the measure for inflation.

Divisionalized financial performance measures Before that, Bacidore et al. (1997) had proposed refined EVA (REVA), using the market value of assets, rather than their book value. Refined EVA was found to be superior to EVA in later studies (for example, Lee and Kim, 2009, on the hospitality industry) but was rejected by other authors (for example, Ferguson and Leistikow, 1998). While the debate is not closed, it is often suggested that non-financial measures may provide important contributions to assess the value of a firm

Transfer pricing Transfer pricing Transfer prices are used to define the financial value of flows of goods, intangibles, services and capital between subunits of organizations. Transfer pricing is a major issue in large organizations and multinationals, in particular when highly vertically integrated

Transfer pricing Definition and purposes of transfer pricing Transfer prices are the prices of flows of economic goods between divisions of the same organization. Transfer prices influence the revenues of the selling division (the supplier) and the costs of the buying division (the receiver). Although from a corporate perspective this intra-organizational exchange might seem irrelevant at first sight, transfer prices do clearly influence the profitability of each division. Higher transfer prices increase suppliers’ revenues and profits, at the expense of increasing buyers’ costs and decreasing their profits. So, when organizations are decentralized, transfer prices influence divisional managers’ decision about buying from (and selling to) inside or outside the organization. These decisions may lead to different production quantities and have a substantial impact on organization-wide profitability.  

Transfer pricing Transfer prices have three main purposes:   1) To motivate divisional managers to make good economic decisions from an organization-wide perspective.   2) To evaluate managerial and economic performance at divisional level.   3) To shift profits across locations, for tax and other purposes.

Transfer pricing Marginal cost transfer prices   Marginal cost transfer prices (like the other types of transfer prices analysed below) are valuable when the intermediate product market prices are difficult or impossible to get, in particular when the market for the intermediate product does not exist at all.   Marginal cost transfer price = Supplier division’s variable unit costs (Raw materials + Other variable inputs)

Transfer pricing Full-cost transfer prices  Full-cost transfer prices include not only the supplier division’s unit variable costs, but also fixed costs. Full-cost transfer price = Supplier division’s variable + Fixed unit costs   However, this approach has three problems. First, it does not ensure goal congruence. By increasing the transfer price above the supplier division’s marginal cost, it promotes decisions by the buying division which reduce group-wide profitability.   Second, defining transfer prices based on full costs increases the problem, already present in the previous method, potentially caused by inaccurate allocation of indirect costs, because now both variable and fixed costs are at stake.   Third, because the supplier division’s profit margin is still not included in the transfer price, this method still does not fully solve the evaluation bias problem of the previous method; it stills introduces a bias against the seller and in favour of the buyer.

Transfer pricing ‘Cost plus a mark-up’ transfer prices This method sets transfer prices by adding a mark-up to the supplier division’s costs in order to allow it to make a profit and approximate market prices. This makes transfer prices more adequate for divisional evaluation than previous cost-based alternatives. This method is particularly useful if there is no competitive market price. If this method uses full costs data, then the mark-up should only reflect the profit margin; alternatively, if it uses marginal costs, then the mark-up should reflect both fixed costs and the profit margin. Cost-plus a mark-up transfer price = Supplier division’s variable + Fixed unit costs ( ) × (1 + Supplier division’s profit margin)  

Transfer pricing Negotiated transfer prices When there are imperfect external markets, there may be a case for setting negotiated transfer prices through a bargaining process between the two parties. In not perfectly competitive markets, slight differentiation possibilities, based on product characteristics or on other sales terms, or the   power of particular market participants, may allow multiple prices to coexist. Market price and cost information may be used in this bargaining process, but note that such information may also be ignored.

Transfer pricing Politics and roles of management accountants in transfer-pricing negotiations   Management accountants are often at the hub of potentially difficult bargaining processes. The negotiation of transfer prices is an example that makes the political dimension of organizations – and of its participants, management accountants included – particularly visible. However, this dimension of the roles of management accountants is often overlooked. At a theoretical level, management accountants are usually prescribed a supposedly neutral role – a role that, in practical terms, is presented as one endorsing the perspective of the organization as a whole

Transfer pricing Method variations to overcome limitations   Transfer pricing at ‘marginal costs plus a fixed lump-sum fee’   The risk of adopting tax-compliant transfer prices for management control   Cools and Emmanuel (2007) suggest that multinationals may now be led to prioritize tax compliance in transfer pricing and hence adopt tax-compliant methods for internal purposes as well. Why? To reduce the risk of being investigated by increasingly aggressive tax authorities, potentially imposing large transfer prices adjustments and heavy penalties in case of non-compliance with tax legislation.