Segment Reporting and Transfer Pricing Module 23 Segment Reporting and Transfer Pricing

Segment Reports Segment Reports Follow the Organization Structure: Cost Center – Ex.: Maintenance Department Compare actual costs with the budget Revenues—Ex.: Western Sales Territory Compare actual sales with the budgeted sales Profits—A Movie Compare profits with the budgeted profits Profits and Investment—Electronics, Inc. (Sub.) Compare Ret. on Investment to required ROI

Terms for Costs of Segments Variable costs Ex: Materials usage Direct fixed costs FC directly traceable to segment: Segment manager Allocated common costs Indirect tracing of costs to a unit: share of a engineering cost by product lines on time Unallocated common costs Central costs of many segments: Home office should not be allocated, but some companies do…

Example Profit Centers North Territory South Territory Total Sales $16,000. $18,000. $34,000. Less variable costs (5,600) (6,100) (11,700) Contribution margin 10,400. 11,900. 22,300. Less direct fixed costs (2,000) (1,600) (3,600) Territory margin 8,400. 10,300. 18,700. Less allocated segment costs (1,200) (1,400) (2,600) Territory income $ 7,200. $ 8,900. 16,100. Less unallocated common costs (1,500) Net income $14,600. Segment margin is relevant for measuring the short-term effects of decisions to continue or discontinue a segment. Segment income is relevant for measuring the long-term effects of decisions to continue or discontinue a segment.

Return on Investment (ROI) A measure of the earnings per dollar of an investment Assumes financing decisions are made at the corporate level Investment center income Investment center asset base ROI = Evaluated by comparing to previously identified performance criteria, such as Overall company ROI Budget ROI Often rank ordered with awards of bonuses/raises to highest performers and bottom performers warned or dumped.

However… High ROI divisions tend to only take on extremely high return projects resulting in slow growth. Example: West Texas Division has an ROI of 50% on an asset base of $20 million: Superstars—BIG Bonuses! Now Project X12 has a promised return of 30% and requires an investment of $10 million. If West Texas takes on the project then ROI decreases: [50%*$20MM + 30%*$10MM]/[$20MM+$10MM)= [$10,000,000 + $3,000,000]/$30,000,000 = 43.3% Superstars would be less shiny! Will West Texas Division take on this project? (Never…) Also, West Texas would be better off to shrink any part of their organization that earns less than 50%!

Residual Income Residual Income is an alternative measure to ROI: RI = Division Income – Min Rate of Return X Asset Base West Texas: Set required return to 15%. Residual income before X12: 50%*$20MM – 15%*$10MM = $8,500,000 Residual income with X12: $8,500,000 + [30%*$10 MM – 15%*$10MM]= $10,000,000 West Texas Division should expand as long as projects earn more than the required return.

Economic Value Added (EVA®) Used to evaluate investment center performance A variation of residual income Significant differences from residual income Weighted average cost of capital used instead of required rate of return Net assets are used as the evaluation base After-tax income is used as investment center income Corrects for potential distortions in economic net income caused by GAAP Total assets less current liabilities An average of the after-tax cost of all long-term borrowing and the cost of equity financing

The West Texas Division added $4,500,000 in value to AST Distributors. Economic Value Added AST Distributors has an 10% cost of capital and a 40% income tax rate. Amounts for the West Texas Division for 2012 are: Assets $20,000,000 Division income $ 10,000,000 Current liabilities $ 5,000,000 EVA = Division income after tax - Cost of capital x (Assets – Current Liabilities] = ($10,000,000×(1.0-0.4) – 0.10×($20,000,000–$5,000,000) = = $6,000,000 - $1,500,000 = $4,500,000 The West Texas Division added $4,500,000 in value to AST Distributors.

Balanced Scorecard In general: “We get what we measure” With ROI, Residual Income, EVA we tend to get short-term behaviors! Long-term performance requires customer relations, new products, well trained & loyal employees… Balanced Scorecard: A comprehensive performance measurement system that includes financial measures and measures related to: Customers Internal processes Innovation and learning

Examples of Key Indicators Key financial indicators Cost, Revenue, Profit, or Cash Flow Return on investment (ROI), Residual Income, or Economic Value Added Key customer indicators Average customers per hour Number of customer complaints per period Number of sales returns per period Key operating indicators On-time delivery Quality of units produced Employee turnover per period Key growth and innovation indicators New products introduced during period Products discontinued during period Number of sales promotions Special offers, discounts, etc.

Transfer Pricing The transfer price is an internal value assigned a product or service that one division provides to another. Normally occurs between profit or investment centers Higher transfer prices result in: More profits to the selling divisions and less to the buying divisions Lower volume and profit for company as a whole Transfer prices may be based on market prices (where available) or costs, or they may be negotiated.

Market Price as the Transfer Price Best method of setting transfer prices, if there is an existing market with established prices for internal products, BUT most often there is not an established market. Preserves divisional autonomy and leads divisions to act in a manner that maximizes corporate profits Assuming divisions are free to buy and sell outside the firm Often specified as market price minus a discount when selling and administrative costs are lower on transfers.

Cost Plus Markup as Transfer Price Allows supplying divisions to increase earnings May result in some undesired behavior: Passing along inefficiencies, no penalty for inefficiency Stifle buyers’ demand and profits in low volume periods Supplying divisions tend to have higher ROI than buying divisions… Variations on “cost” and “markup”: variable only, standardized, total costs including administration, dual transfer price (e.g. VC and FC+MU%), opportunity costs, fixed fees versus % markup

Negotiated Price as the Transfer Price Supplying and buying divisions agree on a price through negotiation Use for relatively few transfers with similar powered negotiators Divisions should be free to withdraw and go elsewhere