Investment Centers and Transfer Pricing CHAPTER 13 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Decision-Making is pushed down. Delegation of Decision Making (Decentralization) Decentralization often occurs as organizations continue to grow. 13-2

Decentralization Advantages Allows organization to respond more quickly to events. Frees top management from day-to-day operating activities. Uses specialized knowledge and skills of managers. 13-3

Decentralization Challenge Goal Congruence: Managers of the subunits make decisions that achieve top-management goals. 13-4

Measuring Performance in Investment Centers Investment Center managers make decisions that affect both profit and invested capital. Investment Center managers make decisions that affect both profit and invested capital. Corporate Headquarters Investment Center Evaluation Return on investment, residual income, or economic value added 13-5

Return on Investment (ROI) ROI = Income Invested Capital ROI = Income Sales Revenue × Invested Capital Sales Margin Sales Margin Capital Turnover 13-6

Return on Investment (ROI) Holly Company reports the following: Income $ 30,000 Sales Revenue$ 500,000 Invested Capital$ 200,000 Let’s calculate ROI. 13-7

ROI = Income Sales Revenue × Invested Capital Return on Investment (ROI) ROI = $30,000 $500,000 × $200,000 ROI = 6% × 2.5 = 15% 13-8

Economic Value Added Economic value added tells us how much shareholder wealth is being created. 13-9

Economic Value Added Investment center’s after-tax operating income – Investment charge = Economic Value Added Weighted- average cost of capital  Investment center’s total assets Investment center’s current liabilities – () After-tax cost of debt Market value of debt Cost of equity capital Market value of equity  (() ) Market value of debt Market value of equity   13-10

Improving R0I Three ways to improve ROI Increase Sales Prices Decrease Expenses Expenses Lower Lower Invested Capital Invested Capital 13-11

Improving R0I Holly’s manager was able to increase sales revenue to $600,000, which increased income to $42,000. There was no change in invested capital. Let’s calculate the new ROI

ROI = Income Sales Revenue × Invested Capital Return on Investment (ROI) ROI = $42,000 $600,000 × $200,000 ROI = 7% × 3.0 = 21% Holly increased ROI from 15% to 21%

ROI - A Major Drawback As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s 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? 13-14

Residual Income Investment center profit – Investment charge = Residual income Investment capital × Imputed interest rate = Investment charge Investment center’s minimum required rate of return 13-15

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. Let’s calculate residual income

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 center’s minimum required rate of return 13-17

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? 13-18

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

Issues: Measuring Investment Capital Three issues must be considered before we can properly measure the investment capital: 1. What assets should be included? a. Total assets b. Total productive assets. c. Total assets less current liabilities. d. Only the assets controllable by the manager being evaluated

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

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

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... greater profits for the battery division. Auto DivisionBattery Division lower profits for the auto division

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

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 =

Scenario I: No Excess Capacity The Battery Division makes a standard 12-volt battery. Production capacity300,000 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? 13-26

Transfer price Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer = + Transfer price = $18 variable cost per battery + $22 Contribution lost if outside sales given up Transfer price = $40 per battery Scenario I: No Excess Capacity 13-27

Scenario I: No Excess Capacity $40 transfer price 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

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

Scenario II: Excess Capacity The Battery Division makes a standard 12-volt battery. Production capacity300,000 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? 13-30

Transfer price Additional outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer = + Transfer price = $18 variable cost per battery + Transfer price = $18 per battery Scenario II: Excess Capacity $

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 $

Scenario II: Excess Capacity Transfer will occur. $18 transfer price $39 transfer price Transfer will not occur. Transfer will not occur

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

Goal Congruence Conflicts may arise between the company’s interests and an individual manager’s interests when transfer-price-based performance measures are used

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

Setting Transfer Prices Top management may become swamped with pricing disputes causing division managers to lose autonomy. I just won’t pay $65 for that part! You really don’t have any choice! Now, here is what the two of you are going to do

Centrally Established Transfer Prices As a general rule, a market price-based transfer pricing policy contains the following guidelines 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. As a general rule, a market price-based transfer pricing policy contains the following guidelines 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

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

Cost-Based Transfer Prices Some companies use the following measures of cost to establish transfer prices... Variable cost Full absorption cost l Beware of treating unit fixed costs as variable

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 high-import-duty countries

End of Chapter 13 Let’s transfer some of your capital to me so that my rate of return will be higher! 13-42