Managerial Accounting: An Introduction To Concepts, Methods, And Uses Chapter 13 Investment Center Performance Evaluation Maher, Stickney and Weil

C Learning Objectives (Slide 1 of 3) Identify the benefits and disadvantages of decentralization. Identify the issues that must be addressed when using return on investment as a divisional performance measure. Identify examples of differential analysis to make-or-buy decisions with different transfer prices. Discuss transfer pricing issues and methods.

C Learning Objectives (Slide 2 of 3) Discuss multinational transfer prices. Identify types of costs to be considered in measuring divisional operating cost. Identify issues in measuring the investment base for calculating return on investment. Explain the contribution approach alternative to return on investment for division performance measurement.

C Learning Objectives (Slide 3 of 3) Describe the purpose of the return on investment calculation, and identify its shortcomings. Explain how to calculate economic value added, and identify its use.

C Nature of Divisionalized Organizations (Slide 1 of 2) Top managers delegate or decentralize authority and responsibility Major advantages of a decentralized organization include: Allows local personnel to respond quickly to a changing environment Frees top management from detailed operating decisions Divides large, complex problems into manageable chunks Helps train managers and provides a basis for their evaluation Motivates managers by allowing them to make their own decisions

C Nature of Divisionalized Organizations (Slide 2 of 2) Disadvantage - local managers may not act in ways consistent with overall organizational goals There may be conflicts between goals of a division and overall goals of the organization Planning and control systems try to create goal congruence where division managers are motivated to act in ways consistent with overall organizational goals

C Return on Investment (Slide 1 of 2) Divisions are expected to contribute to the company’s profitability However, division profits need to be considered in light of the amount of funds invested in the division Return on investment (ROI) is calculated as follows: Division Operating Profit Division Investment

C Return on Investment (Slide 2 of 2) When using ROI as a divisional performance measure, the following questions must be addressed: How does the firm measure revenue, especially for transfers between divisions? Which costs are deducted in measuring divisional operating costs? How is the investment in the division measured?

C Transfer Pricing (Slide 1 of 2) Transfers of products or services between units in the organization are recorded in the accounting records using a transfer price Transfer prices are commonly used in performance evaluation, product costing and decision making Determining the appropriate transfer price is important

C Transfer Pricing (Slide 2 of 2) Determining the appropriate transfer price depends critically on whether the selling division has excess capacity As a general rule, if the selling division has: Excess capacity - transfer price should equal differential cost of production (usually variable cost) No excess capacity- transfer price should be market price

C Alternative Ways to Set Transfer Prices Idea is to set transfer prices so that buyer and seller have goal congruence with organization’s goals Three general alternatives available for setting transfer prices Top management sets transfer prices Top management establishes transfer price policies followed by divisions Division managers negotiate transfer prices

C Top Management Intervention If top management sets transfer prices, the “right” transfer prices may result, but Top management may become swamped with pricing disputes Division managers lose flexibility and other advantages of decentralization If transactions between divisions are infrequent, direct intervention in setting transfer prices may be beneficial

C Centrally Established Transfer Price Policies (Slide 1 of 4) Transfer pricing policy should: Allow divisional autonomy Encourage managers to pursue corporate goals consistent with their own personal goals Be compatible with the performance evaluation system

C Centrally Established Transfer Price Policies (Slide 2 of 4) Economic transfer pricing rule - transfer at differential outlay cost to the selling division (typically variable cost), plus opportunity cost of making the internal transfer Rule of thumb - if the selling division has: Excess capacity - transfer price should equal differential cost of production (usually variable cost) No excess capacity- transfer price should be market price

C Centrally Established Transfer Price Policies (Slide 3 of 4) Transfer prices based on market price Generally considered the best basis when a competitive market exists for the product and market prices are readily available Good estimation of differential cost + opportunity cost Advantage - Both buying and selling managers can buy and sell all they want at market price

C Centrally Established Transfer Price Policies (Slide 4 of 4) Transfer prices based on costs could be based on: Full-absorption costs Activity-based costing Cost-plus transfers Standard costs or actual costs

C Motivational Aspects of Transfer Pricing (Slide 1 of 2) If transfer pricing policy does not give the supplier a profit, motivational problems can arise Fails to motivate seller to transfer internally, since there is no contribution toward profit If all transfers are internal, it may be more appropriate to set up division as a cost center

C Motivational Aspects of Transfer Pricing (Slide 2 of 2) Possible solutions to motivational problems include: Using dual transfer prices - Charge the buyer the cost of the unit and credit selling division with cost plus a profit allowance Using balanced scorecard principles to evaluate selling manager’s performance and explicitly incorporate internal transfers in the reward system

C Division Managers Negotiate Transfer Prices Under this system, managers act as if they managed independent companies Advantage - preserves autonomy of division managers Disadvantages May require a great deal of management effort Final price may depend more on negotiating skills rather than on what is best for the company

C Global Transfer Pricing (Slide 1 of 2) Nearly half of companies use transfer prices based on cost About one-third use a market price- based system Negotiated prices tend to fall between the market price and some measure of cost

C Global Transfer Pricing (Slide 2 of 2) In international transactions, as well as transfers across state lines, transfer prices may affect tax liabilities, royalties, and other payments Companies may be motivated to use transfer prices as a mechanism to increase profits in low-tax jurisdictions and reduce profits in high-tax jurisdictions Major problem for many states and countries

C Measuring Division Operating Profits (Slide 1 of 5) In measuring divisional operating costs, management must decide how to treat the following costs: Controllable direct operating costs Noncontrollable direct operating costs Controllable indirect operating costs Noncontrollable indirect operating costs

C Measuring Division Operating Profits (Slide 2 of 5) The issue is whether to include these costs in determining division operating profits for purposes of performance evaluation Direct versus indirect refers to whether the cost associates directly with the division Controllable versus noncontrollable refers to whether the manager can affect the cost

C Measuring Division Operating Profits (Slide 3 of 5) Direct costs - almost always deducted in determining division operating profits Can separate out costs assigned to a division from those assigned to a manager Could, for example, exclude costs that can’t be controlled by a manager from that manager’s performance evaluation

C Measuring Division Operating Profits (Slide 4 of 5) Indirect controllable operating costs- may be at least partially controllable by division managers Example: Centralized service department costs such as the training function If division is charged for use of services of these departments, division may avoid using them Could be counter-productive

C Measuring Division Operating Profits (Slide 5 of 5) Indirect noncontrollable operating costs May be necessary costs but division manager lacks the ability to control these costs (e.g., salaries of top corporate management) May want to allocate these costs to divisions to raise awareness that sales revenue must cover not only divisional costs but also those of central headquarters

C Assets Included in Investment Base When calculating ROI, assets to be included in the denominator must be determined and valued Most firms use acquisition cost Using book value can cause problems Managers may be reluctant to replace older assets due to the negative impact on ROI

C Components of Return on Investment Return on Investment (ROI) is calculated as follows: ROI = Profit Margin % X Investment Turnover Ratio Profit Margin = Profit Margin X Divisional Revenues Divisional Divisional Divisional Investment Revenues Investment

C Economic Value Added An alternative to ROI is Economic Value Added (EVA) calculated as follows: EVA = NOPAT - (WACC X Investment) Where:NOPAT=Net Operating Profit After Tax WACC=Weighted-Average Cost of Capital Investment=Total Assets - Noninterest- Bearing Current Liabilities

C If you have any comments or suggestions concerning this PowerPoint Presentation for Managerial Accounting, An Introduction To Concepts, Methods, And Uses, please contact: Dr. Donald R. Trippeer, CPA Colorado State University-Pueblo