Transfer Pricing & Utilizing Assets Employed Chapters 5 & 6, Management Control Systems, 12th Ed., Anthony and Govindarajan

Transfer Pricing The pricing system for the transfer of goods or services between two profit centers within the same organization. Can also apply to services provided by corporate staff units.

Objectives of a Transfer Price Provide relevant info to provide for optimum company profits Induce goal congruent decisions Measure economic performance Simple and easy to understand

Fundamental Principle The fundamental principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors. [Text, p. 202]

Various Situations Market Price Constrained Cost-Based Limited Markets Excess / Shortage of Industry Capacity Cost-Based Cost Basis Profit Markup

Various Situations Upstream Fixed Costs and Profits Agreement (meet periodically and determine) Two-Step (combine variable & fixed costs) Profit Sharing Two Sets of Prices (outside sales price & standard cost)

Corporate Services Control over Service Provided Optional Use of that Service Simplicity of Pricing

Transfer Price Administration Negotiation Arbitration / Conflict Resolution Product Classification

Measuring and Controlling Assets Employed The terms “profit center” and “investment center” are often used interchangeably Profit center measured on profit in relation to a profit target Investment center measured on return on the assets used to earn profit

Assets Current Plant, Property, & Equipment Leased Idle Intangible Cash Receivables Inventories Plant, Property, & Equipment Leased Idle Intangible

Definitions Return of Investment (ROI) Economic Value Added (EVA) A Ratio (Income Statement & Balance Sheet) Income / Assets Employed Economic Value Added (EVA) A Dollar Amount Net Operating Profit – Capital Charge

Why Use EVA? Profit objectives are consistent Investments yielding above cost of capital are attractive Different interest rates may be used for different investments Causes the creation and growth of added value for the corporation

EVA Calculation EVA = Net Operating Profit – Capital Charge Where OR Capital Charge = Cost of Capital * Capital Employed Cost of Capital is Weighted Average OR EVA = Capital Charge * (ROI – Cost of Capital)