1. Variance Analysis Transfer Pricing Executive Compensation

2. Who Said This? (A) The words or the language, as they are written or spoken, do not seem to play any role in my mechanism of thought. The psychical entities which seem to serve as elements in thought are certain signs and more or less clear images which can be "voluntarily" reproduced and combined. There is, of course, a certain connection between those elements and relevant logical concepts. It is also clear that the desire to arrive finally at logically connected concepts is the emotional basis of this rather vague play with the above-mentioned elements. But taken from a psychological viewpoint, this combinatory play seems to be the essential feature in productive thought--before there is any connection with logical construction in words or other kinds of signs which can be communicated to others. 2

3. (B) The above-mentioned elements are, in my case, of visual and some of muscular type. Conventional words or other signs have to be sought for laboriously only in a secondary stage, when the mentioned associative play is sufficiently established and can be reproduced at will. (C) According to what has been said, the play with the mentioned elements is aimed to be analogous to certain logical connections one is searching for. (D) Visual and motor. In a stage when words intervene at all, they are, in my case, purely auditive, but they interfere only in a secondary stage, as already mentioned. (E) It seems to me that what you call full consciousness is a limit case which can never be fully accomplished. This seems to me connected with the fact called the narrowness of consciousness (Enge des Bewusstseins)" 3

4. Moments of Truth Apple University – Think Different corporate university – Therapeutic alliance between technology and the liberal arts – Stanford political philosopher Joshua Cohen has lectured about pianist Glenn Gould’s meticulous effort to record and then re- record the famous Bach Goldberg Variations. Abraham Lincoln’s famous “with malice toward none” second inaugural address Straight line from the moments of truth of Lincoln and others to the situation Cook faced when Jobs died. 4

5. Qualities of Top CFOs Well-developed planning and forecasting processes. Strong analytical talent in finance that’s able to partner with other areas of the business. Adoption of enterprise-wide information standards. Strong risk management. Effective identification of new opportunities for revenue 5

6. Elements of Org Design (Nexus of Contracts) Decision Rights Managerial Evaluation and Capital Investments Performance Metrics

7. Nexus of Contracts and Impersonal Leadership Decision Rights Managerial Evaluation and Capital Investments Performance Metrics FINITE Communication

8. Agenda for Variances Motivate the need for variance analysis Describe the organizational use of variances Discuss the mechanics of variance analysis Example: Ross Parts Takeaway

9. Variance Analysis Organizations that have a budget typically compare the actual results to the budget at the end of the period. Variance: Difference between actual and budgeted results: ActualBudgetVariance Revenue:$1,150$1,000$150F Direct Material:$450$400$50U Direct Labor:$425$450$25F Overheard:$100 $0 Profit$175$50$125F

10. Labeling Convention – Variance that implies a higher profit: favorable (F) Actual revenue is higher than budgeted Actual costs are lower than budgeted – Variance that implies a lower profit: unfavorable (U) Actual revenue is lower than budgeted Actual costs are higher than budgeted

11. Goal of Variance Analysis ActualBudgetVariancePossible reasons for the variance Sales:$1,150$1,000$150FSales volume, sales price Direct Material:$450$400$50USales volume, material costs, material usage Direct Labor:$425$450$25FSales volume, labor costs, labor usage Overheard:$100 $0Sales volume, resource costs, resource usage Profit$175$50$125F - All of the above - Quantify the impact of the individual factors on the total variances

12. Purpose of Variance Analysis Performance evaluation: Who is responsible for the overall results? – How well did our sales/ marketing people do? – How efficiently did our production dept. use the resources? – How well did our sourcing dept. negotiate with suppliers? Planning and Investment: Should we change our product mix? Should we change our suppliers?

13. Mechanics of Variance Analysis We can quantify the impact of the individual factors by decomposing the variances: The decomposition uses a common unit of measure, namely $ – It is difficult to compare #units, kg, $/unit, etc., across products

14. Variance Analysis - Mechanics We can quantify the impact of the individual factors by decomposing the variances: Sales variance: Cost variances: A: actual; E: expected; V: sales volume; O: output quantity; P: price (sales price or price of input unit); I: amount of input used per unit of output Actual Costs (AO x AI x AP) (AO x AI x EP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) Input Price VarianceEfficiency Variance Production Volume Variance Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Output Price VarianceSales Volume Variance

15. Example: Ross Parts Ross Parts produces the RP-24 Budget for 2011: Per UnitTotal: 100,000 Units Sales:$20$2,000,000 Costs: Direct materials:2kg @ $3= $6$ 600,000 Direct labor:0.2 hrs. @ $25= $5$500,000 Overhead :$300,000 Profit:$600,000

16. Example: Ross Parts Actual results for 2011: Total Sales:100,000 units @ $20.50$2,050,000 Costs: Direct materials:194,000 kg @ $3.50/kg$ 679,000 Direct labor:21,000 hrs. @ $23/hr.$483,000 Overhead :$300,000 Profit:$588,000 Actual Direct Material usage per unit:194,000 kg/ 100,000 units = 1.94kg/ unit Actual Direct Labor usage per unit:21,000 hrs./ 100,000 units = 0.21 hrs.

17. Example: Ross Parts Sales variance (Volume is Sales Volume): 100,000 x $20.50100,000 x $20100,000 x $20 = $2,050,000= $2,000,000= $2,000,000 A: actual; E: expected; V: sales volume; O: output quantity; P: price (sales price or price of input unit); I: amount of input used per unit of output Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Price VarianceVolume Variance Output Price Variance: $50,000 F Volume Variance: $0

18. Cost variances (Volume is Production Volume): Direct Material 100,000 x 1.94 x $3.50100,000 x 1.94 x $3100,000 x 2 x $3100,000 x 2 x $3 = $679,000= $582,000= $600,000= $600,000 $97,000 U$18,000 F0 Direct Labor 100,000 x 0.21 x $23100,000 x 0.21 x $25100,000 x 0.2 x $25100,000 x 0.2 x $25 = $483,000= $525,000= $500,000= $500,000 $42,000 F$25,000 U0 Overhead$300,000 A: actual; E: expected; V: sales volume; O: output quantity; P: price (sales price or price of input unit); I: amount of input used per unit of output Actual Costs (AO x AI x AP) (AO x AI x EP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) Input Price Variance Efficiency Variance Volume Variance “Spending Variance”

19. Variance Decomposition Summary Sales variances Price variance$50,000 F Volume variance$0$50,000 F Direct material variances Price variance97,000 U Efficiency variance18,000 F Volume variance$079,000 U Direct labor variances Price variance42,000 F Efficiency variance25,000 U Volume variance$017,000 F Overhead Variance$0 Profit Variance$12,000 U Q: Why is this summary useful to management?

20. Summary of Variances Variance: Difference between actual results and budget. Variance Analysis: Quantitative decomposition of total variances into individual components (volume variance, price variance, cost variance, efficiency variance). Purpose of variance analysis: – Performance evaluation: Who is responsible for the overall results? – Planning and Investment

21. Variance Analysis - Worksheet We can quantify the impact of the individual factors by decomposing the variances: Sales variance: Cost variances: A: actual; E: expected; V: sales volume; O: output quantity; P: price (sales price or price of input unit); I: amount of input used per unit of output Actual Costs (AO x AI x AP) (AO x AI x EP) Flexible Budget (AO x EI x EP) (Master) Budget (EO x EI x EP) Input Price VarianceEfficiency Variance Production Volume Variance Actual Sales (AV x AP) Flexible Budget (AV x EP) (Master) Budget (EV x EP) Output Price VarianceSales Volume Variance

22. Agenda for Transfer Pricing Describe the issue of transfer pricing – Transfer price setting – Objectives of transfer price Develop the “optimal” transfer pricing rule Takeaway

23. Transfer Pricing Setting In many organizations, divisions transfer products and services to each other – The copying division transfers xeroxed copies to Ross Executive MBA program – The copying division reports lots of costs – The Executive MBA program reports lots of revenue Can Ross management reward the Executive MBA program for its revenue and penalize the copy center for its costs? – No, because the two divisions are interlinked.

24. Transfer Pricing Definition How to recognize such interconnections among the divisions? – Set an “internal” price for xeroxing services The “price” at which the goods or services are exchanged across divisions within an organization is called the “transfer price” – The transfer price represents revenue for the selling unit (Copy center) – And cost for the buying unit (Executive MBA program)

25. Transfer Prices Objective Why does the transfer price matter? – For a given transfer price, the effect on firm profits is zero (The cost to the buying unit are offset by the revenues to the selling unit) Objectives of the transfer pricing system: – Provide information for capital resource allocation decisions – Provide information for the evaluation of the manager and the business unit This information can impact profits – How you split the pie changes the size of the pie

26. Current System Division A creates and transfers an intermediate good to Division B, who processes it further and sells it. Division A Incremental cost per unit = $6 Division B Own cost per unit = $2 Profit = $20 – $2 = $18 Final Market Price is $20 Profit = – $6

27. Optimal Transfer Price Suppose the market for the intermediate good is “perfect” Optimal transfer price = market price per unit Selling Division Incremental cost per unit = $6 Buying Division Own cost per unit = $2 Intermediate market price = $11 Final Market Price is $20

28. Optimal Transfer Price The transfer price is the market price for the intermediate good, namely $11 Selling division profit: Transfer price – Own cost $11 – $6 = $5 Buying division profit: Final price – Own cost – Transfer price $20 – $2 – $11 = $7

29. Optimal Transfer Price Suppose there is no market for the intermediate good Optimal transfer price = selling division’s incremental cost per unit Selling Division Incremental cost per unit= $6 Buying Division Own cost = $2 No intermediate market Final Market Price is $20

30. Optimal Transfer Price The transfer price is the production cost for the intermediate good, namely $6 Selling division profit: Transfer price – Own cost $6 – $6 = $0 (This division is thus a cost center) Buying division profit: Final price – Own cost – Transfer price $20 – $2 – $6 = $12

31. Optimal Transfer Price The “general rule” of transfer pricing If a perfect market for the transferred product exists Transfer price = Market Price – In the previous example, the market price was $11 If no intermediate market exists Transfer price = Incremental (Marginal) Cost of the Selling Division – In the previous example, this cost was $6

32. Measuring Incremental Costs In some instances, producing an extra unit – Requires investment in long-term “chunky” capacity How to compute incremental (marginal) costs in such a situation? A suggested solution is a two-step transfer pricing scheme – Charge a fixed fee every quarter or year (to cover for capacity costs) – Charge variable fee based on the budgeted incremental unit cost

33. Measuring Capacity Costs Division A has spare capacity (for which it has to pay) – Division B asks for one extra unit of product from Division A Should Division A charge B the full cost or just the incremental cost? Taxi-cab example

34. Summary of Transfer Prices The definition of a transfer price – A price charged by one unit of an organization to another unit for a product or service Transfer price impacts divisional profits and provides information for: – Capital resource allocation to divisions – Divisional manager performance evaluation Formulas exist but must be applied with judgment – Can we change TP often when outside market is highly volatile?

35. Executive Compensation Goals – Give proper long-term and short-term incentives – Retention and recruiting tool – Fairness Compensation Committee sets executive compensation – Who are these people? – How often do they meet? – How much are they paid? – How much is management paid? How effective can they be? – What is the use of a board anyway? – Advisory Role. What is it? 35

36. Executive Compensation Compensation Committee sets: – Formula-based compensation Performance measure target Compensation target Payout – Discretionary compensation – Clawback Provisions 36

37. Executive Compensation Forms of compensation payoffs – Salary – Cash bonus – Stock Restricted stock – Options Option is the option to buy a share at a pre-specified price Vests over several years Undoing the effects with side-contracting? 37

38. Boards vs Management Board typically less informed than management – Advisory Role Cannot give true operational guidance – Set compensation schemes in this environment More formula and outcome based CEO vs Lower-level management – Less of an advisory role More guidance More communication – Set compensation schemes in this environment Both input and outcome based 38

39. Theory of Markets and Organizations How does the committee come up with the targets? – Benchmarking and Competition – HR companies Theory of the firm is a theory of the market – Organizations exist to exploit economies of scale and synergies – Enormous symbiosis between organizations and markets Labor markets Product markets Capital markets 39

40. Theory of Markets and Organizations Economic growth of countries – Extractive organizations vs Innovative organizations Development of Markets is development of Organizations – Extractive legal and political institutions – “Fair” and “Trustworthy” legal and political institutions – The ultimate American innovator The Federal Government 40

41. Upcoming Cases – Software Associates Variances – Birch Paper Transfer Pricing – Polysar Variance + Transfer Pricing – Finance