1. Internal Performance Measurement and Transfer Pricing
EMBA Presentation
November 17, 2016
Internal Performance Measurement and Transfer Pricing

2. Internal Performance Measurement
Responsibility Centers
Residual Income
Return on Investment
EVA

3. Responsibility Centers
Cost center
Profit center
Investment center

4. Schematic Investment Center Profit Center Profit Center Cost Center

5. Summary of Performance Centers
Type of Center
Decision Rights
Performance Measures
Cost
Input Mix
Cost controls
Profit
Product Mix, Selling Prices, Input Mix
Actual Profits, Budget Comparisons
Investment
Input Mix, Product Mix, Selling Prices, Capital Invested
ROI, Residual Income, EVA

6. Schematic of the ROI Method
Sales
Sales
Turnover
Divided by
Total
Investment
ROI
Multiplied by
Earnings
Return on
Sales
Divided by
Sales

7. ROI Example Sales $9,000,000 Net Operating Income $ 720,000
Total Investment $4,000,000
Sales Turnover $9,000,000  $4,000,000 = 2.25
Return on Sales $720,000  $9,000,000 = 8%
ROI 2.25 x .08 = 18%

8. Criticisms of ROI
Managers may make decisions that increase the ROI in the short run
Managers often inherit costs over which they have no control
Managers may reject investment opportunities that are good for the organization, but negatively impact the segment

9. Residual Income
Focuses on the residual return after deducting the minimum
return required by top management
Average
Operating
Assets
Minimum
Required
Rate of Return
Residual Income = NOI – X

10. Example of Residual Income

11. Criticisms of Residual Income
Absolute number that ignores investment center size
Does not measure risk factors
Opportunity cost of capital is different between investment centers

12. Calculation of EVA Adjusted Weighted Cost of Capital
EVA = Accounting – X
Earnings Total Capital

13. Calculation of EVA Earnings
Earnings per GAAP
Less cost of capital used by the center
Plus R & D expenses deducted
Add amortization of R & D
Equals EVA Earnings

14. Capital Formula for EVA
Total Capital Invested Plus Capitalized R & D Costs

15. Example Using EVA Operating Income plus R & D Expenses $900,000
Less Amortization of R & D Expenses ,000
Adjusted Earning for EVA $800,000
Invested Capital $4,000,000
Plus Capitalized R & D 1,000,000
EVA Capital $5,000,000
EVA Rate 16%

16. Controllability Principle

17. Westinghouse Nuclear Case

20. Transfer Pricing Topics
What is transfer pricing?
Terms
Delco example
Transfer pricing methods
Car dealership example
Summary of transfer pricing methods
International and tax ramifications

21. A transfer price is the price one sub-unit charges another for a product or service supplied to it

22. Terms Full cost – includes both fixed and variable components
Variable cost – includes only the costs directly related to producing the product
Idle capacity – plant capacity available for additional manufacturing without incurring more fixed costs
Substitute products – competitive products are available in the open market a lower price

23. Congruence Problems
Management expects sub-units to act in a manner that maximizes firm-wide profits
Management desires that product family members be used throughout the firm
Unit managers operate in a manner that optimizes the profitability of their unit which is often reflected in their incentives

24. Delco Example Delco $40 Manufactures Batteries After Market ?
Outside market $40
Full cost $30
Variable cost $20
Delco has excess capacity
Chevrolet

25. Transfer Pricing Methods
Market based
Cost based
Negotiated
Dual

26. Market Prices Lead to Optimal Decisions
When:
The market for the intermediate product is perfectly competitive
Interdependence of subunits is minimal
No additional costs in buying or selling in the external market compared to the internal

27. Cost Based Transfer Prices
Full cost – price includes both the fixed and variable component
If excess capacity is used, there should be no additional fixed costs
Fixed costs may be allocated between external and internal sales
Full costing may be more appropriate where a firm uses ABC costing
Variable cost – includes only the incremental cost

28. Negotiated Prices Mutual agreement between sub-units
May have no relationship to cost or market prices
May be affected by a unit’s ability to negotiate

29. Dual Pricing
In this case, the selling division and the buying division do not pay or receive the same amount
Seller gets full cost and buyer pays market
Difference rolls to a corporate account
May cause divisional tax calculation problems
Selling unit has no incentive to control costs

30. Car Dealer Example Departments: New Vehicles, Used Vehicles, Service,
Body Shop, and Parts Department
New Used Body Service Retail
Service labor rate $40 $ $65
Body shop labor rate $40 $40 $40 $65
Parts mark-up 15% 15% 15% 15% 30%

31. Summary of Methods Domestic Multinational Market based 26% 35%
Cost based:
Variable 3% 0%
Full cost 49% 42%
Other % %
Total 53% 43%
Negotiated 17% 14%
Other % %
TOTAL 100% 100%

32. International and Tax Ramifications
Large firms are global in nature
Firms sell products between international subsidiaries or joint ventures
Tax rates vary between countries
International firms will transfer price to minimize total taxes paid

33. Eastman Kodak Case

34. Copyright, Frank Ilett, 2016