1. Performance Measurement and Transfer Pricing

2. Financial and Nonfinancial Performance Measures
Some organizations present financial and
nonfinancial performance measures for
their subunits in a single report
– the balanced scorecard.
Most scorecards include:
– profitability measures
– customer-satisfaction measures
– internal measures of efficiency, quality, and time
– learning and growth (innovation) measures

3. Management Control Systems
A management control system is a means of
gathering and using information to coordinate
the planning and control functions of the
company.
It guides the behavior of managers towards
attaining the goals shown in the Balanced
Scorecard.

4. Evaluating Management Control Systems
Motivation
Goal congruence
Effort
Lead to rewards
Monetary
Nonmonetary

5. Organization Structure
Total centralization
Total decentralization

6. Benefits of Decentralization
Allows for greater responsiveness to local needs
Leads to gains from quicker decision making
Increases motivation of subunit managers
Assists management development and learning
Allows top management to focus on strategy

7. Costs of Decentralization
Suboptimal decision making may occur
Focuses the manager’s attention on the subunit
rather than the organization as a whole
Lack of coordination among
autonomous managers
Results in duplication of activities

8. Responsibility Centers
Cost
center
Revenue
center
Profit
center
Investment
center

9. Measuring Managers Performance
Evaluation Tool
Cost/Revenue
Center
Standard Cost/Flexible
Budget Variances
Profit
Center
Budgeted income
statement
Investment
Center
Return on investment,
residual income and EVA

10. Accounting-Based Performance Measure Example
Relax Inns owns three small hotels –
one each in Bombay, Delhi, and Manali.
At present, Relax Inns does not
allocate the total long-term debt of
the company to the three separate hotels.

11. Delhi Hotel Current assets 400,000 Long-term assets 600,000
Total assets 1,000,000
Current liabilities ,000
Revenues 1,200,000
Variable costs ,000
Fixed costs ,000
Operating income ,000

12. Relax Inns Balance Sheet
Total current assets 1,350,000
Total long-term assets 6,150,000
Total assets 7,500,000
Total current liabilities ,000
Long-term debt ,800,000
Stockholders’ equity 2,200,000
Total liabilities and equity 7,500,000

13. Approaches to Measuring Performance
Three approaches include a measure of investment:
Return on investment (ROI)
Residual income (RI)
Economic value added (EVA®)
A fourth approach, return on sales (ROS),
does not measure investment.

14. Return on Investment Return on investment (ROI) is an
accounting measure of income
divided by an accounting
measure of investment.
Return on investment (ROI)
= Income ÷ Investment

15. What is the return on investment
for the Delhi Hotel?
Denver Hotel: 240,000 Operating income
÷ 1,000,000 Total assets = 24%

16. Residual Income Residual income (RI) = Income
– (Required rate of return × Investment)
Assume that Relax Inns’ required
rate of return is 12%.
What is the residual income from the Delhi hotel?

17. Residual Income = 240,000 - (1,000,000 X 12%)
Delhi Hotel:
Residual Income = 240, (1,000,000 X 12%)
= 120,000

18. Economic Value Added Economic value added (EVA®)
= After-tax operating income
– [Weighted-average cost of capital
× (Total assets – current liabilities)]

19. Economic Value Added Total assets minus current liabilities
can also be computed as:
Long-term assets + Current assets
– Current liabilities, or…
Long-term assets + Working capital

20. Economic Value Added Economic value added (EVA) substitutes the
following specific numbers in the RI calculations:
1. Income equal to after-tax operating income
2. A required rate of return equal to the
weighted-average cost of capital
3. Investment equal to total assets minus
current liabilities

21. Economic Value Added Example
Assume that Relax Inns has two sources of
long-term funds:
1. Long-term debt with a market value and
book value of 4,800,000 issued at an
interest rate of 10%
2. Equity capital that also has a market value of
4,800,000 and a book value of 2,200,000
Tax rate is 30%.

22. Economic Value Added Example
What is the after-tax cost of debt?
0.10 × (1 – Tax rate) = 0.07, or 7%
Assume that Relax Inns’ cost of
equity capital is 14%.
What is the weighted-average cost of capital?

23. Economic Value Added Example
WACC = [(7% × Market value of debt)
+ (14% × Market value of equity)]
÷ (Market value of debt + Market value of equity)
WACC = [(0.07 × 4,800,000)
+ (0.14 × 4,800,000)] ÷ 9,600,000
WACC = 336, ,000 ÷ 9,600,000
WACC = 0.105, or 10.5%

24. Economic Value Added Example
What is the after-tax operating income
for the Denver Hotel?
Denver Hotel:
Operating income 240,000 × 0.7 = 168,000

25. Economic Value Added Example
What is the investment?
Delhi Hotel: Total assets 1,000,000
– Current liabilities 150,000 = 850,000

26. Economic Value Added Example
What is the weighted-average cost of capital
times the investment for Delhi?
Delhi Hotel: 850,000 × 10.5% = 89,250

27. Economic Value Added Example
What is the economic value added?
Delhi Hotel: 168,000 – 89,250 = 78,750
The EVA® charges managers for the cost
of their investments in long-term assets
and working capital.

28. Return on Sales The income-to-revenues (sales) ratio, or return
on sales (ROS) ratio, is a frequently used
financial performance measure.
What is the ROS for the Delhi hotel?
Delhi Hotel: 240,000 ÷ 1,200,000 = 20%

29. Transfer Pricing
The amount charged when one division sells goods or services to another division
Batteries
Battery Division
Auto Division

30. Transfer-Pricing Methods
Negotiated transfer prices
Cost-based transfer prices
Market-based transfer prices

31. Negotiated Transfer Prices
A negotiated transfer price results from discussions between the selling and buying divisions.
Upper limit is determined by the buying division.
Lower limit is determined by the selling division.
Range of Acceptable Transfer Prices
A negotiated transfer price results from discussions between the selling and buying divisions.
Negotiated transfer prices have two advantages.
First, they preserve the autonomy of the divisions, which is consistent with the spirit of decentralization. The managers negotiating the transfer price are likely to have much better information about the potential costs and benefits of the transfer than others in the company.
Second, the range of acceptable transfer prices is the range of transfer prices within which the profits of both divisions participating in the transfer would increase. The lower limit is determined by the selling division. The upper limit is determined by the buying division.

32. Barker Company – An Example
Assume the information as shown with respect to The Battery Division and Vehicle Division (both Division’s are owned by Barker Company).
Assume the information as shown with respect to Imperial Beverages and Pizza Maven (both companies are owned by Harris and Louder).

33. Barker Company –Scenario 1
Suppose that the Battery Division is operating at capacity.
What is the lowest acceptable transfer price from the viewpoint of the Battery Division?
What is the highest acceptable transfer price from the viewpoint of the Vehicle Division?
Will a transfer take place?
The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as shown.
The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as shown.
If Pizza Maven had no outside supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses.
Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

34. General Guideline for Determining a Minimum Transfer Price
= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division

35. Barker Company – Scenario 1
As indicated, the Battery Division is operating at capacity. The Battery Division’s acceptable transfer price is calculated as:
The Vehicle Division’s acceptable transfer price is calculated as:
The selling division’s (Imperial Beverages) lowest acceptable transfer price is calculated as shown.
The buying division’s (Pizza Maven) highest acceptable transfer price is calculated as shown.
If Pizza Maven had no outside supplier for ginger beer, then its highest acceptable transfer price would be equal to the amount it expects to earn by selling the ginger beer, net of its own expenses.
Let’s calculate the lowest and highest acceptable transfer prices under three scenarios.

36. Barker Company – Scenario 1
If Battery Division has no idle capacity (0 batteries) and must sacrifice other customer orders (50,000 batteries) to meet Vehicle Division’s demands (50,000 barrels), then the lowest and highest possible transfer prices are computed as follows:
Selling division’s lowest possible transfer price:
Part I
If Imperial Beverages has no idle capacity and must sacrifice other customer orders (two thousand barrels) to meet the demands of Pizza Maven (two thousand barrels), then the lowest and highest possible transfer prices will be computed as shown.
Part II
The lowest acceptable transfer price, as determined by the seller, is twenty pounds.
Part III
The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, there is no range of acceptable transfer prices. This is a desirable outcome for Harris Louder because it would be illogical to give up sales of twenty pounds to save costs of eighteen pounds.
Buying division’s highest possible transfer price:
Therefore, there is no range of acceptable transfer prices.

37. Barker Company – Scenario 2
Refer to the original data. Assume that the Battery Division has enough idle capacity to supply the Vehicle Division’s needs without diverting batteries from the outside market.
What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place?
Part I
If Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Maven’s demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown.
Part II
The lowest acceptable transfer price, as determined by the seller, is eight pounds.
Part III
The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

38. Barker Company – Scenario 3
Refer to the original data. Suppose the Battery Division is selling 275,000 batteries per month on the outside market. The Vehicle Division can put only one kind of batteries in its vehicles. It cannot buy 25,000 batteries from an outside supplier and 25,000 batteries from the Battery Division: it must buy all of its batteries from one source. The Battery Division must sacrifice some outside customer orders to meet the Vehicle Division’s demands.
What is the lowest acceptable transfer price from the viewpoint of the Battery Division? In what price range will a transfer take place? Is this transfer “goal-congruent” for the Company (Barker)?
Part I
If Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Maven’s demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown.
Part II
The lowest acceptable transfer price, as determined by the seller, is eight pounds.
Part III
The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

39. An Example
Materials used by the Truck Division of Structure Motors are currently purchased from outside suppliers at a cost of $260 per unit. However, the same materials are available from the Component Division. The Component Division has unused capacity and can produce the materials needed by the Truck Division at a variable cost of $190 per unit.
If a transfer price of $230 per unit is established and 40,000 units of material are transferred with no reduction in the Component Division’s current sales, how much would Structure Motors’ total income from operations increase?
How much would the Truck Division’s income from operations increase?
How much would the Component Division’s income from operations increase?
Let’s change the transfer price to $250. Recalculate a, b and c above. What additional insights can we gain?
Part I
If Imperial Beverages has sufficient idle capacity (three thousand barrels) to satisfy Pizza Maven’s demands (two thousand barrels) without sacrificing sales to other customers, then the lowest and highest possible transfer prices will be computed as shown.
Part II
The lowest acceptable transfer price, as determined by the seller, is eight pounds.
Part III
The highest acceptable transfer price, as determined by the buyer, is eighteen pounds. Therefore, the range of acceptable transfer prices is eight pounds to eighteen pounds.

40. Cost-Based Transfer Prices
Some companies use the following measures of cost to establish transfer prices . . .
Variable cost (₤18 for the Battery Division). The selling division will never show a profit on any internal transfer.
Full absorption cost (₤25 for the Battery Division)
Will the Battery Division transfer at Full Cost if it has no capacity?
What happens if the Battery Division has capacity and the Auto Division can sell batteries at ₤23 in a foreign country?
Mark-up (e.g. 120% of full cost, or ₤30 per battery). 35

41. Transfers at Market Price
A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.
Note:
1. A market price approach works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity. In the Battery Division example, the price would be set at ₤40.
2. A market price approach does not work well when the selling division has idle capacity. What happens if the Battery Division has excess capacity? Will it prefer to sell at a price below ₤40?
A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the transfer pricing problem.
It works best when the product or service is sold in its present form to outside customers and the selling division has no idle capacity.
With no idle capacity the real cost of the transfer from the company’s perspective is the opportunity cost of the lost revenue on the outside sale.
It does not work well when the selling division has idle capacity. In this case, market-based transfer prices are likely to be higher than the variable cost per unit of the selling division. Consequently, the buying division may make pricing and other decisions based on incorrect, market-based cost information rather than the true variable cost incurred by the company as a whole.

42. An International Perspective
Since tax rates are different in different countries, companies have incentives to set transfer prices that will:
Increase revenues in low-tax countries.
Increase costs in high-tax countries. 40