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. 

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)"

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. 

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

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:
Actual
Budget
Variance
Revenue:
$1,150
$1,000
$150F
Direct Material:
$450
$400
$50U
Direct Labor:
$425
$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
Quantify the impact of the individual factors on the total variances
Actual
Budget
Variance
Possible reasons for the variance
Sales:
$1,150
$1,000
$150F
Sales volume, sales price
Direct Material:
$450
$400
$50U
Sales volume, material costs, material usage
Direct Labor:
$425
$25F
Sales volume, labor costs, labor usage
Overheard:
$100 $0
Sales volume, resource costs, resource usage
Profit
$175
$50
$125F
- All of the above -

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:
Actual Sales
(AV x AP)
Flexible Budget
(AV x EP)
(Master) Budget
(EV x EP)
Output Price Variance
Sales Volume Variance
Actual Costs
(AO x AI x AP)
Flexible Budget
(AO x EI x EP)
(Master) Budget
(EO x EI x EP)
(AO x AI x EP)
Input Price Variance
Efficiency Variance
Production Volume Variance
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

15. Example: Ross Parts Ross Parts produces the RP-24 Budget for 2011:
Per Unit
Total: 100,000 Units
Sales:
$20
$2,000,000
Costs:
Direct materials: $3
= $6
$ 600,000
Direct labor:
0.2 $25
= $5
$500,000
Overhead :
$300,000
Profit:
$600,000
*Print this out.

16. Example: Ross Parts Actual results for 2011: Total Sales:
100,000 $20.50
$2,050,000
Costs:
Direct materials:
194,000 $3.50/kg
$ 679,000
Direct labor:
21,000 $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 $ ,000 x $ ,000 x $20
= $2,050, = $2,000, = $2,000,000
Actual Sales
(AV x AP)
Flexible Budget
(AV x EP)
(Master) Budget
(EV x EP)
Price Variance
Volume Variance
Output Price Variance: $50,000 F
Volume Variance: $0
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

18. Cost variances (Volume is Production Volume):
Direct Material
100,000 x 1.94 x $ ,000 x 1.94 x $3 100,000 x 2 x $ ,000 x 2 x $3
= $679,000 = $582,000 = $600,000 = $600,000
$97,000 U $18,000 F 0
Direct Labor
100,000 x 0.21 x $ ,000 x 0.21 x $ ,000 x 0.2 x $ ,000 x 0.2 x $25
= $483,000 = $525,000 = $500,000 = $500,000
$42,000 F $25,000 U 0
Overhead
$300, $300,000
Actual Costs
(AO x AI x AP)
Flexible Budget
(AO x EI x EP)
(Master) Budget
(EO x EI x EP)
(AO x AI x EP)
Input Price Variance
Efficiency Variance
Volume Variance
“Spending Variance”
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

19. Variance Decomposition Summary
Sales variances
Price variance
$50,000 F
Volume variance $0
Direct material variances
97,000 U
Efficiency variance
18,000 F
79,000 U
Direct labor variances
42,000 F
25,000 U
17,000 F
Overhead Variance
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:
Actual Sales
(AV x AP)
Flexible Budget
(AV x EP)
(Master) Budget
(EV x EP)
Output Price Variance
Sales Volume Variance
Actual Costs
(AO x AI x AP)
Flexible Budget
(AO x EI x EP)
(Master) Budget
(EO x EI x EP)
(AO x AI x EP)
Input Price Variance
Efficiency Variance
Production Volume Variance
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

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.
Final
Market
Price
is $20
Division A
Incremental cost
per unit = $6
Division B
Own cost per unit = $2
Profit = – $6
Profit = $20 – $2 = $18

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

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
Final
Market
Price
is $20
Selling Division
Incremental cost
per unit= $6
Buying Division
Own cost = $2
No intermediate market

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?

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

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?

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
Both input and outcome based

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

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

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