1. Investment Centers and Transfer Pricing13
Chapter Thirteen
Investment Centers
and Transfer Pricing

2. Delegation of Decision Making (Decentralization)
Decision Making is pushed down.
Decentralization often occurs as organizations continue to grow.

3. Advantages Decentralization
Allows organization to respond more quickly to events.
Uses specialized knowledge and skills of managers.
Frees top management from day-to-day operating activities.

4. Challenge Decentralization
Goal Congruence: Organization’s subunit managers
make decisions that achieve top-management goals.

5. Measuring Performance in Investment Centers
Investment Center managers make decisions that affect both profit and invested capital.
Corporate Headquarters
Investment
Center Evaluation
Return on investment,
residual income, or economic value added

6. Return on Investment (ROI)
Income
Invested Capital
ROI =
Income
Sales Revenue ×
Invested Capital
Sales
Margin
Capital Turnover

7. Return on Investment (ROI)
Holly Company reports the following:
Income $ 30,000
Sales Revenue $ 500,000
Invested Capital $ 200,000
Let’s calculate ROI.

8. Return on Investment (ROI)
Income
Sales Revenue ×
Invested Capital
ROI =
$30,000
$500,000 ×
$200,000
ROI = 6% × = 15%

9. Three ways to improve ROI
Improving R0I
Decrease
Expenses
Increase
Sales Prices
Lower
Invested Capital
Three ways to improve ROI

10. Improving R0I Let’s calculate the new ROI.
Holly’s manager was able to increase sales revenue to $600,000 which increased income to $42,000.
There was no change in invested capital.
Let’s calculate the new ROI.

11. Return on Investment (ROI)
Income
Sales Revenue ×
Invested Capital
ROI =
$42,000
$600,000 ×
$200,000
ROI = 7% × = 21%
Holly increased ROI from 15% to 21%.

12. As division manager would you
ROI - A Major Drawback
As division manager at Winston, Inc., your compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, the bigger your bonus.
The company requires an ROI of 15% on all new investments -- your division has been producing an ROI of 30%.
You have an opportunity to invest in a new project that will produce an ROI of 25%.
As division manager would you
invest in this project?

13. ROI - A Major Drawback Gee . . . I thought we were supposed to do what
was best for the
company!
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!

14. Investment center’s minimum required rate of return
Residual Income
Investment center profit
– Investment charge
= Residual income
Investment capital
× Imputed interest rate
= Investment charge
Investment center’s minimum required rate of return

15. Residual Income Let’s calculate residual income.
Flower Co. has an opportunity to invest $100,000 in a project that will return $25,000.
Flower Co. has a 20 percent required rate of return and a 30 percent ROI on existing business.
Let’s calculate residual income.

16. Investment center’s minimum required rate of return
Residual Income
Investment center profit = $25,000
– Investment charge = 20,000
= Residual income = $ 5,000
Investment capital = $100,000
× Imputed interest rate = 20%
= Investment charge = $ 20,000
Investment center’s minimum required rate of return

17. Residual Income
As a manager at Flower Co., would you invest the $100,000 if you were evaluated using residual income?
Would your decision be different if you were evaluated using ROI?

18. Residual Income Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

19. Economic Value Added
Economic value added tells us how much shareholder wealth is being created.

20. ( ) ( ) Economic Value Added
Investment center’s after-tax operating income
– Investment charge
= Economic Value Added
Weighted average cost of capital 
Investment center’s
total assets
Investment center’s current liabilities – ( )
After-tax cost of debt
Market value of debt
Cost of equity capital
Market value of equity  ( ) 

21. Economic Value Added
The Atlantic Division of Suncoast Food Centers reported the following results for the most recent period:
Compute Atlantic Division’s economic value added.

22. First, let’s compute the weighted-average cost of capital
Economic Value Added
First, let’s compute the weighted-average cost of capital
(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)
$40,000, $60,000,000 =

23. Economic Value Added $4,725,000 After-tax operating income – 4,315,680
$6,750,000 × (1 – 30%)
$4,725,000 After-tax operating income
– 4,315,680
= $ 409,320 Economic value added
($45,000,000 – $600,000) × = $4,315,680
(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000) =
$40,000, $60,000,000

24. Measuring Investment Capital
Three issues must be considered before we can properly measure the investment capital.
What assets should be included?
Total assets.
Total productive assets.
Total assets less current liabilities.
Only the assets controllable by the manager being evaluated.

25. Measuring Investment Capital
Three issues must be considered before we can properly measure the investment capital.
Should we measure the investment at the beginning or end-of-period amount, or should we use an average of beginning and end-of- period amounts?
Should the assets be shown at historical or current cost?

26. Let’s calculate ROI using both the gross and net book values.
Gross or Net Book Value
GrizzlyCo is considering an investment that is projected to produce operating profits of $25,000 before depreciation for the next three years.
At the beginning of the first year GrizzlyCo will invest $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used.
GrizzlyCo calculates ROI based on end-of-year asset values.
Let’s calculate ROI using both the gross and net book values.

27. Gross or Net Book Value
($100,000 – $0) ÷ 10 = $10,000 per year

28. Gross or Net Book Value
$100,000 – $10,000 = $90,000 net book value

29. Gross or Net Book Value $15,000 ÷ $90,000 = 16.67%
$15,000 ÷ $90,000 = %
$15,000 ÷ $100,000 = 15%

30. Gross or Net Book Value
The ROI increases each year using net book value even though no
operating changes take place.

31. Gross or Net Book Value
Since older assets, with lower net book values, result in higher ROI, managers are discouraged from investing in new assets.

32. Measuring Investment Center Income
Division managers should be evaluated on profit margin they control.
Exclude these costs:
Costs traceable to the division but not controlled by the division manager.
Common costs incurred elsewhere and allocated to the division.
The key issue is controllability.

33. Inflation: Historical Cost versus Current-Value Accounting
Use of current-value accounting impacts the amount of:
Invested capital.
Income.

34. Other Issues in Segment Performance Evaluation
Short-run performance measures versus long-run performance measures.
Importance of nonfinancial information.
Market position.
Product leadership.
Productivity.
Employee attitudes.

35. Measuring Performance in Nonprofit Organizations
Since income is not the primary measure of performance in nonprofit organizations, performance measures other than ROI and residual income are used.

36. Transfer Pricing
Let’s change topics!

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

38. A higher transfer price for batteries means . . .
Transfer Pricing
The transfer price affects the profit measure for both the selling division and the buying division.
A higher transfer price for batteries means . . .
greater
profits for the
battery division.
Battery Division
Auto Division 5

39. A higher transfer price for batteries means . . .
Transfer Pricing
The transfer price affects the profit measure for both the selling division and the buying division.
A higher transfer price for batteries means . . .
lower profits for the
auto division.
Battery Division
Auto Division 6

40. Goal Congruence
The ideal transfer price allows each division manager to make decisions that maximize the company’s profit, while attempting to maximize his/her own division’s profit.

41. General-Transfer-Pricing Rule
Additional outlay cost per unit incurred because goods are transferred
Opportunity cost per unit to the
organization because of the transfer
Transfer
price = +

42. Scenario I: No Excess Capacity
The Battery Division makes a standard 12-volt battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
The Battery division is currently selling 300, batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model.
What is the appropriate transfer price? 9

43. Scenario I: No Excess Capacity
Additional outlay cost per unit incurred because goods are transferred
Opportunity cost per unit to the
organization because of the transfer
Transfer
price = +
$22 Contribution lost if outside sales given up
Transfer
price
$18 variable cost per battery = +
Transfer
price =
$40 per battery

44. Scenario I: No Excess Capacity
Auto division can purchase 100,000 batteries from an outside supplier for less than $40.
Auto division can purchase 100,000 batteries from an outside supplier for more than $40.
Transfer will not occur.
Transfer will
occur.
$40 transfer price 10

45. Scenario I: No Excess Capacity
General Rule When the selling division is operating at capacity, the transfer price should be set at the market price. 17

46. Scenario II: Excess Capacity
The Battery Division makes a standard 12-volt battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
The Battery division is currently selling 150, batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. It can purchase them for $38 from an outside supplier.
What is the appropriate transfer price? 9

47. Scenario II: Excess Capacity
Additional outlay cost per unit incurred because goods are transferred
Opportunity cost per unit to the
organization because of the transfer
Transfer
price = +
Transfer
price
$18 variable cost per battery = + $0
Transfer
price =
$18 per battery

48. Scenario II: Excess Capacity
General Rule
When the selling division is operating below capacity, the minimum transfer price is the variable cost per unit.
So, the transfer price will be no lower
than $18, and no higher than $38. 14

49. Scenario II: Excess Capacity
Transfer will not
occur.
Transfer will occur.
Transfer will not
occur.
$18 transfer price
$38 transfer price 10

50. Setting Transfer Prices
The value placed on transfer goods is used to make it possible to transfer goods between divisions while allowing them to retain their autonomy. 7

51. Goal Congruence
Conflicts may arise between the company’s interests and an individual manager’s interests when transfer-price-based performance measures are used. 25

52. Setting Transfer Prices
Conflicts may be resolved by . . .
Direct intervention by top management.
Centrally established transfer price policies.
Negotiated transfer prices. 26

53. Setting Transfer Prices
Top management may become swamped with pricing disputes causing division managers to lose autonomy.
I just won’t
pay $65 for
that part!
You really
don’t have any
choice! 27

54. Setting Transfer Prices
Top management may become swamped with pricing disputes causing division managers to lose autonomy.
Now, here is what the two
of you are going to do. 28

55. Centrally Established Transfer Prices
As a general rule, a market price-based transfer pricing policy contains the following guidelines . . .
The transfer price is usually set at a discount from the cost to acquire the item on the open market.
The selling division may elect to transfer or to continue to sell to the outside. 31

56. Centrally Established Transfer Prices
As a general rule, a market price-based transfer pricing policy contains the following guidelines . . .
The transfer price is usually set at a discount from the cost to acquire the item on the open market.
The selling division may elect to transfer or to continue to sell to the outside.
The discount depends
on cost savings from
selling internally.
Cost savings may
include items like
transportation. 31

57. Negotiating the Transfer Price
A system where transfer prices are arrived at through negotiation between managers of buying and selling divisions.
Much management time is used in the negotiation process.
Negotiated price may not be in the best interest of overall company operations. 38

58. Imperfect Markets
Transfer pricing can be quite complex when selling and buying divisions cannot sell and buy all they want in perfectly competitive markets. 29

59. Cost-Based Transfer Prices
Some companies use the following measures of cost to establish transfer prices . . .
Variable cost
Full absorption cost
Beware of treating unit fixed costs as variable. 35

60. An International Perspective
Since tax rates and import duties 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.
Reduce cost of goods transferred to high- import-duty countries. 40

61. Behavioral Issues: Risk Aversion and Incentives
The design of a managerial performance evaluation system using financial performance measures involves a trade-off between:
Incentives for the manager to act in the organization’s interests.
Risks imposed on the manager because financial performance measures are only partially controlled by the manager.
And 36

62. Goal Congruence and Internal Control Systems
A well-designed internal control system includes a set of procedures to prevent these major lapses in responsible behavior:
Fraud.
Corruption.
Financial Misrepresentation.
Unauthorized Action.

63. End of Chapter 13
Let’s transfer some of your capital to me so that my rate of return will be higher!