1. EMBA Presentation November 15,2012

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

3. Responsibility Centers  Cost center  Profit center  Investment center

4. Schematic Cost Center Cost Center Cost Center Cost Center Profit Center Profit Center Investment Center

5. Summary of Performance Centers Type of CenterDecision Rights Performance Measures CostInput MixCost controls ProfitProduct Mix, Selling Prices, Input Mix Actual Profits, Budget Comparisons InvestmentInput Mix, Product Mix, Selling Prices, Capital Invested ROI, Residual Income, EVA

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

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 Residual Income = NOI – Average Operating Assets X Minimum Required Rate of Return

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 100,000 Adjusted Earning for EVA$800,000 Invested Capital$4,000,000 Plus Capitalized R & D1,000,000 EVA Capital$5,000,000 EVA Rate16%

16. Controllability Principle

17. Westinghouse Nuclear Case

18. 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

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

20. 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

21. 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

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

23. Transfer Pricing Methods  Market based  Cost based  Negotiated  Dual

24. 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

25. 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

26. 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

27. 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

28. Car Dealer Example Departments:New Vehicles, Used Vehicles, Service, Body Shop, and Parts Department NewUsedBodyServiceRetail Service labor rate$40$40 $65 Body shop labor rate$40$40$40$65 Parts mark-up15%15%15%15%30%

29. Summary of Methods DomesticMultinational Market based26%35% Cost based: Variable3%0% Full cost 49%42% Other 1% 1% Total 53% 43% Negotiated17%14% Other 4% 8% TOTAL100%100%

30. 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

31. Taxes Paid on Box of Contact Lenses in The Netherlands Transfer Price at 80 Euros Transfer Price at 110 Euros Taxes Paid in Netherlands: Revenue (Transfer Price)€ 80€110 Variable Cost (50) Taxable Income€ 30€ 60 Tax Rate 30% Dutch Taxes€ 9€ 18

32. Taxes Paid in Australia Transfer Price at 80 Euros Transfer Price at 110 Euros Taxes Paid in Australia: Revenue (Australian Dollars)A$ 85 Transfer Price in Euros: 80 x.70A$ (56)- 110 x.70-A$ (77) Taxable IncomeA$ 29A$ 8 Tax Rate40% Australian TaxesA$ 11.6A$ 3.20 Converted to Euros at.70 Rate€ 16.57€ 4.57

33. Comparison of Results Transfer Price at 80 Euros Transfer Price at 110 Euros Dutch Taxes € 9.00 € 18.00 Australian Taxes16.574.57 Total € 25.57 € 22.57

34. Eastman Kodak Case

35. Copyright, Frank Ilett, 2012