CHAPTER 13

INVESTMENT CENTERS AND TRANSFER PRICING

Learning Objectives

1. Explain the role of managerial accounting in achieving goal congruence.

2. Compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA).

3. Explain how a manager can improve ROI by increasing either the sales margin or capital turnover.

4. Describe some advantages and disadvantages of both ROI and residual income as divisional performance measures.

5. Explain how to measure a division’s income and invested capital.

6. Use the general economic rule to set an optimal transfer price.

7. Explain how to base a transfer price on market prices, costs, or negotiations.

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Chapter Overview

I. Delegation of Decision Making A. Obtaining goal congruenceB. Management by objectives (MBO)

II. Measuring Performance of Investment CentersA. Return on investment (ROI)

1. Sales margin and capital turnover2. Strategies to increase ROI3. Problems with ROI

B. Residual incomeC. Economic value added

1. Weighted-average cost of capital

III. Measuring Income and Invested CapitalA. Defining and measuring invested capital B. Measuring investment-center incomeC. Impact of inflation

IV. Transfer Pricing A. General transfer-pricing rule

1. No excess capacity2. Excess capacity3. Difficulties of implementation

B. Market-based transfer pricesC. Negotiated transfer pricesD. Cost-based transfer pricesE. Divisional autonomyF. An international perspective

V. Risk Aversion and Incentives

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Key Lecture Concepts

1. DELEGATION OF DECISION MAKING

Most large organizations are decentralized into divisions and other sizable subunits. These subunits are usually considered investment centers, as managers are held accountable not only for profits but also for the use of invested capital.

Managerial accountants must design a responsibility-accounting framework whereby evaluation systems encourage goal congruence of the subunits.

With goal congruence, the behavior of managers throughout an organization is directed toward attainment of top management’s goals.

Management by objectives (MBO) is a philosophy in which managers participate in setting organizational goals. MBO encourages goal congruence by bringing managers into the goal-setting process and giving them a view of subunit and overall company objectives.

As a company grows it will often decentralize to better control operations and make better decisions. Performance evaluation measures thus become necessary for each of the subunits. Three commonly used performance measures for investment centers are return on investment, residual income, and economic value added.

2. MEASURING PERFORMANCE OF INVESTMENT CENTERS

Return on investment (ROI)

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ROI shows the return from a given amount of invested capital:

ROI = Income ÷ Invested capital

There are really two components of ROI: sales margin and capital turnover.

Sales margin—the amount of profit generated by each dollar of sales. Computed as:

Sales margin = Income ÷ Sales revenue

Capital turnover—the number of sales dollars produced by every dollar of invested capital. Computed as:

Capital turnover = Sales revenue ÷ Invested capital

The two components are multiplied by each other (i.e., sales margin x capital turnover) and the sales component will cancel out, leaving income ÷ invested capital.

ROI captures the interrelationships of both elements, as both are needed for a successful operation.

As an example, a jewelry store typically has a very low turnover but is profitable because of its high sales margin. On the other hand, a grocery store has a much lower sales margin but is successful because of high turnover.

Managers strive to increase ROI.

Sales margin can be increased by increasing income. This can be accomplished by increasing sales prices

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(and more than offsetting a possible decrease in demand) or by decreasing expenses.

Capital turnover can be increased by increasing total sales revenue or decreasing invested capital (the latter accomplished perhaps by reducing inventory).

ROI measures return in a percentage form rather than in absolute dollars, which is helpful when comparing segments of different sizes.

A drawback to using ROI is the potential of decreased goal congruence. For example, assume that top management desires an ROI of at least 15% (the cost of capital) and a particular division currently has an ROI of 20%. If a new project being considered is predicted to have an ROI of 18%, top management would opt for an “accept” decision. However, since the project would decrease the division’s present ROI, the division manager may decide to reject the project rather than reduce overall performance.

Residual income

Residual income shows the amount of income a given division (or project) earns in excess of a firm’s minimum goal.

This performance measure integrates the corporate cost of capital as an imputed interest rate and improves goal congruence. The formula is:

Residual income = Divisional profit - (Divisional invested capital x Imputed interest rate)

As long as the residual income of a project is a positive amount, the project is deemed attractive because it increases a manager’s income pool. Thus, any project that returns more than the cost of capital will be accepted in accordance with top management’s desire.

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Since residual income is expressed in absolute dollar terms, an analyst forfeits the ability to compare firms/divisions of differing sizes on a common basis.

Both ROI and residual income are useful, but both tools have drawbacks. Therefore, companies will use a combination of ROI and residual income (as well as other measures) to evaluate performance.

Economic value added (EVA)

Economic value added (EVA), which is conceptually similar to residual income, measures the amount of shareholder wealth being created. It is computed as follows:

EVA = Investment center after-tax income – [(Investment center total assets – Investment center current liabilities) x Weighted-average cost of capital]

The weighted-average cost of capital (WACC) measures the average cost of a company’s debt and equity capital.

The cost of debt capital to a firm is the after-tax cost of interest, after-tax because interest payments are tax deductible.

The cost of equity capital is the rate that a company’s investors could earn on investments of similar risk.

The formula to compute the weighted-average cost of capital is:

WACC = [(After-tax cost of debt capital x Market value of debt) + (Cost of equity capital x Market value of

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equity)] ÷ (Market value of debt + Market value of equity)

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3. MEASURING INCOME AND INVESTED CAPITAL

Income and invested capital, factors in the ROI, residual income, and EVA performance models, can each be defined in several ways.

Invested capital can be defined as total assets, productive assets, or total assets minus current liabilities, with each definition having a different impact on performance.

This decision is further complicated when combined with the additional decision of whether to use net book value or gross value of long-lived assets. Issues to consider in this decision include:

The use of net book value produces valuations that are consistent with those shown on the balance sheet.

The methods to compute depreciation could be criticized as being arbitrary.

The use of declining net book values could result in misleading increases in ROI, residual income, and EVA over time.

Another decision involves income measurement. Income should be defined as controllable income if the performance model is to be a motivator and if responsibility accounting is used by the firm.

Although inflation will likely affect an investment center’s performance, most companies use historical-cost figures (rather than inflation-adjusted amounts). One reason behind this practice is that historical-cost data are readily available because of their presence in the financial statements.

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4. TRANSFER PRICING

In large corporations, segments of the organization often transfer goods and services to each other. The price charged between segments is the transfer price.

The transfer price affects the income of the buying and selling units and therefore affects (1) the performance evaluations of both managers and (2) the operating decisions that the managers might make.

If managerial decisions are unaffected and there are no tax complexities involving multinational companies, the transfer price has no impact on overall company profit.

When managers have authority to make decisions on whether to trade with either internal or external entities, the transfer price must be set in a way that brings the managers’ goals into agreement with overall company goals.

Goal congruence is achieved by following a general transfer-pricing rule:

Transfer price = Additional unit outlay cost incurred because goods are transferred + Opportunity cost per unit to the organization because of the transfer

Using the general rule, the selling division is reimbursed for the variable costs of the product or service plus any margin forgone by not selling in the external marketplace.

In situations where the external market is willing to buy all the goods and services made (no excess capacity), the opportunity cost of selling instead to an internal division is the contribution margin lost on the outside sales.

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If there is no external buyer (excess capacity exists), the product or service would transfer at an amount equal to variable cost, as there would be no contribution margin forgone.

The general model is often difficult to implement because of problems in measuring a transfer's opportunity cost. Many sellers in a market, unique goods and services, a need to invest in special equipment, and other factors complicate the calculation, forcing the adoption of other methods.

Market-based prices

Such prices are consistent with the responsibility-accounting concepts of profit and investment centers, as managers of these units on evaluated based on their abilities to buy goods and services at market and to sell goods and services at market.

Negotiated prices

Some companies allow buying and selling units to negotiate the transfer price, particularly if no external market exists.

Even in the case of an external price, the external price might serve as the starting point in negotiations, with adjustment downward because of the absence of certain costs on internal sales (e.g., sales commissions and advertising).

A drawback to negotiation is the possibility of competition rather than coordination between the divisions.

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Cost-based prices

Transfer prices may be based on a cost-plus scheme by marking up either variable cost or full cost by a percentage. The policy of marking up full cost carries with it the risk that an individual manager will evaluate costs incorrectly and make erroneous decisions.

Other transfer pricing issues

Transfer prices are used in a decentralized environment where managers have authority to make decisions and control operations. When transfer-pricing disputes arise, top management should step aside and let the division managers resolve the issues, as such intervention undermines divisional autonomy.

Operating in an international marketplace complicates the transfer-pricing decision because of different income tax rates along with the presence of import duties. Companies will consider whether tax rates are high or low and set a transfer price accordingly (if permitted by law).

5. RISK AVERSION AND INCENTIVES

Performance-evaluation systems must include incentives for managers to achieve goal congruence. Such systems, though, are often affected by factors beyond a manager’s control, with the manager confronting various risks while doing his or her job.

Since most people have an aversion to risk, they must be compensated for the risks they take. This is often done in the form of higher salaries and bonuses.

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The design of a performance-evaluation and reward system involves a trade-off (and delicate balance) between the incentives that push a manager to act in an organization’s best interests and the risks that the manager faces.

Teaching Overview

The subject matter in this chapter is difficult to teach. I have drawn this conclusion based on student reaction to my presentations and, perhaps more important, numerous conversations with colleagues from around the country. The interest level that accompanies many other managerial accounting topics is often lacking with this material.

Students tend to have little trouble grasping the ideas behind ROI, residual income, and EVA. Transfer pricing is another matter. I purposely keep my presentation on this last topic very light, just trying to convey the basics. I have found a very effective way to introduce students to the idea that, aside from an impact on decision making, transfer prices have no effect on overall reported profit (i.e., the revenue of one segment is offset by the cost of another). Team a male and female student together and ask them to assume that they are a married couple. Hand one student a $10 bill and ask the recipient to pass it along to the other person. Next, ask the class who is better off, who is worse off, and, importantly, what happens to the “financial health” of the married couple because of the transfer.

Exercise 13-29 is a good demonstration problem to use when discussing ROI and residual income along with the evaluation of new investments. I also select Problem 13-47, as well as bits and pieces from Problem 13-46 when introducing the idea of transfer pricing.

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Links to the Text

Homework Grid

Item No.Learnin

gObjectiv

es

Completion

Time (min.)

SpecialFeature

s*

Exercises:13-24 2 1013-25 3 1513-26 2 513-27 2 1513-28 2 2013-29 1, 2 3013-30 2 30 W13-31 2, 4, 5 15 C13-32 1 10 E13-33 2, 3 15 I13-34 6 1013-35 7 25

Problems:13-36 2, 4 2513-37 2, 3 4513-38 3 2013-39 2, 4 25 C13-40 2, 4, 5 4013-41 2, 4, 5 4013-42 2, 4 35 G13-43 2, 4 3013-44 2 3513-45 2 35 I13-46 6, 7 40 E13-47 7 2513-48 6, 7 30 I13-49 6, 7 40

Cases:13-50 1, 2, 4 40 C13-51 6, 7 45 G13-52 6 50 I, G

* C = Oral/written communication E = Ethics G = Group work I = International W = Web-based application

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Links to the Ancillaries

Video Programs

McGraw-Hill has produced various videos that are relevant to the instruction of managerial/cost accounting. Information about these videos (including a description of those applicable to this chapter) appears in Appendix A.

Test Bank Grid

Learning

Objective

Multiple-Choice

QuestionsExercis

es

Discussion

Questions

1 1, 2, 3, 42 5, 6, 7, 8, 9,

10, 11, 12, 13, 14, 15, 18, 19, 20, 24, 25, 26, 27, 28, 29, 30, 31, 32, 33, 34, 35, 36, 37, 38, 39, 40

64, 65, 66, 67, 68, 69, 70

3 16, 17 674 19, 20, 21,

22, 2368, 69, 70

78

5 41, 42, 43, 44, 45

79

6 46, 47, 48, 49, 50, 51, 52, 53, 54, 55, 56, 57

71, 72, 73, 74, 75, 76, 77

80

7 58, 59, 60, 61, 62, 63

72, 73, 74, 75, 76, 77

81

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