Investment Centers and Transfer Pricing
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Transcript of Investment Centers and Transfer Pricing
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Investment Centers
and Transfer Pricing
Investment Centers
and Transfer Pricing
Chapter 13
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
1
Learning Objective
1
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S u p erv iso r S u p erv iso r
M id d leM a na ge m e nt
S u p erv iso r S u p erv iso r
M id d leM a na ge m e nt
T opM a na ge m e nt
Decision Makingis pushed down.
Delegation of Decision MakingDelegation of Decision Making(Decentralization)(Decentralization)
Decentralization often occurs as organizations continue to grow.
13-3
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DecentralizationDecentralization
AdvantagesAllows organization
to respond morequickly to events.
Frees top managementfrom day-to-day
operating activities.
Uses specializedknowledge and
skills of managers.
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DecentralizationDecentralization
ChallengeGoal Congruence:
Managers of the subunits make decisions that achieve
top-management goals.
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
2
Learning Objective
2
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Measuring PerformanceMeasuring Performancein Investment Centersin Investment Centers
Investment Center Investment Center managers make managers make decisions that decisions that
affect both profit affect both profit and invested and invested
capital.capital.Corporate HeadquartersCorporate Headquarters
InvestmentCenter
Evaluation
Return on investment, residual income, or
economic value added
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13-8
Return on Return on InvestmentInvestment (ROI) (ROI)
ROI = Income
Invested Capital
ROI = Income
Sales Revenue×
Sales RevenueInvested Capital
SalesMargin
SalesMargin
CapitalTurnover
CapitalTurnover
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Holly Company reports the following:
Income $ 30,000
Sales Revenue $ 500,000
Invested Capital $ 200,000
Let’s calculate ROI.Let’s calculate ROI.
Return on Return on InvestmentInvestment (ROI) (ROI)
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ROI = Income
Sales Revenue×
Sales RevenueInvested Capital
Return on Return on InvestmentInvestment (ROI) (ROI)
ROI = $30,000
$500,000×
$500,000$200,000
ROI = 6% × 2.5 = 15%
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Economic Value AddedEconomic Value Added
Economic value added tells us how much shareholder wealth is being created.
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Economic Value AddedEconomic Value Added Investment center’s after-tax operating income– Investment charge = Economic Value Added
Weightedaverage
cost of capital
Investmentcenter’s
total assets
Investmentcenter’s
current liabilities–( )
After-taxcost ofdebt
Marketvalue
of debt
Cost ofequity capital
Marketvalue
of equity( () )
Marketvalue
of debt
Marketvalue
of equity
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Economic Value AddedEconomic Value Added
The Atlantic Division of Suncoast Food Centers reportedthe following results for the most recent period:
Atlantic's pretax income 6,750,000$ Atlantic's total assets 45,000,000 Atlantic's current liabilities 600,000 Market value of Suncoast's debt 40,000,000 Market value of Suncoast's equity 60,000,000 Interest rate on Suncoast's debt 9%Cost of Suncoast's equity capital 12%Tax rate 30%
Compute Atlantic Division’s economic value added.
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Economic Value AddedEconomic Value Added
(9% × (1 – 30%) × $40,000,000) + (12% × $60,000,000)
$40,000,000 + $60,000,000= 0.0972
First, let’s compute theweighted-average cost of capital
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Economic Value AddedEconomic Value Added
$4,725,000 After-tax operating income– 4,315,680= $ 409,320 Economic value added
(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)
$40,000,000 + $60,000,000
($45,000,000 – $600,000) × 0.0972 = $4,315,680
= 0.0972
$6,750,000 × (1 – 30%)
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
3
Learning Objective
3
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Improving R0IImproving R0I
Three ways to improve ROI
IncreaseIncrease SalesSales Prices Prices
DecreaseDecrease ExpensesExpenses
LowerLower InvestedInvested Capital Capital
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• 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.Let’s calculate the new ROI.
Improving R0IImproving R0I
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ROI = Income
Sales Revenue×
Sales RevenueInvested Capital
Return on Return on InvestmentInvestment (ROI) (ROI)
ROI = $42,000
$600,000×
$600,000$200,000
ROI = 7% × 3.0 = 21%
Holly increased ROI from 15% to 21%.
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ROI - A Major DrawbackROI - 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 As division manager would you invest in this project?invest in this project?
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Residual IncomeResidual Income
Investment center profit– Investment charge = Residual income
Investment capital× Imputed interest rate= Investment charge
Investment center’sminimum required
rate of return
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Residual IncomeResidual 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.Let’s calculate residual income.
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Residual IncomeResidual 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’sminimum required
rate of return
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
4
Learning Objective
4
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Residual IncomeResidual 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?
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Residual IncomeResidual Income
Residual income encourages managers to Residual income encourages managers to make profitable investments that wouldmake profitable investments that would
be rejected by managers using ROI.be rejected by managers using ROI.
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
5
Learning Objective
5
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Issues: Measuring Investment Issues: Measuring Investment CapitalCapital
Three issues must be considered before we can properly measure the investment
capital: What assets should be included?
1. Total assets.
2. Total productive assets.
3. Total assets less current liabilities.
4. Only the assets controllable by the manager being evaluated.
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Measuring Investment CapitalMeasuring Investment Capital
The Second Issue
1. 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?
2. Should the assets be shown at historical or current cost?
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Gross or Net Book ValueGross 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 $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used.
• GrizzlyCo calculates ROI based on end-of-year asset values.
Let’s calculate ROI using both the gross and net book values.
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Gross or Net Book ValueGross or Net Book Value
Year
Profits before
Depreciation Depreciation
Expense Operating
Profits
Gross Book Value
Net Book Value
1 25,000$ 10,000$ 15,000$ 100,000$ 90,000$ 2 25,000 10,000 15,000 100,000 80,000 3 25,000 10,000 15,000 100,000 70,000
($100,000 – $0) ÷ 10 = $10,000 per year
$100,000 – $10,000 = $90,000 net book value
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Year
Net Operating
Profits Net Book
Value ROI
Gross Book Value ROI
1 15,000$ 90,000$ 16.67% 100,000$ 15.00%2 15,000 80,000 18.75% 100,000 15.00%3 15,000 70,000 21.43% 100,000 15.00%
Gross or Net Book ValueGross or Net Book Value
$15,000 ÷ $100,000 = 15%
$15,000 ÷ $90,000 = 16.67%
Since older assets, with lower net bookvalues, result in higher ROI, managers are
discouraged from investing in new assets.
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Measuring InvestmentMeasuring InvestmentCenter IncomeCenter Income
Division managers should be evaluated on profit margin they control.– Exclude these costs:
Costs traceable to the division but not Costs traceable to the division but not controlled by the division manager.controlled by the division manager.
Common costs incurred elsewhere and Common costs incurred elsewhere and allocated to the division.allocated to the division.
The key issue is controllability.
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Inflation: Historical Cost versusInflation: Historical Cost versusCurrent-Value AccountingCurrent-Value Accounting
Use of current-value accounting impacts the amount of:
1. Invested capital.
2. Income.
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Other Issues in Segment Other Issues in Segment Performance EvaluationPerformance Evaluation
• Short-run performance measures versus long-run performance measures.
• Importance of nonfinancial information.– Market position.– Product leadership.– Productivity.– Employee attitudes.
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Measuring Performance in Measuring Performance in Nonprofit OrganizationsNonprofit Organizations
Since income is not the primary measure of performance in
nonprofit organizations, performance measures other thanROI and residual income are used.
Since income is not the primary measure of performance in
nonprofit organizations, performance measures other thanROI and residual income are used.
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Transfer PricingTransfer Pricing
Let’s change topics!
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
6
Learning Objective
6
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The transfer price affects the profit measure for both the selling division and the buying division.
A higher transferprice for batteries
means . . .
greaterprofits for the
battery division.
Auto DivisionBattery Division
Transfer PricingTransfer Pricing
lower profitsfor the
auto division.
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Goal CongruenceGoal Congruence
The ideal transfer price allowseach division manager to make
decisions that maximize thecompany’s profit, while
attempting to maximize his/herown division’s profit.
The ideal transfer price allowseach division manager to make
decisions that maximize thecompany’s profit, while
attempting to maximize his/herown division’s profit.
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General-Transfer-Pricing RuleGeneral-Transfer-Pricing Rule
Transferprice
Additional outlaycost per unit
incurred becausegoods aretransferred
Opportunity costper unit to theorganizationbecause ofthe transfer
= +
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• 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 300,000
batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model.
Scenario I: No Excess CapacityScenario I: No Excess Capacity
What is the appropriate transfer price?
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Transferprice
Additional outlaycost per unit
incurred becausegoods aretransferred
Opportunity costper unit to theorganizationbecause ofthe transfer
= +
Transferprice = $18 variable
cost per battery +$22 Contribution
lost if outsidesales given up
Transferprice = $40 per battery
Scenario I: No Excess CapacityScenario I: No Excess Capacity
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Scenario I: No Excess CapacityScenario I: No Excess Capacity
$40transfer
price
Auto division canpurchase 100,000batteries from anoutside supplier
for less than $40.
Auto division canpurchase 100,000batteries from anoutside supplier
for more than $40.
Transferwill notoccur.
Transferwill
occur.
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General Rule
When the selling division is operating at capacity, the transfer price should
be set at the market price.
Scenario I: No Excess CapacityScenario I: No Excess Capacity
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• 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 150,000
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.
Scenario II: Excess CapacityScenario II: Excess Capacity
What is the appropriate transfer price?
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Transferprice
Additional outlaycost per unit
incurred becausegoods aretransferred
Opportunity costper unit to theorganizationbecause ofthe transfer
= +
Transferprice = $18 variable
cost per battery +
Transferprice = $18 per battery
Scenario II: Excess CapacityScenario II: Excess Capacity
$0
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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 lowerthan $18, and no higher than $39.
Scenario II: Excess CapacityScenario II: Excess Capacity
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Scenario II: Excess CapacityScenario II: Excess Capacity
Transferwill
occur.
$18transfer
price
$39transfer
price
Transferwill notoccur.
Transferwill notoccur.
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
7
Learning Objective
7
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Setting Transfer PricesSetting 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.
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Goal CongruenceGoal Congruence
Conflicts may arise between the company’s interests and an individual manager’s interests
when transfer-price-based performance measures are used.
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Conflicts may be resolved by . . .
1. Direct intervention by top management.
2. Centrally established transfer price policies.
3. Negotiated transfer prices.
Setting Transfer PricesSetting Transfer Prices
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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!
Setting Transfer PricesSetting Transfer Prices
Now, here is what the twoof you are going to do.
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As a general rule, a market price-based transfer pricing policy contains the
following guidelines . . .
1. The transfer price is usually set at a discount from the cost to acquire the item on the open market.
2. The selling division may elect to transfer or to continue to sell to the outside.
As a general rule, a market price-based transfer pricing policy contains the
following guidelines . . .
1. The transfer price is usually set at a discount from the cost to acquire the item on the open market.
2. The selling division may elect to transfer or to continue to sell to the outside.
Centrally EstablishedCentrally EstablishedTransfer PricesTransfer Prices
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Negotiating the Transfer PriceNegotiating the Transfer Price
A system where transfer prices are arrived at through negotiation between managers of
buying and selling divisions.
A system where transfer prices are arrived at through negotiation between managers of
buying and selling divisions.
Much managementtime is used in the
negotiation process.
Much managementtime is used in the
negotiation process. Negotiated price may notbe in the best interest of
overall company operations.
Negotiated price may notbe in the best interest of
overall company operations.
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Cost-Based Transfer PricesCost-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 Beware of treating unit fixed costs as variable. variable.
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An International PerspectiveAn International Perspective
Since tax rates and import duties are different in different countries, companies have incentives to set transfer prices that will:
1. Increase revenues in low-tax countries.
2. Increase costs in high-tax countries.
3. Reduce cost of goods transferred to high- import-duty countries.
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Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Learning Objective
8
Learning Objective
8
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Behavioral Issues:Behavioral Issues:Risk Aversion and IncentivesRisk Aversion and Incentives
The design of a managerial performanceevaluation system using financial performance
measures involves a trade-off between:
Incentives for the manager to act inthe organization’s
interests.
Risks imposed on themanager because
financial performance measures are onlypartially controlledby the manager.
And
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Goal Congruence andGoal Congruence andInternal Control SystemsInternal 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.
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End of Chapter 13End of Chapter 13
Let’s transfer some of yourLet’s transfer some of yourcapital to me so that my ratecapital to me so that my rate
of return will be higher!of return will be higher!