Investment Centers

and Transfer Pricing

Delegation of Decision Making
(Decentralization)

Top Decision Making

is pushed down.
M anagem ent

M i d d le M i d d le
M anagem ent M anagem ent

S u p e r v is o r S u p e r v is o r S u p e r v is o r S u p e r v is o r

Decentralization often occurs as organizations continue to grow.

13-2
 Advantages
Allows organization Uses specialized
to respond more knowledge and
quickly to events. skills of managers.

Frees top management

from day-to-day
operating activities.

13-3
 Challenge
Goal Congruence:
Managers of the subunits
make decisions that achieve
top-management goals.

13-4
Investment Center
managers make
decisions that
affect both profit
and invested
capital. Corporate Headquarters

Investment Return on investment,

Center residual income, or
Evaluation economic value added

13-5
 Income
ROI =
Invested Capital

Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital

Sales
Sales Capital
Capital
Margin
Margin Turnover
Turnover
13-6
Return on Investment (ROI)

Holly Company reports the following:

Income $ 30,000
Sales Revenue $ 500,000
Invested Capital $ 200,000

Let’s calculate ROI.

13-7
 Income Sales Revenue
ROI = ×
Sales Revenue Invested Capital

$30,000 $500,000
ROI = ×
$500,000 $200,000

ROI = 6% × 2.5 = 15%

13-8
Economic value added tells us how much
shareholder wealth is being created.

13-9
 Investment center’s after-tax operating income
– Investment charge
= Economic Value Added

( )
Investment Investment Weighted
center’s – center’s  average
total assets current liabilities cost of capital

( ) ( )
After-tax Market Cost of Market
cost of  value  equity  value
debt of debt capital of equity
Market Market
value  value
of debt of equity
13-10
Economic Value Added
The Atlantic Division of Suncoast Food Centers reported
the 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.

13-11
 First, let’s compute the
weighted-average cost of capital

(9% × (1 – 30%) × $40,000,000) + (12% × $60,000,000)

= 0.0972
$40,000,000 + $60,000,000

13-12
$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) × 0.0972 = $4,315,680

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

= 0.0972
$40,000,000 + $60,000,000

13-13
Improving R0I
 Decrease
Expenses
 Increase  Lower
Sales Invested
Prices Capital

Three ways to improve ROI

13-14
Improving R0I
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.

13-15
 Income Sales Revenue
ROI = ×
Sales Revenue Invested Capital

$42,000 $600,000
ROI = ×
$600,000 $200,000

ROI = 7% × 3.0 = 21%

Holly increased ROI from 15% to 21%.
13-16
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?
13-17
 Investment center profit
– Investment charge
= Residual income

Investment capital
× Imputed interest rate
= Investment charge

Investment center’s
minimum required
rate of return
13-18
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.

13-19
 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
13-20
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?
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

13-22
Issues: Measuring Investment Capital
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.

13-23
Measuring 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?

13-24
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.

13-25
 Profits Gross Net
before Depreciation Operating Book Book
Year Depreciation Expense Profits Value 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

13-26
 Net Gross
Operating Net Book Book
Year Profits Value ROI 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%

$15,000 ÷ $90,000 = 16.67%

$15,000 ÷ $100,000 = 15%

Since older assets, with lower net book

values, result in higher ROI, managers are
discouraged from investing in new assets. 13-27
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.

13-28
Inflation: Historical Cost versus
Current-Value Accounting
Use of current-value accounting impacts the amount of:
1. Invested capital.
2. Income.

13-29
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.

13-30
 Since
Since income
income isis not
not the
the primary
primary
measure
measure ofof performance
performance in in
nonprofit
nonprofit organizations,
organizations,
performance
performance measures
measures other
other than
than
ROI
ROI and
and residual
residual income
income areare used.
used.

13-31
Let’s change topics!
13-32
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 . . .

Battery Division greater

lower profits
Auto Division
profits for the
battery division. for the
auto division.
13-33
The
The ideal
ideal transfer
transfer price
price allows
allows
each
each division
division manager
manager to to make
make
decisions
decisions that
that maximize
maximize thethe
company’s
company’s profit,
profit, while
while
attempting
attempting to to maximize
maximize his/her
his/her
own
own division’s
division’s profit.
profit.

13-34
 Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

13-35
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 300,000
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?

13-36
 Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

$22 Contribution
Transfer $18 variable
price = cost per battery + lost if outside
sales given up
Transfer
price = $40 per battery
13-37
Auto division can Auto division can
purchase 100,000 purchase 100,000
batteries from an batteries from an
outside supplier outside supplier
for less than $40. for more than $40.

Transfer Transfer
will not $40 will
occur. transfer occur.
price
13-38
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.

13-39
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 150,000
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.

What is the appropriate transfer price? 13-40

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

Transfer $18 variable

price = cost per battery + $0

Transfer
price = $18 per battery
13-41
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 $39.
13-42
Transfer Transfer Transfer
will not will will not
occur. occur. occur.

$18 $39
transfer transfer
price price

13-43
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.

13-44
Goal Congruence
Conflicts may arise between the company’s
interests and an individual manager’s interests
when transfer-price-based performance measures
are used.

13-45
Setting Transfer Prices
Conflicts may be resolved by . . .

1. Direct intervention by top management.

2. Centrally established transfer price policies.
3. Negotiated transfer prices.

13-46
Setting Transfer Prices
Top management may become swamped with
pricing disputes causing division managers to lose
autonomy.
You really
don’t have any Now, here is what the two
choice!
of you are going to do.
Ij
pa ust
y w
th $6 on
at 5 ’t
p a f or
rt !

13-47
Centrally Established
Transfer Prices
As
As aa general
general rule,
rule, aa market
market price-based
price-based
transfer
transfer pricing
pricing policy
policy contains
contains the the
following
following guidelines
guidelines .. .. ..
1.1. The
Thetransfer
transferprice
priceisisusually
usuallyset
setat
ataa
discount
discountfrom
fromthe
thecost
costto
toacquire
acquirethe
theitem
item
on
onthe
theopen
openmarket.
market.
2.2. The
Theselling
sellingdivision
divisionmay
mayelect
electto
totransfer
transferor
or
to
tocontinue
continueto tosell
sellto
tothe
theoutside.
outside.

13-48
Negotiating the Transfer Price
AAsystem
systemwhere
wheretransfer
transferprices
pricesare
arearrived
arrivedat
atthrough
through
negotiation
negotiationbetween
betweenmanagers
managersof ofbuying
buyingand
andselling
selling
divisions.
divisions.

Much
Much management
management
time
time is
is used
used in
in the
the
negotiation
negotiation process.
process. Negotiated
Negotiated price
price may
may not
not
be
be in
in the
the best
best interest
interest of
of
overall
overall company
company operations.
operations.
13-49
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.

13-50
Behavioral Issues:
Risk Aversion and Incentives
The design of a managerial performance
evaluation system using financial performance
measures involves a trade-off between:
Risks imposed on the
Incentives for the manager because
manager to act in financial performance
the organization’s
And measures are only
interests. partially controlled
by the manager.
13-51
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.

13-52
Let’s transfer some of your
capital to me so that my rate
of return will be higher!

13-53