Investment Centers and Transfer Pricing

1. 13 ChapterThirteen Investment Centers and Transfer Pricing

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

3. Decentralization Advantages Allows organization to respond morequickly to events. Uses specializedknowledge andskills of managers. Frees top managementfrom day-to-dayoperating activities.

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

5. Return on investment, residual income, oreconomic value added Measuring Performancein Investment Centers Investment Center managers make decisions that affect both profit and invested capital. Corporate Headquarters Investment CenterEvaluation

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

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. Income Sales Revenue Sales Revenue Invested Capital ROI = × $30,000 $500,000 $500,000 $200,000 ROI = × Return on Investment (ROI) ROI = 6% × 2.5 = 15%

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

10. 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.

11. Income Sales Revenue Sales Revenue Invested Capital ROI = × $42,000 $600,000 $600,000 $200,000 ROI = × Return on Investment (ROI) ROI = 7% × 3.0 = 21% Holly increased ROI from 15% to 21%.

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

14. Residual Income Investment center profit – Investment charge = Residual income Investment capital ×Imputed interest rate = Investment charge Investment center’sminimum requiredrate of return

15. 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 profit = $25,000 – Investment charge = 20,000 = Residual income = $ 5,000 Residual Income Investment capital = $100,000 ×Imputed interest rate = 20% = Investment charge = $ 20,000 Investment center’sminimum requiredrate 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. Weightedaveragecost of capital  ( ) Investmentcenter’s total assets Investmentcenter’scurrent liabilities – ( ) ( ) After-taxcost ofdebt Marketvalueof debt Cost ofequity capital Marketvalueof equity    Marketvalueof debt Marketvalueof equity  Economic Value Added Investment center’s after-tax operating income – Investment charge = Economic Value Added

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

22. (9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000) = 0.0972 $40,000,000 + $60,000,000 Economic Value Added First, let’s compute theweighted-average cost of capital

23. Economic Value Added $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

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. 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 ÷ $100,000 = 15%

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

31. Gross or Net Book Value Since older assets, with lower net bookvalues, result in higher ROI, managers arediscouraged from investing in new assets.

32. The key issue is controllability. Measuring InvestmentCenter 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.

33. Inflation: Historical Cost versusCurrent-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 innonprofit organizations, performance measures other thanROI and residual income are used.

36. Transfer Pricing Let’s change topics!

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

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

39. Transfer Pricing The transfer price affects the profit measure for both the selling division and the buying division. A higher transferprice for batteriesmeans . . . lower profitsfor the auto division. Battery Division Auto Division

40. Goal Congruence The ideal transfer price allowseach division manager to makedecisions that maximize thecompany’s profit, whileattempting to maximize his/herown division’s profit.

41. General-Transfer-Pricing Rule Additional outlaycost per unitincurred becausegoods aretransferred Opportunity costper unit to the organizationbecause ofthe 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 300,000 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?

43. Scenario I: No Excess Capacity Additional outlaycost per unitincurred becausegoods aretransferred Opportunity costper unit to the organizationbecause ofthe transfer Transfer price + = $22 Contributionlost if outsidesales given up Transfer price $18 variable cost per battery = + Transfer price = $40 per battery

44. Scenario I: No Excess Capacity Auto division canpurchase 100,000batteries from anoutside supplierfor less than $40. Auto division canpurchase 100,000batteries from anoutside supplierfor more than $40. Transferwill notoccur. Transferwill occur. $40transferprice

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

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 150,000 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?

47. Scenario II: Excess Capacity Additional outlaycost per unitincurred becausegoods aretransferred Opportunity costper unit to the organizationbecause ofthe 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.

49. Scenario II: Excess Capacity Transferwill not occur. Transferwilloccur. Transferwill not occur. $18transferprice $38transferprice

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.