mcgraw-hill/irwin 12b-1 investment centers and transfer pricing 1212 supplementary slides chapter...
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Investment Centersand Transfer Pricing
12Supplementary Supplementary SlidesSlidesChapter Twelve Chapter Twelve
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S upervisor S upervisor
M iddleM anagem ent
S upervisor S upervisor
M iddleM anagem ent
T opM anagem ent
Decision Makingis pushed down.
Delegation of Decision Making(Decentralization)
Decentralization often occurs as organizations continue to grow.
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Decentralization
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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Decentralization
ChallengeGoal Congruence:
Organization’s subunit managers make decisions that achieve
top-management goals.
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Measuring Performancein 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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Return on Investment (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 Investment (ROI)
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ROI = Income
Sales Revenue×
Sales RevenueInvested Capital
Return on Investment (ROI)
ROI = $30,000
$500,000×
$500,000$200,000
ROI = 6% × 2.5 = 15%
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Improving 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 Holly’s manager was able to increase sales revenue to $600,000 which sales revenue to $600,000 which increased income to $42,000.increased income to $42,000.
There was no change in invested capital.There was no change in invested capital.
Let’s calculate the new ROI.Let’s calculate the new ROI.
Improving R0I
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ROI = Income
Sales Revenue×
Sales RevenueInvested Capital
Return on Investment (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 Drawback As division manager at Winston, Inc., your As division manager at Winston, Inc., your
compensation package includes a salary plus bonus compensation package includes a salary plus bonus based on your division’s ROI -- the higher your ROI, based on your division’s ROI -- the higher your ROI, the bigger your bonus.the bigger your bonus.
The company requires an ROI of 15% on all new The company requires an ROI of 15% on all new investments -- your division has been producing an investments -- your division has been producing an ROI of 30%.ROI of 30%.
You have an opportunity to invest in a new project that You have an opportunity to invest in a new project that will produce an ROI of 25%.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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As division manager,I wouldn’t invest in
that project becauseit would lower my pay!
ROI - A Major DrawbackGee . . .
I thought we weresupposed to do what
was best for the company!
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Residual 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 Income
Flower Co. has an opportunity to invest Flower Co. has an opportunity to invest $100,000 in a project that will return $25,000.$100,000 in a project that will return $25,000.
Flower Co. has a 20 percent required rate of Flower Co. has a 20 percent required rate of return and a 30 percent ROI on existing return and a 30 percent ROI on existing business. business.
Let’s calculate residual income.Let’s calculate residual income.
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Residual 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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Residual Income
As a manager at Flower As a manager at Flower Co., would you invest Co., would you invest the $100,000 if you the $100,000 if you were evaluated using were evaluated using residual income?residual income?
Would your decision be Would your decision be different if you were different if you were evaluated using ROI? evaluated using ROI?
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Residual Income
Residual income encourages managers to Residual income encourages managers to make profitable investments that wouldmake profitable investments that would
be rejected by managers using ROI.be rejected by managers using ROI.
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Economic Value Added
Economic value added tells us how much shareholder wealth is being created.
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Economic Value Added Investment center’s after-tax operating income– Investment charge = Economic Value Added
Weightedaverage
cost of capital
Investmentcenter’s
total assets
Investmentcenter’s
current liabilities–( )
After-taxcost ofdebt
Marketvalue
of debt
Cost ofequity capital
Marketvalue
of equity( () )
Marketvalue
of debt
Marketvalue
of equity
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Economic Value Added
The Atlantic Division of Suncoast Food Centers reportedthe following results for the most recent period:
Atlantic's pretax income 6,750,000$ 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 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 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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Measuring Investment Capital
Three issues must be considered before we can properly measure the investment capital..
What assets should be included?What assets should be included? Total assets.Total assets. Total productive assets.Total productive assets. Total assets less current liabilities.Total assets less current liabilities. Only the assets controllable by the manager being Only the assets controllable by the manager being
evaluated.evaluated.
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Measuring Investment Capital
Three issues must be considered before we can properly measure the investment capital.
Should we measure the investment at the Should we measure the investment at the beginning or end-of-period amount, or should beginning or end-of-period amount, or should we use an average of beginning and end-of- we use an average of beginning and end-of- period amounts? period amounts?
Should the assets be shown at historical or Should the assets be shown at historical or current cost? current cost?
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Gross or Net Book Value
GrizzlyCo is considering an investment that is projected to GrizzlyCo is considering an investment that is projected to produce operating profits of $25,000 before depreciation for produce operating profits of $25,000 before depreciation for the next three years.the next three years.
At the beginning of the first year GrizzlyCo will invest At the beginning of the first year GrizzlyCo will invest $100,000 in an asset that has a ten-year life and no salvage $100,000 in an asset that has a ten-year life and no salvage value. Straight-line depreciation is used.value. Straight-line depreciation is used.
GrizzlyCo calculates ROI based on end-of-year asset values.GrizzlyCo calculates ROI based on end-of-year asset values.
Let’s calculate ROI using both the Let’s calculate ROI using both the gross and net book values gross and net book values..
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Gross or Net Book Value
Year
Profits before
Depreciation Depreciation
Expense Operating
Profits
Gross Book Value
Net Book Value
1 25,000$ 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 = $10,000 per year
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Gross or Net Book Value
Year
Profits before
Depreciation Depreciation
Expense Operating
Profits
Gross Book Value
Net Book Value
1 25,000$ 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 – $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 Value
$15,000 ÷ $100,000 = 15%
$15,000 ÷ $90,000 = 16.67%
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The ROI increases each year usingnet book value even though no operating changes take place.
Gross or Net Book Value
Year
Net Operating
Profits Net Book
Value ROI
Gross Book Value ROI
1 15,000$ 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%
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Since older assets, with lower net bookvalues, result in higher ROI, managers arediscouraged from investing in new assets.
Gross or Net Book Value
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%
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Measuring InvestmentCenter Income
Division managers should be evaluated on Division managers should be evaluated on profit margin they control.profit margin they control. Exclude these costs: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 versusCurrent-Value Accounting
Use of current-value accounting impacts Use of current-value accounting impacts the amount of:the amount of: Invested capital.Invested capital. Income.Income.
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Other Issues in Segment Performance Evaluation
Short-run performance measures versus Short-run performance measures versus long-run performance measures.long-run performance measures.
Importance of nonfinancial information.Importance of nonfinancial information. Market position.Market position. Product leadership.Product leadership. Productivity.Productivity. Employee attitudes.Employee attitudes.
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Measuring Performance in Nonprofit 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 Pricing
Let’s change topics!
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Transfer Pricing
The amount charged when one division sells The amount charged when one division sells goods or services to another divisiongoods or services to another division
Battery Division Auto Division
Batteries
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The transfer price affects the profit measure for The transfer price affects the profit measure for both the selling division and the buying division.both the selling division and the buying division.
A higher transferprice for batteries
means . . .
greaterprofits for the
battery division.
Auto DivisionBattery Division
Transfer Pricing
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lower profitsfor the
auto division.
The transfer price affects the profit measure for The transfer price affects the profit measure for both the selling division and the buying division.both the selling division and the buying division.
Auto DivisionBattery Division
Transfer Pricing
A higher transferprice for batteries
means . . .
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Goal 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 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.The Battery Division makes a standard 12-volt battery.
Production capacityProduction capacity 300,000 units300,000 units
Selling price per batterySelling price per battery $40 (to outsiders)$40 (to outsiders)
Variable costs per batteryVariable costs per battery $18$18
Fixed costs per batteryFixed costs per battery $7 (at 300,000 units)$7 (at 300,000 units) The Battery division is currently selling 300,000 The Battery division is currently selling 300,000
batteries to outsiders at $40. The Auto Division can batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. use 100,000 of these batteries in its X-7 model.
Scenario 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 Capacity
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Scenario 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 When the selling division is operating at capacity, the transfer operating at capacity, the transfer
price should beprice should be set at the market price. set at the market price.
Scenario I: No Excess Capacity
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The Battery Division makes a standard 12-volt battery.The Battery Division makes a standard 12-volt battery.
Production capacityProduction capacity 300,000 units300,000 units
Selling price per batterySelling price per battery $40 (to outsiders)$40 (to outsiders)
Variable costs per batteryVariable costs per battery $18$18
Fixed costs per batteryFixed costs per battery $7 (at 300,000 units)$7 (at 300,000 units) The Battery division is currently selling 150,000 The Battery division is currently selling 150,000
batteries to outsiders at $40. The Auto Division can batteries to outsiders at $40. The Auto Division can use 100,000 of these batteries in its X-7 model. It can use 100,000 of these batteries in its X-7 model. It can purchase them for $38 from an outside supplier. purchase them for $38 from an outside supplier.
Scenario 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 Capacity
$0
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General Rule
When the selling division is operating When the selling division is operating below capacity, the minimum below capacity, the minimum
transfer price is the variable cost transfer price is the variable cost per unit.per unit.
So, the transfer price will be no lowerthan $18, and no higher than $38.
Scenario II: Excess Capacity
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Scenario II: Excess Capacity
Transferwill
occur.
$18transfer
price
$38transfer
price
Transferwill notoccur.
Transferwill notoccur.
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Setting Transfer Prices
The value placed on transfer goods is used The value placed on transfer goods is used to make it possible to transfer goods to make it possible to transfer goods
between divisions while allowing them to between divisions while allowing them to retain their autonomyretain their autonomy..
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Goal Congruence
Conflicts may arise between the company’s Conflicts may arise between the company’s interests and an individual manager’s interests and an individual manager’s interests when transfer-price-based interests when transfer-price-based performance measures are used.performance measures are used.
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Conflicts may be resolved by . . .may be resolved by . . .
Direct intervention by top management.Direct intervention by top management. Centrally established transfer price policies.Centrally established transfer price policies. Negotiated transfer prices.Negotiated transfer prices.
Setting Transfer Prices
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Top management may become swamped Top management may become swamped with pricing disputes causing division with pricing disputes causing division
managers to lose autonomy.managers to lose autonomy.
I just won’tpay $65 forthat part!
You really don’t have any
choice!
Setting Transfer Prices
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Now, here is what the twoof you are going to do.
Top management may become swamped Top management may become swamped with pricing disputes causing division with pricing disputes causing division
managers to lose autonomy.managers to lose autonomy.
Setting Transfer Prices
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As a general rule, a market price-based transfer pricing policy contains the following
guidelines . . .
The transfer price is usually set at a discount from the cost to acquire the item on the open market.
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 . . .
The transfer price is usually set at a discount from the cost to acquire the item on the open market.
The selling division may elect to transfer or to continue to sell to the outside.
Centrally EstablishedTransfer Prices
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As a general rule, a market price-based transfer pricing policy contains the following
guidelines . . .
The transfer price is usually set at a discount from the cost to acquire the item on the open market.
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 . . .
The transfer price is usually set at a discount from the cost to acquire the item on the open market.
The selling division may elect to transfer or to continue to sell to the outside.
Centrally EstablishedTransfer Prices
The discount dependson cost savings from
selling internally.Cost savings mayinclude items like
transportation.
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Negotiating 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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Imperfect Markets
Transfer pricing can be quite complex Transfer pricing can be quite complex when selling and buying divisions cannot when selling and buying divisions cannot
sell and buy all they want in perfectly sell and buy all they want in perfectly competitive markets.competitive markets.
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Cost-Based Transfer Prices
Some companies use the following Some companies use the following measures of cost to establish transfer measures of cost to establish transfer
prices . . .prices . . . Variable costVariable cost Full absorption costFull absorption cost
Beware of treating unit fixed costs as Beware of treating unit fixed costs as variable. variable.
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An International Perspective
Since tax rates and import duties are different in different countries, companies have incentives to set transfer prices that will:
Increase revenues in low-tax countries.Increase revenues in low-tax countries.
Increase costs in high-tax countries.Increase costs in high-tax countries.
Reduce cost of goods transferred to high-Reduce cost of goods transferred to high- import-duty countries. import-duty countries.
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Behavioral Issues:Risk 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 andInternal 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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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!