12B-1
12
Supplementary Slides
Chapter Twelve
Investment Centers
and Transfer Pricing
McGraw-Hill/Irwin
Delegation of Decision Making
(Decentralization)
Decision Making
is pushed down.
Top
Management
Middle
Management
Supervisor
Supervisor
12B-2
Middle
Management
Supervisor
Supervisor
Decentralization often occurs as organizations continue to grow.
McGraw-Hill/Irwin
12B-3
Decentralization
Advantages
Allows organization
to respond more
quickly to events.
Uses specialized
knowledge and
skills of managers.
Frees top management
from day-to-day
operating activities.
McGraw-Hill/Irwin
12B-4
Decentralization
Challenge
Goal Congruence:
Organization’s subunit managers
make decisions that achieve
top-management goals.
McGraw-Hill/Irwin
Measuring Performance
in Investment Centers
Investment Center
managers make
decisions that
affect both profit
and invested
capital.
Investment
Center
Evaluation
McGraw-Hill/Irwin
12B-5
Corporate Headquarters
Return on investment,
residual income, or
economic value added
12B-6
Return on Investment (ROI)
Income
ROI =
Invested Capital
ROI =
Income
Sales Revenue
Sales
Margin
McGraw-Hill/Irwin
Sales Revenue
×
Invested Capital
Capital
Turnover
12B-7
Return on Investment (ROI)
Holly Company reports the following:
Income
Sales Revenue
Invested Capital
$ 30,000
$ 500,000
$ 200,000
Let’s calculate ROI.
McGraw-Hill/Irwin
12B-8
Return on Investment (ROI)
ROI =
Income
Sales Revenue
ROI =
$30,000
$500,000
Sales Revenue
×
Invested Capital
×
ROI = 6% × 2.5 = 15%
McGraw-Hill/Irwin
$500,000
$200,000
12B-9
Improving R0I
 Decrease
Expenses
 Increase
Sales
Prices
 Lower
Invested
Capital
Three ways to improve ROI
McGraw-Hill/Irwin
12B-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.
McGraw-Hill/Irwin
12B-11
Return on Investment (ROI)
ROI =
Income
Sales Revenue
ROI =
$42,000
$600,000
Sales Revenue
×
Invested Capital
×
$600,000
$200,000
ROI = 7% × 3.0 = 21%
Holly increased ROI from 15% to 21%.
McGraw-Hill/Irwin
12B-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?
McGraw-Hill/Irwin
12B-13
ROI - A Major Drawback
Gee . . .
I thought we were
supposed to do what
was best for the
company!
McGraw-Hill/Irwin
As division manager,
I wouldn’t invest in
that project because
it would lower my pay!
12B-14
Residual Income
Investment center profit
– Investment charge
= Residual income
Investment capital
× Imputed interest rate
= Investment charge
Investment center’s
minimum required
rate of return
McGraw-Hill/Irwin
12B-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.
McGraw-Hill/Irwin
12B-16
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’s
minimum required
rate of return
McGraw-Hill/Irwin
12B-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?
McGraw-Hill/Irwin
12B-18
Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.
McGraw-Hill/Irwin
12B-19
Economic Value Added
Economic value added tells us how much
shareholder wealth is being created.
McGraw-Hill/Irwin
12B-20
Economic Value Added
Investment center’s after-tax operating income
– Investment charge
= Economic Value Added
(
(
Investment
center’s
total assets
Investment
center’s
current liabilities
–
After-tax
Market
cost of  value
debt
of debt
Market
value
of debt
McGraw-Hill/Irwin
)
Weighted

average
cost of capital
Cost of
Market
 equity  value
capital
of equity
Market
 value
of equity
) (
)
12B-21
Economic Value Added
The Atlantic Division of Suncoast Food Centers reported
the following results for the most recent period:
Atlantic's pretax income
Atlantic's total assets
Atlantic's current liabilities
Market value of Suncoast's debt
Market value of Suncoast's equity
Interest rate on Suncoast's debt
Cost of Suncoast's equity capital
Tax rate
$
6,750,000
45,000,000
600,000
40,000,000
60,000,000
9%
12%
30%
Compute Atlantic Division’s economic value added.
McGraw-Hill/Irwin
12B-22
Economic Value Added
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
McGraw-Hill/Irwin
12B-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
McGraw-Hill/Irwin
12B-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.
McGraw-Hill/Irwin
12B-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-ofperiod amounts?
 Should the assets be shown at historical or
current cost?
McGraw-Hill/Irwin
12B-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.
McGraw-Hill/Irwin
12B-27
Gross or Net Book Value
Year
1
2
3
Profits
Gross
before
Depreciation Operating
Book
Depreciation
Expense
Profits
Value
$
25,000 $
10,000 $
15,000 $ 100,000
25,000
10,000
15,000
100,000
25,000
10,000
15,000
100,000
($100,000 – $0) ÷ 10 = $10,000 per year
McGraw-Hill/Irwin
Net
Book
Value
$ 90,000
80,000
70,000
12B-28
Gross or Net Book Value
Year
1
2
3
Profits
Gross
before
Depreciation Operating
Book
Depreciation
Expense
Profits
Value
$
25,000 $
10,000 $
15,000 $ 100,000
25,000
10,000
15,000
100,000
25,000
10,000
15,000
100,000
Net
Book
Value
$ 90,000
80,000
70,000
$100,000 – $10,000 = $90,000 net book value
McGraw-Hill/Irwin
12B-29
Gross or Net Book Value
Year
1
2
3
Net
Gross
Operating
Net Book
Book
Profits
Value
ROI
Value
ROI
$
15,000 $ 90,000 16.67% $ 100,000 15.00%
15,000
80,000 18.75% 100,000 15.00%
15,000
70,000 21.43% 100,000 15.00%
$15,000 ÷ $90,000 = 16.67%
$15,000 ÷ $100,000 = 15%
McGraw-Hill/Irwin
12B-30
Gross or Net Book Value
Year
1
2
3
Net
Gross
Operating
Net Book
Book
Profits
Value
ROI
Value
ROI
$
15,000 $ 90,000 16.67% $ 100,000 15.00%
15,000
80,000 18.75% 100,000 15.00%
15,000
70,000 21.43% 100,000 15.00%
The ROI increases each year using
net book value even though no
operating changes take place.
McGraw-Hill/Irwin
12B-31
Gross or Net Book Value
Year
1
2
3
Net
Gross
Operating
Net Book
Book
Profits
Value
ROI
Value
ROI
$
15,000 $ 90,000 16.67% $ 100,000 15.00%
15,000
80,000 18.75% 100,000 15.00%
15,000
70,000 21.43% 100,000 15.00%
Since older assets, with lower net book
values, result in higher ROI, managers are
discouraged from investing in new assets.
McGraw-Hill/Irwin
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.
McGraw-Hill/Irwin
12B-32
Inflation: Historical Cost versus
Current-Value Accounting
Use of current-value accounting impacts
the amount of:
 Invested capital.
 Income.
McGraw-Hill/Irwin
12B-33
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.
McGraw-Hill/Irwin
12B-34
Measuring Performance in
Nonprofit Organizations
Since income is not the primary
measure of performance in
nonprofit organizations,
performance measures other than
ROI and residual income are used.
McGraw-Hill/Irwin
12B-35
12B-36
Transfer Pricing
Let’s change topics!
McGraw-Hill/Irwin
12B-37
Transfer Pricing
The amount charged when one division sells
goods or services to another division
Batteries
Battery Division
McGraw-Hill/Irwin
Auto Division
12B-38
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
McGraw-Hill/Irwin
greater
profits for the
battery division.
Auto Division
12B-39
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
McGraw-Hill/Irwin
lower profits
for the
auto division.
Auto Division
12B-40
Goal Congruence
The ideal transfer price allows
each division manager to make
decisions that maximize the
company’s profit, while
attempting to maximize his/her
own division’s profit.
McGraw-Hill/Irwin
12B-41
General-Transfer-Pricing Rule
Transfer
price
McGraw-Hill/Irwin
=
Additional outlay
cost per unit
incurred because
goods are
transferred
+
Opportunity cost
per unit to the
organization
because of
the transfer
12B-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?
McGraw-Hill/Irwin
12B-43
Scenario I: No Excess Capacity
Transfer
price
=
Additional outlay
cost per unit
incurred because
goods are
transferred
Transfer
price
=
$18 variable
cost per battery
Transfer
price
=
$40 per battery
McGraw-Hill/Irwin
+
Opportunity cost
per unit to the
organization
because of
the transfer
+
$22 Contribution
lost if outside
sales given up
12B-44
Scenario I: No Excess Capacity
Auto division can
purchase 100,000
batteries from an
outside supplier
for less than $40.
Auto division can
purchase 100,000
batteries from an
outside supplier
for more than $40.
Transfer
will not
occur.
Transfer
will
occur.
McGraw-Hill/Irwin
$40
transfer
price
12B-45
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.
McGraw-Hill/Irwin
12B-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?
McGraw-Hill/Irwin
12B-47
Scenario II: Excess Capacity
=
Additional outlay
cost per unit
incurred because
goods are
transferred
+
Transfer
price
=
$18 variable
cost per battery
+
Transfer
price
=
$18 per battery
Transfer
price
McGraw-Hill/Irwin
Opportunity cost
per unit to the
organization
because of
the transfer
$0
12B-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.
McGraw-Hill/Irwin
12B-49
Scenario II: Excess Capacity
Transfer
will not
occur.
Transfer
will
occur.
$18
transfer
price
McGraw-Hill/Irwin
Transfer
will not
occur.
$38
transfer
price
12B-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.
McGraw-Hill/Irwin
12B-51
Goal Congruence
Conflicts may arise between the
company’s interests and an individual
manager’s interests when transfer-pricebased performance measures are used.
McGraw-Hill/Irwin
12B-52
Setting Transfer Prices
Conflicts may be resolved by . . .
 Direct intervention by top management.
 Centrally established transfer price policies.
 Negotiated transfer prices.
McGraw-Hill/Irwin
12B-53
Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.
You really
don’t have any
choice!
McGraw-Hill/Irwin
I just won’t
pay $65 for
that part!
12B-54
Setting Transfer Prices
Top management may become swamped
with pricing disputes causing division
managers to lose autonomy.
Now, here is what the two
of you are going to do.
McGraw-Hill/Irwin
Centrally Established
Transfer Prices
12B-55
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.
McGraw-Hill/Irwin
Centrally Established
Transfer Prices
12B-56
As a general rule, a market price-based
transfer pricing policy contains the following
The discount. depends
guidelines
..
on cost savings from
selling
internally.
 The transfer price
is usually
set at a
Cost
savings
may the item
discount from the
cost
to acquire
include items like
on the open market.
transportation.
 The selling division may elect to transfer or
to continue to sell to the outside.
McGraw-Hill/Irwin
12B-57
Negotiating the Transfer Price
A system where transfer prices are arrived
at through negotiation between managers
of buying and selling divisions.
Much management
time is used in the
negotiation process.
McGraw-Hill/Irwin
Negotiated price may not
be in the best interest of
overall company operations.
12B-58
Imperfect Markets
Transfer pricing can be quite complex
when selling and buying divisions cannot
sell and buy all they want in perfectly
competitive markets.
McGraw-Hill/Irwin
12B-59
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.
McGraw-Hill/Irwin
12B-60
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 costs in high-tax countries.
 Reduce cost of goods transferred to highimport-duty countries.
McGraw-Hill/Irwin
Behavioral Issues:
Risk Aversion and Incentives
12B-61
The design of a managerial performance
evaluation system using financial performance
measures involves a trade-off between:
Incentives for the
manager to act in
the organization’s
interests.
McGraw-Hill/Irwin
And
Risks imposed on the
manager because
financial performance
measures are only
partially controlled
by the manager.
Goal Congruence and
Internal Control Systems
12B-62
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.
McGraw-Hill/Irwin
12B-63
Let’s transfer some of your
capital to me so that my rate
of return will be higher!
McGraw-Hill/Irwin