4.

MEASURING THE PERFORMANCE OF INVESTMENT CENTERS USING RESIDUAL

INCOME AND ECONOMIC VALUE ADDED
A. Residual Income

Residual Income (RI) is the difference between operating income and the minimum
dollar return required on a company’s operating assets.

RI is calculated as follows:

Residual Income = Operating income – (Minimum rate of return × Average operating

assets)

Cornerstone 11-5: How to Calculate Residual Income

See Mowen and Hansen text for demo problems.

The minimum rate of return is the same as the hurdle rate for ROI.

If residual income is greater than zero, the division is earning more than the
minimum required rate or return.

B. Advantages of Residual Income

Unlike ROI, the use of residual income encourages managers to accept any project
that earns above the minimum rate of return.

C. Disadvantages of Residual Income

Residual income, like ROI, can encourage a short-run orientation.

Unlike ROI, residual income is not a relative measure of profitability, which makes it
difficult to compare investments centers of different sizes (such as operating assets
of $10,000,000 versus $1,000,000).

One way to address this disadvantage is to use both ROI and residual income for
performance evaluation.
D. Economic Value Added

Economic value added (EVA) is a performance measure calculated as after-tax

operating profit minus the total annual cost of capital.

EVA is calculated as follows:

EVA = After-tax operating income – (actual percentage cost of capital × Total capital
employed)

Total capital employed includes:

amounts paid for buildings, land, and machinery

other expenditures meant to have a long-term payoff, such as research and

development and employee training. These costs are included in total capital
employed even if they are expensed as required by GAAP for financial accounting
purposes.

A positive EVA indicates that the company earned operating profit greater than the
cost of the capital used. The company is creating wealth. If EVA is negative, then the
company is destroying capital.

Whereas ROI is a percentage rate of return, EVA is a dollar figure. EVA emphasizes
after-tax operating profit and the actua lcost of capital.

Stock prices follow EVA better than earnings per share or return on equity.

Using EVA for Individual Projects

EVA can be calculated for individual projects as follows:

EVA = Project income – Cost of capital

= Project income – (Cost of capital % × Assets employed)

Using EVA encourages managers to accept any project that earns above the
minimum rate.
Behavioral Aspects of EVA

EVA encourages managers to consider the cost of financial investment (the cost of
capital) when making decisions. Therefore, EVA helps to encourage desirable
behavior from division managers that an emphasis on operating income alone
cannot.

5. TRANSFER PRICING

Transfer prices are prices charged for goods transferred between two divisions of
the same firm. The output of the selling division is used as input of the buying
division.

A. Impact of Transfer Pricing on Divisions and the Firm as a Whole

Transfer pricing affects the transferring divisions and the overall firm through its
impact on:

divisional performance measures

firmwide profits, and

divisional autonomy.

Impact on Divisional Performance Measures

The price charged for transferred goods is revenue to the selling division and cost of
goods sold to the buying division.

Thus, profits and profit-based performance measures (ROI and EVA) of both divisions
are affected by the transfer price.

Impact on Firmwide Profits

While the actual transfer price nets out for the company as a whole, transfer pricing
affects profits earned by the company as a whole if it affects divisional behavior.

Divisions, acting independently, may set transfer prices that maximize divisional
profits but adversely affect firmwide profits.
Impact on Autonomy

Because transfer pricing decisions can affect firmwide profitability, top management
is often tempted to intervene and dictate desirable transfer prices.

If such intervention becomes a frequent practice, however, the organization has

effectively abandoned decentralization and all of its advantages.

B. The Transfer Pricing Problem

The transfer pricing problem concerns finding a transfer pricing system that
simultaneously satisfies the following three objectives:

1. Accurate performance evaluation. No one divisional manager should benefit

at the expense of another.

2. Goal congruence. Divisional managers are motivated to select actions that

maximize firmwide profits.

3. Divisional autonomy. Central management should not interfere with the

decision-making freedom of divisional managers.

Although direct intervention by central management to set specific transfer prices

may not be advisable, general transfer pricing guidelines or policies may be useful.

C. Transfer Pricing Policies

In a decentralized organization, top management sets the transfer pricing policy, but
divisions decide whether or not to transfer.

Several transfer pricing policies used in practice are:

Market price

cost-based transfer price

negotiated transfer prices

D. Market Price

If there is a perfectly competitive outside market for the transferred goods, the
optimal transfer price is the market price. (In a perfectly competitive market, the
selling division can sell all it wishes at the prevailing market price.)

The opportunity cost approach also identifies the market price as the optimal
transfer price.

The minimum transfer price for the selling division is the market price, because the
selling division receives the market price whether it sells the product internally or
externally.

The maximum transfer price for the buying division is the market price, because the
buying division pays the market price whether it purchases the product internally or
from an outside supplier.

E. Cost-Based Transfer Prices

Three types of cost-based transfer prices are:

full cost

full cost plus markup, and

variable cost plus fixed fee.

If cost-based transfer prices are used, standard cost s should be used in order to
avoid passing on the inefficiencies of one division to another.

F. Negotiated Transfer Prices

If a perfectly competitive market for the transferred goods exists, the optimal
transfer price is the market price.

If a perfectly competitive market for the transferred goods does no t exist, a

negotiated transfer price may be a practical alternative.

The opportunity cost approach to transfer pricing identifies:

 the minimum transfer price, which is the transfer price that would leave the selling
division indifferent between selling the goods to an outside party or transferring the
goods to an internal division

the maximum transfer price, which is the transfer price that would leave the buying
division indifferent between buying the goods from an outside party or purchasing
from an internal division

Opportunity costs for the buying division and selling division form the upper and
lower boundaries for the transfer price.

Minimum Transfer Price Maximum Transfer Price

Opportunity Cost for Selling Division Opportunity Cost for Buying Division

The selling division wants a high transfer price that will increase its income. The
buying division wants a low transfer price that will increase its income.

Avoidable Distribution Costs

If the selling division avoids costs such as distribution costs by selling internally, the
opportunity cost to the selling division is the market price minus the avoidable cost.

Minimum Transfer Price Maximum Transfer Price

Market Price Less Selling Market Price

Division’s Avoidable Costs
Excess Capacity

When the selling division has excess capacity, a bargaining range exists.

The lower limit of the bargaining range is the selling division’s incremental costs. This
is the minimum the selling division would be willing to accept.

The upper limit of the range is the lower of:

the buying division’s outside purchase price, or

the transfer price that results in a zero contribution margin on the goods for the
buying division.

This is the maximum amount the buying division would be willing to pay.

Disadvantages of Negotiated Transfer Prices

Three disadvantages of negotiated transfer prices are as follows:

1. One divisional manager who has private information may take advantage of
another divisional manager.

2. Performance measures may be distorted by the negotiating skills of

managers.

3. Negotiation can consume considerable time and resources.

Advantages of Negotiated Transfer Prices

Negotiated transfer prices can help achieve the three objectives of:

goal congruence
autonomy, and

accurate performance evaluation.

If negotiation helps insure goal congruence, top management is not as likely to

intervene and divisional autonomy is not diminished.

If the negotiating skills of managers are comparable or if the firm views negotiating
skills as an important part of being a manager, concerns about accurate performance
evaluation are avoided.

6. APPENDIX: THE BALANCED SCORECARD: BASIC CONCEPTS

The Balanced Scorecard is a strategic responsibility accounting system that

translates an organization’s mission and strategy into operational objectives and
performance measures for four different perspectives:
1. Financial perspective, which describes the economic consequences of actions taken
in the other three perspectives

2. Customer perspective, which defines the customer and market segments in which
the business operates

3. Internal business process perspective, which describes the internal processes

needed to provide value for customers and owners

4. Learning and growth (infrastructure) perspective, which defines the capabilities

that an organization needs to create long-term growth and improvement: employee
capabilities, information systems capabilities, and employee attitudes of motivation,
empowerment, and alignment