CHAPTER 13

Investment Centers and

Transfer Pricing

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Delegation of Decision Making
(Decentralization)
Decision-Making
Top
is pushed down.
Management

Middle Middle
Management Management

Supervisor Supervisor Supervisor Supervisor

Decentralization often occurs as organizations continue to grow.

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Decentralization

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.

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Decentralization

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

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Measuring Performance
in Investment Centers
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

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Return on Investment (ROI)

ROI = Income
Invested Capital

Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital

Sales Capital
Margin Turnover

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Return on Investment (ROI)

Holly Company reports the following:

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

Let’s calculate ROI.

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Return on Investment (ROI)

Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital

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

ROI = 6% × 2.5 = 15%

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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

Investment Investment Weighted-

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

After-tax Market Cost of Market

( cost of  value
debt of debt ) (  equity  value
capital of equity )
Market Market
value  value
of debt of equity
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Improving R0I
Decrease
Expenses
Increase Lower
Sales Invested
Prices Capital

Three ways to improve ROI

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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.

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Return on Investment (ROI)

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%.
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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?
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Residual Income
Investment center profit
– Investment charge
= Residual income

Investment capital
× Imputed interest rate
= Investment charge

Investment center’s
minimum required
rate of return
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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.

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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’s
minimum required
rate of return
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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?

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Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

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Issues: Measuring Investment Capital
Three issues must be considered before we can properly measure
the investment capital:
1. What assets should be included?
a. Total assets
b. Total productive assets.
c. Total assets less current liabilities.
d. Only the assets controllable by the manager
being evaluated.

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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.

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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.

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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 Auto Division

profits for the lower profits
battery division. for the
auto division.
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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.

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 General-Transfer-Pricing Rule

Additional outlay Opportunity cost

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

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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?

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 Scenario I: No Excess Capacity
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
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Scenario I: No Excess Capacity

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
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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.

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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?

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 Scenario II: Excess Capacity
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
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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.
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Scenario II: Excess Capacity

Transfer Transfer Transfer

will not will will not
occur. occur. occur.

$18 $39
transfer transfer
price price

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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.

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

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Setting Transfer Prices
Conflicts may be resolved by . . .
1. Direct intervention by top management.
2. Centrally established transfer price policies.
3. Negotiated transfer prices.

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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.

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Centrally Established
Transfer Prices

As a general rule, a market price-based transfer

pricing policy contains the following
guidelines . . .
1. The transfer price is usually set at a
discount from the cost to acquire the item
on the open market.
2. The selling division may elect to transfer or
to continue to sell to the outside.

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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.

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

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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:
1. Increase revenues in low-tax countries.
2. Increase costs in high-tax countries.
3. Reduce cost of goods transferred to
high-import-duty countries.

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

13-42