Hilton MA 12e Chap013

Chapter 13
Investment Centers
and Transfer Pricing
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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.

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.
Goal Congruence and MBO
Obtaining goal congruence is consistent with a

broad managerial approach called management
by objectives, or MBO.
 Goal congruence is obtained when managers of

subunits strive to achieve goals set by top
management
 Can be a behavioral challenge to achieve
 Key factor in designing the responsibility-
accounting system used by the organization
Measuring Performance
in Investment Centers
Investment Center managers make
decisions that affect both profit and
invested capital.
Three measures can be used to evaluate the

performance of investment centers: return on
investment (ROI), residual income (RI), and
economic value added (EVA® ).
Return on Investment
ROI = Income
Invested Capital
Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital
Sales Capital
Margin Turnover
Return on Investment – Example (1 of 2)
ROI = Income
Invested Capital
6,750,000 135,000,000
ROI = ×
135,000,000 45,000,000
Sales Capital
Margin Turnover
Return on Investment – Example (2 of 2)
The Atlantic Division of Suncoast Food

Center’s ROI is as follows:
Income $ 6,750,000
Invested Capital $ 45,000,000
= 15%
Economic Value Added Measure
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
Economic
Economic
ValueValue
AddedAdded
Measure
Measure
(Example) (Example)
The Atlantic Division of Suncoast Food Centers reported
the 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.

Weighted-Average Cost of Capital (1 of
Weighted-Average Cost of Capital (1 of 2)
2)
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
Weighted-Average Cost of Capital (2 of
Weighted-Average Cost of Capital (2 of 2)
2)
$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
Options for Improving ROI (1 of 2)
Increase Decrease Decrease

Sales Price Expenses Investment
Options for Improving ROI (2 of 2)
Atlantic Division ROI:
Improved Sales Same Capital Revised ROI

Margin Turnover
6% 3 18%
Same Sales Improved Capital Revised ROI
Margin Turnover
5% 4 20%
Residual Income
Investment center profit
– Investment charge
= Residual income
Investment capital
× Imputed interest rate
= Investment charge
Investment center’s
minimum required
rate of return
Residual Income – Example (1 of 2)
 A company has an opportunity to invest $100,000 in
a project that will return $25,000.
 The company has a 20 percent required rate of
return and a 30 percent ROI on existing business.
Let’s calculate residual income.
Residual Income – Example (2 of 2)
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
Comparing ROI to Residual Income
Pros and Cons of Residual Income
• Residual income better
facilitates goal congruence
• Incorporates minimum
Advantages required rate of return on
invested capital.
• Should not be used to

compare the performance of
different-sized investment
Drawback centers, incorporates a bias
in favor of the larger
investment center.
Measuring Investment Capital (1 of 3)
Three issues must be considered before we
can properly measure the investment of
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.
2. 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? Historical cost or current value?
3. Should we measure based on the gross value of the

assets, or the net book value of the assets?
Gross or Net Book Value (1 of 3)
 A company 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, they will invest $100,000
in an asset that has a ten-year life, no salvage value.
Straight-line depreciation is used.
 They calculate ROI based on end-of-year asset values.
Let’s calculate ROI using both the

gross and net book values.
Gross
Profits before Depreciation Operating Book Net Book
Year Depreciation Expense Profits Value 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
$100,000 – $10,000 = $90,000 net book value
Gross
Net Operating Net Book Book
Year Profits Value ROI 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%
$15,000 ÷ $90,000 = 16.67%
$15,000 ÷ $100,000 = 15%

Since older assets with lower net book values,
result in higher ROI, managers are
discouraged from investing in new assets.
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.
Inflation: Historical-Cost versus
Current-Value Accounting
 During periods of inflation, historical-cost asset
values soon cease to reflect the cost of replacing
those assets.
 Most managers believe that measures based on
historical-cost accounting are adequate when used in
conjunction with budgets and performance targets.
 Using historical-cost accounting for internal
purposes is that it is required for external reporting.
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.
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.
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.
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
Scenario I: No Excess Capacity (1 of 2)
Scenario I: No Excess Capacity (2 of 2)
General Rule
When the selling division is operating at
capacity, the transfer price should be
set at the market price.
Scenario II: Excess Capacity
General Rule
When the selling division is operating below
capacity, the minimum transfer price is the
variable cost per unit.
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.
Goal Congruence
Conflicts may arise between the

company’s interests and an individual
manager’s interests when transfer-
price-based performance measures are
used.
Setting Transfer Prices
Conflicts may be resolved by . . .
• Direct intervention by top management.
• Centrally established transfer price policies.
• Negotiated transfer prices.
Top management may become swamped with

pricing disputes causing division managers to
lose autonomy.
Centrally Established
Transfer Prices
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.
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.
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.
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 high-
import-duty countries.
Behavioral Issues:
Risk Aversion and Incentives
The design of a managerial performance

evaluation system using financial performance
measures involves a trade-off between:
Risks imposed on the
Incentives for the manager because
manager to act in financial performance
the organization’s
and measures are only
interests. partially controlled
by the manager.
Goal Congruence and
Internal 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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Chapter 13

Supervisor Supervisor Supervisor Supervisor

Decentralization often occurs as organizations continue to grow.

Frees top management

Obtaining goal congruence is consistent with a

 Goal congruence is obtained when managers of

Three measures can be used to evaluate the

Income Sales Revenue

The Atlantic Division of Suncoast Food

Investment Investment Weighted-

After-tax Market Cost of Market

Atlantic's pretax income $ 6,750,000

Compute Atlantic Division’s economic value added.

First, let’s compute the

(9% × (1 – 30%) × $40,000,000) + (12% × $60,000,000)

$4,725,000 After-tax operating income

($45,000,000 – $600,000) × 0.0972 = $4,315,680

(9% × (1 – 30%) × $40,000,000) + (.12 × $60,000,000)

Increase Decrease Decrease

Atlantic Division ROI:

Improved Sales Same Capital Revised ROI

Let’s calculate residual income.

Investment capital = $100,000

• Should not be used to

2. Should we measure the investment at the

3. Should we measure based on the gross value of the

Let’s calculate ROI using both the

($100,000 – $0) ÷ 10 = $10,000 per year

$100,000 – $10,000 = $90,000 net book value

$15,000 ÷ $90,000 = 16.67%

$15,000 ÷ $100,000 = 15%

Division managers should be evaluated on profit

 Short-run performance measures versus long-run

Since income is not the primary

The ideal transfer price allows

Additional outlay Opportunity cost

The value placed on transfer goods is

Conflicts may arise between the

Top management may become swamped with

Some companies use the following measures of

Beware of treating unit fixed costs as variable.

Since tax rates and import duties are different in

The design of a managerial performance

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