CHAPTER 13

Investment Centers and

Transfer Pricing

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Delegation of Decision Making
(Decentralization)

T op Decision-Making
is pushed down.
M a n a ge m e nt

M id d le M id d le
M a na ge m e nt M a n a g e m e nt

S u p e rv is or S u p erv is or S u p erv is or S u p erv is or

Decentralization often occurs as organizations continue to grow.

13-2
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.

13-3
Decentralization

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

13-4
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

13-5
Return on Investment (ROI)

ROI = Income
Invested Capital

Income Sales Revenue

ROI = ×
Sales Revenue Invested Capital

Sales Capital
Margin Turnover

13-6
Return on Investment (ROI)

Holly Company reports the following:

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

Let’s calculate ROI.

13-7
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%

13-8
Improving R0I
Decrease
Expenses
Increase Lower
Sales Invested
Prices Capital

Three ways to improve ROI

13-9
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.

13-10
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%.
13-11
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?
13-12
Residual Income
Investment center profit
– Investment charge
= Residual income

Investment capital
× Imputed interest rate
= Investment charge

Investment center’s
minimum required
rate of return
13-13
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.

13-14
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
13-15
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?

13-16
Residual Income
Residual income encourages managers to
make profitable investments that would
be rejected by managers using ROI.

13-17
 Comparing ROI to Residual Income

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 Pros and Cons of Residual Income

• Residual income better

Advantag facilitates goal congruence
• Incorporates minimum required
es rate of return on invested
capital.

• Should not be used to compare

Drawbac the performance of different-
sized investment centers,

k incorporates a bias in favor of

the larger investment center.

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Economic Value Added
Economic value added tells us how much
shareholder wealth is being created.

13-20
Economic Value Added
Investment center’s after-tax operating income
– Investment charge
= Economic Value Added

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

( ) ( )
After-tax Market Cost of Market
cost of  value  equity  value
debt of debt capital of equity
Market Market
value  value
of debt of equity
13-21
Economic Value Added
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.

13-22
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

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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

13-24
End of Chapter 13
Let’s transfer some of your
capital to me so that my rate
of return will be higher!

13-25