Agenda Today

• Consider measures of profitability in

terms of purpose, strengths and
weaknesses
• Introduce some reporting issues from
chapter 12 as time permits
• Outline basic transfer pricing issues as
time permits

W. Bentz EMBA 802 1

The Organization
as a System of
Interrelated
Elements
W. Bentz EMBA 802 2
 Economic Performance
• In recorded history to date, the most
limited resource has been capital.
– Developing companies need capital
(unless they can sell the .com
connection!)
– Undercapitalization is the leading cause
of failure among small businesses.
– Developing countries are severely
limited by a lack of capital.

W. Bentz EMBA 802 3

 Economic Performance
– Japan’s progress in the economic
development race can be attributed to
the financing of industry by patient banks
and very high savings rates across the
entire population. Excessive emphasis
on growth and leverage have caused
significant problems in recent history, but
the emergence of Japan as an economic
power is impressive nevertheless. The
wealth of nations is a big deal.

W. Bentz EMBA 802 4

 Dimensions of Economic Perf.
• Purchasing power return per dollar
invested (i.e., return from the most
scarce resource)
• Risk of expected returns on
investment (business risk and
financial risk)
• Timing of the expected returns (time
value of money and opportunity to
recycle the purchasing power)
W. Bentz EMBA 802 5
 The Performance Issue
• Guide, encourage and reward
executive performance to achieve
economic results that are accepted by
current and prospective owners.
– Strategic alignment
– Shareholder value
– Prudent risks
– Avoid pitfalls of sunk costs, status-quo,
risk-avoidance, etc.
W. Bentz EMBA 802 6
 Has the problem changed?
• Yes, the pace of innovation and
change has increased with all the
associated risks.
• Yes, global markets greatly increase
the risks to local companies and to
companies that once operated as
local monopolies.

W. Bentz EMBA 802 7

 Has the problem changed?
• Yes, deregulation in telecommunications,
transportation, electricity generation,
natural gas, interest rates, and other areas
increases competition and risk. The next
battleground will be financial services.
• Yes, governments are less concerned
about monopolistic practices and abuses.
Therefore, the rate of consolidation has
accelerated almost across the board.
W. Bentz EMBA 802 8
 The Objective
• Increased shareholder value
– Actions
– Plans
– Communication
• Greater strategic focus
• Attention to job by executives

W. Bentz EMBA 802 9

 Key Concepts
• Cost of capital is the cash flow
required to compensate investors for
the riskiness of the business given the
amount of capital invested.
– Measuring the minimum required is not
so clear in the case of equity.
– Investors appear to buy growth,
especially steady growth, even in the
absence of current cash flow.
– Buybacks, dividends, splits, are relevant
W. Bentz EMBA 802 10
 Creating Shareholder Value
• The EVA theory is that the firm creates
shareholder value by investing in
projects that earn more than the cost of
capital, thus creating a “surplus.” This
is consistent with the notion of
investing in projects with a positive net
present value, even if the firm
continues to invest until the marginal
return on investment equals the cost of
capital.
W. Bentz EMBA 802 11
 Market Value Added
• Market value added is the difference
between what investors have invested
in a firm, and the market value
(stocks, bonds, options, etc.) of that
firm. This is the cumulative amount
investors have contributed to the firm
directly, not what they happened to
have paid for their own stocks and
bonds. It is a entity measure of
performance.
W. Bentz EMBA 802 12
 MVA & Capital
• MVA = [market value of equity +
market value of preferred shares +
market value of debt] - total invested
capital
• Assets = Liabilities + Owners’ Equity

• Assets = Liabilities + [Invested capital

+ Retained earnings (earned capital)]

W. Bentz EMBA 802 13

 Stern & Stewart’s EVA®
• To get invested capital, S&S
– allude to some 164 equity “adjustments”
– address 20-25 in some detail
– use around 5 adjustments in actual
practice

W. Bentz EMBA 802 14

 Stern & Stewart’s EVA®
• More defensible ones include
– R&D (add back and amortize)
– LIFO (add reserve amount = FIFO -
LIFO)
– Deferred taxes (add back amount)
– Goodwill (add back cumulative
amortization)

W. Bentz EMBA 802 15

 Stern & Stewart’s EVA®
• For their measure of return, S&S refer
to NOPAT, net operating profit after
tax
• We would call this “income from
operations (adjusted) after tax”, but
IFOAT is not as marketable.

W. Bentz EMBA 802 16

 Stern & Stewart’s EVA®
• To their credit, S&S now recognize
the impact of the above adjustments
on “capital” as having a
corresponding impact on NOPAT

W. Bentz EMBA 802 17

 Stern & Stewart’s EVA®
• Start with income from operations
+ current R&D expense
- amortization of cumulative R&D
+ increase (decrease) in LIFO
reserve
+ increase (decrease) in deferred
taxes

W. Bentz EMBA 802 18

 • The good news--most positive actions
should lead to an improvement in
EVA, just as they would result in an
increase in residual income.
– Increase throughput and the utilization of
assets.
– Disposal of excess assets
– Find and implement projects earning at
least the cost of capital
– Focus on more profitable products
W. Bentz EMBA 802 19
 Stern & Stewart’s EVA®
• The not-so-good news--most positive
actions that lead to the improvement of
EVA also lead to the improvement in
residual income.
• The incremental value of EVA does not
appear to justify the hype and cost
• Many of the adjustments considered by
S&S end up being more arbitrary than
current financial reporting standards.

W. Bentz EMBA 802 20

 Investment Centers
• See profit centers
• Probable additional controllable
factors
– Investment in current operating
assets
– Investment in plant &
equipment

W. Bentz EMBA 802 21

 Investment Centers
• Challenges
– Allocation of common assets
• Cash
• Receivables
• Warehouse space
• Transportation resources
– Valuation of investment
• Inflation and currency effects
W. Bentz EMBA 802 22
 Invest.Centers (Cont.)
• Examples
– Lazarus store in City Center
Mall
– Marysville Honda plant
– EDS processing centers

W. Bentz EMBA 802 23

 Divisions
• Investment centers with broad
responsibilities
• Not necessarily large entities
when business units
• Associated with more
decentralized control
• Financial controls dominate,
• Equivalent of large corporations
W. Bentz EMBA 802 24
 Transfer Pricing
• A transfer price is the price at which a
product or service is transferred from
one entity to another entity within the
same firm.
• Significant issue in international sales
• The pricing of transfers is necessary
to simulate market forces on profit
centers, investment centers and
divisions.
W. Bentz EMBA 802 25
Transfer Pricing f(decentralization)
• Purposes
– Decentralize managerial responsibilities to
local managers.
– Provide managerial incentives to operating
executives
– Distribute overall profitability among
contributing entities
– Distribute overall profitability among taxing
entities
– Isolate efficiency effects in the responsible
unit.
W. Bentz EMBA 802 26
 Linkage Example
Return on
Corporate Assets

VP Inventory Output/ Output/square

Manufacturing days equipment
$ foot occupied

Plant Manufacture Finished goods Days vendor

Manager cycle time inventory days lead time

Department Machine Percentage good Number unplanned

downtime output/total output schedule changes
Manager

Defective Parts
Process availability Wait on QC
Drivers subassembly

No Changeover Power
manpower times failure
W. Bentz EMBA 802 27
 1996 Prentice Hall Business Publishing Management Accounting, 2nd ed., Atkinson, Banker, Kaplan, and Young 11-17
 Transfer Pricing Methods
• Incremental cost (economic
theory)
• Full cost (Where’s the profit?)
• Full cost plus a profit
• Negotiated price (Non-value)
• Administered price
• Market-based price
W. Bentz EMBA 802 28
 Transfer Price = Internal Price
Corporate
Entity
Primary or inter-
mediate producer

Transfer Intermediate Producer

price or Distributor

Final External
price Customer
W. Bentz EMBA 802 29
 Note!!
• The selling division’s “price” is the
buying division’s cost for
divisional performance
measurement purposes.
• Production mix and volume
decisions are incremental
analysis-type decisions in a multi-
entity context.
W. Bentz EMBA 802 30