Investment Centers

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13
ChapterThirteen

• Investment Centers
• and Transfer Pricing

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Delegation of Decision Making(Decentralization)
Decision Makingis pushed down.
Decentralization often occurs as organizations
continue to grow.
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Decentralization
Advantages
Allows organization to respond morequickly to
events.
Uses specializedknowledge andskills of managers.
Frees top managementfrom day-to-dayoperating
activities.
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Decentralization
Challenge
Goal CongruenceOrganizations subunit managers
make decisions that achievetop-management goals.
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Measuring Performancein Investment Centers
Investment Center managers make decisions that
affect both profit and invested capital.
Corporate Headquarters
Investment CenterEvaluation
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Return on Investment (ROI)
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Return on Investment (ROI)

• Holly Company reports the following
• Income 30,000
• Sales Revenue 500,000
• Invested Capital 200,000

Lets calculate ROI.
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Return on Investment (ROI)
ROI 6 2.5 15
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Improving R0I

• Decrease
• Expenses

• Increase
• Sales Prices

• Lower
• Invested Capital

• Three ways to improve ROI

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Improving R0I

• Hollys manager was able to increase sales
  revenue to 600,000 which increased income to
  42,000.
• There was no change in invested capital.

Lets calculate the new ROI.
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Return on Investment (ROI)
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 divisions 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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ROI - A Major Drawback
As division manager, I wouldnt invest in that
project because it would lower my pay!
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Question

• The biggest challenge in making a decentralized
  organization function effectively is
• A. earning maximum profits through fair
  practices.
• B. minimizing losses.
• C. taking advantage of the specialized knowledge
  and skills of highly talented managers.
• D. obtaining goal congruence among division
  managers.
• E. developing an adequate budgetary control
  system.

15
Question

• ROI is most appropriately used to evaluate the
  performance of
• A. cost center managers.
• B. revenue center managers.
• C. profit center managers.
• D. investment center managers.
• E. both profit center managers and investment
  center managers.

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Question

• Horace Company had sales revenue and operating
  expenses of 4,500,000 and 3,800,000,
  respectively, for the year just ended. If
  invested capital amounted to 6,000,000, the
  firm's ROI was
• A. 11.67.
• B. 75.00.
• C. 133.33.
• D. 857.14.
• E. some other figure.

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Question

• Mission, Inc., reported a return on investment of
  12, a capital turnover of 5, and income of
  180,000. On the basis of this information, the
  company's invested capital was
• A. 300,000.
• B. 900,000.
• C. 1,500,000.
• D. 7,500,000.
• E. some other amount.

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Residual Income
Investment center profit Investment charge
Residual income
Investment capital Imputed interest rate
Investment charge
Investment centersminimum requiredrate 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.

Lets calculate residual income.
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Residual Income
Investment capital 100,000 Imputed
interest rate 20 Investment charge
20,000
Investment centersminimum requiredrate 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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Question

• The basic idea behind residual income is to have
  a division maximize its
• A. earnings per share.
• B. income in excess of a corporate imputed
  interest charge.
• C. cost of capital.
• D. cash flows.
• E. invested capital.

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Question

• Hasty Corporation uses an imputed interest rate
  of 12 in the calculation of residual income.
  Division C, which is part of Hasty, had invested
  capital of 800,000 and an ROI of 15. On the
  basis of this information, C's residual income
  was
• A. (24,000).
• B. 24,000.
• C. 96,000.
• D. 120,000.
• E. some other amount.

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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 centers after-tax operating
income Investment charge Economic Value
Added
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Economic Value Added
The Atlantic Division of Suncoast Food Centers
reportedthe following results for the most
recent period
Compute Atlantic Divisions economic value added.
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Economic Value Added
First, lets compute theweighted-average cost of
capital
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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
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Question

• Which of the following elements is not used in
  the calculation of economic value added for an
  investment center?
• A. An investment center's after-tax operating
  income.
• B. An investment center's total assets.
• C. An investment center's return on investment.
• D. An investment center's current liabilities.
• E. A company's weighted-average cost of capital.
  

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Question

• The following information relates to Blackstone,
  Inc.
• Total assets6,000,000After-tax operating income
  900,000Current liabilities 500,000
• If the company has a 12 weighted-average cost
  of capital, its economic value added would be
• A. 120,000.
• B. 180,000.
• C. 240,000.
• D. 292,000.
• E. some other amount.

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Measuring Investment Capital

• Three issues must be considered before we can
  properly measure the investment capital.
• What assets should be included?
• Total assets.
• Total productive assets.
• Total assets less current liabilities.
• Only the assets controllable by the manager being
  evaluated.

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Measuring Investment Capital

• Three issues must be considered before we can
  properly measure the investment capital.
• 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?
• Should the assets be shown at historical or
  current cost?

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Gross or Net Book Value

• GrizzlyCo 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 GrizzlyCo will
  invest 100,000 in an asset that has a ten-year
  life and no salvage value. Straight-line
  depreciation is used.
• GrizzlyCo calculates ROI based on end-of-year
  asset values.
• Lets calculate ROI using both the gross and
  net book values.

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Gross or Net Book Value
(100,000 0) 10 10,000 per year
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Gross or Net Book Value
100,000 10,000 90,000 net book value
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Gross or Net Book Value
15,000 90,000 16.67
15,000 100,000 15
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Gross or Net Book Value
The ROI increases each year usingnet book value
even though no operating changes take place.
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Gross or Net Book Value
Since older assets, with lower net bookvalues,
result in higher ROI, managers arediscouraged
from investing in new assets.
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Inflation Historical Cost versusCurrent-Value
Accounting

• Use of current-value accounting impacts the
  amount of
• Invested capital.
• Income.

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Measuring Performance in Nonprofit Organizations
Since income is not the primary measure of
performance innonprofit organizations,
performance measures other thanROI and residual
income are used.
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Question

• Given that ROI measures performance over a period
  of time, invested capital would most
  appropriately be figured by using
• A. beginning-of-year assets.
• B. average assets.
• C. end-of-year assets.
• D. total assets.
• E. only current assets.

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Question

• The income calculation for a division manager's
  ROI should be based on
• A. divisional contribution margin.
• B. profit margin controllable by the division
  manager.
• C. profit margin traceable to the division.
• D. divisional income before interest and taxes.
• E. divisional net income.

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Transfer Pricing
Lets change topics!
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Transfer Pricing
The amount charged when one division sells goods
or services to another division
Battery Division
Auto Division
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Transfer Pricing

• The transfer price affects the profit measure
  for both the selling division and the buying
  division.

A higher transferprice for batteriesmeans . . .
greater profits for the battery division.
Auto Division
Battery Division
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Transfer Pricing

• The transfer price affects the profit measure
  for both the selling division and the buying
  division.

A higher transferprice for batteriesmeans . . .
lower profitsfor the auto division.
Auto Division
Battery Division
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Goal Congruence
The ideal transfer price allowseach division
manager to makedecisions that maximize
thecompanys profit, whileattempting to
maximize his/herown divisions profit.
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General-Transfer-Pricing Rule
Additional outlaycost per unitincurred
becausegoods aretransferred
Opportunity costper unit to the organizationbeca
use ofthe transfer
Transfer price


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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 outlaycost per unitincurred
becausegoods aretransferred
Opportunity costper unit to the organizationbeca
use ofthe transfer
Transfer price


22 Contributionlost if outsidesales given up
Transfer price
18 variable cost per battery


Transfer price

40 per battery
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Scenario I No Excess Capacity
Auto division canpurchase 100,000batteries from
anoutside supplierfor less than 40.
Auto division canpurchase 100,000batteries from
anoutside supplierfor more than 40.
Transferwill notoccur.
Transferwill occur.
40transferprice
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Scenario I No Excess Capacity

• General RuleWhen 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 outlaycost per unitincurred
becausegoods aretransferred
Opportunity costper unit to the organizationbeca
use ofthe transfer
Transfer price


Transfer price
18 variable 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 38.
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Scenario II Excess Capacity
Transferwilloccur.
Transferwill not occur.
Transferwill not occur.
18transferprice
38transferprice
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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 companys
  interests and an individual managers interests
  when transfer-price-based performance measures
  are used.

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Setting Transfer Prices

• Conflicts may be resolved by . . .
• Direct intervention by top management.
• Centrally established transfer price policies.
• Negotiated transfer prices.

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Setting Transfer Prices

• Top management may become swamped with pricing
  disputes causing division managers to lose
  autonomy.

I just wont pay 65 for that part!
You really dont have any choice!
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Setting Transfer Prices

• Top management may become swamped with pricing
  disputes causing division managers to lose
  autonomy.

Now, here is what the two of you are going to do.
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Centrally EstablishedTransfer 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.

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Centrally EstablishedTransfer 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.

The discount depends on cost savings from selling
internally. Cost savings may include items
like transportation.
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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 managementtime is used in thenegotiation
process.
Negotiated price may notbe in the best interest
ofoverall 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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Question

• Which of the following describes the goal that
  should be pursued when setting transfer prices?
• A. Maximize profits of the buying division.
• B. Maximize profits of the selling division.
• C. Allow top management to become actively
  involved when calculating the proper dollar
  amounts.
• D. Establish incentives for autonomous division
  managers to make decisions that are in the
  overall organization's best interests (i.e., goal
  congruence).
• E. Minimize opportunity costs.

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• Woodstone's Southern Division is currently
  purchasing a part from an outside supplier for
  26 per unit. The company's Northern Division,
  which has excess capacity, makes and sells this
  part for external customers at a variable cost of
  19 and a selling price of 29. If Northern
  begins sales to Southern, it (1) will use the
  general transfer-pricing rule and (2) will be
  able to reduce variable cost on internal
  transfers by 2. If sales to outsiders will not
  be affected, Northern should establish a transfer
  price of
• A. 17.
• B. 19.
• C. 27.
• D. 29.
• E. some other amount.

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• Laissez Faire, has two divisions the Cologne
  Division and the Bottle Division. The Bottle
  Division produces containers that can be used by
  the Cologne Division. The Bottle Division's
  variable manufacturing cost is 2, shipping cost
  is 0.10, and the external sales price is 3. No
  shipping costs are incurred on sales to the
  Cologne Division, and the Cologne Division can
  purchase similar containers in the external
  market for 2.60.

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• The Bottle Division has sufficient capacity to
  meet all external market demands in addition to
  meeting the demands of the Cologne Division.
  Using the general rule, the transfer price from
  the Bottle Division to the Cologne Division would
  be
• A. 2.00.
• B. 2.10.
• C. 2.60.
• D. 2.90.
• E. 3.00.

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• Assume the Bottle Division has no excess
  capacity and could sell everything it produced
  externally. Using the general rule, the transfer
  price from the Bottle Division to the Cologne
  Division would be
• A. 2.00.
• B. 2.10.
• C. 2.60.
• D. 2.90.
• E. 3.00.

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Behavioral IssuesRisk Aversion and Incentives
The design of a managerial performanceevaluation
system using financial performancemeasures
involves a trade-off between
Incentives for the manager to act inthe
organizationsinterests.
Risks imposed on themanager becausefinancial
performance measures are onlypartially
controlledby the manager.
And
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End of Chapter 13
Lets transfer some of yourcapital to me so
that my rateof return will be higher!