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C H A P T E R N I N E T E E N

Strategic Performance Measurement: Investment Centers After studying this chapter, you should be able to . . .

1. Explain the use and limitations of return on investment (ROI) for evaluating investment centers 2. Explain the use and limitations of residual income (RI) for evaluating investment centers 3. Explain the use and limitations of economic value added (EVA ® ) for evaluating investment centers 4. Explain the objectives of transfer pricing and the advantages and disadvantages of various

transfer-pricing alternatives 5. Discuss important international issues that arise in transfer pricing

As indicated in the preceding chapter, when an organization decentralizes it does so to achieve certain objectives, including maximization of shareholder value. From top management’s viewpoint, one of the costs of decentralization is the need to implement an effective perform-ance-measurement system. The traditional approach to the design of such a system is to focus on the tenet of controllability: subunits of a decentralized organization (and their managers) should, as much as possible, be evaluated only on factors they can control, or at least influ-ence, by their actions. In previous chapters, we’ve looked at how top management can evaluate the financial performance of lower-level units of the organization (viz., cost centers and profit centers). This chapter covers issues related to the performance of investment centers—the highest subunit level of an organization. By definition, managers of these units exercise con-trol over revenues, costs, and level of investment. Thus, the evaluation of financial perform-ance of these units should logically incorporate a measure of invested capital. Such measures allow top management to compare the financial performance of different investment centers within the organization. As indicated in the vignette that follows, the task of evaluating the performance of investment units is complicated when these units exchange goods and services with one another. That is, in such situations a “transfer price” between units must be chosen to evaluate the financial performance of both the buying unit and the selling unit. Setting an appropriate transfer price is especially challenging in an international context.

Five Steps in the Evaluation of the Financial Performance of Strategic Investment Units in an Organization Global Electronics, Inc. (a fictitious company) was started five years ago by a small group of entrepreneurial students. The company produces innovative electronics products that appeal to young, educated individuals. Global is pursuing a low-cost, high-volume strategy. In fact, the company has from its inception grown rapidly and now does business in all 50 states as well as selected countries abroad. Its incentive to go abroad is to reduce cost and to facili-tate growth in foreign sales. The company is decentralized and organized into a series of cost centers, profit centers, and investment centers. Recently, to take advantage of income-tax opportunities, Global has established several foreign subsidiaries, which both produce and distribute the company’s products. Initially, the company felt little need for a comprehensive performance-evaluation system. However, with recent growth and development, the owners

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846 Part Four Management-Level Control

of the company are looking at alternative models for evaluating the performance of the vari-

ous units into which the company is divided. Business consultants with whom the owners

met recently recommended the following five-step process for developing a performance-

measurement system for Global.

1. Determine the strategic issues surrounding the problem. Global Electronics, Inc.,

has organized itself into a number of decentralized units, including strategic investment units

where the managers have broad responsibility over operating decisions and level of invest-

ment in the unit. The owners of the company want to institute a performance-measurement

system that would allow the owners to evaluate the financial performance of each of the

investment centers it has created.

2. Identify the alternative actions. The primary task is to choose one or more financial-

performance indicators that incorporate in the measure the level of investment in each unit.

Proposed alternative indicators include return on investment (ROI), residual income (RI), or

economic value added (EVA®). 1 Global must also choose the time period over which finan-

cial performance will be evaluated (i.e., one year versus time-series basis). For interdivisional

transfers of products and services, Global must choose an appropriate transfer-pricing system

from among the following alternatives: variable cost, full cost, market price, or negotiated

price. Further, the company must determine whether transfer prices will be recorded at actual,

at budgeted, or at standard cost. 2 Finally, Global must decide whether to use a single or a dual

transfer-pricing system.

3. Obtain information and conduct analyses of the alternatives. The choice of a

performance-evaluation system for decentralized units, such as investment centers, has

important behavioral consequences. For example, to a greater or lesser extent the aforemen-

tioned choices maintain or decrease managerial autonomy, increase or decrease managerial

motivation, and to a greater or lesser extent result in goal congruency. Further, some choices

as to system design are simpler (administratively) to implement and maintain. In terms of

selecting the appropriate transfer-pricing method, there are significant income-tax consider-

ations, particularly given the (now) international scope of the company’s operations. To pro-

tect itself, the company is considering entering into an advance pricing agreement (APA) with

the IRS regarding its transfer-pricing method to be used for both domestic and international

purposes. Finally, the company is concurrently considering the introduction of a balanced

scorecard (BSC) (see Chapter 18) and so management needs to consider choice of perfor-

mance metric(s) in conjunction with the design of its BSC.

4. Based on strategy and analysis, choose and implement the desired alternative. After

discussion of these issues with its consultants, the company chooses a mix of financial-

performance indicators and a specific transfer-pricing system that attempts to balance imple-

mentation costs against behavioral benefits and income-tax considerations. The high-level

financial-performance indicators should be linked strategically to the company’s BSC. Over-

all, the proposed performance-evaluation system for its investment centers will help Global

implement its growth strategy and determine where growth is most profitable.

5. Provide an ongoing evaluation of the effectiveness of the step 4 implementation. The financial performance of all strategic investment centers of the company is evaluated

quarterly, in conjunction with both subunit and corporate scorecards. Further, the financial-

performance metrics are benchmarked to best-in-class performance of Global’s competitors.

Changes to the way financial performance is evaluated, as well as potential changes to the

transfer-pricing system used by the company, are discussed during quarterly meetings with

the owners of the company.

The rest of this chapter is divided into two parts. In part one we discuss alternatives for

evaluating the financial performance of investment centers. In part two we discuss the issue of

transfer pricing. In both cases, our approach is to discuss both the advantages and limitations

of various alternatives that exist. As you will see, evaluation of the financial performance of

1 EVA® is a registered trademark of Stern Stewart & Co. 2 As noted in Chapter 14, standard costs are normative —they represent the costs that should be incurred under relatively efficient operating conditions.



Chapter 19 Strategic Performance Measurement: Investment Centers 847

investment centers is important, but incomplete. Thus, a strategic analysis of the performance of an investment center must also include nonfinancial-performance indicators, such as those included in an entity’s balanced scorecard. In fact, all of these points were considered by the management of Global in its attempt to implement a performance-evaluation system for its investment centers.

Part One: Financial-Performance Indicators for Investment Centers Under the notion of controllability, it is appropriate for top management to evaluate the profit-ability of each investment center in relation to the amount of capital invested in the subunit. In practice, top management can use one or a combination of the following metrics: return on investment (ROI), residual income (RI), or economic value added (EVA®). Each of these measures is discussed in this part of the chapter. In general, we evaluate each of these alterna-tives on the basis of the following criteria:

• Extent to which the measure motivates a high level of effort on the part of subunit managers.

• Extent to which the use of the measure results in goal congruency (consistency between decisions made by managers and the goals of top management).

• Extent to which the measure rewards managers fairly for their effort and skill, and for the effectiveness of the decisions they make.

Please keep the preceding criteria in mind as you study the rest of this chapter.

Return on Investment

The most commonly used measure of short-term financial performance of an investment center is return on investment (ROI) , which is defined as some measure of profit divided by some measure of investment in the business unit. ROI is a percentage, and the larger the percentage, the better the ROI. The achieved level of ROI depends on many factors, including general economic conditions, and, in particular, the current economic conditions of the company’s industry. For example, cyclical industries such as airlines and home con-struction have ROIs that vary significantly under differing economic conditions. In calcu-lating ROI, “profit” (i.e., the numerator of the ratio) for an investment center (compared to the firm as a whole) is typically defined as divisional operating income. The amount of “investment” (i.e., the denominator of the ratio) is often determined by the assets of the business unit.

ROI Equals Return on Sales Times Asset Turnover 3 ROI is the product of two components, return on sales and asset turnover. Since sales and profits relate to a period of time, for consistency the amount of assets used to calculate ROI usually is determined from the simple average of the value of assets at the start of the period and the value of assets at the end of the period.

ROI Return on sales Asset turnover

ROIProfi

! "

!tt

SalesSalesAssets

"

Return on sales (ROS) , or profit per sales dollar, measures the manager’s ability to control expenses and increase revenues to improve profitability. Return on sales is also called profit margin. Asset turnover (AT) , the amount of dollar sales achieved per dollar of investment, measures the manager’s ability to increase sales from a given level of investment. Together, the two components of ROI tell a more complete story of the manager’s performance and enhance

3 ROI based on asset turnover and return on sales is often referred to as the DuPont approach since it was originated by Donaldson Brown, chief financial officer of DuPont Corporation early in the 1900s.

LEARNING OBJECTIVE 1Explain the use and limitations of return on investment (ROI) for evaluating investment centers.

LEARNING OBJECTIVE 1Explain the use and limitations of return on investment (ROI) for evaluating investment centers.

Return on investment (ROI)is some measure of profit divided by some measure of investment in the business unit.

Return on investment (ROI)is some measure of profit divided by some measure of investment in the business unit.

Return on sales (ROS),or profit per sales dollar, measures the manager’s ability to control expenses and increase revenues to improve profitability.

Asset turnover (AT),amount of dollar sales achieved per dollar of investment, measures the manager’s ability to increase sales from a given level of investment.

Return on sales (ROS),or profit per sales dollar, measures the manager’s ability to control expenses and increase revenues to improve profitability.

Asset turnover (AT),amount of dollar sales achieved per dollar of investment, measures the manager’s ability to increase sales from a given level of investment.


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top management’s ability to evaluate and compare different units within the organization. For example, research has shown that firms with different operating strategies tend also to have a different mix of return on sales versus asset turnover. Firms with high operating leverage (see Chapter 9) tend to have low asset turnover and high return on sales; those with low operating leverage and commodity-like products tend to have the highest asset turnover and the lowest return on sales. Please see the above RWF item for an elaboration on these points.

Illustration of Evaluation Using ROI Assume that CompuCity is a retailer with three product lines, computers, software, and com-puter help books. The company has stores in three regions, the Boston area, South Florida, and the Midwest. Each store sells only books, computers, and software. CompuCity’s profits for the Midwest declined last year, due in part to increased price competition in the computer unit.

Because of this decline in profits, top management uses ROI to study the performance of the Midwest region. Each product line is considered an investment center for evaluation pur-poses. CompuCity knows that the markups are highest in software and lowest for computers because of price competition. Investment in each unit consists of the inventory for sale and the value of the real estate and improvements of the retail stores. Inventory is relatively low in the computer unit since merchandise is restocked quickly from the manufacturers. Inventory is also low in the book unit because about 40 percent of CompuCity’s books are on consignment from publishers.

The current book value (recorded cost) of the real estate and store improvements is allo-cated to each of the three units on the basis of square feet of floor space used. The software unit occupies the largest amount of floor space, followed by computers and books. Panel 1 of Exhibit 19.1 shows the operating income, sales, and investment information for the Midwest region of CompuCity in 2009 and 2010. Panel 2 shows the calculation of ROI, including ROS and asset turnover, for the Midwest region for both 2009 and 2010.

The data in Exhibit 19.1 indicate that Midwest region’s ROI has fallen (from 14.4 per-cent in 2009 to 13.5 percent in 2010) due mainly to a decline in overall ROS (from 6.1 percent in 2009 to 5.1 percent in 2010). Further analysis shows that the drop in ROS is due to the sharp decline in ROS for the computer product line (from 4 percent in 2009 to 2 percent in 2010). The computer unit’s decline in ROS is likely the result of the increased price competition.

The analysis also shows that software is the most profitable business unit (based on an ROI of 20 percent in 2010); this is so primarily because of the relatively high ROS (highest at

The figure to the right shows the relationship between asset turno-ver (AT) and return on sales (ROS) for a return on imvestment of 10 percent. Any point falling above the line would represent an ROI of greater than 10 percent; a point falling below this line would be an ROI of less than 10 percent. The curve shows that there are lots of different combinations of AT and ROS that will produce an ROI of 10 percent. Also, it is common that different industries will fall at differ-ent points of the figure. For example, restaurants typically have low ROS and higher AT so they will appear to the upper left of the figure (for example in 2008 Einstein Noah Restaurant Group, Inc. had an ROS of 5% and AT of 2.57, for an ROI of 13%). In contrast, utilities typically have lower AT and higher ROS (for example, Duke Energy in 2008 had an ROS of 10.3% and AT of 0.26, for an ROI of 2.7%).

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REAL-WORLD FOCUS Industries Differ in the Relationship of Return on Sales and Asset Turnover


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10 percent since the markup on software products is relatively high). In contrast, the computer and book units have higher asset turnovers due to the lower required levels of inventory and floor space than the computer unit, and the large percentage of consignment inventory for the book unit. ROI has also improved significantly for the software unit because of the decline in investment, due either to a reduction in inventory or a decrease in floor space for software (recall that investment is allocated to the units on the basis of floor space).

Strategic Analysis Using ROI Use of ROI enables CompuCity to evaluate the short-term financial performance of each of the three units. CompuCity can set performance goals for each unit in terms of both return on sales (ROS) and asset turnover (AT). The unit managers then have very clear goals to increase sales and reduce costs, reduce inventory, and use floor space effectively. To be effective, the goals should recognize differences in the competitive factors among the units. For example, a lower ROS should be expected of the computer unit because of competitive pricing that affects that unit.

Exhibit 19.1 data also reflect the way that competitive factors in the computer unit and business relationships regarding inventory in the computer and book units affect profit-ability. This provides a useful basis for an improved analysis, that is, for determining how the firm should position itself strategically. How should CompuCity’s competitive approach be changed in view of recent and expected changes in the competitive environment? Per-haps the computer unit should be reduced and the software unit expanded. Which stores in the Midwest are successful, and why? A value-chain analysis might provide insight into strategic competitive advantage and opportunity. For example, CompuCity might find it more profitable to reduce its computer unit and replace it with products that are potentially more profitable, such as printers, pagers, cell phones, fax machines, supplies, and computer accessories.

Return on Investment: Measurement Issues If ROI is used to evaluate the relative performance of business units, then income and invest-ment should be determined consistently and fairly across these units.

1. Income and investment, to the extent possible, be measured in the same way for each unit. For example, all units to be evaluated should use the same inventory cost-flow assumption (FIFO or LIFO) and the same depreciation method. 4

2. The measurement method must be reasonable and fair for all units. For example, if some units have much older assets than other units have, the use of net book value (NBV) for assets can significantly bias the ROI measures in favor of the older units.

4 Each of the policies also has the effect of either simultaneously increasing income and increasing investment or simultaneously decreasing income and decreasing investment. Since ROI is a ratio that normally is between zero and 1, an increase in income increases ROI although investment also has increased by the same amount, and vice versa.

The cost of training employees can be 15 percent or more of total pay-roll costs in some firms. These significant expenditures are incurred because of the importance of investing in the job-related abilities of the firm’s employees. Since employee training costs are not included on the balance sheet as assets according to generally accepted account-ing principles, the training function within a firm is often not viewed as an investment center. In contrast, other firms consider training to

be one of the most strategically important investments they make and, accordingly, determine an ROI value for it. Software vendors and con-sultants assist firms in developing the proper measurements.

Source: Based on Ann P. Bartel, “Measuring the Employer’s Return on Invest-ments in Training: Evidence from the Literature,” Industrial Relations, July 2000, pp. 502–24; and Felix Barber and Rainer Strack, “The Surprising Economics of the People Business,” Harvard Business Review, June 2005, pp. 81–90.

REAL-WORLD FOCUS Measuring Return on Investment in Employee Training


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To illustrate the effect of an accounting policy on divisional ROIs, assume that all units of CompuCity expense all furniture and other items used to display products; these items cost $2,000 per year. Suppose the computer unit decides to capitalize these expenses. What is the short-term effect on ROI if depreciation is $500 per year on these items? The increase in the NBV of assets for the Computer Unit is $1,500, and the net effect on income for this unit is $1,500. Exhibit 19.2 compares the Computer Unit to the Book Unit before the change (Panel 1) and after the change (Panel 2).

The illustration shows that the decision to capitalize the display costs in the short run increased the Computer Unit’s assets, income, and ROI. Although the Book Unit has the higher ROI when both units expense display costs, the Computer Unit’s decision to capitalize these costs while the Book Unit does not has caused the Computer Unit to at least temporarily have the higher ROI.

Which Assets to Include in the ROI Calculation A common method for calculating ROI is to define investment as the net cost of long-lived assets plus working capital (i.e., current assets minus current liabilities). A key criterion for including an asset in ROI is the degree to which the unit controls it. For example, if the unit’s cash balance is controlled at the firmwide level, only a portion (or perhaps none) of the cash balance should be included in the investment amount for calculating divisional ROI. Similarly, receivables and inventory should include only those controllable at the unit level.

Long-lived assets commonly are included in investment if they are traceable to the unit (for shared assets, see the next section). Management problems arise, however, if the long-lived assets are leased or if some significant portion of them is idle. Leasing requires a clear firmwide policy regarding how to treat leases in determining ROI so that unit managers are properly motivated to lease or not to lease, as is the firm’s policy. In general, the leased assets should be included as investments since they represent assets used to generate income, and the failure to include them can cause a significant overstatement of ROI.

For idle assets, the main issue is again controllability. If the idle assets have an alternative use or are readily saleable, they should be included in the investment amount for ROI. Also, if top management wants to encourage the divestment of idle assets, including idle assets in ROI would motivate the desired action since divestment would reduce investment and increase ROI. Alternatively, if top management sees a potential strategic advantage to holding the idle assets, excluding idle assets from ROI would provide the most effective motivation since holding idle assets would not affect the ROI calculation.

Measuring Investment: Allocating Shared Assets When shared facilities, such as a common maintenance facility, are involved, management must determine a fair sharing arrangement. As in joint cost allocation (Chapter 7), top man-agement should trace the assets to the business units that used them and allocate the assets that cannot be traced on a basis that is as close to actual usage as possible. For example, the

EXHIBIT 19.2Effect on ROI of Capitalizing Certain Costs: CompuCity (Midwest Region)

Panel 1: ROI Prior to Capitalizing Display Materials (same as Exhibit 19.1, 2010) Computer Unit Book Unit

Assets $62,500 $50,000Income $5,000 $5,000ROI 8% 10%

Panel 2: Year-One Results—Book Unit Expenses Display Costs While the Computer Unit Capitalizes These Costs

Assets $64,000 ! $62,500 " $1,500 $50,000Income $6,500 ! $5,000 " $1,500 $5,000ROI 10.16% ! $6,500/$64,000 10%



852

investment in a vehicle maintenance facility might be allocated on the basis of the number of

vehicles in each unit or on the total value of these vehicles.

Alternatively, the required capacity and therefore the investment in the joint facility are

sometimes large because the user units require high levels of service at periods of high demand.

In this case, the assets should be allocated according to the peak demand by each individual

unit; units with higher peak-load requirements would be allocated a relatively larger portion

of the total investment cost. For example, a computer services department might require a

high level of computer capacity because certain units within the company require a large

amount of service at certain times.

Measuring Investment: Current Values The amount of investment is typically the historical cost of divisional assets , which is

defined as the book value of current assets plus the net book value (NBV) of long-lived

assets. Net book value (NBV) for a depreciable asset is the difference between original cost of

the asset and accumulated depreciation on that asset. A problem arises when the long-lived

assets are a significant portion of total investment because most long-lived assets are stated

at historical-cost, and price changes since their purchase can make the historical-cost figures

irrelevant and misleading.

If the relatively small historical-cost value is used for investment in ROI, the result is

that ROI can be significantly overstated relative to ROI determined with the current value

of the assets. The consequence is that the use of historical-cost ROI can mislead strategic

decision makers, since the inflated ROI figures can create an illusion of profitability. The

illusion is removed when the assets are replaced later at their current value.

For example, a division that enjoys a relatively high ROI of 20 percent based on NBV (e.g.,

income of $200,000 and NBV of assets of $1,000,000) would find that if replacement cost of

the assets were four times book value (4 " $1,000,000 ! $4,000,000), the ROI after replace-

ment would become a relatively low 5 percent ($200,000/$4,000,000). Strategically, the firm

should have identified the low profitability of this business unit in a timely manner, but use of

historical-cost ROI can delay this recognition. Thus, instead of measuring assets at historical

cost (for purposes of calculating ROI) an organization may choose some measure of current

value of these assets. Presumably, the resulting ROIs better inform management about the true

profitability of its various business units. Note, however, that if current-cost data are not cur-

rently being reported (for example, for financial accounting purposes) the organization in this

case will incur additional information-gathering costs.

In addition to its strategic value, the use of current value helps to reduce the unfairness of

historical-cost NBV when comparing among business units with different aged assets. Units

with older assets under the NBV method have significantly higher ROIs than units with newer

assets because of the effect of price changes and of accumulating depreciation over the life of

Historical cost of divisional assetsis the book value of current

assets plus the net book value

(NBV) of long-lived assets.

Net book value (NBV)is the original cost of a

depreciable asset less

accumulated depreciation to date

on that asset.

Historical cost of divisional assetsis the book value of current

assets plus the net book value

(NBV) of long-lived assets.

Net book value (NBV)is the original cost of a

depreciable asset less

accumulated depreciation to date

on that asset.

Coca-Cola is made up of two separate companies, the Coke com-pany and the bottling company, Coca-Cola Enterprises (CCE). The Coke company produces and sells the highly profitable proprietary concentrate to the bottlers that compete in a price-sensitive mar-ket. Once a part of a combined company, CCE was spun off as a separate entity in 1986. A favorable result of the spin-off for the Coke company is that the bottling company carries most of the assets of the two entities, the bottling plants and equipment. This means that the Coke company has consistently high ROIs (averaging nearly 20 percent in recent years) while the CCE company has consistently low ROIs (averaging about 2 percent in recent years). The spin-off

clearly has had the effect of improving the reported ROIs for the Coke company. The increased ROIs are attributable both to a high return on sales (because of the high margins on the concentrate) and to a high asset turnover (because the bottling facilities are on the books of CCE). Because CCE is 38 percent controlled by Coke (35 percent as of December 31, 2008), the Securities and Exchange Commission has considered whether the two entities should be combined for financial reporting, which would result in ROIs under 10 percent for the com-bined entity.

Source: “Has Coke Been Playing Accounting Games?” BusinessWeek, May 13, 2002, pp. 98–99.

REAL-WORLD FOCUS Coke and Its Bottlers: Two Units and Two ROIs




the assets. If the old and new assets are contributing equivalent service, the bias in favor of the

unit with older assets is unfair to the manager of a unit with newer assets.

Measures of Current Value The three methods for developing or estimating the current val-

ues of assets are (1) gross book value, (2) replacement cost, and (3) liquidation value. Gross book value (GBV) is historical cost without the reduction for accumulated depreciation. It is a

rough estimate of the current value of the assets. GBV improves on NBV because it removes

the bias due to differences in the age of assets and differences in depreciation methods used

across different business units. However, it does not address potential price changes in the as-

sets since the time of original purchase.

Replacement cost represents the current cost to replace the assets at the current level of

service and functionality. In contrast, liquidation value is the estimated price that could be

received from sale of the assets of a business unit. In effect, replacement cost is a purchase

price and liquidation value is a sales price. Generally, replacement cost is higher than liquida-

tion value.

GBV is preferred by those who value the objectivity of a historical-cost number; original

purchase cost is a reliable, verifiable number. In contrast, replacement cost is preferred when

ROI is used to evaluate the manager or the unit as a continuing enterprise because the use of

replacement cost is consistent with the idea that the assets will be replaced at the current cost

and the business will continue. On the other hand, liquidation value is most useful when top

management is using ROI to evaluate the business unit for potential disposal, and the relevant

current cost is the sales (i.e., liquidation) value of the assets.

To illustrate, consider CompuCity’s three marketing regions. CompuCity has 15 stores in

the Midwest, 18 in the Boston area, and 13 in South Florida. CompuCity owns and manages

each store. Exhibit 19.3 shows the NBV, GBV, estimated replacement cost, and estimated liq-

uidation value for 2010 for the stores in each region. 5

The stores in the Boston area, where CompuCity began, are among the oldest and are

located in areas where real estate values have risen considerably. The newer stores (in the

Midwest and Florida) are also experiencing significant appreciation in real estate values. ROI

based on NBV shows the Boston area to be the most profitable. Additional analysis based on

GBV, however, shows that when considering that the Boston area stores are somewhat older,

the ROI figures for all three regions are comparable, illustrating the potentially misleading

information from ROI based on NBV.

Replacement cost is useful in evaluating managers’ performance because it best measures

the investment in the continuing business: the ROI figures show that all three regions are

somewhat comparable, with South Florida slightly in the lead.

Liquidation value provides a somewhat different picture. The ROI based on liquidation value

for the Boston area is very low relative to the other two areas. Because of the significant appre-

ciation in real estate values at the Boston area stores, the liquidation value for the Boston region

5 The values for net book value (NBV) and gross book value in Exhibit 19.3 represent the simple average of beginning-of-year and end-of-year values (beginning and ending values are not shown). Replacement cost and liquidation value are estimated as of the point when ROI is calculated.

Gross book value (GBV)is historical cost without the

reduction for accumulated

depreciation.

Gross book value (GBV)is historical cost without the

reduction for accumulated

depreciation.

Replacement costrepresents the current cost to

replace the assets at the current

level of service and functionality.

Replacement costrepresents the current cost to

replace the assets at the current

level of service and functionality.

Liquidation valueis the estimated price that could

be received from the sale of the

assets of a business unit.

Liquidation valueis the estimated price that could

be received from the sale of the

assets of a business unit.

Measure of Assets

Net Book Gross Book Replacement LiquidationRegion Income Value Value Cost Value

Financial data: Midwest $26,000 $192,500 $250,500 $388,000 $ 332,000 Boston area 38,500 212,000 445,000 650,000 1,254,600 South Florida 16,850 133,000 155,450 225,500 195,000Return on investment: Midwest 13.5% 10.4% 6.70% 7.8% Boston area 18.2 8.7 5.9 3.1 South Florida 12.7 10.8 7.5 8.6

EXHIBIT 19.3 Investment Data and ROI for CompuCity in Its Three Marketing Regions (000s omitted)




is quite high. The replacement cost figure is lower than liquidation cost because of the assump-

tion that if CompuCity replaces its stores in the Boston area, these stores would be located where

the real estate values are lower. The analysis of liquidation-based ROIs is useful for showing

CompuCity management that the real estate value of these stores could now exceed their value

as CompuCity retail locations. Perhaps the company should sell these stores and relocate else-

where in areas whose values are near those suggested by the replacement-cost figures.

Strategic Issues Regarding the Use of ROI The use of ROI for performance-evaluation purposes is well entrenched in business practice.

However, management accountants should be aware of some of the limitations or deficiencies

of using ROI to evaluate the performance of investment centers. We address four such issues:

applicability of ROI as a performance indicator in the knowledge-based economy; goal-con-

gruency problems associated with the use of any short-term financial-performance indicator,

such as ROI; behavioral consequences associated with using different models (e.g., NPV and

ROI) for investment decision making and subsequent performance evaluation; and, incentive

effects regarding new investment by the most profitable units of the organization.

Value Creation in the New Economy As indicated in footnote 3, the ROI metric was developed for use by industrial-age companies

(DuPont, General Motors, etc.). For such companies, the ROI performance indicator served

its purpose well: its use allowed top management to effectively allocate capital across organi-

zational subunits, such as investment centers. In short, companies in that era competed by

how effectively they managed their physical assets (plant, property, and equipment). It was

entirely appropriate, therefore, to evaluate these units on the basis of the amount of profit

generated by the use of these physical assets.

Today’s business environment is drastically different. Value creation for many companies

competing in what can be called the knowledge-based economy consists of managing intan-

gible, as well as tangible, assets. Examples of such assets are: the skills level of the organi-

zation’s employees (i.e., human capital); distinctive processes, including supply chains; loyal

customers; and, innovative products and services. Thus, in today’s competitive environment

a broader performance-measurement and control system is demanded, such as the use of a

balanced scorecard (BSC), covered in this text in Chapters 2 and 18. Although including high-

level financial goals such as ROI, an entity’s BSC is broader in that it includes the drivers of

that financial performance, many of which are nonfinancial in nature. Chapter 18 discusses a

food-ingredients company’s use of the BSC in strategic performance measurement. Selected

Real-World Focus items in the present chapter provide examples of alternative approaches to

implementing ROI in the knowledge-based economy.

Short-Term Focus of the Metric Somewhat related to the above, we note that ROI (and, as we shall see, RI as well) are short-

term measures of profitability and as such are subject to manipulation on the part of manag-

ers. ROI is a ratio. Thus, managers, particularly those whose bonuses are tied to realized ROI

figures, are motivated to do whatever it takes to increase the numerator of the calculation or to

decrease the denominator, or both. Some actions border on the unethical, if not illegal. Other

actions (e.g., delaying needed repairs and maintenance, reducing spending on critical research

and development activities or on productivity-improvement programs) can be myopic in

nature. That is, they can provide a short-term boost to reported profits (i.e., to the numerator

of the ROI metric), but at the expense of the long-term competitive position of the business.

On the denominator side, the use of ROI can provide further goal-congruency problems:

it can discourage managers from making investments that increase the value of the organiza-

tion. There are two dimensions to this problem: (1) there can be a disconnect between the

method used to make capital-budgeting decisions (e.g., discounted cash flow [DCF] decision

models, as discussed in Chapter 12) and the method used subsequently to evaluate managerial

performance, and (2) the disincentive effects on short-term ROI associated with new invest-

ment opportunities. We explore these issues in the following two sections. Both situations can

motivate suboptimal decision-making on the part of divisional managers.


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Decision Model and Performance Model Inconsistency As we demonstrated in Chapter 12, long-term investment projects should be evaluated using a discounted cash flow (DCF) decision model, such as net present value (NPV). Such a model compares the present value of expected after-tax cash flows from a project to the present value of cash outflows (investment outlays) for the project. If the NPV is positive, the project in question should be accepted because the expectation is that the project will increase the value of the organization.

In practice, the divisional manager’s financial performance may be judged using an accounting-based metric such as ROI. The use of two different metrics, one for making the investment decision (NPV) and the other for evaluating subsequent financial performance (ROI) creates an inherent and significant incentive problem: it may discourage managers from making investment decisions that add value to the organization (i.e., NPV > 0) yet have unfa-vorable short-term effects on ROI. One solution to this problem is to calculate depreciation, for ROI purposes, on a present-value basis. (This issue is explored in end-of-chapter assign-ment 19-43.) The end result is that the use of present-value depreciation aligns the decision-making model with the model used subsequently to evaluate divisional performance.

As demonstrated in the following section, investment disincentive effects can exist even when ROI, rather than NPV, is used to evaluate long-term investment proposals.

ROI: Disincentive for New Investment by the Most Profitable Units Business units evaluated on ROI have an important disincentive that conflicts with the goals of the firm: ROI encourages units to invest only in projects that earn higher than the unit’s current ROI so that the addition of the investment improves the unit’s overall ROI. Thus, the most profitable units have a corresponding disincentive to invest in any project that does not exceed their current ROI, even those projects that, on a present-value basis, are attractive to the organization as a whole. 6

The disincentive for new investment hurts the firm strategically in two ways. First, it rejects investment projects that would be beneficial. Second, to take advantage of a unit’s apparent management skill, ROI evaluation provides a disincentive for the best units to grow. In con-trast, the units with the lowest ROI have an incentive to invest in new projects to improve their ROI. Management skills could be lacking in the low-ROI units, however.

The disincentive can be illustrated if we assume that CompuCity’s Boston region has an option to purchase for $22,500 a telephone switch that can increase the capacity of its toll-free service number and reduce operating costs by $10,000 per year. The switch is expected to last for three years and have no salvage value. Exhibit 19.4 shows the determination of ROI for the

6 As we demonstrated in Chapter 12, an attractive project is one that has a positive estimated net present value (NPV).

A useful way to consider the issue of short- versus long-term per-formance evaluation is to consider, as the balanced scorecard does, financial versus nonfinancial factors. Using only financial factors such as ROI tends to produce a short-term focus as managers seek to maximize current revenues and reduce current costs. In contrast, the use of nonfinancial measures such as employee training, prod-uct development, and customer satisfaction can cause managers to focus on these measures, which will build the base for profitability and strategic success in the long term.

Another way to consider short-term versus long-term performance measurement is to look beyond only physical and monetary assets to intangible assets, which are very real but difficult to measure. For

example, employee training is not an asset on the balance sheet, yet it has real value. How is its value measured in dollars, as is the case for other assets? Although expenditures on research and development (R&D) likely bring future benefits, what dollar value can we now place on these benefits? R&D is not typically included in the assets used to measure ROI, nor are training expenses, or advertising and marketing expenses.

Sources: Based on Alan M. Webber, “New Math for a New Economy,” Fast Company, January–February 2000, pp. 214–24; Baruch Lev, Intangibles: Man-agement, Measurement, and Reporting (Washington, DC: Brookings Institution Press, 2001); and, Felix Barber and Rainer Strack, “The Surprising Economics of the People Business,” Harvard Business Review, June 2005, pp. 81–90.

REAL-WORLD FOCUS Long-Term versus Short-Term Performance Measurement: Intangible Assets


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Chapter 18 Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard 839

managers’ compensation. The firm has continued to grow in both sales and profits over the recent years, but top management has observed that it is not growing as fast as other firms in the indus-try. Moreover, the building products business is experiencing strong overall growth due in part to the rapid increase in construction in the mid-atlantic states where Charleston competes. The firm’s CEO is concerned that it is losing ground in the industry at a time of improving opportuni-ties. The CEO believes that the problem might be in the firm’s performance measurement system and sets up a task force to determine how the firm should proceed.

Required You are assigned to lead the task force. What are your suggestions for the CEO regarding Char-leston’s performance measurement system?

18-53 Choice of Strategic Business Unit Hamilton-Jones, a large consulting firm in Los Angeles, has experienced rapid growth over the last five years. To better serve its clients and to better manage its practice, the firm decided two years ago to organize into five strategic business units, each of which serves a significant base of clients: accounting systems, executive recruitment and compensation, client-server office information systems, manufacturing information systems, and real-estate con-sulting. Each client SBU is served by a variety of administrative services within the firm, including payroll and accounting, printing and duplicating, report preparation, and secretarial support. Ham-ilton-Jones management closely watches the trend in the total costs for each administrative support area on a month-to-month basis. Management has noted that the costs in the printing and duplicating area have risen 40 percent over the last two years, a rate that is twice that of any other support area.

Required Should Hamilton-Jones evaluate the five strategic business units as cost or profit centers? Why? How should the administrative support areas be evaluated?

18-54 Choice of Strategic Business Unit Martinsville Manufacturing Company develops parts for the automobile industry. The main product line is interior systems, especially seats and carpets. Mar-tinsville operates in a single large plant that has 30 manufacturing units: carpet dyeing, seat frame fabrication, fabric cutting, and so on. In addition to the 30 manufacturing units, there are six manu-facturing support departments: maintenance, engineering, janitorial, scheduling, materials receiv-ing and handling, and information systems. The costs of the support departments are allocated to the 30 manufacturing units on the basis of direct labor cost, materials costs, or the square feet of floor space in the plant occupied by the unit. In the case of the maintenance department, the cost is allocated on the basis of square feet. Maintenance costs have been relatively stable in recent years, but the firm’s accountant advises that the amount of maintenance cost is a little high relative to the industry average.

Required What are the incentive effects on the manufacturing units of the current basis for allocating main-tenance costs? What would be a more desirable way, if any, for allocating these costs? Explain your answer.

18-55 Design of Strategic Business Unit MetroBank is a fast-growing bank that serves the region around Jacksonville, Florida. The bank provides commercial and individual banking services, including investment and mortgage banking services. The firm’s strategy is to continue to grow by acquiring smaller banks in the area to broaden the base and variety of services it can offer. The bank now has 87 strategic business units, which represent different areas of service in different locations. To sup-port its growth, MetroBank has invested several million dollars in upgrading its information serv-ices function. The number of networked computers and of support personnel has more than doubled in the last four years and now accounts for 13 percent of total operating expenses. Two years ago, MetroBank decided to charge information services to the SBUs based on the head count (number of employees) in each SBU. Recently, some of the larger SBUs have complained that this method overcharges them and that some of the smaller SBUs are actually using a larger share of the total information services resources. MetroBank’s controller has decided to investigate these complaints. His inquiry of the director of the information services department revealed that the larger depart-ments generally use more services, but some small departments in fact kept him pretty busy. Based on this response, the controller is considering changing the charges for information services to the basis of actual service calls in each SBU rather than the head count.

Required Is the information services department at MetroBank a profit center or a cost center? Which type of unit should it be, and why? Also, evaluate the controller’s decision regarding the basis for charging information services costs to the SBUs.

18-56 Profit Centers: Hospitals Suburban General Hospital owns and operates several community hos-pitals in North Carolina. One of its hospitals, Cordona Community Hospital, is a not-for-profit


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purchase of the switch using the straight-line method of depreciation. The ROI for its purchase is expected to be 13.33 percent in the first year, and 22.22 percent and 66.67 percent in the sec-ond and third years, respectively. 7

Using NBV, the Boston region’s ROI is currently 18.2 percent ( Exhibit 19.3 ). Consequently, the division might not purchase the switch because the first year’s return of 13.33 percent is less than the division’s current ROI. Buying the switch would reduce Boston’s ROI from 18.16 percent to 17.77 percent [($38,500 " $10,000 # $7,500)/($212,000 " $18,750)] in the first year. In later years, the ROI from the switch would substantially exceed Boston’s current ROI, but the manager might not be able (or willing) to wait for that improvement if strong pressure for current profits exists.

Moreover, from a firmwide perspective, since the rate of return on the switch in each year exceeds the firm’s threshold rate of return of 12 percent, the Boston region should purchase it. Thus, a significant limitation of ROI is that it can cause investment center managers to decline some investments, in conflict with firmwide interests. This situation is an excellent example of a goal-congruency problem: the use of ROI to evaluate the short-term financial performance of subunit managers may not motivate decisions that increase the value of the business. One way to address this limitation is to use an alternative measure of investment center profitability, called residual income.

Residual Income

In contrast to ROI, which is a percentage, residual income (RI) is a dollar amount equal to the income of a business unit less an imputed charge for the level of investment in the unit. The charge is determined by multiplying a desired minimum rate of return by the the level of investment in the division. 8 Residual income can be interpreted as the income earned after the division has “paid” a charge for the funds invested by top management in the division.

The RI calculation for CompuCity is illustrated in Exhibit 19.5 using a minimum rate of return of 12 percent. Note that since all three subunits have an ROI higher than 12 percent, all also have a positive RI. Note, too, that in this case each unit’s ranking on ROI is the same as its ranking based on RI: the Boston area unit has the highest ROI and residual income. However, this will not always be the case.

The issues regarding the measurement of investment and income for RI are the same as those discussed earlier for ROI. However, RI does have the advantage of motivating a subunit to pursue an investment opportunity as long as the investment’s expected return exceeds the minimum return set by the firm. For example, using RI, the Boston region would accept the opportunity to purchase the telephone switch described in Exhibit 19.4 because this invest-ment would increase the unit’s residual income. The RI in the first year after the investment in the switch would be

$13,310 ($38,500 $10,000 $7,500) 0.12 ($21! " # # $[ 22,000 $18,750)" ] This amounts to a $250 improvement over the unit’s current RI ($13,060, from Exhibit 19.5 ).

7 Using the discounted cash flow methods explained in Chapter 12, the purchase of the switch has an internal rate of return (IRR) of approximately 16 percent ($22,500/$10,000 ! 2.250; the PV annuity factor for 16 percent and three years is 2.246). 8 Conceptually, the minimum desired rate of return is defined as an entity’s weighted-average cost of capital. However, we are speaking here about the evaluation of an investment center, not firmwide performance. Thus, adjustments to the firm’s WACC are likely appropriate when evaluating subunit performance.

LEARNING OBJECTIVE 2Explain the use and limitations of residual income for evaluating investment centers.

LEARNING OBJECTIVE 2Explain the use and limitations of residual income for evaluating investment centers.

Residual income (RI)is a dollar amount equal to the income of a business unit less a charge for the level of investment in the diviision.

Residual income (RI)is a dollar amount equal to the income of a business unit less a charge for the level of investment in the diviision.

EXHIBIT 19.4 ROI for Boston Region’s Proposed Investment

First Year Second Year Third Year

Depreciation expense (straight-line method) $7,500 ! $22,500/3 $7,500 $7,500NBV at year-end $15,000 ! $22,500 # $7,500 $7,500 ! $15,000 # $7,500 $ 0 ! $7,500 # $7,500Average NBV for the year $18,750 ! ($22,500 " $15,000)/2 $11,250 ! ($15,000 " $7,500)/2 $3,750 ! ($7,500 " $0)/2

ROI 13.33% ! $10,000 # $7,500 22.22% ! $10,000 # $7,500 66.67% ! $10,000 # $7,500 $18,750 $11,250 $3,750


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An additional advantage of RI is that a firm can adjust the required rates of return for differ-ences in risk. For example, units with higher business risk can be evaluated at a higher minimum rate of return. The increased risk might be due to obsolete products, increased competition in the industry, or other economic factors affecting the business unit. In Exhibit 19.5 we used the same minimum rate of return when calculating the RI of each business division of CompuCity. How-ever, this is not required or perhaps even desirable. We could have used different rates of return for each division, in order to capture risk differences across the three divisions of the company.

Another advantage is that it is possible to calculate a different investment charge for differ-ent types of assets. For example, a higher minimum rate of return could be used for long-lived assets that are more likely to be specialized in use and thus not so readily saleable.

Time Period of Analysis Both ROI and RI are short-term indicators of financial performance. That is, they both gen-erally reflect one-year performance. Because of this, some organizations choose to evalu-ate these performance indicators over multiple years. Trend analysis, perhaps combined with competitive benchmarking, would yield more informative indications of an investment cent-er’s financial performance. By including multiple years in the evaluation window, there may be less incentive to engage in short-term behaviors that are dysfunctional in terms of long-term profitability. Finally, in the discussion of ROI we pointed out that the use of present-value depreciation is one mechanism for achieving compatibility between the model used for long-term investment decision making and the model used subsequently to evaluate manage-rial performance. The use of multiyear residual income figures is thought to accomplish the same objective. Why? Because the NPV of residual incomes over the life of a project, if cash flows are exactly as predicted, will be exactly equal to the NPV of net after-tax cash flows. In short, the use of multiyear RI figures helps to achieve goal congruency.

EXHIBIT 19.5 Illustration of Residual Income Calculations for CompuCity Divisions

Income Net Book Value

Financial data (from Exhibit 19.3): Midwest $26,000 $192,500 Boston area 38,500 212,000 South Florida 16,850 133,000Return on investment (ROI): Midwest 13.51% Boston area 18.16% South Florida 12.67% Residual income (RI): Midwest $2,900 = $26,000 # (0.12 $ $192,500) Boston area $13,060 = $38,500 # (0.12 $ $212,000) South Florida $890 = $16,850 # (0.12 $ $133,000)

In a knowledge-based economy, people are the most important asset. Managing human capital is therefore of strategic concern for many organizations today, as indicated by the discussion in the text and various other Real-Word Focus boxes in this chapter. Pricewa-terhouseCoopers Saratoga, part of the Human Resource Services Advisory Practice of the firm, maintains a global database on human capital performance metrics and provides benchmark data for indus-try sectors (banking, insurance, finance, etc.) and geographic loca-tions (U.K., U.S., Western Europe, etc.). PwC Saratoga uses a unique metric, the HR ROI, to estimate the value added per FTE (full-time equivalent) employee. HC ROI is calculated as the ratio of pretax

profit, prior to employment costs, to employee investment (total com-pensation), as follows:

HC ROIRevenue Nonwage costs

Number of FTEs!

#

$ AAverage remunerationBecause the metric is in ratio form, it is useful for making compari-

sons across commercial sectors, regions, and nations. This metric cov-ers all of the following: revenue production, cost incurrence, employment level, and amount invested in employees. As such, it provides direction for improving the return on human capital for a given organization.Source: PricewaterhouseCoopers, “Managing People in a Changing World—Key Trends in Human Capital: A Global Perspective, 2008.”

REAL-WORLD FOCUS Calculating the Human Capital Return on Investment (HC ROI)


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Limitations of Residual Income (RI) Although the residual income measure deals effectively with the disincentive problem of ROI, it has its own limitations. A key issue is that because RI is not a percentage, it is not useful for comparing units of significantly different sizes. RI favors larger units that would be expected to have larger residual incomes, even with relatively poor performance. Moreover, relatively small changes in the minimum rate of return can dramatically affect the RI for units of dif-ferent size, as illustrated in Exhibit 19.6 . Although both units A and B have the same ROI of 15 percent, the RI amount differs significantly: $300,000 for unit A, but only $22,500 for unit B. The difference would be greater for a smaller minimum return.

ROI and RI can complement each other in the evaluation of investment centers. The advan-tages and limitations of each measure are summarized in Exhibit 19.7 .

EXHIBIT 19.6 The Effect of Unit Size and Minimum Desired Rate of Return on Residual Income (RI)

Business Unit A Business Unit B

Investment $10,000,000 $750,000Income $1,500,000 $112,500ROI 15% = $1,500,000/$10,000,000 15% = $112,500/$750,000Residual income, at a minimumdesired return of 12 percent $300,000 = $1,500,000 # (0.12 $ $10,000,000) $22,500 = $112,500 # (0.12 $ $750,000)

EXHIBIT 19.7 Advantages and Limitations of ROI and Residual Income (RI)

Advantages Limitations

ROI • Easily understood by managers • Disincentive for high-ROI units to invest in • Comparable to interest rates and to rates of projects with ROI higher than the minimum return on alternative investments rate of return but lower than the unit’s • Widely used current ROI • Can lead to goal-congruency problems (e.g., suboptimal investment decision making)

Residual income • Supports incentive to accept all projects with • Favors large unitsROI above the minimum rate of return

• Can use the minimum rate of return to adjust • Can be difficult to determine a minimumfor differences in risk rate of return for organizational subunits

• Can use a different minimum rate of return for different types of assets

Both ROI and residual income • Comprehensive financial measure; includes • Can mislead strategic decision making; not key elements important to top management: as comprehensive as the balanced

revenues, costs, and level of investment scorecard, which includes customer • Comparability; expands top management’s satisfaction, business processes, and span of control by allowing comparison learning, as well as financial measures; of business units the balanced scorecard is linked to strategy • Measurement issues; variations in the measurement of inventory and long-lived assets and in the treatment of nonrecurring items, income taxes, foreign exchange effects, and the use/cost of shared assets • Short-term focus; investments with long-term benefits might be neglected; captures financial performance for only a single year ; may cause goal-congruency problems within the organization • Failure to capture value-creating activities (i.e., managing an organization’s intangible assets)


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Economic Value Added

Economic value added (EVA®) is an estimate of a business’s economic profit generated during a given period. In its simplest form, EVA® can be defined as profit less an imputed charge for the use of assets (capital) during the period. We might depict this measure of earnings as follows:

Sales Less: Operating expenses (including taxes) Less: Financing expense (cost of capital $ amount of invested capital) EVA®

As with RI and ROI, EVA® is a potentially useful metric for evaluating the financial per-formance of investment units because it explicitly incorporates the level of invested capital in the measure. That is, similar to residual income (RI), no measure of return on investment is indicated until there is a recovery of the cost of capital. Similar to RI, EVA® motivates man-agers to increase investment as long as such investments return at least $1 beyond the cost of capital. In this sense, this use of EVA® is thought to better align the interests of shareholders and managers of a company.

On the surface, RI and EVA® look confusingly similar. There is a major difference, how-ever. Residual income (RI) is calculated entirely using reported (i.e., GAAP-based) accounting data. As such, the resulting measure of profitability suffers from all of the limitations associ-ated with historical-based accounting statements. By contrast, EVA® attempts to approximate economic, rather than accounting, earnings and level of invested capital.

Thus, RI and EVA® are similar in form but strikingly different in terms of measurement. The overall objective of EVA® is to provide an estimate of the value added to (or destroyed by) each division of an organization (or the entire organization itself) during a given period. As such, EVA® is one approach to what we call value-based management.

Estimating EVA® The equation listed above for EVA® can be expanded as follows:

EVA NOPAT Average invested capital® ! # $( )k

LEARNING OBJECTIVE 3Explain the use and limitation of economic value added (EVA®) for evaluating investment centers.

LEARNING OBJECTIVE 3Explain the use and limitation of economic value added (EVA®) for evaluating investment centers.

Economic value added (EVA®)is an estimate of a business unit’s economic profit generated during a given period.

Economic value added (EVA®)is an estimate of a business unit’s economic profit generated during a given period.

When a company’s or a unit’s business model doesn’t call for substan-tial capital investment (for example, it is a “people-intensive” industry such as service industries), then ROI may be relatively high, very sensi-tive to small changes in investment, and highly volatile, and thus often inappropriate as a tool for comparing the performance of business units or companies. For example, two of the most innovative and suc-cessful companies, Apple and Google, are not capital-intensive firms.

One way to measure performance that is appropriate in this case is to divide annual economic profit (EVA® or residual income) by revenue, a measure that gives executives a clearer picture of abso-lute and relative value creation among companies, irrespective of a particular company’s or business unit’s absolute level of investment. ROI will always be an essential measure for management perform-ance measurement. But in businesses with low levels of investment, replacing ROI with economic profit divided by revenue can make

internal and peer comparisons much more meaningful. Examples of actual application of this financial measure are provided in the source listed below (McKinsey).

Another approach is to determine economic profit by explicitly including the cost and productivity of the personnel employed by the company. This approach is recommended for companies that are people-intensive, such as the hotel industry. Please see the refer-ence below by Barber and Strack for additional detail regarding this approach.

Source: Mikel Dodd and Werner Rehm, “Comparing Performance When Invested Capital Is Low,” The McKinsey Quarterly, November 2005 (www.mckinseyquarterly.com/); Felix Barber and Rainer Strack, “The Surprising Economics of the People Business,” Harvard Business Review, June 2005, pp. 81–90; Jena McGregor, “The World’s Most Innovative Companies,” Busi-nessWeek, April 24, 2006, pp. 63–74.

REAL-WORLD FOCUS Return on Investment and Economic Profi t When a Company Is Not Capital-Intensive


http://www.mckinseyquarterly.com/

http://www.mckinseyquarterly.com/



where NOPAT After-tax operating income afte! cash , rr depreciation that is the total pool

o

( , ‘‘

ff cash funds available to suppliers of capittal

Revenues Cash operating costs Depre

’’)

! # # cciation Cash taxes on

operating income

#

It is precisely because of the deduction for depreciation that the earnings figure in the com-

putation of EVA® is referred to as net operating profit after tax (i.e., as NOPAT). In the

above formulation, capital ! economic capital ! cash contributed by suppliers of funds to

the business (or business unit).

Finally, note that in determining the imputed charge for invested capital, k represents the

weighted-average cost of capital (WACC). 9

An alternative specification of EVA® is:

EVA capital® ! # "( )r k

where r ! Rate of return on capital what economist( ss might call

NOPAT/In

cash on cash return)

! vvested capital

and k ! WACC.

The primary advantage of the preceding formulation is its associated interpretation:

If r > k during a period, then shareholder value was increased during that period (i.e., EVA®

was positive) .

As seen from the above, in order to calculate EVA® for a period, we need to estimate both

NOPAT and capital. Stewart, in the seminal work in the area, lists 164 possible adjustments to

reported accounting data to estimate NOPAT and capital. 10

In the EVA® literature, adjustments

to the capital figures reported in financial statements are referred to as equity-equivalent (EE) adjustments.

The actual number of adjustments in practice is typically much less than 164. Note that if

no adjustments to reported accounting data were made, then the EVA® reduces to RI. The fol-

lowing table lists some common adjustments that analysts can make when estimating EVA®.

Some Common EVA® Adjustments

• Deferred income tax expense reserves • LIFO reserve

• R&D expenses

• Bad-debt reserve

• Change in deferred tax reserve• Change in LIFO reserve • Change in bad debt reserve • Unusual gain/loss

Adjustments to NOPATAdjustments to “capital”

Alternative Approaches to Estimating EVA® NOPAT and EVA® Capital Stewart provides two alternative ways for estimating an entity’s EVA®: the operating approach, and the financing approach. Which of the two methods you use is simply a matter of personal

preference. If applied correctly, both yield the same estimate of EVA®.

Financing Approach In the financing approach, NOPAT is estimated by building up to the rate of return on capital

from the standard return on equity (ROE) calculation in three steps:

1. Eliminate financial leverage (i.e., the effect of debt financing).

2. Eliminate so-called financial distortions.

3. Eliminate so-called accounting distortions.

9 See Chapter 12 for a discussion of the calculation of the weighted-average cost of capital (WACC) for a company as a whole. As indicated in footnote 8, supra, adjustments to the firmwide WACC may be needed when estimating divisional discount rates. 10 G. Bennett Stewart III, The Quest for Value, New York: Harper Collins, 1995.




As a result of the first two adjustments above, NOPAT will represent the total returns

available to all providers of capital to the company. The NOPAT return therefore represents

the productivity of capital employed in the business, irrespective of how investments in that

capital were financed.

To calculate EVA® capital using the financing approach, you would first determine the

total of interest-bearing debt plus capitalized leases. To this figure, you would add the book

value of common equity (par value of stock, capital in excess of par, and retained earnings),

the book value of preferred stock, and noncontrolling interests (if any). Finally, we must

account for equity equivalents, such as the estimated present value of noncapitalized leases,

the balance sheet amount of deferred taxes, and the LIFO reserve (if any). The resulting figure

represents an estimate of EVA® capital.

Operating Approach The operating approach to estimating NOPAT essentially consists of starting with (cash) sales

and then subtracting depreciation and recurring cash economic expenses. Next, we deduct the

amount of cash operating taxes, after which time we are left with EVA® NOPAT. In estimat-

ing the amount of cash taxes paid, we adjust reported income tax expense by the change in the

deferred tax account during the period. Note that interest expense, because it is a financing

charge, is ignored in the determination of EVA® NOPAT. What this means, therefore, is that

we must remove (that is, add back to income tax expense) the assumed income tax benefit

associated with the deductibility of interest expense. Finally, to estimate EVA® NOPAT we

make a number of “EE” adjustments (e.g., the effect of a change in the LIFO reserve account,

and imputed interest on noncapitalized leases). The resulting profit figure should be the same

as the NOPAT figure calculated under the financing approach.

Under the operating approach, EVA® capital is estimated basically by looking at the left-

hand side of the entity’s balance sheet. We define EVA® capital as net working capital (NWC)

plus net fixed assets (NFA), where NWC is defined as (adjusted) current assets less NIBCLS

(noninterest-bearing current liabilities). Typical EE adjustments that are made to reported bal-

ance sheet data include adjustments for the LIFO reserve and for the present value of non-

capitalized leases. In effect, we capitalize these leases and therefore put them on par with

capitalized leases, if any, that already appear on the company’s balance sheet.

Problems 19-46 and 19-47 at the end of the chapter explore the issue of estimating EVA®

using the operating approach and financing approach, respectively. 11

Using Average Total Assets

For purposes of calculating ROI, RI, and EVA®, at what point in the accounting period are

assets measured? In practice, accountants use the average of the beginning and ending bal-

ances of the year for total assets in these performance metrics. The reason is that since income

is applicable to the entire year, then using a simple average of the amount of total assets for

the year is consistent with the period covered by the income. For example, CompuCity’s ROI

for 2010 (using information from Exhibit 19.1 and assuming the investment amounts shown

in the exhibit are for the year-end) would be calculated as 13.89%:

ROI$26,000

$ $ /!

$!

( )182 000 192 500 213 89

, ,. %

Part Two: Transfer Pricing Transfer pricing is the determination of an exchange price for a product or service when dif-

ferent business units within a firm exchange it. The products can be final products sold to

outside customers or intermediate products provided to other internal units. Regardless of

whether subunits of an organization are considered profit centers (Chapter 18) or investment

centers, transfer prices are needed for performance-evaluation purposes. For example, without

11 Additional guidance for estimating EVA® NOPAT and EVA® capital are provided in the following sources: G. Bennett Stewart III, The Quest for Value (New York: Harper Collins, 1995), and D. S. Young and S. F. O’Byrne, EVA® and Value-Based Management: A Practical Guide to Implementation (New York: McGraw-Hill, 2001).

Transfer pricingis the determination of an

exchange price for a product or

service when different business

units within a firm exchange it.

Transfer pricingis the determination of an

exchange price for a product or

service when different business

units within a firm exchange it.


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transfer prices it would not be possible to implement the performance metrics discussed in part one of this chapter (i.e., ROI, RI, and EVA ® ).

When Is Transfer Pricing Important?

Transfers of products and services between business units is most common in firms with a high degree of vertical integration. Such firms engage in a number of different value-creating activities in the value chain. Wood product, food product, and consumer product firms are examples. For instance, a computer manufacturer must determine transfer prices if it prepares the chips, boards, and other components and assembles the computer itself. (See Exhibit 2.3 in Chapter 2: Value Chain for the Computer-Manufacturing Industry.) A useful way to visu-alize the transfer-pricing context is to create a graphic such as the one in Exhibit 19.8 that illustrates the business units involved in the transfer of products and services and identifies them as inside or outside the firm, international or domestic. Exhibit 19.8 shows the transfers for a hypothetical computer manufacturer, High Value Computer (HVC), that purchases a key component, the x-chip, from both internal and external suppliers and purchases other compo-nents from international sources. The internal unit that manufactures x-chips sells them both internally and externally. Where it is known, the transfer price is shown in Exhibit 19.8 .

The management accountant’s role is to help determine the proper transfer price for the internal sales of the x-chip. We begin by considering the objectives of transfer pricing.

Objectives of Transfer Pricing

Transfer prices are used to accomplish certain objectives. It is against these objectives that alterna-tive transfer-price options can be evaluated. As is the case with the financial-performance metrics discussed in part one of this chapter, we can identify three primary objectives for transfer prices:

1. Motivate a high level of effort on the part of subunit managers (i.e., extent to which a par-ticular transfer-pricing method maintains divisional autonomy).

2. Goal congruency (i.e., achieve consistency between decisions made by managers and the goals of top management); for example, one important goal of transfer pricing is to minimize, within allowable limits, income-tax consequences of intradivisional transfers of goods and services.

3. Reward managers fairly for their effort and skill, and for the effectiveness of the decisions they make.

LEARNING OBJECTIVE 4Explain the objectives of transfer pricing, and the advantages and disadvantages of various transfer-pricing alternatives.

LEARNING OBJECTIVE 4Explain the objectives of transfer pricing, and the advantages and disadvantages of various transfer-pricing alternatives.

Price ! $85

INTERNAL TO THEFIRM–FOREIGN

INTERNAL TO THEFIRM–DOMESTIC EXTERNAL

Supplier ofParts and

Components

x-ChipUnit

Purchaserof x-Chips

Manufac-turingUnit

SalesUnit

SalesUnit

Seller ofx-Chips

Price ! $95

Price ! Transfer Price

Price ! $850

Price ! $400

EXHIBIT 19.8 Transfer Pricing Context for High Value Computer (HVC)


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From a practical standpoint, specific transfer-pricing alternatives can also be evaluated in terms of implementation/administrative costs. In the next section we discuss several transfer-pricing methods, including advantages and disadvantages of each of these methods.

Transfer-Pricing Methods

The four available methods for determining the transfer price are: variable cost, full cost, market price, and negotiated price.

The variable-cost method sets the transfer price equal to the selling unit’s variable cost, with or without a mark-up. This method is desirable when the selling unit has excess capac-ity and the transfer price’s chief objective is to satisfy the internal demand for the goods. The relatively low transfer price encourages buying internally. To motivate an internal transfer and because of equity considerations, some companies add a mark-up to variable cost when determining the transfer price. One alternative in this regard is to add a lump-sum amount to variable costs. Also, variable costs can be defined either as actual or as standard costs.

The full-cost method sets the transfer price equal to variable costs plus an allocated share of the selling unit’s fixed costs, with or without a markup for profit. Advantages of this approach are that it is well understood and that the information is readily available in the accounting records. A key disadvantage is that it includes fixed costs, which can cause improper decision making (Chapter 11). To improve on the full-cost method, firms can use the activity-based cost method described in Chapter 5. 12 Again, costs can be defined either as actual or as standard costs.

The market-price method sets the transfer price as the current price of the product in the external market. Its key advantage is objectivity; it best satisfies the arm’s-length criterion desired for both management and tax purposes. A key disadvantage is that the market price, especially for intermediate products, is often not available.

The negotiated-price method involves a negotiation process and sometimes arbitration between units to determine the transfer price. This method is desirable when the units have a history of significant conflict and negotiation can result in an agreed-upon price. The pri-mary limitation is that the method can reduce the desired autonomy of the units. Further, this method may be costly and time-consuming to implement.

Firms can also use two or more methods, called dual pricing . For example, when numerous conflicts exist between two units, standard full cost might be used as the buyer’s transfer price, while the seller might use market price. 13

The advantages and limitations of each of the four methods are summarized in Exhibit 19.9 .

Choosing the Right Transfer-Pricing Method: The Firmwide Perspective One aspect of transfer pricing is whether the transfer price will lead to actions that benefit the organization as a whole. Looked at differently, we might ask whether the transfer price motivates an internal transfer when this benefits the firm, and whether it motivates an external sale when such a sale is warranted (from the an organization-wide perspective). To guide such a decision, three questions must be addressed:

1. Is there an outside supplier? 2. Is the seller’s variable cost less than the market price? 3. Is the selling unit operating at full capacity?

Exhibit 19.10 shows the influence of each of these three factors on the choice of a transfer price and on the decision to purchase inside or out.

First: Is there an outside supplier? If not, there is no market price, and the best transfer price is based on cost or negotiated price. If there is an outside supplier, we must consider the relationship of the inside seller’s variable cost to the market price of the outside sup-plier by answering the second question.

12 For an explanation of the use of activity-based costing in transfer pricing, see Robert S. Kaplan, Dan Weiss, and Eyal Desheh, “Transfer Pricing with ABC,” Management Accounting, May 1997, pp. 20–28, and Gary J. Colbert and Barry H. Spicer, “Linking Activity-Based Costing and Transfer Pricing for Improved Decisions and Behavior,” Journal of Cost Management, May–June 1998, pp. 20–26. 13 For an illustration of dual allocation in transfer pricing, see David W. Young, “Two-Part Transfer Pricing Improves IDS Financial Control,” Healthcare Financial Management, August 1998, pp. 56–65.

The variable-cost methodsets the transfer price equal to the variable cost of the selling unit.

The variable-cost methodsets the transfer price equal to the variable cost of the selling unit.

The full-cost methodsets the transfer price equal to the variable cost plus allocated fixed cost for the selling unit.

The full-cost methodsets the transfer price equal to the variable cost plus allocated fixed cost for the selling unit.

The market-price methodsets the transfer price as the current price of the product in the external market.

The market-price methodsets the transfer price as the current price of the product in the external market.

The negotiated-price methodinvolves a negotiation process and sometimes arbitration between units to determine the transfer price.

The negotiated-price methodinvolves a negotiation process and sometimes arbitration between units to determine the transfer price.

Dual pricinginvolves the use of multiple prices for an internal transfer.

Dual pricinginvolves the use of multiple prices for an internal transfer.


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Second: Is the seller’s variable cost less than the market price? If not, the seller’s costs are likely far too high, and from the standpoint of the organization as a whole the buyer should buy outside. On the other hand, if the seller’s variable costs are less than the market price, we must consider the capacity in the selling unit by answering the third question. (Note: We focus on variable costs in this second step because commonly the transfer-pricing issue is addressed as a short-term decision in which fixed costs are not expected to differ whether the internal transfer is made or is not made. In this case, the analysis is very much like the make-or-buy decision problem covered in Chapter 11—the fixed costs of the seller are irrelevant since they will not change in the short run.)

Method Advantages Limitations

Variable cost • Provides the proper motivation for the manager • Inappropriate for long-term decision making into make the correct short-term decision, in which which fixed costs are relevant, and pricesthe seller’s fixed costs are not expected to change. must cover fixed as well as variable costs

When the seller’s variable cost is less than the buyer’s • Unfair to seller if seller is profit or outside price, the variable cost transfer price will investment center (i.e., no profit recognized cause internal sourcing, the correct decision on the transfer)Full cost • Easy to implement • Irrelevance of fixed cost in short-term decision • Intuitive and easily understood making; fixed costs should be ignored in the • Preferred by tax authorities over variable cost buyer’s choice of whether to buy inside or • Appropriate for long-term decision making in outside the firm which fixed costs are relevant, and prices must • If used, should be standard rather than actual cover fixed as well as variable costs cost (allows buyer to know cost in advance and prevents seller from passing along inefficiencies) Market price • Helps to preserve unit autonomy • Intermediate products often have no market price • Provides incentive for the selling unit to be • Should be adjusted for any cost savings competitive with outside suppliers associated with an internal transfer, such as • Has arm’s-length standard desired by taxing authorities reduced selling costs Negotiated price • Can be the most practical approach when significant • Need negotiation rule and/or arbitration

conflict exists procedure, which can reduce autonomy • Is consistent with the theory of decentralization • Potential tax problems; might not be considered arm’s length • Can be costly and time-consuming to implement • Resulting profitability measures (e.g., ROI or RI) are partly a function of the negotiating skills of the manager, rather than the operational performance of the business unit

EXHIBIT 19.9 Advantages and Limitations of Alternative Transfer-Pricing Methods

First: Is there an outside supplier? If there is no outside supply; If there is an outside supply, answer the second question;Second: Is the seller’s variable cost less than the outside price? If it is greater than the outside price, the seller must look for ways to reduce cost If seller’s variable costs are less than the outside price, answer the third question;Third: Is the selling unit operating at full capacity? If seller has excess capacity, then

If the seller is at full capacity And if the contribution of the outsidesales to the entire firm isgreater than the savings ofthe inside purchase

Or if the contribution of the outsidesales to the entire firm isless than the savings of theinside purchase

Decision to Transfer Transfer Price

Buy inside

Buy outside

Buy inside

Buy inside

Buy outside

Cost or negotiated price

No transfer price

Low: variable costHigh: market price

Market price

No transfer price

EXHIBIT 19.10 Choosing the Right Transfer Price


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Third: Is the selling unit operating at full capacity? That is, will the order from the inter-nal buyer cause the selling unit to deny other sales opportunities? If not, the selling division should provide the order to the internal buyer at a transfer price somewhere between variable cost and market price. In contrast, if the selling unit is at full capacity, we must determine and compare the cost savings of internal sales versus the selling division’s opportunity cost of lost sales. If the cost savings to the inside buyer are higher than the cost of lost sales to the seller, then from the standpoint of the organization as a whole, the buying unit should buy inside, and the proper transfer price should be the market price.

Determining the correct transfer price and correct transfer decision can be illustrated using the High Value Computer (HVC) case ( Exhibit 19.8 ). HVC has the option to purchase the x-chip outside the firm for $85 or to manufacture it. Note that if the manufacturing unit of HVC purchases the x-chip from the outside suppler, it must add a component to the x-chip at a vari-able cost of $5 to make the x-chip function as desired; this additional step would not be neces-sary if the x-chip is purchased internally. Also, note that the x-chip production unit can sell its chip outside for $95 but there is a variable selling cost of $2 per unit; there is no selling cost for internal transfer. The relevant information is presented in the top portion of Exhibit 19.11 . The lower portion of Exhibit 19.11 shows the calculation of the relevant costs for each option.

EXHIBIT 19.11 Transfer-Pricing Example: The High Value Computer Company

Key assumptions: The manufacturing unit can buy the x-chip inside or outside the firm. The x-chip unit can sell inside or outside the firm. The x-chip unit is at full capacity (150,000 units). One x-chip is needed for each computer manufactured by High Value. Other information: Sales price of computer for HVC’s computer unit $850 Variable manufacturing cost of the computer unit (excluding x-chip)

($400 parts and $250 labor) 650 Variable x-chip manufacturing cost for HVC’s x-chip unit 60 Price of x-chip from outside supplier, to HVC computer unit 85 Variable cost to computer unit to add needed component to outside supplier’s x-chip 5 Price of x-chip from HVC’s x-chip unit to outside buyer 95 Variable selling cost to the x-chip unit for outside sales 2

Option 1: X-Chip Unit Sells OutsideHigh Value manufactures 150,000 computers, using x-chips purchased for $85 from outside supplier; High Value’s x-chip unit sells 150,000 units for $95 each to outside buyer.

Contribution Income Statement*

(000s omitted)

Computer Manufacturing Unit X-Chip Unit TotalSales (price = $850, $95) $127,500 $14,250 $141,750Less: Variable costs x-chip ($85 + $5) 13,500 13,500 Other costs ($650, $60 + $2) 97,500 9,300 106,800

Contribution margin $ 16,500 $ 4,950 $ 21,450

Option 2: X-Chip Unit Sells InsideHigh Value manufactures 150,000 computers, using x-chips purchased for $60 (variable cost) from the inside supplier.

Computer Manufacturing Unit X-Chip Unit Total

Sales (price = $850, $60) $127,500 $9,000 $136,500Less: Variable costs x-chip ($60) 9,000 9,000 Other costs ($650, $60) 97,500 9,000 106,500

Contribution margin $ 21,000 — $ 21,000

* It is assumed that fixed costs will not differ for the two options; thus, these costs are excluded from the analysis.


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A comparison of options 1 and 2 in Exhibit 19.11 shows that the firm as a whole benefits under option 1 when the manufacturing unit purchases the x-chip outside, and the x-chip unit also sells outside. The reason is that the computer manufacturing unit’s savings of $30 from internal transfer ($30 ! $85 outside price plus $5 for additional variable cost to add a component to the x-chip less $60 variable cost of the internal x-chip unit) is less than the x-chip unit’s opportunity cost of lost sales, $33 ($95 less $60 manufacturing cost less $2 sell-ing cost). The opportunity cost of the x-chip unit is important since the unit is at full capacity. The $450,000 difference between the two options is due to the net difference identified above, ($33 # $30) $ 150,000 ! $450,000. In summary, we can answer the same three questions for HVC in the following way:

First: Is there an outside supplier? High Value has an outside supplier, so we must compare the inside seller’s variable costs to the outside seller’s price. Second: Is the seller’s variable cost less than the market price? For High Value, it is, so we must consider the utilization of capacity in the inside selling unit. Third: Is the selling unit operating at full capacity? For High Value, it is, so we must consider the contribution of the selling unit’s outside sales relative to the savings from selling inside. Again, for High Value the contribution of the selling unit’s outside sales is $33 per unit, which is higher than the savings from selling inside ($30). Therefore, High Value’s selling unit should choose outside sales and make no internal transfers.

General Transfer-Pricing Rule

The preceding discussion, and accompanying summary ( Exhibit 19.10 ), may seem over-whelming to you in terms of detail and complexity. It may also seem as if the transfer-pricing decision can be mechanized according to a set of rules. This is certainly not the case because as we stated at the beginning of this section of the chapter, the ultimate transfer-pricing deci-sion is a function of several considerations. One of these is the extent to which the transfer price motivates the “correct” decision from the standpoint of the firm as a whole. Thus, in interpreting Exhibit 19.10 you should understand that the stated rules relate to this issue.

In Chapter 11 we introduced you to the notion of relevant costs for decision making. One definition of such costs is the sum of out-of-pocket costs plus opportunity costs (if any). We can appeal to this same notion in the context of setting an appropriate transfer price. Thus, the essence of Exhibit 19.10 can be summarized by the following General Transfer-Pricing Rule:

Minimum Incremental (i.e.,

transfer price!

out-of-pocket) cost of the producing divission Opportunity

cost to the organization

"

(if any) by making an internal transfer

From the standpoint of the firm as a whole, the preceding rule will generally ensure that the optimum decision (transfer internally or not) will be motivated by the transfer price. At the same time, we should correctly view the amount indicated by the general rule as a minimum amount that the selling division should accept. In Chapter 11, we essentially saw the same thing: in deciding whether a business should accept a special (i.e., one-time) order, the mini-mum specified price was the sum of out-of-pocket costs plus opportunity cost (if any). (Recall the notion of opportunity cost: benefit forgone by taking a particular course of action.) Mini-mum within the context of the special sales order means the floor below which the firm would

Foreign Currency Translation, Transfer Pricing, and Profits

Cost Management in Action

The decline in value of Southeast Asian currencies (the Indonesian rupiah, Thai baht, Malaysian ringgit, and Sri Lanka rupee) relative to the U.S. dollar in the early 2000s appeared to be an opportunity for some Southeast Asian manufacturers to increase their exports to U.S. retailers and manufacturers. The idea is that the falling currency prices would make the Asian goods less expensive in U.S. dollars,

which would increase their appeal in the United States relative to other products and thus increase demand. Nike, which has a number of manufacturing plants in Southeast Asia, says, however, that these currency changes will not have much effect on U.S. prices. Is Nike likely to miss the potential to lower prices and increase U.S. sales?(Refer to Comments on Cost Management in Action at end of Chapter.)


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Effective transfer pricing can enhance a company’s overall profitabil-ity, but there is a delicate balance between smart business and smart government as businesses seek to minimize tax payments and coun-tries seek to maximize tax revenue. For those businesses without adequate transfer-planning the risk of staggering penalties imposed by the IRS is very real, as the following two examples illustrate.

• In a recent case, Symantec Corporation found itself in a $1 billion transfer-pricing dispute with the IRS after the company acquired software maker Veritas in 2005. According to the IRS, licens-ing fees Veritas received from an Irish subsidiary were too low, and the company accounting records credited U.S. operations with too much of the cost of creating certain technologies. This approach increased income at the Irish subsidiary, which oper-ated in a lower-tax environment and therefore allowed the com-pany to lower its U.S. tax liability.

• In September 2006, GlaxoSmithKline agreed to pay the U.S. gov-ernment $3.4 billion to settle a 17-year dispute with the IRS over the company’s transfers between the U.K. parent company and its American subsidiary. This was the largest settlement of a tax dispute in U.S. history. The investigations carried out by IRS found that the American subsidiary of GlaxoSmithKline overpaid its U.K. parent company for drug supplies during 1989–2005 period, mainly for its blockbuster drug, Zantac. These overpayments were meant to reduce the company’s profit in the United States and thereby its tax bill. Other items under dispute included the value of marketing

in the United States, and trademarks and other intangible assets that were developed and owned by the U.K. parent company. The IRS charged the company for engaging in what is viewed as manipulative transfer pricing.

All kinds of transactions within related entities are subject to transfer-pricing rules, including raw material; finished products; and payments such as management fees, intellectual property royalties, loans, interest on loans, payments for technical assistance and know-how, and other transactions. These rules generally require intrafirm trans-actions to be recorded at an “arm’s length” basis, which means that any transaction between two entities of the same company should be priced as if the transaction were conducted between two unrelated parties.

As the above two examples show, the penalties for not adhering to transfer-pricing rules can be very significant. In the United States, transfer-pricing rules are contained in Internal Revenue Code Section 482. Companies that violate these rules may be responsible for addi-tional tax and interest, and depending on circumstances uncovered in an audit, the IRS can impose penalties of 20 percent or 40 percent of the underpaid tax. Furthermore, there is the chance that both coun-tries involved in a transfer-pricing dispute would assess taxes on the same profits, effectively doubling the amount of tax owed.

Sources: “How to Minimize Risks of an IRS Transfer Pricing Review,” RSM Advantage 3, no. 6 (October 2006); and, “Transfer Pricing Studies Can Lead to Planning Opportunities,” RSM McGladrey, October 2006.

REAL-WORLD FOCUS The Risk of Inadequate Transfer-Pricing Planning

not normally consummate the deal. The same logic would apply in the transfer-pricing case. Here, opportunity cost is the contribution margin the organization forgoes, if any, by transfer-ring internally rather than making the sale to an external party.

We conclude here by noting that estimating opportunity costs may not be an easy task, or even possible in some situations. For example, unless the product in question is traded in a purely competitive market (e.g., commodity-type products), then selling price, and therefore opportunity cost, are partly a function of the amount of internal versus external sales by the producer. These interactions complicate efforts to determine an opportunity cost associated with internal transfers. As another example, the product in question may be in the form of an intermediate product for which no organized external market exists. In such cases, the organization would have to rely on the use of one of the other transfer-pricing options.

International Issues in Transfer Pricing

Two surveys have found that more than 80 percent of multinational firms (MNCs) see transfer pricing as a major international tax issue, and more than half these firms said it was the most important issue. 14 Most countries now accept the Organization of Economic Cooperation and Development’s model treaty, which calls for transfer prices to be adjusted using the arm’s-length standard, that is, to a price that unrelated parties would have set. The model treaty is widely accepted, but the way countries apply it can differ. However, worldwide support is

14 Based on information from two surveys: (1) the Ernst & Young Transfer Pricing Global Survey of 400 MNCs, as reported in the Ernst & Young Business UpShot, October 1997; and (2) a survey of 210 companies in the United States, United Kingdom, Japan, Australia, the Netherlands, France, and Germany, as reported in Accounting Today, August 21–September 10, 1995.

LEARNING OBJECTIVE 5Discuss important international issues that arise in transfer pricing.

LEARNING OBJECTIVE 5Discuss important international issues that arise in transfer pricing.



868

strong for an approach to limit attempts by MNCs to reduce tax liability by setting transfer

prices that differ from the arm’s-length standard. 15

The arm’s-length standard calls for setting transfer prices to reflect the price that unrelated

parties acting independently would have set. The arm’s-length standard is applied in many

ways, but the three most widely used methods are (1) the comparable-price method, (2) the

resale-price method, and (3) the cost-plus method. The comparable-price method is the most

commonly used and the most preferred by tax authorities. It establishes an arm’s-length price

by using the sales prices of similar products made by unrelated firms. 16

The resale-price method is used for distributors and marketing units when little value is

added and no significant manufacturing operations exist. In this method, the transfer price

is based on an appropriate markup using gross profits of unrelated firms selling similar

products.

The cost-plus method determines the transfer price based on the seller’s costs plus a gross

profit percentage determined by comparing the seller’s sales to those of unrelated parties or to

unrelated parties’ sales to those of other unrelated parties.

By keeping detailed records of the determination of cost, the management accountant can

assist in determining the appropriate transfer price for international transfers of goods and

services. The application of modern costing techniques, such as ABC (Chapter 5), would

be particularly useful in terms of justifying a particular transfer price. While it is true that

there are limits to the transfer price charged in multinational transactions, it is also true that

minimizing worldwide tax is a legitimate business objective. By setting a (legitimate) high

transfer price for goods or services transferred to a unit operating in a relatively high-tax

country, a company can reduce its tax liability. Such a transfer price would increase the cost

and thus reduce the income of the purchasing unit, thereby minimizing taxes for this unit. At

the same time, the higher profits shown by the selling unit (as a result of the high transfer

price) would be taxed at lower rates in the seller’s home country.

Other International Considerations In addition to income tax, there are other considerations that bear upon the transfer-price

decision in an international context. These include minimizing customs charges, using trans-

fer prices to deal with currency restrictions of foreign countries, and dealing with the risk of

expropriation of assets.

Risk of Expropriation Expropriation occurs when a government takes ownership and control of assets that a foreign

investor has invested in that country. In managing the relationship with any one country, the

15 For further information on international taxation and transfer pricing, see B. J. Arnold and M. J. McIntyre, International Tax Primer, 2nd ed. (Boston: Kluwer Law International, 2002). 16 In this context, unrelated indicates that the firm has no common ownership interest.

The arm’s-length standardsays that transfer prices should

be set so they reflect the price

that unrelated parties acting

independently would have set.

The comparable-price methodestablishes an arm’s-length

price by using the sales prices

of similar products made by

unrelated firms.

The resale-price methodis based on determining an

appropriate markup based on

gross profits of unrelated firms

selling similar products.

The cost-plus methoddetermines the transfer price

based on the seller’s cost plus

a gross profit percentage

determined by comparing

the seller’s sales to those of

unrelated parties.

The arm’s-length standardsays that transfer prices should

be set so they reflect the price

that unrelated parties acting

independently would have set.

The comparable-price methodestablishes an arm’s-length

price by using the sales prices

of similar products made by

unrelated firms.

The resale-price methodis based on determining an

appropriate markup based on

gross profits of unrelated firms

selling similar products.

The cost-plus methoddetermines the transfer price

based on the seller’s cost plus

a gross profit percentage

determined by comparing

the seller’s sales to those of

unrelated parties.

Expropriationoccurs when a government

takes ownership and control of

assets that a foreign investor has

invested in that country.

Expropriationoccurs when a government

takes ownership and control of

assets that a foreign investor has

invested in that country.

The question of setting the right transfer price arises in any organiza-tion where its units exchange goods or services. One example is the United States Agency for International Development (USAID). USAID (www.usaid.gov) provides economic and humanitarian assistance in more than 100 countries including Rwanda, Afghanistan, and Kenya. Because USAID is a very large organization, it often purchases from or supplies services to other federal government agencies. Because of the frequency of this activity, USAID has developed financial

policies that explain the nature of direct and indirect costs and the acceptable methods for developing transfer prices.

Source: The USAID policies are set out in its Automated Directives System (ADS) (www2.usaid.gov/policy/ads/), and the specific policies regarding transfer pricing are provided in ADS Number 306 related to interagency agreements (www.usaid.gov/policy/ads/300/306.pdf), especially sections 306.3.5.7 through 306.3.6.8.

REAL-WORLD FOCUS Transfer Pricing in the Federal Government


http://www.usaid.gov

http://www.usaid.gov/policy/ads/300/306.pdf

http://www.usaid.gov/policy/ads/300/306.pdf



management accountant attempts to find a strategic balance among these sometimes conflicting

objectives. When a significant risk of expropriation exists, the firm can take appropriate actions

such as limiting new investment or developing improved relationships with the foreign govern-

ment (e.g., by actually paying higher taxes to that government via the transfer-pricing decision).

Minimization of Customs Charges The transfer price amount can affect the overall cost, including the customs charges, of goods

imported from a foreign unit. For example, if customs charges on the parts and components

imported by the domestic manufacturing unit are significant in amount, High Value Compu-

ter’s relatively low transfer price on these imports would be beneficial in terms of reducing the

amount of customs charges.

Currency Restrictions As a foreign unit accumulates profits, a problem arises in some countries that limits the

amount and/or timing of repatriation of these profits to the parent company. One way to deal

with these restrictions is to set the transfer price so that profits accumulate at a relatively low

rate. This issue therefore provides managers and the management accountant with additional

planning opportunities in certain circumstances.

Advance Pricing Agreements An advance pricing agreement (APA) is an agreement between the Internal Revenue Service

(IRS) and a firm that establishes an agreed-upon transfer price. The APA usually is obtained

before the firm engages in the transfer. The APA program’s goal is to resolve transfer-pricing

disputes in a timely manner and to avoid costly litigation. The program supplements the dis-

pute resolution methods already in place: administrative (IRS), judicial, and treaty mecha-

nisms. Two-thirds of the MNCs in a recent survey indicated that they expected to use APAs in

determining their transfer prices. 17

Return on investment (ROI) and residual income (RI) are two of the most commonly used and

well-understood measures for evaluating the financial performance of investment centers.

ROI, which is defined as the ratio of operating income generated by the investment center

to the level of investment in the investment center, has several disadvantages: a short-term

focus, the difficulty in determining a unique measure for earnings and investment, and

investment-disincentive effects.

RI is computed as the investment center’s earnings less a capital charge based on a mini-

mum desired rate of return. RI solves some, but not all, of ROI’s problems. For example,

both have a short-term focus, both rely on accrual-based accounting numbers, and both focus

solely on financial performance.

The increased interest in the balanced scorecard (BSC) and in economic value added

(EVA ® ) suggests that firms are adapting performance-appraisal systems for investment centers

to include a long-term strategic focus.

When an organization’s business units exchange goods or services internally and

management desires to assess the financial performance of these units, a transfer price

must be associated with the internal transfers. The management accountant can serve an

important role by overseeing many objectives of transfer pricing: performance evaluation

(of management and business units), tax minimization, management of foreign curren-

cies and risks, and other strategic objectives. Common transfer-pricing methods include

variable cost, full cost, market value, and negotiated price. Cost-based transfer prices can

be set either at actual or at standard cost (see Chapter 14). In setting the transfer price,

management considers the availability and quality of outside supply, the internal selling

unit’s capacity utilization, and the firm’s strategic objectives in determining the proper

17 For a recent survey of advance pricing agreements in 27 different countries, see Susan C. Borkowski, “Transfer Pricing Advance Pricing Agreements: Current Status by Country,” The International Tax Journal, Spring 2000, pp. 1–16. For U.S. APA procedures, see Steven C. Wrappe, Ken Milani, and Julie Joy, “The Transfer Price Is Right,” Strategic Finance, July 1999, pp. 39–43.

An advance pricing agreement (APA)is an agreement between the

Internal Revenue Service (IRS)

and a firm that establishes an

agreed-upon transfer price.

An advance pricing agreement (APA)is an agreement between the

Internal Revenue Service (IRS)

and a firm that establishes an

agreed-upon transfer price.

SummarySummary




transfer price. A general transfer-pricing guideline specifies that the minimum transfer

price to the selling division is the sum of out-of-pocket costs plus opportunity costs to

the seller (if any). Some companies use dual pricing in which two separate transfer prices

are used to price an internal transfer.

Perhaps the most important aspect in determining a transfer price for international trans-

fers is minimizing international taxes. With the efforts of various international groups, each

country monitors transfer prices used in international trade. The most common transfer-pric-

ing methods used for international trade include the comparable-price method, the resale-

price method, and the cost-plus method. A firm can determine the acceptability (to various

countries) of its transfer-pricing method by requesting what is called an advance pricing agreement (APA).

advance pricing agreements

(APAs), 869 arm’s-length standard, 868 asset turnover (AT), 847 comparable-price method, 868 cost-plus method, 868 economic value added,

(EVA ® ), 859 dual pricing, 863

Key Terms expropriation, 868 full-cost method, 863 gross book value (GBV), 853 historical cost of divisional

assets, 852 liquidation value, 853 market-price method, 863 negotiated-price method, 863 net book value, 852

replacement cost, 853 resale-price method, 868 residual income (RI), 856 return on investment (ROI), 847 return on sales (ROS), 847 transfer pricing, 861 variable-cost method, 863

Foreign Currency Translation, Transfer Pricing, and Profits Nike is probably correct that U.S. prices for its products and those of its competitors will not change much.

The reason is that the cost elements of its products from Southeast Asia affected by the falling local curren-

cies, primarily labor costs, represent only a modest portion of the total product cost. Most of the cost of these

manufactured products is for materials, which are imported from the United States and elsewhere outside

Southeast Asia. Thus, the effect of the falling Southeast Asian currencies on total product cost is likely to

be small; Nike estimates it to be 10 percent or less although some currencies have fallen to less than half of

their previous value to the dollar.

Moreover, Southeast Asian manufacturers find that they have increased financing costs and sometimes

reduced financing availability when the local currency falls and the raw materials from the United States

and elsewhere become more expensive. For some of these manufacturers, the total operating and financing

cost (in U.S. dollars) might even increase.

From a transfer-pricing perspective, the dramatic change in currency value presents real problems in

performance evaluation. Should the local manufacturing unit be responsible for costs in U.S. currency or in

terms of the local currency? Are the currency fluctuations controllable by the local managers? The answers

to these questions are difficult and complex, but many companies expect their local managers to take steps

to mitigate the negative effects of currency fluctuations by buying or selling options or other financial in-

struments, for example.

Source: Based on Jonathan Moore and Moon Ihlwan, “Cheaper Exports? Not So Fast,” BusinessWeek, February 2, 1998, pp. 48–49.

1. Return on Investment (ROI) and Residual Income (RI) Selected data from an investment center of IROL, INC. follow:

Sales $8,000,000 Net book value of assets, beginning 2,500,000 Net book value of assets, end 2,600,000 Net operating income 640,000 Minimum rate of return 12%

Comments on Cost Management

in Action

Comments on Cost Management

in Action

Self-Study Problems (For solutions, please turn

to the end of the chapter.)

Self-Study Problems (For solutions, please turn

to the end of the chapter.)


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Required 1. Calculate return on sales (ROS), asset turnover (AT), and return on investment (ROI).

2. Calculate residual income.

2. Transfer Pricing Johnston Chemical Company manufactures a wide variety of industrial chemicals and adhesives. It pur-chases much of its raw material in bulk from other chemical companies. One chemical, T-Bar, is prepared in one of Johnston’s own plants. T-Bar is shipped to other Johnston plants at a specified internal price.

The Johnston adhesive plant requires 10,000 barrels of T-Bar per month and can purchase it from an outside supplier for $150 per barrel. Johnston’s T-Bar unit has a capacity of 20,000 barrels per month and is presently selling that amount to outside buyers at $165 per barrel. The difference between the T-Bar unit’s price of $165 and the outside firm’s T-Bar price of $150 is due to short-term pricing strategy only; the mate-rials are equivalent in quality and functionality. The T-Bar unit’s selling cost is $5 per barrel, and its variable cost of manufacturing is $90 per barrel.

Required 1. From the standpoint of the company as a whole, should the adhesive unit purchase T-Bar inside or

outside the firm? Show calculations to support your answer.

2. Based on your answer in requirement 1, what is T-Bar’s proper transfer price?

3. How would your answer to requirements 1 and 2 change if the T-Bar unit had a capacity of 30,000 bar-rels per month?

19-1 What is meant by the term investment center? How is the financial performance of investment centers measured?

19-2 What are the three financial-performance measures for investment centers?

19-3 What is return on investment, and how is it calculated?

19-4 What are the measurement issues to consider when using return on investment (ROI)?

19-5 What are the advantages and limitations of return on investment (ROI) as a performance measure?

19-6 What is meant by the arm’s-length standard, and for what is it used?

19-7 What are the components of residual income (RI)?

19-8 What are the advantages and limitations of residual income (RI) as a performance measure?

19-9 What are the objectives of measures used to evaluate the financial performance of investment centers?

19-10 What is return on equity, how is it calculated, and how is it interpreted?

19-11 What are the three methods most commonly used in international taxation to determine a transfer price acceptable to tax authorities? Explain each method briefly.

19-12 What does expropriation mean, and what is the role of transfer pricing in this regard?

19-13 How does the concept of economic value added EVA® compare, as a measure of financial perform-ance, to return on investment and residual income?

19-14 Smith Branded Apparel designs t-shirts for businesses and corporations. The accounting manager has presented the latest quarter’s return on sales of 10 percent and asset turnover of 1.5. What is the company’s current return on investment (ROI)?

19-15 Williams Manufacturing uses scrap metal to produce various tools, such as drill bits, hammer heads, saw blades, and nails. The CEO has asked you to analyze the saw blades division to determine asset turnover for last quarter. You find that the saw blades division had an ROI of 20 percent, sales of $10 million, and operating profits of $1 million. What was the asset turnover rate for last quarter?

19-16 Scott Healthcare provides a walk-in clinic for its patients and a pharmacy for any medication pre-scribed by the doctor. Last year Scott generated total sales of $500,000 and $100,000 in profits. Scott also had average assets of $250,000 for the year. What are Scott Healthcare’s return on sales, asset turnover, and return on investment?

19-17 Matthews Produce harvests and sells Florida oranges. Matthews has hired you to determine its return on investment (ROI) based on both net book value and on gross book value. You are given that profits are $2 million, the net book value (NBV) of operating assets is $10 million, and the gross book value (GBV) of these assets is $40 million. What is ROI based on NBV and based on GBV?

19-18 Foreman Publishing Company’s income for the most recent quarter was $500,000, and the average net book value of assets during the quarter was $1.5 million. If the company has a required rate of return of 15 percent on investment, what was residual income for the quarter?

QuestionsQuestions

Brief Exercises Brief Exercises


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19-19 Tinsley Plastics manufactures plastic bottles used for beverages and household cleaners. The aver-age net book value (NBV) of assets during the quarter is estimated as $500,000. If the required rate of return is 10 percent on average assets, and the firm wants to have residual income (RI) of $100,000 for this quarter, what must its profits be?

19-20 Moore Money is a financial services firm specializing in fixed-income investments. You have been asked by the accounting manager to analyze the company’s financial data from last quarter. You find the firm had return on investment (ROI) of 15 percent and asset turnover of 0.5. What was the firm’s return on sales?

19-21 King Mattresses sells both mattress sets and bed frames. Last quarter total sales were $50,000 for mattress sets and $25,000 for bed frames. ROI was 10 percent for both divisions, while asset turnover was 5 for mattress sets and 2 for bed frames. What was the amount of operating profit for each division?

19-22 Using the data from 19-21 above, compute King Mattresses’ total return on sales (ROS).

19-23 Felton Co. produces rubber bands for commercial and home use. Felton reported $1 million residual income (RI) with $20 million net book value (NBV) of assets and $5 million in income for the year. What was the required rate of return?

19-24 Chacon Enterprises manufactures energy-efficient glass for commercial and residential use. Last year Chacon reported sales of $10 million, profits of $2 million, and an asset turnover of 2. What was Chacon’s return on investment (ROI)?

19-25 Cano Inc. sells retail apparel. You have been asked to compute ROI using average assets for last quarter. Profits were $50,000, beginning-of-quarter assets were $150,000, and end-of-quarter assets were $190,000. What was the ROI?

19-26 Investment Centers; The Sales Life Cycle (Review of Chapter 18) The sales life cycle is used to describe the phases a product goes through from introduction to withdrawal from the market. The four phases are: (a) introduction, (b) growth, (c) maturity, and (d) decline and withdrawal.

In the introduction phase, the firm relies on product differentiation to attract new customers to the product. In the growth phase, the product attracts competition, although differentiation is still an advantage for the firm. In the maturity phase, competition is keen, and cost control and quality considerations become important. In the final phase, differentiation again becomes important as do cost control and quality (see Chapter 13 and Chapter 18 for more detail).

Required At which phases of the sales life cycle, if any, should investment-center evaluation methods be used, and why?

19-27 Investment Centers; The Cost Life Cycle As explained in Chapter 13, the cost life cycle consists of the phases a product goes through within a firm to prepare the product for distribution and service. The five phases of the cost life cycle are: (a) research and development, (b) design, (c) production, (d) marketing and distribution, and (e) customer service.

The early phases of the cost life cycle are particularly important in that a relatively high percent-age (some say as high as 80 percent or more) of the product’s life-cycle costs are determined at these phases. That is, the downstream costs of manufacturing, service, and repair are a direct consequence of the quality of the design.

Required At which phases of the cost life cycle, if any, should investment-center evaluation methods be used, and why?

19-28 Return on Investment (ROI) and Residual Income (RI) Consider the following data (in millions) from Midwest Financial, Inc., which has two main divisions: mortgage loans, and consumer loans:

Mortgage Loans Consumer LoansAverage total assets $2,000 $20,000Operating income $400 $2,500ROI 20% 12.5%

Required 1. Based on ROI, which division is more successful? Why?

2. Midwest uses RI as a measure of the financial performance of its divisions. What is the residual income (RI) for each division if the minimum desired rate of return is: (a) 10 percent, (b) 15 percent, and (c) 20 percent? Which division is more successful under each of these rates?

Exercises Exercises


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19-29 Return On Investment (ROI); Comparisons of Three Investment Centers (Divisions)

Required Fill in the blanks:

Division

X Y Z Sales $1,500,000 $750,000 $ Operating Income 150,000 75,000 Investment (assets) 600,000 2,500,000 Return on sales 0.5% Asset turnover 1.5 Return on investment 1%

19-30 ROI, Residual Income, and EVA ® Jean Cooper Cosmetics (JCC) manufactures a variety of prod-ucts and is organized into three divisions (investment centers): soap products, skin lotions, and hair products. Information about the most recent year’s operations follows. The information includes the value of intangible assets including research and development, patents, and other innovations that are not included on JCC’s balance sheet. Were these intangibles to be included in the financial statements (as they are for EVA ® ), the increase in the balance sheet and the increase in after-tax operating income are as given below.

Intangibles’ Operating Average Value of Effect on Division Income Total Assets Intangibles Income

Soap products $3,250,000 $60,000,000 $1,500,000 $1,000,000 Skin lotion s 2,750,000 33,000,000 8,000,000 6,000,000 Hair products 5,000,000 55,000,000 1,000,000 700,000

Minimum desired rate of return 5.00% Cost of capital 4.00%

Required 1. Calculate the ROI for each division.

2. Calculate the residual income (RI) for each division.

3. Calculate EVA ® for each division and comment on your answers for ROI, RI, and EVA ® .

19-31 ROI, Residual Income, and EVA ® Gordon Distributors has three operating divisions that are defined by geographical regions. The financial results for the most recent year are shown below. The firm’s total assets using generally accepted accounting principles (GAAP) are shown at net book value (NBV). Gordon uses a minimum desired rate of return of 12 percent for selecting new projects and for evaluating the three divisions using residual income (RI). The firm’s weighted-average cost of capital is 8 percent.

Net Book Value NBV PlusRegion Net Operating Income (NBV) Intangibles Eastern $35,440 $195,500 $225,600 Central 41,000 212,000 233,000 Western 23,600 133,000 135,000 (All figures in thousands)

Required 1. Calculate the ROI for each division.

2. Calculate the RI for each division.

3. Gordon has estimated the amount of intangibles that are not recorded on the firm’s financial statements using generally accepted accounting principles and has included that additional information above. Assume that adjusting for the unrecorded intangibles would increase net operating income of the Eastern,


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Central, and Western divisions by $22,000, $15,000, and $1,500, respectively, after tax. Determine the EVA ® for each division.

4. Compare and interpret the differences between your answers in parts 1, 2, and 3.

19-32 ROI, Goal-Congruency Issues As indicated in the chapter, ROI is well entrenched in business prac-tice. However, its use can have negative incentive effects on managerial behavior. For example, assume you are the manager of an investment center and that your annual bonus is a function of achieved ROI for your division. You have the opportunity to invest in a project that would cost $250,000 and that would increase annual operating income of your division by $25,000. (This level of return is considered acceptable from top management’s standpoint.) Currently, your division gen-erates annual operating profits of approximately $300,000, on an asset base (i.e., level of invest-ment) of $2,000,000.

Required 1. What is the current return on investment (ROI) being realized by your division (i.e., before considering

the new investment)?

2. What would happen to the near-term ROI of your division after adding the effect of the new investment?

3. As manager of this division, given your incentive-compensation plan, would you be motivated to make the new investment? Why or why not?

4. Can you offer any recommendations for improving the design of the incentive-compensation plan under which you are working? That is, can you think of a plan that would result in increased goal congruency between your incentives and the goals of the company?

19-33 Transfer Pricing; Decision Making Daniels Inc., which manufactures sports equipment, consists of several operating divisions. Division A has decided to go outside the company to buy materials since division B informed it that the division’s selling price for the same materials would increase to $200. Information for division A and division B follows:

Outside price for materials $150 Division A’s annual purchases 10,000 units Division B’s variable costs per unit $140 Division B’s fixed costs , per year $1,250,000 Division B’s capacity utilization 100%

Required 1. Will the company benefit if division A purchases outside the company? Assume that division B cannot

sell its materials to outside buyers.

2. Assume that division B can save $200,000 in fixed costs if it does not manufacture the material for divi-sion A. Should division A purchase from the outside market?

3. Assume the situation in requirement 1. If the outside market value for the materials drops $20, should A buy from the outside? Explain.

19-34 Transfer Pricing; Decision Making Using the information from requirement 1 of exercise 19-33 , assume that division B could sell 10,000 units outside for $210 per unit with variable marketing costs of $8. Should division B sell outside or to division A? Explain.

19-35 Target Sales Price; Return On Investment (ROI) Preferred Products, a bicycle manufacturer, uses normal volume as the basis for setting prices. That is, it sets prices on the basis of long-term volume predictions and then adjusts these prices only for large changes in pay rates or material prices. You are given the following information:

Materials, wages, and other variable costs $300 per unit Fixed costs $200,000 per year Target return on investment (ROI) 20% Normal volume 1,500 units per year Investment (average total assets) $800,000


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Required 1. What sales price is needed to attain the 20 percent target ROI?

2. What ROI rate will be earned at sales volumes of 2,000 and 1,000 units, respectively, using the sales price you determined in requirement 1?

19-36 ROI, Return On Sales, and Asset Turnover Roberts, Inc., has the following financial results for the years 2010 through 2012 for its three regional divisions:

2010 2011 2012

Revenue Southwest $15,000 $22,000 $26,000 Midwest 6,600 7,200 7,000 Southeast 12,500 12,800 13,300 Total $34,100 $42,000 $46,300

Net Operating Income Southwest $ 1,100 $ 1,200 $ 1,400 Midwest 1,250 1,500 1,550 Southeast 900 1,200 1,600 Total $ 3,250 $ 3,900 $ 4,560

Average Total Assets Southwest $14,000 $14,000 $16,500 Midwest 4,200 4,200 4,200 Southeast 5,300 5,600 5,600 Total $23,500 $23,800 $26,300

Required Calculate return on sales (ROS), asset turnover (AT) and return on investment (ROI) for each division and for the firm as a whole for each of the three years 2010, 2011, and 2012.

19-37 ROI; Different Measures for Total Assets Benjamin Joseph, Inc., has the following financial data for 2010 for its three regional divisions:

Historical Cost Current Cost

Operating Net Book Gross Replacement LiquidationRegion Income Value Book Value Cost Value North Atlantic $55,000 $225,000 $450,000 $990,000 $350,000 Mid Atlantic 44,000 289,000 310,000 380,000 445,000 South Atlantic 33,000 115,000 166,000 650,000 980,000

Required Calculate return on sales (ROS) for each division for 2010. The sales in the North, Mid, and South Atlantic regions are $2,350,000, $1,450,000, and $500,000, respectively. Calculate investment (asset) turnover and ROI for each of the four measures of investment.

19-38 Economic Profit and Employee Productivity; Service Industries A recent Harvard Business Review article points out a new way to calculate economic profit that could be more appropriate for service firms and other “people-intensive” companies. Instead of focusing on investment and return on invest-ment, the focus is on employee productivity, both in terms of generating revenues and reducing costs.

The approach is to first determine economic profit in the conventional way, except that we ignore taxes, so that economic profit is before tax, as follows:

Economic profit Operating profit Capital ch! # aarge

Assume the following information for a hotel chain that wishes to adopt the new method. The firm has $100 million in operating profit, $1 billion in investment, and uses a cost of capital rate of 5 percent, so the capital charge is $50 million and the economic profit is $50 million. Relevant calculations are contained in Part 1 of the following schedule.


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Part 1: Economic Profit (in thousands, except cost of capital rate)Revenue $500,000Operating costs Personnel costs 300,000 Other costs 100,000Operating profit $100,000Operating profit before personnel costs (OPBP) $400,000Investment (capital) $1,000,000Cost of capital, rate 0.05Capital charge $ 50,000Economic profit ! Operating profit # Capital charge $ 50,000

Part 2: Economic Profit Calculated Using Employee ProductivityNumber of employees 10,000Employee productivity Operating profit before personnel cost per employee ($400,000/10,000) $40 Capital charge per employee ($50,000/10,000) 5 Employee productivity $35Less personnel cost per employee 30Economic profit per employee ! Productivity # Cost $ 5Total economic profit, all employees $50,000Note: All numbers in thousands except for number of employees

The next step is to decompose economic profit using employee productivity. To do this we first determine operating profit before personnel costs (OPBP):

OPBP Operating profit Personnel costs

$400,0

! "

000 $100,000 $300,000! " Employee productivity can be determined by calculating OPBP less capital charge, per employee. For this example, since there are 10,000 employees, OPBP is $40,000 per employee and the capital charge is $5,000 per employee, so that productivity is $35,000 per employee. The next step is to determine per-sonnel cost per employee, $30,000, and subtract that from employee productivity to obtain economic profit per employee, $5,000 (i.e., $35,000 # $30,000). Total economic profit for all employees is thus $5,000 $ 10,000, or $50 million, the same amount as determined in the conventional way. The value of the decomposition of economic profit into employee productivity and personnel costs per employee is that it provides measures that the hotel chain can benchmark to other hotel chains. It also provides a direct measure of the profit that is being generated per employee relative to the average personnel cost for each employee. Measures of revenue per employee and personnel cost per employee are widely used in the hospital, health and human services, and other people-oriented service industries.

Source: Felix Barber and Rainer Strack, “The Surprising Economics of the People Business,” Harvard Business Review, June 2005, pp. 81–90.

Required Use the above approach and assume a chain of residential care facilities that employs 15,000 people, has a cost of capital of 6 percent, and has the following information (000s).

Revenue $600,000 Operating costs Personnel costs 360,000 Other costs 150,000 Operating profit $ 90,000 Investment $1,000,000

Determine the productivity per employee, personnel costs per employee, and economic profit per employee.

19-39 General Transfer-Pricing Rule Glendale Manufacturing is organized into two divisions: Fabrica-tion and Assembly. Components transferred between the two divisions are recorded at a predeter-mined transfer price. Standard variable manufacturing cost per unit in the Fabrication Division is $500. At the present time, this division is working to capacity. Fabrication estimates that the units it


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produces could be sold on the external market for $650. The product under consideration is viewed as a commodity-type product, with no differentiating features or characteristics.

Required 1. What roles are played by transfer prices? That is, why are transfer prices needed? 2. Use the general transfer-pricing rule presented in the chapter to determine an appropriate transfer price.

Why (or in what sense) is the amount you calculated considered an appropriate transfer price? 3. What if the Fabrication Division had excess capacity? How would this change the indicated transfer

price? Why is the amount you determined considered an appropriate transfer price? 4. Are there any downsides of using the general transfer-pricing rule to determine the transfer price for

internal transfers?

19-40 ROI; Different Measures for Assets Ready Products, Inc., operates two divisions, each with its own manufacturing facility. The accounting system reports the following data for 2010:

HEALTH CARE PRODUCTS DIVISIONIncome Statement for the Year

Ended December 31, 2010 (000s)

Revenues $600Operating costs 470

Operating income $130

COSMETICS DIVISIONIncome Statement for the Year

Ended December 31, 2010 (000s)

Revenues $600Operating costs 400

Operating income $200

Ready estimates the useful life of each manufacturing facility to be 15 years. As of the end of 2010, the plant for the health-care division is four years old, while the manufacturing plant for the cosmetics division is six years old. Each plant had the same cost at the time of purchase, and both have useful lives of 15 years with no salvage value. The company uses straight-line depreciation and the depreciation charge is $70,000 per year for each division. The manufacturing facility is the only long-lived asset of either division. Current assets are $300,000 in each division.

An index of construction costs, replacement cost, and liquidation values for manufacturing facil-ities for the period that Ready has been operating is as follows:

Liquidation Value

Year Cost Index Replacement Cost Health-care Cosmetics 2004 80 $1,000,000 $800,000 $ 800,000 2005 82 1,000,000 800,000 800,000 2006 84 1,100,000 700,000 700,000 2007 89 1,150,000 600,000 700,000 2008 94 1,200,000 600,000 800,000 2009 96 1,250,000 600,000 900,000 2010 100 1,300,000 500,000 1,000,000

Required 1. Compute ROI for each division using the historical cost of divisional assets (including current assets) as

the investment base. Interpret the results. 2. Compute ROI for each division, incorporating current-cost estimates as follows:

a. Gross book value (GBV) of long-lived assets, plus book value of current assets. b. GBV of long-lived assets restated to current cost using the index of construction costs, plus book

value of current assets. c. Net book value of long-lived assets restated to current cost using the index of construction costs,

plus book value of current assets. d. Current replacement cost of long-lived assets, plus book value of current assets. e. Current liquidation value of long-lived assets, plus book value of current assets.

ProblemsProblems


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3. Which of the measures calculated in requirement 2 would you choose to (a) evaluate the performance of each division manager, and (b) decide which division is most profitable for the overall firm. What are the strategic advantages and disadvantages to the firm of each measure for both (a) and (b)?

19-41 Calculating ROI & RI and Comparing Results Blackwood Industries manufactures die machinery. To meet its expansion needs, it recently (2008) acquired one of its suppliers, Delta Steel. To main-tain Delta’s separate identity, Blackwood reports Delta’s operations as an investment center. Black-wood monitors all of its investment centers on the basis of return on investment (ROI). Management bonuses are based on ROI, and all investment centers are expected to earn a minimum 10 percent return before income taxes.

Delta’s ROI has ranged from 14 percent to 18 percent since 2008. The company recently had the opportunity for a new investment that would have yielded a 13 percent ROI. However, division management decided against the investment because it believed that the investment would decrease the division’s overall ROI.

The 2010 operating statement for Delta follows. The division’s operating assets were $15,000,000 at the end of 2010, a 5 percent increase over the 2009 year-end balance.

DELTA DIVISION Operating Statement for Year Ended

December 31, 2010 (000s omitted)

Sales $25,000 Cost of goods sold 16,600

Gross profit 8,400 Operating expenses: Administration $2,340 Selling 3,610 5,950

Operating income $ 2,450

Required 1. Calculate the following performance measures for 2010 for the Delta division:

a. Return on average investment in operating assets.

b. Residual Income (RI) calculated on the basis of average operating assets.

2. Which performance measure (ROI or RI) should Blackwood Industries use to provide the proper incen-tive for each division to act autonomously in the firm’s best interests? Would Delta’s management have been more likely to accept the capital investment opportunity if RI had been used as a performance measure instead of ROI? Explain.

3. What type of strategic performance measurement do you recommend for the Delta division? Explain.

19-42 ROI and Incentive/Goal-Congruency Issues Assume the purchase of new equipment (e.g., deliv-ery trucks) used in a product-delivery service (such as UPS or FedEx). This equipment is needed to improve delivery service and respond to recent environmental goals embraced by the company. The cost of the new equipment is $1 million; the expected useful life of these assets is five years. Estimated salvage value at the end of five years is $0. The company in question will depreciate these assets over a five-year period using straight-line depreciation. The anticipated increase in operating income (before depreciation deductions) attributable to the use of the new equipment is $300,000. Ignore taxes.

Required 1. Generate a schedule of the year-by-year ROIs associated with this investment opportunity. For purposes

of these calculations, define the investment base (denominator of the ROI ratio) as average net book value (NBV) of the assets during the year.

2. Generate a second schedule showing the year-by-year ROIs for this investment opportunity under the assumption that the denominator in the ROI calculation is defined as the gross book value of the assets to be acquired.

3. Why do the results differ in (1) and (2) above? What behavioral issue is associated with the use of (1) versus (2) above?

4. What impact would the use of an accelerated depreciation method have on the conclusions above in (1) and (2)? For example, prepare a new schedule of annual ROIs under the assumption that the double-declining-balance depreciation method is used. (Assume a switch to straight-line depreciation in year 4. Thus, the total depreciation charge over the five-year period should be $1 million.)


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5. Would the use of the residual income (RI) measure of financial performance eliminate the behavioral issue raised above? Why or why not? For the options specified above in parts 1,2, and 4, show the year-by-year RIs for this investment, based on a weighted-average cost of capital (WACC) of 10 percent. For each of the four options, base the imputed interest charge each year on a simple average of beginning-of-year and end-of-year asset values.

19-43 ROI, Present-Value Depreciation As indicated in the chapter, there are goal-congruency problems associated with the use of ROI as an indicator of investment-center financial performance. One such problem relates to the bias against accepting new investments because of the adverse effect on a center’s ROI metric. Assume, for example, that a manager of an investment center can invest in a new, depreciable asset costing $30,000, and that this asset has a three-year life with no salvage value. Cash inflows associated with this investment are projected to be as follows: $12,000, $14,400, and $17,280. (Ignore taxes.) This scenario leads to an estimated internal rate of return (IRR) of 20 percent. Assume that the minimum required rate of return is 15 percent.

Required 1. Demonstrate, using the IRR function in Excel, that the IRR on this proposed investment is indeed

20 percent.

2. Calculate the year-by-year ROI (accounting rate of return) on this proposed investment, using each year as the denominator of your calculation the beginning-of-year book value of the asset. Assume the asset will be depreciated using the straight-line method. What incentive effects can you anticipate based on the data you generated?

3. Recalculate the year-by-year ROI (accounting rate of return) on this proposed investment, this time using “present value” depreciation (defined as the change in the present value of the asset during the period). Use the project’s anticipated IRR (20 percent) as the discount factor in your calculations. As in (2) above, define the denominator of your calculation as the beginning-of-year book value of the invest-ment. ( Hint: Your depreciation figures should be $6,000, $9,600, and $14,400, respectively, for years 1, 2, and 3.) What incentive effects do you anticipate based on your calculations?

4. Calculate for each of three years the residual income (RI) for this proposed investment. RI is defined as income after (present-value) depreciation and after a capital charge assessed on beginning-of-year book value of the asset. For purposes of these calculations assume a 10 percent cost of capital (discount rate). Use the built-in function in Excel to estimate the NPV of the proposed investment. ( Hint: Your answer should be approximately $5,800.) At a discount rate of 10 percent, determine the net present value (NPV) of the residual income (RI) figures you estimated. What is the potential value of using multiyear RI figures determined with present-value depreciation?

19-44 Residual Income (RI), Performance Evaluation Time Horizon As referenced in the five-step proc-ess presented at the beginning of this chapter, one issue that confronts top management is selection of an appropriate time period for evaluating the financial performance of the company’s investment centers. This exercise demonstrates why, in conjunction with residual income (RI), it is desirable to evaluate financial performance over a multiyear period. The primary point is that, by doing so, top management is better able to align manager goals and incentives with organizational goals.

Assume, as covered in Chapter 12, that your company uses the net present value (NPV) method to evaluate capital investment opportunities. Generally speaking, this means that a long-term invest-ment project will be undertaken if the present value of future net cash flows (after-tax) is positive when discounted at the firm’s weighted-average cost of capital (WACC). The following facts pertain to an investment opportunity that is available to the manager of one of the investment centers in your company. Investment outlay cost, time period 0, equals $800,000. This amount relates to an asset with a five-year life, and no salvage value, that will be depreciated using the straight-line (SL) method. The investment is expected to increase cash inflows by $300,000 per year. Assume a discount rate of 10 per-cent, both for purposes of calculating NPV and for calculating annual residual income (RI) figures.

Required 1. Prepare a schedule that contains annual cash-flow data, annual operating income amounts, and annual

residual income (RI) figures. What is the estimated NPV of the proposed investment? What is the present value (PV) of the stream of expected residual incomes (RIs) from this investment?

2. From a behavioral perspective, what is the primary implication of the analysis you conducted above in (1)?

19-45 Transfer Pricing; Decision Making Phoenix Inc., a cellular communication company, has multiple divisions. Each division’s management is compensated based on the division’s operating income. Division A currently purchases cellular equipment from outside markets and uses it to produce communication systems. Division B produces similar cellular equipment that it sells to outside


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customers but not to division A at this time. Division A’s manager approaches division B’s manager with a proposal to buy the equipment from division B. If it produces the cellular equipment that division A desires, division B would incur variable manufacturing costs of $60 per unit.

Relevant Information about Division BSells 50,000 units of equipment to outside customers at $130 per unit.Operating capacity is currently 80 percent; the division can operate at 100 percent.Variable manufacturing costs are $70 per unit.Variable marketing costs are $8 per unit.Fixed manufacturing costs are $580,000.

Income per Unit for Division A (assuming parts purchased outside, not from division B)Sales revenue $320Manufacturing costs: Cellular equipment 80 Other materials 10 Fixed costs 40 Total manufacturing costs 130Gross margin 190Marketing costs: Variable 35 Fixed 15 Total marketing costs 50Operating income per unit $140

Required 1. Division A wants to buy all 25,000 units from division B at $75 per unit. Should division B accept

or reject the proposal? How would your answer differ if (a) Division A requires all 25,000 units in the order to be shipped by the same supplier, or (b) Division A would accept partial shipment from Division B?

2. What is the range of transfer prices over which the divisional managers might negotiate a final transfer price? Provide a rationale for the range you provide.

19-46 EVA ® NOPAT and EVA ® Capital: Operating Approach You are provided with the following finan-cial statement information from Astro, Inc. for its most recent fiscal year.

Statement of Financial Position (Balance Sheet)End of Year (000s)

AssetsCash $ 35Net Accounts Receivable (A/R) 190Inventory 190Other current assets 95

Total current assets $ 510Property, plant, and equipment (net) 605Other long-term assets 120

Total assets $1,235

Liabilities and Stockholders’ EquityShort-term debt (@10%) $ 100Accounts payable 150Income taxes payable 20Other current liabilities 200

Total current liabilities $ 470


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Long-term debt (8%) 150Other long-term liabilities 120

Total liabilities $ 740Deferred income taxes 70Common equity 425

Total liabilities and shareholders’ equity $1,235

The statement of income for the company for the year just ended is as follows:

Statement of IncomeMost Recent Year (000s)

Net sales $2,000Cost of goods sold (CGS) 1,670

Gross margin 330Less: SG&A costs 185 Depreciation 35 Other operating expenses 50

Total expenses 270

Net operating profit 60Less: Interest expense 22Plus: Other income 12

Income before tax 50Less: Income tax (@ 40%) 20

Net profit after tax $ 30

Assume a weighted-average cost of capital (WACC) of 10.7% and an income tax rate of 40%.

Required 1. Prepare, using the operating approach, an estimate of EVA ® NOPAT. In addition to the above data, you

discovered the following: increase during the year of the LIFO reserve, $2; imputed interest expense on noncapitalized leases, $4; and increase in deferred tax liability during the year, $5. ( Hint: The cor-rect answer is $53; the amount of cash taxes paid on operating profit during the year is $25.) What is the rationale for the various adjustments you made to the company’s reported income statement?

2. Prepare, using the operating approach, an estimate of EVA ® capital. ( Hint: The correct answer is $925.) In addition to the above information, you note the following: end-of-year value of the LIFO reserve, $10; and present value of noncapitalized leases, $50. What is the rationale for the adjustments you made to reported balance sheet amounts in order to estimate EVA ® capital?

3. Given the company’s WACC, what is the estimated EVA ® for the year? How do you interpret this figure?

19-47 EVA ® NOPAT and EVA ® Capital: Financing Approach Refer to the preceding problem for reported financial statement data for Astro, Inc.

Required 1. Prepare, using the financing approach, an estimate of EVA ® NOPAT. In addition to the above data,

you’ve discovered the following: increase during the year of the LIFO reserve, $2; imputed inter-est expense on noncapitalized leases, $4; and increase in deferred tax liability during the year, $5. ( Hint: The correct answer is $53.) What is the rationale for the various adjustments you made to the company’s reported income statement?

2. Prepare, using the financing approach, an estimate of EVA ® capital. ( Hint: The correct answer is $925.) In addition to the above information, you note the following: end-of-year value of the LIFO reserve, $10; and present value of noncapitalized leases, $50. What is the rationale for the adjustments you made to reported balance sheet amounts in order to estimate EVA ® capital?

3. Given the company’s WACC, what is the estimated EVA ® for the year? How do you interpret this figure?


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19-48 Return on Investment; Residual Income Raddington Industries is a diversified manufacturer with several divisions, including the Reigis Division. Raddington monitors its divisions on the basis of both unit contribution and return on investment (ROI), with investment defined as average operat-ing assets employed. All investments in operating assets are expected to earn a minimum return of 9 percent before income taxes.

Reigis’s cost of goods sold is considered to be entirely variable; however, its administrative expenses do not depend on volume. Selling expenses are a mixed cost with 40 percent attributed to sales volume. The 2010 operating statement for Reigis follows. The division’s operating assets employed were $80,750,000 at November 30, 2010, unchanged from the year before.

REIGIS STEEL DIVISION Operating Statement

For the Year Ended November 30, 2010(000s omitted)

Sales revenue $35,000 Less expenses: Cost of goods sold $18,500 Administrative expenses 3,955 Selling expenses 2,700 25,155

Income from operations, before tax $ 9,845

Required 1. Calculate Reigis Steel Division’s unit contribution if it produced and sold 1,484,000 units during the

year ended November 30, 2010.

2. Calculate the following performance measures for 2010 for Reigis:

a. Pretax ROI, based on average operating assets employed.

b. Residual income (RI), calculated on the basis of average operating assets employed.

3. Reigis management is presented the opportunity to invest in a project that would earn an ROI of 10 per-cent. Is Reigis likely to accept the project? Why or why not?

4. Identify several items that Reigis should control if it is to be fairly evaluated as a separate investment center within Raddington Industries using either ROI or RI performance measures.

(CMA Adapted)

19-49 Divisional Performance Evaluation Darmen Corporation is one of the major producers of prefabri-cated homes in the home building industry. The corporation consists of two divisions: (1) Bell Divi-sion, which acquires the raw materials to manufacture the basic house components and assembles them into kits, and (2) Cornish Division, which takes the kits and constructs the homes for final home buyers. The corporation is decentralized and the management of each division is measured by its income and return on investment.

Bell Division assembles seven separate home kits using raw materials purchased at the prevail-ing market prices. The seven kits are sold to Cornish for prices ranging from $45,000 to $98,000. The prices are set by corporate management of Darmen using prices paid by Cornish when it buys comparable units from outside sources. The smaller kits with the lower prices have become a large portion of the units sold because the final home buyer is faced with prices that are increasing more rapidly than personal income. The kits are manufactured and assembled in a new plant just pur-chased by Bell this year. The division had been located in a leased plant for the past four years.

All kits are assembled upon receipt of an order from Cornish Division. When the kit is com-pletely assembled, it is loaded immediately on a Cornish truck. Thus, Bell Division has no finished goods inventory.

The Bell Division’s accounts and reports are prepared on an actual cost basis. There is no budget and no product standards have been developed. A factory overhead rate is calculated at the beginning of each year. The rate is designed to charge all overhead to the product each year. Any under- or over-applied overhead is allocated to the cost of goods sold account and work in process inventories.

Bell Division’s performance report follows. This report forms the basis of the evaluation of the division and its management by the corporate CFO. Additional information regarding corporate and division practices is as follows: • The corporate office does all the personnel and accounting work for each division.

• The corporate personnel costs are allocated on the basis of number of employees in the division.




• The corporate accounting costs are allocated to the division on the basis of total costs excluding

corporate charges.

• The division administration costs are included in factory overhead.

• The financing charges include a corporate imputed interest charge on division assets and any

divisional lease payments.

• The division investment for the return on investment (ROI) calculation includes division inven-

tory and plant and equipment at gross book value.

BELL DIVISIONPerformance Report

For the Year Ended December 31, 2010

Increase or (Decrease) from 2009 to 2010

2010 2009 Amount Percent Change

Summary DataDivision income ($000 omitted) $ 34,222 $ 31,573 $ 2,649 8.4%Return on investment (ROI) 37% 43%

Production Data (in units)Kits started 2,400 1,600 800 50.0Kits shipped 2,000 2,100 (100) (4.8)Kits in process at year-end 700 300 400 133.3

Financial Data ($000 omitted)Sales $138,000 $162,800 ($24,800) (15.2)Production costs of units sold Raw material $ 32,000 $ 40,000 $ (8,000) (20.0) Labor 41,700 53,000 (11,300) (21.3) Factory overhead 29,000 37,000 (8,000) (21.6)

Cost of units sold $102,700 $130,000 $(27,300) (21.0)

Other costs Corporate charges for Personnel services $ 228 $ 210 $ 18 8.6 Accounting services 425 440 (15) (3.4) Financing costs 300 525 (225) (42.9)

Total other costs $ 953 $ 1,175 $ (222) (18.9)

Increase or (Decrease) from 2009 to 2010

2010 2009 Amount Percent ChangeAdjustments to income Unreimbursed fire loss — $ 52 $ (52) (100.00) Raw material losses due to improper storage $ 125 — $ 125 —

Total adjustments $ 125 $ 52 $ 73 140.4

Total deductions $103,778 $131,227 $(27,449) (20.9)

Division income $ 34,222 $ 31,573 $ 2,649 8.4

Division Investment $ 92,000 $ 73,000 $ 19,000 26.0Return on Investment 37% 43%

Required 1. What performance-evaluation system does Darmen Corporation use? Discuss the value of the system in

evaluating the Bell Division and its management.

2. Present specific recommendations to the management of Darmen Corporation to improve its

performance-evaluation system.

(CMA Adapted)


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19-50 Performance Evaluation; Strategy Map; Review of Chapter 18; Correlation Analysis Maydew Man-ufacturing Inc. is a large manufacturer of lawn and garden equipment including mowers, edgers, till-ers, related equipment, and accessories. The firm has been very successful in recent years, and sales have grown more than 10 percent in each of the last five years. The firm is organized into 15 invest-ment centers based on product-line groups. Return on investment (ROI) and residual income (RI) calculations have been made for each of the last four years and used in management compensation for the last two years. Recently Maydew’s top management has contracted with MM&PC, a large consulting firm to review the performance-measurement process at the firm. One of MM&PC’s key recommendations has been to consider the implementation of the balanced scorecard (BSC) both for performance measurement and for strategic management. As a step in this direction, MM&PC has asked Maydew for some data on ROI and other measures being considered for the BSC to analyze the relationships among these data. It is hoped that the analysis will help MM&PC develop a strategy map for the firm. The following data show the most recent year’s ROI for each investment center and the average for the last three years for training hours per employee in the center, customer retention rate in the unit (customers are primarily large department store chains and other distributors of lawn and garden equipment), the QSV score, and the defect rate (per thousand products). The QSV score is a measure of the Quality-Service-Value of the investment center made by an analysis of a variety of operating data including the results of on-site inspection of each unit by key operating executives and other measures of operating performance (the highest score is 10, and the lowest is 0).

Training Hours Customer QSV DefectManager ROI per Employee Retention Score Rate

1 21.3 98 99.3 7 3.3 2 15.4 122 98.2 8 4.7 3 9.6 67 86.7 6 11.2 4 12.4 88 84.5 9 13.7 5 18.6 92 91.4 8 2.1 6 4.5 33 90.7 4 28.9 7 8.8 49 88.9 6 1.2 8 22.6 77 93.5 10 12.4 9 11.8 102 95.5 9 8.0 10 14.6 95 91.1 6 7.4 11 16.5 87 92.7 6 2.8 12 12.1 80 86.4 8 4.9 13 6.2 66 80.2 4 15.3 14 1.3 50 78.0 4 22.8 15 9.7 78 85.5 7 30.5

Required 1. Using the concept of the strategy map, consider how the nonfinancial factors (training hours, customer

retention, QSV, and defect rate) affect ROI. Which of these variables has the greatest influence on ROI? Use regression and correlation analysis to address this requirement.

2. Explain which two managers you would rate as the best overall and which you would rate as the worst overall, and give reasons why.

19-51 General Transfer-Pricing Rule; Goal Congruence American Motors, Inc., is divided, for performance-evaluation purposes, into several investment centers. The Automobile Division of American Motors purchases most of its transmission systems from another unit of the company. The Transmission Division’s incremental cost for manufacturing a standard transmission is approxi-mately $900 per unit. This division is currently working at 75 percent of capacity. The current mar-ket price for a standard transmission is approximately $1,250.

Required 1. Using the general guideline equation presented in the chapter, what is the minimum price at which the

Transmission Division would sell its output to the Automobile Division?

2. Suppose now that American Motors requires that whenever divisions with excess capacity sell their out-put internally to other divisions of the company, they must do so at the incremental cost of the supply-ing (producing) division. Evaluate this transfer-pricing rule vis-à-vis each of the following objectives: autonomy, goal congruency, performance evaluation of the divisions, and motivation/incentive effects.




3. If the two divisions of American Motors were to negotiate a transfer price, what is the likely range of pos-

sible prices? Evaluate the use of a negotiated transfer price using the same objectives listed above in (2).

4. Which, in your opinion, is the preferable transfer-pricing method—(2) or (3) above? Why?

(CMA Adapted)

19-52 Transfer Pricing—International Example A subsidiary company located in country A purchases

$1 00 worth of goods. It then repackages, exports, and sells those goods to the parent company,

located in country B, for $200. The parent company sells the goods for $300. Therefore, both enti-

ties have a $100 profit. Assume that the income tax rate in country A is 20 percent, while the tax rate

in country B is 60 percent.

Required 1. Given the above facts and assumptions, what is the company’s combined (i.e., worldwide) after-tax

income for this transaction? (Show calculations.)

2. Consider now a transfer-pricing approach in which the subsidiary sells the goods to the parent company

for $280, and the parent company then sells the goods for $300. What is the revised worldwide (i.e.,

combined) after-tax profit for this transaction? (Show calculations.)

3. What is the effect of the transfer-pricing decision when the income-tax rates for the two countries in

question are equal?

4. What limitations exist regarding the setting of transfer prices for multinational transfers?

19-53 Transfer Pricing, International Considerations, and Strategy As indicated in the chapter, deter-

mining the appropriate transfer price in a multinational setting is a very complex problem, with

multiple strategic considerations. Consider as an example a U.S. company with a subsidiary in Italy

and a subsidiary in Ireland. The Italian subsidiary produces a product at a cost of $1,000 per unit.

This unit is then sold to the Irish subsidiary, which adds $100 of cost to each unit. The unit is then

shipped to the U.S. parent company, which adds an additional $100 of cost to each unit. The unit is

then sold to a U.S. customer for $2,000. Assume that the tax rate in Italy is 30 percent, the tax rate in

Ireland is 15 percent, and the tax rate in the United States is 35 percent.

Required 1. Define the term transfer price. Why is the issue of transfer pricing of strategic concern to organizations?

2. Fundamentally, what creates income tax planning opportunities as regards the determination of transfer

pricing in a multinational setting? Where could one go to obtain information regarding stated income-

tax rates for various countries?

3. Assume that the transfer price associated with the sale to the Irish subsidiary is $1,200, and that the

transfer price for the sale to the U.S. parent company is $1,600. Under this situation, what is the income

tax paid by each of the following: (a) the Italian subsidiary, (b) the Irish subsidiary, (c) the U.S. parent

company, and (d) the consolidated entity (i.e., worldwide tax paid)?

4. Assume now that the transfer price associated with the sale to the Irish subsidiary is $1,100, and that the

transfer price for the sale to the U.S. parent company is $1,800. Under this situation, what is the income

tax paid by each of the following: (a) the Italian subsidiary, (b) the Irish subsidiary, (c) the U.S. parent

company, and (d) the consolidated entity (i.e., worldwide tax paid)?

5. What considerations, including qualitative factors, bear on the transfer-pricing decision in a multina-

tional context?

19-54 Transfer-Pricing Methods Lynsar Corporation started as a single plant to produce its major com-

ponents and then assembled its main product into electric motors. Lynsar later expanded by develop-

ing outside markets for some components used in its motors. Eventually, the company reorganized

into four manufacturing divisions: bearing, casing, switch, and motor. Each manufacturing division

operates as an autonomous unit, and divisional performance is the basis for year-end bonuses.

Lynsar’s transfer-pricing policy permits the manufacturing divisions to sell either externally or

internally. The price for goods transferred between divisions is negotiated between the buying and

selling divisions without any interference from top management.

Lynsar’s profits for the current year have dropped although sales have increased, and the

decreased profits can be traced almost entirely to the motor division. Jere Feldon, Lynsar’s chief

financial officer, has learned that the motor division purchased switches for its motors from an

outside supplier during the current year rather than buying them from the switch division, which is

at capacity and has refused to sell to the motor division. It can sell them to outside customers at a

price higher than the actual full (absorption) manufacturing cost that has always been negotiated in

the past with the motor division. When the motor division refused to meet the price that the switch


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division was receiving from its outside buyer, the motor division had to purchase the switches from an outside supplier at an even higher price.

Jere is reviewing Lynsar’s transfer-pricing policy because he believes that suboptimization has occurred. Although the switch division made the correct decision to maximize its division profit by not transferring the switches at actual full manufacturing cost, this was not necessarily in Lynsar’s best interest because of the price the motor division paid for them. The motor division has always been Lynsar’s largest division and has tended to dominate the smaller divisions. Jere has learned that the casing and bearing divisions are also resisting the motor division’s expectation to use the actual full manufacturing cost as the negotiated price.

Jere has requested that the corporate accounting department study alternative transfer-pricing methods to promote overall goal congruence, motivate divisional management performance, and optimize overall company performance. Three transfer-pricing methods being considered follow. The one selected will be applied uniformly across all divisions.

• Standard full manufacturing costs plus markup.

• Market selling price of the products being transferred.

• Outlay (out-of-pocket) costs incurred to the point of transfer plus opportunity cost to the seller, per unit.

Required 1. Discuss the following:

a. The positive and negative motivational implications of employing a negotiated transfer price system for goods exchange between divisions.

b. The motivational problems that can result from using actual full (absorption) manufacturing costs as a transfer price.

2. Discuss the motivational issues that could arise if Lynsar Corporation decides to change from its current policy of covering the transfer of goods between divisions to a revised transfer-pricing policy that would apply uniformly to all divisions.

3. Discuss the likely behavior of both buying and selling divisional managers for each transfer-pricing method listed earlier, if it were adopted by Lynsar.

(CMA Adapted)

19-55 Transfer-Pricing Issues When transfer prices are based on actual cost, a supplying division often has no incentive to reduce cost. For example, a design change that would reduce the supplying divi-sion’s manufacturing cost would benefit only downstream divisions if the transfer price is based on a markup over cost.

Required What can or should be done to provide the supplying division an incentive to reduce manufactur-ing costs when the transfer price is cost-based?

19-56 Transfer Pricing; International Taxation Harris Company has a manufacturing subsidiary in Singa-pore that produces high-end exercise equipment for U.S. consumers. The manufacturing subsidiary has total manufacturing costs of $1,500,000, plus general and administrative expenses of $350,000. The manufacturing unit sells the equipment for $2,500,000 to the U.S. marketing subsidiary, which sells it to the final consumer for an aggregate of $3,500,000. The sales subsidiary has total market-ing, general, and administrative costs of $200,000. Assume that Singapore has a corporate tax rate of 33 percent and that the U.S. tax rate is 46 percent. Assume that no tax treaties or other special tax treatments apply.

Required What is the effect on Harris Company’s total corporate-level taxes if the manufacturing subsidi-ary raises its price by 20 percent to the sales subsidiary?

19-57 Transfer Pricing; Strategy Advanced Manufacturing Inc. (AMI) produces electronic components in three divisions: industrial, commercial, and consumer products. The commercial products division annually purchases 10,000 units of part 23–6711, which the industrial division produces for use in manufacturing one of its own products. The commercial division is growing rapidly. The commer-cial division is expanding its production and now wants to increase its purchases of part 23–6711 to 15,000 units per year. The problem is that the industrial division is at full capacity. No new investment in the industrial division has been made for some years because top management sees little future growth in its products, so its capacity is unlikely to increase soon.

The commercial division can buy part 23–6711 from HighTech Inc. or from Britton Electric, a customer of the industrial division, now purchasing 650 units of part 88–461. The industrial division’s sales to Britton would not be affected by the commercial division’s decision about part 23–6711.




Industrial division Data on part 23–6711: Price to commercial division $185 Variable manufacturing costs 155 Price to outside buyers 205 Data on part 88–461: Variable manufacturing costs $ 65 Sales price 95 Other suppliers of part 23–6711: HighTech Inc., price $200 Britton Electric, price 210

Required 1. What is the proper decision regarding where the commercial division should purchase the additional

5,000 parts and what is the correct transfer price?

2. Assume that the industrial division’s sales to Britton would be cancelled if the commercial division does

not buy from Britton. What would be the unit cost to AMI in this case, and would the desired transfer

price change?

3. What are the strategic implications of your answer to requirement 1? How can AMI become more com-

petitive in one or more of its divisions?

19-58 Return on Investment (ROI); Residual Income (RI) Jump-Start Co. (JSC), a subsidiary of Mason

Industries, manufactures go-carts and other recreational vehicles. Family recreational centers that

feature go-cart tracks as well as miniature golf courses, batting cages, and arcade games have

increased in popularity. As a result, Mason management has been pressuring JSC to diversify into

some of these other recreational areas. Recreational Leasing Inc. (RLI), one of the largest firms

that leases arcade games to these family recreational centers, is looking for a buyer. Mason’s top

management believes that RLI’s assets could be acquired for an investment of $3.2 million and has

strongly urged Bill Grieco, JSC’s division manager, to consider the acquisition.

Bill has reviewed RLI’s financial statements with his controller, Marie Donnelly; they believe

that the acquisition may not be in JSC’s best interest. “If we decide not to do this, the Mason people

are not going to be happy,” Bill said. “If we could convince them to base our bonuses on something

other than ROI, maybe this acquisition would look more attractive. How would we do if the bonuses

were based on RI using the company’s 15 percent cost of capital?”

Mason has traditionally evaluated all divisions on the basis of ROI, which is the ratio of operat-

ing income to total assets. The desired rate of return for each division is 20 percent. The manage-

ment team of any division reporting an annual increase in ROI is automatically eligible for a bonus.

To be eligible for a bonus, the management of divisions reporting a decline in ROI must provide

convincing explanations for the decline. The bonus for divisions with a declining ROI is limited to

50 percent of the amount of the bonus paid to divisions reporting an increase.

The following are the condensed financial statements of JSC and RLI for the fiscal year ended

May 31, 2010.

JSC RLI Sales revenue $10,500,000 — Leasing revenue — $2,800,000 Variable expenses 7,000,000 1,000,000 Fixed expenses 1,500,000 1,200,000 Operating income $ 2,000,000 $ 600,000

Current assets $ 2,300,000 $1,900,000 Long-term assets 5,700,000 1,100,000 Total assets $ 8,000,000 $3,000,000

Current liabilities $ 1,400,000 $ 850,000 Long-term liabilities 3,800,000 1,200,000 Shareholders’ equity 2,800,000 950,000 Total liabilities and shareholders’ equity $ 8,000,000 $3,000,000


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Required 1. If Mason Industries continues to use ROI as the sole measure of divisional performance, explain why

JSC would be reluctant to acquire RLI. Support your answer with appropriate calculations.

2. If Mason Industries could be persuaded to use RI to measure JSC’s performance, explain why JSC would be more willing to acquire RLI. Support your answer with appropriate calculations.

3. Discuss how the behavior of division managers is likely to be affected by the use of:

a. ROI as a performance measure.

b. RI as a performance measure.

(CMA Adapted)

19-59 Return on Investment (ROI) Videonet Company manufactures highly specialized products for networking video-conferencing equipment. Production of specialized units are, to a large extent, performed under contract, with standard units manufactured according to marketing projections. Maintenance of customer equipment is an important area of customer satisfaction. With the recent downturn in the computer industry, the video-conferencing equipment segment has suffered, caus-ing a slide in Videonet’s financial performance. Its income statement for the fiscal year ended Octo-ber 31, 2010, follows.

VIDEONET COMPANYIncome Statement

For the Year Ended October 31, 2010(000s omitted)

Net sales: Equipment $6,500 Maintenance contracts 1,800 Net sales $8,300Expenses: Cost of goods sold 4,600 Customer maintenance 1,000 Selling expense 600 Administrative expense 900 Interest expense 150 Total expenses $7,250Income before tax 1,050 Income tax 420Net income $ 630

Videonet’s return on sales before interest and income tax was 14.5 percent in fiscal 2010 when the industry average was 18 percent. Its total asset turnover was two times, and its return on average assets before interest and income tax was 29 percent, both well below the industry average. To improve performance and raise these ratios closer to, or above, industry averages, Bill Hunt, Vid-eonet’s president, established the following goals for fiscal 2011:

Return on sales, before interest and income tax 15% Total asset turnover 3 times Return on average assets, before interest and income tax 35%

To achieve Hunt’s goals, Videonet’s management team considered the growth in the international video-conferencing market and proposed the following actions for fiscal 2011:

• Increase equipment sales prices by 10 percent.

• Increase the cost of each unit sold by 3 percent for needed technology, and quality improvements and for increased variable costs.

• Increase maintenance inventory by $250,000 at the beginning of the year and add two mainte-nance technicians at total cost of $130,000 to cover wages and related travel expenses. These revisions are intended to improve customer service and response time. The increased inventory will be financed at an annual interest rate of 12 percent; no other borrowings or loan reductions are contemplated during fiscal 2011. All other assets will be held to fiscal 2010 levels.

(continued)


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• Increase selling expenses by $250,000, but hold administrative expenses at 2010 levels.

• The effective combined federal and state income tax rate for 2011 is expected to be 40 percent, the same as it was in 2010.

These actions were taken to increase equipment unit sales by 8 percent, with a corresponding 8 per-cent growth in maintenance contracts.

Required 1. Prepare a budgeted income statement for Videonet for the fiscal year ending October 31, 2011, on the

assumption that the proposed actions are implemented as planned and that the increased sales objectives will be met.

2. Calculate the following ratios for Videonet for fiscal year 2011 and determine whether Bill Hunt’s goals will be achieved:

a. Return on sales (ROS), before interest and income tax.

b. Total asset turnover.

c. Return on average assets, before interest and income tax.

3. Discuss the limitations and difficulties that can be encountered in using the ratios in requirement 2, particularly when making comparisons to industry averages.

(CMA Adapted)

19-60 Strategy; Strategic Performance Measurement; Transfer Pricing Ajax Consolidated has several divisions; however, only two transfer products to other divisions. The mining division refines tol-dine, which it transfers to the metals division where toldine is processed into an alloy and is sold to customers for $150 per unit. Ajax currently requires the mining division to transfer its total annual output of 400,000 units of toldine to the metals division at total (actual) manufacturing cost plus 10 percent. Unlimited quantities of toldine can be purchased and sold on the open market at $90 per unit. The mining division could sell all the toldine it produces at $90 per unit on the open market, but it would incur a variable selling cost of $5 per unit.

Brian Jones, the mining division’s manager, is unhappy transferring the entire output of toldine to the metals division at 110 percent of cost. In a meeting with Ajax management, he said, “Why should my division be required to sell toldine to the metals division at less than market price? For the year just ended in May, the contribution margin on metals was more than $19 million on sales of 400,000 units while the mining division’s contribution was just over $5 million on the transfer of the same number of units. My division is subsidizing the profitability of the metals division. We should be allowed to charge the market price for toldine when we transfer it to the metals division.”

The following is the detailed unit cost structure for both the mining and metals divisions for the fiscal year ended May 31, 2010:

Cost per Unit

Mining Division Metals Division Transfer price from mining division — $66 Direct material $12 6 Direct labor 16 20 Manufacturing overhead 32 * 25 † Total cost per unit $60 $117

* Manufacturing overhead in the mining division is 25 percent fixed and 75 percent variable. † Manufacturing overhead in the metals division is 60 percent fixed and 40 percent variable.

Required 1. Explain whether transfer prices based on cost are appropriate as a divisional performance measure and

why.

2. Using the market price as the transfer price, determine the contribution margin for both divisions for the year ended May 31, 2010.

3. If Ajax were to institute the use of negotiated transfer prices and allow divisions to buy and sell on the open market, determine the price range for toldine that both divisions would accept. Explain your answer.

4. Identify which of the three types of transfer prices—cost-based, market-based, or negotiated—is most likely to elicit desirable management behavior at Ajax and thus benefit overall operations. Explain your answer.




19-61 Transfer Pricing; Strategy Better Life Products (BLP), Inc., is a large U.S.–based manufacturer of

health-care products; it specializes in cushions, braces, and other remedies for a variety of health

problems experienced by elderly and disabled persons. BLP knows that its industry is price-competitive

and hopes to compete through rapid growth, primarily within the United States, where it has a well-

established brand image. Because of the competitive industry conditions, BLF is focusing on cost

and price reductions as a principal way to attract customers. Because of rising domestic production

costs, lower production costs in other countries, and a modest increase in global demand for its prod-

ucts, BLP manufactures some of these products outside the United States. Much of the materials for

use by foreign manufacturers is shipped from the United States to the foreign manufacturer, which

assembles the final product. In this way, BLP takes advantage of the foreign country’s lower labor

costs. For this purpose, BLP has formed three divisions, one in the United States to purchase and

perform limited assembly of the raw materials; one a foreign division to complete the manufactur-

ing, especially of the labor-intensive components of manufacturing; and one a marketing and sales

division in the United States. Sales of BLP’s products are approximately 80 percent in the United

States, 10 percent in Canada, and 10 percent worldwide. The foreign divisions tend to focus only on

manufacturing because of the specialized nature of the products and because of BLP’s desire to have

the U.S. sales division coordinate all sales activities. BLP now has 18 U.S. divisions and 23 foreign

divisions operating in this manner.

Foreign divisions’ shipments to the United States are subject to customs duties according to the

U.S. Tariff Code, which adds to BLP’s cost of the foreign-based manufacturing. However, the code

requires U.S. companies to pay duty on only the value added in foreign countries. For example, a prod-

uct imported from an Argentine company to BLP pays customs on only the amount of the product’s

cost resulting from labor incurred in Argentina. To illustrate, a product with $10 of materials shipped

from the United States to Argentina that incurs $10 of labor costs in Argentina is charged a tariff based

on the $10 of labor costs, not the $20 of total product cost. Thus, for tariff purposes, having as small a

portion of total product cost from the foreign country as possible is advantageous to BLP.

BLP division managers, including those of the foreign manufacturing facilities, are evaluated

on the basis of profit. Jorge Martinez is the manager of the manufacturing plant in Argentina; his

compensation from BLP is based on meeting profit targets.

BLP uses a transfer-pricing approach common in the industry to allow each of the company’s

divisions to determine the transfer pricing autonomously through interdivision negotiations. In

recent years, however, top management has played an increased role in such negotiations. In particu-

lar, when the divisions determine a transfer price that can lead to increased taxes, foreign exchange

exposure, or tariffs, the corporate financial function becomes involved. This has meant that the

transfer prices charged by foreign divisions to U.S. sales divisions have fallen to reduce the value

added by the foreign country and thereby reduce the tariffs. To avoid problems with U.S. and Argen-

tine government agencies, the transfer prices have been reduced slowly over time.

One effect of this transfer-pricing strategy has been the continued decline of the foreign divi-

sions’ profitability. Jorge and others have difficulty meeting their profit targets and personal com-

pensation goals because of the continually declining transfer prices.

Required 1. Assess BLP’s manufacturing and marketing strategies. Are they consistent with each other and with

what you consider to be the firm’s overall business strategy?

2. Assess BLP’s performance-measurement system. What changes would you suggest and why?

19-62 Transfer Pricing; Ethics Target Manufacturing, Inc., is a multinational firm with sales and manu-

facturing units in 15 countries. One of its manufacturing units, in country X, sells its product to a

retail unit in country Y for $200,000. The unit in Country X has manufacturing costs of $100,000

for these products. The retail unit in country Y sells the product to final customers for $300,000.

Target is considering adjusting its transfer prices to reduce overall corporate tax liability.

Required 1. Assume that both country X and country Y have corporate income tax rates of 40 percent and that no

special tax treaties or benefits apply to Target. What would be the effect on Target’s total tax burden if

the manufacturing unit raises its price from $200,000 to $240,000?

2. What would be the effect on Target’s total taxes if the manufacturing unit raised its price from $200,000

to $240,000 and the tax rate in country X is 20 percent and in country Y is 40 percent?

3. Comment on the ethical issues you observe, if any, in this case.

19-63 Strategic Performance Measurement With the multinational company (MNC) becoming a sig-

nificant business structure throughout the world, a growing problem is developing in the analysis


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of the MNC’s financial results. When the incidents in this problem occurred, the U.S. dollar was strengthening considerably relative to other currencies. Besides causing economic problems in many developing countries, it also created a problem in the proper evaluation of a multinational’s subsidi-aries and their contribution to its total results.

Security System Corporation provides financial services for dealers and consumers in a variety of construction and consumer product areas. The firm is searching for the proper method to evaluate its subsidiaries. Of concern is each subsidiary’s contribution to the company’s overall earnings and how to evaluate whether the specific goals developed by the subsidiary’s management have been met.

In search of answers, the company is concerned with the following concepts:

• Analysis of results: In local currency or U.S. dollars?

• Management’s explanation of variances: In local currency or U.S. dollars?

• What should the time frames be for comparative data: Plan or forecast?

The company has six distinctive business segments in the new-residential-housing market: con-sumer appliance market, commercial nonresidential construction, consumer aftermarket, home fur-nishings market, automotive market, and capital goods markets. Last year the company achieved 30 percent of its revenues and 35 percent of its earnings from its international subsidiaries. How-ever, years ago, when one British pound sterling equaled US$2.33 (whereas now it’s one pound ! US$1.62), the company achieved 35 percent of its revenue—but more significantly, 47 percent of its earnings—from its international subsidiaries. During the past five years, although the U.S. dollar equivalent of earnings from the international subsidiaries has declined from 47 percent of the total to 35 percent, most operations have reported significant, steady year-to-year gains when expressed in the local currency.

All operations report their monthly financial data to the company’s world headquarters in U.S. dollars. They use the existing exchange rate at the close of business on the last day of the month. The company reports the exchange based on accounting guidelines (except for one or two special situa-tions). The comparisons of the monthly financial data are made against a financial plan that uses a predetermined exchange rate for the various months of the year.

Over the past five years, as the U.S. dollar has fluctuated against foreign currencies, the company has analyzed the financial results of its operations totally in U.S. dollars. It then compares these results to a fixed-plan exchange rate.

The company establishes exchange rates to be used each year, many times optimistically, and then sets an earnings per share (EPS) target on that basis. If the dollar strengthens even more, the company misses its targets and prepares statements showing that a particular group missed its planned targets when, in fact, all of the group’s operations could have exceeded their local currency plans but are losing on the comparison because of unfavorable exchange-rate effects.

Required How should the firm measure its results to enhance its competitive position? How can it safe-guard its overall EPS target if it uses local currencies in the reporting system? Where does the responsibility for the U.S.-dollar-denominated goals lie?

(CMA Adapted)

19-64 Transfer Pricing; Decision Making Bramwell Adhesives, Inc, manufactures chemicals and adhe-sives for commercial and industrial use. Division A is currently purchasing 300 barrels per year of a required chemical (PB4) from an outside supplier for $550 per barrel. The $550 price is a com-petitive, fair price, but Division A is not satisfied with the service and reliability of the supplier. Fortunately, Division A has discovered that another Bramwell division, Division B, has the technol-ogy to manufacture PB4. Division B would have to purchase some new equipment to produce PB4, but the equipment is readily available and can be installed in a timely manner for $90,000. With the purchase of the machine, Division B would have the capacity to produce up to 1,000 barrels of the chemical per year. Division A would be willing to commit to a three-year contract for 300 barrels per year if the divisions could agree on a transfer price.

Division B projects the following costs per barrel for PB4.

Variable manufacturing cost $200 Fixed costs per barrel * 300 Profit margin for Division B (20% of total cost) 100 Total projected price of PB4 to Div A $600 * Allocation of the cost of purchased equipment over three years, based on an assumed production of 300 barrels in each of the three years.


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Required 1. Is the purchase of the new equipment for $90,000 relevant to the decision to transfer internally and/or

the determination of the transfer price?

2. Should Division B sell PB4 to Division A and, if so, at what price?

19-65 Return on Customer; Review of Chapter 5 The concept of return on investment (ROI) has been adapted widely for a variety of uses. One recent development is to extend customer profitability analysis to include the concept of “return on customer.” In Chapter 5, we presented an approach for using ABC to determine the full cost of serving a customer, including product and service, thereby determining the net profit from serving that customer. The analysis was further extended in Chap-ter 5 to calculate a measure of the expected value of the customer based on expected future sales. That value was called customer lifetime value (CLV), which is the net present value of all estimated future profits from the customer. For example, assume a customer is expected to produce profits of $20,000 per year for each of the next three years. Using a discount rate of 6 percent, the CLV for this customer is 2.673 $ $20,000 ! $53,460. (The PV annuity factor, 2.673, is obtained from Appendix C, Chapter 12.)

Return on customer (ROC) can be measured as the increase in customer value plus the current year profit on the customer, relative to the prior year value of the customer. The first step in calculat-ing ROC is to determine the customer lifetime value (CLV) at the end of each year. CLV can rise or fall, as our projections of future profits from the customer increase or decrease. Suppose we have the following information for customer Y:

Customer Lifetime Value at the end of 2009 ! $2,000,000 Customer Lifetime Value at the end of 2010 ! $2,500,000 Profit on sales to customer Y during 2010 ! $250,000

ROC for customer Y for 2010 is determined as follows:

ROCProfit from customer Y in Change i

!"2010 nn CLV from to

CLV for customer Y2009 2010

iin

ROC for customer Y$ $

2009250 000 2 500

!", ,( ,, , ,

, ,000 2 000 000

2 000 000

37 5

#

!

$$

)

. %

ROC gives management a way to further analyze the profitability of a given customer. The goal is to attract and retain high-ROC customers.

Required Assume Customer X has a CLV at the beginning of the year of $150,000, a CLV at the end of the year of $75,000, and that profits from sales to X were $25,000 during the year. Customer Z has a CLV at the end of the year of $100,000, a CLV at the beginning of the year of $50,000, and profits from sales this year of $10,000. Determine the ROC for each customer and interpret the results for these two customers.

19-66 Return on Investment (ROI) for Innovative Companies A survey by BusinessWeek and the Boston Consulting Group identified the world’s 25 most innovative companies, looking at three dimensions of innovation: process innovation, product innovation, and business model innovation. The top-five companies were Apple, Google, 3M, Toyota, and Microsoft. The top-25 companies were great per-formers over the 10-year period 1995–2005. The 25 companies had an average return on sales of 3.4 percent in comparison to 0.40 percent for the Standard & Poor’s 1200 Global Stock Index. The top 25 stock returns, based on increase in stock price and dividends over this 10-year period, averaged a 14.3 percent annual return, in contrast to the 11.1 percent return for the S&P Global 1200. These companies are surpassing the Global 1200 companies in part because of superior innovation.

Required What are the issues to consider in calculating the return on investment (ROI), residual income (RI), and EVA ® for a highly innovative company?

19-67 Research Assignment, Strategy Obtain from your library a copy of following article: Laurie Bassie and Daniel McMurrer, “Maximizing Your Return on People,” Harvard Business Review (March 2007), pp. 115–123. The authors of this article state (p. 123): “Globalization has left only one true path to profitability for firms operating in high-wage, developed nations: to base their com-petitive strategy on exceptional human capital management (HCM) . . . managing human capital by


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instinct and intuition becomes not only inadequate, but reckless. The most competitive companies will be those that manage their employees like the assets they are.”

Required After reading the above-referenced article, answer the following questions: 1. What is the general issue addressed by the authors of this article? That is, what managerial problem are

they discussing?

2. The authors develop a framework that, they assert, can be useful for increasing the long-term value of investments in human capital. What are the two major factors in the authors’ framework? How can the framework be used by managers as part of a comprehensive management accounting and control system?

3. The authors provide three examples of how their evaluation/assessment framework was used in practice to assess the quality of an organization’s HCM. For each example, indicate how organizational perform-ance was defined, and how the evaluation framework proposed by the authors was used to improve that performance. (That is, what principal results were achieved?)

1. Return on Investment (ROI) and Residual Income (RI)

1. ROS Operating income/Sales

$ /$

!

! 640 000 8 000, , ,0000

0 08! .

Asset turnover Sales/Average investment

$

!

! 8,0000 000 2 500 000 2 600 000 2

3 137

, , , , ,.

/ $ $ /

ti

( )"

! mmes

ROI ROS Asset turnover! $

! $

!

0 08 3 137

25 1

. .. %

2. Residual income Operating income Average i! # ( nnvestment Minimum rate of return

$

$

!

)

640 000, ## " $

!

([( ) ] )$ $ /

$

2 500 000 2 600 000 2 0 12

334 0

, , , , ., 000

2. Determining the Proper Transfer Price 1. Since the T-Bar unit is at full capacity and the contribution on outside sales of $70 ( ! $165 # $5 # $90)

is higher than the $60 cost saving of inside production ( ! $150 # $90), the T-Bar unit should sell out-side and the adhesive unit should purchase T-Bar for $150 outside the firm.

2. From the standpoint of the company as a whole, the correct decision is induced if we appeal to the general transfer-pricing rule. The minimum transfer price, from the firm’s standpoint, is the sum of out-of-pocket costs of the T-Bar division ($90) plus the opportunity cost, if any, incurred because of an internal transfer ($70 = $165 # $90 # $5), or a total of $160. At this amount, the adhesive division will be motivated to purchase externally (at $150/unit) and the T-Bar unit will be indifferent between selling internally (contribution margin per unit = $160 # $90 = $70) and selling externally (contribution mar-gin per unit = $165 # $90 # $5 = $70). Because of the latter, we say that $160 represents a minimum transfer price.

3. If the T-Bar unit has excess capacity, it can sell T-Bar both internally and externally. The correct transfer price is then the price that will cause the adhesive unit to purchase internally; that is, any price between variable cost of the seller ($90) and the outside market price to the adhesive unit ($150). The units might agree on a price by considering what is a fair return to each unit and in effect split the profit on the sale between them. The actual outcome of the negotiations for the transfer price depends on a number of fac-tors, including the negotiation skills of the two managers.

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