EMBA Presentation
November 15,2012
INTERNAL PERFORMANCE
MEASUREMENT AND TRANSFER
PRICING
Internal Performance
Measurement
 Responsibility Centers
 Residual Income
 Return on Investment
 EVA
Responsibility Centers
 Cost center
 Profit center
 Investment center
Schematic
Investment
Center
Profit
Center
Cost
Center
Cost
Center
Profit
Center
Cost
Center
Cost
Center
Summary of Performance
Centers
Type of Center
Decision Rights
Performance
Measures
Cost
Input Mix
Cost controls
Profit
Product Mix, Selling
Prices, Input Mix
Actual Profits,
Budget Comparisons
Investment
Input Mix, Product
Mix, Selling Prices,
Capital Invested
ROI, Residual
Income, EVA
Schematic of the ROI Method
Sales
Sales
Turnover
ROI
Divided by
Total
Investment
Multiplied by
Earnings
Return on
Sales
Divided by
Sales
ROI Example
Sales
Net Operating Income
Total Investment
$9,000,000
$ 720,000
$4,000,000
Sales Turnover $9,000,000  $4,000,000 = 2.25
Return on Sales $720,000  $9,000,000 = 8%
ROI 2.25 x .08 = 18%
Criticisms of ROI
 Managers may make decisions that increase the
ROI in the short run
 Managers often inherit costs over which they
have no control
 Managers may reject investment opportunities
that are good for the organization, but negatively
impact the segment
Residual Income
Focuses on the residual return after deducting the minimum
return required by top management
Residual Income = NOI –
Average
Operating
Assets
X
Minimum
Required
Rate of Return
Example of Residual Income
Global Equities Corporation
Analyis of ROI and Residual Income
Sales
Net Operating Income
Average Operating Assets
Europa
American
Division
Division
$ 3,000,000
$ 210,000
$ 1,000,000
$ 9,000,000
$ 720,000
$ 4,000,000
Return on Investment (ROI)
21%
18%
Residual Income Approach:
Assume Global Expects a 15% return on net operating assets
Return on Average Operating Assets at 15%
$
150,000
$
600,000
Net Operating Income
$
210,000
$
720,000
Residual Income
$
60,000
$
120,000
Greatest deficiency is that the method does not take into consideration size of the segment
Criticisms of Residual
Income
 Absolute number that ignores investment
center size
 Does not measure risk factors
 Opportunity cost of capital is different
between investment centers
Calculation of EVA
Adjusted
EVA = Accounting –
Earnings
Weighted Cost of Capital
X
Total Capital
Calculation of EVA Earnings
•
•
•
•
•
Earnings per GAAP
Less cost of capital used by the center
Plus R & D expenses deducted
Add amortization of R & D
Equals EVA Earnings
Capital Formula for EVA
Total Capital Invested Plus Capitalized R & D Costs
Example Using EVA
Operating Income plus R & D Expenses
Less Amortization of R & D Expenses
Adjusted Earning for EVA
Invested Capital
Plus Capitalized R & D
EVA Capital
EVA Rate
$900,000
100,000
$800,000
$4,000,000
1,000,000
$5,000,000
16%
Controllability Principle
Westinghouse Nuclear Case
Transfer Pricing Topics
 What is transfer pricing?
 Terms
 Delco example
 Transfer pricing methods
 Car dealership example
 Summary of transfer pricing methods
 International and tax ramifications
A transfer price is the
price one sub-unit charges
another for a product or
service supplied to it
Terms
 Full cost – includes both fixed and variable
components
 Variable cost – includes only the costs directly
related to producing the product
 Idle capacity – plant capacity available for
additional manufacturing without incurring more
fixed costs
 Substitute products – competitive products are
available in the open market a lower price
Congruence Problems
 Management expects sub-units to act in a
manner that maximizes firm-wide profits
 Management desires that product family
members be used throughout the firm
 Unit managers operate in a manner that
optimizes the profitability of their unit which is
often reflected in their incentives
Delco Example
Delco
Manufactures
Batteries
?
Chevrolet
$40
After Market
Outside market
Full cost
Variable cost
$40
$30
$20
Delco has excess capacity
Transfer Pricing Methods
 Market based
 Cost based
 Negotiated
 Dual
Market Prices Lead to
Optimal Decisions
When:
 The market for the intermediate product is
perfectly competitive
 Interdependence of subunits is minimal
 No additional costs in buying or selling in the
external market compared to the internal
Cost Based Transfer Prices
 Full cost – price includes both the fixed and variable
component
 If excess capacity is used, there should be no additional
fixed costs
 Fixed costs may be allocated between external and internal
sales
 Full costing may be more appropriate where a firm uses
ABC costing
 Variable cost – includes only the incremental cost
Negotiated Prices
 Mutual agreement between sub-units
 May have no relationship to cost or market
prices
 May be affected by a unit’s ability to
negotiate
Dual Pricing
 In this case, the selling division and the buying
division do not pay or receive the same amount
 Seller gets full cost and buyer pays market
 Difference rolls to a corporate account
 May cause divisional tax calculation problems
 Selling unit has no incentive to control costs
Car Dealer Example
Departments:
Service labor rate
Body shop labor rate
Parts mark-up
New Vehicles, Used Vehicles, Service,
Body Shop, and Parts Department
New
$40
$40
15%
Used
$40
$40
15%
Body
15%
Service Retail
$65
$40
$65
15%
30%
Summary of Methods
Domestic
Multinational
Market based
26%
35%
Cost based:
Variable
Full cost
Other
Total
3%
49%
1%
53%
0%
42%
1%
43%
Negotiated
17%
14%
4%
8%
100%
100%
Other
TOTAL
International and Tax
Ramifications
 Large firms are global in nature
 Firms sell products between international
subsidiaries or joint ventures
 Tax rates vary between countries
 International firms will transfer price to
minimize total taxes paid
Taxes Paid on Box of Contact
Lenses in The Netherlands
Transfer
Price at
80 Euros
Transfer
Price at
110 Euros
Taxes Paid in Netherlands:
Revenue (Transfer Price)
€ 80
Variable Cost
Taxable Income
Tax Rate
Dutch Taxes
(50)
€110
(50)
€ 30
€ 60
30%
30%
€
9
€ 18
Taxes Paid in Australia
Transfer
Price at
80 Euros
Transfer
Price at
110 Euros
Taxes Paid in Australia:
Revenue (Australian Dollars)
A$ 85
A$ 85
Transfer Price in Euros:
80 x .70
110 x .70
A$ (56)
-
-
A$ (77)
A$ 29
A$ 8
40%
40%
Australian Taxes
A$ 11.6
A$ 3.20
Converted to Euros at .70 Rate
€ 16.57
€ 4.57
Taxable Income
Tax Rate
Comparison of Results
Transfer
Price at
80 Euros
Transfer
Price at
110 Euros
Dutch Taxes
€ 9.00
€ 18.00
Australian Taxes
16.57
4.57
€ 25.57
€ 22.57
Total
Eastman Kodak Case
Copyright, Frank Ilett, 2012