16
Financial
Performance
Evaluation and
Transfer Pricing in
the Decentralized
Firm
PowerPresentation® prepared by
David J. McConomy, Queen’s University
Copyright © 2004 by Nelson, a division of Thomson Canada Limited.
16-1
Learning Objectives

Define responsibility accounting and
describe four types of responsibility
centres.

Explain why companies decentralize.
Copyright © 2004 by Nelson, a division of Thomson Canada Limited.
16-2
Learning Objectives

Compute and interpret return on
investment (ROI), residual income (RI)
and economic value added (EVA).

Explain the role of transfer pricing in
decentralized companies.
Copyright © 2004 by Nelson, a division of Thomson Canada Limited.
16-3
Responsibility Accounting
Responsibility accounting is a system that
measures the results of each responsibility
centre according to the information managers
need to operate their centres.
There are four major types of responsibility centres:
•
Cost centre
•
Revenue centre
•
Profit centre
•
Investment centre
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16-4
Decentralization: The Major Issues

The degree of decentralization

Performance measurement

Management compensation

The setting of transfer prices
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16-5
Reasons for Decentralization
There are many reasons to explain why firms
decide to decentralize, including:
1. Utilization of local information
2. Strategic focus of central
management
3. Training and motivational
opportunities for managers
4. Enhanced competition among
divisions
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16-6
Measuring the Performance of
Investment Centres

Return on Investment
(ROI)

Residual Income (RI)

Economic Value Added
(EVA)
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16-7
Components of ROI
Decomposition of the ROI formula:
ROI = Operating income/Average operating assets
= (Operating income/Sales) x (Sales/Average
operating assets)
= Operating income margin x Operating asset
turnover
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16-8
An ROI Example
2004
Sales
Operating income
Average operating assets
Electronics Div.
$30,000,000
1,800,000
10,000,000
2005
Sales
Operating income
Average operating assets
$40,000,000
2,500,000
10,000,000
Medical Supplies Div.
$117,000,000
3,510,000
19,500,000
$117,000,000
2,925,000
19,500,000
Minimum return of 10%
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16-9
Margin and Turnover Comparisons
Electronics
2004
2005
Medical Products
2004
2005
Margin
6.0%
5.0%
3.0%
2.5%
Turnover
x 3.0
x 4.0
x 6.0
x 6.0
18.0%
20.0%
18.0%
15.0%
ROI
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16-10
Advantages of ROI

Relationships among sales, expenses, and
investments.

Cost efficiency.

Operating asset efficiency.
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16-11
Disadvantages of the ROI Measure

Focus on divisional profitability at the
expense of overall company profitability

Focus on the short term at the expense of
the long term
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16-12
Components of RI
Decomposition of the RI formula:
RI = Operating income- (Minimum rate of return x Operating
assets)
= Operating income – Minimum return on Assets
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16-13
An RI Example
Operating Income
Average Operating Assets
Minimum Return
Residual Income
Project 1
$1,300,000
10,000,000
10%
Project 2
$640,000
4,000,000
10%
$300,000
$240,000
Both projects have a positive residual income, take them both if funds
are available.
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16-14
Advantages of Residual Income

Focus on accepting projects that are
advantageous to the company
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16-15
Disadvantages of the RI Measure

Focus on the short term at the
expense of the long term

An absolute measure of profitability
makes it difficult to compare
alternatives
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16-16
Economic Value Added
Economic value added (EVA) is after-tax
operating profit minus the total annual
cost of capital.
EVA = After-tax operating income (Weighted average cost of capital x
total capital employed)
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16-17
Cost of Capital
There are two steps
involved in computing
cost of capital:
1.
determine the weighted
average cost of capital
(a percentage figure)
2.
determine the total
dollar amount of capital
employed
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16-18
Weighted Average
Cost of Capital
Suppose that a company has two sources of financing: $2 million of longterm bonds paying 9 percent interest and $6 million of common stock,
which is considered to be of average risk. If the company’s tax rate is 40
percent and the rate of interest on long-term government bonds is 6
percent, the company’s weighted average cost of capital is computed as
follows:
Amount
Percent
Bonds
$2,000,000
0.25
.09(1.0 - 0.4) = .054
0.0135
Equity
6,000,000
0.75
.06 + .06
0.0900
Total
$8,000,000
========
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x
After-tax cost
= Weighted Cost
= .120
0.1035
=====
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EVA Example
Suppose that Mahalo, Inc., had after-tax operating
income last year of $1,700,000. Mahalo, Inc. pays a
marginal tax rate of 40 percent. Three sources of
financing were used by the company:
–
$2 million of mortgage bonds paying 8 percent interest,
–
$3 million of unsecured bonds paying 10 percent
interest, and
–
$10 million in common stock, which was considered to
be no more or less risky than other stocks.
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16-20
Weighted Average Cost of Capital
The weighted average cost of capital for Mahalo, Inc. is computed as follows:
Amount
Mortgage bonds
Percent x After-Tax Cost = Weighted Cost
$ 2,000,000
0.133
0.048
0.006
3,000,000
0.200
0.060
0.012
Common stock
10,000,000
0.667
0.120
0.080
Total
$15,000,000
=========
Unsecured bonds
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0.098
====
16-21
EVA Example
Mahalo’s EVA is calculated as follows:
After tax operating income
$1,700,000
Less: Cost of capital
1,470,000
EVA
$230,000
========
The positive EVA means that Mahalo, Inc. earned operating
profit over and above the cost of capital used.
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16-22
Behavioural Aspects of EVA

A number of companies have discovered that EVA
helps to encourage the right kind of behaviour from
their divisions in a way that emphasis on operating
income alone cannot. The underlying reason is
EVA’s reliance on the true cost of capital.

In many companies, the responsibility for
investment decisions rests with corporate
management. As a result, the cost of capital is
considered a corporate expense. If a division builds
inventories and investment, the cost of financing
that investment is passed along to the overall
(corporate) income statement and does not show up
as a reduction from the division’s operating income.
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16-23
Features of EVA for Internal Performance
Evaluation
1. A major advantage of EVA is that it
discourages managers from using their
current ROI as the effective hurdle rate to
turn down investments.
2. Like ROI, EVA encourages short run
orientation.
3. EVA uses an absolute measure of
profitability, making direct comparison of
profitability of divisions with different
investment bases unfair since the level of
investment may differ.
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16-24
Multiple Performance Measurements

Why have Multiple
Performance
Measures?
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
Tends to Focus on Long-run
Discourages Myopic Behaviour
16-25
Transfer Pricing
The transferred good is
revenue to the selling
division and cost to the
buying division. This value
is called a transfer price.
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16-26
Transfer Pricing: General Concerns
Some Major Issues

Impact on divisional performance measures

Impact on firm-wide profits

Impact on divisional autonomy
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16-27
Transfer Pricing Approaches



Market price
Negotiated transfer prices
Cost-based transfer prices
–
–
Variable cost
Full (absorption cost)
Transfer price = Variable cost per unit + Lost contribution per
unit on outside sales
This relationship identifies the minimum and maximum transfer
prices
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16-28
A Transfer Pricing Problem
Assume the following data for Division A:
Capacity in units
Selling price to outside
Variable cost per unit
Fixed costs per unit (based on capacity)
50,000
$15
8
5
Division B would like to purchase units for Division A.
Division B is currently purchasing 5,000 units per year
from and outside source at a cost of $14.
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16-29
A Transfer Problem Example
(continued)
1.
2.
3.
Assume Division A has idle capacity in excess of 10,000 units:
Minimum transfer price = Variable cost + Lost contribution margin
= $8 + $0
= $8
Assume Division A is working at capacity:
Transfer Price
= Variable cost + Lost contribution margin
= $8 + $7
= $15 (market price)
Assume Division A is working at capacity, but a negotiated $2 in
variable costs can be avoided on intercompany sales.
Transfer Price
= Variable cost + Lost contribution margin
= $6 + $7
= $13 (negotiated price)
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16-30