Investment Centers and Transfer
Pricing

Top managers of large companies evaluate their
divisions as investment centers. The manager of an
investment center is held accountable for the center’s
profit and the capital invested to earn that profit.
– Decentralized companies must create an incentive program
to maximize the goal congruence that business units have
with the company’s overall objectives.
– The biggest factor in deciding how well the responsibility
accounting system works creating a system that properly
directs managers’ efforts toward organizational goals.

This chapter covers ways in which a company can
best measure business unit performance and set
transfer pricing between business units
Return on Investment (ROI)

The most common investment center performance
measure is return on investment.
ROI = Income / Invested Capital
or
(Income / Sales Revenue) * (Sales Revenue / Invested Capital)
or
Sales Margin * Capital Turnover

ROI’s drawback: it ignores the firm’s cost of raising capital
– Because of this, many managers prefer to use residual income
Residual Income
ROI = Investment Center’s Profit (Investment Center’s Invested Capital * Imputed Interest Rate)

The imputed interest rate is the estimated interest charge set to
reflect the company’s minimum required rate of return on
invested capital.
– The drawback for residual income is that it can only be used to
compare investment centers of similar size or a bias is incorporated
in favor of the larger investment center.
Measuring Income and Invested
Capital



Both ROI and residual income rely on profit and invested capital
in their formulas.
Since these performance measures are computed for a period
of time, the balances used in calculating income and invested
capital should be an average of the value during the measured
period of time.
The assets used to determine invested capital depend upon the
management structure of the investment center.
– Average total assets are used when the manager has considerable
authority in making decisions about all of the divisions’ assets,
including non-productive assets.
– Total productive assets leads to the correct measurement when
divisions are instructed to keep non-productive assets in progress.
– Total assets less current liabilities measures investment capital
when managers can secure bank loans and short term credit.
Transfer Pricing


The transfer price is the price charged when one division sells
goods or services to another division.
Setting transfer prices is a difficult process because the price
affects investment center profitability.
– A high transfer price results in high profit for the selling investment
center and low profit for the buying investment center
– A low transfer price results in low profit for the selling investment
center and high profit for the buying investment center

The price must be set to establish incentives for decentralized
investment center managers to make decisions that support the
overall goals of the organization.
General Transfer-Pricing Rule
Additional outlay cost per
Opportunity cost per unit
unit incurred because +
to the organization
Transfer Price =
goods are transferred
because of the transfer
Transfer Pricing Options

External Market Price
– Use if the selling unit has no excess capacity and perfect
competition exists.
– Here, the general transfer rule and the external market price are
equal
– The long-run average external market price should be used,
because distressed market prices can severely affect transfer
pricing profitability.

Negotiated Transfer Price
– It is common for managers to negotiate transfer prices from the
external market price.
– This can split the cost savings between both units, but can lead to
divisiveness and competition between investment centers.
Cost-Based Transfer Pricing
Options

Variable Cost
– Variable cost is used as the transfer price
– The biggest drawback with using variable cost is that when excess
capacity exists, the selling unit can’t show contribution margin on
the transferred goods.

Full Cost
– FC - VC + allocated fixed overhead
– The biggest drawback affects the buying unit’s view of costs as
fixed for the company as a whole as the variable costs for the
buying unit.