Chapter 18
Strategic Investment Units and Transfer Pricing
Teaching Notes for Cases
18-1. Investment SBUs; Strategy; International Issues
1. The prior performance measurement system was called “performance income,” and is best described as a profit SBU method. Tvhe focus was on divisional profits.
2. The new system called “asset management,” is best described as an investment SBU method. The system is focused on return on investment, as described in the case, where it is called “return on capital.” The advantage of the investment SBU approach is that it focuses managers’ attention on the management of assets. Also, it brings managers’ incentives in line with that of the entire firm, to increase the return on investment of the firm.
The change to the investment SBU is consistent with Polymer’s new strategy, which is to withdraw from activities, which do not fit the overall firm’s competitive advantage. The investment SBU approach is useful here to identify those units where the profitability is marginal, since the firm wishes to focus on the most profitable units, and divest or consolidate the others. ROI provides a useful basis to make this analysis. Thus, choosing investment SBUs is consistent with the present competitive strategy.
ROI is often the desired performance measure in firms such as Polymer, where the activities are diverse and complex, and comparison among the activities is difficult.
3. A common view is that foreign exchange gains and losses are a non-controllable element that should be excluded from the manager’s evaluation. In contrast, many now view the manager’s responsibility more broadly and urge that foreign exchange can be managed. The potential for exchange rate losses can be managed by hedging, that is, purchasing financial instruments, which protect the firm from significant swings in currencies. A common argument is that the firm is in the business of making and selling products and services, and the management of foreign exchange can be delegated to financial service firms, banks, etc., which will provide the desired hedging. The cost of hedging is small relative to the potential losses.
Also, managers can adapt to foreign exchange changes by relocating manufacturing and other activities over the longer term. Overall, the firm should be watchful of what individual managers are doing to adapt to foreign exchange changes, both favorable and unfavorable. For this reason, it is desirable to include foreign exchange gains and losses in the manager’s performance evaluation, as Polymer Products is doing.
Income taxes, like foreign exchange, are often viewed as uncontrollable to the manager. However, this overlooks the fact that the manager can often take steps to reduce taxes, by relocating operations and changing sources of supply, etc. Thus, in a manner similar to that of foreign exchange noted above, it is desirable for income taxes to be also included in the manager’s performance evaluation. This places the appropriate incentive for the manager to reduce taxes for the benefit of the firm as a whole.
A common problem with both profit SBUs and investment SBUs is that the performance measures promote short-term decision making. In this case, Polymer Products has adopted a “performance shares” approach. This is described in the next to last paragraph of the case: “...stock which is accessible only after 3 years...” Performance shares are a type of deferred income in which the compensation to the manager depends on the success of certain critical financial and non-financial measures over a period of time (see Chapter 20 for a discussion of this method). In effect, Polymer Products has recognized the inherent bias to the short-term in the ROI measure, and is using performance shares to provide an incentive for longer term thinking and action by the managers.
18-2. Transfer Pricing; Strategy
1. In order to maximize short-run contribution margin, the Cole Division should accept the contract from Wales Company. This conclusion is supported by the following calculations ($000's omitted throughout the calculations.). See graphic below which shows product flows, prices and variable costs to assist in understanding the analysis.
From the Cole Division Point of view
a. Cole transfer to Diamond
Transfer price - Cole to Diamond
(3,000 units @ $1,500 each) $4,500
Variable cost
Purchase from Bayside
(3,000 units @ $600 each) $1,800
Processing by Cole
(3,000 units @ $500 each) 1,500
Total variable cost 3,300
Contribution margin $1,200
b. Cole accepts Wales contract
Selling Price (3,500 units @ $1,250 each) $4,375
Variable cost
Purchase from Bayside
(3,500 units @ $500 each) $1,750
Processing by Cole
(3,500 units @ $400 each) 1,400
Total variable cost 3,150
Contribution margin $1,225
Conclusion for the Cole Division
Contribution margin from Wales contract $1,225
Contribution margin from Diamond sale 1,200
Difference in favor of Wales contract $ 25
From the point of view of the cost to the entire company:
a. Cole transfer to Diamond
Variable cost
Bayside
(3,000 units @ $300 each) $900
Cole
(3,000 units @ $500 each) 1,500
Total variable cost $2,400
b. Cole accepts Wales contract; then the following shows the three parts to the calculation, including the opportunity cost of lost contribution to Bayside and Cole:
1. Contribution of Wales Contract to Cole
Selling Price (3,500 units @ $1,250 each) $4,375
Variable cost
Purchase from Bayside
(3,500 units @ $250 each) $875
Processing by Cole
(3,500 units @ $400 each) 1,400
Total variable cost 2,275
Contribution to Cole $2,100
2. Plus: Contribution of London Contract to Bayside
Selling Price (3,000 x $400) $1,200
Variable Cost (3,000 x $200) 600
Contribution to Bayside $600
3. Less: Cost of outside purchase to Diamond
Selling price to Diamond: (3,000 x $1,500) $4,500
Net Cost to the company of the Wales contract to Cole
= $4,500 - $600 - $2,100 $1,800
Conclusion for the Entire Company; Relevant Costs
Cole Transfers to Diamond $2,400
Cole Sells to Wales 1,800
Difference favoring the Wales Contract $ 600
It appears that the solution is to have Cole Division accept the Wales contract, either from the division’s or the company’s point of view, though the calculations differ considerably. From the firm’s point of view, the Wales contract is a lot more attractive than it is to the Cole Division ($600 versus $25).
18-2 (continued)
2. The strategic issues Robert Products should consider include:
· Is the structure of the transfer pricing system set properly so that division managers choose what is in the best interests of the firm? In this case, Cole Division should choose the Wales contract, but that should be based on the best interests of the firm, including the contribution of sales to the Bayside division for sales to London if Diamond buys from London.
· What is the promise of future business with the Wales Company? If this will be a one time sale, then this is a far less attractive contract than if there is a promise of future sales.
· How will it affect the reputation or other opportunities to Robert Products to have done business with Wales and London?
· Will the product from London be equivalent in quality and service to the product from the Dole division?
18-3 Transfer Pricing (Foreign Sales Corporations)
1. A wide variety of responses are likely for this case exercise, depending on the depth of the student’s research. There are a number of useful references on Foreign Sales Corporations (FSCs), one of which is noted in the case assignment. Also, two recent articles in Business Week are useful: “This Tax Break Could Trigger a War,” by Paul Magnusson, September 4, 2000, p103 and “U.S. Exporters Get the Word: Guilty,” by Paul Magnusson, August 16, 1999, p 42.
Note: Since the status of FSCs is under active consideration within the U.S. Congress at the present time (April 2001), it is possible that the matter might have been settled at the time the case is assigned. If the matter has been settled, then the nature of the assignment should shift to an understanding and critique of the nature of the settlement or legal change that was enacted, including the expected effects on U.S. exporters and the firms they compete with globally.
2. I would expect the students to address at least a number of the following issues (in no particular order):
a) The ethical issue: should U.S. exporters have what appears to be an unfair advantage in international trade?
b) The legal issue: are FSCs in conflict with international law?
c) Have FSCs accomplished the goal set in 1971 when the law establishing FSCs was enacted? Some say the law was enacted to narrow the U.S. trade gap at the time, but the trade gap has continued to grow.
d) Who most benefits from FSCs and who is most adversely affected, and why? The group most helped by FSCs are the U.S. exporters such as Boeing and Kodak while competitors in the EU (European Union) are hurt because they do not have access to the favorable tax treatment.
e) What are the impacts of FSCs in monetary terms? Business Week reports tax savings to U.S. corporations of approximately $2.3 billion in 1992.
f) What is the outlook for FSCs in the future?
18-4 Interior Systems, Inc
The purpose of this case is to introduce and critique the use of “residual income” measures for decision making, performance evaluation and incentive compensation. As indicated in the case, Stern Stewart’s version of residual income, Economic Value Added (EVA®), has become increasingly popular in recent years. EVA® has received favorable press coverage and adoptions from major corporations including Briggs & Stratton Corp., Coca-Cola Co., and Eli Lilly and Co (see Tully 1993, 1998; Fisher 1995). The case has been used successfully at the undergraduate level, in M.B.A. programs and in executive programs. At the M.B.A. level, the authors have used the case with both traditional full-time students as well as Executive M.B.A. students. As indicated by our dedication on the title page, the case was inspired by our interaction with Professor Bill Alberts. Although the case materials are fictitious, they benefited greatly from discussions with Bill and a number of executives at companies that considered or adopted EVA®. For example, the situation in Airline Interiors division (discussed below) is loosely based on the Boeing Company.
The Setting
Each division of Interior Systems (the Company) has a different market and different key drivers for success; e.g, Airline Interiors’ (AI) key drivers are innovation, new orders (leading to a backlog) and, probably, productivity improvements (though this latter item is not discussed in the case). Since sales lag orders (potentially by years), accounting numbers are slow in reporting performance and are likely to be poorly correlated with stock price movements (once the Company is publicly traded). In contrast, Office Solutions (OS) is selling in the intensely price-competitive office furniture market. Current period sales and expenses are key indicators of success. The division shows earnings and sales growth, but ROA is declining. (ROA is not explicitly provided but can be easily calculated.) OS has excess capacity and proposes to add a “profitable” new product to its line of office furniture, the E-chair.
Suggested Solution to Case Questions in the Engagement Letter (Exhibit 7)
1. EVA® calculations are included in exhibit TN-1 (for Airline Interiors) and exhibit TN-2 (for Office Solutions).Major points include:
AI division EVA® performance:
• Strong in 1991 and 1992; EVA® is positive, consistent with creating increased shareholder value.
• Very negative during downturn of 1993 and 1994 (consistent with destroying shareholder value)—but recovery in 1995.
• Over the past five years, the three positive EVA® years have not overcome the two negative EVA® years. Not surprisingly, EVA® appears to fluctuate with cycles in the industry. To get a picture of AI’s long-term profitability, one would have to observe a complete business cycle.
OS division EVA® performance:
• Positive in 1991, somewhat negative in 1992–1994 and increasingly negative in 1995.
• Trend suggests that OS division is destroying shareholder value and therefore has not yet met the goal of stabilizing the cycles experienced by the AI division.
2. EVA® is likely to affect managerial decisions. (See exhibit TN-4 for elaboration and summary of results from Wallace [1997], a study on firms’ adoption of EVA®-like incentive plans.)
2a. Other things equal, management should find that fewer projects are viewed as acceptable since each project must now earn greater than the overall, after-tax, weighted cost of capital. (With profits as a performance measure, any project that earns more than the imbedded cost of debt increases earnings.) Profitable projects (such as the E-chair proposal) will be rejected if they are not predicted to cover the cost of capital. Exhibit TN-3A includes a traditional discounted expected cash flow analysis and exhibit TN-3B presents a discounted expected EVA® analysis of the E-chair proposal using the assumption that the necessary capital investment is $4 million. Note that, given the same set of assumptions (discussed next), both approaches arrive at the same NPV. Exhibits TN-3C and 3D repeat the calculations using the assumption that the necessary capital investment is $4.5 million.
Assumptions (not made explicit in the case) include:
• The single year of cash flows provided in exhibit 4 is representative of all years of the project’s life. This suggests that there is no learning curve and no decay in performance throughout the project’s life. Constant performance throughout the project’s life is consistent with no competitive entry and thus is a particularly strong assumption.
• Tax treatment is based on income before EVA® adjustments.
• The appropriate hurdle rate for this project is OS division’s 1995 cost of capital (from exhibit 3).
• No inflation throughout the life of the project. (A close approximation would be to assume the division’s cost of capital is a “real” [vs. nominal] rate of return and is appropriately matched against “real” [vs. nominal] cash flows in exhibit 4. This is not precisely correct because, for example, tax savings related to depreciation deductions are nominal cash flows.)
Given the above assumptions, the quantitative attractiveness of the E-chair proposal hinges on the size of the initial investment in depreciable assets.
At $4 million (provided in exhibits TN-3A and 3B), the project has:
• a payback of 6.5 years
• positive incremental earnings in each year
• negative EVA® for 1997 through 1999
• a positive NPV of $265,000
At $4.5 million (provided in 10C and D), the project has:
• a payback of 7 years
• positive incremental earnings in each year
• negative EVA® for 1997 through 2001