Investment Centers and Transfer Pricing

CHAPTER 13

Investment Centers and Transfer Pricing

ANSWERS to Review Questions

13-1Goal congruence means a meshing of objectives, in which the managers throughout an organization strive to achieve goals that are consistent with the goals set by top management. Goal congruence is important for organizational success because managers often are unaware of the effects of their decisions on the organization's other subunits. Also, it is natural for people to be more concerned with the performance of their own subunit than with the effectiveness of the entire organization. In order for the organization to be effective, it is important that everyone in it be striving for the same ultimate objectives.

13-2The managerial accountant's primary objective in designing a responsibility-accounting system is to provide incentives for the organization's subunit managers to strive toward achieving the organization's goals.

13-3Under the management-by-objectives (MBO) philosophy, managers participate in setting goals that they then strive to achieve. These goals may be expressed in financial or other quantitative terms, and the responsibility-accounting system is used to evaluate performance in achieving them. The MBO approach is consistent with an emphasis on obtaining goal congruence throughout an organization.

13-4An investment center is a responsibility-accounting center, the manager of which is held accountable not only for the investment center's profit but also for the capital invested to earn that profit. Examples of investment centers include a division of a manufacturing company, a large geographical territory of a hotel chain, and a geographical territory consisting of several stores in a retail company.

13-5

13-6A division's ROI can be improved by improving the sales margin, by improving the capital turnover, or by some combination of the two. The manager of the automobile division of an insurance company could improve the sales margin by increasing the profit margin on each insurance policy sold. As a result, every sales dollar would generate more income. The capital turnover could be improved by increasing sales of insurance policies while keeping invested capital fixed, or by decreasing the invested assets required to generate the same sales revenue.

13-7Example of the calculation of residual income: Suppose an investment center's profit is $100,000, invested capital is $800,000, and the imputed interest rate is 12 percent:

Residual income = $100,000  ($800,000) (12%) = $4,000

The imputed interest rate is used in calculating residual income, but it is not used in computing ROI. The imputed interest rate reflects the firm's minimum required rate of return on invested capital.

13-8The chief disadvantage of ROI is that for an investment that earns a rate of return greater than the company's cost of raising capital, the manager in charge of deciding about that investment may have an incentive to reject it if the investment would result in reducing the manager's ROI. The residual-income measure eliminates this disadvantage by including in the residual-income calculation the imputed interest rate, which reflects the firm's cost of capital. Any project that earns a return greater than the imputed interest rate will show a positive residual income.

13-9The rise in ROI or residual income across time results from the fact that periodic depreciation charges reduce the book value of the asset, which is generally used in determining the investment base to use in the ROI or residual-income calculation. This phenomenon can have a serious effect on the incentives of investment-center managers. Investment centers with old assets will show higher ROIs than investment centers with relatively new assets. This result can discourage investment-center managers from investing in new equipment. If this behavioral tendency persists for a long time, a division's assets can become obsolete, making the division uncompetitive.

13-10The economic value added (EVA) is defined as follows:

Economic value added differs from residual income in its subtraction of the investment center’s current liabilities and its specific use of the weighted-average cost of capital.

13-11a.Total assets: Includes all divisional assets. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets, including nonproductive assets.

b.Total productive assets: Excludes assets that are not in service, such as construction in progress. This measure is appropriate when a division manager is directed by top management to keep nonproductive assets, such as vacant land or construction in progress.

c.Total assets less current liabilities: All divisional assets minus current liabilities. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. This approach encourages investment-center managers to minimize resources tied up in assets and maximize the use of short-term credit to finance operations.

13-12The use of gross book value instead of net book value to measure a division's invested capital eliminates the problem of an artificially increasing ROI or residual income across time. Also, the usual methods of computing depreciation, such as straight-line or declining-balance methods, are arbitrary. As a result, some managers prefer not to allow these depreciation charges to affect ROI or residual-income calculations.

13-13It is important to make a distinction between an investment center and its manager, because in evaluating the manager's performance, only revenues and costs that the manager can control or significantly influence should be included in the profit measure. The objective of the manager's performance measure is to provide an incentive for that manager to adhere to goal-congruent behavior. In evaluating the investment center as a viable economic investment, all revenues and costs that are traceable to the investment center should be considered. Controllability is not an issue in this case.

13-14Pay for performance is a one-time cash payment to an investment-center manager as a reward for meeting a predetermined criterion on a specified performance measure. The objective of pay for performance is to get the manager to strive to achieve the performance target that triggers the payment.

13-15An alternative to using ROI or residual income to evaluate a division is to look at its income and invested capital separately. Actual divisional profit for a period of time is compared to a flexible budget, and variances are used to analyze performance. The division's major investments are evaluated through a postaudit of the investment decisions. This approach avoids the necessity of combining profit and invested capital in a single measure, such as ROI or residual income.

13-16During periods of inflation, historical-cost asset values soon cease to reflect the cost of replacing those assets. Therefore, some accountants argue that investment-center performance measures based on historical-cost accounting are misleading. Most managers, however, believe that measures based on historical-cost accounting are adequate when used in conjunction with budgets and performance targets.

13-17Examples of nonfinancial measures that could be used to evaluate a division of an insurance company include the following: (1) new policies issued and insurance claims settled in a specified period of time, (2) average time required to settle an insurance claim, and (3) number of insurance claims settled without litigation versus claims that require litigation.

13-18Nonfinancial information is useful in measuring investment-center performance because it gives top management insight into the summary financial measures such as ROI or residual income. By keeping track of important nonfinancial data, top managers often can see a problem developing before it becomes a serious problem. For example, if a manufacturer's rate of defective products has been increasing over some period of time, management can observe this phenomenon and take steps to improve product quality before serious damage is done to customer relations.

13-19The goal in setting transfer prices is to establish incentives for autonomous division managers to make decisions that support the overall goals of the organization. Transfer prices should be chosen so that each division manager, when striving to maximize his or her own division's profit, makes the decision that maximizes the company's profit.

13-20Four methods by which transfer prices may be set are as follows:

(a)Transfer price = additional outlay costs incurred because goods are transferred + opportunity costs to the organization because of the transfer.

(b)Transfer price = external market price.

(c)Transfer prices may be set on the basis of negotiations among the division managers.

(d)Transfer prices may be based on the cost of producing the goods or services to be transferred.

13-21When the transferring division has excess capacity, the opportunity cost of producing a unit for transfer is zero.

13-22The management of a multinational company has an incentive to set transfer prices so as to minimize the income reported for divisions in countries with relatively high income-tax rates, and to shift this income to divisions with relatively low income-tax rates. Some countries' tax laws prohibit this practice, while other countries' laws permit it.

13-23Multinational firms may be charged import duties, or tariffs, on goods transferred between divisions in different countries. These duties often are based on the reported value of the transferred goods. Such companies may have an incentive to set a low transfer price in order to minimize the duty charged on the transferred goods.

Solutions to exercises

Exercise 13-24 (10 minutes)

Sales margin

/ = / / = / / = / 8%
Capital turnover / = / / = / / = / 2.5
Return on investment / = / / = / / = / 20%

Exercise 13-25 (15 minutes)

There are an infinite number of ways to improve the division's ROI to 25 percent. Here are two of them:
1. / Improve the sales margin to 10 percent by increasing income to $5,000,000:
ROI / = / sales margin  capital turnover
= /
= / 10%  2.5 = 25%
Since sales revenue remains unchanged, this implies a cost reduction of $1,000,000 at the same volume.
2. / Improve the turnover to 3.125 by decreasing average invested capital to $16,000,000:
ROI / = / sales margin  capital turnover
= /
= / 8%  3.125 = 25%
Since sales revenue remains unchanged, this implies that the firm can divest itself of some productive assets without affecting sales volume.

Exercise 13-26 (5 minutes)

Residual income / = / investment center income / – /
= / $4,000,000 – ($20,000,000  11%)
= / $1,800,000

EXERCISE 13-27 (20 MINUTES)

The weighted-average cost of capital (WACC) is defined as follows:

The interest rate on Golden Gate Construction Associates’ $60 million of debt is 10 percent, and the company’s tax rate is 40 percent. Therefore, Golden Gate’s after-tax cost of debt is 6 percent [10%  (140%)]. The cost of Golden Gate’s equity capital is 15 percent. Moreover, the market value of the company’s equity is $90 million. The following calculation shows that Golden Gate’s WACC is 11.4 percent.

EXERCISE 13-28 (20 MINUTES)

The economic value added (EVA) is defined as follows:

For Golden Gate Construction Associates, we have the following calculations of each division’s EVA.

Division / After-Tax Operating Income
(in millions) / Total Assets
(in millions) / Current Liabilities
(in millions) / WACC / Economic Value Added
(in millions)

Real Estate

/ $20(1.40) /  / $100 /  / $6 /  / .114 / = / $1.284
Construction / $18(1.40) /  / $ 60 /  / $4 /  / .114 / = / $4.416

Exercise 13-29 (30 minutes)

1. / Average investment in productive assets:
Balance on 12/31/x1...... / $12,600,000
Balance on 1/1/x1 ($12,600,000  1.05)...... / 12,000,000
Beginning balance plus ending balance...... / $24,600,000
Average balance ($24,600,000  2)...... / $12,300,000
a. / ROI / = /
= /
= / 20%
b. / Income from operations before income taxes...... / $ 2,460,000
Less: imputed interest charge:
Average productive assets...... / $12,300,000
Imputed interest rate...... /  .15
Imputed interest charge...... / 1,845,000
Residual income...... / $ 615,000

Exercise 13-29 (continued)

2. / Yes, Fairmont’s management probably would have accepted the investment if residual income were used. The investment opportunity would have lowered Fairmont’s 20x1 ROI because the project's expected return (18 percent) was lower than the division's historical returns (19.3 percent to 22.1 percent) as well as its actual 20x1 ROI (20 percent). Management may have rejected the investment because bonuses are based in part on the ROI performance measure. If residual income were used as a performance measure (and as a basis for bonuses), management would accept any and all investments that would increase residual income (i.e., a dollar amount rather than a percentage) including the investment opportunity it had in 20x1.

EXERCISE 13-30 (30 MINUTES)

1. Students’ calculation of return on investment and residual income will depend on the company selected and the year when the internet search is conducted. Students will need to decide how to determine the income and the invested assets to use in both calculations. The discussion in the text will serve as a guide in this regard.

1. Some companies’ annual reports include a calculation and discussion of ROI in the “management report and analysis” section or the “financial highlights” section. Students’ calculation of ROI may differ from management’s due to differing assumptions about the determination of income and invested capital.

Exercise 13-31 (15 minutes)

Memorandum
Date: / Today
To: / President, Sun Coast Food Centers
From: / I. M. Student
Subject: / Behavior of ROI over time
When ROI is calculated on the basis of net book value, it will typically increase over time. The net book value of the bundle of assets declines over time as depreciation is recorded. The income generated by the bundle of assets often will remain constant or increase over time. The result is a steady increase in the ROI, as income remains constant (or increases) and book value declines.
This effect will not exist (or at least will not be as pronounced) if the firm continues to invest in new assets at a roughly steady rate across time.

Exercise 13-32 (10 minutes)

1. / The same employee is responsible for keeping the inventory records and taking the physical inventory count. In addition, when the records and the count do not agree, the employee changes the count, rather than investigating the reasons for the discrepancy. This leaves open the possibility that the employee would steal inventory and conceal the theft by altering both the records and the count. Even without any dishonesty by the employee, this system is not designed to control inventory since it does not encourage resolution of discrepancies between the records and the count.
2. / The internal control system could be strengthened in two ways:
(a) / Assign two different employees the responsibilities for the inventory records and the physical count. With this arrangement, collusion would be required for theft to be concealed.
(b) / Require that discrepancies between the inventory records and the physical count be investigated and resolved when possible.

Exercise 13-33 (15 minutes)

1. / Sales margin / = / / = / / = / 5%
*Income = £100,000 = £2,000,000 – £1,100,000 – £800,000
/ Capital turnover / = / / = / / = / 2
/ ROI / = / / = / / = / 10%

Exercise 13-33 (continued)

2. / ROI = 15% / = / / = /
Income / = / 15%  £1,000,000 / = / £150,000
Income / = / sales revenue – expenses = £150,000
Income / = / £2,000,000 – expenses = £150,000
Expenses / = / £1,850,000
Therefore, expenses must be reduced to £1,850,000 in order to raise the firm's ROI to 15 percent.
3. / Sales margin / = / / = /
ROI / = / sales margin  capital turnover
= / 7.5%  2
= / 15%

Exercise 13-34 (10 minutes)

1. / Transfer price / = / outlay
cost / + / opportunity
cost
= / $300* + $80† = $380
*Outlay cost = unit variable production cost
†Opportunity cost / = / forgone contribution margin
= / $380 – $300 = $80
2. / If the Fabrication Division has excess capacity, there is no opportunity cost associated with a transfer. Therefore:
Transfer price / = / outlay
cost / + / opportunity
cost
= / $300 + 0 = $300

Exercise 13-35 (25 minutes)

1. / The Assembly Division's manager is likely to reject the special order because the Assembly Division's incremental cost on the special order exceeds the division's incremental revenue:
Incremental revenue per unit in special order.. / $465
Incremental cost to Assembly Division per unit
in special order:
Transfer price...... / $374
Additional variable cost...... / 100
Total incremental cost...... / 474
Loss per unit in special order...... / $(9)
2. / The Assembly Division manager's likely decision to reject the special order is not in the best interests of the company as a whole, since the company's incremental revenue on the special order exceeds the company's incremental cost:
Incremental revenue per unit in special order. / $465
Incremental cost to company per unit in special order:
Unit variable cost incurred in Fabrication Division / $300
Unit variable cost incurred in Assembly Division / 100
Total unit variable cost...... / 400
Profit per unit in special order...... / $ 65
3. / The transfer price could be set in accordance with the general rule, as follows:
Transfer price / = / outlay
cost / + / opportunity
cost
= / $300 + 0*
= / $300
*Opportunity cost is zero, since the Fabrication Division has excess capacity.
Now the Assembly Division manager will have an incentive to accept the special order since the Assembly Division's incremental revenue on the special order exceeds the incremental cost. The incremental revenue is still $465 per unit, but the incremental cost drops to $400 per unit ($300 transfer price + $100 variable cost incurred in the Assembly Division).

solutions to Problems

Problem 13-36 (25 minutes)

The answer to the question as to which division is the most successful depends on the firm's cost of capital. To see this, compute the residual income for each division using various imputed interest rates.
(a) / Imputed interest rate of 10%:
Division I / Division II
Divisional profit...... / $900,000 / $200,000
Less:Imputed interest charge:
I: $6,000,000  10%...... / 600,000
II: $1,000,000  10%...... / ______ / 100,000
Residual income...... / $300,000 / $100,000
(b) / Imputed interest rate of 14%:
Division I / Division II
Divisional profit...... / $900,000 / $200,000
Less:Imputed interest charge:
I: $6,000,000  14%...... / 840,000
II: $1,000,000  14%...... / ______ / 140,000
Residual income...... / $ 60,000 / $ 60,000
(c) / Imputed interest rate of 15%:
Divisional profit...... / $900,000 / $200,000
Less:Imputed interest charge:
I: $6,000,000  15%...... / 900,000
II: $1,000,000  15%...... / ______ / 150,000
Residual income...... / $ 0 / $ 50,000
If the firm's cost of capital is 10 percent, then Division I has a higher residual income than Division II. With a cost of capital of 15 percent Division II has a higher residual income. At a 14 percent cost of capital, both divisions have the same residual income. This scenario illustrates one of the advantages of residual income over ROI. Since the residual income calculation includes an imputed interest charge reflecting the firm's cost of capital, it gives a more complete picture of divisional performance.

Problem 13-37 (45 minutes)

Division A / Division B / Division C
Sales revenue...... / $2,000,000e / $10,000,000 / $ 800,000l
Income...... / $ 400,000 / $ 2,000,000 / $ 200,000k
Average investment...... / $2,000,000f / $ 2,500,000 / $1,000,000j
Sales margin...... / 20% / 20%a / 25%
Capital turnover...... / 1 / 4b / .8i
ROI...... / 20%g / 80%c / 20%
Residual income...... / $ 240,000h / $ 1,800,000d / $ 120,000
Explanatory notes:
c ROI = sales margin  capital turnover = 20%  4 = 80%
d Residual income=income – (imputed interest rate)(invested capital)
=$2,000,000 – (8%)($2,500,000) = $1,800,000
e Sales margin / = /
20% / = /
Therefore, sales revenue = $2,000,000
fCapital turnover / = /
1 / = /
Therefore, invested capital = $2,000,000
gROI / = / sales margin  capital turnover
ROI / = / 20%  1 = 20%

problem 13-37 (continued)