Lecture Managerial accounting: Creating value in a dynamic business environment (10th edition): Chapter 13 - Ronald W. Hilton, David E. Platt

Chapter 13 - Investment centers and transfer pricing. After completing this chapter, you should be able to: Explain the role of managerial accounting in achieving goal congruence; compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA); explain how a manager can improve ROI by increasing either the sales margin or capital turnover;...

Chapter 13 Investment Centers and Transfer Pricing Copyright © 2014 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Delegation of Decision Making (Decentralization) Decision-Making is pushed down Top M anagem ent M i d d le M anagem ent S u p e r v is o r S u p e r v is o r M i d d le M anagem ent S u p e r v is o r S u p e r v is o r Decentralization often occurs as organizations continue to grow 13­2 Decentralization Advantages Allows organization to respond more quickly to events Uses specialized knowledge and skills of managers Frees top management from day-to-day operating activities 13­3 Decentralization Challenge Goal Congruence: Managers of the subunits make decisions that achieve top-management goals 13­4 Return on Investment (ROI) ROI = Income Invested Capital ROI = Income Sales Revenue Sales Sales Margin Margin Sales Revenue × Invested Capital Capital Capital Turnover Turnover 13­5 Return on Investment (ROI) Holly Company reports the following: Income Sales Revenue Invested Capital $ 30,000 $ 500,000 $ 200,000 Let’s calculate ROI 13­6 Return on Investment (ROI) ROI = Income Sales Revenue ROI = $30,000 $500,000 Sales Revenue × Invested Capital × $500,000 $200,000 ROI = 6% × 2.5 = 15% 13­7 Economic Value Added Economic value added tells us how much shareholder wealth is being created 13­8 Economic Value Added Investment center’s after-tax operating income – Investment charge = Economic Value Added ( ( Investment center’s total assets Investment center’s current liabilities – ) ( After-tax Market cost of  value debt of debt Market value of debt   ) Weighted average cost of capital ) Cost of Market equity  value capital of equity Market value of equity 13­9 Improving R0I Decrease Expenses Increase Sales Prices Lower Invested Capital Three ways to improve ROI 13­10 Residual Income As a manager at Flower Co., would you invest the $100,000 if you were evaluated using residual income? Would your decision be different if you were evaluated using ROI? 13­11 Residual Income Residual income encourages managers to make profitable investments that would be rejected by managers using ROI 13­12 Gross or Net Book Value Year Profits Gross before Depreciation Operating Book Depreciation Expense Profits Value $ 25,000 $ 10,000 $ 15,000 $ 100,000 25,000 10,000 15,000 100,000 25,000 10,000 15,000 100,000 Net Book Value $ 90,000 80,000 70,000 ($100,000 – $0) ÷ 10 = $10,000 per year $100,000 – $10,000 = $90,000 net book value 13­13 Gross or Net Book Value Year Net Gross Operating Net Book Book Profits Value ROI Value ROI $ 15,000 $ 90,000 16.67% $ 100,000 15.00% 15,000 80,000 18.75% 100,000 15.00% 15,000 70,000 21.43% 100,000 15.00% $15,000 ÷ $90,000 = 16.67% $15,000 ÷ $100,000 = 15% Since older assets, with lower net book values, result in higher ROI, managers are discouraged from investing in new assets 13­14 Measuring Investment Center Income Division managers should be evaluated on profit margin they control Exclude these costs: Costs traceable to the division but not controlled by the division manager Common costs incurred elsewhere and allocated to the division The key issue is controllability 13­15 Transfer Pricing The transfer price affects the profit measure for both the selling division and the buying division A higher transfer price for batteries means Battery Division greater profits for the battery division lower profits for the auto division Auto Division 13­16 Goal Congruence The The ideal ideal transfer transfer price price allows allows each each division division manager manager to to make make decisions decisions that that maximize maximize the the company’s company’s profit, profit, while while attempting attempting to to maximize maximize his/her his/her own own division’s division’s profit profit 13­17 General-Transfer-Pricing Rule Transfer price = Additional outlay cost per unit incurred because goods are transferred + Opportunity cost per unit to the organization because of the transfer 13­18 Centrally Established Transfer Prices As Asaageneral general rule, rule,aamarket marketprice-based price-based transfer transferpricing pricingpolicy policycontains containsthe the following followingguidelines guidelines 1 The Thetransfer transferprice priceis isusually usuallyset setat ataa 2 discount discountfrom fromthe thecost costto toacquire acquirethe theitem item on onthe theopen openmarket market The Theselling sellingdivision divisionmay mayelect electto totransfer transferor or to tocontinue continueto tosell sellto tothe theoutside outside 13­19 Negotiating the Transfer Price AA system systemwhere wheretransfer transferprices pricesare arearrived arrivedat atthrough through negotiation negotiationbetween betweenmanagers managersof ofbuying buyingand andselling selling divisions divisions Much Much management management time time is is used used in in the the negotiation negotiation process process Negotiated Negotiated price price may may not not be be in in the the best best interest interest of of overall overall company company operations operations 13­20 Cost-Based Transfer Prices Some companies use the following measures of cost to establish transfer prices Variable cost Full absorption cost Beware of treating unit fixed costs as variable 13­21 Behavioral Issues: Risk Aversion and Incentives The design of a managerial performance evaluation system using financial performance measures involves a trade-off between: Incentives for the manager to act in the organization’s interests And Risks imposed on the manager because financial performance measures are only partially controlled by the manager 13­22 Goal Congruence and Internal Control Systems A well-designed internal control system includes a set of procedures to prevent these major lapses in responsible behavior: Fraud Corruption Financial Misrepresentation Unauthorized Action 13­23 ... transfer 13? ?18 Centrally Established Transfer Prices As Asaageneral general rule, rule,aamarket marketprice-based price-based transfer transferpricing pricingpolicy policycontains containsthe the... top management from day-to-day operating activities 13? ?3 Decentralization Challenge Goal Congruence: Managers of the subunits make decisions that achieve top-management goals 13? ?4 Return on Investment... performance evaluation system using financial performance measures involves a trade-off between: Incentives for the manager to act in the organization’s interests And Risks imposed on the manager