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;...

Investment Centers and Transfer Pricing

Chapter 13

Advantages

Allows organization

to respond more quickly to events.

Frees top management

from day-to-day operating activities.

Uses specialized knowledge and skills of managers.

Return on Investment (ROI)

Sales Margin

Sales

Capital Turnover

Return on Investment (ROI)

Holly Company reports the following:

Income $ 30,000 Sales Revenue $ 500,000 Invested Capital $ 200,000

Let’s calculate ROI.

ROI = Income

Sales Revenue Invested Capital

Return on Investment (ROI)

$500,000

$200,000 ROI = 6% × 2.5 = 15%

Economic Value Added

Economic value added tells us how much

shareholder wealth is being created.

Economic Value Added

Investment center’s after-tax operating income

– Investment charge

= Economic Value Added

averagecost of capital

of debt

Cost of equity capital

Market value

of equity



Market value

of debt

Market value

of equity



Improving R0I

Three ways to improve ROI

Increase Sales

Prices

Decrease Expenses

Lower Invested Capital

 Would your decision be

different if you were

evaluated using ROI?

Residual Income

Residual income encourages managers to

make profitable investments that would

be rejected by managers using ROI.

Gross or Net Book Value

Year

Profits before Depreciation

Depreciation Expense

Operating Profits

Gross Book Value

Net Book Value

Year

Net Operating Profits

Net Book Value ROI

Gross Book Value ROI

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.

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

greater profits for the battery division.

Auto Division

for the

Goal Congruence

The ideal transfer price allows each division manager to make decisions that maximize the

company’s profit, while attempting to maximize his/her

own division’s profit.

The ideal transfer price allows each division manager to make

decisions that maximize the

company’s profit, while attempting to maximize his/her

own division’s profit.

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

Centrally Established

Transfer Prices

As a general rule, a market price-based

transfer pricing policy contains the

following guidelines

1. The transfer price is usually set at a

discount from the cost to acquire the item

on the open market

2. The selling division may elect to transfer or

to continue to sell to the outside

As a general rule, a market price-based

transfer pricing policy contains the

following guidelines

1. The transfer price is usually set at a

discountfrom the cost to acquire the item

on the open market

2. The selling division may elect to transfer or

to continue to sell to the outside

Negotiating the Transfer Price

A system where transfer prices are arrived at through

negotiation between managers of buying and selling

divisions.

A system where transfer prices are arrived at through

negotiation between managers of buying and selling

time is used in the

be in the best interest of overall company operations

Negotiated price may not

be in the best interest of overall company operations

Cost-Based Transfer Prices

Some companies use the following measures of cost to establish transfer

prices

Beware of treating unit fixed costs as variable

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

by the manager.

And

Goal Congruence and

Internal Control Systems

A well-designed internal control system includes a set of

procedures to prevent these major lapses in responsible