emba presentation november 15,2012. internal performance measurement responsibility centers ...
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INTERNAL PERFORMANCE MEASUREMENT AND TRANSFER
PRICING
EMBA PresentationNovember 15,2012
Internal Performance Measurement Responsibility Centers Residual Income Return on Investment EVA
Responsibility Centers
Cost center Profit center Investment center
Schematic
CostCenter
CostCenter
CostCenter
CostCenter
ProfitCenter
ProfitCenter
InvestmentCenter
Summary of Performance Centers
Type of Center Decision RightsPerformance
Measures
Cost Input Mix Cost controls
Profit Product Mix, Selling Prices, Input Mix
Actual Profits, Budget Comparisons
Investment Input Mix, Product Mix, Selling Prices, Capital Invested
ROI, Residual Income, EVA
Schematic of the ROI Method
Sales
TotalInvestment
Earnings
Sales
SalesTurnover
ROI
Return onSales
Divided by
Divided by
Multiplied by
ROI Example
Sales $9,000,000Net Operating Income $ 720,000Total Investment $4,000,000
Sales Turnover $9,000,000 $4,000,000 = 2.25Return on Sales $720,000 $9,000,000 = 8%ROI 2.25 x .08 = 18%
Criticisms of ROI
Managers may make decisions that increase the ROI in the short run
Managers often inherit costs over which they have no control
Managers may reject investment opportunities that are good for the organization, but negatively impact the segment
Residual Income
Focuses on the residual return after deducting the minimum return required by top management
Residual Income = NOI – Average OperatingAssets
XMinimumRequiredRate of Return
Example of Residual IncomeGlobal Equities Corporation
Analyis of ROI and Residual Income Europa
Division
American
Division
Sales 3,000,000$ 9,000,000$ Net Operating Income 210,000$ 720,000$ Average Operating Assets 1,000,000$ 4,000,000$
Return on Investment (ROI) 21% 18%
Residual Income Approach:
Assume Global Expects a 15% return on net operating assets
Return on Average Operating Assets at 15% 150,000$ 600,000$
Net Operating Income 210,000$ 720,000$
Residual Income 60,000$ 120,000$
Greatest deficiency is that the method does not take into consideration size of the segment
Criticisms of Residual Income
Absolute number that ignores investment center size
Does not measure risk factors
Opportunity cost of capital is different between investment centers
Calculation of EVA
Adjusted Weighted Cost of Capital EVA = Accounting – X Earnings Total Capital
Calculation of EVA Earnings
• Earnings per GAAP• Less cost of capital used by the center• Plus R & D expenses deducted• Add amortization of R & D• Equals EVA Earnings
Capital Formula for EVA
Total Capital Invested Plus Capitalized R & D Costs
Example Using EVA
Operating Income plus R & D Expenses $900,000Less Amortization of R & D Expenses 100,000Adjusted Earning for EVA $800,000
Invested Capital $4,000,000Plus Capitalized R & D 1,000,000EVA Capital $5,000,000
EVA Rate 16%
Controllability Principle
Westinghouse Nuclear Case
Transfer Pricing Topics
What is transfer pricing? Terms Delco example Transfer pricing methods Car dealership example Summary of transfer pricing
methods International and tax ramifications
A transfer price is the price one sub-unit charges another for a product or service supplied to it
Terms
Full cost – includes both fixed and variable components
Variable cost – includes only the costs directly related to producing the product
Idle capacity – plant capacity available for additional manufacturing without incurring more fixed costs
Substitute products – competitive products are available in the open market a lower price
Congruence Problems
Management expects sub-units to act in a manner that maximizes firm-wide profits
Management desires that product family members be used throughout the firm
Unit managers operate in a manner that optimizes the profitability of their unit which is often reflected in their incentives
Delco Example
Delco
ManufacturesBatteries After Market
$40
Chevrolet
? Outside market $40Full cost $30Variable cost $20
Delco has excess capacity
Transfer Pricing Methods
Market based Cost based Negotiated Dual
Market Prices Lead to Optimal Decisions
When: The market for the intermediate
product is perfectly competitive Interdependence of subunits is
minimal No additional costs in buying or
selling in the external market compared to the internal
Cost Based Transfer Prices
Full cost – price includes both the fixed and variable component If excess capacity is used, there should be no
additional fixed costs Fixed costs may be allocated between external
and internal sales Full costing may be more appropriate where a
firm uses ABC costing
Variable cost – includes only the incremental cost
Negotiated Prices
Mutual agreement between sub-units May have no relationship to cost or
market prices May be affected by a unit’s ability to
negotiate
Dual Pricing
In this case, the selling division and the buying division do not pay or receive the same amount
Seller gets full cost and buyer pays market
Difference rolls to a corporate account May cause divisional tax calculation
problems Selling unit has no incentive to control
costs
Car Dealer Example
Departments: New Vehicles, Used Vehicles, Service, Body Shop, and Parts Department
New Used Body Service
Retail
Service labor rate $40 $40
$65
Body shop labor rate $40 $40 $40
$65
Parts mark-up 15% 15% 15% 15%
30%
Summary of Methods
Domestic Multinational
Market based 26% 35%
Cost based: Variable 3% 0% Full cost 49% 42% Other 1% 1% Total 53% 43%
Negotiated 17% 14%
Other 4% 8%
TOTAL 100% 100%
International and Tax Ramifications
Large firms are global in nature
Firms sell products between international subsidiaries or joint ventures
Tax rates vary between countries
International firms will transfer price to minimize total taxes paid
Taxes Paid on Box of Contact Lenses in The Netherlands
TransferPrice at
80 Euros
Transfer Price at
110 Euros
Taxes Paid in Netherlands:
Revenue (Transfer Price) € 80 €110
Variable Cost (50) (50)
Taxable Income € 30 € 60
Tax Rate 30% 30%
Dutch Taxes € 9 € 18
Taxes Paid in Australia
Transfer Price at
80 Euros
TransferPrice at
110 Euros
Taxes Paid in Australia:
Revenue (Australian Dollars) A$ 85 A$ 85
Transfer Price in Euros:
80 x .70A$
(56) -
110 x .70 - A$
(77)
Taxable Income A$ 29 A$ 8
Tax Rate 40% 40%
Australian TaxesA$
11.6 A$
3.20
Converted to Euros at .70 Rate€
16.57 € 4.57
Comparison of Results
TransferPrice at
80 Euros
Transfer Price at
110 Euros
Dutch Taxes € 9.00 €
18.00
Australian Taxes 16.57 4.57
Total €
25.57 €
22.57
Eastman Kodak Case
Copyright, Frank Ilett, 2012