cba macc mba scm performance measurement and transfer pricing 2011(1)

8/3/2019 Cba Macc Mba Scm Performance Measurement and Transfer Pricing 2011(1)

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copyright Nandu J Nagarajan 1

Strategic Cost Management

NANDU J. NAGARAJAN

Performance measurement and incentives


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PERFORMANCE MEASUREMENT AND

INCENTIVES

CHAPTER 14



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Decentralization

Managerial responsibility should be tied tothe allocation of decision rights. Thus, ourchoice of performance measures should belinked to the level of decentralization

Cost Centers cost

Revenue Centers sales, market share, CRM

Profit Centers All of the above

Investment Centers All of the above & investment Corporate versus divisional versus individual measures

Line of sight measures

Financial versus non-financial measures


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PERFORMANCE MEASUREMENT

Tailor performance measurement to the businessunit

Link performance measurement to a units

short and long-term targets Combine financial and operating performance in

the measurement (Income Statement valuedrivers and Balance Sheet value drivers)

Avoid too many measures (LBO model versusBalanced Score Card)

Identify performance measures that serve asearly warning indicators


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CHOOSING PERFORMANCE

MEASURES

Performance measures should be linked to value Managers should be able to influence the

performance measures through their actions Effect of other factors such as external shocks

and other individuals should not be excessive In the absence of these conditions holding, the

performance measure will impose risk on themanagers to overcome moral hazard but may notinduce value creation

Financial or non-financial performance measures?Financial e.g., EBIT, ROI, RI, EVANon-financial e.g., customer satisfaction,

quality, cycle time


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FINANCIAL MEASURES OF

PERFORMANCE

There are four main categories of financialmeasures:

1) Income

2) Cash

3) Return

4) Value


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CASH FLOW MEASURES

Gross cash flow

Earnings before interest, tax anddepreciation/amortization (EBITDA)


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INCOME MEASURES

Earnings before interest and tax (EBIT)

EBITDA Depreciation/Amortization

Net operating profit after tax (NOPAT)

EBIT ( 1- tax rate) Net Income (NI)

EBIT + Interest Income InterestExpense

Earnings per share (EPS):

NI/ # of shares outstanding


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RETURN MEASURES

Return on Equity (ROE):

Net income/Total common equity

ROI: After Tax Income/Assets (Divisional)

Dupont ratio:

(After tax Income/Sales) x (Sales/TA) = ROI ROI also defined as Operating Income/TA

Identify value drivers based on different components ofROE

Return on Capital Employed (ROCE) or Return on NetAssets (RONA):

NOPAT/ Net Assets (TA-Current Liabilities)


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SINGLE PERIOD VALUEADDED

MEASURES

Residual Income (RI): After Tax Incomeminus a charge for assets

Economic Value Added (EVA):

Stern Stewart measure of economic profitminus a charge for capital employed


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WHICH FINANCIAL MEASURES?

COMMON FINANCIAL MEASURES

ROI

Residual Income (RI)

Earnings before interest, tax and depreciation(EBITDA)

Economic Value Added (EVA)

Net Operating Profit After Taxes (Stern Stewart)

- (Weighted Average x (CapitalCost of Capital) Employed)

EVA = NOPAT (SS) WACC X CE


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MORE ON EVA

NOPAT (SS) modifies profit calculation comparedto NOPAT

Change in EVA associated with change inshareholder value

Ways to increase EVA* Increase net profit without increasing

capital* Reduce capital employed in projects

earning returns lower than the cost ofcapital

* Invest capital in projects with returnshigher than the cost of capital


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CRITICAL THINKING EXAMPLE

Consider the following data for the twogeographical divisions of the PittsburghHome Products (PHP) Company that operateas profit centers:

Allegheny Ohio

Total assets $1,000,000 $5,000,000

Current liabilities 250,000 3,000,000Operating income 200,000 750,000

Tax Rate: 40%


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(CONTINUED)

REQUIRED

Calculate the ROI for each division using after taxincome as the measure of income and using totalassets as the measure of investment.

Allegheny: $ 200,000(1-.40)/1,000,000 = 12%

Ohio: $ 750,000(1-.40)/5,000,000 = 9%

Allegheny is doing better

Some analysts compute ROCE as after taxincome divided by capital employed ( 16% and22.5%, respectivelyaccording to this criterion,Ohio is doing better)


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PROBLEMS WITH THE ROI

MEASURE

Definition of numerator (after tax income) and denominator(total assets)

Operating income is subject to several accountingadjustments such as expensing advertising and R&D,

inventory valuations, and amortizing goodwill

ROI is a myopic measure not consistent with NPV criterion

Decentralization with use of the ROI measure can lead toagency problemswrong decisions by managers

Case 1: Managers ROI is 20%, cost of capital is 15%,project return is 18%

Case 2: Managers ROI is 15%, cost of capital is 20% andproject return is 18%


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(CONTINUED)

Pittsburgh Home Products Company hasused RI as a measure of managementperformance, the variable it wants a

manager to maximize. Using thiscriterion, what is the RI for each divisionusing operating income and total assets, ifthe required rate of return on investment

is 10 percent?


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RESIDUAL INCOME

CALCULATIONS

Residual income is defined as :

After Tax Income (required rate of return) x (total assets)

Allegheny:

$120,000 - (0.10 x $1,000,000) = $ 20,000 Ohio:

$ 450,000 (0.10 x $5,000,000) = ($50,000)

Allegheny is doing better Required rate of return should be set at cost of capital If set at accounting rate of return, ordering of divisional

performance could be different


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EVALUATING RESIDUAL

INCOME

Does not have the problem that ROI has in being anefficiency measure, so managers get overly focused on onenumber

It is a myopic one period measure

However, present value of Residual Income equals NPV

It also has several measurement problems

Where does rate of return come from? Is it set at cost ofcapital?

Bias towards larger divisions?

Not as popular as ROI


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(CONTINUED)

Pittsburgh Home Products has two sources offunds: long-term debt with a market value of$3,500,000 and an interest rate of 10%, andequity capital with a market value of $3,500,000at a cost of equity of 14 percent.

PHPs income tax rate is 40 percent. PHP applies the same weighted-average cost of

capital to both divisions, since each division facessimilar risks.

Calculate the EVA for each division. Which of the measures calculated in

requirements 1, 2, and 3 would you recommendPHP use?


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EVA CALCULATIONS

Recall that EVA = NOPAT WACC X CE

Usually the first step is to calculate theNOPAT. To do this the effect of accounting

adjustments have to be undone, forexample (Vyaderm case)

1)Capitalize R&D

2) Capitalize advertising3) Switch to FIFO instead of LIFO

inventory valuation


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EVA (CONTINUED)

These adjustments have implications both for theIncome Statement and the Balance Sheet. SternStewart lists more than a hundred adjustments,but in practice 7-10 are most common

For simplicity, we have ignored theseadjustments in our numerical example. However,in the Vyaderm case we will consider someadjustments. Please study these carefully.

Next, the net after tax operating income is

calculated:Allegheny: $200,000 (1-0.40) = $120,000

Ohio : $750,000 (1-0.40) = $450,000


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EVA (CONTINUED)

The Weighted average cost of capital(WACC) is calculated by weighting thecost of equity and the after tax cost of

debt by their proportions in the unitscapital structure. PHP has 50% equity and50% debt

WACC = 0.14 X 0.5 + 0.10 (1-0.4) x 0.5

= 0.10


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EVA (CONTINUED)

Capital Employed is:

Total Assets Current Liabilities

Allegheny:

$1,000,000 $250,000 = $750,000

Ohio:

$5,000,000 $3,000,000 = $2,000,000


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EVA (CONTINUED)

EVA calculation:

NOPAT WACC X CE

Allegheny:

$120,000 - 0.10 x 750,000 = $45,000

Ohio:

$ 450,000 0.10 x 2,000,000 = $250,000

Therefore, the Ohio division is performingbetter


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LIMITATIONS OF EVA

Operationally, determining the cost of capital atthe divisional level is not easy

You need to have complete financial statementsfor the EVA center. Allocations of costs andassets, transfer pricing and other inter-divisionalproblems can impact the effect of EVA as aperformance measure

Macroeconomic factors outside the managerscontrol, such as interest rates, can affect cost ofcapital

Operationally, subjective factors can creep intothe EVA calculation in determining the managersbonus payout

EVA can operate as a myopic measure also. It isbased on accounting profit not cash flows


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SYMPTOMS OF PERFORMANCE

MEASUREMENT FAILURE Performance is acceptable on all dimensions

except profit. Customers dont buy even when prices are

competitive. No one notices when performance measurement

reports are not produced. Managers spend a lot of time debating the meaning

of the measures. Share price performance is lethargic despite solid

financial performance. You havent changed your performance measures in

a long time. Youve recently changed your corporate strategy.

(Vitale/Mavrinac)


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Problems 14-40 and 14-41



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VYADERM PHARMACEUTICALS

Case documents the companys implementationof EVA

Class discussion issues in addition to numericalissues listed in course outline

What are the industry factors affecting theDermatology division?

What are the various stages in the evolution ofthe EVA system?

What is the importance of EVA value drivers?

What are the EVA numbers for dermatology for2000 and 2001 What should be done about managers 2000

bonus?


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Balanced Score Card perspectives and

Strategy Maps

Financial

Customer

Business Process

Learning and Growth


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GOVERNANCE

AND INTERNAL CONTROL

Management control mechanisms in companies are veryimportant

Recall the example of Barings Bank

The Barings Bank example shows that weaknesses inmanagement control can lead to value destruction.

Management control mechanisms involve the system ofchecks and balances, performance measurement andreward systems and coordination mechanisms

One important coordination mechanism with strongimplications for value is transfer pricing

Transfer pricing is the pricing of goods and services inintra-company transfers


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TRANSFER PRICING

CHAPTER 15



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TRANSFER PRICING Vertically integrated companies or companies with common

services use transfer pricing as an internal control andcoordination mechanism.

We will see that transfer pricing arises when companiesvertically integrate through acquisitions for strategicreasons including avoiding hold-up problems

Because managers are evaluated based on theperformance of their divisions in decentralizedenvironments, transfer pricing creates externalities that cancloud incentive control and evaluation

The objectives of transfer pricing are:- tax minimization- managing internal sourcing- evaluating divisional performance- implementing corporate strategy


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TRANSFER PRICING

(CONTINUED)

Transfer pricing formula:TP = Incremental cost +Opportunity

cost for supplying division

Operationally for the supplier,

TP = (marginal cost/unit) variable cost/unit + change in fixed cost/unit + lost

contribution margin for not makingoutside sales

Assumes constant marginal cost


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EXAMPLE

The Hong Kong Home Products companyhas two divisions, Appliances and KitchenDesigns . The Appliance division suppliesrefrigerators to the Kitchen Designs

division. The capacity of the appliancedivision is 2000 refrigerators per year. Thevariable cost of production is $60 perrefrigerator. The fixed cost per unit is

$100 ( based on a volume of 2000 units).The market price for this category ofrefrigerator is $225 per unit.


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EXAMPLE ( CONTINUED)

Required:

1. If the Appliance division is at capacity, what isthe optimal transfer price?

2. If the Appliance division has excess capacity,

what is the best decision for the company, as awhole, buy inside or outsource?

3. What transfer price with divisionaldecentralization will provide the optimal solutionfor the company?

4. What other factors would become important ifthe Kitchen Designs division is located in Manila,Phillipines?


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TRANSFER PRICING METHODS

Transfer pricing methods

- Market - based pricing

- Variable cost pricing

- Full cost pricing

- Negotiated transfer pricing

- Dual transfer pricing

Value Chain considerations andmanagerial incentives become veryimportant in transfer pricing


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Problems 15-26, 15-27 and 15-29


cba macc mba scm performance measurement and transfer pricing 2011(1)

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