Investment Centers and Transfer Pricing

Top managers of large companies evaluate their divisions as investment centers. The manager of an investment center is held accountable for the center’s profit and the capital invested to earn that profit.– Decentralized companies must create an incentive program to

maximize the goal congruence that business units have with the company’s overall objectives.

– The biggest factor in deciding how well the responsibility accounting system works creating a system that properly directs managers’ efforts toward organizational goals.

This chapter covers ways in which a company can best measure business unit performance and set transfer pricing between business units

Return on Investment (ROI)

The most common investment center performance measure is return on investment.

or

or

ROI’s drawback: it ignores the firm’s cost of raising capital – Because of this, many managers prefer to use residual income

ROI = Income / Invested Capital

(Income / Sales Revenue) * (Sales Revenue / Invested Capital)

Sales Margin * Capital Turnover

Residual Income

The imputed interest rate is the estimated interest charge set to reflect the company’s minimum required rate of return on invested capital.– The drawback for residual income is that it can only be used to

compare investment centers of similar size or a bias is incorporated in favor of the larger investment center.

ROI = Investment Center’s Profit - (Investment Center’s Invested Capital * Imputed Interest Rate)

Measuring Income and Invested Capital Both ROI and residual income rely on profit and invested capital in

their formulas. Since these performance measures are computed for a period of time,

the balances used in calculating income and invested capital should be an average of the value during the measured period of time.

The assets used to determine invested capital depend upon the management structure of the investment center.– Average total assets are used when the manager has considerable

authority in making decisions about all of the divisions’ assets, including non-productive assets.

– Total productive assets leads to the correct measurement when divisions are instructed to keep non-productive assets in progress.

– Total assets less current liabilities measures investment capital when managers can secure bank loans and short term credit.

Transfer Pricing

The transfer price is the price charged when one division sells goods or services to another division.

Setting transfer prices is a difficult process because the price affects investment center profitability.– A high transfer price results in high profit for the selling investment

center and low profit for the buying investment center

– A low transfer price results in low profit for the selling investment center and high profit for the buying investment center

The price must be set to establish incentives for decentralized investment center managers to make decisions that support the overall goals of the organization.

General Transfer-Pricing Rule

= + Transfer PriceAdditional outlay cost per

unit incurred becausegoods are transferred

Opportunity cost per unitto the organization

because of the transfer

Transfer Pricing Options External Market Price

– Use if the selling unit has no excess capacity and perfect competition exists.

– Here, the general transfer rule and the external market price are equal

– The long-run average external market price should be used, because distressed market prices can severely affect transfer pricing profitability.

Negotiated Transfer Price– It is common for managers to negotiate transfer prices from the

external market price.

– This can split the cost savings between both units, but can lead to divisiveness and competition between investment centers.

Cost-Based Transfer Pricing Options

Variable Cost– Variable cost is used as the transfer price

– The biggest drawback with using variable cost is that when excess capacity exists, the selling unit can’t show contribution margin on the transferred goods.

Full Cost– FC - VC + allocated fixed overhead

– The biggest drawback affects the buying unit’s view of costs as fixed for the company as a whole as the variable costs for the buying unit.