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TABLE OF CONTENTS

 Investment Center  Return on Investment  Residual Income  Economic Value Added  Multiple Measures of Performance

 Investment Center
An autonomous business unit or division or segment whose manager has control over fixing prices and incurring costs besides having control over the use of investment funds. It is a term used for business units within an enterprise. It performance are measured against its use of capital. In 1980, Ezzamel and Hiton surveyed operations of 129 large companies in the UK. They found out that all these companies have small autonomous units headed by a manager who was given necessary powers to make production schedules, set prices and credit terms and approve budgets for purchase and advertisement. However, in the matter of long term investments, all managers were closely supervised by the top management. When sub-units are free to take decision, there is an element of decentralization where authority is distributed or delegated to the managers. Decentralization brings rewards as it motivates the managers; enable them to take decisions at the spot keeping in view local environments etc. It has some drawbacks like inconsistency across divisions of the same company. The performance of each Investment Center is measure by using a variety of tools some of which are briefly discussed as under.

 Return on Investment
1. Return on investment (ROI) measures profits earned per dollar of investment. a) It is the most common measure o f performance for an investment center. ROI =
Operating income Average operating assets

ROI =

Operating income Sales

Sales Average operating assets

ROI = Operating income margin Operating asset turnover b) Operating income is earnings before interest and taxes. c) Operating Assets are all assets acquired to generate operating income. Operating Assets includes cash, receivables, inventories, land, buildings and equipment.

Average operating assets =

Beginning net book value + Ending net book value 2

2. Margin is the ratio of operating income to sales. 3. Turnover shows how productively assets are being used to generate sales. 4. Advantages of using ROI includes: a) It encourages managers to pay careful attention to the relationships among sales,expenses, and investments. b) It encourages cost efficiency by focusing on reduci ng no value-added activities and/or improving productivity. c) It discourages excessive investment in operating assets and, thus, encourages efficient investment. 5. Disadvantages of the ROI measure include: a) It discourages managers from investing in projects that would increase the profitability of the company as a whole but would decrease the divisional ROI measure. Managers would reject projects with an ROI less than a divisions current ROI but higher than the firms cost of capital. b) It can encourage myopic behavior, in that managers may over emphasize short -run results at the expense of the long -term profitability.

 Residual Income
1. Residual income(RI) is the difference between operating income and the minimum dollar return required on a companys operating assets. RI = Operating income (Minimum rate of return Operating assets) 2. Advantage of residual income: A manager will accept any project that earns above the minimum rate of return because they will increase the company -wide profitability. 3. Disadvantages of residual income: a) RI an absolute measure of return that makes it difficult to compare divisions of different sizes. Solution: Compute a residual return on investment.
RI erati

erage

Residual return on investment =

assets

b) May encourage myopic behavior. Same disadvantage as for ROI.

 Economic Value Added


1. Economic value added (EVA) is after-tax operating profit minus the total annual cost of capital. EVA =After-tax operating income (Weighted average cost of capital Total capital employed) a) EVA is a dollar figure rather than a percentage rate of return. b) EVA emphasizes after-tax operating profits and actual cost of capital. c) EVA uses the weighted average cost of capital, which is measured on an after-tax basis. Computation of the cost of capital employed involves the following steps: I) Determine the weighted average cost of capital as a percentage. Identify all sources of invested funds. Multiply the proportion of capital from each source of financing by its after -tax cost.

 Interest expenses of debt financing are tax deductible. Thus,


After-tax cost of capital for debt = Cost (1 Tax rate)

 There are no tax adjustments for equity.


Over time, stockholders receive an average return that is 6% higher than the return on long-term government bonds. II) Determine the total dollar amount of capital employed, including:

 Buildings, land, and machinery.  Other investments meant to have a long -term payoff, such as research and development, employee training, and so on. d) Positive EVA means that the firm creates wealth (value) by earning operating profit over and above the cost of capital used. EVA has a higher correlation with stock prices than other accounting measures of return because it relates profit to the amount of resources needed to achieve it.
2. Behavioral Aspects of EVA a) EVA encourages managers to maintain a balanced emphasis on operating income and capital employed. It helps lower -level management understand that capital employed is not free. b) EVA can be improved by reducing capital usage.

 Multiple Measures of Performance


 Modern managers use multiple measures of performance and include non-financial measures as well as financial measures.  ROI, residual income and EVA are financial performance measures.  Non-financial performance measures linked to long-run success factors include market share, customer complaints, personnel turn over rates, and personnel development.

TRANSFER PRICING

TABLE OF CONTENTS
 Transfer pricing  Transfer pricing methods  Transfer pricing related issues  Shared services pricing  Objectives

 TRANSFER PRICING
The price one subunit of an organisation charges for a product/service supplied to another subunit of the same organisation is called a transfer price. Transfer prices are necessary when either one of the two centres involved the supplier or the receiver  is a profit or an investment centre. Therefore transfer prices may be used also with revenue and cost centres. There are four main reasons companies use transfer pricing: 1) Saving on taxes 2) Facilitating performance measurement 3) Providing relevant informatio n for trade-off decisions 4) Inducing goal congruent decisions Saving on taxes Saving on taxes is often the main reason behind the implementation of transfer pricing policies between divisions, in particular when the divisions are located in different countries. Transfer payments have an impact directly on the declared benefit of divisions and also on the amount of income taxes that they will pay. Facilitating performance measurement Facilitating performance measurement of the units involved is another reason for implementing a transfer pricing policy. If a profit centre were to receive parts or services without a corresponding charge against his income, the profit measure would be fla wed since its costs would be understated. Likewise, a profit centre that supplies a product or service to another internal client without corresponding revenue would have understated its profit. Measuring divisional performance stimulates managers perform ance but may have the opposite effect if done improperly. Providing relevant information for trade -off decisions Providing relevant information required for making trade -off decisions is another reason. Transfer prices tell a purchasing manager how much a product or service will cost. He can use this information in making a variety of decisions, including whether to make or buy a component, whether to invest in new machinery, whether to launch a product, etc. Inducing goal congruent decisions Inducing goal congruent decisions within the organisation is another reason. Producing a product internally may not be the most economical decision for the company. The purchasing division may be able to obtain a similar product for a lower cost than the transfer price, while the supplying division may be able to use the capacity to produce something more profitable. However, there could be strategic reasons to buy internally. Two conditions must be maintained for a transfer pricing policy to work effectively. First the purchasing and supplying divisions must be free to negotiate prices with each other. Secondly the purchasing division must be free to seek other suppliers and the supplying division must be free to seek other customers. The basic principle of transfer pricing is that:

The transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors.

 TRANSFER PRICING METHODS


There are three main methods for determining transfer prices: - Negotiated transfer prices - Market-based transfer prices - Cost-based transfer prices Negotiated transfer prices The preferable method of determining the transfer price is through negotiation between the buyer and seller. In this way the parties are f ree to set the price that satisfies both. Often this negotiation will be based on information about market prices and internal costs, however there is no requirement that either be used. Market-based prices Sometimes in order to avoid excessive negotiation, organisations prefer to establish a policy that dictates a formula to be used. In such cases, if possible, the policy should require that the transfer price be based on the price that could be obtained for the product if it were to be sold to a customer outside the company. If the supplier does not have external customers for its own product, sometimes market prices can be deduced from observing competitors prices. Cost-based transfer price In many situations external reference points do not e xist, for example, when products are produced uniquely for internal markets and outside selling is either impossible because of a lack of customers or prohibited because of strategic concerns. In such cases, production cost is used as the base for setting the price. This presents a number of choices to managers. Prices can be based on full costs, including costs such as administration and research or only on variable costs. The price could be based on the standard or budgeted cost or alternatively the actual cost incurred. The price could assume full capacity utilisation or be based on actual or forecasted volumes. Decisions need to be made also whether the supplying division should include a profit margin in the transfer price. Various methods can be used to calculate the amount of profit to be included in the price. Dual pricing In some cases, management chooses to have two different prices for the same transaction one for the seller and a lower one for the purchaser. This method, known as dual pricing, is possible since transfer prices are recorded by internal accounting systems only and no cash usually exchanges hands. An example would occur when the selling division receives a price based on full cost while the purchasing division is assumed to pay mar ket price (which is lower). Dual pricing is used to ensure that transfers are made internally without penalising the performance evaluation of either division. However this method also has several drawbacks. There is a possibility of confusion due to the presence of different amounts. There is also less pressure on the supplying unit to control costs. For these reasons dual pricing is rarely used.

Actual transfer pricing practice is varied. One Canadian survey (15 years old) estimated that 18% of firms use a negotiated price 34% use the market price 6 % use variable cost 37% use absorption or full cost 5% use some other method

Transfer pricing environment Transfer pricing policy strategies are highly related to the organisational structure of the company, characterized by the degree of autonomy of divisions. In highly decentralized divisions such as investment centres and profit centres, transfer prices are necessary. Most often, market prices will govern the transfer and divisions will likely choose the sou rce offering the lowest price for a product or a service. In a more centralized environment, especially when the sourcing division is acquired or established to carry out a corporate strategy of vertical integration, internal sourcing is mandatory.

 TRANSFER PRICING RELATED ISSUES


The efficiency issue The transfer pricing policy chosen should reflect the strategic goals of the company. Some firms, for example, use internal sales as a way to improve plant capacity utilisation. In such cases profit centre managers have no control over purchasing decisions and are required to buy internally whenever possible. However this policy brings the risk that the performance of some individual units will be adversely affected. In the absence of market competition, it is likely that the supplying unit will transfer some of its inefficiencies to the purchaser rather than improving productivity. The economy issue Transfer pricing systems create other risks. The purchasing unit will normally be unaware of the marginal cost to the company and will base its purchase decision only on the transfer price. This may lead to sub -optimal decisions for the enterprise as whole. This situation is further exaggerated when the transfer price includes a profit margin for the supplier where products or components pass through several profit centres. The goal congruent issue Another issue is the conflict between tax and behavioural concerns. Products and services are increasingly transferred among units within the same company but belon ging to different national legal entities. In such situations it is possible to minimise total taxes paid by allowing profits to accumulate in legal entities that have lower tax rates. This opportunity has proven to be compelling for many companies and tra nsfer prices are often set in order to reduce tax rather than to motivate performance and improve decision -making. Such a policy can have unfortunate consequences since the short term benefits of tax decisions can be easily estimated while the short and lo ng-term costs related to performance are impossible to estimate with any accuracy. 9

From a behavioural standpoint, managers should use transfer prices to improve decision making and motivate better performance. However these goals are often seen as of less er importance than are tax concerns.

 SHARED SERVICES PRICING


Shared services are services provided by one responsibility centre for others. The main difference between shared services and transfer prices is that fees are charged for a bundle of services and it is normally impossible or impractical to identify specific transactions. For example the administration department will perform many tasks for other functional departments including bookkeeping, payment of accounts receivable and auditing of fixed assets. Some accounting systems are designed so that the costs of these services are assigned to user departments to better reflect the costs incurred by these departments. While shared services are a normal part of complex management organisation not all se rvices are charged and indeed most are not. Pricing shared services is difficult and can lead to confusion. Moreover designing and maintaining the accounting systems needed to price shared services can require significant resources. The main objective for pricing shared services is to improve performance measurement of the units that receive the services and provide comparability with other units that manage such services in-house. However care must be taken in designing the pricing formula to minimise unpr oductive behaviour that might be caused by the measurement system itself. A trade-off exists between accuracy and simplicity. For example the costs of the information technology (IT) department can be assigned to users on the basis of the services provided (of which there could be many types) or more simply on the number of computer screens within each department. While the latter is much simpler to administer and understand, there is a risk that managers will abuse the system by arbitrarily reducing the nu mber of screens they use. If the relationship between overall IT costs and the number of screens installed is weak, reducing the number of screens would likely add costs for the user departments in other ways and have little effect on the overall costs of the IT department. Care needs to be taken in designing systems to allocate shared services. Management accountants who design such systems must be aware of the strategic reasons for the system in the first place and be vigilant for dysfunctional consequen ces of the measurement process.

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OBJECTIVES

Present transfer pricing Prices charged by a division to another division for products and services transferred by the former to the latter are called transfer prices. The main reasons for using transfer prices are to save on taxes, to facilitate performance measuring, to provide managers with relevant information for decision-making and to induce congruent decisions in decentralized organisations. Describe methods of transfer pricing Three methods are de scribed: negotiated transfer prices, market -based transfer prices and cost-based transfer prices. Negotiated transfer prices are preferable since the parties are free to set a price that satisfies both of them. Market -based and cost-based prices are often used as a basis for negotiated prices. When there exists a market for the product, the market price is a good reference because it is objective and independent. When there is no market, companies rely on cost -based prices. Discuss transfer pricing related issues Beyond the tax related issue, there are important issue related to efficiency, economy and goal congruence. Transfer price policies have an impact of managers behaviour as the policies influence their evaluation. Present shared services pricing Shared services are charged for a bundle of services provided by one responsibility centre to another one. The main objective of pricing shared services is to improve performance management of the divisions that provides the services by supplying the managem ent with measures that could be compared with similar services elsewhere.

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