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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
Chapter 19
Strategic Performance Measurement: Investment Centers & Transfer Pricing
Learning Objectives
LO 19-1 Explain the use and limitations of return on investment (ROI) for evaluating investment
centers.
LO 19-2 Explain the use and limitations of residual income for evaluating investment centers.
LO 19-3 Explain the use and limitations of economic value added (EVA®) for evaluating
investment centers.
LO 19-4 Explain the objectives of transfer pricing, and the advantages and disadvantages of
various transfer-pricing alternatives.
LO 19-5 Discuss important international issues that arise in transfer pricing.
New in this Edition
Eight new Real-World Focus (RWF) items dealing with the following topics: ROI for
Sustainability Projects; Estimating the ROI for a College Diploma; Strategic Application of ROI
(Business Segment) Analysis; Estimating the (Short-Term) ROI for an MBA Degree;
Sustainability—the ROI of “Doing the Right Thing”; Linking Incentive Compensation to Levels
of Economic Profit; Apple Computer and Transfer Pricing—Risk Implications; International
Transfer Pricing Applied to SG&A Costs; and, Increased Scrutiny and Risk—Multinational
Transfer Pricing.
Expanded discussion of the transfer-pricing decision in an international context
Revision of five end-of-chapter problems
Addition of pedagogical reference (Baker et al., 2009) regarding concerns associated with the use
of EVA® (H. Kent Baker, Prakash Deo, and Tarun Mukherjee, "EVA Revisited," Journal of
Financial Education, Fall 2009, pp. 1-22.)
Teaching Suggestions
A good way to begin this chapter is by reviewing with students the “Five Steps in the Evaluation of the
Financial Performance of Investment Centers in an Organization,” which appears at the beginning of the
chapter. This material provides a broad overview of the two major parts of the chapter.
Part one of Chapter 19 deals with the problem of evaluating the financial performance of subunits
classified as “investment centers.” Financial performance metrics include: return on investment (ROI),
residual income (RI), and economic value added (EVA®). Our goal is to present the advantages and
disadvantages/limitations of each of these metrics. Part Two of the chapter, transfer pricing, covers the
issue as to how interdivisional transfers of goods and services (between and among profit centers and
investment centers in an organization) are handled for performance-evaluation purposes. We present some
general guidelines that can be used to establish an appropriate transfer price and we include international
considerations (both income tax as well as other considerations) in the setting of transfer prices for
multinational companies. Because of the technical nature of the subject matter, we find that at least two
class meetings need to be devoted to each of the two main parts of the chapter.
Part One: Financial-Performance Indicators for Investment Centers
My objectives in class meeting #1 are to cover the following issues that pertain to various financial-
performance metrics that can be applied to responsibility units classified as “investment centers”:
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
1. Definition of the term “investment center”
2. Financial performance indicators for investment centers:
a. ROI
b. RI
c. EVA® (including both the Operating Approach and the Financing Approach to estimating
EVA® capital and EVA® NOPAT)
3. Advantages and limitations of each of the above methods
4. Complications associated with both “earnings” and “investment”—the two major components
comprising financial-performance indicators of investment centers.
On the second class meeting I follow up my initial lecture (see above) by working several end-of-chapter
assignments (exercises and/or problems), focusing on those that raise issues regarding complications
associated with the use of the above-referenced financial-performance metrics.
Part Two: Transfer Pricing
There are four main issues I address in transfer pricing. One is the decision-making issuefrom the
standpoint of both the organization as a while and from the standpoint of the selling unit itself, should the
product/service be transferred internally or not, and if so, at what price? The second issue is the role of
taxes in determining an appropriate transfer price. Given the growth in importance of this issue in recent
years, the coverage in the text is intended to be appropriately introductory in scope, without going into the
details one would cover in a course on international taxation. Third, I emphasize the use of a graphic
approach (Exhibit 19-8) as a way to structure the transfer pricing discussion. Fourth, I end my lectures by
using Exhibit 19.9 to summarize the advantages and limitations of each of four transfer-pricing methods
(viz., variable cost, full cost, market price, and negotiated price). I conclude with a presentation and
discussion of a “general transfer pricing rule,” as well as a discussion of practical difficulties associated
with this rule. I point out to students that the general transfer pricing rule is an application of a primary
point they learned in chapter 11 (relevant costs and decision-making): relevant costs for decision-making
consist of out-of-pocket costs + opportunity costs.
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
Assignment Matrix
End-of-Chapter Assignments Learning Objectives Text Features
7e 6e
Transition
6e to 7e
X = Included in Connect
Est.
Time
1. ROI (Return on Investment)
2. RI (Residual Income)
3. EVA® (Economic Value Added)
4. Transfer pricing: objectives & ethods
5. Transfer pricing: global tax issues
Strategy
Service
International/Global
Ethics
Sustainability
Brief Exercises
19-11 19-11 - X 5 min X
19-12 19-12 - X 5 min X
19-13 19-13 - X 5 min X
19-14 19-14 - X 5 min X
19-15 19-17 - X 5 min X
19-16 19-18 - X 5 min X
19-17 19-19 - X 5 min X
19-18 19-15 - X 5 min X
19-19 19-16 - X 5 min X
19-20 19-20 - X 5 min X
Exercises
19-21 19-21 - X 15 min X
19-22 19-22 Revised X 25 min X
19-23 19-23 Revised X 25 min X
19-24 19-24 - X 20 min X
19-25 19-25 - X 25 min X X
19-26 19-26 - X 20 min X X X
19-27 19-27 - X 25 min X X X
19-28 19-28 - X 30 min X X X
19-29 19-29 - - 40 min X X X X
19-30 19-30 - - 15 min X
19-31 19-31 - X 45 min X
19-32 19-32 - X 25 min X
19-33 19-33 - X 20 min X
19-34 19-34 - X 25 min X X
Problems
19-35 19-35 Revised - 50 min X X X
19-36 19-36 Revised - 75 min X
Continued on next page …
Chapter 19 Assignment Matrix—Continued
End-of-Chapter Assignments Chapter Learning Objectives Text Features
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
7e 6e
Transition
6e to 7e
X = Included in Connect
Est.
Time
1. ROI (Return on Investment)
2. RI (Residual Income)
3. EVA® (Economic Value Added)
4. Transfer pricing: objectives & methods
5. Transfer pricing: global tax issues
Strategy
Service
International/Global
Ethics
Sustainability
19-37 19-37 Revised - 60 min X
19-38 19-39 - - 60 min X X X
19-39 19-40 - - 60 min X X
19-40 19-41 - - 60 min X X
19-41 19-43 Revised - 45 min X X
19-44 19-44 Revised - 25 min X X X
19-43 19-45 - - 60 min X
19-44 19-46 - - 60 min X
19-45 19-47 - - 60 min X
19-46 19-48 - - 90 min X X
19-47 19-49 Revised - 40 min X
19-48 19-50 - - 50 min X
19-49 19-51 - - 45 min X
19-50 19-52 - - 45 min X X
19-51 19-53 Revised - 50 min X X
19-52 19-54 Revised - 30 min X X X
19-53 19-55 - - 45 min X X
19-54 19-56 - - 60 min X
X
X
- 19-38 Deleted - -
- 19-42 Deleted - -
- 19-57 Deleted -
- 19-58 Deleted -
Lecture Notes
Part One: Financial-Performance Indicators for Investment Centers
A. The Notion of Investment Centers. While profit centers are commonly used due to their strong
motivation and goal congruence effects, firms cannot use profit alone to compare one business unit to
other business units or to alternative investments, because the other units and investments are likely to be
of different sizes and have different operating characteristics. Therefore, a method to compare a unit to
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
other units and alternative investments is needed. One such method is the return on investment (ROI),
which is the profit per dollar invested. Financial performance measures applied to investment centers
have the following objectives:
To motivate managers to exert a high level of effort to achieve upper management’s goals.
To provide the right incentive for managers to make the decisions consistent with the goals
set by top management.
To determine fairly the rewards earned by the managers for their efforts and skill and the
effectiveness of their decision-making.
Thus, alternative performance metrics can be judged in reference to the above-listed criteria.
B. Return on Investment (ROI). The most commonly used investment center performance measure is
ROI, which is a percentage—the larger the percentage, the better the ROI. When the value of ownership
interest is used for investment, ROI is often called return on equity (ROE). ROE is of special interest to
shareholders and business owners because it is a direct measure of the firm’s return to owners.
1. ROI Equals Return on Sales (ROS) × Asset Turnover (AT). We can enhance the ROI measure’s
usefulness by showing it as the product of two components:
ROI = Return on Sales (ROS) × Asset turnover (AT)
ROI = (Profit ÷ Sales) × (Sales ÷ Assets)
a. Return on sales (ROS). ROS is a measure of (operating) profit per sales dollar; it measures the
investment center manager’s ability to control expenses and increase revenues to improve
profitability.
b. Asset turnover (AT). Asset turnover, the amount of dollar sales achieved per dollar of
investment, measures the manager’s ability to increase sales from a given level of investment
(i.e., with a given level of assets).
2. Use of ROI. For ROI to be useful for comparing the performance of different investment centers,
income and investment must (to the extent possible) be measured in the same way for each unit. Also,
the measurement method must be reasonable and fair for all units.
3. ROI in Practice: Measurement Issues
Measuring Income and Investment: Effect of Accounting-Policy Choices. Accounting policies
regarding the measurement of “investment” and the determination of “income” have a direct
effect on ROI. Revenue and expense recognition policies affect ROI by determining when a sale
is recognized as revenue and when an expenditure is recognized as an expense. These policies
affect and timing of sales and expenses. Similarly, the firm has accounting policies for measuring
inventory and long-lived assets that affect income and investments:
For long-lived assets:
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
a. Depreciation policy. The determination of the useful life of the asset and the depreciation
method used affect both income and investment. Larger depreciation charges reduce ROI.
b. Capitalization policy. The firm’s capitalization policy identifies when an item is expensed or
capitalized as an asset. If an item is expensed, the effect reduces ROI.
For inventory:
a. Inventory measurement methods. The choice of inventory cost flow assumption (FIFO,
LIFO) affects income and the measurement of inventory. Methods that increase cost of
goods sold and decrease inventory reduce ROI.
b. Absorption costing. The effect of absorption costing creates an upward bias on net income
and therefore on ROI when inventory levels are rising and the reverse when levels are
falling.
c. Disposition of variances. Standard cost variances can be closed to the cost of goods sold
accounts or prorated to the inventory accounts; the choice has a direct effect on income and
inventory balances.
These five measurement issues affect the proper interpretation of “income” and “investment” and
thus, ROI.
4. Other Measurement Issues for Determining “Income” (i.e., the numerator in the ROI
metric). In addition to the firm’s accounting policies, other effects on income should be considered
when using ROI:
a. Nonrecurring items. Income can be affected by nonrecurring charges or revenues and then
would not be comparable to income of prior periods or of other investment centers.
b. Income taxes. Income taxes can differentially affect the various units with the result that after-
tax net income may not be comparable.
c. Foreign exchange. Business units that operate in foreign countries are subject to foreign
exchange rate fluctuations that can affect the income and the value of investments of these
units.
d. Joint cost sharing. When businesses share a common facility or cost, the cost is often allocated
to the units on some fair-share basis. Different allocation methods result in different costs for
each unit, and therefore they affect the units’ income.
5. Measuring the Level of “Investment”—Which Assets to Include? A common method for
calculating ROI is to define investment as the cost of long-lived assets plus working capital. A key
criterion for including an asset in ROI is the degree to which the investment center controls it. Long-
lived assets commonly are included in investments if they are traceable to the unit. In general, leased
items should be included as investments since they represent assets used to generate income, and the
failure to include them can cause a significant overstatement of ROI. For idle assets, the main issue is
controllability; if the idle assets have an alternative use or are readily saleable, they should be
included in the investment amount for ROI.
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