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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
6. Measuring the Level of “Investment”: Allocating Shared Assets. As in joint cost allocation, top
management should trace the assets to the business units that used them and allocate the assets that
cannot be traced on a basis that is as close to actual usage as possible. If the required capacity and
investment are large because the user requires a high level of service during a high demand period,
then the assets should be allocated according to the peak demand by each individual unit. Units with
higher peak-load requirements that cause the need for capacity then receive a relatively larger portion
of the investment.
7. Measuring the Level of “Investment”—Current Values. The amount of investment is typically
the historical cost of the assets. The historical cost amount is the book value of current assets plus the
net book value (NBV) of the long-lived assets. Net book value (NBV) is the asset’s historical cost less
accumulated depreciation. A problem arises when the long-lived assets are a significant portion of
when the assets are replaced later at their current value, and the amount of income might not have
been sufficient to support replacement of the asset at the current higher value. In addition, the use of
current value helps to reduce the unfairness of historical cost NBV when comparing SBUs with
different aged assets.
8. Measuring Current Value. The three methods for developing or estimating the current market
value of assets are:
a. Gross book value (GBV). GBV is the historical cost without the reduction for depreciation. It is
a very rough estimate of the current value of the assets. GBV improves on NBV because it
removes the bias due to differences in the age of assets. However, GBV doesn’t address
potential price changes in the assets. Those who value the objectivity of a historical number
prefer GBV.
b. Replacement cost. Replacement cost represents the current cost to replace the assets at the
current level of service and functionality. It is preferred when ROI is used to evaluate the
manager or the unit as a continuing enterprise.
c. Liquidation value. Liquidation value is the price that could be received for the sale of assets.
Generally, liquidation value is lower than the replacement cost. It is most useful when top
management is using ROI to evaluate the investment center for potential disposal.
9. Strategic Issues in Using ROI. In addition to the measurement issues mentioned above, there are
two several strategic issues that must be considered:
a) Value creation in the new economy—ROI was conceived and developed during a time
when physical assets were the primary means of generating value. This is no longer the
case for many companies and industries today.
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
c) Decision model and performance model inconsistencies. Discounted cash flow (DCF)
higher than the unit’s current ROI so that the addition of the investment improves the
unit’s overall ROI right away. Thus, the most profitable units have a corresponding
disincentive to invest in any project that does not exceed their current ROI, although the
project would have a good (in excess of a minimum threshold) return and therefore be
attractive from the standpoint of the organization as a whole.
C. Residual Income (RI). In contrast to ROI, which is a percentage, residual income (RI) is a dollar
amount equal to the income of a business unit less an imputed charge for investment in the unit. The
charge is determined by multiplying a desired minimum rate of return by the investment amount. RI can
be interpreted as the income earned after the unit has “paid” a charge for the funds it needs to invest in the
unit.
The issues regarding the measurement of income and investment for RI are the same as
those discussed for ROI.
RI has the advantage of enabling a unit to pursue an investment opportunity as long as the
investment’s return exceeds the minimum return set by the firm.
An additional advantage of RI is that a firm can adjust the required rates of return for
Limitations of RI. Although the RI measure deals effectively with the distinctive problems of ROI, it
has its own limitations. A key one is that because RI is not a percentage, it suffers the same problem
of profit centers in not being useful for comparing units of significantly different size. RI favors larger
units that would be expected to have larger RIs, even with relatively poor performance. Moreover,
relatively small changes in the minimum rate of return can dramatically affect the RI for units of
different size.
Text Exhibit 19.7 provides a summary of the advantages and disadvantages of using ROI versus RI for
the financial performance of investment centers.
D. Economic Value Added (EVA®). EVA® is a business unit’s income after taxes and after deducting
the cost of capital. The idea is very similar to what we have explained as RI. The objectives of the
measures are the same: to effectively motivate investment center managers and to properly (fairly)
measures their performance.
Though similar on the surface, RI and EVA® are substantively different. EVA® requires an estimate of
net operating profit after tax (NOPAT), which is an estimate of an entity’s economic earnings. EVA® also
requires an adjusted measure of capital (called EVA® capital) as the investment base. Stern Stewart, in
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
their classic book on the subject, discuss over 160 possible adjustments to reported accounting
information—adjustments needed to eliminate so-called accounting distortions.
A distinctive feature of Cost Management is an expanded discussion of two alternative approaches for
estimating EVA® NOPAT and EVA® capital: the operating approach, and the financing approach.
Part Two: Transfer Pricing
A. Transfer Pricing. Transfer pricing is the determination of an exchange price for a product or service
when different business units within a firm exchange it. A transfer pricing system is therefore needed to
creating activities within the value chain.
B. Objectives of Transfer Pricing:
1. International Transfer Pricing Objectives. With the globalization of business, the international
aspect of transfer pricing is becoming a critical concern, particularly with tax issues. Other
international objectives include:
a. Minimization of custom charges. The transfer price can affect the overall cost, including the
customs charges, or goods imported from a foreign unit.
b. Currency restrictions. As a foreign unit accumulates profits, a problem arises in some countries
significant risk of expropriation exists, the firm can take appropriate actions such as limiting
new investment or developing improved relations with the foreign government.
2. Transfer Pricing Methods. Firms commonly use two or more of the following methods; this
practice is called dual pricing.
a. Variable cost method. The variable cost method sets the transfer price equal to the selling unit’s
variable cost. This method is desirable when the selling unit has excess capacity and transfer
price’s chief objective is to satisfy the internal demand for the goods.
b. Full-cost method. The full cost method sets the transfer price equal to variable costs plus the
selling unit’s allocated fixed costs. Advantages of this approach are that it is well understood
d. Negotiated price method. The negotiated price method involves a negotiation process and
sometimes arbitration between units to determine the transfer price. This method is desirable
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
when the units have a history of significant conflict and negotiation can result in an agreed-
upon price. The limitation is that this method can reduce the autonomy of the units.
e. Text Exhibit 19.9 provides a useful summary of the primary advantages and disadvantages
associated with each of the above-four transfer pricing alternatives.
C. Choosing the Right Transfer Pricing Alternative. The three key factors to consider in deciding
whether to make internal transfers, and if so, in setting the transfer price are presented in text Exhibit
19.10 and are summarized as follows:
a. Is there an outside supplier? If not, there is no transfer price, and the best transfer price is based
on cost or negotiated price. If there is an outside supplier, we must consider the relationship of
the inside seller’s variable cost to the market price of the outside supplier by answering the next
question.
order to the internal buyer at a transfer price between variable cost and market price. If the
selling unit is at full capacity, we must determine and compare the cost savings of internal sales
versus the selling division’s opportunity cost of lost sales. If the cost savings to the inside buyer
are higher than the cost of lost sales to the seller, the buying unit should buy inside, and the
proper transfer price should be the market price.
This three-question analysis is from top management’s perspective and is thus the desired outcome if the
units make these decisions autonomously. A good approach that preserves much of the units’ autonomy is
to set clear guidelines regarding top management’s objectives on transfer pricing.
The discussion here should conclude with a presentation and discussion of the general transfer-pricing
model, as well as a discussion regarding practical difficulties in implementing this general model. Of
particular merit is relating the general model to the definition of “relevant cost” as defined and used in
Chapter 11 (Decision Making) of the text, that is, relevant cost = out-of-pocket costs + opportunity costs.
D. International Tax Issues in Transfer Pricing. Most countries now accept the Organization of
Economic Cooperation and Development’s model treaty, which calls for transfer pricing to be adjusted
using the arm’s-length standard, that is, to a price that unrelated parties would have set. The model treaty
price by using the sales price of similar products made by unrelated firms.
b. Resale price method. The resale price method is based on determining an appropriate markup
based on gross profits of unrelated firms selling similar products.
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Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
c. Cost-plus method. The cost-plus method determines the transfer price based on the seller’s cost
plus a gross profit percentage determined by comparing the seller’s sales to those of unrelated
parties.
E. Advance Pricing Agreements (APAs). APAs are agreements between the IRS and the firm using
transfer prices that establish the agreed-upon transfer price. The APA usually is obtained before the firm
engages in the transfer. The APA program’s goal is to resolve transfer pricing disputes in a timely manner
and to avoid costly litigation.
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