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Chapter 19 - Strategic Performance Measurement: Investment Centers
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Teaching Notes for Readings
Reading 19-1: “Does ROI Apply to Robotic Factories?” by Gerald H. Lander and
Mohamed E. Bayou, Management Accounting (May 1992), pp. 49-53.
This article provides a useful summary of the limitations of ROI performance evaluation of investment
centers. Three criteria for appropriate ROI measures are proposed: (1) the ROI measure must include
long-term performance, (2) the ROI measure must consider cash flows, and (3) the ROI measure must
consider the time value of money. Also, the authors argue that the ROI measure should be consistent with
the phases of the project life:
First: acquisition of the new investment
Second: use of the new investment
Third: disposition of the investment
Four methods are developed and illustrated for a hypothetical investment in robotics. The four methods
are: (1) annual book ROI, (2) average ROI (over the project’s life), (3) discounted book ROI, and (4)
discounted cash flow ROI. The authors explain how the different methods are to be used at the different
phases of the project’s life.
Discussion Questions:
1. Which ROI method(s) should be used at each of the phases of the project’s life?
2. What is the profitability index and how is it used?
3. What are the limitations of ROI, and how does the authors’ proposed approach deal with these
limitations?
The limitations are presented in the first section of the article:
a. short term focus
b. the rejection of good projects by high-ROI divisions (noted in the chapter as the reason why a
The authors’ approach is to limit the problems of ROI by using DCF-ROI for all phases of the
investment’s life. There is no discussion of why so few firms do this in practice, or of the difficulties in
implementing a DCF-based evaluation system.
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Note: This article makes extensive use of the concept of the time value of money, and thus can also be
used in Chapter 12, Capital Budgeting (Long-term Investment Analysis).
Reading 19-2: “Transfer Pricing with ABC” by Robert S. Kaplan, Dan Weiss, and
Eyal Desheh, Management Accounting (May 1997), pp. 20-22, 24-26, 28.
This article explains how Teva Pharmaceutical Industries Ltd adopted transfer pricing and ABC to
enhance profits, to improve coordination between operations and marketing, and to reduce the
proliferation of new product lines and small volume orders. The article explains why a marginal cost
(based on materials cost only) approach and other traditional approaches to transfer pricing did not work
for Teva. Teva introduced ABC costing in its plants, and used this cost information for transfer pricing.
The article explains how the ABC based transfer pricing system incorporated batch level costs, product-
based costs, and plant-based costs.
Discussion Questions:
1. Why did Teva introduce transfer pricing?
2. What were the goals of the new transfer pricing system? How did top management, divisional
managers, and financial staff differ about these goals?
a) To encourage marketing managers to make decisions consistent with the long-run profit of
their division. The new system should not promote decisions that would improve profit of a
division at the expense of the corporation as a whole.
capacity management, and make vs. buy).
Division managers wanted a system that would:
d) recognize that each division manager would act in the best interests of their own division
The financial staff wanted a system that would:
Overall, the financial staff was primarily focused on the implementation of the system, and the division
managers more interested in the outcomes (the incentive effects, etc.) of the system.
3. Why did traditional approaches for transfer pricing not work at Teva, and why did the ABC
approach work instead?
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• the traditional methods for overhead allocation did not capture the actual cost structure at Teva’s
plants
continuous conflict and excessive time on nonproductive discussions.
The ABC system addressed these issues because it provided a more accurate cost number such that
overhead costs were properly accounted for, and the problems associated with the variable costs and
negotiation methods could be avoided.
4. How did the ABC transfer pricing system incorporate batch level costs? Product-level costs?
Plant-level costs?
• product-level and plant-level costs: see Table 4 in the article
5. What are some of the benefits of the ABC transfer pricing system at Teva?
• better understanding and forecasting of cost behavior
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Reading 19-3: “Free Lunches and ROI” by Harry Zvi Davis, Solomon Appel, and
Gordon Cohn, Management Accounting Quarterly, Vol. 9, No. 2 (Winter 2008),
pp. 16-25.
This article begins with an observation that ROI is the mostly widely used financial-performance
indicator, for both investment centers and entire business entities. It then develops a scenario in which,
apparently, divisional managers are able to secure for one another a “free lunch” (i.e., something for
nothing). As such, the paper provides motivates students to think about the ability of managers to
manipulate, to their own advantage, metrics by which their performance (and rewards) will be gauged.
Discussion Questions
1. Explain the primary differences and similarities between ROI (return on investment) and RI
(residual income).
Both ROI and RI are summary measures of financial performance. Both are measures of short-term
performance. Both rely on reported accounting information. Both can be used to assess the
performance of business segments classified as “investment centers.”
The instructor who has covered the topic of capital budgeting may want at this point to draw a
parallel to the use of NPV versus IRR: the former represents an absolute measure of project
profitability, while the latter is a relative measure of profitability. (See question 3 below.)
2. What primary limitation of using a relative performance measure (i.e., a ratio, such as ROI) to
evaluate the performance of managers and organizational subunits is illustrated in this paper?
In this article, the authors pose the question: “Is there such a thing as a free lunch?” They raise this
question in the context of an example where, at least to the naked eye, “performance” (i.e., ROI) was
created from “nothing” (that is, from inter-divisional transfers of units).
Each of two divisional managers had total assets of approximately $3.5 billion, and each had 24
In Year 1 (see Table 2) Jill transferred segments L6 to L19 to Jack. Both Jill and Jack received major
bonuses that year for improving their ROI. That is, all segments L6 through L19 had an ROI greater
than 5.09%. After these transfers, Jill’s ROI increased from 19.27% to 21.61%, while Jack’s
increased from 5.09% to 7.86%--seemingly a “free lunch.” (The mathematical proof of this
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phenomenon is contained in the sidebar titled “Transferring Segments Affects Average ROI.”) Note,
however, that the ROI for the entire firm (absent any efficiency gains) was left unchanged by the
transfers, 11.76% (see Table 6).
metric used to assess financial performance of the investment centers (and the incentive compensation
of the divisional managers).
3. Can you think of any other shortcomings of using a relative, compared to an absolute, measure
of financial performance? (For those instructors who have covered the topic of capital
budgeting, you might make reference here to the difference between two discounted cash flow
[DCF] decision models: NPV and IRR.)
We know from the discussion in Chapter 19 that relative performance measures, such as ROI, are
subject to manipulation by managers on two fronts: the numerator and the denominator. That is, we
know that when a manager’s performance is assessed using ROI he/she has strong incentives to
certain circumstances (see the Appendix in Chapter 12 for a fuller discussion), leads to an optimal
capital budget.
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Reading 19-4: “A Better Way to Gauge Profitability” by David C. Burns, J.
Timothy Sale, and Jens A. Stephan, Journal of Accountancy (August 2008), pp.
38-42. (Available on-line at:
http://www.journalofaccountancy.com/Issues/2008/Aug/ABetterWaytoGaugeProfi
tability.htm).
This article offers and extension to the original “Du Pont” formula for calculating return on equity (ROE).
While the discussion in chapter 19 focuses on organizational subunits classified as investment centers, the
analysis of ROE would be relevant when the investment center is defined as a subsidiary or as an entire
company. The goal of the expanded approach suggested by the authors of this article is to better isolate
operating performance. The measure they propose in this regard is referred to as “return on net operating
assets” (RNOA).
Discussion Questions
1. Why is the issue of financial ratio analysis of interest to accountants and auditors?
(a) Ratios represent an efficient way to summarize a mass of performance-related data.
(e) Financial ratios can be used as high-level performance metrics in an entity’s balanced scorecard
(BSC).
2. Describe the original Du Pont formula (ratio) for assessing financial performance. What are the
major components of the ratio, and what information is conveyed by each of these components?
The original Du Pont formula focuses on a decomposition of an entity’s return on equity (ROE).
Thus, ROE is depicted as a function of: return on assets (ROA) and financial leverage. ROA can be
defined as net income (NI) divided by total assets (or, average total assets over a given period), while
the capital structure.
Note that: ROE = ROA × Financial Leverage = (NI ÷ Assets) × (Assets ÷ Equity) = NI ÷ Equity
From the above, we can deduce that for a firm with no debt in its capital structure, financial leverage
= 1.0 so that ROE = ROA.
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3. What do the authors allege is the primary deficiency of the original Du Pont formula?
The authors maintain that the original Du Pont formula (see #2 above) failed to adequate distinguish
performance.
4. Describe what the authors call their “advanced” version of the Du Pont formula. In what sense
does this revised ratio address the issue specified above in (3)?
The core concept introduced in the advanced version of the Du Pont formula is “return on net
operating assets” (RNOA); RNOA, according to the authors, provides a better indication of operating
performance in the sense that this measure is independent of leverage effects. From a controllability
(i.e., behavioral) perspective, this adjustment is clearly desirable: operating managers typically do not
have control over decisions related to capital structure (i.e., the issuance of debt versus equity capital).
Yet, these decisions, according to the original Du Pont formula, directly affect the ROA metric. By
that is unaffected by the mix between debt and equity (FLEV) and independent of the spread between
the rate of return on net operating assets and the effective interest rate paid by the company on
borrowed funds. Naturally, however, both FLEV and Spread affect an entity’s return on equity
(ROE), which is obvious from the above formula.
5. What is the relationship between ROI (discussed in Chapter 19) and ROE? What is the
relationship between ROI and RNOA (as defined in this article)?
ROI (return on investment) can be calculated either for a company as a whole or for major subunits
classified for performance-assessment purposes as “investment centers.” In both cases, the ratio is
defined as some measure of earnings (i.e., “return”) to some measure of invested capital (such as total
before interest ÷ assets) + [(RNOA – Interest rate on debt) × (interest bearing debt/equity)]. Thus,
Chapter 19 - Strategic Performance Measurement: Investment Centers
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both ROI and RNOA can be thought of as components of ROE, the former in the conventional Du
Pont model, and the latter in the “advanced” Du Pont model.
Reading 19-5: “Probing Financial Statements in a Post-Sarbanes-Oxley World” by
Carlos A. De Mello-e-Souza and Vidya N. Awasthi, Strategic Finance (April
2009), pp. 37-45.
This article recommends a broadened view of the process of financial analysis, to include (in addition to
conventional ratio analysis) issues of accounting quality and security valuation. This expanded
framework for analysis is applied to three publicly held companies: Wal-Mart, Costco, and Target.
(Notes: Because of the linkage to valuation, this paper could be assigned in conjunction with text Chapter
20. Also, note that two of the three companies examined in this paper are the ones whose performance
was analyzed in Reading 19-4. As such, the instructor might want to assign these two readings as a pair.)
Discussion Questions
1. According to the author of this article, what are the four steps (or stages) that are used
conventionally in the analysis of a company’s financial statements?
a) Stage One—Preliminary Data Adjustments (to achieve uniformity of data across different
companies)
b) Stage Two—Ratio Analysis (using the adjusted data produced in Stage One as well as market-
d) Stage Four—Valuation (i.e., comparison between estimated market values based on accounting
data and observed equity values)
2. The author of this article examines the financial performance of Wal-Mart over the period
1998-2007. How do the four performance indicators for Wal-Mart over this period compare to
those of its two primary competitors, Costco and Target?
Accounting Rates of Return
(ROA) across these three companies over the same period was smaller: Wal-Mart, 15%; Target, 12%;
and, Costco, 12%.
Profitability Measures
From 1998 through 2007, the average profit margins of the three companies was as follows: Wal-
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Asset Productivity (Turnover)
Turnover is a measure of how productively each organization used its assets to generate sales volume.
As indicated by the data presented in Table 1, average asset turnover was highest for Costco, and
lowest for Target; the performance of Wal-Mart was between these two competitors. The point to
segment improved over the period 2000 through 2007, the performance of this segment still lagged
behind the performance of its domestic segment. More detailed data regarding this issue is presented
in Table 2 and in Figure 6.
Accounting Quality
As noted in Figure 7, for all three entities reported earnings (from continuing operations) did not grow
out of proportion with operating cash flows, providing some evidence regarding the “quality” of the
accounting numbers reported over time by each company. The general point to make to students is the
3. What does the author of this article suggest as disclosure-related issues associated with the
valuation scenarios reflected in Table 3?
Table three presents a sensitivity analysis regarding “fair values” of Wal-Mart stock (as of January
31, 2008) as a function of assumptions regarding two value-related factors: (1) growth rate in sales,
and (2) profitability, measured as return on assets (ROA). On the basis of this sensitivity analysis, the
author raises the following two disclosure-related issues:
(1) In any scenario at or above steady-state growth, the market seemed to be undervaluing Wal-Mart
stock. What was the reason for this discrepancy between market value and “fair value” (determined
company to achieve this goal be useful in terms of reducing uncertainty regarding this issue?
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Reading 19-6: “Transfer Prices: Functions, Types, and Behavioral Implications,”
by Peter Schuster and Peter Clarke, Management Accounting Quarterly (Winter
2010), pp. 22-32.
Transfer prices affect the profit reported in each responsibility center of a company and can be used to
influence decision making. Showing a variety of examples, the authors describe the functions and types of
transfer prices and discuss the possible behavioral consequences of using them.
Discussion Questions
1. What is the connection between the theory of decentralization and the use of transfer pricing?
Organizations decentralize, that is, diffuse decision-making authority to lower levels of the
organization, because they believe that this organizational design choice results in improved long-term
performance. This can be attributed to increased motivation and other behavioral effects. However, all
design choices have associated costs: one of the most significant cost associated with a decentralized
organizational structure is the need to develop and implement an effective monitoring system—how
well did each subunit of the organization use its decision-making authority. When subunits are
2. Evaluate the advantages and disadvantages of each of the following three transfer pricing
choices: marked-based transfer prices, cost-based transfer prices, and negotiated transfer prices.
Market-Based Transfer Prices
Advantages
1. Market-based transfer prices are consistent with the theory of decentralization.
evaluation and decision-making purposes.
Figure 1 in the article shows that using an external market price for the intermediate-product
transfer between subunits is consistent with the theory of decentralization and, further,
presents the correct economic “signal” regarding the value to the organization as a whole for
internal versus external transfers. Subunit 2, by accepting the supplementary offer (at a special
Figure 2 of the article presents a situation where the incremental production cost per unit in
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correct incentive, from the standpoint of the organization as a whole: subunit 2 will reject the
special (supplemental) offer of $240 per unit from an external buyer. As such, subunit 1 would
sell in the external market. Both it and the firm as a whole are better off by $25/unit (i.e., $125
– $100).
Figure 3 illustrates a situation where there are internal cost savings (here, $16 of selling &
distribution cost savings per unit) when subunit 1 sells internally rather than externally;
further, subunit 2 also realizes cost savings ($15/unit, related to quality-control costs) when it
buys internally (from subunit 1) rather than purchasing externally in the market. (The authors
refer to these situations as representing “synergies” between the two subunits.) The purpose of
this figure, compared to the previous two situations, is to illustrate the point that when
synergies between subunits exist, the use of a market-based transfer price will not necessarily
decisions (sell internally or sell externally).
Disadvantages
1. An established market price may not exist for an intermediate good/service.
2. May, in the short run, induce suboptimal decision-making (particularly when excess [i.e., idle]
market price, etc.
Cost-Based Transfer Prices
Advantages
Disadvantages
1. There is no singular, best definition of “cost.” Cost can be defined as: variable (or, incremental)
or full, standard or actual, and pure cost versus cost-plus.
2. The use of actual costs may not provide appropriate incentives for the producing/selling
economic decisions, but if used in its pure form would not provide any profit or mark-up to the
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selling/producing division. Further, the determination of an optimal cost-based transfer price
assumes the existence of linear cost functions. As Case example 4 shows, the existence of
nonlinear cost functions makes the problem intractable.
5. If marginal costing is used to set transfer prices, there may be disincentives for
problem might be addressed through the use of a transfer price defined as a lump-sum fixed
cost plus variable costs (again, defined either as actual or standard cost, and either “as is” or
including a profit mark-up). The authors refer to this situation as a two-tier transfer pricing
scheme.
Negotiated Transfer Prices
In some sense, and this is true particularly when divisions (subunits) within an organization operate
autonomously and independently, allowing divisions to negotiate a transfer price creates a “market
within the company.” That is, it produces results that approximate the financial results that would be
obtained were the subunits of the organization dealing with external parties. Put another way, this
approach to transfer pricing is consistent with the theory of decentralization.
On the negative side, negotiated systems can be time-consuming to implement and can lead to subunit
hostilities (it’s basically a zero-sum game: a higher transfer price that is negotiated benefits one unit to
the detriment of another unit). Some criticize negotiated transfer pricing because the resulting prices
can more reflect the negotiating skills of the parties rather than optimum resource allocation and
decision making. These problems are intensified to the extent that market prices do not exist for the
goods or services transferred internally.
Summary: as can be seen from the discussion in the article, and the comments above, transfer prices
serve different purposes: profit allocation (among subunits)—a feedback or control purpose, and
criteria that are used to judge individual transfer-pricing alternatives. One possible solution, mentioned
in the text and in the article in conjunction with an examples provided in Figure 6, is the use of what is
called a dual-rate system: alternative transfer prices for a given transaction, each of which is designed
to induce a desired behavior. Note, however, that such a system may impose higher costs on the
organization, once again emphasizing the point that no single transfer-pricing alternative is likely
optimal vis-à-vis all criteria for judging the transfer price.
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19-7: “Multinational Transfer Pricing: Management Accounting Theory
versus Practice,” by Laurel Adams and Ralph Drtina, Management Accounting
Quarterly (Fall 2010), pp. 20-31.
Management accounting has traditionally used a theoretical, economics-based approach for determining
transfer prices. Nevertheless, international tax law requires that transfer prices be based on an arm’s-
length standard. This article compares the consequences of setting transfer prices under these two
approaches, which are dependent on whether the selling division is operating at or below full capacity. To
ensure that tax compliance obligations are considered when establishing transfer prices, we recommend
that the theoretical approach be modified such that there is no adjustment for capacity utilization. This
represents a significant shift in the traditional approach to teaching transfer pricing.
Discussion Questions
1. Provide an overview of the primary thesis (argument) raised by the authors of this manuscript.
This article points to a possible inconsistency in terms of the setting of transfer prices in theory (i.e., in
the literature of management accounting) versus actual practice (i.e., based on international tax law). In
terms of the former, transfer prices should be set to maximize economic efficiency; as such, we can
2. How, specifically, does the issue of capacity utilization affect the theoretically appropriate
transfer price (i.e., the transfer price that leads to economic efficiency for the firm as a whole)?
The basic model is that the relevant transfer price for short-term decision-making is equal to the
“general model” shown in Chapter 19 of the text: incremental (i.e., out-of-pocket) costs + opportunity
cost, if any. (Also as noted in the text, this general model establishes the floor for the appropriate
transfer price. That is, it establishes the minimum transfer price that would help ensure profit
maximization for the firm as a whole.)
Selling/Producing Division is Operating at Less than Capacity
In this case, by definition “opportunity costs” of the selling division are zero. Thus, the minimum
transfer price would be incremental cost (which is usually, but not necessarily, the variable cost
incurred by the producing division). Of course, at this minimum price the producing division would
generate no incremental profit on the internal transfer of goods. To induce a transfer, therefore, some
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In this case, the market price provides both the correct “signal” for economic decision making and
3. Provide an overview of legal imperatives regarding transfer pricing in an international context.
Because of differential income-tax rates across countries, opportunities for minimizing world-wide
taxes (and maximizing both after-tax income and cash flow for an organization) exist through the
transfer-pricing mechanism. Essentially, the goal (from a planning, and tax, standpoint) is to attempt to
The authors then raise the issue as to when the application of the theoretical (or economics-based)
approach coincides with the “arm’s length” requirement for international tax purposes. Data presented
in Tables 1 and 2 of the article provide background information for this discussion. Table 1 assumes a
situation where the selling division is operating at capacity, while Table 2 provides data for the
situation where the selling division has excess (i.e., idle) capacity.
Taken together, these two tables lead to four possible outcomes (explored in Tables 1-4—see question
4 below). The issue then addressed by the authors is “whether the management accounting
(conceptual) approach results in transfer prices that satisfy international tax law.”
4. Provide a summary of the analysis of data reported in Tables 1, 2, 3, and 4 of the article.
Table 1 (i.e., selling division is operating at capacity): if there are no synergies (interdependencies)
between selling and buying divisions, and an external market price exists, then the economic-based
transfer price at $650 would yield no profit for the selling division and therefore would violate the
arm’s length requirement (i.e., an external transaction would likely not occur if the selling division
earned no profit on the transfer). Alternatively, we might view this as allocating the $350 (profit)
difference between the two divisions. (If the transfer price is set at $650, then all of the profit on the
transfer is allocated to the buying division.) The primary point, however, is that an arm’s length
transaction would dictate a transfer price equal to the external market price of $1,000. Anything lower
would violate the spirit if not the requirements of international tax law.
Table 3 assumes that the selling division is operating at capacity but that the circumstances for internal
versus external sales are not comparable. Here, “noncomparable” relates not to differential costs
(which are readily estimable), but rather to differences in risk associated with an internal versus
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external transfer. There is the cost of risk the seller might incur OR avoid by selling internally that,
according to the authors, can be used to by the seller in terms of establishing an “arm’s-length price.”
Further, the authors suggest that this ability “to adjust for risk permits a wider range of (acceptable)
Comments:
1. It is not clear what the source of this recommendation by the authors is. For example, is it the
opinion of the authors? Is it statutorily backed?
2. The choice of the $50 amount as the example offered by the authors is interesting. Might it (that is,
the low dollar amount) suggest that the leeway under the authors’ recommendation is rather limited
in terms of its impact on world-wide taxes paid?
3. It is also interesting that in discussing Table 3 the authors do not state explicitly that internal cost
savings realized because of internal transfers (i.e., situations where there are synergies associated
with internal transfers), these cost reductions can be used for tax purposes to justify a transfer price
below external market price. This possibility is not raised until later in the article when the authors
state: “As discussed in case 3, tax law allows transfer-price differences based on avoidable costs,
such as bad debts.”
In Table 4, the authors examine the situation where (similar to the case illustrated in Table 2) the
selling division is operating at less than capacity, and (similar to the case illustrated in Table 3) there
are non-comparable circumstances regarding internal versus external transfers. According to the
authors, the opportunity that exists in this context is basically the same as the case 3 (above).
A summary analysis by the authors is presented in Table 5 in the article.
5. What recommendation do the authors offer on the basis of the analysis contained in Tables 1-5
and the accompany discussion?
Table 5 indicates that in four of six situations, the theoretical (marginal costing) or managerial
accounting recommendation for setting transfer prices is inconsistent with the arm’s-length
requirement for international tax purposes. When the selling division has idle capacity, transfer prices
set using a marginal-costing (i.e., economic) approach fail to satisfy tax requirements. When the
selling division has no idle capacity and economic circumstances for internal and external transfers are
comparable, then the marginal costing approach is acceptable for tax purposes.
Given the summary in Table 5, the authors recommend that “all transfer prices be set as if the firm
were operating a fully capacity” (i.e., as if idle capacity were zero). Two justifications of this
recommendation are offered by the authors:
