Chapter 13 – Investment Centers and Transfer Pricing
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CHAPTER 13
INVESTMENT CENTERS AND TRANSFER PRICING
Learning Objectives
1. Explain the role of managerial accounting in achieving goal congruence.
2. Compute an investment center’s return on investment (ROI), residual income
(RI), and economic value added (EVA).
4. Describe some advantages and disadvantages of both ROI and residual income
as divisional performance measures.
6. Use the general economic rule to set an optimal transfer price.
8. Understand the behavioral issues of incentives, goal congruence, and internal
controls.
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Chapter Overview
I. Delegation of Decision Making
A. Obtaining goal congruence
B. Management by objectives (MBO)
C. Adaptation of management control systems
II. Measuring Income and Invested Capital
A. Invested capital
B. Measuring investment-center income
C. Inflation: Historical-cost versus current-value accounting
III. Other Issues in Segment Performance Devaluation
A. Alternatives to ROI, residual income, and economic value added (EVA)
B. Importance of nonfinancial information
C. Measuring performance in nonprofit organizations
IV. Transfer Pricing
A. Goal congruence
B. General transfer-pricing rule
C. Transfers based on the external market price
V. Behavioral Issues: Risk Aversion and Incentives
VI. Goal Congruence and Internal Control Systems
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Key Lecture Concepts
I. Delegation of Decision Making
• Most large organizations are decentralized into divisions and other sizable
subunits. These subunits are usually considered investment centers, as
• Managerial accountants must design a responsibility-accounting
framework whereby evaluation systems encourage goal congruence of
the subunits.
➢ With goal congruence, the behavior of managers throughout an
organization is directed toward attainment of top management’s
goals.
• As a company grows it will often decentralize to better control operations
and make better decisions. Performance evaluation measures thus
become necessary for each of the subunits.
• Return on investment (ROI)
➢ ROI shows the return from a given amount of invested capital:
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▪ Sales margin—the amount of profit generated by each dollar
of sales. Computed as:
➢ ROI captures the interrelationships of both elements, as both are
needed for a successful operation.
➢ Managers strive to increase ROI.
▪ Sales margin can be increased by increasing income. This
can be accomplished by increasing sales prices (and more
➢ ROI measures return in a percentage form rather than in absolute
dollars, which is helpful when comparing segments of different
sizes.
➢ A drawback to using ROI is the potential of decreased goal
congruence.
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• Residual income
➢ Residual income shows the amount of income a given division (or
project) earns in excess of a firm’s minimum goal.
➢ This performance measure integrates a corporate imputed interest
rate and improves goal congruence. The formula is:
➢ As long as the residual income of a project is a positive amount, the
project is deemed attractive because it increases a manager’s
➢ Since residual income is expressed in absolute dollar terms, an
analyst forfeits the ability to compare firms/divisions of differing
sizes on a common basis.
➢ Both ROI and residual income are useful, but both tools have
Teaching Tip: To further emphasize the problems of comparing units of
vastly different size on the basis of dollar measures, you may want to cite
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➢ Economic value added (EVA), which is conceptually similar to
residual income, measures the amount of shareholder wealth being
created. It is computed as follows:
EVA = Investment center after-tax income – [(Investment
➢ The weighted-average cost of capital (WACC) measures the
average cost of a company’s debt and equity capital.
▪ The cost of debt capital is the after-tax cost of interest, after-
tax because interest payments are tax deductible.
II. Measuring Income and Invested Capital
• Income and invested capital, factors in the ROI, residual income, and EVA
performance models, can each be defined in several ways.
• Invested capital can be defined as total assets, productive assets, or total
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➢ The “definition decision” is further complicated when combined
with the additional decision of whether to use net book value or
gross value of long-lived assets. Issues to consider in this decision
include:
▪ The use of net book value produces valuations that are
consistent with those shown on the balance sheet.
• Another decision involves income measurement. Income should be
defined as controllable income if the performance model is to be a
motivator and if responsibility accounting is used by the firm.
III. Other Issues in Segment Performance Devaluation
• Some firms use alternatives to ROI, residual income, and economic value
added. These three measures are short-run performance measures.
IV. Transfer Pricing
• Goal congruence is achieved by following a general transfer-pricing rule:
Transfer price = Additional unit outlay cost incurred because goods are
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transferred + Opportunity cost per unit to the organization because of the
transfer
➢ Using the general rule, the selling division is reimbursed for the
variable costs of the product or service plus any margin forgone by
not selling in the external marketplace.
➢ In situations where the external market is willing to buy all the
➢ If there is no external buyer (excess capacity exists), the product or
service would transfer at an amount equal to variable cost, as there
would be no contribution margin forgone.
➢ The general model is often difficult to implement because of
• Market-based prices
➢ Such prices are consistent with the responsibility-accounting
• Negotiated prices
➢ Some companies allow buying and selling units to negotiate the
transfer price, particularly if no external market exists.
➢ Even in the case of an external price, the external price might serve
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• Cost-based prices
➢ Transfer prices may be based on a cost-plus scheme by marking up
either variable cost or full cost by a percentage. The policy of
• Other transfer pricing issues
➢ Transfer prices are used in a decentralized environment where
managers have authority to make decisions and control operations.
When disputes arise, top management should step aside and let the
V. Behavioral Issues: Risk Aversion and Incentives
• Performance-evaluation systems must include incentives for managers to
achieve goal congruence. Such systems, though, are often affected by
factors beyond a manager’s control, with the manager confronting various
risks while doing his or her job.
VI. Goal Congruence and Internal Control Systems
• An internal control system is designed to provide reasonable assurance of
the achievement of objectives in three areas:
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➢ The effectiveness and efficiency of operations;
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Teaching Overview
The subject matter in this chapter is difficult to teach. I have drawn this conclusion
based on student reaction to my presentations and, perhaps more telling, numerous
conversations with colleagues from around the country. The interest level that
accompanies many other managerial accounting topics is often lacking with this
material.
Exercise 13-29 is a good demonstration problem to use when discussing ROI and
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Links to the Text
Homework Grid – CHAPTER 13
Item No.
Learning
Objectives
Completion
Time (min.)
Exercises:
13-24
2
10
13-25
3
15
13-26
2
5
13-27
2
15
13-28
2
20
13-29
1, 2
30
13-30
2, 4, 5
30
13-31
1, 8
15
13-32
2
10
13-33
2
15
13-34
6
10
13-35
7
25
Problems:
13-36
2, 4
25
13-37
2, 3
45
13-38
3
20
13-39
2, 4
25
13-40
2, 4, 8
40
13-41
2, 4, 5
40
13-42
2, 4, 5
35
13-43
2, 4, 8
30
13-44
2
35
13-45
2
35
13-46
7
40
13-47
6, 7, 8
25
13-48
6, 7, 8
30
13-49
6, 7
40
Cases:
13-50
1, 2, 4, 8
40
13-51
6, 7, 8
45
13-52
6, 7, 8
50