Investment Center & Transfer Pricing

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Department of Management Studies (MBA-3rd Batch).

Jagannath University, Dhaka .

Assignment.

Course Title - Cost & Management Accounting (MGT-5105).

Course Teacher - Mr. Md. Quamrul Islam (Associate Professor,JNU).

Topic - Investment Center & Transfer Pricing.

Section - B , Group – H .

Roll Range : 094963 – 094972.

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Introduction : The creation of divisions allows for the operation of a system of

responsibility accounting. Responsibility accounting is a system of accounting that segregates revenues and costs into areas of personal Responsibility in order to monitor and asses the performance of each part of an organization.

A Responsibility center is a department or organizational function whose performance is the direct responsibility of a specific manager.

In the weakest form of decentralization a system of cost centers might be used. As decentralization becomes stronger the responsibility accounting framework will be based around profit centers. In its strongest form investment centers are used.

What is an 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. De-centralization bring 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 in-consistency 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.

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Return on Investment (ROI)One popular method was pioneered by E.I.du Pont de Nemours and Company. It is commonly known as the DuPont return on investment (ROI) model, and is pictured at under(Figure 1.1).This model consists of a margin subcomponent (Operating Income/Sales Revenue) and a turnover subcomponent (Sales Revenue/Invested Capital).These two subcomponents can be multiplied to arrive at the ROI.Thus, ROI=(Operating Income/Sales Revenue) × (Sales Revenue/Invested Capital).A bit of algebra reveals that ROI  reduces to a much simpler formula: Operating Income/Invested Capital.

÷

X

÷

Figure:1.1

But, a prudent manager who is to be evaluated under the ROI model will quickly realize that the subcomponents are important. Notice that ROI can be increased by any of the following actions: increasing sales, reducing expenses, and/or decreasing the deployed assets. The DuPont approach encourages managers to focus on increasing sales, while controlling costs and being mindful of the amount invested in productive assets. A disadvantage of the ROI approach is that some "profitable" opportunities may be passed by managers because they fear potential dilution of existing successful endeavors.

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Margin Margin

Return On Investment (ROI)

Return On Investment (ROI)

Sales Revenue

Sales Revenue

Tournover Tournover

Invested Capital

Invested Capital

Operating income

Operating income Sales Revenue

Sales

Sales Revenue

Sales

How To Calculate ROI:Holy company reports following:

Particulars Amount (Tk)

Operating Income 8000000

Sales Revenue 60000000

Invested Capital 40000000

Lets calculate ROI,

ROI=(Operating Income/Sales Revenue) × (Sales Revenue/Invested Capital)

ROI=(800000 / 60000000) × (60000000 / 4000000)

ROI=0.133 × 15=20 %.

OR,

ROI=Operating Income /Invested Capital

ROI =8000000/40000000

ROI=0.2 × 100=20%.

Advantages & Limitations of ROI:

Advantages Limitations

1.Easily understood by managers.

2.Comparable to interest rates and the rates of return on alternative investments.

3.Widely used and reported in the business press.

1.Goal congruency issue: incentive for high ROI units to invest in projects with ROI higher than the minimum rate of return but lower than the unit’s current ROI.

2.Comparability across SBUs can be problematic.

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Residual Income (RI):It is net operating income which an investment center earns over and above the minimum required return on its operating assets. Like ROI,RI is another approach to measuring an investment center's performance.

Though ROI and RI have the same roots and results, RI proves better in certain circumstances as explained below:

If ROI is made a criteria, managers would be reluctant to make additional investment in fixed assets as it may bring down the ROI. In previous example, a manager was happy with an ROI of 20%. If an additional sum of Tk.10 million is made which would bring incremental return of Tk.1.2 million, this would bring down overall ROI to 18.4% {(8 m+ 1.2 m) / (40 m + 10 m)}.

But RI would give results in monetary term which would show an increase. Supposing, Cost of Fund (minimum required returns) was 10%, RI in the foregoing example, before additional investment, would be Tk.4 million {(8m - (40 m x 10%)}. With additional Investment and the returns, it would increase to Tk.4.2 million (8m+1.2m) - {(40 m + 10m) x 10%}. Thus RI would increase by Tk.200,000 which is a good sign.

Advantages and Limitations of RI:

Advantages Limitations

1.Supports incentive to accept all projects with ROI > minimum rate of return.

2.Can use the minimum rate of return to adjust for differences in risk.

3.Can use a different minimum rate of return for different types of assets.

1.Favors large units when the minimum rate of return is low.

2.Not as intuitive as ROI.

3.May be difficult to obtain a minimum rate of return at the subunit level.

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Economic Value Added (EVA):The term “Economic Value Added (EVA)” is a registered trademark of Stern Stewart & Co, a consulting firm which implements the EVA concept for large companies. Economic Value Added (EVA) sharpens the view of corporate governance by redefining its goal. It has long been accepted that companies should seek to maximize profits. The firm of Stern and Stewart attempts to change the target somewhat by saying that shareholders will benefit if the firm maximizes EVA instead of accrual profits.

Economic value added (EVA) uses accounting information to improve decisions and motivate employees. According to Erik Stern, president international of Stern Stewart, “Although EVA is based on accounting, when implemented the system must be simple and operational or it is irrelevant.EVA is not a metric but a way of thinking, a mindset. While the language is technical, the lifestyle is operational.”Central to the concept is the idea of opportunity cost.Capital is used in each division of the organization. That division is required to earn a rate of return based on the amount of capital it uses and the cost of that capital.The firm’s cash flow is subtracted from the required profits, based on the rate of return, to give economic profits.

Using this method, the divisions earning the highest returns are favored. More capital is invested in them. Those which earn less but are still above the target return also receive capital allocations. Divisions below the target return are re-evaluated. These are sold off if it appears they will be unable to meet the threshold. The term used for terminating a division is “harvesting”. The thinking is that the division may have grown ripe (mature),thereby making it eligible for harvest (sale or discontinuation).

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Calculation of EVA:

The basic formula for calculating EVA is :

Net Sales

- Operating Expenses

Operating Profit(EBIT)

- Taxes

Net Operating Profit After Tax (NOPAT)

- Capital Charges (Invested Capital × WACC1)

Economic Value Added (EVA)

Some Specific Usages of EVA Include:

To set organizational goals.

Performance measurement.

Determining of bonuses.

Communication with shareholders and investors.

motivation of managers.

Capital budgeting.

Corporate valuation.

1 WACC=Weighted Average Cost of Capital

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What is Transfer Pricing :A transfer price is the price charged when one segment of a company provides goods or services to another segment of the company. Setting transfer prices is a difficult process because the price affects investment center profitability. A high transfer price results in high profit for the selling investment center and low profit for the buying investment center. A low transfer price results in low profit for the selling investment center and high profit for the buying investment center. The price must be set to establish incentives for decentralized investment center managers to make decisions that support the overall goals of the organization.

General Transfer-Pricing Rule :

= +

Transfer Pricing Objectives :

To motivate managers.

To provide an incentive for managers to make decisions consistent with the firm’s goals To provide a basis for fairly rewarding managers.

Minimization of customs charges.

Minimize total (i.e., worldwide) income taxes.

Currency restrictions.

Risk of expropriation (government seizure).

Transfer Pricing Methods :

Managers are intensively interested in how transfer prices are set, since transfer prices can have a dramatic effect on the apartment profitability of a division. Four common approaches are used to set transfer prices. These are,

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Transfer PriceTransfer PriceAdditional outlay

cost per unit incurred because goods are

transferrd.

Additional outlay cost per unit incurred

because goods are transferrd.

Opportunity cost per unit to the

organization because of the transfer.

Opportunity cost per unit to the

organization because of the transfer.

1. External Market Price

– Use if the selling unit has no excess capacity and perfect competition exists.

– Here, the general transfer rule and the external market price are equal.

– The long-run average external market price should be used, because distressed market prices can severely affect transfer pricing profitability.

2. Negotiated Transfer Price

– It is common for managers to negotiate transfer prices from the external market price.

– This can split the cost savings between both units, but can lead to divisiveness and competition between investment centers.

3.Variable Cost Based Transfer Pricing

– Variable cost is used as the transfer price.

– The biggest drawback with using variable cost is that when excess capacity exists, the selling unit can’t show contribution margin on the transferred goods.

4.Full Cost Based Transfer Pricing

– FC - VC + allocated fixed overhead.

– The biggest drawback affects the buying unit’s view of costs as fixed for the company as a whole as the variable costs for the buying unit.

International Aspects of Transfer Pricing:The objective of transfer pricing change when multinational corporations involved and the goods and services being transferred cross international borders. The objective of international transfer pricing focus on minimizing taxes, duties, and foreign exchange risks, along with enhancing a company's competitive position and improving its relations with foreign governments.

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