When comparing various divisions within a company, describe what problems can arise from evaluating divisions that have different accounting methods, as described in Chapter 11 of your text. Cite three examples of accounting methods that could cause divisions' profits to differ. Your initial post should be 200-250 words.

chapter 11 Analysis of Decentralized Operations Ingram Publishing/Thinkstock Learning Objectives After studying Chapter 11, you will be able to: Define the components of division net income, division direct profit, division controllable profit, and division contribution margin. Describe the problems of selecting an investment base for evaluating performance. Evaluate a division manager's performance using return on investment, residual income, and the economic value added approach. Identify the criteria for developing and evaluating transfer pricing policies. Discuss the advantages and disadvantages of alternative transfer pricing methods. Explain how the importance of intracompany dealings, the existence of external markets, and the relative power positions of the divisions affect transfer pricing. Understand transfer pricing issues in the international arena. sch80342_11_c11_445-488.indd 445 12/20/12 11:54 AM CHAPTER 11 Chapter Outline Chapter Outline 11.1 Review of Responsibility Centers 11.2 Advantages of Decentralization 11.3 Measurement of Financial Performance Return on Investment Residual Income Economic Value Added Ethical Concerns Relating to Performance Measures 11.4 Performance Evaluation Systems in Service Organizations 11.5 Intracompany Transactions and Transfer Pricing Problems Desired Qualities of Transfer Prices and Policies Transfer Prices Evaluating Transfer Pricing Methods According to the Criteria 11.6 Maximizing International Profits: The Role of Transfer Prices Minimization of World-Wide Taxes Avoidance of Financial Restrictions Gaining Host Country Approval Dividing the Profit Pie: Whose Is Whose? Shagari Petroleum Company is a large Nigerian oil company headquartered in Lagos. The company has five operating divisions: Exploration & Production, Trading & Supply, Gas Processing, Refining, and Marketing & Distribution. Each division is responsible for generating a profit and for managing its investment in assets. Debates have raged among division managers about who earned what profits since, in many cases, \"Your revenues are my costs.\" The Exploration & Production Division has the task of finding, developing, and producing oil and gas reserves. Oil produced is sold to the Trading & Supply Division or to outside customers, depending on who offers the best prices. Gas produced is sold to the Gas Processing Division, petrochemical companies, or pipeline companies. The Trading & Supply Division is responsible for meeting the crude oil needs of the Refining Division. It purchases crude oil from the Exploration & Production Division and the open market. Crude oil not sold to Refining is marketed overseas. Consequently, the division engages in speculative buying and selling as a major means of generating profits. Although the Gas Processing Division may purchase gas from other companies, 90 percent of its gas needs are met by the Exploration & Production Division. Processing results in liquid petroleum gas products such as ethane, propane, and butane. These products are sold to the Marketing & Distribution Division and to petrochemical companies. sch80342_11_c11_445-488.indd 446 12/20/12 11:54 AM Section 11.1 Review of Responsibility Centers CHAPTER 11 The Refining Division has refineries in Kano, on the Niger River, and in Ibadan. The refineries have the capability to produce a full range of petroleum products. Finished products are sold either to the Marketing & Distribution Division or to an overseas wholesale market. Marketing & Distribution sells to utilities and international resellers, plus industrial, governmental, commercial, and residential customers. It buys its products from the Refining and Gas Processing Divisions. If shortages occur, it may purchase from overseas wholesale markets. The division sells a wide range of products. It owns a barge fleet, tanker trucks, and some pipeline facilities for transporting the products. Other product shipments are contracted with shipping companies. Since the divisions each generate profits and have tremendous investments in assets, Shagari Petroleum wants to develop an appropriate measure for evaluating the financial performance of the divisions and their managers. Also, a transfer price policy should value intracompany deals fairly. Introduction O ne of the most striking characteristics of organizations over the past thirty years has been top management's desire to grow and yet retain the advantages of smallness. Companies have decentralized operations to retain this element of smallness, to build \"entrepreneurial spirit,\" and to motivate division managers to act as the heads of their \"own\" companies. In general, a decentralized company is one in which operating subunits (usually called divisions) are created with definite organizational boundaries, each with managers who have decision-making authority. Thus, responsibility for portions of the company's profits can be traced to specific division managers. Even though the amount of authority granted to these managers varies among companies, the spirit of decentralization is clearto divide a company into relatively self-contained divisions and allow them to operate in an autonomous fashion. This chapter discusses two problem areas common to evaluating divisional performance. First, we discuss various evaluation measures and how these measures can be used. Then we discuss criteria, approaches, and problems associated with transfer prices for goods and services moving among divisions. 11.1 Review of Responsibility Centers B efore discussing decentralization and performance measures, it is essential to review the types of responsibility centers first introduced in Chapter 6. A responsibility center is any organizational unit where control exists over costs or revenues. Managers of cost centers have control over the incurrence of cost but not over revenues. Cost centers are usually found at lower levels of an organization but may include entire plants or even entire parts of an organization, such as manufacturing or the controller's office. In contrast, managers sch80342_11_c11_445-488.indd 447 12/20/12 11:54 AM Section 11.2 Advantages of Decentralization CHAPTER 11 of profit centers have control over both costs and revenues. These managers are responsible for generating revenues and for the costs incurred in generating those revenues. In investment centers, managers control costs, revenues, and assets used in operations. The investment involves plants and equipment, receivables, inventories, and, in some cases, payables traceable to the investment center's operations. Companies or subsidiaries could be investment centers or profit centers, depending on whether the corporate headquarters gives investment responsibility to these levels. Investment responsibility is defined as authority to buy, sell, and use assets. Top management's intent often determines the type of responsibility center. In a large company, a data processing center could be a cost center, either absorbing its own costs or allocating its costs to users of the firm's computer operations. As a profit center, it would be allowed to charge a rate for data processing services it provides to internal users and be expected to earn a profit on its operations. To create an investment center, the manager would be given responsibility to acquire equipment and update services from funds generated by its charges for services provided. Often, organizational structures create natural cost, profit, or investment centers. But managerial intent is perhaps the most important factor in determining how a decentralized unit will be viewed and managed. 11.2 Advantages of Decentralization D ecentralization is the delegation of decision-making authority to lower management levels in an organization. The degree of decentralization depends on the amount of decision-making authority top management delegates to successively lower managerial levels. Advantages of decentralizing include: 1. Motivated managers. Managers who actively participate in decision making are more committed to working for the success of their divisions and are more willing to accept the consequences of their actions, whether positive or negative. 2. Faster decisions. In a decentralized organization, managers who are close to the decision point and familiar with the problems and situations are allowed to make the decisions. Consequently, decisions can be made faster without moving data up the organization and having a decision made by a manager far removed from the action. 3. Enhanced specialization. Delegating authority permits the various levels of management to do those things each does best. For example, top management can concentrate on strategic planning and policy development; middle management on tactical decisions and management control; and lower management on operating decisions. 4. Defined span of control. As an organization increases in size, top management has more difficulty controlling the organization. Decentralizing the authority defines more narrowly the span of control for each manager and thus makes the control system more manageable. 5. Training. Experience in decision making at low management levels results in trained managers who can assume higher levels of responsibility when needed. sch80342_11_c11_445-488.indd 448 12/20/12 11:54 AM CHAPTER 11 Section 11.3 Measurement of Financial Performance To realize the full benefits of these advantages, top management must address the following issues: 1. Competent people. Without competent people, the best policies break down; a lack of control reduces the efficiency and effectiveness of operations. 2. Measurement system. The same measurement system should be used for all divisions. Top management must develop policies that provide consistency in reporting periods, methods of reporting, and methods of data collection. 3. Clear corporate goals. Left to themselves, division managers may work for their own interests without consideration of benefits to the entire organization. Top management needs to focus all managers' efforts on corporate goals through planning and incentive systems. Formulating the best method for controlling and evaluating divisions is usually more complex than any other single control activity within a company. Motivation, control, and managerial behavior are broad topics and are far beyond the scope of this book. 11.3 Measurement of Financial Performance I n previous chapters, planning and control methods were discussed. We apply these to cost, profit, and investment center evaluations. Cost controls used in cost centers are also relevant for profit and investment centers. Revenue and profit measurements used in profit centers are also applied to investment centers. Thus, we can build the following planning and control structure: Centers: Cost Profit Investment Expense budgeting X X X Flexible budgets X X X Plan versus actual expense comparisons X X X Standard cost variances X X X Revenue and profit budgeting X X Plan versus actual controllable contribution margin. X X Plan versus actual direct contribution margin X X Asset utilization and rate of return target setting X Plan versus actual asset utilization comparisons X Plan versus actual rates of return comparisons X It is rare that financial measures alone can evaluate the performance of a responsibility center. Product or service quality, delivery reliability, market share, and responsiveness to customers are all nonfinancial measures critical to the overall success of a firm. Both financial and nonfinancial goals are often part of a manager's business plan. We discuss in detail nonfinancial performance measures in the next chapter. sch80342_11_c11_445-488.indd 449 12/20/12 11:54 AM CHAPTER 11 Section 11.3 Measurement of Financial Performance For profit and investment centers, selecting proper financial performance measures is not an easy task. The financial measures chosen: Send messages to all managers about what is important to the firm's executive managers. Are often the basis for calculating incentive compensation, personnel evaluations, and promotion decisions. Influence the allocation of new capital and personnel resources. Rate of return on investment is widely accepted as the primary measure of performance for investment centers. Return on Investment Return on investment (ROI) is defined as a ratio: Return on investment 5 Profit 4 Investment We can decompose this ratio into two elements for better control and evaluation: Return on investment 5 (Profit 4 Sales) 3 (Sales 4 Investment ) The first term, Profit 4 Sales, is return on sales (ROS) (sometimes called the profit margin). It measures the percentage of each sales dollar that is turned into profit. The second term, Sales 4 Investment, is asset turnover, which measures the ability to generate sales from the assets a division employs. Implementing the ROI concept raises a number of issues. Problems exist in defining the profit numerator as well as the investment denominator. Even then, divisions within a company may be dissimilar, creating \"apples and oranges\" comparisons. The Numerator - Division Profit The choice of the profit figure is not simple. The first problem is how the profit number will be used. Will it be used to evaluate the division as an economic unit or to evaluate the division manager's performance? A different profit is appropriate for each. Once the purpose is decided, the next problem is how to construct the best measure from several profit concepts commonly available. Assume that a division of Taratoot Financial Consulting reports the following profit and loss data (all numbers in thousands): Division revenues $1,000 Direct division costs: Variable operating costs 700 Fixed division overhead - controllable at the division level 100 Fixed division overhead - noncontrollable at the division level 50 Indirect division costs: Allocated (fixed) home office overhead sch80342_11_c11_445-488.indd 450 60 12/20/12 11:54 AM CHAPTER 11 Section 11.3 Measurement of Financial Performance Four alternative income statements organize the data for different purposes. Revenue Division contribution margin Division contribution margin Segment margin Division net profit $1,000 $1,000 $1,000 $1,000 700 700 700 700 100 100 100 50 50 Direct cost: Variable costs $300 Fixed controllable costs $200 Fixed noncontrollable costs. $150 Indirect cost: Allocated corporate overhead 60 $90 Division Net Profit The best profit measure for division performance may appear to be division net profit. However, the division net profit calculation includes allocated corporate overhead. An example of this cost would be the cost of operating the president's office. Although each division benefits from these costs, they are not controllable at the division level nor traceable to specific divisions. Generally, division net profit is a poor indicator of a division's performance. The main arguments for using division net profit are that the division manager is made aware of the entire firm's operating costs and that these costs must be covered by the divisions' earnings. Another argument is that the allocated corporate overhead costs stimulate division managers to pressure corporate managers to control their costs. Corporate overhead expenses that are traceable to specific divisions should be assigned directly to those divisions. Allocated corporate overhead expenses are likely to be arbitrary and open to question by the division managers. Often, division managers spend much time attempting to reduce their costs by getting top management to change the allocation procedure. Segment Margin Segment margin is defined as total division revenue less direct costs of the division. This concept avoids the main difficulty of division net profit since common costs of the firm are excluded. The segment margin is the most useful profit measure for comparing divisions' performances, for resource allocation decisions, and for corporate planning purposes. All revenues and costs traceable to the divisions are included. Often, corporate-level decision makers use the segment margin to indicate where additional investments should be made to generate the greatest incremental returns. Certainly, sch80342_11_c11_445-488.indd 451 12/20/12 11:54 AM Section 11.3 Measurement of Financial Performance CHAPTER 11 specific projects must justify themselves, as Chapter 10 demonstrates. But more attention will be paid to high performing divisions. Division Controllable Margin Division controllable margin is defined as total division revenue less all costs that are directly traceable to the division and that are controllable by the division manager. This calculation is best for managerial performance measurement, because it reflects the division manager's ability to execute assigned responsibilities. Any variances between actual and plan can be explained in terms of factors over which the division manager has control. Sometimes direct costs are traceable to a division but cannot be controlled at that level. For instance, a division head's salary is controllable only at a higher management level. Also, some division costs, such as long-term leases and depreciation, are from past investment decisions that may have been made by higher level managers or previous division managers. These direct but noncontrollable costs should be excluded from the profit calculation for managerial evaluations. If this is not done, the division profit used for performance evaluation may be affected by actions outside the division or of prior managers. Some factors in the division controllable margin may be difficult for the division manager to influence; for example, the materials prices may increase. Even though the price cannot be changed, perhaps alternate materials can be used or alternate sources of supply can be found. Problems of this nature may be difficult to solve, but they are part of the division management's responsibility. Failure to solve such problems is different from being unable to take action due to lack of authority. Division Contribution Margin The division contribution margin is defined as total revenue less variable costs. Although contribution margin is useful in decision making, for performance evaluation its defect is obvious: namely, direct and controllable fixed costs are excluded from the calculation. Variable costs do have an important role in intracompany pricing policies and decisions, which are discussed later in this chapter. The Denominator - Investment If divisions are to be evaluated by ROI, it is necessary to measure the investment base. The investment base may be total direct assets, net direct assets, or net direct assets managed. Net direct assets would be traceable assets minus any traceable liabilities. Again, the distinction between direct and controllability is important. Certain assets may be traced to a division but not be in service or usable by the division manager. Since ROI is a measure for a period of time, which date during that period should be chosen to measure the amount of assets? Usually, a simple average of the beginning and ending amounts is used. sch80342_11_c11_445-488.indd 452 12/20/12 11:54 AM Section 11.3 Measurement of Financial Performance CHAPTER 11 Asset Identification The first task is to decide which assets to assign to each division. Many assets can be traced directly to a division. For example, much of a firm's physical property can be traced to a particular division. A division may handle its own receivables and inventory and may even have jurisdiction over its own cash. But sometimes, these traceable assets are centrally administered and controlled. By proper account coding, it is possible to trace receivables and inventories to specific divisions. Cash, as a corporate asset, is rarely traceable to specific divisions. For assets that are common to several divisions, no amount of coding, sorting, or classifying will enable tracing them to the divisions. An example of a common asset would be the administrative offices used by two product divisions. Any basis of allocation would be arbitrary. As with home office expenses, avoiding these arbitrary allocations generally improves the analysis. Asset Valuation Once the assets have been identified with the divisions, the value of the assets must be determined. It may seem that the assets should be stated at some current value (e.g., replacement cost, original cost adjusted for price-level changes) rather than on a historicalcost basis. The obvious difficulty is measurement. How can replacement costs be determined? If a common-dollar base is desirable, which price-level index should be used? It is easier to raise questions than to give answers. Preferred Relationships Matching an income measure and an investment base is the next step. If the purpose is to evaluate the division itself, segment margin would be the natural match with net division direct assets, which are assets traceable to the specific division less traceable liabilities. To evaluate the division managers, controllable margin should be matched with net direct managed assets. Managed assets include the assets controlled by the division manager having the authority to acquire, use, and dispose of these assets. Additional Problems With ROI Using the ROI concept as a means of evaluating performance raises some concerns about how effective ROI can be and about potential undesirable impacts that may arise from its use. Comparability Among Divisions One of the major concerns is that ROI comparisons should use the same definitions for the same purposes. Divisions being compared should have the same or similar accounting methods. The same depreciation method should apply to similar classes or categories of assets. Likewise, incorrect comparisons result when one division uses FIFO for inventories and another division uses LIFO. Also, each division being compared should have the same or similar policies for capitalizing or expensing costs. For instance, one division sch80342_11_c11_445-488.indd 453 12/20/12 11:54 AM Section 11.3 Measurement of Financial Performance CHAPTER 11 might expense tools whenever they are purchased. Another division might capitalize the original tools plus any increments and expense replacement tools. It would be inappropriate to compare these two divisions on the basis of ROI without making appropriate adjustments. Motivational Impact on Managers From top management's point of view, division managers should be working to achieve the overall objectives of the organization. This requires strategies, policies, techniques, and incentives to act as motivators for division managers. Goal congruence is the term often used to link each division manager's goals with top management's goals. Individual managers may have personal and organizational goals that differ from top management's goals. When designing managerial performance criteria, senior management must carefully select measures to promote goal congruence. Thus, managers should be motivated to work for their own benefit while, at the same time, benefiting the whole organization. ROI may sometimes promote decisions that are not goal congruent. For example, suppose that the Northern Division of Ellman's Payroll Service is currently earning 25 percent ROI. The division manager may be reluctant to make additional investments at, perhaps, 20 percent because the average return of the division would drop. However, if new investments in other divisions of the company yield only 15 percent, company management may prefer that the investment with a yield of 20 percent be accepted. The high-earning manager may still be reluctant to lower the average ROI from 25 percent even though company management has set 15 percent as the base rate for comparison. Thus, the use of ROI might restrict additional investment to the detriment of companywide profitability. Improving ROI Since division managers are expected to improve ROI, they look to components they can control. ROI can be improved in three direct ways: by increasing sales, by decreasing expenses, and by reducing the level of investment. To see how individual changes affect the ROI calculation, consider the following data for the Sports Division of Eddington Entertainment Corporation: sch80342_11_c11_445-488.indd 454 Sales: $2,500,000 Variable costs: 1,500,000 Contribution margin: $1,000,000 Fixed costs: 600,000 Net income: $400,000 Investment base: $2,000,000 Return on sales: 16.00% [$400,000 / $2,500,000] Asset turnover: 1.25 times [$2,500,000 / $2,000,000] ROI: 20.00% [$400,000 / $2,000,000] 12/20/12 11:54 AM Section 11.3 Measurement of Financial Performance CHAPTER 11 Increase Sales Looking at ROI as a product of return on sales and asset turnover might give the impression that the sales figure is neutral, since it is the denominator in the return on sales and the numerator in asset turnover. However, suppose the Sports Division can increase ticket sales without increasing unit variable costs or fixed costs. The return on sales improves. This happens anytime the percentage increase in total expenses is less than the percentage increase in dollar sales. The increase in sales also improves the asset turnover as long as there is not a proportionate increase in assets. The objectives are to attain the highest level of net income from a given amount of sales and the highest level of sales from a given investment base. Continuing the numerical example for the Sports Division, assume that ticket sales and total variable costs increase by 5 percent and that fixed costs and the investment base remain constant. ROI, return on sales, and asset turnover all increase, as follows: Sales (105%): $2,625,000 Variable costs (105%): 1,575,000 Contribution margin: $1,050,000 Fixed costs: 600,000 Net income: $ 450,000 Investment base: $2,000,000 Return on sales: 17.14% [$450,000 / $2,625,000] Asset turnover: 1.31 times [$2,625,000 / $2,000,000] ROI: 22.50% [$450,000 / $2,000,000] Reduce Expenses Often, the easiest path to improved ROI is to implement a cost reduction program (focusing on certain expense areas or across-the-board cuts). Reducing costs is usually the first approach managers take when facing a declining return on sales. A rather typical pattern has emerged. First, review the discretionary fixed costs, either individual cost items or programs representing a package of discretionary fixed costs, and find those that can be curtailed or eliminated quickly. Second, look for ways to make employees more efficient by eliminating duplication, nonvalue-adding time, or downtime and by increasing individual workloads. Third, review costs of resource inputs for operations and seek less costly choices. Reduce Investment Base Managers have traditionally sought to control sales and expenses. Their sensitivity to asset management, however, has not always been at the same high level. Managers, whose performances are evaluated using ROI, will find that trimming any excess investment can have a significant impact on the asset turnover and, therefore, on ROI. Reducing unnecessary investment often involves selling or writing off unused or unproductive assets. Recently, many companies have reduced investment in inventories, and also lowered nonvalue-added expenses, by changing to just-in-time inventory systems. Referring to the sch80342_11_c11_445-488.indd 455 12/20/12 11:54 AM Section 11.3 Measurement of Financial Performance CHAPTER 11 original Sports Division data, assume that its managers are able to reduce the investment by 4 percent but still maintain the same level of sales and expenses. As a result, both the asset turnover and ROI increase: Sales (105%): $2,500,000 Variable costs (105%): 1,500,000 Contribution margin: $1,000,000 Fixed costs: 600,000 Net income: $400,000 Investment base: $1,920,000 Return on sales: 16.00% [$400,000 / $2,500,000] Asset turnover: 1.30 times [$2,500,000 / $1,920,000] ROI: 20.83% [$400,000 / $1,920,000] If the eliminated investment is a depreciable asset, depreciation expense will also be reduced. This causes a compound reaction: profitability increases, return on sales increases, and ROI increases by improvement in both the return on sales and the asset turnover. Contemporary Practice 11.1 ROI of College Education \"Snob appeal often plays a big role in the selection of a college by high school seniors and their families... But what happens when you look at earnings per dollar spent to get an education? Before you spot a single Ivy League or big-name private school, public campuses grab 17 of PayScale's first 18 spots... Leading is Georgia Tech's 13.9% return on investment. Next is the University of Virginia's 13.3%.\" (Katzeff, 2011) Residual Income The use of residual income has been proposed as an alternative to ROI. Residual income focuses attention on a dollar amount (instead of a ratio) and on a minimum expected return. The maximization of a dollar amount will tend to be in the best interest of both the division manager and the company as a whole. In general, residual income is defined as the operating profit of a division less an imputed charge for the operating capital used by the division. The same measurement and valuation problems we encountered with ROI still apply to residual income. But motivational problems should be eased. Assume that, for Bakin Moving Company, a division's current controllable margin (before any imputed capital charge) is $250,000 and the relevant investment is $1,000,000. The ROI, then, is 25 percent. Suppose top management wants sch80342_11_c11_445-488.indd 456 12/20/12 11:54 AM CHAPTER 11 Section 11.3 Measurement of Financial Performance division management to accept incremental investments so long as the return is greater than 15 percent. We refer to this rate as a minimum desired rate of return. This minimum desired rate of return is then used to calculate an imputed charge for division investment funds. The residual income would be calculated as follows: Division controllable margin (before imputed capital charge) Less imputed capital charge (15% x $1,000,000) Division residual income $250,000 150,000 $100,000 The advantage of this evaluation measure is that the division manager is concerned with increasing a dollar amount (in this case, the $100,000) and is likely to accept incremental investments which have a yield of over 15 percent. The division manager's behavior, then, is congruent with company-wide objectives. This would less likely be true with the ROI measure, since any incremental investment earning less than 25 percent pulls down the division's current ROI. A disadvantage with residual income arises when comparing the performance of divisions of different sizes. For example, a division with $50 million in assets should be expected to have a higher residual income than one with $2 million in assets. The stage of growth and other risk factors influence the potential profits that a division can generate. Consequently, top management might select different minimum desired rates of return for each division to recognize the unique role each plays in the organization. For example, a start-up division may be more expensive to operate than a division in the mature stagejustifying a lower initial rate of return. Economic Value Added In recent years, an approach quite similar to residual income has been developed to evaluate performance. Like residual income, the economic value added (EVA) approach deducts a minimum rate of return (i.e., cost of capital x total capital) from the division's profits, as follows: EVA 5 Adjusted accounting profit 2 (Cost of capital 3 Total capital) Hence, like residual income, the EVA measure is a dollar amount. ROI, in contrast, is a pure number (i.e., no unit of measure associated with it). The adjusted accounting profit is an after-tax profit with some expenses, such as research and development, treated differently than is done for external reporting requirements. Managers often have incentives to reduce expenses by cutting amounts spent on items such as research and development. To counteract this short-sighted inclination, research and development can be treated as a depreciable asset rather than as an expense, which would not be allowed for external reporting. The resulting profit number better reflects the division's long-run profit potential. The total capital would also include these expenditures. Another frequent adjustment to total capital is the exclusion of current liabilities. sch80342_11_c11_445-488.indd 457 12/20/12 11:54 AM Section 11.3 Measurement of Financial Performance CHAPTER 11 Whereas the capital charge in the residual income measure is usually based on the minimum desired rate of return, EVA uses the actual cost of capital. The EVA approach often determines the cost of capital differently than the traditional weighted average cost of capital calculation, which is a weighted average of the cost of debt and the cost of equity. EVA derives a cost of capital based on the industry and risk characteristics of the particular division. Many large companies such as Tenneco, Equifax, Coca-Cola, and AT&T have begun using the EVA approach and linking EVA to incentive compensation. EVA is viewed as the amount which is added to shareholder wealth. When divisions are making investments that earn returns higher than the cost of capital, then the company's shareholders should earn a return in excess of their expectations, and the company's stock price is likely to rise. Ethical Concerns Relating to Performance Measures Division managers can increase short-run profits of divisions to the detriment of the company as a whole. For example, it may be possible to delay maintenance costs. Such an action will increase short-run profits but adversely affect long-run profitability of the division and the company. Expenditures that engender employee loyalty such as employee physical fitness programs may be eliminated. By reducing training costs, the division manager may not develop long-run top management personnel. Our earlier discussion that the use of ROI may not promote goal congruent behavior has ethical implications also. A manager should consider whether it is ethical to reject an investment that would benefit the company even though it would reduce the manager's average ROI. Contemporary Practice 11.2 Conflicts of Interest with ROI An experiment with individuals in graduate and executive education managerial accounting classes, who averaged about six years of full-time work experience, investigated investment decisions where the participants would be evaluated using ROI. In one setting, the investment under consideration would benefit the company but would reduce the current ROI of the participant. The study estimated that about 51 percent of the respondents would reject the investment. In another setting, a proposed asset replacement would benefit the company in the long-run but would lower the participant's current ROI because the book value of assets is used in the denominator of ROI. The study estimated that about 38 percent of the respondents would reject the investment (Schneider, 2004). sch80342_11_c11_445-488.indd 458 12/20/12 11:54 AM Section 11.5 Intracompany Transactions and Transfer Pricing Problems CHAPTER 11 11.4 Performance Evaluation Systems in Service Organizations S ervice organizations, like manufacturers, also need evaluation systems. Evaluation criteria and measures can depend on whether the service organization is commercial or not-for-profit. Profit-oriented operations have an incentive to be profitable. They may use ROI, residual income, or EVA, if an appropriate profit measure and an investment base are available. Obviously, organizations such as CPA firms, law firms, insurance agencies, and consulting firms do not have large investment bases. Personnel is their prime resource. Furthermore, they often lease equipment, space, cars, and other operating assets. Using ROI, residual income, or EVA in these situations will not give a realistic measure of performance for the divisions within the organization. Return on revenue is a better measure and a greater management motivator than are ROI, residual income, and EVA. Not-for-profit organizations are different because profits are not the prime interest of managers. Moreover, revenues are often unrelated to services performed; rather, they come from funding agencies. For example, a police department obtains its operating funds from the local government. The department's mandate is to provide law enforcement services within the limits imposed by the operating funds. But how does one measure the level of services performedby the number of cases investigated? by time spent on cases? by the number of arrests? Finding criteria for evaluating performance is not an easy task in notfor-profit settings. 11.5 Intracompany Transactions and Transfer Pricing Problems I n calculating division profit, problems arise when the divisions are not completely independent. If one division furnishes goods or services to another division, a transfer price must be set to determine the buying division's cost and the selling division's revenue. The following list illustrates a variety of intracompany transactions: 1. A centralized accounting department serves all divisions of a company, and its costs are allocated to divisions based on the number of employees in each division. 2. One department provides repairs and maintenance for production departments' equipment in a factory and bills for those services at an average actual cost per hour of service. 3. A Data Processing Services Division provides computer-based information systems services to all other divisions in the company and allocates costs on the basis of predetermined prices for volumes of transactions and data handled. 4. Plant A produces components which are shipped to Plant B for assembly into an end product which is then transferred to the Sales Division for sale to outside customers. Components and products are billed at a \"full cost plus a profit\" basis between Plants A and B and between Plant B and the Sales Division. sch80342_11_c11_445-488.indd 459 12/20/12 11:54 AM CHAPTER 11 Section 11.5 Intracompany Transactions and Transfer Pricing Problems 5. Plant J sells strategic raw materials to a variety of customers, including Plant K in the same company. Managers negotiate a special price each year for the raw materials, depending on the supply and demand factors for each plant. 6. Division R sells an industrial product to a broad array of customers. Division S happens to need the product and buys from the sister division at the prevailing market price because of the product's high quality or the division's delivery reliability. This continuum of accounting approaches for intracompany dealings is shown in Figure 11.1. While not representing any numerical measuring scale, this line does illustrate the range of accounting techniques for intracompany transactions. At one end is pure (arbitrary) cost allocation. At the other end is pure market-driven pricing. Figure 11.1: Continuum of accounting approaches for intracompany transactions Arbitrary Cost Allocation Percentage Actual Cost Allocation Based on Use Usage-Based Cost Allocation with a Predetermined rate Cost Plus a Profit Negotiated Price Market Price On the left side of the continuum, overhead or administrative costs are being roughly redistributed to other units using cost drivers, benefits received, or even arbitrary rules. Commonly, service departments are transferring costs to producing departments. The middle portion involves internal sales of goods and services where external markets do not exist or where company policies force the divisions to deal with each other internally. The right end of the continuum represents situations where external markets do exist and where market prices are used, in part or in total, as the exchange price. Buyers seek suppliers. Sellers seek customers. If an intracompany sale takes place, it is the best source for the buyer and a profitable sale for the seller and for the company as a whole. Desired Qualities of Transfer Prices and Policies No one transfer pricing method will be best for all situations. A manager who has spent years supervising internal sales and purchases for a major company has said: \"Perhaps the optimal policy is one that will produce the least amount of dysfunctional behavior or, at best, an amount that we can tolerate.\" Hopefully, policies encourage positive behavior. But dysfunctional behavior, actions which hurt the firm's results, can be frequent by-products. Let us first outline the criteria for creating a transfer pricing system; second, discuss alternative transfer prices; and third, identify the ability of each price to meet the criteria. Criteria for a transfer price can be reduced to four main elements: sch80342_11_c11_445-488.indd 460 12/20/12 11:54 AM Section 11.5 Intracompany Transactions and Transfer Pricing Problems CHAPTER 11 1. Goal congruence. Will the transfer price encourage each manager to make decisions that will maximize profits for the firm as a whole? In decentralized organizations, perhaps one of the most difficult tasks is to get everyone to pull toward the common goalthe financial success of the whole firm. Success of each division will not guarantee the optimal success for the whole firm. 2. Performance evaluation. Will the transfer price allow corporate-level managers to measure the financial performance of division managers in a fair manner? How will power positions that certain divisions have over other divisions be neutralized? For instance, if one division sells its entire output to another division, the buyer can demand concessions from the seller that can cause the seller to appear unprofitable. If the two divisions are to remain independent, the pricing policy must allow the seller to get a reasonable price for its output. 3. Autonomy. Will the transfer price policy allow division managers to operate their divisions as if they were operating independent businesses? If a division manager must ask for approval from some higher level, the firm's policies have diluted the autonomy of its managers. If autonomy is restricted greatly, the objectives of decentralization are defeated. 4. Administrative cost. Is the transfer pricing system easy and inexpensive to operate? As with all accounting costs, an incremental cost should generate a positive contribution margin. Where internal transaction volume is large and complex, a more extensive internal pricing system is justified. Administrative costs also include waiting for decisions, hours spent haggling, and internal divisiveness. These four criteria should be prioritized when forming transfer pricing policies. Different situations will demand different transfer pricing policies and therefore different prioritizations. Transfer Prices The most common transfer prices are: 1. Market price. 2. Cost-based prices including: (a) Actual full cost. (b) Target or predetermined full cost. (c) Cost plus a profit. (d) Variable cost. 3. Negotiated price. 4. Dual prices. We will now examine each method with comparison to the transfer pricing criteria. Market Price Market price is a price set between independent buyers and sellers. Two contrasting conditions are typical: sch80342_11_c11_445-488.indd 461 12/20/12 11:54 AM Section 11.5 Intracompany Transactions and Transfer Pricing Problems CHAPTER 11 1. A market price exists, and both buyer and seller have access to other sellers and buyers for the same products. 2. A market price is not readily available, but a pseudo-price is created either by using similar products or by getting outside bids for the same item. Market price meets more of the transfer pricing criteria than any other method. But finding a market price may be difficult since one may not exist. Examples include intermediate components, industrial supplies, and \"make or buy\" jobs. The buyer's purchasing department may request bids from outside suppliers. If, because of company policy, the outside bidders are rarely considered seriously, the outside bidders will not play this game for long. Bidding is an expensive process. Some companies have a policy of considering outside vendors seriously and committing a certain percentage of business to these bidders to help keep the system viable. Even if a market price exists, it may not be applicable. For instance, catalog prices may only vaguely relate to actual sales prices. Market prices may change often. Also, internal selling costs may be less than would be incurred if the products were sold to outsiders, and so the market price should be adjusted downward. Despite the problems of finding a valid market price, managers generally agree that market prices are best for most transfer pricing situations. A market transfer price parallels the actual market conditions under which these divisions would operate if they were independent companies. Goal Congruence When excess capacity exists, market prices may not lead to goal congruence. For instance, Division A, which has excess capacity and a mixture of fixed and variable product costs ($50 per unit and $100 per unit, respectively), could benefit greatly from additional production volume. Division A sells its output on the market for $200 per unit. Division B is looking for a supplier for a part that Division A can easily provide. Division B asks for bids from a variety of suppliers. Company C, an unrelated firm, may be selected because it has bid $160 per unit. This price is well above Division A's variable cost but below A's market-price bid. Managers in A and B are making the best decisions for their respective divisions as they see it, but total company profit is hurt. The firm as a whole would be better off by $60 per unit ($160 2 $100) if Division B purchased from Division A. But Division B would need to pay Division A a price $40 higher ($200 2 $160), or Division A would have to accept a lower contribution margin ($160 2 $100 5 $60) than its regular business generates ($200 2 $100 5 $100). Many believe that this is a small cost to incur if the individual division managers act in an aggressive, competitive style. What is lost from lack of goal congruence is gained in greater profits from highly motivated quasi-entrepreneurs. Depending on results in specific firms, this trade-off may or may not be justified. Performance Evaluation and Autonomy Market prices form an excellent performance indicator because they cannot be manipulated by the individuals who have an interest in profit calculations. A market price sch80342_11_c11_445-488.indd 462 12/20/12 11:54 AM Section 11.5 Intracompany Transactions and Transfer Pricing Problems CHAPTER 11 eliminates negotiations and squabbling over costs and definitions of fairness. If market power positions exist, they also exist in the general marketplace. Where market prices are less clear and are either created or massaged, the pure advantage of market prices declines. In fact, as we move away from a true market price, the price becomes a negotiated price, which is discussed later. Administrative Cost As part of normal buying and selling, the transfer price is determined almost costlessly. As we move away from a clear market price, costs increase. Negotiations are expensive in terms of consuming executive time, getting outside bids, and creating support data for negotiating positions. Cost-Based Prices Unless market price is readily available, most transfer prices are based on production costs. Three issues stand out in cost-based transfer prices: 1. Actual cost versus a standard or budgeted cost. 2. Cost versus cost plus a profit. 3. Full cost versus variable cost. Actual Cost Versus a Standard or Budgeted Cost A primary problem with an actual full-cost transfer price is that it gives the selling division no incentive to control costs. All product costs are transferred to the buying division, \"reimbursed\" as revenue to the selling division. This can create a serious competitive problem for the vertically integrated firm that passes parts through numerous divisions before selling a product in a competitive market. Historically, this has been a problem for General Motors Corporation. Moving to a standard or budgeted cost helps promote cost control but is not a perfect solution. If a budget or standard cost is used for cost control and also for transfer pricing, profit pressures may well subvert the cost system and damage its usefulness as a cost control device. Furthermore, who sets the standard? Is it a tight or lax standard? Cost Versus Cost Plus a Profit If cost only is used as a transfer price, the selling unit cannot earn a profit. Full cost plus a profit percentage is a popular solution. Adding a percentage to cost for a profit creates a question: \"What percentage?\" Somehow 10 percent seems attractive and common. This is, however, an arbitrary choice. Perhaps a markup percentage can be calculated that will cover operating expenses and provide a target return on sales or assets. Even here, these prices fail to produce the kind of competitive environment that decentralization promotes. sch80342_11_c11_445-488.indd 463 12/20/12 11:54 AM CHAPTER 11 Section 11.5 Intracompany Transactions and Transfer Pricing Problems Full Cost Versus Variable Cost Another version of cost-based transfer pricing is variable cost. With variable-cost transfer prices, only variable production costs are transferred. These costs are generally materials, direct labor, and variable overhead. Variable cost has the major advantage of encouraging maximum profits for the entire firm when excess capacity exists. This will be illustrated later. The obvious problem is that the selling division must absorb all of its fixed costs. That division is now a loss division, nowhere near a profit center. With these issues in mind, how well do cost-based transfer prices match with the evaluation criteria? Goal Congruence Full-cost transfer prices generally produce suboptimal profits for the firm as a whole. Variable-cost transfer prices generate an optimal firm-wide profit when the selling division has excess capacity. Otherwise, market prices yield optimal firm-wide profits. In general, the definition of the most goal-congruent transfer price is out-of-pocket costs plus any opportunity cost of transferring to the next division. Usually, out-of-pocket costs are the variable costs. The opportunity cost is the contribution margin earned from the best alternative use of the seller's capacity. When there is no excess capacity, the out-of-pocket cost plus opportunity cost equals the market price. These relationships are summarized in Figure 11.2. Figure 11.2: Goal-congruent transfer prices Goal-Congruent Transfer Price = Out-of-Pocket Cost + Opportunity Cost of Transferring Goal-Congruent Transfer Price If Seller has Opportunity Cost Out-of-Pocket Excess Capacity Equals Zero Cost If Seller has Opportunity Cost Market No Excess Capacity Exists Price The following example highlights these concepts. Assume that Division A sells to Division B. The output of Division A is Product A, which can be sold to an outside market or to Division B to be processed further and sold as Product B. One unit of Product B uses one unit of Product A. In Division A, variable costs are $100 per unit, and Product A sells for $175. In Division B, additional variable costs are $200 per unit, and Product B sells for sch80342_11_c11_445-488.indd 464 12/20/12 11:54 AM CHAPTER 11 Section 11.5 Intracompany Transactions and Transfer Pricing Problems $350. This scenario is diagrammed in Figure 11.3. Arrows indicate costs flowing out of the divisions and revenues flowing into them. Figure 11.3: Diagram of example transaction possibilities Unit Variable Cost = $100 Unit Variable Cost = $200 Division A Division B Unit Selling Price = $175 Unit Selling Price = $350 Suppose Division A has excess capacity. Thus, there is no opportunity cost of transferring to Division B, and the company would receive a contribution of $50 per unit ($350 2 $200 2 $100), assuming that these units do not increase total fixed costs. A full-cost transfer price, however, might not promote a transfer. If the fixed costs per unit for Products A and B totaled more than $50, Division B would not accept a transfer since its costs would be more than $350 per unit. Consequently, the full-cost transfer price is not goal congruent. Using a variable-cost transfer price, Division B would accept the units since now its total cost of $300 per unit is less than $350. The variable-cost transfer price is, therefore, goal congruent. Now suppose that Division A has no excess capacityall units produced can be sold to the outside market for $175. By selling outside instead of transferring to Division B, the company would receive a contribution of $75 per unit ($175 2 $100) rather than just $50 ($350 2 $200 2 $100). A variable-cost transfer price, however, would not achieve this higher profit because Division B would readily accept transfers to earn $50 per unit. In contrast, a market price would be goal congruent. With a transfer price of $175, Division B's costs would total $25 more than its revenue ($350 2 $200 2 $175), so it would not take any units from Division A. We summarize these analyses using the preceding decision rule: Excess capacity: Goal congruent transfer price 5 Out-of-pocket cost 1 Opportunity cost 5 $100 1 $0 5 $100 sch80342_11_c11_445-488.indd 465 12/20/12 11:54 AM Section 11.5 Intracompany Transactions and Transfer Pricing Problems CHAPTER 11 No excess capacity: Goal congruent transfer price 5 Out-of-pocket cost 1 Opportunity cost 5 $100 1 ($175 2 $100) 5 $175 Performance Evaluation and Autonomy Clearly, a variable-cost transfer price provides little help in performance evaluation if the division is considered to be a profit or investment center. Autonomy is also violated since close working relationships and much exchange of data are expected. When using fullcost transfer prices, an added profit percentage is necessary to get the seller to a profit position. It is difficult to support any cost-based approach as a strong performance evaluation method for profit centers. Cost-based transfer prices are best suited to cost centers. Administrative Cost Cost-based transfer prices are easy to obtain since they are outputs of the cost accounting system. Perhaps this is why, in spite of its weaknesses, cost-based transfer pricing is the most widely used transfer pricing approach. Negotiated Price The use of negotiated transfer prices is often suggested as a compromise between marketbased and cost-based transfer prices. Real advantages may exist in allowing two division managers to arrive at the transfer price through arm's-length bargaining. The selfinterests of the division managers may serve the company objectives. Negotiated prices are helpful when: 1. Cost savings occur from selling and buying internally. 2. Additional internal sales fill previously unused capacity, allowing the buyer and seller to share any incremental profit. As long as the negotiators have relatively equal power positions, negotiations can create a quasi-free market. Friction and bad feelings that may arise from centrally controlled transfer prices may be eliminated. Goal Congruence Often, the company as a whole benefits from the buying and selling divisions negotiating a price that is agreeable to both parties. Fairness is an issue that must be weighed. The firm as a whole will win if the divisions elect to enter negotiations freely. Performance Evaluation and Autonomy A negotiated price may be a suitable surrogate for a market price. A market atmosphere is created if buyers and sellers are free to go outside and if neither division has an unfair power positionsuch as a monopoly position for purchases or sales. sch80342_11_c11_445-488.indd 466 12/20/12 11:54 AM Section 11.5 Intracompany Transactions and Transfer Pricing Problems CHAPTER 11 Negotiations can be between buyer and seller alone or involve the corporate office. If negotiations lead to arbitration by the corporate office or if corporate policies interfere with free negotiations, autonomy suffers. The corporate office has the delicate problem of keeping hands off and yet monitoring divisional dealings to prevent significant noncongruent behavior. Administrative Cost Negotiations are often expensive, consume time of key executives, and may cause an internal unit to be created to handle these relationships. If intracompany sales are important to a division, its managers must put a high priority on these negotiations. Its sales and profit levels are at stake. In highly integrated companies, negotiation costs can be a major operating expense. Dual Transfer Prices A dual transfer pricing system allows the selling division to \"sell\" at a real or synthetic market price (such as full cost plus a profit percentage). The transfer price to the buying division is usually the variable cost (plus perhaps identifiable opportunity costs). Use of dual transfer prices has been suggested as a way of creating a profit, and thus a positive motivation, in both the selling and buying divisions. Such a system, however, does expand the corporate office accounting task. Intracompany sales and duplicate profits have to be eliminated before total company profits can be determined. Goal Congruence and Performance Evaluation The advantages of a dual transfer price system rest on being able to evaluate performance of both units as profit centers and to encourage behavior that will benefit the firm as a whole. Thus, the dual system provides the buying division with incremental cost information and at the same time allows the selling division to show a profit. Such a system encourages the congruence of divisional goals with company-wide goals. If the selling division has substantial fixed costs to cover, a danger does exist that the buying division will sell at cut-rate prices and fail to cover all fixed costs. Here active corporate-level monitoring may be needed. Autonomy and Administrative Cost Costs and corporate interference are the practical considerations and the major obstacles to the use of dual transfer pricing systems. From an accounting point of view, each division records its own transactions, and the central office must monitor, record, and track intracompany dealings, a clear violation of autonomy. In financial statements for the combined company, accounts representing intracompany transactions are eliminated. For example, a selling division will record a sale and establish a receivable; a buying division will record a purchase and set up a payable. In eliminating the intracompany accounts, any intracompany profits in the buying division's inventory will be adjusted out. The home office must have a special accounting system to track all transactions of a dual pricing system. These extra costs must be outweighed by the benefits of better performance evaluation and goal congruence. sch80342_11_c11_445-488.indd 467 12/20/12 11:54 AM CHAPTER 11 Section 11.6 Maximizing International Profits: The Role of Transfer Prices Commonly, the dual transfer pricing system is an academic approach to solving transfer pricing conflicts. But occasionally, a real world firm will put a dual pricing system in place. Given the right circumstances and intent of management, a dual system can generate the desired combination of benefits. Evaluating Transfer Pricing Methods According to the Criteria Having discussed the transfer pricing criteria and the methods commonly used, an assessment of the relative strengths and weaknesses is as follows: Goal congruence Market prices Performance evaluation Autonomy Administrative cost Strong Very Strong Very Strong Low, if available Actual cost Poor Poor Poor Very Low Full cost plus profit Poor Average Average Low Cost-based prices: Variable cost Strong Very Poor Poor Often Low Negotiated prices Strong Strong Strong to Poor High Dual prices Strong Strong Poor High (Variable Cost) (Market Price) Remember that specific cases can produce very different answers in each area. Clearly, no one transfer price serves all purposes. Managers must rank their priorities and select transfer pricing policies that fit the situation. Perhaps the goal really is to select a transfer pricing policy that creates the least disruption or adverse managerial behavior. 11.6 Maximizing International Profits: The Role of Transfer Prices \"B uy low, and sell high\" is the proverbial route to profits. However, other factors determine how much profit is kept and how much is taxed or restricted in global business. Income taxes, import duties, and limits on repatriation of profits are major components in creating complex international financial management problems. In a truly global world, goods and cash should flow across borders without restriction and without tariffs being imposed. Also, tax rates would be the same in all countries with little inflation and minimal changes in currency exchange rates. Absent these ideals, the company's controller must develop strategies to minimize financial risks and to maximize profits and cash flow. Historically, transfer pricing has been used to manipulate profit levels internationally. Because a transfer between subunits of a firm does not occur at arm's length, manipulation of the transfer price can occur. Cost-based transfer prices can include, at management's discretion, more or fewer costs. Transfer prices for a multinational company are more complex because conditions differ in each country in which the company does business. Governments are concerned because transfer prices affect tax revenues. Companies are concerned because transfer prices affect direct cash flows for payments of goods, taxes, prices, and management performance evaluations. sch80342_11_c11_445-488.indd 468 12/20/12 11:54 AM Section 11.6 Maximizing International Profits: The Role of Transfer Prices CHAPTER 11 Naturally, we want managers to make decisions that enhance company goal congruence. However, international transfer pricing goes beyond domestic needs to include: Minimization of world-wide income taxes and import duties. Avoidance of financial restrictions, including the movement of cash. Approvals from the host country. Assume that Firm A in Country A and Firm B in Country B are subsidiaries of the same holding company, International Pearls. The following cases could exist: 1. If income tax rates are high in Country A and low in Country B, use a low transfer price for sales from Firm A to Firm B. More profits will be shifted to Firm B, lowering total tax payments. 2. If import duties are high for imports into Country B, use a low transfer price for sales from Firm A to Firm B. Low duties are paid; profits are higher. 3. If Country B restricts cash withdrawals from the country or imposes a tax on dividends paid to the holding company, use a high transfer price on sales from Firm A to Firm B. This allows a greater cash outflow from Country B through payments for purchases. When these simple cases are fused and more issues are added, situations quickly become complex, particularly when revenue-hungry governments are involved. Minimization of World-Wide Taxes Manipulation opportunities in the transfer price setting process mean taxable profits can be shifted from a country with high income tax rates to a country with lower taxes. For example, assume that the tax rate in Brazil is 50 percent, while the tax rate in the U.S. is 35 percent. A U.S. subsidiary of a multinational company sells a product to its sister subsidiary in Brazil. If we assume that a normal transfer price is $16 per unit but that the transfer price for units going into Brazil is set at $20 per unit, the U.S. subsidiary's profit will be higher by $4 per unit ($20 2 $16) which is taxed at 35 percent. When the Brazilian subsidiary sells the units, its cost of goods is higher and profits are lower by $4 per unit. Therefore, $4 per unit is taxed at 35 percent, not 50 percent. International taxation occurs when a domestic government imposes taxes on income or wealth generated within its boundaries by a company based in a foreign country. Also, taxes are levied on income earned by a domestic company from activities in foreign countries. A company is taxed in the foreign country and in the multinational's home-base country. For example, Pharmacia & Upjohn is a U.S.-based pharmaceutical firm with extensive global operations. It must comply with U.S. tax laws and tax laws of each country in which it does business. International taxation has dramatic impacts on management decisions, such as where a company should invest, what form of business organization is used, what products are produced where, how pr