Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
Chapter 19
Strategic Performance Measurement: Investment Centers & Transfer Pricing
Learning Objectives
LO 19-5 Discuss important international issues that arise in transfer pricing.
New in this Edition
• Eight new Real-World Focus (RWF) items dealing with the following topics: ROI for
Sustainability Projects; Estimating the ROI for a College Diploma; Strategic Application of ROI
(Business Segment) Analysis; Estimating the (Short-Term) ROI for an MBA Degree;
Sustainability—the ROI of “Doing the Right Thing”; Linking Incentive Compensation to Levels
of Economic Profit; Apple Computer and Transfer Pricing—Risk Implications; International
Transfer Pricing Applied to SG&A Costs; and, Increased Scrutiny and Risk—Multinational
Transfer Pricing.
• Expanded discussion of the transfer-pricing decision in an international context
• Revision of five end-of-chapter problems
• Addition of pedagogical reference (Baker et al., 2009) regarding concerns associated with the use
of EVA® (H. Kent Baker, Prakash Deo, and Tarun Mukherjee, "EVA Revisited," Journal of
Financial Education, Fall 2009, pp. 1-22.)
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
4. Complications associated with both “earnings” and “investment”—the two major components
comprising financial-performance indicators of investment centers.
On the second class meeting I follow up my initial lecture (see above) by working several end-of-chapter
assignments (exercises and/or problems), focusing on those that raise issues regarding complications
associated with the use of the above-referenced financial-performance metrics.
Part Two: Transfer Pricing
There are four main issues I address in transfer pricing. One is the decision-making issue⎯from the
standpoint of both the organization as a while and from the standpoint of the selling unit itself, should the
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
Assignment Matrix
End-of-Chapter Assignments
Learning Objectives
Text Features
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
Lecture Notes
Part One: Financial-Performance Indicators for Investment Centers
A. The Notion of Investment Centers. While profit centers are commonly used due to their strong
motivation and goal congruence effects, firms cannot use profit alone to compare one business unit to
other business units or to alternative investments, because the other units and investments are likely to be
of different sizes and have different operating characteristics. Therefore, a method to compare a unit to
other units and alternative investments is needed. One such method is the return on investment (ROI),
which is the profit per dollar invested. Financial performance measures applied to investment centers
have the following objectives:
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
• To motivate managers to exert a high level of effort to achieve upper management’s goals.
1. ROI Equals Return on Sales (ROS) × Asset Turnover (AT). We can enhance the ROI
measure’s usefulness by showing it as the product of two components:
ROI = Return on Sales (ROS) × Asset turnover (AT)
ROI = (Profit ÷ Sales) × (Sales ÷ Assets)
3. ROI in Practice: Measurement Issues
Measuring Income and Investment: Effect of Accounting-Policy Choices. Accounting
policies regarding the measurement of “investment” and the determination of “income” have a
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
b. Capitalization policy. The firm’s capitalization policy identifies when an item is expensed or
capitalized as an asset. If an item is expensed, the effect reduces ROI.
For inventory:
a. Inventory measurement methods. The choice of inventory cost flow assumption (FIFO,
4. Other Measurement Issues for Determining “Income” (i.e., the numerator in the ROI
metric). In addition to the firm’s accounting policies, other effects on income should be considered
when using ROI:
a. Nonrecurring items. Income can be affected by nonrecurring charges or revenues and then
would not be comparable to income of prior periods or of other investment centers.
5. Measuring the Level of “Investment”—Which Assets to Include? A common method for
7. Measuring the Level of “Investment”—Current Values. The amount of investment is typically
the historical cost of the assets. The historical cost amount is the book value of current assets plus the
net book value (NBV) of the long-lived assets. Net book value (NBV) is the asset’s historical cost
less accumulated depreciation. A problem arises when the long-lived assets are a significant portion
8. Measuring Current Value. The three methods for developing or estimating the current market
value of assets are:
a. Gross book value (GBV). GBV is the historical cost without the reduction for depreciation. It is
a very rough estimate of the current value of the assets. GBV improves on NBV because it
9. Strategic Issues in Using ROI. In addition to the measurement issues mentioned above, there are
two several strategic issues that must be considered:
a) Value creation in the new economy—ROI was conceived and developed during a time
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
c) Decision model and performance model inconsistencies. Discounted cash flow (DCF)
techniques are used to make capital investment decisions (see Chapter 12), while
historical-cost-based ROI metrics are used to evaluate subsequent performance.
d) Disincentives for new investment by the most profitable units. Business units evaluated on
ROI have an important disincentive that conflicts with their achievement of the
investment center’s objectives. ROI encourages units to invest in projects that only earn
higher than the unit’s current ROI so that the addition of the investment improves the
unit’s overall ROI right away. Thus, the most profitable units have a corresponding
disincentive to invest in any project that does not exceed their current ROI, although the
project would have a good (in excess of a minimum threshold) return and therefore be
attractive from the standpoint of the organization as a whole.
C. Residual Income (RI). In contrast to ROI, which is a percentage, residual income (RI) is a dollar
amount equal to the income of a business unit less an imputed charge for investment in the unit. The
charge is determined by multiplying a desired minimum rate of return by the investment amount. RI can
be interpreted as the income earned after the unit has “paid” a charge for the funds it needs to invest in the
unit.
• The issues regarding the measurement of income and investment for RI are the same as
those discussed for ROI.
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
in their classic book on the subject, discuss over 160 possible adjustments to reported accounting
information—adjustments needed to eliminate so-called accounting distortions.
A distinctive feature of Cost Management is an expanded discussion of two alternative approaches for
estimating EVA® NOPAT and EVA® capital: the operating approach, and the financing approach.
1. International Transfer Pricing Objectives. With the globalization of business, the international
aspect of transfer pricing is becoming a critical concern, particularly with tax issues. Other
international objectives include:
a. Minimization of custom charges. The transfer price can affect the overall cost, including the
2. Transfer Pricing Methods. Firms commonly use two or more of the following methods; this
practice is called dual pricing.
a. Variable cost method. The variable cost method sets the transfer price equal to the selling unit’s
variable cost. This method is desirable when the selling unit has excess capacity and transfer
price’s chief objective is to satisfy the internal demand for the goods.
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing
19.10 and are summarized as follows:
a. Is there an outside supplier? If not, there is no transfer price, and the best transfer price is based
on cost or negotiated price. If there is an outside supplier, we must consider the relationship of
the inside seller’s variable cost to the market price of the outside supplier by answering the next
question.
b. Is the seller’s variable cost less than the market price? If not, the seller’s costs are likely too
high, and the buyer should buy outside. If the seller’s variable costs are less than the market
price, we must consider the capacity if the selling unit by answering the final question.
c. Is the selling unit operating at full capacity? That is, will the order from the internal buyer cause
the selling unit to deny other sales opportunities? If not, the selling division should provide the
order to the internal buyer at a transfer price between variable cost and market price. If the
selling unit is at full capacity, we must determine and compare the cost savings of internal sales
versus the selling division’s opportunity cost of lost sales. If the cost savings to the inside buyer
are higher than the cost of lost sales to the seller, the buying unit should buy inside, and the
proper transfer price should be the market price.
Chapter 19 - Strategic Performance Measurement: Investment Centers & Transfer Pricing