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Investment Center Return on Investment Residual Income Economic Value Added Multiple Measures of Performance
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. Decentralization brings 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 inconsistency 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.
Return on Investment
1. Return on investment (ROI) measures profits earned per dollar of investment. a) It is the most common measure o f performance for an investment center. ROI =
Operating income Average operating assets
ROI =
ROI = Operating income margin Operating asset turnover b) Operating income is earnings before interest and taxes. c) Operating Assets are all assets acquired to generate operating income. Operating Assets includes cash, receivables, inventories, land, buildings and equipment.
2. Margin is the ratio of operating income to sales. 3. Turnover shows how productively assets are being used to generate sales. 4. Advantages of using ROI includes: a) It encourages managers to pay careful attention to the relationships among sales,expenses, and investments. b) It encourages cost efficiency by focusing on reduci ng no value-added activities and/or improving productivity. c) It discourages excessive investment in operating assets and, thus, encourages efficient investment. 5. Disadvantages of the ROI measure include: a) It discourages managers from investing in projects that would increase the profitability of the company as a whole but would decrease the divisional ROI measure. Managers would reject projects with an ROI less than a divisions current ROI but higher than the firms cost of capital. b) It can encourage myopic behavior, in that managers may over emphasize short -run results at the expense of the long -term profitability.
Residual Income
1. Residual income(RI) is the difference between operating income and the minimum dollar return required on a companys operating assets. RI = Operating income (Minimum rate of return Operating assets) 2. Advantage of residual income: A manager will accept any project that earns above the minimum rate of return because they will increase the company -wide profitability. 3. Disadvantages of residual income: a) RI an absolute measure of return that makes it difficult to compare divisions of different sizes. Solution: Compute a residual return on investment.
RI erati
erage
assets
Buildings, land, and machinery. Other investments meant to have a long -term payoff, such as research and development, employee training, and so on. d) Positive EVA means that the firm creates wealth (value) by earning operating profit over and above the cost of capital used. EVA has a higher correlation with stock prices than other accounting measures of return because it relates profit to the amount of resources needed to achieve it.
2. Behavioral Aspects of EVA a) EVA encourages managers to maintain a balanced emphasis on operating income and capital employed. It helps lower -level management understand that capital employed is not free. b) EVA can be improved by reducing capital usage.
TRANSFER PRICING
TABLE OF CONTENTS
Transfer pricing Transfer pricing methods Transfer pricing related issues Shared services pricing Objectives
TRANSFER PRICING
The price one subunit of an organisation charges for a product/service supplied to another subunit of the same organisation is called a transfer price. Transfer prices are necessary when either one of the two centres involved the supplier or the receiver is a profit or an investment centre. Therefore transfer prices may be used also with revenue and cost centres. There are four main reasons companies use transfer pricing: 1) Saving on taxes 2) Facilitating performance measurement 3) Providing relevant informatio n for trade-off decisions 4) Inducing goal congruent decisions Saving on taxes Saving on taxes is often the main reason behind the implementation of transfer pricing policies between divisions, in particular when the divisions are located in different countries. Transfer payments have an impact directly on the declared benefit of divisions and also on the amount of income taxes that they will pay. Facilitating performance measurement Facilitating performance measurement of the units involved is another reason for implementing a transfer pricing policy. If a profit centre were to receive parts or services without a corresponding charge against his income, the profit measure would be fla wed since its costs would be understated. Likewise, a profit centre that supplies a product or service to another internal client without corresponding revenue would have understated its profit. Measuring divisional performance stimulates managers perform ance but may have the opposite effect if done improperly. Providing relevant information for trade -off decisions Providing relevant information required for making trade -off decisions is another reason. Transfer prices tell a purchasing manager how much a product or service will cost. He can use this information in making a variety of decisions, including whether to make or buy a component, whether to invest in new machinery, whether to launch a product, etc. Inducing goal congruent decisions Inducing goal congruent decisions within the organisation is another reason. Producing a product internally may not be the most economical decision for the company. The purchasing division may be able to obtain a similar product for a lower cost than the transfer price, while the supplying division may be able to use the capacity to produce something more profitable. However, there could be strategic reasons to buy internally. Two conditions must be maintained for a transfer pricing policy to work effectively. First the purchasing and supplying divisions must be free to negotiate prices with each other. Secondly the purchasing division must be free to seek other suppliers and the supplying division must be free to seek other customers. The basic principle of transfer pricing is that:
The transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors.
Actual transfer pricing practice is varied. One Canadian survey (15 years old) estimated that 18% of firms use a negotiated price 34% use the market price 6 % use variable cost 37% use absorption or full cost 5% use some other method
Transfer pricing environment Transfer pricing policy strategies are highly related to the organisational structure of the company, characterized by the degree of autonomy of divisions. In highly decentralized divisions such as investment centres and profit centres, transfer prices are necessary. Most often, market prices will govern the transfer and divisions will likely choose the sou rce offering the lowest price for a product or a service. In a more centralized environment, especially when the sourcing division is acquired or established to carry out a corporate strategy of vertical integration, internal sourcing is mandatory.
From a behavioural standpoint, managers should use transfer prices to improve decision making and motivate better performance. However these goals are often seen as of less er importance than are tax concerns.
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OBJECTIVES
Present transfer pricing Prices charged by a division to another division for products and services transferred by the former to the latter are called transfer prices. The main reasons for using transfer prices are to save on taxes, to facilitate performance measuring, to provide managers with relevant information for decision-making and to induce congruent decisions in decentralized organisations. Describe methods of transfer pricing Three methods are de scribed: negotiated transfer prices, market -based transfer prices and cost-based transfer prices. Negotiated transfer prices are preferable since the parties are free to set a price that satisfies both of them. Market -based and cost-based prices are often used as a basis for negotiated prices. When there exists a market for the product, the market price is a good reference because it is objective and independent. When there is no market, companies rely on cost -based prices. Discuss transfer pricing related issues Beyond the tax related issue, there are important issue related to efficiency, economy and goal congruence. Transfer price policies have an impact of managers behaviour as the policies influence their evaluation. Present shared services pricing Shared services are charged for a bundle of services provided by one responsibility centre to another one. The main objective of pricing shared services is to improve performance management of the divisions that provides the services by supplying the managem ent with measures that could be compared with similar services elsewhere.
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