Module 23

1. Module 23 Segment Reporting and Transfer Pricing

2. Segment Reports • Segment Reports Follow the Organization Structure: • Cost Center – Ex.: Maintenance Department • Compare actual costs with the budget • Revenues—Ex.: Western Sales Territory • Compare actual sales with the budgeted sales • Profits—A Movie • Compare profits with the budgeted profits • Profits and Investment—Electronics, Inc. (Sub.) • Compare Ret. on Investment to required ROI

3. Terms for Costs of Segments • Variable costs • Ex: Materials usage • Direct fixed costs • FC directly traceable to segment: Segment manager • Allocated common costs • Indirect tracing of costs to a unit: share of a engineering cost by product lines on time • Unallocated common costs • Central costs of many segments: Home office should not be allocated, but some companies do…

4. Segment margin is relevant for measuring the short-term effects of decisions to continue or discontinue a segment. Example Segment income is relevant for measuring the long-term effects of decisions to continue or discontinue a segment.

5. Investment center income Investment center asset base ROI = Return on Investment (ROI) • Evaluated by comparing to previously identified performance criteria, such as • Overall company ROI • Budget ROI • Often rank ordered with awards of bonuses/raises to highest performers and bottom performers warned or dumped. A measure of the earnings per dollar of an investment Assumes financing decisions are made at the corporate level

6. However… • High ROI divisions tend to only take on extremely high return projects resulting in slow growth. • Example: • West Texas Division has an ROI of 50% on an asset base of $20 million: Superstars—BIG Bonuses! • Now Project X12 has a promised return of 30% and requires an investment of $10 million. • If West Texas takes on the project then ROI decreases: • [50%*$20MM + 30%*$10MM]/[$20MM+$10MM)= • [$10,000,000 + $3,000,000]/$30,000,000 = 43.3% • Superstars would be less shiny! • Will West Texas Division take on this project? (Never…) • Also, West Texas would be better off to shrink any part of their organization that earns less than 50%!

7. Residual Income • Residual Income is an alternative measure to ROI: • RI = Division Income – Min Rate of Return X Asset Base • West Texas: • Set required return to 15%. • Residual income before X12: • 50%*$20MM – 15%*$20MM = $7,000,000 • Residual income with X12: • $7,000,000 + [30%*$10 MM – 15%*$10MM]= $8,500,000 • West Texas Division should expand as long as projects earn more than the required return.

8. Economic Value Added (EVA®) Total assets less current liabilities An average of the after-tax cost of all long-term borrowing and the cost of equity financing • Used to evaluate investment center performance • A variation of residual income • Significant differences from residual income • Weighted average cost of capital used instead of required rate of return • Net assets are used as the evaluation base • After-tax income is used as investment center income • Corrects for potential distortions in economic net income caused by GAAP

9. Economic Value Added EVA = Division income after tax - Cost of capital x (Assets – Current Liabilities] = ($10,000,000×(1.0-0.4) – 0.10×($20,000,000–$5,000,000) = = $6,000,000 - $1,500,000 = $4,500,000 The West Texas Division added $4,500,000 in value to AST Distributors. AST Distributors has an 10% cost of capital and a 40% income tax rate. Amounts for the West Texas Division for 2012 are:

10. Balanced Scorecard • In general: “We get what we measure” • With ROI, Residual Income, EVA we tend to get short-term behaviors! • Long-term performance requires customer relations, new products, well trained & loyal employees… • Balanced Scorecard: A comprehensive performance measurement system that includes financial measures and measures related to: • Customers • Internal processes • Innovation and learning

11. Examples of Key Indicators

12. Transfer Pricing • The transfer price is an internal value assigned a product or service that one division provides to another. • Normally occurs between profit or investment centers • Higher transfer prices result in: • More profits to the selling divisions and less to the buying divisions • Lower volume and profit for company as a whole • Transfer prices may be based on market prices (where available) or costs, or they may be negotiated.

13. Market Price as the Transfer Price • Best method of setting transfer prices, if there is an existing market with established prices for internal products, BUT most often there is not an established market. • Preserves divisional autonomy and leads divisions to act in a manner that maximizes corporate profits • Assuming divisions are free to buy and sell outside the firm • Often specified as market price minus a discount when selling and administrative costs are lower on transfers.

14. Cost Plus Markup as Transfer Price • Allows supplying divisions to increase earnings • May result in some undesired behavior: • Passing along inefficiencies, no penalty for inefficiency • Stifle buyers’ demand and profits in low volume periods • Supplying divisions tend to have higher ROI than buying divisions… • Variations on “cost” and “markup”: variable only, standardized, total costs including administration, dual transfer price (e.g. VC and FC+MU%), opportunity costs, fixed fees versus % markup

15. Negotiated Price as the Transfer Price • Supplying and buying divisions agree on a price through negotiation • Use for relatively few transfers with similar powered negotiators • Divisions should be free to withdraw and go elsewhere