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Fall 2015 Strategic Performance Measurement: Investment Centers

Chapter Nineteen With Bailey’s additions and edits. Fall 2015 Strategic Performance Measurement: Investment Centers. Learning Objectives. Part One Explain the use and limitations of return on investment (ROI) for evaluating investment centers

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Fall 2015 Strategic Performance Measurement: Investment Centers

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  1. Chapter Nineteen With Bailey’s additions and edits Fall 2015Strategic Performance Measurement: Investment Centers

  2. Learning Objectives Part One • Explain the use and limitations of return on investment (ROI) for evaluating investment centers • Explain the use and limitations of residual incomefor evaluating investment centers • Explain the use and limitations of economic value added (EVA®) for evaluating investment centers

  3. Learning Objectives (continued) Part Two • Explain the objectives of transfer pricing, and the advantages and disadvantages of various transfer-pricing alternatives • Discuss the important international issues that arise in transfer pricing

  4. Investment Centers • Many firms use profit centers to evaluate managers, but firms cannot use profit alone to compare one business unit to other business units because of: • Differences in size • Differences in operating characteristics • To evaluate the financial performance of investment centers, we need to somehow incorporate the level of invested capital into the performance measure

  5. Financial Performance Measures for Investment SBUs Strategic objectives for financial-performance measures for investment SBUs are: • Motivate managers to exert a high level of effort to achieve the goals of the firm (increase ROI, etc.) • Provide the right incentive for managers to make decisions that are consistent with the goals of top management (goal congruence) • Fairly determine the rewards earned by the managers for their effort and skill (ROI = sound basis for comparison between units of different size)

  6. Measures of Financial Performance: Investment Centers Alternative measures for evaluating the financial performance of investment centers: • Return on investment (ROI) • Residual income (RI) • Economic value added (EVA®)

  7. Return on Investment (ROI) • ROI is the most common measure of investment center short-run financial performance • The higher the percentage, the better the indicated financial performance • In practice, be aware that there are different ways to define “profit” and “investment” for purposes of determining ROI

  8. Return on Investment (ROI) (continued) The two components of ROI give a more complete picture of management performance (goals should be set for each of the two component measures): • Return on sales (ROS) or profit margin, a firm’s profit per sales dollar, measures the manager’s ability to control expenses and increase revenue to improve profitability • Asset turnover (AT), the amount of dollar sales achieved per dollar of investment, measures the manager’s ability to increase sales from a given level of investment

  9. ROI Example CompuCity sells computers, software, and books in three locations, Boston, South Florida, and the Midwest. The company’s profit’s declined in the Midwest last year. CompuCity’s operating results and the corresponding ROI calculations appear on the next slide.

  10. ROI Example: Exhibit 19.1 $8,000 Income/$200,000 Sales $200,000 Sales/$50,000 Investment 4.00% ROS x 4.00 AT

  11. Accounting Policy Issues and ROI: Things to Consider When ROI is Used to Evaluate Relative Performance of Investment Centers • Depreciation policy–the determination of the useful life of the asset and the depreciation method affect both “income” and “investment”; larger depreciation charges reduce ROI • Capitalization policy–the firm’s capitalization policy identifies when an item is expensed or capitalized as an asset; an expensed item reduces the numerator of ROI, a capitalized item increases the denominator.

  12. Defining the ROI Measure • How is “investment” defined (i.e., which assets should be included in the measure of investment)? • “Investment” is commonly defined as the net cost of long-lived assets plus working capital • A key criterion for including an asset in ROI is the degree to which the unit controls it; only those controllable at the unit level should be included • The value of intangibles should also be considered • Allocating shared assets? • Management must determine a fair sharing arrangement • Assets should be allocated according to peak demand if user units require high levels of service at periods of high demand

  13. Measurement Issues: ROI How should “investment” be measured? • The amount of investment is typically measured at the historical cost of the assets • Historical cost is amount of the book value of current assets plus the net book value (NBV) of the long-lived assets • NBV is the asset’s historical cost less accumulated depreciation • A problem arises when long-lived assets are a significant portion of total investment because historical cost often does not reflect current market value • Relatively small historical cost value = significantly overstated ROI (and the “illusion of profitability”)

  14. Measurement Issues: ROI Assets can be measured at either historical cost (NBV or GBV) or at some measure of current value: • Net book value (NBV) is historical (acquisition) cost, less accumulated depreciation/amortization • Gross book value (GBV) is the historical cost without the reduction for depreciation (removes the age bias) • Replacement cost represents the current cost to replace the assets at the current level of service and functionality (purchase price) • Liquidation value is the price that could be received from their sale (sale price or “exit value”)

  15. ROI Measurement Issues(Exhibit 19.3) CompuCity has three marketing regions: 15 stores in the Midwest; 18 in the Boston area; and 13 in South Florida. Current value information appears below.

  16. Asset Measurement in ROI Calculations: Summary Analysis • At first glance the Boston area appears to be the most profitable, but when the age of the store is factored in (GBV), the ROI figures for all three regions are comparable • Replacement cost is useful for evaluating manager’s performance (South Florida is slightly in the lead) • The analysis of liquidation-based ROIs is useful for showing CompuCity management that the real estate value of these stores could now exceed their value as CompuCity retail locations

  17. Strategic Issues Regarding the Use of ROI for Performance-Evaluation Purposes • Value-creation in the new economy—can this be captured by the ROI measure? • Short-run focus of the metric: • Numerator issues? • Denominator issues? • Decision model and performance-evaluation model inconsistency (e.g., NPV vs. ROI in capital investment)

  18. Summary Comments: Selected Advantages and Limitations of ROI Advantages Limitations • 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 • Comparability across investment centers can be problematic • Easily understood by managers • Comparable to interest rates and the rates of return on alternative investments • Widely used and reported in the business press

  19. Goal-Congruency Problem with ROI • ROI has a disincentive for new investment by the most profitable units because ROI encourages units to only invest in projects that earn higher than the unit’s current ROI • Managers evaluated on ROI may reject profitable investment opportunities that dilute their high ROI

  20. Residual Income (RI) • In contrast to ROI (which is a percentage, i.e., a relative performance indicator), residual income (RI) is a dollar amount: RI = investment center income less an imputed charge for the investment in the unit • RI can be interpreted as the income earned after the unit has “paid” a charge for the funds invested in the unit

  21. Residual Income (RI) Example(From Exhibit 19.5)

  22. Residual Income (RI) Example (Exhibit 19.5) In this case (but not always), the RI calculation for CompuCity produces the same relative profitability ranking as the ROI calculation

  23. Selected Advantages and Limitations of RI Advantages Limitations • Supports incentive to accept all projects with ROI > minimum rate of return • Can use the minimum rate of return to adjust for differences in risk • Can use a different minimum rate of return for different types of assets • Favors large units when the minimum rate of return is low • Not as intuitive as ROI • May be difficult to obtain a minimum rate of return at the subunit level

  24. Advantages of Both ROI and RI (Exhibit 19.7, partial) • Congruent with top management goals for return on assets • Comprehensive financial measure--includes all the elements important to top management: revenues, costs, and level of investment • Comparability: expands top management’s span of control by allowing comparison across SBUs

  25. Limitations of Both ROI and RI (Exhibit 19.7, partial) • May mislead strategic decision making: not as comprehensive as the BSC, which includes customer satisfaction, internal processes, and learning as well as financial measures; the BSC is explicitly linked to strategy • Accounting issues: variations exist in the definition and measurement of “investment” and in the determination of “profits” • Short-term focus: investments with long-term benefits may be neglected

  26. Economic Value Added (EVA®) • Economic value added (EVA®) is a business unit’s income after taxes and after deducting the cost of capital • EVA®is registered trademark of Stern Stewart & Co. • EVA® approximates an entity’s “economic profit” • EVA® involves numerous adjustments to reported accounting income and level of investment (Stern Stewart reports up to 160 such adjustments!!) • Similar to Residual Income (RI), EVA motivates managers to increase investment as long as the expected return (in $ terms) above the cost of capital is positive

  27. Economic Value Added (EVA®) (continued) EVA® = NOPAT – (k× Average invested capital) NOPAT = after-tax cash operating income, after depreciation (i.e., the “total pool of cash funds available to suppliers of capital”) = Revenues – Cash operating costs – Depreciation – Cash taxes on operating income k = minimum rate of return (hurdle rate), e.g., WACC Thus, EVA® = (r – k) × capital, where r = NOPAT/invested capital (“cash on cash return”)

  28. Economic Value Added (EVA®) (continued) To estimate EVA, it is necessary to adjust reported accounting numbers (both earnings and level of investment; the latter are referred to as equity-equivalent adjustments, or EE for short)

  29. Transfer Pricing • Transfer pricing is the determination of an exchange price for a intra-organizational transfers of goods or services (e.g., Division A “sells” subassemblies to Division B) • Products can be final products also sold to outside customers (e.g., batteries for automobiles) or intermediate products (e.g., special components or subassemblies) • Transfers of products and services between business units is most common in firms with a high degree of vertical integration

  30. The Importance of Transfer Pricing • Evaluation of a division for sale • (What earnings are relevant?) • Minority interest in a subsidiary • (Is subsidiary being “plundered”?) • Tax minimization • (Can shift income to some degree.) • Governmental contracting • (Endorses full-cost TPs.)

  31. Transfer Pricing Objectives • Same as those for evaluating the performance of profit and investment centers: • 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 • Specific international issues include: • Minimization of customs charges • Minimize total (i.e., worldwide) income taxes • Currency restrictions • Risk of expropriation (government seizure)

  32. Who Determines the TP System? • Top management! • How much autonomy will unit managers have? • Completely free to deal independently? • Some restrictions on going outside (outsourcing)?

  33. Transfer Pricing Methods • Variable cost (standard or actual), with or without a mark-up for “profit” • Full cost (standard or actual), with or without a markup for “profit” • Market price (perhaps reduced by any internal cost savings realized by the selling division) • Negotiated price between buyer and selling units, perhaps with a provision for arbitration

  34. Comparing Transfer Pricing Methods:Variable Cost The relatively low transfer price encourages buying internally (the correct decision from the overall firm’s standpoint when there is excess capacity) Advantage Limitation Unfair to the seller unit (profit or investment center) because no “profit” on the transfer is recognized

  35. Comparing Transfer Pricing Methods:Full Cost Advantages Limitations • Easy to implement—data already exist for financial reporting purposes • Intuitive and easily understood • Preferred by tax authorities over variable cost • Irrelevance of fixed cost in short-term decision making; fixed costs should be ignored in the buyer’s choice of whether to buy inside or outside the firm • If used, should be standard rather than actual cost

  36. Comparing Transfer Pricing Methods:Market Price Advantages Limitations • Helps preserve subunit autonomy • Provides for the selling unit to be competitive with outside suppliers • Has arm’s-length standard desired by international taxing authorities • Often intermediate products have no market price • Should be adjusted for cost savings such as reduced selling costs, no commissions, etc.

  37. Comparing Transfer Pricing Methods:Negotiated Price • May be the most practical approach when significant conflict exists • Is consistent with the theory of decentralization Advantages Limitations • Need negotiation rule and/or arbitrations procedure, which can reduce autonomy • Potential tax problems; IRS may not agree it’s “arm’s length” • Potential sub-optimization (dysfunctional decisions)

  38. Choosing a Transfer Pricing Method • Firms can use two or more methods, called dual pricing, one method for the buying unit and a different one for the selling unit • Top management’s three considerations in setting the most advantageous transfer price: • Is there an outside supplier (market price)? • Is the seller’s variable cost less than the market price? (If not, probably should outsource!) • Is the selling unit operating at full capacity (would displace regular sales)?

  39. What Can Happen Regarding Goal Congruence?

  40. Setting Transfer Prices (“General TP Rule”) Range of Acceptable Prices in Negotiation: Ceiling: The outside market price that buyer would pay [Room to share benefit.] Floor: The outlay costs of supplier + opportunity cost. • If idle capacity, it’s just outlay cost • If no idle capacity, then it’s sales price to current outside customer.

  41. Example (hidden slides) • Note: I am skipping a detailed example (“High Value Computer”) that is a bit tedious for class presentation. You can look at it later or we may revisit it.

  42. International Transfer Pricing: Eli Lily Case (1957) • IRS objected to tax return • Lily had used variable costs as TP basis • Court decided the true purpose was tax avoidance, held for IRS • Established market-based TPs for tax purposes

  43. “I deal with tax avoidance---he deals with tax evasion.”

  44. Tax & Multinational Transfer Pricing • Transfer prices often have tax implications. • Tax factors include not only income taxes, but also payroll taxes, customs duties, tariffs, sales taxes, and other levies on organizations. • Section 482 of the U.S. Internal Revenue Service Code governs taxation of multinational transfer pricing.

  45. Multinational Transfer Pricing • Section 482 requires that transfer prices for both tangible and intangible property between a company and its foreign division be set to equal the price that would be charged by an unrelated third party in a comparable transaction.

  46. Multinational Transfer Pricing • Transfer prices can reduce income tax payments by recognizing more income in low tax rate countries and less income in high tax rate countries. • Tax regulations of different countries restrict the transfer prices that companies can choose.

  47. The End

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