Divisional performance appraisal and transfer pricing p5

Assumed knowledge

 

9 builds on the following knowledge from PM:

 

  • Divisional performance measures

 

  • Transfer pricing.

 

2      Introduction to divisional performance management

 

A feature of modern business management is the practice of splitting a business into semi-autonomous units with devolved authority and responsibility. Such units could be described as ‘divisions’, subsidiaries or strategic business units (SBUs) but the principles are the same.

 

It is common in APM to have to apply your knowledge of performance management to more complex business structures such as divisional structures.

 

This   will review some of the methods available for appraising divisional performance.

 

3      Problems associated with divisional structures

 

Before looking at the methods for divisional performance appraisal it is worth noting that divisional structures may result in the following problems:

 

  • Co-ordination – how to co-ordinate different divisions to achieve overall corporate objectives.

 

  • Goal congruence – managers will be motivated to improve the performance of their division, possibly at the expense of the larger organisation.

 

  • Controllability – divisional managers should only be held accountable for those factors that they can control. The performance of a division’s manager must be appraised separately to the performance of the division. It may be difficult to determine exactly what is and what is not controllable.

 

 

 

  • Inter-dependence of divisions – the performance of one division may depend to some extent on others, making it difficult to measure performance levels.

 

  • Head office costs – whether/how head office costs should be

 

  • Transfer prices – how transfer prices should be set as these effectively move profit from one division to another.

 

Illustration 1 – Inter-dependence of divisions

 

 

 

Suppose division A makes components that are subsequently used in division B to make the finished item that is then sold to customers. The following are examples of areas where the performance of B will be affected by problems in A.

 

  • Productivity – suppose some staff in division A are ill, slowing down the supply of components to division B. This will slow down division B as well, unless adequate inventories are held.

 

  • Profitability – suppose the transfer pricing system includes an element of actual cost. Cost overruns in A would be passed on to B.

 

  • Quality – poor quality work in A will ultimately compromise the quality of the finished product.

 

  • Service levels – customer queries to B could involve A’s component in which case they need to be re-directed. Division A may not be as customer-focused as B, compromising customer goodwill.

 

 

Management of a division

 

 

 

The management of a division are normally remunerated on a basis linked to the performance they achieve. Typically, they are given performance targets and only if they achieve those targets do they get a salary bonus.

 

The central idea is that the manager of a division is in the same position as an independent entrepreneur. If he experiences the risks and rewards of business ownership, then he/she will act in a manner calculated to maximise the value of the division – or that is the theory. The modern variation on this theme is to give management ‘share options’ – the right to buy shares at a given price. If the share price performs well, (and the stock market is a good judge of business performance), then the manager benefits. The theory is that this promotes goal congruence between managers and shareholders.

 

 

Having decentralised, it is essential that senior management monitor and control the performance of the divisions and of those people with direct responsibility for those divisions. An accounting information system (a management control system) must be in place to allow for divisional assessment. The system used must have a close bearing on divisional goals and must recognise that some costs of a division will be controllable by its managers and some will not.

 

4      Responsibility accounting

 

Responsibility accounting is based on the principle of controllability,

 

i.e. managers should only be made accountable and be assessed on those aspects of performance they can control.

 

The controllability principle may result in the establishment of different performance measures for the division and its manager.

 

In practice, it can be difficult to establish which items are controllable and which are uncontrollable. For example, an increase in supplier’s prices may be seen as something that the divisional manager cannot control. However, it could be argued that the cost is controllable since the divisional manager may be able to change the source or type of supply.

 

Types of responsibility centres

 

There are three types of responsibility centre.

 

When assessing divisional performance it is vital that the measures used match the type of division:

 

Type of division Description Typical measures
Cost centre • Division incurs costs • Total cost
but has no revenue • Cost variances
stream.
• Cost per unit and other
cost ratios
• Non-financial
performance indicators
(NFPIs), for example
related to quality,
productivity, efficiency.

 



Type of division Description Typical measures
Profit centre • Division has both costs All of the above plus:
and revenue. • sales
• Manager does not
• profit
have the authority to
• sales variances
alter the level of
investment in the • margins
division.
• market share
• working capital ratios
(depending on the
division concerned)
• NFPIs related to
customer satisfaction.
Investment • Division has both costs All of the above plus:
centre and revenue. • return on investment
• Manager does have (ROI)
the authority to invest • residual income (RI)
in new assets or
• economic value added
dispose of existing
ones. (EVA).
These are discussed in
more detail below.

 

5      Return on investment (ROI)

 

5.1 What is ROI?

 

ROI is the divisional equivalent of ROCE. It shows the operating profit that is generated for every $1 of assets employed. If ROI is used to appraise the performance of the divisional manager then only the controllable elements of operating profit and capital employed should be included (as discussed in the previous section).

2 Advantages and disadvantages of ROI

 

Advantages Disadvantages
• Widely used and accepted since • May lead to dysfunctional
it is in line with ROCE which is decision making (see below).
frequently used to assess • Increases with age of asset if
overall business performance.
net book values (NBVs) are
• As a relative measure it enables used (see below).
comparisons to be made with • Different accounting policies can
divisions or companies of
confuse comparisons.
different sizes.
• Exclusion from capital employed
• It can be broken down into
of intangible assets, such as
secondary ratios for more
brands and reputation.
detailed analysis, i.e. profit
•
margin and asset turnover. The corporate objective of
maximising total shareholders’
wealth is not achieved by
making decisions on the basis of
ROI.
• It may encourage the
manipulation of profit and capital
employed figures to improve
results and, for example, to
obtain a bonus payment.

 

Dysfunctional decision making

 

There is a risk that if ROI is used as a performance measure, management may only take decisions which will increase divisional ROI, regardless of wider corporate benefits.

 

The test your understanding below illustrates the problem of dysfunctional behaviour.

 

Test your understanding 1

 

 

 

Managers within MV are appraised on the ROI of their division. The company’s cost of capital is 15%.

 

Jon, a divisional manager, has the following results:

 

$
Annual profit 30,000
Investment 100,000

 

Within his division, the purchase of a new piece of equipment has been proposed. This equipment would cost $20,000, would yield an extra $4,000 of profit per annum and would have many other non-financial and environmental benefits to the division and the company as a whole.

 

Required:

 

Will Jon invest in the new equipment? Is this the correct decision for the company?

 

Age of assets

 

The ROI will increase with the age of the asset. This may encourage divisional managers to hold onto old, and potentially inefficient, assets rather than investing in new ones.

 

The test your understanding below illustrates this problem.

 

 

Test your understanding 2

 

 

 

McKinnon Co sets up a new division in Blair Atholl investing $800,000 in fixed assets with an anticipated useful life of 10 years and no scrap value. Annual profits before depreciation are expected to be a steady $200,000.

 

Required:

 

You are required to calculate the division’s ROI for its first three years based on the opening book value of assets. Comment on your results.

 

6      Residual income

 

6.1 Introduction

 

The problems of dysfunctional behaviour and holding onto old assets can be addressed by using residual income (RI) to appraise divisional performance.

 

6.2 What is residual income (RI)?
Controllable operating profit X
Less imputed interest (controllable capital employed × cost of capital) (X)
–––
RI X
–––
Decision rule: if the RI is positive:
• accept the project or
• appraise the division as performing favourably.

 

6.3 Advantages and disadvantages of RI

 

Advantages Disadvantages
• It reduces the problems of ROI, • It is difficult to decide upon an
i.e. dysfunctional behaviour and appropriate cost of capital.
holding onto old assets. • It does not facilitate
•
Interpreting the result is simple; comparisons between divisions
if the RI is positive then the since the RI is driven by the size
division is generating a return of the divisions and their
above that required by the investment.
finance providers. • It does not always result in
• The cost of financing a division decisions that are in the best
is brought home to divisional interests of the company (EVA
managers. is a superior measure to RI in
• Different cost of capitals can be this respect).
•
applied to different divisions Different accounting policies can
based on their risk profiles. confuse comparisons (as for
ROI).
• It may encourage the
manipulation of profit and capital
employed figures to improve
results and, for example, to
obtain a bonus payment (as for
ROI).

 

6.4 Comparison of ROI and RI

 

Test your understanding 3

 

 

 

Division Z has the following financial performance:
Operating profit $40,000
Capital employed $150,000
Cost of capital 10%

 

Required:

 

Would the division wish to accept a new possible investment costing $10,000 which would earn an annual operating profit of $2,000 if the evaluation was on the basis of:

 

  • ROI

 

  • RI?

 

Is the division’s decision in the best interests of the company?

 

 

Test your understanding 4

 

 

KM is considering a new project and has gathered the following data:

 

The initial investment is $66 million which will be required at the beginning of the year. The project has a three year life with a nil residual value. Depreciation is calculated on a straight-line basis.

 

The project is expected to generate revenue of $85m in year 1, $90m in year 2 and $94m in year 3. These values may vary by 6%.

 

The direct costs will be $50m in year 1, $60m in year 2 and $70m in year 3. These may vary by 8%.

 

Cost of capital may also vary from 8% to 10% for the life of the project.

 

Use the written down value of the asset at the start of each year to represent the value of the asset for the year.

 

Ignore tax.

 

Required:

 

Prepare two tables for:

 

  • the best outcome and

 

  • the worst outcome

 

showing the annual operating profit, residual income and return on investment for each year of the project and the NPV.

 

 

7      Annuity depreciation

 

Annuity depreciation

 

 

 

  • As discussed, the use of ROI and RI does not always result in decisions that are in the best interests of the company.

 

  • Specifically, a project with a positive net present value (NPV) at the company’s cost of capital may show poor ROI or RI results in early years, leading to its rejection by the divisional manager.

 

  • Annuity depreciation is one attempt to resolve this problem.

 

Example:

 

Division X is currently generating a ROI of 12%. It is considering a new project. This requires an investment of $1.4 million and is expected to yield net cash inflows of $460,000 per annum for the next four years. None of the initial investment will be recoverable at the end of the project.

 

The company has a cost of capital of 8%. Annual accounting profits are to be assumed to equal annual net cash inflows less depreciation, and tax is to be ignored.

 

Required:

 

  • Calculate and comment on the NPV of the project.

 

  • Calculate and comment on the ROI and RI of the project.

 

  • Calculate and comment on the ROI and RI of the project using annuity depreciation.

 

  • Calculate and comment on the ROI and RI of the project at the project IRR of 12%.

 

Solution:

 

  • NPV calculation

 

Time CF ($) DF 8% PV ($)
0 (1,400,000) 1 (1,400,000)
1 – 4 460,000 3.312 1,523,520

 

NPV = 123,520

 

Conclusion: the project has a positive NPV and is therefore worthwhile accepting from the company’s point of view.

 

 

  9
(b)  ROI and RI
Year 1 Year 2 Year 3 Year 4
$000 $000 $000 $000
NBV at start of year 1,400 1,050 700 350
––––– ––––– ––––– –––––
Net cash inflow 460 460 460 460
Depreciation (350) (350) (350) (350)
––––– ––––– ––––– –––––
Profit 110 110 110 110
Imputed interest @ (112) (84) (56) (28)
8%
––––– ––––– ––––– –––––
RI (2) 26 54 82
––––– ––––– ––––– –––––
ROI 7.9% 10.5% 15.7% 31.4%

 

Conclusion: If the manager’s performance is measured (and rewarded) on the basis of RI or ROI, he is unlikely to accept the project. The first year’s RI is negative, and the ROI does not exceed the company’s cost of capital until year 2, or the ROI currently being earned until year 3. Divisional managers will tend to take a short-term view. More immediate returns are more certain, and by year 3 he may have moved jobs.

 

  • ROI and RI using annuity depreciation Annuity depreciation is calculated as follows:

Step 1: Calculate the equivalent annual cost (EAC) of the initial investment

 

EAC = Initial investment ÷ cumulative discount factor at the company’s cost of capital

 

  • $1.4m ÷ 3.312

 

  • $422,705

 

 

Step 2: Calculate annual depreciation

 

Annual depreciation = EAC – interest on opening NBV e.g. for year 1 = 422,705 – (1,400,000 × 8%)

 

= $310,705
The ROI and RI can now be calculated as follows:
Year 1 Year 2 Year 3 Year 4
NBV at start of $000 $000 $000 $000
year 1,400 1,089.3 753.7 391.3
––––– ––––––– –––––– ––––––
Net cash inflow 460 460 460 460
Depreciation (310.7) (335.6) (362.4) (391.4)
–––––– ––––––– –––––– ––––––
Profit 149.3 124.4 97.6 68.6
Imputed interest
@ 8% (112) (87.1) (60.3) (31.3)
–––––– ––––––– –––––– ––––––
RI 37.3 37.3 37.3 37.3
–––––– ––––––– –––––– ––––––
ROI 10.7% 11.4% 12.9% 17.5%

 

Conclusion: The project now has an equal, positive, RI over its life, which will encourage the manager to invest, a decision compatible with that using NPV.

 

However, there is still a problem if ROI is used as the performance measure, in that the short-term low rate of return may not encourage investment in what is, in fact, a worthwhile project. A way round this is to use annuity depreciation at a different rate that will ensure a level ROI over the project life. The rate to be used will be the IRR of the project.

 

 

  • ROI and RI using annuity depreciation at the project IRR

 

12% is now used instead of 8% in computing both the EAC of the investment and the interest on capital, yielding the following results:

 

Year 1 Year 2 Year 3 Year 4
$000 $000 $000 $000
NBV at start of
year 1,400 1,108 781 414.7
––––– ––––– ––––– ––––––
Net cash inflow 460 460 460 460
Depreciation (292) (327) (366.3) (410.2)
––––– ––––– –––––– ––––––
Profit 168 133 93.7 49.8
Imputed interest (168) (133) (93.7) (49.8)
@12%
––––– ––––– –––––– ––––––

 

RI 0 0 0 0
––––– ––––– –––––– ––––––
ROI 12% 12% 12% 12%

 

Conclusion:

 

The ROI and the RI is now level over the project life, ensuring a consistent decision whether the short-term or long-term view is taken. Using 12% as an appraisal rate for the project yields consistent results under all three methods (NPV, ROI and RI) i.e. the project is at break-even.

 

This somewhat contrived approach is probably less useful than the one above when RI is used to assess performance.

 

In addition, the use of annuity depreciation does not produce helpful results when cash flows are uneven.

 

8      Economic value added

 

8.1 What is economic value added (EVA)?

 

  • EVA is a measure of performance similar to residual income. However, adjustments are made to financial profits and capital to truly reflect the economic value generated by the company.

 

  • It is a measure of performance that is directly linked to shareholder wealth.

 

  • It is important to note that EVA can be used to appraise organisation-wide performance as well as divisional performance.

 

 

Calculating EVA
$
Net operating profit after tax (NOPAT) X
Less: adjusted value of capital employed at beginning of the year ×
WACC (X)
–––––
EVA X/(X)
–––––

 

Decision rule: a positive EVA is favourable, since the organisation is providing a return greater than that required by the providers of finance.

 

8.2 Adjustments required to operating profit and capital employed

 

Change to operating Change to capital
profit employed
Depreciation and Add back depreciation. Adjust value to reflect
non-current assets Deduct economic economic depreciation
and not accounting
depreciation which
depreciation.
reflects the true value of
assets during the period. In addition, adjust value to
reflect replacement cost of
non-current assets rather
than the book value.
Provisions Add increase in Add back the value of
provisions in the period, provisions in the period.
e.g. debt provisions,
deferred tax provisions.
Deduct reduction in
provisions in the period.
These represent over-
prudence in the financial
accounts.
Non-cash Add back since they do Add to retained profit at
expenses not represent cash paid the end of the year.
and may be as a result of
profit manipulation and
not real costs.
Interest paid net of Interest payments are
tax, i.e. interest × (1 taken into account in
– tax rate) WACC.

 

Expenditure on Add back, i.e. capitalise Increase capital
advertising, the entire expense. employed at the end of
research and Deduct amortisation for the year.
development and Increase capital
the period (if mentioned).
employee training
employed in respect to
similar add backs in
previous year’s
investments.
Operating leases Add lease payments. Add present value of
Deduct depreciation on future lease payments.
Operating leases should
operating lease assets.
be treated in the same
way as financial leases
(i.e. capitalised) to prevent
firms from using operating
leases to reduce capital
employed and hence
increase EVA.
Summary NOPAT calculation
$
Controllable operating profit X
Add:
accounting depreciation X
increase in provisions X
non-cash expenses X
advertising, research and development and employee X
training costs
operating lease payments X
Deduct:
economic depreciation (X)
decrease in provisions (X)
amortisation of advertising, research and development (X)
and employee training
depreciation of operating lease assets (X)
tax paid plus tax relief on interest (interest × tax rate) (X)
= NOPAT X

 

8.3 What is the WACC?

 

WACC = (proportion of equity × cost of equity) + (proportion of debt × post tax cost of debt)

 

For example, suppose that a company is 60% financed by equity which has a cost of 10% pa and 40% financed by debt which has an after tax cost of 6%

 

WACC = (0.60 × 0.10) + (0.40 × 0.06) = 0.084 therefore 8.4%

 

 

8.4 Evaluation of EVA

 

EVA assesses the value created by managers, so is a more appropriate tool for measuring performance than a profit based measure. However, it is not without its drawbacks.

 

Advantages Disadvantages
Maximisation of EVA will create real Requires numerous adjustments to
wealth for shareholders. profit and capital employed figures
which can be cumbersome. (The full
version requires more than 100
adjustments to the information in the
financial statements).
The adjustments made mean the Does not facilitate comparisons
measure is closer to cash flow than to between divisions since EVA is an
accounting profit avoiding the absolute measure (as is RI).
distortion of results by the accounting
policies in place.
The cost of financing a division is There are many assumptions made
bought home to the division’s when calculating the WACC, making
manager. its calculation difficult and potentially
inaccurate. In addition, the WACC is
for the company as a whole whereas
the cost of capital chosen when
calculating RI can reflect the risk of
the division.
Long-term value-adding expenditure Based on historical data whereas
can be capitalised, removing any shareholders are interested in future
incentive that managers may have to performance.
take a short-term view.
Interpreting the result is simple; if the
EVA is positive then the division is
generating a return above that
required by the finance providers.

 

 

Rationale behind the required adjustments for EVA Accounting adjustments

 

 

Stern Stewart argues that profits calculated in accordance with financial reporting principles do not reflect the economic value generated by the company and so need adjusting.

 

There are three main reasons for these adjustments:

 

  • To convert from accrual to cash accounting.

 

  • Spending on ‘market building’ items such as research, staff training and advertising costs should be capitalised to the extent that they have not been in the financial statements. Stern Stewart believes that financial reporting standards are too strict in this regard, and discourage managers from investing in items that bring long-term benefits.

 

  • Unusual items of profit or expenditure should be ignored.

 

This can result in 160 adjustments being necessary in calculating NOPAT. The APM examiner will test only the most common adjustments, which are as follows:

 

  • Expenditure on promotional activities, research and development and employee training should be capitalised where they generate long term benefit.

 

Marketing activities for long-term benefit generate future value for the business, so are added back to profit and should also be added to capital employed in the year in which the expenses were incurred. This also means any prior year expenditure is also added in to capital employed.

 

  • The accounting depreciation charge is replaced with a charge for economic depreciation.

 

Economic depreciation reflects the true change in value of assets during the period, unlike accounting depreciation. If no detail is given on economic depreciation then candidates should assume that accounting depreciation represents a reasonable approximation for it.

 

  • Items such as provisions, allowances for doubtful debts, deferred tax provisions and allowances for inventory should be added back to capital employed.

 

These are considered to represent over-prudence on the part of financial accountants, and this understates the true value of capital employed. Any expenses or income recognised in the income statement in respect of movements in such items should also be removed from NOPAT.

 

  • Non-cash expenses should be added back to profits, and to capital employed.

 

Non-cash expenses are correctly added back to profit as such costs are treated as unacceptable accounting adjustments on a cash-based view.

 

  • Changing the treatment of operating leases to match finance leases. Under IAS 17 operating leases are treated differently from finance leases in the financial statements, with finance leases being capitalised and operating leases being excluded from the statement of financial position. This inconsistency means that firms can take advantage of operating leases to reduce the reported capital employed and, therefore, increase the calculated EVATM.

 

When calculating EVATM therefore, operating leases should be capitalised and added to capital employed. On the income statement side, operating lease charges should be added back. In principle, interest and depreciation should then be charged on the assets acquired under finance leases. However, any interest would then be added back to profit in calculating NOPAT, and accounting depreciation would be replaced with economic depreciation.

 

  • The tax charge.

 

The tax cost should be the amount paid adjusted for lost tax on interest and not the adjusted amount of tax charged in the accounts. These “cash taxes” are calculated as follows:

 

Cash taxes = tax charge per income statement – increase (add reduction) in deferred tax provision + tax benefit of interest Note: no further adjustments are made in respect of the tax on the other items adjusted for during the calculation of NOPAT.

 

 

Illustration 2 – Adjusting for operating leases

 

 

Division A is calculating EVA for the first time. It has operating leases on equipment, for which it pays annual rental charges of $40,000. The current value of the operating leases is estimated at $150,000. The economic life of the leased asset is 5 years.

 

Calculating NOPAT

 

  • Add back the operating lease charge of $40,000.

 

  • Deduct the annual ‘economic’ depreciation of $30,000 (assume equal annual depreciation of $150,000 ÷ 5 years).

 

  • NET IMPACT – add back $10,000 (the implied interest charge on the lease).

 

 

Calculating the adjusted value of capital employed

 

  • The net book value of the operating leases should be added back, i.e. $150,000.

 

  • The annual economic cost of these assets is $30,000

($150,000 ÷ 5) and so the capital employed would be depreciated by this amount each year thereafter.

 

 

Test your understanding 5

 

 

 

Division B has a reported operating profit of $8.4 million, which includes a charge of $2 million for the full cost of developing and launching a new product that is expected to generate profits for 4 years.

 

The company has an after tax weighted average cost of capital of 10%.

 

The operating book value of the division’s assets at the beginning of the year is $60 million, and the replacement cost has been estimated at $75 million.

 

Assume the tax charge is $0.

 

Required:

 

Calculate division B’s EVA.

 

Student accountant articles: visit the ACCA website, www.accaglobal.com, to review the two articles on ‘economic value added versus profit based measures of performance’.

 

9      Value-based management

 

This is a slight aside but it is worth covering here since it follows on from our discussion of EVA.

 

As mentioned in the previous  , businesses (and the divisions within them) are under increasing pressure to look at the long-term value of the business since this is what investors will be interested in.

 

Value-based management (VBM) is an approach to management whereby the company’s strategy, objectives and processes are aligned to help the company focus on the key drivers of shareholder wealth and hence the maximisation of this value.

 

 

 

Measuring shareholder value

 

Traditionally, financial measures such as EPS and ROCE were used to quantify shareholder value. However, none of these measures directly correlates with the market value of the company (i.e. shareholder value).

 

VBM is an approach which takes the interests of the shareholders as its primary focus.

 

VBM begins from the view that the value of a company is measured by its discounted cash flows. The idea being that value is only created when companies generate returns which beat their cost of capital.

 

VBM then focuses the management of the company on those areas which create value. A key to this process is the identification of the drivers of value and then a concentration of effort at all levels (strategic, tactical and operational) on these drivers in order to increase the value of the firm.

 

Illustration 3 – Value drivers

 

 

 

There are seven key strategic drivers of shareholder value:

 

  • revenue

 

  • operating margin

 

  • cash tax rate

 

  • incremental capital expenditure

 

  • investment in working capital

 

  • cost of capital

 

  • growth period.

 

Each level of management will be able to link its activities to one or more of these value drivers. For example, a key value driver at operational level may be departmental service levels. This will link to the strategic drivers of revenue and operating margin.

 

Implementing VBM

 

The implementation of VBM will involve four steps:

 

  • Step 1 – a strategy is developed to maximise value.

 

  • Step 2 – key value drivers are identified and performance targets (both short and long term) are defined for those value drivers. Targets may be developed by benchmarking against competitors.

 

  • Step 3 – a plan is developed to achieve the targets.

 

  • Step 4 – performance metrics and reward systems are created that are compatible with these targets. Staff at all levels of the firm should be motivated to achieve the new targets set.

 

 

Measures used in VBM

 

Measures include:

 

  • EVA – this is the primary measure used. A positive EVA indicates value creation while a negative one indicates destruction.

 

  • Market value added (MVA) – this is the accumulated EVAs generated by an organisation since it was formed.

 

  • Shareholder value analysis – this is the application of a discounted cash flow technique to valuing the whole business rather than a single potential investment.

 

MVA and shareholder value analysis

 

 

 

As well as EVA, consultants have produced a number of other value based measures, with each claiming its own merits.

 

  • Market value added (MVA)

 

MVA is the value added to the business by management since it was formed, over and above the money invested in the company by shareholders and long term debt holders. A positive MVA means value has been added and a negative MVA means value has been destroyed.

 

MVA can effectively be seen as the accumulated EVAs generated by an organisation over time. As such it should be highly correlated with EVA values. If year after year a company has a positive EVA then these will add up to give a high MVA.

 

  • Shareholder value analysis

 

SVA is an application of discounted cash flow techniques to valuing the whole business rather than a potential investment.

 

One problem in the estimation of future values is that theoretically the cash flows go to infinity. A practical way to resolve this is to take free cash flows for a few years into the future (the ‘competitive advantage period’) and then estimate the residual value of the organisation using either some market multiple or book value. The valuation of the company and hence the individual shares can be directly derived from the SVA.

 



One criticism of the above is that the estimation of the terminal value is subjective. There is a problem in determining how many years’ cash flows can be realistically projected into the future and therefore at which point the terminal value should be calculated. However, all valuation methods depend upon estimating future dividends, earnings or cash flows and hence they all contain some element of subjectivity.

 

 

The techniques available for increasing and monitoring value will be/have been covered in other  s and include (amongst others):

 

  • the balanced scorecard

 

  • business process re-engineering

 

  • TQM

 

  • JIT

 

  • ABC and ABM

 

 

VBM evaluation

 

VBM focuses on value as opposed to profit, thus focusing on the long-term rather than purely the short-term. This makes the organisation more forward looking.

 

However, VBM can become an exercise in valuing everything and changing nothing.

 

In addition, management information systems may need to be adapted to take account of the need to measure non-financial indicators.

 

Since EVA is one of the key measures used in VBM, the advantages and disadvantages of EVA will also be relevant here.

 

Question practice

 

Take the time to review and attempt the scenario-based question below. It contains an exam standard EVA calculation and also requires an explanation of VBM.

 

Test your understanding 6

 

 

 

EcoHomes is an innovative company that was born from the demand of customers for high quality, bespoke homes at affordable prices. The company is based in the country of Geeland and is divided into three geographical areas; North, East and West. The company’s mission is ‘to make environmentally sound homes available to the general public in a way that ensures accessibility and quality of the product’.

 

EcoHomes is an off-site timber frame manufacturer, producing the shell of the house in their state of the art factory using sustainably sourced, certified timber. The controlled environment assures customers of the best quality available. EcoHomes prides itself on being a ‘one-stop shop’ providing the customer with a full design and build and a fixed price quotation which includes all the planning, demolition, ground works, house build and landscaping.

 

EcoHomes is starting to lose market share and its key goal of ‘being the number one bespoke house builder in Geeland’ is starting to slip away. The fall in market share is primarily due to the entry of two new competitors into the market. The first of these, Dream Homes, provides cutting edge house designs and premium quality builds (but at prices to match). The second new competitor, Bespoke Homes 4all, undercuts EcoHomes on price but is not able to provide the same quality, design, build or finish.

 

EcoHomes has just released a profit warning for the first quarter of the current year, 20X2. This has caused the board to reconsider its position and to take action to address the changed environment. Some cost cutting has already begun, such as the commencement of a voluntary redundancy programme and the introduction of a pay freeze for all employees. However, the board recognises that it will need to take more radical steps to fully address the issues it is facing.

 

EcoHomes has traditionally used EPS and ROCE to quantify shareholder value. The CEO understands that a number of EcoHomes’ rivals are now using a value -based management (VBM) approach to performance management and he thinks that it may be a useful development for EcoHomes given the tough competitive environment. Financial data for EcoHomes for the last two years is provided in appendix 1. The CEO has come to you to advise him on the implications of a switch to VBM.

 

Appendix: Financial data for EcoHomes
20X1 20X0
$m $m
Operating profit 130 110
Interest 20 18
——— ———
Profit before tax 110 92
Tax @ 25% 27.5 23
——— ———
Profit after tax 82.5 69

 

Further information is as follows:

 

  • The allowance for doubtful debts was $6 million at 1 January 20X0, $5 million at 31 December 20X0 and $7 million at 31 December 20X1.

 

  • Research and development costs of $10 million were incurred during each of the year’s 20X0 and 20X1 on a new project, Project Light which is part completed. These costs were expensed in the income statement.

 

 

 

  • At 1 January 20X0, the company had completed another research project, Project Glass. Total expenditure on this project was

 

$30 million, none of which had been capitalised in the financial statements. The product developed by Project Glass went on sale on 1 January 20X0. The product has a two year lifecycle and no further sales of this product are expected after 31 December 20X1.

 

  • The company incurred non-cash expenses of $0.3 million in both years.

 

  • Capital employed was $670 million at 1 January 20X0 and $740 million at 1 January 20X1.

 

  • The pre-tax cost of debt was 5% in each year. The estimated cost of equity was 12% in 20X0 and 14% in 20X1. The rate of corporation tax was 25% in both years.

 

  • The company’s capital structure was 60% equity and 40% debt.

 

  • There was no provision for deferred tax.

 

Required:

 

Write a report to the CEO of EcoHomes addressing the following:

 

  • Perform an assessment of EcoHomes using economic value added (EVA). Briefly comment on the results of your calculations.

 

(14 marks)

 

  • Evaluate the use of value-based management (VBM) approaches to performance management.

 

(7 marks)

 

(Total: 21 marks)

 

10    Transfer pricing

 

10.1 Introduction

 

The transfer price is the price at which goods or services are transferred from one division to another within the same organisation.

 

The transfer price chosen will have a direct impact on the performance of the divisions.

 

Characteristics of a good transfer price

 

  • Goal congruence – the transfer price that is negotiated and agreed upon by the buying and selling divisions should be in the best interests of the company overall.

 

  • Fairness – the divisions must perceive the transfer price to be fair since the transfer price set will impact divisional profit and hence performance evaluation.

 

  • Autonomy – the system used to set the transfer price should seek to maintain the autonomy of the divisional managers. This autonomy will improve managerial motivation.

 

  • Bookkeeping – the transfer price chosen should make it straightforward to record the movement of goods or services between divisions.

 

  • Minimise global tax liability – multinational companies can use their transfer pricing policies to move profits around the world and thereby minimise their global tax liability.

 

10.2 The general rules for setting transfer prices

 

Scenario 1: There is a perfectly competitive market for the product/service transferred

 

Transfer price = market price

 

A perfect market means that there is only one price in the market, there are no buying and selling costs and the market is able to absorb the entire output of the primary division and meet all the requirements of the secondary division.

 

Scenario 2: The selling division has surplus capacity

Practical considerations when setting the transfer price Considerations when using the market price

  • As mentioned, if a perfectly competitive market exists for the product, then the market price is the best transfer price.

 

  • However, care must be taken to ensure the division’s product is the same as that offered by the market (for example, quality and delivery terms are the same). If not, an adjusted market price should be used.

 

  • In addition, the market price should be adjusted for costs not incurred on an internal transfer, for example, delivery costs and marketing costs.

 

Considerations when using a cost based approach

 

  • The cost may be:

 

the marginal cost – as mentioned, this will be the very minimum the selling division will accept. This will be preferred by the buying division, i.e. they will consider the price to be fair.

 

the full cost – this will be preferred by the selling division, i.e. they will consider the price to be fair.

 

the opportunity cost – if there is no spare capacity in the selling division, the opportunity cost should be added to the marginal cost/full cost.

 

  • The selling division will want to recognise an element of profit on its transfer (since it will most probably be a profit centre). Therefore, the final transfer price can be set at cost + % profit.

 

  • Standard cost should be used rather than actual cost to avoid inefficiencies being transferred from one department to another and to aid planning and budgeting.

 

  • ‘Fairness’ is one of the key characteristics of a good transfer price. Two alternative approaches that may be perceived as fair by both the buying and the selling divisions are:

 

marginal cost plus a lump sum (two part tariff) – the selling division transfers each unit at marginal cost and a periodic lump sum charge is made to cover fixed costs.

 

dual pricing – the selling division records one transfer price (e.g. full cost + % profit) and the buying division records another transfer price (e.g. marginal cost). This will be perceived as fair but will result in the need for period-end adjustments in the accounts.

 

Illustration 4 – Practical methods of transfer pricing

 

 

 

Manuco

 

Manuco has been offered supplies of special ingredient Z at a transfer price of $15 per kg by Helpco, which is part of the same group of companies. Helpco processes and sells special ingredient Z to customers external to the group at $ 15 per kg. Helpco bases its transfer price on total cost-plus 25% profit mark-up. Total cost has been estimated as 75% variable and 25% fixed.

 

Required:

 

Discuss the transfer prices at which Helpco should offer to transfer special ingredient Z to Manuco in order that group profit maximising decisions may be taken on financial grounds in each of the following situations.

 

  • Helpco has an external market for all its production of special ingredient Z at a selling price of $15 per kg. Internal transfers to Manuco would enable $1.50 per kg of variable packing cost to be avoided.

 

  • Conditions are as per (i) but Helpco has production capacity for 3,000 kg of special ingredient Z for which no external market is available.

 

  • Conditions are as per (ii) but Helpco has an alternative use for some of its spare production capacity. This alternative use is equivalent to 2,000 kg of special ingredient Z and would earn a contribution of $6,000.

 

 

Solution

 

  • Since Helpco has an external market, which is the opportunity foregone, the relevant transfer price would be the external selling price of $15 per kg. This will be adjusted to allow for the $1.50 per kg avoided on internal transfers due to packing costs not required, i.e. the transfer price is $13.50 per kg.

 

  • In this situation Helpco has no alternative opportunity for 3,000 kg of its special ingredient Z. It should, therefore, offer to transfer this quantity at marginal cost. This is variable cost less packing costs avoided = $9 – $1.50 = $7.50 per kg (note: total cost = $15 × 80% = $12; variable cost = $12 × 75% = $9). The remaining amount of special ingredient Z should be offered to Manuco at the adjusted selling price of $13.50 per kg (as above).

 

  • Helpco has an alternative use for some of its production capacity, which will yield a contribution equivalent to $3 per kg of special ingredient Z ($6,000/2,000 kg). The balance of its spare capacity (1,000 kg) has no opportunity cost and should still be offered at marginal cost. Helpco should offer to transfer: 2,000 kg at $7.50 + $3 = $10.50 per kg; 1,000 kg at $7.50 per kg (= marginal cost); and the balance of requirements at $13.50 per kg.

 

 

Test your understanding 7

 

 

 

X, a manufacturing company, has two divisions: Division A and Division B. Division A produces one type of product, ProdX, which it transfers to Division B and also sells externally. Division B has been approached by another company which has offered to supply 2,500 units of ProdX for $35 each.

 

The following details for Division A are available:
Sales revenue: $
Sales to division B @ $40 per unit 400,000
External sales @ $45 per unit 270,000
Less:
Variable cost @$22 per unit 352,000
Fixed costs 100,000
–––––––
Profit 218,000
–––––––

 

External sales of Prod X cannot be increased, and division B decides to buy from the other company.

 

Required:

 

  • Calculate the effect on the profit of division A.

 

  • Calculate the effect on the profit of company X.

 

Test your understanding 8

 

 

 

A company operates two divisions, Able and Baker. Able manufactures two products, X and Y. Product X is sold to external customers for $42 per unit. The only outlet for product Y is Baker.

 

Baker supplies an external market and can obtain its semi-finished supplies (product Y) from either Able or an external source. Baker currently has the opportunity to purchase product Y from an external supplier for $38 per unit. The capacity of division Able is measured in units of output, irrespective of whether product X, Y or a combination of both are being manufactured.

 

The associated product costs are as follows:

 

X Y
Variable costs per unit 32 35
Fixed overheads per unit 5 5
––– –––
Total unit costs 37 40

 

Required:

 

  • Using the above information, provide advice on the determination of an appropriate transfer price for the sale of product Y from division Able to division Baker under the following conditions:

 

  • when division Able has spare capacity and limited external demand for product X

 

  • when division Able is operating at full capacity with unsatisfied external demand for product X.

 

  • The design of an information system to support transfer pricing decision making necessitates the inclusion of specific data. Identify the data that needs to be collected and how you would expect it to be used.

 

Question practice

 

Take the time to review and attempt the scenario-based question below. It contains an exam standard transfer pricing calculation and also requires an explanation of transfer pricing.

 

 

Test your understanding 9

 

 

 

The Thornthwaite division is a member of the Kentmere group, and manufactures a single product, the Yoke.

 

It sells this product to external customers, and also to Froswick, another division in the group. Froswick further processes the Yoke and then sells it on to external customers.

 

The divisions have the freedom to set their own transfer prices, and also to choose their own suppliers.

 

The Kentmere group uses Residual Income (RI) to assess divisional performance, and each year it sets a target RI for each division. The group uses a cost of capital of 12%.

 

Each divisional manager receives a salary, plus a bonus equal to that salary for hitting its RI target.

 

There has recently been much discussion at board level about the impact of internal transfers and their impact on reported performances. In part this was prompted by a comment from a retired shareholder, Mr Brearley, at the recent shareholder meeting. He said that he had read a lot in the press about bonus schemes and their dysfunctional impact on corporate performance. The directors want to know whether or not Kentmere has any such issues.

 

The managers of both divisions have provided you with the following information for the next quarter (quarter 3):

 

Thornthwaite division

 

Budgeted information for quarter 3:

Maximum production capacity 200,000 units

External demand 170,000 units

External selling price $45

Variable cost per unit $30

Fixed production costs $2,500,000

Capital employed $6,000,000

Target RI $250,000

 

Froswick division

 

Froswick has found an external supplier willing to supply Yokes at a price of $42 per unit.

 

Required:

 

  • Froswick requires 50,000 Yokes. Calculate the transfer price that Thornthwaite would set to achieve its target RI.

 

(6 marks)

 

  • What prices should Thornthwaite set in order to maximise group profits? Explain the basis of your calculations.

 

(4 marks)

 

  • Is Mr Brearley correct to be concerned about the bonus scheme? Draft some briefing notes for the board so that they can prepare their response, including supporting calculations and suggested improvements to the transfer pricing and bonus policies.

 

(10 marks)

 

(Total: 20 marks)

 

10.4 International transfer pricing

 

Almost two thirds of world trade takes place within multi-national companies.

Transfer pricing in multi-national companies has the following complications:

 

Taxation

 

The selling and buying divisions will be based in different countries. Different taxation rates in these countries allows the manipulation of profit through the use of transfer pricing.

 

Illustration 5 – Taxation and transfer pricing

 

 

 

Rosca Coffee is a multinational company. Division A is based in Northland, a country with a tax rate of 50%. This division transfers goods to division B at a cost of $50,000 per annum. Division B is based in Southland, a country with a tax rate of 20%. Based on the current transfer price of $50,000 the profit of the divisions and of the company is as follows:

 

Division A Division B Company
$ $ $
External sales 100,000 120,000 220,000
Internal transfers to div B 50,000 50,000
Fixed and variable costs (70,000) (40,000) (110,000)
Transfer costs from div A (50,000) (50,000)
––––––– ––––––– –––––––
Profit before tax 80,000 30,000 110,000
Profit after tax 40,000 24,000 64,000

 

 

Rosca Coffee want to take advantage of the different tax rates in Northland and Southland and have decided to reduce the transfer price from $50,000 to $20,000. This will result if the following revised profit figures:

 

Division A Division B Company
$ $ $
External sales 100,000 120,000 220,000
Internal transfers to div B 20,000 20,000
Fixed and variable costs (70,000) (40,000) (110,000)
Transfer costs from div A (20,000) (20,000)
––––––– ––––––– –––––––
Profit before tax 50,000 60,000 110,000
Profit after tax 25,000 48,000 73,000

 

Conclusion: the manipulation of the transfer price has increased the company’s profits from $64,000 to $73,000.

 

Remittance controls

 

  • A country’s government may impose restrictions on the transfer of profits from domestic subsidiaries to foreign multinationals.

 

  • This is known as a ‘block on the remittances of dividends’ i.e. it limits the payment of dividends to the parent company’s shareholders.

 

  • It is often done through the imposition of strict exchange controls.

 

  • Artificial attempts at reducing tax liabilities could, however, upset a country’s tax authorities. Many tax authorities have the power to alter the transfer price and can treat the transactions as having taken place at a fair arm’s length price and revise profits accordingly.

 

Test your understanding 10

 

 

 

Required:

 

Discuss how a multinational company could avoid the problem of blocked remittances.

 

 

Additional example on international issues

 

 

 

A multinational organisation, C, has 2 divisions each in a different country

– Divisions A and B. Suppose Division A produces a product X where the domestic income tax rate is 40% and transfers it to Division B, which operates in a country with a 50% rate of income tax. An import duty equal to 25% of the price of product X is also assessed. The full cost per unit is $190, the variable cost $60.

 

Required:

 

The tax authorities allow either variable or full cost transfer prices.

Determine which should be chosen.

 

Solution
Effect of transferring at $190 instead of $60:
$
Income of A is $130 higher and so A pays $130 × 40% more (52)
income tax
Income of B is $130 lower and so C pays $130 × 50% less 65
income tax
Import duty is paid by B on an additional $130, and so C pays (32.5)
$130 × 25% more duty
Net effect (cost) of transferring at $190 instead of $60 (19.5)
Additional example on international issues

 

Conclusion: C should transfer at variable cost.

 

Student accountant article: visit the ACCA website, www.accaglobal.com, to review the article on ‘transfer pricing’.

 

 

11    Exam focus

 

Exam sitting Area examined Question Number of
number marks
Divisional performance
Mar/June 2017 measurement including the use of 4 25
net profit and EVA
Sept/Dec 2016 Transfer pricing 4(b)(c) 17
Mar/June 2016 Divisional performance appraisal 1(ii) – (iv) 24
Sept/Dec 2015 Responsibility centres 3(b)(ii) 4
Sept/Dec 2015 EVA 1(i) 15
June 2015 EVA, ROI and RI, responsibility 4 25
centres
June 2014 EVA and VBM 1(iii)(iv) 19
June 2013 Transfer pricing 4 25
December 2012 EVA 3(a) 13
June 2012 EVA 1(ii) 3
June 2011 RI, ROI, EVA, transfer pricing 1(a)(b) 24
December 2010 EVA and VBM 3 20

Test your understanding 1

 

 

 

Before After Investment
Profit ($) 30,000 34,000 4,000
Investment ($) 100,000 120,000 20,000
ROI 30% 28% 20%

 

  • Jon’s decision – from a personal point of view, the ROI of Jon’s division will go down and his bonus will be reduced or lost as a result. Therefore, Jon will reject the investment.

 

  • However, the new equipment has a ROI of 20%. This is higher than the company’s cost of capital (required return) of 15% and therefore Jon should accept the new investment.

 

Conclusion: dysfunctional behaviour has occurred.

 

 

 

Test your understanding 2

 

 

 

 

Year Opening Annual Closing Pre- Post ROI
book book value of dep’n dep’n
value of depreciation assets profits profits
assets
$000 $000 $000 $000 $000
1 800 80 720 200 120 15%
2 720 80 640 200 120 17%
3 640 80 560 200 120 19%

 

Conclusion: The ROI increases, despite no increase in annual profits, merely as a result of the book value of assets falling. Therefore, the divisional manager will be rewarded for holding onto old, and potentially inefficient, assets.

 

Test your understanding 3
(a) ROI
Current ROI = ($40k/$150k) × 100 26.7%
ROI with new investment = ($42k/$160k) × 100 26.3%
ROI of the new investment = ($2k/$1 0k) × 100 20%
Decision: The division would not accept the investment since it
would reduce the division’s ROI.
However, this is not in the best interests of the company since the
ROI (20%) is greater than the company’s cost of capital (10%).
(b) RI
Current RI = $40k – (10% × $150k) $25k
RI with new investment = $42k – (10% × $160k) $26k
Decision: The division would accept the investment since it
generates an increase in RI of $1,000.
This decision is in the best interests of the company.
Test your understanding 4
(a) Best outcome
RI and ROI Year 1 Year 2 Year 3
$m $m $m
NBV @ start of year (66.0) (44.0) (22.0)
––––– ––––– –––––
Revenue (add 6%) 90.1 95.4 99.6
Less direct cost (minus 8%) (46.0) (55.2) (64.4)
––––– ––––– –––––
Net cash flow 44.1 40.2 35.2
Less depreciation (22.0) (22.0) (22.0)
Operating profit 22.1 18.2 13.2
Less imputed interest @ 8% (5.3) (3.5) (1.8)
RI 16.8 14.7 11.4
ROI 33.5% 41.4% 60.0%
NPV @ 8% discount factor
Timing CF DF PV
t0 (66.0) 1.000 (66.0)
t1 44.1 0.926 40.8
t2 40.2 0.857 34.5
t3 35.2 0.794 28.0
–––––
NPV 37.3
–––––

 

 

 

 

 

(b)  Worst outcome
RI and ROI Year 1 Year 2 Year 3
$m $m $m
NBV @ start of year (66.0) (44.0) (22.0)
Revenue (minus 6%) 79.9 84.6 88.4
Less direct cost (add 8%) (54.0) (64.8) (75.6)
––––– ––––– –––––
Net cash flow 25.9 19.8 12.8
Less depreciation (22.0) (22.0) (22.0)
Operating profit 3.9 (2.2) (9.2)
Less imputed interest @ 10% (6.6) (4.4) (2.2)
RI (2.7) (6.6) (11.4)
ROI 5.9% –5.0% –41.8%
NPV @ 10% discount factor
Timing CF DF PV
t0 (66.0) 1.000 (66.0)
t1 25.9 0.909 23.5
t2 19.8 0.826 16.4
t3 12.8 0.751 9.6
––––– ––––– –––––
NPV (16.5)
–––––
Test your understanding 5
NOPAT
$m
Controllable operating profit 8.4
Add back items that add value: development costs 2
Deduct amortisation of development costs ($2m ÷ 4 years) (0.5)
———
NOPAT 9.9
———
Adjusted value of capital employed
$m
Opening book value of assets 60
Adjustment to reflect the replacement cost of assets 15
($75m – $60m) ———
Adjusted value of capital employed 75
———

 

  9
EVA
$m
NOPAT 9.9
Less: adjusted value of capital employed × WACC (7.5)
($75m × 10%)
———
EVA 2.4
———
Test your understanding 6
REPORT
To: CEO
From: A accountant
Date: April 20X2
Subject: EVA calculation and evaluation of VBM
Introduction

 

This report performs an assessment of EcoHomes using economic value added (EVA) and evaluates the use of value-based management as a tool for managing performance.

 

(a)  EVA calculation
(W1) Calculation of NOPAT
20X1 20X0
$m $m
Operating profit 130 110
Add research costs expensed (Project Light) 10 10
Less amortisation of prior year expenses (Project (15) (15)
Glass)
Add increase in allowance for doubtful debts 2 (1)
Add non-cash expenses 0.3 0.3
Less cash taxes (W3) (32.5) (27.5)
––––– –––––
NOPAT 94.8 76.8

 

 

(W2) Calculation of adjusted capital employed at 1 January

 

20X1 20X0
$m $m
Capital at 1 January per statement of financial 740 670
position
Add allowance for bad and doubtful debts 5 6
Add capitalisation of research and development 10
(Project Light)
Add capitalisation of research and development 15 30
(Project Glass)
Add non-cash expenses incurred during 20X0 0.3
––––– –––––
Adjusted capital employed at 1 January 770.3 706
(W3) Calculation of net tax
20X1 20X0
$m $m
Tax charge per income statement 27.5 23
Add tax relief on interest (interest × 25%) 5 4.5
––––– –––––
Cash taxes 32.5 27.5
(W4) Weighted average cost of capital (WACC)
20X1: (60% × 14%) + ((40% × 5% × (1 – 25%)) = 9.9%
20X0: (60% × 12%) + ((40% × 5% × (1 – 25%)) = 8.7%

 

EVA = NOPAT – (WACC × adjusted capital employed)

 

20X1: 94.8 – (9.9% × 770.3) = $18.54 million

 

20X0: 76.8 – (8.7% × 706) = $15.38 million

 

Conclusion:

 

EVA is positive in both 20X0 and 20X1 showing that EcoHomes is adding value in both periods. The EVA increased by 20.5% year on year from $15.38 million in 20X0 to $18.54 million in 20X1. This is particularly pleasing given the level of competition within the industry. However, it will be necessary to closely monitor the EVA to ensure that there is no reduction in the figure in 20X2.

 

  • Evaluation of value-based management

 

Value-based management (VBM) is an approach to management whereby the company’s strategy, objectives and processes are aligned to help the company focus on the key drivers of shareholder wealth and hence the maximisation of value.

 

Traditionally, EcoHomes used the financial measures of ROCE and EPS to quantify shareholder value. However, neither of these measures directly correlates with the market value of the company (shareholder value).

 

VBM takes the interests of shareholders as its primary objective. EVA is the primary measure used, (other methods include market value added and shareholder value analysis). A positive EVA indicates value creation (as in 20X0 and 20X1 in EcoHomes) while a negative one indicates destruction. EVA is consistent with net present value (NPV). Maximisation of EVA will create real wealth for shareholders.

 

Although EVA is calculated using the profit figure, the profit is adjusted in order to bring it closer to a cash flow measure of performance which is less affected by various accounting adjustments such as depreciation. Long-term value added expenditure can be capitalised, removing any incentive that managers may have to take a short-term view.

 

EVA will also bring the cost of financing home to EcoHomes’ managers.

 

A major disadvantage of VBM measures such as EVA, compared to say EPS or ROCE, is the unfamiliarity and complexity of the calculation. Staff will need to be trained and shareholders educated in order to overcome this.

 

Another disadvantage of EVA is the large number of assumptions made when calculating the WACC. It should also be remembered that calculations such as EVA are based on historical data whereas shareholders are interested in future performance.

 

 

Test your understanding 7

 

 

  • Division A will lose the contribution from internal transfers to Division B. Contribution foregone = 2,500 × $(40 – 22) = $45,000 reduction.

 

(b)

 

$ per unit
Cost per unit from external supplier 35
Variable cost of internal manufacture saved 22
–––
Incremental cost of external purchase 13
–––
Reduction in profit of X = $13 × 2,500 units
= $32,500

 

 

Test your understanding 8

 

 

  • (i) The transfer price should be set between $35 (minimum price Able will sell for) and $38 (maximum price Baker will pay). Able has spare capacity, therefore the marginal costs to the group of Able making a unit is $35. If the price is set above $38, Baker will be encouraged to buy outside the group, decreasing group profit by $3 per unit.

 

  • If Able supplies Baker with a unit of Y, it will cost $35 and they (both Able and the group) will lose $10 contribution from X. Therefore, the minimum price able will sell for is $45. So long as the bought-in external price of Y to Baker is less than $45, Baker should buy from that external source.

 

  • The following are required.

 

– Marginal costs (i.e. unit variable costs) and incremental fixed costs for various capacity levels for both divisions.

 

–    External market prices if appropriate.

 

– External bought-in prices from suppliers outside the group. – Opportunity costs from switching products.

 

–    Data on capacity levels and resource requirements.

 

Test your understanding 9

 

 

 

  • We must assume that Thornthwaite can divert sales away from existing customers, as it only has 30,000 units of spare capacity. This may not be possible because of existing contractual arrangements, or the adverse impact on goodwill and future sales. Target Residual Income = $250,000.

 

Charge for capital employed = $6,000,000 × 12% = $720,000. So, required profit = 250 + 720 = $970,000

As fixed costs are $2,500,000, the required contribution is 2,500 + 970 = $3,470,000

 

If we transfer 50,000 units to Froswick, we can sell 150,000 units externally at a contribution of (45 – 30) = $15/unit.

 

So, contribution from external sales = 150,000 × $15 = $2,250,000

 

We therefore require contribution of 3,470 – 2,250 = $1,220,000 from internal transfer of 50,000 units. Contribution required per unit = $1,220,000/50,000 = $24.40 per unit.

 

Therefore transfer price Thornthwaite would set = 24.4 + 30 = $54.40.

 

  • The transfers should be made on an opportunity cost basis. Thornthwaite has spare capacity of 30,000 units, and since the variable cost of production is less than the price at which Froswick can buy in from an external supplier, it should use this capacity.

 

The transfer price should be at least equal to Thornthwaite’s marginal cost of $30, but less than the external price that Froswick can buy in at of $42.

 

Once this spare capacity has been used up, we do not want Thornthwaite to turn away external customers paying $45/unit as this would only save $42/unit from Froswick buying in. Hence, when there is no spare capacity the transfer price should be set at the external selling price of $45/unit. This would encourage Froswick to buy in externally.

 

Summary:

 

Transfer 30,000 units at >marginal cost of $30 (but less than the buy-in price of $42).

 

Set a transfer price of $45 for units in excess of 30,000, to encourage Froswick to buy externally.

 

  • Briefing notes on the potential dysfunctional effect of the bonus scheme at Kentmere

 

The first thing to note is that the bonus is material – the divisional manager can double his/her pay by hitting the RI target. It is likely that this will influence decisions that the manager takes.

 

A decentralised structure encourages local managers to optimise their own reported performance. They are not necessarily that concerned with corporate performance overall, especially as this is not linked to their rewards. This may well encourage dysfunctional behaviour since a decision that looks good for an individual division may not be in the best interests of the company overall. This is indeed the case here.

 

We can use the figures given to illustrate this:

 

If Thornthwaite sets the transfer price calculated of $54.40, Froswick will exercise its right to buy from the external supplier at a price of $42. This is clearly dysfunctional as Thornthwaite could have used its spare capacity to manufacture 30,000 units internally at a marginal cost of $30/unit.

 

This causes a net cost to the group of 30,000 × (30 – 42) = $360,000.

 

Using the opportunity costs for the transfer price as calculated in part (b) would avoid this dysfunctional behaviour, but would of course mean that Thornthwaite misses its RI target.

 

 

Improvements to transfer pricing policy:

 

A transfer pricing policy should have the following attributes:

 

– The transfer price should motivate the correct decision for the company as a whole.

 

– It should preserve the local autonomy rather than being imposed.

 

–    It should provide a margin to both parties.

 

–    It should be simple to operate and understand.

 

Clearly our current system, whilst being simple, does not meet these criteria. Allowing Thornthwaite to set the transfer price means that it will seek to meet its own objectives, which will in turn mean that Froswick rejects the transfer and buys from outside. This is dysfunctional and causes a loss to the group as a whole.

 

One solution would be to use a two – part system. Goods could be transferred at marginal cost during the period, with a lump sum period end recharge to cover Thornthwaite’s fixed costs and to allocate profit. This would require Head Office intervention as the two divisions would clearly disagree on what the lump sum should be!

 

Improvements to the bonus scheme:

 

The problem with the current bonus scheme is that it is based on the achievement of a single target figure, which it seems can readily be manipulated by setting a higher transfer price. It provides a classic example of “what you measure is what you get”, and so dysfunctional behaviour results.

 

We need a scheme that encourages a corporate view rather than a parochial divisional view, so Thornthwaite’s bonus should be linked to the overall Company performance and not its own result. This in turn means that it should incorporate measures like quality, efficiency improvements and staff welfare.

 

This is more difficult, because as models such as Fitzgerald and Moon’s Building Blocks tell us, rewards should be based on principles such as clarity, motivation and controllability. A divisional manager may feel that overall company performance is outside their direct control, and lacks the necessary clarity.

 

So, in conclusion Mr Brearley is correct to be concerned. There are fundamental weaknesses in linking the bonus to a single measure, and particularly one that can be manipulated by adjusting the transfer price.

 

Test your understanding 10

 

Blocked remittances might be avoided by means of:

 

  • increasing transfer prices paid by the foreign subsidiary to the parent company (see below)

 

  • lending the equivalent of the dividend to the parent company

 

  • making payments to the parent company in the form of:

 

–    royalties

 

–    payments for patents

 

–    management fees and charges

 

  • charging the subsidiary company additional head office overheads.

 

Note: The government of the foreign country might try to prevent many of these measures being used.

 

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