Presupuesto de cada una de las iniciativas

Services are intangible in nature. This characteristic of services makes it difficult for pricing. Charging business units for services furnished by corporate staff units becomes challenging work due to intangibility of services. While pricing corporate services, we exclude the cost of central service staff units over which business units have no control (e.g., central accounting, public relations, and administration). If these costs are charged at all, they are allocated, and the allocations do not include a profit component. The allocations are not transfer prices.

 We need to consider two types of transfers:

O For central services that the receiving unit must accept but can at

least partially control the amount used.

O For central services that the business unit can decide whether or not to use.

Business units may be required to use company staffs for services such as information technology and research and development. In these situations, the business unit manager cannot control the efficiency with which these activities are performed but can control the amount of the service received. There are three schools of thought about such services.

One school holds that a business unit should pay the standard variable cost of the discretionary services. If it pays less than this, it will be motivated to use more of the service than is economically justified. On the other hand, if business unit managers are required to pay more than the variable cost, they might not elect to use certain services that senior management believes worthwhile from the company's viewpoint. This possibility is most likely when senior management introduces a new service, such as a new project analysis program. The low price is analogous to the introductory price that companies sometimes use for new products.

A second school of thought advocates a price equal to the standard variable cost plus a fair share of the standard fixed costs-that is, the full cost. Proponents argue that if the business units do not believe the services are worth at least this amount, something is wrong with either the quality or the efficiency of the service unit. Full cost represents the company's long run costs, and this is the amount that should be paid.

A third school advocates a price that is equivalent to the market price, or to standard full cost plus a profit margin. The market price would be used if available (e.g., costs charged by a computer service bureau); if not, the price would be full cost plus a return on investment. The rationale for this position is that the capital employed by service units should earn a return just as the capital employed by manufacturing units does. Also, the business units would incur the investment if they provided their own service.

 Optional Use of Services

In some cases, management may decide that business units can choose whether to use central service units. Business units may procure the service from outside, develop their own capability, or choose not to use the service at all. This type of arrangement is most often found for such activities as information technology, internal consulting groups, and maintenance work. These service centers are independent; they must stand on their own feet. If the internal services are not competitive with outside providers, the scope of their activity will be contracted or their services may be outsourced completely.

For example, Commodore Business Machines outsourced one of its central service activities-customer service-to Federal Express. James Reeder, Commodore's vice president of customer satisfaction, said, "At that time we didn't have the greatest reputation for customer service and satisfaction. But this was FedEx's specialty, handling more than 300,000 calls for service each day. Commodore arranged for FedEx to handle the entire telephone customer service operation from FedEx's hub in Memphis.

After losing $29 million online the previous year, Borders Group turned to rival Amazon.com to manage its online sales. Borders get to maintain an Internet sales channel and gains the operational effectiveness provided by Amazon.com while being able to focus on the growth of its bricks and mortar business.

In this situation, business unit managers control both the amount and the efficiency of the central services. Under these conditions, these central groups are profit centers. Their transfer prices should be based on the same considerations as those governing other transfer prices.

(Numerical) MCS – 2004

Division B of Shayana company contracted to buy from Div. A, 20,000 units of a component for the final product made by Div. B. The transfer price for this internal transaction was set at Rs. 120 per unit by mutual agreement. This comprises of (per unit) Direct and Variable labour cost of

Rs. 20; Material Cost of Rs.60; Fixed overheads of Rs.20 (lumpsum Rs.4 lacs) and Rs.20 lacs that Div. A would require for this additional activity. During the year, actual off take of Div. B was 19,600 units. Div. A was able to reduce material consumption by 5% but its budgeted investment overshot by 10%.

a) As Financial controller of Div. A, compare Actual Vs Budgeted Performance

b) Its implications for Management Control? Solution: a) Particulars Budgeted (Rs. Per Unit) Budgeted (Total in Rs.) Actual (Rs. Per Unit) Actual (Total in Rs.) Direct and Variable Labour Cost 20 4,00,000 20 3,92,000 Material Cost 60 12,00,000 57 11,17,200 Fixed Overheads 20 4,00,000 4,00,000 Total Cost 100 20,00,000 19,09,200 Transfer Price 120 24,00,000 119.86 23,49,200 Profit 20 4,00,000 4,40,000 Investment 20 20,00,000 22,00,000 ROI = Profit/Investment 20% 20%

Despite of increase in investment by 10%, there is negligible difference in transfer price. Also the sales have decreased by 400 units. Therefore we can say that additional investment has not achieved any positive results.

SET-4

Q.1) A)Explain the concept of ROI. What are its advantages?

Return on investment (ROI) is the ratio of profit before tax to the gross investment. ROI is calculated with the help of the following formula:

For 20,000 Units

For 19,600 Units

ROI = (Pre-Tax Profit/Sales) X (Sales/Net Assets) or (Pre-Tax Profits/Net Assets) The numerator is profit before tax as reported in the P&L account. The profit should include only the profits arising out of the normal activities of the division. Unusual items of receipts and expenses should be excluded from the profit figure. One should also ignore windfalls and income from investments not related to the

operations of the division. Tax is excluded from the numerator because the marginal of the SBU is not responsible for or in control of the tax paid.

Capital employed can be ascertained from the balance sheet by including fixed and current assets. Assets not currently put to divisional use should be excluded from the investment base. One also needs to exclude their relative earnings if any. The company should also exclude intangible assets like goodwill, deferred revenue expenses, preliminary expenses, etc.

ROI can be improved by:

o Increasing the profit margin on sales. o Increasing the capital turnover

o Increasing both profit margin and capital turnover.

o Reducing cost as that adds to the total earnings of the firm.

o Increasing the profits by expanding present operations or developing new product line, increasing market share, etc.

o Diversifying, introducing productivity improvement measures, expansion,

replacement of old equipments Advantages of ROI

o ROI relates return to the level of investment and not sales as the rate of return is more realistic.

o ROI can be decomposed into other variables as shown. These variables have tremendous analytical value.

o ROI is an effective tool for inter-firm comparison. Question 1 (b):

Many experts regard EVA as a concept superior to ROI and yet in certain cases, EVA does not do justice to the evaluation of investment center. Explain this phenomenon with as illustration.

EVA does not solve all the problems of measuring profitability in an investment center. In particular, it does not solve the problem of accounting for fixed assets discussed above unless annuity depreciation is also used, and this is rarely done in practice. If gross book value is used, a business unit can increase its EVA by taking actions contrary to the interests of the company, as shown in Exhibit 7-3. If net book value is used, EVA will increase simply due to the passage of time.

Furthermore, EVA will be temporarily depressed by new investments because of the high net book value in the early years. EVA does solve the problem created by differing profit potentials. All business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment exceeds the required rate prescribed by the measurement system.

Moreover, some assets may be undervalued when they are capitalized, and others when they are expensed. Although the purchase cost of fixed assets is ordinarily capitalized, a substantial amount of investment in start-up costs, new product

development, dealer organization, and so forth may be written off as expenses, and, therefore, not appear in the investment base. This situation applies especially in marketing units. In these units the investment amount may be limited to inventories, receivables, and office furniture and equipment. When a group of units with varying degrees of marketing responsibility are ranked, the unit with the relatively larger marketing operations will tend to have the highest EVA.

In view of all these problems, some companies have decided to exclude fixed assets from the investment base. These companies make an interest charge for controllable assets only, and they control fixed assets by separate devices. Controllable assets are, essentially, receivables and inventory. Business unit management can make day-to-day decisions that affect the level of these assets. If these decisions are wrong, serious consequences can occur-quickly. For example, if inventories are too high, unnecessary capital is tied up, and the risk of obsolescence is increased;

whereas, if inventories are too low, production interruptions or lost customer business can result from the stockouts. To focus attention on these important controllable items, some companies, such as Quaker Oats, 17 include a capital charge for the items as an element of cost in the business unit income statement. This acts both to motivate business unit management properly and also to measure the real cost of resources committed to these items.

Investments in fixed assets are controlled by the capital budgeting process before the fact and by post completion audits to determine whether the anticipated cash flows, in fact, materialized. This is far from being completely satisfactory because actual savings or revenues from a fixed asset acquisition may not be identifiable. For example, if a new machine produces a variety of products, the cost accounting system usually will not identify the savings attributable to each product.

The argument for evaluating profits and capital investments separately is that this often is consistent with what senior management wants the business unit manager to accomplish; namely, to obtain the maximum long-run cash flow from the capital investments the business unit manager controls and to add capital investments only when they will provide a net return in excess of the company's cost of funding that investment. Investment decisions, then, are controlled at the point where these decisions are made. Consequently, the capital investment analysis procedure is of primary importance in investment control. Once the investment has been made, it is largely a sunk cost and should not influence future decisions. Nevertheless,

management wants to know when capital investment decisions have been made incorrectly, not only because some action may be appropriate with respect to the person responsible for the mistakes but also because safeguards to prevent a recurrence may be appropriate.

Q.2 What are the different methods to evaluate the performance of an investment centre? Discuss the merits and demerits of each? Which method would you recommend?

The following techniques are useful in evaluating the performance of an investment centre:

1. Return on investment (ROI):

The rate of return on investment is determined by dividing net profit or income by the capital employed or investment made to achieve that profit.

ROI = Profit / Invested capital * 100 ROI consists of two components viz. Profit margin

Investment turnover

ROI = Net profit / Investment

It will be seen from the above formula that ROI can be improved by increasing one or both of its components viz. the profit margin and the investment turnover in any of the following ways:

Increasing the profit margin

Increasing the investment turnover

Increasing both profit margin and investment turnover

Capital employed is taken to be the total of shareholders funds, loans etc

The profit figure used is in calculating ROI is usually taken from the profit and loss account, profit arising out of the normal activities of the company should only be taken.

Capital employed for the company as a whole can be arrived at as follows:

Share capital of the company xxx

Reserves and surplus xxx

Loans (secured/unsecured) xxx

--- xxx Less: a. Investment outside the business xxx b. Preliminary expenses xxx

c. Debit balance of P & L A/c xxx xxx --- xxxx

Merits:

Return on investment analysis provides a strong incentive for optimum utilization of the assets of the company. This encourages managers to obtain assets that will

provide a satisfactory return on investment and to dispose off assets that are not providing an acceptable return. In selecting amongst alternative long-term

investment proposals, ROI provides a suitable measure for assessment of profitability of each proposal.

Demerits:

ROI analysis is not very suitable for short-term projects and performances. In the initial stages a new investment may yield a small ROI which may mislead the management. Most likely the rate would improve in course of time when the initial difficulties are overcome.

The book value of assets decline due to depreciation, the investment base will continuously decrease in value, causing the rate of return to increase.

2. Residual income:

Residual income can be defined as the operating profit (or income) of the company less the imputed interest on the assets used by the company. In other words, interest on the capital invested in the company is treated as a cost and any surplus is the residual income. Residual income is profit minus notional interest charge on capital employed.

Residual income is affected by the size of the organization and therefore will not provide a basis for evaluation of organizational performance. This is probably the main reason why the management continues to make use of ROI which is relative measure.

Not all projects start off with positive or sufficiently large positive profits in the early years of a project to produce a positive increment to residual income. It has been argued that a more suitable measure of performance for investment centres, which could encourage managers to be more willing to undertake marginally profitable projects, is residual income.

We recommend RI as a method of evaluating performance of an investment centre. Because when RI is adopted for evaluation purposes, emphasis is placed on

marginal profit amount above the cost of capital rather than on the rate itself. Q.3 What are the objectives of Transfer Pricing?

Transfer price if designed appropriately has the following objectives:

It should provide each segment with the relevant information required to determine the optimum trade-off between company costs and revenues.It should induce goal congruent decisions-i.e. the system should be so designed that decisions that

improve business unit profits will also improve company profits. It should help measure the economic performance of the individual profit centers. The system should be simple to understand and easy to administer.

 What is ideal transfer price in the situations of Limited Market Shortage of

Capacity in the industry

The ideal transfer price in the situations of Limited Market

By limited market it means that the markets for buying and selling profit centers may be limited.

Even in case of limited market the transfer price that is ideal or satisfies the

requirement of a profit center system is the competitive price. In case if a company is not buying or selling its product in an outside market there are some ways to find the competitive price. They are as follows:

If published market prices are available, they can be used to establish transfer prices. However, these should be prices actually paid in the market-place and the conditions that exist in the outside market should be consistent with those existing within the company.

For example, market prices that are applicable to relatively small purchases are not valid in this case.

Market prices are set by bids. This generally can be done only if the low bidder has a reasonable chance of obtaining the business. One company accomplishes this by buying about one-half of a particular group of products outside the company and one-half inside the company. The company then puts all of the products out to bid, but selects one-half to stay inside. The company obtains valid bids, because low bidders can expect to get some of the business. By contrast, if a company requests bids solely to obtain a competitive price and does not award the contracts to the low bidder, it will soon find that either no one bids or that the bids are of questionable value.

If the production profit center sells similar products in outside markets, it is often possible to replicate a competitive price on the basis of the outside price. If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products. This can be done by calculating the cost of the difference in design and other conditions of sale between the competitive products and the proprietary products.

In this case, the output of the buying profit center is constrained and again company profits may not be optimum. Some companies allow either buying profit center to appeal a sourcing decision to a central person or committee. In this scenario a buying profit center could appeal a selling profit center’s decision to sell outside. The person/group would then make a sourcing decision on the basis of the

company’s best interests. In every case the transfer price would be the competitive price. In other words, the profit center is appealing only the sourcing decision. Even if there are constraints on sourcing, the market price is the best transfer price. If the market price can be approximated, it is ideal transfer price.

 When do you use Cost Based Transfer Pricing?

We use cost-based transfer pricing if there is no way of approximating valid competitive price. Transfer prices may be set up on the basis of cost plus a profit, even though such transfer prices may be complex to calculate and the results less satisfactory than a market-based price.

Two aspects need to be considered for cost-based transfer pricing:

The cost basis: The usual basis is the standard cost. Actual costs should not be used because production inefficiencies will then be passed on to the buying profit center.