Managerial Accounting - Investment Centers & Transfer Pricing

Zain Packages Ltd has three divisions i.e. Paper, Printing and Packaging Division. The company makes cartons, boxes, packets, bags and wrappers. If the company earns a profit, each of the three divisions would brag of its efforts. If the company incurs a loss, each division would pass on the buck to others. The Chief Executive can decide on his or her own but it would be fraught with suspicion from those whose work was not appreciated.

In order to inseminate some transparency in the performance appraisal, each division can be turned into an autonomous unit called Investment Center. Each would be headed by a manager who would be responsible to incur costs, fix prices and buy additional fixed assets. Eventually, there would be a separate P&L Account for each division and so it would be clear as to who has contributed what in the total profit of the company.

But it is not so simple as it seems as the divisions are interlinked. The paper division is responsible for producing quality paper which is passed on to Printing Division for making printed sheets of different sizes. The Packaging Division collects the printed sheets and converts them into packages for various industries particularly cigarettes and food processing units. The question arises at which price the products (paper and printed paper sheets) would be sold internally to the next division. That calls for Transfer Pricing which is the subject matter of this hub.

What is an Invetment Center?

An autonomous business unit or division or segment whose manager has control over fixing prices and incurring costs besides having control over the use of investment funds. It is a term used for business units within an enterprise. It performance are measured against its use of capital.

In 1980, Ezzamel and Hiton surveyed operations of 129 large companies in the UK. They found out that all these companies have small autonomous units headed by a manager who was given necessary powers to make production schedules, set prices and credit terms and approve budgets for purchase and advertisement. However, in the matter of long term investments, all managers were closely supervised by the top management.

When sub-unts are free to take decision, there is an element of decentralization where authority is distributed or delegated to the managers. Decntralisation bring rewards as it motivates the managers, enable them to take decions at the spot keeping in view local environments etc. It has some drawbacks like inconsistancy across divsions of the same company.

The performance of each Investment Center is measure by using a variety of tools some of which are briefly dis cussed as under:

Return on Investment (ROI)

ROI is a simple ratio easy to calculate. Total returns are divided by total assets and multiplied by 100 to arrive at a percentage. For example, in 2008, the returns were Rs.8,000,000 while investments were Rs.40,000.000, the ROI being 20% (8,000,000 / 40,000,000).

A manager in a cost center is given a benchmark of certain ROI say 20%. If actual ROI is equal to or more than this, the manager has done well.

Some complications arise in calculating ROI like whether the returns should be before or after profit. Similarly, in case of investments, whether these should be total assets or total operating assets or net total assets. Suppose, totals assets are to be taken as a base, a question would arise whether these should be gross or depreciated.

ROI would differ in each scenario but if consistency is maintained across divisions and over the period of time, the decisions would remain un-affected.

Residual Income (RI)

It is net operating income which an investment center earns over and above the minimum required return on its operating assets. Like ROI, RI is another approach to measuring an investment center's performance.

Though ROI and RI have the same roots and results, RI proves better in certain circumstances as explained below:

  • If ROI is made a criteria, managers would be reluctant to make additional investment in fixed assets as it may bring down the ROI. In previous example, a manager was happy with an ROI of 20%. If an additional sum of Rs.12 million is made which would bring incremental return of Rs.1.2 million, this would bring down overall ROI to 18.4% {(8 m+ 1.2 m) / (40 m + 10 m)}.
  • But RI would give results in monetary term which would show an increase. Supposing, Cost of Fund (minimum required returns) was 10%, RI in the foregoing example, before additional investment, would be Rs.4 million {(8m - (40 m x 10%)}. With additional Investment and the returns, it would increase to Rs.4.2 million (8m+1.2m) - {(40 m + 10m) x 10%}. Thus RI would increase by Rs.200,000 which is a good sign.

Economic Value Added (EVA)

Economic Value Added (EVA) is an extension of RI. Under EVA, companies often modify their accounting principles. R&D would be treated as intangible assets rather than an expense. Moreover, current liabilities would be excluded from total liabilities and equity. Many more adjustment would be made. This has been explained in detail under another hub with the same title: Economic Value Added.

The three measures are compared as follows:

What is Transfer Pricing?

Transfer pricing refers to the pricing of products or services transferred within an organization.

When Investment Centers have been established, these would be considered as autonomous units. They would be free to purchase their raw materials direct from the market or from their own departments. In case of the latter, there are many advantages like (i) it would be cheaper to buy from own departments, (ii) there would be more quality assurance and reliability. Also, it would be beneficial to the selling department because (i) there would no packing and external transportation costs, and (ii) there would be no bad debt.

OBJECTIVES OF TRANSFER PRICING?

Chief Executive of a big company cannot monitor and control operations of each and every sub-unit. So the sub-units are turned into Investment Centers and necessary authority is delegated to their managers.But in a decentralization, there are difficulties in evaluating the performance of the managers. Further, there is a problem of coordination. So a method is needed to ascertain contribution of each sub-unit to the total profit of the organization. A common solution to this problem is to set prices for intermediate goods which are transferred from one division to another. These prices are known as transfer prices to be used for:

  • Performance evaluation of each manager based on the contribution made by the sub-unit.
  • Coordination of all sub-units for achieving the organisational goals.
  • Deciding what to charge for transfer a product or service to the next department.
  • to preserve autonomy of a sub-unit.
  • Motivation of the managers as they would certainly get rewards for good performance through a transparent system.

Methods of Transfer Pricing

1) EXTERNAL MARKET PRICE

  • If an external price is available, it would be a good price indicator. The transfer price should be the same as market price less an amount representing savings in packing and transportation cost etc.
  • In an ideal situation, a sub-unit would have an option to sell directly to the maket should a reasonable transfer price is not agreed upon. Same is the case with the buying department.

2) COST PLUS MARKUP

  • Sub units can fix a markup on cost to get a reasonable return which would enable them to achieve the required ROI. Such a markup may be based on variable cost or full cost. It would make no difference except that basing on variable cost would be convenient.
  • Supposing variable and full costs of a department are Rs.300 and Rs.500 respectively. Suppose further that the manager thinks a fair price for his or her product to be Rs.600. So in case of variable cost, the markup would be 100% and in case of full cost 20%. Same results would be achieved in both the cases.

3) NEGOTIATED PRICES

  • If there is no outside market, the buying and selling department may negotiate prices.

Summary

A good accounting system should promote goal congruence among its employees. In other words, all employees should work and take decision keeping in view objectives of the company. Various techniques have been used for this purpose such as Management By Objectives. The accounting system can make its contribution by segregating profitability of each division or sub division through declaring each division as an Investment centre.

ROI, RI and EVA are used as performance indicators but the transfer mechanism has to be addressed. An example was given of a Packaging Company. While its Package Unit sells in the market and earns revenues, this was not the case when paper was transferred to Printing Unit and printed sheets were passed on to Packaging Division. Here comes the question of Transfer Pricing. As a general rule, a transfer price should be equal to opportunity cost for the product.

With a sound system of Transfer Pricing, it become easy to prepare unit wise P&L account and to observe non-financial factors to evaluate performance of an individual unit. With such a transparency and accountability, overall results of company would be smooth achieving targets set at the start of the year.

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Comments 21 comments

Rufi Shahzada profile image

Rufi Shahzada 7 years ago from Karachi

Dear Sir,

ROI, RI and EVA are explained so well. Thanks for constantly adding to my knowledge Sir.

Regards,

Rufi Shahzada


hafeezrm profile image

hafeezrm 7 years ago from Pakistan Author

Thanks for your comments.


Syed Kabeer Ehsan profile image

Syed Kabeer Ehsan 6 years ago

Dear Teacher,

Methods of transfer pricing

(1) External market price

(2) Cost plus markup

(3) Negotiated pricing

these concepts help me a lot SIR, and i can apply them in my marketing major subjects in pricing stratigies, thanque very much sir.


hafeezrm profile image

hafeezrm 6 years ago from Pakistan Author

Thanks syed kabeer for your comments.


Accounting firm 6 years ago

More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again

http://www.kpmgaccountingfirm.info


Mohamed JAHEES 6 years ago

pLEASE EXPLAIN TRANSFER PRICING SUMS WITH EXAMPLE

ACCA PAPER f5


hafeezrm profile image

hafeezrm 6 years ago from Pakistan Author

When studying divisional performance, profit generated by a department is the best indicator. Unfortunately, division which are engaged in making work-in-process like ginned cotton, yarn and gray cloth do not generate revenues as they pass their products to next division for further processing and sales.

In order to give some benefits to intermediary divisions, transfer pricing has been introudced. Ideally, a divisional head would be asked that there are two choices: (1) outright selling of the product like yarn or gray cloth in the open market or (ii) selling it to own unit willing to pay equal price. Since selling outside would involve a lot of paperwork, packing, transporting and risk (physical as well as credit), it would be prudent to sell it to own unit at somewhat lesser price price. Such a price is based on cost plus markup or market price minus some discount or negotiated price as discussed in the article. This is known as transfer pricing.

While such prices benefit the efficient divisions, it has no effect on overall profitability of the company.


Lee-ann  6 years ago

hello,

Thank you for your notes.

Just wondering what are some of the advantages of having an investment centre manager.


hafeezrm profile image

hafeezrm 6 years ago from Pakistan Author

Thanks Lee ann for reading my hub. At the moment, I am traveling in Europe and may not explain it much.

Investment centre is a sort of autonomous unit and is appraised on the basis of ROI. It motivates manager to work hard and promotes efficiency.


Niraj Dhakal 6 years ago

Is fixed cost relevant or irrelevant in the process of drop or continue


hafeezrm profile image

hafeezrm 6 years ago from Pakistan Author

In droping or continuing a product, fixed is irrelvant since it would be common to both situations. Incremental analysis is carried to guage the impact of droping a product which takes into account avoidable costs like veriable costs etc.


babri 5 years ago

thanks sir i think more explaination is required for better understanding of menagerial students


babri 5 years ago

thanks sir


bhavisha patel 4 years ago

wish you would explain more on the objective


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

Thanks Babri and Bhavisha Patel for your comments.


Ravi 4 years ago

Hello Sir,

I hav learned the concept and understood it. However, due to no proper solutions available in any books It is difiicultu to implement the concepts in the Problems.

It would be great that if you provide me with an example: like

Two divisions A and B of satyam Enterprises operates as Profit Centers.Division A normally purchases annually 10,000 nos.of required component from Division B ;which has recently informed Division A that it will increase selling price per unit to Rs.1,100.Division decided to purchase the components from open market available at Rs.1000 per unit.Naturally ,Division B is not happy and justified its decision to increase price due to inflation and added that overall company profitability will reduce and thae decision will lead to excess capacity in Division B ,whose variable and fixed costs per unit are respectively Rs.950 and Rs.1,100

(a)Assuming that no alternate use exists for excess capacity in Division B,will company as a whole benefit id Division A buys from the market

(b)If the market price reduced by Rs.80 per unit.What would be the effect on the company (assuming Division B still has excess capacity)if A buys from the market.

(c)If excess capacity of Division B could be used for alternative sales at yearly cost savings of Rs.14.5 Lacs,should Division A purchase from outside?

Justify your answer with figures.


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

Some problem in the question:

B would charge Rs.1,100 per unit from A. B's own cost is Rs.950 VC + 1,100 FC = 2,250 while the same product A can purchase from the market at Rs.1,000. Does not make any sense.


mohit kinger 3 years ago

plz explain negotiated price with example


Ha le 3 years ago

dear sir,

can you give me a specific case in the world that use ROI to conduct transfering price ?

thanks and best regard!


hafeezrm profile image

hafeezrm 3 years ago from Pakistan Author

@Mohit Kinger and @Ha Le,

Kindly search for answers on the internet.


chandru 3 years ago

simple solution sir thanks a lot for this

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