CHAPTER III

INVESTMENT CENTERS AND TRANSFER PRICING

The cost accounting system in an organization supports the management control
system by structuring accounts to reflect the delegation of decision authority. This
structure is then used to evaluate the performance of managers in decentralized
units. The use of accounting for performance evaluation is often called responsibility
accounting. It classifies organization units (such as a division, a region, or a store)
into centers based on the decision authority delegated to the center’s manager.
The five basic kinds of decentralized units are cost centers, discretionary cost centers,
revenue centers, profit centers, and investment centers. The responsibility accounting
classification is useful because it suggests the type of performance measure
appropriate for a center.
Managers of investment centers have responsibility for profits and investment in
assets. These managers have relatively large amounts of money with which to make
capital budgeting and other decisions affecting the use of assets. For example, cost
center managers are often restricted as to the amount of money they can invest in
assets (perhaps $5,000), while investment center managers can make acquisitions
costing up to $500,000 without higher approval. Investment centers are evaluated
using some measure of profit related to the invested assets in the center.
Investment center managers have decision authority that affects revenues and costs
and hence, profits, but they also have authority as to asset usage.
Measuring Performance in Investment centers
Return on Investment

If managers have responsibility for asset acquisition, usage, and disposal, an

effective performance measure must include the effect of assets. One of the most
common performance measures for divisional managers is return on investment
(ROI) , which is computed as follows:
ROI = After tax income
Divisional assets

= After tax income X Sales

Sales Divisional assets

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 = Profit margin ratio X Asset turnover

The profit margin ratio is a measure of the investment center’s ability to control its
costs for a given level of revenues. The lower the costs required to generate a dollar
of revenue, the higher the profit margin. The asset turnover ratio is a measure of
the investment center’s ability to generate sales for each dollar of assets invested in
the center.
Relating profits to capital investment is an intuitively appealing concept. Capital is
a scarce resource. If one unit of a company shows a low return, the capital could be
better employed in another unit where the return is higher, invested elsewhere, or
paid to stockholders.
Relating profits to investment also provides a scale for measuring performance.

Suppose, for example, that Celimar Company earned operating income last year as
shown in the following income statement:
Sales $480,000
Cost of goods sold 222,000
Gross margin $258,000
Selling and administrative expense 210,000
Operating income $ 48,000

At the beginning of the year, the net book value of operating assets was $277,000.
At the end of the year, the net book value of operating assets was $323,000. Then:

Average operating assets = (Beginning assets + Ending assets)/2

= ($277,000 + $323,000)/2
= $300,000

Margin = Operating income/Sales = $48,000/$480,000 = 0.10 or 10 percent

Turnover = Sales/Average operating assets = $480,000/$300,000 = 1.6
ROI = Margin X Turnover = 0.10 X 1.6 = 0.16 or 16 percent
Alternatively,

ROI= Operating income/Average operating assets = $48,000/$300,000

While both approaches yield the same ROI, the calculation of margin and turnover
gives a manager valuable information.

Advantages of ROI

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At least three positive results stem from the use of ROI:

1. It encourages managers to focus on the relationship among sales, expenses,

and investment, as should be the case for a manager of an investment center.
2. It encourages managers to focus on cost efficiency.
3. It encourages managers to focus on operating asset efficiency.

Disadvantages of the ROI Measure

Overemphasis on ROI can produce myopic behavior. Two negative aspects

associated with ROI are frequently mentioned:

1. It can produce a narrow focus on divisional profitability at the expense of

profitability for the overall firm.
2. It encourages managers to focus on the short run at the expense of the long
run.
Measuring the Performance of Investment Centers Using Residual Income and
Economic Value Added
To compensate for the tendency of ROI to discourage investments that are profitable
for the company but that lower a division’s ROI, some companies have adopted
alternative performance measures such as residual income. Economic value added
is an alternate way to calculate residual income and is being used in a number of
companies.
Residual Income Measures
One of the problems we identified with divisional income as a business unit
performance measure is that it does not explicitly consider the investment usage by
the unit. The reason is that accounting income is designed to report the return to
the owners of the organization and then let them compare the return to their cost
of capital. One approach to incorporate investment usage, which we just described,
divides income by investment.
A second approach is to modify divisional income by subtracting the cost of
invested capital (the cost of capital multiplied by the division’s assets, which
measures the investment in the division) from accounting income.

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Specifically, we define residual income (RI) as

Residual income = After-tax income - (Cost of capital X Divisional assets)

In other words, residual income is the divisional income less the cost of the
investment required to operate the division. The cost of capital is the payment
required to finance projects. The computation of the cost of capital is a subject for
finance courses. Residual income is similar to the economist’s notion of profit as
being the amount left over after all costs, including the cost of the capital employed
in the business unit, are subtracted.
One advantage of residual income over ROI is that it is not a ratio. Managers’
evaluated using residual income invests only in projects that increase residual
income. Therefore, there is no incentive for managers in divisions with low residual
incomes to invest in projects with negative residual incomes. The reason is that the
residual income for the division is the sum, not the weighted average, of the
residual income for the project and the residual income for the division prior to the
investment in the project.
Limitations of Residual Income

The residual income approach has one major disadvantage. It cannot be used to
compare the performance of divisions of different sizes. You would expect larger
divisions to have more residual income than smaller divisions, not necessarily
because they are better managed but simply because they are bigger. This problem
can be reduced by focusing on the percentage change in residual income from year
to year rather than on the absolute amount of the residual income.
One approach to reducing the problem of managerial myopia, the distortion in
incentives that results from problems with accounting measures, is to modify
divisional income so that it better reflects economic performance. Such an approach
is the idea behind economic value added (EVA).
Economic Value Added (EVA)
A specific way of calculating residual income is economic value added. It is said that
if EVA is positive, then the company is creating wealth; if EVA is negative, then the
company is destroying wealth.

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Consider the old saying, “It takes money to make money.” EVA helps the company
to determine whether the money it makes is more than the money it takes to make
it. Over the long term, only those companies creating capital, or wealth, can
survive.
As a form of residual income, EVA is a dollar figure, not a percentage rate of return.
The key feature of EVA is its emphasis on after-tax operating profit and the actual
cost of capital. Residual income, on the other hand, uses a minimum expected rate
of return. Investors like EVA because it relates profit to the amount of resources
needed to achieve it. A number of companies have been evaluated on the basis of
EVA.
Calculating EVA. The most contemporary measure of investment center
performance is economic value added (EVA), which is defined as follows:
EVA = Investment center’s after tax operating income – [(Investment center’s
total assets – Investment center’s current liabilities) X Weighted average
cost of capital]

Like residual income, the economic value added is a dollar amount. However, it
differs from residual income in two important ways. First, an investment center’s
current liabilities are subtracted from its total assets. Second, the weighted-average
cost of capital is used in the calculation.

Weighted average cost of capital

WACC = ( After tax cost of debt capital) (Market value of debt) + ( Cost of equity

capital) (Market value of equity)_____________________________________

Market value of debt + Market value of equity

Alternative Definitions of Investment

Companies use a variety of definitions for measuring investment in divisions. Four

common alternative definitions used in the construction of accounting-based
performance measures are as follows:

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1. Total assets available—includes all assets, regardless of their intended purpose.
2. Total assets employed—total assets available minus the sum of idle assets and
assets purchased for future expansion.
3. Total assets employed minus current liabilities—total assets employed,
excluding assets financed by short-term creditors. One negative feature of defining
investment in this way is that it may encourage subunit managers to use an
excessive amount of short-term debt because short-term debt reduces the amount
of investment.
4. Stockholders’ equity—calculated by assigning liabilities among subunits and
deducting these amounts from the total assets of each subunit. One drawback of
this method is that it combines operating decisions made by hotel managers with
financing decisions made by top management.
Companies that use ROI or RI generally define investment as the total assets
available. When top management directs a subunit manager to carry extra or idle
assets, total assets employed can be more informative than total assets available.
Companies that adopt EVA define investment as total assets employed minus
current liabilities. The most common rationale for using total assets employed
minus current liabilities is that the subunit manager often influences decisions on
current liabilities of the subunit.
Transfer Pricing
In decentralized organizations, much of the decision-making power resides in its
individual subunits. In these cases, the management control system often uses
transfer prices to coordinate the actions of the subunits and to evaluate their
performance.
The transfer price is the value or amount recorded in a firm’s accounting records
when one business unit sells (transfers) a good or service to another business unit.
The accounting records in the two units (responsibility centers) treat this
transaction in exactly the same way as a sale to an outside customer. Because the
exchange takes place within the organization, however, the firm has considerable
discretion in setting this transfer price. Just as with prices determined on an open
market, transfer prices are widely used for decision making, product costing, and

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performance evaluation; hence, it is important to consider alternative transfer
pricing methods and their advantages and disadvantages.
From the corporation’s viewpoint, of course, the total profit associated with the item
is simply the price paid by the external buyer less the costs incurred by the selling
division less the additional cost incurred by the buying division before the item is
sold. The transfer price is not a factor in this calculation and, therefore, does not
affect corporate profit if the transaction occurs.
What makes the transfer price important is that it affects the division managers’
decisions about whether to engage in the transaction. Because the managers of
both the selling division and the buying division are evaluated on division profit, not
company profit, they consider the effect of all sales, both internal and external, on
their division, not company, profit. This aspect of decentralized decision making
means that the definition of the transfer price can affect corporate profitability. If
one of the managers decides not to participate in the transaction, even though the
transaction is profitable for the corporation, the corporation forgoes any profit from
the opportunity. The optimal transfer price, then, is the price that leads both
division managers, each acting in his or her own self-interest, to make decisions
that are in the firm’s best interest. In other words, if a transaction would increase
firm profits, it must be profitable for both divisions, to make the transaction at the
given transfer price, or the given transfer price cannot be the optimal price. If a
transaction is not profitable for the corporation, the transfer price, to be optimal,
must make the sale unprofitable for at least one of the two transacting divisions.
General Transfer-Pricing rule
Management’s objective in setting a transfer price is to encourage goal congruence
among the division managers involved in the transfer. A general rule that will
ensure goal congruence is given below:

Transfer price = Additional outlay cost per unit incurred because goods are

transferred + Opportunity cost per unit to the organization

because of the transfer

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The general rule specifies the transfer price as the sum of two cost components. The
first component is the outlay cost incurred by the division that produces the goods
or services to be transferred. Outlay costs will include the direct variable costs of
the product or service and any other outlay costs that are incurred only as a result
of the transfer. The second component in the general transfer-pricing rule is the
opportunity cost incurred by the organization as a whole because of the transfer.
An opportunity cost is a benefit that is forgone as a result of taking a particular

action.
Broadly, there are three bases available for determining transfer prices, but many
options are also available within each base.
These methods are:
(1) Market Prices
(2) Cost-Based Prices
(3) Negotiated Prices
(4) Dual Prices
(1) Market-Based Prices:
Market price refers to a price in an intermediate market between independent
buyers and sellers. When there is a competitive external market for the transferred
product, market prices work well as transfer prices. When transferred goods are
recorded at market prices, divisional performance is more likely to represent the
real economic contribution of the division to total company profits. If the goods
cannot be bought from a division within the company, the intermediate product
would have to be purchased at the current market price from the outside market.
Divisional profits are therefore likely to be similar to the profits that would be
calculated if the divisions were separate organizations.
Consequently, divisional profitability can be compared directly with the profitability
of-similar companies operating in the same type of business. Managers of both
buying and selling divisions are indifferent between trading with each other or with
outsiders. No division can benefit at the expense of another division. In the market
price situation, top management will not be tempted to intervene.

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Market-based prices are based on opportunity costs concepts. The opportunity cost
approach signals that the correct transfer price is the market price. Since the
selling division can sell all that it produces at the market price, transferring
internally at a lower price would make the division worse off.
Similarly the buying division can always acquire the intermediate goods at the
market price, so it would be unwilling to pay more for an internally transferred
goods. Since the minimum transfer price for the selling division is the market price
and the maximum price for the buying division is also the market price, the only
possible transfer price is the market price.
The market price can be used to resolve conflicts among the buying and selling
divisions. From the company viewpoint, market price is the optimal so long as the
selling division is operating at full capacity. The market price does not allow any
gains or losses in efficiency of the selling division. It saves administrative costs as
the use of competitive market prices are free from any dispute, argument and bias.
Further, transfer prices based on market prices are consistent with the
responsibility accounting concepts of profit centers and investment centers. In
addition to encouraging division managers to focus on divisional profitability,
market based transfer prices help to show the contribution of each division to
overall company profit.
However, there are some problems using the market price approach:
(i) Appropriate Market Price may not Exist:
Firstly, finding a competitive market price may be difficult if such a market does not
exist. Catalogue price may only vaguely relate to actual sales prices. Market prices
may change often. Also, internal selling expenses may be less than would be
incurred if the products were sold to outsiders.
Further, the fact that two responsibility centers are parts of one company indicates
that there may be some advantages from being part of one company and not being
two separate companies dealing with each other in the market. For example, there
may be more certainty about the internal division’s product quality or delivery
reliability. Or the selling division may make a specialized product for which there

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are not substitutes in the market. Hence, it may not be possible to use market
prices.
(ii) Excess Production Capacity:
Another problem with market prices can occur when a selling division is not
operating at full capacity and cannot sell all its products. To illustrate this point,
assume that material used by Division A in a company is being purchased from
outside market at Birr 200 per unit.
The same materials are produced by Division B. If Division B is operating at full
capacity, say of 50,000 units and can sell all its products to either Division A or to
outside buyers, then the use of transfer price of Birr 200 per unit (market price) has
no effect on Division B’s income or total company profit. Division B will earn
revenue of Birr 200 per unit on all its production and sales, regardless of who buys
its product and Division A will pay Birr 200 per unit, regardless of whether it
purchases the materials from Division B or from an outside supplier. In this
situation, the use of market price as the transfer price is appropriate.
However, if Division B is not operating at full capacity and unused capacity exists
in that division, the use of market price may not lead to maximization of total
company profit. To illustrate this point, assume that Division B has unused
capacity of 30,000 units and it can continue to sell only 50,000 units to outside
buyers.
In this situation, the transfer price should be set to motivate the manager of
Division A to purchase from Division B if the variable cost per unit of product of
Division B is less than the market price. If the variable costs are less than Birr 200
per unit but the transfer price is set equal to the market price of Birr 200, then the
manager of Division A is indifferent as to whether materials are purchased from
Division B or from outside suppliers, since the cost per unit to Division B would be
the same, Birr 200.
However, Division A’s purchase of 20,000 units of materials from outside suppliers
at a cost of Birr 200 per unit would not maximize overall company profit, since this
market price per unit is greater than the unit variable cost of Division B, say Birr

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100. Hence, the intra-company transfer could save the company the difference
between the market price per unit and Division B’s unit variable expenses. This
savings of Birr 100 per unit would add Birr 20,00,000 (20,000 units X Birr100) to
overall company profit.
Transfer prices based on market prices are consistent with the responsibility
accounting concept of profit centers and investment centers. In addition to
encouraging division managers to focus on divisional profitability, market-based
transfer prices help to show the contribution of each division to overall company
profit. When aggregate divisional profits are determined for the year, and ROI and
RI are computed, the use of a market based transfer price helps to assess the
contributions of each division to overall corporate profits.
Hilton sums up difficulty associated with general rule of transfer pricing in
the following words:
(i) Difficulty in Measuring Opportunity Costs:
The general transfer-pricing rule will always promote goal-congruent decision
making if the rule can be implemented. However, the rule is often difficult or
impossible to implement due to the difficulty of measuring opportunity costs. Such
a cost-measurement problem can arise for a number of reasons. One reason is that
the external market may not be perfectly competitive. Under perfect competition,
the market price does not depend on the quantity sold by anyone producer.
Under imperfect competition, a single producer or group of producers can affect the
market price by varying the amount of product available in the market. In such
cases, the external market price depends on the production decisions of the
producer. This in turn means that the opportunity cost incurred by the company as
a result of internal transfers depends on the quantity sold externally. These
interactions may make it impossible to measure accurately the opportunity cost
caused by a product transfer.
(ii) Nature of Transferred Goods:
Other reasons for difficulty in measuring the opportunity cost associated with a
product transfer include uniqueness of the transferred goods or services, a need for

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the producing division to invest in special equipment in order to produce the
transferred goods, and interdependencies among several transferred products or
services. For example, the producing division may provide design services as well as
production of the goods for a buying division. What is the opportunity cost
associated with each of these related outputs of the producing division? In many
such cases it is difficult to sort out the opportunity costs.
(iii) Distress Market Prices:
Occasionally an industry will experience a period of significant excess capacity and
extremely low prices. For example, when gasoline prices soared due to a foreign oil
embargo, the market prices for recreational vehicles and power boats fell
temporarily to very low levels.
Under such extreme conditions, basing transfer prices on market prices can lead to
decisions that are not in the best interests of the overall company. Basing transfer
prices on artificially low distress market prices could lead the producing division to
sell or close the productive resources devoted to producing the product for transfer.
Under distress market prices, the producing division manager might prefer to move
the division into a more profitable product line.
While such a decision might improve the division’s profit in the short run, it could
be contrary to the best interests of the company overall. It might be better for the
company as a whole to avoid divesting itself of any productive resources and to ride
out the period of market distress. To encourage an autonomous division manager to
act in this fashion, some companies set the transfer price equal to the long-run
average external market price, rather than the current (possibly depressed) market
price.
(2) Cost Based Prices:
When external markets do not exist or are not available to the company or when
information about external market prices is not readily available, companies may
decide to use some forms of cost-based transfer pricing system.
Cost-based transfer prices may be in different forms such as variable cost, actual
full cost, full cost plus profit margin, standard full cost.

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(a)  Variable Cost:
Variable cost-based pricing approach is useful when the selling division is operating
below capacity. The manager of the selling division will generally not like this
transfer price because it yields no profit to that division. In this pricing system, only
variable production costs are transferred. These costs are direct materials, direct
labour and variable factory overhead.
Variable cost has the major advantage of encouraging maximum profits for the
entire firm. By passing only variable costs alone to the next division, production
and pricing decisions are based on cost- volume-profit relationships for the firm as
a whole. The obvious problem is that selling division is left holding all its fixed costs
and operating expenses. That division is now a loss division, no where near a profit
centre.
(b) Actual Full Cost:
In actual full cost approach, transfer price is based on the total product cost per
unit which will include direct materials, direct labour and factory overhead. When
full cost is used for transfer pricing, the selling division cannot realise a profit on
the goods transferred. This may be disincentive to the selling division. Further, full
cost transfer pricing can provide perverse incentives and distort performance
measures. A full cost transfer price would have shut down the chances of any
negotiation between divisions about selling at transfer prices.
(c) Full Cost Plus Profit Margin:
Full cost plus mark up (or profit margin) overcomes the weaknesses of full cost
basis transfer pricing system. The full cost plus price include the allowed cost of the
item plus a markup or other profit allowance. With such a system, the selling
division obtains a profit contribution on units transferred and hence, benefits if
performance is measured on the basis of divisional operating profits. However, the
manager of the buying division would naturally object that his costs (and hence
reported performance) are adversely affected.

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The basic question in full cost plus markup is ‘what should be the percentage of
mark up.’ It can be suggested that the mark up percentage should cover operating
expenses and provide a target return on sales or assets.
(d)  Standard Costs:
In actual cost approaches, there is a problem of measuring cost. Actual cost does
not provide any incentive to the selling division to control cost. All product costs are
transferred to the buying division. While transferring actual costs any variances or
inefficiencies in the selling division are passed along to the buying division.
The problem of isolating the variances that have been transferred to subsequent
buyer division becomes extremely complex. To promote responsibility in the selling
division and to isolate variances within divisions, standard costs are usually used
as a basis for transfer pricing in cost-based systems.
Whether transferring at differential costs or full costs, standard costs, where
available, are often used as the basis for the transfer. This encourages efficiency in
the selling division because inefficiencies are not passed onto the buying division.
Otherwise, the selling division can transfer cost inefficiencies to the buying division.
Use of standard cost reduces risk to the buyer. The buyer knows that standard
costs will be transferred and avoids being charged with suppliers’ cost overruns.
(3) Negotiated Prices:
Negotiated prices are generally preferred as a middle solution between market
prices and cost- based prices. Under negotiated prices, the managers involved act
much the same as the managers of independent companies. Negotiation strategies
may be similar to those employed when trading with outside markets. If both
divisions are free to deal either with each other or in the external market, the
negotiated price will likely be close to the external market price. If all of a selling
division’s output cannot be sold in the external market (that is, a portion must be
sold to the buying division), the negotiated price will likely be less than the market
price and the total margin will be shared by the divisions.
The conditions under which a negotiated transfer price will be successful
include:

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1. Some Form of Outside Market for the Intermediate Product:
This avoids a bilateral monopoly situation in which the final price could vary over
too large a range, depending on the strength and skill of each negotiator.
2. Sharing of all Market Information Among the Negotiators:
This should enable the negotiated price to be close to the opportunity cost of one or
preferably both divisions.
3. Freedom to Buy or Sell Outside:
This provides the necessary discipline to the bargaining process.
4. Support and Occasional Involvement of Top Management:
The parties must be urged to settle most disputes by themselves; otherwise the
benefits of decentralization will be lost. Top management must be available to
mediate the occasional unresolvable dispute or to intervene when it sees that the
bargaining process is clearly leading to suboptimal decisions. But such involvement
must be done with restraint and tact if it is not to undermine the negotiating
process.
Negotiated price avoids mistrusts, bad feelings and undesirable bargaining interests
among divisional managers. Also, it provides an opportunity to achieve the
objectives of goal congruence, autonomy and accurate performance evaluation. The
overall company is beneficiary if selling and buying divisions can agree upon some
mutually transfer prices. Negotiated transfer price is considered as a vital
integrating tool among divisions of a company which is necessary to achieve goal
congruence.
If negotiations help ensure goal congruence, top management has little temptation
to intervene between divisions. The agreed prices also can be used for performance
measurement without creating any friction. The use of negotiated prices is
consistent with the concept of decentralized decision-making in the divisionalised
firms.
However, negotiated prices have the following disadvantages:
(1) A great deal of management effort, time and resources can be consumed in the
negotiating process.

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(2) The final emerging negotiated price may depend more on the divisional
manager’s ability and skill to negotiate than on the other factors. Thus,
performance measures will be distorted leading to incorrect evaluation of divisional
performance.
(3) One divisional manager having some private information may take advantage of
another divisional manager.
(4) It is time-consuming for the managers involved.
(5) It leads to conflicts between divisions.
(6) It may lead to a suboptimal level of output if the negotiated price is above the
opportunity cost of supplying the transferred goods.
Garrison and Noreen observe:
“The difficulty is that not all managers understand their own businesses and not all
managers are cooperative. As a result, negotiations often break down even when it
would .be in the manager’s own best interest to come to an agreement. Sometimes
that is the fault of the way managers are evaluated. If managers are pitted against
each other, rather than against their own past performance or reasonable bench-
marks, a non-cooperative atmosphere is almost guaranteed. Nevertheless, it must
be admitted that even with the best performance evaluation system, some people by
nature are not cooperative.”
(4) Dual Prices:
Under dual prices of transfer pricing, selling division sells the transferred goods at a
(i) market or negotiated market price or (ii) cost plus some profit margin. But the
transfer price for the buying division is a cost-based amount (preferably the variable
costs of the selling division). The difference in transfer prices for the two divisions
could be accounted for by special centralized account. This system would preserve
cost data for subsequent buyer departments, and would encourage internal
transfers by providing a profit on such transfers for the selling divisions.
Dual prices give motivation and incentive to selling divisions as goods are
transferred at market price and this arrangement provides a minimal cost to the
buying division as well. Market price can be considered as the most appropriate

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base for the selling division. Thus dual pricing-system has the function of
motivating both the selling division and buying division to make decisions that are
consistent with the overall goals of decentralization—goal congruence, accurate
performance measurement, autonomy, adequate motivation to divisional manager.
Summary View:
Transfer pricing policy aims to drive the divisions, who are more inclined to act in
their individual self-interest and consider their own costs, prices and market
opportunities, toward behavior that is best for the organization. Economies of scale,
synergies and saving transaction costs motivate divisional managers to conduct
transactions within the company rather than using market-based transactions with
external supplier and customers.
In reality, no particular transfer pricing system can be suggested for all
decentralized companies as no one transfer price will be helpful to them in
achieving all their goals and objectives. The divisionalised companies should first
determine their goals and priorities before selecting a transfer pricing.
Therefore, the transfer pricing methods selected by a particular business enterprise
must reflect the requirements and characteristics of that enterprise and must
ultimately be judged by the decision making behaviour that it motivates. Anderson
and Sollenberger have presented their evaluation of different transfer pricing
approaches as follows:

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Kaplan and Atkinson have given the following recommendations in choosing a
transfer pricing practice:
1. Where a competitive market exists for the intermediate product, the market
price, less selling, distribution, and collection expenses for outside customers,
represents an excellent transfer price.
2. Where an outside market exists for the intermediate product but is not perfectly
competitive and where a small number of different products are transferred, a
negotiated-transfer- price system will probably work best, since the outside market
price can serve as an approximation of the opportunity cost. At least occasional
transactions with outside suppliers and customers must occur if both divisions are
to have credibility in the negotiating process and if reliable quotes from external
firms are to be obtained.
3. When no external market exists for the intermediate product, transfers should
occur at the long-run marginal cost of production. This cost will facilitate the
decision making of the purchasing division by providing the stability needed for
long-run planning but at the same time exposing the cost structure so that short-
run improvements and adjustments can be made. A periodic fixed fee based on
capacity reserved for the buying division is incorporated in the marginal cost
calculation.

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The fixed fee, ideally based on product and facility-sustaining costs from an ABC
model, should allocate the capacity-related costs of the facility in proportion to each
user’s planned use of the facility’s resources. The fixed fee forces the purchasing
division to recognize the full cost of the resources required to produce the
intermediate product internally, and it provides a motivation for the producing
divisions to cooperate in choosing the proper level of productive capacity to acquire.
4. A transfer price based on fully allocated costs per unit (using present, that is,
non-ABC, methods of allocation) or full cost plus markup has no discernible
desirable properties. Although the full-cost transfer price, has limited economic
validity, it remains widely used. The marginal cost calculated from an ABC model
does provide the capability for managers to use a full-cost approach that is
consistent with economic theory.

Review problems
Problem 1
You are a house flipper. You purchased a house at the courthouse auction for
$75,000 and spent $35,000 in renovations. After sales, expenses, and commission,
you netted $160,000 on the sale of the renovated house.
Required: What is the ROI?
Problem 2
Stellar Systems Company manufactures guidance systems for rockets used to
launch commercial satellites. The company’s Software Division reported the
following results for 2015.
Income $300,000
Sales revenue 2,000,000
Invested capital (total assets) 3,000,000
Average balance in current liabilities 20,000
Stellar Systems’ weighted average cost of capital (WACC) is 9 percent, and the
company’s tax rate is 40 percent. Moreover, the company’s required rate of
return on invested capital is 9 percent.
Required:
1. Compute the software Division’s sales margin, Capital turnover, Return on
investment (ROI), Residual income, and Economic value added (EVA) for
2015.
2. If income and sales remain the same in 2016, but the division’s capital
turn over improves to 80 percent, compute the following for 2016: a)
Invested capital and b) ROI
Problem 3
Stellar Systems Company’s Microprocessor Division sells a computer module to the
company’s Guidance Assembly Division, which assembles completed guidance

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systems. The Microprocessor Division has no excess capacity. The computer
module costs $10,000 to manufacture, and it can be sold in the external market to
companies in the computer industry for $13,500.
Required: Compute the transfer price for the computer module using the general
transfer-pricing rule.
Problem 4
Golden Gate Construction Associates, a real estate developer and building
contractor in San Francisco, has two sources of long-term capital: debt and equity.
The cost to Golden Gate of issuing debt is the after-tax cost of the interest
payments on the debt, taking into account the fact that the interest payments are
tax deductible. The cost of Golden Gate’s equity capital is the investment
opportunity rate of Golden Gate’s investors, that is, the reat they could earn on
investments of similar risk to that of investing in Golden Gate Construction
Associates. The interest rate on Golden Gate’s $60 million of long-term debt is 10
percent, and the company’s tax rate is 40 percent. The cost of Golden Gate’s equity
capital is 15 percent. Moreover, the market value (and book value) of Golden Gate’s
equity is $90 million.
Required: Calculate Golden Gate Construction Associates’ Weighted average cost of
capital.

Answers for the Review problems on Investment Centers and

Transfer Pricing
1. Your net profit is going to be what you netted ($160,000) minus what you
spent ($75,000 + $35,000), so it is $50,000. Your total investment is also
what you spent ($75,000 + $35,000), which is $110,000.
ROI = Net Profit / Total Investment * 100
ROI = 50,000 / 110,000 * 100
ROI = .45 * 100
ROI = 45%
2. Compute the software Division’s sales margin, Capital turnover, Return on
investment (ROI), Residual income, and Economic value added (EVA) for
2015.
Profit Margin = Income/Sales Revenue = $300,000/ $2,000,000=15%
Capital turnover = Sales Revenue/ Invested capital
= $2,000,000/$3,000,000 = 67%
Return on investment = Income/ Invested capital
= $300,000/$3,000,000 =10%
Residual Income= Operating income – (Imputed interest rate X
Operating assets)
= $300,000 - ( 0.09 X $3,000,000) = $30,000
Economic Value added

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 ( Investment center’s
Investment total assets –
center’s after-tax Investment center’s
operating income current liabilities) X
Weighted average
= $300,000(1-.40)- [(3,000,000- $20,000) X 0.09]
= $(88,200)
cost of capital
If income and sales remain the same in 2016, but the division’s capital turn over
improves to 80 percent, compute the following for 2016: a) Invested capital and b)
ROI
a) Capital turnover = Sales revenue/ Invested capital
= $2,000,000/ ? = 80%
Therefore: Invested capital = $2,000,000/.80 = $2,500,000
b) New ROI = 15% X 80% = 12%

3. Transfer price= Outlay + Opportunity cost

= $10,000 + ($13,500- $10,000)
= $13,500
The $3,500 opportunity cost of a transfer is the contribution margin that will be
forgone if a computed module is transferred instead of sold in the external market
4.
( After tax (Market (Cost of (Market
Weighted
= +
cost of debt value of equity value of
average cost of capital) debt) capital) equity)
capital +
Market Market
of debt value of
equity

= [10% X(1-.40)] X ($60,000,000) +(15% X $90,000,000)

$60,000,000 + $90,000,000
= .06 X $60,000,000 + .15 X $90,000,000
$150,000,000
= $3,600,000 + 13,500,000 = 11.4%
$150,000,000

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