TM 18-1 RETURN ON INVESTMENT (ROI) ROI = Net operating income (NI) Average operating assets (I) OR: ROI = = (NI/Sales) x (Sales/Assets) Return on Sales x Turnover Example: A division has the following data: Sales NI Average investment (I) $100,000 20,000 200,000 ROI = = = = = = = NI/I $20,000/$200,000 10% Return on Sales x Turnover ($20,000/$100,000) x ($100,000/$200,000) .20 x .50 10% ROI TM 18-2 ADVANTAGES OF ROI 1. It encourages managers to pay careful attention to the relationships among sales, expenses, and investment. 2. It encourages cost efficiency. 3. It discourages excessive investment in operating assets. Example: A division has the following data: Sales $100,000 NI 20,000 Average investment 200,000 1. Assume that sales increase by $20,000 and that net income increases by $10,000. ROI = = $30,000/$200,000 15% Notice that ROI has increased by 50%. 2. Assume that costs decreased by $10,000 and that sales and investment remain unchanged. ROI = = $30,000/$200,000 15% Again, ROI has increased by 50%. 3. Assume that investment decreases by $50,000 with net income remaining the same. ROI = = $20,000/$150,000 13.33% Notice that ROI has increased by 33.33%. TM 18-3 DISADVANTAGES OF ROI 1. ROI discourages managers from investing in projects that would decrease a division’s ROI but which would increase the profitability of the company as a whole. 2. ROI encourages mangers to focus on the short-run at the expense of the long-run. Example: Consider the following independent projects: Project A $100,000 10,000 10% Project B $500,000 60,000 12% Investment Net Income ROI The division’s ROI is 14% and the firm’s cost of capital is 8%. Will the division manager invest in A, B, both, or neither? Explain. TM 18-4 RESIDUAL INCOME Residual income = Operating Income - (R x Operating Assets) Where R is the desired rate of return Example: Consider the following independent projects: Project A $100,000 10,000 10% Project B $500,000 60,000 12% Investment Net Income ROI The firm’s cost of capital is 8%. The divisional ROI is 14%. Residual income: Net Income R x investment Residual income Project A $10,000 (8,000) $ 2,000 Project B $60,000 (40,000) $20,000 Using Residual Income, the incentive is to invest in each project because residual income increases in each case. TM 18-5 A CONTINGENCY THEORY APPROACH TO TRANSFER PRICING A. Organizational Structure 1. Competitive Organizationshighly diversified companies with emphasis on divisional independence, e.g. electronic companies, conglomerates. Systems: Profits, ROI compared with budget internally and externally Transfer Pricing: Market-based pricing 2. Cooperative Organizationshighly vertically- integrated companies with emphasis on divisional interdependence, e.g. chemical, petroleum, steel, or automobile companies. Systems: Costs compared with budgets and history Transfer Pricing: Standard full cost, cost plus investment 3. Collaborative Organizationscompanies that emphasize both the interdependence of vertical integration and the independent contributions of business units as diversified business, e.g. matrix structures, divisions that share corporate manufacturing or sales units, aerospace and defense contract industries, chemical companies. Systems: Combination of costs, profit and ROI compared with budget Transfer pricing: Standard full cost, cost plus investment TM 18-6 B. Market Situation 1. Those products transferred between divisions that are likely never to be produced outside the company. Transfer pricing: Standard full cost, standard cost plus profit allowance, negotiated price. 2. Those products that management may be willing to purchase from outside sources but only on a relatively long-term basis because their manufacture requires a significant investment in facilities and skills. Transfer pricing: Estimated long-term competitive prices or standard costs plus profit allowance. 3. Those products that can be produced outside the company without any significant disruption to present operations; usually small volume, produced with general-purpose equipment. Transfer pricing: Selling division negotiates or bids on business, buying division decides on the source. 4. Those products that are (a) sold to both company and outside sources, or (b) purchased from outside sources as well as being produced within the company. Transfer pricing: Actual competitive price.