ROI and EVA® as Performance measures and their effects on managerial behaviour2
Market-based Transfer Pricing5
Full Cost Transfer Pricing6
Cost-plus a mark-up transfer Pricing6
Negotiated Transfer Pricing7
“Managing for value has become the mantra of today’s executives as the reality of competitive environments force businesses to focus on improving profitability.” (H.D. Fletcher, D.B. Smith, Journal of Business Strategies, March 1st 2004) Many will agree that in this increasingly globalized business world competitiveness is of top priority in every business. Short-term focus and restricted vision are the worst enemies, especially for large organizations operating in varying markets or even industries. The role of PMS is two-fold: On the one hand the aim is –like the name indicates- the evaluation of outcomes delivered by the organization’s employees respectively subdivisions. The second purpose may not be equally evident; nevertheless it is as important as the first: Through their specific choice of the employed PMS, top management communicates the areas of assignment, preferred courses and methods of action to its employees. From the employees’ perspective the stipulated PMS express top management’s expectations and instructions regarding what areas they should focus their efforts on and how to reach the predefined targets. The responsibility for the appropriate
ness of the chosen PMS therefore rests on top management while the divisions’ managers are responsible for their execution. For the sake of answering the underlying question of this assignment the characteristics of ROI and EVA® are examined regarding their tendency to provoke short-termed decisions. The second part discusses the advantages of four different approaches to transfer pricing. As a perimeter to this work only divisionalised organizations shall be focused on.
ROI and EVA® as Performance measures and their effects on managerial behaviour
“The accounting rate of return suffers from the serious defect that it ignores the time value of money” (Drury 2009, p.146). ROI is a measure that reviews the outcomes of a specified period in retrospect. Ignoring the point in time of the cash flow realisation renders the realistic comparison of the made investment with alternative investment options impossible. It is therefore not guaranteed that projects with favourable ROI ratios also represent the best investment choice. Thus there is the danger that Investment choices are misinterpreted due to ignoring their realistic, discounted values. Furthermore predictions about the future development of certain investments cannot be achieved through the Rate of Return employment. Furthermore, the fact that top management in many organizations links managerial rewards directly to the achievement of a certain ROI percentage introduces the danger that executing managers become restricted in their vision when evaluating alternative courses of action. Because managers in general will be aiming to comply with standards set up by top management for reasons of integrity, they will try to produce favourable ROI ratios even if this doesn’t make sense from an objective economical point of view. Or, as John Dearden puts it: “Since the manager is evaluated on his ability to improve ROI, he will be motivated to do so.” (Dearden 2000, p.2) Division managers who can’t realise or don’t want to address these issues will stick to actions that improve ROI even if that means corrupting the overall long-term benefit of the company. These actions include avoiding necessary investments in assets necessary for the future or the premature sale of assets which are perfectly fine. On the other hand, if the required ROI percentage is unrealistically low, managers might be encouraged to artificially expand the asset pool so that the Rate of Return...