Computation of the Return on Investment and Sales Factor - Report Example

? Strategic Management Accounting Introduction Strategic management differs a lot from the financial management accounting. The differences are with respect to the intent or purpose of evaluation. The strategic management helps to gain a company to gain a strategic edge, while financial management is concerned only with maintaining the financial soundness of the company (Bajaj, 2001). The two types of financial management differs in the sense that financial management can only provide the company a glimpse of where it is standing right now in terms of financial soundness. While strategic management enables a company to go beyond the boundaries of the normal financial management. Strategic management helps the management to align the financial strategies of the company with other strategies namely the marketing strategies, operational strategies and human resource strategies (Bonaccorsi and Daraio, 2009). Financial management cannot connect with the external and internal requirements of the business, thus it is used only as a fact finding method. Whereas, strategic management helps to integrate the external impact on the business together with the internal strength and weakness of the organization and create new set of strategies. The paper presents a critical analysis between the use of return on investment and economic value added as means of measuring the performance. Both the techniques are used only for short term periods and not for achieving long term goals (Chrol, 2011). The discussion pertains to how the two different kinds of technique can be used for achieving long goals. Apart from that, the advantages and disadvantages of four different pricing techniques are discussed namely, market based transfer pricing, full cost transfer pricing, cost plus mark-up transfer prices and negotiated transfer prices. Part A Critical evaluation of the statement “Both Return on Investment (ROI) and Economic Value Added (EVA), when used as performance measures in an organisation, encourage managers to be short-term in their focus and decision making” Both ROI and EVA are used for performance evaluation but only for the short term purpose. The managers face problems if these two kinds of techniques are applied for evaluating the performance of the company for the long term purpose. In order to discuss how the two different types of techniques can be used for the long term purpose, both the techniques need to be discussed separately and in depth (Clark and Mathur, 2011). In order to understand how ROI can be modified to use for taking long term decision it is imperative to note that ROI actually consist of two different parts. One is the return on sales and the other one is the asset turnover. Returns on sales indicate the profit per sales dollar which measures the ability of the manager to control expenses and at same time increase the profitability by increasing the revenue. The other one is the asset turnover, which indicates the amount of dollar received for each dollar invested. It measures the capability of the manager to increase the rate of revenue generation with the increase in the rate of investment. If ROI is going to be used for taking long term decisions then the focus should be on the asset turnover value. If control is gained over the value of the asset turnover then the ROI can be used for long term decision purposes (Das, Quelch and Swartz, 2000). In order to gain better control over the asset turnover the depreciation policy and the capitalization policy need to be modified. The determination of the useful life of asset and depreciation method used has an effect on both the income and investment aspects. This in turn affects the ROI. It is seen that if the depreciation charges are kept unusually high then the ROI is reduced to larger extent. In computation of the return on investment, sales factor is the only constant value, whereas both income and investment are variables. By making the right adjustment in the depreciation policy the depreciation charges can be reduced significantly. The reduction in the depreciation charges in turn helps to keep the costs low and the income higher at the same time. The managers have the habit of depreciating the fixed assets heavily by reducing the life expectancy of the machines. For example, a machine which has a life expectancy of about 15 years is abnormally depreciated by reducing the life expectance to 10 years or so theoretically (Flint, Woodruff and Gardial, 2002). Apart from the modification of the depreciation policy, the capitalization policy can also be modified. For example, a firm’s capitalization policy indicates the way an item is expensed or capitalised as an asset. Most of the time the short term assets are capitalised as expenses and this in turn reduces the numerator of the ROI. For this reason the ROI decreases in value. If the capitalization policy is tweaked in such a way that the items are regarded as asset instead of being expenses then the denominator value will decrease and this in turn will lead to the increase in the ROI. For example, if the firm clears the prepaid expenses beforehand then these are going to be regarded as current assets in the balance sheet. There are various kinds of long term expenses that the firm can clear beforehand and these expenses will be treated as long term assets. This in turn will increase the asset base of the company. The other kind of modifications that can be made in order to treat ROI as a tool for making long term decision are adjustments of inventory measurement methods, disposition of the variances and full costing (Garrick, 2011). If the managers want to use the EVA as another tool to make long term decisions and planning purposes then there are two factors that need to be closely adjusted which are adjustment to capital and adjustment to after tax cash operating income. EVFA is calculated using the after tax operating income and average invested capital. There are two important parts to the operating income parts which are depreciation and taxes. If the depreciation charges are deferred over a number of years, or in other words the depreciation charges are kept smaller in amount then the operating income will increase. Another important part of the operating income is the cash taxes. The cash taxes can be paid in lump sum amount. This will be treated then as prepayments. Prepayments are not treated as expenses rather they are treated as part of the asset (Ger, 2000). This will help to increase after tax operating income. The discussion so far pertained to the adjustment of the after tax operating income. Another important part of the calculation of the EVA is the adjustment to the capital. This is perhaps the most important part of the strategy on the ways to use the EVA for long term planning purposes. The capital involves both long term capital; as well as short term capital. The strategy is to increase the proportion of the long term capital in such a way that the EVA reflects the long term goals and objectives of the company. To increase the long term capital percentage, the company can increase the bad debt reserves, increase the LIFO reserves and increase the research and development expenses (Gina, 2013). The research and development leads to the development of the intellectual properties, which can be included as part of the capital, since they are meant to be used for long term purposes. Part B 1. Market based transfer pricing Advantages In market based transfer price the transfer price is set equal to the price of the product in the competitive market. Market based transfer pricing does not required any kind of routinely carried out negotiation processes, which is time consuming and cumbersome. Most of the time the companies that resort to this kind of transfer pricing technique do not have any kind of idle capacity, so the market price can be chosen as the base price. This kind of transfer pricing helps to preserve the subunit autonomy. The other advantages are that this kind of transfer pricing method helps the selling unit to be competitive with suppliers who are coming from the outside. There are also other kinds of advantages. These are concerned mainly with the international taxation procedures (Graham and Campbell, 2012). This kind of transfer pricing methods incorporates the arms length standard, which is preferred by the international taxation authorities. This kind of transfer pricing is appropriate if it is a perfect market. The other types of advantages are that market based transfer pricing is one of the most simple and easily understood method. They make the process of performance evaluation easier. This kind of transfer pricing also reduces the points and areas of possible conflicts between the various divisions (Lev and Thiagarajan, 2013). Market based transfer pricing are usually consistent with the environment outside. Disadvantages Market based transfer pricing can be carried out only when the market is competitive in nature. This kind of transfer pricing does not leave any scope for the generation of synergies between sub-units. Issues arise when the market prices are not known. Unlike other modes of transfer pricing, this kind of transfer pricing method does not use any kind of negotiation process. Due to this, the possibilities of generating benefits through cooperation get limited. Unlike the main or the final products, the intermediate products do not have any kind of market price. This kind of transfer pricing needs to be adjusted for cost savings, such as reduced selling costs, and no commissions. These kinds of transfer pricing strategies help to achieve only short term goals (Lipe, 2013). Apart from that the advantages are that market based prices are applicable if perfect market conditions exists and is characterized by single price for both the sellers and the buyers and there is neither any buying cost nor any kind selling costs. Although, in reality the market is seldom perfect in nature, yet there exists more than one price for both buyers and the sellers. 2. Full cost transfer pricing Advantages This kind of transfer pricing is applicable if imperfect market conditions are present. As this kind of transfer pricing does not support preserving the sub-units autonomy, so the mother unit or the main unit fixes the rules and regulations that govern the way the transfer pricing can be fixed by the sub-units. This kind of transfer pricing helps to fix the price of the products in such a way that all kind of costs can be covered by this kind of pricing method (Ou, 2012). This kind of method is easy to implement because of the reason that the data which is needed to fix the prices is already present for financial reporting purposes. Full cost transfer pricing is intuitive and can be easily understood. As there are certain tax benefits from the point of view of the tax authorities. For this reason it is preferred more by the tax authorities in comparison to the variable cost method. Disadvantages This kind of transfer pricing is not useful for evaluating the sub-units’ performance, if the transfer price does not exceed the full cost. Even if the transfer cost does exceed the full cost then also performance of the sub-units cannot be evaluated properly due to the arbitrary nature of the results. This kind of transfer autonomy does not help to maintain the sub-unit autonomy. This kind of transfer pricing method does not consider fixed costs. This is a sort of disadvantage for making decisions. If the buyer wants to buy it from outside or inside of the firm, then the fixed costs are ignored. If this kind of cost is at all used then the standard cost should be used instead of the actual costs. The difference between fixed costs and variable costs are blurred. Due to this blurring absorption costs lead to dysfunctional behavior (Bonaccorsi and Daraio, 2009). As this kind of transfer pricing encourages the inefficiencies to be passed on, so this kind of transfer pricing lacks incentive to control the expenditures. The purchasing departments treat all the costs as variable costs and this leads to taking dysfunctional decisions. Dysfunctional decisions usually arise if expensive products are produced. 3. Cost plus a markup transfer prices Advantages If there is presence of excess capacity then this kind of transfer pricing can be applied. This kind of transfer pricing is also called variable cost transfer pricing. The buyer unit has a substantially more advantage than the seller, since no profit is recognized on the transfer. Another advantage of this kind of transfer pricing is that the use of this kind of transfer pricing helps to achieve goal congruence (Clark and Mathur, 2011). When the price is based on the budgeted costs, the management does not have to bother much about maintain the costs. Disadvantages The department which is using the variable transfer prices cannot cover for the fixed costs. This kind of transfer pricing excludes unavoidable fixed costs. Sometimes there are certain fixed costs that are unique to the company and which incurs when the operations are run. Cost plus markup transfer prices do not consider such fixed costs. As a result the price at which the buyer sells sometimes fail to cover for the costs incurred in such avoidable fixed costs (Garrick, 2011). If the proportion of unavoidable costs is very high then the sale price can only cover a small proportion of the fixed costs. The use of cost plus markup transfer prices distorts the fixed and variables costs. If the prices are based on actual costs then the there is less incentive for the management to control the costs. 4. Negotiated transfer prices Advantages In negotiated transfer pricing the regional managers are at the helm of the negotiations and deals. Just like a free market where the prices are determined by the natural process of supply and demand, the same kind of nature is prevalence in negotiated transfer pricing. The other advantage is that the company does not have to bother too much to complete the formalities and paperwork, thus the process takes place without much technical glitches and red tapes. Red tapes indicate unnecessarily prolonging the completion of a job due to slow execution of the process (Lipe, 2013). Imperfect markets are characterized by different selling costs, because both internal and external sales are different. This occurs if the transfer prices are set above the prevailing or the planned market price then it is optimal in nature. Other advantages are that corporate or central management intervention helps to ensure that the optimal output levels are set. Since the managers are equipped with all the information needed and at same time knows exactly how to use the information then there is high chance that the negotiated solution will emerge. The negotiated solution becomes acceptable to both the division and the group. This kind of transfer pricing is more beneficial if significant amount of conflict exists. This kind of transfer pricing is consistent with the theory of decentralization (Ou, 2012). Disadvantages The regional managers between whom the deal is finalized may not share a smooth and open relationship that would facilitate the process of this informal negotiated deal. Sometimes the higher management may impose additional restrictions on the rules and clauses guiding this informal process of negotiation. This elongates the process unnecessarily. The use of negotiated transfer pricing leads to sub optimal decision. Other than that that the whole process in a time consuming affair. If the managers do not have strong bargaining skills then in almost 90% of the cases the deal does not falls through (Bonaccorsi and Daraio, 2009). Or in other words the deal cannot be completed successfully. The managers need to be trained and experienced beforehand in order to complete a successful negotiated transfer pricing. Negotiated transfer pricing sometimes becomes inappropriate in certain circumstances particularly in those situations, where there is no presence of market for intermediate products or where imperfect market exists and due to this there is bargaining disadvantage. Autonomy can be reduced since there is need for negotiation rule or arbitrations procedure (Clark and Mathur, 2011). There can be potential tax problems due to use of this kind of pricing methodology. Apart from that, sub optimization or dysfunctional decisions can also be taken. Conclusion It can be concluded that the strategic management accounting differs from the financial management accounting in many ways. The scope and applicability of strategic management accounting is substantially more than the scope and ability of the financial management accounting. This is because of the reason that unlike the financial management accounting, strategic management accounting has greater degree of freedom. This kind of freedom gives the managers to go beyond the mere interpretation of the financial results and give total control of the financial results. There are various domains of strategic management accounting, although only two aspects are discussed. One is the aspect of the transfer pricing. The transfer pricing methods discussed here reflect upon the various ways, the strategic management accounting can be used to increase the profitability and sustainability of the companies. One of the basic points that are covered in the transfer pricing methods is how different methods of transfer pricing can affect the autonomy of the companies. It is evident from the discussion that the autonomy of the company, the negotiation of the managers and the market condition are interlinked to each other. The other aspect of the discussion pertains to the ways the managers can use the ROI and EVA for long term planning and decision purposes. The discussion points out to the fact that the managers have to use the return on sales and asset turnover in such a way that the return on investment can be increased. Through the detailed discussion it can be concluded that the return on investment can be controlled with the help of depreciation policy and capitalization policy. The other factors that also need to be controlled carefully are inventory management methods, full costing methods and the disposition of variances. 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