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David answered on
Dec 31 2021
ROI & EVA: Measures to overcome the short-term nature of decision making & Transfer Pricing
Methods: Advantages and Disadvantages 1
ROI & EVA: Measures to overcome the short-term nature of decision making &
Transfer pricing methods: Advantages and disadvantages
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ROI & EVA: Measures to overcome the short-term nature of decision making & Transfer Pricing
Methods: Advantages and Disadvantages 2
Abstract
This paper focuses on the measures that can be adopted to overcome the short-term nature of
decision making of performance measures, namely, Return on Investment (ROI) and Economic
Value Added (EVA). It also provides details about how these measures are calculated with few
examples. The second focus of this paper is about the four methods of transfer pricing along with
its advantages and disadvantages.
ROI & EVA: Measures to overcome the short-term nature of decision making & Transfer Pricing
Methods: Advantages and Disadvantages 3
Table of contents
Part 1: Performance measures…………………………………………………………………4
Return on Investment (ROI) …………………………………………………………...4
ROI: Short-term in focus and decision making when used as a performance measure………4
Economic Value Added (EVA):………………………………………………………6
EVA: Short-term in focus and decision making when used as a performance measure……..6
Measures to overcome the short-term nature of ROI & EVA:………………………………..8
Part 2: Transfer Pricing……………………………………………………………………………….10
Market based transfer prices……………………………………………………………………10
Full cost transfer prices…………………………………………………………………………12
Cost plus a mark-up transfer prices…………………………………………………………….14
Negotiated transfer prices……………………………………………………………………….15
Conclusion………………………………………………………………………………………………..16
References…………………………………………………………………………………………………17
ROI & EVA: Measures to overcome the short-term nature of decision making & Transfer Pricing
Methods: Advantages and Disadvantages 4
Part 1: Performance measures
Performance measures are the metrics or measures used to evaluate the performance or
efficiency of the managers in utilization of the assets and generating income. The widely used
performance measures include Return on Investment (ROI) and Economic Value Added (EVA).
Both of these measures encourage the managers to be short-term in decision making but EVA is
a superior method than the ROI method due to its greater merits on comparison.
Return on Investment (ROI)
Return on investment is a profitability measure and also being used as a performance measure
for managers. Return on investment denotes the returns earned as a percentage of total
investment. It is also called as the return on assets. Whenever details about the average assets are
available, this figure will be considered instead of the total assets at the end of the year. The
average assets can be calculated by taking the average of the beginning and the ending total
assets. This ratio can be computed as follows:
Return on Investment (ROI) = Net income/Average investment
If ROI is calculated for a company’s division, then ROI = Division’s net income/Division’s
investment.
ROI: Short-term in focus and decision making when used as a performance measure
ROI as a performance measure is purely based on profitability and does not aim at wealth
creation. Higher the profits are shown, higher would be the ROI. Profits can be manipulated in
many ways. A manager may increase the volume of credit sales without being concerned about
ad debts expense and investment in accounts receivable, just to show increase in revenue and
ROI & EVA: Measures to overcome the short-term nature of decision making & Transfer Pricing
Methods: Advantages and Disadvantages 5
profits. This may result in more uncollectibles and implied interest cost for the company for cash
lockage in receivables. The focus for the manager here is short-term, just to improve revenue
for the period, without considering the long-term effects of such decisions. The problem of
uncollectibles will not occur immediately in the short-term but in the long-term. But at the same
time the manager would also be concerned about investment in receivables as this is going to
increase the investment amount in the denominator. The manager may also postpone some
expenses to show higher profits. For example, if performance is measured based on ROI, the
manager may be induced not to show the utility cost bills that a
ived at the end of the
accounting period. This explains the nature of short-term focus.
Example of performance evaluation based on ROI:
Let us assume that a company has a net income of $30,000 and average investment in assets as
$200,000 and the required return of the company is 10%.
ROI = $30,000/$200,000 15%
In this case, ROI of 15% is higher than the required return of 10%. This, as a performance
measure, will indicate that the manager has performed well. If the ROI had been, say 8%,
indicates that the manager has not performed well.
Although ROI has advantages, it suffers from the following limitations:
1. Any profitable project would be rejected by the managers for want of increased
investment. This is because increased investment would reduce the ROI in the initial
stages which would lower their pay.
2. It is not as efficient way as EVA as it does not cover all the aspects of business cycle.
ROI & EVA: Measures to overcome the short-term nature of decision making & Transfer Pricing
Methods: Advantages and Disadvantages 6
3. Increase in ROI is not necessarily good for the owners or the shareholders. Maximizing
ROI alone cannot be the goal or target for operating business.
4. ROI is a problematic controlling tool and cannot be relied always.
5. Evaluation using ROI can lead to under-investment.
6. Focused in short-term decision making and not long term.
Economic Value Added (EVA):
EVA measures the residual income available after deducting the cost of investment. It measures
the real economic profit available to the owners. If the cost of investment is higher, lower would
e the EVA and if the cost of investment is lower, higher would be the EVA. EVA is calculated
as follows:
EVA = Net operating profit after taxes (NOPAT) – Cost of investment
If the compensation is based on EVA, it will address the issues relating to higher investment in
assets like inventory, accounts receivable etc.
EVA: Short-term in focus and decision making when used as a performance measure
Although EVA as a performance measure gives significance to value creation by owners, it is
again short-term focused in decision making. For example, if annual incentives are given to the
managers based on EVA, the managers would be focused to increase the period’s...