APT TECHNICAL CPD - MAF TRANSFER PRICING AND PERFORMANCE EVALUATION
Transfer Pricing and performance evaluation Nicholas Riemer Nicholas.Riemer@firstrand.co.za
Agenda • Workflow to understanding Transfer pricing and performance evaluation • What is Performance management? Generic Problem • What is Transfer pricing? Generic problem • Industry considerations? • What is the specific problem? • How to incorporate into your file
TP and performance Workflow Approach
Generic problem Performance evaluation • Strategy: Long-term plan of action • Budgeting: Short-term plan of action • Performance Evaluation • Control function • Historic • Performance Management • Planning function • Future
Performance evaluation • Central structure vs. Divisionalized/Decentralized • Can top management control operations? • Risk of divisionalization that it does not ensure goal concurrence • Develop performance measure that ensures goal concurrence • Financial vs. Non financial measures • Strategy
Divisionalization • Advantages • Speed and quality of decisions • Self – fulfillment • Strategic planning • Risks/Disadvantages • Goal concurrence NB • Loses control
Divisionalization • Pre-requisites • Diversified activities • Independent (autonomous) • Relation must be regulated (Transfer Pricing)
Performance evaluation • Divisional vs. Managerial • CONTROLABALITY (Profit/cash & Investment) • Can only measure performance on what manager/division control! • Every expense is controlled by someone – include at the relevant level • Manager • Division
Performance evaluation Performance evaluation Manager Controllability Compare divisions with each other: Avoidability DON’T TAKE INTO Division ACCOUNT Unavoidable Head Office Costs Compare with external comp: TAKE INTO ACCOUNT
Performance evaluation • Investment/Asset-base (Controllability) 1. Economic value? 2. Replacement cost? 3. Original cost? 4. Written down value?
PERFORMANCE EVALUATION • Purpose of performance evaluation: • Checks position / communicate position / confirms position / compels improvement • Controllability & choice of basis (method) • Controllability : though not always fully controllable, the measure should at least be influence by the person or unit being measured • Choice of method: “what you measure is what you get”. Centre's: cost / profit / investment (mostly required to measure)
PERFORMANCE EVALUATION • Profit based measures: • Basis / problems • ROI • Controllable profit/controllable assets • Profit Centre (not investment Centre) • Residual Income • Profit and Investment Centre.
PERFORMANCE EVALUATION • Wealth creation measures: • EVA = EBIAT – ((Assets – current liabilities) x Cost of capital) • 173 adjustments to Acc numbers • Adjustments to bring closer to cash • (controllable profit) – (a cost for the capital employed) = value added • Controllable cost of capital: based on risk profile • ST Assets controllable by manager? • MVA = PV of all future EVA’s
The components/principles of an ideal performance evaluation system • Should be based on controllability • Should look at the short/medium and long term • Should comprise a basket of measures • Should ensure goal congruency • Should consist of financial as well as non-financial measures • Must ensure execution of strategy (These principles can be used as a structured means in order to criticise an existing performance evaluation system)
Industry Considerations • Banks a big user of Divisionalization • Inter division funding costs or FTP Funding transfer price • SLA Service level agreements between divisions • 2018 APT Banking case study • Big move in financial sector to NIACC neutral charges on loans or other services in an attempt to bring on the client from a transactional banking point of view. • Service industries applying Divisionalzation, key issues have been incorrect performance remuneration. Purely on profits, thus decisions not made in the best interest of the company. • Move toward correct performance evaluation, managers also rewarded for joint revenue generated in other divisions. • Deloitte Report move toward decentralization, Impact on industries and challenges facing the adoption. 16
Specific problems • Currently a centralized process wants to move to Divisionalization • Currently incorrect performance management, need to assist. • Assisting with the different types of management assessments which can be made as well as divisional performance management. • Assisting with new strategy of goal congruence by implementing initiatives to drive the company as a whole forward as opposed to just the division.
Transfer Pricing Generic issue
Transfer Pricing Introduction • Purpose of transfer pricing (criticise or evaluate) • Goal congruency (good economic decisions) • Performance evaluation/Managing performance • Further practical issues • Taxation; Consolidations, Segmental reporting, International transfer pricing.
Different Transfer Pricing Options Purpose • Goal congruency • Relevancy principals • Performance Measurement • Wants to include profit • Wants to cover fixed costs as well
Transfer Pricing Options Goal Concurrency Performance COMPETITIVE MARKET EXISTS Market Price P P NO EXTERNAL MARKET EXISTS Variable Cost + Profit Margin x x Full Cost + Profit Margin P x Marginal/Variable (without markup) P x Full Cost (without mark-up) x x Marginal/Variable cost + Opportunity cost P x (variable but taking market value into account – refer example above) NEGOTIATED TRANSTER PROCESS Module and Working example
Negotiated Transfer Price • The minimum T/F price • From the point of view of the transferring division • Variable cost plus opportunity cost minus internal savings • BASIC PRINCIPLE • Relevancy – want to be at least in the same position as before the transfer
Negotiated Transfer Price • Maximum T/F price • From the point of view of the receiving division • BASIC PRINCIPLE • Relevancy – want to be at least in the same position as before the transfer • Point where contribution = 0 • Maximum price limited to Market price!
Transfer prices conclusion • Perfect market exists • Use market prices • Imperfect market exists • Negotiated price method (relevancy principles to determine minimum and maximum) • No external market exists • Long run marginal cost • Variable • Fixed lump sum • Treat as Cost Centre • Use standards 24
Other important discussions • Capital budgeting • EVA • EVA and NPV • ROI and ARR • Valuations • EVA • Budgeting
Building a file • Coverage!!!!! • Summarized Theory • Practical information summarized industry • Link to previous lectures and develop the same technique for each trigger. • Good luck for Assessment 2
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