Questions from Managerial Accounting class week 2

Question 01: What do you think is the major disadvantage of the ROI method of performance evaluation?

Personally, the only disadvantage to ROI I observed comes from its comparison with the average ROI of the firm. I think that there is not a disadvantage to using ROI as long as the average of the whole firm is not the comparison metric.  Simply use the cost of capital as the metric that needs to be overcome.  I know that this may seem to be a simple solution to the question.  However, I think the question does not consider the possibility of a different solution.

Question 02: If you have experienced transfer pricing in your company or career please describe and give your opinion on the pros and cons.

Much more intriguing is transfer pricing question.  When working at Enterprise Rent-A-Car (I worked there two years “because they got an excellent corporate structure and they… *they* give *you* the tools to be your own boss.”) I experienced this first hand.  This example is a stark contrast to the one given in the text but it does have some great lessons.

Enterprise’s business model is based on the home city market.  The home city market is the market that rents to people wanting to use vehicles for there and back rentals only.  The market is quite different than the airport rental market. The majority of the customers are replacement rentals, customers using a car because their car is in the body shop from an accident, or in a mechanic’s shop for repairs.  Twin Falls is actually quite isolated compared to other branches because the nearest branches were approximately 2 hours away.

Let me give some additional background to help everyone understand from our text, the cost center was the local branches Enterprise operated.  The group (approximately 35 – 40 branches in Idaho and Utah) would be the equivalent of a profit center.  Enterprise also goes by the full cost transfer price method.  When a vehicle is received at one branch, it is assigned the full price of the purchase of the vehicle less depreciation.  One final note, Enterprise Rent-A-Car in Idaho and Utah used the controllability principle in its management style, managers were directly responsible for costs associated with the fleets under their control.

We experienced transfer pricing when vehicles were sent on one-way rentals from one branch to another.  Often branch managers would use this to send out vehicles that they did not want.  The branch may have a large vehicle like a 15 passenger van that had high monthly depreciation expense and very little rental need except in peak traveling times.  Branch managers would also send less desirable vehicles away from their branches to get vehicles that would please the customer better.  In some companies, customer service is not as important.  However, with Enterprise, customer service ratings were a means to determine eligibility for promotion.

Given that the cost was fixed, the sending branch had immense power, they were not required to notify the receiving branch and could send poor vehicles at will.  I observed sending branches also use this as an opportunity to try and get damaged vehicles past the receiving branch’s personnel.  This was a huge risk to the group, often the general managers of the groups would have discussions on which group would have to front the cost of a repair.  The risk management trainer spent many hours training individuals to correctly assess damage so that they did not have to front the costs of a vehicle sent to them one way from another group.

As the branches were cost centers, branch managers would also have heated discussions about damaged vehicles sent one way between them and who had to accept responsibility.  One problem in both branch and group one ways, was the fact that even if the receiving branch did not have to pay for the repair, the depreciation expense during the repair remained the responsibility of the receiving branch.  This means that the variable costs associated with having an asset that did not produce income would go up.  This was not without good reason, a vehicle needed to be on the local branch’s books so that they could check on its repair status and get it back into the fleet as soon as possible.

Risk management’s use of time to keep other branches from abusing the situation is one drawback to this system.  This caused additional costs in all the groups because the cost of damage that was missed at local branches in the group was the second highest risk for the company.  The additional variable costs and the receipt of lower net income producing cars also made this a less than desirable situation for a receiving branch.

The only redeeming quality is that it met needs of the individual heading one way from one state to another.

My opinion is that this was a necessary evil of doing business.  The distaste it created caused ethical questions for managers regularly, it also encouraged employees to avoid sending vehicles one way.  I know that Hertz has a business model that is different and allows for more one-way rentals, I would be interested to see what their cost structure/transfer pricing methods are in relation to this.

Bibliography

McKay, A. (Director). (2008). Step Brothers [Motion picture]. USA.

Zimmerman, J. L. (2014). Accounting for decision making and control (8th ed.). New York: McGraw-Hill.