Management Control Systems, Transfer Pricing, and Multinational Considerations

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Management Control Systems,Transfer Pricing,
andMultinational Considerations

• Chapter 22

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Learning Objective 1
Describe a management control system and
its three key properties.
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Management Control Systems
A management control system is a means of
gathering and using information.
It guides the behavior of managers and employees.
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Management Control Systems
Financial data
Nonfinancial data
Formal control system
Informal control system
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Evaluating ManagementControl Systems
Motivation
Goal congruence
Effort
Lead to rewards
Monetary
Nonmonetary
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Learning Objective 2
Describe the benefits and costs of
decentralization.
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Organization Structure
Total decentralization
Total centralization
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Benefits of Decentralization
Creates greater responsiveness to local needs
Leads to gains from quicker decision making
Increases motivation of subunit managers
Assists management development and learning
Sharpens the focus of subunit managers
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Costs of Decentralization
Suboptimal decision making may occur
Focuses the managers attention on the
subunit rather than the organization as a whole
Increases the costs of gathering information
Results in duplication of activities
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Decentralization inMultinational Companies
Decentralization enables country managers to make
decisions that exploit their knowledge of local
business and political conditions.
Multinational corporations often rotate managers
between foreign locations and corporate
headquarters.
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Responsibility Centers
Cost center
Revenue center
Investment center
Profit center
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Learning Objective 3
Explain transfer prices and four criteria used to
evaluate them.
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Transfer Pricing
A transfer price is the price one subunit
charges for a product or service supplied to
another subunit of the same organization.
Intermediate products are the products transferred
between subunits of an organization.
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Transfer Pricing
Transfer pricing should help achieve a companys
strategies and goals.
fit the organizations structure
promote goal congruence
promote a sustained high level of management
effort
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Learning Objective 4
Calculate transfer prices using three different
methods.
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Transfer-Pricing Methods
Market-based transfer prices
Cost-based transfer prices
Negotiated transfer prices
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Transfer-PricingMethods Example
Lomas Co. has two divisions Transportation and
Refining.
Transportation purchases crude oil in Alaska
and sends it to Seattle.
Refining processes crude oil into gasoline.
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Transfer-PricingMethods Example
External market price for supplying crude oil per
barrel 13
Transportation Division Variable cost per barrel
of crude oil 2 Fixed cost per barrel of
crude oil 3 Total 5
The pipeline can carry 35,000 barrels per day.
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Transfer-PricingMethods Example
External purchase price for crude oil per
barrel 23
Refining Division Variable cost per barrel of
gasoline 8 Fixed cost per barrel of
gasoline 4 Total 12
The division is buying 20,000 barrels per day.
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Transfer-PricingMethods Example
The external market price to outside parties is
60 per barrel.
The Refining Division is operating at 30,000
barrels capacity per day.
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Transfer-PricingMethods Example
What is the market-based transfer price from
Transportation to Refining?
23 per barrel
What is the cost-based transfer price at 112 of
full costs?
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Transfer-PricingMethods Example
Purchase price of crude oil 13 Variable
costs per barrel of crude oil 2 Fixed costs
per barrel of crude oil 3 Total
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1.12 18 20.16
What is the negotiated price?
Between 20.16 and 23.00 per barrel.
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Transfer-PricingMethods Example
Assume that the Refining Division buys 1,000
barrels of crude oil from the Transportation
Division.
The Refining Division converts these
1,000 barrels of crude oil into 500 gallons
of gasoline and sells them.
What is the Transportation Division
operating income using the market-based price?
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Transfer-PricingMethods Example
Transportation Division Revenues (23
1,000) 23,000 Deduct costs (18 1,000)
18,000 Operating income 5,000
What is the Refining Divisions operating income
using the market-based price?
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Transfer-PricingMethods Example
Refining Division Revenues (60
500) 30,000 Deduct costs Transferred-in
(23 1,000) 23,000 Division variable (8
500) 4,000 Division fixed (4 500)
2,000 Operating income 1,000
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Transfer-PricingMethods Example
What is the operating income of both divisions
together?
Transportation Division 5,000 Refining
Division 1,000 Total 6,000
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Transfer-PricingMethods Example
What is the Transportation Divisions
operating income using the 112 of full cost
price?
Transportation Division Revenues (20.16
1,000) 20,160 Deduct costs (18.00 1,000)
18,000 Operating income 2,160
What is the Refining Division operating income
using the full cost price?
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Transfer-PricingMethods Example
Refining Division Revenues (60
500) 30,000 Deduct costs Transferred-in
(20.16 1,000) 20,160 Division variable
(8.00 500) 4,000 Division fixed (4.00
500) 2,000 Operating income 3,840
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Transfer-PricingMethods Example
What is the operating income of both divisions
together?
Transportation Division 2,160 Refining
Division 3,840 Total 6,000
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Learning Objective 5
Illustrate how market-based transfer prices
promote goal congruence in perfectly competitive
markets.
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Market-Based Transfer Prices
By using market-based transfer prices in a
perfectly competitive market, a company can
achieve the following
Goal congruence
Management effort
Subunit performance evaluation
Subunit autonomy
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Market-Based Transfer Prices
Market prices also serve to evaluate the economic
viability and profitability of divisions
individually.
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Market-Based Transfer Prices
When supply outstrips demand, market prices may
drop well below their historical average.
Distress prices are the drop in prices expected
to be temporary.
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Learning Objective 6
Avoid making suboptimal decisions when
transfer prices are based on full cost plus a
markup.
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Cost-Based TransferPrices Example
The Refining Division of Lomas Co.
is purchasing crude oil locally for 23 a barrel.
The Refining Division located an
independent producer in Alaska that is willing to
sell 20,000 barrels of crude oil per day at 17
per barrel delivered to the pipeline
(Transportation Division).
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Cost-Based TransferPrices Example
The Transportation Division has excess capacity
and can transport the crude oil at its variable
costs of 2 per barrel.
Should Lomas purchase from the independent
supplier?
Yes.
There is a reduction in total costs of 80,000.
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Cost-Based TransferPrices Example
Alternative 1 Buy 20,000 barrels from the local
supplier at 23 per barrel.
The total cost to Lomas is 20,000 23
460,000
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Cost-Based TransferPrices Example
Alternative 2 Buy 20,000 barrels from the
independent supplier in Alaska at 17 per barrel
and transport it to Seattle at 2 per barrel.
The total cost to Lomas is 20,000 19
380,000
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Cost-Based TransferPrices Example
Suppose the Transportation Divisions transfer
price to the Refining Division is 112 of full
cost.
What is the cost to the Refining Division?
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Cost-Based TransferPrices Example
Purchase price of crude oil 17 Variable
costs per barrel of crude oil 2 Fixed costs
per barrel of crude oil 3 Total
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1.12 22 24.64
24.64 20,000 492,800
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Cost-Based TransferPrices Example
What is the maximum transfer price?
It is the price that the Refining Division
can pay in the local external market (23).
What is the minimum transfer price?
The minimum transfer price is 19 per barrel.
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Learning Objective 7
Understand the range over which two divisions
negotiate the transfer price when there is unused
capacity.
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Prorating
Lomas Co. may choose a transfer price that
splits on some equitable basis the difference
between the maximum transfer price and the
minimum transfer price.
23 19 4
Suppose that variable costs are chosen as the
basis to allocate this 4 difference.
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Prorating
The Transportation Divisions variable costs are
2 1,000 2,000.
The Refining Divisions variable costs to refine
1,000 of crude oil into 500 barrels of gasoline
are 8 500 4,000.
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Prorating
The Transportation Division gets to keep 2,000
6,000 4 1.33.
The Refining Division gets to keep 4,000
6,000 4 2.67.
What is the transfer price from
the Transportation Division?
17.00 2.00 1.33 20.33
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Dual Pricing
An example of dual pricing is for Lomas Co. to
credit the Transportation Division with 112 of
the full cost transfer price of 24.64 per barrel
of crude oil.
Debit the Refining Division with the
market-based transfer price of 23 per barrel of
crude oil.
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Negotiated Transfer Prices
Negotiated transfer prices arise from the outcome
of a bargaining process between selling and
buying divisions.
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Learning Objective 8
Construct a general guideline for determining a
minimum transfer price.
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Comparison of Methods
Achieves Goal Congruence
Market Price
Yes, if markets competitive
Cost-Based
Often, but not always
Negotiated
Yes
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Comparison of Methods
Useful for Evaluating Subunit Performance
Market Price
Yes, if markets competitive
Cost-Based
Difficult, unless transfer price exceeds full cost
Negotiated
Yes
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Comparison of Methods
Motivates Management Effort
Market Price
Yes
Cost-Based
Yes, if based on budgeted costs less incentive
if based on actual cost
Negotiated
Yes
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Comparison of Methods
Preserves Subunit Autonomy
Market Price
Yes, if markets competitive
Cost-Based
No, it is rule based
Negotiated
Yes
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Comparison of Methods
Other Factors
Market Price
No market may exist
Cost-Based
Useful for determining full-cost easy to
implement
Negotiated
Bargaining takes time and may need to be reviewed
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General Guideline
Minimum transfer price Incremental costs per
unit incurred up to the point of transfer
Opportunity costs per unit to the selling division
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General Guideline
Assume a perfectly competitive market, with no
idle capacity.
Transportation Division can sell all the crude
oil it transports to the external market in
Seattle for 23 per barrel.
What is the minimum transfer price?
(19 4) or (13 2 8) 23 Market price
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General Guideline
Assume that an intermediate market exists that is
not perfectly competitive, and the selling
division has idle capacity.
If the Transportation Division has idle capacity,
its opportunity cost of transferring the oil
internally is zero.
What is the minimum transfer price?
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General Guideline
It would be 15 per barrel for oil
purchased under the long-term contract, or...
19 per barrel for oil purchased and transported
from the independent supplier in Alaska.
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Learning Objective 9
Incorporate income tax considerations
in multinational transfer pricing.
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Multinational Transfer Pricing
IRC Section 482 requires that transfer prices
for both tangible and intangible property between
a company and its foreign division be set to
equal the price that would be charged by an
unrelated third party in a comparable transaction.
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End of Chapter 22