2009 Foster School of Business Cost Accounting L.DuCharme 1 Management Control Systems, Transfer Pricing, and Multinational Considerations Chapter 22

2009 Foster School of Business Cost Accounting L.DuCharme 1

Management Control Systems,Transfer Pricing, and

Multinational Considerations

Chapter 22


Overview

• What is a Management Control System?• Centralized vs. decentralized control structure• Transfer pricing:

– Function

– Setting TPs

– Dual TPs

– Negotiated TPs (Calculating Min. & Max. range)

– International tax issues


Management Control Systems

A management control system is a meansof gathering and using information.

It guides the behavior of managers and employees.


Management Control Systems

Financial data

Formal control system

Nonfinancial data

Informal control system


Evaluating ManagementControl Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary


Organization (control) Structure

Total decentralization

Total centralization


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


Limitations of Decentralization

Suboptimal decision making may occur

Focuses the manager’s attention on the subunitrather than the organization as a whole

Increases the costs of gathering information

Results in duplication of activities


Decentralization inMultinational Companies

Decentralization enables country managers tomake decisions that exploit their knowledge

of local business and political conditions.

Multinational corporations often rotatemanagers between foreign locations

and corporate headquarters.Control Problem: Barings Bank (200 yrs old)—1995 Nick Leeson caused over ₤1 B loss.


Responsibility Centers

Costcenter

Revenuecenter

Investmentcenter

Profitcenter


Transfer Pricing

A transfer price is the price one subunit chargesfor a product or service supplied to another

subunit of the same organization.

Intermediate products are the productstransferred between subunits of an

organization.


Transfer Pricing

Transfer pricing should: (1) help achievea company’s strategies and goals.

(2) fit the organization’s structure

(3) promote goal congruence

(4) promote a sustained high level of management effort


Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices


Market-Based Transfer Prices

By using market-based transfer pricesin a perfectly competitive market, acompany can achieve the following:

Goal congruence

Management effort

Subunit performance evaluation

Subunit autonomy



Market prices also serve to evaluate theeconomic viability and profitability

of divisions individually.



When supply outstrips demand, market pricesmay drop well below their historical average.

Distress prices are the drop in pricesexpected to be temporary.

Basing transfer prices on depressed market prices will not always lead to optimal decisions for an organization.


Cost-based Transfer Prices

When transfer prices are

based on full cost plus a

markup, suboptimaldecisions can result.


Dual Transfer Prices

An example of dual pricing is for Larry & Co.to credit the Selling Division with

112% of the full cost transfer price of $24.64per barrel of crude oil.

Debit the Buying Division with the market-basedtransfer price of $23 per barrel of crude oil.

And debit a corporate account for the difference!


Negotiated Transfer Prices

Negotiated transfer prices arise from theoutcome of a bargaining process between

selling and buying divisions.


General Guideline: min. & max. transfer price

Minimum transfer price= Incremental costs per unit incurred

up to the point of transfer+ Opportunity costs per unit to the selling division

Incremental cost often times = variable costOpportunity costs often times = lost CMOpportunity costs could = lost savings

Maximum transfer price = Market price


Min. & Max. transfer price--examples

Some examples:

(1) Slowcar(2) S.F. Manufacturing


Slowcar Company

• The Assembly Division of SLOWCAR Company has offered to purchase 90,000 batteries from the Electrical Division (ED) for $104 per unit. At a normal volume of 250,000 batteries per year, production costs per battery are:

• Direct materials $40• Direct labor 20• Variable factory overhead 12• Fixed factory overhead 42• Total $114• The Electrical Division has been selling 250,000 batteries per year to outside

buyers for $136 each. Capacity is 350,000 batteries/year. The Assembly Division has been buying batteries from outside suppliers for $130 each.

• Should the Electrical Division manager accept the offer? Will an internal transfer be of any benefit to the company?


SF Manufacturing

• The SF Manufacturing Co. has two divisions in Iowa, the Supply Division and the BUY Division. Currently, the BUY Division buys a part (3,000 units) from Supply for $12.00 per unit. Supply wants to increase the price to BUY to $15.00. The controller of BUY claims that she cannot afford to go that high, as it will decrease the division’s profit to near zero. BUY can purchase the part from an outside supplier for $14.00. The cost figures for Supply are:

• Direct Materials $3.25• Direct Labor 4.75• Variable Overhead 0.60• Fixed Overhead 1.20• A. If Supply ceases to produce the parts for BUY, it will be able to avoid one-

third of the fixed MOH. Supply has no alternative uses for its facilities. Should BUY continue to get the units from Supply or start to purchase the units from the outside supplier? (From the standpoint of SF as a whole).

• (What is the min. & max. transfer price if BUY and SUPPLY negotiate?)


SF Mfg.—continued

• Now, assume that Supply could use the facilities currently used to produce the 3,000 units for BUY to make 5,000 units of a different product. The new product will sell for $16.00 and has the following costs:

• Direct Materials $3.00• Direct Labor 4.30• Variable Overhead 5.40

• B. What is the min. & max. transfer price if BUY and SUPPLY negotiate?

• C. What should be done from the company’s point of view? Why?


Comparison of Methods

Achieves Goal Congruence

Market Price: Yes, if markets competitive

Cost-Based: Often, but not always

Negotiated: Yes



Useful for Evaluating Subunit Performance


Cost-Based:Difficult, unless transferprice exceeds full cost

Negotiated: Yes



Motivates Management Effort

Market Price: Yes

Cost-Based:Yes, if based on budgetedcosts; less incentive ifbased on actual cost

Negotiated: Yes



Preserves Subunit Autonomy


Cost-Based: No, it is rule based

Negotiated: Yes



Other Factors

Market Price: No market may exist

Cost-Based:Useful for determiningfull-cost; easy to implement

Negotiated:Bargaining takes time andmay need to be reviewed


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 (arm’s length).This still leaves a little “room to wiggle.”

Documents

2009 Foster School of Business Cost Accounting L.DuCharme 1 Management Control Systems, Transfer Pricing, and Multinational Considerations Chapter 22