Financial Performance and Transfer Pricing ACCT7320Controllership November 9, 2011

Financial Performance Financial Performance and Transfer Pricingand Transfer Pricing

ACCT7320ACCT7320ControllershipControllership

November 9, 2011November 9, 2011

Management Control Management Control SystemsSystems

A A management control system management control system -- -- involves gathering and using information involves gathering and using information for planning and control decisions. for planning and control decisions.

A management control system guides A management control system guides the the behaviorbehavior of managers and of managers and employeesemployees Basis for evaluation and rewardBasis for evaluation and reward Consistent with “agency theory”Consistent with “agency theory”

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Management Control Management Control SystemsSystems

A management control system collects:A management control system collects:• Financial data such as cost, revenue, and Financial data such as cost, revenue, and

net incomenet income• Usually an important factor!Usually an important factor!

• Nonfinancial dataNonfinancial data• As seen on BSCAs seen on BSC

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Four Types of Financial Four Types of Financial Responsibility CentersResponsibility Centers

1 Cost center –manager accountable for Cost center –manager accountable for costscosts only. only.

2 Revenue center –manager Revenue center –manager accountable for accountable for revenuesrevenues only. only.

3 Profit center –manager accountable Profit center –manager accountable for for revenues and costsrevenues and costs..

4 Investment center –manager Investment center –manager accountable for accountable for investments, investments, revenues, and costsrevenues, and costs..

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Evaluating Management Evaluating Management Control Systems Control Systems

MotivationMotivation – desire to attain a – desire to attain a selected goal combined with the selected goal combined with the resulting drive or pursuit toward that resulting drive or pursuit toward that goal.goal.

Goal congruence Goal congruence – subordinates’ – subordinates’ individual goals are consistent with individual goals are consistent with top management’s goals. top management’s goals.

Effort Effort – exertion toward a goal.– exertion toward a goal.

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Organization StructureOrganization Structure Total Total decentralizationdecentralization means means

minimum constraints, maximum minimum constraints, maximum freedom for managers at the lowest freedom for managers at the lowest levels to make decisions.levels to make decisions.

Total Total centralizationcentralization means maximum means maximum constraints, minimum freedom for constraints, minimum freedom for managers at the lowest levels to managers at the lowest levels to make decisions.make decisions.

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Benefits of DecentralizationBenefits of Decentralization– Creates greater responsiveness to local Creates greater responsiveness to local

needsneeds– Leads to gains from quicker decision Leads to gains from quicker decision

makingmaking– Increases motivation of subunit managersIncreases motivation of subunit managers– Aids management development and Aids management development and

learninglearning– Sharpens the focus of subunit managersSharpens the focus of subunit managers

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Recall the Recall the Costs of Costs of DecentralizationDecentralization

– Leads to suboptimal decision making Leads to suboptimal decision making (incongruent or dysfunctional decision (incongruent or dysfunctional decision making due to loss of control)making due to loss of control)

– Focuses manager’s attention on the Focuses manager’s attention on the subunit rather than the organization as subunit rather than the organization as a wholea whole

– Increases costs of gathering informationIncreases costs of gathering information– Results in duplication of activitiesResults in duplication of activities

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Decentralization in Decentralization in Multinational CompaniesMultinational Companies

Multinational corporations are often Multinational corporations are often decentralizeddecentralized centralized control of subunits in three centralized control of subunits in three

or four different continents is hardor four different continents is hard DecentralizationDecentralization enables managers enables managers

to apply their knowledge of local to apply their knowledge of local business and political conditions.business and political conditions.

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Decentralization in Decentralization in Multinational CompaniesMultinational Companies

Often rotate managers between foreign Often rotate managers between foreign locations and corporate headquarters.locations and corporate headquarters.

Job rotation with decentralization helps Job rotation with decentralization helps develop managers’ abilities to operate develop managers’ abilities to operate in the global environment.in the global environment.

A drawback to decentralizing A drawback to decentralizing multinational companies is the lack of multinational companies is the lack of control.control.

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Transactions between Transactions between DivisionsDivisions

What happens when transactions What happens when transactions occur between divisions (subunits)?occur between divisions (subunits)? Effects on individual divisional Effects on individual divisional

performanceperformance Effects on the overall organizationEffects on the overall organization

The control design of the control The control design of the control system affects the outcomesystem affects the outcome

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Transfer PricingTransfer Pricing A A transfer price transfer price is the price one subunit is the price one subunit

charges for a product/service supplied to charges for a product/service supplied to another subunit of the same organization.another subunit of the same organization.

Creates revenues for the selling subunit Creates revenues for the selling subunit and purchase costs for the buying subunit, and purchase costs for the buying subunit, affecting each subunit’s operating income.affecting each subunit’s operating income. Overall organization’s income unaffected upon Overall organization’s income unaffected upon

consolidation!consolidation!

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Transfer PricingTransfer Pricing What is the behavioral objective for What is the behavioral objective for

transfer prices?transfer prices? Subunit managers need only consider Subunit managers need only consider

how their actions how their actions will affect subunit will affect subunit performanceperformance without evaluating their without evaluating their impact on companywide performance.impact on companywide performance.

A well designed TP policy will lead to A well designed TP policy will lead to goal congruence goal congruence

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Major Decisions about TPs

Two major decisions in transfer pricing policy:• Sourcing -- should segments be free to decide

whether to sell/buy from other segments• Pricing method-- what transfer price should be

set for any transfer Criteria for “good” policy?

goal congruence managerial effort subunit autonomy [where desired]

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Transfer-Pricing MethodsTransfer-Pricing Methods Three general methods for transfer Three general methods for transfer

pricing:pricing:1 Market-basedMarket-based

• Price of a similar product/ service publicly listedPrice of a similar product/ service publicly listed 2 Cost-basedCost-based

• Some basis of “cost” (plus a margin?)Some basis of “cost” (plus a margin?)

3 NegotiatedNegotiated• Whatever the subunit managers agreeWhatever the subunit managers agree

[Also Dual Method:[Also Dual Method:• Revenue to seller, cost to buyer Revenue to seller, cost to buyer not equalnot equal]]

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Effects on IncomeEffects on Income

Except for tax impacts, Except for tax impacts, nono impact on impact on overall consolidated incomeoverall consolidated income

Affects Affects distributiondistribution of income among of income among segmentssegments

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The Importance of Transfer Pricing

Evaluation of a division for sale (What earnings are relevant?)

Minority interest in a subsidiary (Is subsidiary being "plundered"?)

Tax minimization (Can shift income to some degree.)

Governmental contracting (Endorses full-cost TPs.)

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What Can Happen Regarding Goal What Can Happen Regarding Goal Congruence?Congruence?

From corporation’s viewpoint, it’s an outsourcing From corporation’s viewpoint, it’s an outsourcing decision!decision!

Internal Internal productionproduction is is better for the better for the

company company overalloverall

OutsourcingOutsourcing is is better for better for company company overalloverall

Deal is Deal is completecomplete

d d internallyinternally

Good outcomeGood outcome Bad outcomeBad outcome

Purchaser Purchaser goes goes

outsideoutsideBad outcomeBad outcome Good outcomeGood outcome 1818

Will the Desired Outcome Occur?If outsourcing is desirable, there will be a range

of acceptable prices:Ceiling: The outside market price that buyer would pay

[Room to share benefit.]Floor: The outlay costs of supplier + opportunity cost.

If idle capacity, there is no opportunity cost. If no idle capacity, then it’s sales price to current

outside customer.

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Comparison of MethodsComparison of Methods

Market Price:Market Price: Yes, if markets Yes, if markets competitivecompetitive

Cost-Based:Cost-Based: Often, but not alwaysOften, but not always Negotiated:Negotiated: Yes Yes

Achievement of Goal Congruence

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Cost-Based:Cost-Based: Difficult, unless transfer Difficult, unless transfer price price exceeds full costexceeds full cost

Negotiated:Negotiated: YesYes

Usefulness for Evaluating Subunit Performance

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Market Price:Market Price: YesYes Cost-Based:Cost-Based: Yes, if based on Yes, if based on

budgeted budgeted costs; less costs; less incentive if based incentive if based on on actual costactual cost

Negotiated:Negotiated: Yes Yes

Motivating Management Effort

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Cost-Based:Cost-Based: No, it is rule basedNo, it is rule based Negotiated:Negotiated: Yes Yes

Preserving Subunit Autonomy

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Market Price:Market Price: No market may existNo market may exist Cost-Based:Cost-Based: Useful for determining full-Useful for determining full-

cost; easy to cost; easy to implementimplement

Negotiated:Negotiated: Bargaining takes time and Bargaining takes time and may need to be may need to be

reviewed reviewed

Other Factors to Consider

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Tax & Multinational Transfer Tax & Multinational Transfer PricingPricing

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Importance Continued:Importance Continued:Eli Lily Case (1957)Eli Lily Case (1957)

IRS objected to tax return Lily had used variable costs as TP basis Court decided the true purpose was tax

avoidance, held for IRS Established market-based TPs for tax purposes

Eli L ily Tax C ase (1957 )

E th ica l [P resc rip tion ]D ru g s

P aten tD ru g s

W estern Hem isphere T rade CorporationCom pare DISCs, FSCs

O th er P rod u c ts

E li L ilyP rarm aceu tica ls

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Tax & Multinational Transfer Tax & Multinational Transfer PricingPricing

Transfer prices often have tax Transfer prices often have tax implications.implications.

Tax factors include not only income taxes, Tax factors include not only income taxes, but also payroll taxes, customs duties, but also payroll taxes, customs duties, tariffs, sales taxes, and other levies on tariffs, sales taxes, and other levies on organizations.organizations.

Section 482 of the U.S. Internal Revenue Section 482 of the U.S. Internal Revenue Service Code governs taxation of Service Code governs taxation of multinational transfer pricing.multinational transfer pricing.

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Multinational Transfer Multinational Transfer PricingPricing

Section 482 requires that transfer Section 482 requires that transfer prices for both tangible and prices for both tangible and intangible property between a intangible property between a company and its foreign division be company and its foreign division be set to equal the price that would be set to equal the price that would be charged by an unrelated third party charged by an unrelated third party in a comparable transaction.in a comparable transaction.

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Multinational Transfer Multinational Transfer PricingPricing

Transfer prices can reduce income Transfer prices can reduce income tax payments by recognizing more tax payments by recognizing more income in low tax rate countries income in low tax rate countries and less income in high tax rate and less income in high tax rate countries.countries.

Tax regulations of different countries Tax regulations of different countries restrict the transfer prices that restrict the transfer prices that companies can choose.companies can choose.

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The EndThe End

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Documents

Financial Performance and Transfer Pricing ACCT7320Controllership November 9, 2011