Management Control Systems, Transfer Pricing, and Multinational Considerations

Chapter 22
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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
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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 Management Control Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary
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Nonmonetary
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Organization (control) 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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Limitations 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 in Multinational 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.
Control Problem: Barings Bank (200 yrs old)1995 Nick Leeson caused over 1 B loss.
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Responsibility Centers
Cost center Revenue center

Profit center
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Investment center
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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: (1) help achieve a companys strategies and goals. (2) fit the organizations structure (3) promote goal congruence (4) promote a sustained high level of management effort
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Transfer-Pricing Methods
Market-based transfer prices

Cost-based transfer prices Negotiated transfer prices

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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.
Basing transfer prices on depressed market prices will not always lead to optimal decisions for an organization.
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Cost-based Transfer Prices

When transfer prices are based on full cost plus a markup, suboptimal decisions can result.
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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 $24.64 per barrel of crude oil. Debit the Buying Division with the market-based transfer price of $23 per barrel of crude oil. And debit a corporate account for the difference!
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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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General Guideline: min. & max.

transfer price
Maximum transfer price = Market 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 cost Opportunity costs often times = lost CM Opportunity costs could = lost savings
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Min. & Max. transfer price--examples

Some examples:

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

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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?

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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 divisions 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 onethird 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?)

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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 companys point of view? Why?

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Comparison of Methods
Achieves Goal Congruence

Market Price: Yes, if markets competitive

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

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Comparison of Methods
Useful for Evaluating Subunit Performance

Market Price: Yes, if markets competitive Cost-Based: Negotiated:

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Difficult, unless transfer price exceeds full cost Yes

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Comparison of Methods
Motivates Management Effort

Market Price: Yes

Cost-Based: Negotiated:
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Yes, if based on budgeted costs; less incentive if based on actual cost Yes
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Comparison of Methods
Preserves Subunit Autonomy

Market Price: Yes, if markets competitive

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

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Comparison of Methods
Other Factors

Market Price: No market may exist Cost-Based:

Negotiated:
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Useful for determining full-cost; easy to implement Bargaining takes time and may need to be reviewed
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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 (arms length). This still leaves a little room to wiggle.
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