Management Control Systems, Transfer Pricing, and Multinational Considerations

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1 1 CH:22 Management Control Systems, Transfer Pricing, and Multinational Considerations Transfer pricing is the price one subunit of a company charges for the services it provides another subunit of the same company. Top management uses transfer prices (1) to focus managers attention on the performance of their own subunits and (2) to plan and coordinate the actions of different subunits to maximize the company s income as a whole. While transfer pricing is productive, it can also be contentious, because managers of different subunits often have very different preferences about how transfer prices should be set. For example, some managers prefer the prices be based on market prices. Others prefer the prices be based on costs alone. Learning Objective 1 Describe a management control system and its three key properties. Management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout an organization and to guide the behavior of its managers and other employees. Some companies design their management control system around the concept of the balanced scorecard. For example, ExxonMobil s management control system contains financial and nonfinancial information in each of the four perspectives of the balanced scorecard. Management control systems consist of formal and informal control systems. The formal management control system of a company includes explicit rules, procedures, performance measures, and incentive plans that guide the behavior of its managers and other employees. The informal management control system includes shared values, loyalties, and mutual commitments among members of the organization, company culture, and the unwritten norms about acceptable behavior for managers and other employees.

2 2 Evaluating Management Control Systems To be effective, management control systems should be closely aligned with the organization s strategies and goals, also be designed to support the organizational responsibilities of individual managers. 1- Motivation is the desire to attain a selected goal (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort aspect). 2- Goal congruence exists when individuals and groups work toward achieving the organization s goals that is, managers working in their own best interest take actions that align with the overall goals of top management. 3- Effort is the extent to which managers strive or endeavor in order to achieve a goal. Effort goes beyond physical exertion, such as a worker producing at a faster rate, to include mental actions as well

3 3 Learning Objective 2 Describe the benefits and costs of decentralization. - Decentralization is the freedom for managers at lower levels of the organization to make decisions. Autonomy is the degree of freedom to make decisions. The greater the freedom, the greater the autonomy. As we discuss the issues of decentralization and autonomy, we use the term subunit to refer to any part of an organization. A subunit may be a large division, such as the refining division of ExxonMobil, or a small group, such as a two-person advertising department of a local clothing chain. -Benefits of Decentralization 1- Creates greater responsiveness to local needs. 2- Leads to gains from quicker decision making. 3- Increases motivation of subunit managers. 4- Assists management development and learning. 5- Sharpens the focus of subunit managers. -Costs of Decentralization Advocates of more-centralized decision making point to the following costs of decentralizing decision making: 1- Suboptimal decision making may occur. also called ( incongruent decision making or dysfunctional decision making). 2-Focuses the manager s attention on the subunit rather than the organization as a whole. 3- Increases the costs of gathering information. 4- Results in duplication of activities. -Comparison of Benefits and Costs To choose an organization structure that will implement a company s strategy, top man- agers must compare the benefits and costs of decentralization, often on a function-by- function basis

4 4 -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. Responsibility Centers 1.Cost center- the manager is accountable for costs only. 2.Revenue center -the manager is accountable for revenues only. 3.Profit center -the manager is accountable for revenues and costs. 4.Investment center- the manager is accountable for investments, revenues, and costs. Learning Objective 3 Explain transfer prices and four criteria used to evaluate them. -Transfer Pricing 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 anorganization. 4 criteria to evaluate transfer pricing: Transfer pricing should help achieve a - company s strategies and goals. - fit the organization s structure - promote goal congruence - promote a sustained high level of management effort

5 5 Learning Objective 4 Calculate transfer prices using three different methods. 1-Market-based transfer prices. 2- Cost-based transfer prices. 3- Negotiated transfer prices. Transfer-Pricing Methods 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. 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 فغب $ 5 The pipeline can carry 35,000 barrels per day. External purchase price for crude oil per barrel: $23 Refining Division: Variable cost per barrel of gasoline $8 $ 8 Fixed cost per barrel of gasoline $4 Total $ 12 The division is buying 20,000 barrels per day. -The external market price to outside parties is $60 per barrel. -The Refining Division is operating at 30,000 barrels capacity per day.

6 6 Requiredis the market-based transfer price - 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? First: Purchase price of crude oil $13 Variable costs per barrel of crude oil 2 Fixed costs per barrel of crude oil 3 TOTAL $18 Second: 1.12 $18 = $20.16 transfer p -What is the negotiated price? (Between $20.16 and $23.00 per barrel.) 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? Transportation Division: Revenues: ($23 1,000) $23,000 Deduct costs: ($18 1,000) ( 18,000 ) = Operating income $ 5,000 -What is the Refining Division s operating income using the market-based price? Refining Division: Revenues: ($60 500) $30,000 )Deduct costs): (-) Transferred-in ($23 1,000) 23,000 Division variable ($8 500) 4,000 Division fixed ($4 500) =Operating income$ 2,000 1,000

7 7 -What is the operating income of both divisions together? Transportation Division $5,000 ) + (Refining Division 1,000 Total $6,000 What is the Transportation and Refining Division s operating income using the 112% of full cost price? Transportation Division: Revenues: ($ ,000) = $20,160 Deduct costs: ($ ,000) = 18,000 operating income $ 2,160 Refining Division : Revenues ($60 500) $30,000 Deduct costs (-) Transferred-in ($ ,000) 20,160 Division variable ($ ) 4,000 Division fixed ($ ) 2,000 Operating income $ 3,840 -What is the operating income of both divisions together? Transportation Division Refining Division(+) $2,160 3,840 Total $6,000

8 8 LO 5 : Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets. * By using market based transfer prices in a perfectly competitive market the, a company can achieve the following: Goal congruence, Management effort, Subunit performance evaluation, Subunit autonomy. * Market prices also serve to evaluate the economic viability and profitability of divisions individually. * When supply outstrips demand, market prices may drop well below their historical average. * Distress prices are the drop in prices expected to be temporary. Lo 6 : Avoid making suboptimal decisions when transfer prices are based on full cost plus a markup. Example The Refining Division of Lomas & Co. is purchasing 20,000 barrels 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). 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? 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 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 (17+2) = $380,000 SO Yes. Because There is a reduction in total costs of $80,000 (460, ,000 = 80,000 )

9 9 Suppose the Transportation Division s transfer price to the Refining Division is 112% of full cost Plus $ 3 fixed cost. What is the cost to the Refining Division? Purchase price of crude oil $17 Variable costs per barrel of crude oil 2 Fixed costs per barrel of crude oil 3 Total $22 112% $22 = $24.64 SO $ ,000 = $492,800 What is the maximum transfer price? It is the price that the Refining Division can ($23). What is the minimum transfer price? The minimum transfer price is $19 per barrel. pay in the local external market Lo 7 Understand the range over which two divisions negotiate the transfer price when there is unused capacity. 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. So $23 $19 = $4 Suppose that variable costs are chosen as the basis to allocate this $4 difference. The Transportation Division s variable costs are $2 1,000 = $2,000. The Refining Division s variable costs to refine 1,000 of crude oil into 500 barrels of gasoline are $8 500 = $4,000. 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? $ $ $1.33 = $20.33 * Negotiated Transfer Prices : Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

10 10 LO9 Incorporate income tax considerations in multinational transfer pricing. * 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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