Management Control Systems, Transfer Pricing, and Multinational Considerations

1. Management Control Systems,Transfer Pricing, andMultinational Considerations Chapter22

2. 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

3. Management Control Systems A management control system is a means of gathering and using information. It guides the behavior of managers and employees.

4. Management Control Systems Financial data Nonfinancial data Formal control system Informal control system

5. Evaluating ManagementControl Systems Effort Motivation Goal congruence Lead to rewards Monetary Nonmonetary

6. Organization (control) Structure Total decentralization Total centralization

7. 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

8. Limitations of Decentralization Suboptimal decision making may occur Focuses the manager’s attention on the subunit rather than the organization as a whole Increases the costs of gathering information Results in duplication of activities

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

10. Responsibility Centers Cost center Revenue center Profit center Investment center

11. 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.

12. Transfer Pricing Transfer pricing should: (1) help achieve a company’s strategies and goals. (2) fit the organization’s structure (3) promote goal congruence (4) promote a sustained high level of management effort

13. Transfer-Pricing Methods Market-based transfer prices Cost-based transfer prices Negotiated transfer prices

14. 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

15. Market-Based Transfer Prices Market prices also serve to evaluate the economic viability and profitability of divisions individually.

16. 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.

17. Cost-based Transfer Prices When transfer prices are based on full cost plus a markup, suboptimal decisions can result.

18. 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!

19. Negotiated Transfer Prices Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

20. 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

21. Min. & Max. transfer price--examples Some examples: (1) Slowcar (2) S.F. Manufacturing

22. 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?

23. 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 Labor4.75 • Variable Overhead0.60 • Fixed Overhead1.20 • 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?)

24. 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 Labor4.30 • Variable Overhead5.40 • 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?

25. Comparison of Methods Achieves Goal Congruence Market Price: Yes, if markets competitive Cost-Based: Often, but not always Negotiated: Yes

26. 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

27. 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

28. Comparison of Methods Preserves Subunit Autonomy Market Price: Yes, if markets competitive Cost-Based: No, it is rule based Negotiated: Yes

29. 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

30. 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.”