Management Control Systems, Transfer Pricing, and Multinational Considerations

1
Management Control Systems,Transfer Pricing,and
Multinational Considerations

• Chapter 22Accounting 3300Professor Richard E.
  McDermott

2
Management Control Systems

• Management control systems are a means of
  gathering and using information.

• Information is used to
• Aid and coordinate planning and control decisions
  within an organization.
• Guide the behavior of managers and other
  employees.

3
Management Control Systems

• Many management control systems contain some or
  all of the balanced scorecard perspectives.
• Financial
• Customer
• Internal business process
• Learning and growth

4
Evaluating Management Control Systems

• To be effective, management control systems
  should be closely aligned to the firm strategies
  and goals.
• Systems should be designed to fit the company
  structure and decision-making responsibility of
  individual managers.

5
Two Aspects of Motivation

• Goal Congruence exists when individuals and
  groups work toward achieving the organizations
  goals managers working in their own best
  interests take actions that align with the
  overall goals of top management.

6
Two Aspects of Motivation

• Effort is exertion toward reaching a goal,
  including both physical and mental actions.

7
Organizational Structure and 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.

8
Decentralization Versus Centralization

• Total decentralization means minimum constraints
  and maximum freedom for managers at the lowest
  levels of an organization to make decisions.
• Total centralization means maximum constraints
  and minimum freedom for managers at the lowest
  levels of an organization to make decisions.

9
Decentralization and Multinational Firms

• Companies that operate in multiple countries are
  often decentralized why?
• What do you think is the biggest drawback to
  decentralization with multinational companies?

10
Choices about Responsibility Centers

• Regardless of the degree as decentralization,
  management control systems used one or a mix of
  the four types of responsibility centers.
• Cost centers
• Revenue centers
• Profit centers
• Investment centers

11
Transfer Pricing

• A transfer price is the price one subunit of a
  corporation charges for a product or service
  supplied to another subunit of the same
  organization.
• Management control systems use transfer prices to
  coordinate the actions of subunits and to
  evaluate their performance.

12
Transfer Pricing

• The transfer price creates revenues for the
  selling subunits and purchasing cost for the
  buying subunits, affecting each subunits
  operating income.
• The product or service transferred between
  subunits is called the intermediate product.

13
Three Transfer Pricing Methods

• Market based transfer prices
• Cost-based transfer prices
• Negotiated transfer prices

14
Dual Pricing

• Dual pricing is one version of cost-based
  pricing.
• Dual pricing uses two separate transfer pricing
  methods to price each transfer from one subunit
  to another
• Example the selling division receives full cost
  price, while the buying division pays market
  price.

15
Dual Pricing

• With the previous example, what happens to the
  difference between full cost received by the
  selling division and market price paid by the
  buying division?

16
Multinational Transfer Pricing and Tax
Considerations

• Transfer prices often have tax implications.
• Tax factors include
• income taxes,
• payroll taxes,
• customs duties,
• tariffs,
• sales taxes,
• value added taxes,
• environmental related taxes, and
• other government levies.

17
Minimum Transfer Price
Transfer price marginal cost opportunity cost
Of course you have seen this formula before . . .
18
Problem 22-16

• Durham Corporation makes exclusive furniture.
• Describe the financial and nonfinancial measures
  you would include in the companys balanced
  scorecard management control system.

19
Authors Answer

• Durham produces and sells furniture of unique
  design and outstanding quality.
• Clearly, it is pursuing a product-differentiation
  strategy.

20
Authors Answer

• Its balanced-scorecard-based management control
  system should reflect that strategy and measure
  and communicate the degree to which the
  organization meets its strategic goals.
• Some possible financial and non-financial
  measures are

21
Possible Financial Measures

• profit margins
• stock price
• net income
• return on investment
• cash flow from operations
• design costs as a percentage of sales

22
Possible Non-Financial Measures

• Market share in the high-end furniture segment.
• Customer repeat purchases.
• Number of mentions of Durham furniture in design
  and architecture magazines.
• Recognized quality certifications, number of
  innovative designs.

23
Possible Non-Financial Measures

• Ability to attract and keep the best designers.
• Employee satisfaction.
• Employee pride in Durhams identity.

24
Problem 22-18

• Hexton Chemicals has seven independent operating
  divisions.
• These are assisted by support groups such as
  environmental management.

25
Problem 22-18

• Environmental management engineers must seek
  business from the divisions.
• The work must be paid by the operating divisions.

26
Problem 22-18

• Is the environmental group centralized or
  decentralized?
• The environmental-management group appears to be
  decentralized because its managers have
  considerable freedom to make decisions.

27
Problem 22-18

• They can choose which projects to work on and
  which projects to reject.
• Top management will adjust the size of the
  environmental-management group to match the
  demand for the groups services by operating
  divisions.

28
Problem 22-18

• What type of responsibility is the environmental
  management group?
• The environmental-management group is a cost
  center.
• The group is required to charge the operating
  divisions for environmental services at cost and
  not at market prices that would help earn the
  group a profit.

29
Problem 22-18

• What benefits and problems do you see in
  structuring the environmental group in this way?
  
• Does it lead to goal congruence?

30
Benefits

• The operating managers have incentives to
  carefully weigh and conduct cost-benefit analyses
  before requesting the environmental groups
  services.
• The operating managers have an incentive to
  follow the work and the progress made by the
  environmental team.

31
Benefits

• The environmental group has incentives to fulfill
  the contract, to do a good job in terms of cost,
  time, and quality, and to satisfy the operating
  division to continue to get business.

32
Problems

• The contract requires extensive internal
  negotiations in terms of cost, time, and
  technical specifications.
• The environmental group needs to continuously
  sell its services to the operating division,
  and this could potentially result in loss of
  morale.

33
Problems

• Experimental projects that have long-term
  potential may not be undertaken because operating
  division managers may be reluctant to undertake
  projects that are costly and uncertain, whose
  benefits will be realized only well after they
  have left the division.

34
Problem 22-19

• User Friendly Computer with headquarters in San
  Francisco, manufactures and sells a desktop
  computer.
• The company has three divisions each of which is
  located in a different country.

35
Three Divisions

• China Division manufactures memory devices and
  keyboards.
• South Korean Division assembles desktop
  computers using internally manufactured parts and
  memory devices and keyboards from the China
  division.
• US Division packages and distributes desktop
  computers.

36
Additional Information

• Each division is run as a profit center.
• The cost for work done in each division for a
  single desktop computer is as follows.

37
Additional Information

• Chinese income tax rate is 40.
• A South Korean income tax rate is 20.
• United States income tax rate is 30.
• Exchange rates
• 8 yuan 1.00 US dollar
• 1,200 won 1.00 US dollar

38
Additional Information

• Each desktop computer is sold through retail
  outlets in the United States for 3200.

39
Additional Information

• Both China and South Korea sell part of their
  production under a private label.
• The Chinese division sells a comparable
  memory/keyboard package to a Chinese manufacturer
  for 3600 yuan.
• The South Korea division sells a comparable
  desktop computer to a South Korean distributor
  for 1,560,000 won

40
Part One

• Calculate the after tax operating income per unit
  earned by each division under the following
  transfer pricing methods (a) market price, ( b)
  200 of full costs, and (c) 300 of variable
  costs.
• Income taxes are not included in the computation
  of cost based transfer prices.

41
Analysis

• This is a three-country, three-division transfer
  pricing problem with three alternative transfer
  pricing methods.

42
Analysis

• Lets take this approach in solving the problem
• First begin by summarizing the costs in US
  dollars.
• Then organize this data into transfer price
  alternatives.
• Then prepare income statements for each division
  using each transfer price method, summing to see
  the total corporate net income under each
  alternative.

43
Summary of Costs in US Dollars

• China Plant
• Variable costs 1000 yuan 125 per subunit
• Fixed costs 1800 yuan 225 per subunit.
• South Korea Plant
• Variable costs 360,000 won 300 per unit
• Fixed cost 490,000 won 400 per unit.
• United States Plant
• Variable costs 100 per unit
• Fixed costs 200 per unit

44
Market Prices for Private Label Sale Alternatives

• China Plant 3600 yuan 450 per subunit
• South Korea Plant 1,560,000 won 1300 per unit.

45
Transfer Prices

• Market Price as a transfer price
• China to South Korea 450 per subunit
• South Korea to U.S. Plant 1,300 per unit

46
Transfer Prices

• 200 of Full Cost as a transfer price
• China to South Korea 2.0 ? (125 225) 700
  per subunit
• South Korea to U.S. Plant 2.0 ? (700 300
  400) 2,800 per unit

Where does this come from?
It is the transfer price of the memory devices
and keyboards from China
47
Transfer Prices

• 300 of Variable Costs
• China to South Korea 3.0 ? 125 375 per
  subunit
• South Korea to U.S. Plant 3.0 ? (375 300)
  2,025 per unit

48
Lets Start in China which makes the memory
devices and keyboards.
These figures were calculated on the earlier
slides.
49
The rest of this data is given in the problem
50
Now Lets Move to South Korea that does assembly.
These are the costs transferred from China under
each transfer pricing assumption.
51
These costs will be transferred to the United
States under each pricing assumption.
52
Finally we package and distribute in the United
States
53
So what transfer pricing scheme gives the company
the greatest profit?
The company will maximize its net income by using
200 of full costs as the transfer price. This is
because method B sources the largest proportion
of income in S. Korea, the country with the
lowest income rate.
54
Problem 22-20

• British Columbia lumber has a raw lumber division
  and a finished lumber division.
• The variable costs are
• Raw Lumber Division 100 per 100 board feet of
  raw lumber.
• Finished Lumber Division 125 per 100 board feet
  of finished lumber.

55
Problem 22-20

• Assume there is no board feet lost in processing
  raw lumber into finished lumber.
• Raw lumber can be sold at 200 per 100 board
  feet.
• Finished lumber can be sold at 275 per 100 board
  feet.

56
Question

• Should British Columbia Lumber processed raw
  lumber into its finished form?
• The way to solve a problem like this is to
  subtract incremental costs from incremental
  revenue.
• (275 -200) - 125 (50) incremental loss
• Do not processed raw lumber into finished lumber.

57
Question

• Assume that internal transfers are made at 110
  of variable costs.
• Will each division maximize its division
  operating income by adopting the action that is
  in the best interests of British Columbia Lumber
  as a whole?

58
Analysis
No, Raw Lumber Division will maximize reported
income by selling raw lumber, while the finished
lumber will maximize division income by selling
finished lumber.
59
Analysis
The best option for the company as a whole is to
sell raw lumber only, as (100 0) is greater
than (10 40). That is not the answer the
110 of variable cost transfer price gives.
60
Question

• Assume that internal transfers are made at market
  prices.
• Will each division maximize its division
  operating income contribution by adopting the
  action that is in the best interest of the
  British Columbias a whole?

61
Analysis
Probably, since the Raw Lumber Division would be
indifferent between selling the lumber in raw or
finished form.
62
Problem 22-23

• The Mornay Company manufactures telecommunication
  equipment.
• The company is marketing divisions throughout the
  world.
• A division in Vietnam imports 1000 units of
  product 4a36 from the United States.

63
The Following Information Is Available
Suppose the US and Austrian tax authorities only
allow transfer prices that are between the full
manufacturing cost of 500 and market price of
650, based on comparable imports into Austria.
64
Additional Information

• The Austrian import duty is charged on the price
  at which the product is transferred into Austria.
• Any import duty paid to the Austrian authorities
  is a deductible expense for calculating Austrian
  income taxes due.

65
Question

• Calculate the after-tax operating income earned
  by the US and Austrian divisions from
  transferring 1000 units of the products at full
  manufacturing costs per unit.
• Do the same calculation based on a transfer price
  of market price of comparable imports (income
  taxes are not included in the computation of the
  cost based transfer prices).

66
The company will maximize profits by setting the
minimum transfer price at full manufacturing cost.
67
Problem 22-25

• The Allison-Chambers Corporation, is organized
  along decentralized product lines with each
  division acting as a profit center.

68
Problem 22-25

• Division managers have full authority with regard
  to sale of division output to outsiders and other
  divisions.
• Division C has always purchased its tractor
  engine component from Division A.

69
More Information

• However, when informed that Division A is
  increasing its selling price to 150, Division
  Cs manager decides to purchase the engine
  component from external suppliers.

70
More Information

• Division A insist that, because of the recent
  installation of some highly specialized equipment
  and the resulting high depreciation charges, it
  will not be able to earn an adequate return on
  its investment unless it raises its price.

71
More Information

• Division As manager appeals to top management
  for support in the dispute with Division C and
  supplies the following operating data.
• Cs annual purchase of the tractor engine
  components 1,000 units
• As variable cost per unit of the tractor engine
  components -- 120
• As fixed cost per unit of the tractor engine
  component -- 20.

72
Question

• Assume there are no alternative uses for the
  internal facilities.
• Determine rather the company as a whole will
  benefit if Division C purchased the component
  from external suppliers at 135 per unit.

73
Analysis
The company as a whole will not benefit if
Division C purchases from external suppliers.
74
Question and Answer

• Question What should the transfer price be set
  at so the division managers acting in their own
  best interest take actions that are in the best
  interest of the company as a whole?
• Answer Any transfer price between 120 and 135
  will achieve goal congruence.

75
Question

• Assume that the internal facilities of Division A
  would not otherwise be idle.
• By not producing 1,000 units for Division C,
  Division As equipment and other facilities would
  be used for other production operations that
  would result in annual cash operating savings of
  18,000.
• Should Division C now purchase from external
  suppliers?

76
Answer
77
Answer
78
Answer
The company as a whole will benefit if it
Division C purchases from external suppliers as
we reduce costs more than the price of purchasing
externally.
79
Question

• Assume that there are no alternative uses for
  Division As internal facilities and that the
  price from outsiders drops 20.
• Should Division C purchase from external
  suppliers?
• What should the transfer price for the components
  be set so that division managers have goal
  congruence?

80
Answer
81
Answer
82
Answer
The company will benefit if Division C purchases
from the external supplier.
Goal congruence will be achieved if the transfer
price is set equal to the total relevant costs of
purchasing from Division A.
83
Problem 22-26

• Refer to Exercise 22-25, assume that Division A
  can sell the 1,000 units to other customers at
  155 per unit, with variable marketing cost of 5
  per unit.
• Determine whether Allison-Chambers will benefit
  if Division C purchases the 1,000 units from
  external suppliers at 135.

84
Problem 22-26
There is a net disadvantage to the company of
having C purchasing from outside the company.
85
Problem 22-26
This disadvantage is more than offset, however by
having Division A sell 1,000 units on the
outside. The decision? Have Division C buy
outside! This nets us 30,000 - 15,000
15,000 additional contribution margin.
86
Problem 22-28

• Europa Inc. has two divisions, A and B, which
  manufacture expensive bicycles.
• Division A produces the bicycle frame, and
  Division B assembles the rest of the bicycle onto
  the frame.

87
Problem 22-28

• There is a market for both the subassembly and
  the final product.
• Each division has been designated as a profit
  center.
• The transfer price for the subassembly has been
  set at the long-run average market price.
• Data for each division follows.

88
Problem 22-28
89
Problem 22-28

• The manager for Division B has made the following
  calculation

Should transfers be made to Division B if there
is no unused capacity in Division A? Is the
market price the correct price?
90
Problem 22-28

• No, transfers should not be made internally, as
  the company as a whole can make more by selling
  the product on the outside.

91
Problem 22-28

• If Division B assembles the bicycle the company
  still has an overall contribution margin per unit
  of 30 as calculated below

92
Problem 22-28

• However, if the company simply sells the bicycle
  frame, its contribution margin is 80 as shown
  below.

93
Problem 22-28

• Since there is no excess capacity, and therefore
  an opportunity cost of every unit sold inside the
  company, the market price is the correct transfer
  price.
• Lets illustrate it with the general guideline
  described in the chapter.

Additional incremental cost per unit
Opportunity Cost Per unit to the Supplying
division
Minimum transfer price


200

120

(200 - 120)
94
Question

• Assume that Division As maximum capacity is
  1,000 units per month and sales to the
  intermediate market are now 800 units.
• Should 200 units be transferred to Division B?
• If so at what transfer price?

95
Answer

• Since there is no opportunity cost, the correct
  price would range between
• incremental cost opportunity cost 120 0
  120.
• This would be the ideal price for Division B
• 120 30 (contribution margin now earned by
  the assembly division) 150
• This would be the ideal price for Division A.
• The negotiated price would probably be somewhere
  between 120 and 150, so that the assembly
  division could make at least some of its desired
  30 contribution margin.

96
Answer

• Above 200 units, the price would be 200 per
  unit, the market price, since there is an
  opportunity cost equal to the contribution given
  up by Division A.
• The transfer price therefore is
• incremental cost of making the frame of 120
  lost contribution margin from not selling to
  outside customers of (200 - 120 80) 120
  80 200!
• At no excess capacity, the correct transfer price
  is always market price.

97
Question

• Suppose Division A quoted a transfer price of
  150 for up to 200 units.
• What would be the contribution margin to the
  company as a whole if the transfer were made?

98
Answer

• Division B would show zero contribution margin.
• The company as a whole, however, would generate a
  contribution margin of 30 per unit on the 200
  units transferred.
• Any price between 120 and 150 would induce the
  transfer that would be desirable for the company
  as a whole.

99
Answer

• A motivational problem may arise regarding how to
  split the 30 contribution between Division A and
  Division B.
• Unless the price is below 150, Division B
  generates no contribution margin and has little
  incentive to buy.

100
Problem 22-30

• Crango Products is a cranberry cooperative with
  two divisions Harvesting and Processing.
• Currently all output is converted into cranberry
  juice by Processing and sold to large companies.
• The Processing Division has a yield of 500
  gallons of juice per 1,000 pounds of cranberries.

101
Problem 22-30

• Cost information is given below

102
Question

• Compute Crangos operating income from harvesting
  500,000 pounds of cranberries during June 2006
  and processing them into juice.

103
Question

• Crango rewards its division managers with a bonus
  equal to 5 of operating income.
• Compute the bonus earned by each manager for each
  of the following transfer pricing methods
• 200 of full cost
• Market price

104
Answer
105
Question

• Which transfer pricing method will each division
  manager prefer?
• The Harvesting Division manager will prefer to
  transfer at 200 of full costs because this
  method gives a higher bonus. The Processing
  Division manager will prefer transfer at market
  price for its higher resulting bonus.

106
Question

• How might Crango resolve any conflicts that may
  arise on the issue of transfer pricing?
• Basing division managers bonuses on overall
  Crango profits in addition to division operating
  income. This will motivate each manager to
  consider what is best for Crango overall and not
  be concerned with the transfer price alone.
• Letting the two divisions negotiate the transfer
  price between themselves. However, this may
  result in constant re-negotiation between the two
  managers each accounting period.
• Using dual transfer prices However, a cost-based
  transfer price will not motivate cost control by
  the Harvesting Division manager. It will also
  insulate that division from the discipline of
  market prices.

107
Problem 22-32

• Industrial Diamonds has two divisions
• South African Mining Division which polishes raw
  diamonds for use in industrial polishing tools.
• US Processing Division which polishes raw
  diamonds for use in industrial cutting tools.

108
Problem 22-32

• The Processing Divisions yield is 50.
• It takes two pounds of raw diamonds to produce 1
  pound of top-quality polished industrial
  diamonds.
• Although all of the Mining Divisions annual
  output of 2,000 pounds of raw diamonds is sent
  for processing to the United States, there is
  also an active market for raw diamonds in South
  Africa.

109
Problem 22-32

• The foreign exchange rate is 7 ZAR (South African
  Rands) 1.00 US Dollar.
• The information shown on the following slide is
  for the two divisions.

Largest hand dug diamond mine in South Africa
110
Information on Diamond Divisions
111
Question

• Compute the annual pre-tax operating income, in
  US dollars, of each division using 200 of full
  cost and market price transfer pricing methods.
• Then calculate after-tax income using same
  methods.

112
AnswerPre-tax Operating Income
113
AnswerAfter-Tax Income
The Mining Division manager would prefer 200 of
full cost for the purpose of calculating a bonus.
The Processing Division manager, however, would
prefer market price.
114
Question

• In addition to tax minimization, what other
  factors might Industrial Diamonds consider in
  choosing a transfer-pricing method?
• Performance evaluation
• Management motivation
• Pricing and product emphasis
• External market recognition
• Overall income of the company
• Income or dividend repatriation restrictions
• Competitive position of subsidiaries in their
  respective markets
•  

115
AnswerAfter-Tax Income
Due to differing tax rates, the company will pay
less tax and keep more profit if they use full
cost as the transfer price.
116
Problem 22-33

• Dropped as per Web.

The End!