Management-Control Systems Transfer Pricing and Multinational Considerations Copyright

Management-Control Systems, Transfer Pricing, and Multinational Considerations Copyright © 2015 Pearson Education, Inc. All Rights Reserved

CHAPTER 22 LEARNING OBJECTIVES 1. 2. 3. 4. 5. Describe a management control system and its three key properties Describe the benefits and costs of decentralization Explain transfer prices and the four criteria managers use to evaluate them Calculate transfer prices using three methods Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -2

CHAPTER 22 LEARNING OBJECTIVES, CONCLUDED 6. 7. 8. 9. Understand how to avoid making suboptimal decisions when transfer prices are based on full cost plus a markup Describe the range of feasible transfer prices when there is unused capacity and alternative methods for arriving at the eventual hybrid price Apply a general guideline for determining a minimum transfer price Incorporate income tax considerations in multinational transfer pricing Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -3

MANAGEMENT CONTROL SYSTEMS A 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. Well-designed management control systems use information from both within the company and from outside the company. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -4

MANAGEMENT CONTROL SYSTEMS, CONT’D 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 formal control system is composed of several systems such as: The management accounting system for information about the firm’s costs, revenues and income. The human resources system for information about the recruiting and training of employees, absenteeism and accidents. The quality system for information about yields, defective products and late deliveries to customers. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -5

MANAGEMENT CONTROL SYSTEMS, CONCLUDED Consist of formal and informal control systems: The informal management control system includes the shared values, loyalties, and mutual commitments among members of the organization, the company’s culture, and the unwritten norms about acceptable behavior for managers and other employees. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -6

EFFECTIVE MANAGEMENT CONTROL To be effective, management control systems should be closely aligned to the firm’s strategies and goals. Management control systems should also be designed to support the organizational responsibilities of individual managers. Management control systems must be aligned with an organization’s structure. An organization with a decentralized structure will have different issues to consider when designing its management control system than a firm with a centralized structure. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -7

EFFECTIVE MANAGEMENT CONTROL, CONT’D Effective management control systems should motivate managers and other employees. Motivation is the desire to attain a selected goal (goal-congruence aspect) combined with the resulting pursuit of that goal (effort aspect). Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -8

TWO ASPECTS OF MOTIVATION Goal congruence exists when individuals and groups work toward achieving the organization’s goals—managers working in their own best interest take actions that align with the overall goals of top management. Effort is the extent to which managers strive or endeavor in order to achieve a goal. Effort goes beyond physical exertion to include mental actions as well. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -9

DECENTRALIZATION Decentralization is an organizational structure that gives managers at lower levels the freedom to make decisions. Autonomy is the degree of freedom to make decisions. The greater the freedom, the greater the autonomy. Subunit refers to any part of an organization. It may be a large division or a small group. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -10

BENEFITS OF DECENTRALIZATION Creates greater responsiveness to the needs of a subunit’s customers, suppliers, and employees. Leads to gains from faster decision making by subunit managers. Assists management development and learning. Sharpens the focus of subunit managers and broadens the reach of top management. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -11

COSTS OF DECENTRALIZATION Leads to suboptimal decision making, which arises when a decision’s benefit to one subunit is more than offset by the costs or loss of benefits to the organization as a whole. Also called incongruent decision making or dysfunctional decision making. Leads to unhealthy competition. Results in duplication of output. Results in duplication of activities. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -12

COMPARING BENEFITS AND COSTS Top managers must compare the benefits and costs of decentralization when choosing an organizational structure. Decisions related to the type and source of long-term financing are made least frequently at the decentralized level. Centralizing its income tax strategies allows an organization to optimize across subunits by offsetting the income in one subunit with losses in others. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -13

DECENTRALIZATION AND MULTINATIONAL FIRMS Multinational firms, companies that operate in multiple countries, are often decentralized because centralized control of a company with subunits around the world is often physically and practically impossible. Decentralization enables managers in different countries to make decisions that exploit their knowledge of local business and political conditions and to deal with uncertainties in their individual environments. Biggest drawback to international decentralization: loss or lack of control and the resulting risks. Multinational corporations that implement decentralized decision making usually design their management control systems to measure and monitor the performance of divisions. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -14

CHOICES ABOUT RESPONSIBILITY CENTERS Recall from chapter 6 that a responsibility center is a segment or subunit of the organization whose manager is accountable for a specified set of activities. To measure the performance of subunits in centralized or decentralized companies, the management control system uses one or a mix of the four types of responsibility centers: Cost center Revenue center Profit center Investment center Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -15

TRANSFER PRICING In a decentralized organization, much of the decision-making power resides in its individual subunits. Those subunits often supply goods or services to one another. In that case, top management uses transfer prices to coordinate the actions of the subunits and to evaluate the performance of their managers. Transfer price—the price one subunit (department or division) charges for a product or service supplied to another subunit of the same organization. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -16

TRANSFER PRICING, CONT’D The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit affecting each subunit’s operating income. The operating incomes can be used to evaluate the subunits’ performances and to motivate their managers. Intermediate product—the product or service transferred between subunits of an organization. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -17

CRITERIA FOR EVALUATING TRANSFER PRICES To help a company achieve its goals, transfer prices should meet four key criteria: 1. Promote goal congruence so that division managers acting in their own interest will take actions that are aligned with the objectives of top management. 2. Induce managers to exert a high level of effort. 3. Help top managers evaluate the performance of individual subunits. 4. Preserve autonomy of subunits if top managers favor a high degree of decentralization. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -18

THREE TRANSFER PRICING METHODS There are three broad categories of methods top managers can use to determine transfer prices. They are as follows: 1. Market-based transfer prices. 2. Cost-based transfer prices. 3. Hybrid transfer prices. Under what circumstances should each of these options be used? Let’s look in more detail at each category. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -19

MARKET-BASED TRANSFER PRICES Top managers may choose to use the price of a similar product or service that is publicly available. Sources of prices include trade associations, competitors, and so on. Or, they may select the external price a subunit charges outside customers. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -20

MARKET-BASED TRANSFER PRICES, CONT’D Transferring products or services at market prices generally leads to optimal decisions when three conditions are satisfied: The market for the intermediate product is perfectly competitive. 2. The interdependencies of subunits are minimal. 3. There are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally. 1. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -21

MARKET-BASED TRANSFER PRICES, CONCLUDED A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions. Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and preserve subunit autonomy. Perhaps should not be used if the market is currently in a state of “distress pricing. ” Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -22

COST-BASED TRANSFER PRICES Top managers choose a transfer price based on the costs of producing the intermediate product. Examples include: Full-cost bases. Variable-cost bases. Useful when market prices are unavailable, inappropriate, or too costly to obtain, such as when markets are not perfectly competitive, when the product is specialized or when the internal product is different from the products available externally in terms of its quality and the customer service provided for it. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -23

COST-BASED TRANSFER PRICES, CONT’D Despite its limitations, managers generally prefer to use full-cost-based transfer prices because: They represent relevant costs for long-run decisions. They facilitate external pricing based on variable and fixed costs. They are the least costly to administer. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -24

COST-BASED TRANSFER PRICES, CONCLUDED Full-cost transfer pricing also raises many issues: How are the subunit’s indirect costs allocated to products? 2. Have the correct activities, cost pools and cost-allocation bases been identified? 3. Should the chosen fixed-cost rates be actual or budgeted? 1. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -25

HYBRID TRANSFER PRICES Takes into account both cost and market information. Top management may set the prices by specifying a transfer price that is an average of the cost of producing and transporting the product internally and the market price for comparable products. Types of hybrid transfer prices: Prorating the difference between maximum and minimum transfer prices. Negotiated pricing. (most common hybrid type) Dual pricing. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -26

HYBRID TRANSFER PRICING, CONT’D Prorating the difference between the maximum and minimum cost-based transfer prices. Dual-pricing—using two separate transferpricing methods to price each transfer from one subunit to another. Example: selling division receives full cost pricing, and the buying division pays market pricing. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -27

NEGOTIATED TRANSFER PRICES Occasionally, subunits of a firm are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties. May or may not bear any resemblance to cost or market data. Often used when market prices are volatile. Represent the outcome of a bargaining process between the selling and buying subunits. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -28

COMPARISON OF TRANSFERPRICING METHODS Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -29

MINIMUM TRANSFER PRICE The minimum transfer price in many situations should be: Incremental cost is the additional cost of producing and transferring the product or service. Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally. Copyright © 2015. Pearson Education, Inc. All Rights Reserved 22 -30

HOW MULTINATIONALS USE TRANSFER PRICING TO MINIMIZE THEIR TAXES Transfer pricing is an important accounting priority for managers around the world. The reason is that parent companies can save large sums of money in taxes depending on the transfer pricing methods they use. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -31

HOW MULTINATIONALS USE TRANSFER PRICING TO MINIMIZE THEIR TAXES, CONCLUDED Transfer prices affect not just income taxes, but also payroll taxes, customs duties, tariffs, sales taxes, value-added taxes, environment-related taxes, and other government levies. Tax factors, particularly income taxes, are an important consideration for managers when determining transfer prices. Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -32

TERMS TO LEARN PAGE NUMBER REFERENCE Autonomy Page 843 Decentralization Page 843 Dual pricing Page 856 Dysfunctional decision making Page 844 Effort Page 842 Goal congruence Page 842 Incongruent decision making Page 844 Intermediate product Page 846 Management control system Page 841 Motivation Page 842 Perfectly competitive market Page 850 Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -33

TERMS TO LEARN PAGE NUMBER REFERENCE Suboptimal decision making Page 844 Transfer price Page 846 Copyright © 2015 Pearson Education, Inc. All Rights Reserved 22 -34

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