topic 7 management control systems, transfer pricing, and multinational considerations

Topic 7

Management Control Systems,

Transfer Pricing,

and Multinational Considerations

22-2To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.

Management Control Systems

Management Control Systems are 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



Many management control systems contain some or all of the balanced scorecard perspectives:

1. Financial

2. Customer

3. Internal Business Process

4. Learning and Growth



Consist of Formal and Informal control systems: Formal systems include explicit rules,

procedures, performance measures, and incentive plans that guide the behavior of its managers and other employees

Informal systems include shared values, loyalties, and mutual commitments among members of the company, corporate culture, and unwritten norms about acceptable behavior


Evaluating Management Control Systems To be effective, management control systems

should be closely aligned to the firm’s strategies and goals

Systems should be designed to fit the company’s structure and decision-making responsibility of individual managers


Evaluating Management Control Systems Effective management control systems

should also motivate managers and their employees

Motivation is the desire to attain a selected goal (goal-congruence) combined with the resulting pursuit of that goal (effort)


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 exertions toward reaching a goal, including both physical and mental actions


Organization 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


Decentralization vs. 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

Companies’ structures generally fall somewhere in between these two extremes, as each has benefits and costs. A structure is chosen based on cost vs. benefit analysis


Benefits of Decentralization

Creates greater responsiveness to local needs

Leads to gains from faster decision making Increases motivation of subunit managers Assists management development and

learning Sharpens the focus of subunit managers


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


Costs of Decentralization

Focuses manager’s attention on the subunit rather than the company as a whole

Increases costs of gathering information Results in duplication of activities


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


Choices about Responsibility Centers Regardless of the degree of decentralization,

management control systems use one or a mix of the four types of responsibility centers: Cost Center Revenue Center Profit Center Investment Center


Transfer Pricing

Transfer Price – the price one subunit (department or division) 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


Transfer Pricing

The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income

Intermediate Product – the product or service transferred between subunits of an organization


Three Transfer Pricing Methods

1. Market-based Transfer Prices

2. Cost-based Transfer Prices

3. Negotiated Transfer Prices


Market-Based Transfer Prices

Top management chooses to use the price of a similar product or service that is publicly available. Sources of prices include trade associations, competitors, etc.



Lead to optimal decision making when three conditions are satisfied:

1. The market for the intermediate product is perfectly competitive

2. Interdependencies of subunits are minimal3. 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



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 subunit autonomy

Perhaps should not be used if the market is currently in a state of “distress pricing”


Cost-Based Transfer Prices

Top management chooses a transfer price based on the costs of producing the intermediate product. Examples include: Variable Production Costs Variable and Fixed Production Costs Full Costs (including life-cycle costs) One of the above, plus some markup

Useful when market prices are unavailable, inappropriate, or too costly to obtain


Cost-Based Transfer Pricing Alternatives Prorating the difference between the

maximum and minimum cost-based transfer prices

Dual-Pricing – using two separate transfer-pricing methods to price each transfer from one subunit to another. Example: selling division receives full cost pricing, and the buying division pays market pricing


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


Comparison of Transfer-Pricing Methods

Criteria Market-Based

Cost- Based Negotiated

Achieves Goal Congruence

Yes, when markets are competitive

Often, but not always

Yes

Useful for Evaluating Subunit Performance


Difficult unless transfer price

exceeds full cost and even then is

somewhat arbitrary

Yes, but transfer prices are affected

by bargaining strengths of the

buying and selling divisions




Cost- Based Negotiated

Motivates Management Effort

Yes Yes, when based on budgeted costs; less incentive to control

costs if transfers are based on actual costs

Yes

Preserves Subunit Autonomy


No, because it is rule-based

Yes, because it is based on

negotiations between subunits




Cost- Based

Negotiated

Other Factors No market may exist or markets

may be imperfect or in distress

Useful for determining full

cost of products; easy to

implement

Bargaining and negotiations take

time and may need to be reviewed

repeatedly as conditions

change


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, environment-related taxes, and other government levies


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

Minimum Transfer Price =

Incremental cost per unit incurred up to the point of

transfer +Opportunity Cost per unit

to the selling subunit


Multinational Transfer Pricing and Tax Considerations Section 482 of the US Internal Revenue Code

governs taxation of multinational transfer pricing

Section 482 requires that transfer prices between a company and its foreign division or subsidiary equal the price that would be charged by an unrelated third party in a comparable transaction Transfer price could be market-based or “cost-plus”

based

topic 7 management control systems, transfer pricing, and multinational considerations

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