Management Control Systems,

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CH:22
, 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.
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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
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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
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-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
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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.
-The external market price to outside parties is $60 per barrel.
-The Refining Division is operating at 30,000 barrels capacity per day.
External purchase price for crude oil per
barrel: $23
External market price for supplying crude oil per
barrel: $13
Refining Division:
Variable cost per barrel of gasoline $8 $ 8
Fixed cost per barrel of gasoline $4
Total $ 12
Transportation Division:
Variable cost per barrel of crude oil $ 2
Fixed cost per barrel of crude oil $ 3
فغبTotal $ 5
The pipeline can carry 35,000 barrels per day.
The division is buying 20,000 barrels per day.
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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 ($4 × 500) 2,000
=Operating income$ 1,000
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-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?
Refining Division :
Revenues ($60 × 500) $30,000
Deduct costs (-)
Transferred-in ($20.16 × 1,000) 20,160
Division variable ($8.00 × 500) 4,000
Division fixed ($4.00 × 500) 2,000
Transportation Division:
Revenues: ($20.16 × 1,000) = $20,160
Deduct costs: ($18.00 × 1,000) = 18,000
operating income $ 2,160
Operating income $ 3,840
-What is the operating income of both divisions together?
Transportation Division
Refining Division(+)
$2,160
3,840
Total
$6,000
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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 –
380,000 = 80,000 )
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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
Variable costs per barrel of crude oil
$17
2
Fixed costs per barrel of crude oil
3
Total
$22
112% × $22 = $24.64 SO $24.64 × 20,000 = $492,800
What is the maximum transfer price?
It is the price that the Refining Division can pay in the local external market
($23).
What is the minimum transfer price?
The minimum transfer price is $19 per barrel.
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?
$17.00 + $2.00 + $1.33 = $20.33
* Negotiated Transfer Prices :
Negotiated transfer prices arise from the outcome of a bargaining process
between selling and buying divisions.
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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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