Chapt 22 Management-Control Systems, Transfer Pricing, and Multinational Considerations We will cover only “transfer pricing”, pages 840-841; 846-862 © 2012 Pearson Prentice Hall. All rights reserved.

Transfer Pricing Learning Objectives Apply a general guideline for determining a minimum transfer price under full and idle (unused) capacity Calculate the transfer price range and decide if, economically, a transfer between sub-units should be made Know the four key transfer pricing criteria needed to help firms achieve their goals Understand the potential impact of income taxes in multinational transfer pricing © 2012 Pearson Prentice Hall. All rights reserved.

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. © 2012 Pearson Prentice Hall. All rights reserved.

Transfer Pricing 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. © 2012 Pearson Prentice Hall. All rights reserved.

Transfer Pricing To help a company achieve its goals, transfer prices should meet four key criteria: Promote goal congruence so that division managers acting in their own interest will take actions that are aligned with the objectives of top management. Induce managers to exert a high level of effort. Help top managers evaluate the performance of individual subunits. Preserve autonomy of subunits if top managers favor a high degree of decentralization. © 2012 Pearson Prentice Hall. All rights reserved.

Transfer Pricing There are three broad categories of transfer price methods that top managers can use to determine transfer prices. They are: Market-based transfer prices. Cost-based transfer prices. Hybrid transfer prices. We will focus on Hybrid transfer prices. © 2012 Pearson Prentice Hall. All rights reserved.

Market-Based Transfer Prices Top management uses the price of similar products or services that is publicly available. Sources of prices include trade associations, competitors, and so on. 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 One of the above, plus some markup Useful when market prices are unavailable, inappropriate, or too costly to obtain © 2012 Pearson Prentice Hall. All rights reserved.

Hybrid Transfer Prices Takes into account both cost and market information Types of hybrid transfer prices: 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 pricing © 2012 Pearson Prentice Hall. All rights reserved. 8

Minimum Transfer Price - useful in negotiating a 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 or lost on outside sales. © 2012 Pearson Prentice Hall. All rights reserved.

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. 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. © 2012 Pearson Prentice Hall. All rights reserved.

Multinational Transfer Pricing and Tax Considerations Section 482 of the U.S. Internal Revenue Code governs taxation of multinational transfer pricing. It 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 can be market-based or “cost-plus” based. © 2012 Pearson Prentice Hall. All rights reserved.

Multinational Transfer Pricing and Tax Considerations In 1991, the IRS went to trial against Yamaha Motor, Hitachi Ltd, and other Japanese electronics companies. The issue was ‘transfer pricing’ cases where the IRS was trying to collect more than $12 Billion in additional taxes from more than 30 companies. The government claimed that these companies underpaid taxes on the profits of their US subsidiaries by deflating the prices the US subs charge to their foreign parent for goods and services. “Japanese-owned companies’ US sales rose 50%, but reported Net Income (they paid taxes on) dropped by two-thirds!” © 2012 Pearson Prentice Hall. All rights reserved.

Multinational Transfer Pricing and Tax Considerations US Subsidiary (High tax) Foreign Corp (Low tax) P P -VC____ -VC______ CM CM -F -F =Op Inc =Op Inc x High taxes x Low taxes Net inc Net inc © 2012 Pearson Prentice Hall. All rights reserved.

Transfer Pricing – exercises and problems Print the Transfer Pricing examples. © 2012 Pearson Prentice Hall. All rights reserved.