1. 2009 Foster School of Business Cost Accounting L.DuCharme 1 Management Control Systems, Transfer Pricing, and Multinational Considerations Chapter 22

2. 2009 Foster School of Business Cost Accounting L.DuCharme 2 Overview What is a Management Control System? Centralized vs. decentralized control structure Transfer pricing: –Function –Setting TPs –Dual TPs –Negotiated TPs (Calculating Min. & Max. range) –International tax issues

3. 2009 Foster School of Business Cost Accounting L.DuCharme 3 Management Control Systems A management control system is a means of gathering and using information. It guides the behavior of managers and employees.

4. 2009 Foster School of Business Cost Accounting L.DuCharme 4 Management Control Systems Financial data Formal control system Nonfinancial data Informal control system

5. 2009 Foster School of Business Cost Accounting L.DuCharme 5 Evaluating Management Control Systems MotivationGoal congruence Effort Lead to rewards MonetaryNonmonetary

6. 2009 Foster School of Business Cost Accounting L.DuCharme 6 Organization (control) Structure Total decentralization Total centralization

7. 2009 Foster School of Business Cost Accounting L.DuCharme 7 Benefits of Decentralization Creates greater responsiveness to local needs Leads to gains from quicker decision making Increases motivation of subunit managers Assists management development and learning Sharpens the focus of subunit managers

8. 2009 Foster School of Business Cost Accounting L.DuCharme 8 Limitations of Decentralization Suboptimal decision making may occur Focuses the manager’s attention on the subunit rather than the organization as a whole Increases the costs of gathering information Results in duplication of activities

9. 2009 Foster School of Business Cost Accounting L.DuCharme 9 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. Control Problem: Barings Bank (200 yrs old)—1995 Nick Leeson caused over ₤1 B loss.

10. 2009 Foster School of Business Cost Accounting L.DuCharme 10 Responsibility Centers Cost center Revenue center Investment center Profit center

11. 2009 Foster School of Business Cost Accounting L.DuCharme 11 Transfer Pricing A transfer price 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 an organization.

12. 2009 Foster School of Business Cost Accounting L.DuCharme 12 Transfer Pricing Transfer pricing should: (1) help achieve a company’s strategies and goals. (2) fit the organization’s structure (3) promote goal congruence (4) promote a sustained high level of management effort

13. 2009 Foster School of Business Cost Accounting L.DuCharme 13 Transfer-Pricing Methods Market-based transfer prices Cost-based transfer prices Negotiated transfer prices

14. 2009 Foster School of Business Cost Accounting L.DuCharme 14 Market-Based Transfer Prices By using market-based transfer prices in a perfectly competitive market, a company can achieve the following: Goal congruence Management effort Subunit performance evaluation Subunit autonomy

15. 2009 Foster School of Business Cost Accounting L.DuCharme 15 Market-Based Transfer Prices Market prices also serve to evaluate the economic viability and profitability of divisions individually.

16. 2009 Foster School of Business Cost Accounting L.DuCharme 16 Market-Based Transfer Prices When supply outstrips demand, market prices may drop well below their historical average. Distress prices are the drop in prices expected to be temporary. Basing transfer prices on depressed market prices will not always lead to optimal decisions for an organization.

17. 2009 Foster School of Business Cost Accounting L.DuCharme 17 Cost-based Transfer Prices When transfer prices are based on full cost plus a markup, suboptimal decisions can result.

18. 2009 Foster School of Business Cost Accounting L.DuCharme 18 Dual Transfer Prices An example of dual pricing is for Larry & Co. to credit the Selling Division with 112% of the full cost transfer price of $24.64 per barrel of crude oil. Debit the Buying Division with the market-based transfer price of $23 per barrel of crude oil. And debit a corporate account for the difference!

19. 2009 Foster School of Business Cost Accounting L.DuCharme 19 Negotiated Transfer Prices Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

20. 2009 Foster School of Business Cost Accounting L.DuCharme 20 General Guideline: min. & max. transfer price Minimum transfer price = Incremental costs per unit incurred up to the point of transfer + Opportunity costs per unit to the selling division Incremental cost often times = variable cost Opportunity costs often times = lost CM Opportunity costs could = lost savings Maximum transfer price = Market price

21. 2009 Foster School of Business Cost Accounting L.DuCharme 21 Min. & Max. transfer price-- examples Some examples: (1) Slowcar (2) S.F. Manufacturing

22. 2009 Foster School of Business Cost Accounting L.DuCharme 22 Slowcar Company The Assembly Division of SLOWCAR Company has offered to purchase 90,000 batteries from the Electrical Division (ED) for $104 per unit. At a normal volume of 250,000 batteries per year, production costs per battery are: Direct materials $40 Direct labor 20 Variable factory overhead 12 Fixed factory overhead 42 Total $114 The Electrical Division has been selling 250,000 batteries per year to outside buyers for $136 each. Capacity is 350,000 batteries/year. The Assembly Division has been buying batteries from outside suppliers for $130 each. Should the Electrical Division manager accept the offer? Will an internal transfer be of any benefit to the company?

23. 2009 Foster School of Business Cost Accounting L.DuCharme 23 SF Manufacturing The SF Manufacturing Co. has two divisions in Iowa, the Supply Division and the BUY Division. Currently, the BUY Division buys a part (3,000 units) from Supply for $12.00 per unit. Supply wants to increase the price to BUY to $15.00. The controller of BUY claims that she cannot afford to go that high, as it will decrease the division’s profit to near zero. BUY can purchase the part from an outside supplier for $14.00. The cost figures for Supply are: Direct Materials $3.25 Direct Labor 4.75 Variable Overhead 0.60 Fixed Overhead 1.20 A. If Supply ceases to produce the parts for BUY, it will be able to avoid one- third of the fixed MOH. Supply has no alternative uses for its facilities. Should BUY continue to get the units from Supply or start to purchase the units from the outside supplier? (From the standpoint of SF as a whole). (What is the min. & max. transfer price if BUY and SUPPLY negotiate?)

24. 2009 Foster School of Business Cost Accounting L.DuCharme 24 SF Mfg.—continued Now, assume that Supply could use the facilities currently used to produce the 3,000 units for BUY to make 5,000 units of a different product. The new product will sell for $16.00 and has the following costs: Direct Materials$3.00 Direct Labor 4.30 Variable Overhead 5.40 B. What is the min. & max. transfer price if BUY and SUPPLY negotiate? C. What should be done from the company’s point of view? Why?

25. 2009 Foster School of Business Cost Accounting L.DuCharme 25 Comparison of Methods Achieves Goal Congruence Market Price:Yes, if markets competitive Cost-Based:Often, but not always Negotiated:Yes

26. 2009 Foster School of Business Cost Accounting L.DuCharme 26 Comparison of Methods Useful for Evaluating Subunit Performance Market Price:Yes, if markets competitive Cost-Based: Difficult, unless transfer price exceeds full cost Negotiated:Yes

27. 2009 Foster School of Business Cost Accounting L.DuCharme 27 Comparison of Methods Motivates Management Effort Market Price:Yes Cost-Based: Yes, if based on budgeted costs; less incentive if based on actual cost Negotiated:Yes

28. 2009 Foster School of Business Cost Accounting L.DuCharme 28 Comparison of Methods Preserves Subunit Autonomy Market Price:Yes, if markets competitive Cost-Based:No, it is rule based Negotiated:Yes

29. 2009 Foster School of Business Cost Accounting L.DuCharme 29 Comparison of Methods Other Factors Market Price:No market may exist Cost-Based: Useful for determining full-cost; easy to implement Negotiated: Bargaining takes time and may need to be reviewed

30. 2009 Foster School of Business Cost Accounting L.DuCharme 30 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 (arm’s length). This still leaves a little “room to wiggle.”