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22

ManagementControlSystems,TransferPricing,andMultinationalConsiderations

TRANSITIONNOTES

Thesectiononevaluatingmanagementcontrolsystemshasbeenstreamlinedandrewrittenashasthesectioncomparingbenefitsandcostsofdecentralization.Thematerialondistresspricesindiscussingmarket-basedtransferpricinghasbeenexpanded.Theillustrationofcost-basedtransferpricingusingfullcostasabasishasbeenrewritten.Thesectiononnegotiatedtransferpriceshasbeenexpanded.

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I.LEARNINGOBJECTIVES

1.Describeamanagementcontrolsystemanditsthreekeyproperties

2.Describethebenefitsandcostsofdecentralization

3.Explaintransferpricesandfourcriteriausedtoevaluatethem

4.Calculatetransferpricesusingthreemethods

5.Illustratehowmarket-basedtransferpricespromotegoalcongruenceinperfectlycompetitivemarkets

6.Understandhowtoavoidmakingsuboptimaldecisionswhentransferpricesarebasedonfullcostplusamarkup

7.Describetherangeoverwhichtwodivisionsnegotiatethetransferpricewhenthereisunusedcapacity

8.Applyageneralguidelinefordeterminingaminimumtransferprice

9.Incorporateincometaxconsiderationsinmultinationaltransferpricing

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II.CHAPTERSYNOPSIS

Chapter22discussesthelinksamongmanagementcontrolsystems,strategy,organizationalstructure,andaccountinginformation.Thecostsandbenefitsofcentralizedanddecentralizedorganizationalstructuresarecompared.Pricingofproductstransferredbetweendifferentcompanydivisionsordepartmentsisreviewedandtheimpactoftransferpriceonsubunitandcorporateprofitsisexamined.

III.POINTSOFEMPHASIS

1.Studentsfrequentlyareawareofthetermmanagementcontrolsystem,butmaynothaveagraspofwhatitreallyis.Theyshouldunderstandthedefinitionandpropertiesofsuchasystem.

2.Decentralizationisacentralconceptinbusinesseswithdiverseoperations.Studentsshouldbeawareoftheadvantagesanddisadvantagesofadecentralizedmanagementstructure.

3.Withtheprevalenceofdecentralization,transferpricingisprevalent.Studentsshouldunderstandtheneedfortransferpricinginadecentralizedoperation,thecriteriatobeconsideredinsettingtransferprices,andthemethodsbywhichtransferpricingmaybedone.Becertaintheyunderstandthatthereisnofinal,correctwaytodotransferpricing;astheenvironmentchanges,sowillthetransfer-pricingmethods.

4.Inanincreasinglyglobaleconomy,internationalissuesintransferpricingrelatedtoincomeandothertaxesshouldbetakenunderconsideration.Theeffectsofdifferenttaxratesshouldbeunderstood,alongwithstrategiesthatareavailabletoexploitthesedifferences.

IV.CHAPTEROUTLINE

1

Describeamanagementcontrolsystem

...gathersinformationforplanningandcontrol

decisions

anditsthreekeyproperties

...alignswithstrategy,supportsorganizational

responsibilityofmanagers,andmotivates

employees

306

1.1Amanagementcontrolsystemisameansofgatheringandusinginformationtoaidandcoordinateplanningandcontroldecisionsthroughoutanorganization.

1.2Somecompaniesdesignthemanagementcontrolsystemaroundtheconceptofthebalancedscorecard,withfinancialandnonfinancialinformationineachofthefourperspectivesofthescorecard:

?Financialperspective—stockprice,netincome,ROI

?Customerperspective—customersatisfaction,repeatpurchases,marketshare

?Internal-business-process-perspective—quality,downtime,defectrate

?Learning-and-growthperspective—Employeetraining,absenteeism

TEACHINGPOINT.Inmaintainingstudentawarenessofthebalancedscorecard,havethembrainstormmeasuresthatagoodmanagementcontrolsystemwouldincludeineachoftheperspectives.Whentheyidentifyameasure,havethemlabelitasfinancialornonfinancialandexplainwhyitisausefulmeasureasapartofthatperspective.

1.3Most(ifnotall)companieswillhavetheformalmanagementcontrolsystemandtheinformalsystem.Theformalmanagementcontrolsystemconsistsoftheexplicitrules,procedures,performancemeasures,andincentiveplansthatguidethebehaviorofmanagersandemployees.

1.4Theinformalmanagementsystemincludessharedvalues,loyalties,andmutualcommitmentsamongmembersofthecompany,companyculture,andunwrittennormsaboutacceptablebehavior.

TEACHINGPOINT.Astimeallows,exploreaspectsoftheinformalmanagementsystem—howitcanworkforthecompany,andhowitcanbeadetriment.Havethestudentsidentifyelementsoftheinformalsystemtheyhaveencounteredinorganizationstheyhavebeenapartof.

1.5Effectivemanagementcontrolsystemsshouldbecloselyalignedwiththecompany’sstrategiesandgoalsandshouldfittheorganizationalstructureanddecision-makingresponsibilityofindividualmanagers.

1.6Threekeypropertiesofaneffectivesystemare:

?Motivation—thedesireonthepartofmanagersandotheremployeestoattainaselectedgoal,combinedwiththepursuitofthatgoal.

?Goalcongruence—Individualsandgroupsworktowardachievingtheorganization’sgoalwhileworkingintheirownbestintereststhatalignwiththeoverallgoalsoftopmanagement..

TEACHINGPOINT.ObservethatgoalcongruenceisNOTthesameasgoaladoption.Theemployeehasgoalsthatarenotthesameasthecompanygoals,butbyworkingtowardhis/hergoalstheemployeehelpsmeetthecompanygoals.

307

?

Effort—exertiontowardachievingagoal.Thisgoesbeyondphysicalexertiontoincludephysicalandmentalactions.

RefertoQuizQuestion1

2

Describethebenefitsofdecentralization

...responsivenesstocustomers,fasterdecision

making,managementdevelopment

andthecostsofdecentralization

...lossofcontrol,duplicationofactivities

2.1Amanagementcontrolsystemmustfitthestructureoftheorganization.Althoughgenerallyseenasbeneficial,adecentralizedsystemhasadditionalissuestoconsiderinthestructureofitsmanagementcontrolsystem.

2.2Decentralizationisthefreedomformanagersatlowerlevelsoftheorganizationtomakedecisions.Autonomyisthedegreeoffreedomtheyhave.

2.3Thereareanumberofbenefitstodecentralization.

?Therecanbegreaterresponsivenesstolocalneeds.Themanageronsiteshouldhaveagreaterfeelforwhatwillsellinthestorethansomeoneinacorporateofficethousandsofmilesaway.

?Duetotheshortdecisionchain,decisionscanbemadefaster,givingthecompanyanopportunitytorespondtoopportunitiesmorequickly.

?Subunitmanagersexperienceincreasedmotivationwhengiventhechancetoexerciseinitiative.

?Givingmanagersmoreresponsibilityhelpsdevelopanexperiencedpoolofmanagementtalenttofillhigher-levelmanagementpositionswithinthecompany.

?Thesubunitmanagersaremorefocused.Topmanagementisfreetospendmoretimeandeffortonstrategicplanning.

2.4Forallitsbenefits,though,decentralizationisnotwithoutitscosts.

?Decentralizationmayleadtosuboptimaldecisionmakingwhenadecisiontobenefitonesubunitismorethanoffsetbythecoststotheorganizationasawhole.

oSuboptimaldecisionmaking—alsocalledincongruentdecisionmakingordysfunctionaldecisionmaking—ismostlikelytooccurwhenthesubunitsinthecompanyarehighlyinterdependent.

308

o

Suboptimaldecisionmakingalsooccurswhensubunitmanagersdonothavethenecessaryskillstodotheirjobs.

?Manager’sattentionisfocusedmoreonthesubunitratherthanthecompanyasawhole,andloyaltiesmayliewiththesubunitfirst.

?Thereisanincreasedcostofgatheringinformationasmanagersmayneedtospendtoomuchtimeobtaininginformationaboutvarioussubunitswithintheorganizationinordertocoordinatetheiractions.

?Theremaybeduplicationofactivitiesasseveralsubunitsmayundertakethesameactionseparately.

2.5Inchoosinganorganizationalstructure,topmanagementmustcomparethecostsandbenefitsofdecentralization.

?Decentralizationinmultinationalcompaniespresentsaspecialchallenge.Centralizedcontrolmaybephysicallyimpracticalduetolanguages,customs,cultures,businesspractices,rules,lawsandregulationsthat

varyfromcountrytocountry.

?Inaddition,whendecentralizingwithmultinationals,thereisariskfromthelackofcontrol.

2.6Adecentralizedorganizationmusthaveameasureoftheperformanceofthedecentralizedsubunits.

TEACHINGPOINT.Inchoosingthemethodtomeasuretheperformanceofadecentralizedunit,managersmustrememberthatresponsibilitymustbeequaltocontrol.Someonecannotbeheldresponsibleforwhattheycannotcontrol.Touseanexampleinclass,youcanselectastudentandsaysomethingtotheeffectthatthisstudentmadeabadgradeonthelasttest.Butitwasn’thisfault,Iamgoingtoholdthepoortestscoreagainstthestudentseatednexttohim.Thestudentswillimmediatelyseehowridiculousthispositionis,andyoucanrelatethattoimproperlyholdingsomeoneinacompanyresponsibleforwhatisoutoftheircontrol.

2.7AspreviouslydiscussedinChapter6,therearefourtypesofresponsibilitycenters:

?Costcenter—themanagerisaccountableforcostsonly.

?Revenuecenter—themanagerisaccountableforrevenuesonly.

?Profitcenter—themanagerisaccountableforrevenuesandcosts.

?Investmentcenter—themanagerisaccountableforinvestments,revenues,andcosts.

RefertoQuizQuestions2and3

309

3

Explaintransferprices

...priceonesubunitchargesanotherforproduct

andfourcriteriausedtoevaluatethem

...goalcongruence,managementeffort,subunit

performanceevaluation,andsubunitautonomy

3.1Atransferpriceisthepriceonesubunitchargesforaproductorservicesuppliedtoanothersubunitofthesameorganization.Theproductorservicetransferredbetweensubunitsiscalledanintermediateproduct,whichmaybeworkedonfurther,orsoldtoanexistingcustomer.

TEACHINGPOINT.Acostcentercanbetreatedasaprofitcenterbychargingusersfortheproductorservicerenderedbythesubunit.Forexample,theMaintenanceDepartmentmaychargeinternalusersofitsservicesapredeterminedtransferprice,allowingittobeaccountedforasaprofitcenter.

3.2Therearefourcriteriausedtoevaluatetransferprices:

?Thepriceshouldpromotegoalcongruence.

?Theyshouldmotivateahighlevelofmanagementeffort.

?Thepriceshouldhelptopmanagementevaluateperformanceofindividualsubunits.

?Thetransferpriceshouldpromoteahighdegreeofsubunitautonomy,iftopmanagementfavorsahighdegreeofdecentralization.

RefertoQuizQuestion4

4

Calculatetransferpricesusingthreemethods

...market-based,cost-based,negotiated

310

Threemethodsfordeterminingtransferpricesare:market-based,cost-based,andnegotiated.

?

?

?

Market-basedtransferpricescanbeusedwhenthereisanexternalmarketpricefortheproductorservicebeingprovided.Frequently,thismaybethepricetheunitchargesoutsidecustomers.

Cost-basedtransferpricescanbeusedbasedonthecostofproducingtheproductinquestion.Variouscostbases,suchasvariableproductioncost,variableandfixedproductioncost,orfullcostmaybeused.

Negotiatedtransferpricesmaybeusedwhenthesubunitsarefreetonegotiatethetransferpricebetweenthemselvesandthentodecidewhethertobuyandsellinternallyordealwithexternalparties.Obviously,thesubunitshavethegreatestamountofautonomyunderthissystem.

TEACHINGPOINT.Illustrateeachofthesethreeapproaches

bygoingthroughtheHorizonPetroleumexampleinthetext.

Discusswhichmethodeachmanagerwouldpreferandwhy.

(Exhibit22-1summarizesHorizonPetroleum’scostsand

pricesinthetwodivisions.)

(Exhibit22-2presentsdivisionoperatingincomesforeach

transfer-pricingmethodatHorizonPetroleum.)

RefertoExercises22-20and22-21

5

Illustratehowmarket-basedtransferprices

promotegoalcongruenceinperfectlycompetitive

markets

...divisionmanagerstransactinginternallyare

motivatedtotakethesameactionsasiftheywere

transactingexternally

5.1Market-basedtransferpricesgenerallyleadtooptimaldecisionswhenthreeconditionsaresatisfied:

?themarketfortheintermediateproductisperfectlycompetitive

?interdependenciesofsubunitsareminimal

?therearenoadditionalcostsorbenefitstothecompanyasawholefrombuyingorsellingintheexternalmarketinsteadoftransferringinternally.

311

5.2Aperfectlycompetitivemarketexistswhenthereisahomogeneousproductwithbuyingpricesequaltosellingpricesandnoindividualbuyerscanaffectthesepricesbytheirownactions.Usingmarket-basedtransferpricesinthisenvironmentwillallowacompanytomeetthefourcriteriaofevaluatingtransferprices.

5.3Whensupplyoutstripsdemand,marketpricesmaydropwellbelowhistoricalaverages.Ifthisisatemporarycondition,theselowmarketpricesarecalleddistressprices.Theexistenceofdistresspricescreatesaproblemformanagementinjudgingperformance.Shouldtheyusethedistresspriceorthelong-runaverageprice?

RefertoQuizQuestions5Problems22-27and22-28

6

Understandhowtoavoidmakingsuboptimal

decisionswhentransferpricesarebasedonfull

costplusamarkup

...insituationswhenbuyingdivisionsregardthe

fixedcostsandthemarkupasvariablecosts

6.1Cost-basedtransferpricesarehelpfulwhenmarketpricesareunavailable,inappropriate,ortoocostlytoobtain.Inutilizingthismethodmanagersmustdeterminetheappropriatedefinitionoffullcost.Theyalsomustdeterminehowmuch,ifany,markupshouldbeapplied.

6.2Thisapproachcanleadtosuboptimaldecisions.Ifthepriceisbasedonactualcosts,thesellingdivisionhasnoincentivetocontrolcosts.

6.3Underthefullcostapproach,eachsubunit’sfixedcostsmustbeallocatedtoproducts.ThisbringsupahostofallocationquestionssimilartothosediscussedinChapter14—budgetedoractualcostrates?Havethecorrectactivities,costpools,andallocationbasesbeenchosen?

6.4Theproductcouldbetransferredatvariablecost.Thispromotesgoalcongruence,butresultsinanoperatinglossforthesupplyingdepartment.

6.5Oneapproachtoaddressingthisproblemisforthepurchasingdepartmenttomakeafixedpaymenttothesupplyingdepartment,ineffectpayingforusingthecapacityofthesupplyingdepartment.

6.6Analternativeapproachistochooseatransferpricethatsplitsthedifferencebetweenfullcostandvariablecost.Thisisaprorationapproach.

312

6.7Adualpricingapproachhasbeenutilizedbysomecompanies.Realizingthatthereisseldomasinglecost-basedtransfermethodthatmeetsthefourtransfer-pricingcriteria,adualpricingschemeusestwoseparatetransferpricestopriceeachtransferbetweenunits.Thesellingdivisionwouldgetcreditforfullcostandthebuyingdivisionpaysmarketprice.Thedifferenceisrecordedintoacorporatecostaccount.

RefertoQuizQuestions6

7

Describetherangeoverwhichtwodivisions

negotiatethetransferpricewhenthereisunused

capacity

...fromvariablecosttomarketpriceofthe

producttransferred

7.1Thethirdmethodofdeterminingtransferpricesisanegotiatedprice.Thistransferpriceistheresultofabargainingprocessbetweensellingandbuyingsubunits.

7.2Underthisapproacheachdivisionmanagerismotivatedtoputforthefforttoincreasedivisionoperatingincome.However,disadvantagesincludethetimeandenergyspentonthenegotiations,plusthefactthatoneofthenegotiatorsmayhaveabargainingadvantage.

RefertoQuizQuestions7and8Exercise22-25;Problems22-28and22-29

8

Applyageneralguidelinefordetermininga

minimumtransferprice

...incrementalcostplusopportunitycostof

supplyingdivision

8.1Insettingtransferprices,managersfrequentlyfindthatthereisnotransfer-pricingmethodthatmeetsallcriteria.Marketconditions;thegoalofthetransfer-pricingsystem;thecriteriagoalcongruence,managementeffort,subunitperformance,andsubunitautonomymustallbeconsidered.

(Exhibit22-3summarizesthepropertiesofthedifferenttransfer-pricingmethods.)

313

8.2Theminimumtransferpriceshouldbetheincrementalcostofproducingandtransferringtheproduct.Themaximumtransferpricewouldbethepriceavailableforexternalpurchase.

8.3Differentsituationscallforvariationsinapplicationofthisgeneralrule.

?Withaperfectlycompetitivemarketandnounusedcapacitybythesellingdivision,thetransferpriceshouldbetheexternalmarketprice,asthesellingdivisionhasnoincentivetosellitatalowerprice.

?Whenthereisanexternalmarketthatisnotperfectlycompetitiveandthereisunusedcapacity,capacityutilizationcanbeincreasedonlybydecreasingprices.Inthiscase,theincrementalcostperunitwouldbeanappropriatetransferprice.

?Whenthereisnoexternalmarketfortheproduct,anypricebetweentheincrementalcostandtheexternalpriceforpurchasewouldfulfillgoalcongruence.

RefertoQuizQuestion9

Exercises22-22and22-26

9

Incorporateincometaxconsiderationsin

multinationaltransferpricing

..settransferpricestominimizetaxpaymentsto

theextentpermittedbytaxauthorities

9.1Transferpricesoftenhavetaximplicationswhentheintermediateproductisbeingsoldortransferredbetweensubunitsoperatingunderdifferenttaxrates.Incometaxesarethemajorconsideration,butpayrolltaxes,customsduties,tariffs,salestaxes,andvalue-addedtaxes,environmental-relatedtaxes,andothergovernmentleviesmustbeconsidered.

9.2Incometaxconsiderationsdictatethattotalcompanyincomewillbemaximizedwhenthetransferpriceresultsinthesubunitswiththelowesttaxraterealizingthelargestprofit.However,managersneedtobeawareoffinancialaccounting,tax,andotherregulatoryissuesthatrestrictthepricesthatmaybechargedinthesesituations.

9.3Tomeetthesevaryingobjectives,acompanymaychoosetomaintainonesetofaccountingrecordsfortaxreportingandanotherforinternalmanagementreporting.Thisoftenraisessuspicionsamongthetaxingauthorities,socompaniesoftenresorttoothermanagementcontroltechniques.

9.4Tariffsaretreatedinamannersimilartoincometaxes—companieshaveincentivestolowertransferpricesforproductsimportedintoacountrytoreducetariffsontheseproducts.

314

9.5Anotherconsiderationintheinternationalarenaisthattransferpricesaresometimesinfluencedbynationalrestrictionsondividend-orotherincome-relatedpaymentstopartiesoutsidetheirnationalborders.Byincreasingthetransferprice,theincomecanbereducedandmoremoneyremovedfromthehostcountrywithoutbeingsubjecttoincome-relatedrestrictions.

RefertoQuizQuestion10Exercises22-19,22-23,and22-24

315

V.OTHERRESOURCES

Pleasevisitthetextbookcompanionwebsiteat.Todownloadtheseandotherresources,visittheInstructor’sResourceCenteroraccessthemontheInstructor’sResourceDVD(IR-DVD).

ThefollowingexhibitswerementionedinthischapteroftheInstructor’sManual,andhavebeenincludedinthePowerPointLecturepresentationcreatedspecificallyforthischapter.YoumayusethePowerPointLecturepresentations“asis”,ormodifythemtosuityourindividualneeds.

Exhibit22-1summarizesHorizonPetroleum’scostsandpricesinthetwodivisions.

Exhibit22-2presentsdivisionoperatingincomesforeachtransfer-pricingmethodat

HorizonPetroleum.

Exhibit22-3summarizesthepropertiesofthedifferenttransfer-pricingmethods.

DownloadpdfimagesoftextbookillustrationsandexhibitsfromtheImageLibraryoraccessthemviayourIR-DVD.

SolutionstoSelectEnd-of-ChapterProblemsmentionedinthischapter,whichhavebeenfullyworkedoutinPowerPoint,areavailablefordownloadandincludedontheIR-

DVD.

316

CHAPTER22QUIZ

1.Ifmanagementdecidestopursueanunwisegoal,themanagementcontrolsystemforthatcompanyshould

a.reinforcethiscompanygoal.

b.bescrappedbecauseanunwisegoalwillharmthecompanyandshouldnotbereinforcedwithasystematicapproach.

c.notbechangedfromthepreviouswisegoalstoincorporatethecurrentunwisegoal.

d.nottiethemanagers’rewardtothepursuitofanunwisegoal.

2.Whichofthefollowingisnotabenefitassociatedwithdecentralization?

a.Quickerdecisionmaking

b.Increasedmotivationofsubunitmanagers

c.Increasedcompetitionamongmanagers

d.Greaterresponsivenesstolocalneeds

3.Whichofthefollowingisacostassociatedwithdecentralization?

a.Notenoughtimespentingatheringinformationaboutdifferentsubunitsoftheorganization

b.Decreasedloyaltytowardtheorganizationasawhole

c.Moremanagementdevelopmentandlearning

d.Lackofday-to-dayinvolvementbytopmanagementinoperatingdecisions

4.[CPAAdapted]Inadecentralizedorganizationinwhichsubunitsmaybuygoodsfromoneanother,thetransfer-pricingsystemshouldbedesignedprimarilyto

a.allowsubunitmanagerstobuyfromexternalparties.

b.increasetheconsolidatedvalueofinventory.

c.minimizethedegreeofautonomyofsubunitmanagers.

d.evaluateperformanceofindividualsubunitsandtheirmanagers.

5.[CPAAdapted]Inordertomotivatesubunitmanagerstoexertefforttomaximizetheirownsubunit’soperatingincome,interdivisionaltransfersofaproductpreferablyshouldbemadeatprices

a.equaltofullyallocatedcoststotheproducingsubunit.

b.equaltothemarketpriceoftheproduct.

c.equaltovariablecostsoftheproducingsubunit.

d.negotiatedbytopmanagement.

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Thefollowingdataapplytoquestions6–10.

TheSantaFeManufacturingCompanyhastwodivisionsinKansas,theHoltonDivisionandtheDerbyDivision.Currently,Derbybuysapart(10,000units)fromHoltonfor$16perunit.HoltonhaspurchasednewequipmentandwantstoincreasethepricetoDerbyto$18perunit.ThecontrollerofDerbyclaimsthatshecannotaffordtogothathigh,asitwilldecreasethedivision’sprofittonearzero.Derbycanbuyt