Management Control Systems Transfer Pricing

By Vinit Arondekar M1101 Nirvisha Bhuta M1105 Shariq Qureshi M1146 Poorva Saurkar M1150 Gauri Sawant M1152

Management Control Systems

Management control systems are a means of gathering and using information for planning and control decisions. Information is used to:
Aid and coordinate planning and control decisions within an organization. Guide the behavior of managers and other employees. Basis for evaluation and reward Consistent with agency theory

Management Control Systems

A management control system collects:
Financial data such as cost, revenue, and net income Nonfinancial data

Four Types of Financial Responsibility Centers

1 Cost center manager accountable for costs only. 2 Revenue center manager accountable for revenues only. 3 Profit center manager accountable for revenues and costs. 4 Investment center manager accountable for investments, revenues, and costs.

Management Control Systems

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

Evaluating Management Control Systems

To be effective, management control systems should be closely aligned to the firm strategies and goals. Systems should be designed to fit the company structure and decision-making responsibility of individual managers.

Evaluating Management Control Systems

Motivation desire to attain a selected goal combined with the resulting drive or pursuit toward that goal. Goal congruence subordinates individual goals are consistent with top managements goals. Effort exertion toward a goal.

Evaluating Management Control Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary

Nonmonetary

Organizational 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 Versus 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.

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

Costs of Decentralization
Suboptimal decision making may occur Focuses the managers attention on the subunit rather than the organization as a whole

Increases the costs of gathering information Results in duplication of activities

Decentralization and Multinational Firms

Companies that operate in multiple countries are often decentralized why? What do you think is the biggest drawback to decentralization with multinational companies?

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.

Choices about Responsibility Centers

Regardless of the degree as decentralization, management control systems used one or a mix of the four types of responsibility centers.
Cost centers Revenue centers Profit centers Investment centers

Transfer Pricing
A transfer price is the price one subunit of a corporation 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 subunits and purchasing cost for the buying subunits, affecting each subunits operating income. The product or service transferred between subunits is called the intermediate product.

Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

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.

Transfer-Pricing Methods Example

External market price for supplying crude oil per barrel: Transportation Division: Variable cost per barrel of crude oil Fixed cost per barrel of crude oil Total
The pipeline can carry 35,000 barrels per day.

$13

$ 2 3 $ 5

Transfer-Pricing Methods Example

External purchase price for crude oil per barrel: Refining Division: Variable cost per barrel of gasoline Fixed cost per barrel of gasoline Total
The division is buying 20,000 barrels per day.

$23

$ 8 4 $12

Transfer-Pricing Methods Example

The external market price to outside parties is $60 per barrel. The Refining Division is operating at 30,000 barrels capacity per day.

Transfer-Pricing Methods Example

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?

Transfer-Pricing Methods Example

Purchase price of crude oil Variable costs per barrel of crude oil Fixed costs per barrel of crude oil Total
1.12 $18 = $20.16 What is the negotiated price? Between $20.16 and $23.00 per barrel.

$13 2 3 $18

Transfer-Pricing Methods Example

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?

Transfer-Pricing Methods Example

Transportation Division: Revenues: ($23 1,000) $23,000 Deduct costs: ($18 1,000) 18,000 Operating income $ 5,000 What is the Refining Divisions operating income using the market-based price?

Transfer-Pricing Methods Example

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

Transfer-Pricing Methods Example

What is the operating income of both divisions together? Transportation Division $5,000 Refining Division 1,000 Total $6,000

Transfer-Pricing Methods Example

What is the Transportation Divisions operating income using the 112% of full cost price? Transportation Division: Revenues: ($20.16 1,000) $20,160 Deduct costs: ($18.00 1,000) 18,000 Operating income $ 2,160

What is the Refining Division operating income using the full cost price?

Transfer-Pricing Methods Example

Refining Division: Revenues ($60 500) Deduct costs: Transferred-in ($20.16 1,000) Division variable ($8.00 500) Division fixed ($4.00 500) Operating income

$30,000 20,160 4,000 2,000 $ 3,840

Transfer-Pricing Methods Example

What is the operating income of both divisions together?

Transportation Division Refining Division Total

$2,160 3,840 $6,000

Comparison of Methods
Achievement of Goal Congruence Market Price: Yes, if markets competitive Cost-Based: Often, but not always Negotiated: Yes

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Comparison of Methods
Usefulness for Evaluating Subunit Performance Market Price: Yes, if markets competitive Cost-Based: Difficult, unless transfer price exceeds full cost Negotiated: Yes

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Comparison of Methods
Motivating Management Effort
Market Price: Yes Cost-Based: Yes, if based on budgeted costs; less incentive if based on actual cost Negotiated: Yes

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Comparison of Methods
Preserving Subunit Autonomy
Market Price: Yes, if markets competitive Cost-Based: No, it is rule based Negotiated: Yes

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Comparison of Methods
Other Factors to Consider
Market Price: Cost-Based: Negotiated: No market may exist Useful for determining fullcost; easy to implement Bargaining takes time and may need to be reviewed

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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, environmental related taxes, and other government levies.

Problem 1
User Friendly Computer with headquarters in San Francisco, manufactures and sells a desktop computer. The company has three divisions each of which is located in a different country.

Three Divisions
China Division manufactures memory devices and keyboards. South Korean Division assembles desktop computers using internally manufactured parts and memory devices and keyboards from the China division. US Division packages and distributes desktop computers.

Additional Information
Each division is run as a profit center. The cost for work done in each division for a single desktop computer is as follows.
China Division South Korea Division United States Division Variable costs = Fixed cost = Variable cost = 1000 yuan 1800 yuan 360,000 won

Fix cost =
Variable cost = Fixed costs =

480,000 won
$100 $200

Additional Information
Chinese income tax rate is 40%. A South Korean income tax rate is 20%. United States income tax rate is 30%. Exchange rates:
8 yuan = $1.00 US dollar 1,200 won = $1.00 US dollar

Additional Information
Each desktop computer is sold through retail outlets in the United States for $3200.

Additional Information
Both China and South Korea sell part of their production under a private label. The Chinese division sells a comparable memory/keyboard package to a Chinese manufacturer for 3600 yuan. The South Korea division sells a comparable desktop computer to a South Korean distributor for 1,560,000 won

Question
Calculate the after tax operating income per unit earned by each division under the following transfer pricing methods: (a) market price, ( b) 200% of full costs, and (c) 300% of variable costs. Income taxes are not included in the computation of cost based transfer prices.

Analysis
This is a three-country, three-division transfer pricing problem with three alternative transfer pricing methods.

Analysis
Lets take this approach in solving the problem: First begin by summarizing the costs in US dollars. Then organize this data into transfer price alternatives. Then prepare income statements for each division using each transfer price method, summing to see the total corporate net income under each alternative.

Summary of Costs in US Dollars

China Plant:
Variable costs: 1000 yuan = $125 per subunit Fixed costs: 1800 yuan = $225 per subunit.

South Korea Plant:

Variable costs: 360,000 won = $300 per unit Fixed cost: 480,000 won = $400 per unit.

United States Plant:

Variable costs: $100 per unit Fixed costs: $200 per unit

Market Prices for Private Label Sale Alternatives:

China Plant: 3600 yuan = $450 per subunit South Korea Plant: 1,560,000 won = $1300 per unit.

Transfer Prices
Market Price as a transfer price: China to South Korea = $450 per subunit South Korea to U.S. Plant = $1,300 per unit

Transfer Prices
200% of Full Cost as a transfer price China to South Korea: 2.0 ($125 + $225) = $700 per subunit South Korea to U.S. Plant: 2.0 ($700 + $300 + $400) = $2,800 per unit
Where does this come from?
It is the transfer price of the memory devices and keyboards from China

Transfer Prices
300% of Variable Costs: China to South Korea: 3.0 $125 = $375 per subunit South Korea to U.S. Plant: 3.0 ($375 + $300) = $2,025 per unit

Lets Start in China which makes the memory devices and keyboards.
Method A Internal Transfers at Market Price 1. China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Div income per unit Income tax at 40% Division net income per unit Method B Internal Transfers at 200% of Full Costs Method C Internal Transfers at 300% of Variable Costs

$ 450 125 225 350 100 40 $ 60

$ 700 125 225 350 350 140 $ 210

$ 375 125 225 350 25 10 $ 15

These figures were calculated on the earlier slides.

Method A Internal Transfers at Market Price 1. China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Division income per unit Income tax at 40% Division net income per unit

Method B Internal Transfers at 200% of Full Costs

Method C Internal Transfers at 300% of Variable Costs

$ 450 125 225 350 100 40 $ 60

$ 700 125 225 350 350 140 $ 210

$ 375 125 225 350 25 10 $ 15

The rest of this data is given in the problem

Now Lets Move to South Korea that does assembly.

Method A Internal Transfers at Market Price 2. So. Korea Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 20% Division net income per unit Method B Internal Transfers at 200% of Full Costs Method C Internal Transfers at 300% of Variable Costs

$1,300 450 300 400 1,150 150 30 $ 120

$2,800 700 300 400 1,400 1,400 280 $1,120

$2,025 375 300 400 1,075 950 190 $ 760

These are the costs transferred from China under each transfer pricing assumption.

Method A Internal Transfers at Market Price 2. So. Korea Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 20% Division net income per unit

Method B Internal Transfers at 200% of Full Costs

Method C Internal Transfers at 300% of Variable Costs

$1,300 450 300 400 1,150 150 30 $ 120

$2,800 700 300 400 1,400 1,400 280 $1,120

$2,025 375 300 400 1,075 950 190 $ 760

These costs will be transferred to the United States under each pricing assumption.

Finally we package and distribute in the United States

Method A Internal Transfers at Market Price 3. US Division Division revenue per unit Cost per unit: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Total division cost per unit Division operating income per unit Income tax at 30% Division net income per unit $3,200 1,300 100 200 1,600 1,600 480 $1,120

Method B Internal Transfers at 200% of Full Costs $3,200 2,800 100 200 3,100 100 30 $ 70

Method C Internal Transfers at 300% of Variable Costs $3,200 2,025 100 200 2,325 875 262.5 $ 612.5

So what transfer pricing scheme gives the company the greatest profit?

Division Net Income China Division So. Korea Division US Division User Friendly Computer, Inc.

Market Price 60 120 1,120 $1,300 $

200% of Full Costs $ 210 1,120 70 $1,400

300% of Variable Cost 15.00 760.00 612.50 $1,387.50 $

The company will maximize its net income by using 200% of full costs as the transfer price. This is because method B sources the largest proportion of income in S. Korea, the country with the lowest income rate.

Problem 2
Crango Products is a cranberry cooperative with two divisions: Harvesting and Processing. Currently all output is converted into cranberry juice by Processing and sold to large companies. The Processing Division has a yield of 500 gallons of juice per 1,000 pounds of cranberries.

Problem 2
Cost information is given below:
Harvesting Division Variable cost per pound of cranberries Fixed cost per pound of cranberries Selling price per pound of cranberries in outside market Processing Division $0.10 Variable processing cost per gallon of juice produced $0.25 Fixed cost per gallon of juice produced $0.60 Selling price per gallon of juice $0.20 $0.40 $2.10

Question
Compute Crangos operating income from harvesting 500,000 pounds of cranberries during June 2006 and processing them into juice.
Pounds of cranberries harvested Gallons of juice processed (500 gals per 1,000 lbs.) Revenues (250,000 gals. $2.10 per gal.) Costs Harvesting Division Variable costs (500,000 lbs. $0.10 per lb.) Fixed costs (500,000 lbs. $0.25 per lb.) Total Harvesting Division costs Processing Division Variable costs (250,000 gals. $0.20 per gal.) Fixed costs (250,000 gals. $0.40 per gal.) Total Processing Division costs Total costs Operating income 500,000 250,000 $525,000

$ 50,000 125,000 175,000 $ 50,000 100,000 150,000 325,000 $200,000

Question
Crango rewards its division managers with a bonus equal to 5% of operating income. Compute the bonus earned by each manager for each of the following transfer pricing methods:
200% of full cost Market price

Answer
Transfer price per pound (($0.10 + $0.25) 2; $0.60) 1. Harvesting Division Revenues (500,000 lbs. $0.70; $0.60) Costs Division variable costs (500,000 lbs. $0.10 per lb.) Division fixed costs (500,000 lbs. $0.25 per lb.) Total division costs Division operating income Harvesting Division manager's bonus (5% of operating income) 2. Processing Division Revenues (250,000 gals. $2.10 per gal.) Costs Transferred-in costs Division variable costs (250,000 gals. $0.20 per gal.) Division fixed costs (250,000 gals. $0.40 per gal.) Total division costs Division operating income Processing Division managers bonus (5% of operating income)

200% of Full Costs Market Price $0.70 $0.60

$350,000 50,000 125,000 175,000 $175,000 $8,750

$300,000 50,000 125,000 175,000 $125,000 $6,250

$525,000 350,000 50,000 100,000 500,000 $ 25,000 $1,250

$525,000 300,000 50,000 100,000 450,000 $ 75,000 $3,750

Question
Which transfer pricing method will each division manager prefer? The Harvesting Division manager will prefer to transfer at 200% of full costs because this method gives a higher bonus. The Processing Division manager will prefer transfer at market price for its higher resulting bonus.

Question
How might Crango resolve any conflicts that may arise on the issue of transfer pricing?
Basing division managers bonuses on overall Crango profits in addition to division operating income. This will motivate each manager to consider what is best for Crango overall and not be concerned with the transfer price alone. Letting the two divisions negotiate the transfer price between themselves. However, this may result in constant re-negotiation between the two managers each accounting period.

Problem 3
Industrial Diamonds has two divisions:
South African Mining Division which polishes raw diamonds for use in industrial polishing tools. US Processing Division which polishes raw diamonds for use in industrial cutting tools.

Problem 3
The Processing Divisions yield is 50%. It takes two pounds of raw diamonds to produce 1 pound of top-quality polished industrial diamonds. Although all of the Mining Divisions annual output of 2,000 pounds of raw diamonds is sent for processing to the United States, there is also an active market for raw diamonds in South Africa.

Problem 3
The foreign exchange rate is 7 ZAR (South African Rands) = $1.00 US Dollar. The information shown on the following slide is for the two divisions.

Largest hand dug diamond mine in South Africa

Information on Diamond Divisions

South African Mining Division Variable cost per pound of raw diamonds 560 ZAR

Fixed cost per pound of raw diamonds

Market price per pound of raw diamonds Tax rate US Polishing Division Variable cost per pound of raw diamonds Fixed cost per pound of raw diamonds Market price per pound of raw diamonds Tax rate

1,540
3,150 18%

ZAR
ZAR

150 700 5,000 30%

US Dollar US Dollar US Dollar

Question
Compute the annual pre-tax operating income, in US dollars, of each division using 200% of full cost and market price transfer pricing methods. Then calculate after-tax income using same methods.

AnswerPre-tax Operating Income

200% of Full Cost Mining Division Division revenues, $600, $450 x 2,000 Costs Division variable costs, $80 x 2,000 Division fixed costs, $220 x 2,000 Total division costs Division operating income Processing Division Division revenues, $5,000 x 1,000 Costs Transferred-in costs, $600, $450 x 2,000 Division variable cost, $150 x 1,000 Division fixed costs, $700 x 1,000 Total division costs Division operating income Market Price

$1,200,000
160,000 440,000 600,000 $ 600,000 $5,000,000 1,200,000 150,000 700,000 2,050,000 $2,950,000

$ 900,000
160,000 440,000 600,000 $ 300,000 $5,000,000 900,000 150,000 700,000 1,750,000 $3,250,000

AnswerAfter-Tax Income
200% of Full Cost Market Price

Mining Division Division operating income Income tax at 18% Division after-tax operating income Processing Division Division operating income Income tax at 30% Division after-tax operating income

$600,000 108,000 $492,000 $2,950,000 885,000 $2,065,000

$300,000 54,000 $246,000 $3,250,000 975,000 $2,275,000

The Mining Division manager would prefer 200% of full cost for the purpose of calculating a bonus. The Processing Division manager, however, would prefer market price.

Question
In addition to tax minimization, what other factors might Industrial Diamonds consider in choosing a transfer-pricing method?
Performance evaluation Management motivation Pricing and product emphasis External market recognition
Overall income of the company Income or dividend repatriation restrictions Competitive position of subsidiaries in their respective markets

AnswerAfter-Tax Income
200% of Full Cost Market Price

Mining Division Division operating income Income tax at 18% Division after-tax operating income Processing Division Division operating income Income tax at 30% Division after-tax operating income

$600,000 108,000 $492,000 $2,950,000 885,000 $2,065,000

$300,000 54,000 $246,000 $3,250,000 975,000 $2,275,000

Due to differing tax rates, the company will pay less tax and keep more profit if they use 200% of full cost as the transfer price.