Management Control Systems, Transfer Pricing, and Multinational Considerations

CHAPTER 22
Management Control Systems,

Transfer Pricing,
and Multinational Considerations
Management Control Systems
 Management Control Systems are 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
To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 22-2
 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
 Consist of Formal and Informal control
systems:
 Formal systems include explicit rules,
procedures, performance measures, and
incentive plans that guide the behavior of its
managers and other employees
 Informal systems include shared values,
loyalties, and mutual commitments among
members of the company, corporate culture,
and unwritten norms about acceptable
behavior
Evaluating
 To be effective, management control systems
should be closely aligned to the firm’s
strategies and goals
 Systems should be designed to fit the
company’s structure and decision-making
responsibility of individual managers
Evaluating
 Effective management control systems
should also motivate managers and their
employees
 Motivation is the desire to attain a selected
goal (goal-congruence) combined with the
resulting pursuit of that goal (effort)
Two Aspects of Motivation
 Goal Congruence exists when individuals and
groups work toward achieving the
organization’s goals – managers working in
their own best interest take actions that align
with the overall goals of top management
 Effort is exertions toward reaching a goal,
including both physical and mental actions
Organization 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 vs. 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
 Companies’ structures generally fall somewhere in
between these two extremes, as each has benefits
and costs. A structure is chosen based on cost vs.
benefit analysis
Benefits of Decentralization
 Creates greater responsiveness to local
needs
 Leads to gains from faster decision making
 Increases motivation of subunit managers
 Assists management development and
learning
 Sharpens the focus of subunit managers
Costs of Decentralization
 Leads to Suboptimal Decision Making, which
arises when a decision’s benefit to one
subunit is more than offset by the costs or
loss of benefits to the organization as a
whole.
 Also called Incongruent Decision Making or
Dysfunctional Decision Making
Costs of Decentralization
 Focuses manager’s attention on the subunit
rather than the company as a whole
 Increases costs of gathering information
 Results in duplication of activities
Decentralization and
Multinational Firms
 Multinational Firms – companies that operate in multiple
countries – are often decentralized because centralized
control of a company with subunits around the world is
often physically and practically impossible
 Decentralization enables managers in different
countries to make decisions that exploit their knowledge
of local business and political conditions and to deal
with uncertainties in their individual environments
 Biggest Drawback to International Decentralization:
Loss or lack of control
Choices about
Responsibility Centers
 Regardless of the degree of decentralization,
management control systems use one or a
mix of the four types of responsibility centers:
 Cost Center
 Revenue Center
 Profit Center
 Investment Center
Transfer Pricing
 Transfer Price – the price one subunit
(department or division) 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 subunit and purchase costs for the
buying subunit, affecting each subunit’s
operating income
 Intermediate Product – the product or service
transferred between subunits of an
organization
Three Transfer Pricing Methods
1. Market-based Transfer Prices
2. Cost-based Transfer Prices
3. Negotiated Transfer Prices
Market-Based Transfer Prices
 Top management chooses to use the price of
a similar product or service that is publicly
available. Sources of prices include trade
associations, competitors, etc.
 Lead to optimal decision making when three
conditions are satisfied:
1. The market for the intermediate product is
perfectly competitive
2. Interdependencies of subunits are minimal
3. There are no additional costs or benefits to
the company as a whole from buying or
selling in the external market instead of
transacting internally
 A perfectly competitive market exists when there is a
homogeneous product with buying prices equal to
selling prices and no individual buyer or seller can
affect those prices by their own actions
 Allows a firm to achieve goal congruence, motivating
management effort, subunit performance evaluations,
and subunit autonomy
 Perhaps should not be used if the market is currently
in a state of “distress pricing”
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
 Full Costs (including life-cycle costs)
 One of the above, plus some markup
 Useful when market prices are unavailable,
inappropriate, or too costly to obtain
Cost-Based Transfer Pricing
Alternatives
 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 Transfer Prices
 Occasionally, subunits of a firm are free to negotiate
the transfer price between themselves and then to
decide whether to buy and sell internally or deal with
external parties
 May or may not bear any resemblance to cost or
market data
 Often used when market prices are volatile
 Represent the outcome of a bargaining process
between the selling and buying subunits
Comparison of
Transfer-Pricing Methods
Criteria Market- Cost- Based Negotiated
Based
Achieves Goal Yes, when markets Often, but not Yes
Congruence are competitive always
Useful for Evaluating Yes, when markets Difficult unless Yes, but transfer
Subunit Performance are competitive transfer price prices are affected
exceeds full cost by bargaining
and even then is strengths of the
somewhat arbitrary buying and selling
divisions
Comparison of
Criteria Market- Cost- Based Negotiated
Based
Motivates Yes Yes, when based on Yes
Management Effort budgeted costs; less
incentive to control
costs if transfers are
based on actual costs
Preserves Subunit Yes, when markets No, because it is Yes, because it is

Autonomy are competitive rule-based based on
negotiations
between subunits
Comparison of
Criteria Market- Cost- Negotiated
Based Based
Other Factors No market may Useful for Bargaining and
exist or markets determining full negotiations take
may be imperfect cost of products; time and may
or in distress easy to need to be
implement reviewed
repeatedly as
conditions
change
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
Minimum Transfer Price
 The minimum transfer price in many
situations should be:
Incremental cost per unit
Minimum incurred up to the point of Opportunity Cost per unit
Transfer Price = transfer + to the selling subunit
 Incremental cost is the additional cost of

producing and transferring the product or
service
 Opportunity cost is the maximum contribution
margin forgone by the selling subunit if the
product or service is transferred internally
Multinational Transfer Pricing and
Tax Considerations
 Section 482 of the US Internal Revenue Code
governs taxation of multinational transfer
pricing
 Section 482 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 could be market-based or “cost-plus”
based

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CHAPTER 22

Management Control Systems,

Preserves Subunit Yes, when markets No, because it is Yes, because it is

 Incremental cost is the additional cost of

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