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CH:22

Management Control Systems, Transfer Pricing, and

Multinational Considerations

Transfer pricing is the price one subunit of a company charges for the services it provides another subunit of the same company.

Top management uses transfer prices (1) to focus managers attention on the performance of their own subunits and (2) to plan and coordinate the actions of different subunits to maximize the companys income as a whole. While transfer pricing is productive, it can also be contentious, because managers of different subunits often have very different preferences about how transfer prices should be set. For example, some managers prefer the prices be based on market prices. Others prefer the prices be based on costs alone.

Learning Objective 1

Describe a management control system and its three key properties. Management control system is 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. Some companies

design their management control system around the concept of the balanced

scorecard. For example, ExxonMobils management control system contains

financial and nonfinancial information in each of the four perspectives of the

balanced scorecard.

Management control systems consist of formal and informal control systems.

The formal management control system of a company includes explicit rules,

procedures, performance measures, and incentive plans that guide the behavior of

its managers and other employees.

The informal management control system includes shared values, loyalties, and

mutual commitments among members of the organization, company culture, and

the unwritten norms about acceptable behavior for managers and other employees.

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Evaluating Management Control Systems

To be effective, management control systems should be closely aligned with the

organizations strategies and goals , also be designed to support the organizational

responsibilities of individual managers.

1- Motivation is the desire to attain a selected goal (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort

aspect).

2- Goal congruence exists when individuals and groups work toward achieving the organizations goalsthat is, managers working in their own

best interest take actions that align with the overall goals of top

management.

3- Effort is the extent to which managers strive or endeavor in order to achieve a goal. Effort goes beyond physical exertion, such as a worker

producing at a faster rate, to include mental actions as well

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Learning Objective 2

Describe the benefits and costs of 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. As we discuss the issues of

decentralization and autonomy, we use the term subunit to refer to any part of an

organization. A subunit may be a large division, such as the refining division of

ExxonMobil, or a small group, such as a two-person advertising department of a

local clothing chain.

Benefits of Decentralization-

1- Creates greater responsiveness to local needs.

2- Leads to gains from quicker decision making.

3- Increases motivation of subunit managers. 4- Assists management development and learning. 5- Sharpens the focus of subunit managers. Costs of Decentralization-

Advocates of more-centralized decision making point to the following costs of

decentralizing decision making:

1- Suboptimal decision making may occur. also called ( incongruent decision making or dysfunctional decision making).

2-Focuses the managers attention on the subunit rather than the organization as

a whole.

3- Increases the costs of gathering information. 4- Results in duplication of activities.

-Comparison of Benefits and Costs To choose an organization structure that will implement a companys strategy, top man- agers must compare the benefits and costs of decentralization, often on a function-by- function basis

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-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.

tersCen Responsibility

1.Cost center- the manager is accountable for costs only.

2.Revenue center -the manager is accountable for revenues only.

3.Profit center -the manager is accountable for revenues and costs.

4.Investment center- the manager is accountable for investments, revenues, and costs.

Learning Objective 3

Explain transfer prices and four criteria used to evaluate them.

for a product or service is the price one subunit chargesTransfer Pricing -

supplied to another subunit of the same organization.

-are the products transferred between subunits of an sIntermediate product -

organization.

4 criteria to evaluate transfer pricing:

Transfer pricing should help achieve a

- companys strategies and goals.

fit the organizations structure -

promote goal congruence-

promote a sustained high level-

of management effort

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Learning Objective 4

Calculate transfer prices using three different methods.

1-Market-based transfer prices.

2- Cost-based transfer prices.

3- 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.

-The external market price to outside parties is $60 per barrel.

-The Refining Division is operating at 30,000 barrels capacity per day.

External purchase price for crude oil per barrel: $23

External market price for supplying crude oil per barrel: $13

Refining Division: $ 8 $8 Variable cost per barrel of gasoline

$4 Fixed cost per barrel of gasoline $ 12Total

Transportation Division: $ 2 Variable cost per barrel of crude oil

$ 3 Fixed cost per barrel of crude oil $ 5Total

The division is buying 20,000 barrels per day.

The pipeline can carry 35,000 barrels per day.

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Requiredis the market-based transfer price - What is the market-based transfer price from Transportation to Refining?

per barrel 23$

- What is the cost-based transfer price at 112% of full costs?

First:

Purchase price of crude oil $13

Variable costs per barrel of crude oil 2

Fixed costs per barrel of crude oil 3

TOTAL $18 Second:

1.12 $18 = $20.16

transfer p

-What is the negotiated price?

(Between $20.16 and $23.00 per barrel.)

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.

based -What is the Transportation Division operating income using the market-

price?

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 -

based price?-market

Division:Refining

Revenues: ($60 500) $30,000 )-( :)Deduct costs)

23,000 Transferred-in ($23 1,000)

4,000 Division variable ($8 500)

2,000 Division fixed ($4 500)

Operating income$ 1,000 =

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What is the operating income of both divisions together?-

Transportation Division $5,000

Refining Division 1,000 (+ )

Total $6,000

Divisions operating income and Refining TransportationWhat is the

using the 112% of full cost price?

Refining Division :

Revenues ($60 500) $30,000

)-( Deduct costs

20,160 Transferred-in ($20.16 1,000)

4,000 Division variable ($8.00 500)

2,000 Division fixed ($4.00 500)

Transportation Division:

Revenues: ($20.16 1,000) = $20,160

Deduct costs: ($18.00 1,000) = 18,000

$ 3,840 Operating income $ 2,160 operating income

-What is the operating income of both divisions together?

Transportation Division

Refinin