Management Control Systems, Transfer Pricing, and Multinational Considerations

Management-Control Systems,Transfer Pricing,

and Multinational Considerations

© 2012 Pearson Prentice Hall. All rights reserved.

Management Control SystemsManagement 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.


Management Control Systems Many management control systems contain

some or all of the balanced scorecard perspectives:

1. Financial2. Customer3. Internal business process4. Learning and growth


Management Control SystemsConsist 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 Management Control SystemsTo 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 Management Control SystemsEffective 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 MotivationGoal 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 DecentralizationDecentralization 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. CentralizationTotal 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. Structure chosen cost vs. benefit analysis.


Benefits of DecentralizationCreates greater responsiveness to subunit’s

customers, suppliers, and employeesLeads to gains from faster decision makingIncreases motivation of subunit managersAssists management development and

learningSharpens the focus of subunit managers


Costs of DecentralizationLeads 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 DecentralizationFocuses manger’s attention on the subunit

rather than the company as a wholeResults in duplication of outputResults in duplication of activities


Decentralization and Multinational FirmsMultinational 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 CentersRegardless of the degree of decentralization,

management control systems use one or a mix of the four types of responsibility centers:Cost centerRevenue centerProfit centerInvestment center


Transfer PricingTransfer 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 PricingThe 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 Methods1. Market-based transfer prices2. Cost-based transfer prices3. Hybrid transfer prices


Market-Based Transfer PricesTop management chooses to use the price of

similar product or service that is publicly available. Sources of prices include trade associations, competitors, and so on.


Market-Based Transfer Prices 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.


Market-Based Transfer PricesA 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 PricesTop management chooses a transfer price

based on the costs of producing the intermediate product. Examples include:Variable production costsVariable and fixed production costsFull costs (including life-cycle costs)One of the above, plus some markup

Useful when market prices are unavailable, inappropriate, or too costly to obtain


Hybrid Transfer PricesTakes into account both cost and market

informationTypes of hybrid transfer prices:

Prorating the difference between maximum and minimum transfer prices

Dual pricingNegotiated pricing


Hybrid Transfer PricingProrating 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 PricesOccasionally, 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


Transfer Pricing Illustration


Transfer Pricing Example A


Minimum Transfer PriceThe minimum transfer price in many

situations should be:

Minimum Transfer Price =

Incremental cost per unit incurred up to the point of

transfer +Opportunity Cost per unit

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 ConsiderationsTransfer 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.


Multinational Transfer Pricing and Tax ConsiderationsSection 482 of the U.S. 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.


Management Control Systems, Transfer Pricing, and Multinational Considerations

Business

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