Financial Performance and Transfer Pricing

1. Financial Performance and Transfer Pricing ACCT7320 Controllership November 9, 2011

2. Management Control Systems • A management control system -- involves gathering and using information for planning and control decisions. • A management control system guides the behavior of managers and employees • Basis for evaluation and reward • Consistent with “agency theory”

3. Management Control Systems A management control system collects: • Financial data such as cost, revenue, and net income • Usually an important factor! • Nonfinancial data • As seen on BSC

4. Four Types of Financial Responsibility Centers • Cost center –manager accountable for costs only. • Revenue center –manager accountable for revenues only. • Profit center –manager accountable for revenues and costs. • Investment center –manager accountable for investments, revenues, and costs.

5. 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 management’s goals. • Effort – exertion toward a goal.

6. Organization Structure • Total decentralization means minimum constraints, maximum freedom for managers at the lowest levels to make decisions. • Total centralization means maximum constraints, minimum freedom for managers at the lowest levels to make decisions.

7. Benefits of Decentralization • Creates greater responsiveness to local needs • Leads to gains from quicker decision making • Increases motivation of subunit managers • Aids management development and learning • Sharpens the focus of subunit managers

8. Recall the Costs of Decentralization • Leads to suboptimal decision making (incongruent or dysfunctional decision making due to loss of control) • Focuses manager’s attention on the subunit rather than the organization as a whole • Increases costs of gathering information • Results in duplication of activities

9. Decentralization in Multinational Companies • Multinational corporations are often decentralized • centralized control of subunits in three or four different continents is hard • Decentralization enables managers to apply their knowledge of local business and political conditions.

10. Decentralization in Multinational Companies • Often rotate managers between foreign locations and corporate headquarters. • Job rotation with decentralization helps develop managers’ abilities to operate in the global environment. • A drawback to decentralizing multinational companies is the lack of control.

11. Transactions between Divisions • What happens when transactions occur between divisions (subunits)? • Effects on individual divisional performance • Effects on the overall organization • The control design of the control system affects the outcome

12. Transfer Pricing • A transfer price is the price one subunit charges for a product/service supplied to another subunit of the same organization. • Creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income. • Overall organization’s income unaffected upon consolidation!

13. Transfer Pricing • What is the behavioral objective for transfer prices? • Subunit managers need only consider how their actions will affect subunit performance without evaluating their impact on companywide performance. • A well designed TP policy will lead to goal congruence

14. Major Decisions about TPs • Two major decisions in transfer pricing policy: • Sourcing -- should segments be free to decide whether to sell/buy from other segments • Pricing method-- what transfer price should be set for any transfer • Criteria for “good” policy? • goal congruence • managerial effort • subunit autonomy [where desired]

15. Transfer-Pricing Methods • Three general methods for transfer pricing: • Market-based • Price of a similar product/ service publicly listed • Cost-based • Some basis of “cost” (plus a margin?) • Negotiated • Whatever the subunit managers agree [Also Dual Method: • Revenue to seller, cost to buyer not equal]

16. Effects on Income • Except for tax impacts, no impact on overall consolidated income • Affects distribution of income among segments

17. The Importance of Transfer Pricing • Evaluation of a division for sale • (What earnings are relevant?) • Minority interest in a subsidiary • (Is subsidiary being "plundered"?) • Tax minimization • (Can shift income to some degree.) • Governmental contracting • (Endorses full-cost TPs.)

18. What Can Happen Regarding Goal Congruence?From corporation’s viewpoint, it’s an outsourcing decision!

19. Will the Desired Outcome Occur? If outsourcing is desirable, there will be a range of acceptable prices: Ceiling: The outside market price that buyer would pay [Room to share benefit.] Floor: The outlay costs of supplier + opportunity cost. • If idle capacity, there is no opportunity cost. • If no idle capacity, then it’s sales price to current outside customer.

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

21. 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

22. 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

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

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

25. Tax & Multinational Transfer Pricing

26. Importance Continued:Eli Lily Case (1957) • IRS objected to tax return • Lily had used variable costs as TP basis • Court decided the true purpose was tax avoidance, held for IRS • Established market-based TPs for tax purposes

27. Tax & Multinational Transfer Pricing • Transfer prices often have tax implications. • Tax factors include not only income taxes, but also payroll taxes, customs duties, tariffs, sales taxes, and other levies on organizations. • Section 482 of the U.S. Internal Revenue Service Code governs taxation of multinational transfer pricing.

28. Multinational Transfer Pricing • Section 482 requires that transfer prices for both tangible and intangible property between a company and its foreign division be set to equal the price that would be charged by an unrelated third party in a comparable transaction.

29. Multinational Transfer Pricing • Transfer prices can reduce income tax payments by recognizing more income in low tax rate countries and less income in high tax rate countries. • Tax regulations of different countries restrict the transfer prices that companies can choose.

30. The End