Management Control Systems, Transfer Pricing, and Multinational Considerations

1. Management Control Systems,Transfer Pricing, andMultinational Considerations Chapter 22

2. Learning Objective 1 Describe a management control system and its three key properties.

3. Management Control Systems A management control system is a means of gathering and using information. It guides the behavior of managers and employees.

4. Management Control Systems Financial data Nonfinancial data Formal control system Informal control system

5. Evaluating ManagementControl Systems Motivation Goal congruence Effort Lead to rewards Monetary Nonmonetary

6. Learning Objective 2 Describe the benefits and costs of decentralization.

7. Organization Structure Total decentralization Total centralization

8. 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

9. Costs of Decentralization Suboptimal decision making may occur Focuses the manager’s attention on the subunit rather than the organization as a whole Increases the costs of gathering information Results in duplication of activities

10. Decentralization inMultinational 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.

11. Responsibility Centers Cost center Revenue center Profit center Investment center

12. Learning Objective 3 Explain transfer prices and four criteria used to evaluate them.

13. Transfer Pricing A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization. Intermediate products are the products transferred between subunits of an organization.

14. Transfer Pricing Transfer pricing should help achieve a company’s strategies and goals. – fit the organization’s structure – promote goal congruence – promote a sustained high level of management effort

15. Learning Objective 4 Calculate transfer prices using three different methods.

16. Transfer-Pricing Methods Market-based transfer prices Cost-based transfer prices Negotiated transfer prices

17. Transfer-PricingMethods 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.

18. Transfer-PricingMethods Example The purchase price of crude oil per barrel (incurred by Transportation): $13 Transportation Division: Variable cost per barrel of crude oil $ 2 Fixed cost per barrel of crude oil 3 Total $ 5 The pipeline can carry 35,000 barrels per day.

19. Transfer-PricingMethods Example External purchase price for crude oil per barrel: $23 Refining Division: Variable cost per barrel of gasoline $ 8 Fixed cost per barrel of gasoline 4 Total $12 The division is buying 20,000 barrels per day.

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

21. Transfer-PricingMethods 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?

22. Transfer-PricingMethods Example Purchase price of crude oil $13 Variable costs per barrel of crude oil 2 Fixed costs per barrel of crude oil 3 Total $18 1.12 ×$18 = $20.16 What is the negotiated price? Between $20.16 and $23.00 per barrel.

23. Transfer-PricingMethods 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?

24. Transfer-PricingMethods Example Transportation Division: Revenues: ($23 × 1,000) $23,000 Deduct costs: ($18 × 1,000) 18,000 Operating income $ 5,000 What is the Refining Division’s operating income using the market-based price?

25. Transfer-PricingMethods 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

26. Transfer-PricingMethods Example What is the operating income of both divisions together? Transportation Division $5,000 Refining Division 1,000 Total $6,000

27. Transfer-PricingMethods Example What is the Transportation Division’s 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?

28. Transfer-PricingMethods Example Refining Division: Revenues ($60 × 500) $30,000 Deduct costs: Transferred-in ($20.16 × 1,000) 20,160 Division variable ($8.00 × 500) 4,000 Division fixed ($4.00 × 500) 2,000 Operating income $ 3,840

29. Transfer-PricingMethods Example What is the operating income of both divisions together? Transportation Division $2,160 Refining Division 3,840 Total $6,000

30. Learning Objective 5 Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets.

31. Market-Based Transfer Prices By using market-based transfer prices in a perfectly competitive market, a company can achieve the following: Goal congruence Management effort Subunit performance evaluation Subunit autonomy

32. Market-Based Transfer Prices Market prices also serve to evaluate the economic viability and profitability of divisions individually.

33. Market-Based Transfer Prices When supply outstrips demand, market prices may drop well below their historical average. Distress prices are the drop in prices expected to be temporary.

34. Learning Objective 6 Avoid making suboptimal decisions when transfer prices are based on full cost plus a markup.

35. Cost-Based TransferPrices Example The Refining Division of Lomas & Co. is purchasing crude oil locally for $23 a barrel. The Refining Division located an independent producer in Alaska that is willing to sell 20,000 barrels of crude oil per day at $17 per barrel delivered to the pipeline (Transportation Division).

36. Cost-Based TransferPrices Example The Transportation Division has excess capacity and can transport the crude oil at its variable costs of $2 per barrel. Should Lomas purchase from the independent supplier? Yes. There is a reduction in total costs of $80,000.

37. Cost-Based TransferPrices Example Alternative 1: Buy 20,000 barrels from the local supplier at $23 per barrel. The total cost to Lomas is: 20,000 × $23 = $460,000

38. Cost-Based TransferPrices Example Alternative 2: Buy 20,000 barrels from the independent supplier in Alaska at $17 per barrel and transport it to Seattle at $2 per barrel. The total cost to Lomas is: 20,000 × $19 = $380,000

39. Cost-Based TransferPrices Example Suppose the Transportation Division’s transfer price to the Refining Division is 112% of full cost. What is the cost to the Refining Division?

40. Cost-Based TransferPrices Example Purchase price of crude oil $17 Variable costs per barrel of crude oil 2 Fixed costs per barrel of crude oil 3 Total $22 1.12 ×$22 = $24.64 $24.64 × 20,000 = $492,800

41. Cost-Based TransferPrices Example What is the maximum transfer price? It is the price that the Refining Division can pay in the local external market ($23). What is the minimum transfer price? The minimum transfer price is $19 per barrel.

42. Learning Objective 7 Understand the range over which two divisions negotiate the transfer price when there is unused capacity.

43. Prorating Lomas & Co. may choose a transfer price that splits on some equitable basis the difference between the maximum transfer price and the minimum transfer price. $23 – $19 = $4 Suppose that variable costs are chosen as the basis to allocate this $4 difference.

44. Prorating The Transportation Division’s variable costs are $2 × 1,000 = $2,000. The Refining Division’s variable costs to refine 1,000 of crude oil into 500 barrels of gasoline are $8 × 500 = $4,000.

45. Prorating The Transportation Division gets to keep $2,000 ÷ $6,000 × $4 = $1.33. The Refining Division gets to keep $4,000 ÷ $6,000 × $4 = $2.67. What is the transfer price from the Transportation Division? $17.00 + $2.00 + $1.33 = $20.33

46. Dual Pricing An example of dual pricing is for Lomas & Co. to credit the Transportation Division with 112% of the full cost transfer price of $24.64 per barrel of crude oil. Debit the Refining Division with the market-based transfer price of $23 per barrel of crude oil.

47. Negotiated Transfer Prices Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

48. Learning Objective 8 Construct a general guideline for determining a minimum transfer price.

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

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