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CHAPTER 22
Management Control Systems,
Transfer Pricing,
and Multinational Considerations
22-2To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-3To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Management Control Systems
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
22-4To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Management Control Systems
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
22-5To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Evaluating Management Control Systems 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
22-6To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Evaluating Management Control Systems 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)
22-7To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-8To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-9To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-10To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-11To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-12To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-13To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-14To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-15To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-16To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-17To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Three Transfer Pricing Methods
1. Market-based Transfer Prices
2. Cost-based Transfer Prices
3. Negotiated Transfer Prices
22-18To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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.
22-19To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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 minimal3. 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
22-20To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Market-Based Transfer Prices
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”
22-21To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-22To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-23To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-24To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Comparison of Transfer-Pricing Methods
Criteria Market-Based
Cost- Based Negotiated
Achieves Goal Congruence
Yes, when markets are competitive
Often, but not always
Yes
Useful for Evaluating Subunit Performance
Yes, when markets are competitive
Difficult unless transfer price
exceeds full cost and even then is
somewhat arbitrary
Yes, but transfer prices are affected
by bargaining strengths of the
buying and selling divisions
22-25To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Comparison of Transfer-Pricing Methods
Criteria Market-Based
Cost- Based Negotiated
Motivates Management Effort
Yes Yes, when based on budgeted costs; less incentive to control
costs if transfers are based on actual costs
Yes
Preserves Subunit Autonomy
Yes, when markets are competitive
No, because it is rule-based
Yes, because it is based on
negotiations between subunits
22-26To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Comparison of Transfer-Pricing Methods
Criteria Market-Based
Cost- Based
Negotiated
Other Factors No market may exist or markets
may be imperfect or in distress
Useful for determining full
cost of products; easy to
implement
Bargaining and negotiations take
time and may need to be reviewed
repeatedly as conditions
change
22-27To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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
22-28To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
Minimum Transfer Price
The minimum transfer price in many situations should be:
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
Minimum Transfer Price =
Incremental cost per unit incurred up to the point of
transfer +Opportunity Cost per unit
to the selling subunit
22-29To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved.
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