Management Control Systems – Transfer Pricing

ByVinit Arondekar M1101Nirvisha Bhuta M1105Shariq Qureshi M1146Poorva Saurkar M1150Gauri Sawant M1152

Management Control Systems

• Management control systems are a means of gathering and using information for planning and control decisions.

• Information is used to:– Aid and coordinate

planning and control decisions within an organization.

– Guide the behavior of managers and other employees.

– Basis for evaluation and reward

– Consistent with “agency theory”

Management Control Systems

A management control system collects:• Financial data such as cost, revenue, and

net income• Nonfinancial data

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Four Types of Financial Responsibility Centers

1 Cost center –manager accountable for costs only.

2 Revenue center –manager accountable for revenues only.

3 Profit center –manager accountable for revenues and costs.

4 Investment center –manager accountable for investments, revenues, and costs.

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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

Evaluating Management Control Systems

• To be effective, management control systems should be closely aligned to the firm strategies and goals.

• Systems should be designed to fit the company structure and decision-making responsibility of individual managers.

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.

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Evaluating ManagementControl Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary

Organizational 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.

Decentralization Versus 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.

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

Costs of Decentralization

Suboptimal decision making may occur

Focuses the manager’s attention on the subunitrather than the organization as a whole

Increases the costs of gathering information

Results in duplication of activities

Decentralization and Multinational Firms

• Companies that operate in multiple countries are often decentralized – why?

• What do you think is the biggest drawback to decentralization with multinational companies?

Decentralization inMultinational Companies

Decentralization enables country managers tomake decisions that exploit their knowledge

of local business and political conditions.

Multinational corporations often rotatemanagers between foreign locations

and corporate headquarters.

Choices about Responsibility Centers

• Regardless of the degree as decentralization, management control systems used one or a mix of the four types of responsibility centers.– Cost centers– Revenue centers– Profit centers– Investment centers

Transfer Pricing

• A transfer price is the price one subunit of a corporation 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 Pricing

• The transfer price creates revenues for the selling subunits and purchasing cost for the buying subunits, affecting each subunits operating income.

• The product or service transferred between subunits is called the intermediate product.

Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices

Transfer-PricingMethods Example

Lomas & Co. has two divisions:Transportation and Refining.

Transportation purchasescrude oil in Alaska and

sends it to Seattle.

Refining processescrude oil

into gasoline.

Transfer-PricingMethods Example

External market price for supplyingcrude oil per barrel: $13

Transportation Division:Variable cost per barrel of crude oil $ 2Fixed cost per barrel of crude oil 3Total $ 5

The pipeline can carry 35,000 barrels per day.

Transfer-PricingMethods Example

External purchase price forcrude oil per barrel: $23

Refining Division:Variable cost per barrel of gasoline $ 8Fixed cost per barrel of gasoline 4Total $12

The division is buying 20,000 barrels per day.

Transfer-PricingMethods Example

The external market price to outsideparties is $60 per barrel.

The Refining Division is operatingat 30,000 barrels capacity per day.

Transfer-PricingMethods Example

What is the market-based transfer pricefrom Transportation to Refining?

$23 per barrel

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

Transfer-PricingMethods Example

Purchase price of crude oil $13Variable costs per barrel of crude oil 2Fixed costs per barrel of crude oil 3Total $18

1.12 × $18 = $20.16

What is the negotiated price?

Between $20.16 and $23.00 per barrel.

Transfer-PricingMethods Example

Assume that the Refining Division buys1,000 barrels of crude oil from the

Transportation Division.

The Refining Division converts these 1,000barrels of crude oil into 500 gallons of

gasoline and sells them.

What is the Transportation Division operatingincome using the market-based price?

Transfer-PricingMethods Example

Transportation Division:Revenues: ($23 × 1,000) $23,000Deduct costs: ($18 × 1,000) 18,000Operating income $ 5,000

What is the Refining Division’s operatingincome using the market-based price?

Transfer-PricingMethods Example

Refining Division:Revenues: ($60 × 500) $30,000Deduct costs:

Transferred-in ($23 × 1,000) 23,000Division variable ($8 × 500) 4,000Division fixed ($4 × 500) 2,000

Operating income $ 1,000

Transfer-PricingMethods Example

What is the operating income of bothdivisions together?

Transportation Division $5,000Refining Division 1,000Total $6,000

Transfer-PricingMethods Example

What is the Transportation Division’s operatingincome using the 112% of full cost price?

Transportation Division:Revenues: ($20.16 × 1,000) $20,160Deduct costs: ($18.00 × 1,000) 18,000Operating income $ 2,160

What is the Refining Division operatingincome using the full cost price?

Transfer-PricingMethods Example

Refining Division:Revenues ($60 × 500) $30,000Deduct costs:

Transferred-in ($20.16 × 1,000) 20,160Division variable ($8.00 × 500) 4,000Division fixed ($4.00 × 500) 2,000

Operating income $ 3,840

Transfer-PricingMethods Example

What is the operating income of bothdivisions together?

Transportation Division $2,160Refining Division 3,840Total $6,000

Comparison of Methods

• Market Price: Yes, if markets competitive• Cost-Based: Often, but not always• Negotiated: Yes

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Achievement of Goal Congruence

Comparison of Methods

• Market Price: Yes, if markets competitive• Cost-Based: Difficult, unless transfer price

exceeds full cost• Negotiated: Yes

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Usefulness for Evaluating Subunit Performance

Comparison of Methods

• Market Price: Yes• Cost-Based: Yes, if based on budgeted

costs; less incentive if based on actual cost

• Negotiated: Yes

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Motivating Management Effort

Comparison of Methods

• Market Price: Yes, if markets competitive• Cost-Based: No, it is rule based• Negotiated: Yes

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Preserving Subunit Autonomy

Comparison of Methods

• 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

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Other Factors to Consider

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, – environmental related taxes, and – other government levies.

Problem 1

• User Friendly Computer with headquarters in San Francisco, manufactures and sells a desktop computer.

• The company has three divisions each of which is located in a different country.

Three Divisions

• China Division – manufactures memory devices and keyboards.

• South Korean Division – assembles desktop computers using internally manufactured parts and memory devices and keyboards from the China division.

• US Division – packages and distributes desktop computers.

Additional Information

• Each division is run as a profit center.• The cost for work done in each division for a

single desktop computer is as follows.

China Division Variable costs = 1000 yuan

Fixed cost = 1800 yuan

South Korea Division Variable cost = 360,000 won

Fix cost = 480,000 won

United States Division Variable cost = $100

Fixed costs = $200

Additional Information

• Chinese income tax rate is 40%.• A South Korean income tax rate is 20%.• United States income tax rate is 30%.• Exchange rates:

– 8 yuan = $1.00 US dollar– 1,200 won = $1.00 US dollar

Additional Information

• Each desktop computer is sold through retail outlets in the United States for $3200.

Additional Information

• Both China and South Korea sell part of their production under a private label.

• The Chinese division sells a comparable memory/keyboard package to a Chinese manufacturer for 3600 yuan.

• The South Korea division sells a comparable desktop computer to a South Korean distributor for 1,560,000 won

Question

• Calculate the after tax operating income per unit earned by each division under the following transfer pricing methods: (a) market price, ( b) 200% of full costs, and (c) 300% of variable costs.

• Income taxes are not included in the computation of cost based transfer prices.

Analysis

• This is a three-country, three-division transfer pricing problem with three alternative transfer pricing methods.

Analysis

• Let’s take this approach in solving the problem:• First begin by summarizing the costs in US dollars.• Then organize this data into transfer price

alternatives.• Then prepare income statements for each

division using each transfer price method, summing to see the total corporate net income under each alternative.

Summary of Costs in US Dollars

• China Plant:– Variable costs: 1000 yuan = $125 per subunit– Fixed costs: 1800 yuan = $225 per subunit.

• South Korea Plant:– Variable costs: 360,000 won = $300 per unit– Fixed cost: 480,000 won = $400 per unit.

• United States Plant:– Variable costs: $100 per unit– Fixed costs: $200 per unit

Market Prices for Private Label Sale Alternatives:

China Plant: 3600 yuan = $450 per subunitSouth Korea Plant: 1,560,000 won = $1300 per

unit.

Transfer Prices

Market Price as a transfer price:China to South Korea = $450 per subunitSouth Korea to U.S. Plant = $1,300 per unit

Transfer Prices

200% of Full Cost as a transfer priceChina to South Korea: 2.0 ($125 + $225) =

$700 per subunitSouth Korea to U.S. Plant: 2.0 ($700 + $300 +

$400) = $2,800 per unit

Where does this come from?

It is the transfer price of the memory devices and

keyboards from China

Transfer Prices

300% of Variable Costs:China to South Korea: 3.0 $125 = $375 per

subunitSouth Korea to U.S. Plant: 3.0 ($375 + $300) =

$2,025 per unit

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

1. China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Div income per unit Income tax at 40% Division net income per unit

$ 450

125 225 350

100 40$ 60

$ 700

125 225 350

350 140$ 210

$ 375

125 225

350 25

10$ 15

These figures were calculated on the earlier slides.

Let’s Start in China which makes the memory devices and keyboards.

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

1. China Division Division revenue per unit Cost per unit: Division variable cost per unit Division fixed cost per unit Total division cost per unit Division income per unit Income tax at 40% Division net income per unit

$ 450

125 225 350

100 40$ 60

$ 700

125 225 350

350 140$ 210

$ 375

125 225

350 25

10$ 15

The rest of this data is given in the problem

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

2. So. Korea DivisionDivision revenue per unitCost per unit:Transferred-in cost per unitDivision variable cost per unitDivision fixed cost per unit

Total division cost per unitDivision operating income per unitIncome tax at 20%Division net income per unit

$1,300

450300

400 1,150

150 30$ 120

$2,800

700 300

400 1,400 1,400 280$1,120

$2,025

375300

400 1,075

950 190$ 760

These are the costs transferred from China under each transferpricing assumption.

Now Let’s Move to South Korea that does assembly.

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

2. So. Korea DivisionDivision revenue per unitCost per unit:Transferred-in cost per unitDivision variable cost per unitDivision fixed cost per unit

Total division cost per unitDivision operating income per unitIncome tax at 20%Division net income per unit

$1,300

450300

400 1,150

150 30$ 120

$2,800

700 300

400 1,400 1,400 280$1,120

$2,025

375300

400 1,075

950 190$ 760

These costs will be transferred to the United States under eachpricing assumption.

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

3. US DivisionDivision revenue per unitCost per unit:

Transferred-in cost per unitDivision variable cost per unitDivision fixed cost per unit

Total division cost per unitDivision operating income per unitIncome tax at 30%Division net income per unit

$3,200

1,300 100

200 1,600 1,600 480$1,120

$3,200

2,800 100

200 3,100

100 30$ 70

$3,200

2,025100

200 2,325

875 262.5$ 612.5

Finally we package and distribute in the United States

Division Net Income MarketPrice

200% ofFull Costs

300% ofVariable Cost

China DivisionSo. Korea DivisionUS DivisionUser Friendly Computer, Inc.

$ 60120

1,120$1,300

$ 2101,120

70$1,400

$ 15.00760.00

612.50$1,387.50

The company will maximize its net income by using 200% of full costs asthe transfer price. This is because method B sources the largest proportion of income in S. Korea, the country with the lowest income rate.

So what transfer pricing scheme gives the company the greatest profit?

Problem 2

• Crango Products is a cranberry cooperative with two divisions: Harvesting and Processing.

• Currently all output is converted into cranberry juice by Processing and sold to large companies.

• The Processing Division has a yield of 500 gallons of juice per 1,000 pounds of cranberries.

Problem 2

• Cost information is given below:Harvesting Division Processing Division

Variable cost per pound of cranberries

$0.10 Variable processing cost per gallon of juice produced

$0.20

Fixed cost per pound of cranberries

$0.25 Fixed cost per gallon of juice produced

$0.40

Selling price per pound of cranberries in outside market

$0.60 Selling price per gallon of juice $2.10

Question• Compute Crango’s operating income from

harvesting 500,000 pounds of cranberries during June 2006 and processing them into juice.

Pounds of cranberries harvested   500,000 Gallons of juice processed (500 gals per 1,000 lbs.)   250,000Revenues (250,000 gals. $2.10 per gal.) $525,000Costs   Harvesting Division Variable costs (500,000 lbs. $0.10 per lb.) $ 50,000   Fixed costs (500,000 lbs. $0.25 per lb.) 125,000   Total Harvesting Division costs 175,000 Processing Division Variable costs (250,000 gals. $0.20 per gal.) $ 50,000   Fixed costs (250,000 gals. $0.40 per gal.) 100,000   Total Processing Division costs 150,000 Total costs 325,000Operating income $200,000

Question

• Crango rewards its division managers with a bonus equal to 5% of operating income.

• Compute the bonus earned by each manager for each of the following transfer pricing methods:– 200% of full cost– Market price

 200% of

Full Costs Market PriceTransfer price per pound (($0.10 + $0.25) 2; $0.60) $0.70 $0.60    1. Harvesting Division  Revenues (500,000 lbs. $0.70; $0.60) $350,000 $300,000Costs Division variable costs (500,000 lbs. $0.10 per lb.) 50,000 50,000 Division fixed costs (500,000 lbs. $0.25 per lb.) 125,000 125,000 Total division costs 175,000 175,000Division operating income $175,000 $125,000Harvesting Division manager's bonus (5% of operating income) $8,750 $6,250   2. Processing Division  Revenues (250,000 gals. $2.10 per gal.) $525,000 $525,000Costs Transferred-in costs 350,000 300,000 Division variable costs (250,000 gals. $0.20 per gal.) 50,000 50,000 Division fixed costs (250,000 gals. $0.40 per gal.) 100,000 100,000 Total division costs 500,000 450,000Division operating income $ 25,000 $ 75,000Processing Division manager’s bonus (5% of operating income) $1,250 $3,750

Answer

Question

• Which transfer pricing method will each division manager prefer?

• The Harvesting Division manager will prefer to transfer at 200% of full costs because this method gives a higher bonus. The Processing Division manager will prefer transfer at market price for its higher resulting bonus.

Question

• How might Crango resolve any conflicts that may arise on the issue of transfer pricing?– Basing division managers’ bonuses on overall Crango profits in

addition to division operating income. This will motivate each manager to consider what is best for Crango overall and not be concerned with the transfer price alone.

– Letting the two divisions negotiate the transfer price between themselves. However, this may result in constant re-negotiation between the two managers each accounting period.

Problem 3

• Industrial Diamonds has two divisions:– South African Mining Division which polishes raw

diamonds for use in industrial polishing tools.– US Processing Division which polishes raw

diamonds for use in industrial cutting tools.

Problem 3

• The Processing Division’s yield is 50%.• It takes two pounds of raw diamonds to

produce 1 pound of top-quality polished industrial diamonds.

• Although all of the Mining Division’s annual output of 2,000 pounds of raw diamonds is sent for processing to the United States, there is also an active market for raw diamonds in South Africa.

Problem 3

• The foreign exchange rate is 7 ZAR (South African Rands) = $1.00 US Dollar.

• The information shown on the following slide is for the two divisions.

Largest hand dug diamond mine inSouth Africa

Information on Diamond DivisionsSouth African Mining Division

Variable cost per pound of raw diamonds 560 ZAR

Fixed cost per pound of raw diamonds 1,540 ZAR

Market price per pound of raw diamonds 3,150 ZAR

Tax rate 18%

US Polishing Division

Variable cost per pound of raw diamonds 150 US Dollar

Fixed cost per pound of raw diamonds 700 US Dollar

Market price per pound of raw diamonds 5,000 US Dollar

Tax rate 30%

Question

• Compute the annual pre-tax operating income, in US dollars, of each division using 200% of full cost and market price transfer pricing methods.

• Then calculate after-tax income using same methods.

Answer—Pre-tax Operating Income

200% ofFull Cost

MarketPrice

Mining DivisionDivision revenues, $600, $450 x 2,000Costs Division variable costs, $80 x 2,000 Division fixed costs, $220 x 2,000 Total division costsDivision operating incomeProcessing DivisionDivision revenues, $5,000 x 1,000Costs Transferred-in costs, $600, $450 x 2,000 Division variable cost, $150 x 1,000 Division fixed costs, $700 x 1,000 Total division costsDivision operating income

$1,200,000

160,000 440,000 600,000$ 600,000

$5,000,000

1,200,000150,000

700,000 2,050,000$2,950,000

$ 900,000

160,000 440,000 600,000$ 300,000

$5,000,000

900,000150,000

700,000 1,750,000$3,250,000

Answer—After-Tax Income

200% ofFull Cost

MarketPrice

Mining DivisionDivision operating incomeIncome tax at 18%Division after-tax operating income

$600,000 108,000$492,000

$300,000 54,000

$246,000Processing DivisionDivision operating incomeIncome tax at 30%Division after-tax operating income

$2,950,000 885,000$2,065,000

$3,250,000 975,000$2,275,000

The Mining Division manager would prefer 200% of full cost for the purpose of calculating a bonus.

The Processing Division manager, however, would prefer market price.

Question• In addition to tax minimization, what other factors

might Industrial Diamonds consider in choosing a transfer-pricing method?– Performance evaluation– Management motivation– Pricing and product emphasis– External market recognition– Overall income of the company– Income or dividend repatriation restrictions– Competitive position of subsidiaries in their respective markets

Answer—After-Tax Income

200% ofFull Cost

MarketPrice

Mining DivisionDivision operating incomeIncome tax at 18%Division after-tax operating income

$600,000 108,000$492,000

$300,000 54,000

$246,000Processing DivisionDivision operating incomeIncome tax at 30%Division after-tax operating income

$2,950,000 885,000$2,065,000

$3,250,000 975,000$2,275,000

Due to differing tax rates, the company will pay less tax and keep more profit if they use 200% of full cost as the transfer price.