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ManagementControlSystems,TransferPricing,andMultinationalConsiderations

TransitionNotes

Thesectiononevaluatingmanagementcontrolsystemshasbeenstreamlinedandashasthesectioncomparingbenefitsandcostsofdecentralization.Thematerialondistresspricesindiscussingmarket-basedtransferpricinghasbeenexpanded.Thechapterhasbeenupdatedtoreflectthechangestotransferpricingbroughtonbythe2017TaxCutsandJobsAct.

*ThischapterwaspreviouslyChapter22.

EXERCISESANDPROBLEMS

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I. LEARNINGOBJECTIVES

Describeamanagementcontrolsystemanditsthreekeyproperties.

Describethebenefitsandcostsofdecentralization.

Explaintransferpricesandthefourcriteriamanagersusetoevaluatethem.

Calculatetransferpricesusingthreemethods.

Illustratehowmarket-basedtransferpricespromotegoalcongruenceinperfectlycompetitivemarkets.

Understandhowtoavoidmakingsuboptimaldecisionswhentransferpricesarebasedonfullcostplusamarkup.

Describetherangeoffeasibletransferpriceswhenthereisunusedcapacityandalternativemethodsforarrivingattheeventualhybridprice.

Applyageneralguidelinefordeterminingaminimumtransferprice.

Incorporateincometaxconsiderationsinmultinationaltransferpricing.

CHAPTERSYNOPSIS

Chapter23discussesthelinksamongmanagementcontrolsystems,strategy,organizationalstructure,andaccountinginformation.Thecostsandbenefitsofcentralizedanddecentralizedorganizationalstructuresarecompared.Pricingofproductstransferredbetweendifferentcompanydivisionsordepartmentsisreviewedandtheimpactoftransferpriceonsubunitandcorporateprofitsisexamined.

POINTSOFEMPHASIS

Studentsfrequentlyareawareofthetermmanagementcontrolsystem,butmaynothaveagraspofwhatitreallyis.Theyshouldunderstandthedefinitionandpropertiesofsuchasystem.

Decentralizationisacentralconceptinbusinesseswithdiverseoperations.Studentsshouldbeawareoftheadvantagesanddisadvantagesofadecentralizedmanagementstructure.

Withtheprevalenceofdecentralization,transferpricingisprevalent.Studentsshouldunderstandtheneedfortransferpricinginadecentralizedoperation,thecriteriatobeconsideredinsettingtransferprices,andthemethodsbywhichtransferpricingmaybedone.Becertaintheyunderstandthatthereisnofinal,correctwaytodotransferpricing;astheenvironmentchanges,sowillthetransfer-pricingmethods.

Inanincreasinglyglobaleconomy,internationalissuesintransferpricingrelatedtoincomeandothertaxesshouldbetakenunderconsideration.Theeffectsofdifferenttaxratesshouldbeunderstood,alongwithstrategiesthatareavailabletoexploitthesedifferences.

CHAPTEROUTLINE

LEARNING

OBJECTIVE

1

Describeamanagementcontrolsystem

…gathersinformationforplanningandcontroldecisions

anditsthreekeyproperties

…alignswithstrategy,supportsorganizationalresponsibilityofmanagers,andmotivatesemployees

Amanagementcontrolsystemisameansofgatheringandusinginformationtoaidandcoordinateplanningandcontroldecisionsthroughoutanorganizationandtoguidethebehaviorofitsmanagersandotheremployees.

Somecompaniesdesignthemanagementcontrolsystemaroundtheconceptofthebalancedscorecard,withfinancialandnonfinancialinformationineachofthefourperspectivesofthescorecard(seeChapter13formoredetailsonthefourperspectives).

Managementcontrolsystemsconsistofformalandinformalcontrolsystems.Theformalmanagementcontrolsystemincludestheexplicitrules,procedures,performancemeasures,andincentiveplansthatguidethebehaviorofmanagersandemployees.Theformalcontrolsystemiscomposedofseveralsystems,suchasthemanagementaccountingsystem,thehumanresourcessystem,andthequalitysystem.

Theinformalmanagementsystemincludessharedvalues,loyalties,andmutualcommitmentsamongmembersofthecompany,companyculture,andunwrittennormsaboutacceptablebehavior.

TEACHINGPOINT.Astimeallows,exploreaspectsoftheinformalmanagementsystem—howitcanworkforthecompany,andhowitcanbeadetriment.Havethestudentsidentifyelementsoftheinformalsystemtheyhaveencounteredinorganizationstheyhavebeenapartof.

Effectivemanagementcontrolsystemsshouldbecloselyalignedwiththecompany’sstrategiesandgoalsandshouldfittheorganizationalstructureanddecision-makingresponsibilityofindividualmanagers.

Threekeypropertiesofaneffectivesystemare:

Motivation—thedesireonthepartofmanagersandotheremployeestoattainaselectedgoal(thegoal-congruenceaspect),combinedwiththepursuitofthatgoal(theeffortaspect).

Goalcongruence—Individualsandgroupsworktowardachievingtheorganization’sgoalwhileworkingintheirownbestintereststhatalignwiththeoverallgoalsoftopmanagement.

TEACHINGPOINT.Observethatgoalcongruenceisnotthesameasgoaladoption.Theemployeehasgoalsthatarenotthesameasthecompanygoals,butbyworkingtowardhisorhergoalstheemployeehelpsmeetthecompanygoals.

Effort—exertiontowardachievingagoal.Thisgoesbeyondphysicalexertiontoincludephysicalandmentalactions.

RefertoQuizQuestion1

LEARNING

OBJECTIVE

2

Describethebenefitsofdecentralization

…responsivenesstocustomers,fasterdecisionmaking,managementdevelopment

andthecostsofdecentralization

…lossofcontrol,duplicationofactivities

2.1 Amanagementcontrolsystemmustfitthestructureoftheorganization.Althoughgenerallyseenasbeneficial,anorganizationwithadecentralizedsystemhasadditionalissuestoconsiderinthestructureofitsmanagementcontrolsystem.

2.2 Decentralizationisanorganizationalstructurethatgivesmanagersatlowerlevelsthefreedomtomakedecisions.Autonomyisthedegreeoffreedomtheyhavetomakedecisions.

2.3 Thereareanumberofbenefitstodecentralization:

Createsgreaterresponsivenesstotheneedsofasubunit’scustomers,suppliers,andemployees.

Leadstogainsfromfasterdecisionmakingbysubunitmanagers.Decentralizationspeedsdecisionmaking,creatingacompetitiveadvantageovercentralizedorganizations.

Assistsmanagementdevelopmentandlearning.Subunitmanagersaremoremotivatedandcommittedwhentheycanexerciseinitiative.

Sharpensthefocusofsubunitmanagersandbroadensthereachoftopmanagement.

2.4 Forallitsbenefits,though,decentralizationisnotwithoutitscosts.

Decentralizationmayleadtosuboptimaldecisionmakingwhenadecisiontobenefitonesubunitismorethanoffsetbythecoststotheorganizationasawhole.

Suboptimaldecisionmaking—alsocalledincongruentdecisionmakingordysfunctionaldecisionmaking—ismostlikelytooccurwhenthesubunitsinthecompanyarehighlyinterdependent.

Leadstounhealthycompetition.Manager’sattentionisfocusedmoreonthesubunitratherthanthecompanyasawhole,andloyaltiesmayliewiththesubunitfirst.

Duplicationofoutputduetointernalcompetitionmayexist.

Theremaybeduplicationofactivitiesasseveralsubunitsmayundertakethesameactionseparately.

2.5 Inchoosinganorganizationalstructure,topmanagementmustcomparethecostsandbenefitsofdecentralization.

Decentralizationinmultinationalcompaniespresentsaspecialchallenge.Centralizedcontrolmaybephysicallyimpracticalduetolanguages,customs,cultures,businesspractices,rules,laws,andregulationsthatvaryfromcountrytocountry.

Inaddition,whendecentralizingwithmultinationals,thereisariskfromthelackofcontrol.

2.6 Adecentralizedorganizationmusthaveameasureoftheperformanceofthedecentralizedsubunits.

TEACHINGPOINT.Inchoosingthemethodtomeasuretheperformanceofadecentralizedunit,managersmustrememberthatresponsibilitymustbeequaltocontrol.Someonecannotbeheldresponsibleforwhattheycannotcontrol.Touseanexampleinclass,youcanselectastudentandsaysomethingtotheeffectthatthisstudentmadeabadgradeonthelasttest.Butitwasn’thisfault,youaregoingtoholdthepoortestscoreagainstthestudentseatednexttohim.Thestudentswillimmediatelyseehowridiculousthispositionis,andyoucanrelatethattoimproperlyholdingsomeoneinacompanyresponsibleforwhatisoutoftheircontrol.

2.7 AspreviouslydiscussedinChapter6,therearefourtypesofresponsibilitycenters:

Costcenter—themanagerisaccountableforcostsonly.

Revenuecenter—themanagerisaccountableforrevenuesonly.

Profitcenter—themanagerisaccountableforrevenuesandcosts.

Investmentcenter—themanagerisaccountablefor,revenues,costsandinvestments.

RefertoQuizQuestions2and3Exercises23-17,part1,2and3

LEARNING

OBJECTIVE

3

Explaintransferprices

…priceonesubunitchargesanotherforproduct

andfourcriteriamanagersusetoevaluatethem

…goalcongruence,managementeffort,subunitperformanceevaluation,andsubunitautonomy

3.1 Atransferpriceisthepriceonesubunitchargesforaproductorservicesuppliedtoanothersubunitofthesameorganization.Theproductorservicetransferredbetweensubunitsiscalledanintermediateproduct,whichmaybeworkedonfurther,orsoldtoanexternalcustomer.

TEACHINGPOINT.Acostcentercanbetreatedasaprofitcenterbychargingusersfortheproductorservicerenderedbythesubunit.Forexample,theMaintenanceDepartmentmaychargeinternalusersofitsservicesapredeterminedtransferprice,allowingittobeaccountedforasaprofitcenter.

3.2 Therearefourcriteriausedtoevaluatetransferprices:

Thepriceshouldpromotegoalcongruencesothatdivisionmanagersactingintheirowninterestwilltakeactionsthatarealignedwiththeobjectivesoftopmanagement.

Theyshouldinducemanagerstoexertahighlevelofmanagementeffort.

Thepriceshouldhelptopmanagementevaluateperformanceofindividualsubunits.

Thetransferpriceshouldpromoteahighdegreeofsubunitautonomy,iftopmanagementfavorsahighdegreeofdecentralization.

LEARNING

OBJECTIVE

4

Calculatetransferpricesusingthreemethods

…(a)market-based,(b)cost-based,or(c)hybrid,eachofwhichyieldsdifferentoperatingincomesforthesubunits.

4.1 Threemethodsfordeterminingtransferpricesare:market-based,cost-based,andhybrid.

Market-basedtransferpricescanbeusedwhenthereisanexternalmarketpricefortheproductorservicebeingprovided.Frequently,thismaybethepricetheunitchargesoutsidecustomers.

Cost-basedtransferpricescanbeusedbasedonthecostofproducingtheproductinquestion.Variouscostbases,suchasvariableproductioncost,variableandfixedproductioncost,orfullcostmaybeused(allproductcostsandcostsfromotherbusinessfunctions,suchasR&D,marketing,anddistribution).

Hybridtransferpricestakeintoaccountbothcostandmarketinformation.Subunitsarefreetonegotiatethetransferpricebetweenthemselvesandthentodecidewhethertobuyandsellinternallyordealwithexternalparties.Obviously,thesubunitshavethegreatestamountofautonomyunderthissystem.

TEACHINGPOINT.IllustrateeachofthesethreeapproachesbygoingthroughtheHorizonPetroleumexampleinthetext.Discusswhichmethodeachmanagerwouldpreferandwhy.

(Exhibit23-1summarizesHorizonPetroleum’scostsandpricesinthetwodivisions.)

(Exhibit23-2presentsdivisionoperatingincomesforeachtransfer-pricingmethodatHorizonPetroleum.)

RefertoQuizQuestions4and5Exercises23-16,part4,23-17

LEARNING

OBJECTIVE

5

Illustratehowmarket-basedtransferpricespromotegoalcongruenceinperfectlycompetitivemarkets

…divisionmanagerstransactinginternallyaremotivatedtotakethesameactionsasiftheyweretransactingexternally

5.1 Market-basedtransferpricesgenerallyleadtooptimaldecisionswhenthreeconditionsaresatisfied:

Themarketfortheintermediateproductisperfectlycompetitive.

Interdependenciesofsubunitsareminimal.

Therearenoadditionalcostsorbenefitstothecompanyasawholefrombuyingorsellingintheexternalmarketinsteadoftransferringinternally.

5.2 Aperfectlycompetitivemarketexistswhenthereisahomogeneousproductwithbuyingpricesequaltosellingpricesandnoindividualbuyersorsellerscanaffectthesepricesbytheirownactions.Usingmarket-basedtransferpricesinthisenvironmentwillallowacompanytomeetthefourcriteriaofevaluatingtransferprices.

Ifmarketsarenotperfectlycompetitive,sellingpricesaffectthequantityofproductsold.

5.3 Whensupplyoutstripsdemand,marketpricesmaydropwellbelowhistoricalaverages.Ifthisisatemporarycondition,theselowmarketpricesarecalleddistressprices.Theexistenceofdistresspricescreatesaproblemformanagementinjudgingperformance.Shouldtheyusethedistresspriceorthelong-runaverageprice?

Problem23-27

LEARNING

OBJECTIVE

6

Understandhowtoavoidmakingsuboptimaldecisionswhentransferpricesarebasedonfullcostplusamarkup

…buyingdivisionsshouldnotregardthefixedcostsandthemarkupasvariablecosts

6.1 Cost-basedtransferpricesarehelpfulwhenmarketpricesareunavailable,inappropriate,ortoocostlytoobtain.Inutilizingthismethod,managersmustdeterminetheappropriatedefinitionoffullcost.Theyalsomustdeterminehowmuch,ifany,markupshouldbeapplied.

6.2 Thisapproachcanleadtosuboptimaldecisions.Ifthepriceisbasedonactualcosts,thesellingdivisionhasnoincentivetocontrolcosts.

6.3 Underthefullcostapproach,eachsubunit’sfixedcostsmustbeallocatedtoproducts.Thisbringsupahostofallocationquestions—budgetedoractualcostrates?Havethecorrectactivities,costpools,andallocationbasesbeenchosen?

6.4 Transferringtheproductatvariablecostspromotesgoalcongruence,butresultsinanoperatinglossforthesupplyingdepartment.Oneapproachtoaddressingthisproblemisforthepurchasingdepartmenttomakeafixedpaymenttothesupplyingdepartment,ineffectpayingforusingthecapacityofthesupplyingdepartment.

RefertoQuizQuestion6Problem23-31

LEARNING

OBJECTIVE

7

Describetherangeoffeasibletransferpriceswhenthereisunusedcapacity

…fromvariablecosttomarketpriceoftheproducttransferred

andalternativemethodsforarrivingattheeventual

hybridprice

...proration,negotiationbetweendivisions,anddual

pricing

7.1 Theprorationapproachisanalternativetofullcostandvariablecosttransferpricesthatsplitsthedifferencebetweenthetwoapproaches.

7.2 Negotiatedpriceisthemostcommonhybridmethodandistheresultofabargainingprocessbetweensellingandbuyingsubunits.Eachdivisionmanagerismotivatedtoputforthefforttoincreasedivisionoperatingincome.Disadvantagesincludethetimeandenergyspentonthenegotiations,andthefactthatoneofthenegotiatorsmayhaveabargainingadvantage.

7.3 Managerssometimesuseadual-pricingapproach,onethatusestwoseparatetransferpricestopriceeachtransferbetweenunits.Thesellingdivisionwouldgetcreditforfullcostandthebuyingdivisionpaysmarketprice.Thedifferenceisrecordedintoacorporatecostaccount.

7.4 Althoughdualpricingpromotesgoalcongruence,itisnotwidelyusedduetothefactthatitcreatesproblemsincomputingtaxableincomeinsubunitslocatedindifferenttaxingjurisdictions.

RefertoQuizQuestions7and8 Exercise23-19andProblems23-28and23-29

LEARNING

OBJECTIVE

8

Applyageneralguidelinefordeterminingaminimumtransferprice

…incrementalcostplusopportunitycostofsupplyingdivision

8.1 Insettingtransferprices,managersfrequentlyfindthatthereisnotransfer-pricingmethodthatmeetsallcriteria.Marketconditions;thegoalofthetransfer-pricingsystem;thecriteriaofgoalcongruence,managementeffort,subunitperformance,andsubunitautonomymustallbeconsidered.

(Exhibit23-3summarizesthepropertiesofthedifferenttransfer-pricingmethods.)

8.2 Theminimumtransferpriceshouldbetheincrementalcostofproducingandtransferringtheproduct.Themaximumtransferpricewouldbethepriceavailableforexternalpurchase.

8.3 Differentsituationscallforvariationsinapplicationofthisgeneralrule.

Withaperfectlycompetitivemarketandnounusedcapacitybythesellingdivision,thetransferpriceshouldbetheexternalmarketprice,asthesellingdivisionhasnoincentivetosellitatalowerprice.

Whenthereisanintermediatemarketthatisnotperfectlycompetitiveandthereisunusedcapacity,capacityutilizationcanbeincreasedonlybydecreasingprices.Inthiscase,theincrementalcostperunitwouldbeanappropriatetransferprice.

Whenthereisnoexternalmarketfortheproduct,anypricebetweentheincrementalcostandtheexternalpriceforpurchasewouldfulfillgoalcongruence.

RefertoQuizQuestion9 Exercises23-21andProblem23-26

LEARNING

OBJECTIVE

9

Incorporateincometaxconsiderationsinmultinationaltransferpricing

…settransferpricestominimizetaxpaymentstotheextentpermittedbytaxauthorities

9.1 Transferpricesoftenhavetaximplicationswhentheintermediateproductisbeingsoldortransferredbetweensubunitsoperatingunderdifferenttaxrates.Incometaxesarethemajorconsideration,butpayrolltaxes,customsduties,tariffs,salestaxes,value-addedtaxes,environmental-relatedtaxes,andothergovernmentleviesmustbeconsidered.

9.2 Incometaxconsiderationsdictatethattotalcompanyincomewillbemaximizedwhenthetransferpriceresultsinthesubunitswiththelowesttaxraterealizingthelargestprofit.However,managersneedtobeawareoffinancialaccounting,tax,andotherregulatoryissuesthatrestrictthepricesthatmaybechargedinthesesituations.

9.3 Tomeetthesevaryingobjectives,acompanymaychoosetomaintainonesetofaccountingrecordsfortaxreportingandanotherforinternalmanagementreporting.Thisoftenraisessuspicionsamongthetaxingauthorities,socompaniesoftenresorttoothermanagementcontroltechniques.

9.4 Tariffsaretreatedinamannersimilartoincometaxes—companieshaveincentivestolowertransferpricesforproductsimportedintoacountrytoreducetariffsontheseproducts.

9.5 Anotherconsiderationintheinternationalarenaisthattransferpricesaresometimesinfluencedbynationalrestrictionsondividend-orotherincome-relatedpaymentstopartiesoutsidetheirnationalborders.Byincreasingthetransferprice,theincomecanbereducedandmoremoneyremovedfromthehostcountrywithoutbeingsubjecttoincome-relatedrestrictions.

RefertoQuizQuestion10 Exercises23-20,23-22,and23-23

V. OtherResources

Todownloadinstructorresources,visittheInstructor’sResourceCenterat/irc.

ThefollowingexhibitswerementionedinthischapteroftheInstructor’sManual,andhavebeenincludedintheImageLibrary.

Exhibit23-1summarizesHorizonPetroleum’scostsandpricesinthetwodivisions.

Exhibit23-2presentsdivisionoperatingincomesforeachtransfer-pricingmethodatHorizonPetroleum.

Exhibit23-3summarizesthepropertiesofthedifferenttransfer-pricingmethods.

CHAPTER23QUIZ

Ifmanagementdecidestopursueanunwisegoal,themanagementcontrolsystemforthatcompanyshould

reinforcethiscompanygoal.

bescrappedbecauseanunwisegoalwillharmthecompanyandshouldnotbereinforcedwithasystematicapproach.

notbechangedfromthepreviouswisegoalstoincorporatethecurrentunwisegoal.

nottiethemanagers’rewardtothepursuitofanunwisegoal.

Whichofthefollowingisnotabenefitassociatedwithdecentralization?

Quickerdecisionmaking

Increasedmotivationofsubunitmanagers

Increasedcompetitionamongmanagers

Greaterresponsivenesstolocalneeds

Whichofthefollowingisacostassociatedwithdecentralization?

Notenoughtimespentingatheringinformationaboutdifferentsubunitsoftheorganization

Decreasedloyaltytowardtheorganizationasawhole

Moremanagementdevelopmentandlearning

Lackofday-to-dayinvolvementbytopmanagementinoperatingdecisions

[CPAAdapted]Inadecentralizedorganizationinwhichsubunitsmaybuygoodsfromoneanother,thetransfer-pricingsystemshouldbedesignedprimarilyto

allowsubunitmanagerstobuyfromexternalparties.

increasetheconsolidatedvalueofinventory.

minimizethedegreeofautonomyofsubunitmanagers.

evaluateperformanceofindividualsubunitsandtheirmanagers.

[CPAAdapted]Inordertomotivatesubunitmanagerstoexertefforttomaximizetheirownsubunit’soperatingincome,interdivisionaltransfersofaproductpreferablyshouldbemadeatprices

equaltofullyallocatedcoststotheproducingsubunit.

equaltothemarketpriceoftheproduct.

equaltovariablecostsoftheproducingsubunit.

negotiatedbytopmanagement.

Thefollowingdataapplytoquestions6through10.

TheSantaFeManufacturingCompanyhastwodivisionsinKansas,theHoltonDivisionandtheDerbyDivision.Currently,D