GE PPT Ch22 Lecture 3 Transfer Pricing Revised

Management-Control Systems,
Transfer Pricing,
and Multinational Considerations
Copyright © 2015 Pearson Education

1. Describe a management control system and
its three key properties
2. Describe the benefits and costs of
decentralization
3. Explain transfer prices and the four criteria
managers use to evaluate them
4. Calculate transfer prices using three
methods
5. Illustrate how market-based transfer prices
promote goal congruence in perfectly
competitive markets

22-2
6. Understand how to avoid making
suboptimal decisions when transfer prices
are based on full cost plus a markup
7. Describe the range of feasible transfer
prices when there is unused capacity and
alternative methods for arriving at the
eventual hybrid price
8. Apply a general guideline for determining a
minimum transfer price
9. Incorporate income tax considerations in
multinational transfer pricing

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A management control system is 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.
 Some companies design their management
control system around the concept of the
balanced scorecard.
 Well-designed management control systems use
information from both within the company and
from outside the company.

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 Consist of formal and informal control
systems:
 The formal management control system of a
company includes explicit rules, procedures,
performance measures, and incentive plans that
guide the behavior of its managers and other
employees. The formal control system is
composed of several systems such as:
 The management accounting system for information
about the firm’s costs, revenues and income.
 The human resources system for information about the
recruiting and training of employees, absenteeism and
accidents.
 The quality system for information about yields,
defective products and late deliveries to customers.
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 Consist of formal and informal control
systems:
 The informal management control system

includes the shared values, loyalties, and mutual
commitments among members of the
organization, the company’s culture, and the
unwritten norms about acceptable behavior for
managers and other employees.
Copyright © 2015.Pearson Education

22-6
 To be effective, management control systems
should be closely aligned to the firm’s strategies
and goals.
 Management control systems should also be

designed to support the organizational
responsibilities of individual managers.
 Management control systems must be aligned

with an organization’s structure. An organization
with a decentralized structure will have
different issues to consider when designing its
management control system than a firm with a
centralized structure.

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 Effective management control systems
should motivate managers and other
employees.
 Motivation is the desire to attain a selected

goal (goal-congruence aspect) combined with
the resulting pursuit of that goal (effort
aspect).

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 Goalcongruence 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 the extent to which managers strive
or endeavor in order to achieve a goal.
Effort goes beyond physical exertion to
include mental actions as well.

22-9
 Decentralization is an organizational
structure that gives managers at lower levels
the freedom to make decisions.
 Autonomy is the degree of freedom to make

decisions. The greater the freedom, the
greater the autonomy.
 Subunitrefers to any part of an organization.

It may be a large division or a small group.

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 Createsgreater responsiveness to the needs
of a subunit’s customers, suppliers, and
employees.
 Leads to gains from faster decision making by

subunit managers.
 Assists management development and

learning.
 Sharpens the focus of subunit managers and

broadens the reach of top management.

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 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.
 Leads to unhealthy competition.

 Results in duplication of output.
 Results in duplication of activities.

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 Topmanagers must compare the benefits and
costs of decentralization when choosing an
organizational structure.
 Decisionsrelated to the type and source of

long-term financing are made least
frequently at the decentralized level.
 Centralizing its income tax strategies allows

an organization to optimize across subunits
by offsetting the income in one subunit with
losses in others.
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 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 and the resulting risks.
 Multinational corporations that implement
decentralized decision making usually design their
management control systems to measure and monitor
the performance of divisions.
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A responsibility center is a segment or subunit
of the organization whose manager is
accountable for a specified set of activities.
 Tomeasure the performance of subunits in

centralized or decentralized companies, the
management control system uses one or a
mix of the four types of responsibility
centers:
 Cost center
 Revenue center
 Profit center
 Investment center
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In a decentralized organization, much of the
decision-making power resides in its individual
subunits. Those subunits often supply goods or
services to one another.
 In that case, top management uses transfer

prices to coordinate the actions of the
subunits and to evaluate the performance of
their managers.
 Transfer price—the price one subunit

(department or division) charges for a
product or service supplied to another
subunit of the same organization.
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 The transfer price creates revenues for the
selling subunit and purchase costs for the
buying subunit affecting each subunit’s
operating income.
 The operating incomes can be used to

evaluate the subunits’ performances and to
motivate their managers.
 Intermediate product—the product or service

transferred between subunits of an
organization.

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To help a company achieve its goals, transfer
prices should meet four key criteria:
1. Promote goal congruence so that division

managers acting in their own interest will take
actions that are aligned with the objectives of
top management.
2. Induce managers to exert a high level of effort.
3. Help top managers evaluate the performance
of individual subunits.
4. Preserve autonomy of subunits if top managers
favor a high degree of decentralization.

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There are three broad categories of methods
top managers can use to determine transfer
prices. They are as follows:
1. Market-based transfer prices.

2. Cost-based transfer prices.
3. Hybrid transfer prices.
Under what circumstances should each of

these options be used? Let’s look in more
detail at each category.

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Horizon Petroleum
 The transportation division has obtained rights to certain oil fields
in the Matamoros area. It has a long-term contract to purchase
crude oil extracted from these fields at $72 per barrel. The division
transports the oil to Houston and then “sells” it to the refining
division. The pipeline from Matamoros to Houston can transport
40,000 barrels of crude oil per day.
 The refining division has been operating at capacity (30,000 barrels

of crude oil a day), using oil supplied by Horizon’s transportation
division (an average of 10,000 barrels per day) and oil bought from
another producer and delivered to the Houston refinery (an average
of 20,000 barrels per day at $85 per barrel).
 The refining division sells the gasoline it produces to outside parties

at $190 per barrel.

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Horizon Petroleum
 The exhibit below summarizes the information
above.
 The transfer prices from the transportation
division to the refining division under each of the
method is as follows:
 A market-based transfer price of 85 per barrel of crude oil based on
the competitive market price in Houston.
 A cost-based transfer price at, say, 105% of full cost, where the full
cost is the cost of the crude oil purchased in Matamoros plus the
transportation division’s own variable and fixed costs : 1.05 X ($72 +
$1 + $3) = $79.80.
 A hybrid transfer price of, say, $82 per barrel of crude oil, which is
between the market- based and cost-based transfer prices. We
describe later in this section the various ways in which hybrid prices
can be determined.

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22-22
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 The Exhibit presents division operating incomes per 100 barrels
of crude oil purchased under each transfer-pricing method.
 Transfer prices create income for the selling division and

corresponding costs for the buying division that cancel out
when divisional results are consolidated for the company as a
whole.
 The exhibit assumes all three transfer pricing methods yield

transfer prices that are in a range that does not cause division
managers to change their business relationship;
 That is Horizon Petroleum total operating income from

'purchasing, transporting, and refining the 100 barrels of crude
oil and selling the 50 barrels of gasoline is the same (S1,200)
regardless of the internal transfer prices used '
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 Topmanagers may choose to use the price of
a similar product or service that is publicly
available. Sources of prices include trade
associations, competitors, and so on.
 Or,they may select the external price a

subunit charges outside customers.

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 Transferring products or services at market
prices generally leads to optimal decisions
when three conditions are satisfied:
1. The market for the intermediate product is
perfectly competitive.
2. The interdependencies of subunits are
minimal.
3. 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.

22-26
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.
 Allowsa firm to achieve goal congruence,

motivating management effort, subunit
performance evaluations, and preserve
subunit autonomy.
 Perhapsshould not be used if the market is

currently in a state of “distress pricing.”
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 Topmanagers choose a transfer price based on
the costs of producing the intermediate
product. Examples include:
 Full-cost bases.
 Variable-cost bases.
 Useful when market prices are unavailable,

inappropriate, or too costly to obtain, such as
when markets are not perfectly competitive,
when the product is specialized or when the
internal product is different from the products
available externally in terms of its quality and
the customer service provided for it.

22-28
 Despite its limitations, managers generally
prefer to use full-cost-based transfer prices
because:
 They represent relevant costs for long-run

decisions.
 They facilitate external pricing based on

variable and fixed costs.
 They are the least costly to administer.

22-29
 Full-cost transfer pricing also raises many
issues:
1. How are the subunit’s indirect costs allocated

to products?
2. Have the correct activities, cost pools and

cost-allocation bases been identified?
3. Should the chosen fixed-cost rates be actual

or budgeted?

22-30
 Takes into account both cost and market
information.
 Top management may set the prices by specifying a

transfer price that is an average of the cost of
producing and transporting the product internally
and the market price for comparable products.
 Types of hybrid transfer prices:

 Prorating the difference between maximum and
minimum transfer prices.
 Negotiated pricing. (most common hybrid type)
 Dual pricing.

22-31
 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.

22-32
 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.
 Representthe outcome of a bargaining
process between the selling and buying
subunits.
22-33
22-34
 Theminimum transfer price in many situations
should be:
Incremental cost per unit

Minimum incurred up to the point of Opportunity Cost per unit
Transfer Price = transfer + to the selling subunit
 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.

22-35
 Basedon the example, the minimum transfer price
would be (refer to slide 22)
 Transport division’s incremental cost = RM 73.00
 Transport division’s opportunity cost per barrel of

transferring the oil internally is the contribution
margin per barrel forgone by not selling the crude
oil in the external market (market price RM 85.00)
Minimum transfer price = RM 73 + RM 12 = RM 80.00

22-36
 Transfer pricing is an important accounting
priority for managers around the world.
 The reason is that parent companies can save
large sums of money in taxes depending on the
transfer pricing methods they use.
 Transfer prices affect not just income taxes, but also
payroll taxes, customs duties, tariffs, sales taxes,
value-added taxes, environment-related taxes, and
other government levies.
 Tax factors, particularly income taxes, are an
important consideration for managers when
determining transfer prices.
22-37
Operating Income Income tax
Transfer Transport Refining Total Transport Refining Total
Pricing Division Division Division Division
Method Mexico (USA) Mexico (USA)
(RM) (RM) (RM) (RM) (RM) (RM)
Tax rate Tax rate
30% 20%
Market 900 300 1200 270 60 330
price
105% of 380 820 1200 114 164 278
full cost
Hybrid 600 600 1200 180 120 300
Cost
Refer to slide 23 for details

22-38
 Minimizing firm’s income tax conflicts with other
objectives that the firm hope to achieve via
transfer pricing.
 Assume market for crude oil in perfectly competitive.
 In this case, market based transfer price achieves goal
congruence, provides incentive for management
efforts and evaluate the performance of the
transportation division.
 As per the table above, Horizon would favor using
105% of the full cost as transfer cost as its total tax
will be minimized.

22-39
LECTURE EXERCISES
Exercise 1
Ajax Corporation has two divisions.The Mining division makes Toldine,
which is then transferred to the Metals division. Toldine is further
processed by the Metals division and is sold to customers at a price of
$150 per unit. The Mining division is currently required by Ajax to transfer
its total yearly output of 200,000 units of Toldine to the Metals division at
110% of full manufacturing cost. Unlimited quantities of Toldine can be
purchased and sold on the outside market at $90 per unit.
The following table gives the manufacturing cost per unit in the Mining and
Metals divisions for 2017:
Mining Metal
Division Division
(RM) (RM)
Direct Material Cost 12 6
Direct Material Labour Cost 16 20
Variable Manufacturing Overhead Cost 8 15
Fixed Manufacturing Overhead Cost 24 10
Total Manufacturing Cost Per Unit 60 51
22-40
Required:
1. Calculate the operating incomes for the Mining and Metals

divisions for the 200,000 units of Toldine transferred under the
following transfer-pricing methods: (a) market price and (b) 110% of
full manufacturing cost.
1. Which transfer-pricing method does the manager of the Mining

division prefer? What arguments might he make to support this
method?

22-41
Exercise 2
Janus Aeronautics, which sells aircraft, has two profit centers, Systems
and Assembly. Systems makes navigation equipment and transfers them
to Assembly, which then puts together the aircraft for external sale.
Systems can make up to 200 units a year at a variable cost of $1 million
each. Assembly has variable costs of $16 million per aircraft.
Assembly receives an order for 6 planes for a price of $19 million each.
Suppose that Systems has no ability to sell its output externally and has
excess capacity.
Required
1. Would the top management of Janus want the divisions to take the
order?
2. What range of transfer prices would induce the managers of Systems
and Assembly to take the decision you identified in requirement 1?
3. Now suppose that Systems can sell any navigation systems it makes
externally for $2.5 million per unit. The division incurs advertising and
distribution costs of $250,000 per system for external sales.
4. Would the top management of Janus want the divisions to take the
order?
5. What range of transfer prices would induce the managers of Systems
and Assembly to take the decision you identified in requirement 4?
22-42
Exercise 3
Quasar Electronics makes solar panels at its plant in Akron, Ohio. Its
variable cost per panel is $100 and the full manufacturing cost is $225.
Quasar ships 100,000 panels to a division in Madrid, Spain. Net of
marketing and distribution costs, the Madrid division sells the panels
throughout the European Union at an average price of $400.
Quasar pays a 35% tax on the U.S. division's income. Spain levies a 40%
tax rate on income in the Madrid division. Both tax authorities only permit
transfer prices that are between the full manufacturing cost per unit and a
market price of $300, based on comparable imports into Spain.
Required
(a) What transfer price should Quasar select to minimize the company's
tax liability?
In an effort to protect local manufacturers, Spain introduces customs duties

on solar panel imports. A 16% customs duty is now levied on the price at
which panels are transferred into the country. The duty is a deductible
expense for calculating Spanish income for the purposes of income tax.

22-43
(b) Calculate the after-tax operating income earned by the U.S. and
Spanish divisions from transferring 100,000 solar panels :
(i) at the full manufacturing cost per unit and
(ii) at the market price of comparable imports.
(c) In the presence of the customs duty, what transfer price should Quasar
select to minimize the company's tax liability? Explain your reasoning.

22-44
Exercise 4
Transfer-pricing methods, goal congruence. Calgary Lumber has a raw

lumber division and a finished lumber division. The variable costs are as
follows:
1. Raw lumber division: $125 per 100 board-feet of raw lumber

2. Finished lumber division: $145 per 100 board-feet of finished lumber
Required:
Assume that there is no board-feet loss in processing raw lumber into
finished lumber. Raw lumber can be sold at $175 per 100 board-feet.
Finished lumber can be sold at $345 per 100 board-feet.
(a) Should Calgary Lumber process raw lumber into its finished form?
Show your calculations.
(b) Assume that internal transfers are made at 130% of variable cost. Will
each division maximize its division operating-income contribution by
adopting the action that is in the best interest of Calgary Lumber as a
whole? Explain.

22-45
(c) Assume that internal transfers are made at market prices. Will each
division maximize its division operating-income contribution by adopting
the action that is in the best interest of Calgary Lumber as a whole?
Explain.

22-46

GE PPT Ch22 Lecture 3 Transfer Pricing Revised

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Management-Control Systems,

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

Copyright © 2015 Pearson Education

 The informal management control system

Copyright © 2015.Pearson Education

 Management control systems should also be

 Management control systems must be aligned

Copyright © 2015.Pearson Education

 Motivation is the desire to attain a selected

Copyright © 2015.Pearson Education

Copyright © 2015 Pearson Education

 Autonomy is the degree of freedom to make

 Subunitrefers to any part of an organization.

Copyright © 2015.Pearson Education

 Leads to gains from faster decision making by

 Assists management development and

 Sharpens the focus of subunit managers and

Copyright © 2015 Pearson Education

 Also called incongruent decision making or

 Leads to unhealthy competition.

Copyright © 2015 Pearson Education

 Decisionsrelated to the type and source of

 Centralizing its income tax strategies allows

 Tomeasure the performance of subunits in

 In that case, top management uses transfer

 Transfer price—the price one subunit

 The operating incomes can be used to

 Intermediate product—the product or service

Copyright © 2015.Pearson Education

1. Promote goal congruence so that division

Copyright © 2015 Pearson Education

1. Market-based transfer prices.

Under what circumstances should each of

Copyright © 2015.Pearson Education

 The refining division has been operating at capacity (30,000 barrels

 The refining division sells the gasoline it produces to outside parties

Copyright © 2015.Pearson Education

Copyright © 2015.Pearson Education

 Transfer prices create income for the selling division and

 The exhibit assumes all three transfer pricing methods yield

 That is Horizon Petroleum total operating income from

 Or,they may select the external price a

Copyright © 2015 Pearson Education

Copyright © 2015.Pearson Education

 Allowsa firm to achieve goal congruence,

 Perhapsshould not be used if the market is

 Useful when market prices are unavailable,

Copyright © 2015.Pearson Education

 They represent relevant costs for long-run

 They facilitate external pricing based on

 They are the least costly to administer.

Copyright © 2015.Pearson Education

1. How are the subunit’s indirect costs allocated

2. Have the correct activities, cost pools and

3. Should the chosen fixed-cost rates be actual

Copyright © 2015.Pearson Education

 Top management may set the prices by specifying a

 Types of hybrid transfer prices:

 Negotiated pricing. (most common hybrid type)

Copyright © 2015 Pearson Education

 Dual-pricing—using two separate transfer-