Management Control Systems,

Transfer Pricing, and

Multinational Considerations
Chapter 22

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 Overview
• What is a Management Control System?
• Centralized vs. decentralized control structure
• Transfer pricing:
– Function
– Setting TPs
– Dual TPs
– Negotiated TPs (Calculating Min. & Max. range)
– International tax issues

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 Management Control Systems

A management control system is a means

of gathering and using information.

It guides the behavior of managers and

employees.

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 Management Control Systems

Financial data

Nonfinancial data

Formal control system

Informal control system

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 Evaluating Management
Control Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary
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 Organization (control) Structure

Total decentralization

Total centralization
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 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

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 Limitations 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

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 Decentralization in
Multinational 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.
Control Problem: Barings Bank (200 yrs old)—1995 Nick Leeson caused
over ₤1 B loss.
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 Responsibility Centers

Cost Revenue
center center

Profit Investment
center center

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 Responsibility Centers

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.

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 Transfer Pricing

Transfer pricing should: (1) help achieve

a company’s strategies and goals.
(2) fit the organization’s structure
(3) promote goal congruence
(4) promote a sustained high level
of management effort
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 Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices

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 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
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 Market-Based Transfer Prices

Market prices also serve to evaluate the

economic viability and profitability
of divisions individually.

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 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.
Basing transfer prices on depressed market prices will not
always lead to optimal decisions for an organization.

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 Cost-based Transfer Prices

When transfer prices are

based on full cost plus a
markup, suboptimal
decisions can result.

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 Dual Transfer Prices

An example of dual pricing is for Larry & Co.

to credit the Selling Division with
112% of the full cost transfer price of $24.64
per barrel of crude oil.
Debit the Buying Division with the market-based
transfer price of $23 per barrel of crude oil.
And debit a corporate account for the difference!
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 Negotiated Transfer Prices

Negotiated transfer prices arise from the

outcome of a bargaining process between
selling and buying divisions.

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 General Guideline: min. & max.
transfer price
Maximum transfer price = Market price

Minimum transfer price

= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division
Incremental cost often times = variable
cost
Opportunity costs often times = lost CM
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Opportunity costs could = lost savings
 Min. & Max. transfer price--examples

Some examples:

(1) Slowcar
(2) S.F. Manufacturing

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 Slowcar Company
• The Assembly Division of SLOWCAR Company has offered to purchase
90,000 batteries from the Electrical Division (ED) for $104 per unit. At a
normal volume of 250,000 batteries per year, production costs per battery are:
• Direct materials $40
• Direct labor 20
• Variable factory overhead 12
• Fixed factory overhead 42
• Total $114
• The Electrical Division has been selling 250,000 batteries per year to outside
buyers for $136 each. Capacity is 350,000 batteries/year. The Assembly
Division has been buying batteries from outside suppliers for $130 each.

• Should the Electrical Division manager accept the offer? Will an internal
transfer be of any benefit to the company?

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 SF Manufacturing
• The SF Manufacturing Co. has two divisions in Iowa, the Supply Division and
the BUY Division. Currently, the BUY Division buys a part (3,000 units)
from Supply for $12.00 per unit. Supply wants to increase the price to BUY
to $15.00. The controller of BUY claims that she cannot afford to go that
high, as it will decrease the division’s profit to near zero. BUY can purchase
the part from an outside supplier for $14.00. The cost figures for Supply are:
• Direct Materials $3.25
• Direct Labor 4.75
• Variable Overhead 0.60
• Fixed Overhead 1.20
• A. If Supply ceases to produce the parts for BUY, it will be able to avoid one-
third of the fixed MOH. Supply has no alternative uses for its facilities.
Should BUY continue to get the units from Supply or start to purchase the
units from the outside supplier? (From the standpoint of SF as a whole).
• (What is the min. & max. transfer price if BUY and SUPPLY negotiate?)

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 SF Mfg.—continued
• Now, assume that Supply could use the facilities currently used to produce the
3,000 units for BUY to make 5,000 units of a different product. The new
product will sell for $16.00 and has the following costs:
• Direct Materials $3.00
• Direct Labor 4.30
• Variable Overhead 5.40

• B. What is the min. & max. transfer price if BUY and SUPPLY negotiate?

• C. What should be done from the company’s point of view? Why?

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 Comparison of Methods

Achieves Goal Congruence

Market Price: Yes, if markets competitive

Cost-Based: Often, but not always
Negotiated: Yes

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 Comparison of Methods

Useful for Evaluating Subunit Performance

Market Price: Yes, if markets competitive

Difficult, unless transfer
Cost-Based:
price exceeds full cost
Negotiated: Yes

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 Comparison of Methods

Motivates Management Effort

Market Price: Yes

Yes, if based on budgeted
Cost-Based: costs; less incentive if
based on actual cost
Negotiated: Yes
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 Comparison of Methods

Preserves Subunit Autonomy

Market Price: Yes, if markets competitive

Cost-Based: No, it is rule based
Negotiated: Yes

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 Comparison of Methods

Other Factors

Market Price: No market may exist

Useful for determining
Cost-Based:
full-cost; easy to implement
Bargaining takes time and
Negotiated:
may need to be reviewed
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 Multinational Transfer Pricing

IRC Section 482 requires that transfer prices

for both tangible and intangible property
between a company and its foreign division
be set to equal the price that would be
charged by an unrelated third party in a
comparable transaction (arm’s length).
This still leaves a little “room to wiggle.”

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