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CHAPTER 22 MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING,

By Jack Scott,2014-12-25 14:21
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CHAPTER 22 MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING,

    CHAPTER 22

    MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING,

    AND MULTINATIONAL CONSIDERATIONS

    22-1 A management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout the organization and to guide the behavior of its managers and employees. The goal of the system is to improve the collective decisions within an organization.

    22-2 To be effective, management control systems should be (a) closely aligned to an organization's strategies and goals, (b) designed to fit the organization's structure and the decision-making responsibility of individual managers, and (c) able to motivate managers and employees to put in effort to attain selected goals desired by top management. 22-3 Motivation combines goal congruence and effort. Motivation is the desire to attain a selected goal specified by top management (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort aspect).

    22-4 The chapter cites five benefits of decentralization:

    1. Creates greater responsiveness to local needs

    2. Leads to gains from faster decision making

    3. Increases motivation of subunit managers

    4. Aids management development and learning

    5. Sharpens the focus of subunit managers

     The chapter cites four costs of decentralization:

    1. Leads to suboptimal decision making

    2. Results in duplication of activities

    3. Focuses managers‘ attention on the subunit rather than the company as a whole

    4. Increases costs of gathering information

    22-5 No. Organizations typically compare the benefits and costs of decentralization on a function-by-function basis. For example, companies with highly decentralized operating divisions frequently have centralized income tax strategies.

    22-6 No. A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. The two segments can be cost centers, profit centers, or investment centers. For example, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an example of transfer pricing.

22-7 The three general methods for determining transfer prices are:

    1. Market-based transfer prices

    2. Cost-based transfer prices

    3. Negotiated transfer prices

    22-1

22-8 Transfer prices should have the following properties. They should

    1. promote goal congruence,

    2. be useful for evaluating subunit performance,

    3. motivate management effort, and

    4. preserve a high level of subunit autonomy in decision making.

    22-9 No, the chapter illustration demonstrates how division operating incomes differ

    dramatically under the variable costs, full costs, and market price methods.

    22-10 Transferring products or services at market prices generally leads to optimal decisions

    when (a) the market for the intermediate product market is perfectly competitive, (b)

    interdependencies of subunits are minimal, and (c) 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.

    22-11 One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal decisions for the company as a whole. An example of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally. This situation often arises where full-cost-based transfer prices are used. This situation can make the fixed costs of the supplying division appear to be variable costs of the purchasing division. Another limitation is that the supplying division may not have sufficient incentives to control costs if the full-cost-based transfer price uses actual costs rather than standard costs.

     The purchasing division sources externally if market prices are lower than full costs. From the viewpoint of the company as a whole, the purchasing division should source from outside only if market prices are less than variable costs of production, not full costs of production.

    22-12 Reasons why a dual-pricing approach to transfer pricing is not widely used in practice include:

    1. The manager of the supplying division uses a cost-based method to record revenues and

    does not have sufficient incentives to control costs.

    2. This approach does not provide clear signals to division managers about the level of

    decentralization top management wants.

    3. This approach tends to insulate managers from the frictions of the marketplace because

    costs, not market prices, affect the revenues of the supplying division.

    4. It leads to problems in computing the taxable income of subunits located in different tax

    jurisdictions.

    22-13 Disagree. Cost and price information are often useful starting points in the negotiation process. Costs, particularly variable costs of the "selling" division, serve as a "floor" below which the selling division would be unwilling to sell. Prices that the "buying" division would pay to purchase products from the outside market serves as a "ceiling" above which the buying division would be unwilling to buy. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices. But the negotiated price will generally fall between the variable costs-based floor and the market price-based ceiling.

    22-2

    22-14 Yes. The general transfer-pricing guideline specifies that the minimum transfer price equals the additional outlay costs per unit incurred up to the point of transfer plus the opportunity

    costs per unit to the supplying division. When the supplying division has idle capacity, its opportunity costs are zero; when the supplying division has no idle capacity, its opportunity costs are positive. Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not.

    22-15 Alternative transfer-pricing methods can result in sizable differences in the reported operating income of divisions in different income tax jurisdictions. If these jurisdictions have different tax rates or deductions, the net income of the company as a whole can be affected by the choice of the transfer-pricing method.

22-16 (25 min.) Decentralization, responsibility centers.

    1. The manufacturing plants in the Manufacturing Division are cost centers. Senior management determines the manufacturing schedule based on the quantity of each type of lighting product specified by the sales and marketing division and detailed studies of the time and cost to manufacture each type of product. Manufacturing managers are accountable only for costs. They are evaluated based on achieving target output within budgeted costs.

    2a. If manufacturing and marketing managers were to directly negotiate the prices for manufacturing various products, Quinn should evaluate manufacturing plant managers as profit centersrevenues received from marketing minus the costs incurred to produce and sell output.

    2b. Quinn Corporation would be better off decentralizing its marketing and manufacturing decisions and evaluating each division as a profit center. Decentralization would encourage plant managers to increase total output to achieve the greatest profitability, and motivate plant managers to cut their costs to increase margins. Manufacturing managers would be motivated to design their operations according to the criteria that meet the marketing managers‘ approval, thereby improving cooperation between manufacturing and marketing.

     Under Quinn's existing system, manufacturing managers had every incentive not to improve. Manufacturing managers' incentives were to get as high a cost target as possible so that they could produce output within budgeted costs. Any significant improvements could result in the target costs being lowered for the next year, increasing the possibility of not achieving budgeted costs. By the same line of reasoning, manufacturing managers would also try to limit their production so that production quotas would not be increased in the future. Decentralizing manufacturing and marketing decisions overcomes these problems.

    22-3

    22-17 (15 min.) Decentralization, goal congruence, responsibility centers. 1. The environmental management organization appears to be decentralized because managers of the environmental management group have considerable freedom to make decisions. They can choose which projects to work on and which projects to reject. Top management will adjust the size of the environmental management group to match the demand for the group‘s

    services by operating divisions.

    2. The environmental management group is a cost center. The group is required to charge the operating divisions for environmental services at cost and not at market prices that would help earn the group a profit.

    3. The benefits of structuring the environmental management group in this way are:

    a. The operating managers have incentives to carefully weigh and conduct cost-benefit

    analyses before requesting the environmental group's services.

    b. The operating managers have an incentive to follow the work and the progress made

    by the environmental team.

    c. The environmental group has incentives to fulfill the contract, to do a good job in

    terms of cost, time, and quality, and to satisfy the operating division in order to

    continue to get business.

    The problems in structuring the environmental group in this way are:

    a. The contract requires extensive internal negotiations in terms of cost, time, and technical

    specifications.

    b. The environmental group needs to continuously "sell" its services to the operating division,

    and this could potentially result in loss of morale.

    c. Experimental projects that have long-term potential may not be undertaken because

    operating division managers may be reluctant to undertake projects that are costly and

    uncertain, whose benefits will be realized only well after they have left the division. To the extent that the focus of the environmental group is on short-run projects demanded by the operating divisions, the current structure leads to goal congruence and motivation. Goal congruence is achieved because both operating divisions and the environmental group are motivated to work toward the organizational goals of reducing pollution and improving the environment. The operating divisions will be motivated to utilize the services of the environmental group to achieve the environmental goals set for them by top management. The environmental group will be motivated to deliver high-quality services in a cost-effective way in order to continue to create a demand for their services. The one issue that top management needs to guard against is that experimental projects with long-term potential that are costly and uncertain may not be undertaken under the current structure. Top management may want to set up a committee to study and propose such long-run projects for consideration and funding by corporate management.

    22-4

22-18 (35 min.) Multinational transfer pricing, effect of alternative transfer-

    pricing methods, global income tax minimization.

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

    transfer-pricing methods. Summary data in U.S. dollars are: China Plant

     Variable costs: 1,000 Yuan ? 8 Yuan per $ = $125 per subunit

     Fixed costs: 1,800 Yuan ? 8 Yuan per $ = $225 per subunit South Korea Plant

     Variable costs: 360,000 Won ? 1,200 Won per $ = $300 per unit

     Fixed costs: 480,000 Won ? 1,200 Won per $ = $400 per unit U.S. Plant

     Variable costs: = $100 per unit

     Fixed costs: = $200 per unit

    Market prices for private-label sale alternatives:

     China Plant: 3,600 Yuan ? 8 Yuan per $ = $450 per subunit

     South Korea Plant: 1,560,000 Won ? 1,200 Won per $ = $1,300 per unit

The transfer prices under each method are:

     a. Market price

     China to South Korea = $450 per subunit

     South Korea to U.S. Plant = $1,300 per unit

     b. 200% of full costs

     China to South Korea

     2.0 ($125 + $225) = $700 per subunit

     South Korea to U.S. Plant

     2.0 ($700 + $300 + $400) = $2,800 per unit

     c. 300% of variable costs

     China to South Korea

     3.0 $125 = $375 per subunit

     South Korea to U.S. Plant

     3.0 ($375 + $300) = $2,025 per unit

    22-5

22-18 (Cont‘d.)

     Method A Method B Method C

     Internal Internal Internal

    Transfers Transfers Transfers

    at Market at 200% of at 300% of

    Price Full Costs Variable Costs

    1. China Division

     Division revenue per unit $ 450 $ 700 $ 375

     Deduct:

     Division variable cost per unit 125 125 125

     Division fixed cost per unit 225 225 225

     Division operating income per unit 100 350 25

     Income tax at 40% 40 140 10

     Division net income per unit $ 60 $ 210 $ 15

    2. South Korea Division

     Division revenue per unit $1,300 $2,800 $2,025

     Deduct:

     Transferred-in cost per unit 450 700 375

     Division variable cost per unit 300 300 300

     Division fixed cost per unit 400 400 400

     Division operating income per unit 150 1,400 950

     Income tax at 20% 30 280 190

     Division net income per unit $ 120 $1,120 $ 760

    3. United States Division

     Division revenue per unit $3,200 $3,200 $3,200

     Deduct:

     Transferred-in cost per unit 1,300 2,800 2,025

     Division variable cost per unit 100 100 100

     Division fixed cost per unit 200 200 200

     Division operating income per unit 1,600 100 875

     Income tax at 30% 480 30 262.5

     Division net income per unit $1,120 $ 70 $ 612.5

2. Division net income:

     Market 200% of 300% of

     Price Full Costs Variable Cost

    China Division $ 60 $ 210 $ 15.00 South Korea Division 120 1,120 760.00 U.S. Division 1,120 70 612.50 User Friendly Computer Inc. $1,300 $1,400 $1,387.50

    22-6

22-18 (Cont‘d.)

User Friendly will maximize its net income by using the 200% of full costs, transfer-pricing

    method. This is because the 200% of full cost method sources most income in the countries with

    the lower income tax rates.

     22-18 Excel Application

     User Friendly Computer, Inc.

    Original Data

    U.S. $ per yuan 0.125

    U.S. $ per won 0.00083

     China Division

    Price per memory/keyboard package 3,600 yuan

    Variable costs 1,000 yuan

    Fixed costs 1,800 yuan

    Income tax rate 40%

     South Korea Division

    Price per computer 1,560,000 won

    Variable costs 360,000 won

    Fixed costs 480,000 won

    Income tax rate 20%

     U.S. Division

     Price per computer $3,200

    Variable costs $100

    Fixed costs $200

    Income tax rate 30%

    22-7

    22-18 (Cont‘d.)

    Problem 1

     Method B:

     Method A: Internal Method C:

     Internal Transfers at Internal

    Transfers at 200% of Full Transfers at

     Market Price Costs 300% of Variable Costs

    China Division

    Division revenues per unit $450 $700 $375

    Deduct:

    Division variable costs per unit 125 125 125 Division fixed costs per unit 225 225 225

    Division operating income per unit 100 350 25

    Income tax 40 140 10 Division net income per unit $ 60 $210 $ 15

    South Korea Division

    Division revenues per unit $1,300 $2,800 $2,025

    Deduct:

    Transferred in costs per unit 450 700 375 Division variable costs per unit 300 300 300 Division fixed costs per unit 400 400 400

    Division operating income per unit 150 1,400 950

    Income tax 30 280 190 Division net income per unit $ 120 $1,120 $ 760

    United States Division

    Division revenues per unit $3,200 $3,200 $3,200

    Deduct:

    Transferred in costs per unit 1,300 2,800 2,025 Division variable costs per unit 100 100 100 Division fixed costs per unit 200 200 200

    Division operating income per unit 1,600 100 875

    Income tax 480 30 262.50 Division net income per unit $1,120 $ 70 $612.50

    Problem 2

    Division Net Income Market Price 200% of Full 300% of Variable

    Costs Costs

    China Divison $60 $210 $15

    South Korea Division $120 $1,120 $760

    U.S. Division $1,120 $70 $612.50 User Friendly Computer, Inc. $1,300 $1,400 $1,387.50

    22-8

22-19 (30 min.) Transfer-pricing methods, goal congruence.

    1. Alternative 1: Sell as raw lumber for $200 per 100 board feet:

     Revenue $200

     Variable costs 100

     Contribution margin $100 per 100 board feet

     Alternative 2: Sell as finished lumber for $275 per 100 board feet:

     Revenue $275

     Variable costs:

     Raw lumber $100

     Finished lumber 125 225

     Contribution margin $ 50 per 100 board feet

British Columbia Lumber will maximize its total contribution margin by selling lumber in its

    raw form.

     An alternative approach is to examine the incremental revenues and incremental costs in

    the Finished Lumber Division:

     $200 $ 75 Incremental revenues, $275

     Incremental costs 125

     Incremental loss $ (50) per 100 board feet

2. Transfer price at 110% of variable costs:

     = $100 + ($100 0.10)

     = $110 per 100 board feet

     Sell as Raw Lumber Sell as Finished Lumber

    Raw Lumber Division

    Division revenues $200 $110

    Division variable costs 100 100

    Division operating income $100 $ 10

Finished Lumber Division

    Division revenues $ 0 $275

    Transferred-in costs 110

    Division variable costs 125

    Division operating income $ 0 $ 40

The Raw Lumber Division will maximize reported division operating income by selling raw

    lumber, which is the action preferred by the company as a whole. The Finished Lumber Division

    will maximize division operating income by selling finished lumber, which is contrary to the

    action preferred by the company as a whole.

    22-9

22-19 (Cont‘d.)

    3. Transfer price at market price = $200 per 100 board feet.

     Sell as Raw Lumber Sell as Finished Lumber

    Raw Lumber Division

    Division revenues $200 $200

    Division variable costs 100 100

    Division operating income $100 $100

Finished Lumber Division

    Division revenues $ 0 $275

    Transferred-in costs 200

    Division variable costs 125

    Division operating income $ 0 $ (50)

    The Raw Lumber Division will maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole. Finished Lumber Division will

    maximize division operating income by not further processing raw lumber; not further processing is preferred by the company as a whole.

    22-10

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