Management Control Systems,

Transfer Pricing, and

Multinational Considerations

Chapter 22

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

 Learning Objective 1

Describe a management
control system and its
three key properties.
 Management Control Systems

A management control system is a means

of gathering and using information.
It guides the behavior of managers and employees.
Management Control Systems

Financial data

Nonfinancial data

Formal control system

Informal control system

 Evaluating Management
Control Systems

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary
 Learning Objective 2

Describe the benefits and

costs of decentralization.
 Organization Structure

Total decentralization

Total centralization
 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 subunit
rather than the organization as a whole
Increases the costs of gathering information
Results in duplication of activities
 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.
Responsibility Centers

Cost Revenue
center center

Profit Investment
center center
 Learning Objective 3

Explain transfer prices and four

criteria used to evaluate them.
 Transfer Pricing

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.
 Transfer Pricing

Transfer pricing should help achieve

a company’s strategies and goals.
– fit the organization’s structure
– promote goal congruence
– promote a sustained high level
of management effort
 Learning Objective 4

Calculate transfer prices using

three different methods.
 Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices

 Transfer-Pricing
Methods Example

Lomas & Co. has two divisions:

Transportation and Refining.
Transportation purchases Refining processes
crude oil in Alaska and crude oil
sends it to Seattle. into gasoline.
 Transfer-Pricing
Methods Example

External market price for supplying

crude oil per barrel: $13
Transportation Division:
Variable cost per barrel of crude oil $ 2
Fixed cost per barrel of crude oil 3
Total $ 5
The pipeline can carry 35,000 barrels per day.
 Transfer-Pricing
Methods Example

External purchase price for

crude oil per barrel: $23
Refining Division:
Variable cost per barrel of gasoline $ 8
Fixed cost per barrel of gasoline 4
Total $12
The division is buying 20,000 barrels per day.
 Transfer-Pricing
Methods Example

The external market price to outside

parties is $60 per barrel.
The Refining Division is operating
at 30,000 barrels capacity per day.
 Transfer-Pricing
Methods Example

What is the market-based transfer price

from Transportation to Refining?

$23 per barrel

What is the cost-based transfer price

at 112% of full costs?
 Transfer-Pricing
Methods Example

Purchase price of crude oil $13

Variable costs per barrel of crude oil 2
Fixed costs per barrel of crude oil 3
Total $18
1.12 × $18 = $20.16
What is the negotiated price?
Between $20.16 and $23.00 per barrel.
 Transfer-Pricing
Methods Example

Assume that the Refining Division buys

1,000 barrels of crude oil from the
Transportation Division.
The Refining Division converts these 1,000
barrels of crude oil into 500 gallons of
gasoline and sells them.
What is the Transportation Division operating
income using the market-based price?
 Transfer-Pricing
Methods Example

Transportation Division:
Revenues: ($23 × 1,000) $23,000
Deduct costs: ($18 × 1,000) 18,000
Operating income $ 5,000
What is the Refining Division’s operating
income using the market-based price?
 Transfer-Pricing
Methods Example

Refining Division:
Revenues: ($60 × 500) $30,000
Deduct costs:
Transferred-in ($23 × 1,000) 23,000
Division variable ($8 × 500) 4,000
Division fixed ($4 × 500) 2,000
Operating income $ 1,000
 Transfer-Pricing
Methods Example

What is the operating income of both

divisions together?
Transportation Division $5,000
Refining Division 1,000
Total $6,000
 Transfer-Pricing
Methods Example

What is the Transportation Division’s operating

income using the 112% of full cost price?
Transportation Division:
Revenues: ($20.16 × 1,000) $20,160
Deduct costs: ($18.00 × 1,000) 18,000
Operating income $ 2,160
What is the Refining Division operating
income using the full cost price?
 Transfer-Pricing
Methods Example

Refining Division:
Revenues ($60 × 500) $30,000
Deduct costs:
Transferred-in ($20.16 × 1,000) 20,160
Division variable ($8.00 × 500) 4,000
Division fixed ($4.00 × 500) 2,000
Operating income $ 3,840
 Transfer-Pricing
Methods Example

What is the operating income of both

divisions together?
Transportation Division $2,160
Refining Division 3,840
Total $6,000
 Learning Objective 5

Illustrate how market-based

transfer prices promote goal
congruence in perfectly
competitive markets.
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
Market-Based Transfer Prices

Market prices also serve to evaluate the

economic viability and profitability
of divisions individually.
 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.
 Learning Objective 6

Avoid making suboptimal

decisions when transfer
prices are based on full
cost plus a markup.
 Cost-Based Transfer
Prices Example

The Refining Division of Lomas & Co. is

purchasing crude oil locally for $23 a barrel.
The Refining Division located an independent
producer in Alaska that is willing to sell 20,000
barrels of crude oil per day at $17 per barrel
delivered to the pipeline (Transportation Division).
 Cost-Based Transfer
Prices Example

The Transportation Division has excess

capacity and can transport the crude oil
at its variable costs of $2 per barrel.
Should Lomas purchase from the
independent supplier?
Yes.
There is a reduction in total costs of $80,000.
 Cost-Based Transfer
Prices Example

Alternative 1:
Buy 20,000 barrels from the
local supplier at $23 per barrel.
The total cost to Lomas is:
20,000 × $23 = $460,000
 Cost-Based Transfer
Prices Example

Alternative 2:
Buy 20,000 barrels from the independent
supplier in Alaska at $17 per barrel and
transport it to Seattle at $2 per barrel.
The total cost to Lomas is:
20,000 × $19 = $380,000
 Cost-Based Transfer
Prices Example

Suppose the Transportation Division’s

transfer price to the Refining Division
is 112% of full cost.
What is the cost to the Refining Division?
 Cost-Based Transfer
Prices Example

Purchase price of crude oil $17

Variable costs per barrel of crude oil 2
Fixed costs per barrel of crude oil 3
Total $22
1.12 × $22 = $24.64
$24.64 × 20,000 = $492,800
 Cost-Based Transfer
Prices Example

What is the maximum transfer price?

It is the price that the Refining Division can
pay in the local external market ($23).
What is the minimum transfer price?
The minimum transfer price is $19 per barrel.
 Learning Objective 7

Understand the range over

which two divisions negotiate
the transfer price when
there is unused capacity.
 Prorating

Lomas & Co. may choose a transfer price

that splits on some equitable basis the
difference between the maximum transfer
price and the minimum transfer price.
$23 – $19 = $4
Suppose that variable costs are chosen as
the basis to allocate this $4 difference.
 Prorating

The Transportation Division’s variable

costs are $2 × 1,000 = $2,000.
The Refining Division’s variable costs to
refine 1,000 of crude oil into 500 barrels
of gasoline are $8 × 500 = $4,000.
 Prorating

The Transportation Division gets to keep

$2,000 ÷ $6,000 × $4 = $1.33.
The Refining Division gets to keep
$4,000 ÷ $6,000 × $4 = $2.67.
What is the transfer price from the
Transportation Division?
$17.00 + $2.00 + $1.33 = $20.33
 Dual Pricing

An example of dual pricing is for Lomas & Co.

to credit the Transportation Division with
112% of the full cost transfer price of $24.64
per barrel of crude oil.
Debit the Refining Division with the market-based
transfer price of $23 per barrel of crude oil.
 Negotiated Transfer Prices

Negotiated transfer prices arise from the

outcome of a bargaining process between
selling and buying divisions.
 Learning Objective 8

Construct a general guideline

for determining a minimum
transfer price.
 Comparison of Methods

Achieves Goal Congruence

Market Price: Yes, if markets competitive

Cost-Based: Often, but not always
Negotiated: Yes
 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
 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
 Comparison of Methods

Preserves Subunit Autonomy

Market Price: Yes, if markets competitive

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

Minimum transfer price

= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division
 General Guideline

Assume a perfectly competitive market,

with no idle capacity.
Transportation Division can sell all the crude oil
it transports to the external market in Seattle
for $23 per barrel.
What is the minimum transfer price?
($19 + $4) or ($13 + $2 + $8) = $23 = Market price
 General Guideline

Assume that an intermediate market exists

that is not perfectly competitive, and the
selling division has idle capacity.
If the Transportation Division has idle
capacity, its opportunity cost of transferring
the oil internally is zero.
What is the minimum transfer price?
 General Guideline

It would be $15 per barrel for oil purchased

under the long-term contract, or...
$19 per barrel for oil purchased and
transported from the independent
supplier in Alaska.
 Learning Objective 9

Incorporate income tax

considerations in
multinational
transfer pricing.
 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.
 End of Chapter 22

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster