Management-Control Systems,

Transfer Pricing,
and Multinational Considerations

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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
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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 firms 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 companys culture, and the
unwritten norms about acceptable behavior for
managers and other employees.

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 To be effective, management control systems
should be closely aligned to the firms
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 organizations 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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 Goal congruence exists when individuals and
groups work toward achieving the
organizations goalsmanagers 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.

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 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.
Subunit refers to any part of an organization.
It may be a large division or a small group.

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 Creates greater responsiveness to the needs
of a subunits 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 decisions 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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 Top managers must compare the benefits and
costs of decentralization when choosing an
organizational structure.
Decisions related 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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Recall from chapter 6 that a responsibility center
is a segment or subunit of the organization whose
manager is accountable for a specified set of
activities.
To measure 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 pricethe 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 subunits
operating income.
The operating incomes can be used to
evaluate the subunits performances and to
motivate their managers.
Intermediate productthe 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? Lets look in more
detail at each category.

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 Top managers 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.

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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.
Allows a firm to achieve goal congruence,
motivating management effort, subunit
performance evaluations, and preserve
subunit autonomy.
Perhaps should 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.
Usefulwhen 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.
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 Despiteits 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.

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 Full-cost transfer pricing also raises many
issues:
1. How are the subunits 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?

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 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.
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 Prorating the difference between the
maximum and minimum cost-based transfer
prices.
Dual-pricingusing 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.

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 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.
Represent the outcome of a bargaining
process between the selling and buying
subunits.

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 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.

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 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.

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 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.

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TERMS TO LEARN PAGE NUMBER REFERENCE
Autonomy Page 843
Decentralization Page 843
Dual pricing Page 856
Dysfunctional decision making Page 844
Effort Page 842
Goal congruence Page 842
Incongruent decision making Page 844
Intermediate product Page 846
Management control system Page 841
Motivation Page 842
Perfectly competitive market Page 850

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TERMS TO LEARN PAGE NUMBER REFERENCE
Suboptimal decision making Page 844
Transfer price Page 846

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