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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Management Control Systems A management control system is a means of gathering and using information. It guides the behavior of managers and employees.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Management Control Systems Financial data Formal control system Nonfinancial data Informal control system

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Evaluating Management Control Systems MotivationGoal congruenceEffort Lead to rewards MonetaryNonmonetary

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Describe the benefits and costs of decentralization.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Organization Structure Total decentralization Total centralization

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

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Responsibility Centers Cost center Revenue center Investment center Profit center

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 3 Explain transfer prices and four criteria used to evaluate them.

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 4 Calculate transfer prices using three different methods.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Transfer-Pricing Methods Market-based transfer prices Cost-based transfer prices Negotiated transfer prices

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Transfer-Pricing Methods Example Lomas & Co. has two divisions: Transportation and Refining. Transportation purchases crude oil in Alaska and sends it to Seattle. Refining processes crude oil into gasoline.

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

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

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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 = $20.16 What is the negotiated price? Between $20.16 and $23.00 per barrel.

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

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Transfer-Pricing Methods Example What is the operating income of both divisions together? Transportation Division$5,000 Refining Division 1,000 Total$6,000

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Transfer-Pricing Methods Example What is the operating income of both divisions together? Transportation Division $2,160 Refining Division 3,840 Total$6,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 5 Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets.

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Market-Based Transfer Prices Market prices also serve to evaluate the economic viability and profitability of divisions individually.

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 6 Avoid making suboptimal decisions when transfer prices are based on full cost plus a markup.

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

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

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

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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 = $24.64 $24.64 × 20,000 = $492,800

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 7 Understand the range over which two divisions negotiate the transfer price when there is unused capacity.

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 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? $ $ $1.33 = $20.33

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Negotiated Transfer Prices Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 8 Construct a general guideline for determining a minimum transfer price.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of Methods Achieves Goal Congruence Market Price:Yes, if markets competitive Cost-Based:Often, but not always Negotiated:Yes

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of Methods Useful for Evaluating Subunit Performance Market Price:Yes, if markets competitive Cost-Based: Difficult, unless transfer price exceeds full cost Negotiated:Yes

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of Methods Motivates Management Effort Market Price:Yes Cost-Based: Yes, if based on budgeted costs; less incentive if based on actual cost Negotiated:Yes

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of Methods Preserves Subunit Autonomy Market Price:Yes, if markets competitive Cost-Based:No, it is rule based Negotiated:Yes

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison of Methods Other Factors Market Price:No market may exist Cost-Based: Useful for determining full-cost; easy to implement Negotiated: Bargaining takes time and may need to be reviewed

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster General Guideline Minimum transfer price = Incremental costs per unit incurred up to the point of transfer + Opportunity costs per unit to the selling division

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

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

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 9 Incorporate income tax considerations in multinational transfer pricing.

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

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster End of Chapter 22