Financial Performance and Transfer Pricing ACCT7320Controllership November 9, 2011

Management Control Systems A management control system -- involves gathering and using information for planning and control decisions. A management control system -- involves gathering and using information for planning and control decisions. A management control system guides the behavior of managers and employees A management control system guides the behavior of managers and employees Basis for evaluation and reward Basis for evaluation and reward Consistent with “agency theory” Consistent with “agency theory” 2

Management Control Systems A management control system collects: Financial data such as cost, revenue, and net incomeFinancial data such as cost, revenue, and net income Usually an important factor!Usually an important factor! Nonfinancial dataNonfinancial data As seen on BSC As seen on BSC 3

Four Types of Financial Responsibility Centers 1 Cost center –manager accountable for costs only. 2 Revenue center –manager accountable for revenues only. 3 Profit center –manager accountable for revenues and costs. 4 Investment center –manager accountable for investments, revenues, and costs. 4

Evaluating Management Control Systems Motivation – desire to attain a selected goal combined with the resulting drive or pursuit toward that goal. Motivation – desire to attain a selected goal combined with the resulting drive or pursuit toward that goal. Goal congruence – subordinates’ individual goals are consistent with top management’s goals. Goal congruence – subordinates’ individual goals are consistent with top management’s goals. Effort – exertion toward a goal. Effort – exertion toward a goal. 5

Organization Structure Total decentralization means minimum constraints, maximum freedom for managers at the lowest levels to make decisions. Total decentralization means minimum constraints, maximum freedom for managers at the lowest levels to make decisions. Total centralization means maximum constraints, minimum freedom for managers at the lowest levels to make decisions. Total centralization means maximum constraints, minimum freedom for managers at the lowest levels to make decisions. 6

Benefits of Decentralization – Creates greater responsiveness to local needs – Leads to gains from quicker decision making – Increases motivation of subunit managers – Aids management development and learning – Sharpens the focus of subunit managers 7

Recall the Costs of Decentralization – Leads to suboptimal decision making (incongruent or dysfunctional decision making due to loss of control) – Focuses manager’s attention on the subunit rather than the organization as a whole – Increases costs of gathering information – Results in duplication of activities 8

Decentralization in Multinational Companies Multinational corporations are often decentralized Multinational corporations are often decentralized centralized control of subunits in three or four different continents is hard centralized control of subunits in three or four different continents is hard Decentralization enables managers to apply their knowledge of local business and political conditions. Decentralization enables managers to apply their knowledge of local business and political conditions. 9

Decentralization in Multinational Companies Often rotate managers between foreign locations and corporate headquarters. Often rotate managers between foreign locations and corporate headquarters. Job rotation with decentralization helps develop managers’ abilities to operate in the global environment. Job rotation with decentralization helps develop managers’ abilities to operate in the global environment. A drawback to decentralizing multinational companies is the lack of control. A drawback to decentralizing multinational companies is the lack of control. 10

Transactions between Divisions What happens when transactions occur between divisions (subunits)? What happens when transactions occur between divisions (subunits)? Effects on individual divisional performance Effects on individual divisional performance Effects on the overall organization Effects on the overall organization The control design of the control system affects the outcome The control design of the control system affects the outcome 11

Transfer Pricing A transfer price is the price one subunit charges for a product/service supplied to another subunit of the same organization. A transfer price is the price one subunit charges for a product/service supplied to another subunit of the same organization. Creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income. Creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income. Overall organization’s income unaffected upon consolidation! Overall organization’s income unaffected upon consolidation! 12

Transfer Pricing What is the behavioral objective for transfer prices? What is the behavioral objective for transfer prices? Subunit managers need only consider how their actions will affect subunit performance without evaluating their impact on companywide performance. Subunit managers need only consider how their actions will affect subunit performance without evaluating their impact on companywide performance. A well designed TP policy will lead to goal congruence A well designed TP policy will lead to goal congruence 13

Major Decisions about TPs Two major decisions in transfer pricing policy: Sourcing -- should segments be free to decide whether to sell/buy from other segments Pricing method-- what transfer price should be set for any transfer Criteria for “good” policy? goal congruence managerial effort subunit autonomy [where desired] 14

Transfer-Pricing Methods Three general methods for transfer pricing: Three general methods for transfer pricing: 1 Market-based Price of a similar product/ service publicly listed Price of a similar product/ service publicly listed 2 Cost-based Some basis of “cost” (plus a margin?) Some basis of “cost” (plus a margin?) 3 Negotiated Whatever the subunit managers agree Whatever the subunit managers agree [Also Dual Method: Revenue to seller, cost to buyer not equal] Revenue to seller, cost to buyer not equal] 15

Effects on Income Except for tax impacts, no impact on overall consolidated income Except for tax impacts, no impact on overall consolidated income Affects distribution of income among segments Affects distribution of income among segments 16

The Importance of Transfer Pricing Evaluation of a division for sale (What earnings are relevant?) Minority interest in a subsidiary (Is subsidiary being "plundered"?) Tax minimization (Can shift income to some degree.) Governmental contracting (Endorses full-cost TPs.) 17

What Can Happen Regarding Goal Congruence? From corporation’s viewpoint, it’s an outsourcing decision! Internal production is better for the company overall Outsourcing is better for company overall Deal is completed internally Good outcome Bad outcome Purchaser goes outside Bad outcome Good outcome 18

Will the Desired Outcome Occur? If outsourcing is desirable, there will be a range of acceptable prices: Ceiling: The outside market price that buyer would pay [Room to share benefit.] Floor: The outlay costs of supplier + opportunity cost. If idle capacity, there is no opportunity cost. If no idle capacity, then it’s sales price to current outside customer. 19

Comparison of Methods Market Price:Yes, if markets competitive Market Price:Yes, if markets competitive Cost-Based:Often, but not always Cost-Based:Often, but not always Negotiated:Yes Negotiated:Yes Achievement of Goal Congruence 20

Comparison of Methods Market Price:Yes, if markets competitive Market Price:Yes, if markets competitive Cost-Based:Difficult, unless transfer price exceeds full cost Cost-Based:Difficult, unless transfer price exceeds full cost Negotiated:Yes Negotiated:Yes Usefulness for Evaluating Subunit Performance 21

Comparison of Methods Market Price:Yes Market Price:Yes Cost-Based:Yes, if based on budgeted costs; less incentive if based on actual cost Cost-Based:Yes, if based on budgeted costs; less incentive if based on actual cost Negotiated:Yes Negotiated:Yes Motivating Management Effort 22

Comparison of Methods Market Price:Yes, if markets competitive Market Price:Yes, if markets competitive Cost-Based:No, it is rule based Cost-Based:No, it is rule based Negotiated:Yes Negotiated:Yes Preserving Subunit Autonomy 23

Comparison of Methods Market Price:No market may exist Market Price:No market may exist Cost-Based:Useful for determining full- cost; easy to implement Cost-Based:Useful for determining full- cost; easy to implement Negotiated:Bargaining takes time and may need to be reviewed Negotiated:Bargaining takes time and may need to be reviewed Other Factors to Consider 24

Tax & Multinational Transfer Pricing 25

Importance Continued: Eli Lily Case (1957) IRS objected to tax return Lily had used variable costs as TP basis Court decided the true purpose was tax avoidance, held for IRS Established market-based TPs for tax purposes 26

Tax & Multinational Transfer Pricing Transfer prices often have tax implications. Transfer prices often have tax implications. Tax factors include not only income taxes, but also payroll taxes, customs duties, tariffs, sales taxes, and other levies on organizations. Tax factors include not only income taxes, but also payroll taxes, customs duties, tariffs, sales taxes, and other levies on organizations. Section 482 of the U.S. Internal Revenue Service Code governs taxation of multinational transfer pricing. Section 482 of the U.S. Internal Revenue Service Code governs taxation of multinational transfer pricing. 27

Multinational Transfer Pricing 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. 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. 28

Multinational Transfer Pricing Transfer prices can reduce income tax payments by recognizing more income in low tax rate countries and less income in high tax rate countries. Transfer prices can reduce income tax payments by recognizing more income in low tax rate countries and less income in high tax rate countries. Tax regulations of different countries restrict the transfer prices that companies can choose. Tax regulations of different countries restrict the transfer prices that companies can choose. 29

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