1. Financial Performance and Transfer Pricing
ACCT7320
Controllership
December 1, 2010

2. Management Control Systems
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
Basis for evaluation and reward
Consistent with “agency theory”

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

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

5. Evaluating Management Control Systems
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.
Effort – exertion toward a goal.

6. Organization Structure
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.

7. 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

8. 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

9. Decentralization in Multinational Companies
Multinational corporations are often decentralized
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.

10. Decentralization in Multinational Companies
Often rotate managers between foreign locations and corporate headquarters.
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.

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

12. Transfer Pricing
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.

13. Transfer Pricing 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.
A well designed TP policy will lead to goal congruence

14. 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]

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

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

17. 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.)

18. What Can Happen Regarding Goal Congruity?
Internal production is better for company overall
Outsourcing is best for company overall
Deal is completed internally
Good outcome
Bad outcome
Purchaser goes outside

19. Setting Transfer Prices
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, it’s just outlay cost
If no idle capacity, then it’s sales price to current outside customer.

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

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

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

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

24. Other Factors to Consider
Comparison of Methods
Other Factors to Consider
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

25. Tax & Multinational Transfer Pricing

26. 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

27. Tax & Multinational Transfer Pricing
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.
Section 482 of the U.S. Internal Revenue Service Code governs taxation of multinational transfer pricing.

28. 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.

29. 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.
Tax regulations of different countries restrict the transfer prices that companies can choose.

30. The End