Financial Performance and
Transfer Pricing
ACCT7320
Controllership
December 1, 2010
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
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Basis for evaluation and reward
Consistent with “agency theory”
2
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
3
Four Types of Financial
Responsibility Centers
1
2
3
4
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.
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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.
5
Organization Structure

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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.
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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
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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
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Decentralization in
Multinational Companies

Multinational corporations are often
decentralized

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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.
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Decentralization in
Multinational Companies
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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.
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Transactions between Divisions

What happens when transactions occur
between divisions (subunits)?
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Effects on individual divisional performance
Effects on the overall organization
The control design of the control system
affects the outcome
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Transfer Pricing

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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.
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Transfer Pricing

What is the behavioral objective for
transfer prices?
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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
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Major Decisions about TPs

Two major decisions in transfer pricing policy:
•
•
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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?

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goal congruence
managerial effort
subunit autonomy [where desired]
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Transfer-Pricing Methods
Three general methods for transfer
pricing:

Market-based
1
•
Price of a similar product/ service publicly listed
Cost-based
2
•
Some basis of “cost” (plus a margin?)
Negotiated
3
•
Whatever the subunit managers agree
[Also Dual Method:
•
Revenue to seller, cost to buyer not equal]
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Effects on Income

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Except for tax impacts, no impact on
overall consolidated income
Affects distribution of income among
segments
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The Importance of Transfer Pricing

Evaluation of a division for sale
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Minority interest in a subsidiary

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(Is subsidiary being "plundered"?)
Tax minimization
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(What earnings are relevant?)
(Can shift income to some degree.)
Governmental contracting
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(Endorses full-cost TPs.)
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What Can Happen Regarding Goal
Congruity?
Internal
production is
Outsourcing is
better for
best for company
company overall
overall
Deal is
completed
internally
Purchaser
goes
outside
Good outcome
Bad outcome
Bad outcome
Good outcome
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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.
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If idle capacity, it’s just outlay cost
If no idle capacity, then it’s sales price to current
outside customer.
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Comparison of Methods
Achievement of Goal Congruence
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Market Price: Yes, if markets competitive
Cost-Based: Often, but not always
Negotiated: Yes
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Comparison of Methods
Usefulness for Evaluating Subunit Performance
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Market Price: Yes, if markets competitive
Cost-Based: Difficult, unless transfer price
exceeds full cost
Negotiated: Yes
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Comparison of Methods
Motivating Management Effort


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Market Price: Yes
Cost-Based: Yes, if based on budgeted
costs; less incentive if based
on actual cost
Negotiated: Yes
22
Comparison of Methods
Preserving Subunit Autonomy
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Market Price: Yes, if markets competitive
Cost-Based: No, it is rule based
Negotiated: Yes
23
Comparison of Methods
Other Factors to Consider
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Market Price: No market may exist
Cost-Based: Useful for determining fullNegotiated:
cost; easy to implement
Bargaining takes time and
may need to be reviewed
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Tax & Multinational Transfer Pricing
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Importance Continued:
Eli Lily Case (1957)
Eli Lily Tax Case (1957 )
Eli Lily
Prarmaceuticals
Ethical [Prescription]
Drugs

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Patent
Drugs
Western Hemisphere Trade Corporation
Compare DISCs, FSCs
Other Products
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
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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.
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.
28
Multinational Transfer Pricing

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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.
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The End
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