Chapter 18 - Control systems and transfer pricing

Question 1

1 Describe a management control system

Answer 1

A management control system is a means of gathering and using information to aid and coordinate the process of making planning and control decisions throughout the organisation, and to guide employee behaviour.

Question 2

What four levels are information for management control gathered at?

Answer 2

1 Total-organisation level – for example, stock price, net income, return on investment, cash flow from operations, total employment, pollution control, and contributions to the community.
2 Customer/market level – for example, customer satisfaction, time taken to respond to customer requests for products, and cost of competitors’ products.
3 Individual-facility level – for example, materials costs, labour costs, absenteeism and accidents in various divisions or business functions (such as R&D, manufacturing and distribution).
4 Individual-activity level – for example, the time taken and costs incurred for receiving, storing, assembling and dispatching goods in a warehouse; scrap rates, defects and units reworked on a manufacturing line; the number of sales transactions and sales euros per salesperson; and the number of shipments per employee at distribution centres.

Question 3

What are the formal and informal components of the management control system?

Answer 3

The formal management control system of an organisation includes those explicit rules, procedures, performance measures and incentive plans that guide the behaviour of its managers and employees. The formal control system itself consists of several systems. The management accounting system is a formal accounting system that provides information on costs, revenues and income. The informal part of the management control system includes such aspects as shared values, loyalties and mutual commitments among members of the organisation and the unwritten norms about acceptable behaviour for promotion that also influence employee behaviour.

Question 4

2 What are the important elements of an effective management control systems?

Answer 4

Effective management control systems are closely aligned to the organisation’s strategy, fit the organisation’s structure and the decision-making responsibility of individual managers, and motivate managers and employees to give effort to achieve the organisation’s goals.

Question 5

What is goal congruence?

Answer 5

Goal congruence exists when individuals and groups work towards the organisational goals that top management desires - that is, managers working in their own best interest take actions that further the goals of top management.

Question 6

Define effort and motivation

Answer 6

the desire to attain a selected goal (the goal-congruence aspect) combined with the resulting drive towards that goal (the effort aspect).Effort exertion towards a goal. Effort goes beyond physical exertion_

Question 7

Define decentralisation

Answer 7

The essence of decentralisation is the freedom for managers at lower levels of the organisation to make decisions. Total decentralisation means minimum constraints and maximum freedom for managers at the lowest levels of an organisation to make decisions. Total centralisation means maximum constraints and minimum freedom for managers at the lowest level. In most companies - somewhere in between.

Question 8

3 Describe 5 benefits of decentralisation

Answer 8

The benefits of decentralisation include:
(a) greater responsiveness to local needs, (b) gains from quicker decision making, (c) increased motivation of subunit managers, (d) greater management development and learning, and (e) sharper management focus.

Question 9

3 Describe 4 costs of decentralisation

Answer 9

The costs of decentralisation include:
(a) suboptimal decision making (control loss, arises when a decision’s benefit to one subunit is more than offset by the costs to the organisation as a whole), (b) duplication of activities, (c) decreased loyalty towards the organisation (focus on subunit rather than whole organisation), and (d) increased costs of information gathering (spending too much time negotiating the prices for inter products or services transferred between subunits).

Question 10

How does the management control system measure the performance of subunits?

Answer 10

The management control system uses one or a mix of the four types of responsibility centre presented in ch. 14: Cost centre, revenue centre, profit centre and investment centre. Remember: The labels are independent of the degree of decentralisation in an organisation.

Question 11

What is a transfer price and what is transfer pricing?

Answer 11

Transfer price: the price one subunit (segment, department, division etc.) of an organisation charges for a product or service supplied to another subunit of the same organisation.
In decentralised organisations, individual subunits of an organisation act as separate units. In these settings, the management control system often uses transfer prices to coordinate actions and to evaluate performance of the subunits.
An intermediate product is a product transferred from one subunit to another subunit of the same organisation.
The transfer price creates revenue for the selling subunit and a purchase cost for the buying subunit, affecting operating profit for both subunits. The operating profits can be used to evaluate the performance of each subunit and to motivate managers.

Question 12

4 Identify three general methods for determining transfer prices and understand how a transfer-pricing method can affect the operating profit of individual subunits

Answer 12

Transfer prices can be (a) market-based, (b) cost-based, or (c) negotiated. Different transfer-pricing methods produce different revenues and costs for individual subunits, and hence different operating profits for them.

Question 13

5 How do market-based transfer prices generally promote goal congruence in perfectly competitive markets?

Answer 13

Transferring products or services at market prices generally leads to optimal decisions when three conditions are satisfied: (1) the intermediate market is perfectly competitive, (2) interdependencies of subunits are minimal, and (3) there are no additional costs or benefits to the corporation as a whole in using the market instead of transacting internally. By using market-based transfer prices in perfectly competitive markets, a company can meet the criteria of goal congruence, management effort and (if desired) subunit autonomy.
In perfectly competitive markets, there is no idle capacity, and division managers can buy and sell as much as they want at the market price. Setting the transfer price at the market price motivates division managers to deal internally and to take exactly the same actions as they would if they were dealing in the external market.

Question 14

What is a distress price?

Answer 14

When supply outstrips demand, market prices may drop well below their historical average. If the drop in prices is expected to be temporary, these low market prices are sometimes called ‘distress prices’. Deciding whether a current market price is a distress price is often difficult.

Question 15

Which transfer-pricing method should be used for judging performance if distress prices prevail?

Answer 15

Some companies use the distress prices themselves, but others use long-run average prices, or ‘normal’ market prices. In the short run, the manager of the supplier division should meet the distress price as long as it exceeds the incremental costs of supplying the product or service; if not, the supplying division should stop producing and the buying division should buy the product or service from an outside supplier. These actions would increase overall company-wide operating income. If the long-run average market price is used, forcing the manager to buy internally at a price above the current market price will hurt the buying division’s short-run performance and understate its profitability. If, however, prices remain low in the long run, the manager of the supplying division must decide whether to dispose of some manufacturing facilities or shut down and get the buying division to purchase the product from outside.

Question 16

When are cost-based transfer prices helpful?

Answer 16

Cost-based transfer prices are helpful when market prices are unavailable, inappropriate, or too costly to obtain. For example, the product may be specialised or unique, price lists may not be widely available, or the internal product may be different from the products available externally in terms of quality and service.

Question 17

6 When can a transfer price may lead to suboptimal decisions?

Answer 17

A transfer price based on full cost plus a mark-up may lead to suboptimal decisions because it leads the ‘buying’ division to regard the fixed costs and the mark-up of the selling division as variable costs.

Question 18

What is dual pricing?

Answer 18

There is seldom a single transfer price that simultaneously meets the criteria of goal congruence, management effort and subunit autonomy. Some companies turn to dual pricing, using two separate transfer-pricing methods to price each interdivisional transaction. An example of dual pricing arises when the selling division receives a full cost plus mark-up-based price and the buying division pays the market price for the internally transferred products.
Dual pricing is not widely used in practice even though it reduces the goal-congruence problems associated with a pure cost-plus-based transfer-pricing method. One concern of top management is that the manager of the supplying division does not have sufficient incentive to control costs with a dual-price system. A second concern is that the dual-price system confuses division managers about the level of decentralisation top management seeks. Above all, dual pricing tends to insulate managers from the frictions of the marketplace. Managers should know as much as possible about their subunit’s buying and selling markets, and dual pricing reduces the incentive to gain this knowledge.

Question 19

7 What is the range over which two divisions generally negotiate the transfer price when there is unused capacity?

Answer 19

When there is excess capacity, the transfer price range for negotiations generally lies between the minimum price at which the selling division is willing to sell (its variable costs) and the maximum price the buying division is willing to pay (the price at which the product is available from outside suppliers).

Question 20

8 Present a general guideline for determining a minimum transfer price in transfer-pricing situations

Answer 20

The general guideline for transfer pricing states that the minimum transfer price equals the incremental costs per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division resulting from transferring products or services internally.
The term incremental or outlay costs in this context represents the additional costs that are directly associated with the production and transfer of the products or services. Opportunity costs are defined here as the maximum contribution forgone by the supplying division if the products or services are transferred internally

Question 21

9 Recognise income tax considerations in multinational transfer pricing

Answer 21

Transfer prices can reduce income tax payments by recognising higher profits in low-tax-rate countries and lower profits in high-tax-rate countries.