Management Control System
CHAPTER 22 MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING, AND MULTINATIONAL CONSIDERATIONS 22-1A management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout the organization and to guide the behavior of its managers and employees. The goal of the system is to improve the collective decisions within an organization. 2-2To be effective, management control systems should be (a) closely aligned to an organization’s strategies and goals, (b) designed to fit the organization’s structure and the decision-making responsibility of individual managers, and (c) able to motivate managers and employees to put in effort to attain selected goals desired by top management. 22-3Motivation combines goal congruence and effort. Motivation is the desire to attain a selected goal specified by top management (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort aspect). 2-4 The chapter cites five benefits of decentralization: 1. Creates greater responsiveness to local needs 2. Leads to gains from faster decision making 3. Increases motivation of subunit managers 4. Aids management development and learning 5. Sharpens the focus of subunit managers The chapter cites four costs of decentralization: 1. Leads to suboptimal decision making 2. Results in duplication of activities 3. Focuses managers’ attention on the subunit rather than the company as a whole 4.
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Increases costs of gathering information 22-5 No. Organizations typically compare the benefits and costs of decentralization on a function-by-function basis. For example, companies with highly decentralized operating divisions frequently have centralized income tax strategies. 22-6 No. A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. The two segments can be cost centers, profit centers, or investment centers.
For example, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an example of transfer pricing. 22-7The three general methods for determining transfer prices are: 1. Market-based transfer prices 2. Cost-based transfer prices 3. Negotiated transfer prices 22-8Transfer prices should have the following properties. They should 1. promote goal congruence, 2. be useful for evaluating subunit performance, 3. motivate management effort, and 4. preserve a high level of subunit autonomy in decision making. . No, the chapter illustration demonstrates how division operating incomes differ dramatically under the variable costs, full costs, and market price methods. 10. Transferring products or services at market prices generally leads to optimal decisions when (a) the market for the intermediate product market is perfectly competitive, (b) interdependencies of subunits are minimal, and (c) there are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally. 2-11One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal decisions for the company as a whole. An example of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally. This situation often arises where full-cost-based transfer prices are used. This situation can make the fixed costs of the supplying division appear to be variable costs of the purchasing division.
Another limitation is that the supplying division may not have sufficient incentives to control costs if the full-cost-based transfer price uses actual costs rather than standard costs. The purchasing division sources externally if market prices are lower than full costs. From the viewpoint of the company as a whole, the purchasing division should source from outside only if market prices are less than variable costs of production, not full costs of production. 22-12Reasons why a dual-pricing approach to transfer pricing is not widely used in practice include: 1.
The manager of the supplying division uses a cost-based method to record revenues and does not have sufficient incentives to control costs. 2. This approach does not provide clear signals to division managers about the level of decentralization top management wants. 3. This approach tends to insulate managers from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division. 4. It leads to problems in computing the taxable income of subunits located in different tax jurisdictions. 2-13Disagree. Cost and price information are often useful starting points in the negotiation process. Costs, particularly variable costs of the “selling” division, serve as a “floor” below which the selling division would be unwilling to sell. Prices that the “buying” division would pay to purchase products from the outside market serves as a “ceiling” above which the buying division would be unwilling to buy. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices.
But the negotiated price will generally fall between the variable costs-based floor and the market price-based ceiling. 22-14Yes. The general transfer-pricing guideline specifies that the minimum transfer price equals the additional outlay costs per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division. When the supplying division has idle capacity, its opportunity costs are zero; when the supplying division has no idle capacity, its opportunity costs are positive.
Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not. 22-15Alternative transfer-pricing methods can result in sizable differences in the reported operating income of divisions in different income tax jurisdictions. If these jurisdictions have different tax rates or deductions, the net income of the company as a whole can be affected by the choice of the transfer-pricing method. 22-16(25 min. )Decentralization, responsibility centers. 1. The manufacturing plants in the Manufacturing Division are cost centers.
Senior management determines the manufacturing schedule based on the quantity of each type of lighting product specified by the sales and marketing division and detailed studies of the time and cost to manufacture each type of product. Manufacturing managers are accountable only for costs. They are evaluated based on achieving target output within budgeted costs. 2a. If manufacturing and marketing managers were to directly negotiate the prices for manufacturing various products, Quinn should evaluate manufacturing plant managers as profit centers—revenues received from marketing minus the costs incurred to produce and sell output. b. Quinn Corporation would be better off decentralizing its marketing and manufacturing decisions and evaluating each division as a profit center. Decentralization would encourage plant managers to increase total output to achieve the greatest profitability, and motivate plant managers to cut their costs to increase margins. Manufacturing managers would be motivated to design their operations according to the criteria that meet the marketing managers’ approval, thereby improving cooperation between manufacturing and marketing. Under Quinn’s existing system, manufacturing managers had every incentive not to improve.
Manufacturing managers’ incentives were to get as high a cost target as possible so that they could produce output within budgeted costs. Any significant improvements could result in the target costs being lowered for the next year, increasing the possibility of not achieving budgeted costs. By the same line of reasoning, manufacturing managers would also try to limit their production so that production quotas would not be increased in the future. Decentralizing manufacturing and marketing decisions overcomes these problems. 22-17(15 min. ) Decentralization, goal congruence, responsibility centers. . The environmental management organization appears to be decentralized because managers of the environmental management group have considerable freedom to make decisions. They can choose which projects to work on and which projects to reject. Top management will adjust the size of the environmental management group to match the demand for the group’s services by operating divisions. 2. The environmental management group is a cost center. The group is required to charge the operating divisions for environmental services at cost and not at market prices that would help earn the group a profit. . The benefits of structuring the environmental management group in this way are: a. The operating managers have incentives to carefully weigh and conduct cost-benefit analyses before requesting the environmental group’s services. b. The operating managers have an incentive to follow the work and the progress made by the environmental team. c. The environmental group has incentives to fulfill the contract, to do a good job in terms of cost, time, and quality, and to satisfy the operating division in order to continue to get business.
The problems in structuring the environmental group in this way are: a. The contract requires extensive internal negotiations in terms of cost, time, and technical specifications. b. The environmental group needs to continuously “sell” its services to the operating division, and this could potentially result in loss of morale. c. Experimental projects that have long-term potential may not be undertaken because operating division managers may be reluctant to undertake projects that are costly and uncertain, whose benefits will be realized only well after they have left the division.
To the extent that the focus of the environmental group is on short-run projects demanded by the operating divisions, the current structure leads to goal congruence and motivation. Goal congruence is achieved because both operating divisions and the environmental group are motivated to work toward the organizational goals of reducing pollution and improving the environment. The operating divisions will be motivated to utilize the services of the environmental group to achieve the environmental goals set for them by top management.
The environmental group will be motivated to deliver high-quality services in a cost-effective way in order to continue to create a demand for their services. The one issue that top management needs to guard against is that experimental projects with long-term potential that are costly and uncertain may not be undertaken under the current structure. Top management may want to set up a committee to study and propose such long-run projects for consideration and funding by corporate management. 22-18(35 min. )Multinational transfer pricing, effect of alternative transfer-pricing methods, global income tax minimization. . This is a three-country, three-division transfer-pricing problem with three alternative transfer-pricing methods. Summary data in U. S. dollars are: China Plant Variable costs: 1,000 Yuan ? 8 Yuan per $ = $125 per subunit Fixed costs: 1,800 Yuan ? 8 Yuan per $ = $225 per subunit South Korea Plant Variable costs: 360,000 Won ? 1,200 Won per $ = $300 per unit Fixed costs: 480,000 Won ? 1,200 Won per $ = $400 per unit U. S. Plant Variable costs:= $100 per unit Fixed costs:= $200 per unit Market prices for private-label sale alternatives: China Plant:3,600 Yuan ? Yuan per $ = $450 per subunit South Korea Plant: 1,560,000 Won ? 1,200 Won per $= $1,300 per unit The transfer prices under each method are: a. Market price •China to South Korea = $450 per subunit •South Korea to U. S. Plant = $1,300 per unit b. 200% of full costs •China to South Korea 2. 0 ( ($125 + $225) = $700 per subunit •South Korea to U. S. Plant 2. 0 ( ($700 + $300 + $400) = $2,800 per unit c. 300% of variable costs •China to South Korea 3. 0 ( $125 = $375 per subunit •South Korea to U. S. Plant 3. 0 ( ($375 + $300) = $2,025 per unit 22-18 (Cont’d. ) |Method A |Method B |Method C | | |Internal |Internal |Internal | | |Transfers |Transfers |Transfers | | |at Market |at 200% of |at 300% of | | |Price |Full Costs |Variable Costs | | | | | | | | | | | | |1.
China Division | | | | | | | | | | |Division revenue per unit | |$ 450 | | |$ 700 | | |$ 375 | | |Deduct: | | | | | | | | | | |Division variable cost per unit | |125 | | |125 | | |125 | | |Division fixed cost per unit | |225 | | |225 | | |225 | | |Division operating income per unit | |100 | | |350 | | |25 | | |Income tax at 40% | |40 | | |140 | | |10 | | |Division net income per unit | |$ 60 | | |$ 210 | | |$ 15 | | | | | | | | | | | | | |2.
South Korea Division | | | | | | | | | | |Division revenue per unit | |$1,300 | | |$2,800 | | |$2,025 | | |Deduct: | | | | | | | | | | |Transferred-in cost per unit | |450 | | |700 | | |375 | | |Division variable cost per unit | |300 | | |300 | | |300 | | |Division fixed cost per unit | |400 | | |400 | | |400 | | |Division operating income per unit | |150 | | |1,400 | | |950 | | |Income tax at 20% | |30 | | |280 | | |190 | | |Division net income per unit | |$ 120 | | |$1,120 | | |$ 760 | | | | | | | | | | | | | |3.
United States Division | | | | | | | | | | |Division revenue per unit | |$3,200 | | |$3,200 | | |$3,200 | | |Deduct: | | | | | | | | | | |Transferred-in cost per unit | |1,300 | | |2,800 | | |2,025 | | |Division variable cost per unit | |100 | | |100 | | |100 | | |Division fixed cost per unit | |200 | | |200 | | |200 | | |Division operating income per unit | |1,600 | | |100 | | |875 | | |Income tax at 30% | |480 | | |30 | | |262. 5 | | |Division net income per unit | |$1,120 | | |$ 70 | | |$ 612. 5 | | 2. Division net income: |Market |200% of |300% of | | |Price |Full Costs |Variable Cost | | | | | | |China Division |$ 60 |$ 210 |$ 15. 00 | |South Korea Division |120 |1,120 |760. 00 | |U. S. Division |1,120 |70 |612. 50 | |User Friendly Computer Inc. |$1,300 |$1,400 |$1,387. 50 | 22-18 (Cont’d. ) User Friendly will maximize its net income by using the 200% of full costs, transfer-pricing method.
This is because the 200% of full cost method sources most income in the countries with the lower income tax rates. |22-18 Excel Application | | | |User Friendly Computer, Inc. | | | | | | | |Original Data | | | | | |U. S. $ per yuan |0. 125 | | |U. S. $ per won |0. 0083 | | | | | | |China Division | | | |Price per memory/keyboard package |3,600 |yuan | |Variable costs |1,000 |yuan | |Fixed costs |1,800 |yuan | |Income tax rate |40% | | | | | | |South Korea Division | | | |Price per computer |1,560,000 |won | |Variable costs |360,000 |won | |Fixed costs |480,000 |won | |Income tax rate |20% | | | | | | |U. S. Division | | | |Price per computer |$3,200 | | |Variable costs |$100 | | |Fixed costs |$200 | | |Income tax rate | 30% | | | | | | 22-18(Cont’d. ) Problem 1 | | | | | |Method A: |Method B: |Method C: | | |Internal |Internal |Internal | | |Transfers at |Transfers at |Transfers at | | |Market Price |200% of Full Costs |300% of Variable Costs | | | | | | | | | | | | | | | | |China Division | | | | |Division revenues per unit | $450 | $700 | $375 | |Deduct: | | | | |Division variable costs per unit | 125 | 125 | 125 | |Division fixed costs per unit | 225 | 225 | 225 | |Division operating income per unit | 100 | 350 | 25 | |Income tax | 40 | 140 | 10 | |Division net income per unit | $ 60 | $210 | $ 15 | | | | | | |South Korea Division | | | | |Division revenues per unit | $1,300 $2,800 | $2,025 | |Deduct: | | | | |Transferred in costs per unit |450 | 700 | 375 | |Division variable costs per unit | 300 | 300 | 300 | |Division fixed costs per unit | 400 | 400 | 400 | |Division operating income per unit | 150 | 1,400 | 950 | |Income tax | 30 | 280 | 190 | |Division net income per unit | $ 120 | $1,120 | $ 760 | | | | | | |United States Division | | | | |Division revenues per unit | $3,200 | $3,200 | $3,200 | |Deduct: | | | | |Transferred in costs per unit | 1,300 | 2,800 | 2,025 | |Division variable costs per unit | 100 | 100 | 100 | |Division fixed costs per unit | 200 | 200 | 200 | |Division operating income per unit | 1,600 | 100 | 875 | |Income tax | 480 | 30 | 262. 50 | |Division net income per unit | $1,120 | $ 70 | $612. 50 | | | | | | |Problem 2 | | | | | | | | |Division Net Income |Market Price |200% of Full Costs |300% of Variable | | | | |Costs | |China Divison | $60 | $210 | $15 | |South Korea Division | $120 | $1,120 | $760 | |U. S. Division | $1,120 | $70 | $612. 50 | |User Friendly Computer, Inc. | $1,300 | $1,400 | $1,387. 50 | | | | | | 22-19(30 min. ) Transfer-pricing methods, goal congruence. 1. Alternative 1: Sell as raw lumber for $200 per 100 board feet: Revenue$200
Variable costs 100 Contribution margin$100 per 100 board feet Alternative 2: Sell as finished lumber for $275 per 100 board feet: Revenue$275 Variable costs: Raw lumber$100 Finished lumber 125 225 Contribution margin$ 50 per 100 board feet British Columbia Lumber will maximize its total contribution margin by selling lumber in its raw form. An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, $275 – $200$ 75 Incremental costs 125 Incremental loss$ (50) per 100 board feet 2. Transfer price at 110% of variable costs: = $100 + ($100 ( 0. 10) = $110 per 100 board feet |Sell as Raw Lumber |Sell as Finished Lumber | |Raw Lumber Division | | | |Division revenues |$200 |$110 | |Division variable costs |100 |100 | |Division operating income |$100 |$ 10 | | | | | |Finished Lumber Division | | | |Division revenues |$ 0 |$275 | |Transferred-in costs |— |110 | |Division variable costs | |125 | |Division operating income |$ 0 |$ 40 | The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by selling finished lumber, which is contrary to the action preferred by the company as a whole. 22-19 (Cont’d. ) 3. Transfer price at market price = $200 per 100 board feet. |Sell as Raw Lumber |Sell as Finished Lumber | |Raw Lumber Division | | | |Division revenues |$200 |$200 | |Division variable costs |100 |100 | |Division operating income |$100 |$100 | | | | | |Finished Lumber Division | | | |Division revenues |$ 0 |$275 | |Transferred-in costs |— |200 | |Division variable costs |— |125 | |Division operating income |$ 0 |$ (50) | The Raw Lumber Division will maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole.
Finished Lumber Division will maximize division operating income by not further processing raw lumber; not further processing is preferred by the company as a whole. 22-20 (30 min. ) Effect of alternative transfer-pricing methods on division operating income. | | |Internal Transfers at 110% of | | | |Internal Transfers at Market |Full Costs | | | |Prices Method A |Method B | | |1.
Mining Division | | | | |Revenues: | | | | |$90, $661 ? 400,000 units |$36,000,000 |$26,400,000 | | |Deduct: | | | | |Division variable costs: | | | | |$522 ? 00,000 units |20,800,000 |20,800,000 | | |Division fixed costs: | | | | |$83 ? 400,000 units |3,200,000 |3,200,000 | | |Division operating income |$12,000,000 |$ 2,400,000 | | | Metals Division | | | | |Revenues: | | | | |$150 ? 00,000 units |$60,000,000 |$60,000,000 | | |Deduct: | | | | |Transferred-in costs: | | | | |$90, $66 ? 400,000 units |36,000,000 |26,400,000 | | |Division variable costs: | | | | |$364 ? 400,000 units |14,400,000 |14,400,000 | | |Division fixed costs: | | | | |$155 ? 00,000 units |6,000,000 |6,000,000 | | |Division operating income |$ 3,600,000 |$13,200,000 | | 1$66 = $60 ? 110% 2Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor + 75% of Manufacturing overhead = $12 + $16 + 75% ? $32 = $52 3Fixed cost per unit = 25% of Manufacturing overhead = 25% ? $32 = $8 4Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40% of Manufacturing overhead = $6 + $20 + 40% ? $25 = $36 5Fixed cost per unit in Metals Division = 60% of Manufacturing overhead = 60% ? $25 = $15 22-20 (Cont’d. ) 2. Bonus paid to division managers at 1% of division operating income will be as follows: | |Method B | | |Method A |Internal Transfers at 110% | | |Internal Transfers at Market |of Full Costs | | |Prices | | |Mining Division manager’s bonus | | | |(1% ( $12,000,000; 1% ( $2,400,000) |$120,000 |$ 24,000 | |Metals Division manager’s bonus | | | |(1% ( $3,600,000; 1% ( $13,200,000) |36,000 |132,000 | The Mining Division manager will prefer Method A (transfer at market prices) because this method gives $120,000 of bonus rather than $24,000 under Method B (transfers at 110% of full costs).
The Metals Division manager will prefer Method B because this method gives $132,000 of bonus rather than $36,000 under Method A. 3. Brian Jones, the manager of the Mining Division, will appeal to the existence of a competitive market to price transfers at market prices. Using market prices for transfers in these conditions leads to goal congruence. Division managers acting in their own best interests make decisions that are also in the best interests of the company as a whole. Jones will further argue that setting transfer prices based on cost will cause Jones to pay no attention to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full costs. 22-21(30 min. )Transfer pricing, general guideline, goal congruence. . Using the general guideline presented in the chapter, the minimum price at which the Airbag Division would sell airbags to the Igo Division is $110, the incremental costs. The Airbag Division has idle capacity (it is currently working at 80% of capacity). Hence, its opportunity cost is zero—the Airbag Division does not forgo any external sales and, hence, does not forgo any contribution margin from internal transfers. Transferring airbags at incremental cost achieves goal congruence. 2. Transferring products internally at incremental cost has the following properties. a. Achieves goal congruence—Yes, as described in requirement 1 above. b.
Useful for evaluating subunit performance—No, because transfer price does not exceed full costs. By transferring at incremental costs and not covering fixed costs, the Airbag Division will show a loss. This loss, the result of the incremental cost-based transfer price, is not a good measure of the economic performance of the subunit. 22-21 (Cont’d. ) c. Motivating management effort—Yes, if based on budgeted costs (actual costs can then be compared to budgeted costs). If, however, transfers are based on actual costs, Airbag Division management has little incentive to control costs. d. Preserves subunit autonomy—No. Because it is rule-based, the Airbag Division has no say in and, hence, no ability to set the transfer price. 3.
If the two divisions were to negotiate a transfer price, the range of possible transfer prices will be between $110 and $140 per unit. The Airbag Division has excess capacity that it can use to supply airbags to the Igo Division. The Airbag Division will be willing to supply the airbags only if the transfer price equals or exceeds $110, its incremental costs of manufacturing the airbags. The Igo Division will be willing to buy airbags from the Airbag Division only if the price does not exceed $140 per airbag, the price at which the Igo division can buy airbags in the market from outside suppliers. Within the price range or $110 and $140, each division will be willing to transact with the other and maximize overall income of Nogo Motors.
The exact transfer price between $110 and $140 will depend on the bargaining strengths of the two divisions. The negotiated transfer price has the following properties. a. Achieves goal congruence—Yes, as described above. b. Useful for evaluating subunit performance—Yes, because the transfer price is the result of direct negotiations between the two divisions. Of course, the transfer prices will be affected by the bargaining strengths of the two divisions. c. Motivating management effort—Yes, because once negotiated, the transfer price is independent of actual costs of the Airbag Division. Airbag Division management has every incentive to manage efficiently to improve profits. d.
Preserves subunit autonomy—Yes, because the transfer price is based on direct negotiations between the two divisions and is not specified by headquarters on the basis of some rule (for example, Airbag Division incremental costs). 4. Neither method is perfect, but negotiated transfer pricing (described in requirement 3) has more favorable properties than the cost-based transfer pricing (described in requirement 2). Both transfer-pricing methods achieve goal congruence, but negotiated transfer pricing facilitates the evaluation of subunit performance, motivates management effort, and preserves subunit autonomy, whereas the transfer price based on incremental costs does not achieve these objectives. 22-22(25 min. ) General guideline, transfer price range. 1.
If the Screen Division sells screens in the outside market, it will receive, for each screen, the market price of the screen minus variable marketing and distribution costs per screen = $110 – $4 = $106. The incremental cost of manufacturing each screen is $70. The Screen Division is operating at capacity. Hence, the opportunity cost per screen of selling the screen to the Assembly Division rather than in the outside market is the contribution margin the Screen Division would forgo if it transferred screens internally rather than sold them in the outside market. Contribution margin per screen = $106 – $70 = $36. Using the general guideline, [pic]=[pic] That is, Minimum transfer price per screen = $70 + $36 = $106 2.
If the two division managers were to negotiate a transfer price, the range of possible transfer prices is between $106 and $112 per screen. As calculated in requirement 1, the Screen Division will be willing to supply screens to the Assembly Division only if the transfer price equals or exceeds $106 per screen. If the Assembly Division were to purchase the screens in the outside market, it will incur a cost of $112, the cost of the screen equal to $110 plus variable purchasing costs of $2 per screen. Hence, the Assembly Division will be willing to buy screens from the Screen Division only if the price does not exceed $112 per screen. Within the price range of $106 and $112 per screen, each division will be willing to transact with the other.
The exact transfer price between $106 and $112 will depend on the bargaining strengths of the two divisions. 23. (25 min. ) Multinational transfer pricing, global tax minimization. 1. Solution Exhibit 22-23 shows the after-tax operating incomes earned by the U. S. and Austrian divisions from transferring 1,000 units of Product 4A36 using (a) full manufacturing cost per unit, and (b) market price of comparable imports as transfer prices. 2. There are many ways to proceed, but the first thing to note is that the transfer price that minimizes the total of company import duties and income taxes will be either the full manufacturing cost or the market price of comparable imports.
Consider what happens every time the transfer price is increased by $1 over, say, the full manufacturing cost of $500. This results in the following a. an increase in U. S. taxes of 40% ? $1$0. 400 b. an increase in import duties paid in Austria, 10% ? $10. 100 c. a decrease in Austrian taxes of 44% ? $1. 10 (the $1 increase in transfer price + $0. 10 paid by way of import duty) (0. 484) Net effect is an increase in import duty and tax payments of$0. 016 Hence, Mornay Company will minimize import duties and income taxes by setting the transfer price at its minimum level of $500, the full manufacturing cost. 22-23 (Cont’d. ) Solution Exhibit 22-23
Division Incomes of U. S. and Austrian Divisions from Transferring 1,000 Units of Product 4A36 | | |Method A: | | | | | |Internal Transfers |Method B: | | | | |at Full Manufacturing Cost|Internal Transfers | | | | | |at Market Price | | |U. S.
Division | | | | | |Revenues: | | | | | |$500, $650 ? 1,000 units | |$500,000 |$650,000 | | |Deduct: | | | | | |Full manufacturing cost: | | | | | |$500 ? ,000 units | |500,000 |500,000 | | |Division operating income | |0 |150,000 | | |Division income taxes at 40% | |0 |60,000 | | |Division after-tax operating income | |$ 0 |$ 90,000 | | | | | | | | |Austrian Division | | | | | |Revenues: | | | | | |$750 ? ,000 units | |$750,000 |$750,000 | | |Deduct: | | | | | |Transferred-in costs: | | | | | |$500 ? 1,000, $650 ? 1,000 units | |500,000 |650,000 | | |Import duties at 10% of transferred-in price | | | | | |$50 ? 1,000, $65 ? ,000 units | |50,000 |65,000 | | |Division operating income | |200,000 |35,000 | | |Division income taxes at 44% | |88,000 |15,400 | | |Division after-tax operating income | |$112,000 |$ 19,600 | | 22-24 (30 min. ) Multinational transfer pricing, goal congruence (continuation of 22-23). 1. After-tax operating income if Mornay Company sold all 1,000 units of Product 4A36 in the United States is Revenues, $600 ? 1,000 units$600,000 Full manufacturing costs, $500 ? 1,000 units 500,000 Operating income100,000 Income taxes at 40% 40,000 After-tax operating income$ 60,000 From Exercise 22-23, requirement 1, Mornay Company’s after-tax operating ncome if it transfers 1,000 units of Product 4A36 to Austria at full manufacturing cost and sells the units in Austria is $112,000. Therefore, Mornay should sell the 1,000 units in Austria. 2. Transferring Product 4A36 at the full manufacturing cost of the U. S. Division minimizes import duties and taxes (Exercise 22-23, requirement 2), but creates zero operating income for the U. S Division. Acting autonomously, the U. S. Division manager would maximize division operating income by selling Product 4A36 in the U. S. market, which results in $60,000 in after-tax division operating income as calculated in requirement 1, rather than by transferring Product 4A36 to the Austrian division at full manufacturing cost.
Hence, the transfer price calculated in requirement 2 of Exercise 22-23 will not result in actions that are optimal for Mornay Company as a whole. 3. The minimum transfer price at which the U. S. division manager acting autonomously will agree to transfer Product 4A36 to the Austrian division is $600 per unit. Any transfer price less than $600 will leave the U. S. Division’s performance worse than selling directly in the U. S. market. Because the U. S. Division can sell as many units that it makes of Product 4A36 in the U. S. market, there is an opportunity cost of transferring the product internally equal to $250 (selling price $600 ( variable manufacturing costs, $350). [pic]=[pic] =$350 + $250 = $600
This transfer price will result in Mornay Company as a whole paying more import duties and taxes than the answer to Exercise 22-23, requirement 2, as calculated below: U. S. Division Revenues, $600 ? 1,000 units$600,000 Full manufacturing costs 500,000 Division operating income100,000 Division income taxes at 40% 40,000 Division after-tax operating income$ 60,000 22-24 (Cont’d. ) Austrian Division Revenues, $750 ? 1,000 units`$750,000 Transferred in costs, $600 ? 1,000 units600,000 Import duties at 10% of transferred-in price, $60 ? 1,000 units 60,000 Division operating income90,000 Division income taxes at 44% 39,600 Division after-tax operating income$ 50,400 Total import duties and income taxes at transfer prices of $500 and $600 per unit for 1,000 units of Product 4A36 follow: |Transfer Price of | | | |$500 per Unit | | | |(Exercise 22-23, |Transfer Price of | | |Requirement 2) |$600 per Unit | |(a) U. S. income taxes |$ 0 |$ 40,000 | |(b) Austrian import duties |50,000 |60,000 | |(c) Austrian income taxes |88,000 |39,600 | | |$138,000 |$139,600 | The minimum transfer price that the U. S. ivision manager acting autonomously would agree to results in Mornay Company paying $1,600 in additional import duties and income taxes. A student who has done the calculations shown in Exercise 22-23, requirement 2, can calculate the additional taxes from a $600 transfer price more directly, as follows: Every $1 increase in the transfer price per unit over $500 results in additional import duty and taxes of $0. 016 per unit So, a $100 increase ($600 – $500) per unit will result in additional import duty and taxes of $0. 016 ? 100 = $1. 60 For 1,000 units transferred, this equals $1. 60 ? 1,000 = $1,600 22-25(20 min. )Transfer-pricing dispute.
This problem is similar to the Problem for Self-Study in the chapter. 1. Company as a whole will not benefit if Division C buys on the outside market: Purchase costs from outsider, 1,000 units ? $135 $135,000 Deduct: Savings in variable costs by reducing Division A output, 1,000 units ? $120 120,000 Net cost (benefit) to company as a whole by buying from outside$ 15,000 Any transfer price between $120 to $135 per unit will achieve goal congruence. Division managers acting in their own best interests will take actions that are in the best interests of the company as a whole. 2. Company will benefit if C purchases from the outsider supplier: Purchase costs from outsider, 1,000 units ? 135 $135,000 Deduct: Savings in variable costs, 1,000 units ? $120$120,000 Savings due to A’s equipment and facilities assigned to other operations 18,000 138,000 Net cost (benefit) to company as a whole by buying from outside $ (3,000) Division C should purchase from outside suppliers. 3. Company will benefit if C purchases from the outside supplier: Purchase costs from outsider, 1,000 units ? $115 $115,000 Deduct: Savings in variable costs by reducing Division A output, 1,000 units ? $120 120,000 Net cost (benefit) to company as a whole by buying from outside$ (5,000) The three requirements are summarized below (in thousands): |(1) |(2) |(3) | |Total purchase costs from outsider |$135 |$135 |$115 | |Total relevant costs if purchased from Division A | | | | |Total incremental (outlay) costs if purchased from A |120 |120 |120 | |Total opportunity costs if purchased from A |– |18 |– | |Total relevant costs if purchased from A |120 |138 |120 | |Operating income advantage (disadvantage) to | | | | |company as a whole by buying from A |$ 15 |$ (3) |$ (5) | Goal congruence would be achieved if the transfer price is set equal to the total relevant costs of purchasing from Division A. 22-26(5 min. ) Transfer-pricing problem (continuation of 22-25). The company as a whole would benefit in this situation if C purchased from outside suppliers. The $15,000 disadvantage to the company as a whole by purchasing from the outside supplier would be more than offset by the $30,000 contribution margin of A’s sale of 1,000 units to other customers.
Purchase costs from outside supplier, 1,000 units ? $135$135,000 Deduct variable cost savings, 1,000 units ? $120 120,000 Net cost to company as a whole by buying units from outside$ 15,000 A’s sales to other customers, 1,000 units ? $155$155,000 Deduct: Variable manufacturing costs, $120 ? 1,000 units $120,000 Variable marketing costs, $5 ? 1,000 units 5,000 Total variable costs 125,000 Contribution margin from selling units to other customers$ 30,000 22-27(20–30 min. ) Pertinent transfer price. This problem explores the “general transfer-pricing guideline” discussed in the chapter. 1. No, transfers should not be made to Division B if there is no excess capacity in Division A.
An incremental (outlay) cost approach shows a positive contribution for the company as a whole. Selling price of final product$300 Incremental costs in Division A$120 Incremental costs in Division B 150 270 Contribution$ 30 However, if there is no excess capacity in Division A, any transfer will result in diverting products from the market for the intermediate product. Sales in this market result in a greater contribution for the company as a whole. Division B should not assemble the bicycle since the incremental revenue Europa can earn, $100 per unit ($300 from selling the final product – $200 from selling the intermediate product) is less than the incremental costs of $150 to assemble the bicycle in Division B. Alternatively put,
Europa’s contribution margin from selling the intermediate product exceeds Europa’s contribution margin from selling the final product. Selling price of intermediate product$200 Incrementral (outlay) costs in Division A 120 Contribution$ 80 The general guideline described in the chapter is =+ =$120 + ($200 – $120) =$200, which is the market price 22-27 (Cont’d. ) The market price is the transfer price that leads to the correct decision; that is, do not transfer to Division B unless there are extenuating circumstances for continuing to market the final product. Therefore, B must either drop the product or reduce the incremental costs of assembly from $150 per bicycle to less than $100. 2.
If (a) A has excess capacity, (b) there is intermediate external demand for only 800 units at $200, and (c) the $200 price is to be maintained, then the opportunity costs per unit to the supplying division are $0. The general guideline indicates a minimum transfer price of: $120 + $0 = $120, which is the incremental or outlay costs for the first 200 units. B would buy 200 units from A at a transfer price of $120 because B can earn a contribution of $30 per unit [$300 – ($120 + $150)]. In fact, B would be willing to buy units from A at any price up to $150 per unit because any transfers at a price of up to $150 will still yield B a positive contribution margin.
Note, however, that if B wants more than 200 units, the minimum transfer price will be $200 as computed in requirement 1 because A will incur an opportunity cost in the form of lost contribution of $80 (market price, $200 – outlay costs of $120) for every unit above 200 units that are transferred to B. The following schedule summarizes the transfer prices for units transferred from A to B. Units Transfer Price 0–200$120–$150 200–1,000$200 For an exploration of this situation when imperfect markets exist, see the next problem. 3. Division B would show zero contribution, but the company as a whole would generate a contribution of $30 per unit on the 200 units transferred. Any price between $120 and $150 would induce the transfer that would be desirable for the company as a whole.
A motivational problem may arise regarding how to split the $30 contribution between Division A and B. Unless the price is below $150, B would have little incentive to buy. Note: The transfer price that may appear optimal in an economic analysis may, in fact, be totally unacceptable from the viewpoints of (1) preserving autonomy of the managers, and (2) evaluating the performance of the divisions as economic units. For instance, consider the simplest case discussed previously, where there is idle capacity and the $200 intermediate price is to be maintained. To direct that A should sell to B at A’s variable cost of $120 may be desirable from the viewpoint of B and the company as a whole.
However, the autonomy (independence) of the manager of A is eroded. Division A will earn nothing, although it could argue that it is contributing to the earning of income on the final product. If the manager of A wants a portion of the total company contribution of $30 per unit, the question is: How is an appropriate amount determined? This is a difficult question in practice. The price can be negotiated upward to somewhere between $120 and $150 so that some “equitable” split is achieved. A dual transfer-pricing scheme has also been suggested, whereby the supplier gets credit for the full intermediate market price and the buyer is charged with only 22-27 (Cont’d. ) variable or incremental costs.
In any event, when there is heavy interdependence between divisions, such as in this case, some system of subsidies may be needed to deal with the three problems of goal congruence, management effort, and subunit autonomy. Of course, where heavy subsidies are needed, a question can be raised as to whether the existing degree of decentralization is optimal. 22-28 (30–40 min. ) Pricing in imperfect markets (continuation of 22-27). An alternative presentation, which contains the same numerical answers, can be found at the end of this solution. 1. Potential contribution from external intermediate sale is 1,000 ( ($195 – $120)$75,000 Contribution through keeping price at $200 is 800 ( $80. 64,000 Forgone contribution by transferring 200 units$11,000 Opportunity cost per unit to the supplying division by transferring internally: pic] = $55 Transfer price = $120 + $55 = $175 An alternative approach to obtaining the same answer is to recognize that the incremental or outlay cost is the same for all 1,000 units in question. Therefore, the total revenue desired by A would be the same for selling outside or inside. Let X equal the transfer price at which Division A is indifferent between selling all units outside versus transferring 200 units inside. 1,000 ( $195 = (800 ( $200) + 200X X = $175 The $175 price will lead to the correct decision. Division B will not buy from Division A because its total costs of $175 + $150 will exceed its prospective selling price of $300.
Division A will then sell 1,000 units at $195 to the outside; Division A and the company will have a contribution margin of $75,000. Otherwise, if 800 units were sold at $200 and 200 units were transferred to Division B, the company would have a contribution of $64,000 plus $6,000 (200 units of final product ( $30), or $70,000. A comparison might be drawn regarding the computation of the appropriate transfer prices between the preceding problem and this problem: 22-28 (Cont’d. ) = + Perfect markets:= $120 + (Selling price – Outlay costs per unit) = $120 + ($200 – $120) = $200 Imperfect markets:= $120 + = $120 + [pic]= $175 aMarginal revenues of Division A from selling 200 units outside rather than transferring to Division B ($195 ? 1,000) – ($200 ? 800) = $195,000 – $160,000 = $35,000. bIncremental (outlay) costs incurred by Division A to produce 200 units = $120 ? 200 = $24,000. Therefore, selling price ($195) and marginal revenues per unit ($175 = $35,000 ? 200) are not the same. The following discussion is optional. These points should be explored only if there is sufficient class time: Some students will erroneously say that the “new” market price of $195 is the appropriate transfer price. They will claim that the general guideline says that the transfer price should be $120 + ($195 – $120) = $195, the market price. This conclusion assumes a perfect market.
But, here, there are imperfections in the intermediate market. That is, the market price is not a good approximation of alternative revenue. If a division’s sales are heavy enough to reduce market prices, marginal revenue will be less than market price. It is true that either $195 or $175 will lead to the correct decision by B in this case. But suppose that B’s variable costs were $120 instead of $150. Then B would buy at a transfer price of $175 (but not at a price of $195, because then B would earn a negative contribution of $15 per unit [$300 – ($195 + $120)]. Note that if B’s variable costs were $120, transfers would be desirable: Division A contribution is: 00 ( ($200 – $120) + 200 ($175 – $120)= $75,000 Division B contribution is: 200 ( [$300 – ($175 + $120)]= 1,000 Total contribution$76,000 22-28 (Cont’d. ) Or the same facts can be analyzed for the company as a whole: Sales of intermediate product, 800 ( ($200 – $120)=$64,000 Sales of final products, 200 ( [300 – ($120 + $120)]= 12,000 Total contribution$76,000 If the transfer price were $195, B would not accept the transfer and would not earn any contribution. As shown above, Division A and the company as a whole will earn a total contribution of $75,000 instead of $76,000. 2. a. Division A can sell 900 units at $195 to the outside market and 100 nits to Division B, or 800 at $200 to the outside market and 200 units to Division B. Note that, under both alternatives, 100 units can be transferred to Division B at no opportunity cost to A. Using the general guideline, the minimum transfer price of the first 100 units [901–1000] is: TP1 = $120 + 0 = $120 If Division B needs 100 additional units, the opportunity cost to A is not zero, because Division A will then have to sell only 800 units to the outside market for a contribution of 800 ( ($200 – $120) = $64,000 instead of 900 units for a contribution of 900 ( ($195 – $120) = $67,500. Each unit sold to B in addition to the first 100 units has an opportunity cost to A of ($67,500 – $64,000) ? 00 = $35. Using the general guideline, the minimum transfer price of the next 100 units [801–900] is: TP2 = $120 + $35 = $155 Alternatively, the computation could be: Increase in contribution from 100 more units, 100 ( $75$7,500 Loss in contribution on 800 units, 800 ( ($80 ( $75) 4,000 Net “marginal revenue”$3,500 ? 100 units = $35 (Minimum) transfer price applicable to first 100 units offered by A is $120 + $0 = $120 per unit (Minimum) transfer price applicable to next 100