CHAPTER 8: MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING AND MULTINATIONAL

CONSIDERATIONS
Management Control Systems

• A management control system is a means of gathering and using information to aid

and coordinate the planning and control decisions throughout an organization and
to guide the behavior of its managers and other employees.
• Some companies design their management control system around the concept of
the balanced scorecard.
• Well-designed management control systems use information from both within the
company and outside the company.

• Management Control Systems consist of formal and informal control systems:

– The formal management control system of a company includes explicit rules,
procedures, performance measures, and incentive plans that guide the
behavior of its managers and other employees. The formal control system is
composed of several systems such as:
 – The management accounting systems, which provide information about the
firm’s costs, revenues and income
– The human resources systems, which provide information about the recruiting
and training of employees, absenteeism and accidents
– The quality system, which provides information about yields, defective
products and late deliveries to customers

• The informal management control system includes the shared values, loyalties,
and mutual commitments among members of the organization, the company’s
culture, and the unwritten norms about acceptable behavior for managers and
other employees.

Effective Management Control

• To be effective, management control systems should be closely aligned to the

organization’s strategies and goals.
• Management control systems should also be designed to support the
organizational responsibilities of individual managers.
• Management control systems must be aligned with an organization’s structure. An
organization with a decentralized structure will have different issues to consider
when designing its management control system than a firm with a centralized
structure.

• Effective management control systems should also motivate managers and other
employees.
• Motivation is the desire to attain a selected goal (goal-congruence aspect)
combined with the resulting pursuit of that goal (effort aspect).
 Two Aspects of Motivation
• Goal congruence exists when individuals and groups work toward achieving the
organization’s goals—that is, managers working in their own best interest take
actions that align with the overall goals of top management.
• Effort is the extent to which managers strive or endeavor in order to achieve a
goal. Effort goes beyond physical exertion to include mental actions as well.

Decentralization
• Decentralization is an organizational structure that gives managers at lower levels
the freedom to make decisions.
• Autonomy is the degree of freedom to make decisions. The greater the freedom,
the greater the autonomy.
• Subunit refers to any part of an organization. It may be a large division or a small
group.
 Benefits of Decentralization

• Creates greater responsiveness to the needs of a subunit’s customers, suppliers,

and employees.
• Leads to gains from faster decision making by subunit managers.
• Assists management development and learning.
• Sharpens the focus of subunit managers and broadens the reach of top
management.

Costs of Decentralization
• Leads to suboptimal decision making, which arises when a decision’s benefit to
one subunit is more than offset by the costs or loss of benefits to the organization
as a whole.
– Also called incongruent decision making or dysfunctional decision making
• Leads to unhealthy competition
• Results in duplication of output
• Results in duplication of activities
 Decentralization in Multinational Companies
• Multinational firms, companies that operate in multiple countries, are often
decentralized because centralizing the control of their subunits around the world
can be physically and practically impossible.
• Decentralization enables managers in different countries to make decisions that
exploit their knowledge of local business and political conditions and enables them
to deal with uncertainties in their individual environments.
• Biggest drawback to international decentralization: loss or lack of control and the
resulting risks.
• Multinational corporations that implement decentralized decision making usually
design their management control systems to measure and monitor the
performance of divisions.
 Transfer Pricing

Transfer price—the price one subunit (department or division) charges for a product or
service supplied to another subunit of the same organization.
In a decentralized organization, much of the decision-making power resides in its
individual subunits. Those subunits often supply goods or services to one another.
• In that case, top management uses transfer prices to coordinate the actions of the
subunits and to evaluate the performance of their managers.

• The transfer price creates revenues for the selling subunit and purchase costs for
the buying subunit affecting each subunit’s operating income.
• The operating incomes can be used to evaluate the subunits’ performances and to
motivate their managers.
• Intermediate product—the product or service transferred between subunits of an
organization.
• In a well-designed transfer-pricing system, managers focus on maximizing the
performance of their subunits and in doing so optimize the performance of the
company as a whole.
 Criteria for Evaluating Transfer Prices

To help a company achieve its goals, transfer prices should meet four key criteria:
1. Promote goal congruence so that division managers acting in their own interest will
take actions that are aligned with the objectives of top management.
2. Induce managers to exert a high level of effort.
3. Help top managers evaluate the performance of individual subunits.
4. Preserve autonomy of subunits if top managers favor a high degree of
decentralization.

Calculating Transfer Prices

There are three broad categories of methods top managers can use to determine
transfer prices. They are as follows:
1. Market-based transfer prices.
2. Cost-based transfer prices.
3. Hybrid transfer prices.
Under what circumstances should each of these options be used? Let’s look in more
detail at each category.
 Market-Based Transfer Prices

• Transferring products or services at market prices generally leads to optimal

decisions when three conditions are satisfied:
1. The market for the intermediate product is perfectly competitive.
2. The interdependencies of subunits are minimal.
3. 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.

Imperfect Competition
• If markets are not perfectly competitive, selling prices affect the quantity of product
sold.
• When the market for the intermediate good is imperfectly competitive, the transfer
price must generally be set below the external market price (but above the selling
division’s variable cost) in order to induce efficient transfers.
Cost-Based Transfer Prices
Useful when market prices are unavailable, inappropriate, or too costly to obtain, such
as when markets are not perfectly competitive, when the product is specialized or when
the internal product is different from the products available externally in terms of its
quality and the customer service provided for it.
• Top managers choose a transfer price based on the costs of producing the
intermediate product. Examples include:
 Full-cost bases
 Variable-cost bases

• Despite its limitations, managers generally prefer to use full-cost-based transfer

prices because:
• They represent relevant costs for long-run decisions.
• They facilitate external pricing based on variable and fixed costs.
• They are the least costly to administer.
 Hybrid Transfer Prices
• Takes into account both cost and market information.
• Top management may set the prices by specifying a transfer price that is an
average of the cost of producing and transporting the product internally (the
minimum price) and the market price for comparable products (the maximum
price).
• Types of hybrid transfer prices:
 Prorating the difference between maximum and minimum transfer prices.
 Negotiated pricing (most common hybrid type).
 Dual pricing.

Negotiated Transfer Prices

• Occasionally, subunits of a firm are free to negotiate the transfer price between
themselves and then to decide whether to buy and sell internally or deal with
external parties.
• May or may not bear any resemblance to cost or market data.
• Often used when market prices are volatile.
• Represent the outcome of a bargaining process between the selling and buying
subunits.
 Additional Approaches
• Prorating the difference between the maximum and minimum cost-based transfer
prices.
• Dual-pricing—using two separate transfer-pricing methods to price each transfer
from one subunit to another. Example: selling division receives full cost pricing, and
the buying division pays market pricing.
QUESTION

Azog Corporation has two divisions. The Mining Division makes Thorin, which is then
transferred to the Metal division. Thorin is further processed by the Metal division and is sold
to customers at a price of $150 per unit. The Mining division is currently acquired by Azog to
transfer its total yearly output of 200,000 units of Thorin to the Metal division at 110% of full
manufacturing cost. Unlimited quantities of Thorin can be purchased and sold on the outside
market of $90 per unit.

The following table gives the manufacturing cost per unit in the Mining and Metals divisions for
2017.
Mining Division Metals Division
Direct material costs 12 6
Direct manufacturing labour 16 20
cost
Variable manufacturing 8 15
overhead cost
Fixed manufacturing 24 10
overhead cost
Total manufacturing cost per 60 51
unit

1. Calculate the operating incomes for the Mining and Metal division for 200,000 units of
Thorin transferred under the following transfer-pricing methods: (a) market price and (b)
110% of full manufacturing cost.
2. Which transfer-pricing method does the manager of the Mining division prefer? What
arguments might he make to support this method?
 Method A Method B
Internal Internal
Transfers at Transfers at
Market 110% of Full
Prices Costs
1. Mining Division
Revenues:
$90, $661 
200,000 units $18,000,000 $13,200,000
Costs:
Division variable
costs:
$362  200,000
units 7,200,000 7,200,000
 Division fixed costs:
$24  200,000
units 4,800,000 4,800,000
Total division
costs 12,000,000 12,000,000
Division operating
income $ 6,000,000 $ 1,200,000

Metal Division
Revenues:
$150  200,000
units $30,000,000 $30,000,000
Costs:
Transferred-in
costs:
$90, $66 
200,000 units 18,000,000 13,200,000
Division variable
costs:
$413  200,000
units 8,200,000 8,200,000
Division fixed costs:
$10  200,000
units 2,000,000 2,000,000
Total division
costs 28,200,000 23,400,000
 Division operating
income $ 1,800,000 $ 6,600,000

$66 = Full manufacturing cost per unit in the Mining Division, $60  110%
1

2
Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor +
Variable manufacturing overhead = $12 + $16 + $8 = $36
3
Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40%
of manufacturing overhead = $6 + $20 + $15 = $41

2. 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.