Transfer Pricing and Multinational Management Control Systems

Management Control Systems

 Management control systems are a means of gathering and using information to aid

and coordinate the planning and control decisions throughout an organization and to

guide the behaviour of its managers and other employees.

 Many MCS contain some or all of the balanced scorecard perspectives, integrating

financial and non-financial information.

 Well-designed MCS use information from both with-in the company (ie. net income

and employee satisfaction) and outside the company (ie. stock price and customer

satisfaction).

 Consist of formal and informal control systems:

o Formal systems include explicit rules, procedures, performance measures, and

incentive plans that guide the behaviour of its managers and other employees.

o Informal systems include shared values, loyalties, and mutual commitments

among members of the company, corporate culture, and unwritten norms about

acceptable behaviour.

Evaluation Management Control Systems

 To be effective, management control systems should be closely aligned to the firm’s

strategies and goals.

 Systems should be designed to fit the company’s structure and decision-making

responsibility of individual managers.

  Effective management control systems should also motivate managers and their

employees.

 Motivation is the desire to attain a selected goal (goal-congruence) combined with the

resulting pursuit of that goal (effort).

Two Aspects of Motivation

 Goal congruence exists when individuals and groups work toward achieving the

organization’s goals—managers working in their own best interest take actions that

align with the overall goals of top management.

 Effort is exertions toward reaching a goal, including both physical and mental actions.

Organization Structure and Decentralization

 Decentralization is the freedom for managers at lower levels of the organization to

make decisions.

 Autonomy is the degree of freedom to make decisions. The greater the freedom, the

greater the autonomy.

Decentralization vs. Centralization

 Total decentralization means minimum constraints and maximum freedom for

managers at the lowest levels of an organization to make decisions.

 Total centralization means maximum constraints and minimum freedom for managers

at the lowest levels of an organization to make decisions.

 Companies’ structures generally fall somewhere in between these two extremes, as

each has benefits and costs.

Benefits of Decentralization
  Creates greater responsiveness to subunit’s customers, suppliers, and employees

 Leads to gains from faster decision making

 Increases motivation of subunit managers

 Assists management development and learning

 Sharpens the focus of subunit managers

Cost of Decentralization

1. 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.

o Also called incongruent decision making or dysfunctional decision making

2. Focuses manager’s attention on the subunit rather than the company as a whole.

3. Results in duplication of output if subunits provide similar products or services.

Decentralization in Multinational Companies

 Multinational firms are often decentralized because centralized control of a company

with subunits around the world is often physically and practically impossible.

 Decentralization enables managers in different countries to make decisions that exploit

their knowledge of local business and political conditions and to deal with

uncertainties in their individual environments.

 Biggest drawback is loss or lack of control.

Decision About Responsibility Centers

 Regardless of the degree of decentralization, MCS use one or a mix of the four types of

responsibility centers:

o Cost center, Revenue center, Profit center and Investment center

  Profit centres can be highly centralized

o managers have little leeway in making decisions

 Cost centers can be highly decentralized

o Managers may have great latitude on capital expenditures and where to purchase

materials or services

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.

 MCS use transfer prices to coordinate the actions of subunits and to evaluate their

performance.

 The transfer price creates revenues for the selling subunit and purchase costs for the

buying subunit affecting each subunit’s operating income.

 Intermediate product—the unfinished product or service transferred between

subunits of an organization.

o Production stages may be in separate subunits of the organization, that may be

geographically apart

o Product may be processed further by the transferee or sold directly to an external

customer

Alternative Transfer Pricing Methods

1. Market-based transfer prices

2. Cost-based transfer prices

3. Negotiated transfer prices

Criteria for Evaluating Transfer Prices

 In all MCS, transfer prices should help achieve a company’s strategies and goals and

fit its organizational structure.

 Transfer pricing should:

1. Promote goal congruence

2. Induce managers to exert a high level of effort

3. Help top management evaluate performance of individual subunits

4. Preserve a high degree of subunit autonomy in decision making

Transfer Pricing – Illustration

Inter-Provincial Transfers and Taxes

 Provincial governments prefer transfer prices at market price as it is an arm’s-length

price

 Split of taxable income between provinces impacts both operating cash flow and net

income
  Advance transfer price arrangement (APA), can be negotiated with tax authorities in

advance

o Avoids costly and time-consuming disputes with tax authorities

Market-Based Transfer Prices

 Top management chooses to use the price of similar product or service that is

publicly available.

 Optimal decision-making under 3 conditions:

1. Intermediate market is perfectly competitive.

2. Interdependencies of subunits are minimal.

3. No additional costs or benefits to the company as a whole from buying or

selling in the external market instead of transacting internally.

 A perfectly competitive market exists when there is a homogeneous product with

buying prices equal to selling prices and no individual buyer or seller can affect those

prices by their own actions.

 Allows a firm to achieve goal congruence, motivating management effort, subunit

performance evaluations, and subunit autonomy.

 Perhaps should not be used if the market is currently in a state of “distress pricing.”

 Distress prices:

o “Temporary” price declines due to excess supply

o In the short term, supplier division should meet the distress price as long as it

exceeds incremental costs

o In the long term, supplier division should stop producing

Cost-Based Transfer Prices

 Top management chooses a transfer price based on the costs of producing the

intermediate product. Examples include:

o Variable production costs

o Variable and fixed production costs

o Full costs (including life-cycle costs)

o One of the above, plus some markup

 Useful when market prices are unavailable, inappropriate, or too costly to obtain.

 Full-cost bases

o Many companies use transfer prices based on full costs that contain an allocation

of fixed overhead

o Can lead to suboptimal decisions in decentralized companies

o Full-cost based on ABC cost drivers can provide more refined allocation bases

 Variable cost bases

o Can lead to divisions recording large losses and income due to transfer pricing

Hybrid Transfer Pricing

 Takes into account both cost and market information.

 Types of hybrid transfer prices:

o Prorating the difference between maximum and minimum transfer prices

o Dual pricing

o Negotiated pricing
  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.

o Difference in pricing is absorbed by corporate office rather than operating

units

o Promotes goal congruence

o Not widely used in practice

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.

Comparison of Transfer-Pricing Methods

Minimum Transfer Price Guideline

 The minimum transfer price in many situations should be:

o Minimum Transfer Price = Incremental costs per unit incurred up to the point of

transfer + Opportunity costs per unit to the supplying division

 Incremental cost - the additional cost of producing and transferring the product/service.

 Opportunity cost - the maximum contribution margin forgone by the selling subunit if

the product/service is transferred internally.

Multinational Transfer Pricing and Tax Considerations

 Transfer prices across borders have tax implications.

o Tax factors include income taxes, payroll taxes, customs duties, tariffs, sales

taxes, valuea-added taxes, environment-related taxes, other government levies,

etc.

 Establishing an arm’s-length price for value-added services such as marketing and

intangibles is difficult
  Income Tax Act of Canada (section 247) limits transfer pricing to 5 methods

Setting Transfer Prices: 5 Methods

 Traditional transaction methods:

1. Comparable uncontrolled price – internal market- based price

2. Resale price method – the calculated arm’s-length resale price

3. Cost-plus method

 Transactional profit methods:

4. Profit split method

5. Transactional net margin method

Tax Minimization Strategies

 Establish a legitimate subsidiary in a tax haven

o Have no tax treaties with Canada

 Establish a legitimate subsidiary in an international financial centre with very low tax

rates

o Have tax treaties with Canada

 Request an advance pricing arrangement with all involved tax authorities