12/04/2022

MANAGEMENT CONTROL SYSTEMS

AND TRANSFER PRICING
LECTURE 11

Outline

Management control systems

Evaluating management control systems
Decentralisation
Responsibility centers
Transfer pricing

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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
behavior of its managers and other employees.

Management Control Systems

Formal systems: explicit rules, procedures, performance

measures, and incentive plans that guide the behavior of
its managers and other employees.

Informal systems: shared values, loyalties, and mutual

commitments among members of the company, corporate
culture, and unwritten norms about acceptable behavior.

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To be effective, management
control systems should be
Evaluating closely aligned to the firm’s
strategies and goals.
Management
Control Systems should be designed to
Systems fit the company’s structure and
decision-making responsibility
of individual managers.

Evaluating Management Control Systems

• 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).

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Two Aspects of Motivation

Goal congruence exists when

individuals and groups work
toward achieving the
organization’s goals—managers Effort is exertions toward
reaching a goal, including both
working in their own best
physical and mental actions.
interest take actions that align
with the overall goals of top
management.

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.

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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. Structure chosen cost vs.
benefit analysis

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

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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
• Focuses manger’s attention on the subunit rather than the
company as a whole
• Results in duplication of output
• Results in duplication of activities

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Decentralization and
Multinational Firms

• Multinational firms, companies that operate in multiple countries,

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 to international decentralization: loss or lack of
control

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Choices about
Responsibility Centers

• Regardless of the degree of decentralization, management control

systems use one or a mix of the four types of responsibility
centers:
• Cost center
• Revenue center
• Profit center
• Investment center

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Transfer price—the price one

subunit (department or division)
charges for a product or service
supplied to another subunit of
the same organization.
Transfer
Pricing Management control systems
use transfer prices to
coordinate the actions of
subunits and to evaluate their
performance.

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Transfer Pricing

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 product or service
transferred between subunits of an organization.

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Three Transfer Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Hybrid transfer prices

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Market-Based Transfer Prices

• Top management chooses to use the price of similar

product or service that is publicly available. Sources of
prices include trade associations, competitors, and so on

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Market-Based Transfer Prices

• Lead to optimal decision-making when three conditions are

satisfied:
1. The market for the intermediate product is perfectly
competitive.
2. 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.

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Market-Based Transfer Prices

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.”

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Cost-Based Transfer Prices

Top management chooses a transfer price based on the costs of

producing the intermediate product. Examples include:
• Variable production costs
• Variable and fixed production costs
• Full costs (including life-cycle costs)
• One of the above, plus some markup
Useful when market prices are unavailable, inappropriate, or too
costly to obtain

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Lecture example – E22-19

• Calgary Lumber has a raw lumber division and a finished lumber

division.
The variable costs are as follows:
• Raw lumber division: $125 per 100 board-feet of raw lumber
• Finished lumber division: $145 per 100 board-feet of finished
lumber
• Assume that there is no board-feet loss in processing raw lumber
into finished lumber. Raw lumber can be sold at $175 per 100
board-feet. Finished lumber can be sold at $345 per 100 board-
feet.

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Lecture example – E22-19

1. Should Calgary Lumber process raw lumber into its finished form?
Show your calculations.
2. Assume that internal transfers are made at 130% of variable cost.
Will each division maximize its divi- sion operating-income
contribution by adopting the action that is in the best interest of
Calgary Lumber as a whole? Explain.
3. Assume that internal transfers are made at market prices. Will each
division maximize its division operating-income contribution by
adopting the action that is in the best interest of Calgary Lumber as
a whole? Explain

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Lecture example – Cost-based transfer price

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Lecture example – Market-based transfer price

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Hybrid Transfer Prices

Takes into account both cost and market

information

Types of hybrid transfer prices:

• Prorating the difference between maximum and minimum

transfer prices
• Dual pricing
• Negotiated pricing

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Hybrid Transfer Prices

• 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.

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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.

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Comparison of Transfer-Pricing Methods

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Minimum Transfer Price

— Incremental cost is the additional cost of producing and transferring

the product or service.
— Opportunity cost is the maximum contribution margin forgone by
the selling subunit if the product or service is transferred
internally

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Multinational Transfer Pricing and Tax

Considerations

• Transfer prices often have tax implications.

• Tax factors include income taxes, payroll taxes, customs duties,
tariffs, sales taxes, value-added taxes, environment-related taxes,
and other government levies

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