A management control system is a means

of gathering and using information.

It guides the behavior of managers and employees.

 Financial data

Nonfinancial data

Formal control system

Informal control system

Motivation Goal congruence Effort

Lead to rewards

Monetary Nonmonetary
Total decentralization

Total centralization
Creates greater responsiveness to local needs

Leads to gains from quicker decision making

Increases motivation of subunit managers

Assists management development and learning

Sharpens the focus of subunit managers

 Suboptimal decision making may occur

Focuses the manager’s attention on the subunit

rather than the organization as a whole

Increases the costs of gathering information

Results in duplication of activities

 Cost Revenue
center center

Profit Investment
center center
If two or more profit center is jointly responsible
for
Product development
Manufacturing and
Marketing
each should share in the revenue that is generated
when the product is finally sold.
The Transfer price is a mechanism for distributing
this revenue.
 A transfer price is the price one subunit charges
for a product or service supplied to another
subunit of the same organization.
 Intermediate products are the products
transferred between subunits of an
organization.
 It involve two profit center and profit element
 So price is same as goods and services are
transferred to independent unit.
 objective:
 It should provide each segment with the relevant
information required to determine the optimum
tradeoff between company cost and revenues
 It should induce goal congruent decisions that is the
system should be so designed that decision improve
business unit to earn more profit
 It should help measure the economic performance of
the individual profit center
 It should be easy to calculate simple to administer.
 The transfer pricing issue is actually pricing in general
modified slightly to take into account factor that are
unique to internal transaction price.
 The fundamental principle is that transfer is similar to
price that would be charged if product were sold to
outside customer. When profit center buys or sells
product two decision are made for each product-
 Should the company be produce or purchase from
outside. This is sourcing decision.
 If produced inside what should be price.This is
transfer price decesion.
Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices

 By using market-based transfer prices
in a perfectly competitive market, a
company can achieve the following if following thing is present
Competent people,Freedom to source,Full information and Negotiation

Goal congruence

Management effort

Subunit performance evaluation

Subunit autonomy
 Market prices also serve to evaluate the
economic viability and profitability
of divisions individually.

The person/group would then make a sourcing decision on the basis of the company’s
best interests.
Even if there are constraints on sourcing, the market price is the best transfer price.
If the market price can be approximated, it is ideal transfer price
 Cost-based transfer prices

 We use cost-based transfer pricing if there is no way of approximating valid

competitive price. Transfer prices may be set up on the basis of cost plus a profit,
even though such transfer prices may be complex to calculate and the results less
satisfactory than a market-based price
 Two aspects need to be considered for cost-based transfer pricing:
 The cost basis: The usual basis is the standard cost. Actual costs should not be used
because production inefficiencies will then be passed on to the buying profit center.
If the standard costs are used, there is a need to provide an incentive to set tight
standards and to improve standards.
 The profit markup: In calculating the profit markup, there also are two decisions

 The simplest and most widely used base is percentage of costs. If this base is used,
however, no account is taken of capital required.
 A conceptually better base is a percentage of investment. But there may be a major
practical problem in calculating the investment applicable to a given product. If the
historical cost of the fixed assets is used, new facilities designed to reduce prices
could actually increase costs because old assets are undervalued
 Negotiated transfer prices arise from the
outcome of a bargaining process between
selling and buying divisions.
 Lomas & Co. has two divisions:
Transportation and Refining.

Transportation purchases Refining processes

crude oil in Alaska and crude oil
sends it to Seattle. into gasoline.
External market price for supplying
crude oil per barrel: $13

Transportation Division:
Variable cost per barrel of crude oil $ 2
Fixed cost per barrel of crude oil 3
Total $ 5

The pipeline can carry 35,000 barrels per day.

External purchase price for
crude oil per barrel: $23

Refining Division:
Variable cost per barrel of gasoline $ 8
Fixed cost per barrel of gasoline 4
Total $12

The division is buying 20,000 barrels per day.

The external market price to outside
parties is $60 per barrel.

The Refining Division is operating

at 30,000 barrels capacity per day.
What is the market-based transfer price
from Transportation to Refining?

$23 per barrel

What is the cost-based transfer price

at 112% of full costs?
 Purchase price of crude oil $13
Variable costs per barrel of crude oil 2
Fixed costs per barrel of crude oil 3
Total $18

1.12 × $18 = $20.16

What is the negotiated price?

Between $20.16 and $23.00 per barrel.

 Assume that the Refining Division buys
1,000 barrels of crude oil from the
Transportation Division.

The Refining Division converts these 1,000

barrels of crude oil into 500 gallons of
gasoline and sells them.

What is the Transportation Division operating

income using the market-based price?
 Transportation Division:
Revenues: ($23 × 1,000) $23,000
Deduct costs: ($18 × 1,000) 18,000
Operating income $ 5,000

What is the Refining Division’s operating

income using the market-based price?
 Refining Division:
Revenues: ($60 × 500) $30,000
Deduct costs:
Transferred-in ($23 × 1,000) 23,000
Division variable ($8 × 500) 4,000
Division fixed ($4 × 500) 2,000
Operating income $ 1,000
 What is the operating income of both
divisions together?

Transportation Division $5,000

Refining Division 1,000
Total $6,000
 What is the Transportation Division’s operating
income using the 112% of full cost price?

Transportation Division:
Revenues: ($20.16 × 1,000) $20,160
Deduct costs: ($18.00 × 1,000) 18,000
Operating income $ 2,160

What is the Refining Division operating

income using the full cost price?
Refining Division:
Revenues ($60 × 500) $30,000
Deduct costs:
Transferred-in ($20.16 × 1,000) 20,160
Division variable ($8.00 × 500) 4,000
Division fixed ($4.00 × 500) 2,000
Operating income $ 3,840
 What is the operating income of both
divisions together?

Transportation Division $2,160

Refining Division 3,840
Total $6,000
 The Refining Division of Lomas & Co. is
purchasing crude oil locally for $23 a barrel.

The Refining Division located an independent

producer in Alaska that is willing to sell 20,000
barrels of crude oil per day at $17 per barrel
delivered to the pipeline (Transportation Division).
 The Transportation Division has excess
capacity and can transport the crude oil
at its variable costs of $2 per barrel.

Should Lomas purchase from the

independent supplier?

Yes.

There is a reduction in total costs of $80,000.

 Alternative 1:
Buy 20,000 barrels from the
local supplier at $23 per barrel.

The total cost to Lomas is:

20,000 × $23 = $460,000
 Alternative 2:
Buy 20,000 barrels from the independent
supplier in Alaska at $17 per barrel and
transport it to Seattle at $2 per barrel.

The total cost to Lomas is:

20,000 × $19 = $380,000
 Suppose the Transportation Division’s
transfer price to the Refining Division
is 112% of full cost.

What is the cost to the Refining Division?

 Purchase price of crude oil $17
Variable costs per barrel of crude oil 2
Fixed costs per barrel of crude oil 3
Total $22

1.12 × $22 = $24.64

$24.64 × 20,000 = $492,800

 What is the maximum transfer price?

It is the price that the Refining Division can

pay in the local external market ($23).

What is the minimum transfer price?

The minimum transfer price is $19 per barrel.

 Understand the range over
which two divisions negotiate
the transfer price when
there is unused capacity.
Lomas & Co. may choose a transfer price
that splits on some equitable basis the
difference between the maximum transfer
price and the minimum transfer price.

$23 – $19 = $4

Suppose that variable costs are chosen as

the basis to allocate this $4 difference.
 The Transportation Division’s variable
costs are $2 × 1,000 = $2,000.

The Refining Division’s variable costs to

refine 1,000 of crude oil into 500 barrels
of gasoline are $8 × 500 = $4,000.
The Transportation Division gets to keep
$2,000 ÷ $6,000 × $4 = $1.33.

The Refining Division gets to keep

$4,000 ÷ $6,000 × $4 = $2.67.

What is the transfer price from the

Transportation Division?

$17.00 + $2.00 + $1.33 = $20.33

 An example of dual pricing is for Lomas & Co.
to credit the Transportation Division with
112% of the full cost transfer price of $24.64
per barrel of crude oil.

Debit the Refining Division with the market-based

transfer price of $23 per barrel of crude oil.