Cost Accounting

Sixteenth Edition, Global Edition

Chapter 22
Management Control
Systems,
Transfer Pricing,
and Multinational
Considerations

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Learning Objectives (1 of 2)
22.1 Describe a management control system and its three
key properties
22.2 Describe the benefits and costs of decentralization
22.3 Explain transfer prices and the four criteria managers
use to evaluate them
22.4 Calculate transfer prices using three methods
22.5 Illustrate how market-based transfer prices promote
goal congruence in perfectly competitive markets

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Learning Objectives (2 of 2)
‪ 22.6 Understand how to avoid making suboptimal decisions
when transfer prices are based on full cost plus a
markup
‪ 22.7 Describe the range of feasible transfer prices when
there is unused capacity and alternative methods for
arriving at the eventual hybrid price
‪ 22.8 Apply a general guideline for determining a minimum
transfer price
‪ 22.9 Incorporate income tax considerations in multinational
transfer pricing

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Management Control Systems
(1 of 3)

• 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.

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Management Control Systems
(2 of 3)
• 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
information‪about‪the‪firm’s‪costs,‪revenues‪and‪income
– 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

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Management Control Systems
(3 of 3)

• The informal management control system includes the

shared values, loyalties, and mutual commitments among
members‪of‪the‪organization,‪the‪company’s‪culture,‪and‪
the unwritten norms about acceptable behavior for
managers and other employees.
• One example of a company slogan that reinforces values
and‪loyalty‪is‪“At‪Ford,‪Quality‪is‪Job‪1”

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Effective Management Control
(1 of 2)

• To be effective, management control systems should be

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

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Effective Management Control
(2 of 2)

• 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).

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Two Aspects of Motivation
• Goal congruence exists when individuals and groups work
toward‪achieving‪the‪organization’s‪goals—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.

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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.

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Benefits of Decentralization
• Creates‪greater‪responsiveness‪to‪the‪needs‪of‪a‪subunit’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.

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Costs of Decentralization
• Leads to suboptimal decision making, which arises when a
decision’s‪benefit‪to‪one‪subunit‪is‪more‪than‪offset‪by‪the‪
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

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Comparing Benefits and Costs
• Top managers must compare the benefits and costs of
decentralization, often on a function-by-function basis,
when choosing an organizational structure.
• Companies report that the decisions made most frequently
at the decentralized level are related to product mix and
advertising.
• Decisions related to the type and source of long-term
financing are made least frequently at the decentralized
level.
• Centralizing its income tax strategies allows an
organization to optimize across subunits by offsetting the
income in one subunit with losses in others.
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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.
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Choices about Responsibility Centers
Recall from Chapter 6 that a responsibility center is a
segment or subunit of the organization whose manager is
accountable for a specified set of activities.
• To measure the performance of subunits in centralized or
decentralized companies, the management control system
uses one or a mix of the four types of responsibility
centers:
 Cost center
 Revenue center
 Profit center
 Investment center
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Transfer Pricing (1 of 2)
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.

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Transfer Pricing (2 of 2)
• The transfer price creates revenues for the selling subunit
and purchase costs for the buying subunit affecting each
subunit’s‪operating‪income.
• The operating incomes can be used to evaluate the
subunits’‪performances‪and‪to‪motivate‪their‪managers.
• 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.

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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.
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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’s‪look‪in‪more‪detail‪at‪each‪category.

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 Market-Based Transfer Prices
(1 of 2)

• 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.

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Market-Based Transfer Prices
(2 of 2)

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
the‪external‪market‪price‪(but‪above‪‪the‪selling‪division’s‪
variable cost) in order to induce efficient transfers.

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Cost-Based Transfer Prices
(1 of 3)

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

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Cost-Based Transfer Prices
(2 of 3)

• 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.

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Cost-Based Transfer Prices
(3 of 3)

• Full-cost transfer pricing also raises many issues:

1. How‪are‪the‪subunit’s‪indirect‪costs‪allocated‪to‪
products?
2. Have the correct activities, cost pools, and cost-
allocation bases been identified?
3. Should the chosen fixed-cost rates be actual or
budgeted?

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Hybrid Transfer Prices
(1 of 3)

• 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.

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Hybrid Transfer Prices
(2 of 3)
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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Hybrid Transfer Prices (3 of 3)
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.

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Comparison of Transfer-pricing
Methods
Exhibit 22.3 Comparison of Different Transfer-Pricing Methods

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General Guideline for Transfer-pricing
Situations
Accountants indicate that the full-cost-based transfer price is
generally the most frequently used method around the world,
followed by market-based transfer price and negotiated
transfer prices.
The transfer price a company will eventually choose
depends on the economic circumstances and the decision
being made.

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Minimum Transfer Price
 The minimum transfer price in many situations should be:

Incremental cost per unit

Minimum incurred up to the point of Opportunity Cost per unit
Transfer Price = transfer + to the selling subunit

 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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How Multinationals Use Transfer
Pricing to Minimize their Taxes (1 of 2)
• Transfer pricing is an important accounting priority for
managers around the world.
• The reason is that parent companies can save large sums
of money in taxes depending on the transfer pricing
methods they use.

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How Multinationals Use Transfer
Pricing to Minimize Their Taxes (2 of 2)
• Transfer prices affect not just income taxes, but also
payroll taxes, customs duties, tariffs, sales taxes, value-
added taxes, environment-related taxes, and other
government levies.
• Tax factors, particularly income taxes, are an important
consideration for managers when determining transfer
prices.

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Terms to Learn—(1 of 2)
TERMS TO LEARN PAGE NUMBER
REFERENCE
Autonomy 878
Decentralization 878
Dual pricing 891
Dysfunctional decision making 880
Effort 878
Goal congruence 878
Incongruent decision making 880
Intermediate product 882
Management control system 877
Motivation 878
Perfectly competitive market 886

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Terms to Learn—(2 of 2)
TERMS TO LEARN PAGE NUMBER
REFERENCE
Suboptimal decision making 880
Transfer price 882

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Copyright

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