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Transfer Pricing and Multinational Considerations

Learning Objective 1

Describe a management control system and its three key properties.

Management Control Systems


A management control system is a means of gathering and using information. It guides the behavior of managers and employees.

Management Control Systems


Financial data Nonfinancial data

Formal control system


Informal control system
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Evaluating Management Control Systems


Motivation Goal congruence Effort

Lead to rewards

Monetary

Nonmonetary
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Learning Objective 2

Describe the benefits and costs of decentralization.

Organization Structure
Total decentralization

Total centralization
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Benefits of Decentralization
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

Costs of Decentralization
Suboptimal decision making may occur Focuses the managers attention on the subunit rather than the organization as a whole Increases the costs of gathering information Results in duplication of activities

Decentralization in Multinational Companies


Decentralization enables country managers to make decisions that exploit their knowledge of local business and political conditions. Multinational corporations often rotate managers between foreign locations and corporate headquarters.

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Responsibility Centers
Cost center Revenue center

Profit center

Investment center
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Learning Objective 3

Explain transfer prices and four criteria used to evaluate them.

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Transfer Pricing
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.

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Transfer Pricing
Transfer pricing should help achieve a companys strategies and goals. fit the organizations structure promote goal congruence promote a sustained high level of management effort
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Learning Objective 4

Calculate transfer prices using three different methods.

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Transfer-Pricing Methods
Market-based transfer prices

Cost-based transfer prices Negotiated transfer prices


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Transfer-Pricing Methods Example


Lomas & Co. has two divisions: Transportation and Refining. Transportation purchases crude oil in Alaska and sends it to Seattle. Refining processes crude oil into gasoline.

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Transfer-Pricing Methods Example


External market price for supplying crude oil per barrel: Transportation Division: Variable cost per barrel of crude oil Fixed cost per barrel of crude oil Total
$13

$ 2 3 $ 5

The pipeline can carry 35,000 barrels per day.


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Transfer-Pricing Methods Example


External purchase price for crude oil per barrel: Refining Division: Variable cost per barrel of gasoline Fixed cost per barrel of gasoline Total
$23

$ 8 4 $12

The division is buying 20,000 barrels per day.


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Transfer-Pricing Methods Example


The external market price to outside parties is $60 per barrel. The Refining Division is operating at 30,000 barrels capacity per day.

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Transfer-Pricing Methods Example


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?
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Transfer-Pricing Methods Example


Purchase price of crude oil Variable costs per barrel of crude oil Fixed costs per barrel of crude oil Total
1.12 $18 = $20.16 What is the negotiated price? Between $20.16 and $23.00 per barrel.
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$13 2 3 $18

Transfer-Pricing Methods Example


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?
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Transfer-Pricing Methods Example


Transportation Division: Revenues: ($23 1,000) $23,000 Deduct costs: ($18 1,000) 18,000 Operating income $ 5,000 What is the Refining Divisions operating income using the market-based price?
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Transfer-Pricing Methods Example


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
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Transfer-Pricing Methods Example


What is the operating income of both divisions together? Transportation Division $5,000 Refining Division 1,000 Total $6,000

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Transfer-Pricing Methods Example


What is the Transportation Divisions 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?
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Transfer-Pricing Methods Example


Refining Division: Revenues ($60 500) Deduct costs: Transferred-in ($20.16 1,000) Division variable ($8.00 500) Division fixed ($4.00 500) Operating income

$30,000 20,160 4,000 2,000 $ 3,840


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Transfer-Pricing Methods Example


What is the operating income of both divisions together? Transportation Division $2,160 Refining Division 3,840 Total $6,000

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Learning Objective 5

Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets.
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Market-Based Transfer Prices


By using market-based transfer prices in a perfectly competitive market, a company can achieve the following: Goal congruence
Management effort

Subunit performance evaluation


Subunit autonomy
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Market-Based Transfer Prices


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

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Market-Based Transfer Prices


When supply outstrips demand, market prices may drop well below their historical average. Distress prices are the drop in prices expected to be temporary.

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Learning Objective 6

Avoid making suboptimal decisions when transfer prices are based on full cost plus a markup.
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Cost-Based Transfer Prices Example


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).

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Cost-Based Transfer Prices Example


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.
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Cost-Based Transfer Prices Example


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

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Cost-Based Transfer Prices Example


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
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Cost-Based Transfer Prices Example


Suppose the Transportation Divisions transfer price to the Refining Division is 112% of full cost. What is the cost to the Refining Division?

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Cost-Based Transfer Prices Example


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


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Cost-Based Transfer Prices Example


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.

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Learning Objective 7

Understand the range over which two divisions negotiate the transfer price when there is unused capacity.
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Prorating
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.
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Prorating
The Transportation Divisions variable costs are $2 1,000 = $2,000. The Refining Divisions variable costs to refine 1,000 of crude oil into 500 barrels of gasoline are $8 500 = $4,000.

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Prorating
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
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Dual Pricing
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.
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Negotiated Transfer Prices


Negotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions.

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Learning Objective 8

Construct a general guideline for determining a minimum transfer price.

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Comparison of Methods
Achieves Goal Congruence
Market Price: Yes, if markets competitive

Cost-Based:
Negotiated:

Often, but not always


Yes

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Comparison of Methods
Useful for Evaluating Subunit Performance
Market Price: Yes, if markets competitive Cost-Based: Negotiated:

Difficult, unless transfer price exceeds full cost Yes

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Comparison of Methods
Motivates Management Effort
Market Price: Yes

Cost-Based: Negotiated:

Yes, if based on budgeted costs; less incentive if based on actual cost Yes
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Comparison of Methods
Preserves Subunit Autonomy
Market Price: Yes, if markets competitive

Cost-Based:
Negotiated:

No, it is rule based


Yes

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Comparison of Methods
Other Factors
Market Price: No market may exist Cost-Based: Negotiated:

Useful for determining full-cost; easy to implement Bargaining takes time and may need to be reviewed
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General Guideline

Minimum transfer price = Incremental costs per unit incurred up to the point of transfer + Opportunity costs per unit to the selling division

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General Guideline
Assume a perfectly competitive market, with no idle capacity. Transportation Division can sell all the crude oil it transports to the external market in Seattle for $23 per barrel. What is the minimum transfer price? ($19 + $4) or ($13 + $2 + $8) = $23 = Market price
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General Guideline
Assume that an intermediate market exists that is not perfectly competitive, and the selling division has idle capacity. If the Transportation Division has idle capacity, its opportunity cost of transferring the oil internally is zero. What is the minimum transfer price?
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General Guideline
It would be $15 per barrel for oil purchased under the long-term contract, or... $19 per barrel for oil purchased and transported from the independent supplier in Alaska.

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Learning Objective 9

Incorporate income tax considerations in multinational transfer pricing.


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Multinational Transfer Pricing

IRC Section 482 requires that transfer prices for both tangible and intangible property between a company and its foreign division be set to equal the price that would be charged by an unrelated third party in a comparable transaction.

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