Management Control Systems,Transfer Pricing,

and Multinational Considerations

Chapter 22Accounting 3300

Professor Richard E. McDermott

Management Control Systems

• Management control systems are a means of gathering and using information.

• Information is used to:– Aid and coordinate

planning and control decisions within an organization.

– Guide the behavior of managers and other employees.

Management Control Systems

Many management control systems contain some or all of the balanced scorecard perspectives.1.Financial2.Customer3.Internal business process4.Learning and growth

Evaluating Management Control Systems

• To be effective, management control systems should be closely aligned to the firm strategies and goals.

• Systems should be designed to fit the company structure and decision-making responsibility of individual managers.

Two Aspects of Motivation

• Goal Congruence exists when individuals and groups work toward achieving the organizations goals – managers working in their own best interests take actions that align with the overall goals of top management.

Two Aspects of Motivation

• Effort is exertion toward reaching a goal, including both physical and mental actions.

Organizational 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 Versus 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.

Decentralization and Multinational Firms

• Companies that operate in multiple countries are often decentralized – why?

• What do you think is the biggest drawback to decentralization with multinational companies?

Choices about Responsibility Centers

• Regardless of the degree as decentralization, management control systems used one or a mix of the four types of responsibility centers.– Cost centers– Revenue centers– Profit centers– Investment centers

Transfer Pricing

• A transfer price is the price one subunit of a corporation charges for a product or service supplied to another subunit of the same organization.

• Management control systems use transfer prices to coordinate the actions of subunits and to evaluate their performance.

Transfer Pricing

• The transfer price creates revenues for the selling subunits and purchasing cost for the buying subunits, affecting each subunits operating income.

• The product or service transferred between subunits is called the intermediate product.

Three Transfer Pricing Methods

• Market based transfer prices• Cost-based transfer prices• Negotiated transfer prices

Dual Pricing

• Dual pricing is one version of cost-based pricing.

• Dual pricing uses two separate transfer pricing methods to price each transfer from one subunit to another

• Example: the selling division receives full cost price, while the buying division pays market price.

Dual Pricing

• With the previous example, what happens to the difference between full cost received by the selling division and market price paid by the buying division?

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, – environmental related taxes, and – other government levies.

Minimum Transfer Price

Transfer price = marginal cost + opportunity cost

Of course you have seen this formula before . . .

Problem 22-16

• Durham Corporation makes exclusive furniture.

• Describe the financial and nonfinancial measures you would include in the company’s balanced scorecard management control system.

Author’s Answer

• Durham produces and sells furniture of unique design and outstanding quality.

• Clearly, it is pursuing a product-differentiation strategy.

Author’s Answer

• Its balanced-scorecard-based management control system should reflect that strategy and measure and communicate the degree to which the organization meets its strategic goals.

• Some possible financial and non-financial measures are:

Possible Financial Measures

• profit margins • stock price • net income • return on investment • cash flow from operations • design costs as a percentage of sales

Possible Non-Financial Measures

• Market share in the high-end furniture segment.

• Customer repeat purchases. • Number of mentions of Durham furniture in

design and architecture magazines. • Recognized quality certifications, number of

innovative designs.

Possible Non-Financial Measures

• Ability to attract and keep the best designers. • Employee satisfaction. • Employee pride in Durham’s identity.

Problem 22-18

• Hexton Chemicals has seven independent operating divisions.

• These are assisted by support groups such as environmental management.

Problem 22-18

• Environmental management engineers must seek business from the divisions.

• The work must be paid by the operating divisions.

Problem 22-18

• Is the environmental group centralized or decentralized?

• The environmental-management group appears to be decentralized because its managers have considerable freedom to make decisions.

Problem 22-18

• They can choose which projects to work on and which projects to reject.

• Top management will adjust the size of the environmental-management group to match the demand for the group’s services by operating divisions.

Problem 22-18

• What type of responsibility is the environmental management group?

• The environmental-management group is a cost center.

• The group is required to charge the operating divisions for environmental services at cost and not at market prices that would help earn the group a profit.

Problem 22-18

• What benefits and problems do you see in structuring the environmental group in this way?

• Does it lead to goal congruence?

Benefits

• The operating managers have incentives to carefully weigh and conduct cost-benefit analyses before requesting the environmental group’s services.

• The operating managers have an incentive to follow the work and the progress made by the environmental team.

Benefits

• The environmental group has incentives to fulfill the contract, to do a good job in terms of cost, time, and quality, and to satisfy the operating division to continue to get business.

Problems

• The contract requires extensive internal negotiations in terms of cost, time, and technical specifications.

• The environmental group needs to continuously “sell” its services to the operating division, and this could potentially result in loss of morale.

Problems

• Experimental projects that have long-term potential may not be undertaken because operating division managers may be reluctant to undertake projects that are costly and uncertain, whose benefits will be realized only well after they have left the division.

Problem 22-19

• User Friendly Computer with headquarters in San Francisco, manufactures and sells a desktop computer.

• The company has three divisions each of which is located in a different country.

Three Divisions

• China Division – manufactures memory devices and keyboards.

• South Korean Division – assembles desktop computers using internally manufactured parts and memory devices and keyboards from the China division.

• US Division – packages and distributes desktop computers.

Additional Information

• Each division is run as a profit center.• The cost for work done in each division for a

single desktop computer is as follows.

China Division Variable costs = 1000 yuan

Fixed cost = 1800 yuan

South Korea Division Variable cost = 360,000 won

Fix cost = 480,000 won

United States Division Variable cost = $100

Fixed costs = $200

Additional Information

• Chinese income tax rate is 40%.• A South Korean income tax rate is 20%.• United States income tax rate is 30%.• Exchange rates:

– 8 yuan = $1.00 US dollar– 1,200 won = $1.00 US dollar

Additional Information

• Each desktop computer is sold through retail outlets in the United States for $3200.

Additional Information

• Both China and South Korea sell part of their production under a private label.

• The Chinese division sells a comparable memory/keyboard package to a Chinese manufacturer for 3600 yuan.

• The South Korea division sells a comparable desktop computer to a South Korean distributor for 1,560,000 won

Part One

• Calculate the after tax operating income per unit earned by each division under the following transfer pricing methods: (a) market price, ( b) 200% of full costs, and (c) 300% of variable costs.

• Income taxes are not included in the computation of cost based transfer prices.

Analysis

• This is a three-country, three-division transfer pricing problem with three alternative transfer pricing methods.

Analysis

• Let’s take this approach in solving the problem:• First begin by summarizing the costs in US dollars.• Then organize this data into transfer price

alternatives.• Then prepare income statements for each

division using each transfer price method, summing to see the total corporate net income under each alternative.

Summary of Costs in US Dollars

• China Plant:– Variable costs: 1000 yuan = $125 per subunit– Fixed costs: 1800 yuan = $225 per subunit.

• South Korea Plant:– Variable costs: 360,000 won = $300 per unit– Fixed cost: 490,000 won = $400 per unit.

• United States Plant:– Variable costs: $100 per unit– Fixed costs: $200 per unit

Market Prices for Private Label Sale Alternatives:

China Plant: 3600 yuan = $450 per subunitSouth Korea Plant: 1,560,000 won = $1300 per

unit.

Transfer Prices

Market Price as a transfer price:China to South Korea = $450 per subunitSouth Korea to U.S. Plant = $1,300 per unit

Transfer Prices

200% of Full Cost as a transfer priceChina to South Korea: 2.0 ($125 + $225) =

$700 per subunitSouth Korea to U.S. Plant: 2.0 ($700 + $300 +

$400) = $2,800 per unit

Where does this come from?

It is the transfer price of the memory devices and

keyboards from China

Transfer Prices

300% of Variable Costs:China to South Korea: 3.0 $125 = $375 per

subunitSouth Korea to U.S. Plant: 3.0 ($375 + $300) =

$2,025 per unit

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

1. China DivisionDivision revenue per unitCost per unit:

Division variable cost per unit

Division fixed cost per unit Total division cost per unit

Division operating income per unit

Income tax at 40%Division net income per

unit

$ 450

125 225 350

100 40$ 60

$ 700

125 225 350

350 140$ 210

$ 375

125 225 350

25

10$ 15

These figures were calculated on the earlier slides.

Let’s Start in China which makes the memory devices and keyboards.

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

1. China DivisionDivision revenue per unitCost per unit:

Division variable cost per unit

Division fixed cost per unit Total division cost per unit

Division operating income per unit

Income tax at 40%Division net income per

unit

$ 450

125 225 350

100 40$ 60

$ 700

125 225 350

350 140$ 210

$ 375

125 225 350

25

10$ 15

The rest of this data is given in the problem

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

2. So. Korea DivisionDivision revenue per unitCost per unit:

Transferred-in cost per unit

Division variable cost per unit

Division fixed cost per unit

Total division cost per unitDivision operating income per unitIncome tax at 20%Division net income per unit

$1,300

450300

400 1,150

150 30$ 120

$2,800

700 300

400 1,400 1,400 280$1,120

$2,025

375300

400 1,075

950 190$ 760

These are the costs transferred from China under each transferpricing assumption.

Now Let’s Move to South Korea that does assembly.

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

2. So. Korea DivisionDivision revenue per unitCost per unit:

Transferred-in cost per unit

Division variable cost per unit

Division fixed cost per unit

Total division cost per unitDivision operating income per unitIncome tax at 20%Division net income per unit

$1,300

450300

400 1,150

150 30$ 120

$2,800

700 300

400 1,400 1,400 280$1,120

$2,025

375300

400 1,075

950 190$ 760

These costs will be transferred to the United States under eachpricing assumption.

Method A Method B Method CInternal

Transfersat Market

Price

InternalTransfers

at 200% ofFull Costs

InternalTransfers

at 300% ofVariable Costs

3. US DivisionDivision revenue per unitCost per unit:

Transferred-in cost per unitDivision variable cost per unitDivision fixed cost per unit

Total division cost per unitDivision operating income per unitIncome tax at 30%Division net income per unit

$3,200

1,300 100

200 1,600 1,600 480$1,120

$3,200

2,800 100

200 3,100

100 30$ 70

$3,200

2,025100

200 2,325

875 262.5$ 612.5

Finally we package and distribute in the United States

Division Net Income MarketPrice

200% ofFull Costs

300% ofVariable Cost

China DivisionSo. Korea DivisionUS DivisionUser Friendly Computer, Inc.

$ 60120

1,120$1,300

$ 2101,120

70$1,400

$ 15.00760.00

612.50$1,387.50

The company will maximize its net income by using 200% of full costs asthe transfer price. This is because method B sources the largest proportion of income in S. Korea, the country with the lowest income rate.

So what transfer pricing scheme gives the company the greatest profit?

Problem 22-20

• British Columbia lumber has a raw lumber division and a finished lumber division.

• The variable costs are:– Raw Lumber Division: $100 per 100 board feet of

raw lumber.– Finished Lumber Division: $125 per 100 board feet

of finished lumber.

Problem 22-20

• Assume there is no board feet lost in processing raw lumber into finished lumber.

• Raw lumber can be sold at $200 per 100 board feet.

• Finished lumber can be sold at $275 per 100 board feet.

Question

• Should British Columbia Lumber processed raw lumber into its finished form?

• The way to solve a problem like this is to subtract incremental costs from incremental revenue.

• ($275 -$200) - $125 = ($50) incremental loss• Do not processed raw lumber into finished

lumber.

Question

• Assume that internal transfers are made at 110% of variable costs.

• Will each division maximize its division operating income by adopting the action that is in the best interests of British Columbia Lumber as a whole?

AnalysisSell As Raw

Lumber Sell As Finished

Lumber

Raw Lumber Division

Division revenues $200 $110

Division variable costs 100 100

Division operating income $100 $10

Finished Lumber Division

Division revenues $0 $275

Transferred in costs 0 110

Division variable costs 0 125

Division operating income $0 $40

No, Raw Lumber Division will maximize reported income by selling raw lumber,while the finished lumber will maximize division income by selling finished lumber.

AnalysisSell As Raw

Lumber Sell As Finished

Lumber

Raw Lumber Division

Division revenues $200 $110

Division variable costs 100 100

Division operating income $100 $10

Finished Lumber Division

Division revenues $0 $275

Transferred in costs 0 110

Division variable costs 0 125

Division operating income $0 $40

The best option for the company as a whole is to sell raw lumber only, as ($100 + 0) is greater than ($10 + $40). That is not the answer the 110% of variable cost transfer price gives.

Question

• 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 the British Columbia’s a whole?

Analysis

Sell as Raw Lumber

Sell as Finished Lumber

Raw Lumber DivisionDivision revenuesDivision variable costsDivision operating incomeFinished Lumber DivisionDivision revenuesTransferred-in costsDivision variable costsDivision operating income

$200 100$100

$ 00

0$ 0

$200 100$100

$275200

125$ (50)

Probably, since the Raw Lumber Division would be indifferent between selling the lumber in raw or finished form.

Problem 22-23

• The Mornay Company manufactures telecommunication equipment.

• The company is marketing divisions throughout the world.

• A division in Vietnam imports 1000 units of product 4a36 from the United States.

The Following Information Is Available

US income tax rate 40%

Austrian income tax rate 44%

Austrian import duty 10%

Variable manufacturing cost per unit $350

Full manufacturing cost per unit $500

Selling price (net of marketing and distribution costs) in Austria.

$750

Suppose the US and Austrian tax authorities only allow transfer prices that are between the full manufacturing cost of $500 and market price of $650, based on comparable imports into Austria.

Additional Information

• The Austrian import duty is charged on the price at which the product is transferred into Austria.

• Any import duty paid to the Austrian authorities is a deductible expense for calculating Austrian income taxes due.

Question

• Calculate the after-tax operating income earned by the US and Austrian divisions from transferring 1000 units of the products at full manufacturing costs per unit.

• Do the same calculation based on a transfer price of market price of comparable imports (income taxes are not included in the computation of the cost based transfer prices).

Method A

Internal Transfers at Full

Manufacturing Cost

Method B Internal

Transfers at Market Price

U.S. Division Revenues: $500, $650 1,000 units Costs: Full manufacturing cost: $500 1,000 units Division operating income Division income taxes at 40% Division after-tax operating income Austrian Division Revenues: $750 1,000 units Costs: Transferred-in costs: $500 1,000, $650 1,000 units Import duties at 10% of transferred-in

price $50 1,000, $65 1,000 units Total division costs Division operating income Division income taxes at 44% Division after-tax operating income

$500,000

500,000 0

0 $ 0

$750,000

500,000

50,000

550,000 200,000

88,000 $112,000

$650,000

500,000 150,000

60,000 $ 90,000

$750,000

650,000

65,000

715,000 35,000 15,400

$ 19,600

The company will maximize profits by setting the minimum transfer price at full manufacturing cost.

Problem 22-25

• The Allison-Chambers Corporation, is organized along decentralized product lines with each division acting as a profit center.

Problem 22-25

• Division managers have full authority with regard to sale of division output to outsiders and other divisions.

• Division C has always purchased its tractor engine component from Division A.

More Information

• However, when informed that Division A is increasing its selling price to $150, Division C’s manager decides to purchase the engine component from external suppliers.

More Information

• Division A insist that, because of the recent installation of some highly specialized equipment and the resulting high depreciation charges, it will not be able to earn an adequate return on its investment unless it raises its price.

More Information

• Division A’s manager appeals to top management for support in the dispute with Division C and supplies the following operating data.– C’s annual purchase of the tractor engine components –

1,000 units– A’s variable cost per unit of the tractor engine

components -- $120– A’s fixed cost per unit of the tractor engine component --

$20.

Question

• Assume there are no alternative uses for the internal facilities.

• Determine rather the company as a whole will benefit if Division C purchased the component from external suppliers at $135 per unit.

Analysis

The company as a whole will not benefit if Division C purchases from external suppliers.

Purchase price paid to external suppliers (1000 units x $135)

$135,000

Deduct savings in variable costs by reducing Division A output ((1000 units x $120)

-$120,000

Net cost to company from purchasing outside $15,000

Question and Answer

• Question: What should the transfer price be set at so the division managers acting in their own best interest take actions that are in the best interest of the company as a whole?

• Answer: Any transfer price between $120 and $135 will achieve goal congruence.

Question

• Assume that the internal facilities of Division A would not otherwise be idle.

• By not producing 1,000 units for Division C, Division A’s equipment and other facilities would be used for other production operations that would result in annual cash operating savings of $18,000.

• Should Division C now purchase from external suppliers?

AnswerPurchase cost paid to external suppliers (1,000 units x $135 $135,000

AnswerPurchase cost paid to external suppliers (1,000 units x $135 $135,000

Deduct savings in variable costs:

Internal variable cost saved per engine 1,000 units x $120 $120,000

Savings by assigning equipment in A to other uses $18,000

Answer

The company as a whole will benefit if it Division C purchases from external suppliers as we reduce costs more

than the price of purchasing externally.

Purchase cost paid to external suppliers (1,000 units x $135 $135,000

Deduct savings in variable costs:

Internal variable cost saved per engine 1,000 units x $120 $120,000

Savings by assigning equipment in A to other uses $18,000

Net benefit by purchasing from outside suppliers $3,000

Question

• Assume that there are no alternative uses for Division A’s internal facilities and that the price from outsiders drops $20.

• Should Division C purchase from external suppliers?

• What should the transfer price for the components be set so that division managers have goal congruence?

AnswerPurchase cost paid to external suppliers (1,000 units x $115) $115,000

AnswerPurchase cost paid to external suppliers (1,000 units x $115) $115,000

Savings by reducing Division A’s output (1,000 units x $120) $120,000

Answer

The company will benefit if Division C purchases from the external supplier.

Goal congruence will be achieved if the transfer price is set equal to the total relevant costs of purchasing from Division A.

Purchase cost paid to external suppliers (1,000 units x $115) $115,000

Savings by reducing Division A’s output (1,000 units x $120) $120,000

Benefit to the company by buying from the outside $5,000

Problem 22-26

• Refer to Exercise 22-25, assume that Division A can sell the 1,000 units to other customers at $155 per unit, with variable marketing cost of $5 per unit.

• Determine whether Allison-Chambers will benefit if Division C purchases the 1,000 units from external suppliers at $135.

Problem 22-26Purchase cost to external suppliers (1,000 units x $135) $135,000

Deduct variable savings (1,000 units x $120) 120,000

Net cost to company as a result from purchasing from external suppliers

$15,000

There is a net disadvantage to the company of having C purchasing from outside the company.

Problem 22-26Purchase cost to external suppliers (1,000 units x $135) $135,000

Deduct variable savings (1,000 units x $120) 120,000

Net cost to company as a result from purchasing from external suppliers

$15,000

Division A sales to other customers (1,000 units x $155) $155,000

Variable manufacturing costs (1,000 units x $120) $120,000

Variable marketing costs (1,000 units x $5) 5,000

Contribution margin from selling to other customers $30,000

This disadvantage is more than offset, however by having Division A sell1,000 units on the outside. The decision? Have Division C buy outside! This nets us $30,000 - $15,000 = $15,000 additional contribution margin.

Problem 22-28

• Europa Inc. has two divisions, A and B, which manufacture expensive bicycles.

• Division A produces the bicycle frame, and Division B assembles the rest of the bicycle onto the frame.

Problem 22-28

• There is a market for both the subassembly and the final product.

• Each division has been designated as a profit center.

• The transfer price for the subassembly has been set at the long-run average market price.

• Data for each division follows.

Problem 22-28Selling price for final product $300

Long-run average selling price for intermediate product 200

Incremental cost per unit for competition in Division B 150

Incremental cost per unit in Division A 120

Problem 22-28

• The manager for Division B has made the following calculation:

Selling price for final product $300

Transferred-in price per unit $200

Incremental unit cost to complete 150 350

Contribution loss on product -$50

Should transfers be made to Division B if there is no unused capacity in Division A? Is the market price the correct price?

Problem 22-28

• No, transfers should not be made internally, as the company as a whole can make more by selling the product on the outside.

Problem 22-28

• If Division B assembles the bicycle the company still has an overall contribution margin per unit of $30 as calculated below:

Sales price of final product $300

Incremental cost per unit in Division A 120

Incremental cost per unit in Division B $150

Contribution margin per unit $30

Problem 22-28

• However, if the company simply sells the bicycle frame, its contribution margin is $80 as shown below.

Selling price of intermediate product $200

Incremental outlay cost per unit in Division A 120

Contribution margin per unit $80

Problem 22-28

• Since there is no excess capacity, and therefore an opportunity cost of every unit sold inside the company, the market price is the correct transfer price.

• Let’s illustrate it with the general guideline described in the chapter. =

Minimum transfer price

=

Additional incremental

cost per unit

+Opportunity CostPer unit to the

Supplying division

=

$200 = $120 + ($200 - $120)

Question

• Assume that Division A’s maximum capacity is 1,000 units per month and sales to the intermediate market are now 800 units.

• Should 200 units be transferred to Division B?• If so at what transfer price?

Answer• Since there is no opportunity cost, the correct

price would range between:– incremental cost + opportunity cost = $120 + 0 =

$120. • This would be the ideal price for Division B

– $120 + $30 (contribution margin now earned by the assembly division) = $150

• This would be the ideal price for Division A.• The negotiated price would probably be

somewhere between $120 and $150, so that the assembly division could make at least some of its desired $30 contribution margin.

Answer

• Above 200 units, the price would be $200 per unit, the market price, since there is an opportunity cost equal to the contribution given up by Division A.

• The transfer price therefore is:– incremental cost of making the frame of $120 + lost

contribution margin from not selling to outside customers of ($200 - $120 = $80) = $120 + $80 = $200!

• At no excess capacity, the correct transfer price is always market price.

Question

• Suppose Division A quoted a transfer price of $150 for up to 200 units.

• What would be the contribution margin to the company as a whole if the transfer were made?

Answer

• Division B would show zero contribution margin.

• The company as a whole, however, would generate a contribution margin of $30 per unit on the 200 units transferred.

• Any price between $120 and $150 would induce the transfer that would be desirable for the company as a whole.

Answer

• A motivational problem may arise regarding how to split the $30 contribution between Division A and Division B.

• Unless the price is below $150, Division B generates no contribution margin and has little incentive to buy.

Problem 22-30

• Crango Products is a cranberry cooperative with two divisions: Harvesting and Processing.

• Currently all output is converted into cranberry juice by Processing and sold to large companies.

• The Processing Division has a yield of 500 gallons of juice per 1,000 pounds of cranberries.

Problem 22-30

• Cost information is given below:Harvesting Division Processing Division

Variable cost per pound of cranberries

$0.10 Variable processing cost per gallon of juice produced

$0.20

Fixed cost per pound of cranberries

$0.25 Fixed cost per gallon of juice produced

$0.40

Selling price per pound of cranberries in outside market

$0.60 Selling price per gallon of juice $2.10

Question• Compute Crango’s operating income from

harvesting 500,000 pounds of cranberries during June 2006 and processing them into juice.

Pounds of cranberries harvested   500,000 Gallons of juice processed (500 gals per 1,000 lbs.)   250,000Revenues (250,000 gals. $2.10 per gal.) $525,000Costs   Harvesting Division Variable costs (500,000 lbs. $0.10 per lb.) $ 50,000   Fixed costs (500,000 lbs. $0.25 per lb.) 125,000   Total Harvesting Division costs 175,000 Processing Division Variable costs (250,000 gals. $0.20 per gal.) $ 50,000   Fixed costs (250,000 gals. $0.40 per gal.) 100,000   Total Processing Division costs 150,000 Total costs 325,000Operating income $200,000

Question

• Crango rewards its division managers with a bonus equal to 5% of operating income.

• Compute the bonus earned by each manager for each of the following transfer pricing methods:– 200% of full cost– Market price

 200% of

Full Costs Market PriceTransfer price per pound (($0.10 + $0.25) 2; $0.60) $0.70 $0.60    1. Harvesting Division  Revenues (500,000 lbs. $0.70; $0.60) $350,000 $300,000Costs Division variable costs (500,000 lbs. $0.10 per lb.) 50,000 50,000 Division fixed costs (500,000 lbs. $0.25 per lb.) 125,000 125,000 Total division costs 175,000 175,000Division operating income $175,000 $125,000Harvesting Division manager's bonus (5% of operating income) $8,750 $6,250   2. Processing Division  Revenues (250,000 gals. $2.10 per gal.) $525,000 $525,000Costs Transferred-in costs 350,000 300,000 Division variable costs (250,000 gals. $0.20 per gal.) 50,000 50,000 Division fixed costs (250,000 gals. $0.40 per gal.) 100,000 100,000 Total division costs 500,000 450,000Division operating income $ 25,000 $ 75,000Processing Division manager’s bonus (5% of operating income) $1,250 $3,750

Answer

Question

• Which transfer pricing method will each division manager prefer?

• The Harvesting Division manager will prefer to transfer at 200% of full costs because this method gives a higher bonus. The Processing Division manager will prefer transfer at market price for its higher resulting bonus.

Question

• How might Crango resolve any conflicts that may arise on the issue of transfer pricing?– Basing division managers’ bonuses on overall Crango profits in addition to

division operating income. This will motivate each manager to consider what is best for Crango overall and not be concerned with the transfer price alone.

– Letting the two divisions negotiate the transfer price between themselves. However, this may result in constant re-negotiation between the two managers each accounting period.

– Using dual transfer prices However, a cost-based transfer price will not motivate cost control by the Harvesting Division manager. It will also insulate that division from the discipline of market prices.

Problem 22-32

• Industrial Diamonds has two divisions:– South African Mining Division which polishes raw

diamonds for use in industrial polishing tools.– US Processing Division which polishes raw

diamonds for use in industrial cutting tools.

Problem 22-32

• The Processing Division’s yield is 50%.• It takes two pounds of raw diamonds to

produce 1 pound of top-quality polished industrial diamonds.

• Although all of the Mining Division’s annual output of 2,000 pounds of raw diamonds is sent for processing to the United States, there is also an active market for raw diamonds in South Africa.

Problem 22-32

• The foreign exchange rate is 7 ZAR (South African Rands) = $1.00 US Dollar.

• The information shown on the following slide is for the two divisions.

Largest hand dug diamond mine inSouth Africa

Information on Diamond DivisionsSouth African Mining Division

Variable cost per pound of raw diamonds 560 ZAR

Fixed cost per pound of raw diamonds 1,540 ZAR

Market price per pound of raw diamonds 3,150 ZAR

Tax rate 18%

US Polishing Division

Variable cost per pound of raw diamonds 150 US Dollar

Fixed cost per pound of raw diamonds 700 US Dollar

Market price per pound of raw diamonds 5,000 US Dollar

Tax rate 30%

Question

• Compute the annual pre-tax operating income, in US dollars, of each division using 200% of full cost and market price transfer pricing methods.

• Then calculate after-tax income using same methods.

Answer—Pre-tax Operating Income

200% ofFull Cost

MarketPrice

Mining DivisionDivision revenues, $600, $450 x 2,000Costs Division variable costs, $80 x 2,000 Division fixed costs, $220 x 2,000 Total division costsDivision operating incomeProcessing DivisionDivision revenues, $5,000 x 1,000Costs Transferred-in costs, $600, $450 x 2,000 Division variable cost, $150 x 1,000 Division fixed costs, $700 x 1,000 Total division costsDivision operating income

$1,200,000

160,000 440,000 600,000$ 600,000

$5,000,000

1,200,000150,000

700,000 2,050,000$2,950,000

$ 900,000

160,000 440,000 600,000$ 300,000

$5,000,000

900,000150,000

700,000 1,750,000$3,250,000

Answer—After-Tax Income

200% ofFull Cost

MarketPrice

Mining DivisionDivision operating incomeIncome tax at 18%Division after-tax operating income

$600,000 108,000$492,000

$300,000 54,000

$246,000Processing DivisionDivision operating incomeIncome tax at 30%Division after-tax operating income

$2,950,000 885,000$2,065,000

$3,250,000 975,000$2,275,000

The Mining Division manager would prefer 200% of full cost for the purpose of calculating a bonus.

The Processing Division manager, however, would prefer market price.

Question• In addition to tax minimization, what other factors

might Industrial Diamonds consider in choosing a transfer-pricing method?– Performance evaluation– Management motivation– Pricing and product emphasis– External market recognition– Overall income of the company– Income or dividend repatriation restrictions– Competitive position of subsidiaries in their respective markets

Answer—After-Tax Income

200% ofFull Cost

MarketPrice

Mining DivisionDivision operating incomeIncome tax at 18%Division after-tax operating income

$600,000 108,000$492,000

$300,000 54,000

$246,000Processing DivisionDivision operating incomeIncome tax at 30%Division after-tax operating income

$2,950,000 885,000$2,065,000

$3,250,000 975,000$2,275,000

Due to differing tax rates, the company will pay less tax and keep more profit if they use full cost as the transfer price.

Problem 22-33

• Dropped as per Web.