Description
A management control system (MCS) is a system which gathers and uses information to evaluate the performance of different organizational resources like human, physical, financial and also the organization as a whole considering the organizational strategies. Finally, MCS influences the behavior of organizational resources to implement organizational strategies.
Management Control Systems, Transfer Pricing, And Multinational Considerations 22-1
A management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout the organization and to guide the behavior of its managers and employees. The goal of the system is to improve the collective decisions within an organization.
22-2
To be effective, management control systems should be (a) closely aligned to an organization's strategies and goals, (b) designed to fit the organization's structure and the decision-making responsibility of individual managers, and (c) able to motivate managers and employees to put in effort to attain selected goals desired by top management.
22-3
Motivation combines goal congruence and effort. Motivation is the desire to attain a selected goal specified by top management (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort aspect).
22-4
1. 2. 3. 4. 5. 1. 2. 3. 4.
The chapter cites five benefits of decentralization: Creates greater responsiveness to local needs Leads to gains from faster decision making Increases motivation of subunit managers Aids management development and learning Sharpens the focus of subunit managers The chapter cites four costs of decentralization: Leads to suboptimal decision making Results in duplication of activities Focuses managers’ attention on the subunit rather than the company as a whole Increases costs of gathering information
22-5
No. Organizations typically compare the benefits and costs of decentralization on a function-by-function basis. For example, companies with highly decentralized operating divisions frequently have centralized income tax strategies.
22-6
No. A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. The two segments can be cost centers, profit centers, or investment centers. For example, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an example of transfer pricing.
22-7
1. 2. 3.
The three general methods for determining transfer prices are: Market-based transfer prices Cost-based transfer prices Negotiated transfer prices
22-1
22-8
1. 2. 3. 4.
Transfer prices should have the following properties. They should promote goal congruence, be useful for evaluating subunit performance, motivate management effort, and preserve a high level of subunit autonomy in decision making. No, the chapter illustration demonstrates how division operating incomes differ dramatically under the variable costs, full costs, and market price methods. Transferring products or services at market prices generally leads to optimal decisions when (a) the market for the intermediate product market is perfectly competitive, (b) interdependencies of subunits are minimal, and (c) 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.
22.9 22.10
22-11
One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal decisions for the company as a whole. An example of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally. This situation often arises where full-cost-based transfer prices are used. This situation can make the fixed costs of the supplying division appear to be variable costs of the purchasing division. Another limitation is that the supplying division may not have sufficient incentives to control costs if the full-cost-based transfer price uses actual costs rather than standard costs. The purchasing division sources externally if market prices are lower than full costs. From the viewpoint of the company as a whole, the purchasing division should source from outside only if market prices are less than variable costs of production, not full costs of production.
22-12
Reasons why a dual-pricing approach to transfer pricing is not widely used in practice
include: 1. The manager of the supplying division uses a cost-based method to record revenues and does not have sufficient incentives to control costs. 2. This approach does not provide clear signals to division managers about the level of decentralization top management wants. 3. This approach tends to insulate managers from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division. 4. It leads to problems in computing the taxable income of subunits located in different tax jurisdictions.
22-13 Disagree. Cost and price information are often useful starting points in the negotiation
process. Costs, particularly variable costs of the "selling" division, serve as a "floor" below which the selling division would be unwilling to sell. Prices that the "buying" division would pay to purchase products from the outside market serves as a "ceiling" above which the buying division would be unwilling to buy. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices. But the negotiated price will generally fall between the variable costs-based floor and the market price-based ceiling.
22-2
22-14 Yes. The general transfer-pricing guideline specifies that the minimum transfer price
equals the additional outlay costs per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division. When the supplying division has idle capacity, its opportunity costs are zero; when the supplying division has no idle capacity, its opportunity costs are positive. Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not.
22-15 Alternative transfer-pricing methods can result in sizable differences in the reported
operating income of divisions in different income tax jurisdictions. If these jurisdictions have different tax rates or deductions, the net income of the company as a whole can be affected by the choice of the transfer-pricing method.
22-16 (25 min.) Decentralization, responsibility centers.
1. The manufacturing plants in the Manufacturing Division are cost centers. Senior management determines the manufacturing schedule based on the quantity of each type of lighting product specified by the sales and marketing division and detailed studies of the time and cost to manufacture each type of product. Manufacturing managers are accountable only for costs. They are evaluated based on achieving target output within budgeted costs. 2a. If manufacturing and marketing managers were to directly negotiate the prices for manufacturing various products, Quinn should evaluate manufacturing plant managers as profit centers—revenues received from marketing minus the costs incurred to produce and sell output. 2b. Quinn Corporation would be better off decentralizing its marketing and manufacturing decisions and evaluating each division as a profit center. Decentralization would encourage plant managers to increase total output to achieve the greatest profitability, and motivate plant managers to cut their costs to increase margins. Manufacturing managers would be motivated to design their operations according to the criteria that meet the marketing managers’ approval, thereby improving cooperation between manufacturing and marketing. Under Quinn's existing system, manufacturing managers had every incentive not to improve. Manufacturing managers' incentives were to get as high a cost target as possible so that they could produce output within budgeted costs. Any significant improvements could result in the target costs being lowered for the next year, increasing the possibility of not achieving budgeted costs. By the same line of reasoning, manufacturing managers would also try to limit their production so that production quotas would not be increased in the future. Decentralizing manufacturing and marketing decisions overcomes these problems.
22-3
22-17 (15 min.) Decentralization, goal congruence, responsibility centers.
1. The environmental management organization appears to be decentralized because managers of the environmental management group have considerable freedom to make decisions. 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. 2. 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. 3. The benefits of structuring the environmental management group in this way are: a. The operating managers have incentives to carefully weigh and conduct cost-benefit analyses before requesting the environmental group's services. b. The operating managers have an incentive to follow the work and the progress made by the environmental team. c. 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 in order to continue to get business.
The problems in structuring the environmental group in this way are: a. The contract requires extensive internal negotiations in terms of cost, time, and technical specifications. b. The environmental group needs to continuously "sell" its services to the operating division, and this could potentially result in loss of morale. c. 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. To the extent that the focus of the environmental group is on short-run projects demanded by the operating divisions, the current structure leads to goal congruence and motivation. Goal congruence is achieved because both operating divisions and the environmental group are motivated to work toward the organizational goals of reducing pollution and improving the environment. The operating divisions will be motivated to utilize the services of the environmental group to achieve the environmental goals set for them by top management. The environmental group will be motivated to deliver high-quality services in a cost-effective way in order to continue to create a demand for their services. The one issue that top management needs to guard against is that experimental projects with long-term potential that are costly and uncertain may not be undertaken under the current structure. Top management may want to set up a committee to study and propose such long-run projects for consideration and funding by corporate management.
22-4
22-18 (35 min.) Multinational transfer pricing, effect of alternative transferpricing methods, global income tax minimization.
1. This is a three-country, three-division transfer-pricing problem with three alternative transfer-pricing methods. Summary data in U.S. dollars are: China Plant Variable costs: Fixed costs: South Korea Plant Variable costs: Fixed costs: U.S. Plant Variable costs: Fixed costs: = $100 per unit = $200 per unit 360,000 Won ÷ 1,200 Won per $ = $300 per unit 480,000 Won ÷ 1,200 Won per $ = $400 per unit 1,000 Yuan ÷ 8 Yuan per $ = $125 per subunit 1,800 Yuan ÷ 8 Yuan per $ = $225 per subunit
Market prices for private-label sale alternatives: China Plant: 3,600 Yuan ÷ 8 Yuan per $ = $450 per subunit South Korea Plant: 1,560,000 Won ÷ 1,200 Won per $ = $1,300 per unit The transfer prices under each method are: a. Market price • China to South Korea = $450 per subunit • South Korea to U.S. Plant = $1,300 per unit 200% of full costs • China to South Korea 2.0 × ($125 + $225) = $700 per subunit • South Korea to U.S. Plant 2.0 × ($700 + $300 + $400) = $2,800 per unit 300% of variable costs • China to South Korea 3.0 × $125 = $375 per subunit • South Korea to U.S. Plant 3.0 × ($375 + $300) = $2,025 per unit
b.
c.
22-5
22-18 (Cont’d.) Method A Internal Transfers at Market Price 1. China Division Division revenue per unit Deduct: Division variable cost per unit Division fixed cost per unit Division operating income per unit Income tax at 40% Division net income per unit 2. South Korea Division Division revenue per unit Deduct: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Division operating income per unit Income tax at 20% Division net income per unit 3. United States Division Division revenue per unit Deduct: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Division operating income per unit Income tax at 30% Division net income per unit 2. Division net income: Market Price China Division South Korea Division U.S. Division User Friendly Computer Inc. $ 60 120 1,120 $1,300 200% of Full Costs $ 210 1,120 70 $1,400 300% of Variable Cost $ 15.00 760.00 612.50 $1,387.50 $ 450 125 225 100 40 $ 60 $1,300 450 300 400 150 30 $ 120 $3,200 1,300 100 200 1,600 480 $1,120 Method B Internal Transfers at 200% of Full Costs $ 700 125 225 350 140 $ 210 $2,800 700 300 400 1,400 280 $1,120 $3,200 2,800 100 200 100 30 $ 70 Method C Internal Transfers at 300% of Variable Costs $ 375 125 225 25 10 $ 15 $2,025 375 300 400 950 190 $ 760 $3,200 2,025 100 200 875 262.5 $ 612.5
22-6
22-18 (Cont’d.) User Friendly will maximize its net income by using the 200% of full costs, transfer-pricing method. This is because the 200% of full cost method sources most income in the countries with the lower income tax rates.
22-18 Excel Application
User Friendly Computer, Inc.
Original Data U.S. $ per yuan U.S. $ per won China Division Price per memory/keyboard package Variable costs Fixed costs Income tax rate South Korea Division Price per computer Variable costs Fixed costs Income tax rate U.S. Division Price per computer Variable costs Fixed costs Income tax rate $3,200 $100 $200 30% 0.125 0.00083 3,600 1,000 1,800 40% 1,560,000 360,000 480,000 20% yuan yuan yuan
won won won
22-7
22-18 (Cont’d.)
Problem 1 Method A: Internal Transfers at Market Price China Division Division revenues per unit Deduct: Division variable costs per unit Division fixed costs per unit Division operating income per unit Income tax Division net income per unit South Korea Division Division revenues per unit Deduct: Transferred in costs per unit Division variable costs per unit Division fixed costs per unit Division operating income per unit Income tax Division net income per unit United States Division Division revenues per unit Deduct: Transferred in costs per unit Division variable costs per unit Division fixed costs per unit Division operating income per unit Income tax Division net income per unit Problem 2 Division Net Income China Divison South Korea Division U.S. Division User Friendly Computer, Inc. Market Price $60 $120 $1,120 $1,300 200% of Full Costs $210 $1,120 $70 $1,400 300% of Variable Costs $15 $760 $612.50 $1,387.50 $450 125 225 100 40 $ 60 $1,300 450 300 400 150 30 $ 120 Method B: Internal Transfers at 200% of Full Costs $700 125 225 350 140 $210 $2,800 700 300 400 1,400 280 $1,120 Method C: Internal Transfers at 300% of Variable Costs $375 125 225 25 10 $ 15 $2,025 375 300 400 950 190 $ 760
$3,200 1,300 100 200 1,600 480 $1,120
$3,200 2,800 100 200 100 30 $ 70
$3,200 2,025 100 200 875 262.50 $612.50
22-8
22-19 (30 min.) Transfer-pricing methods, goal congruence.
1. Alternative 1: Sell as raw lumber for $200 per 100 board feet: Revenue Variable costs Contribution margin $200 100 $100 per 100 board feet
Alternative 2: Sell as finished lumber for $275 per 100 board feet: Revenue Variable costs: Raw lumber Finished lumber Contribution margin $275 $100 125 225 $ 50 per 100 board feet
British Columbia Lumber will maximize its total contribution margin by selling lumber in its raw form. An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, $275 – $200 Incremental costs Incremental loss 2. Transfer price at 110% of variable costs: = $100 + ($100 × 0.10) = $110 per 100 board feet Sell as Raw Lumber Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income $200 100 $100 $ 0 — $ 0 Sell as Finished Lumber $110 100 $ 10 $275 110 125 $ 40 $ 75 125 $ (50) per 100 board feet
The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by selling finished lumber, which is contrary to the action preferred by the company as a whole.
22-9
22-19 (Cont’d.) 3. Transfer price at market price = $200 per 100 board feet. Sell as Raw Lumber Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income $200 100 $100 $ 0 — — $ 0 Sell as Finished Lumber $200 100 $100 $275 200 125 $ (50)
The Raw Lumber Division will maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole. Finished Lumber Division will maximize division operating income by not further processing raw lumber; not further processing is preferred by the company as a whole.
22-10
22-20 (30 min.) Effect of alternative transfer-pricing methods on division
operating income. Internal Transfers at Market Prices Method A 1. Mining Division Revenues: $90, $661 × 400,000 units Deduct: Division variable costs: $522 × 400,000 units Division fixed costs: $83 × 400,000 units Division operating income Metals Division Revenues: $150 × 400,000 units Deduct: Transferred-in costs: $90, $66 × 400,000 units Division variable costs: $364 × 400,000 units Division fixed costs: $155 × 400,000 units Division operating income
1 2
Internal Transfers at 110% of Full Costs Method B
$36,000,000 20,800,000 3,200,000 $12,000,000 $60,000,000
$26,400,000 20,800,000 3,200,000 $ 2,400,000 $60,000,000
36,000,000 14,400,000 6,000,000 $ 3,600,000
26,400,000 14,400,000 6,000,000 $13,200,000
$66 = $60 × 110% Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor + 75% of Manufacturing overhead = $12 + $16 + 75% × $32 = $52 3 Fixed cost per unit = 25% of Manufacturing overhead = 25% × $32 = $8 4 Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40% of Manufacturing overhead = $6 + $20 + 40% × $25 = $36 5 Fixed cost per unit in Metals Division = 60% of Manufacturing overhead = 60% × $25 = $15
22-11
22-20 (Cont'd.) 2. Bonus paid to division managers at 1% of division operating income will be as follows: Method A Internal Transfers at Market Prices Mining Division manager's bonus (1% × $12,000,000; 1% × $2,400,000) Metals Division manager's bonus (1% × $3,600,000; 1% × $13,200,000) $120,000 36,000 Method B Internal Transfers at 110% of Full Costs $ 24,000 132,000
The Mining Division manager will prefer Method A (transfer at market prices) because this method gives $120,000 of bonus rather than $24,000 under Method B (transfers at 110% of full costs). The Metals Division manager will prefer Method B because this method gives $132,000 of bonus rather than $36,000 under Method A. 3. Brian Jones, the manager of the Mining Division, will appeal to the existence of a competitive market to price transfers at market prices. Using market prices for transfers in these conditions leads to goal congruence. Division managers acting in their own best interests make decisions that are also in the best interests of the company as a whole. Jones will further argue that setting transfer prices based on cost will cause Jones to pay no attention to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full costs.
22-21 (30 min.) Transfer pricing, general guideline, goal congruence.
1. Using the general guideline presented in the chapter, the minimum price at which the Airbag Division would sell airbags to the Igo Division is $110, the incremental costs. The Airbag Division has idle capacity (it is currently working at 80% of capacity). Hence, its opportunity cost is zero—the Airbag Division does not forgo any external sales and, hence, does not forgo any contribution margin from internal transfers. Transferring airbags at incremental cost achieves goal congruence. 2. Transferring products internally at incremental cost has the following properties. a. b. Achieves goal congruence—Yes, as described in requirement 1 above. Useful for evaluating subunit performance—No, because transfer price does not exceed full costs. By transferring at incremental costs and not covering fixed costs, the Airbag Division will show a loss. This loss, the result of the incremental costbased transfer price, is not a good measure of the economic performance of the subunit.
22-12
22-21 (Cont'd.) c. Motivating management effort—Yes, if based on budgeted costs (actual costs can then be compared to budgeted costs). If, however, transfers are based on actual costs, Airbag Division management has little incentive to control costs. Preserves subunit autonomy—No. Because it is rule-based, the Airbag Division has no say in and, hence, no ability to set the transfer price.
d.
3. If the two divisions were to negotiate a transfer price, the range of possible transfer prices will be between $110 and $140 per unit. The Airbag Division has excess capacity that it can use to supply airbags to the Igo Division. The Airbag Division will be willing to supply the airbags only if the transfer price equals or exceeds $110, its incremental costs of manufacturing the airbags. The Igo Division will be willing to buy airbags from the Airbag Division only if the price does not exceed $140 per airbag, the price at which the Igo division can buy airbags in the market from outside suppliers. Within the price range or $110 and $140, each division will be willing to transact with the other and maximize overall income of Nogo Motors. The exact transfer price between $110 and $140 will depend on the bargaining strengths of the two divisions. The negotiated transfer price has the following properties. a. b. Achieves goal congruence—Yes, as described above. Useful for evaluating subunit performance—Yes, because the transfer price is the result of direct negotiations between the two divisions. Of course, the transfer prices will be affected by the bargaining strengths of the two divisions. Motivating management effort—Yes, because once negotiated, the transfer price is independent of actual costs of the Airbag Division. Airbag Division management has every incentive to manage efficiently to improve profits. Preserves subunit autonomy—Yes, because the transfer price is based on direct negotiations between the two divisions and is not specified by headquarters on the basis of some rule (for example, Airbag Division incremental costs).
c.
d.
4. Neither method is perfect, but negotiated transfer pricing (described in requirement 3) has more favorable properties than the cost-based transfer pricing (described in requirement 2). Both transfer-pricing methods achieve goal congruence, but negotiated transfer pricing facilitates the evaluation of subunit performance, motivates management effort, and preserves subunit autonomy, whereas the transfer price based on incremental costs does not achieve these objectives.
22-13
22-22 (25 min.) General guideline, transfer price range.
1. If the Screen Division sells screens in the outside market, it will receive, for each screen, the market price of the screen minus variable marketing and distribution costs per screen = $110 – $4 = $106. The incremental cost of manufacturing each screen is $70. The Screen Division is operating at capacity. Hence, the opportunity cost per screen of selling the screen to the Assembly Division rather than in the outside market is the contribution margin the Screen Division would forgo if it transferred screens internally rather than sold them in the outside market. Contribution margin per screen = $106 – $70 = $36. Using the general guideline,
Minimum transfer price per screen =
That is,
Incremental costs per Opportunity costs per screen up to the + screen to the selling division point of transfer Minimum transfer price per screen = $70 + $36 = $106
2. If the two division managers were to negotiate a transfer price, the range of possible transfer prices is between $106 and $112 per screen. As calculated in requirement 1, the Screen Division will be willing to supply screens to the Assembly Division only if the transfer price equals or exceeds $106 per screen. If the Assembly Division were to purchase the screens in the outside market, it will incur a cost of $112, the cost of the screen equal to $110 plus variable purchasing costs of $2 per screen. Hence, the Assembly Division will be willing to buy screens from the Screen Division only if the price does not exceed $112 per screen. Within the price range of $106 and $112 per screen, each division will be willing to transact with the other. The exact transfer price between $106 and $112 will depend on the bargaining strengths of the two divisions.
22.23
(25 min.) Multinational transfer pricing, global tax minimization.
1. Solution Exhibit 22-23 shows the after-tax operating incomes earned by the U.S. and Austrian divisions from transferring 1,000 units of Product 4A36 using (a) full manufacturing cost per unit, and (b) market price of comparable imports as transfer prices. 2. There are many ways to proceed, but the first thing to note is that the transfer price that minimizes the total of company import duties and income taxes will be either the full manufacturing cost or the market price of comparable imports. Consider what happens every time the transfer price is increased by $1 over, say, the full manufacturing cost of $500. This results in the following a. b. c. an increase in U.S. taxes of 40% × $1 an increase in import duties paid in Austria, 10% × $1 a decrease in Austrian taxes of 44% × $1.10 (the $1 increase in transfer price + $0.10 paid by way of import duty) Net effect is an increase in import duty and tax payments of $0.400 0.100
(0.484) $0.016
Hence, Mornay Company will minimize import duties and income taxes by setting the transfer price at its minimum level of $500, the full manufacturing cost. 22-14
22-23 (Cont’d.) SOLUTION EXHIBIT 22-23 Division Incomes of U.S. and Austrian Divisions from Transferring 1,000 Units of Product 4A36 Method A: Internal Method B: Transfers Internal at Full Transfers Manufacturing at Market Cost Price U.S. Division Revenues: $500,000 $650,000 $500, $650 × 1,000 units Deduct: Full manufacturing cost: 500,000 500,000 $500 × 1,000 units 0 150,000 Division operating income 0 60,000 Division income taxes at 40% $ 0 $ 90,000 Division after-tax operating income Austrian Division Revenues: $750 × 1,000 units Deduct: 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 Division operating income Division income taxes at 44% Division after-tax operating income
$750,000
$750,000
500,000 50,000 200,000 88,000 $112,000
650,000 65,000 35,000 15,400 $ 19,600
22-15
22-24 (30 min.) Multinational transfer pricing, goal congruence
(continuation of 22-23). 1. After-tax operating income if Mornay Company sold all 1,000 units of Product 4A36 in the United States is Revenues, $600 × 1,000 units Full manufacturing costs, $500 × 1,000 units Operating income Income taxes at 40% After-tax operating income $600,000 500,000 100,000 40,000 $ 60,000
From Exercise 22-23, requirement 1, Mornay Company's after-tax operating income if it transfers 1,000 units of Product 4A36 to Austria at full manufacturing cost and sells the units in Austria is $112,000. Therefore, Mornay should sell the 1,000 units in Austria. 2. Transferring Product 4A36 at the full manufacturing cost of the U.S. Division minimizes import duties and taxes (Exercise 22-23, requirement 2), but creates zero operating income for the U.S Division. Acting autonomously, the U.S. Division manager would maximize division operating income by selling Product 4A36 in the U.S. market, which results in $60,000 in aftertax division operating income as calculated in requirement 1, rather than by transferring Product 4A36 to the Austrian division at full manufacturing cost. Hence, the transfer price calculated in requirement 2 of Exercise 22-23 will not result in actions that are optimal for Mornay Company as a whole. 3. The minimum transfer price at which the U.S. division manager acting autonomously will agree to transfer Product 4A36 to the Austrian division is $600 per unit. Any transfer price less than $600 will leave the U.S. Division's performance worse than selling directly in the U.S. market. Because the U.S. Division can sell as many units that it makes of Product 4A36 in the U.S. market, there is an opportunity cost of transferring the product internally equal to $250 (selling price $600 ? variable manufacturing costs, $350).
Minimum transfer price per unit =
=
Incremental costs per Opportunity costs per unit up to the point of + unit to the selling transfer (U. S.) division $350 + $250 = $600
This transfer price will result in Mornay Company as a whole paying more import duties and taxes than the answer to Exercise 22-23, requirement 2, as calculated below: U.S. Division Revenues, $600 × 1,000 units Full manufacturing costs Division operating income Division income taxes at 40% Division after-tax operating income $600,000 500,000 100,000 40,000 $ 60,000
22-16
22-24 (Cont’d.) Austrian Division Revenues, $750 × 1,000 units` Transferred in costs, $600 × 1,000 units Import duties at 10% of transferred-in price, $60 × 1,000 units Division operating income Division income taxes at 44% Division after-tax operating income $750,000 600,000 60,000 90,000 39,600 $ 50,400
Total import duties and income taxes at transfer prices of $500 and $600 per unit for 1,000 units of Product 4A36 follow: Transfer Price of $500 per Unit (Exercise 22-23, Requirement 2) $ 0 50,000 88,000 $138,000
(a) (b) (c)
U.S. income taxes Austrian import duties Austrian income taxes
Transfer Price of $600 per Unit $ 40,000 60,000 39,600 $139,600
The minimum transfer price that the U.S. division manager acting autonomously would agree to results in Mornay Company paying $1,600 in additional import duties and income taxes. A student who has done the calculations shown in Exercise 22-23, requirement 2, can calculate the additional taxes from a $600 transfer price more directly, as follows: Every $1 increase in the transfer price per unit over $500 results in additional import duty and taxes of $0.016 per unit So, a $100 increase ($600 – $500) per unit will result in additional import duty and taxes of $0.016 × 100 = $1.60 For 1,000 units transferred, this equals $1.60 × 1,000 = $1,600
22-17
22-25 (20 min.) Transfer-pricing dispute.
This problem is similar to the Problem for Self-Study in the chapter. 1. Company as a whole will not benefit if Division C buys on the outside market: Purchase costs from outsider, 1,000 units × $135 $135,000 Deduct: Savings in variable costs by reducing Division A output, 1,000 units × $120 120,000 Net cost (benefit) to company as a whole by buying from outside $ 15,000
Any transfer price between $120 to $135 per unit will achieve goal congruence. Division managers acting in their own best interests will take actions that are in the best interests of the company as a whole. 2. Company will benefit if C purchases from the outsider supplier: Purchase costs from outsider, 1,000 units × $135 Deduct: Savings in variable costs, 1,000 units × $120 $120,000 Savings due to A's equipment and facilities assigned to other operations 18,000 Net cost (benefit) to company as a whole by buying from outside $135,000
138,000 $ (3,000)
Division C should purchase from outside suppliers. 3. Company will benefit if C purchases from the outside supplier: Purchase costs from outsider, 1,000 units × $115 Deduct: Savings in variable costs by reducing Division A output, 1,000 units × $120 Net cost (benefit) to company as a whole by buying from outside The three requirements are summarized below (in thousands): Total purchase costs from outsider Total relevant costs if purchased from Division A Total incremental (outlay) costs if purchased from A Total opportunity costs if purchased from A Total relevant costs if purchased from A Operating income advantage (disadvantage) to company as a whole by buying from A (1) $135 120 – 120 $ 15 $115,000 120,000 $ (5,000) (2) $135 120 18 138 $ (3) (3) $115 120 – 120 $ (5)
Goal congruence would be achieved if the transfer price is set equal to the total relevant costs of purchasing from Division A.
22-18
22-26 (5 min.) Transfer-pricing problem (continuation of 22-25).
The company as a whole would benefit in this situation if C purchased from outside suppliers. The $15,000 disadvantage to the company as a whole by purchasing from the outside supplier would be more than offset by the $30,000 contribution margin of A's sale of 1,000 units to other customers. Purchase costs from outside supplier, 1,000 units × $135 Deduct variable cost savings, 1,000 units × $120 Net cost to company as a whole by buying units from outside A's sales to other customers, 1,000 units × $155 Deduct: Variable manufacturing costs, $120 × 1,000 units Variable marketing costs, $5 × 1,000 units Total variable costs Contribution margin from selling units to other customers $135,000 120,000 $ 15,000 $155,000 $120,000 5,000 125,000 $ 30,000
22-27 (20–30 min.) Pertinent transfer price.
This problem explores the "general transfer-pricing guideline" discussed in the chapter. 1. No, transfers should not be made to Division B if there is no excess capacity in Division A. An incremental (outlay) cost approach shows a positive contribution for the company as a whole. Selling price of final product $300 Incremental costs in Division A $120 Incremental costs in Division B 150 270 Contribution $ 30 However, if there is no excess capacity in Division A, any transfer will result in diverting products from the market for the intermediate product. Sales in this market result in a greater contribution for the company as a whole. Division B should not assemble the bicycle since the incremental revenue Europa can earn, $100 per unit ($300 from selling the final product – $200 from selling the intermediate product) is less than the incremental costs of $150 to assemble the bicycle in Division B. Alternatively put, Europa’s contribution margin from selling the intermediate product exceeds Europa’s contribution margin from selling the final product. Selling price of intermediate product Incrementral (outlay) costs in Division A Contribution The general guideline described in the chapter is = + = $120 + ($200 – $120) = $200, which is the market price 22-27 (Cont’d.) $200 120 $ 80
22-19
The market price is the transfer price that leads to the correct decision; that is, do not transfer to Division B unless there are extenuating circumstances for continuing to market the final product. Therefore, B must either drop the product or reduce the incremental costs of assembly from $150 per bicycle to less than $100. 2. If (a) A has excess capacity, (b) there is intermediate external demand for only 800 units at $200, and (c) the $200 price is to be maintained, then the opportunity costs per unit to the supplying division are $0. The general guideline indicates a minimum transfer price of: $120 + $0 = $120, which is the incremental or outlay costs for the first 200 units. B would buy 200 units from A at a transfer price of $120 because B can earn a contribution of $30 per unit [$300 – ($120 + $150)]. In fact, B would be willing to buy units from A at any price up to $150 per unit because any transfers at a price of up to $150 will still yield B a positive contribution margin. Note, however, that if B wants more than 200 units, the minimum transfer price will be $200 as computed in requirement 1 because A will incur an opportunity cost in the form of lost contribution of $80 (market price, $200 – outlay costs of $120) for every unit above 200 units that are transferred to B. The following schedule summarizes the transfer prices for units transferred from A to B. Units Transfer Price 0–200 $120–$150 200–1,000 $200 For an exploration of this situation when imperfect markets exist, see the next problem. 3. Division B would show zero contribution, but the company as a whole would generate a contribution 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. A motivational problem may arise regarding how to split the $30 contribution between Division A and B. Unless the price is below $150, B would have little incentive to buy. Note: The transfer price that may appear optimal in an economic analysis may, in fact, be totally unacceptable from the viewpoints of (1) preserving autonomy of the managers, and (2) evaluating the performance of the divisions as economic units. For instance, consider the simplest case discussed previously, where there is idle capacity and the $200 intermediate price is to be maintained. To direct that A should sell to B at A's variable cost of $120 may be desirable from the viewpoint of B and the company as a whole. However, the autonomy (independence) of the manager of A is eroded. Division A will earn nothing, although it could argue that it is contributing to the earning of income on the final product. If the manager of A wants a portion of the total company contribution of $30 per unit, the question is: How is an appropriate amount determined? This is a difficult question in practice. The price can be negotiated upward to somewhere between $120 and $150 so that some "equitable" split is achieved. A dual transfer-pricing scheme has also been suggested, whereby the supplier gets credit for the full intermediate market price and the buyer is charged with only
22-20
22-27 (Cont’d.) variable or incremental costs. In any event, when there is heavy interdependence between divisions, such as in this case, some system of subsidies may be needed to deal with the three problems of goal congruence, management effort, and subunit autonomy. Of course, where heavy subsidies are needed, a question can be raised as to whether the existing degree of decentralization is optimal.
22-28 (30–40 min.) Pricing in imperfect markets (continuation of 22-27).
An alternative presentation, which contains the same numerical answers, can be found at the end of this solution. 1. Potential contribution from external intermediate sale is 1,000 × ($195 – $120) Contribution through keeping price at $200 is 800 × $80. Forgone contribution by transferring 200 units $75,000 64,000 $11,000
Opportunity cost per unit to the supplying division by transferring internally:
$11,000 = $55 200
Transfer price = $120 + $55 = $175 An alternative approach to obtaining the same answer is to recognize that the incremental or outlay cost is the same for all 1,000 units in question. Therefore, the total revenue desired by A would be the same for selling outside or inside. Let X equal the transfer price at which Division A is indifferent between selling all units outside versus transferring 200 units inside. 1,000 × $195 = (800 × $200) + 200X X = $175 The $175 price will lead to the correct decision. Division B will not buy from Division A because its total costs of $175 + $150 will exceed its prospective selling price of $300. Division A will then sell 1,000 units at $195 to the outside; Division A and the company will have a contribution margin of $75,000. Otherwise, if 800 units were sold at $200 and 200 units were transferred to Division B, the company would have a contribution of $64,000 plus $6,000 (200 units of final product × $30), or $70,000. A comparison might be drawn regarding the computation of the appropriate transfer prices between the preceding problem and this problem:
22-21
22-28 (Cont’d.) =+ Perfect markets: = $120 + (Selling price – Outlay costs per unit) = $120 + ($200 – $120) = $200 Imperfect markets: = $120 + = $120 +
$35,000 a ? $24,000 b = $175 200
aMarginal revenues of Division A from selling 200 units outside rather than transferring to Division B = ($195 × 1,000) – ($200 × 800) = $195,000 – $160,000 = $35,000. bIncremental (outlay) costs incurred by Division A to produce 200 units = $120 × 200 = $24,000.
Therefore, selling price ($195) and marginal revenues per unit ($175 = $35,000 ÷ 200) are not the same. The following discussion is optional. These points should be explored only if there is sufficient class time: Some students will erroneously say that the "new" market price of $195 is the appropriate transfer price. They will claim that the general guideline says that the transfer price should be $120 + ($195 – $120) = $195, the market price. This conclusion assumes a perfect market. But, here, there are imperfections in the intermediate market. That is, the market price is not a good approximation of alternative revenue. If a division's sales are heavy enough to reduce market prices, marginal revenue will be less than market price. It is true that either $195 or $175 will lead to the correct decision by B in this case. But suppose that B's variable costs were $120 instead of $150. Then B would buy at a transfer price of $175 (but not at a price of $195, because then B would earn a negative contribution of $15 per unit [$300 – ($195 + $120)]. Note that if B's variable costs were $120, transfers would be desirable: Division A contribution is: 800 × ($200 – $120) + 200 ($175 – $120) = Division B contribution is: 200 × [$300 – ($175 + $120)] = Total contribution $75,000 1,000 $76,000
22-22
22-28 (Cont’d.) Or the same facts can be analyzed for the company as a whole: Sales of intermediate product, 800 × ($200 – $120) Sales of final products, 200 × [300 – ($120 + $120)] Total contribution = = $64,000 12,000 $76,000
If the transfer price were $195, B would not accept the transfer and would not earn any contribution. As shown above, Division A and the company as a whole will earn a total contribution of $75,000 instead of $76,000. 2. a. Division A can sell 900 units at $195 to the outside market and 100 units to Division B, or 800 at $200 to the outside market and 200 units to Division B. Note that, under both alternatives, 100 units can be transferred to Division B at no opportunity cost to A. Using the general guideline, the minimum transfer price of the first 100 units [901–1000] is: TP1 = $120 + 0 = $120 If Division B needs 100 additional units, the opportunity cost to A is not zero, because Division A will then have to sell only 800 units to the outside market for a contribution of 800 × ($200 – $120) = $64,000 instead of 900 units for a contribution of 900 × ($195 – $120) = $67,500. Each unit sold to B in addition to the first 100 units has an opportunity cost to A of ($67,500 – $64,000) ÷ 100 = $35. Using the general guideline, the minimum transfer price of the next 100 units [801–900] is: TP2 = $120 + $35 = $155 Alternatively, the computation could be: Increase in contribution from 100 more units, 100 × $75 Loss in contribution on 800 units, 800 × ($80 ? $75) Net "marginal revenue" (Minimum) transfer price applicable to first 100 units offered by A is $120 + $0 (Minimum) transfer price applicable to next 100 units offered by A is $120 + ($3,500 ÷ 100) (Minimum) transfer price applicable to next 800 units $7,500 4,000 $3,500 ÷100 units = $35 = = = $120 per unit $155 per unit $195 per unit
22-23
22-28 (Cont’d.) b. The manager of Division B will not want to purchase more than 100 units because the units at $155 would decrease his contribution ($155 + $150 > $300). Because the manager of B does not buy more than 100 units, the manager of A will have 900 units available for sale to the outside market. The manager of A will strive to maximize the contribution by selling them all at $195.
This solution maximizes the company's contribution: 900 × ($195 – $120) 100 × ($300 – $270) which compares favorably to: 800 × ($200 – $120) 200 × ($300 – $270) = = $64,000 6,000 $70,000 = = $67,500 3,000 $70,500
ALTERNATIVE PRESENTATION (by James Patell) 1. Company Viewpoint b: Sell 800 outside at $200, transfer 200 Transfer price $200 Variable costs 120 Contribution $ 80 × 800 = $64,000
a: Sell 1,000 outside at $195 Price $195 Variable costs 120 Contribution $ 75 × 1,000 = $75,000 Total contribution given up if transfer occurs* = $75,000 – $64,000 = $11,000 On a per-unit basis, the relevant costs are: + = Transfer price $120 +
$11,000 = $175 200
22-24
22-28 (Cont’d.) By formula, costs are: + – = = 2a. $120 +
200 ×$75 – 200
[ ($200 ? $195) × 800]
200
$120 + $75 – $20 = $175 At most, Division A can sell only 900 units and can produce 1,000. Therefore, at least 100 units should be transferred, at a transfer price no less than $120. The question is whether or not a second 100 units should be transferred.
*Contribution of $30 per unit by B is not given up if transfer occurs, so it is not relevant here.
Company Viewpoint a: Sell 900 outside at $195 Transfer price $195 Variable cost 120 Contribution $ 75 × 900 = $67,500 $ 80 × 800 = $64,000 b: Sell 800 outside at $200, transfer 100 Transfer price $200 Variable cost 120
Total contribution forgone if transfer of 100 units occurs = $67,500 – $64,000 = $3,500 (or $35 per unit) + = Transfer price $120 + 2b. By formula: + – = $120 +
[($200 ? $195) × 800] 100 ×$75 – 100 100
$35
=
$155
= $120 + $75 – $40 = $155 Transfer Price Schedule (minimum acceptable transfer price) Units Transfer Price 0–100 $120 101–200 $155 201–1,000 $195 22.29 (30-35 min.) Effect of alternative transfer-pricing methods on division
operating income.
1. Revenues, 500 pounds × $5 22-25 $2,500
Variable costs: Harvesting, 1,000 × $0.20 Processing, 500 × $0.80 Total variable costs Contribution margin Fixed costs: Harvesting, 1,000 × $0.40 Processing, 500 × $0.60 Total fixed costs Operating income 2. a.
$200 400 600 1,900 $400 300 700 $1,200
150% of Full Cost Harvesting Division to Processing Division = 1.5 × ($0.20 + $0.40) = $0.90 per pound of raw tuna b. Market Price Harvesting Division to Processing Division = $1.00 per pound of raw tuna
22-26
22-29 (Cont’d.) 3. Method A Internal Transfers at 150% of Full Costs $ 900 200 400 $ 300 Method B Internal Transfers at Market Price $1,000 200 400 $ 400
1. Tuna Harvesting Division Division revenues $0.90, $1, × 1,000 pounds of raw tuna Deduct: Division variable costs $0.20 × 1,000 pounds of raw tuna Division fixed costs $0.40 × 1,000 pounds of raw tuna Division operating income 2. Tuna Processing Division Division revenues $5 × 500 pounds of processed tuna Deduct: Transferred-in costs $0.90, $1, × 1,000 pounds of processed tuna Division variable costs $0.80 × 500 pounds processed tuna Division fixed costs $0.60 × 500 pounds processed tuna Division operating income
$2,500 900 400 300 $ 900
$2,500 1,000 400 300 $ 800
Bonus paid to division managers at 10% of division operating income will be as follows: Method A Internal Transfers at 150% of Full Costs Harvesting Division manager’s bonus (10% × $300; 10% × $400) Processing Division manager’s bonus (10% × $900; 10% × $800) $30 90 Method B Internal Transfers at Market Prices $40 80
The Harvesting Division manager will prefer Method B (transfer at market prices) because this method gives $40 of bonus rather than $30 under Method A (transfer at 150% of full costs). The Processing Division manager will prefer Method A because this method gives $90 of bonus rather than $80 under Method B.
22-27
22-30 (25 min.) Goal congruence problems with cost-plus transfer-pricing methods, dual pricing system (continuation of 22-29).
Two examples of goal congruence problems are: a. b. Processing Division manager using an outside supplier when Oceanic Products operating income is maximized by buying from Harvesting Division. Harvesting Division manager selling to an outside purchaser when it is better for Oceanic Products to process internally.
2. Transfer into buying division at market price Harvesting Division to Processing Division = $1.00 per pound of raw tuna Transfer out to selling division at 150% of full costs Harvesting Division to Processing Division = 1.5 × ($0.20 + $0.40) = $0.90 per pound of raw tuna Tuna Harvesting Division Division revenues, $0.90 × 1,000 Division variable costs, $0.20 × 1,000 Division fixed costs, $0.40 × 1,000 Division total costs Division operating income Tuna Processing Division Division revenues, $5.00 × 500 Transferred-in costs, $1.00 × 1,000 Division variable costs, $0.80 × 500 Division fixed costs, $0.60 × 500 Division total costs Division operating income 3. Tuna Harvesting Division Tuna Processing Division Oceanic Products $2,500 $1,000 400 300 1,700 $ 800 Division Operating Income $ 300 800 $1,100 $ 900 200 400 600 $ 300
The overall company operating income from harvesting 1,000 pounds of raw tuna and its processing is $1,200 (see Problem 22-29, requirement 1). A dual transfer-pricing method entails using different transfer prices for transfers into the buying division and transfers out of the supplying division. As a result, the sum of division operating incomes do not equal the total company operating income.
22-28
22-30 (Cont’d.) 4. Problems which may arise if Oceanic Products uses the dual transfer-pricing system include: a. b. c. It may reduce the incentives of the supplying division to control costs since every $1 of cost of the supplying division is transferred out to the buying division at $1.50. A dual transfer-pricing system does not provide clear signals to the individual divisions about the level of decentralization top management seeks. It insulates the Harvesting Division manager from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division
22-31 (40 min.) Multinational transfer pricing, global tax minimization.
This is a two-country two-division transfer-pricing problem with two alternative transfer-pricing methods. Summary data in U.S. dollars are: Philippine Mining Division Variable costs: 4,000 pesos ÷ 40 = $100 per lb. of raw industrial diamonds Fixed costs: 8,000 pesos ÷ 40 = $200 per lb. of raw industrial diamonds U.S. Processing Division Variable costs = $200 per lb. of polished industrial diamonds Fixed costs = $600 per lb. of polished industrial diamonds The market price for raw industrial diamonds in the Philippines is 16,000 pesos ÷ 40 = $400 per lb. of raw industrial diamonds. 1. The transfer prices are: a. 300% of full costs Mining Division to Processing Division = 3.0 × ($100 + $200) = $900 per lb. of raw industrial diamonds b. Market price Mining Division to Processing Division = $400 per lb. of raw industrial diamonds
22-29
22-31 (Cont’d.) 2. Philippine Mining Division Division revenues, $900, $400 × 1,000 Division variable costs, $100 × 1,000 Division fixed costs, $200 × 1,000 Division total costs Division operating income U.S. Processing Division Division revenues, $4,000 × 500 Transferred-in costs, $900, $400 × 1,000 Division variable cost, $200 × 500 Division fixed costs, $600 × 500 Division total costs Division operating income 3. Philippine Mining Division Division operating income Income tax at 20% Division after-tax operating income U.S. Processing Division Division operating income Income tax at 35% Division after-tax operating income 4. Philippine Mining Division: After-tax operating income U.S. Processing Division: After-tax operating income Industrial Diamonds: After-tax operating income 300% of Full Cost $ 900,000 100,000 200,000 300,000 $ 600,000 Market Price $ 400,000 100,000 200,000 300,000 $ 100,000
$2,000,000 900,000 100,000 300,000 1,300,000 $ 700,000 300% of Full Cost $600,000 120,000 $480,000 $700,000 245,000 $455,000 300% of Full Cost $480,000 455,000 $935,000
$2,000,000 400,000 100,000 300,000 800,000 $1,200,000 Market Price $ 100,000 20,000 $ 80,000 $1,200,000 420,000 $ 780,000 Market Price $ 80,000 780,000 $860,000
Industrial Diamonds will maximize companywide net income by using the 300% of full cost transfer-pricing method. This method sources more of the total income in the country with the lower income tax rate.
22-30
22-31 (Cont’d.) 5. The Surveys of Company Practice Box in the chapter lists the factors executives state to be important in decisions on transfer pricing: a. Performance evaluation b. Management motivation c. Pricing and product emphasis d. External market recognition Factors specifically related to multinational transfer pricing include: a. Overall income of the company b. Income or dividend repatriation restrictions c. Competitive position of subsidiaries in their respective markets
22-32 (30–40 min.) Multinational transfer pricing and taxation.
1. Anita Corporation and its subsidiaries' operating income if it manufactures the machine and sells it in Brazil or in Switzerland follows: If Sold in Brazil $1,000,000 500,000 200,000 700,000 $ 300,000 If Sold in Switzerland $950,000 500,000 250,000 750,000 $200,000
Revenue Costs Manufacturing costs Transportation and modification costs Total costs Operating income
Anita Corporation maximizes operating income by manufacturing the machine and selling it in Brazil. 2. Anita Corporation will not sell if the transfer price is less than $500,000––its outlay costs of manufacturing the machine. The Brazilian subsidiary will not agree to a transfer price of more than $800,000. At a price of $800,000, the Brazilian subsidiary's incremental operating income from purchasing and selling the milling machine will be $0 ($1,000,000 – $200,000 – $800,000). The Swiss subsidiary will not agree to a transfer price of more than $700,000. At a price of $700,000, the Swiss subsidiary's incremental operating income from purchasing and selling the milling machine will be $0 ($950,000 – $250,000 – $700,000).
22-31
22-32 (Cont’d.) Any transfer price between $700,000 and $800,000 will achieve the optimal actions determined in requirement 1. For prices in this range, Anita Corporation will be willing to sell, the Brazilian Corporation willing to buy, and the Swiss subsidiary not interested in acquiring the machine. Where within the range of $700,000 to $800,000 that the transfer price will be set depends on the bargaining powers of the Anita Corporation and the Brazilian subsidiary managers. Anita Corporation's main source of bargaining power comes from the threat of selling the machine to the Swiss subsidiary. If the transfer price is set at $700,000, then Anita's operating income, $700,000 – $500,000 Brazilian subsidiary's operating income, $1,000,000 – $700,000 – $200,000 Overall operating income of Anita and subsidiaries Note that the general guideline could be used to derive the minimum transfer price. = = + $500,000 + $200,000 = $700,000 $200,000 100,000 $300,000
Anita's opportunity cost of supplying the machine to the Brazilian subsidiary is the $200,000 in operating income it forgoes by not supplying the machine to the Swiss subsidiary. Note that competition between the Brazilian and Swiss subsidiaries means that the transfer price will be at least $700,000. 3. Consider the optimal transfer prices that can be set to minimize taxes (for Anita and its subsidiaries) (a) for transfers from Anita to the Brazilian subsidiary and (b) for transfers from Anita to the Swiss subsidiary. a. Transfers from Anita to the Brazilian subsidiary should "allocate" as much of the operating income to Anita as possible, since the tax rate in the United States is lower than in Brazil for this transaction. Therefore, these transfers should be priced at the highest allowable transfer price of $700,000 to minimize overall company taxes. Taxes paid: Anita, 0.40 × ($700,000 – $500,000) Brazilian subsidiary, 0.60 × ($1,000,000 – $700,000 – $200,000) Total taxes paid by Anita Corporation and its subsidiaries on transfers to Brazil After-tax operating income: Anita, ($700,000 – $500,000) – $80,000 Brazilian subsidiary ($1,000,000 – $700,000 – $200,000) – $60,000 Total after-tax operating income for Anita Corporation and its subsidiaries on transfers to Brazil $ 80,000 60,000 $140,000 $120,000 40,000 $160,000
22-32
22-32 (Cont’d.) b. Transfers from Anita to the Swiss subsidiary should "allocate" as little of the operating income to Anita as possible, since the tax rate in the United States is higher than in Switzerland for this transaction. Therefore, these transfers should be priced at the lowest allowable transfer price of $500,000 to minimize overall company taxes. $ 0 30,000
Taxes paid: Anita, 0.40 × ($500,000 – $500,000) Swiss subsidiary, 0.15 × ($950,000 – $500,000 – $250,000) Total taxes paid by Anita Corporation and its subsidiaries on transfers to Switzerland After-tax operating income Anita, ($500,000 – $500,000) – $0 Swiss subsidiary ($950,000 – $500,000 – $250,000) – $30,000 Total net income for Anita Corporation and its subsidiaries on transfers to Switzerland $
$30,000 0 170,000
$170,000
From the viewpoint of Anita Corporation and its subsidiaries together, overall after-tax operating income is maximized if the machine is transferred to the Swiss subsidiary (after-tax operating income of $170,000 versus after-tax operating income of $160,000 if the machine is transferred to the Brazilian subsidiary). Note that the corporation and its subsidiaries trade off the lower overall before-tax operating income achieved by transferring to the Swiss subsidiary with the lower taxes that result from such a transfer. Hence, (a) the equipment should be manufactured by Anita, and (b) it should be transferred to the Swiss subsidiary at a price of $500,000. 4. As in requirement 2, the Brazilian subsidiary would be willing to bid up the price to $800,000, while the Swiss subsidiary would be willing to pay only up to $700,000. Anita Corporation, acting autonomously, would like to maximize its own after-tax operating income by transferring the machine at as high a transfer price as possible. As in requirement 2, the price would end up being at least $700,000. Since the taxing authorities will not allow prices above $700,000, the transfer price will be $700,000. At this transfer price, the Swiss subsidiary makes zero operating income and will not be interested in the machine. Hence, Anita Corporation will sell the machine to the Brazilian subsidiary at a price of $700,000. The answer is not the same as in requirement 3, because, acting autonomously, the objective of each manager is to maximize after-tax operating income of his or her own company rather than after-tax operating income of Anita Corporation and its subsidiaries as a whole. Goal congruence is not achieved in this setting. Can the company induce the managers to take the right actions without infringing on their autonomy? This outcome is probably not going to be easy.
22-33
22-32 (Cont’d.) One possibility might be to implement a dual-pricing scheme in which the machine is transferred at cost ($500,000), but under which Anita Corporation is credited with after-tax operating income earned on the machine by the subsidiary it ships the machine to (in this example, $170,000 of net income earned by the Swiss subsidiary). A negative feature of this arrangement is that the $170,000 of after-tax operating income will be "double counted" and recognized on the books of both Anita Corporation and the Swiss subsidiary. Another possibility might be to evaluate the managers on the basis of overall after-tax operating income of Anita Corporation and its subsidiaries. This approach will induce a more global perspective, but at the cost of inducing a larger noncontrollable element in each manager's performance measure. 22.33 (30 min.) Transfer pricing, goal congruence. 1a. & b. As the following calculations show, if Johnson Corporation offers a price of $37 per cassette deck, Sather Corporation should purchase the cassette decks from Johnson. If Johnson Corporation offers a price of $43 per cassette deck, Sather Corporation should manufacture the cassette decks in-house. Buy 10,000 Buy 10,000 cassette decks Transfer cassette decks from Johnson 10,000 cassette from Johnson at $43. Sell decks to at $37. Sell 12,000 cassette Assembly. Sell 12,000 cassette decks in 2,000 in decks in outside outside market outside market market. (1) (2) (3) Incremental cost of Cassette Deck Division supplying 10,000 cassette decks to Assembly $(250,000) $ 0 $ 0 $25 × 10,000; 0; 0 Incremental costs of buying 10,000 cassette decks from Johnson 0 (370,000) (430,000) $0; $37 × 10,000; $43 × 10,000 Revenue from selling cassette decks in outside market 70,000 420,000 420,000 $35 × 2,000; 12,000; 12,000 Incremental costs of manufacturing cassette decks for sale in outside market (50,000) (300,000) (300,000) $25 × 2,000; 12,000; 12,000 Revenue from supplying cassette-head mechanism to Johnson 0 180,000 180,000 $18 × 0; 10,000; 10,000 Incremental costs of supplying cassettehead mechanism to Johnson 0 (120,000) (120,000) $12 × 0; 10,000; 10,000
22-34
Net costs 22-33 (Cont’d.)
$(230,000)
$(190,000)
$(250,000)
At a price of $37 per cassette deck, the net cost of $190,000 is less than the net cost of $230,000 if Sather Corporation made the cassette decks inhouse. Hence, Sather Corporation should outsource to Johnson. At a price of $43 per cassette deck, the net cost of $250,000 is greater than the net cost of $230,000 if Sather Corporation made the cassette decks inhouse. Hence, Sather Corporation should reject Johnson’s offer. 2. For the Cassette Deck Division and the Assembly Division to take actions that are optimal for Sather Corporation as a whole, the transfer price should be set at $41, calculated as follows: The Cassette Deck Division can manufacture at most 12,000 cassette decks and is currently operating at capacity. The incremental costs of manufacturing a cassette deck are $25 per deck. The opportunity cost of manufacturing cassette decks for the Assembly Division is (1) the contribution margin of $10 (selling price, $35 minus incremental costs $25) that the Cassette Deck Division would forgo by not selling cassette decks in the outside market and (2) the contribution margin of $6 (selling price, $18 minus incremental costs, $12) that the Cassette Deck Division would forgo by not being able to sell the cassette-head mechanism to outside suppliers of cassette decks (such as Johnson). Thus, the total opportunity cost of the Cassette Deck Division of supplying cassette decks to Assembly is $10 + $6 = $16 per unit. Using the general guideline,
Incremental cost per Opportunity costs per Minimum transfer cassette deck up to the + cassette deck to the price per cassette deck = selling division point of transfer
= $25 + $16 = $41 Note that, at a price of $41, Sather is indifferent between manufacturing cassette decks inhouse or purchasing them from an outside supplier. Each results in a net cost of $230,000. For an outside price per cassette deck below $41, the Assembly Division would prefer to purchase from outside; above it, the Assembly Division would prefer to purchase from the Cassette Deck Division. When selling prices are uncertain, the transfer price should be set at the minimum acceptable transfer price. For example, if the transfer price were set above the minimum transfer price at $42 per cassette deck, say, and an outside supplier offered to supply the cassette decks at $41.50 per unit, the Assembly Division would purchase the cassette deck from the outside supplier. In fact, as the following calculations show, Sather Corporation, as a whole, would be better off had the Assembly Division purchased the cassette decks from the Cassette Deck Division. The net cost to Sather Corporation if the Cassette Deck Division transfers 10,000 cassette decks to the Assembly Division is $230,000 as calculated in Column 1 of the table
22-35
presented in requirement 1. If an outside supplier supplies cassette decks at $41.50 each, we simply substitute $41.50 × 10,000 = $415,000 for the incremental costs of buying 10,000 cassette
22-36
22-33 (Cont’d.) decks in column 2 or 3 and leave everything else unchanged. This gives a higher net cost of $235,000 to Sather Corporation as a whole. It is only if the price charged by the outside supplier falls below $41 that Sather Corporation as a whole is better off purchasing from the outside market. Setting the transfer price at $41 per unit achieves goal congruence.
22-34 (40?50 min.) Transfer pricing, utilization of capacity.
1. Selling price Direct materials Direct manufacturing labor Contribution margin per unit Contribution margin per hour ($30 ÷ 2; $4 ÷ 0.5) Super-chip $60 2 28 $30 $15 Okay-chip $12 1 7 $ 4 $ 8
Because the contribution margin per hour is higher for Super-chip than for Okay-chip, CIC should produce and sell as many Super-chips as it can and use the remaining available capacity to produce Okay-chip. The total demand for Super-chips is 15,000 units, which would take 30,000 hours (15,000 × 2 hours per unit). CIC should use its remaining capacity of 20,000 hours (50,000 – 30,000) to produce 40,000 Okay-chips (20,000 ÷ 0.5). 2. Options for manufacturing process-control unit Using Super-chip $132 2 28 60 $ 42
Using Circuit Board Selling price $132 Direct materials 60 Direct manufacturing labor (Super-chip) 0 Direct manufacturing labor (Process-control unit) 50 Contribution margin per unit $ 22 Overall Company Viewpoint Alternative 1: No Transfer of Super-chips
Sell 15,000 Super-chips at contribution margin per unit of $30 Transfer 0 Super-chips Sell 40,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 Control units at contribution margin per unit of $22 Total contribution margin
$450,000 0 160,000 110,000 $720,000
22-37
22-34 (Cont’d.) Alternative 2: Transfer 5,000 Super-chips to Process-Control Division. These Super-chips would require 10,000 hours to manufacture, leaving only 10,000 hours for the manufacture of 20,000 Okay-chips (10,000 ÷ 0.5) Sell 15,000 Super-chips at contribution margin per unit of $30 Transfer 5,000 Super-chips to Process-Control Division Sell 20,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 Control units at contribution margin per unit of $42 Total contribution margin $450,000 0 80,000 210,000 $740,000
CIC is better off transferring 5,000 Super-chips to the Process-Control Division. 3. For each Super-chip that is transferred, two hours of time (labor capacity) are given up in the Semiconductor Division, and, in those two hours, four Okay-chips could be produced, each contributing $4.
Minimum transfer price = per Super - chip
= =
Incremental cost Opportunity cost per unit for per unit to + the Semiconductor Division the point of transfer $30 + $16 $46 per unit
If the selling price for the process-control unit were firm at $132, the Process-Control Division would accept any transfer price up to $50 ($60 price of circuit board ? $10 incremental labor cost if Super-chip used). However, consider what happens if the transfer price of Super-chip is set at, say, $49, and the price of the control unit drops to $108. From CIC’s viewpoint: Selling price Direct materials Direct manufacturing labor Contribution margin per hour Using Circuit Board $108 60 50 $ –2 Using Super-chip $108 49 60 $ –1
Process-Control Division will not produce any control units. From the company’s viewpoint, the contribution margin on the control unit if the Super-chip is used is: Selling price Direct materials Direct manufacturing labor (Super-chip) Direct manufacturing labor (process-control unit) Contribution margin per unit $108 2 28 60 $ 18
22-38
22-34 (Cont’d.) The contribution margin per unit from producing Super-chips for the process-control unit exceeds the contribution margin of $16 from producing 4 Okay-chips, each yielding a contribution margin of $4 per unit. Hence the Semiconductor Division should transfer 5,000 Super-chips as the following calculations show: Alternative 1—No transfer (and, therefore, no sales of process-control units) Sell 15,000 Super-chips at contribution margin per unit of $30 Sell 40,000 Okay-chips at contribution margin per unit of $4 Alternative 2—Transfer 5,000 Super-chips. $450,000 80,000 90,000 $620,000 Therefore, if the price for the control unit is uncertain, the transfer price must be set at the minimum acceptable transfer price of $46. 4. For a transfer of any amount between 0 and 10,000 Super-chips (which require 2 hours each to produce), the opportunity cost is the production of Okay-chips (which require ½ hour each). In this range, the relevant costs are equal to the transfer price of $46 established in part 3. If more than 10,000 Super-chips are transferred, the opportunity cost becomes the sale of Super-chips on the outside market. Now the minimum transfer price per Super-chip becomes Sell 15,000 Super-chips at contribution margin per unit of $30 Sell 20,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 control units at contribution margin per unit of $18 $450,000 160,000 $610,000
Incremental Opportunity cost per Super - cost per Super chip up to the + chip to the = $30 + ($60 – $30) = $60, the market price. point of Semiconductor transfer Division
At this transfer price, it is cheaper for the Process-Control Division to buy the circuit board for $60, since $10 of additional direct manufacturing labor cost is saved. The Semiconductor Division should at most transfer 10,000 Super-chips. Internal Demand 0–10,000 10,000–25,000 Transfer Price $46 60
22-39
22-35 (20 min.) Ethics, transfer pricing.
1. Contribution margin for 10,000 units of R47 if variable costs are $14 and $16 per unit, respectively, are as follows: Variable Variable Costs of Costs of $14 per Unit $16 per Unit Transfer price at 200% of variable costs Variable costs per unit Contribution margin per unit Contribution margin for 10,000 units $14 × 10,000; $16 × 10,000 $ $ 28 14 14 $ $ 32 16 16
$140,000
$160,000
2. In assessing the situation, the specific “Standards of Ethical Conduct for Management Accountants,” described in Chapter 1 that the management accountant should consider are listed below. Competence Clear reports using relevant and reliable information should be prepared. Reports prepared on the basis of incorrectly identifying variable costs would violate the management accountant’s responsibility to competence. It is unethical for Lasker to suggest that Tanner should change the variable cost numbers that were prepared for costing product R47 and, hence, the transfer price for R47. The methodology to calculate variable costs has been in place for some time at Durham Industries. The company could certainly re-evaluate this methodology but Tanner cannot do so on his own. Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Increasing the variable costs allocated to R47 will increase the transfer price and, hence, revenues of the Belmont Division. If they changed the method of determining variable costs, Lasker and Tanner would appear to favor the Belmont Division (that manufactures R47) over the Alston Division (that uses R47). This action could be viewed as violating the responsibility for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. In this regard, both Lasker’s and Tanner’s behavior (if Tanner agrees to increase variable costs) could be viewed as unethical. Objectivity The "Standards of Ethical Conduct for Management Accountants" require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, increasing the variable costs of a product to earn higher revenue for a division, in violation of company policy, clearly violates both these precepts. For the various reasons cited above, the behavior of Lasker and Tanner (if he goes along with Lasker’s wishes) is unethical.
22-40
22-35 (Cont’d.) Tanner should indicate to Lasker that the variable costs of R47 are indeed appropriate, given that the methods for computing variable costs and fixed costs have been in place for some time. If Lasker still insists on making the changes and increasing the variable costs of making R47, Tanner should raise the matter with Lasker’s superior. If, after taking all these steps, there is continued pressure to increase the variable cost component, Tanner should consider resigning from the company and not engage in unethical behavior. Some students may raise the issue of whether variable cost transfer pricing is appropriate in this context. The problem does not provide enough details for a complete discussion of this issue. Management may well conclude that the transfer price should not be set as a multiple of variable costs. But that is a management decision. The management accountant should not unilaterally use methods of calculating variable costs that are in direct violation of accepted past practice.
22-36 (40–50 min.) Goal congruence, income taxes, different market conditions.
1. Selling price Savings in purchase costs by making engines inhouse Manufacturing costs: Direct materials Direct manufacturing labor Variable manufacturing overhead Total costs of manufacturing Contribution margin from New Engine Net savings in costs by making existing engine inhouse New Engine $375 Existing Engine Used by Assembly $400 $100 40 25 165 $210 $125 50 25 200 $200
If order for the new engine is accepted, San Ramon earns a contribution margin of $210 × 2,000 units. In this case, Engine Division will be in a position to supply only 2,000 units to Assembly, and Assembly will have to purchase 1,200 engines from outside. The incremental cost of buying engines from outside is $200 × 1,200 Net benefit from accepting order
$420,000
240,000 $180,000
An alternative approach is to compare relevant costs of the accept order and reject order alternatives.
22-41
22-36 (Cont’d.) Accept Order 1. Contribution margin from selling 2,000 units of new engine, $210 × 2,000 2. Incremental cost of making and transferring 2,000 units or 3,200 units of old engines, $200 × 2,000; $200 × 3,200 3. Incremental costs of purchasing 1,200 units from outside, $400 × 1,200 $(420,000) 400,000 480,000 $460,000 $640,000 $640,000 Reject Order
San Ramon Corporation should a. make 2,000 units of the new engine in the Engine Division b. make 2,000 units of the existing engine for the Assembly Division c. have the Assembly Division purchase 1,200 existing engines from the outside market 2. The options facing the Engine Division manager are (a) to sell 2,000 units of the special order engine and make 2,000 units for the Assembly Division, or (b) to make 3,200 units for the Assembly Division. The contribution margin per unit from accepting the special order is $210 per unit. Let the transfer price be $X. Then, we want to find X such that $210 × 2,000 + ($X – $200) 2,000 ($X – $200)(3,200 – 2,000) $X – $200 = ($X – $200) 3,200 = $420,000 =
$420,000 = $350 1,200
X = $550 For transfer prices below $550, the Engine Division gets more by selling 2,000 units outside and transferring 2,000 units to Assembly Division. It will not transfer more than 2,000 units to Assembly even though the transfer price is greater than the variable costs of manufacturing the existing engine, $200 plus the contribution margin per unit from accepting the special order of $210 equal to $410 ($500, say). Why? Because by transferring an additional 1,200 units (say), it will have to give up $420,000 ($210 × 2,000) of contribution margin by not accepting the special order. The Engine Division manager would be willing to transfer 2,000 units for which it has capacity (after fulfilling the outside order) to the Assembly Division provided the transfer price covers the Engine Division's variable costs. So, the range of transfer price that will induce the Engine Division manager to implement the optimal solution in requirement 1 is: TP ? $200 for the first 2,000 units TP ? $550 for the next 1,200 units The Assembly Division manager would be willing to buy from the Engine Division so long as the transfer price is less than or equal to the price at which the Assembly Division can buy the engines on the outside market. TP ? $400
22-42
22-36 (Cont’d.) It will not buy the engines from the Engine Division if TP > $400. The range of TP that will result in both managers favoring the optimal actions in requirement 1 are TPs that satisfy the respective constraints described above. $200 ? TP ? $400 for the first 2,000 units TP = $550 for the next 1,200 units This transfer-pricing scheme will induce both managers to transfer 2,000 units between the Engine and Assembly Divisions, but no more. Because the Assembly Division manager is willing to pay no more than $400 and the Engine Division manager is unwilling to transfer unless the transfer price is above $550, no transfers will occur beyond the first 2,000 units. 3a. The full manufacturing costs of the engines transferred to the Assembly Division are: Direct materials Direct manufacturing labor Variable manufacturing overheads Fixed manufacturing overheads
? $520,000 ? = $260,000 ÷ 2,000 engines ? ? 2 ? ?
$125 50 25
since the engines transferred to the Assembly Division use up half the Engine Division's capacity Total manufacturing cost b.
130 $330
A transfer price of $330 is in the optimal range identified in requirement 2 and, so, will achieve the optimal actions of selling 2,000 engines to the outside party and transferring 2,000 engines to the Assembly Division as identified in requirement 1. The transfer price for the next 1,200 units should be set at $550 so that the Assembly Division will prefer to purchase engines at $400 from the outside market. The transfer price for the next 1,200 units should not be set at the full manufacturing cost of $330 because the Assembly Division will then want to buy the engines internally. This is not in the best interest of San Ramon Corporation as a whole. One advantage of full cost transfer pricing is that it is useful for the firm's long-run pricing decisions. One disadvantage of full cost transfer pricing is that costs that are fixed for the corporation as a whole look like variable costs from the viewpoint of the Assembly Division manager. This is because, by choosing not to have a unit transferred from the Engine Division, the Assembly Division manager would appear to save both the variable and fixed costs of the engine. This could lead to suboptimal decisions.
c.
22-43
22-36 (Cont'd.) 4a. To minimize taxes, San Ramon should transfer the engines at the highest price it can, the market price of $400. The Engine Division would pay no taxes on any income that it would report. By setting the transfer price as high as possible, the Assembly Division would minimize the income it would report and, hence, the taxes it would pay. Yes, as in part 3b, the transfer price of $400 for the first 2000 engines is also within the range identified in requirement 2 and so will achieve the outcome desired in requirement 1 (sell 2,000 engines under the outside offer and transfer 2,000 engines to the Assembly Division).
b.
5. San Ramon should use a transfer price of $400 for the first 2,000 units and $550 for the next 1,200 units when transferring engines from the Engine Division to the Assembly Division. This transfer price minimizes tax payments for the San Ramon Corporation as a whole and also achieves goal congruence. That is, at the transfer prices indicated, both Divisions will be content with the following arrangement a. The Engine Division will make 2,000 engines for outside customers and 2,000 engines for the Assembly Division b. The Assembly Division will take 2,000 engines from the Engine Division and 1,200 engines from the outside market Of course, the Assembly Division manager would like to negotiate a price lower than $400 (but greater than $200) for the first 2,000 engines from the Engine Division, but this would increase San Ramon's tax payments. At a transfer price of $400, San Ramon can still evaluate each division's performance on the basis of division operating income because the transfer price of $400 approximates the market prices for the engines transferred from the Engine Division to the Assembly Division. Market-based transfer prices give top management a reasonably good picture of the contributions of the individual divisions to overall companywide profitability.
Chapter 22 Internet Exercise
The Internet exercise is available to students only on the Prentice Hall Companion Website www.prenhall.com/horngren. Students can click on Cost Accounting, 11 th ed., and access the Internet Exercise for the chapter, which links to the Web site of a company or organization. The Internet Exercise on the Web will be updated periodically so that it is current with the latest information available on the subject organization's Web site. A printout copy of the Internet exercise for this chapter as of early 2002 appears below. The solution to the Internet exercise, which will also be updated periodically, is available to instructors from the Companion Website's faculty view. To access the solution, click on Cost Accounting, 11th ed., Faculty link, and then register once to obtain your password through the online form. After the initial registration, you will have a personal login ID and password to use to log in. A printout of the solution to the Internet exercise for this chapter as of early 2002 follows. The exercise and solution provide instructors with an idea of the content of the Internet exercise for this chapter.
22-44
Internet Exercise (Cont’d.) Transfer pricing may be one of the most important tax issues facing multinational corporations today. PriceWaterhouseCoopers (PWC) is one of the world’s largest consulting firms, with more than 150,000 employees in 150 countries. Its Global Tax Services practice provides transfer-pricing consulting services throughout the world. Go to PWC’s main sitemap at http://www.pwcglobal.com/gx/eng/main/sitemap/index.html, and click on the “Global Tax Services” link, followed by the “Transfer Pricing” link. 1. 2. What is transfer pricing, and why is it increasingly important? Use the Quick Search box, and search for the article, “Transfer pricing––a key asset in the "Noughties.” Read the article then answer the following questions a. Why has e-business had an impact on transfer pricing? b. What impact has e-business had on the supply chain? c. Explain how intangible assets such as Web sites, information, concepts, and customer channel lists provide tax-planning opportunities. d. The “arm’s length” transaction is the guiding principle applied by most tax authorities when evaluating intercompany transfer prices. What is the “arm’s length” principle, and why is it difficult to apply to e-business? 3a. The article provides an example of tax-planning opportunities associated with developing an Internet Web site to sell computers. What tax rate would be applied to profits earned by Computer Company if the Web site is located in Ireland? What if the Web site is located in the United States? 3b. Although tax considerations are an important factor when structuring transactions, tax authorities will disallow transactions if they lack economic or commercial substance. Use the Computer Company example to explain what this means. 4. Use the Quick Search box and search for “My Name is Peter Algar.” This link provides a brief description of a typical day of a third-year consultant in PWC’s transfer-pricing practice. What two factors accounted for the strong profits in New Zealand? Solution to Internet Exercise 1. Transfer pricing refers to all aspects of pricing arrangements between related business entities. It applies to intercompany transfers of both products and services. Transfer pricing is becoming increasingly important because of the rapid growth in cross-border intercompany transactions, and because of their increasing complexity. In addition, tax authorities are requiring greater documentation, and are imposing stricter penalties for noncompliance. 2a. E-business is offering companies of all sizes access to new channels for the delivery of products and services. Increasingly these channels are cutting across national boundaries, and more medium-sized businesses are entering international markets that were previously out of reach. This development is driving up the number of international-related party transactions and raising a host of transfer pricing issues. Issues center around how and where profit should be taxed.
22-45
Internet Exercise (Cont’d.) 2b. Geographic proximity is playing a diminished role in the structure of supply chains. For example, a primary distribution site can now serve more geographic markets, and this has enormous transfer pricing and international tax implications. 2c. These intangible assets are relatively portable, and there may be opportunities to move these assets to more tax efficient jurisdictions. 2d. In applying the ‘arm’s-length’ transaction principle, tax authorities asked if the remuneration received in a transaction is what would have been received had entities been operating independently. Several factors make the arm’s length transaction principle more difficult to apply to e-business transactions. First, it’s often difficult to identify the intangible assets in an exchange. Second, tax authorities must decide when intangible assets become valuable, and how profits should be split between entities. 3a. If the Web site is located in Ireland, Computer Co. will face a 10% tax rate. If the Web site is located in the United States it will face a 40% tax rate. 3b. To stand up to tax authorities, transactions must have a commercial substance. For example, if U.S. employees developed the Computer Co. Web site with a U.S. company incurring the cost–– which was subsequently transferred to a shell company in Ireland –– then there is a risk that tax authorities will ignore the form of the arrangement, and effectively allocate the asset and its associated profits to the U.S. company for tax purposes. 4. The two factors are the significant expenditures the New Zealand business made on marketing and the huge growth in the industry in which it operates.
Chapter 22 Case
INFORMATION SYSTEMS CORPORATION: TRANFER PRICES AND GOAL CONGRUECE 1. You may wish to begin the class discussion by asking the first assignment question, “Why do you suppose this plant’s costs are higher than competitors’ market prices?” The most obvious reason is the current idle capacity. Because most costs are fixed, the full cost per unit increases as capacity utilization declines. While this explanation explains a large portion of the current problem, it does not explain why the plant’s costs were higher than competitors’ prices when the plant was operating at capacity (a few years ago). There are three explanations for the latter problem. First, the competitors in the industry employ “forward pricing.” This term, also known as “experience curve pricing” or “volume pricing,” refers to a practice of estimating the average cost to be incurred over several years and pricing the product to earn a profit relative to the projected average cost. In the early periods of production of a new product, this approach means pricing the product below the actual manufacturing cost. The second explanation is more subtle. Note that for several years, the semiconductor division was the company’s only source of RAMs. There was no competition. Without competition there was no strong pressure to be cost effective and unnecessary costs had crept into the process. Third, students may argue that the non-U.S. suppliers of RAMs were dumping their products––selling RAMs in the U.S. at a price below the market value in the country of its creation. U.S. semiconductor manufacturers have charged nonU.S. competition with dumping. 22-46
Case (Cont’d.) 2. There are a number of possible alternatives for establishing an appropriate transfer price for interdivisional transfers. (a) Some of these are based upon cost and would continue to have many of the problems already identified by management. (b) However, since there is an existing outside market for much of the site’s output, a market-based price may be appropriate for the plant’s standard output. (c) The remaining unique proprietary production could be transferred at some “negotiated” market price to maintain a consistent set of measurements throughout the site. Furthermore, use of a market-based price is more in keeping with the concept of profit center responsibility as practiced in most decentralized companies. An income statement can easily be created that would allow management to measure its results against the competition rather than relying solely on measurements that compare actual results to plans or to prior periods. 3. Students are likely to make arguments in support of each of the three alternatives identified in requirement 2. Student comments should make the following points. (a) Some discussion of the general guideline described in Chapter 22. The case facts appear to describe a competitive market for RAMs and idle capacity at the plant. The minimum transfer price in this case is the outlay (variable) costs at the plant. In the short run, Information Systems Corporation (ISC) as a whole benefits if the variable costs at the plant are less than the market price and the purchasing divisions purchase RAMs from the plant rather than from outside suppliers. This outcome will be achieved if the transfer price is set between the plant’s variable costs and the market price. (b) Using current full costs (which are greater than the market price) as the transfer price appears to be a poor choice. This approach will lead purchasing divisions to buy RAMs from outside suppliers. Purchasing from outside would be suboptimal from the viewpoint of ISC as a whole if the variable outlay costs of making RAMs inhouse are less than the market prices. Furthermore, ISC will be unable to evaluate the profitability of the semiconductor division. Is the division worth keeping or should it be shut down and all RAMs purchased from outside? (c) Some discussion of using market prices as transfer prices. The advantage of transferring at market prices is that buying divisions will be willing to buy from the semiconductor division. Management can then evaluate the division’s competitiveness over a period of time. If the division cannot recover all its costs, ISC may be better off shutting down the division and buying all RAMs from outside suppliers. The industry practice for pricing semiconductors is forward pricing based on average costs over a period of years. With such a pricing scheme, there might be a period of loss in the initial years that will be recouped with profits in the future. The average price should permit a gradual recovery of initial start-up costs. Thus, the “buyer” immediately benefits from the projected improvements and also has a sense of commitment from the site that the published price will prevail over a period of time. 22-47
Case (Cont’d.) Using market prices will also result in variable profit markups, depending on the uniqueness of the product. Market prices will yield greater margins on unique items and lower margins on the higher volume, standard products. Naturally, this approach will provide a more attractive base business to support future activities. Using market prices as transfer prices is problematic if the market prices represent temporary “distress prices.” Students who believe that low prices arose as a result of “dumping” activities by foreign companies may argue that these low prices are unlikely to continue. This is a reasonable argument though most of the evidence suggests that low RAM prices are more the result of learning curve effects, long-term excess capacity, technological advances, and forward pricing rather than dumping. Consequently, low market prices for RAMs are likely to prevail over a long period of time. On balance, it appears that market prices are the best choice of transfer price for RAMs at ISC. What the Firm Actually Did The site controller recommended that the site adopt a market-based interdivisional transfer price for its production. This transfer price would enable the “buying” product managers to view the site like the semiconductor industry. In keeping with this strategy, the site would commit to its prices, monitor their competitiveness, have variable markups by product, and offer flexible terms and conditions. These terms and conditions included minimum order quantities to assist in stabilizing production and bring about further cost improvements. Three types of price categories were established: 1. Prices for functionally substitutable products are based upon competitive product prices, as long as a profit can be achieved over the lifetime of the product. This forward pricing technique enabled the site to take advantage of technology learning curve effects and optimize capacity. 2. Unique products have a price developed on a cost-plus approach, but, once again, they are forward priced over the life of the product. 3. Finally, products which are hybrids between being functionally substitutable and unique, are priced with both techniques and are subject to negotiation. To accommodate these changes, the accounting system was modified to model the consumption of the site’s production throughout the corporation by major product. The percentage of interdivisional profit for each product was developed by the site accounting organization and eventually eliminated by the corporate accounting consolidation staff, based upon shipment information provided by the site each month. As “buyers,” product managers saw only the established transfer price in their costs and income statements. The resulting model was highly complex and required considerable programming and systems effort to make it usable. Nevertheless, the model was installed, reviewed with the appropriate state tax authorities and external auditors, and implemented within a year after the decision to adopt the market-based transfer price. The site management has adopted the new measurements and has moved aggressively to compete for its “lost” marketplace.
22-48
doc_735713076.doc
A management control system (MCS) is a system which gathers and uses information to evaluate the performance of different organizational resources like human, physical, financial and also the organization as a whole considering the organizational strategies. Finally, MCS influences the behavior of organizational resources to implement organizational strategies.
Management Control Systems, Transfer Pricing, And Multinational Considerations 22-1
A management control system is a means of gathering and using information to aid and coordinate the planning and control decisions throughout the organization and to guide the behavior of its managers and employees. The goal of the system is to improve the collective decisions within an organization.
22-2
To be effective, management control systems should be (a) closely aligned to an organization's strategies and goals, (b) designed to fit the organization's structure and the decision-making responsibility of individual managers, and (c) able to motivate managers and employees to put in effort to attain selected goals desired by top management.
22-3
Motivation combines goal congruence and effort. Motivation is the desire to attain a selected goal specified by top management (the goal-congruence aspect) combined with the resulting pursuit of that goal (the effort aspect).
22-4
1. 2. 3. 4. 5. 1. 2. 3. 4.
The chapter cites five benefits of decentralization: Creates greater responsiveness to local needs Leads to gains from faster decision making Increases motivation of subunit managers Aids management development and learning Sharpens the focus of subunit managers The chapter cites four costs of decentralization: Leads to suboptimal decision making Results in duplication of activities Focuses managers’ attention on the subunit rather than the company as a whole Increases costs of gathering information
22-5
No. Organizations typically compare the benefits and costs of decentralization on a function-by-function basis. For example, companies with highly decentralized operating divisions frequently have centralized income tax strategies.
22-6
No. A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. The two segments can be cost centers, profit centers, or investment centers. For example, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an example of transfer pricing.
22-7
1. 2. 3.
The three general methods for determining transfer prices are: Market-based transfer prices Cost-based transfer prices Negotiated transfer prices
22-1
22-8
1. 2. 3. 4.
Transfer prices should have the following properties. They should promote goal congruence, be useful for evaluating subunit performance, motivate management effort, and preserve a high level of subunit autonomy in decision making. No, the chapter illustration demonstrates how division operating incomes differ dramatically under the variable costs, full costs, and market price methods. Transferring products or services at market prices generally leads to optimal decisions when (a) the market for the intermediate product market is perfectly competitive, (b) interdependencies of subunits are minimal, and (c) 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.
22.9 22.10
22-11
One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal decisions for the company as a whole. An example of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer-pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally. This situation often arises where full-cost-based transfer prices are used. This situation can make the fixed costs of the supplying division appear to be variable costs of the purchasing division. Another limitation is that the supplying division may not have sufficient incentives to control costs if the full-cost-based transfer price uses actual costs rather than standard costs. The purchasing division sources externally if market prices are lower than full costs. From the viewpoint of the company as a whole, the purchasing division should source from outside only if market prices are less than variable costs of production, not full costs of production.
22-12
Reasons why a dual-pricing approach to transfer pricing is not widely used in practice
include: 1. The manager of the supplying division uses a cost-based method to record revenues and does not have sufficient incentives to control costs. 2. This approach does not provide clear signals to division managers about the level of decentralization top management wants. 3. This approach tends to insulate managers from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division. 4. It leads to problems in computing the taxable income of subunits located in different tax jurisdictions.
22-13 Disagree. Cost and price information are often useful starting points in the negotiation
process. Costs, particularly variable costs of the "selling" division, serve as a "floor" below which the selling division would be unwilling to sell. Prices that the "buying" division would pay to purchase products from the outside market serves as a "ceiling" above which the buying division would be unwilling to buy. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices. But the negotiated price will generally fall between the variable costs-based floor and the market price-based ceiling.
22-2
22-14 Yes. The general transfer-pricing guideline specifies that the minimum transfer price
equals the additional outlay costs per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division. When the supplying division has idle capacity, its opportunity costs are zero; when the supplying division has no idle capacity, its opportunity costs are positive. Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not.
22-15 Alternative transfer-pricing methods can result in sizable differences in the reported
operating income of divisions in different income tax jurisdictions. If these jurisdictions have different tax rates or deductions, the net income of the company as a whole can be affected by the choice of the transfer-pricing method.
22-16 (25 min.) Decentralization, responsibility centers.
1. The manufacturing plants in the Manufacturing Division are cost centers. Senior management determines the manufacturing schedule based on the quantity of each type of lighting product specified by the sales and marketing division and detailed studies of the time and cost to manufacture each type of product. Manufacturing managers are accountable only for costs. They are evaluated based on achieving target output within budgeted costs. 2a. If manufacturing and marketing managers were to directly negotiate the prices for manufacturing various products, Quinn should evaluate manufacturing plant managers as profit centers—revenues received from marketing minus the costs incurred to produce and sell output. 2b. Quinn Corporation would be better off decentralizing its marketing and manufacturing decisions and evaluating each division as a profit center. Decentralization would encourage plant managers to increase total output to achieve the greatest profitability, and motivate plant managers to cut their costs to increase margins. Manufacturing managers would be motivated to design their operations according to the criteria that meet the marketing managers’ approval, thereby improving cooperation between manufacturing and marketing. Under Quinn's existing system, manufacturing managers had every incentive not to improve. Manufacturing managers' incentives were to get as high a cost target as possible so that they could produce output within budgeted costs. Any significant improvements could result in the target costs being lowered for the next year, increasing the possibility of not achieving budgeted costs. By the same line of reasoning, manufacturing managers would also try to limit their production so that production quotas would not be increased in the future. Decentralizing manufacturing and marketing decisions overcomes these problems.
22-3
22-17 (15 min.) Decentralization, goal congruence, responsibility centers.
1. The environmental management organization appears to be decentralized because managers of the environmental management group have considerable freedom to make decisions. 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. 2. 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. 3. The benefits of structuring the environmental management group in this way are: a. The operating managers have incentives to carefully weigh and conduct cost-benefit analyses before requesting the environmental group's services. b. The operating managers have an incentive to follow the work and the progress made by the environmental team. c. 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 in order to continue to get business.
The problems in structuring the environmental group in this way are: a. The contract requires extensive internal negotiations in terms of cost, time, and technical specifications. b. The environmental group needs to continuously "sell" its services to the operating division, and this could potentially result in loss of morale. c. 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. To the extent that the focus of the environmental group is on short-run projects demanded by the operating divisions, the current structure leads to goal congruence and motivation. Goal congruence is achieved because both operating divisions and the environmental group are motivated to work toward the organizational goals of reducing pollution and improving the environment. The operating divisions will be motivated to utilize the services of the environmental group to achieve the environmental goals set for them by top management. The environmental group will be motivated to deliver high-quality services in a cost-effective way in order to continue to create a demand for their services. The one issue that top management needs to guard against is that experimental projects with long-term potential that are costly and uncertain may not be undertaken under the current structure. Top management may want to set up a committee to study and propose such long-run projects for consideration and funding by corporate management.
22-4
22-18 (35 min.) Multinational transfer pricing, effect of alternative transferpricing methods, global income tax minimization.
1. This is a three-country, three-division transfer-pricing problem with three alternative transfer-pricing methods. Summary data in U.S. dollars are: China Plant Variable costs: Fixed costs: South Korea Plant Variable costs: Fixed costs: U.S. Plant Variable costs: Fixed costs: = $100 per unit = $200 per unit 360,000 Won ÷ 1,200 Won per $ = $300 per unit 480,000 Won ÷ 1,200 Won per $ = $400 per unit 1,000 Yuan ÷ 8 Yuan per $ = $125 per subunit 1,800 Yuan ÷ 8 Yuan per $ = $225 per subunit
Market prices for private-label sale alternatives: China Plant: 3,600 Yuan ÷ 8 Yuan per $ = $450 per subunit South Korea Plant: 1,560,000 Won ÷ 1,200 Won per $ = $1,300 per unit The transfer prices under each method are: a. Market price • China to South Korea = $450 per subunit • South Korea to U.S. Plant = $1,300 per unit 200% of full costs • China to South Korea 2.0 × ($125 + $225) = $700 per subunit • South Korea to U.S. Plant 2.0 × ($700 + $300 + $400) = $2,800 per unit 300% of variable costs • China to South Korea 3.0 × $125 = $375 per subunit • South Korea to U.S. Plant 3.0 × ($375 + $300) = $2,025 per unit
b.
c.
22-5
22-18 (Cont’d.) Method A Internal Transfers at Market Price 1. China Division Division revenue per unit Deduct: Division variable cost per unit Division fixed cost per unit Division operating income per unit Income tax at 40% Division net income per unit 2. South Korea Division Division revenue per unit Deduct: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Division operating income per unit Income tax at 20% Division net income per unit 3. United States Division Division revenue per unit Deduct: Transferred-in cost per unit Division variable cost per unit Division fixed cost per unit Division operating income per unit Income tax at 30% Division net income per unit 2. Division net income: Market Price China Division South Korea Division U.S. Division User Friendly Computer Inc. $ 60 120 1,120 $1,300 200% of Full Costs $ 210 1,120 70 $1,400 300% of Variable Cost $ 15.00 760.00 612.50 $1,387.50 $ 450 125 225 100 40 $ 60 $1,300 450 300 400 150 30 $ 120 $3,200 1,300 100 200 1,600 480 $1,120 Method B Internal Transfers at 200% of Full Costs $ 700 125 225 350 140 $ 210 $2,800 700 300 400 1,400 280 $1,120 $3,200 2,800 100 200 100 30 $ 70 Method C Internal Transfers at 300% of Variable Costs $ 375 125 225 25 10 $ 15 $2,025 375 300 400 950 190 $ 760 $3,200 2,025 100 200 875 262.5 $ 612.5
22-6
22-18 (Cont’d.) User Friendly will maximize its net income by using the 200% of full costs, transfer-pricing method. This is because the 200% of full cost method sources most income in the countries with the lower income tax rates.
22-18 Excel Application
User Friendly Computer, Inc.
Original Data U.S. $ per yuan U.S. $ per won China Division Price per memory/keyboard package Variable costs Fixed costs Income tax rate South Korea Division Price per computer Variable costs Fixed costs Income tax rate U.S. Division Price per computer Variable costs Fixed costs Income tax rate $3,200 $100 $200 30% 0.125 0.00083 3,600 1,000 1,800 40% 1,560,000 360,000 480,000 20% yuan yuan yuan
won won won
22-7
22-18 (Cont’d.)
Problem 1 Method A: Internal Transfers at Market Price China Division Division revenues per unit Deduct: Division variable costs per unit Division fixed costs per unit Division operating income per unit Income tax Division net income per unit South Korea Division Division revenues per unit Deduct: Transferred in costs per unit Division variable costs per unit Division fixed costs per unit Division operating income per unit Income tax Division net income per unit United States Division Division revenues per unit Deduct: Transferred in costs per unit Division variable costs per unit Division fixed costs per unit Division operating income per unit Income tax Division net income per unit Problem 2 Division Net Income China Divison South Korea Division U.S. Division User Friendly Computer, Inc. Market Price $60 $120 $1,120 $1,300 200% of Full Costs $210 $1,120 $70 $1,400 300% of Variable Costs $15 $760 $612.50 $1,387.50 $450 125 225 100 40 $ 60 $1,300 450 300 400 150 30 $ 120 Method B: Internal Transfers at 200% of Full Costs $700 125 225 350 140 $210 $2,800 700 300 400 1,400 280 $1,120 Method C: Internal Transfers at 300% of Variable Costs $375 125 225 25 10 $ 15 $2,025 375 300 400 950 190 $ 760
$3,200 1,300 100 200 1,600 480 $1,120
$3,200 2,800 100 200 100 30 $ 70
$3,200 2,025 100 200 875 262.50 $612.50
22-8
22-19 (30 min.) Transfer-pricing methods, goal congruence.
1. Alternative 1: Sell as raw lumber for $200 per 100 board feet: Revenue Variable costs Contribution margin $200 100 $100 per 100 board feet
Alternative 2: Sell as finished lumber for $275 per 100 board feet: Revenue Variable costs: Raw lumber Finished lumber Contribution margin $275 $100 125 225 $ 50 per 100 board feet
British Columbia Lumber will maximize its total contribution margin by selling lumber in its raw form. An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, $275 – $200 Incremental costs Incremental loss 2. Transfer price at 110% of variable costs: = $100 + ($100 × 0.10) = $110 per 100 board feet Sell as Raw Lumber Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income $200 100 $100 $ 0 — $ 0 Sell as Finished Lumber $110 100 $ 10 $275 110 125 $ 40 $ 75 125 $ (50) per 100 board feet
The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by selling finished lumber, which is contrary to the action preferred by the company as a whole.
22-9
22-19 (Cont’d.) 3. Transfer price at market price = $200 per 100 board feet. Sell as Raw Lumber Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income $200 100 $100 $ 0 — — $ 0 Sell as Finished Lumber $200 100 $100 $275 200 125 $ (50)
The Raw Lumber Division will maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole. Finished Lumber Division will maximize division operating income by not further processing raw lumber; not further processing is preferred by the company as a whole.
22-10
22-20 (30 min.) Effect of alternative transfer-pricing methods on division
operating income. Internal Transfers at Market Prices Method A 1. Mining Division Revenues: $90, $661 × 400,000 units Deduct: Division variable costs: $522 × 400,000 units Division fixed costs: $83 × 400,000 units Division operating income Metals Division Revenues: $150 × 400,000 units Deduct: Transferred-in costs: $90, $66 × 400,000 units Division variable costs: $364 × 400,000 units Division fixed costs: $155 × 400,000 units Division operating income
1 2
Internal Transfers at 110% of Full Costs Method B
$36,000,000 20,800,000 3,200,000 $12,000,000 $60,000,000
$26,400,000 20,800,000 3,200,000 $ 2,400,000 $60,000,000
36,000,000 14,400,000 6,000,000 $ 3,600,000
26,400,000 14,400,000 6,000,000 $13,200,000
$66 = $60 × 110% Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor + 75% of Manufacturing overhead = $12 + $16 + 75% × $32 = $52 3 Fixed cost per unit = 25% of Manufacturing overhead = 25% × $32 = $8 4 Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40% of Manufacturing overhead = $6 + $20 + 40% × $25 = $36 5 Fixed cost per unit in Metals Division = 60% of Manufacturing overhead = 60% × $25 = $15
22-11
22-20 (Cont'd.) 2. Bonus paid to division managers at 1% of division operating income will be as follows: Method A Internal Transfers at Market Prices Mining Division manager's bonus (1% × $12,000,000; 1% × $2,400,000) Metals Division manager's bonus (1% × $3,600,000; 1% × $13,200,000) $120,000 36,000 Method B Internal Transfers at 110% of Full Costs $ 24,000 132,000
The Mining Division manager will prefer Method A (transfer at market prices) because this method gives $120,000 of bonus rather than $24,000 under Method B (transfers at 110% of full costs). The Metals Division manager will prefer Method B because this method gives $132,000 of bonus rather than $36,000 under Method A. 3. Brian Jones, the manager of the Mining Division, will appeal to the existence of a competitive market to price transfers at market prices. Using market prices for transfers in these conditions leads to goal congruence. Division managers acting in their own best interests make decisions that are also in the best interests of the company as a whole. Jones will further argue that setting transfer prices based on cost will cause Jones to pay no attention to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full costs.
22-21 (30 min.) Transfer pricing, general guideline, goal congruence.
1. Using the general guideline presented in the chapter, the minimum price at which the Airbag Division would sell airbags to the Igo Division is $110, the incremental costs. The Airbag Division has idle capacity (it is currently working at 80% of capacity). Hence, its opportunity cost is zero—the Airbag Division does not forgo any external sales and, hence, does not forgo any contribution margin from internal transfers. Transferring airbags at incremental cost achieves goal congruence. 2. Transferring products internally at incremental cost has the following properties. a. b. Achieves goal congruence—Yes, as described in requirement 1 above. Useful for evaluating subunit performance—No, because transfer price does not exceed full costs. By transferring at incremental costs and not covering fixed costs, the Airbag Division will show a loss. This loss, the result of the incremental costbased transfer price, is not a good measure of the economic performance of the subunit.
22-12
22-21 (Cont'd.) c. Motivating management effort—Yes, if based on budgeted costs (actual costs can then be compared to budgeted costs). If, however, transfers are based on actual costs, Airbag Division management has little incentive to control costs. Preserves subunit autonomy—No. Because it is rule-based, the Airbag Division has no say in and, hence, no ability to set the transfer price.
d.
3. If the two divisions were to negotiate a transfer price, the range of possible transfer prices will be between $110 and $140 per unit. The Airbag Division has excess capacity that it can use to supply airbags to the Igo Division. The Airbag Division will be willing to supply the airbags only if the transfer price equals or exceeds $110, its incremental costs of manufacturing the airbags. The Igo Division will be willing to buy airbags from the Airbag Division only if the price does not exceed $140 per airbag, the price at which the Igo division can buy airbags in the market from outside suppliers. Within the price range or $110 and $140, each division will be willing to transact with the other and maximize overall income of Nogo Motors. The exact transfer price between $110 and $140 will depend on the bargaining strengths of the two divisions. The negotiated transfer price has the following properties. a. b. Achieves goal congruence—Yes, as described above. Useful for evaluating subunit performance—Yes, because the transfer price is the result of direct negotiations between the two divisions. Of course, the transfer prices will be affected by the bargaining strengths of the two divisions. Motivating management effort—Yes, because once negotiated, the transfer price is independent of actual costs of the Airbag Division. Airbag Division management has every incentive to manage efficiently to improve profits. Preserves subunit autonomy—Yes, because the transfer price is based on direct negotiations between the two divisions and is not specified by headquarters on the basis of some rule (for example, Airbag Division incremental costs).
c.
d.
4. Neither method is perfect, but negotiated transfer pricing (described in requirement 3) has more favorable properties than the cost-based transfer pricing (described in requirement 2). Both transfer-pricing methods achieve goal congruence, but negotiated transfer pricing facilitates the evaluation of subunit performance, motivates management effort, and preserves subunit autonomy, whereas the transfer price based on incremental costs does not achieve these objectives.
22-13
22-22 (25 min.) General guideline, transfer price range.
1. If the Screen Division sells screens in the outside market, it will receive, for each screen, the market price of the screen minus variable marketing and distribution costs per screen = $110 – $4 = $106. The incremental cost of manufacturing each screen is $70. The Screen Division is operating at capacity. Hence, the opportunity cost per screen of selling the screen to the Assembly Division rather than in the outside market is the contribution margin the Screen Division would forgo if it transferred screens internally rather than sold them in the outside market. Contribution margin per screen = $106 – $70 = $36. Using the general guideline,
Minimum transfer price per screen =
That is,
Incremental costs per Opportunity costs per screen up to the + screen to the selling division point of transfer Minimum transfer price per screen = $70 + $36 = $106
2. If the two division managers were to negotiate a transfer price, the range of possible transfer prices is between $106 and $112 per screen. As calculated in requirement 1, the Screen Division will be willing to supply screens to the Assembly Division only if the transfer price equals or exceeds $106 per screen. If the Assembly Division were to purchase the screens in the outside market, it will incur a cost of $112, the cost of the screen equal to $110 plus variable purchasing costs of $2 per screen. Hence, the Assembly Division will be willing to buy screens from the Screen Division only if the price does not exceed $112 per screen. Within the price range of $106 and $112 per screen, each division will be willing to transact with the other. The exact transfer price between $106 and $112 will depend on the bargaining strengths of the two divisions.
22.23
(25 min.) Multinational transfer pricing, global tax minimization.
1. Solution Exhibit 22-23 shows the after-tax operating incomes earned by the U.S. and Austrian divisions from transferring 1,000 units of Product 4A36 using (a) full manufacturing cost per unit, and (b) market price of comparable imports as transfer prices. 2. There are many ways to proceed, but the first thing to note is that the transfer price that minimizes the total of company import duties and income taxes will be either the full manufacturing cost or the market price of comparable imports. Consider what happens every time the transfer price is increased by $1 over, say, the full manufacturing cost of $500. This results in the following a. b. c. an increase in U.S. taxes of 40% × $1 an increase in import duties paid in Austria, 10% × $1 a decrease in Austrian taxes of 44% × $1.10 (the $1 increase in transfer price + $0.10 paid by way of import duty) Net effect is an increase in import duty and tax payments of $0.400 0.100
(0.484) $0.016
Hence, Mornay Company will minimize import duties and income taxes by setting the transfer price at its minimum level of $500, the full manufacturing cost. 22-14
22-23 (Cont’d.) SOLUTION EXHIBIT 22-23 Division Incomes of U.S. and Austrian Divisions from Transferring 1,000 Units of Product 4A36 Method A: Internal Method B: Transfers Internal at Full Transfers Manufacturing at Market Cost Price U.S. Division Revenues: $500,000 $650,000 $500, $650 × 1,000 units Deduct: Full manufacturing cost: 500,000 500,000 $500 × 1,000 units 0 150,000 Division operating income 0 60,000 Division income taxes at 40% $ 0 $ 90,000 Division after-tax operating income Austrian Division Revenues: $750 × 1,000 units Deduct: 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 Division operating income Division income taxes at 44% Division after-tax operating income
$750,000
$750,000
500,000 50,000 200,000 88,000 $112,000
650,000 65,000 35,000 15,400 $ 19,600
22-15
22-24 (30 min.) Multinational transfer pricing, goal congruence
(continuation of 22-23). 1. After-tax operating income if Mornay Company sold all 1,000 units of Product 4A36 in the United States is Revenues, $600 × 1,000 units Full manufacturing costs, $500 × 1,000 units Operating income Income taxes at 40% After-tax operating income $600,000 500,000 100,000 40,000 $ 60,000
From Exercise 22-23, requirement 1, Mornay Company's after-tax operating income if it transfers 1,000 units of Product 4A36 to Austria at full manufacturing cost and sells the units in Austria is $112,000. Therefore, Mornay should sell the 1,000 units in Austria. 2. Transferring Product 4A36 at the full manufacturing cost of the U.S. Division minimizes import duties and taxes (Exercise 22-23, requirement 2), but creates zero operating income for the U.S Division. Acting autonomously, the U.S. Division manager would maximize division operating income by selling Product 4A36 in the U.S. market, which results in $60,000 in aftertax division operating income as calculated in requirement 1, rather than by transferring Product 4A36 to the Austrian division at full manufacturing cost. Hence, the transfer price calculated in requirement 2 of Exercise 22-23 will not result in actions that are optimal for Mornay Company as a whole. 3. The minimum transfer price at which the U.S. division manager acting autonomously will agree to transfer Product 4A36 to the Austrian division is $600 per unit. Any transfer price less than $600 will leave the U.S. Division's performance worse than selling directly in the U.S. market. Because the U.S. Division can sell as many units that it makes of Product 4A36 in the U.S. market, there is an opportunity cost of transferring the product internally equal to $250 (selling price $600 ? variable manufacturing costs, $350).
Minimum transfer price per unit =
=
Incremental costs per Opportunity costs per unit up to the point of + unit to the selling transfer (U. S.) division $350 + $250 = $600
This transfer price will result in Mornay Company as a whole paying more import duties and taxes than the answer to Exercise 22-23, requirement 2, as calculated below: U.S. Division Revenues, $600 × 1,000 units Full manufacturing costs Division operating income Division income taxes at 40% Division after-tax operating income $600,000 500,000 100,000 40,000 $ 60,000
22-16
22-24 (Cont’d.) Austrian Division Revenues, $750 × 1,000 units` Transferred in costs, $600 × 1,000 units Import duties at 10% of transferred-in price, $60 × 1,000 units Division operating income Division income taxes at 44% Division after-tax operating income $750,000 600,000 60,000 90,000 39,600 $ 50,400
Total import duties and income taxes at transfer prices of $500 and $600 per unit for 1,000 units of Product 4A36 follow: Transfer Price of $500 per Unit (Exercise 22-23, Requirement 2) $ 0 50,000 88,000 $138,000
(a) (b) (c)
U.S. income taxes Austrian import duties Austrian income taxes
Transfer Price of $600 per Unit $ 40,000 60,000 39,600 $139,600
The minimum transfer price that the U.S. division manager acting autonomously would agree to results in Mornay Company paying $1,600 in additional import duties and income taxes. A student who has done the calculations shown in Exercise 22-23, requirement 2, can calculate the additional taxes from a $600 transfer price more directly, as follows: Every $1 increase in the transfer price per unit over $500 results in additional import duty and taxes of $0.016 per unit So, a $100 increase ($600 – $500) per unit will result in additional import duty and taxes of $0.016 × 100 = $1.60 For 1,000 units transferred, this equals $1.60 × 1,000 = $1,600
22-17
22-25 (20 min.) Transfer-pricing dispute.
This problem is similar to the Problem for Self-Study in the chapter. 1. Company as a whole will not benefit if Division C buys on the outside market: Purchase costs from outsider, 1,000 units × $135 $135,000 Deduct: Savings in variable costs by reducing Division A output, 1,000 units × $120 120,000 Net cost (benefit) to company as a whole by buying from outside $ 15,000
Any transfer price between $120 to $135 per unit will achieve goal congruence. Division managers acting in their own best interests will take actions that are in the best interests of the company as a whole. 2. Company will benefit if C purchases from the outsider supplier: Purchase costs from outsider, 1,000 units × $135 Deduct: Savings in variable costs, 1,000 units × $120 $120,000 Savings due to A's equipment and facilities assigned to other operations 18,000 Net cost (benefit) to company as a whole by buying from outside $135,000
138,000 $ (3,000)
Division C should purchase from outside suppliers. 3. Company will benefit if C purchases from the outside supplier: Purchase costs from outsider, 1,000 units × $115 Deduct: Savings in variable costs by reducing Division A output, 1,000 units × $120 Net cost (benefit) to company as a whole by buying from outside The three requirements are summarized below (in thousands): Total purchase costs from outsider Total relevant costs if purchased from Division A Total incremental (outlay) costs if purchased from A Total opportunity costs if purchased from A Total relevant costs if purchased from A Operating income advantage (disadvantage) to company as a whole by buying from A (1) $135 120 – 120 $ 15 $115,000 120,000 $ (5,000) (2) $135 120 18 138 $ (3) (3) $115 120 – 120 $ (5)
Goal congruence would be achieved if the transfer price is set equal to the total relevant costs of purchasing from Division A.
22-18
22-26 (5 min.) Transfer-pricing problem (continuation of 22-25).
The company as a whole would benefit in this situation if C purchased from outside suppliers. The $15,000 disadvantage to the company as a whole by purchasing from the outside supplier would be more than offset by the $30,000 contribution margin of A's sale of 1,000 units to other customers. Purchase costs from outside supplier, 1,000 units × $135 Deduct variable cost savings, 1,000 units × $120 Net cost to company as a whole by buying units from outside A's sales to other customers, 1,000 units × $155 Deduct: Variable manufacturing costs, $120 × 1,000 units Variable marketing costs, $5 × 1,000 units Total variable costs Contribution margin from selling units to other customers $135,000 120,000 $ 15,000 $155,000 $120,000 5,000 125,000 $ 30,000
22-27 (20–30 min.) Pertinent transfer price.
This problem explores the "general transfer-pricing guideline" discussed in the chapter. 1. No, transfers should not be made to Division B if there is no excess capacity in Division A. An incremental (outlay) cost approach shows a positive contribution for the company as a whole. Selling price of final product $300 Incremental costs in Division A $120 Incremental costs in Division B 150 270 Contribution $ 30 However, if there is no excess capacity in Division A, any transfer will result in diverting products from the market for the intermediate product. Sales in this market result in a greater contribution for the company as a whole. Division B should not assemble the bicycle since the incremental revenue Europa can earn, $100 per unit ($300 from selling the final product – $200 from selling the intermediate product) is less than the incremental costs of $150 to assemble the bicycle in Division B. Alternatively put, Europa’s contribution margin from selling the intermediate product exceeds Europa’s contribution margin from selling the final product. Selling price of intermediate product Incrementral (outlay) costs in Division A Contribution The general guideline described in the chapter is = + = $120 + ($200 – $120) = $200, which is the market price 22-27 (Cont’d.) $200 120 $ 80
22-19
The market price is the transfer price that leads to the correct decision; that is, do not transfer to Division B unless there are extenuating circumstances for continuing to market the final product. Therefore, B must either drop the product or reduce the incremental costs of assembly from $150 per bicycle to less than $100. 2. If (a) A has excess capacity, (b) there is intermediate external demand for only 800 units at $200, and (c) the $200 price is to be maintained, then the opportunity costs per unit to the supplying division are $0. The general guideline indicates a minimum transfer price of: $120 + $0 = $120, which is the incremental or outlay costs for the first 200 units. B would buy 200 units from A at a transfer price of $120 because B can earn a contribution of $30 per unit [$300 – ($120 + $150)]. In fact, B would be willing to buy units from A at any price up to $150 per unit because any transfers at a price of up to $150 will still yield B a positive contribution margin. Note, however, that if B wants more than 200 units, the minimum transfer price will be $200 as computed in requirement 1 because A will incur an opportunity cost in the form of lost contribution of $80 (market price, $200 – outlay costs of $120) for every unit above 200 units that are transferred to B. The following schedule summarizes the transfer prices for units transferred from A to B. Units Transfer Price 0–200 $120–$150 200–1,000 $200 For an exploration of this situation when imperfect markets exist, see the next problem. 3. Division B would show zero contribution, but the company as a whole would generate a contribution 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. A motivational problem may arise regarding how to split the $30 contribution between Division A and B. Unless the price is below $150, B would have little incentive to buy. Note: The transfer price that may appear optimal in an economic analysis may, in fact, be totally unacceptable from the viewpoints of (1) preserving autonomy of the managers, and (2) evaluating the performance of the divisions as economic units. For instance, consider the simplest case discussed previously, where there is idle capacity and the $200 intermediate price is to be maintained. To direct that A should sell to B at A's variable cost of $120 may be desirable from the viewpoint of B and the company as a whole. However, the autonomy (independence) of the manager of A is eroded. Division A will earn nothing, although it could argue that it is contributing to the earning of income on the final product. If the manager of A wants a portion of the total company contribution of $30 per unit, the question is: How is an appropriate amount determined? This is a difficult question in practice. The price can be negotiated upward to somewhere between $120 and $150 so that some "equitable" split is achieved. A dual transfer-pricing scheme has also been suggested, whereby the supplier gets credit for the full intermediate market price and the buyer is charged with only
22-20
22-27 (Cont’d.) variable or incremental costs. In any event, when there is heavy interdependence between divisions, such as in this case, some system of subsidies may be needed to deal with the three problems of goal congruence, management effort, and subunit autonomy. Of course, where heavy subsidies are needed, a question can be raised as to whether the existing degree of decentralization is optimal.
22-28 (30–40 min.) Pricing in imperfect markets (continuation of 22-27).
An alternative presentation, which contains the same numerical answers, can be found at the end of this solution. 1. Potential contribution from external intermediate sale is 1,000 × ($195 – $120) Contribution through keeping price at $200 is 800 × $80. Forgone contribution by transferring 200 units $75,000 64,000 $11,000
Opportunity cost per unit to the supplying division by transferring internally:
$11,000 = $55 200
Transfer price = $120 + $55 = $175 An alternative approach to obtaining the same answer is to recognize that the incremental or outlay cost is the same for all 1,000 units in question. Therefore, the total revenue desired by A would be the same for selling outside or inside. Let X equal the transfer price at which Division A is indifferent between selling all units outside versus transferring 200 units inside. 1,000 × $195 = (800 × $200) + 200X X = $175 The $175 price will lead to the correct decision. Division B will not buy from Division A because its total costs of $175 + $150 will exceed its prospective selling price of $300. Division A will then sell 1,000 units at $195 to the outside; Division A and the company will have a contribution margin of $75,000. Otherwise, if 800 units were sold at $200 and 200 units were transferred to Division B, the company would have a contribution of $64,000 plus $6,000 (200 units of final product × $30), or $70,000. A comparison might be drawn regarding the computation of the appropriate transfer prices between the preceding problem and this problem:
22-21
22-28 (Cont’d.) =+ Perfect markets: = $120 + (Selling price – Outlay costs per unit) = $120 + ($200 – $120) = $200 Imperfect markets: = $120 + = $120 +
$35,000 a ? $24,000 b = $175 200
aMarginal revenues of Division A from selling 200 units outside rather than transferring to Division B = ($195 × 1,000) – ($200 × 800) = $195,000 – $160,000 = $35,000. bIncremental (outlay) costs incurred by Division A to produce 200 units = $120 × 200 = $24,000.
Therefore, selling price ($195) and marginal revenues per unit ($175 = $35,000 ÷ 200) are not the same. The following discussion is optional. These points should be explored only if there is sufficient class time: Some students will erroneously say that the "new" market price of $195 is the appropriate transfer price. They will claim that the general guideline says that the transfer price should be $120 + ($195 – $120) = $195, the market price. This conclusion assumes a perfect market. But, here, there are imperfections in the intermediate market. That is, the market price is not a good approximation of alternative revenue. If a division's sales are heavy enough to reduce market prices, marginal revenue will be less than market price. It is true that either $195 or $175 will lead to the correct decision by B in this case. But suppose that B's variable costs were $120 instead of $150. Then B would buy at a transfer price of $175 (but not at a price of $195, because then B would earn a negative contribution of $15 per unit [$300 – ($195 + $120)]. Note that if B's variable costs were $120, transfers would be desirable: Division A contribution is: 800 × ($200 – $120) + 200 ($175 – $120) = Division B contribution is: 200 × [$300 – ($175 + $120)] = Total contribution $75,000 1,000 $76,000
22-22
22-28 (Cont’d.) Or the same facts can be analyzed for the company as a whole: Sales of intermediate product, 800 × ($200 – $120) Sales of final products, 200 × [300 – ($120 + $120)] Total contribution = = $64,000 12,000 $76,000
If the transfer price were $195, B would not accept the transfer and would not earn any contribution. As shown above, Division A and the company as a whole will earn a total contribution of $75,000 instead of $76,000. 2. a. Division A can sell 900 units at $195 to the outside market and 100 units to Division B, or 800 at $200 to the outside market and 200 units to Division B. Note that, under both alternatives, 100 units can be transferred to Division B at no opportunity cost to A. Using the general guideline, the minimum transfer price of the first 100 units [901–1000] is: TP1 = $120 + 0 = $120 If Division B needs 100 additional units, the opportunity cost to A is not zero, because Division A will then have to sell only 800 units to the outside market for a contribution of 800 × ($200 – $120) = $64,000 instead of 900 units for a contribution of 900 × ($195 – $120) = $67,500. Each unit sold to B in addition to the first 100 units has an opportunity cost to A of ($67,500 – $64,000) ÷ 100 = $35. Using the general guideline, the minimum transfer price of the next 100 units [801–900] is: TP2 = $120 + $35 = $155 Alternatively, the computation could be: Increase in contribution from 100 more units, 100 × $75 Loss in contribution on 800 units, 800 × ($80 ? $75) Net "marginal revenue" (Minimum) transfer price applicable to first 100 units offered by A is $120 + $0 (Minimum) transfer price applicable to next 100 units offered by A is $120 + ($3,500 ÷ 100) (Minimum) transfer price applicable to next 800 units $7,500 4,000 $3,500 ÷100 units = $35 = = = $120 per unit $155 per unit $195 per unit
22-23
22-28 (Cont’d.) b. The manager of Division B will not want to purchase more than 100 units because the units at $155 would decrease his contribution ($155 + $150 > $300). Because the manager of B does not buy more than 100 units, the manager of A will have 900 units available for sale to the outside market. The manager of A will strive to maximize the contribution by selling them all at $195.
This solution maximizes the company's contribution: 900 × ($195 – $120) 100 × ($300 – $270) which compares favorably to: 800 × ($200 – $120) 200 × ($300 – $270) = = $64,000 6,000 $70,000 = = $67,500 3,000 $70,500
ALTERNATIVE PRESENTATION (by James Patell) 1. Company Viewpoint b: Sell 800 outside at $200, transfer 200 Transfer price $200 Variable costs 120 Contribution $ 80 × 800 = $64,000
a: Sell 1,000 outside at $195 Price $195 Variable costs 120 Contribution $ 75 × 1,000 = $75,000 Total contribution given up if transfer occurs* = $75,000 – $64,000 = $11,000 On a per-unit basis, the relevant costs are: + = Transfer price $120 +
$11,000 = $175 200
22-24
22-28 (Cont’d.) By formula, costs are: + – = = 2a. $120 +
200 ×$75 – 200
[ ($200 ? $195) × 800]
200
$120 + $75 – $20 = $175 At most, Division A can sell only 900 units and can produce 1,000. Therefore, at least 100 units should be transferred, at a transfer price no less than $120. The question is whether or not a second 100 units should be transferred.
*Contribution of $30 per unit by B is not given up if transfer occurs, so it is not relevant here.
Company Viewpoint a: Sell 900 outside at $195 Transfer price $195 Variable cost 120 Contribution $ 75 × 900 = $67,500 $ 80 × 800 = $64,000 b: Sell 800 outside at $200, transfer 100 Transfer price $200 Variable cost 120
Total contribution forgone if transfer of 100 units occurs = $67,500 – $64,000 = $3,500 (or $35 per unit) + = Transfer price $120 + 2b. By formula: + – = $120 +
[($200 ? $195) × 800] 100 ×$75 – 100 100
$35
=
$155
= $120 + $75 – $40 = $155 Transfer Price Schedule (minimum acceptable transfer price) Units Transfer Price 0–100 $120 101–200 $155 201–1,000 $195 22.29 (30-35 min.) Effect of alternative transfer-pricing methods on division
operating income.
1. Revenues, 500 pounds × $5 22-25 $2,500
Variable costs: Harvesting, 1,000 × $0.20 Processing, 500 × $0.80 Total variable costs Contribution margin Fixed costs: Harvesting, 1,000 × $0.40 Processing, 500 × $0.60 Total fixed costs Operating income 2. a.
$200 400 600 1,900 $400 300 700 $1,200
150% of Full Cost Harvesting Division to Processing Division = 1.5 × ($0.20 + $0.40) = $0.90 per pound of raw tuna b. Market Price Harvesting Division to Processing Division = $1.00 per pound of raw tuna
22-26
22-29 (Cont’d.) 3. Method A Internal Transfers at 150% of Full Costs $ 900 200 400 $ 300 Method B Internal Transfers at Market Price $1,000 200 400 $ 400
1. Tuna Harvesting Division Division revenues $0.90, $1, × 1,000 pounds of raw tuna Deduct: Division variable costs $0.20 × 1,000 pounds of raw tuna Division fixed costs $0.40 × 1,000 pounds of raw tuna Division operating income 2. Tuna Processing Division Division revenues $5 × 500 pounds of processed tuna Deduct: Transferred-in costs $0.90, $1, × 1,000 pounds of processed tuna Division variable costs $0.80 × 500 pounds processed tuna Division fixed costs $0.60 × 500 pounds processed tuna Division operating income
$2,500 900 400 300 $ 900
$2,500 1,000 400 300 $ 800
Bonus paid to division managers at 10% of division operating income will be as follows: Method A Internal Transfers at 150% of Full Costs Harvesting Division manager’s bonus (10% × $300; 10% × $400) Processing Division manager’s bonus (10% × $900; 10% × $800) $30 90 Method B Internal Transfers at Market Prices $40 80
The Harvesting Division manager will prefer Method B (transfer at market prices) because this method gives $40 of bonus rather than $30 under Method A (transfer at 150% of full costs). The Processing Division manager will prefer Method A because this method gives $90 of bonus rather than $80 under Method B.
22-27
22-30 (25 min.) Goal congruence problems with cost-plus transfer-pricing methods, dual pricing system (continuation of 22-29).
Two examples of goal congruence problems are: a. b. Processing Division manager using an outside supplier when Oceanic Products operating income is maximized by buying from Harvesting Division. Harvesting Division manager selling to an outside purchaser when it is better for Oceanic Products to process internally.
2. Transfer into buying division at market price Harvesting Division to Processing Division = $1.00 per pound of raw tuna Transfer out to selling division at 150% of full costs Harvesting Division to Processing Division = 1.5 × ($0.20 + $0.40) = $0.90 per pound of raw tuna Tuna Harvesting Division Division revenues, $0.90 × 1,000 Division variable costs, $0.20 × 1,000 Division fixed costs, $0.40 × 1,000 Division total costs Division operating income Tuna Processing Division Division revenues, $5.00 × 500 Transferred-in costs, $1.00 × 1,000 Division variable costs, $0.80 × 500 Division fixed costs, $0.60 × 500 Division total costs Division operating income 3. Tuna Harvesting Division Tuna Processing Division Oceanic Products $2,500 $1,000 400 300 1,700 $ 800 Division Operating Income $ 300 800 $1,100 $ 900 200 400 600 $ 300
The overall company operating income from harvesting 1,000 pounds of raw tuna and its processing is $1,200 (see Problem 22-29, requirement 1). A dual transfer-pricing method entails using different transfer prices for transfers into the buying division and transfers out of the supplying division. As a result, the sum of division operating incomes do not equal the total company operating income.
22-28
22-30 (Cont’d.) 4. Problems which may arise if Oceanic Products uses the dual transfer-pricing system include: a. b. c. It may reduce the incentives of the supplying division to control costs since every $1 of cost of the supplying division is transferred out to the buying division at $1.50. A dual transfer-pricing system does not provide clear signals to the individual divisions about the level of decentralization top management seeks. It insulates the Harvesting Division manager from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division
22-31 (40 min.) Multinational transfer pricing, global tax minimization.
This is a two-country two-division transfer-pricing problem with two alternative transfer-pricing methods. Summary data in U.S. dollars are: Philippine Mining Division Variable costs: 4,000 pesos ÷ 40 = $100 per lb. of raw industrial diamonds Fixed costs: 8,000 pesos ÷ 40 = $200 per lb. of raw industrial diamonds U.S. Processing Division Variable costs = $200 per lb. of polished industrial diamonds Fixed costs = $600 per lb. of polished industrial diamonds The market price for raw industrial diamonds in the Philippines is 16,000 pesos ÷ 40 = $400 per lb. of raw industrial diamonds. 1. The transfer prices are: a. 300% of full costs Mining Division to Processing Division = 3.0 × ($100 + $200) = $900 per lb. of raw industrial diamonds b. Market price Mining Division to Processing Division = $400 per lb. of raw industrial diamonds
22-29
22-31 (Cont’d.) 2. Philippine Mining Division Division revenues, $900, $400 × 1,000 Division variable costs, $100 × 1,000 Division fixed costs, $200 × 1,000 Division total costs Division operating income U.S. Processing Division Division revenues, $4,000 × 500 Transferred-in costs, $900, $400 × 1,000 Division variable cost, $200 × 500 Division fixed costs, $600 × 500 Division total costs Division operating income 3. Philippine Mining Division Division operating income Income tax at 20% Division after-tax operating income U.S. Processing Division Division operating income Income tax at 35% Division after-tax operating income 4. Philippine Mining Division: After-tax operating income U.S. Processing Division: After-tax operating income Industrial Diamonds: After-tax operating income 300% of Full Cost $ 900,000 100,000 200,000 300,000 $ 600,000 Market Price $ 400,000 100,000 200,000 300,000 $ 100,000
$2,000,000 900,000 100,000 300,000 1,300,000 $ 700,000 300% of Full Cost $600,000 120,000 $480,000 $700,000 245,000 $455,000 300% of Full Cost $480,000 455,000 $935,000
$2,000,000 400,000 100,000 300,000 800,000 $1,200,000 Market Price $ 100,000 20,000 $ 80,000 $1,200,000 420,000 $ 780,000 Market Price $ 80,000 780,000 $860,000
Industrial Diamonds will maximize companywide net income by using the 300% of full cost transfer-pricing method. This method sources more of the total income in the country with the lower income tax rate.
22-30
22-31 (Cont’d.) 5. The Surveys of Company Practice Box in the chapter lists the factors executives state to be important in decisions on transfer pricing: a. Performance evaluation b. Management motivation c. Pricing and product emphasis d. External market recognition Factors specifically related to multinational transfer pricing include: a. Overall income of the company b. Income or dividend repatriation restrictions c. Competitive position of subsidiaries in their respective markets
22-32 (30–40 min.) Multinational transfer pricing and taxation.
1. Anita Corporation and its subsidiaries' operating income if it manufactures the machine and sells it in Brazil or in Switzerland follows: If Sold in Brazil $1,000,000 500,000 200,000 700,000 $ 300,000 If Sold in Switzerland $950,000 500,000 250,000 750,000 $200,000
Revenue Costs Manufacturing costs Transportation and modification costs Total costs Operating income
Anita Corporation maximizes operating income by manufacturing the machine and selling it in Brazil. 2. Anita Corporation will not sell if the transfer price is less than $500,000––its outlay costs of manufacturing the machine. The Brazilian subsidiary will not agree to a transfer price of more than $800,000. At a price of $800,000, the Brazilian subsidiary's incremental operating income from purchasing and selling the milling machine will be $0 ($1,000,000 – $200,000 – $800,000). The Swiss subsidiary will not agree to a transfer price of more than $700,000. At a price of $700,000, the Swiss subsidiary's incremental operating income from purchasing and selling the milling machine will be $0 ($950,000 – $250,000 – $700,000).
22-31
22-32 (Cont’d.) Any transfer price between $700,000 and $800,000 will achieve the optimal actions determined in requirement 1. For prices in this range, Anita Corporation will be willing to sell, the Brazilian Corporation willing to buy, and the Swiss subsidiary not interested in acquiring the machine. Where within the range of $700,000 to $800,000 that the transfer price will be set depends on the bargaining powers of the Anita Corporation and the Brazilian subsidiary managers. Anita Corporation's main source of bargaining power comes from the threat of selling the machine to the Swiss subsidiary. If the transfer price is set at $700,000, then Anita's operating income, $700,000 – $500,000 Brazilian subsidiary's operating income, $1,000,000 – $700,000 – $200,000 Overall operating income of Anita and subsidiaries Note that the general guideline could be used to derive the minimum transfer price. = = + $500,000 + $200,000 = $700,000 $200,000 100,000 $300,000
Anita's opportunity cost of supplying the machine to the Brazilian subsidiary is the $200,000 in operating income it forgoes by not supplying the machine to the Swiss subsidiary. Note that competition between the Brazilian and Swiss subsidiaries means that the transfer price will be at least $700,000. 3. Consider the optimal transfer prices that can be set to minimize taxes (for Anita and its subsidiaries) (a) for transfers from Anita to the Brazilian subsidiary and (b) for transfers from Anita to the Swiss subsidiary. a. Transfers from Anita to the Brazilian subsidiary should "allocate" as much of the operating income to Anita as possible, since the tax rate in the United States is lower than in Brazil for this transaction. Therefore, these transfers should be priced at the highest allowable transfer price of $700,000 to minimize overall company taxes. Taxes paid: Anita, 0.40 × ($700,000 – $500,000) Brazilian subsidiary, 0.60 × ($1,000,000 – $700,000 – $200,000) Total taxes paid by Anita Corporation and its subsidiaries on transfers to Brazil After-tax operating income: Anita, ($700,000 – $500,000) – $80,000 Brazilian subsidiary ($1,000,000 – $700,000 – $200,000) – $60,000 Total after-tax operating income for Anita Corporation and its subsidiaries on transfers to Brazil $ 80,000 60,000 $140,000 $120,000 40,000 $160,000
22-32
22-32 (Cont’d.) b. Transfers from Anita to the Swiss subsidiary should "allocate" as little of the operating income to Anita as possible, since the tax rate in the United States is higher than in Switzerland for this transaction. Therefore, these transfers should be priced at the lowest allowable transfer price of $500,000 to minimize overall company taxes. $ 0 30,000
Taxes paid: Anita, 0.40 × ($500,000 – $500,000) Swiss subsidiary, 0.15 × ($950,000 – $500,000 – $250,000) Total taxes paid by Anita Corporation and its subsidiaries on transfers to Switzerland After-tax operating income Anita, ($500,000 – $500,000) – $0 Swiss subsidiary ($950,000 – $500,000 – $250,000) – $30,000 Total net income for Anita Corporation and its subsidiaries on transfers to Switzerland $
$30,000 0 170,000
$170,000
From the viewpoint of Anita Corporation and its subsidiaries together, overall after-tax operating income is maximized if the machine is transferred to the Swiss subsidiary (after-tax operating income of $170,000 versus after-tax operating income of $160,000 if the machine is transferred to the Brazilian subsidiary). Note that the corporation and its subsidiaries trade off the lower overall before-tax operating income achieved by transferring to the Swiss subsidiary with the lower taxes that result from such a transfer. Hence, (a) the equipment should be manufactured by Anita, and (b) it should be transferred to the Swiss subsidiary at a price of $500,000. 4. As in requirement 2, the Brazilian subsidiary would be willing to bid up the price to $800,000, while the Swiss subsidiary would be willing to pay only up to $700,000. Anita Corporation, acting autonomously, would like to maximize its own after-tax operating income by transferring the machine at as high a transfer price as possible. As in requirement 2, the price would end up being at least $700,000. Since the taxing authorities will not allow prices above $700,000, the transfer price will be $700,000. At this transfer price, the Swiss subsidiary makes zero operating income and will not be interested in the machine. Hence, Anita Corporation will sell the machine to the Brazilian subsidiary at a price of $700,000. The answer is not the same as in requirement 3, because, acting autonomously, the objective of each manager is to maximize after-tax operating income of his or her own company rather than after-tax operating income of Anita Corporation and its subsidiaries as a whole. Goal congruence is not achieved in this setting. Can the company induce the managers to take the right actions without infringing on their autonomy? This outcome is probably not going to be easy.
22-33
22-32 (Cont’d.) One possibility might be to implement a dual-pricing scheme in which the machine is transferred at cost ($500,000), but under which Anita Corporation is credited with after-tax operating income earned on the machine by the subsidiary it ships the machine to (in this example, $170,000 of net income earned by the Swiss subsidiary). A negative feature of this arrangement is that the $170,000 of after-tax operating income will be "double counted" and recognized on the books of both Anita Corporation and the Swiss subsidiary. Another possibility might be to evaluate the managers on the basis of overall after-tax operating income of Anita Corporation and its subsidiaries. This approach will induce a more global perspective, but at the cost of inducing a larger noncontrollable element in each manager's performance measure. 22.33 (30 min.) Transfer pricing, goal congruence. 1a. & b. As the following calculations show, if Johnson Corporation offers a price of $37 per cassette deck, Sather Corporation should purchase the cassette decks from Johnson. If Johnson Corporation offers a price of $43 per cassette deck, Sather Corporation should manufacture the cassette decks in-house. Buy 10,000 Buy 10,000 cassette decks Transfer cassette decks from Johnson 10,000 cassette from Johnson at $43. Sell decks to at $37. Sell 12,000 cassette Assembly. Sell 12,000 cassette decks in 2,000 in decks in outside outside market outside market market. (1) (2) (3) Incremental cost of Cassette Deck Division supplying 10,000 cassette decks to Assembly $(250,000) $ 0 $ 0 $25 × 10,000; 0; 0 Incremental costs of buying 10,000 cassette decks from Johnson 0 (370,000) (430,000) $0; $37 × 10,000; $43 × 10,000 Revenue from selling cassette decks in outside market 70,000 420,000 420,000 $35 × 2,000; 12,000; 12,000 Incremental costs of manufacturing cassette decks for sale in outside market (50,000) (300,000) (300,000) $25 × 2,000; 12,000; 12,000 Revenue from supplying cassette-head mechanism to Johnson 0 180,000 180,000 $18 × 0; 10,000; 10,000 Incremental costs of supplying cassettehead mechanism to Johnson 0 (120,000) (120,000) $12 × 0; 10,000; 10,000
22-34
Net costs 22-33 (Cont’d.)
$(230,000)
$(190,000)
$(250,000)
At a price of $37 per cassette deck, the net cost of $190,000 is less than the net cost of $230,000 if Sather Corporation made the cassette decks inhouse. Hence, Sather Corporation should outsource to Johnson. At a price of $43 per cassette deck, the net cost of $250,000 is greater than the net cost of $230,000 if Sather Corporation made the cassette decks inhouse. Hence, Sather Corporation should reject Johnson’s offer. 2. For the Cassette Deck Division and the Assembly Division to take actions that are optimal for Sather Corporation as a whole, the transfer price should be set at $41, calculated as follows: The Cassette Deck Division can manufacture at most 12,000 cassette decks and is currently operating at capacity. The incremental costs of manufacturing a cassette deck are $25 per deck. The opportunity cost of manufacturing cassette decks for the Assembly Division is (1) the contribution margin of $10 (selling price, $35 minus incremental costs $25) that the Cassette Deck Division would forgo by not selling cassette decks in the outside market and (2) the contribution margin of $6 (selling price, $18 minus incremental costs, $12) that the Cassette Deck Division would forgo by not being able to sell the cassette-head mechanism to outside suppliers of cassette decks (such as Johnson). Thus, the total opportunity cost of the Cassette Deck Division of supplying cassette decks to Assembly is $10 + $6 = $16 per unit. Using the general guideline,
Incremental cost per Opportunity costs per Minimum transfer cassette deck up to the + cassette deck to the price per cassette deck = selling division point of transfer
= $25 + $16 = $41 Note that, at a price of $41, Sather is indifferent between manufacturing cassette decks inhouse or purchasing them from an outside supplier. Each results in a net cost of $230,000. For an outside price per cassette deck below $41, the Assembly Division would prefer to purchase from outside; above it, the Assembly Division would prefer to purchase from the Cassette Deck Division. When selling prices are uncertain, the transfer price should be set at the minimum acceptable transfer price. For example, if the transfer price were set above the minimum transfer price at $42 per cassette deck, say, and an outside supplier offered to supply the cassette decks at $41.50 per unit, the Assembly Division would purchase the cassette deck from the outside supplier. In fact, as the following calculations show, Sather Corporation, as a whole, would be better off had the Assembly Division purchased the cassette decks from the Cassette Deck Division. The net cost to Sather Corporation if the Cassette Deck Division transfers 10,000 cassette decks to the Assembly Division is $230,000 as calculated in Column 1 of the table
22-35
presented in requirement 1. If an outside supplier supplies cassette decks at $41.50 each, we simply substitute $41.50 × 10,000 = $415,000 for the incremental costs of buying 10,000 cassette
22-36
22-33 (Cont’d.) decks in column 2 or 3 and leave everything else unchanged. This gives a higher net cost of $235,000 to Sather Corporation as a whole. It is only if the price charged by the outside supplier falls below $41 that Sather Corporation as a whole is better off purchasing from the outside market. Setting the transfer price at $41 per unit achieves goal congruence.
22-34 (40?50 min.) Transfer pricing, utilization of capacity.
1. Selling price Direct materials Direct manufacturing labor Contribution margin per unit Contribution margin per hour ($30 ÷ 2; $4 ÷ 0.5) Super-chip $60 2 28 $30 $15 Okay-chip $12 1 7 $ 4 $ 8
Because the contribution margin per hour is higher for Super-chip than for Okay-chip, CIC should produce and sell as many Super-chips as it can and use the remaining available capacity to produce Okay-chip. The total demand for Super-chips is 15,000 units, which would take 30,000 hours (15,000 × 2 hours per unit). CIC should use its remaining capacity of 20,000 hours (50,000 – 30,000) to produce 40,000 Okay-chips (20,000 ÷ 0.5). 2. Options for manufacturing process-control unit Using Super-chip $132 2 28 60 $ 42
Using Circuit Board Selling price $132 Direct materials 60 Direct manufacturing labor (Super-chip) 0 Direct manufacturing labor (Process-control unit) 50 Contribution margin per unit $ 22 Overall Company Viewpoint Alternative 1: No Transfer of Super-chips
Sell 15,000 Super-chips at contribution margin per unit of $30 Transfer 0 Super-chips Sell 40,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 Control units at contribution margin per unit of $22 Total contribution margin
$450,000 0 160,000 110,000 $720,000
22-37
22-34 (Cont’d.) Alternative 2: Transfer 5,000 Super-chips to Process-Control Division. These Super-chips would require 10,000 hours to manufacture, leaving only 10,000 hours for the manufacture of 20,000 Okay-chips (10,000 ÷ 0.5) Sell 15,000 Super-chips at contribution margin per unit of $30 Transfer 5,000 Super-chips to Process-Control Division Sell 20,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 Control units at contribution margin per unit of $42 Total contribution margin $450,000 0 80,000 210,000 $740,000
CIC is better off transferring 5,000 Super-chips to the Process-Control Division. 3. For each Super-chip that is transferred, two hours of time (labor capacity) are given up in the Semiconductor Division, and, in those two hours, four Okay-chips could be produced, each contributing $4.
Minimum transfer price = per Super - chip
= =
Incremental cost Opportunity cost per unit for per unit to + the Semiconductor Division the point of transfer $30 + $16 $46 per unit
If the selling price for the process-control unit were firm at $132, the Process-Control Division would accept any transfer price up to $50 ($60 price of circuit board ? $10 incremental labor cost if Super-chip used). However, consider what happens if the transfer price of Super-chip is set at, say, $49, and the price of the control unit drops to $108. From CIC’s viewpoint: Selling price Direct materials Direct manufacturing labor Contribution margin per hour Using Circuit Board $108 60 50 $ –2 Using Super-chip $108 49 60 $ –1
Process-Control Division will not produce any control units. From the company’s viewpoint, the contribution margin on the control unit if the Super-chip is used is: Selling price Direct materials Direct manufacturing labor (Super-chip) Direct manufacturing labor (process-control unit) Contribution margin per unit $108 2 28 60 $ 18
22-38
22-34 (Cont’d.) The contribution margin per unit from producing Super-chips for the process-control unit exceeds the contribution margin of $16 from producing 4 Okay-chips, each yielding a contribution margin of $4 per unit. Hence the Semiconductor Division should transfer 5,000 Super-chips as the following calculations show: Alternative 1—No transfer (and, therefore, no sales of process-control units) Sell 15,000 Super-chips at contribution margin per unit of $30 Sell 40,000 Okay-chips at contribution margin per unit of $4 Alternative 2—Transfer 5,000 Super-chips. $450,000 80,000 90,000 $620,000 Therefore, if the price for the control unit is uncertain, the transfer price must be set at the minimum acceptable transfer price of $46. 4. For a transfer of any amount between 0 and 10,000 Super-chips (which require 2 hours each to produce), the opportunity cost is the production of Okay-chips (which require ½ hour each). In this range, the relevant costs are equal to the transfer price of $46 established in part 3. If more than 10,000 Super-chips are transferred, the opportunity cost becomes the sale of Super-chips on the outside market. Now the minimum transfer price per Super-chip becomes Sell 15,000 Super-chips at contribution margin per unit of $30 Sell 20,000 Okay-chips at contribution margin per unit of $4 Sell 5,000 control units at contribution margin per unit of $18 $450,000 160,000 $610,000
Incremental Opportunity cost per Super - cost per Super chip up to the + chip to the = $30 + ($60 – $30) = $60, the market price. point of Semiconductor transfer Division
At this transfer price, it is cheaper for the Process-Control Division to buy the circuit board for $60, since $10 of additional direct manufacturing labor cost is saved. The Semiconductor Division should at most transfer 10,000 Super-chips. Internal Demand 0–10,000 10,000–25,000 Transfer Price $46 60
22-39
22-35 (20 min.) Ethics, transfer pricing.
1. Contribution margin for 10,000 units of R47 if variable costs are $14 and $16 per unit, respectively, are as follows: Variable Variable Costs of Costs of $14 per Unit $16 per Unit Transfer price at 200% of variable costs Variable costs per unit Contribution margin per unit Contribution margin for 10,000 units $14 × 10,000; $16 × 10,000 $ $ 28 14 14 $ $ 32 16 16
$140,000
$160,000
2. In assessing the situation, the specific “Standards of Ethical Conduct for Management Accountants,” described in Chapter 1 that the management accountant should consider are listed below. Competence Clear reports using relevant and reliable information should be prepared. Reports prepared on the basis of incorrectly identifying variable costs would violate the management accountant’s responsibility to competence. It is unethical for Lasker to suggest that Tanner should change the variable cost numbers that were prepared for costing product R47 and, hence, the transfer price for R47. The methodology to calculate variable costs has been in place for some time at Durham Industries. The company could certainly re-evaluate this methodology but Tanner cannot do so on his own. Integrity The management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Increasing the variable costs allocated to R47 will increase the transfer price and, hence, revenues of the Belmont Division. If they changed the method of determining variable costs, Lasker and Tanner would appear to favor the Belmont Division (that manufactures R47) over the Alston Division (that uses R47). This action could be viewed as violating the responsibility for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information. In this regard, both Lasker’s and Tanner’s behavior (if Tanner agrees to increase variable costs) could be viewed as unethical. Objectivity The "Standards of Ethical Conduct for Management Accountants" require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, increasing the variable costs of a product to earn higher revenue for a division, in violation of company policy, clearly violates both these precepts. For the various reasons cited above, the behavior of Lasker and Tanner (if he goes along with Lasker’s wishes) is unethical.
22-40
22-35 (Cont’d.) Tanner should indicate to Lasker that the variable costs of R47 are indeed appropriate, given that the methods for computing variable costs and fixed costs have been in place for some time. If Lasker still insists on making the changes and increasing the variable costs of making R47, Tanner should raise the matter with Lasker’s superior. If, after taking all these steps, there is continued pressure to increase the variable cost component, Tanner should consider resigning from the company and not engage in unethical behavior. Some students may raise the issue of whether variable cost transfer pricing is appropriate in this context. The problem does not provide enough details for a complete discussion of this issue. Management may well conclude that the transfer price should not be set as a multiple of variable costs. But that is a management decision. The management accountant should not unilaterally use methods of calculating variable costs that are in direct violation of accepted past practice.
22-36 (40–50 min.) Goal congruence, income taxes, different market conditions.
1. Selling price Savings in purchase costs by making engines inhouse Manufacturing costs: Direct materials Direct manufacturing labor Variable manufacturing overhead Total costs of manufacturing Contribution margin from New Engine Net savings in costs by making existing engine inhouse New Engine $375 Existing Engine Used by Assembly $400 $100 40 25 165 $210 $125 50 25 200 $200
If order for the new engine is accepted, San Ramon earns a contribution margin of $210 × 2,000 units. In this case, Engine Division will be in a position to supply only 2,000 units to Assembly, and Assembly will have to purchase 1,200 engines from outside. The incremental cost of buying engines from outside is $200 × 1,200 Net benefit from accepting order
$420,000
240,000 $180,000
An alternative approach is to compare relevant costs of the accept order and reject order alternatives.
22-41
22-36 (Cont’d.) Accept Order 1. Contribution margin from selling 2,000 units of new engine, $210 × 2,000 2. Incremental cost of making and transferring 2,000 units or 3,200 units of old engines, $200 × 2,000; $200 × 3,200 3. Incremental costs of purchasing 1,200 units from outside, $400 × 1,200 $(420,000) 400,000 480,000 $460,000 $640,000 $640,000 Reject Order
San Ramon Corporation should a. make 2,000 units of the new engine in the Engine Division b. make 2,000 units of the existing engine for the Assembly Division c. have the Assembly Division purchase 1,200 existing engines from the outside market 2. The options facing the Engine Division manager are (a) to sell 2,000 units of the special order engine and make 2,000 units for the Assembly Division, or (b) to make 3,200 units for the Assembly Division. The contribution margin per unit from accepting the special order is $210 per unit. Let the transfer price be $X. Then, we want to find X such that $210 × 2,000 + ($X – $200) 2,000 ($X – $200)(3,200 – 2,000) $X – $200 = ($X – $200) 3,200 = $420,000 =
$420,000 = $350 1,200
X = $550 For transfer prices below $550, the Engine Division gets more by selling 2,000 units outside and transferring 2,000 units to Assembly Division. It will not transfer more than 2,000 units to Assembly even though the transfer price is greater than the variable costs of manufacturing the existing engine, $200 plus the contribution margin per unit from accepting the special order of $210 equal to $410 ($500, say). Why? Because by transferring an additional 1,200 units (say), it will have to give up $420,000 ($210 × 2,000) of contribution margin by not accepting the special order. The Engine Division manager would be willing to transfer 2,000 units for which it has capacity (after fulfilling the outside order) to the Assembly Division provided the transfer price covers the Engine Division's variable costs. So, the range of transfer price that will induce the Engine Division manager to implement the optimal solution in requirement 1 is: TP ? $200 for the first 2,000 units TP ? $550 for the next 1,200 units The Assembly Division manager would be willing to buy from the Engine Division so long as the transfer price is less than or equal to the price at which the Assembly Division can buy the engines on the outside market. TP ? $400
22-42
22-36 (Cont’d.) It will not buy the engines from the Engine Division if TP > $400. The range of TP that will result in both managers favoring the optimal actions in requirement 1 are TPs that satisfy the respective constraints described above. $200 ? TP ? $400 for the first 2,000 units TP = $550 for the next 1,200 units This transfer-pricing scheme will induce both managers to transfer 2,000 units between the Engine and Assembly Divisions, but no more. Because the Assembly Division manager is willing to pay no more than $400 and the Engine Division manager is unwilling to transfer unless the transfer price is above $550, no transfers will occur beyond the first 2,000 units. 3a. The full manufacturing costs of the engines transferred to the Assembly Division are: Direct materials Direct manufacturing labor Variable manufacturing overheads Fixed manufacturing overheads
? $520,000 ? = $260,000 ÷ 2,000 engines ? ? 2 ? ?
$125 50 25
since the engines transferred to the Assembly Division use up half the Engine Division's capacity Total manufacturing cost b.
130 $330
A transfer price of $330 is in the optimal range identified in requirement 2 and, so, will achieve the optimal actions of selling 2,000 engines to the outside party and transferring 2,000 engines to the Assembly Division as identified in requirement 1. The transfer price for the next 1,200 units should be set at $550 so that the Assembly Division will prefer to purchase engines at $400 from the outside market. The transfer price for the next 1,200 units should not be set at the full manufacturing cost of $330 because the Assembly Division will then want to buy the engines internally. This is not in the best interest of San Ramon Corporation as a whole. One advantage of full cost transfer pricing is that it is useful for the firm's long-run pricing decisions. One disadvantage of full cost transfer pricing is that costs that are fixed for the corporation as a whole look like variable costs from the viewpoint of the Assembly Division manager. This is because, by choosing not to have a unit transferred from the Engine Division, the Assembly Division manager would appear to save both the variable and fixed costs of the engine. This could lead to suboptimal decisions.
c.
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22-36 (Cont'd.) 4a. To minimize taxes, San Ramon should transfer the engines at the highest price it can, the market price of $400. The Engine Division would pay no taxes on any income that it would report. By setting the transfer price as high as possible, the Assembly Division would minimize the income it would report and, hence, the taxes it would pay. Yes, as in part 3b, the transfer price of $400 for the first 2000 engines is also within the range identified in requirement 2 and so will achieve the outcome desired in requirement 1 (sell 2,000 engines under the outside offer and transfer 2,000 engines to the Assembly Division).
b.
5. San Ramon should use a transfer price of $400 for the first 2,000 units and $550 for the next 1,200 units when transferring engines from the Engine Division to the Assembly Division. This transfer price minimizes tax payments for the San Ramon Corporation as a whole and also achieves goal congruence. That is, at the transfer prices indicated, both Divisions will be content with the following arrangement a. The Engine Division will make 2,000 engines for outside customers and 2,000 engines for the Assembly Division b. The Assembly Division will take 2,000 engines from the Engine Division and 1,200 engines from the outside market Of course, the Assembly Division manager would like to negotiate a price lower than $400 (but greater than $200) for the first 2,000 engines from the Engine Division, but this would increase San Ramon's tax payments. At a transfer price of $400, San Ramon can still evaluate each division's performance on the basis of division operating income because the transfer price of $400 approximates the market prices for the engines transferred from the Engine Division to the Assembly Division. Market-based transfer prices give top management a reasonably good picture of the contributions of the individual divisions to overall companywide profitability.
Chapter 22 Internet Exercise
The Internet exercise is available to students only on the Prentice Hall Companion Website www.prenhall.com/horngren. Students can click on Cost Accounting, 11 th ed., and access the Internet Exercise for the chapter, which links to the Web site of a company or organization. The Internet Exercise on the Web will be updated periodically so that it is current with the latest information available on the subject organization's Web site. A printout copy of the Internet exercise for this chapter as of early 2002 appears below. The solution to the Internet exercise, which will also be updated periodically, is available to instructors from the Companion Website's faculty view. To access the solution, click on Cost Accounting, 11th ed., Faculty link, and then register once to obtain your password through the online form. After the initial registration, you will have a personal login ID and password to use to log in. A printout of the solution to the Internet exercise for this chapter as of early 2002 follows. The exercise and solution provide instructors with an idea of the content of the Internet exercise for this chapter.
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Internet Exercise (Cont’d.) Transfer pricing may be one of the most important tax issues facing multinational corporations today. PriceWaterhouseCoopers (PWC) is one of the world’s largest consulting firms, with more than 150,000 employees in 150 countries. Its Global Tax Services practice provides transfer-pricing consulting services throughout the world. Go to PWC’s main sitemap at http://www.pwcglobal.com/gx/eng/main/sitemap/index.html, and click on the “Global Tax Services” link, followed by the “Transfer Pricing” link. 1. 2. What is transfer pricing, and why is it increasingly important? Use the Quick Search box, and search for the article, “Transfer pricing––a key asset in the "Noughties.” Read the article then answer the following questions a. Why has e-business had an impact on transfer pricing? b. What impact has e-business had on the supply chain? c. Explain how intangible assets such as Web sites, information, concepts, and customer channel lists provide tax-planning opportunities. d. The “arm’s length” transaction is the guiding principle applied by most tax authorities when evaluating intercompany transfer prices. What is the “arm’s length” principle, and why is it difficult to apply to e-business? 3a. The article provides an example of tax-planning opportunities associated with developing an Internet Web site to sell computers. What tax rate would be applied to profits earned by Computer Company if the Web site is located in Ireland? What if the Web site is located in the United States? 3b. Although tax considerations are an important factor when structuring transactions, tax authorities will disallow transactions if they lack economic or commercial substance. Use the Computer Company example to explain what this means. 4. Use the Quick Search box and search for “My Name is Peter Algar.” This link provides a brief description of a typical day of a third-year consultant in PWC’s transfer-pricing practice. What two factors accounted for the strong profits in New Zealand? Solution to Internet Exercise 1. Transfer pricing refers to all aspects of pricing arrangements between related business entities. It applies to intercompany transfers of both products and services. Transfer pricing is becoming increasingly important because of the rapid growth in cross-border intercompany transactions, and because of their increasing complexity. In addition, tax authorities are requiring greater documentation, and are imposing stricter penalties for noncompliance. 2a. E-business is offering companies of all sizes access to new channels for the delivery of products and services. Increasingly these channels are cutting across national boundaries, and more medium-sized businesses are entering international markets that were previously out of reach. This development is driving up the number of international-related party transactions and raising a host of transfer pricing issues. Issues center around how and where profit should be taxed.
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Internet Exercise (Cont’d.) 2b. Geographic proximity is playing a diminished role in the structure of supply chains. For example, a primary distribution site can now serve more geographic markets, and this has enormous transfer pricing and international tax implications. 2c. These intangible assets are relatively portable, and there may be opportunities to move these assets to more tax efficient jurisdictions. 2d. In applying the ‘arm’s-length’ transaction principle, tax authorities asked if the remuneration received in a transaction is what would have been received had entities been operating independently. Several factors make the arm’s length transaction principle more difficult to apply to e-business transactions. First, it’s often difficult to identify the intangible assets in an exchange. Second, tax authorities must decide when intangible assets become valuable, and how profits should be split between entities. 3a. If the Web site is located in Ireland, Computer Co. will face a 10% tax rate. If the Web site is located in the United States it will face a 40% tax rate. 3b. To stand up to tax authorities, transactions must have a commercial substance. For example, if U.S. employees developed the Computer Co. Web site with a U.S. company incurring the cost–– which was subsequently transferred to a shell company in Ireland –– then there is a risk that tax authorities will ignore the form of the arrangement, and effectively allocate the asset and its associated profits to the U.S. company for tax purposes. 4. The two factors are the significant expenditures the New Zealand business made on marketing and the huge growth in the industry in which it operates.
Chapter 22 Case
INFORMATION SYSTEMS CORPORATION: TRANFER PRICES AND GOAL CONGRUECE 1. You may wish to begin the class discussion by asking the first assignment question, “Why do you suppose this plant’s costs are higher than competitors’ market prices?” The most obvious reason is the current idle capacity. Because most costs are fixed, the full cost per unit increases as capacity utilization declines. While this explanation explains a large portion of the current problem, it does not explain why the plant’s costs were higher than competitors’ prices when the plant was operating at capacity (a few years ago). There are three explanations for the latter problem. First, the competitors in the industry employ “forward pricing.” This term, also known as “experience curve pricing” or “volume pricing,” refers to a practice of estimating the average cost to be incurred over several years and pricing the product to earn a profit relative to the projected average cost. In the early periods of production of a new product, this approach means pricing the product below the actual manufacturing cost. The second explanation is more subtle. Note that for several years, the semiconductor division was the company’s only source of RAMs. There was no competition. Without competition there was no strong pressure to be cost effective and unnecessary costs had crept into the process. Third, students may argue that the non-U.S. suppliers of RAMs were dumping their products––selling RAMs in the U.S. at a price below the market value in the country of its creation. U.S. semiconductor manufacturers have charged nonU.S. competition with dumping. 22-46
Case (Cont’d.) 2. There are a number of possible alternatives for establishing an appropriate transfer price for interdivisional transfers. (a) Some of these are based upon cost and would continue to have many of the problems already identified by management. (b) However, since there is an existing outside market for much of the site’s output, a market-based price may be appropriate for the plant’s standard output. (c) The remaining unique proprietary production could be transferred at some “negotiated” market price to maintain a consistent set of measurements throughout the site. Furthermore, use of a market-based price is more in keeping with the concept of profit center responsibility as practiced in most decentralized companies. An income statement can easily be created that would allow management to measure its results against the competition rather than relying solely on measurements that compare actual results to plans or to prior periods. 3. Students are likely to make arguments in support of each of the three alternatives identified in requirement 2. Student comments should make the following points. (a) Some discussion of the general guideline described in Chapter 22. The case facts appear to describe a competitive market for RAMs and idle capacity at the plant. The minimum transfer price in this case is the outlay (variable) costs at the plant. In the short run, Information Systems Corporation (ISC) as a whole benefits if the variable costs at the plant are less than the market price and the purchasing divisions purchase RAMs from the plant rather than from outside suppliers. This outcome will be achieved if the transfer price is set between the plant’s variable costs and the market price. (b) Using current full costs (which are greater than the market price) as the transfer price appears to be a poor choice. This approach will lead purchasing divisions to buy RAMs from outside suppliers. Purchasing from outside would be suboptimal from the viewpoint of ISC as a whole if the variable outlay costs of making RAMs inhouse are less than the market prices. Furthermore, ISC will be unable to evaluate the profitability of the semiconductor division. Is the division worth keeping or should it be shut down and all RAMs purchased from outside? (c) Some discussion of using market prices as transfer prices. The advantage of transferring at market prices is that buying divisions will be willing to buy from the semiconductor division. Management can then evaluate the division’s competitiveness over a period of time. If the division cannot recover all its costs, ISC may be better off shutting down the division and buying all RAMs from outside suppliers. The industry practice for pricing semiconductors is forward pricing based on average costs over a period of years. With such a pricing scheme, there might be a period of loss in the initial years that will be recouped with profits in the future. The average price should permit a gradual recovery of initial start-up costs. Thus, the “buyer” immediately benefits from the projected improvements and also has a sense of commitment from the site that the published price will prevail over a period of time. 22-47
Case (Cont’d.) Using market prices will also result in variable profit markups, depending on the uniqueness of the product. Market prices will yield greater margins on unique items and lower margins on the higher volume, standard products. Naturally, this approach will provide a more attractive base business to support future activities. Using market prices as transfer prices is problematic if the market prices represent temporary “distress prices.” Students who believe that low prices arose as a result of “dumping” activities by foreign companies may argue that these low prices are unlikely to continue. This is a reasonable argument though most of the evidence suggests that low RAM prices are more the result of learning curve effects, long-term excess capacity, technological advances, and forward pricing rather than dumping. Consequently, low market prices for RAMs are likely to prevail over a long period of time. On balance, it appears that market prices are the best choice of transfer price for RAMs at ISC. What the Firm Actually Did The site controller recommended that the site adopt a market-based interdivisional transfer price for its production. This transfer price would enable the “buying” product managers to view the site like the semiconductor industry. In keeping with this strategy, the site would commit to its prices, monitor their competitiveness, have variable markups by product, and offer flexible terms and conditions. These terms and conditions included minimum order quantities to assist in stabilizing production and bring about further cost improvements. Three types of price categories were established: 1. Prices for functionally substitutable products are based upon competitive product prices, as long as a profit can be achieved over the lifetime of the product. This forward pricing technique enabled the site to take advantage of technology learning curve effects and optimize capacity. 2. Unique products have a price developed on a cost-plus approach, but, once again, they are forward priced over the life of the product. 3. Finally, products which are hybrids between being functionally substitutable and unique, are priced with both techniques and are subject to negotiation. To accommodate these changes, the accounting system was modified to model the consumption of the site’s production throughout the corporation by major product. The percentage of interdivisional profit for each product was developed by the site accounting organization and eventually eliminated by the corporate accounting consolidation staff, based upon shipment information provided by the site each month. As “buyers,” product managers saw only the established transfer price in their costs and income statements. The resulting model was highly complex and required considerable programming and systems effort to make it usable. Nevertheless, the model was installed, reviewed with the appropriate state tax authorities and external auditors, and implemented within a year after the decision to adopt the market-based transfer price. The site management has adopted the new measurements and has moved aggressively to compete for its “lost” marketplace.
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doc_735713076.doc