ACT503 Chap.12 Management Control and Transfer Pricing
Management Control and Transfer Pricing
Control systems and the standard they are judged against
A management control system is the means by which an organisation gathers and uses information to aid and coordinate its planning and control decisions and to guide the behaviour of managers and employees.
It includes the formal apparatus of budgets, responsibility reports and performance measures, and the informal shared norms that decide what people do when no report is looking.
It is judged on goal congruence, meaning whether the decisions that make a manager look good are also the decisions that make the organisation better off, and on effort, because a perfectly congruent system that gives no reason to work produces nothing.
Almost every criticism in this chapter is a failure of the first: a measure that rewards a division for doing something the group would rather it did not.
Decentralising buys four things and costs four things
Pushing decisions down produces faster response where the local information is, develops managers by letting them run units, motivates by pairing authority with accountability, and frees the centre for strategy.
It costs suboptimal decisions that suit a division rather than the group, duplication of functions the centre could have run once, the expense of gathering and reconciling information across units, and the loss of a group wide view at the point where trade offs are made.
Transfer pricing exists only because of that second column: if a firm were centralised, no manager would be measured on a result an internal movement changes, and nobody would need to price it.
Four methods, one general rule, and the capacity question
A transfer price is what one subunit charges another for a product or service.
Nothing enters or leaves the group when a transfer happens, so the price cannot create value and can only change the behaviour of two managers measured on their own results. Market based, cost based, negotiated and dual pricing each solve part of the problem and break in a different place, and a full cost transfer price is the most examinable failure because it turns the supplier's fixed cost into the buyer's variable cost.
The general rule sets the minimum acceptable price at incremental cost to the point of transfer plus opportunity cost, and the second term is almost always either the contribution forgone on an outside sale or zero, which is why capacity decides most transfer pricing answers.
What this chapter covers
- 01
What a management control system is, formal and informal
- 02
Goal congruence and effort as the two standards
- 03
Four benefits of decentralising and the cost beside each
- 04
Why transfer pricing exists at all
- 05
Market based, cost based, negotiated and dual pricing
- 06
Why a full cost transfer price distorts a buyer's margin
- 07
The general rule: incremental cost plus opportunity cost
- 08
The bargaining band, and when it is empty
- 09
Taxes, tariffs, currency restrictions and the arm length principle
Apply the general rule under two capacity states
- 3The minimum acceptable price at full capacity, with both terms named.
- 3The group decision at full capacity, argued in group terms.
- 3The same two answers with spare capacity, and the size of the swing.
Key terms
- Management Control System
- The means by which an organisation gathers and uses information to aid and coordinate planning and control decisions and to guide behaviour. It covers both the formal reporting apparatus and the informal norms that operate when no report is looking.
- Goal Congruence
- The condition in which the decisions that make a manager look good are also the decisions that make the organisation better off. It is the standard against which every measure and every transfer price in this chapter is judged.
- Transfer Price
- The price one subunit charges another for a product or service supplied internally. Because nothing enters or leaves the group, it cannot change group profit directly and can only change the behaviour of managers measured on their own results.
- Dual Pricing
- An arrangement in which the supplying division is credited at one price and the buying division charged another, so that each sees the figure that makes it decide correctly. Its cost is that divisional results no longer sum to the group result.
- Arm Length Principle
- The expectation of revenue authorities that a transfer price between related parties matches what unrelated parties would have agreed, and that the basis for it is documented.
- Negotiated Transfer Price
- A price the two divisions agree between themselves. It preserves autonomy and produces a figure both can live with, at the cost of management time and the risk that bargaining skill rather than economics settles it.
Management Control and Transfer Pricing FAQ
Why does a transfer price matter if nothing leaves the group?
Because two managers are each measured on their own result, so the price is revenue for one and cost for the other and decides which of them looks good. It cannot create value, but it can make a division decline work the group wants taken or accept work the group would rather it refused. That is why the subject is taught as a control problem rather than as a costing one.
What is wrong with transferring at full cost plus a markup?
The buying division treats everything it is charged as varying with the quantity it takes, because to that division it does. So the supplier's fixed cost and markup enter the buyer's marginal calculation, both are irrelevant at group level, and the buyer correctly declines orders the group wanted accepted. The decision is rational at the division and wrong at the group.
How does spare capacity change the minimum acceptable price?
It removes the opportunity cost term. At full capacity a transfer displaces an outside sale, so the floor is incremental cost plus the contribution forgone, which usually equals the market price. With spare capacity nothing is displaced, so the floor falls to incremental cost alone and a wide bargaining band opens between that and whatever the buyer would pay outside.
What changes once the two divisions are in different countries?
The price starts to determine where profit is reported and therefore how much tax is paid and where. Import duties are assessed on the declared value, so a price chosen to reduce tax can raise tariffs, and some jurisdictions restrict repatriation of cash. Revenue authorities expect a price unrelated parties would have agreed, and expect it documented, so the operating answer and the tax answer are often different numbers.
Exam move
Work one transfer pricing scenario three times, at full capacity, with ample spare capacity, and with spare capacity covering only part of the order. The third version is the one examinations use and the one that is almost never practised, because it is the only version where the floor is not a single number.
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