MV Chapter 7

five primary types of transfer prices

- Market-based transfer prices - Marginal-cost transfer prices - Full-cost transfer prices - Negotiated Transfer Prices - Variations transfers at marginal cost are rarely used and that most companies internally transfer goods or services at either market prices or variations of full costs ("cost-plus" - full cost plus markup)

The transfer pricing problem

Transfer prices directly affect the revenues of the selling (supplying) profit center, the costs of the buying (receiving) profit center and, consequently, the profits of both entities zero-sum: more revenue for one is more cost for the other When the amount of transfers is significant, failure to set the right transfer prices can significantly affect a number of important decisions (production quantities, sourcing, resource allocations, evaluations of the managers of both the selling and buying profit centers)

Investment centers

managers are held accountable for both some income statement and some balance sheet line items - both the accounting returns (profits) and the ___ made to generate them A corporation is an ___ - ___ managers, top-level corporate managers (including those of subsidiaries, operating groups, and divisions) Accounting returns (the center's bottom line) defined in ratios of profits earned to the investment capital used (ROI, ROE, ROCE)

Revenue centers

managers are held accountable for generating revenues - financial measure of output. if all revenues are not equally "endowed," controlling with a revenue center structure can encourage employees to make "easy" sales rather than those that are most profitable net revenue center if also held accountable for some expenses (salaries, advertising expense) not profit center because not charged for the cost of the goods or services they sell.

Cost (expense) centers

managers are held accountable for some elements of ___ - financial measure of inputs or resources consumed standard ___ (engineered ___): causal relationship between inputs and outputs are direct and easy to quantify (manufacturing departments); control standard cost - cost of the inputs that should have been consumed in producing the output discretionary ___ (managed ___): outputs produced are difficult to value in monetary terms (R&D and administrative departments); relationship between inputs and outputs is not well known; evaluations have a large subjective component, ensure adherence to budgeted level of expenditures firms often turn some "service departments" such as HR, into profit centers by allowing them to charge the other divisions for the services they provide (hiring employees or running training programs). works well if freedom to contract these services from external providers

Financial responsibility centers

responsibility centers in which the assigned responsibilities are defined at least partially in financial terms.

responsibility center management

the apportioning of responsibility (or accountability) for a particular set of outputs and/or inputs to an employee (usually a manager) in charge of an organizational entity (the responsibility center)

perfectly competitive market

the product is homogenous and no individual buyer or seller can unilaterally affect its price.

Negotiated Transfer Prices

the selling and buying profit center managers negotiate between themselves effective only if the profit centers are not captive to one another if large number of transactions - costly in terms of management time often accentuates conflicts between profit center managers, and resolution of the conflicts often requires mediation from corporate management. outcome often depends on negotiating skills and bargaining power

Dual-rate transfer prices

the selling profit center is credited with the market price (or approximation), but the buying profit center pays only the marginal (or full) costs of production double counts the profits the corporation earns on each transaction advantages: 1. managers receive the proper economic signals for their decision-making 2. ensures internal transactions will take place, possible to maintain a vertically integrated production process. disadvantages: 1. can destroy the internal entities' proper economic incentives (shielded from competition) 2. difficult to explain to profit center managers how the double counting has overstated entity profits 3. international - may wish to avoid alarming the tax authorities by the double counting and the retrospective adjustments to the accounts

Marginal-cost transfer prices

total contribution = selling price - marginal cost of the last production or service process stage unfeasible, can be standard variable cost centers at best (performance evaluation depends on the extent to which their actual variable costs for a given output are at or below the standard variable cost) The selling profit center will typically have to record losses because it bears the full cost of production or provision while receiving in revenue only the marginal costs. the profits of the buying profit center will be over- stated because it does not have to pay for even the full cost of the transferred goods or services.

Advantages of financial results control systems

1. paramount in for-profit firms: cash flows can create constraints for non-profit firms 2. summary measure of performance by aggregating the effects of a broad range of operating initiatives: enhances comparability, reduces conflicting signals; valuable for management of complex, diversified firms - management-by-exception; unobtrusive form of control 3. relatively precise and objective: measurement advantages over soft qualitative or subjective information and other quantifiable alternatives (e.g. quality or customer satisfaction measures). 4. cost of implementing is often small relative to that of other forms of management control: accounting information are routinely prepared for and can be readily adapted for control uses.

Purposes of transfer pricing

1. provide the proper economic signals so that the managers affected will make good decisions: influence the selling/buying profit center managers' decisions about how much product/service to supply/buy internally 2. provide useful information for evaluating the performances of both the profit centers and their managers: should not cause profits of either the selling or buying entities to be over/understated 3. ___ can be set to purposely move profits between firm locations: maximize after-tax worldwide profits, balance payments problems and a scarcity of foreign currency reserves, some governments prohibit repatriation of profits; Indirect restrictions: distorted exchange rates, high withholding tax rates; between wholly owned subsidiaries and entities sharing profits with joint venture partners; to an entity positioned for divestment. conflicting purposes - necessary tradeoffs. ___ interventions undermine the benefits of decentralization.

marginal costs plus a fixed lump-sum fee transfer prices

___ fee is designed to compensate the selling profit center for tying up some of its fixed capacity for producing products that are transferred internally. preserves goal congruence (additional unit transfers made at ___ cost), preserves information for evaluation purposes (selling division can recover fixed costs and profit margin through ___ fee), stimulates intra-firm planning and coordination must predetermine the ___ fee based on an estimate of the capacity that each internal customer will require in the forthcoming period: if incorrect, capacity will not be assigned to the most profitable uses; if selling entity changes __ fees - nearly identical to full cost production

Full-cost transfer prices (or full cost plus a markup)

advanatages: 1. provide a measure of long-run viability 2. relatively easy to implement because firms have systems in place to calculate 3. not as distorting for evaluation purposes since the selling profit center is allowed to recover at least the ___ of production or provision. rarely reflects the actual, current cost of producing the products or the services being transferred - poor cost-accounting systems that involve arbitrary overhead cost allocations do not provide an incentive for the selling profit center to transfer internally since they include no profit margin -understated profits, but __ plus a markup do __ plus a markup also provides a crude approximation of the market price that can be used in situations where no competitive external market price exists. But because the markup is internally set, such transfer prices are not responsive to changes in market conditions.

Types of financial responsibility centers

four basic types: investment centers, profit centers, revenue centers, and cost centers. distinguishable by the financial statement line items for which the managers are held accountable in each type of center. there can be considerable variation within each financial responsibility type: e.g., Four types of "profit" centers

management-by-exception

process of getting involved only when problems appear

profit vs. investment centers

profit center managers are held accountable for profits but not for the investments made to generate them.

Profit centers

managers are held accountable for some measure of profits - difference between revenues generated and costs of generating them whether a manager truly has profit center responsibility: significant influence over both revenues and costs? whether an entity is a profit center: whether goal is to maximize profits (non profit: to manage costs, make cost-revenue tradeoffs), revenues can be generated inside or outside the firm sales-focused entities: made into profit centers by charging the standard cost of the products sold - accountable for gross margin; decisions made are based on the incremental contribution cost-focused entities: are assigned revenues based on a simple function of costs; typically when manufacturing and administrative departments supply unique products or services to internal customers only; transmits market place competitive pressures to internal; micro profit centers or pseudo profit centers - no control over revenues, a way to charge the buying entities a cost-based approximation so that their profits are not overstated and can be compared with entities that source externally.

divisionalized organization

managers given authorities to make decisions in all, or at least many, of the functions that affect the success of their division each division is a profit or investment center comprised of multiple cost and revenue centers

Functional Organization

no manager has significant decision-making authority over both the generation of revenues and incurrence of costs, so revenues and costs are brought together in a return measure only at the corporate level cost centers: manufacturing, engineering, and administrative functions; revenue center: sales function

Captivity

not ___: the selling profit center has some possibilities to sell its product outside the company, and the buying profit center has some outside sources of supply ___ erodes bargaining power and undermines the negotiations.

Market-based transfer prices

optimal for decision-making and performance evaluation if a perfectly (or highly) competitive external market exists for internally traded goods or services under competitive conditions: - if selling profit center cannot profit by selling at the market price -shut down - if buying center cannot profit buying inputs at market price - shut down, have selling profit centers sell externally quasi market-based transfer prices: allows deviations (savings of marketing, selling and collecting costs, the costs of special terms)