Ch. 22 Notes - Copyright © Rowland Atiase, 10/21/09...

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Unformatted text preview: Copyright © Rowland Atiase, 10/21/09 Chapter 22 BECENTRALIZATION & TRANSFER PRICING l. introduction This chapter examines the nature of Decentraiization, Profit Centers, and Transfer Pricing. (The next chapter, Chapter 23, concentrates on investment centers, whereby profits are related to the investrrients in subunits of an. organization.) The chapter also integrates all aspects of management accounting: Product costing, manning & Control, and Non— Routine Managerial Decisions. 11. Decentralization & Organization Structure As organizations grow, managers face two continuing problems: (a) Division of Responsibility (b) Coordination of Subunits The essence of Decentralization is flawém é I‘m/Ice Jam's/hm; out {ow @qu of or ' 'a Three Aspects of Decentralization (1) Granting of Authority (2) Duties are Assigned (3) oni as nuSi/Jf/Hy Decentralization is a matter of Degree Total Centralizaticn I Extreme Decentralization Problem of (mfgrmgfijom Problem of Coocé'fl'on Proceggizg Saabw' In practice, there is rarer either extreme centralization or decentralization. (i) Extreme Centralization — Problem of infomation Processing & Decision Making (ii) Extreme Decentralization — Collection of completely Separate Units creating Problem of Coordinating (Ideally, subunits should contribute not only to the success of their organizations but to the success of each other.) The optimal amount of decentralization is the amount that attains top managements overall objectives most efficiently and effectively. Killing a fly with a sledge hammer may be EFFECTIVE but NOT EFFICIENT. (One of my Fall “1993 students, Connie Ng, describes Effectiveness as "Doing the right thing" & Efficiency as "Doing it Right." Another former student ~ Robert Palm of my Spring 1996 class noted the same-clitote was made in a book “Leadership is an Art” by Max Drynce - CEO of Merman Miller Co.) (a) Benefits of {lecentralization (Dec) Claimed Benefits of Dec. (b) Costs of Bee The largest cost of Dec is (probably) Dysfunctional Decision Making (DDM). 5 g 347 MAME W 0'; $142 Sméfiw\7’ is mfg M “figsap 5;, M (051': or less of bwefi¥~ we» eta 6a” laws or we common as « wee/er DDM implies Lack of GMoagmence. a .M—m-n-mm-m. Causes of DEM (a) Performance Measurement/Incentives — particularly where there are strong interdependencies (b) (Divisional) Autonomy Grganization Structure (21) Horizontal Integration For CXamF/€( WW at J’W/ gjfvrg “aroma: flaws“; I W- Hers, (b) Vertical Integration 7%»: a a ~Ww1€mw “I 4" Eh”? Pmlm'f“ (F) Ja/gpfiw 07f #5 /Wf‘&rm_e.d4‘¢.k P P 4‘?”"*r.5 (Ml/um ,‘H W CLOMOme'cS a} [34.5.1(WM Lining c) (be. Forme Liwkcwja) I We will be focusing on Vertically Integrated Decentralized Organizations. Division A manufacturers an intermediate product (IMP) that can be sold on the IMP Market (Mkt) or transferred (i.e., sold internally) to Division B where the IMP is processed further into a Final Product (F 1’) and sold on the FP Mkt. l . FF ‘ PP Mkt Div 3 IMP IMPMkt Div A Note: There are 2 332M mega—of: g 1 fflifimf’e WM iii. Ohieetives of Transfer Pricing Transfer Prices are the monetary values assigned to goods and services exchanged among subunits of an organization. Transfer Pricing is not unique to decentralized Organizations that are Vertieaiiy Integrated. A Centraiiaed Organization might impose transfer prices based on, say, std costs, and might require all purchases or sales of particular items to be made internaiiy. In contrast, a Decentralized Organization might let managers of the seiiing & buying divisions negotiate their prices and might ailow the managers the alternative of buying and selling the IMP on the Gutside (IMP) Market. Transfer pricing also occurs in Horizontain integrated Organizations e. g, Austin Toyota has customer for a Toyota Supra— Biack with pink stripes but does not have the car. Georgetwon Toyota has the car but no customer. At What price should the car he transferred from Georgetown Toyota to Austin Toyota? However, the richest cases of Transfer Pricing are seen with the context of Verticaliy Integrated Decentralized Organizations. Transfer Price information affects many critical decisions concerning the acquisition and allocation of an organization‘s resources. Ideally, Transfer Prices (TP) should guide each manager to choose his inputs and outputs in coordination with other subunits so as to maximize the Profits of the Organization as a whole. But the potential conflicts between the 3 problems of (i) Goal Congruence, (ii) Performance Measurement, and (iii) Autonomy have to be considered. (9pr 7" MC {— 0”; C034» 7 IV. Generai Rule for gflptimaig Transfer Price (PP) The Mar/Min '53? should be: (a) incremental Costs (EC) per unit (Also caiied Additional Outlay Costs (OLC) ) incurred to the point of transfer (often) approximated by Variabie Costs (VCS). plus (b) The Opportunity Costs (Opp Costs) per unit to the supplying division. Why? 72”? 1‘5‘fi‘iflVffie WW Okveirtah‘fy We +44 may [(VL) OLIVfSI&VL fetid/W as sfb 50% m WI) “(erg ' . . e/J Wtstdg a, ownsiage n 56W ‘ 1-4- .5“ If”! CM {or paw-914‘}:- wawcaé' / M “awed? {I'M Aug-Mar Milli/c . > Le m incrementai Costs (EC, in this context) is the additional costs of producing and transferring the IMPS. Opportunity Cost (Opp Cost) ——~ May be defined as iggiqflifl CW8 by the supplying division if the IMPS are transferred internally. These may be foregone CMS or even foregone net proceeds from the sale of facilities in other instances. Note: To apply the general rule, VCS are easiiy determined. Thus the critical aspect of determining the optimai T? is the Opp Cost (per unit). However, the Opp Cost is a function of (Le, depends on) the nature of the IMP Market (Mkt) IVA. Case I Perfectly Competitive IMP Mkt 5.3/11 # Mkt P =1” - If the IMP Mkt is Perfectly Competitive (and interdependencies among subunits are minimal) then Division A can sell as'many units as it can produce at the Mkt price 3 MR = SP/a, and (over the relevant range) the OLC m VC/L‘i is constant. Hence the OPP Cost per unit = CM/u = (Mkt P -— ' ‘ VC/u); Thus applyirig thegeneral rule. The Max T? = VC/u, 1' Om, 'Cos+‘ = VC/u + CMk-t P » vc/i) m Mm P Here then, Mid; Prices are the most desireable TPs because they‘ll generally lead to optimal decisions. Also there are no inherent problems of 3 problems of Decentralization noted above. In sum, if a Division A’s participation in the Mid; has no effect on prices (Le, Perfectly Competitive IMP Mkt), Mkt Prices typically establish the CEILING (01* MAX) for TP. Negotiated Mkt Prices (Optional) IVB.Caee II Imgerfeefly Competitive IMP Mkt The problem of TP would be simple if all IMP Mkts were Perfectly Cempetitive but too often, the IMP mkts are: (a) None—existent (b) Ill~structured or (o) Imperfect imperfect Competition exists (in the extreme case) when one seller one t ) or Buyer ( Mgmogsomglgl — acting alone can exert an influence on the market price. Q! Q2 Q If the IMP Mkt is imperfectly competitive, the Quantity of IMPS sold can be increased from Q1 to Q2 only if the Selling Price is reduced from P1 to P2 for all the Q2 units. Kn General, Whether the New Total Revenue (P2Q2) will be greater than, equal to, or less than the Diet Total Revenue (PlQl) will depend on the elasticity of the Demand Curve (DD). W~Mfl mum—H.- “aw—u—Muwwmm—wm-mm 10 Here then, the optimal TP from the point of the company (Co) as a Whole becomes complex and depends on the existing Interdependencies. (a) Cost (Technoiogicai) Interdependency (b) Demand Interdependency (a) Cast Interdependency For example: increase in the Sales of the Buying Division B leads to a decrease in the Average Cost of the Selling Divisions A. (b) Demand Interdependency For example: Increase in the Market Share of Division B Reads to a decrease in the Market Share of the sellers of the Final Product and thereby decreasing the demand for the IMP in the IMP Mkt and reduced Profits of Division A. Here — There is not :1 TP, rather there is a schedule (if TPS (21 TP function) for various quantities. 11 Case HA Fuii Capacity (with no incentive to reduce Qty and increase price or No evidence thee price can be increase.) Let, Q1 == Physical Capacity = (2130 P}. m Mk1: Price, V = VC/u. QIZQPC Q Here, Opp Cost/unit = Mkt P — V. Therefore, The Max T? = V + (Mkt P — V) a 9 a We sawikcfly Ceme Z Mkt F‘cwrkbf (Same as Case I) (See eg. P22 — 28(1).) 12 Case RB Idle Capacity with No Alternative Use Q1 anQPC - Q M r 144:, me; Let: Qpc m Q2 W W Current Production (Vp) & Sales (Vs) m Q1. Then, Q2 — Q1 2 The Units of Idle Capacity. if Division A has Idle capacity and there is No Alternative Use of the facilities (i.e., the amount of idle capacity), then the Opp Cost on the Units ofIdie Capacity is ZERO. Thus Applying the General Rule: The Min TP m V + 0 = V i.e., The Fioor is V. But this has the problem of incentives for the supplying Division A. (See e.g., P22 ~ 28(2)) Case EEC Idle Capacity But with Alternative Use. Q1 QZmQPC Q Let, Q2 2: Qpc Q1 = The Original Vp & VS Then, Q2 " Q} 2 Mil“ 47L 0H6 Jr'pr [dd/.5 CaFQGV-V But if Revenue and Profits can be increased by reducing price to P2 and increasing Qty to Q2 then the Opp Cost per unit equals the incremental Contribution Margin per unit. (Original) TCMlm P; Ci" —~ G. v (New) TCM2= I07, (3’; ~ QLV’ Incremental TCM= (F; Q1 - P‘@> ., (Q Q > V I 7- "— I Total Opp Cost m Inc TCM m Inc. Revenue - Inc. VCs Opp Cost Per unit = {(P2Q2 - KOO/((22 — (21)} - V m Marginal Revenue (MR) n V m MR " \/ Therefore, applying the General Rule The Max T? = W Owe V) 2 MR (See e.g., 9224290)) 13 14 Case 11M Idle Capacity with Partial Alternative Use Q1 Q2 6“) QsfiQr-o Q Leta Q3 2 Qpc Q “L” The Original Vp & Vs. Then,Q3 - Q; = ' Am! 50+” 0H9 {Md MA:- Cdpaalfiy Suppose (Total) Revenue & Profits can be increased by reducing Price to P2 and increasing Qty to Q2. However; if there is no incentive to increase Qty beyond Q2 (or there is no demand for the final (Q3 — Q2) units of the IMP), then the Amt of Original Idle Capacity (Q3 - Q1) should be split into: (a) The amount of idle Capacity Persisting after Aiternative Use = (Q3 ~ Q2) (1)) The Amt of (Partiai) Alternative Use = (Q; — (2;) (1.) For the units in (a), Same as ID?» The Min TP = V L (2) For the units in (1)), same as fl'é The Max TP = MK Question: Suppose Units in (a) and (b) are equal. Which units would you consider transferring first? Answer: (Am? i a) 5/6 7PM a o r‘ casf m v‘fiese Mails 5: Zero (See e.g., P22 - 29(2)) F? We PW DW 15 Practicai Approaches to TP Sometimes Mkt Prices or Marginal Revenues (MRS) are either unavailable, inappropriate or too costly to be used for TP. But even when data on Mk1; Prices and MRS are available, recall that in Section IV, Optimal TPs were specified as being the Maximum or Minimum. At these extremes one of the Divisions (A or B) may have little incentive to act in a Goal Congment manner. We now examine some practical approaches to Tl), some of which can be used to compiement the theoretical approaches described in Section 3V. Note: Nearly every version of T? has some drawbacks. (a) Full (Absorption) Cost (1) Actuai Absorption Cost (AC) if the TP is based on the Actual Absorption Cost of Div. A, the performance of receiving Division (B) will bear the accumulated efficiencies and inefficiencies of the supplying Division (A) which is not subject to the control of Division B. Standard AC may avoid or minimize the problem of transfer of variances. However, T}? based on even standard AC may still lead to sub—optionai decisions if Division A has idle capacity. 16 Example Division A Division B Std VC/Additional Processing Cost :$3 $4 Std F OH 2 Std AC 5 SLR/u 6 8 Amount of idle capacity 100,000 units. If the TP is set at the standard AC of Division A (Le, $5), Division B will refuse to buy from A because its Divisional Profits will worsen at a rate of $1/unit. But will the transfer be in the interest ofthe company as a whole? Yes. Pro~F0rma Statements 1X $100,000: Div. E Co. as a whole Additional Revenue 8 3 Additional Costs TP - Div. A 5 VCA '3 Std vc — Div. B g Q) veg i Std CM . Li; I This is a clear example of the lack of goal congruence or DDM that is induced by a TP based on (Std) Absorption Cost. 17 (B) Prorating the Overall Contribution Margie One popular solution to ensuring that goal congruence is achieved in the example above is for central management to impose a Std VC Transfer Price but credit each Division with a Prorated Share of the Overall Contribution to Corporate Profits. Note, however, that the basis of proration has to be negotiated. Suppose units to be transferred is 100,000 and 1, unit of IMP is needed for 1 unit of HP. Sales of F? @ $8 $800,000 Std VC; A $300,000 B @9300 299M Overall CM' If the basis of proration is in the ratio o£__Std VC incurre then: Div A's share *3 3/7 x $100,000 = M"; Div B‘s share W 4/7 X $100,000 = M This way Div A would be willing to transfer at $3, knowing that the transfer would improve its showing as a profit center, particularly if the Division A's sales to the outside IMP Mkt will not be affected i.e., idle Capacity or Market Segmentation. pecan/baa“: A955 97L mhb’I—cwm/ 18 (C) Buai l’rieiog The seeming harshness of the foregoing authoritarian approach . in (B) (i.e., central management directive) can be modified if the organization recognizes that it is not necessary to have a single TP. Dual Pricing involves (1) One T? = VCA = $3; for the economic decisions of Div. B (2) Another T P m SPA m $6; for the performance measurement of Div. A (3) Debit a corporate account for the difference the two TPs $3 ($6 - $3). Pro Forma Statement {x $100,000! Div A Div B Co. as a Whole Saies ("one 6’ Std Va 3 3 __ +51 2 £32. (Std) CM ; i .1... m However, 2‘. Divisional Profits > Profits of Co. as a Whole. Thus the problem with the Dual Pricing Scheme is that both Divisional managers Win (i.e., Div A gets credited with its fuil selling price, and Div 8 gets charged a low price for the IMP). But the company as a whole may lose in the long run particularly if both managers get less conscious of cost control. 3K “SC TF5 AV W D'V- fir fitrfprmmrvf WaurW Via Vii. 19‘ Taxes and Tariffs Differences in domestic and foreign subsidiary tax laws, tariffs, state fair trade laws and legality of international transfers may well influence the choice of a TP. For example, to minimize tariffs and domestic income taxes, a company may want to set an nflsnaflx. low selling price (i._e., T?) for a domestic division that ship goods to ,H_w..Mm._.MV,._~A»-— "=._....,.. a foreign subsidiary (i.e., Underinvoieing). The opposite will be true for Investment Tax Credit (i.e., (Bverinvoieing). Accounting Entries for Transfers Transfer Pricing is governed by managerial objectives - e.g., performance measurement, minimizing taxes, and controlling the rate of return. These objectives often lead to transfers in excess of the conventional historical cost used for external reporting. Thus although intracompany transfers may be accounted for and reported in a manner that helps achieve managerial objectives, intra company profit margins (and related Afi & MP) should be eliminated periodically when consolidated financial statements are prepared. 20 Survey Resuits Homgren (1982, p. 634, Le, 5th Ed.) reports that survey of 291 companies revealed that 85% transferred goods internally among ‘ pro-fit centers. The average value of such transfers amounted to 13% of the total companies' cost of goods soid TP 2 VCs by 5% of the Companies (Cos) TP m AbsorptiOIrCost by approx. 25% of Cos. . TP = {Mkt Price, MR, Negotiated Mkt Price or Cost Plus} by approx 70% of Cos. The fact that over 2/3 of companies use the more cumbersome methods of TP suggest the care with which such prices are arrived at and their importance in motivating profit center managers. PROFESSOR ROWLAND K. ATIASE DECENTRALIZATION & TRANSFER PRICING 21 Chapter 22 _ DECENTRALIZATION & TRANSFER PRICING I. Introduction 11. Decentralization & Organization Structure [11. Objective of Transfer Pricing (TP) IV. General Rule for Optimal TP (A) Perfectly Competitive IMP Mkt (B) lmperfectly Competitive IMP Mkt V. Practical Approaches to TP (A) Full (Absorption) Cost (B) Proration of the Over all CM (C) Dual Pricing VI. Taxes & Tariffs VII. Accounting Entries ...
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Ch. 22 Notes - Copyright © Rowland Atiase, 10/21/09...

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