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Chapter 14

COMM-2016EL Chapter Notes - Chapter 14: Profit Center, Transfer Pricing, Historical Cost


Department
Commerce and Administration
Course Code
COMM-2016EL
Professor
Kayla Levesque
Chapter
14

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Chapter 14 Management Control in Decentralized
Organizations
Centralization vs. Decentralization
BENEFITS
Lower-level managers have the best information concerning local conditions and therefore may be able
to make better decisions than their superiors
Managers acquire decision-making ability and other management skills that help them move upward in
the organization, assuring continuity of leadership
Managers enjoy higher status from being independent and thus are better motivated
COSTS
Managers may make decisions that are not in the organization’s best interests; either because they act to
improve their own segment’s performance at the expense of the organization’s or because they are not
aware of relevant facts from other segments
Managers in decentralized organizations also tend to be duplicated services that might be less expensive
if they were centralized (such as accounting, advertising, etc.)
Costs of accumulating and processing information frequency rise because responsibility accounting
reports are needed for top management to learn about and evaluate decentralized units and their manager
Managers may waste time negotiating w/ other units about goods/services one unit provides to the other
MIDDLE GROUND
Decentralization is most successful when an organization’s segments are relatively independent of one another
– that is, the decisions of one manager will not affect the fortunes of another manager
Segment Autonomy – the delegation of decision-making power to segment managers
If management has decided in favour of heavy decentralization, segment autonomy is crucial
For decentralization to work, however, this autonomy must be real, not just lip service
PROFIT CENTRES AND DECENTRALIZATION
Do NOT confuse profit centres (accountability for revenue and expenses) with decentralization (freedom to
make decisions). They are entirely separate concepts
Some profit centre managers possess vast freedom to make decisions
In contrast, other profit centre managers may need top-management approval for decisions
Transfer Pricing
When segments interact greatly, there is an increased possibility that what is best for one segment hurts another
segment enough to have a negative impact on the entire organization
Transfer Prices – the amounts charged by one segment of an organization for a product/service that it supplies
to another segment of the same organization
PURPOSES OF TRANSFER PRICING
Transfer-pricing systems exist to communicate data that will lead to goal-congruent decisions and evaluate
segment performance, thus motivating the selling manager & buying manager toward goal-congruent decisions
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A GENERAL RULE FOR TRANSFER PRICING
Transfer Price = Outlay Cost + Opportunity Cost
The outlay cost is the additional amount the selling division must pay to produce and transfer a product or a
service to another division. It is often the variable cost for producing the item transferred
The opportunity cost is the maximum contribution to profit that the selling segment forgoes by transferring the
item internally
EX. Suppose the selling division’s opportunity cost arises because it can get $10 for the subcomponent on the
market. Thus, the contribution from selling on the market is $4. At any transfer price less than $10, the division
is better off selling the subcomponent on the market rather than transferring it
Thus, the minimum transfer price we would accept is $6 outlay + ($10 - $6) opportunity = $10
Consider how much the item is worth to the buying division… For it to be profitable, the company must be able
to sell the final product for more than the transfer price plus other costs it must incur to finish the product
Transfer is desirable if the total cost to the company for the item is less than its value to the company AND the
selling division’s costs are less than the price the buying division would have to pay to an outside supplier
The 3 most popular transfer-pricing systems are:
1. COST-BASED TRANSFER PRICES
Approximately half of the major companies in the world transfer items at cost. However, there are many
possible definitions of cost
Some companies use only variable cost
Others use full cost plus a profit mark-up, with some using standard costs and others using actual costs
When the transfer price is some version of cost, transfer pricing is nearly identical to cost allocation. However,
two important points differ:
Transferring or allocating costs can disguise a cost’s behaviour pattern
Other problems arise if actual cost is used as a transfer price
oActual cost cannot be known in advance; thus, the buying segment will not be able to plan costs
oBecause inefficiencies are merely passed along to the buying division, the supplying division
lacks incentive to control its costs, thus, using budgeted/standard costs is recommended
2. MARKET-BASED TRANSFER PRICES
If there is a competitive market for the product/service being transferred internally, using the market price as a
transfer price will generally lead to the desired goal congruence and managerial effort
EX. A tent requires 5 m2 of special waterproof fabric. Should the Tent Division obtain the fabric from the
Fabric Division of the company or purchase it externally?
The market price of fabric is $10 per m2, or $50 per tent, and the Fabric Division can sell its entire production
to external customers without incurring any marketing/shipping costs. The Tent manager will refuse to pay a
transfer price < $50 for the fabric for each tent (will not sell 5 m2 of fabric for less than $50)
Now suppose that the Fabric Division incurs a $1 per square metre marketing and shipping cost that can be
avoided by transferring the fabric to the Tent Division instead of selling externally. Most companies would then
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