Mdc Lecture 8
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Management Decisions and Control 22421/0
Management Decisions and Control Lecture 8 Organisational Structure, Management Control and Transfer Pricing 1
Lecture Objectives 2.
Aspects of Organisation Structure
4.
Contingency Theory of Management Accounting
6.
Why do Firms Decentralise?
8.
Role of Accounting in Decentralised Organisations
10.
Performance Measurement for Decentralised Units
12.
Transfer Pricing
14.
General Transfer Pricing Rules
16.
Who Determines Transfer Prices?
18.
Multinational Transfer Pricing and Tax Considerations
2 Management Decisions and Control 22421/0
Aspects of Organisation Structure Centralisation Centralisation refers to the locus of decision making in an organisation. A highly centralised firm is one in which decisions are made by senior executives, while a decentralised firm is one where authority flows down subordinates Formalisation Formalisation is the degree to which procedures are standardised in the organisation. It is operationalised through rules and regulations that govern employees’ behaviour. An organisations level of formalisation tends to be highly correlated with centralisation (Robbins & Barnwell, 1994) Vertical Differentiation Vertical differentiation relates to the number of hierarchical levels or depth of the organisation. Organisations that are centralised and formalised tend to have greater 3 levels in their vertical Management Decisions and Control 22421/0
Aspects of Organisation Structure How should organisations be structured?
Centralisation versus Decentralisation Bureaucratic versus Informal Structure
How should tasks be structured?
Specialisation (division of labour):
Functional Product Market Geographic (location)
4 Management Decisions and Control 22421/0
Contingency Theory of Management Accounting
Contingency theory suggests that there is no one best (or universal) way of organising
The effectiveness of the design of management control systems varies with its organisational contexts (environment, technology etc)
Instead of the individual perspective adopted in early behavioural research, contingency theory takes an organisational perspective. Ie, rather than studying the individual managerial behavioural response to management accounting controls, it looks at how the design of management accounting control systems affect organisational effectiveness, eg. how accounting systems:
Support organisational structure
Help implement a firm's strategy 5
Management Decisions and Control 22421/0
Why do Firms Decentralise?
Environment (ie high uncertainty)
Information specialisation
Timeliness of response
Conservation of top management time
Computational complexity
There are limits on human information processing capacity Miller – humans can only process 7 ± 2 bits of information
Training for local managers
Motivation of local managers
6 Management Decisions and Control 22421/0
Why do Firms Decentralise? However, not all functions are decentralised!
Economies of scale: Decentralisation may result in a duplication of effort, therefore some services, eg Treasury or R&D, tend to be centralised.
Goal congruence: High interdependencies require greater degree of coordination from the centre.
Decentralisation and Accountability:
Decentralisation means giving sub-unit managers decision making power.
However, sub-unit managers tend to be concerned only with their own sub-unit performance. They tend to ignore the detrimental effect of their action on other sub-units in the same organisation.
A system of accountability holds sub-unit manager accountable for their action. It should be designed align the interest of the sub-unit with that of the organisation. A well-designed management accounting system7is which Management Decisions one and Control 22421/0promote goal-congruent behaviour.
Role of Accounting in Decentralised Firms Responsibility Accounting & Responsibility Centres: A system of accountability holds sub-unit manager accountable for their actions. To overcome the problem of the lack of goal congruence, a system of accountability should be designed align the interest of the sub-unit with that of the organisation.
A well-designed management accounting system is one which promote goal-congruent behaviour - ie it's one which motivate managers to take action which benefit them as well as the organisation.
The system of accountability in decentralised organisation is normally based on responsibility accounting.
The basis of responsibility accounting system is the designation of each sub-unit of the organisation as a particular responsibility centre.
A responsibility centre is a sub-unit in an organisation whose Management Decisions and Control 22421/0 manager is held accountable for the sub-unit's activities.
8
Role of Accounting in Decentralised Firms Types of responsibility centres:
Cost centres
Standard Cost centre Discretionary Expense centre
Revenue centres
Profit centres
Investment centres
9 Management Decisions and Control 22421/0
Performance Measurement for Decentralised Firms
Aim is to create goal congruence between an individual’s goals and the organisation’s goals
Controllability principle: a manager should only be held accountable for measures that they can control. A measure is totally controllable if it is affected by his or her action. Uncontrollable factors include:
Economic and competitive factors
Acts of nature
Problems of externalities (interdependencies) - where the activities of one sub-unit affect the performance of other sub-units:
Allocation of corporate level costs (Thompson - pooled interdependencies)
Common revenues (Thompson - sequential interdependencies)
Salesmen of one division promotes the product made by another division
Management Decisions and Control 22421/0
10
Transfer Pricing
Transfer price: internal selling price used when goods or services are transferred between subunits within a divisionalised organisation
Alternative transfer-pricing methods:
Market-based transfer price Cost-based transfer price Negotiated transfer price
Ideally, the chosen transfer-pricing method should lead each subunit manager to make optimal decisions for the organisation as a whole
Transfer prices are sales revenue of the supplying unit and costs of the buying unit
Conflicting role of transfer pricing:
Performance evaluation of profit centre managers Local decision making - transfer price provides signal to managers on product mix/volume decisions 11 If the transfer price is based on full cost plus a mark-up, the fixed Management Decisions and Control 22421/0
Transfer Pricing – External Market Price
If a highly competitive market for the intermediate product exists, then the market price (less certain adjustments: eg discount) is an appropriate transfer price
Conditions of highly a competitive market: the producing division can sell as much of the product as it wishes to outside customers and the purchasing division can buy as much of the product as it wishes from outside suppliers without affecting the price
Advantages of using external market price:
Consistent with responsibility accounting concepts and decentralisation philosophy Encourages business unit managers to focus on business unit profitability Results in a reasonable calculation of profit contribution and managerial performance
A company will usually benefit if the transaction occurs internally profits are kept internally. Internal transfers may be encouraged by means of a discount (adjustments) from market price to reflect savings on selling and collection expenses, and distribution, service or warranty terms associated with external sales.
Difficulties in using market price: Management Decisions and Control 22421/0
12
Transfer Pricing – Cost Base & Negotiated
Cost-based transfer prices Using cost-plus pricing method
Most firms use transfer prices based on full costs
Variable production costs Total variable costs Full production costs Full product costs Covers long-run (capacity) costs
Problem of goal congruence:
When there is excess capacity, the transfer price which will maximise organisational profit is variable costs (as opportunity cost is zero). Thus, selling division is not even covering fixed costs, let alone making a profit so what is the incentive for the selling division
Negotiated transfer price Results from a bargaining process between selling and buying divisions. It may or may not relate to a market price, however market prices typically are the starting point Pro-rating the difference between minimum (variable cost) and 13 maximum transfer price (market price + purchase costs)
Management Decisions and Control 22421/0
General Transfer Pricing Rule General transfer pricing rule Minimum transfer price = incremental outlay costs per unit incurred by the supplying business + opportunity cost per unit to the supplying business Goal congruence and transfer pricing: General transfer pricing rule will always promote goal-congruent decision making Situation 1: No excess capacity The opportunity cost of selling internally is to sell the product to external customers The opportunity cost is the profit forgone on external sales Minimum transfer price is the market price less selling expenses (assume that the firm do not incur selling expenses when selling internally) Situation 2: Excess capacity Opportunity cost = $nil If the transfer price is based on variable costs, then the selling division may not be able to cover fixed costs or make a profit, so 14 Management Decisions and Control 22421/0 what is the incentive for the selling divisional managers?
Who Determines Transfer Prices? Conflict between: Motivation (when the divisional manager is given full autonomy to determine to whom to sell or buy and at what price, eg. use of negotiated transfer price) and
Goal congruence (when central management intervene in transfer pricing decisions to ensure that organisational profit is maximised:
Setting the transfer price or intervening in transfer pricing disputes Developing policies to guide transfer pricing practices)
Methods for dealing with conflicts between buying and selling department Dual Pricing: two separate pricing methods
Selling division sells at one price (cost-plus) and buying division buys at another price (flexible cost)
Two-step pricing:
Selling price reflects flexible cost plus an annual fixed costs 15
Management Decisions and Control 22421/0
Multinational Transfer Pricing Multinational transfer pricing and tax considerations
Multinationals may choose transfer prices which will minimise taxes and duties - subsidiaries in high (low) tax country will sell at a lower (higher) price to subsidiaries in low (high) country Example:
‘Corporate’ profit will increase if Division A inflates the transfer price to Division B Performance evaluation problems?! Corporate
Country A Tax Rate = 10%
Subsidiary/ Division A
Seller
Subsidiary/ Division B
Country B Tax Rate = 40%
Buyer
16 Management Decisions and Control 22421/0
Management Decisions and Control Lecture 8 Organisational Structure, Management Control and Transfer Pricing 1
Lecture Objectives 2.
Aspects of Organisation Structure
4.
Contingency Theory of Management Accounting
6.
Why do Firms Decentralise?
8.
Role of Accounting in Decentralised Organisations
10.
Performance Measurement for Decentralised Units
12.
Transfer Pricing
14.
General Transfer Pricing Rules
16.
Who Determines Transfer Prices?
18.
Multinational Transfer Pricing and Tax Considerations
2 Management Decisions and Control 22421/0
Aspects of Organisation Structure Centralisation Centralisation refers to the locus of decision making in an organisation. A highly centralised firm is one in which decisions are made by senior executives, while a decentralised firm is one where authority flows down subordinates Formalisation Formalisation is the degree to which procedures are standardised in the organisation. It is operationalised through rules and regulations that govern employees’ behaviour. An organisations level of formalisation tends to be highly correlated with centralisation (Robbins & Barnwell, 1994) Vertical Differentiation Vertical differentiation relates to the number of hierarchical levels or depth of the organisation. Organisations that are centralised and formalised tend to have greater 3 levels in their vertical Management Decisions and Control 22421/0
Aspects of Organisation Structure How should organisations be structured?
Centralisation versus Decentralisation Bureaucratic versus Informal Structure
How should tasks be structured?
Specialisation (division of labour):
Functional Product Market Geographic (location)
4 Management Decisions and Control 22421/0
Contingency Theory of Management Accounting
Contingency theory suggests that there is no one best (or universal) way of organising
The effectiveness of the design of management control systems varies with its organisational contexts (environment, technology etc)
Instead of the individual perspective adopted in early behavioural research, contingency theory takes an organisational perspective. Ie, rather than studying the individual managerial behavioural response to management accounting controls, it looks at how the design of management accounting control systems affect organisational effectiveness, eg. how accounting systems:
Support organisational structure
Help implement a firm's strategy 5
Management Decisions and Control 22421/0
Why do Firms Decentralise?
Environment (ie high uncertainty)
Information specialisation
Timeliness of response
Conservation of top management time
Computational complexity
There are limits on human information processing capacity Miller – humans can only process 7 ± 2 bits of information
Training for local managers
Motivation of local managers
6 Management Decisions and Control 22421/0
Why do Firms Decentralise? However, not all functions are decentralised!
Economies of scale: Decentralisation may result in a duplication of effort, therefore some services, eg Treasury or R&D, tend to be centralised.
Goal congruence: High interdependencies require greater degree of coordination from the centre.
Decentralisation and Accountability:
Decentralisation means giving sub-unit managers decision making power.
However, sub-unit managers tend to be concerned only with their own sub-unit performance. They tend to ignore the detrimental effect of their action on other sub-units in the same organisation.
A system of accountability holds sub-unit manager accountable for their action. It should be designed align the interest of the sub-unit with that of the organisation. A well-designed management accounting system7is which Management Decisions one and Control 22421/0promote goal-congruent behaviour.
Role of Accounting in Decentralised Firms Responsibility Accounting & Responsibility Centres: A system of accountability holds sub-unit manager accountable for their actions. To overcome the problem of the lack of goal congruence, a system of accountability should be designed align the interest of the sub-unit with that of the organisation.
A well-designed management accounting system is one which promote goal-congruent behaviour - ie it's one which motivate managers to take action which benefit them as well as the organisation.
The system of accountability in decentralised organisation is normally based on responsibility accounting.
The basis of responsibility accounting system is the designation of each sub-unit of the organisation as a particular responsibility centre.
A responsibility centre is a sub-unit in an organisation whose Management Decisions and Control 22421/0 manager is held accountable for the sub-unit's activities.
8
Role of Accounting in Decentralised Firms Types of responsibility centres:
Cost centres
Standard Cost centre Discretionary Expense centre
Revenue centres
Profit centres
Investment centres
9 Management Decisions and Control 22421/0
Performance Measurement for Decentralised Firms
Aim is to create goal congruence between an individual’s goals and the organisation’s goals
Controllability principle: a manager should only be held accountable for measures that they can control. A measure is totally controllable if it is affected by his or her action. Uncontrollable factors include:
Economic and competitive factors
Acts of nature
Problems of externalities (interdependencies) - where the activities of one sub-unit affect the performance of other sub-units:
Allocation of corporate level costs (Thompson - pooled interdependencies)
Common revenues (Thompson - sequential interdependencies)
Salesmen of one division promotes the product made by another division
Management Decisions and Control 22421/0
10
Transfer Pricing
Transfer price: internal selling price used when goods or services are transferred between subunits within a divisionalised organisation
Alternative transfer-pricing methods:
Market-based transfer price Cost-based transfer price Negotiated transfer price
Ideally, the chosen transfer-pricing method should lead each subunit manager to make optimal decisions for the organisation as a whole
Transfer prices are sales revenue of the supplying unit and costs of the buying unit
Conflicting role of transfer pricing:
Performance evaluation of profit centre managers Local decision making - transfer price provides signal to managers on product mix/volume decisions 11 If the transfer price is based on full cost plus a mark-up, the fixed Management Decisions and Control 22421/0
Transfer Pricing – External Market Price
If a highly competitive market for the intermediate product exists, then the market price (less certain adjustments: eg discount) is an appropriate transfer price
Conditions of highly a competitive market: the producing division can sell as much of the product as it wishes to outside customers and the purchasing division can buy as much of the product as it wishes from outside suppliers without affecting the price
Advantages of using external market price:
Consistent with responsibility accounting concepts and decentralisation philosophy Encourages business unit managers to focus on business unit profitability Results in a reasonable calculation of profit contribution and managerial performance
A company will usually benefit if the transaction occurs internally profits are kept internally. Internal transfers may be encouraged by means of a discount (adjustments) from market price to reflect savings on selling and collection expenses, and distribution, service or warranty terms associated with external sales.
Difficulties in using market price: Management Decisions and Control 22421/0
12
Transfer Pricing – Cost Base & Negotiated
Cost-based transfer prices Using cost-plus pricing method
Most firms use transfer prices based on full costs
Variable production costs Total variable costs Full production costs Full product costs Covers long-run (capacity) costs
Problem of goal congruence:
When there is excess capacity, the transfer price which will maximise organisational profit is variable costs (as opportunity cost is zero). Thus, selling division is not even covering fixed costs, let alone making a profit so what is the incentive for the selling division
Negotiated transfer price Results from a bargaining process between selling and buying divisions. It may or may not relate to a market price, however market prices typically are the starting point Pro-rating the difference between minimum (variable cost) and 13 maximum transfer price (market price + purchase costs)
Management Decisions and Control 22421/0
General Transfer Pricing Rule General transfer pricing rule Minimum transfer price = incremental outlay costs per unit incurred by the supplying business + opportunity cost per unit to the supplying business Goal congruence and transfer pricing: General transfer pricing rule will always promote goal-congruent decision making Situation 1: No excess capacity The opportunity cost of selling internally is to sell the product to external customers The opportunity cost is the profit forgone on external sales Minimum transfer price is the market price less selling expenses (assume that the firm do not incur selling expenses when selling internally) Situation 2: Excess capacity Opportunity cost = $nil If the transfer price is based on variable costs, then the selling division may not be able to cover fixed costs or make a profit, so 14 Management Decisions and Control 22421/0 what is the incentive for the selling divisional managers?
Who Determines Transfer Prices? Conflict between: Motivation (when the divisional manager is given full autonomy to determine to whom to sell or buy and at what price, eg. use of negotiated transfer price) and
Goal congruence (when central management intervene in transfer pricing decisions to ensure that organisational profit is maximised:
Setting the transfer price or intervening in transfer pricing disputes Developing policies to guide transfer pricing practices)
Methods for dealing with conflicts between buying and selling department Dual Pricing: two separate pricing methods
Selling division sells at one price (cost-plus) and buying division buys at another price (flexible cost)
Two-step pricing:
Selling price reflects flexible cost plus an annual fixed costs 15
Management Decisions and Control 22421/0
Multinational Transfer Pricing Multinational transfer pricing and tax considerations
Multinationals may choose transfer prices which will minimise taxes and duties - subsidiaries in high (low) tax country will sell at a lower (higher) price to subsidiaries in low (high) country Example:
‘Corporate’ profit will increase if Division A inflates the transfer price to Division B Performance evaluation problems?! Corporate
Country A Tax Rate = 10%
Subsidiary/ Division A
Seller
Subsidiary/ Division B
Country B Tax Rate = 40%
Buyer
16 Management Decisions and Control 22421/0
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