MANAGEMENT CONTROL AND STRATEGIC PERFORMANCE MEASUREMENT;

STRATEGIC INVESTMENT UNITS AND TRANSFER PRICING

Time Duration and Allotment: Week 5; 3 hours

Abstract:

This focuses on the management control and strategic performance measurement; Strategic Investment
units and Transfer Pricing

Lesson Objectives:

As a result of completing this learning module, students will be able to:

1. Explain the concept and objective of performance evaluation and control system

2. Enumerate the advantages of performance evaluation and control system

3. Describe the pre-requisites to initiate and maintain an effective performance evaluation and
control system

4. Explain the nature of Strategic Investment Unit (SIU) and the different types of SBUs namely,
profit, cost, revenue and investment SBUs

5. Evaluate performance of a profit SBU, cost SBU, investment SBU and revenue SBU

6. Explain the rationale of transfer pricing

7. Define transfer price

8. Discuss the need for transfer price in a decentralized organization

9. Explain the general approaches in setting transfer price

10. Compute the Transfer price using the various approaches

11. Explain the concept of distress prices

12. Discuss the procedure in setting transfer price for service companies

13. Describe the application of multinational transfer pricing

Module Guide: Study topic content presented below. (TOPIC CONTENT)

Study topic content presented below. (TOPIC CONTENT)
TOPIC CONTENT: MANAGEMENT CONTROL AND STRATEGIC PERFORMANCE MEASUREMENT;
Study topic content presented below. (TOPIC CONTENT)
STRATEGIC INVESTMENT UNITS AND TRANSFER PRICING

PERFORMANCE EVALUATION AND CONTROL

• Performance Evaluation

Performance evaluation is the process by which managers at all levels gain information about the
performance of tasks within the firm and judge that performance against: preestablished criteria as set out
in budgets, plans, and goals. Performance is evaluated at many different levels in the firm: top
management, mid-management, and the operating level of individual production and sales employment. In
operations, the performance of individual production supervisors at the operating level are evaluated by
plant managers, who in turn are evaluated by executives at the management level. Similarly, individual
salespersons are evaluated by sales managers who are evaluated in turn by upper-level sales
management.
 • Management Control

Management control refers to the evaluation by upper-level managers of the performance of mid-level
managers. Operational control means the evaluation of operating level employees by mid-level managers.

Objectives of Management Control

The objectives of management control follow:

1. Motivate managers to exert a high level of effort to achieve the goals set by top management.

2. Provide the right incentive for managers to make decisions consistent with the goals set by top
management.

3. Determine fairly the rewards earned by managers for their effort and skill and the effectiveness of their
decision making

STRATEGIC PERFORMANCE MEASUREMENT

Basic Concepts

In a well-managed organization, responsibilities for specific functions among its employees are clearly
identified. A Strategic Investment Unit (SIU) also known as a Responsibility Center is a specific unit of
an organization assigned to a manager who is held accountable for its operations and resources. Each
manager s performance is judged by how well he or she manages those items under his or her control. In
a budgeting program, each manager is assigned responsibility for those terms of revenues and costs in the
budget that he or she is able to control. Each manager is then held responsible for deviations between
budgeted goals and actual results. This concept known as performance evaluation and control is central
to any effective profit planning and control system.

Strategic performance measurement also known as responsibility accounting is a System used by top
management to evaluate SIU managers. It is used when responsibility can be effectively delegated to SIU
managers and adequate measures for evaluating the performance of the managers exist.

Decentralization and Segment Reporting

A decentralized organization is one in which decision making is not confined to a few top executives but
rather is spread throughout the organization, with managers at various levels making Key operating
decisions relating to their sphere of responsibility.

Managers have found that segment reporting is of greatest value in organizations that are decentralized.
In segment reporting, costs and revenues are assigned to Segments to enable management to see where
responsibility lies for control purposes and to measure the performance of segment managers.

Benefits and Limitations of Decentralization

Prerequisites to the Initiation and Maintenance of an Effective Strategic Performance Measurement

or Responsibility Accounting

Decentralization and Segment Reporting

For an effective strategic performance measurement, the following basic conditions are necessary:
1. A well-defined organization structure. This requires that the spheres of jurisdiction which are set forth in
the organization chart must be clearly established and understood and that a manager's financial
responsibilities be defined in advance. This means that a decentralized approach to decision making is
imperative if performance evaluation and control is to achieve the purposes for which it is intended. A
decentralized organization is one in which decision making is not confined to a few top executives but
rather is spread throughout the organization, with managers at various levels making key operating
decisions relating to their sphere of responsibility.

2. Well-defined and established standards of performance in revenues, costs and investments. This
requires that an integrated plan for the control of operations which would provide for cost standards,
expense budgets, sales forecasts, profit planning and programs for capital investment and financing as well
as the necessary procedures to effectuate the plan should be established and maintained.

3. A system of accounting that 1dentifies any revenues, expenses and assets to specific units in the
organization.

4. A system that provides for The preparation of regular performance reports. This requires that a system
of preparing the regular segment reports showing the planned results, actual results- and the variances
should be established. These reports should include only the items that are controllable by the manager of
the strategic investment unit (SIU) and should highlight those items requiring management action.

Strategic Business Units (SBUs) and their Evaluation

An important step in establishing an effective performance evaluation and control system is to determine
the range of authority and influence the manager is permitted to have control over revenues, costs, profit
and investment. This will therefore require the establishment of responsibility SBUs (also known as
responsibility centers) within the organization.

A strategic business unit (SBU) is a unit within the organization which has control over costs, revenues,
profits and/or investment funds.

The types of SBUs are Cost SBUs, Profit SBUs, Investment SBUs, and Revenue
SBUS. Table down below illustrates business segments classified as cost, profit, and
investment SBUS.

Business Segments Classified as Cost, Profit, and Investment SBUs

COST SBU

This is a unit within the organization wherein the manager is responsible for minimizing costs subject to
some output constraints. A distinguishing feature of a cost SBU is that it has no control over generating
revenue or the use of investment funds. Examples are (1) maintenance department of a manufacturing
company; (2) library section of a school; (5) accounting department of a trading concern. The manager of
the cost SBU is responsible for making the projection or budget of costs in his unit based on the expected
level of operation for the period. When approved by the higher authorities (board of directors), the budgets
will serve as the basis for the transactions or activities for the ensuing period.

Performance of a cost SBU is evaluated using the performance reports or variance analysis reports based
on standard costs and flexible budget. The performance or responsibility cost report will show the
comparison between the actual costs incurred and the budgeted costs. The difference between the two
costs if any, referred to as the variance will be reported and if significant, will be analyzed. Responsibility
for the incurrence of the variance will be pinpointed and the manager concerned will be required to explain
or justify the variance. The efficiency of the manager of the cost SBU to control the costs in his unit will be
evaluated on the basis of whether the cause of the variance is within or beyond his control.

A responsibility cost report may be prepared using the format below.

Pro-forma Responsibility Cost Report

Illustrative Problem: Evaluation of a Cost SBU

The department supervisors at Meredith, Inc. are authorized to purchase the direct and indirect materials
needed in production, hire and assign the production workers, and incur various overhead costs for their
department. The equipment used in the department is acquired at a higher management level, but
supervisors are responsible for proper care and maintenance. The salaries of the supervisors are shown
under the cost of supervision.

During the year, Department 7 manufactured 40,000 units as budgeted. Budgeted and actual costs for
Department 7 are given below:
REQUIRED:

(1) Compute the budgeted unit cost of the product and the actual unit cost.
(2) Prepare a responsibility cost report. Show cost variations from the budget.
(3) Does it appear that the supervisor was responsible for a large part of the variation between budgeted
and actual costs?

Requirement.3:

From the computations shown above, it can be observed that P900 of the total P5,000 unfavorable cost
variation are traceable to direct costs over which the department supervisor had control. Therefore, he was
responsible only for the 18% unfavorable cost variation. A larger part of the unfavorable cost variation could
be traced to the costs which were allocated to his department and over which he did not have any control
or authority. He, therefore should not be made answerable for the unfavorable variances arising from
noncontrollable and indirect costs. Performance of the manager of a cost SIU is considered satisfactory if
he is able to provide quality goods or services within the budgeted costs.
PROFIT SBU

This is a unit or segment within the organization wherein the manager is responsible for the generation of
revenues and control or costs incurred in that SBU. Examples are (1) loans and discounts department of a
commercial bank; (2) ladies wear section of a department store: (3) college department of a university. As
in other SBUs, the manager of the profit SBU will likewise be responsible for preparing the budget in his
unit and the approved projections will provide the guidelines and authority for him to enter into transactions
for the budget period.

Performance of a profit SBU is measured by preparing the income statements using the contribution
approach, presenting both the actual results and budgeted figures. The statement will show the comparative
revenue, direct costs and the profit SBU's contribution to indirect costs. The operating performance of the
profit SBU is generally considered satisfactory if it is able to generate or even exceed the expected
contribution to indirect costs or common costs of the company. Table below shows the pro-forma income
statement of a profit SBU.

Illustrative Problem: Evaluation of a Profit SBU

The Nicki Company, a wholesaling company, purchases and repackages three products for resale. During
recent months, the company has recommended that the profit picture would improve if Product 3 were
dropped since it has been showing loss. An income statement of last month, which is considered to be
typical, is given below:
REQUIRED:

Do an analysis to show whether the sales manager's recommendation should be accepted or not. Assume
that Product 3 could not be replaced with some other line, and also assume that the fixed costs would not
change.

Illustrative Problem: Evaluation of Profit SBUs

Answer
(1) Direct costs of the divisions:

Division A P680,000
Division B P720,000
Division C P480,000

(2) No. Not all divisions provide an amount over their direct costs to the total operation. Division B does not
cover its direct cost by P20,000

(3) Division C contributes but cannot cover P80,000 of the allocated cost.

(4) Division A

INVESTMENT SBU

This is a unit or segment within the organization where the manager is responsible for the control of
revenues, costs and investments made in that SB0. Examples include corporate headquarters or division
of a large decentralized organization such as (1) Magnolia Products Division of San Miguel Corporation;
(2) Pharmaceutical Division of Novartis (Phils.) Inc.; (3) Subsidiary companies,

The objectives of an investment SBU or business unit are:

(a) motivate managers to exert a high level of effort to achieve the goals of

(b) provide the right incentive for managers to make decisions that are Consistent with the goals or top
management.

(c) determine fairly the rewards earned by the managers for their effort and skill.

Advantage of ROI

(1) It is easily understood and has gained wide usage.

(2) It is comparable to interest rates of returns of alternative investments

Net operating income [sometime referred to as EBIT (earnings before interest and taxes)] is generally
used because it is consistent with the base to which it is applied, that is, operating assets.

Operating assets include cash, accounts receivable, inventory, plant and equipment (net). and all other
assets held for productive use in the organization. Examples of assets that generally would not be included
in the operating assets category are land held for future use, as investment in another company or a factory
building rented to someone else.
Limitations of ROI

(1) Although ROI is widely used in evaluating performance, this method is subject to some criticisms. One
of these criticisms is that ROI tends to emphasize short-run performance rather than long-run profitability.
Managers may be motivated to reject profitable investment opportunities if the expected rate of return is
lower than the current ROI. ROI may not be fully controllable by the division manager due to the presence
of committed costs. Hence, the ROI makes it difficult to distinguish between a performance of the division
manager and the performance of the division as an investment SBU.

(2) It results to disincentive for high ROI units to invest in projects with ROI greater than the minimum rate
of return but less than unit's current ROI.

It is therefore advisable to use multiple criteria in evaluating performance rather than relying on ROI as a
sole measure. These other criteria include (1) growth in market share (2) increase in productivity (3) product
innovation (4) peso profit (5) receivable and inventory turnover and (6) ability to venture into new and
profitable areas.

In investment SBUs, ROI can be improved by either increasing sales, by reducing expenses or by reducing
assets.

Residual Income

Another approach to measuring performance in an investment SBU is a concept known as Residual

Income.

Residual Income is the net operating income that an investment SBU is able to earn above some minimum
return on the operating assets. Generally, the larger the residual income figure, the better is the
performance rating received by the division's manager.

Advantages of Residual Income

1. A unit pursues an investment opportunity costs as long as the return from the investment exceeds the
minimum rate of return set by the firm.

2. The firm can adjust the required rates of return for differences in risk and types of assets. For example,
units with higher business risk can be evaluated at a higher minimum rate of return. The increased risk
might be due to obsolete products, increased completion in the industry or other economic factors affecting
the business unit.

3. Tt is possible to calculate a different investment charge for different types of assets. For example, one
might use a higher minimum rate of return for long-lived assets than more likely to be specialized in use
and thus not as readily salable.

Limitations of Residual Income

While the residual income measure deals effectively with the disincentive problem of ROI it has also certain
limitations. These are

1. Since residual income is not a percentage, it suffers the same problem of profit SBUs in that it is not
useful for composing units of significantly different sizes. It forms larger unit that would be expected to have
larger residual income, even with relatively poor performance.

2. It is not as intuitive as ROI.

3. It may be difficult to obtain a minimum rate of return.

Economic Value Added

Economic value added (EVA) is a business unit's income after taxes and after deducting the cost of capital.
The idea is very similar to what we nave explained as residual income. The objectives of the measures are
the same to effectively motivate investment SBU managers and to properly measure their performance. In
contrast to residual income, EVA uses the firm’s cost of capital instead of a minimum rate of return. The
cost of capital is usually obtained by calculating a weighted average of the cost of the firm’s two sources of
funds- borrowing and selling stock. For many firms the minimum desired rate of return and the cost of
capital are very nearly the same, with small differences due to adjustments for risk and for strategic goals
such as the desired growth rate tor the firm.

Another difference is that users of EVA do not follow conventional, conservative accounting policies.
Expenses that contribute to the long-term value or the company are capitalized. These expenses usually
are expensed under generally accepted accounting policies. Such expenses include research and
development, certain types of advertising, and training and employee development.

The main advantage of using EVA is that it focuses manager's attention of creating value for shareholders
by earning profit greater than the firm cost of capital.

Illustrative Problem: Performance Evaluation of an Investment SBU

More and more companies are using residual income as a measure of performance they argue that the
residual income approach encourages managers to make profitable investments that would be rejected by
managers who are evaluated by the ROI formula.

Illustrative Problem: Comparison of Performance of Profit SBU

Consider the following data for two comparable divisions, Division A and Division
B of Melo Corporation.

Average operating assets P100,000

Net Operating Income P 20,000
Minimum required rate of return 15%

Division A is evaluated using the ROI while Division B's performance is assessed according to how large
or how small the Residual Income is.

Division A's ROI is 20% while Division B's Residual Income is positive P5,000.

Assume that each of the divisions is presented with an opportunity to make an investment of P25,000 in a
new project that would generate 18% on invested assets.

REQUIRED: Determine if the project is acceptable to Divisions A and B. Explain the reason for your answer.

Solution: Melo Corporation

1. Division A manager in most probability will reject the project because it will reduce his current ROI figure
from 20% to 19.6% (P24,500/ P125,000).

2. Division B manager will be very anxious to accept the new investment opportunity because her concern
is maximizing her residual income. Any project that provides a return greater than the maximum rate
required (15%) will be attractive since it will add to the total amount of the residual income figure. The
residual income will increase from P5,000 to P5,750.

Furthermore, the well-being of both the manager of Division B and the company as a whole will be
maximized by accepting all investment opportunities down the 15% cutoff rate.
REVENUE SBU

This is a unit or segment within an organization where the manager is responsible for selling budgeted
quantities of various products or services at budgeted price.

Examples of managers of revenue SBUs are: A sales representative selling bread to supermarkets, a sales
manager distributing automobile to dealers in specific geographic areas and the manager of the toys
department in a local department store.

Such managers may also be responsible for travel, entertainment, and other marketing expenses. If so,
they are liable to use flexible budgets to control these expenses. but expense control 1s a secondary goal
in a revenue SBU.

Managers of revenue SBUS use variance in sales price and sales mix to monitor or control their operations.
Managers of revenue SBUs are responsible for achieving budgeted levels of contribution margin by
controlling the number or units sold, product mix, and selling prices.

Three types of variances and their formulas are useful to revenue SBU managers in meeting their goals:
Illustrative Problem: Evaluation of a Revenue SBU

Karen Company's actual and budgeted sales and expense data for April are as follows:

REQUIRED: Determine the following variances and indicate whether they are favorable or unfavorable

1. Sales Price Variance

2. Sales Volume variance
3. Sales Mix Variance
TRANSFER PRICING

Rationale

A problem common to most companies operating with decentralized segments is that or placing a fair value
of exchange-of goods and services between segments within the company-the problem of Transfer pricing.

When goods or services are transferred from one unit of an organization to another, the transaction is
recorded in the accounting records. In the days when all companies were small and management was
centralized, accountants transferred goods and services from one cost SIU to another at the cost of
production. Today many companies are giant conglomerates having multiple divisions. Simply transferring
goods and services at cost no longer serves the needs of these decentralized organizations. The problems
revolve around the question of what transfer price to charge between the segments.

A transfer price is the price charged when one segment of a company provides goods or services to
another segment of the company. For example, when the Bakery Division of Rustan's Inc. transfers bread
to the Supermarket division, some transfer price must be agreed upon.

Definition

Transfer price is the value assigned to goods and services transferred between segments within the
company.

The transfer price of interdivisional sales will affect the selling divisions' sales and the buying divisions'
costs but will not have any direct effect on the company' s profit. However, the transfer price policy or the
company can have an indirect effect on company profit by influencing decisions of the division manager.

The Need for Transfer Price

Transfer pricing becomes complex because of the need to evaluate an organization s segments.

To the department selling goods and services, the transfer price is its revenue. To the department buying
the goods and services, the transfer price is its cost. Therefore, transfer prices have a direct bearing on
segment margin. Corporate managers should set transfer pricing policies ensuring that divisions do not
purchase outside when internal facilities with high fixed cost can provide the product. Allowing these
facilities to be idle is detrimental to the overall company. particular transfer pricing basis may also be an
excellent management tool (1) for motivating division managers, (2) for establishing and maintaining cost
control systems and for measuring internal performance. The company should likewise establish a transfer
pricing policy that encourages decentralized managers to make an economically optimal decision for the
company without significantly reducing their autonomy. The transfer pricing policy should allow divisional
autonomy yet encourage managers to pursue corporate goals consistent with their own personal goals.

Alternative Transfer Pricing Schemes

In practice, four general approaches are used on setting transfer price.

1. Minimum Transfer Price

2. Market-based Transfer Price

3. Cost-based Transfer Price

a. Variable Cost

b. Full Cost

c. Alternative Cost Measures

4. Negotiated Transfer Price

Discussion:

1. MINIMUM TRANSFER PRICE

A general rule for making transfers to maximize a company's profits in
either perfect or imperfect market uses the formula:

Transfer Price = Differential costs + Lost contribution margin

per unit per unit on outside sales
(or opportunity costs per unit)

The price set by the transfer pricing formula is equal to the differential costs (generally the variable costs)
of the go0ds being transferred, plus the contribution margin per unit that is lost to the selling division as a
result of giving up outside sales.

It also represents the lower limit since the selling division must receive at least the amount shown by the
formula in order to be as well of as if it sold only to outside customers. The transfer price can be more than
the amount shown by the formula but for an internal transfer to take place, the transfer price should not
exceed the purchase price from the outside suppler.

lf the selling division has sufficient idle capacity to meet the demand of another division without cutting into
the sales of its regular customers, then it does not have any opportunity costs. Hence, the lowest acceptable
transfer price will be equal to the differential or variable costs per unit. From the perspective of a buying
division, the maximum acceptable transfer price is equivalent to the price offered by the outside supplier.

2. MARKET-BASED TRANSFER PRICE

Under this approach, the transfer price is the price at which the goods are sold on the open market.

The market price approach is designed for situations in which there is an outside market for the transferred
product or service; the product or service is sold in its present form to outside customers. If the selling
division has no idle capacity, the market price in the outside market is the perfect choice for the transfer
price. The reason for this is that if the selling division can sell a transferred item on the outside market
instead, then the real cost of the transfer as far as the company is concerned is the opportunity cost of the
lost revenue on the outside sale. Whether the item is transferred internally or sold on the outside market,
the production costs are exactly the same. If the market price is used as the transfer price, the selling
division manager will not lose anything by making the transfer, and the buying division manager will get the
correct signal about how much it really costs the company for the transfer to take place.

This is considered the best transfer price because it dovetails well with the profit SIU concept and makes
profit-based performance evaluations feasible at many levels of the organization. By using market prices
to control transfers, all divisions or segments are able to show profits for their efforts - not just the final
division in the chain of transfers.

This market price approach is particularly useful in highly decentralized organizations. As a general rule,
this policy should contain the following guidelines:

1. The buying division must purchase internally so long as the selling division meets all bona fide
outside prices and wants to sell internally.

2. The selling division must be free to reject internal business if it prefers to sell outside.

3. If the selling division does not meet all bona fide outside prices, then the buying division is free
to purchase outside.

4. As independent and impartial body must be established to settle disagreements between

divisions over transfer prices.

3. COST-BASED TRANSFER PRICE

a. Variable Cost Transfer Price

Under this approach, the transfer price is based only on variable or differential costs. Variable costs
approximate differential costs in
many situations. But when fixed costs increase because of a transfer of goods between segments, they are
differential costs and therefore should be included in the transfer price cost.

The advantage of using this basis is that it ensures in the short-run the best use of total corporate facilities
because it focuses attention on the contribution margin a transfer generates and on how it increases short-
run profitability.

Among the disadvantages of using Variable Costs or Differential Costs basis in setting transfer price are

(1) A company must cover all costs before earning a profit. If fixed costs are ignored, a variable cost transfer
price may be profitable in the short run, but not in the long run.

(2) It allows one segment manager to make a profit at the expense of another segment manager because
the receiving segment receives all the profit.

(3) The use of this method could lead to dysfunctional decisions if a segment must forgo outside sates to
make products for other internal segments.

(4) Transfer prices based on differential costs diminish the autonomy in decision-making of the profit SIUs.
If differential cost varies with volume, the selling segment is dependent on the total demands of the buying
division and its external customers. This will mean that neither segment can make its output decisions
independently.

b. Full Cost Transfer Price

Full cost includes actual manufacturing costs (variable and fixed) plus portions of marketing and
administrative costs. Many companies use full cost because of the following reasons:

(1) It is easy and convenient to apply.

(2) It leaves no intracompany profits in inventory to eliminate when preparing consolidated
statement.
(3) It allows simple and adequate end-product costing for profit analysis by product lines.

his approach however is not suitable for companies with decentralized structures that measure the
profitability of autonomous units. Segments tend to become complacent and less concerned about
controlling costs when they know their costs are merely passed along to the next segment. Another criticism
of full cost is that it does not create incentives for segment managers to control or reduce costs. It likewise
does not provide management with a divisional profit figure for the selling division.

Lastly, full-cost method departs from goal-congruence. Goal congruence means the correspondence or
consistency of individual manager's subgoals with the company's overall goals. The use of full- cost transfer
price can lead to decisions that are not goal congruent when the supplying division is not operating at
capacity. For instance, a division may want to purchase outside the company as an apparent savings.
However, a reduction of the full-cost transfer price to the outside market purchase price would recover all
variable costs and a portion of fixed costs. The company fails to cover these fixed costs because of the
decision to purchase outside. To avoid such suboptimization, top management must order the lowering of
transfer prices or require internal purchasing. These solutions will both dilute the authority of individual
divisions.

Standard full cost may also be used instead of the historical average cost because it eliminates the negative
effect of fluctuations in production efficiency in one division on the reported income of another division.
Division managers can determine in advance what price they will receive or what price they will pay for
transferred goods. The disadvantage mentioned in the previous section will likewise apply in standard full
cost basis.

c. Alternative Cost Measures

a) Full Absorption Cost-based Transfer Price

Many manufacturing firms use full-absorption costs basis because of the difficulty in determining the
opportunity cost to the company of making internal transfer. It must be noted that only the manufacturing
costs, variable and fixed, should be included in full absorption cost. Some advantages of this approach are
1. Costs are available in the company's records.

2. They provide the selling division with a contribution equal to the excess of full-absorption costs over
variable costs, which gives the selling division an incentive to transfer internally.

3. This may be a better measure of the differential costs of transferring internally than the variable costs
because other costs such as unknown engineering and design cost are included.

b) Cost-Plus Transfer

Some companies use cost-plus transfer pricing based on either variable costs or full absorption cost. These
methods generally apply a normal markup to costs as a substitute for market prices when intermediate
market prices are not available.

4. NEGOTIATED TRANSFER PRICE

Under this system, managers are permitted to negotiate the price for internally transferred goods and
services. Managers act much the same as the managers of independent companies and they use
negotiation strategies similar to those employed when trading with outside markets.

A negotiated price is an attempt to simulate an arm's-length transaction between supplying and buying
segment. If companies give segment managers autonomous authority to buy and sell as they think
necessary and if they bargain in good faith, the result of this bargaining is the equivalent of a market price.

The major advantage of negotiated transfer prices is that they preserve the autonomy of the division
manager. However, negotiation may be very time-consuming and require frequent re-examination and
revision of prices. Furthermore, negotiated prices eliminate the objectivity necessary to ensure
maximization of companywide profits. As a result, the negotiated price may distort segment financial
statement and mislead top management in its attempt to evaluate performance and make decisions.
Performance measure may depend more on the manager's ability to negotiate than on other factors.

Distress Prices

When supply outstrips demand, market prices may drop well below their historical average. If the drop in
prices is expected to be temporary, these low market prices are sometimes called "distress prices."
Deciding whether a current market price is a distress price is often difficult. The market prices of several
agricultural commodities, such as wheat and oats, have stayed for many years at what observers initially
believed were temporary distress levels.

Which transfer price should be used for judging performance if distress prices prevail? Some companies
use the distress prices themselves, but others use long- run average prices, or "normal" market prices. In
the short-run, the manager of the selling division should meet the distress price as long as it exceeds the
incremental costs of supplying the product or service. If not, the selling division should stop selling the
product or service to the buying division, which should buy the product or service from an outside supplier.
These actions would increase overall companywide operating income. If the long-run average market price
is used, forcing the manager to buy internally at a price above the current market price will hurt the buying
division's short-run performance and understate its profitability. Using the long-run average market price,
however, provides a better measure of the long-run viability of the supplier division. If price remains low in
the long run, though, the company should use the distress price as the transfer price. manager of the selling
division must then decide whether to dispose of some manufacturing facilities or shut down and have the
buying division purchase the product from an outside supplier.

Transfer Price for Services

Departments of many large organizations may sell services for customers and for each other internally. The
department performing the services to a second department generates revenues from such activity. The
same transfer is the second department's purchase of services. For example, a company typically bill
administrative services, such as computer processing, accounting, payroll and personnel to the
departments they support. In each of the cases, equitable transfer prices must be established to appraise
the department's performance for its own return on invested capital.
The following steps may be followed in setting transfer price for services:

1. Identify the different departments contributing various services.

2 Evaluate the corresponding skill and experience of personnel involved in delivering services.
3. Estimate the cost involved in providing the service. Factors such as time requirements,
qualifications, cost of the facilities needed to provide the service should be considered.
4. Adopt one or any the principles applied to the transfer of products discussed in this chapter (e.g.
cost-based transfer price, market-based).

Multinational Transfer Pricing

Transfer pricing is used worldwide to control the flow of goods and services between segments of
organizations. However, the objective of transfer pricing change when a multinational corporation is
involved and the goods and services being transferred must cross international borders. The objectives of
international transfer pricing focus on minimizing taxes, duties, and tariffs, foreign exchange risks along
with enhancing a company's competitive position and improving its relation with foreign government.

Corporations may change a transfer price that will reduce its total tax bill or that will strengthen a foreign
subsidiary. For example, a division in a high-income tax-rate country produces a subcomponent for another
division in a low-income- tax rate country. By setting a low transfer price, most of the profit from the
production can be recognized in the low-income-tax-rate country, thereby minimizing taxes. On the other
hand, items manufactured by divisions in a low- income-tax-rate country and transferred to a division in a
high-income-tax-rate country should have a high transfer price to minimize taxes.

Sometimes import duties offset income tax effects. Usually import duties are based on the price paid for an
item, whether bought from an outside company or transferred to another division. Therefore, low transfer
prices will be used to lessen the import duties.

Managers should be sensitive to the geographics, political and economic circumstances in which they are
operating, and set transfer price in such a way as to optimize total company performance and at the same
time conform with the laws in various countries where they operate.

Illustrative Problem

The Lewis Company has two divisions, Production and Marketing. Production manufactures designer
pants, which it sells to both the Marketing Division and to other retailers (to the latter under a different brand
name). Marketing operates numerous pants stores, and its sells both Lewis pants and other brands. The
following facts also pertain to the Lewis Company:

• Sales price to retailers if sold by Production: P380 per pair.

• Variable cost to produce: PI90 per pair
• Fixed costs: P2,000,000 per month.
• Production is operating far below its capacity.
• Sales price to customers if sold by Marketing: P500 per pair.
• Variable marketing costs: 5 percent of sales price.

Marketing has decided to reduce the sales price of Lewis pants. The company's variable manufacturing
and marketing costs are differential to this decision, whereas fixed manufacturing and marketing costs are
not.

a. What is the minimum price that can be charged for the pants and still cover differential manufacturing
and marketing costs?
b. What is the appropriate transfer price for this decision?
C. What it the transfer price were set at P380? What effect would this have on the minimum price set by
the marketing manager?
d. How would you answer to questions a and b change if the Production
Division had been operating at full capacity?
Solution: Lewis Company

a. From the company's perspective, the minimum price would be the variable cost of producing and
marketing the goods. It would solve for this minimum price as follows:

The minimum price the company should accept is P200. If the company were centralized, we would expect
this information to be conveyed to the manager of Marketing, who would be instructed not to set a price
below P200.

b. The transfer price that correctly informs the marketing manager about the differential costs of
manufacturing is P190. Production is operating below capacity, so there is no opportunity cost of
transferring internally.

c. If the production manager set the price at P380, the marketing manager would solve for the minimum
price:

So the marketing manager sets the price in excess of P400 per pair, when, in tact prices greater than P200
would have generated a positive contribution margin from the production and sale of pants.

d. For question a:

lf Production is operating at full capacity, the minimum price is

For question b:

If Production Division had been operating at capacity, there would have been implicit opportunity cost of
internal transfer. Production would have foregone a Sale in the wholesale market to make the internal
transfer. The implicit opportunity cost to the company is the lost contribution margin (P380-P190 PI90) from
not selling in the wholesale market.

Thus, it Production had sufficient sales in the wholesale market so that it would have had to forego those
sales to transfer internally, the transfer price should have been
 Activities, Resources, and Assessment
Online Blended Offline
(Hybrid Model) (Asynchronous Model) (Flex Model)
Resources: Resources: Resources:
Schoology App/Messenger Schoology App/Messenger
Strategic Cost Management Strategic Cost Management (2019- Strategic Cost Management
Textbook: (2019-2020 edition) by; Ma. Textbook: 2020 edition) by; Ma. Elenita Textbook: (2019-2020 edition) by; Ma.
Elenita Balatbat Cabrera Balatbat Cabrera Elenita Balatbat Cabrera
Activities: Activities: Activities:
Topic discussion will be through GoogleMeet Topic discussion will be through GoogleMeet Topic discussion will be during classroom
App. Students will be grouped accordingly. App. Students will be grouped accordingly. meetups. Students will be grouped
Each group will be tasked to prepare PPT Each group will be tasked to prepare PPT file accordingly. Each group will be tasked to
file relative to the TOPIC CONTENT, which relative to the TOPIC CONTENT, which will be prepare PPT file relative to the TOPIC
will be presented and graded during the sent via e-mail address. This output will be CONTENT, which will be presented and
teleconferencing. graded accordingly. graded during the class session.

Assessment: Assessment: Assessment:

Topic quiz will be publish at Schoology App. Topic quiz will be publish at Schoology App. Topic quiz will be issued to you and will be
Instructions as to the time allocated for Instructions as to the time allocated for answered at home, which will be
answering and deadline for submission of answering and deadline for submission of quiz immediately due for submission the following
quiz will be announced via Messenger Group will be announced via Messenger Group Chat. day at the box placed at the SVCI guard
Chat. house. Communication as to the receipt the
said quiz will be through text messaging.