Unit 2: Structure of management control and transfer pricing
Management Control System notes · PTU syllabus (MCOP401-18)
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Unit summary
Control is built around responsibility centres and the prices at which they trade with each other. This unit covers revenue, expense (engineered and discretionary — administrative, R&D and marketing), and profit centres, transfer pricing objectives and methods, the arm's length principle, inter-departmental conflicts, international transfer pricing, and measuring and controlling assets employed through ROI and EVA.
After this unit you can
- Explain revenue, expense and profit centres
- Explain transfer pricing objectives and methods and the arm's length principle
- Manage inter-departmental conflicts and international transfer pricing
- Measure investment centre performance with ROI and EVA
PTU syllabus topics
- Responsibility centers — revenue
- expense
- administrative/support
- R&D
- marketing and profit centers
- transfer pricing objectives and methods
- arm's length principle
- managing inter-departmental conflicts
- international transfer pricing
- measuring and controlling assets employed (EVA, ROI)
Revenue centre
Sales
Sales branch
Expense centre
Costs
Production or HR department
Profit centre
Revenues and costs
Product division
Investment centre
Profit and capital employed
Subsidiary company
Topic 1
Responsibility centres
Cost centre
Responsible for costs only — production department, maintenance
Revenue centre
Responsible for revenues — sales department
Profit centre
Responsible for revenues and costs — product division, branch
Investment centre
Responsible for profit and capital invested — subsidiary, strategic business unit
| Centre | Manager controls | Performance measure |
|---|---|---|
| Cost (standard / discretionary) | Inputs and costs | Variance from budget or standard cost |
| Revenue | Sales | Actual vs budgeted sales, market share |
| Profit | Revenues and costs | Controllable profit, contribution |
| Investment | Revenue, cost and assets | ROI, residual income, EVA |
- Transfer pricing: price charged when one division supplies another — market-based, cost-based or negotiated. It affects divisional profits; should promote goal congruence.
Expense centres in detail
- Engineered expense centres: costs can be estimated reliably (manufacturing) — controlled through standard costs.
- Discretionary expense centres: output cannot be measured in money — administrative and support (HR, legal, finance), R&D (long time lags, uncertain outcomes), marketing (order-getting activities); controlled through budgets and management judgement.
- Profit centres: business units responsible for revenue and costs — conditions: manager has authority over sourcing and selling; advantages — speed, motivation, management development; problems — suboptimisation, internal competition, transfer pricing disputes.
Topic 2
Transfer pricing: objectives and methods
Transfer price: the value placed on goods or services transferred between responsibility centres of the same company.
- Objectives: goal congruence, performance evaluation of divisions, divisional autonomy, simplicity, tax and regulatory compliance (international).
Market-based
Market price (best when a competitive market exists)
Cost-based
Variable cost, full cost, cost-plus, standard cost
Negotiated
Divisions bargain
Two-step pricing
Variable cost per unit + periodic fixed fee
Profit sharing / dual pricing
Selling division at market, buying division at cost
Minimum transfer price
Variable cost + Opportunity cost (lost contribution) for the selling division
Example
Division A makes a component with variable cost ₹60, market price ₹100. If A has idle capacity, the minimum price is ₹60; if A is at full capacity, it is ₹100 (₹60 + ₹40 lost contribution).
Topic 3
Arm's length principle, conflicts and international transfer pricing
- Arm's length principle: transfer prices between related parties should equal prices between independent parties in comparable conditions — required by tax laws (OECD Guidelines; India's Sections 92–92F).
- Managing inter-departmental conflicts: clear policies, negotiation procedures, arbitration by a senior manager or committee, dual pricing, transparent cost data.
Topic 4
International transfer pricing
Transfer price: the price charged for goods, services or intangibles between related entities of a multinational group. It shifts profits across countries, so tax authorities require arm's length prices.
- Objectives: performance evaluation, tax minimisation (within law), managing tariffs, repatriation of funds, competitive positioning.
Comparable uncontrolled price (CUP)
Price in comparable independent transactions
Resale price method
Resale price less normal gross margin
Cost plus method
Cost plus normal mark-up
Profit split method
Split combined profit by contributions
Transactional net margin method (TNMM)
Net margin relative to an appropriate base
Other method
Any method reflecting arm's length
- India: Chapter X (Sections 92–92F) — international and specified domestic transactions; Form 3CEB accountant's report; Advance Pricing Agreements (APA) and safe harbour rules; BEPS (OECD) and country-by-country reporting (Master file, CbCR).
Example
An Indian subsidiary sells software services to its US parent at cost + 5%, while comparable firms earn 15%. Tax authorities may adjust the price to cost + 15%, raising Indian taxable income.
Topic 5
Measuring and controlling assets employed: ROI, RI and EVA
Return on investment (ROI)
Divisional operating profit ÷ Divisional investment × 100
ROI (DuPont)
Profit margin (Profit ÷ Sales) × Asset turnover (Sales ÷ Investment)
Residual income (RI)
Divisional profit − (Divisional investment × Cost of capital)
Economic value added (EVA)
NOPAT − (Capital employed × WACC)
Example
Division X: profit ₹3,00,000, investment ₹15,00,000; cost of capital 15%. ROI = 20%. RI = 3,00,000 − 2,25,000 = ₹75,000. A new project offering 18% would lower X's ROI (so the manager may reject it) but adds positive RI (18% > 15%) — so RI promotes goal congruence.
Form
Percentage
Absolute amount
Comparison across divisions
Easy
Difficult (size effect)
Goal congruence
May reject projects above cost of capital but below current ROI
Accepts all projects above cost of capital
Popularity
Widely used
Better for decisions
- Measuring assets employed: cash, receivables, inventory, fixed assets (gross vs net book value; leased assets; idle assets); using net book value can make old assets look more profitable.
Key terms
- Discretionary expense centre
- Centre whose output cannot be measured in money
- Profit centre
- Unit responsible for revenue and costs
- Transfer price
- Price for internal transfers between divisions
- Arm's length principle
- Related parties should price like independent parties
- EVA
- NOPAT minus capital charge at WACC
Quick revision
- Revenue, expense (engineered and discretionary), profit and investment centres.
- Transfer pricing: market, cost, negotiated, two-step, dual pricing.
- Minimum transfer price = variable cost + opportunity cost.
- Arm's length; conflict resolution; international TP methods.
- ROI, RI, EVA for investment centres; assets employed issues.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What is an engineered expense centre?
- Q2.What is a discretionary expense centre?
- Q3.State the objectives of transfer pricing.
- Q4.What is two-step pricing?
- Q5.What is the arm's length principle?
- Q6.Distinguish ROI and EVA.
Long-answer questions
- Q1.Explain the types of responsibility centres.
- Q2.Explain the objectives and methods of transfer pricing.
- Q3.Explain international transfer pricing and the arm's length principle.
- Q4.Explain measurement of investment centre performance using ROI and EVA.
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