Cost Analysis, Profit Planning, and Control

MBA 603Chapter 15 - Multinational Organizations

Overview

• Multinational Corporations have the same control systems and management techniques as domestic ones with several key exceptions:– Cultural Differences– Exchange Rate Fluctuations– Transfer Pricing and Tax Implications

• Specific foreign countries present different political, legal, and tax opportunities that need to be built into control systems.

Cultural Differences

• Culture refers to assumptions, shared values, and specific norms of behavior that vary drastically from one country of operating origin to another.

• Hofstede conducted a study that determined cultural differences based on:– Power Distance: Extent to which power is

unequally distributed and centralized in society.

Cultural Differences - Continued

– Individualism/Collectivism: The degree to which people define themselves as individuals or part of a collective group of society.

– Uncertainty Avoidance: The extent to which people feel uncomfortable or threatened by ambiguous societal situations.

– Masculinity/Femininity: The degree to which dominant societal values emphasize assertiveness and material values (masculine Traits) compared to concern for people and quality of life (feminine).

Cultural Differences - Continued

• Corporations need to adjust their management and control systems to match the specific cultural patterns of the countries they operate in, otherwise they will suffer major operating inefficiencies and lack effectiveness.

• Foreign enterprises that come to operate in the U.S. must also adjust their operations because of our fast paced society and individualism.

Transfer Pricing

• Transfer Pricing arise in multinational operations because of out and global best-cost source strategies.

• Transfer Pricing is the practice of setting costs of components or finished products at a specific level to take advantage of specific factors in host country economic systems.

Transfer Pricing - Continued

• There are several key factors to consider in Transfer Pricing:– Taxation: Income tax rates vary by country and setting

transfer prices at acceptable levels reduces tax exposure.– Tariffs: This cost of importation is usually a less significant

value than taxes and is not a prime consideration.– Foreign Exchange Controls: Some countries limit the flow

of funds in and out of the country so a lower transfer price allows more freedom.

Transfer Pricing - Continued

– Government Regulations: Many countries are sophisticated a control tax laws to govern the flow of goods and their inter-company transfer prices so they maximize tax revenue and hard currency flows.

– Funds Accumulation: As a result of taxes and currency limitations, some firms tend to “move” money around via transfer pricing techniques.

– Joint Ventures: They create specific transfer price issues with the host country partner and are employed on a limited basis.

Transfer Pricing - Continued

• Legal Considerations are pervasive and here are a few examples:– U.S. Multinationals transfer assets to low income

countries to reduce taxes.– U.S. Multinationals set up their “paper HQ’s” in

countries like Bermuda that have no corporate income tax.

– U.S. Multinationals transfer intellectual property (patents) to low tax country and pay lower fees to use them.

Transfer Pricing - Continued

• The Internal Revenue Service has established acceptable tax standards for transfer pricing called Section 482:– Comparable Uncontrolled Price Method: Prices

reflect “arms-length” transactions between unrelated firms as the base price method.

– Resale Price Method: If the preceding method is not available, then the sales price is reduced by the market up and the remaining cost is the transfer price.

Transfer Pricing - Continued

– Cost Plus Method: This form is the lowest priority of the three and revolves around determining the specific cost and adding a markup with allowed adjustments.

• The information in Exhibit 15.1 and the calculation technique examples on Page 760 are well done and help explain the nuances of transfer pricing.

Exchange Rates

• Multinational Enterprises (MNE’s) are impacted by various currency fluctuations depending on the countries they have operations in.

• The performance of various subsidiaries throughout the world are further complicated by specific exposures:– Translation – Transaction– Economic

Exchange Rates - Continued

• Foreign Exchange Rates fluctuate every minute of everyday and monetary denominations are traded 24 by 7.

• These rates illustrate the perceived market value of a countries goods and services based on their purchasing power parity measure of inflation.

• A firm can “hedge” foreign exchange exposure by purchasing forward contracts on a specific county’s currency.

Exchange Rates - Continued

• Different Types of Exchange Rate Exposure manifest themselves in the following:– Translation: MNE’s must consolidate their

financial statements which causes them convert everything to the “home” countries currency.

– Transaction: The cross-border activities that are current obligations but, will not be paid until the future.

Exchange Rates - Continued

– Economic: This area relates to the operating and competitive factors that each MNE operation faces in their business environment.

• Choice of Metric in Performance Evaluation varies per survey conducted by Choi and Czechowicz but it boils down to:– Initial Exchange Rate: The actual value when

budgets are approved.

Exchange Rates - Continued

– Projected Exchange Rate: The projected value when budgets are approved.

– Actual Exchange Rate: The value at the time of the evaluation.

• Please refer to Exhibits 15.3 and 15.4 for further clarification of this issue.

Exchange Rates - Continued

• Performance of the Subsidiary should reflect both the positive and negative aspects of transaction, translation, and economic exposures.

• MNE business decisions should focus on a specific country’s subsidiary’s performance and not that of the management team when considering ongoing operations.

Exchange Rates - Continued

• Management Considerations should be given to the following issues when designing a performance evaluation system:– Subsidiary managers should not be held

accountable for translation effects.– Transaction effects should be managed by the

centralized “HQ” of the MNE in terms of hedging risk and lowering costs.

Exchange Rates - Continued

– Subsidiary manager should be held accountable for the effects of foreign exchange precipitated by economic exposure.

– The overall evaluation of the subsidiary that focuses on either locating in a specific country or relocating to another country should reflect the impact of transaction, translation, and economic exposures.

Exchange Rates - Continued

• A survey has determined that MNEs have no fixed policy for performance evaluation because their system are old and not up to new foreign exchange valuation methods.

• Many of the systems were developed in the 50’s and 60’s and lag behind changes in laws and new developments in currency exchange systems.