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International Issues in Cost Management Prepared by Douglas Cloud Pepperdine University 11-1 Objectives 1. Explain the role the accountant Afterofstudying this in the internationalchapter, environment. you should 2. Discuss the varying levels be able to:of involvement that firms can take in international trade. 3. List the ways accountants can manage foreign currency risk. 4. Tell why multinational firms choose to decentralize. Continued 11-2 Objectives 5. Explain how environmental factors can affect performance evaluation in the multinational firm. 6. Describe the role of transfer pricing in the multinational firm. 7. Discuss ethical issues that affect firms operating in the international environment. 11-3 Where does the management accountant fit into the global Business looks to the business environment? management accountant for international financial and business expertise. 11-4 Management Accounting in the International Environment Skills needed by cost accountants Politics Economics Marketing Management Information systems technology 11-5 Multinational Corporation (MNC) A multinational corporation (MNC) is one that “does business in more than one country in such a volume that its well-being and growth rest in more than one country.” 11-6 Importing and Exporting Importing is the process of bringing product in from a foreign country. Exporting is the process of shipping product to a foreign country. 11-7 Foreign Trade Zones Foreign trade zones are areas near a customs port of entry that are physically on U.S. soil but considered to be outside U.S. commerce. Example: Example: San New Antonio Orleans 11-8 Example of the Advantages of Operating a Plant in a Foreign Trade Zone Roadrunner, Inc., operates a petrochemical plant in a foreign trade zone. Wilycoyote, Inc., operates an identical plant just outside the foreign trade zone. Both plants purchase $400,000 of crude oil from Venezuela. 11-9 Example (continued) Roadrunner Wilycoyote Duty paid at purchase Carrying costs of duty Duty paid at sale $ 0 0 16,800 $24,000 1,920 0 Wilycoyote pays at Totalduty dutytherelated point of Roadrunner payspurchase (6% carrying costs duty at point of sale of $400,000). (0.12 x 8/12 x because it is in a $24,000) foreign trade zone. 11-10 Example (continued) Roadrunner Wilycoyote Duty paid at purchase Carrying costs of duty Duty paid at sale Total duty and dutyrelated costs $ 0 0 16,800 $24,000 1,920 0 $16,800 $25,920 Clearly the advantage approach 11-11 A If company the lawsmay of the choose country to purchase permit, aan existing multinational foreign corporation company, can making simply the purchased set up a wholly company owned a wholly subsidiary owned or branch office subsidiary. in the country. 11-12 Outsourcing is the payment by a Outsourcing technical and company for a of business function professional is becoming formerly donejobs in-house, such as an important issue forneeds resourcepayment for legal to conscious firms. outsideU.S. firms. 11-13 A joint venture is a type of partnership in which investors co-own the enterprise. A special case of joint venture cooperation is the maquiladora—a manufacturing plant located in Mexico that processes imported materials and reexports them, tariff-free, to the United States. 11-14 Foreign Currency Exchange Kinds of risks: Currency risk management Transaction risk Economic risk Translation (accounting ) risk 11-15 A Transaction Risk Example SuperTubs, Inc., a U.S. firm, sells its line of whirlpool tubs to Bonbain, a French distributor. On January 15, Bonbain orders 100 tubs at $1,000 per tub to be paid with francs on March 15. The exchange rate on January 15 is six francs per dollar or 600,000 francs. Suppose that on March 15 the exchange rate is 6.1 francs per dollar. A $1,639 loss is experienced by SuperTubs, Inc. Receivable in dollars on Jan. 15 $100,000 Received in dollars on March 15 (600,000/6.1) 98,361 Exchange loss $ 1,639 11-16 A Transaction Risk Example If the franc had strengthened against the dollar to a rate of 5.9 francs per dollar, a $1,695 gain would occur: Receivable in dollars on Jan. 15 $100,000 Received in dollars on March 15 (600,000/5.9) 101,695 Exchange gain $ 1,695 11-17 Hedging One way of ensuring against gains and losses on foreign currency exchanges is hedging. 11-18 Hedging On March 15, Bonbain pays SuperTubs 600,000 francs. SuperTub pays the exchange dealer 600,000 francs, and the exchange dealer pays SuperTub $99,668 (600,000/6.02). $100,000 – $99,668 = $332 Premium expense 11-19 Managing Economic Risk Economic risk is the impact of exchange rate fluctuations on the present value of a firm’s future cash flows. Example A U.S. consumer can choose to purchase heavy equipment from either Caterpillar (U.S.) or Komatsu (Japan). A piece of equipment is $80,000 from either maker. At an exchange rate of $1 equals 130 yens, the price is set. Assume the dollar strengthens so the exchange rate becomes $1 equals 140 yens. This lowers Katmatsu’s price to $74,286. 11-20 Managing Transaction Risk Example Multinational, Inc., has a foreign division, FD, which has been experiencing eroding sales. Multinational directs FD managers to increase research and development expenditures over the following four quarters: Quarter 1 2 3 4 Expenditures in Local Currency LC LC LC LC 100,000 110,000 121,000 133,100 A 10% increase each quarter 11-21 Managing Transaction Risk Example (continued) Suppose that the dollar has strengthened against the local currency and the quarterly exchange rates of $1 for units of local currency are 1.00, 1.2, 1.35, and 1.50, respectively. Quarter 1 2 3 4 Expenditures in Dollars $100,000 91,667 89,630 88,733 It looks like FD has decreased expenditures. 11-22 Advantages of Decentralization in the MNC The quality of information is better at the local level. Local managers in the MNC are capable of a more timely response in decision making. Social, legal, and language barriers are minimized. Valuable training grounds for foreign subsidiary managers. 11-23 Measuring Performance in the Multinational Firm It is particularly difficult to compare the performance of a manager of a division in one country with the performance of a manager of a division in another country. 11-24 Environmental Variables Facing Local Managers of Divisions Economic Inflation Foreign currency exchange rates Income taxes Transfer prices 11-25 Environmental Variables Facing Local Managers of Divisions Legal and Political Country may not allow cash outflows Country may forbid the import of certain items 11-26 Environmental Variables Facing Local Managers of Divisions Social and Educational Certain systems, like JIT, may not work in all cultures Roads and communication may be inadequate Training centers may need to be established 11-27 Comparison of Divisional ROI An example of misleading results: Assets Brazil Canada Spain $10 18 15 Revenues Net Income Margin Turnover $6 13 10 $3 10 6 0.50 0.77 0.60 0.60 0.72 0.67 ROI 0.30 0.56 0.40 However, the Analysis: Oninflation the basisrate of ROI, in Brazil it appears was 100% that the formanager the year. of the adjusting After Canadianthe subsidiary asset base didfor theinflation, best job while the ROI thewould manager be 60% for of the Brazilian manager. subsidiary did the worst job. 11-28 Other Factors Affecting Performance Evaluation Economic Factors: Organization of central banking system Economic stability Existence of capital markets Currency restrictions Adapted from Wagdy M. Abdallah, “Change the Environment or Change the System,” Management Accounting (October 1986): pp. 33-36. 11-29 Other Factors Affecting Performance Evaluation Political and Legal Factors: Quality, efficiency, and effectiveness of legal structure Effect of defense policy Impact of foreign policy Level of political unrest Degree of governmental control of business Adapted from Wagdy M. Abdallah, “Change the Environment or Change the System,” Management Accounting (October 1986): pp. 33-36. 11-30 Other Factors Affecting Performance Evaluation Educational Factors: Literacy rate Extent and degree of formal education and training systems Extent and degree of technical training Extent and quality of management development programs Adapted from Wagdy M. Abdallah, “Change the Environment or Change the System,” Management Accounting (October 1986): pp. 33-36. 11-31 Other Factors Affecting Performance Evaluation Sociological Factors: Social attitude toward industry and business Cultural attitude toward authority and persons in subordinate positions Cultural attitude toward productivity and achievement (work ethic) Social attitude toward material gain Cultural and racial diversity Adapted from Wagdy M. Abdallah, “Change the Environment or Change the System,” Management Accounting (October 1986): pp. 33-36. 11-32 Transfer Pricing and the Multinational Firm Income Taxes and Transfer Pricing Action Belgian subsidiary of Parent Company produces a component at a cost of $100 per unit. Title to the component is transferred to a reinvoicing center in Puerto Rico at a transfer price of $100 per unit. Tax Impact 42% tax rate $100 revenue – $100 cost = $0 Taxes paid = $0 11-33 Transfer Pricing and the Multinational Firm Income Taxes and Transfer Pricing Action Reinvoicing center in Puerto Rico, also a subsidiary of Parent Company, transfers title of component to U.S. subsidiary of Parent Company at a transfer price of $200 per unit. Tax Impact 0% tax rate $200 revenue – $100 cost = $100 Taxes paid = $0 11-34 Transfer Pricing and the Multinational Firm Income Taxes and Transfer Pricing Action U.S. subsidiary sells component to external company at $200 each. Tax Impact 35% tax rate $200 revenue – $200 cost = $0 Taxes paid = $0 11-35 Transfer Pricing and the Multinational Firm Income Taxes and Transfer Pricing Division B (in the United States) of ABC, Inc., purchases a component from Division C (in Canada). The component can be purchased eternally for $38. The freight and insurance on the item amount to $5; however, commissions of $3.80 need not be paid. Market price Plus: Freight and insurance Less: Commissions Transfer price $38.00 5.00 -3.80 $39.20 11-36 Transfer Pricing and the Multinational Firm Income Taxes and Transfer Pricing If there is no outside market for the component that Division C transfers to Division B, the resale price method is used. If Division B sells the component for $42 and normally receives a 40 percent markup on cost of goods sold, then the transfer price is calculated as follows: Resale price = Transfer price + .40 Transfer price $42 = 1.40 x Transfer price Transfer price = $42/1.40 = $30 11-37 Questions to Ask Concerning Ethics in the International Environment Is the action right legally? Is the action right morally? 11-38 End of Chapter 11-39 11-40