A company makes remotely controllable model car. The company has two compartment
ID: 2476999 • Letter: A
Question
A company makes remotely controllable model car. The company has two compartment, C1 and C2. Division C1 makes car model kit. Compartment C2 assembles and configures model car. A new car model has been developed of which the company will sell for $175 each. Compartment C2 of the company has planned to produce 1,000 units of fully assembled model car using its idle capacity. The compartment can either purchase the model kit from Compartment C1 or purchase it from an outside supplier for $140. The company has a policy that internal transfers are priced at their fully allocated costs.
Assume that the variable cost and allocated fixed cost for each car model kit at Compartment C1 are $80 and $30, respectively.
Also assume that the assembling and administrative variable costs for each model car at Compartment C2 are $55 and $15, respectively.
(1) Assume that Compartment C1 has idle capacity of producing the 1,000 sets of car model kit for Compartment C2. Should the Compartment C2 purchase the car model kit from Compartment C1? Would the company as a whole benefit if Compartment C2 decides to purchase from Compartment C1?
(2) Assume that Compartment C1 doesn’t have any idle capacity and the required car model kit can be sold to outside customers for $125. Would the company as a whole benefit if the Compartment C2 purchases the model kit from Compartment C1?
(3) Assume that the allocated fixed cost for each model car at Compartment C2 is $40. The 1,000 model cars are produced using the model kit from Compartment C1 for the company’s EU sales compartment, which sells the model car for $240 each. Suppose the EU and US governments allow either the variable or fully allocated cost to be used as a transfer price. The US income tax is 35%, the EU income tax is 60%, and the import duty to EU is 15%. Which price should the company use to minimize the total of income taxes and import duties? Compute the saving from your choice of transfer price versus the other.
(4) If EU has passed a new law decreasing the income tax rate to 50% and increasing the import duty to 20%, what would be the choice of transfer price in (3)?
Explanation / Answer
1 The compartment C2 should purchase the car model kit form C1 because the variable cost of C1 is less than the cost of purchase from outsider. Variable cost of C1 is $80 and purchase cost of car model is $140. If the idle capacity of C1 for producing 1,000 kits of model is produced then the profit of the company would be as under: Cost of C1: Variable cost for 1,000 kits @$80 $ 80,000 Fixed cost (1,000 kits @ $30) $ 30,000 Total cost of C1 transferred to C2 $ 110,000 Variable cost: at C2 Assembling cost @ $55 $ 55,000 Administrative variable cost @ $15 $ 15,000 Total cost of car $ 180,000 Sales of 1,000 cars (@ $175) $ 175,000 Loss on sale $ (5,000) If model cars are purchased from outside suppliers @ $140 each then the company profit would be as under: Cost to compartment 2: Purchase cost (1000* $140) $ 140,000 Variable cost: at C2 Assembling cost @ $55 $ 55,000 Administrative variable cost @ $15 $ 15,000 Total cost of cars $ 210,000 Sales ( @ $175 each) $ 175,000 Loss to the company on sale $ (35,000) If the company purchases the new model kit from compartment C1 then it will be in better position than purchasing it from outsider suppliers. 2 If the C1 does not have any idle capacity and the company can sold the kits to outsiders @ $125 each then the profit would be as under: If compartment C1 sell its kits to outsiders the profit of the company would be as under: Selling price $125 Less: Cost to the C1 ($80) Contribution margin $45 If the C2 purchases the kits from outsiders it will costs the company @ $140 each and profit to the company would be as under: Cost to compartment 2: Purchase cost (1000* $140) $ 140,000 Variable cost: at C2 Assembling cost @ $55 $ 55,000 Administrative variable cost @ $15 $ 15,000 Total cost of cars $ 210,000 Sales ( @ $175 each) $ 175,000 Loss to C2 $ (35,000) $ (35,000) Sales to C1 (1000* $125) $ 125,000 Less: Variable cost @ $80 $ (80,000) Fixed cost @ $30 $ (30,000) Profit to C1 $ 15,000 $ 15,000 Profit to the company $ (20,000) If the C2 purchases the kits from outside then the company will face loss of $20,000 whereas if C2 purcahses the kits from C1 then the company will have profit of ($5,000). Therefore the company should purchase the kits from C1 instead of purchasing them from outside. 3 With the increase in transfer by $1 the net effect in the income taxes and import duties would be as under: Tax at US (35% *$1) $0.35 Import duty ($1*15%) $0.15 Tax at EU ($1*60%) $0.60 Total cost effect due to change in $1 in transfer price $1.10 If the transfer price changes by $1 the cost of income tax at US and EU and import duty changes by $1.10. Company: If transfer price is Variable cost If Transfer price is Total cost(incl. fixed cost) Total cost $ 110.00 $ 110.00 Less: Transfer price $ (80.00) $ (110.00) income/(loss) $ (30.00) $ - Income tax at US @ 35% $ - $ - Transfer price to EU $ 80.00 $ 110.00 Import duty @ 15% $ 12.00 $ 16.50 Total cost to EU $ 92.00 $ 126.50 S.P. to EU ($240) ($240) Income $ 148.00 $ 113.50 Income tax at EU @ 60% $ 88.80 $ 68.10 Income after tax $ 59.20 $ 45.40 Therefore it is better if the transfer price would be at variable cost of $80. 4 With the increase in transfer by $1 the net effect in the income taxes and import duties would be as under: Tax at US (35% *$1) $0.35 4 Import duty ($1*20%) $0.20 Tax at EU ($1*50%) $0.50 Total cost effect due to change in $1 in transfer price $1.05 If the transfer price changes by $1 the cost of income tax at US and EU and import duty changes by $1.05. Therefore the company will be in profit if the income tax at EU changes to 50% and import duty changes to 20% inspite of 60% and 15%.
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