INTERNATIONAL HOMEWORK PROBLEM: Transfer Pricing with an Outside Market (same ba
ID: 2715412 • Letter: I
Question
INTERNATIONAL HOMEWORK PROBLEM: Transfer Pricing with an Outside Market (same basic details as domestic homework problem with additional information)
Galati Products, Inc. is headquartered in the U.S. and has just purchased a small Singapore company that manufactures electronic tuners that used as a component part of TV sets. Galati is decentralized and will treat the newly acquired company as an autonomous division with full profit responsibility. The Singapore Tuner Division has the following revenue and costs associated with each tuner that it manufactures and sells:
Selling price........................ $20
Expenses:
Variable......$11
Fixed .........$6 $17
(based on a capacity of 100,000 tuners per year)
Net Operating Income............$3
Assume that variable costs of $11 per unit = Cost of goods sold, and fixed costs of $6 per unit at full capacity = Operating expenses.
Galati Products also has an Assembly Division in the U.S. that assembles TV sets. This division is currently purchasing 40,000 tuners per year from a Korean supplier at a cost of $20 per tuner, less a 5% purchase discount. It adds an additional $180 per unit in variable cost of good sold, and $1,000,000 in operating fixed costs. Assembly sells a total of 40,000 completed TV sets in the market for $XXX per unit.
The president of Galati is anxious to have the Assembly Division begin purchasing its tuners from the Singapore Tuner Division to “keep the profits within the corporate family.” However, corporate tax rate differences between the U.S. (35%) and Singapore (10%) are causing management to use transfer pricing to achieve tax minimization rather than performance evaluation.
Required:
Assume that the Tuner Division in Singapore can sell all of its output to outside TV manufacturers at the normal $20 price.
a. Are the managers of the Tuner and Assembly Divisions likely to voluntarily agree to a transfer price for 40,000 tuners each year? Why or why not? If yes, at what price should the transfer be made to achieve tax minimization?
b. If the Tuner Division meets the price that the Assembly Division is currently paying to its overseas supplier and sells 40,000 tuners to the Assembly Division each year, what will be the effect on the profits of the Tuner Division, the Assembly Division, and the company as a whole? Should the transfer be made?
2. Assume that the Tuner Division is currently selling only 70,000 tuners each year to outside TV manufacturers at the stated $20 price. Also assume that the Assembly Division is currently buying 30,000 tuners externally and selling 30,000 completed TV sets externally, all else remaining the same.
a. Suppose that the Assembly Division's overseas supplier drops its price (net of the purchase discount) to $16 per tuner. Should the Tuner Division meet this price? If the Tuner Division does not meet this price, what will be the effect on the profits of the company as a whole?
b. Assume that the acceptable arm’s length price ranges from $16 to $25 per tuner. At what price should the transfer be made to achieve tax minimization?
Assume that variable costs of $11 per unit = Cost of goods sold, and fixed costs of $6 per unit at full capacity = Operating expenses.
Explanation / Answer
Answer:
The lowest acceptable transfer price from the perspective of the selling division is given by the following formula:
The Tuner Division has no idle capacity, so transfers from the Tuner Division to the Assembly Division would cut directly into normal sales of tuners to outsiders. The costs are the same whether a tuner is transferred internally or sold to outsiders, so the only relevant cost is the lost revenue of $20 per tuner that could be sold to outsiders. This is confirmed below:
Therefore, the Tuner Division will refuse to transfer at a price less than $20 per tuner.
The Assembly Division can buy tuners from an outside supplier for $20, less a 10% quantity discount of $2, or $18 per tuner. Therefore, the Division would be unwilling to pay more than $18 per tuner.
The requirements of the two divisions are incompatible. The Assembly Division won’t pay more than $18 and the Tuner Division will not accept less than $20. Thus, there can be no mutually agreeable transfer price and no transfer will take place.
2. The price being paid to the outside supplier, net of the quantity discount, is only $18. If the Tuner Division meets this price, then profits in the Tuner Division and in the company as a whole will drop by $60,000 per year:
Lost revenue per tuner......................
$20
Outside supplier’s price......................
$18
Loss in contribution margin per tuner..
$2
Number of tuners per year................
× 30,000
Total loss in profits............................
$60,000
Profits in the Assembly Division will remain unchanged, since it will be
paying the same price internally as it is now paying externally.
3. The Tuner Division has idle capacity, so transfers from the Tuner Division to the Assembly Division do not cut into normal sales of tuners to outsiders. In this case, the minimum price as far as the Assembly Division is concerned is the variable cost per tuner of $11. This is confirmed in the following calculation:
The Assembly Division can buy tuners from an outside supplier for $18 each and would be unwilling to pay more than that in an internal transfer. If the managers understand their own businesses and are cooperative, they should agree to a transfer and should settle on a transfer price within the range:
4. Yes, $16 is a bona fide outside price. Even though $16 is less than the Tuner Division’s $17 “full cost” per unit, it is within the range given in Part 3 and therefore will provide some contribution to the Tuner Division.
If the Tuner Division does not meet the $16 price, it will lose $150,000 in potential profits:
Price per tuner........................
$16
Variable costs..........................
11
Contribution margin per tuner...
$ 5
30,000 tuners × $5 per tuner = $150,000 potential increased profits
This $150,000 in potential profits applies to the Tuner Division and to the company as a whole.
5. No, the Assembly Division should probably be free to go outside and get the best price it can. Even though this would result in lower profits for the company as a whole, the buying division should probably not be forced to purchase inside if better prices are available outside.
6. The Tuner Division will have an increase in profits:
Selling price............................
$20
Variable costs..........................
11
Contribution margin per tuner...
$ 9
30,000 tuners × $9 per tuner = $270,000 increased profits
The Assembly Division will have a decrease in profits:
Inside purchase price..............
$20
Outside purchase price............
16
Increased cost per tuner..........
$ 4
30,000 tuners × $4 per tuner = $120,000 decreased profits
The company as a whole will have an increase in profits:
Increased contribution margin in the Tuner Division.....
$ 9
Decreased contribution margin in the Assembly Division................................................................
4
Increased contribution margin per tuner....................
$ 5
30,000 tuners × $5 per tuner = $150,000 increased profits
So long as the selling division has idle capacity and the transfer price is greater than the selling division’s variable costs, profits in the company as a whole will increase if internal transfers are made. However, there is a question of fairness as to how these profits should be split between the selling and buying divisions. The inflexibility of management in this situation damages the profits of the Assembly Division and greatly enhances the profits of the Tuner Division.
Lost revenue per tuner......................
$20
Outside supplier’s price......................
$18
Loss in contribution margin per tuner..
$2
Number of tuners per year................
× 30,000
Total loss in profits............................
$60,000
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